The fragile recovery and the rise in asset prices
Now that Europe is on the mend, the initial phase of the financial crisis is clearly in the rearview mirror. Equity prices, bonds prices and house prices have risen by leaps and bounds even before this economic recovery was clear. Yet, the recovery itself is tentative, making plain the vast gulf between asset markets and the real economy.
In the past, I have pointed to the over-reliance on monetary policy as the driver of the asset price – real economy dichotomy. And while this feels good to investors now, my worry is that there will be some giveback and more. My concern is even more acute now because the pace of growth is picking up. When the US economy was recovering, I believed there was always the chance – even the likelihood – that deficit fetishism would create a double dip in the US as it had done in Europe and the UK. In the US, stocks were advancing at a good clip but the real economy was still weak because the over-reliance on monetary policy had re-created the asset-based economy that relied on asset price growth (and increased private debt) to fuel economic growth. This left the market vulnerable for a correction, one I believed would happen this year.
I think we are finally beyond that phase now. Yes, P/E multiples are expanding into the danger zone but it does not necessarily follow that this means a major correction is on the horizon. But the advance of stocks on multiple expansion without any significant correction does leave me concerned about how violent the next downturn in asset prices will be. I
n today’s links, it was interesting to see that Robert Shiller had teamed up with Jeff Gundlach to form the DoubleLine Shiller Enhanced CAPE fund which is tield to the cyclically-adjusted p/e ratio of the market, something that has risen tremendously over the past four years. Shiller’s comment on this were interesting. He said:
The current adjusted price/earnings of 25 is quite a bit above the average, which is about 16. But it’s not so much above average that I would disqualify stocks as an investment. Based on an updated regression that one of my students initially ran, it is still predicting something like a real return for stocks of 2.5% a year—not superhigh. But I’m starting to get more worried about the market as it keeps going up. When CAPE gets as high as 28, stocks would start to look unattractive.
And I see this as very much in line with the thinking of Jeremy Grantham and Howard Marks. The gist here is that the asset economy is “fully priced” as Warren Buffett put it recently. But the real economy is catching up to the asset economy and that means that the reversion to the mean in CAPE does not have to come exclusively from an asset price fall; it can also come from a rise in real economic growth that feeds through into profits. Nevertheless, as Shiller noted, the expected return has to be weak given how high the current adjusted p/e ratio is.
Gundlach’s comments about Apple were interesting in this context. He said:
We sold Apple, and then it dropped a lot, and then we thought it would drop to $425, but it actually went below $400 last spring and summer. We bought it at $405, and we still hold it. I like Apple because it seems to be almost an asset class. It doesn’t seem to trade like the stock market. Apple seems to be very noncorrelated to the S&P 500, and it is cheap. It generates a lot of cash. The growth prospects were grossly overestimated a year ago. But it’s still a very, very large cash-flowing company. So at about $525, where it traded recently, Apple looks reasonable. I don’t think the stock is going to make a lot of money—it’s not going to $1,000—but it can grind its way higher.
This gets me back to the ‘lack of a correction’ problem. Apple’s fundamentals, while weakening from its heady growth days, are still very, very good. The fact that the stock has corrected is a good thing in that context because it means that Apple’s shares, rather than being fully priced, look “reasonable.” By contrast, for the market as a whole to continue advancing in a sustainable way, we need to see earnings increasing from here at a pace high enough to bring the CAPE down while still allowing a positive return. If earnings rise 6% and stocks rise 2%, that’s a Goldilocks scenario. But that’s not the only scenario. The risk everyone needs to focus on is that the CAPE continues to rise as the rise in stock price outstrips earnings growth. At a cyclically adjusted p/e of 28, we are in bubble territory. And that is bad because bubbles pop and when bubbles pop, asset prices fall while the debt underpinning them does not. In a world of zero rates, that is a problem.
Look at Norway for example. This was a topic I had a number of links on in today’s news post and Gundlach and Shiller mention Norway. Norway’s problem is household debt, which I believe is now around 200% of GDP. Now, if you look up household debt in WIkipedia, there is a point in the discussion that reads as follows:
The International Monetary Fund (IMF) reported in April 2012: “Household debt soared in the years leading up to the Great Recession. In advanced economies, during the five years preceding 2007, the ratio of household debt to income rose by an average of 39 percentage points, to 138 percent. In Denmark, Iceland, Ireland, the Netherlands, and Norway, debt peaked at more than 200 percent of household income. A surge in household debt to historic highs also occurred in emerging economies such as Estonia, Hungary, Latvia, and Lithuania. The concurrent boom in both house prices and the stock market meant that household debt relative to assets held broadly stable, which masked households’ growing exposure to a sharp fall in asset prices. When house prices declined, ushering in the global financial crisis, many households saw their wealth shrink relative to their debt, and, with less income and more unemployment, found it harder to meet mortgage payments. By the end of 2011, real house prices had fallen from their peak by about 41% in Ireland, 29% in Iceland, 23% in Spain and the United States, and 21% in Denmark. Household defaults, underwater mortgages (where the loan balance exceeds the house value), foreclosures, and fire sales are now endemic to a number of economies. Household deleveraging by paying off debts or defaulting on them has begun in some countries. It has been most pronounced in the United States, where about two-thirds of the debt reduction reflects defaults.
My takeaway here was that in every one of those countries just mentioned with household debt over 200% of GDP (except Norway), the enormous household debt led to crisis (and loss socialization). Yet, today policy makers are actively encouraging households to take on more debt. In Norway, for example, the new government is trying to raise the LTV percentage banks can lend to borrowers from 85 to 90%. And this is in an economy that already has a household debt problem. Yes, Norway is wealthy. Yes, there are few economic problems on the horizon. But, no, this is not responsible or macro-prudential economic policy.
Elsewhere in Europe, there is an economic recovery and it is fragile. The rise in asset prices is at odds with this fragility. The rise in asset prices is also at odds with the growth in the real economy in Britain and the US. What we are witnessing is a great multiple expansion. And we need to see the earnings side do the heavy lifting now – or what to now has just been fully-priced markets will be bubble markets. Then, something will certainly break.