Cutting Through the Noise!

The title comes from a Tom Bradley Steadyhand blog.   Tom makes some valid points: equities represent a buying opportunity when shares are as relatively under valued as they are now, and when it would appear no one wants to buy.

In other words, when others are selling and prices have fallen to historically cheap valuations, then ignore the fear and buy, because over time, once demand returns prices will recover, and if things get worse, then maybe we will not need to worry either way.

Equities based on historic price earnings ratios are cheap.  There is no doubt about that, and relative to bond yields, even more so.

A “buy low” when everyone is fearful approach is fine within an overall stable financial system, without the excesses built up over decades that we have.  But if we are about to enter a long period of debt deleveraging and declining final demand presaged by the potential collapse, however temporary, of components of the financial system, then the old adage of buying when everyone else is fearful may not necessarily hold to the same extent.  

As an investment discipline, this type of thinking has served marginal investors well, and I would suggest on average over time will continue to do so.   I am sure that those with very long investment time frames can still use present opportunities to buy shares that have not been as cheap for decades.   One can also easily argue, that today investors are buying at prices that will obviate the buying mistakes of the last 15 years or more, aside from the opportunities of 2009.

Bill Miller must have been thinking the same thing, like John Paulson of hedge fund fame, and similar comment to Tom’s have come from Fidelity’s Anthony Bolton (with respect to his China fund).  All these value focussed investors are of course correct in a sense: you should focus on the value, not on what could happen to make things worse, because of course you would not buy.  Things can always get worse, but more often than not, most of the time prices already discount the worse.  Unless of course, your scenarios are limited and based on past events.

But, I do think it worthwhile to consider the deep and peculiar circumstances in which we find ourselves.  Corporate profits are at all time highs in many markets, yet consumer demand, and its attendant structural imbalances, and output have been held together by fiscal stimulus and low interest rates, with the consequences of such now impacting sovereign debt markets and interest rates on debt, though not central bank rates. 

It is conceivable that we are entering into a deflationary period where overall demand declines: under such a scenario corporate profits and book value are exposed to significant rerating.  It is worth noting that most of a discounted cash flow valuation is derived from the first 10 years of cash flows, and it is precisely these ten years that are at risk from a debt induced deflationary economic environment.  

A small decline in real demand has a significant impact on profits: if profits, let us say, are 10% of National Income and National Income broadly equals GDP, and consumer demand is 70% of GDP, then a a 3% decline in domestic demand = a 21% decline in profitability, and more once we add in write offs to goodwill and other capital items.    If we start off with a P/E of 13, this would lead to a P/E of 16.5, and higher with write offs.   With austerity and debt reduction added to the mix we further reduce the GDP base, thereby further impacting profitability leading to further write offs.  

A deflationary episode is not covered by most bullish, or even value biased, assessments of stock market value, and while I am sympathetic to valuation arguments and contrarian discipline, I think the current environment far too complex to be able to simply refer to what are effectively behavioural benchmarks.   

Yes, value biased investors that do not incorporate detailed analysis of the impact of structural financial and economic imbalances on profits going forward are using behavioural benchmarks to determine investment behaviour: 1- herd behaviour to a certain level of significance.

The current financial infrastructure (debt, assets, government lending, employment, investment, final demand etc) that drives valuations is under risk of being rewritten and we need to assess the impact of the rewrite on valuations, at least, before we can express confidence in our dogma.

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