Market Insight - 9-18-2012

Recent central banking events have created quite a lot for for all investors to think about.  Tie in a series of seemingly never-ending economic and geopolitical calamities and things get murkier still. In one camp, many long term value investors are pointing to five and ten year normalized P/E ratios and indicating that the return environment, mainly in the US, looks ugly over the next ten years.  In another camp, which we'll term the "Don't Fight the Fed" contingent, Benanke's open ended support statement combined with Monti's aggressiveness means that all of our economic and political worries can be pushed to the side; ample liquidity should keep a solid bid under risk assets such as equities.  Is this an either/or situation?  It's always tricky comparing one equity market environment to another, but there is a situation that bears some resemblance to the current situation: 1997/1998.  If we'd lined up the same debate teams at the outset of 1998 and reviewed the situation a decade later, both sides could have declared a victory.  It all depends on timeframe.  Importantly, the series of market events in 1998, and the subsequent action over the following ten years, shows that market analysis, often boiled down to simple straight line statistical constructs, is far from a straight line game.

Looking back briefly, the global economies in 1997 and 1998 were marked by significant macro turmoil.  In late 1997, the Asian currency crisis started, and the turmoil spread throughout the world over the course of 1998.  Latin American countries such as Brazil and Mexico faced stresses.  During the summer of 1998, the Russian debt crisis exploded.  The IMF was putting out fires everywhere.  Missiles were fired at suspected Al Qaeda camps in Afghanistan in August.  Over the entire period, the US body politic was consumed and paralyzed by the Clinton/Lewinsky affair.  Adding insult to injury, a highly leveraged hedge fund, Long Term Capital Management, nearly blew up amid the turmoil in September and brought Wall St. to its collective knees.  Decisive Fed intervention in the LTCM case prevented a much larger market structure calamity.  Going into the summer of 1998, valuations in US markets, for instance, were already significantly stretched, with both 5 and 10 year normalized P/E ratios above 30x.  With a terrible macro backdrop, if there were anytime for a major secular bear market to begin, it certainly could've been then.  At the valuations seen in June 1998, normalized P/E ratios predicted future 10 year real total returns of around -1% per annum.  Fed Chairman Alan Greenspan had delivered a speech two years prior discussing the "irrational exuberance" in the marketplace.  Looking forward, Y2K loomed on the horizon.  Amidst the turmoil, the S&P 500 in the US declined approximately 22% peak to trough from July 1998 to October 1998.  The MSCI World declined approximately 20% peak to trough.  Global markets looked very similar to what we just witnessed in the fall of 2011.  In response, during the fall of 1998, the Federal Reserve lowered the target Fed Funds rate by a a whopping full percentage point sending risk assets around the world off to the races.  The Fed used other mechanisms as well to inject liquidity into the economy ahead of Y2K, helping broader market sentiment.  Market participants were able to ignore geopolitical concerns and focus solely on the internet and technology boom.  From fall 1998 to the spring of 2000, the S&P 500 rallied approximately 50%, providing much gloating among the new internet valuation paradigm and Don't Fight the Fed crowds.  Value investors around the world lagged significantly, with some famous value investors even retiring in 1999.

That's only part of the history, of course.  That last gasp into spring 2000 proved to be the end of the 18 year secular bull market.  Markets declined dramatically from 2000 to late 2002, and market have remained relatively stuck in the mud from 2000 to 2012.

Again, revisiting the "who won" argument, one can demonstrate that both camps could have "won" in 1998.  Despite valuations never before seen, the market was able to rally by 50% in approximately a year and a half making short-term fools of the value camp.  Being short in 1999 on the basis of valuation was a heartburn-inducing strategy to put it mildly.  Looking forward 10-years, however, from the summer of 1998, normalized P/E ratios and general valuation proved to be a reliable forward predictor.  Between the summer of 1998 and the summer of 2008, total real annualized returns for the S&P came in at around 0% to negative 1% per annum depending on which month you choose as your starting point, very close to to the predicted values.  Over the longer-term, the value camp proved prescient.

Fast forward to today.  We've dealt with the European Debt Crisis, China Concerns, debt rating cuts, muddle through economies, you name it.  The dreaded fiscal cliff sits on the horizon, not to mention a contentious Presidential election, future uncertainty in Europe, and future uncertainty in emerging markets.  Normalized valuations, though not as stretched as 1998, remain well above historical average with 5-year normalized P/E at 23.5x and the 10 year normalized P/E at 22.3x.  Normalized P/Es predict that that future 10 year real total returns in the US will come in at around 2% to 3% per annum, unimpressive by historical standards.  Global developed markets look better, but with the recent rallies valuations are average at best.  Yet, in the face of macro concerns and valuation concerns, US markets are close to market new all time highs (in nominal terms).  The S&P is now up approximately 36% from the intra-day lows set last fall.  The Don't Fight the Central Banks armada is out in full force and markets have maintained a healthy posture, even on down days.  Value Cassandras continue to put out their valuation warnings.  Like 1998, both could be right again.  It wouldn't be a surprise in the least to see risk markets maintain their upward trajectory and to see multiples expand in the US and around the world over the next several months (or even couple of years).  By the same token, current long-term valuations point to a market that should remain choppy, frustrating, and underwhelming from a performance perspective over the next 10 years.

What are the morals of the story?  First, timeframe is incredibly important when dealing with expectations.  Explaining a market view can be extremely complicated.  One can be bullish in the short-term but cautious about the long-term, for instance.  Having a process that takes multiple timeframes into account matters.  Second, long-term valuation indicators are not very good at predicting short-term cyclical moves, but have a darn good record in predicting long-term returns.  This seems obvious, but gets lost in the weeds.  Third, for long-term value investors, patience and intestinal fortitude are often required to make it intact through a treacherous investment journey.  At overvalued points like 1998 or the current timeframe, value investors are often maligned as being out of touch while markets march higher and higher and fear recedes into the background.  Over ensuing years however, the patience usually leads to opportunities to buy assets at better prices.  Of course, when better prices arrive at a future date, many people think you're crazy for touching risk assets.