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As we enter 2010, the most important headwinds facing the U.S. stock market are rich valuation and continuing credit risks. Market valuations are certainly better than they were at the market peak in 2000. However, the S&P 500 Index ended 2009 at valuations which are characteristic of those found at prior market peaks including 1972 and 1987. From such valuations, durable market returns have typically not emerged, so whatever merit there might be in accepting market risk is decidedly speculative and short-term.
While near term market returns are extremely difficult to project, it is possible to calculate fairly reliable projections of long-term total returns for the S&P 500, because over the long-term, stock prices track "smooth" fundamental measures such as revenues, cash flows, and normalized (cyclically-adjusted) earnings. For example, over the past century, S&P 500 earnings have fluctuated widely due to economic expansions and recessions, yet they have followed a very well-behaved growth trend when measured from peak-to-peak across economic cycles.
One historically reliable method of projecting longterm market returns is to apply a reasonable range of price/earnings multiples to those future "normalized" earnings. Even assuming that the long-term trend of S&P 500 earnings will remain intact despite deleveraging pressures and a continuing collapse in bank lending, we estimate that the S&P 500 is currently priced to deliver annual total returns averaging just 6.1% over the coming decade. This is certainly better than the similar calculation in 2000, which correctly projected a negative total return.
Unfortunately, it is also the lowest projected return that has historically been observed outside of the late-1990's stock market bubble and a handful of previous market peaks such as 1987. This is not an argument that stocks must decline in the near-term, but it presents a difficult obstacle to risk-taking, because it suggests that further market advances may not be durable. Meanwhile, the U.S. currently faces a predictable wave of resets on Alt-A and Option-ARM mortgages, of approximately the same size as the wave of sub-prime resets that ended in early 2009.
These Alt-A and Option-ARM structures were specifically designed as "teasers" with low interest rates and temporarily optional principal payments— allowing loans to be made without documentation of creditworthiness, in return for post-reset interest terms that were generally higher than a documented lender would have paid. This "yield spread premium" tends to be particularly obnoxious at the point of reset if the mortgage itself is underwater (loan amount in excess of home value). Given that these mortgages were written during the last stages of the housing boom, at the highest prices, it is reasonable to assume that they now sport very high loan-to-value ratios.
From our perspective, the combination of deeply underwater mortgages, tepid employment conditions, and a heavy mortgage reset schedule creates a large threat of further credit losses. The loose-handed government bailout of financial institutions in early 2009 had the result of driving up the values of a wide variety of risky investments, driving the the yields of junk bonds and other low-grade debt to levels that existed in 2008, prior to the onset of major difficulties. While it might be considered natural for investors to bid up risky assets when they feel confident that the government will bail them out if they are incorrect, investors have now placed themselves in a position of relying on such bailouts, while at the same time earning low returns as compensation for the probable volatility.
Stagnant personal income and depressed corporate cash flows appear no more capable of servicing record amounts of debt today than they were at the beginning of this crisis. As a result, consumer credit and bank lending have continued to collapse, despite widespread perceptions of a fresh economic recovery. The depth of this collapse in credit is unprecedented in post-war data.
Historically, sustained economic expansions have commenced with rapid growth in debt-financed classes of spending such as housing, automobiles, durable goods, and capital spending. Recent economic growth has instead been driven primarily by temporary government stimulus, which has offset the erosion in private lending in recent quarters. In the credit markets, the past two years have seen an enormous issuance of new government liabilities.
The amount of U.S. Treasury debt held by the public (outside of agencies such as the Social Security Administration and the Federal Reserve) has already surged by more than 50%, from $5.05 trillion to $7.55 trillion, and record fiscal deficits continue to mount. Meanwhile, the Federal Reserve has expanded the U.S. monetary base from $850 billion to $2.02 trillion, fueled by aggressive purchases of Fannie Mae and Freddie Mac's mortgage-backed securities. As Fannie Mae and Freddie Mac have deeply insolvent balance sheets, their securities can be gradually made whole only with bailout funds obtained by issuing more U.S. Treasury debt.
It is in this context that we should consider inflation risks over the coming decade. At present, inflation risks are hardly considered to be problematic by Wall Street. From the standpoint of the next few years, that complacency is probably well founded, as fresh credit concerns are likely to create additional "safe haven" demand for default-free government liabilities. From a longer-term perspective, however, I believe that inflation will be a major event in the latter part of the coming decade, with the consumer price index roughly doubling over the next ten years. [[Even allowing for compensating adjustments in income sources, that's likely to represent about a 25% 'haircut' in the standard of living, with those on 'fixed-income' suffering the most.: normxxx]]
While the near-term case for inflation hedges appears fairly weak, I expect that we will gradually accept greater exposure to commodities and inflation-protected securities in the Strategic Total Return Fund in the coming years, particularly in response to occasional price weakness. Historically, inflation has been much better correlated with the growth of government spending than with the growth of the monetary base itself. This is particularly true over horizons of four years and beyond.
Ultimately, a massive expansion in government liabilities can do little but undermine the value of the U.S. dollar relative to real goods and services. Our willingness to accept market risk is essentially proportional to the expected return that we anticipate as compensation. Accordingly, we look to adopt a greater exposure to market risk when the expected return from accepting risk increases, or when the expected range of outcomes becomes narrower. The past decade has been challenging in that the S&P 500 has delivered a great deal of volatility, but no net return at all.
That environment has made it difficult to accept substantial market risk for any extended period of time. Presently, two things would improve this situation. One is clarity, the other is better valuation. First and foremost, over the next few quarters, we are likely to discover the extent to which "second wave" credit risks materialize. It is not necessary for the nation to work through all of its economic problems in order for us to accept a constructive position.
However, the most hostile market declines have often been associated with problems (overvaluation, credit strains) that were developing for some time but whose risks were dismissed or underestimated. Presently, what we need most is for several latent problems to become more observable, so that we can have greater clarity about their extent. Among these are the likelihood of surging delinquencies tied to Alt-A and Option-ARM loans, the requirement beginning in January that banks and other financials bring "off balance sheet" entities onto their books, and clarity about the disposition of a mountain of mortgages that are already seriously delinquent, but where foreclosure has been temporarily delayed.
Improved valuations, combined with better clarity, can be expected to move us to a more constructive investment stance. I expect that we will resolve the "two states of the world" issue during the coming quarters, which itself will narrow the range of possible outcomes and— especially if prices retreat— allow us to accept greater amounts of risk in response to improvements in valuations and market action. I look forward to greater optimism as we move through 2010. In any event, I remain focused on our goal of outperforming the major indices over the complete (bull-bear) market cycle, while reducing the impact of periodic market losses. We continue to achieve our objective in that regard.
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Normxxx ______________
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