Sunday, January 10, 2010

>“One chart to rule them all”: why U.S. stocks cannot have just started a major long-term bull market

Our primary reason for remaining cautious on U.S. (and European) equities is that most people are still treating this recession as a garden-variety inventory-correction one, instead of a credit-collapse recession different in character from any other developed-nation recession in the last century other than 1930s America and 1990s Japan. But an even bigger-picture view makes us wary over a longer time frame. The best way to gain this perspective is to examine what drove the 18-year bull run in U.S. stocks from 1982 through 2000 (excluding the credit bubble build-up and internet mania, which were real but minor factors across most of those years). We latched onto this idea when David Rosenberg made some comparisons of today with 1982. We have pushed his comparisons much farther in report.

From the standpoint of an investor in U.S. stocks, the world of 1982 could not have been a less hospitable place. Everything that could go wrong had gone wrong. Inflation and interest rates were sky-high, which reduces stocks’ value because companies’ future cash flows are worth much less or, alternatively, you can earn a better risk-adjusted return by buying bonds instead. The Fed was doing nothing to provide the market with liquidity. Government deficits were relatively low, meaning deficit spending was not contributing much to output growth – and because total government debt was low, fiscal stimulus had a lot of room to run. Households had meager income, little debt, and a high savings rate, meaning they also were not contributing much to growth. The housing supply was tight, and the dollar was high.

Government actions were unfriendly toward businesses and wealthy individuals, and therefore toward corporate profits and capital creation; we had high tax rates, oppressive regulation, and a heavy bias towards unionism and protectionism. As a result, corporate profit margins were near all-time lows.

It is not surprising, then, that investor sentiment and equity valuations were at deep historical lows on any metric: price/earnings multiples, price-to-book multiples, dividend yields, and anything else one could measure. But – and this is the key – things had nowhere to go but up. Every one of those depressing trends was about to reverse. From a shareholder’s perspective, the world looked better and better for the next 18 years. On top of that, shareholders got a boost from a once-per-century trend that was every bit as important: baby boomers increasingly entered their peak years for productivity, earnings, and savings, and they plowed an increasing portion of those savings into stocks. That pushed prices and valuations even higher.

Today we are at nearly the polar opposite of 1982: apart from the current credit bubble collapse, which is nowhere near done, everything that could go right for stocks has already gone right. Short-term interest rates are at zero, inflation is zero, Fed-supplied liquidity and fiscal stimulus have never been higher, the government’s and households’ coffers are now tapped out, government policy towards businesses and capital is accommodating and can only get worse, people expect 2010 profit margins to be back near their all-time highs, and baby boomers are just about to leave their peak earning years and become a huge drag on markets instead of a huge boost.

With all of these factors currently working for stocks, and with most investors thinking “the recession is over” and everyone will get right back to bubble-year behavior, it is not surprising that investor sentiment and valuations are now high. As we did last January, we display our key valuation chart, which tracks the price/earnings ratio using a trailing 10 years of inflation-adjusted earnings (to sidestep problems both with earnings cycles and with faulty earnings forecasts)

To read the full report: U. S. STOCKS