The Next Decade
(August 16, 2009)
Dear Subscribers and Readers,
It is late Saturday night and between being disappointed with the latest “glitch” in Boeing's 787 “Dreamliner” production process, lamenting over the sad state of California's infrastructure, and re-reading Steven Drobny's “Inside the House of Money,” I am also spending quite a bit of time pondering the important trends over the next decade – not only those in the financial markets but on a social/economic basis as well. In our mid-week commentary last week, we brought you what the National Intelligence Council and the CIA believed were the most important global trends over the next 15 to 20 years. Our mid-week commentary came with one important caveat. As mentioned in the commentary (and as one of our subscribers subsequently reminded us), the idea that the world will remain static in 15 to 20 years is always a mistake that forecasters make. And as apparent from the predictions that did not happen or were subsequently revised (e.g., the growing influence of “alternative fuels” in the latest report) from the last report made over five years ago, this is the same mistake that the NIC and the CIA have made as well.
In many ways, such a forecasting method (extrapolating recent trends) is forgivable – as forecasts are inherently done with limited information and predicting a static world, on average, should get one closer to the eventual outcome than by predicting a future that is totally different from today (e.g. the prediction made about the commercialization of flying cars in the 1950s). On the other hand, penning a 20-year forecast with the assumption that the world will remain static will almost surely result in a bad forecast. As Keynes would say, “it is better to be roughly right than precisely wrong.” Such a forecast – while interesting as a starting point for public policy and investment analysts – would be useless for investors interested in taking advantage of future investable trends.
A proper speculation (that is really what it is) of future investment/economic trends by a true investment analyst must not simply be an extrapolation of current trends. Sometimes, a simply extrapolation may work – but in a market where prices are highly efficient, chances are that the financial markets have already priced them in. Just as important, being a true investment analyst means one has to deviate from the consensus at selected points during a market cycle – and this is again one of those times. Finally, the spread of the internet over the last 15 years has really democratized finance and information. Given the unprecedented availability of historical financial information, publications tracking technological trends, global central banking information and policies, and a humongous information network to share ideas and information, there are fortunately many tools and datasets available to make a credible longer-term forecast.
Ever since we started devoting time and resources to MarketThoughts.com in 2004, we have not been shy about making investment calls that seemed bold or anti-consensus at the time. For example, we were one of the few sites to state that the era of cheap energy was coming to a close in our August 29, 2004 commentary (“Three Important Questions for my Readers”). At the time, both the National Intelligence Council and the CIA projected that fossil fuels would remain the dominant source for years to come – and more importantly, that fossil fuels would remain cheap and plentiful up until 2020. We were also one of the first sites to warn about the housing bubble (see our December 12, 2004 commentary, “Housing Bubble?”) – with consistent follow-ups in our June 1, 2005 (“An Update on the U.S. Housing Bubble”), July 17, 2005 (“What to do About the Housing Bubble?”), April 23, 2006 (“The Message of the Fed Cleveland Median CPI”), and April 1, 2007 (“Housing Market Decline Not Over Yet”) commentaries. We also became bearish on the REIT market right at the peak of the market. In our February 1, 2007 commentary (“REIT Market Overheating?”), we discussed Sam Zell's view on the REIT market and asserted that the unprecedented rise in prices of REITs had more to do with the immense liquidity and investors' desperate search for yields rather than fundamentals.
The format of this commentary will be slightly different to that of our regular commentary. In this commentary, we will mostly focus on our long-term outlook – along with my hopes, fears, and my “best guesses” on where the best investment opportunities may lie. I promise you this will be a most fun journey.
Our short-term outlook notwithstanding (both the overbought technical and sentiment indicators suggest a short-term correction for the global equity markets is in store), there is strong evidence – as we have mentioned over the last few months – that we are in at least a cyclical bull market and that the intermediate trend of the US (and global) stock market remains up. Some of the pieces of evidence were covered in our March 13, 2009 commentary (“Market Rally Now In Place”) – including the strong upside breadth and volume over the last five months, the amount of cash on the sidelines, etc, - although some was only clear in retrospect. An example is the number of “positive divergences” in the March 2009 low vs. the November 2008 lows. During the March 2009 lows, the number of new 52-week lows shrank drastically from the November 2008 lows – as exemplified by the relative strength of various consumer cyclical stock prices such as those in the retail and restaurant industries (e.g. JWN, ANF, AEO, CAKE, PCFB, EAT, etc). In retrospect – during the November 2008 lows – the US stock market was discounting the probability of a severe economic recession, if not depression. Meanwhile, during March 2009, the US stock market was discounting the further prospects of a US banking system nationalization (a fear that Hank Paulson put into place when he put the GSEs under conservatorship with no advanced warning in early September 2008). Once the Obama administration took this option off the table and subsequently recapitalized the 19 largest banks in the US, it became clear that a retest of the early March lows again was off the table.
From my vantage point – and based on my current research and many years of historical research – my “best guess” for the US stock market is for the major equity indices (Dow Industrials, S&P 500, etc.) to be mired in a trading range – with an upward bias – over the next three to five years. A few years from now, most of the “deadwood” in American industry and finance would be cleared. Household and corporate balance sheets would also have deleveraged to a certain extent. Most importantly – as I have previously mentioned and will again mention below – there are now technological trends in place which should unleash the next round of productivity increases once they mature in the next three to five years. Since each great secular bull market has its roots in a “new economic era” based on some productivity-enhancing technologies, my sense is that this three to five year trading range will provide a base for the next secular bull market in stocks. Let us now discuss my underlying reasons for such a scenario.
A Three to Five-Year Trading Range
Every weekend, I use much of my time to clear up and summarize any new thoughts I had about the financial markets the previous week – as well as to crystallize my developing thoughts and investment themes that have been lingering in my mind. Since the bottom in early March, I have been spending a lot of my time thinking about the future direction of the US (and global) stock market – not only when this rally will fizzle out buy also at what price level and what our outlook is like over the next year, two years, three years, etc. My prediction of a three to five-year trading range is simply my “best guess,” given the state of the US and global economy, global central bank policies, technological trends, consumers' balance sheets, valuations, etc. At the time of the March lows, I had this to say about the valuation of the S&P 500 index:
“The action over the last three days is no doubt the strongest and most positive action since this bear market began in late 2007, and is in fact significantly stronger than the rally on March 17, 2003 and immediately after – the day that marked the beginning of the four-year bull market in US and global equities. More importantly, based on our valuation, sentiment, and various technical indicators – as well as the amount of cash sitting on the sidelines – the market was much more oversold last week than at any time since probably July 1982 – a period that marked the beginning of a 17-year bull market in US stocks. For example, at the bottom earlier this week, the price-to-book ratio of the S&P 500 traded to a low of 1.2 based on fiscal 2008 earnings. Adjusting for the effects of technology and biotechnology R&D (which in theory should be capitalized on balance sheets as assets), my guess was that the price-to-book ratio of the S&P 500 was closer to 1.0, or the level that it was trading at in July 1982.”
With 2009 and 2010 S&P 500 earnings projected to be positive, and with the R&D-adjusted price-to-book value at 1.0 at its March lows, probability suggests that the March low was the ultimate bear market low. Obviously, “Black Swans” could always occur that could derail this scenario. At the July 1932 bottom, the S&P 500 traded at a price-to-book value of about 0.5. But unless the global financial system or trading system (nearly half of the S&P 500 revenues come from international markets) breaks down, or unless the world becomes embroiled in a major regional/global war, chances are that the March low would stand in any subsequent corrections in the stock market.
In the meantime, the unprecedented easing by the major central banks such as the Federal Reserve, the Bank of England, the Swiss National Bank, etc. and their reluctance to tighten their monetary policies for the foreseeable future means that global monetary policies will continue to act as a tailwind for the equity and credit markets for the foreseeable future. Even should the Federal Reserve pare back its credit easing strategies (i.e. withdrawing liquidity be shrinking its balance sheet), the Fed Funds rate will no doubt stay at its current trading range (0% to 0.25%). Both the Bank Credit Analyst and Goldman Sachs have suggested that the Federal Reserve will not raise rates until 2011 at the earliest (the BCA remarked that historically, the Fed has not raised rates until the unemployment rate starts declining). The old adage “Don't fight the Fed” certainly applies. With the U.S. Dollar Index continuing to hold up, and with the Federal Reserve committed to providing as much liquidity as the market needs, the Fed will continue act as a significant tailwind for the S&P 500 in the near future.
But Henry, aren't US consumers' balance sheets still in the midst of a deleveraging process? Don't these excesses have to be purged before the US bull market could resume (or even before the US bear market ends)?
These are both good questions, but before I answer them, I want to take us back to an earlier age of globalization – that of the 30 years (1884 to 1914) “golden age” of globalization and global investing prior to one of the greatest destructive periods in history, that of World War I. In 1909, the Sir Norman Angell published his famous book “The Great Illusion.” The book sought to dispel the notion that there would be another major regional war (at the time of publication, Germany and the UK was engaged in a naval arms race), arguing that Europe and the world was too economically intertwined for nations (even for those nations who could achieve an outright victory) to benefit from fighting a war. But as we all know understand, such an argument – no matter how satisfactory it was – did not prevent the eruption of World War I nor World War II. On a real return basis, British Consols lost nearly 50% from 1914 to 1920, while Russian, Hungarian, Austrian, and German bonds were worthless by the mid 1920s. Even British securities lost over 25% on a real basis from 1914 to 1920. The only beneficiaries were American securities – which benefited from a “war bride” boom as American companies exported valuable wartime materials to the allies. In today's world of globalization where America is now playing a substantial geopolitical role, any major outbreak of a regional or global war would not be so kind to either American government bonds or equities.
With the “opening up” of China in 1978, the fall of the Berlin War in 1989, and the liberalization of the Indian economy in 1991, we have also experienced our own “golden age of globalization” over the last 30 years. I am under no illusion that a similar conflagration cannot happen again. But one needs to understand why World War I occurred (e.g. imperialist rivalries, secret “entanglement” of European alliances, a naval arms race between Germany and the UK, etc.) and why the financial markets did not price in a major regional war before it was too late in order to understand the potential drives of the next regional war and how such a war would affect the financial markets. Similar to the weeks preceding the beginning of World War I – with the immense amount of central bank liquidity in the world today, and since it has been over 60 years since there has been a war between two major powers, the financial markets most likely won't start pricing in the chance of a major regional war until the very last moment.
At this time, I do not believe there will be a major regional war between two major economic powers over the next 3 to 5 years. I am stating this position with the full understanding that there could be a major conflagration in the Middle East (e.g. one triggered by a bombing of Iran by Israel) or a major terrorist act committed on US soil. At this time, however, there is nothing on the horizon (such as a grab for natural resources or territorial dispute) that suggests a regional war is inevitable in the next three to five years. So even though this potential “Black Swan” scenario is always in the back of my mind, I am going to focus on the questions at hand – that of consumer deleveraging and of having to “purge the excess” before a new bull market in stocks can continue.
First of all, there is no doubt that consumers' balance sheets will continue to deleverage for the foreseeable future, as US consumers start to rebuild their savings and as the US housing stock becomes more affordable again (which means US consumers will take on significantly less mortgage debt). But for those who think this deleveraging will be hugely bearish for the stock market over the next three to five years, please think again. The following quarterly chart shows the growth in mortgage debt and “all other debt” (i.e. the growth in consumer debt excluding mortgage debt) relative to the growth of US household assets from 1Q 1952 to 1Q 2009 (source: the Federal Reserve's Flow of Funds data). While Americans have indeed been “gorging” on credit, it seems that all this gorging has occurred in the mortgage markets over the last 20 or so years:
As mentioned on the above chart, for every dollar in assets that US households accumulated over the last 57 years, they have also accumulated a whopping $3.79 in mortgage debt, while only accumulating $2.15 in all other debts” (e.g. consumer credit, bank loans, margin loans, etc.). Sure, a significant amount of this mortgage debt in recent years came in the form of home equity loans, much of which have gone into consumption spending such as home improvement spending, second or third automobiles, or large screen TVs (readers should not forget that some of these have also gone into “investments” such as education spending), but this does not change the fact that the vast majority of the deleveraging will occur in the US mortgage market. Just like the folks buying technology stocks during the bear market rallies in the NASDAQ Composite from March 2000 to May 2002, the folks purchasing houses today (in general) would most likely not see any gains for years to come. In the long-run, a substantial deleveraging in the US mortgage market would be beneficial to US society, as this would help bring affordability down and allow the Y-gens (especially the Y-gens without inherited wealth from baby boomer parents) to have a chance of owning their own homes.
It is always interesting to see investors jumping into assets that are just coming out of their biggest bull market ever – not unlike the folks “buying the dips” in technology stocks earlier this decade or those buying crude oil or energy stocks right now (or during the early 1980s). Folks that are purchasing real estate in lieu of a diversified portfolio in global equities are making the same mistakes today.
With respect to having to “purge the excesses” from US corporations before the stock market could embark on a sustainable up trend again, I cannot agree more. However, we have already witnessed a substantial amount of such “purging,” especially within the financial sector with the demise of Bear Stearns, Lehman Brothers, Washington Mutual, Wachovia, Countrywide Financial, IndyMac Bank, and now, Colonial BancGroup. Moreover, the US 19 largest banks have already completed a recapitalization scheme that should allow them to not only survive, but to make creditworthy loans going forward. The trouble continues to lie within the regional and community banks (where most of which have a much higher real estate portfolio but have no core earnings power). Should the latest plans to attract private equity funds to the sector succeed, then probability suggests that the US financial sector may have already reached a sustainable bottom back in early March.
Moreover, as discussed in the above comments, the excesses have been concentrated in the US housing and commercial real estate market – not in the US stock market. At the peak of the stock market in late 2007, the S&P 500, trading at a P/B ratio of about 3.0, was not tremendously overvalued, at least relative to a 4.x reading throughout most of the early 1998 to early 2001 period (with the brief exception of the LTCM-related decline in Fall 1998). Sure, the P/B ratio for many financial firms was questionable at the peak – but after two years of write-downs and billions in equity offerings, today's P/B ratio in financial stocks is more “believable” than it ever has been. In addition, the P/B ratio reached a 27-year low of just 1.2 at the early March lows, and adjusting for the effects of technology and biotechnology R&D spending (which in theory should be capitalized on balance sheets as assets, e.g. Amgen's drug pipeline), the P/B ratio of the S&P 500 was most probably closer to 1.0, or the level it hit at the beginning of the great bull market in July 1982. On a P/E basis (based on prior peak earnings, as popularized by John Hussman of the Hussman Funds), the P/E level of the S&P 500 also hit a 27-year low back in early March (following chart is courtesy of Decisionpoint.com):
Similar to the loose monetary policy by Alan Greenspan earlier this decade that created the housing bubble, the unprecedented easing by Bernanke today (as a reaction to the credit crisis and write-downs related to the global housing market) should also support if not provide a boost for the U.S. stock market. That said, there's no doubt that an ongoing deleveraging process in US consumers' balance sheets will put a damper on consumer spending for the next three to five years. Hence our scenario for a trading range in the U.S. equity market for the next three to five years, albeit with a slight upward bias.
A New Secular Bull Market by 2012 to 2014?
To predict whether a new, secular bull market could emerge from the ashes of our current economy, it is important to think about the long-term drivers of both earnings and valuation growth. As we discussed in our June 15, 2008 commentary (“The Capitalist and Productivity Engine”) and our April 27, 2008 commentary (“Reflections and Black Swans”), over the long-run of a capitalist society, economic growth is driven by the sum of Ricardian Growth and Schumpeterian Growth, as well as the interaction between the two (e.g. the innovation in the US semiconductor industry during the 1950s and 1960s, and which were eventually adopted by the Japanese and Taiwanese to produce semiconductors at a more cost-efficient manner). The former is driven by the secular adoption of free trade policies around the world since the end of World War II, while the latter is driven by technological advances and the creation of new management and business techniques. The concept of “Creative Destruction” is a direct result of Schumpeterian Growth.
More specifically, the projected earnings power (on an EPS basis) of the US stock market is based on the following seven important points.
- Projected corporate profit margins, or more specifically, corporate pricing power and expenses (wages, pension expenses, etc.);
- Projected corporate tax rates around the world;
- Projected financing costs, or cost of capital;
- Projected “float” of the global stock market (given that capital is very mobile today) – as expressed in the dollar value of shares that are available to investors today;
- Projected productivity, employment, and population growth – all of which have a direct impact to the build-up of global wealth;
- The ability and willingness of governments around the world to protect private capital and to allow capital to move freely around the world;
- The freedom to trade and the projected increase in trade flows around the world (Ricardo's law of comparative advantage).
Each of the above has a more direct impact on U.S. and global stock prices than projected GDP growth alone. More importantly, the effects of each of the above could be more easily quantified, unlike the “mixture of stuff” that is ever changing in every GDP computation (or in China's case, a make-believe number).
Furthermore, each of the above is not independent of each other. For example, both the cost of capital and corporate tax rates has a direct impact on corporate profit margins. I included corporate tax rates as a separate line item simply because it does not have a uniform effect on all companies. One example is corporate tax breaks for certain industries. When it comes to cost of capital – it is important to note that in a credit “seizure” such as what we experienced a year ago – the cost of capital for certain (highly credit worthy) companies will eventually decline as the Federal Reserve lowers rates, while increasing to near infinity to those which are assumed to be at the margin, such as Lehman Brothers, First Marblehead, Bear Stearns (before its announced takeover by JP Morgan), or Thornburg Mortgage (it had to do an equity offering of around four times its market cap in order to survive). As some of these marginal companies go out of business due to the lack of financing options, corporate profit margins for the companies that survive would dramatically increase as competitors are taken out in their respective industries.
Secondly, the above seven points are meant to be sweeping in nature. For example, the ability of governments to protect private capital does not only mean protection from government confiscation or theft, but from foreign invasion as well. Through the U.S. central bank and FDIC, our system has also built in a significant “safety net” that prevents private bankers from seizing our deposits or mortgaged-assets during a liquidity or a solvency crisis in our financial system (the latter of which is a far cry from the 1970s). Another example is projected productivity growth. Embedded within this statement is the assumption that capitalism will not only survive, but will continue to thrive. The reason is this: The best economic system that allows for sustained productivity growth is capitalism, and nothing else (Joseph Schumpeter went as far as associating technological advances directly with capitalism). Another example is consumer price inflation. While monetary policy can and will have short-term effects on the price level of a typical consumer goods basket, it is productivity growth (or the lack of it) that drives long-term consumer price inflation.
A bear market in global corporate profit growth occurs when one or more of the above points are compromised, such as a rise in protectionist sentiment (which inhibits Ricardian growth, and by extension, productivity growth) or a rise in corporate tax rates. A bear market in global economic growth, however, occurs when Ricardian or Schumpeterian growth is inhibited, or when certain countries or sectors of the economy fail to invest the necessary resources (sources that are available using current technology and labor force) in order to promote future productivity growth. The global crude oil industry is one example of the latter. Sovereign governments today control more than 75% of all global crude oil reserves. With the exception of Canada, Brazil, China, and Algeria, all the world's major oil-producing countries have failed to invest in the necessary infrastructure to increase oil production over the last 20 years, including the United States.
Aside from a universal cure for cancer, or the commercialization of carbon nanotubes as a replacement of steel parts and/or semiconductor parts, there is no doubt that the “biggest bang for the buck” for Schumpeterian Growth comes in the form of a breakthrough in the alternative fuels sector – a breakthrough that would lead to below “grid parity” with the cost of fossil fuels, whether that is in solar, cellulosic ethanol, or algae-based biofuels. While “grid parity” is a great step forward, the true breakthrough that would have a profound impact on the transportation industry will come once more efficient and cheaper lithium-ion battery technologies are commercialized. Given that the majority of daily commutes in the US are for short-haul journeys, it makes every sense in the world to run your automobile on electricity for most of your commutes, especially given today's gasoline prices.
As long as the capitalist engine is not disrupted, the scientific innovators, entrepreneurs, and venture capitalists will ultimately come up with the appropriate solutions, as long as the economic incentives are there. In his seminal work, “Capitalism, Socialism and Democracy,” Joseph Schumpeter effectively equates technological progress as part of the capitalist process. Questioning other economists' views that technological progress may not be inherent in the business processes of capitalism, Schumpeter writes:
Was not the observed performance due to that stream of inventions that revolutionized the technique of production rather than to the businessman's hunt for profits? The answer is in the negative. The carrying into effect of those technological novelties was of the essence of that hunt. And even the inventing itself, as will be more fully explained in a moment, was a function of the capitalist process which is responsible for the mental habits that will produce invention. It is therefore quite wrong – and also quite un-Marxian – to say, as so many economists do, that capitalist enterprise was one, and technological progress a second, distinct factor in the observed development of output; they were essentially one and the same thing or, as we may also put it, the former was the propelling force of the latter.
Capitalism, then, is by nature a form or method of economic change and not only never is but never can be stationary. And this evolutionary character of the capitalist process is not merely due to the fact that economic life goes on in a social and natural environment which changes and by its change alters the data of economic action; this fact is important and these changes (wars, revolutions and so on) often condition industrial change, but they are not its prime movers. Nor is this evolutionary character due to a quasi-automatic increase in population and capital or to the vagaries of monetary systems of which exactly the same thing holds true. The fundamental impulse that sets and keeps the capitalist engine in motion comes from the new consumers' goods, the new methods of production or transportation, the new markets, the new forms of industrial organization that capitalist enterprise creates.
In other words, the capitalist engine is the most efficient way of generating long-term economic growth, and almost by definition, does it by ensuring continuing technological progress and consequently, increasing productivity. On the other hand, if the capitalist engine is ever inhibited (such as by the failed experiments in protectionism in the 1930s and socialism among many other countries after World War II), technological progress and productivity growth will almost surely halt (with the exception of advances in military technology whose primary purpose is to safeguard national security). This would result in a global equity bear market on the mild side, and riots, revolutions, and a severe global recession on the moderate side. On the extreme side, the perma-bears would be right – the only option at that point would be to stock up on canned goods, guns and ammunition, jewelry and gold coins, and hide out in your bomb shelter or bunker in southern New Zealand, as (what remains of the) world will compete ferociously for a decline in natural resources in general – not just energy. That is why the Federal Reserve and the US Treasury was so intent on saving the financial system in its current form (as opposed to nationalization, or worse, letting the banks fail) – as the financial system (which includes private equity and venture capital funds) is instrumental in commercializing new technologies and thus boosting US productivity/economic growth in the long-run.
Fortunately, as we have previously discussed, years of research into better battery technology and alternative fuel sources are starting to bear fruit. While the plug-in all-electric GM Volt (to be commercialized by the end of 2010) has been stealing much of the limelight, other automakers such as Nissan and Tesla are also on target to commercializing their own all-electric vehicles by the end of next year. In addition, Craig Venter – the “father” of the Human Genome project has also been making great strides in algae-based biofuels research. In fact, the recent advances in algae-based biofuels research indicate that they could be much more efficient than cellulosic ethanol (even if the latter is commercialized), and could even help the US achieve energy independence (and will be competitive at a crude oil price of $50 a barrel).
With China now also striving for dominance in alternative fuels and in battery technology research, there is no doubt we will see more breakthroughs in this field over the next few years. At some point in the next three to five years, there is a good chance we could reach “grid parity” with some combination of solar power, algae-based biofuels, and more efficient battery technologies. Such a development would usher in an era of cheap and almost limitless energy source – which would significantly lower the cost of transportation, the cost of computing and supercomputing, and could also expand access to cheap electricity to poverty-stricken worlds such as parts of Africa, India and China. Desalinization plants (which require a tremendous amount of power to operate) could also be feasibly built in parts of the Middle East or China for irrigation or drink-water purposes, which would usher in a new era of water security. Such a development would not only put global productivity growth on a higher path, but would also capture the imagination (which is a required ingredient of every secular bull market) of the investing public. Of course, there are many things that could ultimately derail this scenario, but the lack of American and Chinese innovative skills is the least of my concerns. As long as there is political will to support the sciences, and as long as the financial and capitalist system remains in place, I am optimistic that such a breakthrough is not only possible, but probable in the next three to five years. Combined with a healthier US households' balance sheet (after three to five years of deleveraging), this development should also set the stage for the next secular bull market in US stocks.
I hope all our subscribers have had a great weekend, and I will come back next week and discuss more specific investment themes.
Henry To, CFA