The boom must go on
Posted on April 25, 2007 by Richard Beddard
Filed Under Editor's choice, Markets |
Investors are speculating about the trigger. David Andrew Taylor at Dismally thinks there’s a ‘perfect storm‘ brewing on two fronts: rising interest rates, and a rising Yen. Barry Ritholz says “The wall of worry now looks like the Great Wall of China‘
But the old saying is the market climbs a wall of worry. When we stop worrying and we’re complacent, that’s when we should really be worrying.
So charts and sayings aside, what’s the intellectual case for a continued bull market? I asked Ken Fisher when he visited the UK recently. Ken has a deserved reputation as the US’ most accurate pundit, and more importantly as a canny, and therefore wealthy, investor.
He predicts returns of 10% to 40% from global equities this year. The basis of his bullish forecast is the spread between the earnings yield and government bond yields. The earnings yield is a company’s or market’s earnings per share divided by its price (per share). It’s the inverse of the price earnings ratio and a figure that theoretically shows you the return you get on your investment. A company trading on a PE ratio of 15, for example has an earnings yield of 6% (1/15).
At the beginning of the year the forward earnings yield was 2% higher than the 10 year government bond yield in the US and over 3% in the UK, France, Germany and Japan, yet over long periods the spread between the two has been close to zero. The theory is that when one asset pays more than another, money will flow to it and prices will rise.
“This is the beginning of a process that no-one has ever seen before,” says Ken, “In the past, when the earnings yield has been above the bond yield it’s either been in a single country… Or it happened for a very short time. This is the first time in modern history when the earnings yield has been above the bond yield all around the world.”
Ken says the current generation of chief executives were slow to recognise the significance of the earnings yield/bond yield spread because they replaced the fallen stars of the 1990’s. Keen to avoid the corporate excesses of the technology bubble they stuck to the basics, taking care of marketing and production and focusing on costs and efficiency.
But they’re learning there’s another way to increase profits when the bond yield is below the earnings yield. First they borrow money to buy back and destroy their own higher yielding shares thereby boosting earnings per share. Then they borrow to take over other companies, assuming the profits, and boosting earnings per share. Other CEOs learn to play the game, and the size of the deals increases. Companies compete with each other, and private equity firms, to do bigger and bigger deals more and more quickly.
From there it’s a short hop to a bull market as demand for shares rises, but takeovers and buybacks constrict supply. Prices must rise. How long this mechanism persists depends on a three-way tug-of war between share prices, interest rates and earnings. Rising interest rates (from borrowing) and rising share prices (from constricted supply) act to close the spread between the bond yield and earnings yield. But rising earnings (from takeovers and buybacks) widen it.
What makes it unlikely the market will return to parity soon is the size of the moves required. Ken says it would take a rise in world stockmarkets of about 70%, a rise in global bonds yields of 2.8%, a fall in corporate earnings of about 41% or a combination of those things. He thinks share prices will rise this year, earnings are unlikely to drop, and bond yields will stay put. That’s not enough to close the gap.
Investors’ niggles are either insignificant, or lack the scale to tip the market into a full-blown bear. This is what Ken had to say about some of the them:
The carry trade
Investors are making easy money by borrowing in countries with very low interest rates, like Japan, and lending it in countries with high interest rates like the UK and US. The fear is it’s propping up stockmarkets and, should interest rates rise in Japan or the US dollar fall apart, the prop would be kicked out from under us. Ken disagrees:
“When you unwind the carry trade all that it does is takes the money that was borrowed in one country (and) lent in another country, and return it to its country of origin. You were lending in Britain. Now you close out your loan in Britain and return your capital to Japan. There’s no increase or decrease in capital… It can’t have an overall impact.”
“It’s always true you can spook a market in the short-term the same way you can spook people in a movie theatre by yelling ‘fire!’,” he says. “Every correction has a phony story with it, and people can’t tell if it’s real or not, and so they are panicked by it. But phony stories don’t create real bear markets.”
Private equity bubble
Other ‘worries’ don’t even cut it as short-term scares. Mention a private equity bubble, and he says there isn’t one. The boom in private equity is completely rational:
“All a private equity firm is doing is borrowing at the corporate bond rate, doing a takeover at an earnings yield above the borrowing price, and getting the free earnings… The time you have to fear the private equity firms is when they start selling the companies they’ve bought back to the marketplace”
Perhaps parallels with 1973/4 are more valid than 1987. Then the market fell apart after the conglomerate boom, when investors realised that bigger wasn’t necessarily better. That’s how Ken Fisher sees this boom ending, although not in 2007. The game begins to end when the gap between the earnings yield and bond yield closes, but just as they were slow to learn the game, bosses will be slow to realise it’s over:
“The one time there was something sort of like this in the English speaking countries (but not in the non-English speaking countries) was the 1960’s conglomerate boom, which was fuelled by the exact same thing; the earnings yield being above the bond yield. After the earnings yield/bond yield gap closed they kept doing it. They kept doing it because they liked building their empires. If you remember people like Jim Slater of Slater Walker. He was doing this right over the edge, which is how Slater Walker got into trouble.”
“My view is that there’s a huge gap, it will take a long time to close… It’s not going to happen next month. It’s not going to happen this year. It might take a couple of years. When it closes they’ll keep playing the game too far, and then off the other side you’ll see the reverse of the process, which is the private equity firms selling off the deals they made. That will add supply to the market, which will help drive the market down.”
Footnotes:
- Ken Fisher writes a monthly column on Interactive Investor
Comments
28 Responses to “The boom must go on”
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Great, great, great article Richard.
Like Ken, like the analysis. Hope it’s true.
Hi Dave. I’m glad to hear from you actually. I thought you’d jacked it all in
It’s the most articulate explanation I’ve heard for conditions in the market now. And, as I said he has a good record for calling the market - as evidenced by his Forbes columns (which go back a long way).
Correction: I made a mistake in this post, which I have subsequently corrected before, I think, many people read it. But, for the early birds the original text said to bring about parity between bond yields and earnings yields:
When, of course, a fall in the stockmarket would increase the earnings yield and thefore the gap between it and bond yields, prolonging the bull market. I’ve corrected the post so it says:
Which is what he actually says.
Seems logical. having moved some stocks to cash and bonds recently I will hold off for a while
What Ken says is false when he says
“When you unwind the carry trade all that it does is takes the money that was borrowed in one country (and) lent in another country, and return it to its country of origin. You were lending in Britain. Now you close out your loan in Britain and return your capital to Japan. There’s no increase or decrease in capital… It can’t have an overall impact.”
When anyone borrows money anywhere it is created from nothing by the banks. When it’s paid off it just disappears again. It’s called a Fractional Reserve System and it;s what we have world wide. All the “new” money being created around the Globe is brought into existance via new debt, it doesn’t really exist as when the loans are repayed the “money” just vanishes.
Ken should know better, perhaps he is part of this “system”, which is used to enslave the vast majority via debt to the banks.
Its a reassuring view point. Very clear and logical too.I started buying blue chips about three months ago because they look so cheap, so I am glad someone else thinks it is still OK to buy.
Richard,
As already stated, Ken’s article is succinct and clear, with few issues to cause confusion, or demand mind numbing thought and therefore, it remains a joy to read. My concern is whether Ken’s theory holds water. I accept he has compared current conditions with a few memorable dates, but it would have been even more impressive if he had explained both sides of the calculation. “When did the picture show a swing to a bear market and out of and into etc, etc”.
I’m not detracting from Ken’s theory, it sounds logical and therefore convincing and I would like to have it in my tool-bag. It would help contain my natural scepticism to see both sides of the problem fully examined.
all very rosy then, seems like only a month ago the Chinese spooked markets all over the world with just the smallest hint of a recession. Its like walking on ice at the moment imo.
Excellent article - and I agree fully based on the following: Corporate profits are at all-time high, there’s so much cash swirling around that mergers and takeovers will become more and more prominent. The impact will be stock shortage for the coming 18 months minimum and as such there will be upward movement in share prices in UK/US/EU mainly.
My prediction is 18% rise in FTSE this year followed by 16% next year
For each expert opinion there is invariably an equal and opposite one. Ken’s views are easy to understand, logical, succinct and, as investors, we want to believe them. It may well be that without a negative catalyst they would hold true. However all it takes is a spark - escalating Russian pipeline disputes, more Iranian manouvres, unpredictable government edicts in China - and we could be into the next bear market.
Thanks for all your comments.
In response to the observations that it will just take a spark; a sneeze from China, something in the Middle East, or Russia to to tip us into a bear market.
I think the argument is that yes, those things might one day be the catalyst for a shock that turns into a bear market. But for a true bear market (i.e. sustained falls for many months or years) something else needs to happen - shares need to be overvalued. Otherwise, like the China scare in February, the market rolls on.
Go back to 1973. Events around the time, Watergate, the dog days of the Vietnam War, the Yom Kippur War, The oil embargo, suggest lots of triggers for the crash, but would the stockmarket have reacted so strongly if it weren’t for the exuberance of the ’60’s and early 70’s?
Likewise, this market has overcome lots of potential triggers; crises in the Middle East, hurricanes, oil prices etc. How long have we been worrying about house prices, or levels of debt? One day the market will succumb. But, if you follow this line of thought, not until prices and interest rates rise, and earnings fall, to levels such that investors’ confidence has no foundation.
One of my favourite web pages has a series of Dow charts marked with world events. The 1960’s was a period of generally rising prices, but there were many reasons to worry in the US; war, civil unrest, assassination and devaluation to name four.
Like Angela, Andreas and Dave I find Ken’s a compelling explanation, though critics of the article are right. I’ll keep an open mind about alternative scenarios… and blog on them
Hi Everyone,
Perhaps someone can clarify something for me. Ken Fisher says that you can just close a loan in one place and the money goes back to its source, no damage done.
Now I am truly no expert on this kind of thing. All I can do is compare it to some kind of personal loan, for example a mortgage.
If the interest rates suddenly become too high to be able to pay off this loan, in general I will lose my home, end of story. It is not so easy to just pay off the loan to my expensive UK bank and then perhaps, go and get a matching home loan from my local Japanese Bank, down the road, to cover my mortgage (or perhaps it is ….)
Are the financial markets fundamentally different to this?
Many thanks for any response.
Ken Fisher makes a compelling argument in favour of the current bull market continuing. I am unable to check his corrolations but his reputation is such that one must accept the facts as unquestionably accurate.
Yet I feel this is all too glib an argument. When one starts to justify the future on the basis of past statistics, sound as they may be, then one enters dangerous waters. And I completely disagree on his comments on the carry trade.
My take is rather different.
Notwithstanding growth in economies [America slowing as it is] nor rising earnings in individual companies, the truth is that the players of the Games [ie investors both corporate & individuals] operate not only on rational information & statistics, but also on the irrational [fear and greed] - any one of a dozen scenarios can trigger a change from greed to fear.
But the nub is still the Carry Trade. It is all too easy to suggest that an unwind simply returns the funds from the new investment back to the source [repayment of Yen or CHF] - that is true of itself but that is not the point nor will it have a neutral effect.
The most likely scenario is borrowers of YEN and CHF who have used these funds to invest in higher risk assets [mortgages throughout Eastern Europe, South Afican commodities, shares & currency, British Sterling, Autralian currency etc etc] - if any one of these socalled speculative investments goes sour, then an almighty Double Loss will occur on [a] the sell off investment itself , which will be exacerbated by [b] a fight to repay the CHF or Yen lender which will drive the currency straight upwards.
Best visual explanation is to think of the revolving door analogy. Inside sits the Swiss or Japanese Bank - outside are the parties trying to get in to repay their borrowings. All are rushing for the door. The crowd cannot get in all at once !
Now it is true, this event has not happened dramatically yet. But if you believe as I do, that the commodity prices [whether iron, oil, copper , even private equity takeovers, etc] have been fueled not only by real demand, but also by players using the facility of the Carry Trade to speculate. Then beware !
The frightening part is that no-one knows what is real demand and what is speculation. Nor can anyone quantify how much institutions like Hedge Funds are involved and whether they have margined their borrowings even further.
Pause to think again ?
Cheers,
Misca
Only one result. Up goes the currency, sharply and quickly.
Cheers,
Misca.
I found this very interesting.
W2W’s comment was interesting as well.
Great article with real figure and facts
So one of the options to unwind this general boom is long term interest rates rising by 2.8%. Would this not be possible, when China stops buying the U.S. government bonds that it has hitherto been happy accumulating into its 1.1 trillion dollar foreign currency reserve? How big is this factor compared to the Carry Trade??
Confused and no expert on fixed income…
Hi everyone. I can see the carry trade is a sticking point but confess to knowing no more about it than I put in the article (i.e. reporting Ken Fisher’s view). Having stirred things up a bit I think I should find out more, I’ll let you know what I dig up…
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It is a HUGE mistake to think that very high levels of liquidity are the same as very high levels of money. Most of the new liquidity being created is debt. This liquidity is created from thin air by Banks and other Institutions (mortgage lenders etc) who make loans with “new” money. As long as they have sufficient reserves, the Fractional anking System allows them to go on creating “new” money (read debt). They are able to use derivatives in their reserves, so even the reserves are questionable. Once the tipping point is reached this new “money” will disappear. A simple example is that when you buy a property with a mortgage and the bank creates the money you just have another debt within the system (on the banks books). When the loan is repayed the debt disappears. The money you paid to the original seller just went to cancel their debt (mortage). The only new real money is produced when it is earnt via production. This is why economies like the US and UK are being hollowed out and the Chinese/Japanese/Indian etc economies are getting richer.
You can’t have wages rising at 3% or 4% and assets (property, shares etc) rising at 20%+ without a bust at some point. This time the bubble is worse than at any time in history due to the mounting levels of debt. Hedge Funds are using so much leverage (to get outsized returns) that when the limit is reached (last straw/camels back) the house of cards will implode.
The carry trade plays a BIG role in this debt explosion. But Fisher is dead wrong about what happens when the debts are repaid, because the “money” didn’t exist in the first place.
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