Stocks Are Not As Cheap In
the New Investing Environment

by Hans Wagner, TradingOnlineMarkets.com | January 22, 2009

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The investment climate will be different in the future than it has been in the past. Investors should not expect stock prices to repeat the performance of the past when faced with a climate of massive de-leveraging, government intervention, and increased regulation.

Changing Business Environment

The business environment of the past 30 plus years was characterized by growing global trade, increasing use of leverage, cheap financing and falling corporate and individual taxes. The investing models used over the last few decades will need to be adjusted to reflect these new factors.

Global Trade

Free markets have encouraged a number of actions that have benefited many, some more than others. Companies were able to lower their costs by manufacturing products in low cost countries. Consumers in many parts of the world, including the U.S. are able to buy many products at lower costs than years ago. Global trade has been one of the primary economic engines benefiting most countries. It facilitated the freer flow of trade and investment across borders, resulting in a more integrated international economy. This trade expands economic freedom and spurs competition, globalization should raise the productivity and living standards of people in countries that open themselves to the global marketplace.

For less developed countries, globalization offers access to foreign capital, global export markets, and advanced technology while breaking the monopoly of inefficient and protected domestic producers. Faster growth, in turn, promotes reduction of poverty. While globalization may confront government officials with more difficult choices, the result for their citizens is greater individual freedom. In this sense, globalization acts as a check on governmental power that makes it more difficult for governments to abuse the freedom and property of their citizens.

According to a paper titled The BRIICS and Changes in Global Trade Architecture By Javier Reyes, Martina Garcia and Ralph Lattimore

“The estimated network indices are surprisingly sensitive to major policy changes, including trade policy changes. For example, they show with startling clarity the impact of the international sanctions against the South African apartheid regime and the quick recovery of the country once negotiations for the end of apartheid started in 1990, with the liberalisation of Nelson Mandela. Equally remarkable is the performance of China after the 1979 launch of the „Reforms and Openness’ program by Deng Xiaoping which included the opening of foreign trade. Since 1995 China has become an established member of the core or the global trade network. India‘s trade policy reforms in the early 1990s had a dramatic impact on its rate of convergence towards the core of the world trade network. Following that rise it has paralleled China‘s progression. On a relative scale, the rise of China and other BRIICS to the core means that a number of more developed countries like Australia, Belgium and the Netherlands have tended to move out of the core to the periphery of the trade network “

Unfortunately, it also encourages business executives, especially CEOs, to raise their compensation levels to astronomical heights with outrageous golden parachutes given for not performing. These and other excesses have become the poster child of the bad side of globalization. A number of powerful people are calling for changes in global trade to correct the imbalances. They seek stronger environmental restrictions and changes in labor laws to try to offset low cost advantages. Some have even called for trade embargos and higher import taxes to protect local economies. During the 1930’s, the Great Depression, countries tried to protect their economies by raising import taxes. This had the opposite affect, as it restricted trade and lowered everyone’s standard of living.

De-leveraging

Companies and especially banks found that they had access to low cost credit that allowed them to increase their leverage. A number of investment banks and hedge funds used leverage of 40 to 1, $1.00 of equity and $40 of debt to finance their investments. Since the cost of this debt was less than the return they were receiving on their investments, these firms were able to make substantial amount of money for their investors and themselves. Leverage works well when their investing strategies are correct. It has the reverse affect when the investments produce returns that do not cover their costs or are negative.

Companies as well as individuals used debt to fund their purchases. According to Morgan Stanley, the total American debt of households, companies and governments has risen since 1980 to more than 300% of the GDP, higher than it was during the depression.

When consumers are no longer able to tap their growing asset values to fund their life styles, they curtail their spending. By reducing their borrowing and saving more, they spend less. This causes demand to decline which then affects business, which shed jobs, creating further fall in demand.

Once this process begins, it is difficult to stop. Financial institutions, desperate to repair the damage inflicted on their balance-sheets by mortgage-related securities, sell assets. In doing so, they exacerbate the problem. Forced sales push down the prices of assets, worsening the balance-sheets of other investors, forcing more asset sales, and so on. In the end, the government is the only entity left in the game with a balance-sheet strong enough to keep buying.

Business who have been using debt to help grow their companies face a similar situation. As their sales falter, they struggle to finance this debt, cutting jobs and expenses to try to bring their financial statements into alignment with lower sales. Some will not be able to cover their debt casuing them to default. These defaults just make the problem worse.
This spiral continues until a new equilibrium is achieved when those left finally balance their inflows with their outflows. Unfortunately, this can take longer than many expect. Just look at how long the depression lasted.

Falling Tax Rates

The chart below is from the Tax Foundation’s Comparing International Corporate Tax Rates. It shows a couple of facts that are relevant to investors. First, corporate tax rates around the world have fallen since the mid 1980’s. The lower tax rates have helped to stimulate investment throughout the globe. It also shows that the corporate tax rate in the United States is now one of the highest in the world. Some analysts believe the U.S. should lower the corporate tax rate to bring in them more in line with the rest of the world. Lowering the corporate tax rate might help stimulate investment, however, the new administration look kindly on this outcome.

Governments used lower taxes to stimulate economies by putting more money into the hand of businesses and individuals. The current large deficits raise the specter that it will be more difficult to lower taxes further. The Obama administration has committed to lowering taxes for middle income people as a part of his stimulus package. Many analysts expect taxes on capital gains and upper income levels to rise once the current recession is over.

A new business environment is just beginning. The era of free enterprise with its deregulation and falling tax rates is about to change. Government is stepping in to enforce its will. Investors should not expect the markets to return to their former self. As Bill Gross said in a recent letter to investors, “We are now morphing towards a world where the government fist is being substituted for the invisible hand” of free markets.

What this means to Investors

In response, investors will need to change their view on what makes stocks cheap. More regulation, less leverage and higher taxes will affect the value of stocks going forward. No longer can investors count on the freewheeling economy to hold sway over company valuations. Add in the government largess and investors face a brave new world. Government borrowing will tend to crowd out the private sector. Moreover, the U.S. government now owns about 20% of bank capital while controlling GM and Chrysler. Owning these assets will tend to keep a lid on prices of these securities until it is clear when they will be sold back to the market. New regulations are likely to have a negative, rather than a positive affect on profitability. On the positive side, new regulations could reduce risk.

With their newfound power, the Democrats will try to re-regulate some parts of the economy, especially the financial sector by strengthen financial regulatory agencies and crack down on runaway "greed and scheming" in an effort to restore stability to a reeling U.S. economic system. In addition, they are on record seeking to change labor laws such as creating a new federal law offering a card check-off as an alternative to secret-ballot elections for union representation. President-elect Obama stated he wants to renegotiate NAFTA. Depending on the changes, this could affect any company that has benefited from the freer trade.

Reducing the leverage of banks and companies will tend to lower profit potential while reducing risk. As a result, the profit and Price Earnings (PE) ratio of these companies is likely to be lower over time than has been the case in the past. Investors will need to adjust their valuation methods to adapt to the new rules. More regulation, less leverage, and higher taxes will tend to lower corporate earnings.

If you are interested in learning more about global economic change I suggest reading When Markets Collide: Investment Strategies for the Age of Global Economic Change by Mohamed El-Erian a co-CEO and co-CIO of PIMCO.  This is an intelligent account of the credit crisis: why it happened and how to survive it. Winner of the 2008 Financial Times and Goldman Sachs business book of the year award.

 

Copyright © 2009 Hans Wagner
Editorial Archive

If you wish to learn more on evaluating the market cycles, I suggest you read:

Ahead of the Curve: A Commonsense Guide to Forecasting Business and Market Cycles by Joe Ellis is an excellent book on how to predict macro moves of the market.

Unexpected Returns: Understanding Secular Stock Market Cycles by Ed Easterling.  One of the best, easy-to-read, study of stock market cycles of which I know.

The Disciplined Trader: Developing Winning Attitudes by Mark Douglas.  Controlling ones attitudes and emotions are crucial if you are to be a successful trader.

Bio As a long time investor, I was fortunate to retire at 55. I believe you can employ simple investment principles to find and evaluate companies before committing one's hard earned money. Recently, after my children and their friends graduated from college, I found my self helping them to learn about the stock market and investing in stocks. As a result I created a website that provides a growing set of information on many investing topics along with sample portfolios that consistently beat the market. Feel free to visit the site at http://www.tradingonlinemarkets.com/ 

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Hans Wagner | Colorado, USA | Email | Website

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