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This has one excellent point. Either Corporate bonds are WAAAAYYY too cheap, or Equities are way to expensive. I think you all know what I think. Markets do rationalize over time. I was briefly thinking of becoming bullish on stocks and growth, but its a joke.
Global credit markets have led the downturn in equities since early 2007, and that reflects two thing in my experience, apart from the historic collapse in confidence and liquidity in derivative debt instruments initiated by the sub-prime debacle.
First, the collective intelligence of the fixed income markets exceeds that in equities by a margin; second, equity analysts are generally far better at P&L than balance sheet analysis. In the current environment, earnings forecasts can become academic overnight if insolvency risk has been underestimated, and that goes for the market as a whole as much as individual stocks. Right now, imputed credit market valuations on most blue chip US corporates are a third to a half of those in the stock market.
Either corporate bonds are the buy of the century, or stocks are dangerously overvalued. Equity markets are still childishly obsessed with the silver bullet, one bound and we're free, Hank the Hunk saves the world scenario, as reflected in the increasingly short-lived relief rallies we have seen this year on each new Federal bailout initiative. Grow up people.
Of course, many emerging markets are already down 30-50% from their peaks, as I predicted in July (see Emerging Markets: More like Submerging) but the US has proved resilient to date in a global flight to safety. Not for much longer. We are in the early stages of reversing unsustainable trends in US debt accumulation and consumption; household debt hit 100% of GDP last year; financial sector debt hit 120%.
With the asset side of both balance sheets hit hard by the real estate and now financial asset slump, that historically unprecedented leverage is now being forcibly reversed. The days when turbocharged bank asset growth fuelled easy personal credit and home equity withdrawal, adding 6-7% of GDP share to US consumption in recent years, are history.
Corporate margins and profits as a share of GDP are a one way bet coming off record highs. After the credit bubble, the only question is what mean we are reverting to.
I suspect we will see in undershoot, ie US consumption will slump beneath its long term trend GDP share of 65%, and the US current account deficit will all but disappear, with ominous implications for Asian exporters and their merchandise trade surpluses. If you consider those trade surplus capital exporters like Japan and China as the Gulf Stream of the global financial climate, a current of easy money that has created a benign financing environment for the US, then we face a painful liquidity squeeze going into 2009 as US consumers freeze discretionary spending.
The symbiotic relationship of the past two decades between Asian excess saving and US excess consumption is facing severe stress. Make no mistake, there is plenty of cash out there, whether the $4.3trn in money market accounts (despite last week's panic redemptions), the $650bn odd on US corporate balance sheets, or the $3trn in SWF money (see SWFs: Time to Sell the Family Silver?).
Big as those sums sound, and at the margin they are, they should be seen in the context of over $15trn in US financial sector debt, and the lack of confidence apparent in the key Gulf and Asian SWFs about further US investment given the lack of valuation transparency on derivative exposures. Events such as the Buffet investment in Goldman Sachs (GS) (at an extortionate 10% yield on the perpetual preferred) and a deal by Congress on the TARP this week may give markets another short-term lift.
However, it may be the last one before the reality of a slumping earnings outlook in 2009 finally hits home and creates a selling panic in the next couple of months; I've stated in previous posts that capital preservation is key this Autumn. I expect global growth next year to be 2-2.5% against the IMF forecast of 4%, and S&P earnings to be about $70, against the $100 plus consensus. If that is where the consensus is heading, current valuations are unsustainably high, and US equities face a 20% plus decline to well under 10,000 on the DJIA and 1100 on the S&P.
To put things in some historical context, valuing cyclically adjusted S&P peak earnings at the average long term multiple of 10.4x puts a floor of about 900 on the S&P. It's time to switch off that CNBC chatter and get some perspective.
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