Here I go again! Gosh it was only six years ago that
I cemented my place in stock market history by
predicting that the Dow would fall from 8,500 to 5,000,
instead of going up to 14,000 where it peaked in October
of 2007. Well, I could use the standard set of excuses:
1) No one else saw it coming, 2) I was misinterpreted,
and taken out of context, 3) I was tired, overworked,
and had family problems, or 4) I had just come out of
rehab. But these days what really works is a full
confession. I mean, like, uh, it was totally my fault
and I take full responsibility. The fact is I was only
off by 9,000 points. That's my story, and I'm stickin'
to it.
Well, fools rush in. This time though I'm definitely
older and maybe a little bit wiser. No magic number, nor
a specific target date from the Swami of the Dow. This
one will be more conceptual, but still present a "take"
that you can criticize or damn with faint praise. And
no, despite the title, it doesn't imply that the stock
market is headed to 5,000 and that I was always right or
just a little bit early. It only suggests that I'm
readdressing the critical topic of equity valuation –
that mysterious fragile flower where price is part
perception, part valuation, and part hope or lack
thereof. Press on, Swami.
Let me first announce a fundamental premise with
which I think all rational investors would agree: I
believe in stocks for the long run – but only if
purchased at the right price. That statement packs a
real punch. It says that capitalism is and will remain a
going concern, that risk-taking – over the long run –
will be rewarded, but only from a starting price that
correctly anticipates the economy's growth and its share
of after-tax corporate profits within it. Acknowledging
the above, let's look at a few basic standards of
valuation that historically have stood the test of time,
to see if at least the price is right.
One of them is what is known as the "Q" ratio, or the
value of the stock market relative to the replacement
cost of net assets. The basic logic behind "Q" is that
capitalism works. If the "Q" is above 1.0, then the
market is valuing a company at more than it costs to
reproduce it; stock prices should fall. If it is below
1.0, then stocks are undervalued because new businesses
can't be created at as cheap a price as they can be
bought in the open market. In the short run, this ratio
is volatile as shown below but it tends to be mean
reverting, which is critical. As long as capitalism is a
going concern, "Q" should mean revert to 1.0. If so,
then oh, oh what a "Q"! Today's Q ratio has almost never
been lower and certainly not since WWII, implying
extreme undervaluation, as seen in Chart 1.
Another long-term standard of valuation comes from
the good ol‘ P/E ratio, where earnings per share, or E,
is compared as a function of P, or price. Chart 2, going
all the way back to 1871, shows the same relatively
massive undervaluation, not only in the U.S. but
elsewhere. This has been a global bear market.
Yet here one should be careful. The sage of rationality,
Yale's Robert Shiller, cautions us to look at earnings
on an historical 10-year moving average to remove
adverse or fortuitous cyclicality. When measured on this
basis, P/E's are cheap but less so, slightly below their
mean average for the past century.
Professor Shiller may be on to something, although
even his 10-year approach may not be enough to adjust
for our future economy and its functioning within the
context of a delevering as opposed to a
levering financial system. Recent Investment
Outlooks and indeed, discussions in PIMCO's
Investment Committee and Secular Forums for the past
several years have pointed to the necessity to view
current changes as not only non-cyclical, but
non-secular. They are, in fact, likely to be
transgenerational. We will not go back to what we have
known and gotten used to. It's like comparing Newton and
Einstein: both were right but their rules governed
entirely different domains. We are now morphing
towards a world where the government fist is being
substituted for the invisible hand, where regulation
trumps Wild West capitalism, and where corporate profits
are no longer a function of leverage, cheap financing
and the rather mindless ability to make a deal with
other people's money. Welcome to a new universe
stock market investors! In this rather "sheepish" as
opposed to "brave" new world, here are some
considerations that may affect Q ratios, P/E's, and
ultimately stock prices for years to come:
- Corporate profits have been positively affected
for at least the past several decades by several
trends that appear to be reversing. Leverage and
gearing ratios – the ability of companies to make
money by making paper – are coming down, not going up.
In addition, the availability of cheap financing –
absent government's checkbook – will likely not
return. Narrow yield spreads and low real corporate
interest rates are gone. Last, but not least, the
historical declines of corporate tax rates, shown
graphically in Chart 3, will not likely continue
downward in a Democratically-dominated Washington.
- Globalization's salutary growth rate of recent
years may now be stunted. While public pronouncements
from almost all major economies affirm the necessity
for increased trade and policy coordination, and
avoiding the destructive tendencies of one-off
currency devaluations as a local remedy for global
problems, investors should not bank on the free trade
mentality of recent years to support historic growth
rates. Already we are seeing separate ad hoc policy
responses with very little cooperation. Not only does
the EU's approach differ from that of the U.S., but
France is in many ways an odd man out within its own
community. Asia is legitimately suspicious of any U.S.
endorsed approach given the failure of America's
capitalistic model.
- Animal spirits, and with them the entrepreneurial
dynamism of risk-taking has likely experienced a body
blow. Not only have dancers on the financed-based
dance floor been shown the exit à la Chuck Prince, but
those that remain have been publicly chastened and
handcuffed. Golden parachutes, options, executive
compensation and bonuses themselves are now at risk.
Care to climb to the throne of this new world? Well,
yes, egos will always dominate, but the rules will be
changed and hormone levels lowered.
- The benevolent fist of government is imperative
and inevitable, but it will come at a cost. The
champion of free enterprise, Ronald Reagan, knew that
growth of the private sector was in no small way
dependent on deregulation and the lowering of tax
rates. Now that those trends have necessarily come to
an end, no rational investors should expect innovation
and productivity to be unaffected. Profit and earnings
per share growth will suffer.
My transgenerational stock market outlook is
this: stocks are cheap when valued within the context of
a financed-based economy once dominated by leverage,
cheap financing, and even lower corporate tax rates.
That world, however, is in our past not our future. More
regulation, lower leverage, higher taxes, and a lack of
entrepreneurial testosterone are what we must get used
to – that and a government checkbook that allows for
healing, but crowds the private sector into an awkward
and less productive corner. Dow 5,000? We don't
have to go there if current domestic and global policies
are focused on asset price support and eventual
recapitalization of lending institutions. But 14,000 is
a stretch as well. One only has to recognize that
roughly 20% of bank capital is now owned by the U.S.
government and that a near proportionate share of
profits will flow in that direction as well. Better to
own corporate bonds than corporate stocks, but that's a
story for another Investment Outlook.
William H. Gross
Managing Director
Printer Friendly Version
Email this Article
