SERIOUS MONEY:Despite the anguished commentary, we are not seeing a repeat of the Great Depression, writes Charlie Fell
THE WORLD'S stock markets are under significant pressure once again as economic data shows that the long-awaited downturn has arrived. Fanciful "new era" theories from global decoupling to Fed infallibility have been dismissed as the idea that the recession will be both deep and prolonged has become a consensus view.
This painful reality has contributed to a state of fear and panic among investors who have headed for the exit door in their droves. Withdrawals from equity mutual funds amount to more than $125 billion over the past two months alongside hedge fund redemptions of some $60 billion in just four weeks.
Not surprisingly, the enormous selling pressure has pushed stock prices back to their lows for the year and US stock market averages are on course for their worst calendar year since 1931.
The long-term damage to stock returns has been pronounced as prices have more than halved in real terms from the heady peaks registered eight years ago and are back to levels first seen before the technology bubble of the late 1990s. The disastrous performance has seen a legion of stale bulls convert to the bear camp and amateurish comparisons to the "Great Depression" of the 1930s abound. Irrational despair has taken hold and some of the commentary emanating from the perma-bears echoes the anguish evident in John Steinbeck's The Grapes of Wrath.
The current economic climate is not a repeat of the 1930s. The origins of the Great Depression can be traced to a confluence of factors, not least the poor reconstruction of the gold standard following the first World War, which saw Britain return at a grossly overvalued rate of $4.86 in 1925. The inevitable pressure on sterling saw the Federal Reserve lower interest rates inappropriately in 1927, which contributed to further speculation in an already rampant stock market.
Four years later, as the economy was slipping from recession to depression, interest rates were hiked by two percentage points to 3.5 per cent in order to quash the demand for gold over an increasingly beleaguered dollar.
Policy mistakes alongside complete inaction aggravated the difficulties facing the economy. A laissez-faire attitude prevailed under treasury secretary Andrew Mellon, who declared "liquidate labour, liquidate stocks, liquidate the farmers, liquidate real estate" to "purge the rottenness out of the system". He got his wish but at an enormous cost.
The Dow crashed almost 90 per cent and would not register a new high in real terms until 1958, real corporate earnings dropped to 1873 levels, unemployment soared to 28 per cent and the failure of almost 10,000 banks in the absence of deposit insurance saw depositors lose $140 billion.
To add insult to injury, Mother Nature did her part to make a dire situation even worse through dust storms that saw the loss of 100 million acres of farmland from 1932 to 1934.
It is clear that the inaction and mistakes so characteristic of the 1930s have not been features during the current crisis. Extraordinary measures have already been taken by policymakers across the globe and will continue for as long as it takes to rehabilitate the global financial system. Meanwhile, stock prices alongside the values afforded to other risk assets already incorporate an exceptionally hostile environment. There is value to be found across all risk assets but fear has paralysed most investors.
Concern has grown that the non-financial sector faces a severe earnings downturn in 2009 and analysts are busy slashing their estimates. The notion that stocks are not cheap given the coming decline in profits features regularly in bearish arguments but it is not supported at all by the historical data. Indeed, the considerable resources expended in attempting to produce accurate forecasts of market earnings in the immediate future is incredible given that stocks are a claim on long-term earnings power.
More importantly, history confirms that it is largely a wasted effort as there is simply no relationship between year-on-year changes in stock prices and year-on-year changes in corporate earnings.
A properly constructed price/earnings analysis should assess the stock market's long-term earnings power. The use of relatively simple regression techniques generates an estimate of $65 per share for trend earnings. This easy-to-use technique is based on reported earnings through time and not those rosy operating numbers that exclude all the supposedly once-off bad stuff. Indeed, these once-off charges have been positive each and every year in the past 20 ranging from 2 per cent of operating earnings in 1988 to more than 40 per cent in 2002.
They have averaged more than 12 per cent over the entire period with the obvious implication that what is extraordinary for one company is not so for the market in aggregate.
US stock prices are currently trading on a multiple of 13 times trend earnings, which equates to long-term real returns of more than 7.5 per cent. This is the highest level in two decades and before any changes to tax rates and commission costs are considered.
Stocks are clearly cheap and though the earnings downturn may be sharp, trend profits will be unaffected and consequently any further declines in prices from current levels would increase the risk premium attached to stocks and expected returns thereof.
The downside in stocks is limited at current valuations but they do face stiff competition from the returns on offer across other asset classes, particularly investment-grade corporate bonds. The yields on offer are unlikely to come down until volatility subsides and only then will stocks be able to begin a sustainable advance.
Exposure to stocks should therefore be built slowly and investors may wish to employ put options as protection. It's time to reduce caution.
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