Is There a Long Term Return to Long Term Normalcy?

On a Return to Normalcy looks at the Average 15 Year Normalized PE between 1935 and 2005 and argues that we have just returned to this level since the Dow dipped below 8,750. The implication is that the market has been over-valued for the past two decades and is simply reverting to mean. It is indeed an interesting article - the argument is that historically the Dow returns 6% plus dividends over the long term. Thus when it trades at a price higher than the 15 Year Normalized PE, you are paying a premium to lock in a return of 6% plus dividends.

I enjoy looking at mean reversions, but I do believe that an expectation of a reversion must arise in the context of present circumstances. I believe the market will, on occasion, trade at a premium to the long term normalized PE ratios. At other times it will trade at a discount to the long term normalized PE ratios. It will seldom, if ever, trade at long term normalized PE ratios. When the market does trade at a discount, perceived risks are elevated while real risks are low. When it trades at a premium, perceived risks are low, while real risks are higher. Whether we will now trade at a discount to the long term normalized PE is an open question.

My view is that once the panic subsides, the market will pay a premium on normalized PE's for several decades. There have rarely, if ever, been the kind of triggers for growth that are in place today.

The urbanization and industrialization of India and China has a long way to go; as an aggressive investor with access to capital, intellectual property and management skills, the United States will be a significant beneficiary.

Global GDP has grown and is continuing to grow at a rate in excess of historic norms. Global capacity is short and investment is required. Now that the bank crisis has been addressed by the world community, the healing process has begun. From it will emerge a more responsible financial services industry, which will hopefully focus more on credit quality and will not over-leverage as in the past. Once the de-leveraging is done, growth will recommence, perhaps at a more sedate pace, but nonetheless at a rate of growth higher than the long term average.

If demographics are studied, China will start having an increase in the aged population as a % of the working population only after 2030. In India, it is not expected to happen until closer to 2050. The standing army as it is today is under-served, so there is a big catch up needed. Once that is done, growth needs to be sustained to serve the accelerating population.

Demographically, the United States is an aging nation and as the baby boomers retire, it is perceived that (a) consumption will decrease (lesser demand from older people) and (b) there will be dis-savings as older people withdraw savings from pension funds and social security. However, thus far the United States has maintained an excellent demographic balance through immigration (more recently supported by high birth rates amongst the Hispanic and Asian communities). I expect this to continue because the United States continues to attract the best of the globe to its educational institutions and thus it is able to preserve that competitive edge from home grown and imported intellect.

With the balance between the working and retired being maintained, there should be no unimaginable dis-savings. I would argue that a lesson will have been learnt from past excesses and consumption funded by debt will reduce considerably. This reduced consumption will lower the burden on future generations. The savings that arise as a consequence of lower consumption will be invested. I expect considerable investment within the United States as she strives to re-assert her supremacy as a producer nation. I also expect considerable capital outflows from a capital resource surplus country to capital constrained societies.

It is true that Europe is well into demographic reversal. This is a negative for global GDP growth. It does not however come close to challenging the growth potential exhibited by India and China.

Peace too enjoys a strong relationship with growth. Unlike the first half of the 20th century, we now live in an era of relative peace. With peace, human-kind will focus on creative areas instead of destructive ones; while a war can stimulate GDP, creation alone can sustain it. Humans have an infinite list of desires. The only factor restraining growth is the process of creating wealth to translate a desire into demand (the desire backed by the ability to pay). As too many sweets makes one sick, no doubt there will come a point in time when we as a global community reach saturation. But are we there yet? Some parts of the world may well be approaching an age where growth will slow, even fall, depending on demographics. But for most of the world's population, we are not even close.

For a saturated society, which we are not, one could argue that in the long term, growth should simply equal demographic growth rates plus inflation, or be even lower, because over an infinite period of time. The world cannot sustain an ever growing population forever. A Malthusian correction will ultimately restore the balance between man and nature. But Malthus has been denied time and again by human ingenuity; the fact is that human productivity has grown by geometric progression as has population growth so far. He cannot be denied indefinitely; but is the day of his denial at hand - I think not.

Keynes once pointed out that in the long term we are all dead. I believe most investors must think of the long term. And think of the long term as a series of shorter terms. This wonderful article has provided us with an interesting multi-decade perspective. As investors, what we must do is seek to profit from it. If the Dow continues to deliver growth of over 6% plus dividends, to buy now would be indicative of super-normal profits; i.e. go long. If the Dow can be expected to deliver growth below 6% plus dividends, go short. There are no risks to growth through at least 2030; if anything it will cascade as the compounding works its magic with fast growing global emerging economies.

Growth in financial services growth will slow, de-leveraging has and will continue for a while longer. Money supply will shrink and much of the burden will be carried by consumer discretionary and financial services; the two sectors which caused the pain have now suffered for it and will probably continue to suffer for some more months. Much price damage has been completed; the expectation is for long term growth to slow considerably. For financial services, while enterprise values are likely to stablize and grow, fresh capital induced by new investors and the government, may well cause price appreciation for exsisting shareholders to be at risk.

De-leveraging in commodities and basic materials has a while longer to go since prices in some, mainly Energy, Fertilizer and Agricultural Chemicals, are yet to reach the equilibrium (the marginal cost of production). For Energy, Fertilizer and Agricultural Chemicals, the long term fundamentals are very sound. However, the price levels are well above equilibrium. Absent leveraged players, the prices can be expected to trade above equilibrium because un-leveraged users will most likely forward buy once prices approach equilibrium.

On Energy, I see equilibrium at the $50/$60 range, with an expected price range of $60 to $75 (which is bad for Canadian Oil Sand related plays but okay for ultra deepwater and oilfield services). For Fertilizer and Agricultural Chemicals, the price levels for Phosphates and Potash lie very far below today's levels. Take Potash for example, prices went from $200 to $1,000 in a blink. They were expected to continue rising to at least $1,350 based on elevated food price levels due to growing demand in emerging economies and of course capacity shortage. With several negative catalysts such as non recurrence of the Australian drought, food prices will start reverting to normal levels with supply on the rise.

In addition, analysts appear to have over-looked the price sensitivity in emerging markets; the sad truth is that while India is growing, it is immensely poor with over half the population living on under $2/day. When people buy food grain they do not buy based on the kilogram (based on physical needs) but by the Rs (based on ability to pay). Demand falls as prices rise with absolute poverty. As prices get lower, farmer margins are compressed - demand for fertilizer falls. Ultimately, the sector is strong, but commodity prices need to fall far further; this area too has received much investment from financial leveraged investors!

For the other basic materials, prices are now reflecting (and have even undershot) price levels justified real demand. Equity prices in the basic materials sector reflect reasonable economic cycle CAGR's after considering the demand led capacity created. The price damage in commodities and related basic materials sector equities has been considerable. The prices were elevated primarily by real demand, and pushed to exuberance by leveraged forward buyers, who quite correctly saw continuing and exponential growth in demand; with the leverage gone the prices will return to equilibrium.

Growth in the real economy led by industrials will continue. High quality credit will be in demand by a disciplined financial services sector; it will be available to industrials seeking capital for real growth, and this will put a floor under commodity prices backed by real demand.

As far as I am concerned this is not the end of the world; the problem is making the world believe it.

Comments

[Moon Kil Woong:]

True. We need trust, not the SEC issuing orders like yesterday saying banks and institutions can declare whatever they want for assets no one will buy. They are the primary reason for a complete lack of trust in this market. If I'm a worthy company how do I prove it when the current rules let liars make their books look just as good as mine by marking junk as $0.80 on the dollar and hiding all their derivatives bets?

2008 Oct 13 12:02 AM