2. “One chart to rule them all”: why U.S. stocks cannot have just started a major long-term bull market
Our primary reason for remaining cautious on U.S. (and European) equities is that most people are still treating this recession as a garden-variety inventory-correction one, instead of a credit-collapse recession different in character from any other developed-nation recession in the last century other than 1930s America and 1990s Japan. But an even bigger-picture view makes us wary over a longer time frame. The best way to gain this perspective is to examine what drove the 18-year bull run in U.S. stocks from 1982 through 2000 (excluding the credit bubble build-up and internet mania, which were real but minor factors across most of those years). We latched onto this idea when David Rosenberg made some comparisons of today with 1982. We have pushed his comparisons much farther. Here are our conclusions, in summary form: Factor INTEREST RATES Federal funds rate 10-year Treasury bond yield CAPITAL MARKETS LIQUIDITY Federal Reserve-provided liquidity GOVERNMENT SPENDING Federal deficit / GDP ratio Federal debt / GDP ratio Federal unfunded obligations to future retirees within 20 years MACROECONOMICS Inflation (trailing CPI) Real household income Household debt to GDP Personal savings rate Excess housing supply (vacancy rate) Trade-weighted dollar index (is there room to devalue to boost output?) Tax rates – highest tax bracket Economic regulation Unionization / union power Global trade CORPORATE PROFIT MARGINS S&P 500 margins (long-term avg. = 6%) DEMOGRAPHICS Baby boomer ages 1982 18% and falling 15% and falling None 3% and rising 38% Small 2010 0% and rising 3.9% and rising $trillions and falling 10% and steady or falling 80% Enormous
10% and falling About to rise (productivity gains) 49% and rising 10% and falling 1.6% 120 69% and falling High and falling High and falling Low and rising 5% (actual) Entering peak earning & saving years
-2% and rising Falling (competition from cheap foreign labor) 95% and falling 4% and rising 2.6% 78 35% and rising Low and rising Low and rising High and falling 9% (consensus est.) Earnings done; entering peak dis-saving years
KATANA CAPITAL LLC • 539 SOUTH EUCLID AVE. • OAK PARK, IL 60304 TEL 312.665.0073 • FAX 312.604.1960
EQUITY VALUATIONS S&P 500 PE ratio (1-year trailing) S&P 500 PE ratio (10-year trailing average earnings, inflation adjusted) S&P 500 price/book ratio S&P 500 dividend yield INVESTOR SENTIMENT Percent bullish sentiment
8x 7x 1.0x 6% 10%
28x 23x 2.2x 2% 88%
From the standpoint of an investor in U.S. stocks, the world of 1982 could not have been a less hospitable place. Everything that could go wrong had gone wrong. Inflation and interest rates were skyhigh, which reduces stocks’ value because companies’ future cash flows are worth much less or, alternatively, you can earn a better risk-adjusted return by buying bonds instead. The Fed was doing nothing to provide the market with liquidity. Government deficits were relatively low, meaning deficit spending was not contributing much to output growth – and because total government debt was low, fiscal stimulus had a lot of room to run. Households had meager income, little debt, and a high savings rate, meaning they also were not contributing much to growth. The housing supply was tight, and the dollar was high. Government actions were unfriendly toward businesses and wealthy individuals, and therefore toward corporate profits and capital creation; we had high tax rates, oppressive regulation, and a heavy bias towards unionism and protectionism. As a result, corporate profit margins were near all-time lows. It is not surprising, then, that investor sentiment and equity valuations were at deep historical lows on any metric: price/earnings multiples, price-to-book multiples, dividend yields, and anything else one could measure. But – and this is the key – things had nowhere to go but up. Every one of those depressing trends was about to reverse. From a shareholder’s perspective, the world looked better and better for the next 18 years. On top of that, shareholders got a boost from a once-per-century trend that was every bit as important: baby boomers increasingly entered their peak years for productivity, earnings, and savings, and they plowed an increasing portion of those savings into stocks. That pushed prices and valuations even higher. Today we are at nearly the polar opposite of 1982: apart from the current credit bubble collapse, which is nowhere near done, everything that could go right for stocks has already gone right. Short-term interest rates are at zero, inflation is zero, Fed-supplied liquidity and fiscal stimulus have never been higher, the government’s and households’ coffers are now tapped out, government policy towards businesses and capital is accommodating and can only get worse, people expect 2010 profit margins to be back near their all-time highs, and baby boomers are just about to leave their peak earning years and become a huge drag on markets instead of a huge boost. With all of these factors currently working for stocks, and with most investors thinking “the recession is over” and everyone will get right back to bubble-year behavior, it is not surprising that investor sentiment and valuations are now high. As we did last January, we display our key valuation chart, which tracks the price/earnings ratio using a trailing 10 years of inflation-adjusted earnings (to sidestep problems both with earnings cycles and with faulty earnings forecasts): Page 2
Interest rates and PE ratio (using 10-year trailing average of inflation-adjusted earnings) 50 45 40 35 30 25 20 15 10 5 0 1880 1900 1920 1940 1960 1980 2000
Long-term average PE: 16.2
20 S&P 500 price/earnings ratio (left scale) Long-term risk-free interest rate , percent (right scale) 2000 18 16 1929 1901 1966
Current PE: 22.5
14 12 10 8 6 4 2 0 2020
You can see visually why stock prices could move up so far and for so long following 1982: the PE ratio started at its historical rock-bottom and had a lot of room to run. In contrast, today that ratio is well above its historical average, higher than at any time except previous bubbles, after spending only three months just barely below the average. From here it can march higher only if we get another bubble. In short, all the structural supports for equity valuations have nowhere to go but down. We do not know which structural supports will give way the most, or when, just as those in 1982 could not know precisely how or when things would improve. We also understand that there is money to be made by owning stocks over shorter periods of time, just as there was since mid-March this year. But we expect that, longer term, our one chart above truly does rule all: stocks as a group are to be “rented” rather than “owned.” (More precisely, as a long/short hedge fund, we can buy and hold the stocks we like but vary our long/short exposure to hedge out the market-wide risk to a greater and lesser degree.) We have been studying the strategies one could have used to make money in Japanese stocks over the last 20 years in the face of a 70% multi-decade decline and four 50% rallies. We expect to remain cautious about the overall market for years to come while still betting on individual stocks and attempting to profit from shorter-term market-wide rallies.
Page 3