Opinion

The Great Debate

Economy volatility a hurdle for stocks

March 23, 2010

Rather than inflation, it may turn out that economic volatility is the true test facing equities in the years to come.

Coming in the wake of an almost unprecedented set of circumstances and policies, the outlook for growth and inflation is extremely murky. For equity investors that means there is far less certainty over both the outlook for profits and how to value them than they had grown used to in the 25 years to the onset of the current crisis.

It is not simply that very low interest rates and bloated central bank balance sheets may cause inflation. That is true, but it is also possible that Japanese-style deflation takes hold. There is a higher chance now of wild swings in inflation, growth and monetary policy than any time in the post-World-War-Two period.

This again is about the death of the so-called Great Moderation, a construct that held that economic growth and inflation had somehow become more biddable. That was largely an illusion, but as long as it lasted investors became more willing to pay more for company profits.

The steadier economic growth is, the more predictable corporate profits become. Steady inflation too is a huge boon to investors; it allows for easier discounting of future cashflows and also leads to fewer gut-wrenching mistakes by policy-makers. It is, after all, a lot easier to travel 60 miles on hour on a straight, level road than on one with sharp curves, steep climbs and sudden downhill legs.

Long periods of moderation tend to amplify this effect. Investors become more and more willing to up the multiples they will pay for given streams of future earnings.

What is interesting about the current period is not that investors thought better of their former easy confidence but how quickly something like that confidence has come back. Price/earnings ratios in the United States — currently in the 14-15 neighborhood — have begun climbing once again and are at levels below recent peaks but still far above where they were for much of the 1970s and 1980s. PE ratios fell during most of the last decade, driven downward by the popping of the dotcom bubble more than the evaporation of the Moderation mirage.

The volatility of inflation has already spiked higher, to levels not seen since the 1980s.

“We’ve moved into a rare area … where valuations are far above their typical levels for the current level of economic volatility.” William Hester of the Hussman Funds wrote in a note to investors.

That may well be because investors are betting not that policy-makers are going to be able to stoke growth and control inflation at the same time, but rather that they will stop at nothing to reflate the economy. Betting on Bernanke and against Depression was clearly a good strategy in 2009, but it seems the situation is far more complicated now.

DEMOGRAPHIC SUPPORT FOR EQUITIES EBBS

Tim Bond, strategist at Barclays Capital in London, thinks stock market valuations are fair value now, more or less, but sees them being pressured in coming years by a combination of factors, including economic volatility.

Demographics, Bond argues, will offer dwindling support for equities as the baby boom generation ages and begins to retire. As the late middle-aged prepare to retire, they are likely to hold less in equities, while those actually in retirement will have to begin to eat their savings. That should pressure equity valuations for at least a decade unless, of course, Chinese and Indian savers suddenly and unexpectedly acquire a taste for developed market equities.

I’d bet the traffic mostly runs the other way.

It is also true, and puzzling, that lower levels of global economic growth now appear to be needed to stoke commodity inflation. This, if sustained, will be a headache for central bankers and investors from Beijing to Washington.
In the end, as we have had an officially engineered reflation, the biggest risks to PE ratios come from official policy mistakes. These are of two types: the deliberate and the inadvertent.

A central banker now has a much more difficult time knowing what the actual state of the economy is. No one really understands what will happen to U.S. interest rates as Fed support ends: not you, not me and certainly not the Fed itself. No one knows either when or how banks will begin to lend again in force, stoking the speed of money in the economy, and with it inflation. The Fed could, in good faith, get it horribly wrong.

Further, unemployment is high and will take years to fall to acceptable levels. Continuing to run huge deficits may be the right thing to do in that circumstance, politically, economically or morally, but it is hard to argue that it won’t create temptations for central bankers and raise the risk of economic volatility.

Pricing that risk may take a while, but the effects for equities will be profound.

Comments
4 comments so far | RSS Comments RSS

“something like that confidence has come back” – I wouldn’t say confidence, would call it the “Great Desperation” where other investments have become perceivedly riskier and investors don’t really reflexect about returns but future appreciation (“bubble”) profits – much like in the housing market whoever bought their seventh house on credit was not even not going to live in it, he/she even knew that it would never pay for itself – they purely thought prices would rise further. The same can nw be seen in stock markets, like prior to 2000 – everyone hopes shares will go up until they sell. That will be the second disaster after housing. While this clearly shows the detrimental effects of inflation, central banks stoke a “fear of deflation” as a ruse by central banks to keep inflating the money supply. For deflation to seriously happen, not only the current extreme credit expansion by the central banks and states (through “quantitative easing”, stimulus packages, monetising and then spending national debt etc.) but also the money that was released into the economy PRIOR to the collapse would have to be “mopped up” again. This is nowhere to be seen nor would it be technically possible (confiscation aside) so we will rather see inflation than deflation and for another while rising stock prices as this money has nowhere to go.

Posted by CrisisMaven | Report as abusive
 

Credit is not money. It vanishes with people’s ability to repay and the subsequent devaluation in asset prices when it is the whole country in the same boat.

The credit may be on the ‘books’ but a great percentage of it (if it were honestly accounted) is bad debt.

The boom times were funded entirely by credit (who had real money they hadn’t spent?), the crash saw most highly leveraged, no cash and now no ability to borrow. So where is the money or ‘credit worthiness’ going to come that will be a resurgence in consumer demand?

That multi billions of vanish credit that sustained the boom times is gone and there is nothing to replace it except the average pay check – after servicing debt. But of course fear will make people save.

There has to be a huge contraction in the consumer economy that formerly kept the engines running.

The USA has yet to reach the maximum of its problems in my personal opinion.

We have seen the ominous signs with a failure or recovery in the residential housing market (and certainly builders are going to unemployed for a long time). People are not buying because – banks wont lend, they dont want to buy, the expect prices to drop further…ie deflationary elements at play.

The big problem comes when commercial real estate loans come for roll over this year and next. Loans taken out at the peak of the market – maximum borrowings against maximum valuations. Gulp!! And now not only are those valuations through the floor…who is renting to provide revenue to even service interest?

We have already seen instances of commercial real estate borrowers walk away from their loans, leaving the loss to the banks. This is going to accelerate through this year and it will have flow through effects on the residential markets as well as you would expect.

Bank lending will contract even more, more failures, more unemployment…and so forth. It sounds terrible, it will be terrible. It is simply remarkable that people could think a trillion dollars of credit could disappear and the economy just cruise back to recovery.

The stock market is insane, we all know it, it being artificially inflated but with no volume. It will have a spectacular crash at the end of this.

Posted by Kina | Report as abusive
 

This is a jobless recovery with companies making huge money on exports and international growth, boosting 2010 earnings guidance, buying back their own stock and pursuing M&A. Stocks can continue to go up with the consumer still in the toilet. At least for the next month or two

Posted by Story_Burn | Report as abusive
 

Good article, and I enjoyed reading the comments posted by CrisisMaven, Kina and Story_Burn.

Posted by yr2009 | Report as abusive
 

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