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2012: Year of Quality?



January 26, 2012 – Comments (1)

Location: Somrh's CAPS Blog

Author: Somrh

So I thought I'd offer an overview of my bearish thesis of the market as a whole. That isn't to say that there aren't good opportunities available but I believe better opportunities are coming.

European sovereign Debt

As if we hadn't heard enough about this issue... The reality, of course, is that there's a lot of debt that needs to be repaid or refinanced and it's questionable that those damned PIIGS will be able to pay it back or refinance it at interest rates that it can manage to pay without having heavy damage.

In spite of this it may not have a dramatic effect on the US stock market. At least I could imagine a European fallout harming European demand and perhaps some tightening of credit markets but having only a marginal impact on the US economy and US buisness. But it could very well be much worse. As a result this is a reasonable uncertainty here that could be damaging to the stock market as a whole and cause a major selloff (for a variety of reasons including economic downturn and possibly another US recession.) So I'm leaving this concern on the table.

And it's not just sovereign debt. It's that the European banks have all this crap on their balance sheets. And haircuts will have to occur. The PIIGS collectively have over 2 trillion euros (about $2.75 trillion) in debt. And they have zero capacity to print their way out of it since they're on the "euro standard".

So deleveraging is a necessity imo. (By deleveraging I refer to some process whereby "DEBT to GDP" or some similar metric declines.) And there's historically been 4 ways to deleverage:

Two ways results in lowering debt (numerator):
1) Default/Restructuring
2) Austerity

Two ways are due to increasing GDP (denominator):
3) Real economic growth
4) Inflation

Number 4 is not possible since they are on the euro standard (unless they get off the euro standard which is an entirely different bag of worms). 3 is unlikely since they'd have to run large trade surpluses (with whom?)

They've been trying 2 without much success. That leaves 1 unless someone can come up with some alternative. And we know that will be painful one way or another (all scenarios are painful except for possibly number 3).

Private Debt - the much ignored problem

But beyond sovereign debt problems, something that doesn't get enough discussion is private debt.  The reality is that private debt here in the US is still way above levels we saw in the roaring 20's. See the red line in Figure 1:

If you look at Figure 2, you can see there's a problem in Australia as well. And this is a common problem in many regions of the world.

The reality is that we are in the middle of a deleveraging recession. Many sectors (public and private) in various parts of the world are in one. That's not like the recessions we've seen in the recent past. The last deleveraging recession we really saw in the US was the 1930's.

Our GDP growth in the US over the last 30 years or so has been a result of increasing debt levels. We bought cars on credit, houses on credit, TV's on credit, you name it we bought it on credit. And debt isn't necessarily a bad thing provided that we have the cash flows to maintain that debt. But we've already tapped the equity in our homes and unemployment is still pretty high. Where's the money going to come from? We need income to service that debt. And servicing of debt takes away income from making purchases so where's the GDP going to come from?

We can't keep increasing debt levels at a faster rate than our income levels. Something has to give. So there's a genuine concern that we're going to see slow/nonexistent economic growth. And we aren't used to that. Expansion of debt skyrocketed in the 80's. And that worked out great because it allowed US workers to have their salaries stuck in the 70's (ignore the CEO's who have increased their income about 10 fold in real terms) but we continued to increase the amount of items we purchased. This is stuff we simply can't afford (the CEO's can but let's ignore them for the time being.)

All of this means that companies are going to have a hard time selling products and the high margins we are seeing will have to come down (cue Jeremy Grantham's "revert to the mean"... more from him later.)

Baby Boomers and the Stock Market

But aside from all of that there are other reasons to think we've got it ugly. Consider the Boomer Effect.  Here's a study put out by the San Francisco Fed:

They find a relationship between the MO ratio (ratio of people in their 40's to ratio of people in their 60's) and the PE ratio. The idea is that people in their 40's are in their financial prime, accumulating assets (particularly stocks) while people in their 60's are retiring or preparing to retire so they are liquidating assets (stocks) to pay expenses or transfer to less risky assets. So the MO ratio should be an indicator of the ratio of people dumping money into stocks to those pulling money out of stocks.

It should come as no shock that when you dump money into the stock market prices go up and when you take money out prices go down. And that's precisely what they find.

Based on their model, they project the next 10 years to see a 13% decline. (They assume earnings grow at 3%.) After you factor in dividends (which are at about 2%) you might do slightly better than even. That would amount to less than 1% annualized returns. Those 10 year treasuries don't look so bad after all! (As a side note, I think they're ugly too. I don't know how long they can keep rates that low but I'm not going to risk it and find out the hard way.)

The Stock Market from a Valuation Standpoint

Aside from all of that valuations are high. Shiller PE ratio is almost 22:

Historical average is just above 16 (which is about what Benjamin Graham recommends as a place to buy under). Dividend yields are less than half historical levels. If you assume the less than 2% dividend yield plus an historical real growth rate of 1%, you'll do about 3% real returns over the long term. So stocks aren't that greatly priced. Obviously if you're investing in higher quality/better value stocks, you should do much better than this but it indicates that the market is due for a real correction.

But what if we see a real correction? We haven't had one in a while.

Historically post-bubble periods resulted in an average of 14 years below previous trend. The whole idea that markets rally after a drop off of price is a more recent phenomenon (I wonder if that relates to the expansion of debt we've seen? inquiring minds want to know). If that were to occur again, we'd get something like what Jeremy Grantham predicts:
(You can also find this at

I don't know if Grantham's scenario will pan out or not. But I think 800 for the S&P 500 is a much better level for real investment returns than the current levels.

For those reasons I think 2012 may turn out to be a great year for buying quality stocks. But I'm patiently waiting for better prices to come.

1 Comments – Post Your Own

#1) On January 26, 2012 at 4:27 PM, Goofyhoofy (< 20) wrote:

Several things: Saying "debt is above what it was in the Roaring 20's" may be true, but it may also be irrelevant. Cars go three times as fast as they did back then, too. Is that important? Perhaps the (financial) world has changed and we can handle debt better? It's probably 100 times more than it was in 1903. So what?

I'm not arguing that there wasn't a debt runup that was irresponsible (on the part of people and corporations and government), just that comparing it to 90 years ago may not be the best measure.

Likewise,  I am unpersuaded by the 'coorelation' they find, especially since they seem to be charting periods as small as 5-10 years. during which demographic clusters don't really change all that much. Further, I think it likely that people will not exit the stock market in droves, but will shift from broad mutual funds (hundreds of billions in 401(k)s) to good paying dividend stocks - and live off the interest. I am influenced here by my father, who at 90, has not touched his portfolio for 20 years except to shift a few positions from reinvestment to depositing cash dividends in the account. (And myself, since that is what I have done as well, although not for 20 years.)

Indeed, I could make a reasonable prediction that as people downsize, they will sell their homes and put the excess (if there is to be any!) into market vehicles for cash generation, although some will surely put it in a bank account, CD, or bonds.

None of that argues against your central point: that high quality stocks are the recommendation du jour, but then hasn't that always been true? 

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