Tuesday, July 14, 2015

The Party's Ending.....

Once again investors have mistaken a bubble for a recovery, only this time the bubble is much larger and the "recovery" much smaller. While the party in the 1990s ended badly, the festivities currently underway may end in outright disaster. 

The Party's Ending

It is said history may not repeat, but it often rhymes. If so, there may be a financial sonnet brewing. There are reasons to believe that relative returns globally will turn around now much as they did back in 2000. Perhaps even more decisively.
 
Just as they had back in the late 1990's, investors appear to be ignoring flashing red flags. In its Business and Finance Outlook 2015, the Organization for Economic Cooperation and Development (OECD), a body that could not be characterized as a harbinger of doom, highlighted some of the issues that should be concerning the markets. 

Reuters provides this summary of the report's conclusions:

Encouraged by years of central bank easing, investors are plowing too much cash into unproductive and increasingly speculative investments while shunning businesses building economic growth.

There is a growing divergence between investors rushing into ever riskier assets while companies remain too risk-averse to make investments.

Investors are rewarding corporate managers focused on share-buybacks, dividends, mergers and acquisitions rather than those CEOS betting on long-term investment in research and development.

While these trends have been occurring around the world, they have become most pronounced in the U.S., making valuations disproportionately high relative to other markets. Looking at current valuations through a long term lens provides needed perspective. One of the best ways to do that is with the Cyclically-Adjusted-Price-to-Earnings (CAPE) ratio, which is also known as the Shiller Ratio (named after its developer, the Nobel prize-winning economist Robert Shiller).Using 2014 year-end CAPE ratios that average earnings over a trailing 10-year period, the global valuation imbalances become evident:



As of the end of 2014, the S&P 500 had a CAPE ratio of well over 27, at least 75% higher than the MSCI World Index of around 15. (High valuations are also on evidence in Japan, where similar monetary stimulus programs are underway). On a country by country basis, the U.S. has a CAPE that is at least 40% higher than Canada, 58% higher than Germany, 68% higher than Australia, 90% higher than New Zealand, Finland and Singapore, and well over 100% higher than South Korea and Norway. Yet these markets, despite the strong domestic economic fundamentals that we feel exist, are rarely mentioned as priority investment targets by the mainstream asset management firms.
 
In addition, U.S. stocks currently offer some of the lowest dividend yields to compensate investors for the higher valuations (see chart above). The current estimated 1.87% annual dividend yield for the S&P 500 is far below the current annual dividend yields of Australia, New Zealand, Finland and Norway.
 
If a dramatic shock occurs as it did in 2000, will investors again turn away from high leverage and high valuations to seek more modestly valued investments? Then, as now, we believe those types of assets can more readily be found in non-dollar markets.
 
Another similarity between then and now is the propensity to confuse an asset bubble for genuine economic growth. The dotcom craze of the 1990s painted a false picture of prosperity that was doomed to end badly once market forces corrected for the mal-investments. When that did occur, and stock prices fell sharply, the Fed responded by blowing up an even bigger bubble in real estate. When that larger bubble burst in 2008, the result was not just recession, but the largest financial crisis since the Great Depression.
 
But once again investors have mistaken a bubble for a recovery, only this time the bubble is much larger and the "recovery" much smaller. The middling 2% GDP growth we are currently experiencing is approximately half of what we saw in the late 1990s. In reality, the Fed has prevented market forces from solving acute structural problems while producing the mother of all bubbles in stocks, bonds, and real estate. A return to monetary normalcy is impossible without pricking those bubbles.

Soon the markets will be faced with the unpleasant reality that the U.S. economy may now be so addicted to monetary heroine that another round of quantitative easing will be necessary to keep the bubble from deflating.
 
The current rally in U.S. stocks has gone on for nearly four full years without a 10% correction. Given that high asset prices are one of the pillars that support this weak economy, it is likely that the Fed will unleash another round of QE as soon as the market starts to fall in earnest. 

The realization that the markets are dependent on Fed life support should seal the dollar's fate. Once the dollar turns, a process that began in April of this year, so too should the fortunes of U.S. markets relative to foreign markets. We may be about to embark on what could become the single most substantial period of out-performance of foreign verses domestic markets.
 
While the party in the 1990s ended badly, the festivities currently underway may end in outright disaster. 

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