Investing in La-La-Land
The key fact to know about the financial markets today – all of them, including the markets for shares, bonds, currencies and every other kind of financial instrument – is that they are warped out of recognition and hence totally dysfunctional. Their proper function is to provide information – and to update said information on an ongoing basis – as to the relative value of the instruments traded on them.
However, as a result of the vast amounts of liquidity (read money) being poured into the various markets by governments and central banks – on a scale and with an intensity never imagined before, let alone actually executed – markets are unable to exercise their function and, in consequence, the information they impart is corrupt and not merely wrong, but severely misleading.
A good case can be made that the world’s equity markets are the most egregious examples of corruption and distortion, leading to widespread misallocation of resources. In plain English, people think that equities are reasonable priced, if not actually cheap, and buy them expecting to make a profit. The fact that the market has been going up means that they have made a profit (at least on paper), but it certainly does not mean that the rationale for buying – that values were cheap – was correct. On the contrary, it was and is wrong.
Now it can be argued that “what difference does it make if the rationale was wrong, so long as the outcome is positive?” But that seemingly enticing argument is actually very dangerous. A person adopting a purely speculatively rationale – “I understand the market is warped but, for whatever reason, I want to have a punt and I’m sure that if prices rise I will find a greater idiot to but my shares from me and thereby enable me to realize my profit” – is actually being entirely realistic and therefore has a much better chance of achieving his goal of getting in and out safely and profitably. It is the supposedly solid “investor”, basing himself on the perceived value of the shares he buys, who is in danger.
The big investment banks and houses, needless to say, continue to spew out learned rationales based on seemingly exhaustive research, the bottom line of which is always the same: now is a good time to buy. But there are still respected analysts and fund managers, working mostly in small firms, who are able to cut through the self-serving gobbledygook of the Goldmans and Morgans and tell it as it is, in fairly simple English that is nonetheless rooted in impeccably objective analysis. One of these is John Hussman, who runs the eponymous firm and funds and also writes a weekly newsletter that has a strong following among market professionals.
Hussman has long been concerned about the discrepancy between the poor economic fundamentals that the US ‘boasts’ and the ongoing rise in share prices. Because he is a ‘value’ investor, what concerns him most are corporate earnings, not macro-economic data – and he repeatedly relates to the fact that actual earnings are historically high. This, he warns, should not be a source of encouragement to investors, but rather a very clear warning – because such high earnings are anomalous and they must and will fall in the coming years (indeed, they have already begun to). In a recent letter, he explains why:
On the earnings front, my concern continues to be that investors don’t seem to recognize that profit margins are more than 70% above their historical norms, nor the extent to which this surplus is the direct result of a historic (and unsustainable) deficit in the sum of government and household savings. As a result, investors seem oblivious to the likelihood of earnings disappointments, not only in coming quarters but in the next several years. We continue to expect this disappointment to amount to a contraction in earnings over the next 4 years at a rate of roughly 12% annually.
There you have it. In an economy that is hardly growing, if the share of business profits in the overall economy is rising, this can only come at the expense of other sectors – namely the government and household sectors. If they are not hurting now, that is because they are paying the corporate sector with their existing savings or their future income (ie borrowed money). This is unsustainable, which means it will not last. Savings are desperately low, the ability of the government to borrow ever more is inherently limited and hence the collapse of business profits back to (or below) historic norms is inevitable. So shares are not cheap but actually expensive. That does not guarantee that they will fall, but that’s what has always happened in the past…