Market Commentary
by Byron Wien
 
08/01/2012

Considering Multiple Attrition

It can be a bummer to pick up the paper these days.  There is disturbing news about the pace of the economy in the United States, the resolution of the sovereign debt crisis in Europe, the slowdown in China, the civil strife in Syria, Iran’s nuclear development program and finally the shootings in Colorado.  If that isn’t enough to get you down there’s the Libor rate-setting scandal, the higher than originally announced trading losses at J.P. Morgan, the telephone hacking by reporters in the U.K., the fraud at Peregrine Financial and the problems at Penn State.  Heroes in finance and elsewhere are being brought down daily, it seems.  It’s hard to be upbeat.

I have begun thinking that the dark mood these events are creating may be reflected in the valuation of equities.  Price-earnings ratios, after all, are a reflection of confidence and with all that’s going on, confidence in the future is waning on many levels.  The poor performance of equities over the past decade, together with the “flash crash,” high-frequency trading and the thought that computer-driven algorithms are determining the course of the stock market, has driven individual investors out of equities and into bond funds, and many wonder what will bring them back.  I remain optimistic about the outlook, but I have to recognize that the pattern of negative events together with a subdued growth outlook in the developed world may mean that historical multiple ranges could be undergoing a process of downward adjustment.

Looking at the Standard & Poor’s 500 since 1945, the average annual earnings growth rate has been 8.4% and the average multiple has been 15.4.  On that basis the index at 1380 seems undervalued if operating earnings come through at $100 as the consensus expects.  The problem is that the United States is now a mature economy and world competitive conditions have intensified.  From 1945 to 1980, when Europe and Asia were rebuilding after the war, economic growth in the U.S. was easier to achieve.  When other developed economies began manufacturing and exporting, business conditions became tougher.  After 1990, China and India entered the arena and the environment for growth became even more difficult. 

In their book This Time Is Different, Carmen Reinhart and Ken Rogoff argue that when a country’s debt to Gross Domestic Product (GDP) ratio reaches 90%, it becomes harder for real growth to exceed 2% because the use of leverage becomes more problematic.  If you assume real growth for the U.S. of 2% plus 2% inflation plus 1% productivity improvement, we may be in a period where nominal earnings growth is only 5% compared to the historical rate of 8.4%.  If the average multiple on a growth rate of 8.4% was 15.4, does this mean that the average multiple will come down proportionally?  If that were the case the multiple going forward would be 9.2 and the fair value for the S&P 500 would be below 1000.  Even the shrillest of the bears isn’t projecting a level that low.

Interest rates have to be taken into account, of course.  For years I used a dividend discount model which was based on the fact that stocks competed with bonds for investor capital.  When the 10-year Treasury began to attract “fear capital” a decade ago, Treasury yields dropped to aberrationally low levels and the model lost its predictive value.  With 10-year Treasurys now yielding 1.5% the model would indicate a multiple well in excess of 20.  I find it hard to believe that the multiple for the S&P 500 would drop below 10, but the median price-earnings ratio could drop to 13, making the market today somewhat overvalued rather than undervalued.  I am not quite ready to go there yet, but I wanted to introduce it as a possibility.  The argument against this is that interest rates may stay low for a long time making equities, even with 5% earnings growth, attractive relative to bonds, putting upward pressure on multiples.

What we’re dealing with here is the hallowed “reversion to the mean” concept.  The world has become more complex, more competitive and perhaps more corrupt.  It may have always been this way but the reporting wasn’t as good in the past as it is now.  Economies have become more indebted and governments, certainly in the developed world and perhaps also in the developing world, have become dysfunctional.  These qualitative factors would argue that multiples should be lower as well. 

With the background for equities looking so bleak, it’s probably useful to explore what could go right.  The pattern of both the economy and the market over the past two years has been for the first quarter to be positive, the second and third to be weak and the fourth to be strong.  Could that be repeated this year?  From a market standpoint conditions are promising, because sentiment is understandably negative for all the reasons we’ve already discussed.  We need the fundamentals to turn, however.  Unemployment has to come down, but that could begin to develop because initial unemployment claims have declined sharply.  Real growth has to climb above 2%, and the fledgling recovery in housing could make that happen.  The decline in gasoline prices is putting more money in consumer pockets and that could help during the all-important Christmas shopping season although recent data on retail sales have been disappointing.  So it is possible to expect a better tone to the economy after Labor Day, but there are indications that the economy is having trouble gaining momentum.

Although I still believe the second half will be stronger than the first, business leaders are reluctant to make longer-term decisions about adding workers and capital spending for three reasons.  First, they are having trouble assessing the broader economic implications of Europe’s inability to come up with a longer-term solution to its sovereign debt problem.  Second, the Affordable Care Act and the Fiscal Cliff have clouded the economic outlook for next year.  Third, the negative presidential political campaigns of both parties have drained some hope out of business people who would like to think that leadership in Washington will improve no matter who wins in November.

I think the report that China’s second quarter real GDP came in at 7.6% takes the “hard landing” possibly off the table for a while, although critics are questioning the accuracy of the figures.  The most important cause of uncertainty is Europe, and it is hard to be sanguine about conditions there.  Europe needs significant structural change to resolve the sovereign debt crisis.  The markets were reassured when agreement on the formation of a banking union was reached several weeks ago, but hammering out the details will take time and even that step doesn’t deal with the fundamental problems.  While Spain and Italy may be able to continue to borrow at rates which will prove unsustainable in the long term, their credit markets are not open to the private sector.  Germany and other austerity hawks have softened their stance on deficit reduction for the weaker countries, but it looks like Europe will be in a recession both this year and next with high unemployment leading to the possibility of social unrest.

The European Stabilization Mechanism and the European Financial Stability Facility can provide temporary relief to Spain and Italy to keep the governments in operation as deficits are incurred, but these institutions do not have unlimited resources and the weaker countries will only become viable when growth resumes, which may take a few years.  We have probably seen the last of the Long-Term Refinancing Operation.  The banking union and tighter banking supervision is a positive step but it doesn’t go far enough.  Deposit insurance will also be needed to prevent runs on the banks.  These measures will enable the weaker countries to “muddle through” into next year when the financial problems will intensify once again.

Mario Draghi has said that the European Central Bank will do “whatever it takes to preserve the euro and it will be enough.”  We all know what Europe ultimately needs is a fiscal and political union, such as we have in the United States, although it could be argued that it hardly works perfectly here.  Numerous critics have pointed out that a political union would be impossible because of language and cultural differences.  Even if you set these aside, there is currently no leader in Europe capable of convincing the people in his or her own country that convergence to this degree is a good idea.  Moreover, taking a strong stand on the issue could be terminally damaging to one’s political capital.

For the first time I have come to believe that there may be major change in the European Union as soon as next year.  I have always thought that Greece and Portugal would have trouble meeting their fiscal obligations but now I am worried about Italy and Spain.  I thought that the stronger countries recognized they had a lot to lose by a European Union break-up and they had the resources to carry the weaker countries through a transition period, but I now think the transition period could be infinite and the stronger countries can’t tolerate the profligate ways of their troubled neighbors who lack the political will to force the necessary changes.  As Bridgewater has pointed out, “the worst case scenario for Germany and a few other financially strong countries would be for them to build up much larger exposures to save the euro and have it break up.” 

Although François Hollande appears to be working cooperatively with Angela Merkel in helping to solve the financial problems of the weaker countries, France has plenty of trouble of its own.  Government spending is more than 50% of GDP, unit labor costs are rising and taxes are high and going up.  According to The Boeckh Investment Letter, France, Italy, Spain, Portugal and Greece will need 18 months of financial aid to fund debt rollovers and deficits.  Aside from the financial needs of the governments themselves, the banks in those countries will require almost a trillion euros to cover debt rollovers, loan losses and Basel III capital requirements.  Where will all this money come from?  The stronger countries will be able to borrow money from the European Central Bank because they will be able to demonstrate that they can pay it back.  The weaker countries may have to leave the European Union and print money to sustain their economies.  Obviously it would be a turbulent period, but I believe that’s where we may be heading.  The steps taken recently defer the problems into next year while the continent prepares for the inevitable. 

Trouble in the European Union began with the financial crisis of 2008.  From the time the euro came into being until then, the so-called PIIGS (Portugal, Ireland, Italy, Greece and Spain) had been reducing their debt to GDP ratios.  Now keeping the Union together just appears to be too costly and would endanger the financial integrity of the stronger countries, which would be bearish for the rest of the world.  In the end, the break-up could turn out to be a positive because holding together what is unsustainable has cast a pall over the financial markets.  Establishing a union of the stronger countries and putting the weaker ones back on their own will result in some dislocations but a major cause of uncertainty would be removed from the markets and that could prove to be an important change.  There are, however, at least two alternative outcomes.  Germany (and perhaps some other countries that are strong financially) could choose to separate from the European Union, and go back to their original currencies.  After all, the U.K., a European Union member, kept the pound from the beginning, so there is a precedent for a member having its own currency.  This would leave the weaker countries free to devalue the euro, increasing their competitiveness and reducing the value of their historical obligations.  The second alternative would be for Germany to become the undisputed leader of the Union, putting it in a position to determine fiscal policies for others and enabling it to issue low-interest euro bonds to help the finances of the weaker countries.  These alternatives are unlikely right now, but you never know what will happen when a crisis develops.

While these reflections indicate a certain degree of apprehension about the outlook, I still think we will see higher prices for U.S. equities before year-end and some real values may be developing in Europe over the next year.  In America future market appreciation may be more in line with earnings growth, which means that double-digit returns from the indexes will be hard to come by.  Effective asset allocation will be more important than ever.

Please save the date for future Blackstone webcasts featuring Byron Wien.

Thursday, October 25, 2012 11:00 am ET (registration details to be provided closer to the broadcast date)

Click here to view the replay of the Thursday, July 12, 2012, 11:00 am ET Blackstone Webcast: “Optimistic about the Outlook: Contrarian or Delusional?” featuring Byron Wien, Vice Chairman, Blackstone Advisory Partners.

Click here to view the replay of the Thursday, April 12, 2012, 11:00 am ET Blackstone Webcast: “Can Liquidity Triumph Over Structural Problems?” featuring Byron Wien, Vice Chairman, Blackstone Advisory Partners.

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