It seems that everyone is discussing the recent Bloomberg article about the valuation of the stock market and the potential of another recession. When the article is a classic boxing match between bulls and bears, it completely misses the point of investing in the right asset class. None the less,the article was quoted saying:
Bears say valuations show the U.S. remains in the slowdown that began in 2007. Unlike under Reagan, when U.S. Federal Reserve Chairman Paul Volcker raised borrowing costs as high as 20 percent to combat inflation, interest rates are already near zero, leaving policy makers fewer tools to boost the economy, they say.
Bulls say the ratios are so low because they reflect indiscriminate selling by investors convinced that any slowdown will turn into a repeat of the 2008 credit crisis.
I agree that interest rates cannot go any lower, but that is no reason to be bearish. The zero interest rate policy, together with money printing will eventually work - at least for commodities, but more on that later. There are plenty of other points bears should have noted, including deteriorating economy, which could put a monkey wrench into companies stealer earnings trend over the last 2 years. Let me explain:
For example, consider the chart above, which is a measure of future U.S. economic growth thanks to the Economic Cycle Research Institute. The Weekly Leading Index fell to 122.8 last week ending August 19th, from 123.8 the previous week. At the same time, index's annualized growth rate sank to -2.1 percent from -0.1 percent a week earlier. This was the lowest growth rate since the week of November 26th, 2010.
So what the bears should be saying is that we got on our hands a very reliable leading indicator for the US economy (not a holy grail), that is showing strong signs of weakness. It is currently trading below its two year moving average, which I tend to consider a recession warning. This type of development increases risks of potential S&P earnings contraction, as we can see in the chart below:
Therefore, bears should also note that while earnings have been magnificent during this business cycle, surprising even the bulls, eventually they will mean revert together with corporate profit margins. This quote probably summarises the whole ordeal very well:
“Profit margins are probably the most mean-reverting series in finance, and if profit margins do not mean-revert, then something has gone badly wrong with capitalism. If high profits do not attract competition, there is something wrong with the system and it is not functioning properly.” ~ Jeremy Grantham
The article went onto state that either the stock market is cheap or that earnings will fall:
...S&P 500 traded at 10.8 times analysts’ forecast for profits in the next 12 months of $109.12 a share. For the P/E ratio to reach its five-decade average of 16.4 without shares appreciating, earnings would have to fall to about $71.76 a share... Should companies meet analysts’ profit estimates, the S&P 500 must advance to about 1,790 to trade at the average multiple of 16.4 since 1954, according to data compiled by Bloomberg. That’s more than 50 percent above its last close.
If we think this through we would ask ourselves a few questions. First, one has to ask themselves if revenue (top line) could disappoint due to a recession threat? My answer is most likely so. Second, will profit margins shrink too? My view is almost definitely. Third, what is the chance of earnings falling to $70 or even lower? My answer, once again, decently high. Therefore, 10.8 times Forward P/E ratio doesn't really mean anything, does it? If earnings fall, the stock market will look overvalued, potentially selling off once more. Furthermore, I have to say that Bloomberg's view of S&P 500 at 1790 is totally ludicrous.
"Near stock market tops the price-to-earnings ratio is frequently low because the problem lies less with the “price” than with the “earnings”. In 1929, the US stock market sold for less than 14-times earnings. But then earnings collapsed and stocks plunged by 90%." ~ Marc Faber
So far this whole article portrays quite a negative tone about future prospects of the economy which could impact S&P earnings and therefore the stock prices as well. Up to this point majority of the bears will agree with what I wrote, but I think that agreement stops here. You see, my view is that it's not all is that bad for the bulls, especially if you are commodity bull. When economic activity stagnates, history has proven time and time again that commodities are the right place to be. Let me explain:
Most bears and deflationists do not understand that during prolonged awful economic periods, commodities do very well. Bears will argue that during economic weakness, demand destruction occurs and commodity prices fall. They point to 2008 and say: "you see, you see... I am right!" However, what they failing to understand is that commodity markets are not just moved on the basis of rising and falling demand. The other side of the equation is supply. If you have falling demand, but even faster falling supply, you have a commodity bull market on your hands. And, 2008 has made sure that no new supply streams are coming on line. No one can even get loan, let alone fund a whole new mine. The most interesting thing is that commodities do great when the economy is struggling, when unemployment is extremely high and when consumer confidence is terrible. Consider the chart below:
In the 1930s and 1940s we had the Great Depression, deflation and a huge economic collapse, however the world experienced a roaring 20 year bull market in commodities. While demand was falling and the whole world was de leveraging (just like today), the constant crisis' made sure no investment into commodity supply was being made. Eventually huge shortages developed and the prices of everything went to the sky. On the other hand, in the 1960s and 1970s, majority of the global economy was in total disarray, but once again commodities boomed. Consumer spending collapsed, inflation constantly ravaged economies and created recessions every few years. Once again, huge shortages developed and on top of that, governments everywhere printed money. Eventually the prices of everything went to the sky... again.
Summary: I think the Bloomberg article completely misses the most important point. When global economy suffers, commodities do much better than stocks, bonds or cash. And yet no one even talks about this asset class. So... fast forward to 2000s & 2010s, and the story once again looks similar. Shortages everywhere are developing and global governments everywhere continue to print money, throwing fuel on the fire.
Consider that farming has been a terrible business for over 30 years, the amount of arable land has not increased since 1980s and days of supply for almost every agricultural product are the lowest in 20 years. Cimate change and weather effects have only made things worse and now shortages have developed everywhere. Invest in Agriculture.
Furthermore, the world has not found a major "elephant" Oil field for over 25 years, so over 40% of Corn (and a lot of Sugar supply) is now used in ethanol production. At the same time, known supplies of Oil are decreasing at the rate of 6% per annum. That means in about 15 to 20 years, we will have no global Oil reserves left. Once again, shortages are developing and when prices go sky high, they will even be drilling in front of the White House grass lawn to find some Oil. Invest in Energy.
Despite a potential global slowdown, smart investors should stick with commodities over the next several years, because that is where fundamentals keep getting better and better. Recession or no recession, a roaring bull market in commodities is set to continue due to shortages on the supply side and money printing almost guaranteed by General Bernanke. History does not lie, so is this time going to be different to 1930s and 1970s?