The market is always “unhinged from its fundamentals.” It never trades at some fictional level of “equilibrium.” The markets only concern is how high is high and how low is low. That is the only “discovery” that it cares to ever make. And so, like a pendulum it swings from one extreme to the other. While swinging to and fro, the market is certain to pass through so so-called “fair value” areas, but fair value is of no concern to it.
While the baseline scenario for a muddle-through recovery may persist for many years as it did in the 2003-2007 era, that era was not a sustainable trajectory. The baseline scenarios going into the bursting of the housing bubble was that its overall effect on domestic economic activity would be contained and idiosyncratic.
Turned out, the bursting of that unsustainable bubble poisoned the whole world with a toxicity that still sickens our domestic economy.
When one quotes today’s forward pe multiple at 13-14 and consider that by historically standards to be average, you can not consider that makes investing in the stock market safe at these market multiples.
There is no safety in an “average p/e.” Market prices are not “normally” distributed. As and when the pendulum of the market swings from extreme optimism to extreme pessimism, look out below.
Throughout much of this decade, the market has been undergoing a multiple compression from record highs. There is good reason for that to continue. P/E multiples reached record highs in the US was because fiscal and monetary policies have been too accommodating over the past decade. The trend of overly accommodating policies can’t continue forever…and when that trend ends, it won’t be possible to justify trailing p/es of 15-16 or higher.
The trend towards further multiple compression in spite of the overly accommodating policies is likely to persist too, unless evidence of healthy organic and sustainable growth is achievable in the private sector without relying on the largesse of overly accomodative fiscal and monetary policies combined with aggressive cost cutting measures (laying off 8 million workers) to achieve these record profits and profit margins.
As and when the domestic economy is weaned off unsustainable overly accomodative fiscal and monetary policies in 2012 and beyond, what then, brown cow?
Speaking of GDP and inflation, consider the trajectory of China as a case in point. This morning, in a note to clients, I wrote “China’s GDP peaked in Q1 2010, so their monetary policy tightening is having a slowing effect on their economic activity if not their inflation. The official GDP growth rate still exceeds their inflation rate, which is good. However, the gap between the two are converging as we head into 2011. It is probably a good idea to watch this gap closely in 2011.”
The gap between the global GDP growth rate and the global inflation rates are converging not just in China. Everywhere you look as global policymakers respond to increasing inflationary pressures. Just last week, economists forecast the BOE to be raising rates by the 3rd quarter of 2011 and the ECB cited inflationary pressures building. The ECB citation is a telegraph that they too will be raising rates sooner than later. So, as this gap between global GDP growth and inflation rates converges, both global profits and profit margins will decline. This in turn will be another contributing factor to the trend towards multiple compression.
Now god forbid the forecasters overestimate the earnings growth rates for 2011 and 2012. Yves is correct in pointing out that their are significant offsets to the fiscal stimulus for 2011. And she is right that these drags may more than offset and “overwhelm” the said stimulus. If analysts overreach and actual earnings undershoot the earnings growth forecasts, the stock market will have to be undergo a revaluation to reflect the forecast undershoots.
