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In my view, the future of the stock market is not very bright as we may face a decade of multiple compression.

Whenever the market pulled back sharply, and often at the peak of panic, we would hear the chant of pessimism from the media: the fair value of S&P 500 was around 800, and we faced a downside potential of another 20% from here. This happened in February, when the Dubai crisis triggered a sharp pull back in global stock markets. It also happened recently, during the panic of Euro crisis. The supporters of such pessimism often quoted a chart from Robert Shiller’s famous book of Irrational Exuberance.

The following chart is from Robert Shiller’s website of Irrational Exuberance.

click to enlarge

The chart tells us that the current normalized P/E of 19 is still far above its historical mean. According to the chart, it happens pretty often that after a major market crash in history, the normalized P/E dipped to levels much lower than the historical mean, often years after the crash. Some see from the chart that we are in a secular bear market since 2000, when normalized P/E overshot to extremely high levels, and believe this secular trend of declining multiples won’t be over until the normalized P/E falls below its historical mean. Optimists brush this aside, citing strong rebounding of global economy and stock markets. Some argue for the wider stock ownership in the US compared to the historical level and the risk taking characteristics of American people. Many strongly believe in the results of empirical studies that stocks on average outperform bonds over long term.

I have no intention to put myself into the debate, but if we do assume that multiple compression IS running its course as suggested by the Schiller Chart, we probably can make educated guess as to HOW the course may look like.

Based on information available so far, I can see two possible scenarios for the multiples to go down.

1) Slow growth with more frequent recessions

With the high unemployment rate and the anemic recovery, domestic demand just isn’t enough to drive an annual GDP growth of 2-3%. Banks balance sheet improved significantly, but their loan portfolios are still shrinking, because there isn’t enough demand for loans. Consumer debt level remains high. At bad times like this, it is not likely for consumers to take on debt. Deflation will become a long-term issue, because there is less money to buy the same amount of goods, so the price has to go down. Paul Krugman argued many times that US stimulus wasn’t enough to propel a strong recovery. He also pointed out recently here that the Fed isn’t doing enough to fight deflation. Japanese type “liquidity trap” is already in the shape.

In this scenario, equities may underperform bonds for a prolonged period.

Recessions may become more frequent due to weaker economic growth. During the bull market period, growth may not be strong enough to spur multiple expansion to the high level of the last cycle, and when recession is back, multiples may drop further to be lower than the low point of last recession. Over multiple business cycles, secular bear market drives down multiples lower and lower. People aren’t going to lose interest in stocks overnight, but if investments in stocks fail to pay off repeatedly, more capital will flow out of stock markets and into bonds. The baby boomers may still have childhood memory of an era after the Great Depression that stocks were considered evil. Look at what happened to Japan in the past 20 years, how many Japanese still invest in the stock markets?

Compared to Japan, there are several factors that may help alleviate the problem so that the US may end up with a better story than Japan. First, the demographics of the US is much better than that of Japan. A growing population is one of the most important factors that contribute to long-term economic growth. Second, the US consumer spending habit may help. Japanese and Asians tend to save more than US consumers. Third, the economic structure of the US is quite different from that of Japan. Japanese economy relies heavily on export and the US economy doesn’t.

2) Higher growth pumped up by massive stimulus

If the Fed and the US government decide to fight the deflation and shower the American people with printed dollars to spur growth and job creation (of course it is a big if), what are the measures they may take?

The Fed interest rate is already zero, so they can’t further lower the interest rate. They can resume the mortgage buyback program, but with historically low mortgage rates, the extra benefit by this measure may not be very meaningful.

Even if money printing prevented the country from a long-term deflation, such a dramatic measure portends a high inflationary risk. Stocks won’t do well with high inflation either, particularly if the Fed has to fight off inflation by raising interest rates. The Shiller Chart shows the normalized P/E of the US equity consistently declined throughout the 70s, and dropped to as low as 7 during the early 80s recession when the inflation was eventually fought down.

It appears to me that the Fed and the government have a higher chance to under-stimulate instead of over-stimulate the economy, because they are under pressure to contain the deficit and fear of hyper inflation. So I believe the slow growth scenario is more likely to happen.

If we are truly in an era of multiple compression, how shall we invest in equities during such period?

I believe that investors can profit by paying attention to the following three principles.

1) Invest in emerging markets

Bill Gross pointed out in his investment outlook this February that the deleveraging process of major developed countries after this past financial crisis may last multiple years and result in significant drag on GDP growth. Comparatively, Asia and emerging market countries have much lower debt levels, are still growing rapidly, despite various problems of their own. There are fundamental economics supporting continued growth of these regions, most important of which includes: demographics, growing labor force, improved education level, trend of industrialization and urbanization, etc. However, investing in emerging markets entails higher volatility. For those who are deterred by the volatility of emerging market stocks, another strategy is to invest in multi-nationals with a significant presence in emerging markets; examples are: Coke (NYSE:KO), Yum (NYSE:YUM) and Citi (NYSE:C).

2) Focus on value

At a time of multiple compression, high flyers are crushed. Buy companies at a price much lower than its true worth to ensure a significant margin of safety. Value investors like Warren Buffett had historically invested in the period of 70s and generated great returns. It is important to note that valuation methods based on historical multiples may be misleading, if multiple compression over a long period is expected. I prefer to value a company based on its net asset and the profit it can generate in the long term, without the assumption of a favorable economic environment; and only buy when the price of the stock is significantly lower than the true value of the stock implied by its net asset value and long-term profitability.

3) Focus on quality

In bad economic environment, high quality companies have much greater capability to survive and grow their business. Many multi-national large caps well positioned in their respective industry currently trade at very reasonable multiples, examples are Microsoft (NASDAQ:MSFT), Pfizer (NYSE:PFE), BP (NYSE:BP), Johnson & Johnson (NYSE:JNJ), IBM (NYSE:IBM) and Wal-Mart (NYSE:WMT). With their strong competitive positions, these companies are able to generate strong cash flow for many years to come, in both good and bad times. They pay rich dividends. They also have a significant global presence, allowing them to participate in global opportunities and profit from the growth of emerging markets.

Disclosure: Long in C. No positions in all others.

Source: An Era of Multiple Compression: A Scenario Analysis and How to Invest in Equities