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Stefan D. Abrams, CFA Mr. Abrams is currently a Senior Advisor to the Trust Co. of the West. From 1986 until 2006, Mr. Abrams served as Managing Director, Chief Investment Officer for Asset Allocation of Trust Company of the West. He co-managed a multi-billion dollar global asset allocation... More
  • Post Traumatic Stress Syndrome 0 comments
    Apr 12, 2010 4:23 PM

    In the aftermath of all that has happened since the subprime mortgage crisis began to surface in 2007, through the post-Lehman meltdown of the global financial system, the forced liquidation of financial assets by hedge funds and other leveraged investors, and the capitulation of many individual investors in the first quarter of 2009, just about everything imaginable that could go wrong did go wrong. Currently, there are many lingering after effects even as the financial system heals and most industrialized economies begin a slow, arduous recovery. Nonetheless, these events have had a severe impact on the investment psyche of middle aged and older Americans. From the peak in 2007 until the trough early last year, Household Net Worth declined by about $15 trillion, reflecting lower values for equities, real estate, many privately held businesses and, of course, the retirement nest eggs of millions.

    Despite some recent recovery in Household Net Worth the shock of losing large percentages of the fruits of a lifetime’s work, in some cases all, have left indelible scars and have permanently altered the thinking and outlook of millions of investors. The Madoff and Stanford frauds, among others, have only made the doubts and fears worse. Regrettably, their logic is flawed, but the result is that a generation of investors has become totally risk averse and will, in all likelihood, never again invest in equities. Notwithstanding the reality of the steps that both governments and corporations are talking to emerge from recession and given the ability of multinational corporations to cope with the environment that confronts them, the flight from equities into low yielding savings deposits and other fixed income securities has the potential to do further financial damage to a generation that might well outlive its depleted savings.

    There are numerous fallacies contributing to the fears of investors. Foremost are the erroneous beliefs that an economic recovery cannot be self sustaining without the ongoing fiscal support of government. Also, there is the erroneous belief that the mortgage foreclosure problem, the sorry state of state and local finances, the problems of commercial real estate, the tighter lending standards of banks and, most importantly, the current unwillingness or inability of corporations, large and small, to add to their payrolls, will prevent a recovery. All of these factors represent headwinds, but not obstacles, to a sustained recovery in the US economy. They are the inevitable aftershocks of the financial meltdown and the recession, and because this was a debt deflation caused by the bursting of a credit bubble, the healing process will inevitably require more time than after a typical post-war recession engineered by the Fed to cool off inflation.

    There are engines of economic recovery and expansion which have yet to kick in fully, but as they do, the recovery is likely to become self sustaining, even as the extraordinary fiscal stimulus declines. The economy has yet to experience an upswing in inventories, but since final demand has outpaced production for many months, it is only a matter of time before this changes, and the early signals from railroads and freight companies suggest it may finally be underway. US exports continue to ramp up at a rapid pace, particularly to the emerging economies, which now account for roughly 35% of global GDP. There has been a shrinkage of industrial capacity, which needs to be restored with modern machinery and equipment, which will in time fuel a recovery in capital spending. Households have reduced their indebtedness substantially, and while the personal savings rate may drift higher over time, the largest adjustment has already taken place. Household consumption, more than two-thirds of the economy, is likely to rise in line with incomes, which have already seen considerable compression.

    All of this is continuing even as individual investors pour money into fixed income assets, which run the risk of depreciating in value as monetary policy gradually turns towards normalization. It is unlikely that there will be any time soon a tightening of monetary policy, as has occurred numerous times in the post-war period, when the Fed has been forced to battle inflation, but even a normalization of monetary policy coupled with a continuing upswing in business activity will result in higher interest rates and lower bond values.

    Discouraged investors are unable, it seems, to see the disconnect between the rate of growth of the US economy and the rates of profit growth of many large multinational enterprises, most of which are benefiting from rapid growth in the emerging economies, particularly in Asia and Latin America. Investors buy shares of companies, not a piece of the GDP. Even in a slow growth economy, which is likely to be free of inflation and therefore long-lived, corporate profits will be on a significant growth path, and the value of equities is likely to rise significantly over the next few years, regrettably without the participation of many disheartened individuals. For example, the operating earnings of the S&P 500 could reach their prior peak of $92 by 2011. If BBB bond yields were at 7.50% by then, compared with 6.20% currently, a fair value P/E of 13 would imply a target for early next year of 1225, up from 1166 currently. Moreover, this need not be a peak if the expansion remains free of inflation-induced imbalances.

    As always, there are risks to this scenario. If there is no political will to rein in the soaring fiscal deficits of the industrialized nations, including the US, of course, then the danger to bond holders will increase substantially. As the laboratory case of Greece amply demonstrates, if investors doubt the ability of a nation to service its debts and/or finance itself, the risk premium of its paper will soar, and its bond holders will suffer. Conversely, if the government in question continues to print money in order to service its debts and other obligations, the fear of higher inflation, or even default, will be priced into its bond yields. Conversely, in order to survive, the corporate world is always forced to maintain much higher standards of fiscal integrity. It could well be that in some cases government bond yields will rise above those of their corporations. In any event, it taxes the mind to imagine a scenario in which the total return from bonds will exceed that from equities over the next decade, during which time governments will be struggling to bring their finances into line, while capably managed corporations will benefit from their participation in the industrialization and rising living standards of the vast majority of the world’s population.


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