Equity Premium Will Be Replaced With a Tangible Asset Premium

Geez. Last Friday we made the case that the equity premium in stocks is going to revert to its historic mean. Remember that the equity premium is your willingness to pay more for future corporate earnings today because you believe stocks do better than bonds and cash over time. The larger the corporate cash flows have become in the era of EZ credit, the higher the equity premium has crept.

But you can chuck all that out the door because stocks are rising, right?! Well, not really. If the equity premium does revert to the mean, it will have major ramifications for your wealth game plan. But in the short term, it may not seem like it.

After all, Aussie stocks ARE trading near eight-month highs. Nothing in Friday’s trading activity on the ASX reversed that trend. And as the week begins we read that investors are now pricing global stocks for a 2010 earnings recovery. Confidence about earnings and cash flows is on the rise.

For example, shares in James Hardie were up big in Sydney on Friday on news that U.S. existing home sales were up 3.8%. Houses prices in the States are still down 15.4% in the last year. The average existing home sells for around $181,000-which looks downright affordable by Aussie standards.

Not that the Hardie examples makes a lot of sense. That is, Hardie is the biggest seller of home siding in the U.S. How do existing home sales help its business? They probably don’t, at least not directly. As the statisticians say, correlation is not causation.

But even though rising existing home sales might not directly benefit Hardie, a recovery in the U.S. housing market would. That’s one way of explaining Friday’s performance. And obviously, since the March lows, there’s a palpable sense that the worst of the financial crisis is over and that the lingering recession should evaporate later this year.

We’ll see about all that. We’re sticking to our call that in a Credit Depression, corporate cash flows will revert to the mean and the equity premium will be replaced with a “tangible asset premium.” Of course if we’re wrong about the Credit Depression and the entire global economy reflates and bank lending resumes at pre-bust levels, well then everything will be fine.

Whatever happens, you can bet shares are going to remain volatile. The key element to volatility is uncertainty. And there’s plenty of that going around, especially when you’re talking commodity prices.

Take fertilizer and herbicide stocks. Companies like Mosaic, Agrium, and Potash Corp. have all seen falling stock prices. Falling demand for fertiliser and falling prices took an axe to the income statement in the last year. But now these companies-given the long-term bullish case for food-must look pretty attractive as acquisition targets. Buy depressed earnings before commodity price recovery!

That must be what Sinochem is thinking. As we reported to Diggers and Drillers readers last week, Aussie ag stock Nufarm told the ASX that it’s in preliminary takeover talks with China’s Sinochem Corporation. Sinochem is China’s largest chemicals company.

You know that earnings will recover at Nufarm. They’ll recover because chemicals prices are going to bounce, and their long-term trend-we believe-is up (given how many mouths to feed there are on the planet). This isn’t the first time the Chinese have come knocking on Nufarm’s door by the way.

What’s that? Did someone say tangible asset premium?

Dan Denning
for Markets and Money

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

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2 Comments on "Equity Premium Will Be Replaced With a Tangible Asset Premium"

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The discount that kept me out of Nufarm is that it has geographically far flung medium size businesses with recent past high margins suseptible on a turnover based business. All that diversity creates management risk in my mind. My target price was about $7.50 and it never got down to it so I’m not invested.


a must read on the long-term and short-term cyclical nature of the stock market and forecast


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