Vindication, Complication
By and large, the world’s
economies and financial markets have been performing in line with our
expectations, outlined in several papers since September 11, 2001.
After a bounce due to the end
of inventory liquidation, the world economy has settled into a more subdued
recovery. Typically, economists have been cutting down growth forecasts as
activity slowed and stock markets retraced early gains, but leading indicators
for most countries remain unequivocally positive: if anything, they are
pointing to accelerating, not slowing growth. In addition, economies in Asia
and Europe, which had less of an initial bounce than the United States,
generally seem to be confirming that they have more potential for growth in domestic
consumption than the United States. Because of more savings, less debt and
greater pent-up demand abroad, this also implies that the global economy may have
a reduced dependence on the U.S. economic cycle, which would be welcome.
In spite of these expected
developments, the global investing community has become increasingly gloomy in
recent months. Stock markets, especially in the United States and Europe, have
failed to meet the experts’ hopes at the start of the year and instead have
been testing last year’s lows.
Finally, the announced
weakness of the dollar has materialized, not only against the Euro and the Yen,
but also against currencies such as the Korean won or the Indonesian Rupiah.
We had assumed all along
that “W-shaped” bottoms for stock markets in the United States and Europe were
a distinct possibility, since remaining “bubble” distortions needed more time
to correct. Now, only one final up leg
is still missing to complete these “W-shaped” bottoms, but investors are
increasingly skeptical of this outcome, looking instead for direr scenarios
that might explain the market’s recent behavior. To us, that smells like the
stuff of which market-bottoms are made.
Thanks to significant
exposures to natural resources, basic industries, smaller companies, foreign
equities and gold, our clients’ portfolios have emerged generally unscathed
from the stock market carnage of the past two-and-a-half years. True, in the
last couple of weeks, the bear market has been pulling down stocks
indiscriminately – including ours (which, of course, is very
indiscriminate). But, in true conceited and stubborn contrarian fashion, I also
take this more as a traditional sign of selling climax than of anything else.
After a commendable
performance of our portfolios in the 2000-2002 bear market (to avoid the usual
plethora of disclaimers about individual accounts’ performance, just assume
some mixture of our four historical mutual funds), the main question, going
forward, is: do we continue to ride the positive momentum of many stocks we
hold, or do we try to anticipate an eventual change in market leadership? In
the past, we have found these transitions to be tricky.
This time around, it is
particularly difficult to sort out normal cyclical factors from “secular”
shifts that may be taking place in the economies and financial markets.
From a secular point of
view, we first have to deal with the aftermath of the TMT (Technology-Media-Telecom)
bubble of the late 1990s. In short, we expect this to take time. Actual demand
usually takes years to catch up with the capacity resulting from euphoric
over-investment in bubble sectors; financing dries up just as balance sheets need
to be restored, burdened as they are with excess debt and lean equity reduced
by write-offs; employees laid off in bubble sectors have to find new jobs
elsewhere. While this sorts out, what had been a significant boost to economic
activity becomes a drag. From a stock market point of view, fashions do not
return so fast either, as burned investors gradually despair of ever recouping
their losses, but not without first trying to do so in rally after rally.
Finally, note that the TMT
excesses were not the only bubble of the 1990s. Throughout the decade, the
“indexing” bubble also distorted stock market behavior by pushing ever higher
the shares of the largest capitalization companies in the leading indexes,
while the majority of stocks lagged behind. This explains in part the recent
catch up of smaller companies – another trend which may be expected to survive
for several years.
More importantly, the
general business environment is beginning to change: at the very least, the
1990s trends toward globalization, deregulation and privatization are likely to
be seriously questioned. The unraveling of the TMT bubble, together with the
surfacing of a seemingly endless chain of scandals, has drastically reduced the
credibility of the American economic and business model.
Governments abroad will be
more willing to resist pressure from the United States, the IMF and the World
Bank and look for alternative models of development. Malaysia’s Dr. Mahatir,
who refused both the IMF recommendations and its financial help in
dealing with the Asian crisis, after 1997, was initially considered an
unpredictable fool. Having navigated the storm quite well without help or
advice, he must now look like a hero to the rest of the developing world.
One also senses that trade
liberalization reached its apex with the admittance of China into the World
Trade Organization (WTO). We may be moving into a more mercantilist period,
when trade wars are more likely. Trade is now almost free or is scheduled to
become so within a few years, and most tariffs have been drastically reduced.
And, while this is generally benefiting global consumers and stimulating
development, everyone is also now sharing in the pain that is felt when free
trade confronts rigid economies, or specific sectors and regions within those
economies.
Even some of the more
developed nations now seem, at times, irritated by the loss of sovereignty that
WTO has wrought – not least the United States, as exemplified by its
recently-introduced “punitive” tariffs on foreign steel and the farm subsidy
package. If it is perceived that leaders do not always feel that WTO rules
apply to them, developing countries will be prompt to answer in kind – and with
a great deal of “imagination”, i.e. with bureaucratic and other non-tariff obstacles.
Historically, global trade volumes have tracked closely with world GDP growth,
and a slowdown of international commerce would become a negative for many
economies. This is why, in looking at stock markets in developing countries
(particularly in Asia), I would much rather favor shares of companies primarily
dependant on the growth of consumption in the local or regional markets rather
than those dependant on exports, although we recognize that the two are
intertwined.
In the United States itself,
the population has long accepted large wealth and income disparities because
there was an unwritten understanding:
1) gaining superior wealth or income came from the acceptance of more
risk and responsibility; and 2) with hard work and determination, everyone had
a fair chance of joining the ranks of the privileged. These assumptions have
now been severely tested. As accounting scandals shocked the nation, it became
clear that more than a few executives enriched themselves, not through hard
work or successful management but through cheating. Even before that, obscene
salaries and hiring bonuses had eliminated the financial risk of failure for
top executives. When business strategies failed, a privileged few were
protected by golden parachutes while ordinary workers were being “restructured”
out of their jobs. Finally, unbridled
deregulation occasionally (but spectacularly) led to fraudulent fiascos such as
Enron. All these have contributed to the public’s rising doubts about the
fairness of America’s unwritten social contract.
Just as big government was
discredited in the 1980s, big business has been discredited in the past decade.
The inescapable consequence, in our view, will be a rebirth of populism. In addition
to traditional labor militancy, we are likely to see attempts at re-regulation
or even the re-nationalization of privatized enterprises. The size of
government in America’s economy had already begun to increase again with the
needed expansion of defense and home-security expenditures. Now, more
regulation (as well as resources and jobs) are coming to the accounting and
financial professions, the health industry and probably others like domestic
power.
In the past, “secular”
trends like these have been associated with lower growth, higher inflation or
sometimes both (stagflation). All these trends have also meant lower valuation
parameters for stocks. So, it is entirely conceivable that, for a decade or
more, stock markets will experience their normal cyclical ups and downs, but
around a declining trend in valuations. (This is particularly true if interest
rates begin to rise, as we expect they will.)
These trends probably will
not affect all countries in the same way. Inflation, for example, tends to be a
global phenomenon, but lower growth need not be. As for re-regulation, the
United States and United Kingdom seem ripe for it. But France, for example,
which has managed to survive the globalization, liberalization and
privatization revolution while preserving a bloated bureaucracy as well as
crippling regulations and taxes, could go the other way. If the new government
with a brand new majority (and arguably a popular mandate for renewal) shows
leadership and courage, France could be one of the most interesting
counter-trends of the coming decade. But I would not yet bet on it. France is a
nation of hostages, where the captive (the silent majority) has developed a
sickly attraction for its captors. Politicians both on the left and the right
seem addicted to big government, while splinter groups of unionists, strikers
and extremists retain a disproportionate influence on policy.
From a cyclical perspective,
things look somewhat better. I find little to alter our initial scenario of
subdued growth in the United States but more assertive trends elsewhere –
especially in domestic consumption. The main implication of such a scenario is
that global demand for basic goods and industrial products will keep growing –
probably at a rate slightly faster than the world’s GDP, since developing
economies show a greater materials intensity than more mature ones. Demand for
end-user goods and services – including consumer staples as well as technology
products – should be better outside the United States since international
markets are generally less saturated and, often, will also benefit from greater
pent-up demand.
For materials and basic
industrial goods (especially those where new capacity requires a heavy
investment), there have been practically no capacity additions since 1998, in
the aftermath of the Asian crisis. In fact, closures in several industries have
resulted in decreases in capacity, while global demand has continued to
creep up. This eventually can be expected to restore pricing power in these
industries, which have had none for several years. Possibly, the recent
behavior of industrial commodity prices, exacerbated by the dollar’s weakness,
may be a sign that this has begun to take place. If this is the case, basic
industries, after several years of struggling with deflation, may be one of the
few industries to generate positive surprises during the rest of this economic
cycle.
* * *
From an investment
perspective, the main problem remains valuation.
To start with, of course, no
one knows what earnings currently are. Analysts are still sorting out what real
earning power would have been, for most corporations, without the bubble’s
inflating effect on demand or the accounting shenanigans that distorted the
earnings of many companies. A few observations may help, however.
First, most current
estimates indicate that, except for the worst offenders, the true operating
earnings of our largest corporations may have been 10% to 20% lower than has
been reported. This, of course, reduces not only the current level of earnings,
but also assumed historical growth trends. On the other hand, starting in 2002,
debatable but mandatory new rules on the depreciation of goodwill may
legitimately add about 8% to reported earnings – though with no change in cash
flow. Finally, it is possible that investors, once the storm passes, will be
willing to pay higher multiples for what are perceived to be higher quality
earnings. Note that, until 1997, the growth in earnings of the S&P 500
(excluding non-recurring items) tracked very closely with the (reportedly more
credible) GDP figure for total corporate profits. A huge gap then opened until
mid-2001, but it has since been almost closed. Furthermore, several models like
the ones developed by ISI Group that, in the past, have anticipated corporate
profits trends fairly accurately are pointing to gains for the balance of 2002
and 2003.
Assuming that estimates of
true earnings for the S&P 500 settle around $45-$50 this year, the index is
currently selling for 18 to 20 times 2002 earnings, and probably a somewhat
lower multiple of next year’s profits. And therein lies the problem. While
various valuation models may argue that stocks are now fairly valued, they are
in no way as undervalued as we would like them to be. Multiples are still too
high when compared to other, historical market troughs – including some when
interest rates where as low as they have recently been.
Of course, this could be
corrected by a further sharp fall in the stock market. But, historically, few
bear markets have experienced three consecutive years of negative returns for
the S&P 500. We do not think that is a coincidence. Part of it has to do
with the economic cycle and trends in corporate profits, which seldom last
three full years, and part is due to crowd psychology and its propensity to
overshoot over the near term. Our best guess, therefore, is that the downtrend
in the stock market will be interrupted significantly in the coming year, but
that the upside will be capped by long-term valuation factors. We still expect
sub-par returns overall for a good part of the coming decade, with more down
years than in the 1990s, as earnings catch up with market prices. But this does
not mean that money can’t be made in stocks: simply that selection will be more
important than ever.
Here, we are confronted with
a dilemma. Over the past two-and-a-half years, overextended stocks have
corrected sharply-- more than 70% for many NASDAQ leaders and more than 50% for
many large New York Stock Exchange large leaders. But, at the same time, many
former laggards in basic industries (metals, petroleum, defense, some machinery
and chemicals) have been catching up. As a result of this convergence, there
are few of the discrepancies that we are accustomed to seeing in valuations
between different groups or sectors, and the notions of
value and growth have also become muddled. Bloomberg points out that Citigroup
is the most widely held stock in large-companies value funds, but also the
fifth-largest holding in large-companies growth funds. AIG and IBM also are
among the most widely held stocks in both groups.
Of course, valuations should
not be the same for all stocks, since future trends in sales and earnings growth
will diverge. The coming bull market, even if it is a relatively short one,
will necessarily create new discrepancies, and some stocks will become more
richly valued while others gradually become undervalued.
Typically, stocks that have
done well in a long bear market tend to be discovered and “conceptualized” in
the following bull market. This is our main reason for holding on to our
winners in basic industries and defense. (A second reason is that they also
could be supported by favorable earnings surprises.) Companies that remain
expensive but stand a chance of being carried still higher are global
consumer-product companies like Gillette or Procter and Gamble, and some
financial companies. From current valuation levels, we would tread carefully on
those. Finally, we believe that foreign investment (meant here as investment
outside the United States) remains a nascent trend, although selectivity there
will also be paramount. On the other hand, Merrill Lynch points to a
comparison between the total stock market value of the “tech” sector in
relation to the “tech” component of the GDP (a aggregate variant on the
price-to-sales ratio). This ratio has almost corrected the worst excesses of
the 1990s bubble, but it still some way above the plateau on which it remained
for the 13 years from 1980 to 1993. There will be significant exceptions, but
we do not think that tech stocks as a group will reassert lasting market
leadership for several years.
So far, we have refrained
from the same boasting that the “bubblites” inflicted on us in the late 1990s.
What has prevented us from indulging in what Albert Camus called “the awful
bitterness of those who have been proven right” is that we will not have been
proven fully right unless we successfully navigate the next market turn. Bring
it on…
July 14 (Bastille Day) 2002
New York, NY 10019