Dawn of a New Decade: Fits and Starts
Apocalypse (Not) Now
One year ago the world economy teetered on the edge of the abyss as the financial system upon which it was built appeared headed for systemic collapse. Instead, the system was (at least for the time being) saved by the hundreds of billions of taxpayer dollars committed to the preservation of its largest, most systemically critical (and most politically influential) institutions. As the financial system stabilized businesses cautiously came back to life, conditions in the housing market stabilized and even the eviscerated American consumer continued to buy enough stuff to keep retail sales from falling through the floor. However whether this relative stability will be able to create jobs in sufficient numbers to bring unemployment down from its highest level in 30 years remains to be seen. The economy is precarious. So far the evidence from the steady stream of monthly data points can best be described as “fits and starts” – two steps forward, one (or one and a half) steps back. “Fits and starts” was good enough for world investment markets in 2009 as stocks, bonds and pretty much everything else came roaring back from the low points hit last March. Investors interpreted the lack of truly terrible news as the year wore on as a sign that those 10-15 year lows in March represented a substantial overselling and that we would not be nearing those waters again anytime soon, if ever.
Equities in 2010: Sustainable?
So much for 2009. “Dow 6,000” is no longer a staple of cocktail party conversations. The question now is whether “fits and starts” is a sustainable state of affairs for continued market success in 2010. Stock prices, after all, do not simply move according to their own whims – they are an attempt to reflect the true value of enterprises. That valiant quest for “true value” often misses the mark, but sooner or later the minute details of what generates potential cash flows, upon which that perceived “true” value rests, will necessarily factor into the equation. Enter the Price-Earnings (P/E) ratio, perhaps the most widely-used valuation metric for common stock. It’s easy to focus on the “P” – that number flashes before us every day on CNBC (often without much useful information as to what it means). But the fate of the “P” side of the equation depends to a great extent on what happens with the “E”. In 2010 that presents an interesting dilemma about what to make of the market’s prospects for growth.
At present valuation levels the S&P 500’s 12-month trailing P/E is up in the mid-high 40s while the 12-month forward estimate based on analysts’ consensus earnings forecasts clocks in at a more reasonable-seeming 14.8x (note: when we say that a P/E is “14.8x” we mean that the current price per share of the company is 14.8 times the current earnings per share of the company). What does this mean? Bear in mind that there are two valid ways to look at P/E ratios. The 12-month trailing number tells you how today’s stock prices relate to corporate earnings generated over the past 12 months. There’s nothing mysterious about this – those earnings are already historical facts, so the trailing P/E number is grounded in knowable reality. Not so the 12-month forward P/E, which analysts will tell you is the really important number, because it reflects how present stock prices look compared to future earnings (and presumably we are more concerned about what is to come than what has already been).
The problem, of course, is that nobody actually knows what those future earnings will be. So here come the Wall Street analysts with their complex discounted cash flow models to show us what they think earnings will be. Actually, they tell financial data services providers like I/B/E/S, and the estimates are thus compiled and presented to the investing public as a “consensus”. The more accurate the analyst consensus estimates, the more precisely the 12-month forward P/E informs us whether stocks at current prices are too hot, too cold or just right, like Goldilocks’ porridge. The caveat is that securities analysts are human like the rest of us, and their estimates are subject to human weaknesses (like trimming their own figures to follow the herd and thus not risk sticking out like a sore thumb if they are wrong). Analyst estimates tend to be particularly vulnerable to missing the mark at sharp market turning points (for example they tended to be overly optimistic just ahead of the 2008 market crash and overly pessimistic heading into the post-March ’09 rally).
So what can we make of current valuation levels? Regarding the 12-month trailing number (47.0x as of 1/27/10) we have a pretty straightforward answer. The 12 trailing months from January 2010 extend back to the first quarter of 2009, when corporate earnings were dismal and consumer confidence was at its worst levels. That in significant part explains the bigness of 47.0 – a high numerator and small denominator (the 12-months trailing P/E was actually much, much higher than that one or two quarters ago). What turns that big number into a small (and economically sustainable) number like 14.8x is “E inflation”, i.e. the growth in the denominator of the equation. But to live up to the expectations embodied in that 14.8x number, corporate earnings will need to be growing at brisk, low-double digit rates over the rest of the year. So the message here is that conventional analyst wisdom today has corporate earnings producing a nice long string of pleasant surprises (or “exceeding expectations” in their own vernacular) for the rest of the year.
That view seems to us to be at odds with the most likely (in our opinion) story for the economy this year: that there will be some growth in the U.S. but of a decidedly modest nature, with persistently high unemployment and under-employment, a still-high burden of household debt, languishing income and lackluster housing prices keeping a lid on the amount of growth the private sector can attain. In 2009 we saw that the worst-case scenario did not play out, and while that was certainly grounds for a collective sigh of relief we believe there is still a structural realignment of the global economy that is only in its early stages today. The roller-coaster cycles of boom and bust, asset bubble and market crash, are unsustainable as an ongoing economic model. What is to come in their place is still not clear.
Those Wild and Crazy Fixed Income Markets
Stock markets are of course not the only object of interest and scrutiny. Much of the wild action over the past two years has been in that traditional safe haven known as the bond market. In 2008 U.S. Treasury securities enjoyed double-digit returns, while in 2009 some classes of non-investment grade U.S. corporate bonds returned their investors upwards of 80% - far more than the S&P 500 or other stock indexes, and with equity-like volatility levels to boot. There’s no such thing as a free lunch, though, and today the bond market is fraught with potentially unappealing outcomes. At the short end of the curve there is literally no money to be made. The Federal Reserve brought interest rates down to zero percent in trying to bring the economy back to life. Through its open market operations the Fed is able to exert a direct influence on short-term rates, and as long as the 0% doctrine remains in effect putting money into short-term fixed income instruments will differ little from shoving wads of cash under the mattress. On the other hand, moving out the duration curve to obtain more attractive yields has its own set of risks. The main risk is that if the economy does start to kick into high gear faster or stronger than appears likely, the specter of price inflation will likely prompt the Fed to begin raising rates again. The relationship between interest rates and bond prices is mathematical: when rates go up bond prices go down. It really is as simple as that. Moreover (and again with mathematical certainty), when bond prices decline, the rate of decline is greater for bonds with longer duration. So the price of obtaining yield benefits at the longer end of the maturity curve may be steep indeed.
Our 2010 View in Summation
In a “fits and starts” economy the most perilous trap into which one can fall is to see a couple isolated data points, extrapolate those into a sustained trend and go overweight in a concentration of higher-risk asset classes thought to be the most likely beneficiaries of that imagined trend. Yes – the decade-long performance of the U.S. stock market over the past ten years was significantly below average and the traditional methods of probability and statistics would bolster the case for better results in the years to come. But there is no guarantee that 2010 will be the year that happens, or even that this decade will witness a full-on reversion to the mean. Japan’s Nikkei 225 stock index reached its all-time high of just over 39,000 on the last day of 1989. Twenty years later – twenty years! – it was languishing just above 10,000, or less than a third of its all-time high even before adjusting for inflation. These are things we don’t expect, but sometimes they happen. Do we think the S&P 500 is another Nikkei 225 in the making?
No, we don’t. That is not what we consider a high-probability outcome. But is it a possible, albeit very low probability outcome? Absolutely – and our investment approach has to balance the discipline of optimizing portfolios for expected high-probability outcomes with the presence of mind to recognize that low-probability events do happen, and when they do it is necessary to be agile and nimble. Discipline and agility are our watchwords for 2010. We can’t say whether this is going to be a good year or a bad year, but we feel quite certain that it is going to be an interesting one.