Current environment and to hedge or not to hedge part 2

This follows a thread at Jonathan Chevreau’s Findependence Daysite.

Yes I am highly liquid at the moment.

Market valuations in many markets are not expensive by historical benchmarks, but are not cheap in the context of the present environment.

With regards to valuations, I just do not think that a trailing P/E ratio of, for example, below 10 today is the same as a P/E ratio of below 10 in the early 1980s, or the early to late 1990s. That does not mean that a P/E of less than 10 cannot provide a competitive return relative to bonds, just that it will not provide the type of return you would normally associate with a P/E of 10.

Likewise just because equities yield much more than bonds does not imply that equities are a raging buy: low bond yields at the moment imply tremendous risk and uncertainty over future equity returns.

There is actually a lot of liquidity in the market place, but there is also far too much credit/debt, which if we see defaults, will significantly reduce liquidity and force a further focus on “safe havens”.

The relationship between the demand for and supply of assets is in my opinion, out of balance with the amount of demand the world economy is capable of generating going forward.

The build-up of government debt over the last few years represents to a large extent an artificial support of final demand, just as much as the expansion of private debt leading up to 2007 was likewise unsupportable.

There is therefore the potential for a shock to the system that will lead to a short and sharp decline in final demand and, via debt defaults (amongst other factors), a reduction of the supply and demand for assets, and a subsequent adjustment in the real economy of corporate profits and cash flow.

The existence and size of this imbalance and the catalyst for its resolutions should be the key difference between genuine bulls and bears – that is, if you believe that we have an overhang of excess that is due to be corrected, then you need defensive positions in asset classes that will be impacted by this.

If you believe that there is no excess, then you would overweight equities and perhaps even short bonds.

If you believed that the excess exists but it is not going to fall through the system, and that it can be worked out slowly over time, then you would feel comfortable holding your typical strategic allocation to equities given the valuation differential between equities and bonds.

But with regard to equity valuations, you need to adjust for the fact that after tax profits as a % of GDP are at historical highs: you could knock 20% to 30% off profits just to account for this fact alone. In the US, after tax corporate profits as a % of national income, as of Q2 2011, were some 11%. During previous recessions, profits have fallen to as low as 3.5% (mid 80s), 5.1% in the early 2000s and 4.7% in the early 1970s. So a recession could take corporate profits much lower than current levels and still be reasonable in terms of historical outcomes.


Also, when looking at historical valuations and P/E ratios we need acknowledge that financials which had assumed a large place in the indices prior to 2007 (and still do, especially in places like Canada) are not going to be driving markets or profits forward. The following chart shows US financial sector profits before tax as a % of national income which suggests that much of the decline in profits and capital employed could well come from the financial services sector – given that financial sector leverage has been key to driving debt fuelled growth, it is unlikely that decline in financial sector profits will not have secondary impacts on other sectors. 


Additionally, the sector balance of many indices has changed dramatically over the last few years which means that you could argue for a lower historic P/E ratio against which to benchmark current valuations (note the large increase in commodity and basic industry weightings, which one could argue are at the peak of their earnings’ cycles).

The following chart shows real profit growth on US stocks from 1919 to 1929 (Dec to Dec) versus 1996 to 2006 and real profits growth post December 1929 to December 1939. 


But what of dividend growth? The graph below shows that dividend growth post 1929 was negative for long periods of time and even during the 1996 to 2006 period, dividend growth was next to non-existent until 2002, the start of the low interest rate, low inflation years.


But let is look at an era much close to home: from 1966 (the peak of the 1960s bull market) to the end of 2006: we can see that real dividends and real profits growth were negative from a fairly substantial period of time post 1966 relative to real dividend and real profit starting points. So let us not kid ourselves that long periods of dividend and earnings stress only occurred post 1929 and that anyone investing post 2006 can expect healthy dividend and profit growth. After all, the mid 1960s were not characterized by the excesses that currently inhabit our system.


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