Following the 2008/2009 credit crunch we face the prospects of an extended period of low growth coupled with the risks of major aftershocks. This article articulates the background and outlines how to profit from the volatility that will remain with us during these uncertain times.
1. The US economy, where to now?
In early 2010, when stimulus programs were in full swing, there was much debate about the shape of the economic recovery; V or W-shaped, square root, New Normal etc.
Now in the summer of 2010, with government stimulus ebbing, unemployment holding firm at 9.5%, monthly new jobs created being consistently lower than numbers entering the workforce, and the housing market showing distinct renewed weakness, all signs of normal growth have disappeared.
In reality, a significant period of sub-par growth is no surprise. The once-mighty US consumer, who historically represented 66% of all US economic activity, expanded total household borrowings from 43% to 100% of GDP between 1974 and 2008. A period of deleveraging, which inevitably diminishes consumers spending, had to ensue.
Looking towards 2011 and beyond, we face further erosion of stimulus programs in the US and universally, austerity measures being introduced in a number of western economies, higher taxes at least for some, and ongoing deleveraging efforts by consumers.
Of paramount importance to US consumers is the housing market. Housing is the single biggest store of wealth for Americans. It was the recent bursting of the housing bubble that exposed the perilous state of US consumer’s collective wealth. It is surely impossible for the US to enjoy anything other than a weak recovery until the cornerstone of consumer’s wealth, i.e. the housing market, begins its recovery. In time a better housing market will feed into higher consumer spending and that will lead to better growth, lower unemployment and so on. Many excellent Seeking Alpha commentators have written on this topic, e.g. John Lounsbury or The Pragmatic Capitalist. At present, the housing market seems destined for further softness with no meaningful recovery for 5-6 years. Wherever go home prices, consumer spending trends will follow!
It is becoming increasingly clear that, for some years, the US economy will grow at little more than glacial speed.
2. ...and the global economy?
A weak US recovery has a knock-on effect for other countries; in particular countries exporting to the US will have lower growth. But also, just as leveraging-up in most Western economies helped their growth, the process of their deleveraging will be a significant handicap. Various Western austerity measures will also have an effect. Global growth is estimated to be around 3% during the years ahead, much lower than the 4.7% enjoyed in the 5 years prior to 2008.
A low growth environment has repercussions for investors. Long term earnings outlook for companies is reduced, leading to downward pressure on stock valuations. At the moment stock markets are significantly overvalued – see discussion below.
Second, lower growth amplifies risk. This is particularly true when looking at sovereign debt risks, and, within the US, municipal and state debt risks. After some initial cutbacks, all these debtors have been looking to grow their way out of their debt problems.
For example: The growth assumptions of both the European sovereign debt nations and of some US states and municipalities are predicated on decent economic growth in 2011, 2012 and thereafter. No allowance has been made for years of sluggish growth. Ireland is a case in point. Being one of Europe’s major sovereign debtors, and European home to a large number of US corporations (Intel (NASDAQ:INTC), Microsoft (NASDAQ:MSFT), Google (NASDAQ:GOOG), etc, all attracted by low corporate taxes), it forecasts growth rates of 3.2% annually from 2011 to 2015. Against a backdrop of slow US growth, Ireland’s growth rates will surely require downward revision with negative repercussions for the country’s ability to grow out of its burgeoning debt mountain. It is unsurprising that Ireland’s sovereign debt spreads spiked sharply on August 11, when the DJ Index fell 265 points after the Federal Reserve lowered its outlook for the US recovery. A similar story is playing out with many US municipalities and states where severe budget and headcount cuts will now have to be made because initial hopes of a strong economic recovery were too optimistic.
The message is clear for investors; anticipate that from time to time there will be nasty repeats of the sovereign crises that occurred in April/May 2010, as well as regional municipal debt crises.
With stock markets overvalued, as they are now, investors are particularly vulnerable to event risk.
3. What are appropriate stock valuations in a low-growth environment?
First, let’s look at history. There is widespread understanding that the DJ Index and the S&P500 trade historically at multiples of approximately 15 times earnings. But exactly what “earnings”? It is 15 times trailing 12-month GAAP earnings i.e. after subtracting all write-offs and other charges. For some excellent research please refer to Hussman Funds website, and discussion on Seeking Alpha.
This “15 times trailing 12-month GAAP earnings” average P/E ratio has been calculated over the period 1880 to 2010. No exclusions have been made for unusual periods such as the Great Depression of the 1930s, or for the bubble period of the 1990’s and early 2000’s. Note: during periods of depressed economic activity P/E ratios fall significantly below the long-term average and, conversely, during boom periods, p/e ratios often trend above the long-term averages.
Important: Beware of pundits mixing their p/e metaphors. In particular, phrases such as “Current Year Estimates” and “Next Year’s Earnings” are invariably Operating Earnings (pre write-offs and pre charges) and both are forward looking to some extent. As such these earnings numbers are substantially higher than trailing 12-month GAAP earnings. As a rule of thumb a Next Year’s Operating Earnings should be ascribed a forward p/e of 11.5 to equate to the historic norm of 15 times trailing 12-month GAAP. Thus, if a commentator is recommending a stock on a Next Year P/E as cheap at, say, 16, what they are really saying is that such a stock is overvalued by 40% i.e. a 16 times forward P/E versus the 11.5 GAAP adjusted norm.
In an extended period of sub-par economic growth, what is a reasonable P/E ratio to apply to the S&P 500 index?
There is no perfect answer. Considering the poor growth outlook, investors should realistically adopt a lower than historic P/E ratio for the next few years. Frequently during economic slowdowns, market P/E ratios drop to single digits. On the other hand US companies derive a greater portion of earnings from faster growing markets such as Asia, than they did in years past. Thus, whilst using the historic norm of 15 seems high, equally it seems excessive to opt for a single digit P/E. This leads us to the middle ground where, on balance, a trailing 12-month P/E ratio of 12 seems reasonable, that being just 20% below the historic norm.
This brings us to current market valuations: From the S&P website in July 2010 the estimated 12-month trailing earnings number was $64.35 for the S&P500 (actual trailing 12-month earnings at the end of Q1 2010, per Prof. Robert Shiller, were $60.90). Using a 12 times trailing P/E ratio suggests a fair value of 772. On Wednesday August 18, the S&P closed at 1,094.16, being a p/e ratio of 17. The S&P 500 is overvalued by 40% when using a 12 P/E applicable for a low growth era, and is even overvalued using metrics applicable to historic stronger-growth periods.
4. But aren’t valuations different in a low interest rate environment?
Very low interest rates are a symptom of long-term economic malaise, often with some deflation risk.
Long-term stock investment decisions should be made with respect to long-term valuations and earnings prospects. Investors should not upwardly recalibrate stock buy-levels just because interest rates happen to be low. Buying stocks at elevated valuations, regardless of low interest rates, exposes the investor to the risk of significant capital losses over time. When volatility is a fact of life – as it is now – it is immeasurably better for investors to stay out of the market and to only buy on those occasions when (repeat when, not if) the market experiences severe dips that bring valuations back towards long-term averages.
The Tokyo stock exchange is a good example of how market valuations soften during long periods of low economic growth, even with exceptionally low interest rates. Pre-1990 the Nikkei 225 traded on P/E multiples in the 60-70 range. Currently, the Nikkei index has a 12-month historic P/E of 12, even with 10-year interest rates at 1.02%. Note: This is a lower valuation than the S&P 500 even though US 10-year rates are 2.6 times those of Japan.
For more on periods of unusually low interest rates refer to research done by Hussman Funds.
Notwithstanding the foregoing, it is an undisputed fact that low interest rates do encourage some investors to enter the market periodically, even when valuations are above historic norms.
Supported by this trend, market valuations will expand well beyond fair market value from time to time. This phenomenon is much more likely to occur during periods of favorable news, rather than when economic news is negative. Investors should bear this fact in mind.
5. Be aware of volatility, investor psychology and newsflow
It is not an accident that stock markets are volatile today. Volatility is a common attribute of overvalued markets. When markets are volatile this forces investors’ psychological time horizons to shrink. Furthermore, when nerves are frayed, investors are more susceptible to being swayed by the news du jour.
All in all we have a scenario where investors and stock markets are prone to having mood swings with considerable oscillation during the year, and even within reporting quarters. This background gives investors lots of excellent money-making opportunities, as are now explained:
6. The Investment Blueprint:– Embrace Volatility
With the US economy set for Japanese-style performance, and stocks being significantly overvalued, the predominant force acting on stocks will be gravity i.e. valuations will soften. Typically, the process of reverting towards lower valuations occurs over an extended period, usually lasting several quarters and sometimes years.
Invariably there will sugar highs from time to time via Government programs or takeover excitement, but with consumer deleveraging being an absolute necessity, these programs are unlikely to have anything other than short-term positive effects on markets. And whilst overall economic activity will be anemic there will also be interim periods when the newsflow suggests some acceleration is underway. Then, at least for a time, some investors will believe we are off to the races again. But they will be wrong and the reality of long term low growth will reassert itself. Overall, the trend towards lower valuations will continue, albeit not on a straight line.
Against such a background investors can profit strongly, whilst also protecting capital by; (1) converting into cash all stocks that are meaningfully overvalued, using valuation metrics applicable for a low growth environment, and, (2) with that cash, taking out periodic short-term positions when profitable circumstances present themselves. In summary, rather than being hurt by risk and volatility investors should Embrace Volatility.
(a) Do short-term trades, buying liquid, high beta, deeply discounted mid-cap stocks that should yield at least 10% during multi-week periods when the overall market is in up mode. Purchases should be made after recent market bottoms have been confirmed. Purchase should be executed when both the overall market RSI and the individual stock RSIs are weak.
(b) Sell these short-term long positions within a number of weeks, certainly when overall market and/or individual stocks RSI’s are high.
(c) More aggressive and experienced investors/traders will have their own strategies such as going long or short the S&P 500 (NYSEARCA:SPY), occasionally with options, in accordance with overall market indices being toppy or bottoming, and with reference to anticipated newsflow etc. Such short positions should be closed out relatively quickly because risk factors can increase over time.
Here is an outline listing of the events and happenings that investors can focus on. Some will occur almost every each year whilst others will occur quarterly:
- Almost invariably, there will be investor optimism towards year-end, built on the grounds that the New Year will usher-in an end to the current economic malaise. This will lead to market surges around year-end.
- Following the year-end surges there is likely to be some sell-off in the New Year.
- Mid-year softness. Would you like to hold stocks through the thinly traded summer season if those stocks were considered overvalued?
- China’s economy is maturing and its growth will inevitably slow. Some property related risks are almost sure to crystallize.
- Sovereign debt problems in Europe are certain to worsen over each of the next few years. Most of the countries involved are targeting a balanced budget only by 2014. As various countries reach and pass the Debt/GDP ceiling of 100% there are likely to be further jitters. Japan, with a Debt/GDP ratio of 200%, and growing, is likely to hit the headlines hard in the next two years. Similarly stories are emerging for municipalities and states within the US. These are all big-ticket headlines. And they will occur.
- One of the biggest influences on short-term market direction is the earnings reporting cycle. Investors should bear in mind that there is a substantial difference between US economic growth and growth in profits of many particular US companies. When pre-earnings market jitters compress stock prices across the board this can throw up particularly profitable opportunities.
- Earnings pre-announcements. During periods of economic deceleration the prospects for the approaching earnings cycle usually diminish (unless already baked into guidance). A larger number of companies issuing negative confessional reports will feed through to higher sovereign debt spreads and these worries will, in turn, magnify weaknesses in financial markets.
- Conversely, in periods when economic indicators accelerate, we are likely to see markets advance strongly ahead of earnings. But, since no quick and easy solutions are available for the debt deleveraging problem, investors are advised to sell into strength. Sell early and sell often.
- Regular monthly Housing and Unemployment reports will amplify quarterly stock market trends, frequently during the earnings confessional season.
With due care, individual investors can play these events and trends successfully. By way of example please refer to my earlier Seeking Alpha article; 6 Short-Term Volatility Trades for Q2 2010.
With markets substantially overvalued a Buy & Hold strategy is ill-advised as it exposes the investor to the risk of substantial capital loss. Overvalued markets are volatile and throw up many short-term trading opportunities, both on a quarterly basis and on a year to year basis. Investors can profit from such market swings by selectively and carefully Embracing Volatility.
Be careful out there, the end-game is years away.
Disclosure: No current positions