Musing on the Markets : stagflation

Baby Steps

Vinny Catalano, CFA — Tue, 15 Jul 2008 11:39:00 GMT

commentary from this week’s “Sectors and Styles Strategy Report”*: Sunday evening’s US Treasury and Fed actions may seem bold to some. I beg to differ. Here are a few thoughts for your consideration:

A recent report from respected consultancy Bridgewater Associates upped the ante of banking losses to a whopping $1.6 trillion. In consideration of the fact that only ¼ of that number, $400 billion, has been write-off/down thus far was more than enough reason for investors to buy into the panicky feeling experienced these past weeks. For those who like I subscribe to Soros’ reflexivity thesis, the feedback loop to the real economy via a deleveraging contraction is the single most dangerous consequence of the credit crisis (even if the bank loss number is closer to IMF’s $945 billion figure).

As if that weren’t enough, the oil price crisis, with its worldwide inflationary consequences for all countries, is generating demand destruction in developed countries. Here, too, a feedback loop to developing countries presents yet another dangerous outcome to the world economy. Decoupling goes only so far. These past few weeks, the twin negative forces are being manifested in fear among investors as the valuation inputs from declining earnings and high inflation are producing a dangerous cocktail of lower P/Es and declining earnings that may bring about a stock market decline befitting a super bear.

Investment Strategy Implications Incrementalism is a product of a belief that what is in place will work. Yes, there may be pain but the tools at hand are the tools that will produce the good result in the end. In the case of the governmental powers that be, that belief is market fundamentalism. This is at the heart of the problem and difficulty in reaching sustainable financial and economic solutions. As long as the Treasury, the Fed, the Administration, and the Congress operate under the rules of market fundamentalism, the actions taken will be like baby steps (such as the Bear Stearns and now the Fannie and Freddie bailouts as well as the Term Facilities to commercial and investment banks) when more serious, more comprehensive, more activist solutions are required.

But let me not restate last Thursday’s blog posting and point to the general market consequences that declining earnings and high inflation will produce.

The following rather simple table provides the P/E levels investors might contemplate should earnings experience even a moderately bad decline from last year’s $82.54:

Does the market fully understand and anticipate such a scenario? I doubt it. More likely shorter-term factors are moving the markets as the dominance by momentum-playing hedge funds produce surges and plunges (mostly the latter of late). But the numbers noted in the above table must not be ignored as its outcome seems more likely the longer market fundamentalism ideology results in baby steps.

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Not So Fine at $4.09

Vinny Catalano, CFA — Thu, 03 Jul 2008 12:45:00 GMT

“She’s real fine my 409” 409 Beach Boys

When the price of gas in the US hit $4.09 a gallon, the song that many consumers began singing was decidedly out of tune from the one the Beach Boys sang many decades ago.

Back in the day, 409 had a different, simpler meaning. Summertime, hot rods, muscle cars, and cheap gas. Today’s tune is, unfortunately, more about demand destruction than it is about how to pick up chicks.

Demand destruction is underway on several levels with high energy prices the central part of the scene. Deleveraging is also playing a major role in demand destruction via credit contraction. Then there is threat of greater regulation and more activist governments.

I have noted this more activist role several times before. And, while the US Congress is in recess this week, recent developments show the increased regulatory threat continues and is broadening. Take for example, the recent surprise announcements re CFDs.

Contracts for difference (CFDs) is a swap instrument that many hedge funds (and no doubt other institutional investors) use to establish positions without disclosing the true nature of the ownership. Within the past few days, however, certain rules changes have been instituted by the Financial Services Authority (FSA) that took most professional investors by surprise. Below are a few links re this story.

Investment Strategy Implications

The world economy is experiencing the dark side of both globalization and financial innovation.

Developing economies, mostly China via its policies of excess money creation and subsidies along with hot money flows, continue to provide the demand fodder for high commodities prices, most notably oil. Coupled with capital market flows by major institutional investors away from equities and into commodities (as an asset class), the unsustainably high price of oil will produce one of two high probability outcomes – stagflation (the lite version, most likely) in developed countries or a global recession.

The contraction of financial innovation is also underway as write downs and bail outs force business model changes for financial firms and the consequence of deleveraging produces a substantial cutback in credit creation.

Gas at $4.09 or higher is unsustainable to the world economy. Developed countries can attest to that. So will developing countries, many of whom are heavily dependent on exports to developed countries’ consumers.

The Bank for International Settlements is correct when it declared that the world economy is near a tipping point. For the equity markets, the relevant primary investment question might seem to be “Have the equity markets come to fully appreciate the danger?” In other words, have prices discounted the risks?

I would propose, however, the more relevant question to ask is “Do investors correctly see the complete picture?” In this regard, the answer is more likely no.

409 was in a simpler time. $4.09 is much more complex.

Enjoy the weekend and a happy fourth.

CFD related links: Article 1 Article 2 Article 3

Not That 70s Show

Vinny Catalano, CFA — Tue, 01 Jul 2008 10:08:00 GMT

commentary from this week’s “Sectors and Styles Strategy Report”*:

There has begun to be a fair amount of talk re stagflation and its consequences, both economic and equity valuation. Should the experience in the coming years resemble the stagflationary era of the 1970s, then P/E levels are more than justified to crumble to single digit levels, as they did then.

Dismissing the stagflation threat entirely would be a mistake. Yet, buying into the idea that a 1970s style stagflation environment is in the current economic cards appears to be equally suspect as the world economy are clearly changed considerably since then. There is, however, a stagflationary scenario that does bear serious consideration – stagflation lite.

In a stagflation lite environment, growth stalls like it did in the 1970s but inflation rises at a much more modest degree. In such an environment, the economic impact is obviously more muted, this thanks to a more globalized climate.

From a valuation perspective, P/Es, for example, would be lower than they would be in otherwise less stressed times. But not quite to the degree that they were in the 70s.

Investment Strategy Implications

The broad market investment implications of any version of stagflation are rather straightforward – lower valuation levels. Any time quality of earnings is affected, valuation levels must go down.

In a stagflation lite environment, an investor could kiss the current reasonable S&P 500 P/E level of 19 – 20 times (with the 10 year US Treasury at Approx. 4%) goodbye. Nor would its historical level of 15 times hold. However, only a stagflation period comparable to the 1970s would produce single digit P/E levels as it did then. Hence the higher P/E probability in a stagflation lite world would be somewhere around 12 times earnings.

If that were the case, then an $82 operating earnings (S&P 500) forecast would put the fair value target for the S&P 500 at 984, a full 23% below current levels. Interestingly, 984 brings the S&P 500 down 36% from its high of 1550. In the process, the drop of 554 points from the high achieved in October 2007 would match against the 770 point increase from the low reached in October 2002 (to the high of October 2007) and, therefore, would produce a decline of approximately 75% (from peak to trough). Such a drop would result in a slightly greater than your standard major bull market correction of 2/3s.

Be it stagflation or stagflation lite, it does appear to be touch premature to make such a call. Nevertheless, the market may be taking some of this thinking into consideration, and so should we. More on this prospect in the coming weeks.

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