26th October 2013
‘First, if the bubble were to deflate on its own, would the effect on the economy be exceedingly large? Second, is it unlikely that the Fed could mitigate the consequences? Third, is monetary policy the best tool to use to deflate a house-price bubble? My answers to these questions in the shortest possible form are, “no, no and no.” Incoming Fed Chair Janet Yellen speaking in 2005
Dovish comments like that from Ms. Yellen as well as the soft September payrolls report are driving investors to assume Fed tapering has been postponed toward Q2 next year, if not the indefinite future. The key issue remains very low levels of investment in the US economy, which correlate well with job creation – if private investment remains moribund, escape velocity for the labour market and wider economy will prove elusive. As covered in previous notes, overall investment as a share of GDP is trending down over time for demographic reasons as the economy matures and also as it becomes more IT driven; sustained deflation trends in computer software and hardware give companies more bang for their investment buck, while faster inventory turn via ecommerce has reduced the need for warehousing etc. (think Amazon versus WalMart sales per square foot). Nonetheless, we are several percentage points short of trend investment levels and a key issue for 2014 is whether corporate boards from the US to Japan decide that they have sufficient visibility to justify capacity replacement and/or expansion. Markets face a pivotal moment in coming months; either the unprecedented stimulus since 2009 has failed to ignite a self-sustaining recovery, despite the energy windfall, in which case the Fed is pushing on a monetary string and earnings momentum will roll over in a manner painfully familiar to GEM investors. Alternatively, we finally get the last cylinder of growth firing and corporate investment pushes US growth toward 3% (and the fiscal drag will ease considerably next year), in which case the Fed will have to expedite its balance sheet normalization. I’d still bet on the latter outcome, but either way as the S&P grinds toward 1800, it would be wise to finally begin paring US exposure. Record net cash levels for the S&P 500 certainly support an investment rebound thesis, with the caveat that the tech companies who are the clear winners in the new ‘asset lite’ economy are generating the bulk of that cash, and hoarding it overseas out of reach of the IRS.
It was odd that the Nobel Prize in Economics was split three ways this year and focused on market theory; most market observers are oblivious to a bubble inflating around them, but none more so than academic economists with their beloved general equilibrium models. Among the winners, the one you might trust with your money based on his track record is Prof. Shiller (of US house index fame) who suggests that prices are currently “high” in the US equity market at current levels of his estimated cyclically adjusted PER. This implies that objective measures of the risk premium (expected returns) are lower than average that is, expected risk premia must inevitably rise. 1990’s, when of course Alan Greenspan echoed Janet Yellen’s housing comments in relation to the tech boom although he has since partially recanted). The real contrast between Shiller and his co-winner Prof. Eugene Fama, originator of the Efficient Market Hypothesis, is that he remains agnostic about what risk premium is sustainable. In other words, he doesn’t accept that there is a ‘fair value’, and so has no room for the prediction that prices will fall. In the current circumstance, he might say that investors are highly tolerant of risk i.e. they are willing to accept low expected returns for taking on US equity risk.
The S&P 500 price/revenue ratio of 1.6 is now 2x its pre-1990s historical norm; the 1987 peak occurred at a price/revenue ratio of less than 1x, but of course margins are considerably higher now. A key support remains LT interest rates at historically low levels and share buybacks as companies use record net cash flow relative to GDP to shrink their equity base. Back in the 4th September weekly, which looked in detail at the CAPE and other long term valuation methodologies, I noted that: ‘Some investors take a macro view of corporate profits using the Kalecki equation (Proﬁts = Investment – Household Savings – Government Savings – Foreign Savings + Dividends) and thus argue that the large US deficit has been the big source of (excess) corporate profits. With the deficit now declining and both earnings growth and sales growth on the S&P decelerating, there will be a double whammy of less fiscal stimulus on demand and a shrinking source of profits that needs to offset that impact, preferably by corporate investment. Overall, after the outperformance seen YTD, US equities no longer look compelling, although a push to my original 1800 S&P year-end target is still feasible on inflows from bond/GEM fund refugees.’ Those inflows as much as the rally in 10-yr Treasury yields are a key support near-term; data from EPFR Global shows that $69.7bn was withdrawn from money market funds in the week ending 16th October while equity funds captured net inflows of $17.2bn as the debt ceiling crisis was resolved.