Something is not right

An article on inflation from the Economist two weeks ago has been freaking me out. By now, with the biggest experiment in loose monetary policy the world has ever known, we should be happily inflating our way out of the overleverage aftermath of the 2008 crisis. Yet here we are with core inflation at 1.4%, 1.2% and 0.8% for the G7, US and the Euro zone respectively.

It seems like the air is coming out of the balloon faster than the central bankers can fill it. An article in today’s FT pointed out that real incomes in the average US family are less today than they were in 1989. No matter how much the central bankers want us to go back to the Mall and shop our way out of the current climate, there is something that just doesn’t add up.

Against the background of loose monetary policy and weak underlying fundamentals, I am becoming more convinced that the stock market is overvalued today (which doesn’t mean it will necessarily stop going up!) with the Dow topping 16,000 and S&P500 nearing 1,800 at a PE of 20 (& 15 times 2014 estimated earnings) and the Shiller PE at 24.7.

With my thanks to Fast Eddie, here are some articles on valuations that I have been reading which provide food for thought:

GMO November letter by Ben Inker & Jeremy Grantham

Chumps, Champs, and Bamboo by John Hussman

and the thought provoking

The paradox of wealth and the end of history illusion by William Bernstein

4 responses to “Something is not right

  1. Part of the problem in Europe imho are the banks. Right now nodoby knows whether Smith Bank down the street will be around in one years time (or even tomorrow for arguments sake). Since there are no unified rules, for example when a loan is considered non-performing (eg Italy’s definition is more lax than Germany’s… could you imagine ?) it is hard to draw comparisons and to know how many skeletons are hidden in the various closets. Which in turn hurts inter-bank lending and leaves the ECB as most creditworthy conuterparty… Another issue is the forced disinflation (Spain, Italy, maybe Portugal) or outright deflation (Greece) in the southern countries. In a currency union there are not that many ways to become more competitive. Internal devaluation is one of them and currently en vouge. No wonder we don’t see a hell of inflation all over europe. The “progress” in France is also not very encouraging…

    Regarding the Bernstein paper, Grantham made some similar comments some time ago when he wrote a few papers about demography. It boils down to “if mankind shall survive the world population has to shrink to 4 billion people or so, with according consequences for GDP growth”. So in the very long term GDP growth, thus growth in corporate profits (not sure whether this links really holds, though !) and growth in stock prices should be more muted. But this is really long term stuff, probably best measured in decades, not years. In theory this should affect todays stock prices (discount the next 50 years or so of corporate free cash flows) but I sincerly doubt it… Something that can be backtested, however, is the Shiller PE. Although punters keep on arguing that this time it is really different (unlike the last umpteen times we said so) and that the old rules don’t count anymore. Fact is, however, that years with rich Shiller PEs delivered crappy long-term returns over the next couple of years. Which doesn’t mean that there will be an instant meltdown or something similar, there could also be a prolonged period of stock prices going sideways (think 1970s for example). We shall find out all too soon….



  2. Steeling from Buttonwood: Economic growth and equity returns


  3. Damn, I meant stealing…

  4. Thanks Eddie, interesting article on growth & returns, I need to give it some further thought, makes some bold statements.
    Agree 100% on Europe & banks. I live in Ireland, dysfunctional ….enough said.
    I am having a look through the Shiller and corporate profit arguments from both sides again to challenge my fears for the market!! Will post thoughts.

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