Are we ahead of ourselves? (revisited)

For today’s post I wanted to excerpt a portion of a newsletter that my father in-law Steve, a financial advisor, receives. The following comes from “Leeb’s Market Forecast”:

“It’s amazing that stocks have held up they way they have. Ostensibly, the market’s advance has occurred in anticipation of the economy recovering, but for all the talk of “green shoots” a few months back, the evidence that the economy is indeed improving remains decidedly thin.

“Yes, there may be signs of life in the economy here in the later part of the third quarter and the early going of the fourth quarter thanks to massive government spending and some inventory rebuilding, but we fear this will prove fleeting. Today’s ISM manufacturing index reading was good, for instance. We’ll remind you that this has been a credit-driven recession, however. Recoveries following such recessions tend to be slow drawn out affairs.

“The credit market, which dwarfs the stock market, is unequivocally pointing to continued economic weakness. U.S. Treasury bills fell to their lowest level the other day in the 50 plus years records have been kept. Long-term yields, likewise, have failed to move higher as is normally the case coming out of recession.

“Banks aren’t lending, period, which is why the money supply isn’t growing. And consumers are is such bad shape they aren’t likely to lend a meaningful hand with the recovery anytime soon.”

The newsletter continues to paint a gloomy picture of things. Steve’s question to me was what I thought of what was written above relative to what is going on in the financial markets. Certain questions, asked with a particular context, direct one’s thinking in unexpected directions. Here is what I feel about Leeb’s comments.

First of all I think that Leeb makes some interesting points. It’s my feeling that stocks certainly are pricing GDP growth and an exit from the recession into their levels. However, I feel that GDP growth is inevitable because of the tireless industry of entrepreneurs and workers everywhere. The fact remains that the economy will always have a solid footing as long as folks are interested in doing their jobs better.

Regarding the pace of the recovery: the real question is not when the economy recovers. the real question is whether or not the stock market rise is out of whack with the pace of the recovery. In my opinion, stocks were pricing in a depression rather than a recession from mid-October of last year to mid-March of this year. So much of the liftoff in share prices looks to me more like a recuperation of value that was artificially low due to pure, raw panic on the part of investors. Some of the lift in shares is in fact pricing in a recovery. Whether or not the shares are too expensive relative to the recovery is not knowable ahead of time because no one knows the ultimate result of the recovery. To me it feels as if the market is about fairly valued here. So what does that mean?

Often when it is said that an individual stock, or an entire stock market is fairly valued, people interpret that to mean that money cannot be made by investing. This reflects a fundamental misunderstanding of valuation. When an asset is fairly valued it means that “excess” returns due to previously undervalued assets appreciating to fair value are not available. However, the worth of assets, especially stocks, will continue to change on a daily basis. This is because stocks are interests in businesses and those businesses are “out there” trying to make money. If they succeed then the value of the stocks of those businesses should appreciate to reflect the increased value. This scenario is analogous to the earnings of the business growing, but the P/E multiple staying level.

Additionally, the strength of the business and the solidity and certainty of its ability to earn may increase. In this instance we would expect the P/E multiple to expand to reflect this lower risk scenario. The result in this situation is that earnings might stay flat, but share prices would appreciate as investors gain confidence that the business is likely to repeat its performance.

Lastly, businesses also return capital to stock holders in the form of dividends. If dividends are raised then the return to investors also goes up.

These three factors taken in conjunction are what the market “discounts” when assessing the appropriate price to pay for a business or an entire stock market. [Discounts is a fancy way of saying evaluates.] So where are we stock market-wise? I think there is no question that the earnings of businesses are going to increase. Concurrently, we really should not see much in the way of multiple expansion because right now the timing and magnitude of an economic recovery are uncertain. It is also likely that many companies are not going to increase their dividends anytime soon. This is because they are trying to conserve cash until they are certain of the timing and magnitude of a recovery. Taken together, this still reflects a stock market that ought to increase in conjunction with a rise in earnings. If aggregate earnings increase 5% we should expect a 5% increase in the value of the stock market. This is the scenario that unfolds when the market is priced at fair value. So when a stock market is at fair value there is still growth, but it ought to track earnings and the degree of risk. Does all of this make sense?

OK, so let’s return to Leeb. A lot of Leeb’s supposition rests on his point that the credit markets dwarf the size of the stock market. He is correct, but the two markets have vastly different natures. Credit is a less risky investment and more importantly it is required to make the economy go round. Whereas stock market investing is risky and definitely not required to make the economy go round. For Leeb’s market comparison to be an apples to apples comparison he would have to look at the marginal credit investors relative to equities investors. In other words, he would need to know the reasons why people were investing in credit who weren’t required to. And frankly I don’t know what the marginal credit market investor looks like and I don’t think Leeb does either. Not only that, but the stock market is more an enthusiasm measurer in the short run. That the marginal investor is willing to put money in equities at the nascent beginning of emergence from a deep recession is more important information than that credit investors are pricing economic weakness.

In short, equity investing, because it is much riskier than credit investing, requires a greater level of confidence. So the fact that equity markets are rising in the face of credit market stagnation is the important point; not that credit markets dwarf the size of the equity markets. In my opinion, Leeb is a little confused in his intellectual sorting of this info.

In conclusion, I think the stock market looks fairly valued here. That means that it should track earnings and economic news fairly closely. Given that news is likely to be flat to slightly up, I would expect that is what the stock market will do, too: flat to slightly up. As we emerge from recession then there should be some multiple expansion in addition to earnings growth. And hopefully we should start to see in the next 12-18 months an increase in dividends, too.

Have a great weekend!

Jason