Hope Is Not a Strategy

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Financial markets have ushered in 2012 with a collective sigh of relief. 2011, the year of the never-ending crises, is over. Although the crises continue, equity markets have risen moderately month-to-date. There is clearly hope that things in 2012 will improve. While hope may not be a strategy, past episodes of misplaced hope are instructive. With specific reference to the early 1930s, as the US Great Depresson unfolded, the first quarter was always positive for the stock market. Yet these gains, and more, were given up in the subsequent quarter, and the negative trend continued through the remainder of the year. Thinking specifically about 2012, we can see a number of reasons for caution. However, investors must keep in mind that central banks around the world stand ready to print money in response to deflationary pressures, something missing in the early 1930s. As such, while cash continues to provide liquidity, it fails to provide a reliable store of value.

Some Observations from the Early 1930s

Amid an insolvent financial system dependent on central bank money creation (and an implied bail-out) for survival, the US economy today faces structural economic headwinds comparable in key respects to those it faced in the early 1930s. Even the global context is somewhat similar, in that there was a European banking crisis in the early 1930s which, many believe, exacerbated the downturn in the US.1 As such, it is entirely reasonable to compare contemporary US economic developments to those of the 1930s. It follows that it is also reasonable to compare stock market developments, as these necessarily reflect changing expectations for key economic variables such as growth, inflation and corporate profit margins.

It is well known, of course, that the stock market took a pounding in 1930-32, following the initial crash in Q4 1929. Less well known, however, is that in the years 1930-32, January was one of the better months and Q1 was one of the better quarters. The following table presents these statistics:

Dow Jones Industrial Average Returns

dow returns 1930-1932
Source: Federal Reserve

Now admittedly this is a small sample of data. I would not for a moment purport to claim that, when it comes to the current, multi-year, secular bear market, January and Q1 2012 are likely to be positive. For what it is worth, however, history does suggest that we should not take January’s price action, or that of Q1, as indicative of any sort of trend. Indeed, to the extent that we would take January or Q1 as significant, it would be as a contrary indicator of what to expect for the full year.

These observations contradict the conventional wisdom, which holds that January is in fact a reliable indicator of the full-year trend. This is best explained by pointing out that, in most years, the stock market tends to rise. It might not rise strongly, but rise it normally does, and thus a positive January can appear, by association, to point the way.

The problem, of course, is two-fold. First, association is not causation. Second, and more worrying, is that when the stock market does have a bad year, it tends to drop rather sharply, sometimes wiping out the gains of multiple previous years, as in the early 1930s, the early 2000s or 2008. And, unfortunately, a positive January is next to useless when it comes to avoiding such declines. If anything, the so-called ‘January effect’ is a tempting lure into a bear trap, best avoided by cautious investors.

Contextual Reasons for Caution

To many, stocks appear cheap. Price-earnings multiples are low, implying high earnings yields; non-financial corporate balance sheets are relatively liquid, implying no need to raise funds and dilute shareholders; and there is a huge pool of unemployed workers, constraining wage growth and, by implication, enabling unusually high profit margins. At first glance, therefore, stocks would seem a buy or, at a minimum, fair-value.

Like anything in economics, however, stock market valuations, and the various positives noted above, must be placed in context. When doing so, it is less clear that valuations are attractive.

For this discussion, we are going to leave financials out. Financials’ balance sheets are now so opaque and the sector so micromanaged by policymakers and regulators that I believe financials have become impossible to value. I am not saying financial shares are not attractive here, only that I do not feel that a valuation-based approach to the sector is valid at present. (I have seen one analysis conclude that the financial sector is now so risky for investors that it is simply one big casino. That is being kind. Casino games work according to clear, calculable odds, with outcomes normally distributed. One can ‘value’ a casino game—ie, the expected return on capital ‘invested’—using high school maths and zero economic, market, regulatory, political or insider knowledge. Try that with a too-big-to-fail financial firm.)

So leaving financials aside, how does context inform valuations at present? There are several things to note. First, it should be rather obvious to all observers at this point that the global economy faces major structural economic headwinds. These may be stronger in some places than others but enough of global demand is affected and valuation metrics need to be adjusted accordingly. It makes a huge difference whether one assumes a 4% or 2% trend global real economic growth rate. This newsletter has consistently made the case that global growth will remain sub-par until a substantial deleveraging of both the private and public sectors has taken place. While there has been modest progress on the former front, the global public sector continues to grow its debt pile at an astonishing rate, historically associated with wartime spending.

Second, as I pointed out in last November’s Report (Fighting Solvency Time-Bombs with Liquidity Bazookas), just because a corporation is liquid does not mean it is not leveraged. At the time, I observed that, for example, the corporate debt to net-worth ratio, at 65.6%, was high in a historical comparison, implying elevated corporate leverage. The most recent Federal Reserve data shows that this ratio was 65.5% in Q3 last year, essentially unchanged. Given the structural headwinds noted above and the leveraged state of US corporations, it is a stretch to hope that corporates are going to draw substantially on this liquidity in the coming quarters to expand capacity and, potentially, grow their revenue bases.

Third, turning to wage growth, it is true that, in the US, there is a huge pool of unemployed and also underemployed workers. Domestic wage pressures are likely to remain muted even in the event that there is substantial jobs growth in the coming quarters. In theory, this should be excellent news for corporates looking to expand.

The problem with this theory is that it is purely domestic, not global. In the age of globalisation, what matters to corporations is the marginal cost of labour around the world, not just in one country. Here we discover a troubling trend for corporate profitability, namely, that wages in the developing world—where most jobs are being created—have been trending rapidly higher in recent years. Inevitably, this is going to impact corporates’ profit margins.

Take China as perhaps the most important example. According to available data, annual wage growth has been in the mid-double-digits since the mid-2000s. Due to compounding effects, this means that Chinese wages have doubled over this period. More recently, anecdotal evidence of current wage negotiations, including periodic worker strikes, suggests that rapid wage growth continues.

There is just no way that productivity gains, even those that accrue to economies of scale, can compensate for wage growth of this magnitude. Offshoring benefits for profitability, while real, are subject to the same law of diminishing returns as essentially all economic activity. The great globalisation profits boom is largely over. As it ends, so does the historically elevated level of corporate profit margins.

What is negative for corporate profit margins generally is perhaps positive for jobs growth in the western economies. As China and other emerging markets become relatively more expensive, new jobs are more likely to be created at home. Developed-world workers’ share of national income (GDP) is likely to increase significantly from currently depressed levels. That will need to wait, however, for some of the structural headwinds to abate. Global economic rebalancing takes time.

A final observation here has to do with interest rates. As we know, interest rates are low just about everywhere, in particular in those economies most in need of deleveraging, including the US, Europe and Japan. While no one can predict just how long the deleveraging is going to take, one consequence is that, as deleveraging runs its course and the demand for investment capital again increases, interest rates are going to rise. This is an entirely natural, normal sign of a healthy economy. Just as there is an economic rebalancing now underway globally, there is also one taking place domestically.

Other factors equal, higher interest rates weigh on equity market valuations. Equity P/E ratios are highly sensitive to large moves in interest rates. In the early 1980s, for example, when the gentle deleveraging of the late 1970s turned into something rather rougher amid higher interest rates, the P/E ratio for the broad US stock market fell into the single-digits. I would not be at all surprised to see that happen again. Of course, should that occur, equity valuations will be the most attractive they have been since at least the early 1980s. Not a bad entry point.

Don't Fight Central Banks!

There is an old adage in US financial circles: “Don’t fight the Fed.” At most times, this has been good advice. Purchasing stocks when the Fed was easing policy and selling when they were tightening was a profitable strategy on average in the 1950s, 1960s, 1980s and 1990s. It did not, however, work as well in the 1970s or 2000s, including of course 2011.

As we know, the Fed has held an inflationary policy bias for decades, more fearful of deflation than inflation. What was only implicit, however, became explicit under Fed Chairmen Greenspan and Bernanke. As such, more often than not, “Don’t fight the Fed,” has meant, specifically, “Don’t fight inflationary policies.”

Inflationary policies, while serving certain interests, including those of the financial sector, ultimately create more problems than they solve, by misallocating resources from productive to unproductive uses and also depressing the real savings rate. Eventually, as the inflation costs grow, the capital stock not only ceases to expand, but begins to consume itself through depreciation (ie, a lack of real savings). What is true in theory is also observed in history: Countries with chronically high inflation tend to have lower potential growth rates.

From an equity investor’s perspective, however, inflationary policies are not necessarily to be feared, in particular for an investor who thinks in nominal rather than real terms. While inflation may undermine the economy’s growth potential over time, as long as corporate profits rise more or less in line with inflation, then equity prices can rise alongside. This is not to argue that equity prices in real, inflation-adjusted terms continue to rise, but when the choice is constrained to investing in equities versus either cash or bonds, in a chronically inflationary environment, equities emerge the winner. “Don’t fight the Fed,” translates into specific action: “Buy equities, eschew cash and bonds.”

Now I am under no illusions here. While in the previous section I pointed out that equity valuations should be depressed, given the state of the world, the fact of the matter is, given central banks’ generally inflationary biases, in fact I would prefer an allocation to certain equities, in particular non-financial corporates, to an allocation to bonds. Within bonds, I would prefer an allocation to non-financial corporate junk bonds—closely correlated with equities—rather than to government bonds, yielding less than 2%.

This is not to say that I anticipate an imminent rise in government bond yields. I don’t. But the risks of holding government bonds here are asymmetric. Moreover, at current rates of inflation, a 2% yield translates into a negative real rate of return. Adding taxation into the equation implies an ever lower real rate of return. And while I believe that higher marginal tax rates on savings are about the worst thing that could be done to a deleveraging economy, I sense that, in certain countries, the political winds are blowing that way.

So while in real terms equities do not, in my opinion, offer attractive value here, they do offer better value than either government bonds or cash and should be overweighted in a portfolio limited to these instruments. Of course this raises the question of whether such limits should apply in the first place.

Commodities As An Alternative

Although I didn’t plan things this way, I’ve acquired a reputation as a commodities bull. Back in the 1990s and early 2000s, when I ran interest rate and currency strategy teams at major global investment banks, I had a rather different reputation, as a bond bull and dollar bear.

My conversion to commodities did not come all at once; rather it followed from a series of developments and my analysis thereof. In brief, I realised that, as interest rates decline, the opportunity cost (ie, trade-off) for holding real assets (ie, commodities) declines, shifting the investment demand function for the latter, thereby pushing up prices. Moreover, I realised that, when the dollar declines as a result of a US-centred asset deflation (eg, dot-com or housing market de-bubbling), this merely transfers deflationary pressure from the US to other economies. Beyond a certain point, central banks in other economies then lower interest rates in response and/or peg their currencies.

One by one, as various countries cut rates and/or peg their currencies, investors find that commodities provide not only an alternative but also superior store of value, with gold having the strongest historical claim to this role.2

Sure enough, gold has remained in a secular bull market ever since, versus all currencies, not just versus the dollar. Q4 2011 was not good for gold, but as seen in the below chart, gold still appears to be in an uptrend. It is important to observe, however, that by Q3 2011, gold was beginning to look extremely expensive versus commodities generally, be they other metals, energy, or agricultural products.

By Q3, Gold Was Looking Very Eexpensive Versus Other Commodities
(Jan. 2005 = 100)

gold copper crude wheat 2005-2011
Source: CME Group

Just as history demonstrates that inflationary policies favour equities over bonds and favour gold over paper currencies, so it also demonstrates that there is a limit to just how expensive gold, the ultimate ‘non-consumable’, can become relative to those things that we do consume, notably food, clothing and shelter, and the commoditiy inputs from which they derive.

While there is no magic ratio between gold and everything else, above which you sell the former to buy the latter, there is, of course, common sense. Although I have acquired a reputation as a commodities bull, I would prefer to be regarded as a ‘diversification bull’. In my view, in a world in which central banks are wedded to inflationary policies; in which the dollar has already declined a long way versus most currencies; in which the gold price is already somewhat elevated relative to consumable commodities; I would favour diversifying into the latter. While some might be more attractive than others at present, an investor could do worse than to buy a broadly diversified commodities exchange-traded fund or, for those set up to trade futures, to spread a position around a handful of commodities with relative low correlations to one another, thereby realising superior diversification benefits.

The Most Valuable Commodity of All?

One final thought, when it comes to consumable commodities, is to consider the one which is consumed more than any other, yet is not traded on an exchange: fresh water. While taken for granted in certain parts of the world, in others it is worth its weight in… well, let the markets decide. Water is a vital input into life as we know it, of course. It is an input into many industrial processes. However, by weight, volume, or value, it is a proportionately larger input into agricultural production. While I am on no account a ‘water expert’ I am well-aware just how much of the stuff goes into a bushel of wheat (~50,000 litres), a pair of cotton jeans (~8,000 litres), or a large hamburger (~5,000 litres).

Just because it comes out of the tap when you turn it does not mean that it comes cheaply, especially in the quantities and in the locations required to produce much of what we consume. So for investors who believe that there are serious water scarcity issues looming on the horizon and are looking for simple, straightforward ways to profit, you could do worse than to build a position in agricultural commodities. Even better, most probably, would be to acquire an exposure to water purification and infrastructure firms and facilities in key locations around the world. That, however, is a topic for another Amphora Report.

Resources

1 Americans sometimes treat their Great Depression as an isolated event. It was anything but. Devastated by WWI, continental Europe suffered a series of banking and currency crises in the postwar period. Eventually, in 1931, even the British pound devalued, leaving the dollar as the only gold-backed currency to take the deflationary strain. A wave of US bank failures soon followed.

2 My original research on the relationships between interest rates, currencies, commodities and gold was published in 2003 and is available here.

AMPHORA: A lateral-handled, ceramic vase used for the storage and intermodal transport of various liquid and dry commodities in the ancient Mediterranean.

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