One of the arguments made by bottom-fishers is that not only are stocks “oversold” (a technical notion that reflects recent trading activity, such as trading volumes, price in relationship to various moving day averages) but are also cheap based on fundamental notions of value.
We have been somewhat leery of any long-term valuation notions given the fact that the US economy has gone through 20 years of growing leverage, with a steepening of debt levels in the mid 1990s, and a further ratchet up starting in 2004. The post 1996 period (starting the time Greenspan made, and then retreated from his famous “irrational exuberance” comment) shows a marked deviation from previous valuation norms (and that further suggests that removal or adjustment of the bubble era would have a big impact on norms as well). Click to enlarge:
Gross focuses on the role of leverage versus deleveraging, as well as government intervention, in the prospects for stocks. He concludes that those two factors mean that stocks might not be so cheap after all. Note he first looks at measures like the famed Q ratio, which suggests stocks are a bargain, and then P/E ratios, which are only a tad below their mean for the last 100 years.
Key excerpts from his monthly missive (boldface his):
We will not go back to what we have known and gotten used to. It’s like comparing Newton and Einstein: both were right but their rules governed entirely different domains. We are now morphing towards a world where the government fist is being substituted for the invisible hand, where regulation trumps Wild West capitalism, and where corporate profits are no longer a function of leverage, cheap financing and the rather mindless ability to make a deal with other people’s money. ….
Corporate profits have been positively affected for at least the past several decades by several trends that appear to be reversing. Leverage and gearing ratios – the ability of companies to make money by making paper – are coming down, not going up. In addition, the availability of cheap financing – absent government’s checkbook – will likely not return….
Gross does not mention that this last upturn saw an unprecedented portion of GDP growth going to corporate profits, as opposed to labor. Labor has had no bargaining power, and companies have been running as lean as possible in a nominally good economy. There will likely be some reversal of rules that worked against unions, but it is not clear whether this will help average workers much.
Globalization’s salutary growth rate of recent years may now be stunted…..investors should not bank on the free trade mentality of recent years to support historic growth rates….
Animal spirits, and with them the entrepreneurial dynamism of risk-taking has likely experienced a body blow….the rules will be changed and hormone levels lowered.
The benevolent fist of government is imperative and inevitable, but it will come at a cost….Profit and earnings per share growth will suffer.
My transgenerational stock market outlook is this: stocks are cheap when valued within the context of a financed-based economy once dominated by leverage, cheap financing, and even lower corporate tax rates. That world, however, is in our past not our future. More regulation, lower leverage, higher taxes, and a lack of entrepreneurial testosterone are what we must get used to – that and a government checkbook that allows for healing, but crowds the private sector into an awkward and less productive corner. Dow 5,000? We don’t have to go there if current domestic and global policies are focused on asset price support and eventual recapitalization of lending institutions. But 14,000 is a stretch as well. One only has to recognize that roughly 20% of bank capital is now owned by the U.S. government and that a near proportionate share of profits will flow in that direction as well.
We noted before that in 1980, financial shares were a mere 8% of S&P 500 earnings versus over 40% at the stock market peak. The financial services industry will shrink as the economy delevers. Some of those earnings are not coming back.