Scarce Capital Kidnapped
By Jacob Franklin Cabbiness
"I have seen wicked men and fools, a great many of both; and I believe they both get paid in the end; but the fools first." David Balfour, Kidnapped by Robert Louis Stevenson, 1873
Robert Louis Stevenson's classic Kidnapped is a book about wealth, treachery, and unrequited courage. The book's setting is 16th century England. The protagonist, David Balfour, is only 17 years old when his father's death brings him to the home of his wealthy uncle. From the start, David senses something evil and mysterious. But by the time David realizes he is the rightful heir to a large inheritance, it is too late. Tricked by his uncle, David finds himself on a ship full of rogues and murderers. Due to his uncle's treachery, he is bound for the nascent American colonies to be sold into white slavery--kidnapped! Through much trial and tribulation, David eventually makes his way back to England and claims his rightful fortune.
In a sense, many of today's modern investors have been kidnapped, fleeced of their scarce, hard-earned capital. Though not facing the incredible physical dangers of David Balfour, investors have nonetheless been tricked by the mysterious forces of Wall Street and their cronies in the media. Seduced by the mind-numbing mantra, buy and hold and buy the dip, investors, who made huge sums of money during the '90s, have now lost massive amounts of money as the equity markets have hemorrhaged red ink since U.S. history's greatest equity bubble burst in March 2000.
While Wall Street professionals sold, they urged common folk to hold their equity investments. From the nose-bleed heights of Nasdaq 5000 to the recent ephemeral trough, the Street's message has been unrelenting. In the age-old game of Wall Street, simple mom and pop investors (and some not so simple investors) have yet again been separated from much of the fantastic gains they realized in the previous bull-market mania.
Throughout the dizzying drop of the major U.S. indices many investors have remained hopeful that a new bull market will soon emerge and restore their lost capital. Expectations of double-digit returns are uppermost in the minds of a majority of investors. After all, investors have seen the markets drop and come back with a vengeance time after time during the go-go '90s and expectations of the same phenomena occurring in the next decade run rampant. These same investors, giddy with their previous returns, dream of early retirement, funds for their children's education, and a myriad of other delightful pursuits. Is this reasonable or even likely? In this essay, much of which is based upon the ingenious work of Bill Gross, the preeminent bond-market guru, we will explore whether the double-digit gains investors enjoyed during the past ten years are likely to be duplicated over the next decade.
Let's begin with a primer on investment theory relative to the pricing of equities and the calculating of investment returns. We all know that stock prices can become detached from reality in the sometimes irrational short-term as we witnessed during the dotcom frenzy in 1999 and early 2000. Over the long-term, however, stock prices are influenced by corporate income streams (earnings) and the price to earnings multiple (p/e) investors are willing to pay for those income streams. To use the academic term from my college economics text, this is known as capitalization, the process of transforming future income streams into current value or wealth. In the always rational long-term, this is how stock prices are determined in the open market. Investment returns, then, are calculated by adding the stock price (earnings + p/e) and dividends received while holding the stock. That's simple enough, right?
Now that we've nailed down just how stocks are priced and returns are calculated over the long-term, let's take a close look at earnings, p/e multiples, and dividends in an effort to determine if double-digit returns are likely in the cards for the next decade.
We'll begin with a graph that plots S&P 500 corporate earnings and GDP growth.
GRAPH #1
Note that, for the most part, corporate earnings trail GDP growth over the long-run. That is, if annual GDP growth is, say, 4% then corporate earnings growth will likely come in somewhat less than 4%. This is NOT theory; it is real world experience as shown empirically above. Let me point out, however, that corporate earnings did manage to nearly double nominal GDP growth during the disinflationary '90s, but as Bill Gross correctly points out in his work, this was due primarily to declining interest costs and lower effective corporate tax rates. Interest costs won't go much lower from here, nor will effective corporate tax rates or inflation. Anyone expecting a repeat over the next decade is, in this writer's humble opinion, embarking upon a fool's errand. Enough said, let's move on.
Next we'll look at a chart of inflation and p/e multiples in which the p/e multiple is inverted to show a positive relationship with inflation (Notice that the left side of the graph's vertical axis DECREASES the p/e as we move up the chart while the right side INCREASES the rate of inflation.)
GRAPH #2
The data set reveals that as inflation moves higher, p/e multiples move lower, as in the high-inflation '70s; conversely, as the rate of inflation moves lower, p/e multiples move higher, as in the disinflationary '80s and '90s. The point to understand here is that, all things being equal, high rates of inflation cause a contraction of the p/e multiples investors will pay for corporate earnings while low rates of inflation result in an expansion of the p/e multiples investors will pay for the same level of earnings. Perhaps most important, the graph reveals that p/e multiples in the high 20s to low 30s area, where we are now, are about as high as they can go in a low-inflationary environment.
As we begin to wrap up this essay, we'll now look at a graph which plots the dividend yield on the S&P 500 from 1949 to 2001.
GRAPH #3
There is a VERY important point to derive solely from this graph. The past two secular bull markets began with dividend yields above 7% and 6% respectively in the late '40s and early '80s. Today's dividend yield is around 1.5%. Does this strike you as a point at which we are likely to begin a new bull market?
Conclusion: If earnings increase 4% (Remember, in the long-run investors pay for earnings, and earnings often fail to exceed GDP growth as shown in graph #1; and 4% to 5% GDP growth is about the best we can hope for.) and if p/e multiples don't expand much further (p/e multiples are at maximum low-inflationary levels now as shown in graph #2) and the current dividend yield is 1.5% (graph #3) then returns over the next decade are unlikely to exceed 5.5% or so -- that's 4% earnings growth plus 1.5% dividend yield which equals a 5.5% or so annual return.
This means that investors who desire returns exceeding 5.5% or so in equities over the next decade are doomed unless they are able to time the market by entering equities when they move higher, and exiting equities when they move lower. End --
Special note to our readers:
We have just witnessed the greatest secular bull-market ever, and now we've entered a bear-market for U.S. equities. History strongly suggests to my partners and I that it is very likely a secular bear-market. A secular bear-market implies a long period (years, even decades perhaps!) of stagnant to lower equity prices marked by occasional dramatic rallies and vicious drops in the major indices.
In a bear-market, especially a secular bear-market, investing strategy changes. Bull-markets require one to fully deploy one's capital most of the time to reap gains from rising stock prices. In a bear-market, however, capital preservation is the name of the game. That is to say, keeping one's money and growing it at a reasonably consistent rate is the paramount consideration.
Market timing is EVERYTHING! Patiently awaiting market buy and sell signals is all-important. Expect to see us recommend high cash, or selected bond positions, most of the time in our "strategy" section. We will studiously observe and analyze signals sent to us from sources like politics, intelligence, world events and, perhaps most important, the Invisible Hand of the market itself. It is, admittedly, this very difficult job of determining when to get in and out of the market that we will humbly attempt to perform here at AgoraReport.com. We won't always get it exactly right; no one gets it consistently right all the time--please run from anyone who claims they do.
Thank you for your confidence in us. We will diligently strive to retain it.
agorareport.com |
