April 11, 2003
Why the US Equity Markets Are Not Indestructible
If the boom was comparable to any in history why hasn’t the bust been comparable to any history?
With the US economy teetering on the brink of recession and corporate earnings estimates for the second half of 2003 undoubtedly overstated, S&P's David Braverman says “We are cautiously optimistic for the second half and look forward to an S&P 500 at 950 by Dec. 31”. Given current realities, can it not be safely be assumed that anyone who believes the S&P 500 will rally by 9.1% by years end is simply an optimist? (less the cautiously)
Optimism: A tendency to expect the best possible outcome or dwell on the most hopeful aspects of a situation.
For the realistic investor – meaning the investor that believes tangible increases in corporate profits are required for stock prices to predictably head higher - the optimist is simply anyone who ignores reality.
Current Realities
Stocks (S&P 500) are trading at nearly 30 times historically manipulated earnings, the US government is beginning to ring in record deficits, the Fed’s traditional ammo belt is nearly empty, the consumer is packing a historically high household debt service burden, and industrial capacity is gunning for record lows. Yes, victory in Iraq and upcoming tax cuts are helping investors ignore the threat of recession, and preposterous Wall Street earnings estimates make stocks look more attractive on a forward P/E basis. However, these stated ‘current realities’ are nonetheless irrefutable.
Point being, and to play off the definition of optimism, ‘optimists’ are those that choose to ignore current realities in favor of some ‘better possible outcome’.
Fed President Infected With SARS (Selective, Arbitrary Reality Syndrome)
St. Louis Federal Reserve President William Poole made some baffling remarks during a Q&A yesterday:
“We can afford to be patient (on monetary policy moves) because we have a well-understood mechanism and the market will adjust to the data...If we receive a string of weak data, the market will bring down long-term rates”
This statement contradicts another well known Fed doctrine which argues the Fed should be extra aggressive and early, in an attempt to combat Japanese style deflation. Regardless, Mr. Poole goes on to say:
“If you look at any substantial period of U.S. history, except for the Great Depression, on average the optimists have been right.”
In the 1800s the U.S. suffered through three depressions, and during the last 100 years the U.S. went through its worst depression ever (the 1929 incident) and a series of bear markets/recessions. To be sure, stock market ‘optimists’ have been crushed with a lifetime of losses time and time again through out history. And while the optimists have been ‘right’ in some sense of the word – the U.S. economy still exists and it has grown – often times (i.e. the last 3-years and likely the next 10-years) it pays to be realistic rather than optimistic.
Erecting Marketplace Pillars
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In 1982 the SEC passed a new rule that allowed corporate America to readily buy back shares. In the 1980s new 401K laws (see Revenues Act of 1978 (enacted in 1980), and Tax Reform Act of 1984) were passed to bolster stocks and give corporate America tax breaks. Following the 1987 crash the PPT was born and circuit breakers were installed, and during the 1990s new technological platforms were implemented to increase market efficiencies. Suffice it to say, not only did these types of changes help capital move into stocks during the bull, but they have also helped ensure that capital has not swiftly move out of stocks during the bear.
Optimism Is America’s Greatest Asset. But how do we define ‘optimism’?
It is becoming increasingly apparent that the demise of the U.S. financial markets will not emulate previous incidences of financial destruction. To be sure, nearly every major U.S. stock market bust, including the crash of 1837, numerous debacles during the late 1800s, and 1929, has been brought about in large part by the end of investor optimism. And while investor optimism is undoubtedly an important factor in today’s marketplace, it is how we choose to define ‘investor optimism’ that is critical.
As a result of newly erected ‘market pillars’, during times of crisis companies can readily repurchase shares, and some 401K participants can not readily liquidate assets. Moreover, and as evidence that previous lessons have been learned, the Fed reacts more quickly to market declines and the threat of recession than ever before (sometimes even ‘pre-emptively’), the SEC is ready to change rules within minutes, and the government is prepared to bailout countries (Brazil) and companies (Airlines).
Whatever you choose to call it -- faith in the dollar, optimism in American – the U.S. financial markets are guarded by a labyrinth of complex forces. To borrow Poole’s words, its these ‘well understood mechanisms’ – not merely a simplistic interpretation that when ‘long-term interest rates’ decline stocks should rise – which allow investors to remain confident in the system.
The Reality of Stock Market Confidence
It is a fundamental reality that stock prices are overvalued. This is true whether you care to look at historical market valuations (P/E, P/B) or at a U.S. economy that is not expected to perform strongly, but is expected to grow with more risk (increases in debt as a % GDP, etc). However, it is important to recognize that the structure of the markets was not designed to reflect reality. Rather, today’s U.S. stock markets are structured – referring to how capital moves into and out of stocks and why – with the explicit intent to avoid previous financial catastrophes, and perhaps also to keep prices artificially high.
More than 40% of today’s trading volume is derived from program trades, hedge funds attempt to play the markets without risking naked (unhedged) capital, and due to regulatory confinements equity fund managers must invest a certain amount of their available capital. Strangely enough, liquidity and volatility -- two things that have nothing to do with the intrinsic value of a company – are what make U.S. equity markets the envy of the world and to Institutional speculators.
Yes, pension funds, 401Ks, mutual funds, private investors, etc. are the (relatively dormant) capital base of the markets – and the current sentiment the holders of these assets have could be looked at to figure out ‘investor optimism’. Nevertheless, when Wall Street, Braverman, or Poole comment on ‘the markets’ or argue that they are ‘optimistic’, they are not necessarily reflecting what investors think about current stock prices. Rather, they look to predict when the net influx of sidelined investor capital will roll into stocks, when the next tax cut will help the economy, and when future corporate earnings might justify current stock market overvaluation.
In short, the reality is that confidence in ‘the markets’ is not the same thing as arguing ‘stocks are undervalued’.
Conclusion
The Economic Growth and Tax Relief Reconciliation Act of 2001 increased the amount of money participants can punch into 401Ks. The Fed will likely continue to cut interest rates, print money, and buy/sell Treasurys (stocks). The government has already cut taxes and is looking to do so again. These types of actions are why the U.S. stock market bust has not yet turned into the biggest bust of all time.
However, U.S. history has proven that sooner or later stocks reflect the underlying fundamentals of companies. And while it is difficult to foresee exactly where the next structural crack will emerge (i.e. pension funds allocating less capital to equities), we can nonetheless speculate that, ‘on average’, the stock markets have a greater chance of declining so long as the U.S. economy and corporate earnings remain in a funk.
In sum, the ‘bust’ period is ongoing -- it may take a substantial amount of time before the optimists are right. By contrast, thanks to a market supported by optimism in liquidity, volatility, and an overvalued U.S. dollar (which, if it continues to decline, will limit the amount of stimulus the Fed and government can provide) it may only take a short period of time for this confidence to be lost.
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