Is the Future Any Less ‘Uncertain’ Now?

4 Jun

It may not be the time to exuberant just yet.

The winds of popular sentiment appear to be blowing in one direction with respect to the economy – that is, that the economy is stabilizing and things are looking up. We should see stabilization in the latter half of this year and positive economic growth in the first quarter of next year, we hear. True? Perhaps. I will not make those sorts of predictions because I just do not know (and I know it).

The S&P 500 has rallied about 40% off its early March lows. Emerging market stocks are up close to 70% from their March lows and up 42% for the year, versus an S&P 500 that was up about 5% through yesterday. The CBOE volatility index – VIX – which some call the “fear index” is lower than we saw back in September of last year, prior to the collapse of Lehman and the “economic Pearl Harbor,” as Warren Buffett so eloquently says. Granted, the markets are still about 40% below their highs, indicating another 66% gain needed to get back to even. But they have come up pretty far and fast, and the headwinds to corporate earnings mean stocks’ values have fallen since the highs (and record profit margins) of 2007.

As I laid out at the beginning of the year, our economy is not likely to be the same coming out of this crisis. Consumers are not likely to resume their spendthrift ways going forward. Rather, we’ll probably continue to see higher savings rates and years of deleveraging as consumers align their household cost structures to their income levels. This will probably mean smaller homes and less conspicuous consumption. Accordingly, the source of 70%+ of our economic activity (consumer spending) is likely to be much less robust and become a smaller part of the economy. Capacity utilization will probably be sub-optimal for some time, which means higher structural unemployment and lower wage growth (if not wage rate stagnation). If the government continues its profligate spending without commensurate cuts in entitlements (which it’s actually adding), we will not be able to avoid higher taxes down the road. My personal bias tells me higher taxes are likely because tough decisions on public pensions, Social Security, and Medicare/Medicaid, while probably salable to the public by the popular administration, are not as much fun as tackling health care reform and “green” energy. When the public is willing to suspend disbelief, we get trouble.

The various feedback loops created by all of these elements should result in lower levels of economic growth. Also, corporate returns on equity are likely to be lower and cost of capital higher, meaning price-earnings multiples on stocks might end up structurally lower. Remember, stocks trended strongly upward from 1982 to (roughly) 2007 because of a secular decline in interest rates. We saw interest rates come down from nearly 20% to nearly 0% today. Earnings multiples went from 8 to 20, a roughly 4% annual return solely from multiple expansion. Unfortunately, interest rates are at zero today and a rising interest rate environment is bad for stocks. Look at the market from the early 1940s through the late 1960s – a steady trending market marked by rising P/E multiples and robust corporate earnings growth. From there, the market went nowhere until the early 1980s, paving the way for another strongly upward-trending market. One can argue all they want, but the starting level of valuations plays a major role in long-term stock returns. Judging from this perspective, we clearly lack such tailwinds from where we stand today.

Governments, businesses and consumers do not become aware of all these realities overnight. They take time. It took years for people to go from saving 8-10% of their income (1950s through early 1990s) to 0% (2006), and to double their household debt as a percentage of income. The same goes for businesses and governments (which are run by consumers), who largely didn’t have a “rainy day” contingency plan going into this crisis. I think this is bound to change as we go forward. The result will be a more resilient economy but one that is less optimized should boundless growth and low volatility return.

The market appears fairly valued from both a bottom up and top down standpoint, assuming long-term normal profit margins. That’s not to say it won’t go higher or lower. But from what I’m seeing from a bottom up standpoint, the tremendous bargains we saw in the first quarter of the year are few and far between. Prices at current levels appear to offer only average long-term future return prospects. Yet those willing to dig can find select opportunities available in multiple asset classes.


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