What’s The Upside?

For the last few months, I have been trying to develop an optimistic scenario for the world stock markets, to fit our view of a global economic expansion. To some extent, I viewed this voluntarily bullish bias as acceptable to a contrarian, since even the optimistic expert opinions I read about the economies and the markets reflected more “yes, but...” attitudes than unequivocal long-term bullishness.

The recent stock market corrections reinforced this comfortable feeling of being in the minority, contrarian camp, especially as they were accompanied by threats of minor of economic slowdowns in Asia and stubbornly sticky job surveys in the United States. However, the U.S. economy now seems to be re-accelerating, as are Japan’s and China’s, and the world’s stock markets have resumed their ascent.

But long-term imbalances still loom large over the future of the global economy: the gaping U.S. current account deficit condemns America to suck the world’s capital; in Asia, excess liquidity is flowing inefficiently to increasingly speculative uses; the surge in “offshoring” is disrupting older economies; and the geopolitical environment grows more unstable every passing day.

On that background, end-of-the-world scenarios have been easy to construct. Those, however, I have tended to dismiss, preferring to assume that, with necessary hiccups, the world economy and financial system will continue to muddle through, as they usually do.

Nevertheless, wisdom requires that we accept the risk of investment loss only if the potential gain makes it worthwhile. One big question thus needs to be answered today: “What is to be gained by being bullish?” Unfortunately, as concerns the US stock market at least, the answer seems to be: “Not a lot.”

By definition, stock prices can only go up if either or both corporate profits and price/earnings ratios increase. Let us look first at price/earnings ratios.

Price/Earnings Ratios do not like Yield

The earnings yield is one measure of the financial return on stocks. It is computed by dividing a stock’s earnings per share by that stocks’ price, in the same way that a bond’s current yield is measured by dividing that bond’s annual interest by the bond’s price. Bonds being the most direct competition for stocks within portfolios, when bond yields rise, earnings yields on stocks need to rise to remain attractive to investors.

Stock market participants often prefer to use the inverse of the earnings yield, the price/earnings ratio (or P/E), because it is a more intuitive expression of the expensiveness or cheapness of stocks, moving up or down along with stock prices. It is thus not surprising that P/E ratios historically have tended move inversely to interest rates.

Sources: Global Financial Data; Economagic

The graph above illustrates that, with the usual leads and lags, interest rates and P/E ratios historically have moved logically, in opposite directions. A temporary exception may have been the late fifties, when PE ratios moved up along with interest rates. But, as shown below, this may simply have reflected a catch-up in investors’ expectations after six years of stagnating corporate profits and widespread, earlier anticipations of a post-World War II depression.

The clue to the future of P/E ratios thus lies in the outlook for bond interest rates. Calling for a coming rise in bond rates at this time would not be exactly a contrarian posture: most surveys of institutional investors have shown a negative sentiment towards bonds for at least a year. However, with the increasing specialization of money managers, bearish bond managers only have the option to keep their portfolio maturities shorter than usual (which they seem to have done). In the end, it is their clients that decide to own more or less bonds. Apparently, in a flight from cash that pays near-to-nothing, clients have continued to favor bonds, so that an expectation that bond rates will rise (e.g. bond prices decline) may be more contrarian than it seems.

Also of note is the effect of the declining dollar and the massive intervention in its support by Asian central banks, especially Japanese and Chinese.

Source: Deutsche Bank

When foreign central banks acquire dollars to prevent or slow down the appreciation of their own currencies, they need to invest these dollars. Their usual vehicle is U.S. Treasury bonds, which are probably overvalued currently as a result of the massive currency intervention of the last couple of years.

By pushing down the yield on U.S. treasuries, foreign central banks have made these instruments less attractive. They themselves have moved into the higher-paying bonds of Federal Agencies (Fannie Mae, etc.), while private investors have increasingly been pushed toward riskier assets in their search for yield – corporate bonds, and even lower-rated securities such as “junk bonds”. The net result of all this is that the whole fixed-income universe is now overvalued (yields are too low) and that the odds strongly favor some rise in bond yields.

Beyond these short-term technical factors, it is investors’ inflationary expectations that will eventually determine bond yields. The logic is straightforward: if inflation accelerates, the purchasing power of currency declines; bonds, which mature years into the future, will thus be repaid in money that has a lower purchasing power than today; investors react to this rationally, by lowering the price they are willing to pay to buy bonds today, and bond yields rise as a result.

So, quid of inflation?

Interest Rates may get Inflated

The global economy has been creatively described as currently being in biflation. The current synchronized economic expansion, lukewarm in Europe but more dynamic everywhere else, follows many years of underinvestment in natural resources. As a result, oil, gas, metals and various agricultural crops are in scarce supply and their prices of have been soaring. Conceivably, the current inflation in raw materials would have occurred under any type of synchronized global expansion. But China’s emergence as the workshop of the world has further boosted demand by creating a consuming local middle class and by necessitating huge infrastructure works.

At the same time, however, China has been replacing many other manufacturing centers, in Europe, the United States and Asia. The somewhat unruly explosion of Chinese manufacturing capacity, together with that country’s seemingly inexhaustible supply of cheap labor, is also putting deflationary pressure on world prices for manufactured goods.

The word biflation describe those two concomitant but contradictory pressures. But the precarious balance between inflation and deflation that currently prevails is very unlikely to last forever. One way this contest could end would be a significant contraction of margins for global manufacturers: this is plausible but has not yet happened. Another possible outcome, especially if China is successful in engineering the planned broadening of its budding consumer middle class, is a significant re-acceleration of global price inflation. This is especially so because China’s production is increasingly constrained by infrastructure and resources shortages that may take several years to alleviate.

The tremendous, global money creation that has resulted from widespread anti-deflationary policies by leading central banks (the U.S. Federal Reserve above all), as well as from Asian central banks’ intervention in support of the dollar (which tends to boost local money supplies), speak in favor of an inflationary outcome. This and the ultimate lessening of currency intervention (which has artificially lowered U.S. interest rates) should put upward pressure on bond interest rates in coming years.

Valuations: Back to the Sixties

The “operating” earnings of the Standard & Poor’s 500 are now forecast to land somewhere between $63 and $64 for 2004. With the index currently at 1140, this would represent a P/E of about 18x. As the graph below illustrates, this is much lower than valuation levels reached during the recent bubble, but it remains high by historical standards. In fact, it matches the higher end of a flat band that prevailed between 1959 and 1972 – years when both inflation and bond rates were slowly creeping up, before finally taking off in 1973, after the breakdown of the Bretton Woods system of fixed exchange rates and the sudden quadrupling of oil prices.

Source: Prudential Financial

Ed Yardeni, of Prudential Financial, always stimulating and articulate, is currently one of the most bullish analysts about the stock market. Not only does he anticipate a continuation of the recent corporate profit boom, but he also assumes that P/E ratios will bounce from their current levels, to around 20x on the S&P 500. I did mention, nine months ago, that some P/E recovery was likely after a sharp downward adjustment in 2000-2002, but only as a psychological, temporary reaction – not on a fundamental, valuation rationale. (See: Flashback to The Late 1970s).

In the mid-1960s, both inflation and interest rates hovered around today’s levels. The P/E ratio on the S&P 500 stood around 18x-19x, also like today. The experience of ensuing years, when P/E ratios failed to make decisive new highs and eventually declined lastingly, does not bode well for any significant P/E appreciation over the rest of the current decade.

Profits to the Sky?

With little appreciation potential on the P/E ratio front, the burden of any further advance in the U.S. stock market will fall on corporate profits. So far, the news has been encouraging.

In the first quarter of 2004, total U.S. corporate profits advanced 20% year-to-year, to reach a new record high. This represented a 108% advance from their recession low. The earnings of the S&P 500 index followed a similar pattern.

Source: Prudential Financial

Even optimists have been surprised by the strength of the recovery in corporate profitability. The profit margin of all corporations (as a percentage of Corporate GDP) also broke out to a decisive new high in the fourth quarter of 2003.

Source: Prudential Financial

Several factors have contributed to this performance, including a decent recovery in sales volumes, spectacular gains in productivity, the weakness of the U.S. dollar and the lower cost of money. Unfortunately, I am not convinced that gains can continue to accrue on the recent scale.

Big Only Looks Better

Perhaps the greatest surprise was news that revenues (sales) of the S&P 500 index have recently been growing at almost 10% per year. In what has been regarded as an economy with relatively low intrinsic growth potential, this statistic has lifted the hearts of analysts. However, one reason for this seemingly encouraging performance is that large companies such as those in the S&P 500 index seem to have been taking market share away from smaller ones. Since the notion seems counter-intuitive, I suspect that the mega-mergers that have become the fashion in several industries probably contributed to that “performance”. Unfortunately, mergers may boost individual company revenues, but contribute little to the economy’s overall growth.

The other reason for better-than-expected sales growth at large companies is that they tend to have proportionately more international revenues than smaller ones and that foreign revenues, in a weak dollar environment, have been translating into more dollars.

A recent UBS report estimated that one-fourth of the 9% sales growth at S&P 500 companies in 2003 was generated by the accounting conversion of foreign currency sales into dollars. At companies like Ingersoll Rand or Caterpillar, currency translation may have reached one-third or even one-half of the reported sales growth. The effect on profits was probably greater. According to the Financial Times, of the $81.4 billion increase in profits of U.S. companies in the fourth quarter of 2003, $47.5 billion came from the foreign component of profits. One must assume that currency translation contributed a significant chunk of that foreign component. Much as I believe that the dollar may remain under pressure for several years, it is hard to assign the same value or long-term growth potential to currency-conversion as to results from operations.

“New Era” Productivity Will Meet the Cycle

Another major contributor to the profit recovery has been the return of worker productivity growth to previous historical peaks.

Source: Bridgewater Associates

The advocates of a continuing boom in productivity take a long-term view of structural change in the economy. In their view, the combination of the 1990s technological revolutions and the accelerated globalization of the world economies have shrunk both space and time, which is now being reflected in huge productivity gains.

This does not go without pain and dislocations, as we are reminded in a recent paper by Alexander J. Field in The American Economic Review. Field qualifies the Great Depression years as “the most technologically progressive decade of the century”, and credits the gains in productivity and prosperity of the post-WWII years to the innovations of the previous decade.

We tend to empathize with this view and we had in fact argued, during the 1990s bubble, that the ultimate beneficiaries of that decade’s advances in computing, networking, telecommunications and the Internet eventually would be the users rather than the suppliers. This seems to be happening now.

Nevertheless, it can be costly to confuse structural change and cyclical patterns, because the two do not move at the same pace. In the case of productivity today, some of the recent gains have been due as much to the miserly management of corporate assets and labor following a deep profit recession, as to the adoption of new technologies. There are growing indications that, with the recovery gaining momentum, corporations are getting ready to hire again. And, in past cycles, recoveries in employment have brought (at least temporarily) slowdowns in productivity and profit growth.

Paper Profits

Finally, I should probably mention a note from Jim Grant, of The Interest Rate Observer, who points out that profits from financial companies (banks, brokerage firms, finance companies, etc.), which fluctuated between 12% to 22% of total corporate profits in the 24 years from 1960 to 1984, now account for about 40%. [Paul Kasriel, of Northern Trust comments: “We are not becoming a nation of hamburger flippers, but a nation of stock and bond flippers”.]

This statistic illustrates how the make-up of the U.S. has changed in recent years, to the point where economic statistics that were devised for an industrial economy sometimes can be misleading. On the other hand, when I read reports from financial institutions indicating how much of their recent profits have come from trading the markets for their own accounts, usually with huge leverage and a maze of derivative instruments, I cannot help but wonder how reliable, sustainable or predictable these profits are. This adds yet another level of uncertainty in assessing the future path of corporate profits.

Beware the Social Pendulum

One last set of statistics intrigues me. While corporate profits have been making new highs, the total compensation of U.S. employees has been rising more slowly. Not only has job growth been sluggish, but wages and salaries also have been subdued. As a result, the ratio of corporate profits to employee compensation stands at a post-war high.

As can be seen on the graph above, this ratio has now exceeded a level that historically has been followed by periods when worker compensation rose faster than profits. I believe that this is more than a coincidence: it reflects some kind of social pendulum law. Against the background of a major deterioration in the image of corporate leaders and growing opposition to their cost-cutting methods, including offshoring, the odds of such a reversal have increased markedly, I believe… As a result, for a number of years, I would expect rising labor costs to slow any gains in corporate profitability.

Conclusion: A Long Tunnel

Putting it all together: the current market levels reflect peak profits, record margins that may face an uphill battle in the next several years; at the same time, the stock market valuation, as expressed in its P/E ratio, is relatively high by historical standards and is similar to those at times when interest rates and inflation were as low as presently. After a possible plateau, it seems very plausible that P/Es will decline when inflation and interest rates clearly revive – as happened in the late 1960s and early 1970s. In total, the upside of the stock market seems limited.

This reinforces my views of a market fluctuating within a broad horizontal band for several years. The better buying opportunities, during that period, will appear when the stock market is toward the lower end of that range.

It also reminds me of the old Wall Street adage that it is when cash pays nothing that it is most attractive to own – not necessarily to protect oneself from possible stock market declines, but to have it available when more compelling buying opportunities arise.

François Sicart

^© Tocqueville Asset Management L.P.
April 12, 2004

The information contained herein has been obtained from sources believed to be reliable and to the best of our knowledge is complete. The validity and completeness however cannot be guaranteed by Tocqueville Asset Management.Nothing herein constitutes investment or any other advice and should not be relied upon as such. This document has been prepared solely for information purposes and does not constitute an offer or an invitation to buy or sell securities. Any reference to past performance is not necessarily a guide to the future. Tocqueville Asset Management L.P., their affiliates and their officers, directors, employees, advisors or members of their families as well as the clients for whom they manage portfolios; 1) May have positions in securities or options of issuers mentioned herein and may make purchases or sales of the securities or options while this publication is in circulation; 2) May hold directorships in corporations discussed in this publication. The opinions expressed in this document are those of Tocqueville Asset Management as of the date of the writing and are subject to change.