6 minA liquidity-driven market
"The notion that central banks are in control of events is a myth. It's the other way around." (Dylan Grice, Société Générale) "You simply cannot create investment opportunities when they're not there. When prices are high, it's inescapable that prospective returns are low. The motto of those who reach for return seems to be: 'If you can't get the return you need from safe investments, pursue it via risky investments.' It takes a lot of hard work or a lot of luck to turn something bought at a too-high price into a successful investment. Patient opportunism - waiting for bargains - is often your best strategy." (Howard Marks, Oaktree Capital Management)
Since the European Central Bank set up its long-term repo operation (LTRO), which involves injecting liquidity into the Eurozone banks in the form of three-year loans, the stock markets have gained around 20%.
We are not comfortable with a strategy that involves buying ‘because there is a lot of liquidity' or 'because interest rates are so low'. History shows that each attempt to boost the value of financial assets with cheap money has failed in the long run. That such efforts fail is only logical as instead of resolving fundamental problems, cheap money only tends to make the problems even worse.
For us, the only reason to justify an investment in stocks or any other financial asset is a sufficiently low price(and even then, we restrict our investments to quality securities). Satisfactory returns on an investment can only be achieved if the price paid is sufficiently low. Many analysts are arguing that this is precisely the situation today. However, that is not true. Based on valuation multiples which in the past have been a good indicator of future returns, the current valuation of the US market is compatible with an annualised return of around 4% in the next few years. For some investors, such a return might appear attractive compared to those offered by money-market and bond investments, and they won't think twice about buying stocks. But in our opinion, such a return does not adequately compensate an investor for the risk taken when buying equities.
Around ten months ago, in my ‘Equity markets at a crossroads' post, I said that history showed that there were essentially two types of stock markets:
- structural bull markets, and
- structural sideways markets.
In the first type of market, there is a clear established upward trend. In such a market, an investor who buys and stays invested for 10 to 20 years usually enjoys high returns despite interim corrections. In 2000, the stock markets were well above their 1982 level. In the structural sideways market, this is not the case. In 1982, indices were more or less at the same level as in 1966, and in 2012, they are lower than in 2000. The article went on to say that following the rise in share prices between March 2009 and May 2011, investors were forced to make a choice:
- either they thought that March 2009 was the start of another structural bull market. In this case, the best strategy was to remain invested and not be concerned about small interim corrections;
- or they thought that the rally from March 2009 to May 2011 was only a cyclical bull phase within a structural sideways market (such as the bull cycle of March 2003-October 2007). In this case, the strategy recommended was to gradually move out of the market.
The situation today looks quite similar. After that article was posted, the stock markets went down for six months and, despite the sharp recovery in prices since December, most markets are not higher than they were in May of last year.
Once again, the question is to understand if, following 12 years of sideways market, the stock indices can get out of purgatory and begin a sustainable rise. Before answering this question, a few basic principles.
If a company produces earnings of 1 euro per share and if the market is willing to pay 12 times these earnings, the share price of this company will trade at 12 euros. For the price to rise, the company's earnings will have to rise or the market will have to be willing to pay more for these earnings (meaning that the company's valuation multiple – 12 in this example – will have to rise).
This principle is also true for the market as a whole. The only factors that can push up the stock market are company earnings and valuation multiples. In structural bull markets, both factors rise. This explains why in these markets, returns are very high. Going back to my company described above, if 10 years later, its earnings per share is 2 euros and the market is willing to pay 20 times these earnings, its price will be 40 euros and an investor who paid 12 euros will have made an annualised return of 13%.
On the flip side, in structural sideways markets, earnings usually continue to rise, but valuation multiples tend to fall. The fall in multiples cancels out the rise in earnings and share prices stagnate (structural bear markets are characterised by a fall in valuation multiples and earnings).
To answer the question about whether this is a structural bull or sideways market, one must therefore have anopinion about the direction earnings and valuation multiples will take in the coming years. Incidentally, I emphasise ‘structural' to show that we are talking about investing and not trading.
In terms of earnings, it is true that they have been surprisingly good in the past few years, especially given the weakness of the economic recovery. However, company results published in recent weeks seem to show that a turning point has been reached with pressures on both sales and profit margins (the latter being currently at historical highs). In the longer term, there is also the issue of corporate taxes which have declined in recent decades.
In terms of valuations, opinions are currently divided about whether shares are over- or undervalued. The main point however is that the factors that were behind the rise in valuation multiples are no longer in place, or have actually reversed. Some of the more notable factors are listed here:
- The decline in inflation and interest rates. Today, interest rates are very low. This has nothing to do with a buoyant economic situation but more with an environment marked by debt overhang, artificially weak growth and deflationary trends. The case of Japan shows that in such an environment, there in no longer a positive correlation between low interest rates and high equity valuations;
- The improvement in the geopolitical situation with the end of the Cold War. Today, the geopolitical situation seems to be deteriorating;
- A relatively smooth economic cycle with no major downturns. Some economists had gone as far as announcing the end of the economic cycle, arguing that the industrialised economies would no longer experience severe recessions. We now know today that this smooth cycle was partly due to soaring debt, the logical consequence of an artificially low interest rate policy. In the coming years, the continued process of deleveraging in the corporate sector and the end of the debt build-up in the public sector will weigh on economic growth, which will lead to shorter economic cycles;
- The fact that the fruits of economic prosperity have principally gone to the companies and their shareholders and not to their employees. The share of the labour component in National Income in many countries is today abnormally low. Put differently, company earnings margins are particularly high. This situation cannot go on forever;
- Demographic trends that created a category of investors (the famous baby-boomers) in the 1980s and 1990s for whom shares were the investment of choice. This category of investors is today approaching retirement and needs their savings and regular income (as opposed to the prospect of long-term capital gains) to pay for their retirement.
In light of the above, the conclusion is that the conditions for a new structural bull market are not in place. And that it is better to take profits following the stock market recovery of the past few months, rather than feel obliged to buy from fear of ‘missing the boat'.
This is why an investment strategy that involves buying shares because the central banks are injecting huge liquidity is foreign to us. These cash injections have no impact on how much companies earn and therefore do not boost the ‘earnings' component. They do temporarily have an impact on the ‘valuation' factor by producing an equity rally not based on an increase in earnings. However, experience shows that this kind of rally will not be sustainable in the absence of an improvement in economic fundamentals. Participating in a liquidity-driven rally implies that one is in a position to predict the end of this rally before the others. Few investors are.
