Not That 70s Show

commentary from this week’s “Sectors and Styles Strategy Report”*:

Recently. there has been a fair amount of talk re stagflation and its consequences, both economic and equity valuation. Should the experience in the coming years resemble the stagflationary era of the 1970s, then P/E levels are more than justified to crumble to single digit levels, as they did then.

Dismissing the stagflation threat entirely would be a mistake. Yet, buying into the idea that a 1970s style stagflation environment is in the current economic cards appears to be equally suspect as the world economy are clearly changed considerably since then. There is, however, a stagflationary scenario that does bear serious consideration – stagflation lite.

In a stagflation lite environment, growth stalls like it did in the 1970s but inflation rises at a much more modest degree. In such an environment, the economic impact is obviously more muted, this thanks to a more globalized climate.

From a valuation perspective, P/Es, for example, would be lower than they would in otherwise less stressed times. But not quite to the degree that they were in the 70s.

Investment Strategy Implications

The broad market investment implications of any version of stagflation are rather straightforward – lower valuation levels. Any time quality of earnings is affected, valuation levels must go down.

In a stagflation lite environment, an investor could kiss the current reasonable S&P 500 P/E level of 19 – 20 times (with the 10 year US Treasury at approx. 4%) goodbye. Nor would its historical level of 15 times earnings hold. However, only a stagflation period comparable to the 1970s would produce single digit P/E levels as it did then. Hence the higher P/E probability in a stagflation lite world would be somewhere around 12 times earnings.

If that were the case, then an $82 operating earnings forecast would put the fair value target for the S&P 500 at 984, a full 23% below current levels. Interestingly, 984 brings the S&P 500 down 36% from its high of 1550. In the process, the drop of 554 points from the high achieved in October 2007 would match against the 770 point increase from the low reached in October 2002 (to the high of October 2007) and, therefore, would produce a decline of approximately 75% (from peak to trough). Such a drop would result in a slightly greater than your standard major bull market correction of 2/3s.

Be it stagflation or stagflation lite, it does appear to be a touch premature to make such a call. Nevertheless, the market may be taking some of this thinking into consideration, and so should we. More on this prospect in the coming weeks.

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Quotable Quotes: Wisdom

With each passing data point, it is increasingly clear that the Bernanke Fed is faced with hard choices re the US economy – rising global inflationary pressures AND a potential domestic recession. Did somebody say stagflation?

Perhaps a few words on wisdom would help.


“Wise men speak because they have something to say; Fools because they have to say something.”
Plato

“The well bred contradict other people. The wise contradict themselves.”
Oscar Wilde

“The invariable mark of wisdom is to see the miraculous in the common.”
Ralph Waldo Emerson

“Too bad that all the people who really know how to run the country are busy driving taxi cabs and cutting hair.”
George Burns

Have a good weekend.

A Delicate Balance

To reiterate the point made on this blog one week ago today, “This Fed is attempting to walk that fine line between the real economy effects of the credit squeeze, the moral hazard consequences of a bailout, and the risks that inflation eminating from the global growth story poses.”


This is the essence of the debate investors are having.

The most vocal say the Fed is not acting with a sufficient sense of urgency, that the economy needs more liquidity to avoid what in their view will be a certain recession, that the Fed is taking a far too aloof ivory tower/academic view of the economy and, in the process, is far behind the curve.

Others, the less vocal minority, believe that the Fed should not bail out bad business practices, that the moral hazard consequences send precisely the wrong message, and that the economy will manage its way through a sharp slowdown but not a recession.

And even less vocal and smaller (but slowly growing) minority believe that global growth combined with a weak US dollar will push inflation higher here in the US, which, when combined with weak US domestic growth, produces a stagflationary scenario.

What tends to be lost in all this global macro debate is the calendar.

2008 is not just a US Presidential election year, it is also the year when all members (so, that's what they are called!) of the House of Representatives are up for reelection and many in the Senate are as well. The balance of power is at stake. Well, you tell me – Will the US Congress sit idly by while the US economy rolls over into a recession? Or will earmarks and other pork barrel projects inject a fair amount of stimulus into a moribund economy?

Now, let’s also consider this issue – China. Will China sit idly by as its moment in the global sun (Olympics) becomes clouded as its primary export market, the US, slips into a serious recession? Or will they take central bank and sovereign wealth fund action to provide the necessary liquidity to ensure that its primary customer remains in decent if not excellent shape?

Investment Strategy Implications

There is every reason to believe that the Fed’s balancing act will work. However, the innovative approach taken by the Fed and other central bankers may not sit well with certain market players who want the game that was to be reinstated*. Frankly, that won’t happen. That game is over. A new financial innovation game is being molded, with several of the key components from the old game, namely lots of liquidity, as an integral part of it. To the extent that this creates uncertainty, as all transitional phases do, so be it. Uncertainty produces opportunity - for those who can see through the fear.

Bottom line: Stay fully invested. And be on the lookout for Lunch Money** trades.

*see blog postings "Squealing Away", December 12; “Searching for the Magic Formula”, November 29
**see Topics Discussed "Lunch Money"

A Cake Not A Soufflé

Re the subject of the day, everyone has an opinion so here’s mine: Fed cuts Fed Funds rate ¼ point, cuts the discount rate cut by a ½ point. That, or some version of it, is what is baked into the cake. What is not in the ingredients is a little something extra that the Fed might stir into the mix, perhaps re the terms for loans at the discount window or some other creative, unforeseen way to ease the credit risk pressure. And this may make today’s decision and accompanying language that much more interesting and informative.


Clearly, the Fed’s task goes far beyond what will appease investors. It must strike the balance between a US economic slowdown morphing into a recession and solid global growth with still considerable levels of excess money creation. For example, according to the IMF, the BRIC countries' money supply growth ranges from the upper teens (India) to over 50% (Russia). And when you include the money created by the financial innovation wizards of Wall Street, an abundance of dough is still sloshing around the world.

All this excess liquidity (along with strong global growth) points to the lingering and potentially growing risk of global inflationary pressures in the midst of a US economic slowdown/recession. For the US, this is stagflation on a global scale. And definitely unmanageable by any one central bank (with domestic considerations at the top of its to do list).

Therefore, if the Fed can continue to find the right mixture and progress in appropriate steps and if the market discipline is allowed to continue to do its part, the world’s markets might be able to work their way out of the current mess. The alternative (global stagflation) is unacceptable, let alone highly dangerous.

The Fed wants a cake, not a soufflé.