A side note: Command-control economies like China’s offer certain advantages over messy democracies in the short run (and only in the short run!). For instance, they can pull even a large economy out of recession very fast by forcing banks to lend and corporations to spend; and since property rights are just a minor inconvenience, they can build fast, too. But in the long run, especially once you add corruption into the mix, you have massive misallocation of capital (hence ghost towns) and a banking system that will be crippled once the bubble does what bubbles always do: bursts.
Japan, the most indebted developed country in the world, with debt-to-GDP over 211%, has been stuck in deflation for two decades. Despite its indebtedness, it is paying less on its 10-year bonds (0.86%) than Norway (2.17%), which has debt-to-GDP of 28%. Japan also has one of oldest populations in the world, a population that was a net saver and thus a buyer (financier) of Japanese government debt. Japanese seniors and financial institutions (which hold the bulk of the debt) are about to turn into net spenders and will be selling bonds. Therefore the government will have to either shop its debt outside of Japan and suddenly compete with the Norways of the world for investor capital (and pay skyrocketing interest expenses that will quickly burst its debt bubble), or it will print a lot of money and its central bank will become a connoisseur of its fine debt. So far it has chosen the latter course. Either scenario sets in motion its own ugly chain of consequences.
The US. Oh, our dear US. We are living through one of the most grandiose and untested lab experiments ever conducted by a central bank: QE Infinity. QE 1, which was implemented during the financial crisis, was an attempt by the Fed to prevent a run on the banks. It was the right thing to do, and the Fed did a brilliant job executing it. However, with QEs that followed the Fed has turned our economy into a Lance Armstrong economy. We’ve consumed so many performance-enhancing drugs in the form of endless QEs that it is hard to know how well the economy is really doing. Just as we don’t know whether Lance would have won seven Tour de France titles if it were not for steroids, we don’t know how our economy will fare when QE is withdrawn. Unfortunately, our Lance Armstrong economy will at some point have its Oprah Winfrey moment, when it will have to fess up.
It is very easy to be negative about the global macro picture, and the saying comes to mind here that “You’re not paranoid if they really are after you.”
All the aforementioned problems are very complex in isolation, but the complexity of analysis increases exponentially once you start thinking about how problems in one region impact another. For instance, the monster QE in Japan, which will make Bernanke look like an amateur (it is relatively much larger than his) is driving the yen down, a lot. This will make Japanese goods cheaper and more competitive against those of the Chinese and Koreans, et al. Will this be the final straw that pricks the bubble of the Chinese economy? Will it lead to currency wars? In all honesty, nobody knows. The unknowns remain unknown.
In fact, the great Charlie Munger comes to mind. At the Berkshire Hathaway annual meeting this year he said, “If you are not confused about the economy, you don’t understand it very well.” I am sure this applies not just to the US but to the global economy as well. This is not a prediction of global demise, not at all; but if you are betting on high or even average global growth going forward, you’re putting your money on a very low-probability scenario.
And finally, P/E expansion. If you are comfortable with high profit margins and global growth, you have to believe that P/Es can expand higher from this level. I have news for you: in the past, sideways markets started (bull markets ended) when valuations were at current levels. Secular bull markets start at low P/E levels, because prolonged P/E expansion is like a rocket booster that helps the rocket to overcome the gravity of the earth and sends it into stratosphere. Prolonged P/E expansion converts stock market nonbelievers into believers.
P/E compression is a very likely outcome from where we are today, and therefore markets will do what they did over the last thirteen years, go sideways with lots of cyclical volatility and no returns. In case P/E stagnates – a much lower-probability outcome, the market will very mildly appreciate.
What about QE and low interest rates? Could they take P/E to a new high?
The interest rate environment today is quite different than it was in the ’70s and ’80s. Then, during the last sideways market, interest rates were much, much higher. Stocks may deserve higher valuations than they did then; however, higher valuations would likely prove to be a short-lived phenomenon, since the direction of interest rates matters as much as their absolute level.
The Fed’s unprecedented intervention in the economy has increased the possible range and severity of negative outcomes, from runaway inflation to deflation or a freaky combination of the two (freakflation).
If the Fed succeeds and real growth resumes, this good news will be negated by rising interest rates. I know that the last five years have lowered our economic growth standards, and we’ll be excited if the global economy returns to average (unsteroided, thus sustainable) growth. However, normal economic growth in a rising interest-rate environment would not justify valuations much above average.
If interest rates remain at the present low level for a long time, it will mean we have a different problem: deflation (or freakflation) is not good for stocks or their valuations. Just look at Japan: over the last twenty years, stock valuations declined despite interest rates being at incredibly low levels. Expensive stocks (as I’ve mentioned, stocks in general are very expensive) discount earnings growth. If growth fails to materialize, these P/Es will decline.
So if you believe the future will bring average or even above-average economic growth and that interest rates will remain at this historic level, then I will be proven wrong.
Knowing what we know today, earnings growth for the next five to ten years is unlikely to be exciting and may not even be positive, and price-to-earnings is likely to change for the worse, not the better.
So what?
As I write this, one line from Charles Prince, infamous CEO of Citigroup Inc (NYSE:C), is stuck in my head: “As long as the music is playing, you’ve got to get up and dance.” That was Prince’s explanation for why Citi continued to originate loans even though risks were starting to outweigh returns, and when it should have been obvious to an astute observer that the situation would not end well. We know how that story played out.
Today investors are dancing because Fed is QEing. Right or wrong, the
