Will Malthus be denied --- yet again?
“I think I may fairly make two postulata. First, That food is necessary to the existence of man. Secondly, That the passion between the sexes is necessary and will remain nearly in its present state. These two laws, ever since we have had any knowledge of mankind, appear to have been fixed laws of our nature, and, as we have not hitherto seen any alteration in them, we have no right to conclude that they will ever cease to be what they now are, without an immediate act of power in that Being who first arranged the system of the universe, and for the advantage of his creatures, still executes, according to fixed laws, all its various operations.
Assuming then my postulata as granted, I say, that the power of population is indefinitely greater than the power in the earth to produce subsistence for man. Population, when unchecked, increases in a geometrical ratio.”
Because population grows at geometric progression while production grows at arithmetic progression; as population outstrips food production, natural disasters, famines, wars shall occur to restore the balance between mankind and nature.
What went right for the world? For one, productivity grew exponentially. On the other part, population growth, while exponential, is showing clear signs of defying the laws of nature - as economies mature, there is increasing evidence of falling fertility which arrests population growth. This together with forced and education based birth control, has somewhat slowed population growth from what it could have been. While population growth is restrained from a peak growth rate, increasing longevity does mean a larger standing army and thus a permanent increase in demand.
On the demand side, while resources are finite, the voracious capacity to consume is not; both manual intervention and a Darwinian response by humanity may help delay the Malthusian correction; in the mean time science shall answer the challenge of increasing productivity to sustain the masses. On the supply side, energy is the fuel which fires the engine of industrial growth. Food is the fuel which fires people; without food there are no people; no demand. On health care, I personally find the Biotech industry utterly fascinating; of course I know nothing about the technical side of things, but I do follow the industry and its pipeline drugs closely from an investor perspective. Humans have such a desire to live in perpetuity, be it through life extensions or reincarnations; an industry which tries to satisfy the human quest for immortality must succeed. That aside, I have always wondered whether an answer to the age old Indian epics lies in Biotech; as in is immortality or reincarnation simply a genetic legacy explained; did Rama truly live for an epoch through advanced medicine or is it simply living through passage of a genetic legacy (with death being the consequence of the maternal line being ultimately extinguished); or hybrid beings (mythological beings like Garuda) a genetic possibility. Ultimately science will provide energy alternatives; science will also provide new technology which shall usher in the next green revolution; so too it shall provide drugs which shall continue to increase longevity.
In terms of global demographics, India’s population shall not plateau until 2050. In China, population growth remains on an uptrend through 2030, at which stage it is expected to plateau. In terms of comparison, the opportunities for growth now are unrivalled, perhaps the closest comparable being the rebuilding of Germany, Japan and much of Europe after World War II. This time round, the growth drivers shall be the building of the under-developed world generally and China and India in particular.
Fundamentally, the era of low inflation is over. China as the factory of the world served as a catalyst to usher in an era of low multi decade inflation levels. While the story of China remains untold, the inflation impact has been played out. This does not mean we now usher in an era of hyper inflation; but it does mean that the world needs to adjust to a higher long term inflation rate of 4% (which is really a simple mean reversion rate in a historic context) compared with targeted rates of 2%. In addition to sound business and demographic fundamentals, this expectation is in itself supportive to energy, commodities, health care and staples (agricultural commodities), which are historic beneficiaries during times of rising inflation. Of the four, energy & commodities carry the highest degree of cyclical risk - my view is that we are approaching a cyclical peak within a strong secular bull. Health care carries new drug development risk coupled with patent expiry & generic competition and for this reason while long term fundamentals remain sound, health care has not displayed the typical defensive characteristics as financial markets run past a cyclical peak; yet health care services remains a source of growth and opportunity. Staples remain my favorite; a traditionally defensive sector, with immense growth potential and a natural tendency to profit during periods of higher inflation. Within Staples, food as the fuel of humanity deserves most attention. While there is a degree of cyclical risk associated with fertilizers (agricultural chemicals such as nitrogen and potassium); alternative areas such as seeds, warehousing, food storage and distribution etc. remain solid; seeds remain my favorite - it is my belief that the marriage of biotechnology & agriculture shall produce the next denier of Malthus.
In terms of growth, much of it stems from emerging markets and this shall continue. On a long term basis, the case for investment in health care, energy and staples (food) is compelling; we are in a secular bull which will run to at least 2030. Where we stand today, is at a pause point; emerging markets have grown at a furious pace. There is a need to pause and build capacity before the next phase of growth commences; thus a period of earnings regression while industry invests in increasing capacity while sustaining present business must be expected.
The 30-40 year cycle had peaks at the years 1929, 1966 and 2000. The next peak may be in the year 2030. It takes a couple decades to begin the global adoption of batery powered vehicles, coal liquifaction and synthetic fuels (for example, methanol made from atmospheric carbon dioxide) to make up for the lack of growth of petroleum. Then we can expect a return of "the roaring twenties" (2020-2030). Technological rescue of the economy also brings a technological singularity when computerized life becomes dominant and the rate of innovation is humanly incomprehensible (touted by the Singularity Institute). Technology stocks will soar as never before and some people will get insanely rich. One or a few companies managed by artificial intelligence (instead of human managers) will aquire or outcompete all other companies. After the technological singularity, people will either be integrated with the grid or they will live like primitives.
Will the ensuing rally come? If it comes, will it be a bear market rally? Or, perhaps a V-shaped turn around? Or, perhaps a long U-shaped recovery? What about an L-shaped recovery? In my view, we can look for a fairly sharp rally. Whether it is a bear market rally, or the start of recovery depends on implementation of the bail out package. In my view, we can expect a U style recovery. To determine where we are in the present cycle, I look at Consumer Confidence, Unemployment, GDP , Industrial Production, Real Interest Rates and the Yield Curve.
Consumer confidence appears to have bottomed recently. Unemployment has been rising the past year. And continues to rise; during August, the rate rose to 6.1%. In terms of where we are in the present cycle, GDP growth has been 2.3%, 3.5% and 4.1% in current $ and -.2%, .9% and 2.8% in chained 2000 dollars. During 2007 and thus far during 2008, annualized inflation levels have remained elevated at over 4%; thus GDP growth adjusted for inflation has been negative 3 quarters running.
Industrial production showed signs of stabilization during June and July, but contracted sharply during August; on an August 07 to August 08 basis it is down 1.5%.
Real interest rates are in negative territory while the yield curve has steepened with short term yields nearing 0%.
In normal circumstance, rising consumer confidence after a significant fall is indicative of an economy in full recession. Industrial output continuing to fall indicates early recession; it will typically bottom out during full recession. Three quarters of GDP contraction is indicative of being in full recession. Real interest rates falling are also indicative of an economy in full recession. A normal yield curve (short term yield less than long term), is indicative of full recession. A steep yield curve such as we see today, is normally indicative of early recovery; I suspect that the steep yield curve today, is more a function of sheer terror in the financial services sector than of the stage of recession. People will accept no yield on a short maturity, not so much in anticipation of better upcoming opportunities; the instinct is capital preservation. On balance, I would conclude that the economy is in full recession. It is likely well past the beginning and early contraction and into the middle late contraction; perhaps poised to enter the late stage of contraction.
The late stage of contraction within an economic cycle will typically last six months. This time around I believe that it could take considerably longer. For an economy to recover, the first sector which must heal is financial services. With the bail-out package now likely to be enacted, the healing process has begun. The length of time spent in the healing process will be influenced by the effectiveness in implementation. In addition the problems are of such historic significance, that despite the bail-out package, I cannot contemplate a quick turn around. During the late contraction stage of the economic cycle one normally looks for out-performance in financial services. It is also a good time to search for cyclical and secular trends which determine the key drivers of the next economic cycle, for these are sectors where significant out-performance can be expected. This time round, there are cyclical secular and cyclical themes pointing to significant out-performance in basic materials, industrials and energy. However, there is a powerful adverse force in the state of the financial services sector. The de-leveraging in financial services, together with large reductions in the size of the derivatives market (estimated at $62 trillion) can meaningfully impact basic material and oil prices; this in my view will create an excellent entry opportunity as the strength in these sectors is strongly demand led. During this cycle, sectors with dependence on leverage (discretionary & financials) can also be expected to under-perform. Finally, growth, which is also dependent on leverage can be expected to be out performed by value. My sector calls are noted below.
Financials (Avoid) are presently priced with a healthy respect for solvency risks in addition to liquidity risks associated with the market. The little information available on the bail-out package indicates that solvency and liquidity risks will recede. Thus on an enterprise value basis, we can expect to see an improvement in financial services. Financials should outperform. Now for the depressing news - this does not mean that the present owners of financials will prosper. There are no free rides - the warrants likely to be granted to the government will lead to significant dilution and it is likely that owners will lose even while the sector enterprise values strengthen. In addition do not expect massive credit expansion, growth opportunities in this sector will be low as it de-leverages to shore up capital adeqacy ratios.
Information Technology (Outperform) are likely to outperform. Valuations are not unreasonable and balance sheets are very healthy; even under-leveraged.
Consumer Discretionary (Avoid) The risks remain elevated. The US consumer remains over-leveraged. Asset price deflation will continue - home inventories in the United States have risen from lows of 4 months supply to near 20 months supply; and this despite asset price deflation of over 15%. As credit markets ease, inventories can be expected to start declining; but in my view not without further considerable asset price deflation. I expect peak to trough declines of over 30% as the housing market unwinds. Significant risks are priced in and so there is potential for out performance, but the sector risks are elevated.
Materials (Neutral) the sector remains one with very strong demand led fundamentals. However, there is a $62 trillion derivatives market out there which need to unwind. There is also a need for further de-leverage of financial institutions to strengthen capital ratios. Further price reduction can be expected; but the extent of reduction should be limited due to (a) expected incremental demand from industrials (b) recent price reductions have already occurred. I would rate this sector a hold with accumulation on further price reduction.
Industrials (Outperform) once more a sector with excellent prospects. The balance sheets of corporate America remain strong and under-leveraged. At the same time growth opportunities abound. Valuations too are not unreasonable.
Energy (Neutral) the sector remains one with very strong demand led fundamentals. However, there is a $62 trillion derivatives market out there which need to unwind. There is also a need for further de-leverage of financial institutions to strengthen capital ratios. Further price reduction can be expected. Because of strong secular trends, I would hold and add to positions on significant price declines.
Health-care/Staples/Utilities (Outperform) I believe de-leveraging will shift money flows to defensive and sectors. Income investors are likely to turn to dividend yield too. Of the three, I like health-care best, both for its yield and prevailing valuations.
Back in October 2007 the markets started unwinding. With the benefit of hindsight we now know that it was the beginning of a bear market. The stock market is perhaps the most efficient forward looking indicator, and in October 2007, it told us that a recession could be expected to start during the next six months. It did not lie, and here we are.
Now a typical recession lasts ten months. And the market as a forward looking mechanism bottoms approximately six months before the recession ends. So we should expect the recession started about April 2008, it should end about January 2009 and the market should have bottomed right about July 2008; it did not!
At this point in time the market is looking at historic information and reacting to news that we are relatively deep in recession. So is it pricing in bad news that is potentially already priced in?
Since the market is no fool; what it tells us we must hear. It is telling us that the chances of a longer recession compared with historic norms is more than likely than not. A lot of indicators suggestive of a bottom are now in place. We have seen very high volume selling on down days which is indicative of capitulation. We have seen VIX levels well above historic norms associated with market bottoms. This is a time when de-leveraging and redemption are pressing smart money to behave dumb. Yet the market continues to defy all odds and continue its slide.
What we have not seen is the markets response to the third quarter’s earnings. Its early days, but to date the market response have not been positive. So far, results have been in-line to ahead of expectations with outlook indicative of weakness, though perhaps less than expected. IBM, INTC, JNJ, C, MER and more were all ahead of estimates and while cautious on outlook, where indicated, it was better than expectations. The initial instinctive response has been to sell the news. We are not yet ready to climb the wall of worry. But we need to wait a while longer; far more information will flow through the markets over the coming weeks and it is not the information that is important, it is the markets response to the information which is critical.
As of now, the earliest exit from a recession would be six months from now - April, 2009. I expect an exit later during Q2 2009, mainly because what is needed to initiate a recovery has started (the rescue package of financial services), but more is needed. No, I do not expect a hugely enhanced rescue package; I would like to see energy capitulate. This is important, because it is good for the consumer, perhaps more importantly, it is critical to get industrials fired up for growth.
Oil prices have finally fallen below $70. Oil should retreat to $60 which is my view of an equilibrium price level (marginal cost of production). Since energy stocks have not yet stabilized, I expect oil prices to continue to fall and perhaps even undershoot to the downside. This based on my views that stock prices tend to fall ahead of price declines in the underlying commodity. Absent leadership from financials and technology which typically outperform towards the end of a recession we could see the market grind further down as energy meets its date with equilibrium and capitulates.
Analysts have now started deep cuts to earnings estimates for energy and basic materials. My view is that once these cuts are reflected in 2009 expectations, the SP500 forward earnings will be realistic. I believe we are largely there for all sectors except for energy. This is occurring now and I do not believe it is long to when the market can move on.
How vigorous can the recovery be? Will it be a meek recovery because the consumer has been deeply wounded and financials have been decapitated? Industrials are the one sector which can lead growth; and grow it will particularly with basic material and energy prices at economically rational levels. The vigor of growth in industrials is very dependent on capital availability. So yes, it could be meek. Yet, I expect a fairly vigorous recovery. Corporate balance sheets are surprisingly strong and they are well able to invest with lower levels of leverage. In addition, all the risk averse cash which is sitting on the sidelines will rapidly return once the perceived risks reduce. Finally, emerging markets remain a strong catalyst to long term global growth.
Coming back to why now is important; today markets are well valued and probably close to a bottom. If they fall further, that is fine, the recession might continue a quarter or two beyond expectations - all it means is that you have book losses which will be replaced by profits once the next expansion starts. Does a few months to a year matter in the context of a lifetime of investing? Preserving capital to capture 100% of the up move is something most believe they can do and what almost no-one can do.
I have been told a low is always re-tested. This is true, if we are at a bottom now, it is virtually certain that we will have a rally, followed by a re-test of the lows over the coming six months. Why then am I keen to commit now?
When a rally occurs, the market will move up with vigor; the advance is broad based. When profit taking occurs and drives the market back down, the quality small caps and mid caps and the large caps stay at higher relative values; it is the lower quality issues which get beaten up disproportionately. By buying at the re-test, you compromise quality for price. For example if you own BHI, you might want to switch to SLB to improve portfolio quality and lower portfolio risk; if you own neither, you might want to buy SLB now instead of being forced into buying BHI on valuation at a re-test. The other thing to keep in mind is that during the rally, dividend payers will outperform. When the lows are re-tested, these stocks rarely re-test their lows. Take for example BP; the company has capacity and a long displayed ability to generate large free cash flows, it can deliver 4m bpd through 2010 from existing reserves, it has pretty exciting E&P prospects, it is a leader in alternative energy, it has a re-structure in place to improve HSE and cut costs, it has a good share buy-back program, it increased or maintained its dividend every year as far back as I have looked (Feb 1999) and today it delivers a yield of 8%. When it re-tests its low, you will not get this yield. Today, you can lock in a return equaling the long term market return and look upon any capital gain as a bonus and as the dividends rise in future years, your yield relative to the price you paid continues to go upwards. I am not yet constructive on energy, but BP is certainly a stock I have my eye on.
To conclude, at this point in time companies with superior intellectual capital are going at fire sale prices. So are companies with an ability to consistently generate large free cash flows. So are companies with excellent management teams. These qualities provide a wide safety net and an entry barrier against competition. Buy them; go back to or above your normal asset allocation to equity, re-balance your sector allocations and buy the industry leaders.
The market moves through a cycle. During each phase there are different sectors which outperform and others which underperform. While the intensity and duration of a phase cannot be predicted, economic indicators give a fairly clear picture of where we are in the cycle. This information can be compared to historic data to estimate the intensity and duration of the phase; but that is not enough. Each cycle is unique, you need to judge what needs to be done to heal an economy in contraction and you have to judge whether what is being done addresses the need of the moment. You also have to open your eyes to the world around you to determine what will lead the next expansion & then judge whether the measures taken in the late contraction are adequate to allow the positive forces to take over to lead the next expansion. This is more art than science and since no one person can absorb the full extent of information and respond to it, one way to seek direction is to look at what the market is doing today for "The Market" is the world’s most effective forward looking economic indicator. It is a repository of the world’s financial wisdom. Its direction is influenced collectively by the population of the whole world; regardless of rich or poor. Every $ whether spent in consumption, saved, invested, paid in taxes or transacted in foreign trade results in commerce, the conduct of which drives markets. The market is forward looking. What goes into the market’s mind is historic economic data and forward looking economic data. This information is processed and then a pinch of mass psychology is added to it - the outcome is a market reaction to events that are most likely to occur six months in the future.
So really, the market responds to both economic data and the psychology of the herd. Today, the market is in outright panic. Credit markets have ceased up, no one is lending. The fear is that the extent of liabilities which might crystallize, are greater than the capitalization of the global banks or financial institutions. The governments of the world have responded with massive rescue packages which make additional capital available. Still the fear of insolvency grips the financial services community and they will not lend. This is creating a self perpetuating & fulfilling prophecy; until lending starts, the housing market will continue to be flooded with inventory and absent buyers, asset prices will continue to fall. As the asset prices fall, crystallization of liabilities escalates which contracts capital and makes available even less for lending. It is not just the housing market, the continual declines in all asset prices needs to be arrested before the economy can recover. And the only thing which can arrest the deflation monster is increased lending.
The rescue should come in three phases.
A) The first is bringing in fresh capital to pay for real economic errors; the ability to stay well capitalized after absorbing the cost of historic errors is important. This has been done; in all likelihood the trillions of $’s made available by global governments shall be more than adequate.
B) The next step should limit the damage through legislation to ensure that a real economic loss occurs only once; legislation to ensure that carpet baggers do not profit is important. For example, if I default on a mortgage on my house now valued at $60, which was financed and funded 100% through debt, when the house was valued at $100; the real economic loss is $40. Now suppose the bank I borrowed from financed it’s lending through a sale of $60 worth of low coupon paper collateralized by my house to a pension fund, and retained $40 worth of paper with a high coupon; the real economic loss is still $40 and the buyer of the collateralized paper will suffer no loss. The lender holding the high coupon unsecured paper who thought it was very clever because the total mortgage was asset backed should rightly suffer the entire economic loss. Of course the fresh capital infusion from global governments will maintain the bank’s capital to pay for its past errors. If the pension fund wrote off its $60 paper because the bank could not pay (for any reason including insolvency), it would be incorrect. Even worse would be a situation where the pension fund wrote off $60 as irrecoverable, while the bank recognized a gain of $20 because it did eventually recover $60 on the mortgage; one reason why no carpet bagger laws are important. What would be worst is if the pension fund wrote of the $60 as irrecoverable and the bank wrote off $40; the total loss recognized at $100 would in this situation be worse than the total real economic loss. Tracing the bearer of the true economic loss to ensure a loss is only once recognized, will not be an easy task since the derivatives market is complex and much misunderstood; it is likely that legislation enacted will result in gainful employment to an army of accountants.
Another area that needs a close eye is the credit default swap (CDS) market for this could be a carpet baggers dream. Suppose the clever bank with high coupon paper retained went to another bank and covered its exposure to default through a CDS, the real economic loss would shift to the insuring bank which received a premium for the risks covered. This is fair. Suppose clever bank also went ahead and covered the $60 so that a lower interest payable to the pension fund could be justified because of the twice backed paper. Even in this situation the total economic loss remains $40 and it is borne by the insurer. If the insurer goes bankrupt, and is unable to meet its commitments, we go back to square one – the clever bank suffers the entire real economic loss. In the pandemonium which follows the bankruptcy, there is a risk that a total economic loss in excess of the real economic loss ends up being recognized. Once again, regulations which clearly trace the real economic loss to the bearer of the risk are important.
Now consider this, the size of the CDS market is way larger than the underlying real economic activity. Why? And it is here that the carpet bagger risk is at its highest. If I can purchase a CDS on a possible credit default by my neighbor, if my neighbor defaults, I stand to gain. Ultimately, I have absolutely no insurable interest and this contract should never have been permitted; and since it was it should be declared null and void. Covering a CDS without an insurable interest must have happened, otherwise how could the market exceed the value of the underlying economic activity?
The question to which I cannot find an answer is whether CDS's are issued to a party with no insurable interest; for example could a person get cover for a Lehman Default event without owning the underlying Lehman paper. If the answer is yes, the question of whether the so called insurance contract is legally binding arises because of the absence of an insurable interest. If only insurable interests are covered by CDS, I would argue that the risks, which include default on the payment of interest, insolvency of the issuer and pre-payment of the loan together with interest are the only real economic risks. The CDS is essentially an instrument to shift risk from the owner of paper to an insurer; the intent being to separate risk from the instrument. The way I see it is that a CDS did not really separate risk from the instrument; it failed to achieve its purpose. If an insurer goes bankrupt for failing to pay its obligation; it will result in a distress sale of the insurer’s assets to pay out the obligation to the fullest extent possible. The buyer of the distressed paper will earn future profits being the difference between the actual recovery from the debtor and the price paid for the paper. In the mean time because the insurer defaulted, another insurer who insured the paper of the first insurer will find itself in the same position as the first insurer; again the second insurers assets will be sold in distress and the buyer will profit in the future. Ultimately, what will occur is that the weak hands will go insolvent while strong hands will gain assets bought at below fair value during a distress sale; the total impact will never be more than that part of the debt which actually went bad. So, instead of separating risk from the security, the CDS actually ended up creating risk for the economy. The real questions to answer are (1) where did the money go - that is where the bubbles will have formed and (2) how much of it will likely go bad.
I have no doubt that the availability of a CDS will have encouraged lenders because they thought the risk was covered. It is true that this would have led to an over-leveraged economy (which is no secret). But the real economic risks associated with credit default are the same.
C) The next step must follow; and it must prevent recurrence; it will likely be legislative. But before crying for better regulation and the blood of bankers, do away with stupid legislative acts such as the Community Reinvestment Act, which incentivize bad lending. Having FRE and FNM as obligated to buy, guarantee and re-sell low quality mortgages is bad; it encouraged bad lending practices. Do you really think the extent of sub-prime would have arisen if there had been no buyer for the paper?
While the seriousness of the situation cannot be denied, I believe that the market is presently in a wild panic (and possibly over-reacting) because of the lack of clarity and available quantification; default risk is being disregarded; the market is fully focused only on the price risk caused by the absence of liquidity and a sale in distress; the true economic loss which would arise on default is being ignored. I recognize the fact that over-leverage was widely utilized particularly because of the ease with which default risks could be covered using the now infamous CDS. It is therefore likely that default will be higher than in the past. The gross value of the CDS market is $55 trillion (down from $62 trillion). The actual exposure is normally measured by the net credit equivalent; i.e. the gross value less trades amongst counterparties which cancel out. The net credit risk is normally one fiftieth of the gross exposure; i.e. potentially $1.1 trillion. Now not all of this will go bad. Assume a default rate of 10% (which is higher than the maximum default rate of 8.74% during the Asia crisis) and assume a 25% recovery (below 26% in Asia crisis and 40% in the history of default); we have a potential net economic loss of $82 billion; not nice but possibly manageable. The problem is that the exposure starts rising from $1.1 trillion towards its gross value if there are insolvent counterparties involved in the trade. It is for this reason that I am of the firm view that the CDS market must be legally unwound so that only the real economic risk protected remains and that transaction should be fully reflected solely between a person with an insurable interest and the insurer; this I call the carpet bagger unwind. The US package makes $750 billion available in addition to $1.5T in guarantees of senior notes; in Britain GBP 500 billion is being made available; in EU Euro 1.16 Trillion has been made available; in total the amount now available exceeds a fairly conservative estimate of the losses which will arise.
Where did that money go? Where are the most apparent bubble type formations - are they in real estate, commodities, gold, stock markets? As leverage unwinds, which bubbles will deflate?
I see the bubble in global real estate, not US alone, US, Europe, India, China all have very substantial over-valuation in real estate prices. At this point in time, even after substantial price decline, the pricing of real estate is at a level such that it is unaffordable to end users at long term real interest rates. In my view, US prices could decline as much as 40% from peak to trough; with far higher declines in some of the areas which have inflated beyond reason. In India, I would not be surprised to see peak to trough values decline by as much as 60% to 70%; here the problem is even more significant because end user affordability is just not there; inventory is building up in investor and developer hands – several developers have not even been able to generate positive operating cash flows during the bull run. I also feel commodity valuations reached bubble like values; but these have now pulled back to fundamentally justifiable levels where demand and supply (marginal costs and marginal revenues) are in balance. Oil still needs to unwind further; my view is $60/bbl (marginal cost of ultra deepwater oil) is acceptable, however, at values up to $100 I would not consider an oil bubble because at that value oil is priced at no more than long term inflation adjusted values. Gold is an area I feel difficult to look at; personally, speaking for myself, it would matter not if there were no gold in the world, so I value it at zero; anything over that is a bubble! For the people who love the yellow metal, sorry, this is just not an area I follow.
That brings us to the markets. Like I said at the start of this post; markets are a forward looking indicator influenced by both psychology and economic data. Nevertheless, it must have a starting point; the fair value. At an Index Level of 940, over the last 20 years the SP500 has delivered growth of 5.39% per annum; earnings growth during the same period has been 6%. For the SP500 to be at a reasonable starting point; it would need to be at 1055; from here it should deliver future growth broadly in line with earnings growth. Take the data over 15 years and SP500 has delivered growth of 4.6% per annum; earnings growth during the same period has been 7.3%. For the SP500 to be at a reasonable starting point; it would need to be at 1357; from here it should deliver future growth broadly in line with earnings growth. The price earnings ratio is a simple method which can be used to value markets; it reflects the valuation of economic expectations. To assess the impact of the psychology of the markets, I use a slightly modified PE valuation model (you can see it here). During the beginning of an economic contraction, several people give a lot of importance to dividend yield while others are still satisfied with operating earnings; during this time I look at valuations through the historic multiple based on an absolute number – the sum of operating earnings and dividends. As we progress to the late contraction of an economic cycle, people panic and all they care about is dividends, the market psychology at this stage is better driven by observing market valuations by looking at historic dividend multiples. As we progress to the early stage of economic expansion, the psychology of people shifts in favor of operating earnings once again and so the best determination of valuation is obtained through the traditional multiple of operating earnings. As we progress to the middle and late economic expansion, caution is thrown to the wind, dividends take a back seat and growth is all that matters – in this market valuations are best evaluated by reference to a multiple based on operating earnings less dividends. As we enter the late economic contraction, a time of great economic stress, my fair value for the SP500 is 1247; this is simply the average dividend multiple over the past twenty years multiplied by average annual cash dividends paid out during the last five years. Yet I would point out that 740 is a realistic downside target; during the last 20 years the lowest dividend multiple the markets ever traded at was during 1990, at this time the market traded at 31.1X prior year cash dividends. That multiple applied to 2007 dividends gives a value of 739. Since the market is exhibiting symptoms of outright panic, it will not be surprising if the market achieves the bottom fishing target. A 739 price target indicates an expectation of an annualized negative 10% earnings growth over the coming five years, assuming a starting fair value of 1250 for historic wealth created. I do not believe this is a scenario which can realistically unfold. In years gone past, earnings growth expectations being set at long term US GDP plus inflation was not unreasonable. This basis of estimation needs to change. As the US corporate undertakings lead the charge of globalization, I would set earnings expectations at GLOBAL long term inflation plus GLOBAL GDP growth. Over the next 10 years global GDP growth should run at between 4% and 5%; add to that global inflation of 3% to 4% and we have a earnings growth target of 7% to 9%. For an investor looking for a 12% annual return, using 8% as the earnings growth rate for the coming 5 years and a terminal earnings growth rate of 5% thereafter, the applicable multiple is 17. Applying this multiple to the average earnings over the past five years gives an index value of 1258; buying at this level should set a person up for a 12% annual return over 5 years; buying below this price target is jam.