Tuesday, January 19, 2010

Themes For 2010 - 5 - Asset Markets

In the last three installments of this series I have covered the credit markets, the economy and the government's influence on each.

The picture painted is one of a continuing deflation. This deflationary process should not be seen as "armageddon" or a "bottomless spiral" as some like to imply. It is a removal of excessive debt levels that will otherwise hamper the economy's ability to grow based on its typical catalysts: savings, investment, and production.

Governments, working in conjunction with their central banks, have attempted to remedy the adverse symptoms of recession with conventional and unconventional measures. The unconventional measures (massive bailouts, asset swaps, accounting shenanigans) will not and cannot prevent the eventual realizations of losses outstanding on bad loans and their derivatives. This reality will hinder banks' ability to lend at low rates to risky borrowers, thus cutting off one engine of typical recoveries. Conventional measures (low interest rates, fiscal stimulus) serve as a disincentive to save, and thus hinder the economy's desire to spontaneously and creatively adapt to a new environment.

Large investment houses, hedge funds, and analysts are assuming that the recession of 08-09 is a normal inventory retrenchment, rooted in overcapacity. Taken together with the conventional and unconventional measures noted above, they almost unanimously agree that a "V-shaped" recovery will ensue, as they have before. In 2007, they all unanimously agreed that there was no overcapacity, and therefore could be no recession. As they were proven wrong for ignoring the debt side of the equation then, so will they again. This was not a normal recession. It was brought on by a credit contraction for the first time since the Great Depression.

The unanimity of opinion on this matter should not be understated. Nearly every investment/business professional (+/- 90%) has received their education from the same sources that suggest a) credit growth/contraction has no appreciable impact on the business cycle or the structure of production; b) aggregate debt levels are irrelevant because "we owe it to ourselves." They are wrong on both accounts.

The mathematically based assumptions of these professionals not only influence their views on an imminent economic recovery to "equilibrium" or "potential output," but they influence their views on how asset markets in general will respond. Naturally, these mathematical models with all their flawed assumptions paint a very favourable picture for stocks, corporate bonds, commodities and foreign currencies.

Because I operate from a different perspective, focusing on debt and the effects it has on growth patterns, my views on asset markets are also different. I see the present (and pre-bubble) valuations of these assets as being determined on the availability of credit and thus the ability for people to borrow money for speculative purposes. Comparative valuation analysis of the past 30 years (during which credit growth was excessive) with the previous 100 years of data is supportive of this claim. To date, I have found no other explanation for these discrepancies.

The value of any asset is primarily owed to its ability to generate cashflow. The value of an apartment building is the amount of rents it can generate over the projected life of the building minus property taxes, maintenance costs, and depreciation. But over the past few decades a premium has been applied to this. Because interest rates have been held below the rate of credit growth, asset prices can reasonably be expected to increase. It is a simple calculation for speculators: if outstanding credit is expanding at 8% per year, then the price of an asset should rise to reflect the total amount of credit available to purchase it. But if interest rates are at only 5%, then owning the asset yields a greater return than a savings account.

Neoclassical economists assume that people make decisions based on aggregate levels of inflation (like the CPI). They use that assumption to fix the cost of money (interest rates). Again, they are wrong. People make decisions based on real-life scenarios like that described above, not nebulous, aggregate statistics. The result is that a massive premium has been applied to the value of all assets based on future implied rates of credit growth. That credit growth has hit a wall and is now contracting - as illustrated in Part 2 of this series. In 2008 and early 2009, asset prices successfully eliminated that future implied rate of credit growth from their valuation. But the efforts of governments and central banks have reapplied it by promising to fight credit contraction with all means necessary. Those efforts are failing. It is my contention that markets will eventually realize that credit expansion is not coming back anytime soon and asset prices will again need to readjust to more conventional valuation metrics.


To avoid being sensationalist, I will use the most conservative valuation metric available. The Shiller 10-year real P/E. It takes the last decade of operating earnings, and adjusts for inflation (CPI). Keep in mind that over the last decade, companies booked profits on many sorts of malinvestment like originating bad loans. That all gets counted under "normal operating revenues." But when the loans get written down, they are "one time charges" and therefore don't get counted.

Even using this valuation metric, it is apparent that stocks are at least 25% overvalued from their historical mean. If the economy is indeed in the early stages of a new business cycle as most suggest, then this overvaluation is unprecedented for that position. Valuations have always been much lower for the first few years of an economic expansion. The forward expectations for corporate profits to justify present valuations are out-of-this-world optimistic. David Rosenberg of Gluskin Sheff comments:

We should add here that on a Shiller real 10-year “normalized” earnings basis, the S&P 500 is now trading at 20x, which is 25% above the historical average of 16x. This is the same level of overvaluation heading into October 1987, though at the bubble peak in October 2007, the overvaluation gap was 70%. At the average of prior market peaks, the extent of the overvaluation is 50%. We are not saying that equities as an asset class is in a bubble but they certainly have moved to an overvalued extreme.

Moreover, as we have pointed out recently, what is “normal” is that every percentage point of nominal GDP growth translates into 2.5 percentage points of profits growth. Most economic forecasters see nominal GDP growth at 4% for this year. But strategists see, on average, 36% profit growth. But that 4% growth in nominal GDP is only enough to boost profits by 10%, if the normal relationship holds up. To see such low nominal growth and such strong profit growth is a 1-in-50 event. Maybe the economist and strategist at the Wall Street research houses should sit down with each other.

Analysts are expecting $75+ in earnings for 2010. Based on those estimates, and today's current S&P 500 level of 1148, stocks are trading at a P/E of 15.3. That is considered "fair value." Unfortunately, analysts are a fairly rosy-eyed lot. Even last year they expected to see around $77 in earnings. All they got, even with phantom profits at big banks from accounting breaks, was mid-50s. Again, the rate of profit growth needed to achieve this feat is unprecedented. Readers are free to take those projections at face value. But given the track record of these analysts, one would be wise not to.

So my view is that equity markets will correct to valuation levels commensurate with a trough in economic growth. This is heavily dependent on the credit markets, which are the basis for these present overvaluations. If credit continues to contract, then the inflated earnings from previous credit expansions will prove even more elusive. I project trough "operating" earnings (in a period of contracting credit) somewhere between $38-48. If trough valuation levels are applied to this (6 or 7 in the chart above, but we'll use 10 to be conservative), one can expect the S&P to bottom somewhere between 400-500. How soon that occurs depends largely on the rate of credit contraction, and the amount of time it takes to deleverage the economy sufficiently so that growth can take root from more sustainable levels.

I fully expect that certain sectors of equities and perhaps even certain markets (like South America) have very likely already put in major bottoms. But all assets worldwide are credit sensitive, so a prolonged contraction could still have very noticeable effects on even those areas that are recovering.

Real Estate

Perhaps more than any other asset, residential and commercial real estate is dominated by credit availability. For centuries it has been a common rule of thumb that homebuyers are able to afford 3x their household incomes for the purchase of their primary residence. Banks would almost never lend more than this. But this all changed in the 80's. As quantitative finance and exotic mortgages became normal practice, justifications were found to lend up to 10x one's income for the purchase of a home.

As mentioned above, an asset's value is its ability to generate cashflow. This means rent for real estate. And at present valuations, most areas are still selling at 20x yearly rents or higher. Like stocks, average valuations for real estate are around 12-15 depending on the type and location of the property. We will likely return or sink below those levels prior to a bottom in real estate prices. For bubble areas like Vancouver, this means drastic price reductions or drastic rent increases. Because people can't borrow to pay rent, rents are determined solely by wages. Thus, the only way for this imbalance to be rectified is by either enormous wage increases or price declines. I'll let you figure out which is most likely.

One way or another, we will return to tried, tested and true mortgage practices. This means 3x average household incomes correlates with the average home price. It means mortgages are not issued without a 20% down payment. It means loans are only made if total debt servicing (including credit card, car loans, etc) accounts for less than 40% of one's income. And it means that owners of buildings buy them for their rental revenues - not price appreciation differential over the cost of borrowing.

Most would consider my projections to be apocalyptic. They are merely reversions to long-term historical means. If asset prices were at such levels for hundreds of years before, I can assure you that were they to go back to said levels the sky will not fall, the seas will not boil. And no, the earth will not be covered in eternal darkness (although for investment bankers, living hell may be an appropriate analogy).


I am of the view that commodity prices are impacted by speculative credit flows. I also believe that a fair bit of "hoarding" has occurred in some markets, which has elevated commodity prices past levels that would likely prevail otherwise (read: China).

So to be consistent, I do expect commodity prices in aggregate to decline over the coming years. This decline should take prices back below their March lows. The recovery in the CRB just looks choppy and corrective.

Within the commodity complex, I continue to believe that gold and agricultural commodities will hold up best. But they will be far from immune should credit contract the way I believe it will. Should gold rise past $1160, I see a non-trivial possibility of a blowoff leg higher toward $1800. As of now, I am expecting lower prices over the next year.


Corporate bonds are in the same boat as equities in my opinion. Excluding a couple dozen high-quality borrowers, most corporate issues are risk assets - largely dependent not on ability to repay principal, but on the ability to refinance at maturity.

Government bonds, on the other hand, are a different story. I can understand cases for both extremes on long term interest rates. Should sovereign concerns spread in Europe and elsewhere, risk premiums could begin to be priced in to US, UK and Japanese debt. But I also see the possibility of another "flight to quality" like we saw in 2008. I have no edge on this scenario, so the best I can offer is to stay away from long-term bonds and instead stick to shorter maturities.


Credit contraction and asset price deflation are two peas in the same pod. As I believe credit contraction is unavoidable over the long-term, I also see lower asset prices ruling the roost. In many cases, a return to historical valuation levels would imply drastic reductions in prices. This should be viewed in a positive light. Lower asset prices enable lower wages, which restore competitiveness and lays the foundation for a robust economic recovery. Whether this happens in 2010 is to be determined. But I feel that the probabilities are strongly in favour of such a scenario.

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frank said...

Well thought out commentary.FWIW Rosenberg has been bearish while the S and P and TSX have risen 60% and Emerging markets have done even better.

Eventually he will be right but I have stopped reading analysts who are married to one point of view, be it bearish or bullish.

mike.montchalin said...

This is the kind of commentary I like to read.

!) Credit Contraction will lead to asset deflation.

!!) "People make decisions based on real-life scenarios ..., not nebulous, aggregate statistics. "

!!!) "...commodity prices are impacted by speculative credit flows.")

!!!!) "...Lower asset prices enable lower wages, which restore competitiveness and lays the foundation for a robust economic recovery. Whether this happens in 2010 is to be determined. But I feel that the probabilities are strongly in favour of such a scenario."

Comment: I met a lady from Portland, OR who had bought a house in Detroit for $1,500 + $600 in back taxes. OK! I can see how lower asset prices make significantly lower wages possible.

But I can't see how wages can drop to levels low enough to make labor productive and competitive; not in Detroit or anywhere in the US. Labor laws are not set up to deal with deflation. I can't imagine anyone adjusting to our radical new environment. It seems more likely a Roosevelt or Japanese style nausea with no end in sight. So I hope in a future post you will help me see the bottom of this spiral.

Matt Stiles said...

Thanks Mike,

Indeed, union ideologies of "permanent/guaranteed employment" are a wrench in any attempted return to competitiveness. I'm not sure how easily they'll give up on those fallacies.

But increasing protectionism/nationalism is one way in which competitiveness can return quite quickly (eg. a consumer boycott of China).

Uncertainty is another. I read a great book a while back about how globalization has gone too far in many cases and how "regionalization" will likely replace it (based on logistical savings).

Also note that in part 3, labour productivity is increasing unhampered during the recession, so even as it is growing in the BRICs, the rate of change may slow.

Some ideas. But there are many headwinds and will be for quite some time still.

mike.montchalin said...

Your welcome, Matt.

Of course, the top-down protectionalism, nationalism and tariffs are not a good idea. They will lead to trade wars where nobody wins.

Boycotts! I'm not the poster child, just an example. I am getting really tired of products that don't hold up. It is nothing ideological, just one person making "decisions based on real-life scenarios ..., not nebulous, aggregate statistics. "

I'll bet there are a lot of others, just like me making the same decisions.

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