The Real Index
If the S&P Comp is restated to 2008 price levels, 2008 has had a real index decline of 48%. This is the worst level of decline during the period from 1929 to 2008. The next worst decline in the real index occurred during 1931 (40%) followed by 1937 (38%) and 1974 (36%). Both 1937 and 1974 marked index lows as the following year was up 17% and 21% respectively. During 1931, the index was 10% lower during 1932, but 1933 was 29% higher than 1931.
Did you know that the S&P Comp fell from a high of 21.40 in 1929 to a low of 6.82 in 1932? If you restate the index values at 2008 index price levels, the real index fell from 170 during 1929 to 108 during 1932. During this period, deflation prevailed; long interest rates were in excess of 3% and real interest rates averaged 8.9%. Real GDP fell by 23% during these times; real earnings fell by 68% from a high of 20.32 during 1929 to 6.51 during 1932.
Valuing the real earnings of 6.51 during 1932 at the 11.61 multiples prevalent in the market place today would result in a real index level of 75.60 for 1932. The real index value back in 1932 was 108. Put differently, the market today would need to trade at 1146 to reflect valuations equivalent to those prevalent during 1932.
Valuations today are more pessimistic than the most severe market dislocation during the past century.
The Oil Shock
Did you know that the S&P Comp fell from a high of 106 in 1968 to a low of 67 in 1974? If you restate the index values at 2008 index price levels, the real index fell from 663 during 1968 to 294 during 1974. During this period, inflation prevailed and peaked at over 11% during 1974; healthy disinflation (not deflation) occurred for the next few years. Long interest rates averaged of 6.65% during 1968 to 1974 and real interest rates averaged 0.88%. Real GDP fell by 1.6% from 1973 to 1974; real earnings fell by 18% between 1974 and 1975.
Valuing the real earnings of 39 during 1974 at the 11.61 multiples prevalent in the market place today would result in a real index level of 453 for 1974. The real index value back in 1974 was 294. Put differently, the market today would need to trade at 520 to reflect valuations equivalent to those prevalent during 1974.
History is a Guide
Historic market dislocations are a guide to what might occur in more recent dislocations. But always keep in mind that what actually occurs depends more on the future outlook at the time of dislocation. What to expect in the future?
On the negative side we have debt to GDP running at near 70% compared with 50% on average since 1929. This level of leverage will partly limit the national ability to fiscally stimulate the economy. Yet, with a 70% debt to GDP ratio all is not lost. The ability to inject fiscal stimulus may well be unpopular but it can be done to rescue an economy. We fight different wars today; during the build up to World War II, the debt to GDP ratio rose from 30% during 1941 to 116% during 1945. Some might also consider the rising debt to GDP ratio as healthy; during a time when the private economy de-leverages, the overall debt in the economy can stay unchanged as the nation increases leverage.
GDP & Demographics
The 15 year average demographic growth in the United States has been 1.09%; during the same period real GDP growth has been 2%. Since 1929, the average annualized demographic growth in United States has run at 1.16%; real GDP has grown at 3.25%. Going ahead, demographic growth should slow to nearer 0.85%. Since the US economy is mature, over the long term, US real GDP can be expected to grow at 1.5%.
Since 1929, the average annualized demographic growth in United States has run at 1.16%; real earnings have grown at 1.56% and real GDP has grown at 3.25%. The real index has grown at an average annualized rate of 1.38% which is below earnings growth; this is not surprising since an average earnings payout since 1929 has been 48.75% (last 5, 10 and 15 years have been 35%, 38% and 39% respectively). It is also important to note that earnings have grown at a mere 47% of real GDP growth. Looking at the United States on a stand-alone basis, real earnings growth of at least 1% annualized can be expected and one would expect the real index to grow at a similar rate. In this day and age, it is quite foolish to look at the United States on a stand-alone basis.
During 1974, what was absent was a future earnings growth catalyst; which is probably why the relative valuations were worse than the present. During the Great Depression years, relative valuation probably never got as bad as it is today, because the long term domestic growth expectations remained elevated following the rapid industrialization and reform which occurred during 1870 to 1916.
Today, globalization presents a huge future growth catalyst; and this is the main reason I believe the markets are significantly mispriced. Over the last 15 years, the Great Chinese Expansion has led to annualized real earnings growth of over 5% in the United States. During the Great Chinese Expansion, over the last 15 years, real earnings in the United States have grown at 244% of the GDP growth rate. What is important to note is that since 1929, real earnings have grown on average at a rate of 47% of the average growth in real GDP; contrast this with 244% now and you see the massive positive impact globalization has had on the United States.
Long term, the Great Chinese Expansion will continue; industrialization and reform takes near on 50 years, so the Chinese expansion is at the middle stage; a powerful time. Some moderation in growth can be expected because of the high base effect; however, the reduction caused by slowing growth in a larger Chinese economy, will be more than offset by new growth drivers – Brazil, India and Russia.
For United States real earnings growth, I would look for at least 1% driven by the domestic economy and a further 1.5% driven by global growth drivers; in total real earnings can be expected to grow at 2.5% annualized for the next several decades; that is 5.5% to 6.5% growth including inflation.
Another important consideration is inflation. Average annualized inflation since 1929 has run at 3.26%. Over the last 15 years, inflation has been driven down to 2.74%; the reason is simple – China is the Factory of the World. This positive is now over. The currency in China will strengthen and long term average inflation levels can be expected to rise to 3% to 4% range. In the very near term (12 months), inflation can be expected to dip from 4.45% presently to 2%; de-leveraging in the private economy will provide a healthy dose of disinflation before inflation reverts to its long term natural level of 3% to 4%.
On average, since 1929 interest rates have been at 5.25%; inflation adjusted inflation rates have been 1.92%. Over the last 3 years they have averaged 4.29%/0.80%. Over the past 5 and 10 years they have averaged 4.27%/1.13% and 4.63%/1.87% respectively. This lowering of long term inflation adjusted rates recently has been unhealthy; it has occurred because of the ability to use derivatives to "insure" risk. I would look for real interest rates to increase to 2% - i.e. a 5% to 6% long term rate including inflation.
If we accept a starting point of $69 as average real normalized earnings level which can be grown at a 6% rate (including inflation) in perpetuity; then an investor looking for a 12.5% return (including dividends) should put money to work at 825 levels.
Select Econometrics can be viewed at http://www.maxkapital.com/USEconomicData-MarketDirection.pdf.