Was there a bubble in the equity markets?
In August 2000, the SP500 traded at 1,485. At that time CPI stood at 172.80; today it stands at 215.69 and I expect it to rise to 223 by end 2009. Adjusting the August 2000 value to reflect expected CPI levels brings the real SP500 to a level of to 1,918. At this time the cycle multiple (Price divided by the average 12 month EPS over 67 months) stood at 35. Since 1871, this multiple has been at a median level of 15.2; looking at the post war years (since 1946), this multiple has been at a median level of 16.4. During the post war reconstruction period between 1946 and 1978, the multiple was at a median level of 15.5. During modern times (1978-2009) the Chinese expansion has caused the multiple to rise to median levels of 19.3. During the Greenspan era (August 1987 to March 2006), the median cycle multiple stood at 24; even extending the Greenspan era to include the aftermath (August 1987 to present), the median cycle multiple stood at 24.
By 2003 Feb, the nominal index had fallen to 837, which equates to a real value of 1,020 today. At this time the median cycle multiple was still elevated at 20. In October 2007, the nominal index stood at 1540 which relates to a SP500 level of 1644 at expected CPI levels; the median cycle multiple was at 25. This level is a good 14% below the level achieved during August 2000. In March 2009, the SP500 was at 757, which equates to 794 in real terms; the median cycle multiple was at 11.8; this is 22% below the prior low in 2003 February.
Now the SP500 is over 1,000; the median cycle multiple is at 15.4.
Two things are clear; the first is that the SP500 has been grossly over-valued for several years; even at cyclical bear bottoms the median cycle multiple never went below 20. The second is that the market made a lower high during October 2007 and a lower low during March 2009 on a cycle basis; the SP500 has been in the firm grip of a multi cycle bear since its peak in 2000.
The correction has eliminated over-valuation in the markets so far. It is true that the markets have traded below median cycle multiples for about 9 months; but they have not traded at cycle median multiples levels comparable with prior bear markets; nor have they traded at cycle multiples below median levels for long enough. In my view the final phase of the bear market has yet to come. This will be a phase where the markets trade at below median cycle multiples for an extended period of time; it is a time during which nominal market returns might be "normal" and positive, however real returns might be negative.
Since the early 1990's we have lived in an illusionary world; a world where the perceived value of assets has been well over the intrinsic value of assets. It is now likely that we will start living in a world where the perceived value of an asset will remain below the intrinsic value of the asset. For a value investor these are happy times, for it provides an opportunity to invest at or below intrinsic value.
There are many similarities with the 1930's; but there is a significant difference. In the 1930's the extent of bank failures was calamitous; when banks collapsed, people lost their savings; without access to past savings, recovery was out of the question – to grow capital availability is a must. Unemployment together with loss of savings pushed the economy into a deadly spiral of deflation. Between September 1929 and June 1932, the index lost 85% (81% in real terms) of its value in nominal terms. This time round, the "too big to fail" rationale has protected consumer savings and investments – some would scoff at my comment on investments being "saved"; to them I would say they never worth what they were perceived to be – now they are; intrinsic wealth creation is quite distinct from illusionary, or shall I say delusionary wealth. In addition, the threat of deflation has been countered with very aggressive monetary policy; both in terms of unheard of short term interest rates and in terms of liquidity being infused into markets. This will without doubt have a price; higher future inflation is one likely outcome, slower growth as nations de-leverage is another; higher interest rates resulting from rising risk premiums is yet another; lower consumption caused by higher savings is also likely; and yes, higher taxes will likely be required. So I have no doubt that the next seven to eight years will be subdued; characterized by subdued growth and chronic under valuation.
In some ways the future could be very similar to the post 1974 period. During the sixteen months ended March 1975 the economy went through a contraction. In March 1975, the median cycle multiple stood at 10.4. Median cycle multiples stayed at between 10 and 12 through to July 1977, by which time the nominal SP500 hit 100. After that the median cycle multiple remained below 10 until December 1984, when the nominal SP500 stood at 165. The 1974 bear market bottomed with the SP500 at 67 during December 1975; at that time the SP500 in 2009 CPI levels was 288; it traded at 8.5 times median cycle multiples. In July 1982, the SP500 stood at 109; at that time the SP500 in 2009 CPI levels was 250; it traded at 6.5 times median cycle multiples. In nominal terms, the market had returned well, in real terms it had lost! But this period was amongst the greatest buying opportunities; it was an extended period of time during which stocks could be purchased at a significant discount to intrinsic value. Of course 1974 is different from now; in 1974, the forward outlook was murky – the post war reconstruction was visibly near completion with no visible catalysts for future growth drivers. The China expansion was only initiated in 1978 through policy change; a few years for confidence to develop were more or less a necessity. Where we are today is different; China has clearly grown in leaps and bounds and while it is likely that growth will slow because the economy has now reached a significant size, there is no doubt that there is much additional developmental and urbanization work to be done. At the same time, Brazil, India and Eastern Europe can be expected to provide incremental growth catalysts. This is why I believe that valuations in the 2007-2009 bear did not hit the extreme levels of the 1974 bear. It is also why I feel that at 666 we have seen a generational low for the nominal SP500; I expect the nominal SP500 to peak at 1400 during the cyclical expansion and to trough at 900 during the next cyclical contraction; I hasten to add that, at 900 I expect the median cycle multiple to be below 10. The buying opportunity will create wealth once multiples expand back to their long term median values of 15 after some years of trade below.
For what it is worth, in my view, index investing is not a great idea for the next several years. A strategy which will focus on high quality US stocks with exposure to global emerging markets is the one most likely to pay off. Companies operating in sectors which focus on needs in emerging markets are also likely to pay off. Investing in emerging markets will also pay off – but the risks are higher – political, fiscal, governance, quality and availability of financial information, economic risks are high in these jurisdictions. In addition, you will almost always find a better valued international company compared with a company traded in an emerging market; the money flow into emerging markets creates value bubbles and equally sharp value implosions. To explain what I mean better, would you rather buy Sesa Goa (Iron Ore) or VALE; would you rather buy Tata Steel (Steel) or ArcelorMittal; would you rather buy Hindalco (Aluminum) or Rio Tinto; would you rather buy Sterlite (Copper) or Anglo American? My instinct leads me to buy India in the depths of recessions, because the relative value versus internationals is better; but once hints of an expansion arrive, the value proposition shifts strongly in favor of the internationals. All in all, taking quality and value into consideration, my preference is to invest in the needs of emerging markets, as opposed to in companies of emerging markets. Having said this, there are always exceptions, some of the Dow Global and some of the Dow Emerging Market Titans and some of the Dow India Titans are quality companies, which become great long term buys during global recessions.
Why did the market's collapse? Was it the bursting of the property bubble together with the explosion of the debt bubble?
I believe that valuations of most asset classes were absurd for a long, long time. The bursting of the property bubble is an event which brought into focus the dangerous levels of leverage in the economy. I have titles this post "When Fools Rule", because the debacle we have seen, was caused because of low risk premiums demanded by investors. Since 1871, the cycle earnings yield less the interest rate net of inflation divided by the interest rate net of inflation has run at a median level of 144%; that means that investors have been willing to accept equity risk when cycle earnings yield was 1.44 times the interest rate net of inflation; I call this the equity risk premium. Since 1946, the median equity risk premium has been 130%. Between 1946 and 1978, the post war reconstruction was conducted with higher risk premiums which ran at a median of 217%. Since 1978, these risk premiums declined to 40%; this means that people were willing to accept an earnings yield of an amount less than interest net of inflation to invest. During the Greenspan era the risk premium fell to 16%; today the risk premium is higher at 186%.
Most sectors of the economy are productive; they all produce goods or services which are of use to the real economy. The financial services sector is a dream-maker; they have the ability to provide capital, which make dreams come true. Institutional investors essentially put up some equity and then borrow cheap at the short end of the yield curve and lend higher at the long end of the yield curve. The only thing they really need to get correct is to ensure that borrowers have the capacity to repay the debt and interest. It is amazing that they lacked the intellect to handle this simple task. This lack of intellect is why I title this post "When Fools Ruled".
Why did these bubbles inflate? Was it loose monetary policy? Was it weak regulation? Was it excessive risk taking (risk premium, long era of prosperity and confidence, derivatives, executive compensation)?
During Greenspan's years the median long (GS10) rates ran at a median of 6.1% while inflation ran at a median rate of 2.69%; the net interest rate was 3.58%. Since 1871 the median net interest rate ran at 2.69% and at 2.64% since 1944. So overall monetary policy was tight!
A possible failing of monetary policy was that interest rates were not pushed up once inflation raised its ugly head and ran at over the typical 2% benchmark rate starting April 2004. In my view, even if rates had been increased, it would not have had a significant impact. The problem was with excessive risk taking; excessive executive compensation, the yen carry trade, perceived protection from derivatives and similar risk management tools, over-confidence caused by an extended period of asset over-valuation, all encouraged excessive risk taking. The age of irrational exuberance was well known, but the fed did not have the power to regulate; this was a grave failing. The only tool available was psychological; Mr. Greenspan made comments on irrational exuberance, possibly hoping to rein in animal spirits.
Deregulation in years gone past meant that the fed did not have powers to limit or encourage lending on a sector specific basis. Nor did they have powers to demand higher capital adequacy as excessive risk taking gained in prominence; in fact they could have even had power to reduce capital adequacy requirements during periods when risk taking was subdued. In my view, institutional incompetence is so apparent, that a high degree of regulation is now required; this should include flexible capital adequacy powers, powers to have multiple capital adequacy requirements for different lending risk classes, and powers to have multiple capital adequacy requirements for different sectors. Regulation should also include control over OTC and derivative markets, since these have been central to the crisis. It should also include non banking financial institutions such as hedge funds and private equity houses; these giants are a big gap in the system.
I doubt executive compensation should be regulated; in a sense that is a job which must be undertaken by shareholders. My personal belief is that the sector remains vastly over-compensated, both in the context of their economic function and skill. And I feel regulation which facilitates shareholders ability to influence compensation is beneficial. I do not believe lower compensation will lead to loss of talent required by the sector; you do not need a rocket scientist, a doctor, an engineer or other professional to bring a willing borrower and lender together. It is not difficult to grasp the concept of borrowing short and cheap and lending high and long, while managing credit risk along the way either. A cautious and conservative banker might actually provide a superior result to the overpaid executives and managements in place today.
Why is controlling the damage so difficult? Was it because financial institutions were "too big to fail"?
I think yes. But I do not think making financial institutions "too small to matter" is the answer. A global financial institution is a must to support global business; size does matter. What I believe must change is regulation and the personality and character of financial institutions. It's not all bad, there are gems including amongst others Warren Buffet, Jeremy Grantham and Van R. Hoisington; but there is also a need to reach out to the banker of yesterday – that conservative and cautious blue suit is needed for stability!
Disclosure: Long every stock mentioned in this post, plus I have long positions in several Indian companies and funds.
