The Leadership Void
(July 28, 2011)
Dear Subscribers and Readers,
As discussed by a subscriber on our MarketThoughts.com Forum, the fundamental underpinnings of the market are shaky—not because of the threat of a technical default by the US government per se—but the inability of Congress to come together to raise the debt ceiling. The squabbles of recent weeks are just part of the partisan politics that have plagued Washington for months, if not years. Such partisan politics have led to a massive pandering to the public; and kowtowing to lobbyists—resulting in misguided policies that have played significant roles in the late 2007 to early 2009 financial crisis, ongoing massive farm subsidies (most of which are funneled to industrial farms), the lack of a coherent 21st century energy policy (leading indirectly to the BP oil spill), the massive spending in the Iraqi War, the ongoing budget and current account deficits, and the threat of $65 trillion in unfunded Social Security and Medicare liabilities that would swamp the U.S. welfare state and sap all the vitality, youth, and innovation that have been part of our character for the last few centuries.
This lack of leadership is demonstrated everywhere by our institutions and countries around the world. One recent example happened to be a personal one. As most of you know—while I spend quite a bit of time on MarketThoughts.com—it is still a part-time gig as the revenue stream from our subscribership isn't sufficient to cover my living expenses. I had recently graduated with a dual MBA and MPP degree from UCLA; and had been part of a start-up structured note advisory service just north of Los Angeles. I played a pivotal role, and yet recent events have compelled me to resign from the company the Friday before last. Simply put, the CEO—who used to coach CEOs of Fortune 500 companies—did not know how to run a firm properly. Instead of respecting his employees and treating them well, he engaged in power politics and mind games to keep the team together. This experience had led me to a recent soul-searching exercise—not just a look within myself, but a look around the world. While I have gained significant clarity in what I do not want in life; I have also gained significant clarity on the root cause of things that are “wrong” with the world today. We live in a world of unprecedented prosperity, and yet Congress squabbles on a daily basis and gets nothing done (although some would say this is a good thing). Greece, the birthplace of democracy, is effectively bankrupt. Japan—a country that underwent a complete transformation during the Meiji Restoration, and who experienced one of the great economic miracles after WWII—has been stuck in a rut since its stock market and real estate market peaked in 1990. The lack of leadership in Japan is all the more evident given the recent lack of response to the March 11th earthquake and subsequent tsunami. Today, Japan is still experiencing rolling blackouts due to the closing down of its nuclear plants—blackouts which are causing its manufacturers to accelerate the trend of outsourcing to countries such as South Korea and China.
The inability of the EU to resolve its debt crisis is merely a symptom of its leadership void—starting with the debt-borrowing binge initiated by Greece, Ireland, Portugal and Spain as sovereign yield spreads declined massively after the introduction of the Euro in January 1999. If the Euro is to stay intact in its current form and if Greece and other “peripheral countries” are to stay in the Euro Zone, the Germans would ultimately have to underwrite most of the losses incurred by these countries. The lack of a comprehensive solution over the last 18 months has made the problems worse—but again, it is simply the lack of leadership that is the underlying cause. The “kicking the can down the road” strategy has been used successfully by many politicians since the end of WWII—as much of the world was carried by a massive population, productivity, and debt-borrowing boom. A whole generation of so-called leaders was bred to believe this would continue to work. Alas, this will no longer be the case going forward. The population pyramid is becoming inverted in many developed countries; and the global productivity boom born right after the dissolution of the Soviet Union is now maturing (the commercialization of the quantum computer notwithstanding). Moreover, as the late 2007 to early 2009 financial crisis and the European Sovereign Debt Crisis demonstrated, investors around the world are no longer tolerant of the heavy debt loads incurred by US households and European governments. As such, I believe the European Sovereign Debt Crisis (and to a lesser extent, the controversy surrounding the U.S. debt ceiling) would be an overhang on the markets for at least the rest of this year.
Such cautiousness is also confirmed by the ongoing tightness in the U.S. (and global) liquidity picture, especially with respect to the stock market. One measure is the amount of cash sitting on the sidelines, as measured by the ratio of the amount of money market funds plus checkable deposits divided by the S&P 500's market cap; see our July 26, 2009 commentary for more background. Since its February 2009 peak, it has declined very quickly. As of the close yesterday, however, it is still near its cyclical bull market low, despite the market weakness over the last several months, as shown in the following chart:
Note that we have updated the numbers as of Wednesday evening. As referenced in the above chart, the ratio of investable cash (retail money market funds + institutional money market funds + total checkable deposits outstanding) to the S&P 500 market capitalization has been consistently declining since February 2009. The ratio temporarily bottomed at the end of April 2010, with the ratio rising by 4.00% from the end of April 2010 to the end of August 2010 (from 32.59% to 36.59%). However, with the stock market rally since the end of last summer, this ratio sits near a cyclical bull market low of 29.55% as of yesterday at the close. The low reading in this liquidity indicator, along with the leadership void in the EU and the U.S., suggests that market conditions should remain tough for the rest of this summer.
Finally—our valuation indicators still don't suggest the market has reached a bottom yet. This is exemplified by Morningstar's aggregate valuation, a valuation factor that I regularly track. Morningstar's aggregate valuation of its entire coverage universe of over 2,000 stocks (covered by the competent analysts at Morningstar) – is just under its fair value, as suggested by its current ratio of 0.95 (a value of 1.00 is assigned to a particular stock if it hits Morningstar's definition of “fair value”). Note that ratio sank to as low as 0.55 on November 20, 2008 (this represented its all-time low since the inception of this indicator in mid-2001), and as high as 1.14 on December 31, 2004. Moreover, as shown in the following chart, courtesy of Morningstar, this ratio is still about 5% above where it hit a significant bottom last summer:
Morningstar's proprietary valuation indicator suggests that the stock market is just below its fair value. More important, subscribers should note that – given the trend of corporate earnings over the last two years – Morningstar's underlying growth assumptions in their discounted cash flow analyses have gotten more aggressive since the March 2009 bottom. In addition, the weighted cost of capital has declined dramatically – suggesting that valuations may be more stretched than meets the eye, especially given the overhang from the European sovereign debt crisis and the squabbles over the U.S. debt ceiling. In other words, Morningstar's proprietary valuation indicator suggests that while a further correction isn't imminent, the market will likely remain tough this summer.
Henry To, CFA, CAIA