Investors can find value if they pick and mix

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By:
Charles Dumas
Published on:

Global stock markets are at their cheapest for 25 years. Belated measures taken by the US authorities, and possible stimuli from the new Obama administration – and not forgetting a proper historical analysis – show rewards will come in 2009 for those brave enough to buy, writes Charles Dumas.

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GLOBAL STOCK MARKETS are cheap, and should have a good 2009 as they will be gradually cheered up after the crisis. Most important, the world’s apparently weakest link, the US economy, will be benefiting from three major stimuli over the next few months. First, reversal of the violent commodity price inflation caused by Federal Reserve chairman Ben Bernanke’s precipitate, panicky interest rate cuts of a year ago: the bubble he drove to its peak in Q3 2008 accounts for much of the recent world economic slowdown. Second, a significant wealth effect arising from the Fed’s new policy of buying various types of securities, the price effect of these purchases being perhaps more important in the short run than the quantitative monetary boost. And third, a major fiscal package from the incoming Obama administration.

With core inflation – the CPI excluding food and energy – rising at 2% to 2.5%, the impact of the oil bubble and food price surge in the year to July 2008 was 2.7% for the US: on average world consumers suffered about a 2% effective sales tax from this source. Year-ago rate cuts came at a time of continued bullishness, and the signal that the Fed wanted the dollar down led to a rapid flight into oil and other commodities that hammered global real incomes and consumer confidence.

The US CPI’s 12-month growth rate peaked at 5.5% (see chart 1). Since July, core inflation has slowed, and gasoline prices are down 60% (only a small part seasonally). With gasoline above 5% of the CPI, this means a 3% cut in prices – or an increase in real consumer incomes – from this source. In fact, the reduction of the CPI in the four months to November was 2.8%, and there is more to come in December. If lower prices contribute some 3% to real incomes between Q3 2008 and Q1 2009, with cheaper gasoline giving a boost to consumer confidence, the fastest period of real consumer spending decline may already be behind us. The combination of a 3% drop in prices, some continued modest growth in nominal incomes and sharply lower recent real spending means the savings rate could rise five percentage points between Q3 2008 and Q1 2009 – reaching over 6%. It still needs to go higher but the bulk of the climb could be over even before Obama gets to work with his package.

Chart 1. US Headline CPI

July 2007=100

Source: Lombard Street


The chief benefit of the Fed’s new policy of quantitative easing could be in the wealth effect and the price of key securities, rather than the more vague and longer-term benefits of money creation. The failure of the US authorities to take measures to enforce research, valuation and workable trading conditions in mortgage derivatives is the single biggest problem in global financial markets. If they are now simply going to buy them, the paralysis induced by banks’ mutual fears as to one another’s solvency should start to ease. This should knock on into the LBO loan market, where paralysis to a considerable degree represents collateral damage from the mortgage fiasco. If so, the current grossly excessive corporate bond spreads over treasuries should soon get much narrower. Stocks should also benefit. Much of the sting would be taken out of the financial crisis.

Meanwhile, Obama’s first big policy is a massive fiscal package. This could permit household savings to improve from more than 6% in Q1 2009 to the 10% or so that is needed by mid-2010 without further falls in real consumer spending. If so, allowing for weak housing and business capex, the strong upward drag from government spending (under the package) and net exports could pull the economy back into growth of 1% to 2% in the four quarters to Q2 2010 – versus a continuing recession at perhaps a 1% rate without a significant package.

This implies for 2009 the second, upward leg of the W-shape that we expect for the US economy (and stock market). The flies in the ointment that could lead to the third (renewed downward) leg could make 2010 and/or 2011 much more difficult, but this ought not to prevent a good recovery of oversold stock markets during 2009.

Chart 2 shows the astonishingly good and consistent progress of US stocks in the 138 years since 1871, clinging to the 6.75% growth trend-line for total real return: ie, capital gain plus dividends, minus inflation. This 138 years includes much greater stress periods than the past year, whose problems have been serious but grossly exaggerated.

Chart 2. S&P real value index

Dividends re-invested, inflation-adjusted

Source: Lombard Street


Chart 3 shows the percentage deviations from trend from the material in the earlier chart. Previous low points have been down about 50% from trend, and now we are down 35%. But previous low points include World War I; the Great Depression (nominal US GDP down by half in four years); World War II; and the Great Inflation. The last year’s fall has been massive, and stocks were not heavily overvalued at the 2007 peak.

Chart 3. US S&P real value index

S&P with dividends reinvested, CPI-adjusted, exponential trend removed

Source: Lombard Street


In P/E ratio terms, the US, on a trailing ratio of 11 to 12 for operating earnings, can have a one-third earnings fall in the recession and still be on the long-run P/E of 17, even with recession-trough profits. The European P/E ratio is an even more nugatory 8. Japan looks particularly cheap, as Japanese companies are cash-rich and do not distribute much of their profit, enabling them to take advantage of undervalued assets worldwide.

Why are stocks so cheap? The answer is forced selling by hedge funds and the like. These are the classic conditions in which savvy investors, who have conserved their cash when trouble obviously looms – as was the case in 2006/07 – can snap up what prove to be bargains. Why would they start now? One reason is that the US government buying mortgage derivatives should ease the crisis at its source. And then the clever ones – investors who are short – get very exposed as prices fall and their profits expand. There’s an old Wall Street saying: "Nobody ever made a loss by taking a profit." Even the successful bears can only make a profit by eventually buying.