Close to Fair Value, But Still Unbalanced

A crucial time is approaching for the global economy and stock markets. The policy induced ‘recovery’ from the credit crisis is now petering out. While this inevitability was hardly consensus opinion months ago, most market participants are now coming around to the viewpoint that the developed world faces a low growth future.

This is the reality currently being priced in to stock markets around the world. It’s the reason why we have been content to be predominantly in precious metals and cash, although that will change if the market has another leg down.

So next time you hear someone babbling about the market being cheap because we are trading below historical price earnings (PE) ratios, make a mental note to never listen to them again. It’s either undergraduate analysis or they’re just trying to sell you something…or probably both.

If our future does hold below trend global economic growth, and there is a high probability that it does, markets will of course trade on lower PE ratios than they have historically (on average) done.

This is one of the reasons why investing based on PE ratios makes no sense. It really tells you nothing about a company’s intrinsic value. As we mentioned in last week’s report, the market is now around or getting close to fair value. But that doesn’t mean you should be diving in at this point. There are some pretty heavy undercurrents moving in the global economy and our feeling is they could come to the surface sooner rather than later.

What are these undercurrents?

In short, they are the global financial imbalances that continue to persist, despite the attempts of the credit crisis to correct those imbalances.

Bernanke touched on these imbalances in his speech at the central bankers gab-fest at Jackson Hole last week. ‘Managing fiscal deficits and debt is a daunting challenge for many countries, and imbalances in global trade and current accounts remain a persistent problem.

They remain a persistent problem because governments and central banks won’t allow the imbalances to correct. Take Japan and Germany for example. At the risk of oversimplifying things, their whole post-war economic growth model is based on exports. More accurately, exports to the US.

One of the fringe benefits of the US emerging victorious and financially intact after WWII was that the US dollar became the world’s reserve currency. The vanquished nations of Japan and Germany built export industries that satisfied US consumer demand. This dynamic still exists today only now it’s on a global scale.

Japan and Germany are highly productive nations. They have learned to remain competitive despite persistently strong currencies. (Actually, it would be more accurate to say that they have learned to live with a constantly depreciating US dollar). Only a focus on productivity and use of technology has allowed their export industries to flourish.

But both their economies are overly dependent on the export sector. Japan has just reacted to the recent strength of the yen (which is damaging the prospects of its big exporters) by announcing yet another stimulus package. Like all the others that Japan has announced over the past few decades, it will ultimately be useless.

German second quarter GDP growth recently soared on the back of, you guessed it, rising demand for its exports. Germany was almost the sole beneficiary of the European debt crisis earlier this year because the euro plummeted, making its products more competitive in world markets.

Unfortunately there are a whole bunch of imbalances in the eurozone itself. Germany and to a lesser extent France and northern Europe need a strong currency to discourage exports and encourage imports. In other words, domestic consumption needs to generate more growth at the expense of the export sector. Southern Europe needs a dramatically weaker currency so debt-burdened countries like Greece and Spain can try to trade out of their problems.

And of course there is the export powerhouse of China, which manages its currency (by hoarding foreign exchange reserves) to retain export competitiveness.

On the other side of these exporting nations is predominantly the US, which has a chronic trade deficit. (There are other trade deficit nations but to keep it simple we’ll focus on the US).

And the US trade deficit is simply massive. For the month of June 2010 the deficit was US$50bn (US$600bn annualised). But for all of 2009 the trade deficit was just $380.7bn, almost half the 2008 deficit of nearly US$700bn.

From these numbers you can see what the credit crisis of 2008 and early 2009 was trying to achieve – a lowering of the chronic US trade deficit and by implication, a lowering of the demand for exports from Japan, Germany and China. It was simply the markets way of saying that the imbalances had become too extreme and that an adjustment was necessary.

Our view is that because the markets are a reflection of the collective daily decisions of billions of people, over long periods of time they tend to reflect nature. That is, they move around a bit but the tendency is always towards balance.

Over the past 40 years (since the world went off the gold standard in 1971) the global economy has been moving slowly but surely away from any semblance of balance. The point of maximum imbalance was reached in 2007/08 and the credit crisis ensued. The crisis wasn’t some mysterious occurrence brought about by falling house prices in the US. It was nature’s way of trying to brutally correct the ‘dis-equilibrium’ (as economists like to call it) that had built up over a very long period.

Naturally, politicians and central bankers were not going to stand by and allow the correction to play out. Given the unprecedented nature of the stimulus applied, it was not surprising to see global economic growth rebound. But the stimulus is now wearing off, which is why you’re seeing the prospects for the global economy soften materially.

Which brings us back to the point made at the start of this essay. That is, we are now at a crucial time for the global economy and stock markets. Therefore, over the next few months you should not be surprised to see the market revert to its natural tendency to correct the imbalances that have built up over such a long period of time.

We don’t think this will involve a 2008 style meltdown. Stock prices are lower, and valuations are more attractive now than in 2008. But it does mean that we could be in for another leg down in stock markets around the world, including Australia.

This is more of a hypothesis than a forecast. However it is worth standing back and considering where we have come since the credit crisis, and what has really changed since. Our conclusion is that the imbalances that the credit crisis set out to correct still exist.

One way or another, this process will continue. It will either be a short and very deep correction (unlikely) or a prolonged adjustment over a period of years, the severity of which will be softened by central banks and governments.

The latter is the most likely scenario. In this type of environment, you should expect the market’s PE to contract. It’s the natural response to a lower growth environment and increased risk aversion. It’s called a bear market.

Contrary to what you might hear in the media, bear markets are not all doom and gloom. If you recognise that we’re in one, and set a strategy do deal with it, there is still money to be made.

Consider these statistics from John Maudlin’s most recent e-letter, where he discusses secular (long-term) bull and bear markets.

The first cycle of the twentieth century was a bear. It started in 1901 with the market P/E ratio cresting at 23. Twenty years later, with the P/E ratio firmly in single digits at 5, the bear went into hibernation. Over the twenty years of that secular bear, the Dow Jones Industrial Average (DJIA) had managed to tick up from 71 at year-end 1900 to 72 at year-end 1920.

But, during those two decades, the market moves were far from calm. Annual returns from New Years’ Eve to New Years’ Eve ranged from -38% to +82%! The best-performing three years were +82%, +47%, and +42%. After each of those years I am sure the pundits proclaimed the death of the bear. Yet the three worst years were -38%, -33%, and -31%. As we’ll see with most secular bear cycles, the period was as violent and choppy as the high seas in a monsoon. Across the 20 years in this bear cycle, 45% were positive-return years – but never more than two in a row! The 11 down years were generally singles or pairs, with only one three-year stretch at the start of the cycle. Although the average gain was +30% and the average loss was 17%, the change from beginning to end was a paltry +2% in total.

The message, then, is relatively straightforward. In bear markets, positive returns are nearly just as likely as negative returns. To do well, though, you need to invest like you’re in a bear market. This means you should:

  • Only buy companies at a decent discount to intrinsic value (the bull won’t get you out of trouble if you pay too much)
  • Have lots of patience
  • Hold higher than average levels of cash. Being fully invested at all times is a bull market mantra. Don’t be afraid to hold cash if there is a lack of compelling opportunities.
  • Sell stocks when they become overvalued. Sounds simple, but it’s not.
  • Own gold (and silver) and gold equities. The precious metals are in a bull market. Having exposure to this sector is a must.

This is the basic strategy we’ll be employing for the next few years at least (unless Bernanke goes nuclear with the printing press). Making money in the markets is all about probabilities. The probability of success increases markedly once you recognise the environment you’re in. So if you understand that we’re in a bear market, you’re well ahead of the majority of investors.

Greg Canavan
for Markets and Money

Greg Canavan
Greg Canavan is a contributing Editor of Markets and Money and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to Markets and Money for free here. If you’re already a Markets and Money subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Markets and Money emails. For more on Greg go here.

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