October 20, 2009
Is the stock market overvalued?
David Rosenberg, one of the smartest economists and strategists around, made a very compelling case recently that the stock market is dangerously overvalued. Our reaction to his essay in the September 23, 2009 issue of the Financial Times is that he is basically correct but for the moment it probably doesn’t matter – the market is unlikely to sell off dramatically in the near term. We also agree with Mr. Rosenberg’s argument that the credit markets are not overvalued and offer far more attractive investment opportunities than equities today.
Mr. Rosenberg argues that the S&P 500 is currently trading at its most expensive level in seven years – 26x operating profits and 180x reported profits. Those are indeed tech bubble-like levels. He also points out that the market is priced for 4 percent real economic growth in the coming year, which Mr. Rosenberg views as unlikely. We would point out that reported growth may appear less attractive than real growth if the deflationary dynamic continues to haunt the economy, as HCM expects. Nonetheless, sustainable 4 percent real growth is a tall order in view of the absence of non-governmental sources of growth.
The real question about equity market valuation will come down to corporate earnings, which have managed to surprise on the upside thus far in 2009. The third quarter should again provide reasonably good news on this account, although there will be a lot of noise in the numbers for both the third and fourth quarters. Readers need not be reminded that economic activity came to a grinding halt around this time last year, causing third quarter 2008 numbers to weaken and fourth quarter 2008 numbers to fall off a cliff. As a result, 2009 comparisons with last year’s numbers should be highly flattering. But investors should not be fooled. Companies continue to generate profits from cost cutting and balance sheet mending, not from revenue growth. The true test will come during the fourth quarter of 2009 and 2010, when companies will have an opportunity to operate in an economic environment that, at least on the surface, appears to have stabilized. It is not unreasonable to see companies lose revenues while the economy is experiencing and then recovering from a deep recession. By now, however, the economy has stabilized sufficiently to give us an idea of whether revenue growth is going to resume or not. This is particularly true with respect to the ability of companies to obtain the financing needed to operate their day-to-day businesses. If revenue growth is going to remain below trend, as observers like Mr. Rosenberg expect, then the equity market is certainly going to be in for a difficult time.
Other investors with similar market views have been left behind by the rally. In a September 28 article, The Wall Street Journal highlighted several extremely well-regarded investors that have suffered such a fate this year (“Pessimism Exacts a Price on the Skeptics,” p. C1). Firms such as Peter Thiel’s Clarium Capital (-12 percent thus far in 2009), John Horseman’s Horseman Capital (-20 percent), and Jim Simons’ Renaissance Technologies (-12 percent, although we hear that the fund that manages Mr. Simons’ and his partners’ money is doing better) are suffering from the view articulated by Mr. Thiel that “[t]he recovery is not real. Deep structural problems haven’t been solved and it’s unclear how we will create jobs and get the economy growing again – that’s long been my thesis and it still is.” HCM considers Mr. Thiel among the most thoughtful investors on the scene today, and we take his views very seriously. In fact, we concur with his view that the deep structural problems in the economy have not been solved and if anything has been exacerbated by the measures taken by the government to prevent the economy from falling off a cliff. We do not, however, believe that such negative views will pay off anytime soon because of the return to health of the credit markets. As long as companies can obtain credit at a reasonable cost and on terms they can live with, the economy should continue to slog along and take the stock market along with it.
Readers will remember that HCM was among the few who predicted the crisis before it occurred. We were as negative as anybody. Late last year, HCM warned that the stock indices could drop even lower than they subsequently sunk in March 2009, and we were slow to believe in the rally early this year. We still generally concur with the bearish long-term view of the economy held by David Rosenberg, Peter Thiel and others. That said, we do not believe that the equity or credit markets are due for an imminent reversal (and the two markets are closely linked in today’s interconnected, globalized world). The reason for our optimism is squarely based on our experience in and knowledge of the credit markets, which continue to show every sign of healing. While the initial impetus for this recovery clearly came from government support, the private sector (with the notable exception of the banks1) has stepped in to provide financing for many corporations needing loan extensions or refinancing. There are reasons to be concerned that non-bank financing may become harder to come by in the near future, as we explain below, but abominably low yields and abundant liquidity suggest that reasonably healthy borrowers should be able to access capital for a prolonged period of time, something that was not the case beginning a year ago and lasting for six months thereafter. Moreover, low yields are compelling investors to search out investments that offer them what they view as reliable returns without undue risk. This accounts for the ability of corporations in decent financial health, and even some in not-so-decent health, to raise large amounts of capital in 2009 to refinance or extend their existing debt.
The flip side of such a low interest rate environment is that it may well sow the seeds for another credit bubble. The bubble that burst in 2007-2008 was created by the Federal Reserve keeping interest rates too low for too long, and by investors accepting too little return on their capital for too much risk. While the credit markets were clearly grossly undervalued at the depths of the crisis earlier this year, they have quickly moved to a point of fair valuation in many areas, particularly high quality corporate credit. The danger now is that corporate credit will again overshoot and offer investors too little return for the risks they are assuming. Investors need to retain one of the lessons that the crisis should have taught them: in leveraged companies, every layer of the capital structure is a type of debt because there is a risk of default associated with the issuer. Accordingly, even though this is too much to hope, it would be much better for the markets if investors would remain disciplined and insist on being properly compensated for the risks they are assuming when they invest in credit instruments.
The great dilemma the Federal Reserve is facing is when to raise interest rates again. HCM does not believe that the central bank will raise rates to any significant degree before 2011 at the earliest based on its historical focus on inflation, of which there is virtually none in the U.S. economy today. Nonetheless, the proclivity of the Federal Reserve to keep rates too low for too long has been a major contributor to the series of bubbles that led to the Mother of All Bubbles that burst in 2008, and Chairman Bernanke is going to have to do a better job than his predecessor to avoid a continuation of the policies that served us so poorly in the past.
The death of securitization
On September 17, Standard & Poor’s published revised methodologies and assumptions for rating Collateralized Debt Obligations (CDOs) backed by corporate debt (that’s a long way of saying they screwed up everything before and think they are fixing it now). As a result, the ratings agency placed on negative CreditWatch approximately 4,790 public rated corporate CDO tranches with an approximate face amount of $578 billion. S&P projected that its new methodology would result in average downgrades of one ratings notch for super senior AAA notes and 2-3 notches for junior AAA through BB tranches. Among the key changes S&P made to its ratings assumptions were requirements that BBB tranches must be able to withstand the worst observed corporate default rates since 1981, and AAA notes must be able to survive Great Depression-equivalent macro event default scenarios. In other words, S&P finally acknowledged the Black Swans that were shitting all over it for years. S&P had already made similar moves with respect to its widely discredited ratings in the mortgage area. In the corporate loan area, however, there are important systemic implications to its belated and poorly thought-out actions.
With this announcement, S&P accomplished several things. First, the revisions constitute an admission that its prior ratings were based on profoundly flawed intellectual assumptions and ratings models. Unfortunately, they have replaced their original mistakes with equally serious ones. Second – and most important from a systemic standpoint – the revisions effectively hammer the final nails into the coffin of the securitization of corporate debt. Third, with these revisions S&P unilaterally changed the rules governing hundreds of billions of dollars of Collateralized Loan Obligations that were issued over the past few years. It did so without giving investors in these transactions any right of appeal, or any recourse to recover their potential losses. Investments were made based on earlier ratings which arguably constituted an implied promise by the ratings agencies to maintain the original set of assumptions underlying their ratings. By unilaterally changing these assumptions to account for the first time for Black Swans, S&P has broken its compact with the entire financial world that came to rely on its ratings. This post hoc approach reflects extremely poorly on the intellectual abilities of the credit rating agency.
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