The recent equity collapse may well mark the end of the bear market. But I doubt it. Sure, there is a strong equity rally from oversold levels out there somewhere. And improving corporate and macro news will at some point drive it. But there are powerful opposing forces. Wealth destruction in equity markets, a plummeting dollar and rising risk aversion in debt capital markets will damage the global economy.
New economy productivity is real enough and the benefits are now accruing to profits instead of labour. With about 75% of US S&P500 companies having reported Q2 earnings, profits are up about 9% on Q2 2001. Most US corporations remain pure, productive and profitable. And the quality of profits is going to get a lot better now that the S&P profit bubble has been eliminated. In future, profit growth will be more pedestrian and in line with GDP but the market will learn to trust the numbers.
Bear realities
There are, though, even more good reasons to be bearish. In the 1990s, household wealth grew faster than economies. In the OECD, household wealth rose from three times the value of annual GDP to five times. This wasn’t just a result of rising stock markets. In the US, Australia, Canada and the UK, house prices have reached an unprecedented multiple of rental value. And bond yields halved from double digits, boosting capitalization of fixed income streams to the benefit of bondholders. The massive expansion of the wealth multiplier created the capital to finance ever-rising investment and consumption.
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It won’t do this any more. This expansion was driven by disinflation. You can’t do that twice. More disinflation would mean deflation and asset-value collapse. Any revival of inflation would destroy asset values too. The most likely outcome is for wealth to trend upwards in line with national income. For fund managers that means single-digit returns if we’re lucky.
Residential property is the only asset whose multiple (price to rental income) keeps expanding. But I think we are close to a peak here. Three factors will see to that: less money from the job market; affordability as judged by the ratio of house prices to wages; and wealth destruction by falling equity prices. If prices merely stop rising, loss of wealth gains will hit consumption.
Corrupt corporate management hijacked the shareholder value concept. Now the mantra of creating shareholder value is discredited. That has happened for the wrong reasons but perception is everything. The problem is that from now on corporations will be run more bureaucratically. And in non-Anglo-Saxon economies the baby of shareholder value will be thrown out with the bath water of corrupt corporate management. On balance, shareholders will be the losers. Most places outside the US will see that firms will be run for diverse ends to the detriment of shareholders. The US will get clean profit figures but slow growth in them.
Also, the cornerstones of the global supply-side revolution are being damaged by president George W Bush’s policies of big government, big budget deficits as well as market-distorting subsidies for agriculture and protectionism. The US has lost its capacity to lead global economic reform. Its profit miracle is seen as a sham.
Geopolitically, the US is hellbent on destroying Saddam Hussein. But I don’t expect war with Iraq to do anything but destabilize the Middle East and alienate US allies.
Risk aversion and risk premia are rising in all financial markets – but particularly in debt markets. This spells capital starvation for the needy and the worthy. Emerging markets and capital-thirsty high-risk entrepreneurs are the victims. The price will be low growth and political populism in many emerging markets and a big disappointment in the recovery of productive investment in rich economies. Beyond this, the plummeting dollar increases deflationary pressure on non-US economies, particularly those that became overdependent on the US for exports. That means Asia.
Pension funds and life insurers have suffered big damage from overexposure to equities and will invest more conservatively in future.
If the bulls are right, the market will bounce 10% to 15%. But after that it will do nothing for a long time. That’s because the S&P, at 30 times earnings, is dearer than at any other exit point from a recession or bear market I have seen. Multiples can’t expand because disinflation cannot help them any more without becoming deflation. And deflation would kill profits and make the market more expensive. So the bull case is for markets to rise slowly in line with low single-digit growth in profits.
The bear case is for further falls in equity prices until P/E ratios become cheap. That will probably take some time. I am much more convinced of the bear case.
