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Wednesday 28 March 2012

Risk := ON

Mean reversion in profit margins means that earnings ratios aren't reliable
Quantitative Squeezing

As the immediate fears of market immolation have faded the switch in investors’ heads marked “Risk” has moved to the OFF position. All those little signs of uncertainty, the mass synchronisation of share price movements, the endless twittering and wittering about the imminent end of the known world have faded, to replaced by the normal measures of complacency in the face of unimagined dangers.

It’s likely that the relief generated by the Eurozone’s ability to stitch together a patchwork quilt of compromise to keep Greece from defaulting and the general resilience of corporate profits is only temporary. A reckoning must come when quantitative squeezing replaces quantitative easing. Getting this right requires finessing on a grand scale by the lords of finance; not impossible, merely very, very difficult.

Prolific Profits

As we saw in Blood on the Street, many firms have been achieving record levels of profitability – and that’s generally not sustainable, because profits tend to be mean reverting. Fortunately we have the peerless James Montier to explain why this is so.  In his latest White Paper, What Goes Up Must Comes Down, he shows where these profits are coming from:
“Net investment has generally been the biggest driver of corporate profitability over time. However, the stand-out engine of corporate profits of late has been the fiscal deficit.”
Net investment is the usual source of profits – this is mainly where businesses buy stuff from other businesses, creating a net profit for the seller, and it also includes real-estate investment. As Montier’s analysis shows, net investment collapsed in 2008/2009 and has only recovered fitfully since. The main driver of corporate profits has overwhelmingly been government spending – and the result of this government largesse is that corporate profits are now at record levels.

Technically merely arguing that profits are likely to revert to the mean is to rely on historical precedent, but it’s quite hard to see how record levels of profitability can be sustained under any circumstances from here. Government spending has to fall and unless corporations start splashing out and homeowners and consumers reverse the current trend of repaying debt and start borrowing again that leads to the obvious conclusion that we should expect profits to fall.

Cashed-up Corporations

Of course, there are counter-arguments, along the lines that this time is different. On one hand corporations are sitting on huge amounts of cash, over two trillion dollars in the US alone. The common explanation for this is that there’s a collective failure of nerve amongst managements and this is largely backed up by a study on Why Do U.S. Firms Hold So Much More Cash Than They Used To? which argues that it’s an increase in so-called idiosyncratic risk – essentially risks that you can’t easily predict and hedge against – that’s causing companies to hold increasingly large amounts of cash.

In fact the amount of cash being held seemed to level out in about 2004 but then took off again in 2008 following the bank induced lending drought. The overwhelming impression is that corporate executives simply decided that it was too scary to rely on the world’s financial system and started to hoard cash. Of course, if they could be persuaded to start spending some of this then it would push up net investment and go someway towards offsetting lower government spending.

Dread Bonds

A second source of support for stocks would come from the end of the quantitative easing associated with government deficit spending. At root this is governments purchasing their own bonds, driving the yields on these to astonishing lows, and distorting all sorts of measures. On almost any scale equities look cheap compared to bonds, and only risk aversion on a massive scale or a widespread belief that bond prices somehow aren't reflecting reality can explain the yield gap that’s emerged.

So, as quantitative easing turns to quantitative squeezing and the support for bond prices falls away you’d expect to see some money flow into the stock market to support share prices. Whether this will really happen is another question – and it’s not a question that can be answered by straightforward economics as it  really depends upon how scared investors are of the possible risks in the market. Dread risk – the fear of utter failure – can be all consuming, and can lead to some very irrational pricing decisions (see: Dread Risk: Investing Outside the Goldfish Bowl).

Index Risk

There’s a third factor to consider as well – the over-valuation of stocks simply because they happen to belong to some index or another. As the Horizon Research Group expresses this:
“One implication is that there must now be shares of companies that despite poor or deteriorating businesses or business models are being supported simply because they are already constituents of major equity indices. ETFs keyed to those indices are recipients of growing inflows of funds. This can go on for some time. Ultimately, though, investors who look to share-price performance as a precursor of business performance might one day find themselves painfully re-educated in the verity that whichever security or sector, technique or instrument of the day becomes avidly popular becomes mispriced – until it’s not.”
The implication is the index bubble is supporting both deserving and undeserving stocks, without discrimination. A fall in the markets generally as profit margins fall would, of course, be damaging to the indexes. However, if there are individual firms in those indexes whose prices are pumped up artificially because they’re the index, while the index itself is inflated by the temporary effect of government spending then people investing in those individual stocks could be in for a terrible hammering.

Toxic Time

This is the other side of the story we looked at in Hubble, Bubble, Index Trouble. Index investors themselves are exposed to over-valuation to some extent, but active investors in specific stocks may be doubly exposed. Of course, to take a position in such stocks would imply that they had failed to do the proper due diligence on the firm’s market competitiveness and financial statement and had, instead, invested on the basis of size, reputation and share price momentum. Sadly, that’s not particularly rare, more so when the fear of market collapse recedes.

Potentially this is a toxic combination – corporations failing to invest, mean reverting profit margins and record highs and over-valued stocks in major indexes, all surrounded by a raft of investors being driven by their belief that they’re in a risk "off" situation.  Oddly, for those investors who aren’t willing or able to do the necessary research then indexes are probably still the safest place. For everyone else, it’s time to rally to the value investing flag. When everyone seems to think it’s safe to invest it’s probably time to ratchet up the safety measures and start applying even more care than usual to individual investing decisions.

Game on.  Set Risk := ON.

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  1. While quantitative easing could provide some support for stocks, higher interest rates would provide competition for stocks and possibly hurt corporate earnings.

  2. Actually, "Risk Off", as commonly used, means reducing investment risk. It does not mean believing that the investing environment is now less risky. Conversely, "Risk on" means embracing more investment risk.

  3. Hi Ken

    While quantitative easing could provide some support for stocks, higher interest rates would provide competition for stocks and possibly hurt corporate earnings.

    True, of course. The argument that rising bond yields might not impact equities as much as we'd expect relies on the idea that interest rates won't go up until deleveraging is well under way. See: Fed Tries To Muscle Past 'Seven Lean Years'.

    I guess we'll see.