Long winded Mauldin makes a case, from a different angle, for a 50% drop in the markets. Speed read and you will be okay. A few good points. Slightly edited.
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Investor Expectations
Risk Premiums Get Scary
Predicting a 50% Drop?
"Hopeful" Outcomes
Dollar Merry-Go-Round
By John Mauldin
What a week. A whirlwind tour through Southern California visiting
clients has left me quite tired, but driving through ridiculous
freeway traffic has given me a lot of thinking time. I needed it,
as I have been meditating in the implications of a very important
new article in the AIMR Financial Analysts Journal. It is a lengthy
and devastating analysis of what investors should expect by way of
returns in the stock market over the next decade or so. I will do my
best to give you the highlights.
Plus, there has been a lot of data which has serious implications
for my prediction of a Muddle Through Economy. I have been mulling
over where to start, and I think we will begin with the AIMR article
by Bob Arnot and Peter Bernstein. AIMR is a very mainstream
organization of analysts and economists and NOT prone to bearish
sentiment. The fact that this article is in this journal is
significant.
(Bernstien wrote a magnificent book on the history of risk called
Against the Gods which is extremely readable, even though the topic
of risk can be complex. The AIMR article is still password
protected, though as soon as it is publicly available, I will
provide you with a link.)
Investor Expectations
I have written in the past about investor expectations. Many
individual investors, based upon the past two decades, assume they
can get 15% per year in the future. Most major corporations assume
their pension portfolios will grow 9-10% or more in the coming
years. By the way, these assumptions add to their projected
corporate earnings. If their pension portfolios grow at less that
those rates, they will have to re-state earnings downward and lower
future estimates.
A drop of only a few percent in stock market growth expectations can
lower future earnings estimates at many companies by as much as 10%.
To me, the AIMR article says you can bank on earnings estimates to
be dropped as a result of exuberant projections. You should check to
see if the stocks you own are making aggressive assumptions.
How many times have you had a stock broker quote you the Ibbotson
Survey or something similar which shows the stock market growing 8%
per year over long periods of time? All you have to do is just keep
the faith and buy and hold. You should especially never sell their
funds.
Bernstein and Arnot show that this number is VERY misleading. If you
break it down, it shows you something entirely different.
First, the largest component of stock market return, up until 1982,
was inflation. From 1802 to present, $100 would have grown to $700
million if you assumed all dividends re-invested. However, if you
take out inflation, we are left with a still impressive $37 million.
If you take out dividends, however, you find that your $100 is only
worth $2,099!
Here's the kicker: in 1982, the stock portfolio would have been
worth only $400. The bulk of the growth, over 80% of current value,
came in the last 20 years.
This data simply says that conventional wisdom which says equities
get most of their value from capital appreciation is false. It is
based upon recent experience, and a bubble mentality.
Risk Premiums
Conventional Wisdom says stocks yield a risk premium of 5% over
bonds. You can look at the returns of the last 75 years and
demonstrate that fact. But in 1926, when you looked at actual
expectations, based upon then current yields, the risk premium (that
amount by which stocks were expected to out-perform bonds) was only
1.4%. Investors in 1926 did not expect to get 5% over bonds over the
next 75 years.
But they did. The question one has to ask is why did this happen and
is it likely to repeat itself?
Bernstein and Arnot says the increase in returns was due to a series
of historical accidents. The first was a "decoupling" of yields from
real yields. By that they mean that the coming of inflation changed
the way in which bonds were valued. In essence, in 1926, and for
years after that, bond holders assumed no inflation. Bond-holders
began to demand more in order to compensate for the risk of
inflation. In fact, real returns on bonds were often negative after
WW II. That means inflation was higher than the yields on the bonds.
That change in the way bonds were valued accounted for almost 10% of
the increase in the "risk premium" from 1926 to present.
Secondly, valuation multiples rose dramatically. From a level of 18
times dividends in 1926, we now see dividend multiples of over 70.
This means that a dollar of dividends is valued at over 4 times what
it was 75 years ago. However, the entire increase has happened in
just the last 17 years. Not coincidentally, this was when we had a
bubble. This accounts for over 1/3 of the increase in the risk
premium.
Why were investors willing to take so little risk premium for stocks
over bonds in 1926? Because they did not believe there was "0" risk
in living in America. There were still those who remembered the
Civil War. Four of the largest 15 stock markets in the world had
completely collapsed within recent memory, with many others coming
close to collapsing. The US was not the pre-eminent world power it
has become the last two decades. Historical accident number three is
that investors have become increasingly confident in America. This
is a good thing, I think, but how likely is it that we are going to
grow even more confident from where we are today. Using a rough
analogy, let us say that we have grown 4 times more confident in the
future of America over the past 75 years in terms of being confident
in bonds and stocks. Is it likely we will grow another 4 times?
Thinking back from what the world looked like in 1926, seeing where
we have come and trying to extrapolate that sense of growth in
security into the future, it think it is very unlikely we will feel
significantly better in the future than we do today.
Finally, regulatory reform has done much to increase returns in the
stock market. In the early parts of this century, management would
routinely vote themselves more stock if a company did well, diluting
current investors, and keeping rates of return low. This changed as
securities laws were introduced. This has been a very good thing,
but is not likely to be repeated.
In short, the events which led to the significant increase in the
value of stocks over bonds were basically one time events, and not
likely to be repeated. It is very unlikely that this trend will
continue. Yet that is what would have to happen if the Dow were to
get to 25,000 by 2010 as some predict.
If the risk premium reverts to more normal measures, then either the
stock market, or the bond market, or both, are in for some turmoil.
(See details below.)
The authors show that earnings and dividend growth for the past two
centuries is far less than the forward earnings expectations most
analysts have today. Interestingly, this study uses a different way
to analyze earnings than the National Bureau of Economic Research
that I cited last year, but both conclude that total market earnings
will not grow faster than the economy.
Let's look at some of their direct conclusions. This is a rather
long quote, but it is critical. If you grasp what they are saying,
you could save yourself a lot of investment grief over the coming
decade.
"The historical average equity risk premium, measured relative to
10-year government bonds as the risk premium investors might
objectively have expected on their equity investments, is about
2.4%, half what most investors believe. The "normal" risk premium
might well be a notch lower than 2.4% because the 2.4% objective
expectation preceded actual excess returns for stocks relative to
bonds that were nearly 100 bps higher, at 3.3% a year.
"The current risk premium is approximately zero, and a sensible
expectation for the future real return for both stocks and bonds is
2-4%, far lower than the actuarial assumptions on which most
investors are basing their planning and spending."
Predicting a 50% Drop
Then we come to the meat of the matter:
"On the hopeful side, because the "normal" level of the risk premium
is modest (2.4%or quite possibly less), current market valuations
need not return to levels that can deliver the 5% risk premium
(excess return) that the Ibbotson data would suggest. If reversion
to the mean occurs, then to restore a 2% risk premium, the
difference between 2% and zero still requires a near halving of
stock valuations or a 2% drop in real bond yields (or some
combination of the two). Either scenario is a less daunting picture
than would be required to facilitate a reversion to a 5% risk
premium.
"Another possibility is that the modest difference between a 2.4%
normal risk premium and the negative risk premiums that have
prevailed in recent quarters permitted the recent bubble. Reversion
to the mean might not ever happen, in which case, we should see
stocks sputter along delivering bondlike returns, but at a higher
risk than bonds, for a long time to come."
They then conclude, "The consensus that a normal risk premium is
about 5% was shaped by deeply rooted naiveté in the investment
community, where most participants have a career span reaching no
farther back than the monumental 25-year bull market of 1975-1999.
This kind of mind-set is a mirror image of the attitudes of the
chronically bearish veterans of the 1930s. Today, investors are
loathe to recall that the real total returns on stocks were negative
for most 10-year spans during the two decades from 1963 to 1983 or
that the excess return of stocks relative to long bonds was negative
as recently as the 10 years ended August 1993.
"When reminded of such experiences, today's investors tend to
retreat behind the mantra "things will be different this time." No
one can kneel before the notion of the long run and at the same time
deny that such circumstances will occur in the decades ahead.
Indeed, such crises are more likely than most of us would like to
believe. Investors greedy enough or naive enough to expect a 5% risk
premium and to substantially overweight equities accordingly may
well be doomed to deep disappointments in the future as the realized
risk premium falls far below this inflated expectation."
"Hopeful" Outcomes
I smiled when I read their concept of a "hopeful" outcome. It gives
a new meaning to the word hopeful. Their view of hopeful is only a
50% drop in the stock market or a dropping of long term rates to
levels which imply outright deflation. Or we would see a Muddle
Through Market, with stocks going sideways for many years.
What could make their scenario wrong or irrelevant? They could be
wrong about earnings growth. Earnings could grow rapidly, and thus
valuations drop back to normal levels without the pain suggested in
their study. Many analysts think earnings are going to rebound
dramatically in the near future.
However, my friend Gary Shilling points out in his recent newsletter
that this is not likely. For stock valuations simply to come back to
the mean, earnings would have to grow at 38% in 2002 and 38% in 2003
to get back to an operating earnings P/E of 15.
Shilling does a relatively straight-forward analysis to show that
this would mean a rise in the GDP of 13%, which he says appears
patently impossible. In order for such an event to happen, labor
would have to be willing to give back wages and consumers would have
to be willing to pay a LOT more for products. The Texas Rangers will
be in the World Series before these happen.
In fact, the data shows that the economy is much more likely to grow
around 2.5% for the year. That is not bad, but it is not enough to
help corporate profits grow back to the levels forecast by Wall
Street analysts. Abbey Joseph Cohen still thinks the S&P 500 is
going to 1300. She is wrong.
Dollar Merry-Go-Round
All this has profound implications for the dollar. One of the
hottest and most interesting current debates among economists is
about the value of the dollar. Dollar bulls say that the rest of the
world will continue to buy our stocks, bonds and assets. Why should
demand for the dollar change? They have been right for a long time,
as those who worry about our trade deficit have been wrong in
predicting a crash in the dollar. Why should the next few years be
any different than the past?
For the record, I have been bullish on the dollar for many years, up
until recently. What has made me change my mind?
The "current accounts deficit" is approaching critical mass. Think
of it this way. If you spend more than you make, you have to do
something to make up the difference. You can sell the furniture,
borrow money, hock the kids, get a second job and so on. If you do
nothing, you will soon be bankrupt.
On a macro scale, it is not much different for governments and
currencies. We are buying more products from overseas than we sell.
To make up the difference, foreigners have bought our companies
(called mergers and acquisitions or M&A), bought our stocks and
bonds and sometimes bought our currency (in the form of bonds and t-
bills).
Much of the M&A has been from Europe. This has been drying up at an
alarming rate in the past few months (see below). It is almost like
Europeans smell blood, and realize they will be able to get the US
assets cheaper in the future if the dollar drops.
The longer this stock market goes sideways, the less enthusiastic
the world will be with US equities. If you are not convinced the
dollar is going up, you will invest in your own currencies or in
Euros.
Morgan Stanley analysts Jen and Yilmaz point out that if the world
shifts from the current equity regime to a bond regime (their word)
that the dollar would go from being slightly over-valued to dropping
by as much as 15-20%.
In other words, if Bernstein and Arnot are right and investors are
going to become increasingly interested in the absolute returns,
then the dollar is at real risk.
And then one of my favorite analysts., Stephen Roach, weighs in with
these thought-provoking words:
"Never before has the United States commenced economic recovery with
a current-account gap totaling 4% of its GDP. (They predict it will
rise to 6% in 2003, although Fed studies show that when the trade
gap gets to 5%, serious problems will develop - JM) Given the high
level of import penetration now structurally embedded in the US
economy -- with goods imports at 30% of GDP in early 2002 -- another
stretch of US-led global growth will most assuredly result in a
significant further widening of the external shortfall.
"If such a massive external funding requirement doesn't lead to a
saturation of the foreign appetite for US assets, I'm not sure what
will. Just because America's external financing was manageable in
the 1990s doesn't mean it will be so as the as the ever-widening
current-account deficit now ups the ante on capital inflows.
Needless to say, that conclusion is in direct contradiction to that
of the capital-flow-driven justification of the Bush Administration.
"Interestingly enough, there are signs suggesting that this point of
saturation may now be at hand. As Joe Quinlan and Rebecca McCaughrin
have recently noted, the portfolio portion of capital inflows into
the United States has slowed dramatically in early 2002. Over the
first two months of this year, foreigners purchased just $27 billion
of dollar-denominated assets, a dramatic reduction from the $100
billion pace in the first two months of 2001.
"Meanwhile, foreign direct investment into the United States -- the
other major piece of the capital inflows equation -- has also slowed
dramatically. FDI into the US was $158 billion in 2001 -- only a
little more than half the $295 billion average pace of 1999 and
2000. Fully two-thirds of this slowdown is traceable to diminished
FDI activity from Europe; that's largely a reflection of a dramatic
downshift in the cross-border M&A cycle -- a trend that has
continued into the early months of 2002.
"I remain convinced that America's current-account deficit
represents a key point of tension for the US and global economy. It
is the crux of our "global decoupling" thesis -- that the world can
no longer afford to be dependent on the American growth engine as
the dominant source of economic growth. The coming US current-
account adjustment speaks of a new recipe for sustained global
growth -- a slower pace in the US, a speed-up elsewhere, and a
weaker dollar. The logic of the Bush Administration is flawed in the
sense that it relies on an ever-expanding stream of foreign inflows
into dollar-denominated assets. In this post-bubble era, that may
well turn out to be the ultimate in wishful thinking."
The dollar is headed down, and perhaps the beginning of the drop is
sooner than I had previously thought. You can open foreign
denominated CDs in the Euro or other currencies at Everbank right
here in the USA. This link will take you to their information page:
everbank.com
One of several things will have to happen over time. We will have to
decrease our purchase of foreign goods, although since so much is
manufactured overseas, this is not a short-term solution. Foreign
purchase equal to 30% of GDP is huge.
If the dollar drops, manufacturing and production will come back
into the country, as it will become cheaper to produce things here.
Just as we enjoy cheap foreign products, the drop in the dollar will
make our products cheaper in terms of foreign currencies, and so we
will sell more of them.
The US will still be the premier world economy for some time
(decades and decades) to come, and foreign companies will want to
have a presence here, and will buy our companies and assets, which
will help balance the current accounts deficit.
All these should keep the dollar from the crash that many predict,
but will not save it from the 20% drop that the Morgan Stanley
analysts predict. How soon will all this happen? I don't know, and
neither does anyone else. If I say in the next year or so, it is
just a guess, and that is my guess. Many analysts hazard a guess
which they call a prediction, in case they might be right. If they
are, they will remind you of the accuracy of their prediction. If
not, they assume you will forget. |
