[“This is the beginning of a process that no-one has ever seen before,” says Ken, “In the past, when the earnings yield has been above the bond yield it’s either been in a single country… Or it happened for a very short time. This is the first time in modern history when the earnings yield has been above the bond yield all around the world.”]
Ken Fisher makes the "bull" case...
The boom must go on
Posted by: Richard Beddard
There’s a buzz on the Internet about a chart published on The Big Picture. It purports to show the level of the Dow over the last year against the period leading up to the Crash in October 1987. The two match, almost as if one were a shadow of the other. Back in 1987 the Dow fell 508 points or 22%, its worst one-day fall in history. The inference is it might do so again, although Barry Ritholz, who runs The Big Picture, prefers parallels with 1973, when the Dow was also on the slide.
Investors are speculating about the trigger. David Andrew Taylor at Dismally thinks there’s a ‘perfect storm‘ brewing on two fronts: rising interest rates, and a rising Yen. Barry Ritholz says “The wall of worry now looks like the Great Wall of China‘
But the old saying is the market climbs a wall of worry. When we stop worrying and we’re complacent, that’s when we should really be worrying.
So charts and sayings aside, what’s the intellectual case for a continued bull market? I asked Ken Fisher when he visited the UK recently. Ken has a deserved reputation as the US’ most accurate pundit, and more importantly as a canny, and therefore wealthy, investor.
He predicts returns of 10% to 40% from global equities this year. The basis of his bullish forecast is the spread between the earnings yield and government bond yields. The earnings yield is a company’s or market’s earnings per share divided by its price (per share). It’s the inverse of the price earnings ratio and a figure that theoretically shows you the return you get on your investment. A company trading on a PE ratio of 15, for example has an earnings yield of 6% (1/15).
At the beginning of the year the forward earnings yield was 2% higher than the 10 year government bond yield in the US and over 3% in the UK, France, Germany and Japan, yet over long periods the spread between the two has been close to zero. The theory is that when one asset pays more than another, money will flow to it and prices will rise.
“This is the beginning of a process that no-one has ever seen before,” says Ken, “In the past, when the earnings yield has been above the bond yield it’s either been in a single country… Or it happened for a very short time. This is the first time in modern history when the earnings yield has been above the bond yield all around the world.”
Ken says the current generation of chief executives were slow to recognise the significance of the earnings yield/bond yield spread because they replaced the fallen stars of the 1990’s. Keen to avoid the corporate excesses of the technology bubble they stuck to the basics, taking care of marketing and production and focusing on costs and efficiency.
But they’re learning there’s another way to increase profits when the bond yield is below the earnings yield. First they borrow money to buy back and destroy their own higher yielding shares thereby boosting earnings per share. Then they borrow to take over other companies, assuming the profits, and boosting earnings per share. Other CEOs learn to play the game, and the size of the deals increases. Companies compete with each other, and private equity firms, to do bigger and bigger deals more and more quickly.
From there it’s a short hop to a bull market as demand for shares rises, but takeovers and buybacks constrict supply. Prices must rise. How long this mechanism persists depends on a three-way tug-of war between share prices, interest rates and earnings. Rising interest rates (from borrowing) and rising share prices (from constricted supply) act to close the spread between the bond yield and earnings yield. But rising earnings (from takeovers and buybacks) widen it.
What makes it unlikely the market will return to parity soon is the size of the moves required. Ken says it would take a rise in world stockmarkets of about 70%, a rise in global bonds yields of 2.8%, a fall in corporate earnings of about 41% or a combination of those things. He thinks share prices will rise this year, earnings are unlikely to drop, and bond yields will stay put. That’s not enough to close the gap.
Investors’ niggles are either insignificant, or lack the scale to tip the market into a full-blown bear. This is what Ken had to say about some of the them:
The carry trade
Investors are making easy money by borrowing in countries with very low interest rates, like Japan, and lending it in countries with high interest rates like the UK and US. The fear is it’s propping up stockmarkets and, should interest rates rise in Japan or the US dollar fall apart, the prop would be kicked out from under us. Ken disagrees:
“When you unwind the carry trade all that it does is takes the money that was borrowed in one country (and) lent in another country, and return it to its country of origin. You were lending in Britain. Now you close out your loan in Britain and return your capital to Japan. There’s no increase or decrease in capital… It can’t have an overall impact.”
“It’s always true you can spook a market in the short-term the same way you can spook people in a movie theatre by yelling ‘fire!’,” he says. “Every correction has a phony story with it, and people can’t tell if it’s real or not, and so they are panicked by it. But phony stories don’t create real bear markets.”
Private equity bubble
Other ‘worries’ don’t even cut it as short-term scares. Mention a private equity bubble, and he says there isn’t one. The boom in private equity is completely rational:
“All a private equity firm is doing is borrowing at the corporate bond rate, doing a takeover at an earnings yield above the borrowing price, and getting the free earnings… The time you have to fear the private equity firms is when they start selling the companies they’ve bought back to the marketplace”
Perhaps parallels with 1973/4 are more valid than 1987. Then the market fell apart after the conglomerate boom, when investors realised that bigger wasn’t necessarily better. That’s how Ken Fisher sees this boom ending, although not in 2007. The game begins to end when the gap between the earnings yield and bond yield closes, but just as they were slow to learn the game, bosses will be slow to realise it’s over:
“The one time there was something sort of like this in the English speaking countries (but not in the non-English speaking countries) was the 1960’s conglomerate boom, which was fuelled by the exact same thing; the earnings yield being above the bond yield. After the earnings yield/bond yield gap closed they kept doing it. They kept doing it because they liked building their empires. If you remember people like Jim Slater of Slater Walker. He was doing this right over the edge, which is how Slater Walker got into trouble.”
“My view is that there’s a huge gap, it will take a long time to close… It’s not going to happen next month. It’s not going to happen this year. It might take a couple of years. When it closes they’ll keep playing the game too far, and then off the other side you’ll see the reverse of the process, which is the private equity firms selling off the deals they made. That will add supply to the market, which will help drive the market down.”
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