The Market is the world's most effective forward looking economic indicator. It is a repository of the world's financial wisdom. Its direction is influenced collectively by the population of the whole world; regardless of rich or poor. Every dollar, whether spent in consumption, saved, invested, paid in taxes or transacted in foreign trade, results in commerce, the conduct of which drives markets. The market is forward looking. What goes into the market's mind is historic economic data and forward looking economic data. This information is processed and then a pinch of mass psychology is added to it and the outcome is that the market reacts to events that are most likely to occur six months in the future.
So really, the market responds to both economic data and the psychology of the herd. Today, the market is in outright panic. Credit markets have seized up, no one is lending. The fear is that the extent of liabilities which might crystallize is greater than the capitalization of the global banks or financial institutions.
The governments of the world have responded with massive rescue packages which make additional capital available. Still, the fear of insolvency grips the financial services community and it will not lend. This is creating a self-perpetuating prophecy - until lending starts, the housing market will continue to be flooded with inventory and, absent buyers, asset prices continue to fall. As the asset prices fall, the crystallization of liabilities escalates, which contracts capital and makes even less available for lending. It is not just the housing market, the continual declines in asset prices needs to be arrested before the economy recovers. And the only thing which can arrest the deflation monster is increased lending.
The rescue should come in three phases.
A) The first is bringing in fresh capital to pay for real economic errors; the ability to stay well capitalized after absorbing the cost of historic errors is important. This has been done; in all likelihood the trillions of dollars made available by global governments will be more than adequate.
B) The next step should limit the damage through legislation to ensure that a real economic loss occurs only once; legislation to ensure that carpet baggers do not profit is important.
For example, if I default on a mortgage on my house now valued at $60, which was financed and funded 100% through debt, when the house was valued at $100; the real economic loss is $40. Now suppose the bank I borrowed from financed its lending through a sale of $60 worth of low coupon paper collateralized by my house to a pension fund, and retained $40 worth of paper with a high coupon; the real economic loss is still $40 and the buyer of the collateralized paper will suffer no loss. The lender holding the high coupon unsecured paper who thought it was very clever because the total mortgage was asset backed should rightly suffer the entire economic loss.
Of course the fresh capital infusion from global governments will maintain the bank's capital to pay for its past errors. If the pension fund wrote off its $60 paper because the bank could not pay (for any reason including insolvency), it would be incorrect. Even worse would be a situation where the pension fund wrote off $60 as irrecoverable, while the bank recognized a gain of $20 because it did eventually recover $60 on the mortgage; one reason why no carpetbagger laws are important.
What would be worst is if the pension fund wrote of the $60 as irrecoverable and the bank wrote off $40; the total loss recognized at $100 would in this situation be worse than the total real economic loss. Tracing the bearer of the true economic loss to ensure the loss is only recognized once will not be an easy task since the derivatives market is complex and much misunderstood; it is likely that legislation enacted will result in gainful employment to an army of accountants.
Another area that needs a closed eye is the credit default swap (CDS) market for this could be a carpetbagger's dream. Suppose the clever bank with high coupon paper retained went to another bank and covered its exposure to default through a CDS. The real economic loss would shift to the insuring bank which received a premium for the risks covered. This is fair.
Suppose the clever bank also went ahead and covered the $60 so that a lower interest payable to the pension fund could be justified because of the twice backed paper. Even in this situation the total economic loss remains $40 and it is borne by the insurer. If the insurer goes bankrupt, and is unable to meet its commitments, we go back to square one – the clever bank suffers the entire real economic loss. In the pandemonium which follows the bankruptcy, there is a risk that a total economic loss in excess of the real economic loss ends up being recognized. Once again, regulations which clearly trace the real economic loss to the bearer of the risk are important.
Now consider this, the size of the CDS market is way larger than the underlying real economic activity. Why? And it is here that the carpet bagger risk is at its highest. If I can purchase a CDS on a possible credit default by my neighbor, if my neighbor defaults, I stand to gain. Ultimately, I have absolutely no insurable interest and this contract should never have been permitted; and since it was it should be declared null and void. Covering a CDS without an insurable interest must have happened, otherwise how could the market exceed the value of the underlying economic activity?
The question to which I cannot find an answer is whether CDSs are issued to a party with no insurable interest; for example could a person get cover for a Lehman Default event without owning the underlying Lehman paper? If the answer is yes, the question of whether the so called insurance contract is legally binding arises because of the absence of an insurable interest. If only insurable interests are covered by CDS, I would argue that the risks, which include default on the payment of interest, insolvency of the issuer and pre-payment of the loan together with interest are the only real economic risks. The CDS is essentially an instrument to shift risk from the owner of paper to an insurer; the intent being to separate risk from the instrument.
The way I see it is that a CDS did not really separate risk from the instrument; it failed to achieve its purpose. If an insurer goes bankrupt for failing to pay its obligation, it will result in a distress sale of the insurer's assets to pay out the obligation to the fullest extent possible. The buyer of the distressed paper will earn future profits - the difference between the actual recovery from the debtor and the price paid for the paper. In the meantime, because the insurer defaulted, another insurer who insured the paper of the first insurer will find itself in the same position as the first insurer; again the second insurer's assets will be sold in distress and the buyer will profit in the future.
Ultimately, what will occur is that the weak hands will go insolvent while strong hands will gain assets bought at below fair value during a distress sale; the total impact will never be more than that part of the debt which actually went bad. So, instead of separating risk from the security, the CDS actually ended up creating risk for the economy. The real questions to answer are (1) where did the money go - that is where will the bubbles have formed, and (2) how much of it will likely go bad?
I have no doubt that the availability of a CDS will have encouraged lenders because they thought the risk was covered. It is true that this would have led to an over-leveraged economy (which is no secret). But the real economic risks associated with credit default are the same.
C) The next step must follow; and it must prevent recurrence; it will likely be legislative. But before crying for better regulation and the blood of bankers, do away with stupid legislative acts such as the Community Reinvestment Act, which incentivize bad lending. Obligating FRE and FNM to buy, guarantee and re-sell low quality mortgages is bad; it encouraged bad lending practices. Do you really think the extent of sub-prime would have arisen if there had been no buyer for the paper?
While the seriousness of the situation cannot be denied, I believe that the market is presently in a wild panic (and possibly overreacting) because of the lack of clarity and quantification. Default risk is being disregarded; the market is fully focused only on the price risk caused by the absence of liquidity and a sale in distress; the true economic loss which would arise on default is being ignored.
I recognize the fact that over-leverage was widely utilized particularly because of the ease with which default risks could be covered using the now infamous CDS. It is therefore likely that default will be higher than in the past. Assume a default rate of 10% (which is higher than the maximum default rate of 8.74% during the Asia crisis) and assume a 25% recovery (below 26% in Asia crisis and 40% in the history of default) - we have a potential net economic loss of $4.125T. The US package makes $750 billion available in addition to $1.5T in guarantees of senior notes. In Britain, GBP 500 billion is being made available. In the EU, Euro 1.16 trillion has been made available. In total the amount now available exceeds a fairly conservative estimate of the losses which will arise.
Where did that money go? Where are the most apparent bubble type formations - are they in real estate, commodities, gold, stock markets? As leverage unwinds, which bubbles will deflate?
I see the bubble in global real estate, not the US alone. The US, Europe, India, and China all have very substantial over-valuation in real estate prices. At this point in time, even after substantial price declines, the pricing of real estate is at a level such that it is unaffordable to end users at long term real interest rates. In my view, US prices could decline as much as 40% from peak to trough, with far higher declines in some of the areas which have inflated beyond reason. In India, I would not be surprised to see peak to trough values decline by as much as 60% to 70%. Here the problem is even more significant because end user affordability is just not there. Inventory is building up in investor and developer hands – several developers have not even been able to generate positive operating cash flows during the bull run.
I also feel commodity valuations have reached bubble-like values; but these have now pulled back to fundamentally justifiable levels where demand and supply (marginal costs and marginal revenues) are in balance. Oil still needs to unwind further; my view is $60/bbl (marginal cost of ultra deepwater oil) is acceptable; however, at values up to $100 I would not consider an oil bubble because at that value oil is priced at no more than long term inflation adjusted values. Gold is an area that is difficult to look at. Personally, speaking for myself, it would not matter if there were no gold in the world, so I value it at zero; anything over that is a bubble! For the people who love the yellow metal, sorry, this is just not an area I follow.
That brings us to the markets. Like I said at the start of this post; markets are a forward looking indicator influenced by both psychology and economic data. Nevertheless, they must have a starting point - the fair value. At an Index Level of 940, over the last 20 years the SP500 has delivered growth of 5.39% per annum; earnings growth during the same period has been 6%. For the SP500 to be at a reasonable starting point; it would need to be at 1055; from here it should deliver future growth broadly in line with earnings growth. Take the data over 15 years and SP500 has delivered growth of 4.6% per annum; earnings growth during the same period has been 7.3%. For the SP500 to be at a reasonable starting point; it would need to be at 1357; from here it should deliver future growth broadly in line with earnings growth.
The price earnings ratio is a simple method which can be used to value markets; it reflects the valuation of economic expectations. To assess the impact of the psychology of the markets, I use a slightly modified PE valuation model (you can see it here). During the beginning of an economic contraction, several people give a lot of importance to dividend yield while others are still satisfied with operating earnings; during this time I look at valuations through the historic multiple based on an absolute number – the sum of operating earnings and dividends.
As we progress to the late contraction of an economic cycle, people panic and all they care about is dividends. The market psychology at this stage is better driven by observing market valuations by looking at historic dividend multiples.
As we progress to the early stage of economic expansion, the psychology of people shifts in favor of operating earnings once again and so the best determination of valuation is obtained through the traditional multiple of operating earnings.
As we progress to the middle and late economic expansion, caution is thrown to the wind, dividends take a back seat and growth is all that matters. In this market valuations are best evaluated by reference to a multiple based on operating earnings less dividends.
As we enter the late economic contraction, a time of great economic stress, my fair value for the SP500 is 1247; this is simply the average dividend multiple over the past twenty years multiplied by average annual cash dividends paid out during the last five years. Yet I would point out that 740 is a realistic downside target.
During the last 20 years, the lowest dividend multiple the markets ever traded at was during 1990. At this time the market traded at 31.1X prior year cash dividends. That multiple applied to 2007 dividends gives a value of 739. Since the market is exhibiting symptoms of outright panic, it will not be surprising if the market achieves the bottom fishing target. A 739 price target indicates an expectation of an annualized negative 10% earnings growth over the coming five years, assuming a starting fair value of 1250 for historic wealth created.
I do not believe this is a scenario which can realistically unfold. In years gone past, earnings growth expectations being set at long term US GDP plus inflation was not unreasonable. This basis of estimation needs to change. As the US corporate undertakings lead the charge of globalization, I would set earnings expectations at GLOBAL long term inflation plus GLOBAL GDP growth. Over the next 10 years global GDP growth should run at between 4% and 5%; add to that global inflation of 3% to 4% and we have a earnings growth target of 7% to 9%. For an investor looking for a 12% annual return, using 8% as the earnings growth rate for the coming 5 years and a terminal earnings growth rate of 5% thereafter, the applicable multiple is 17. Applying this multiple to the average earnings over the past five years gives an index value of 1258; buying at this level should set a person up for a 12% annual return over 5 years; buying below this price target is jam.