Special Monthly Market Commentary: April 2009
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Inflation or Deflation?
The Federal Reserve recently announced that it would continue its buying binge, adding U.S. Treasuries and additional mortgage debt securities to its ever-growing balance sheet in an attempt to keep interest rates low and thaw the credit markets. These actions, on top of massive injections of liquidity into the system, are being enacted as the global economy continues to suffer from perhaps its most significant downturn since the 1930s. Warren Buffett recently stated in the annual Berkshire Hathaway Inc. Shareholder Letter that, “In poker terms, the Treasury and the Fed have gone ‘all in.’” With the announcement on March 19, the authorities once again stated, “We will do whatever it takes to stop deflation,” while possibly also signaling that, “Things may be worse economically than we originally thought.” So the real questions are…can they stop deflation? And, if so, at what cost?
No doubt, the authorities are moving aggressively to get credit flowing again and to prevent the economy from spiraling further into negative territory. We believe that ultimately they will be successful in doing so. However, the ultimate timing and cost remains unclear. The actions they are taking at this point may ultimately prevent the massive deflation we saw during the Great Depression. CPI fell approximately 23% cumulatively from 1929 to 1933, while nominal GDP declined 42%! This drop in nominal GDP was the real driver behind a complete collapse in earnings that caused stock prices to crash by 89%. It is hard to imagine that such a scenario could happen again, given that we are no longer on the monetary gold standard, and given the Federal Reserve’s current tact of furiously printing money.
While not nearly the same magnitude as the Great Depression, Japan also suffered a collapse in GDP and stock prices following the peak of its real estate and stock markets in 1989. Nearly twenty years later, the prices on the Nikkei 225 Index are still over 75% lower than their peak. While Japan did not technically suffer a “depression” during this period, they certainly experienced low growth, as the chart below shows, and have had an average deflation in prices of approximately 0.50% per year for the last 19 years. As you see from this chart, nominal GDP growth effectively mirrored the earnings growth of companies on the Nikkei 225 Index during this period.
Japan’s Stock Market Trials in Recent Decades Were Exacerbated by Excessively High Valuations
Source: PMFA, Factset
Coincidence? We don’t think so. In fact, long-term nominal GDP growth in the United States has been highly correlated to earnings growth of the companies traded on the U.S. stock market over the last 100 years, as illustrated below.
Corporate Earnings Track Closely with Nominal GDP Growth
Source: PMFA, Robert J. Shiller, “Irrational Exuberance” Princeton University Press, 2000, 2005, updated
This is why the authorities are so intent on reflating the economy, actively pursuing a policy of creating inflation to avoid a protracted deflationary period. If prolonged deflation takes hold, then nominal GDP growth and corporate earnings would also suffer, causing stagnant or lower stock prices (with a similar result for other risk assets). However, 10 years from now, even in a low-growth environment, stock prices may not be lower either. Consider the following chart.
Low P/E Ratios Generally Lead to Better Subsequent Returns
Source: PMFA, Robert J. Shiller, “Irrational Exuberance” Princeton University Press, 2000, 20005, updated
When 10-year rolling real P/E ratios dropped to 12, as they did on March 9 with the S&P at a level of 676, the ratio reached one of its lowest levels in almost two decades. We reviewed the subsequent nominal price changes of the market (excluding dividends) over all of the 10-year time frames that followed similar pricing levels, dating back to 1887. When such a low level was reached, the market was at a higher level 10 years later approximately 96% of the time. When dividends are considered, the frequency of subsequent positive periods is even higher. The U.S. stock market has already suffered a significant decrease in value, but there is no doubt that it could retrench further in the short run. However, even when making comparisons to Japan, we must not forget that the stock market losses in Japan during the last 19 years came as a result of the 81% drop in the P/E ratio, not from a drop in nominal earnings. The U.S. stock market peaked in 1999 with a P/E ratio of approximately 30, which was substantially lower than the valuation multiples of Japanese equities at their peak. Given the drop that has already occurred, and the focus on reflating the economy, it seems unlikely that American companies will be worth less in 10 years than they are today. However, future growth in share prices will be highly dependent on growth in earnings, and thereby nominal GDP growth.
The possible outcomes from here remain incredibly divergent. Economists and the general public are concerned about deflation while also being concerned about the potential hyper-inflationary effects of so much money printing. A great deal of uncertainty persists as to what the next few years will bring, and in this type of environment, we continue to believe that it is critical for investors to be highly diversified. At current pricing levels, we believe that stocks are most likely to have positive returns over the next 10 years, and their earnings streams have proven to be a long-term inflation hedge. (As illustrated earlier herein, earnings growth follows nominal GDP). That said, volatility remains elevated, and prices would likely fall further if economic news is worse than expected or if policy responses are perceived to miss the mark.
In this environment, it is dangerous to make a one-way bet on deflation or inflation. Therefore, we will continue to diversify portfolios in a way that allows clients to have some portion of their portfolio that should perform well in either outcome. Maintaining exposure to stocks and other risk-oriented assets provide the opportunity to participate in market upside when a rally occurs. Conversely, we continue to suggest that clients have adequate risk-averse assets in their portfolio to provide peace of mind, support their spending needs for the next few years, and offer the potential to take advantage of lower prices in risk assets should they present themselves in the short run.
Past performance does not guarantee future results. All investments include risk and have the potential for loss as well as gain.
Data sources for peer group comparisons, returns, and standard statistical data are provided by the sources referenced and are based on data obtained from recognized statistical services or other sources believed to be reliable. However, some or all information has not been verified prior to the analysis, and we do not make any representations as to its accuracy or completeness. Any analysis non-factual in nature constitutes only current opinions, which are subject to change. Benchmarks or indices are included for information purposes only to reflect the current market environment; no index is a directly tradable investment. There may be instances when consultant opinions regarding any fundamental or quantitative analysis may not agree.
Plante Moran Financial Advisors (PMFA) publishes this update to convey general information about market conditions and not for the purpose of providing investment advice. Investment in any of the companies or sectors mentioned herein may not be appropriate for you. You should consult a representative from PMFA for investment advice regarding your own situation.
Inflation or Deflation?
The Federal Reserve recently announced that it would continue its buying binge, adding U.S. Treasuries and additional mortgage debt securities to its ever-growing balance sheet in an attempt to keep interest rates low and thaw the credit markets. These actions, on top of massive injections of liquidity into the system, are being enacted as the global economy continues to suffer from perhaps its most significant downturn since the 1930s. Warren Buffett recently stated in the annual Berkshire Hathaway Inc. Shareholder Letter that, “In poker terms, the Treasury and the Fed have gone ‘all in.’” With the announcement on March 19, the authorities once again stated, “We will do whatever it takes to stop deflation,” while possibly also signaling that, “Things may be worse economically than we originally thought.” So the real questions are…can they stop deflation? And, if so, at what cost?
No doubt, the authorities are moving aggressively to get credit flowing again and to prevent the economy from spiraling further into negative territory. We believe that ultimately they will be successful in doing so. However, the ultimate timing and cost remains unclear. The actions they are taking at this point may ultimately prevent the massive deflation we saw during the Great Depression. CPI fell approximately 23% cumulatively from 1929 to 1933, while nominal GDP declined 42%! This drop in nominal GDP was the real driver behind a complete collapse in earnings that caused stock prices to crash by 89%. It is hard to imagine that such a scenario could happen again, given that we are no longer on the monetary gold standard, and given the Federal Reserve’s current tact of furiously printing money.
While not nearly the same magnitude as the Great Depression, Japan also suffered a collapse in GDP and stock prices following the peak of its real estate and stock markets in 1989. Nearly twenty years later, the prices on the Nikkei 225 Index are still over 75% lower than their peak. While Japan did not technically suffer a “depression” during this period, they certainly experienced low growth, as the chart below shows, and have had an average deflation in prices of approximately 0.50% per year for the last 19 years. As you see from this chart, nominal GDP growth effectively mirrored the earnings growth of companies on the Nikkei 225 Index during this period.
Japan’s Stock Market Trials in Recent Decades Were Exacerbated by Excessively High Valuations
Source: PMFA, Factset
Coincidence? We don’t think so. In fact, long-term nominal GDP growth in the United States has been highly correlated to earnings growth of the companies traded on the U.S. stock market over the last 100 years, as illustrated below.
Corporate Earnings Track Closely with Nominal GDP Growth
Source: PMFA, Robert J. Shiller, “Irrational Exuberance” Princeton University Press, 2000, 2005, updated
This is why the authorities are so intent on reflating the economy, actively pursuing a policy of creating inflation to avoid a protracted deflationary period. If prolonged deflation takes hold, then nominal GDP growth and corporate earnings would also suffer, causing stagnant or lower stock prices (with a similar result for other risk assets). However, 10 years from now, even in a low-growth environment, stock prices may not be lower either. Consider the following chart.
Low P/E Ratios Generally Lead to Better Subsequent Returns
Source: PMFA, Robert J. Shiller, “Irrational Exuberance” Princeton University Press, 2000, 20005, updated
When 10-year rolling real P/E ratios dropped to 12, as they did on March 9 with the S&P at a level of 676, the ratio reached one of its lowest levels in almost two decades. We reviewed the subsequent nominal price changes of the market (excluding dividends) over all of the 10-year time frames that followed similar pricing levels, dating back to 1887. When such a low level was reached, the market was at a higher level 10 years later approximately 96% of the time. When dividends are considered, the frequency of subsequent positive periods is even higher. The U.S. stock market has already suffered a significant decrease in value, but there is no doubt that it could retrench further in the short run. However, even when making comparisons to Japan, we must not forget that the stock market losses in Japan during the last 19 years came as a result of the 81% drop in the P/E ratio, not from a drop in nominal earnings. The U.S. stock market peaked in 1999 with a P/E ratio of approximately 30, which was substantially lower than the valuation multiples of Japanese equities at their peak. Given the drop that has already occurred, and the focus on reflating the economy, it seems unlikely that American companies will be worth less in 10 years than they are today. However, future growth in share prices will be highly dependent on growth in earnings, and thereby nominal GDP growth.
The possible outcomes from here remain incredibly divergent. Economists and the general public are concerned about deflation while also being concerned about the potential hyper-inflationary effects of so much money printing. A great deal of uncertainty persists as to what the next few years will bring, and in this type of environment, we continue to believe that it is critical for investors to be highly diversified. At current pricing levels, we believe that stocks are most likely to have positive returns over the next 10 years, and their earnings streams have proven to be a long-term inflation hedge. (As illustrated earlier herein, earnings growth follows nominal GDP). That said, volatility remains elevated, and prices would likely fall further if economic news is worse than expected or if policy responses are perceived to miss the mark.
In this environment, it is dangerous to make a one-way bet on deflation or inflation. Therefore, we will continue to diversify portfolios in a way that allows clients to have some portion of their portfolio that should perform well in either outcome. Maintaining exposure to stocks and other risk-oriented assets provide the opportunity to participate in market upside when a rally occurs. Conversely, we continue to suggest that clients have adequate risk-averse assets in their portfolio to provide peace of mind, support their spending needs for the next few years, and offer the potential to take advantage of lower prices in risk assets should they present themselves in the short run.
Past performance does not guarantee future results. All investments include risk and have the potential for loss as well as gain.
Data sources for peer group comparisons, returns, and standard statistical data are provided by the sources referenced and are based on data obtained from recognized statistical services or other sources believed to be reliable. However, some or all information has not been verified prior to the analysis, and we do not make any representations as to its accuracy or completeness. Any analysis non-factual in nature constitutes only current opinions, which are subject to change. Benchmarks or indices are included for information purposes only to reflect the current market environment; no index is a directly tradable investment. There may be instances when consultant opinions regarding any fundamental or quantitative analysis may not agree.
Plante Moran Financial Advisors (PMFA) publishes this update to convey general information about market conditions and not for the purpose of providing investment advice. Investment in any of the companies or sectors mentioned herein may not be appropriate for you. You should consult a representative from PMFA for investment advice regarding your own situation.
