Note to Bond King: Check Your Math

Tuesday, August 7th, 2012

by Seth J. Masters, AllianceBernstein

August 6, 2012

The Wall Street Journal published an article on August 1 headlined: “Bill Gross: Equities are Dead.” In fairness to Gross, what he actually wrote in his August “Investment Outlook” was, “the cult of equities is dying.” We agree with most of Gross’s argument—but not with his unsupported forecast of extremely low  stock returns.

Let’s take a look at Gross’s claims:

1) Gross notes that bonds have outperformed stocks for the last 10, 20 and 30 years. With long US Treasuries currently yielding 2.7%, it is unlikely that bonds will replicate the performance of decades past.

We agree. That is why stocks are attractive today relative to bonds. Bonds—having outperformed—are now unusually expensive and have low expected returns going forward. By contrast, stocks—having performed poorly—are cheaper than normal and are likely to significantly outperform bonds over the next 10 years.

2) Gross argues that US stocks can’t maintain their 6.6% average annualized real return over the last 100 years. The 6.6% real equity return was 3% higher than real GDP growth, with shareholders gaining at the expense of labor and government. Labor and government must demand some recompense for wealth creation, and GDP growth itself must slow due to deleveraging.

We agree. We are now in a lower return environment. The question is, how low? Let’s concede that stocks will grow in line with real GDP. Over the long haul, real GDP growth primarily reflects population (growing a little over 1%) and productivity (growing just above 2%). That would give us a projected real equity return of maybe 3%—less than half the historical 6.6% rate.

3) Gross asserts that stocks will have a nominal return of 4%.

This is where Gross’s math gets fuzzy. Why this sudden switch to nominal instead of real returns? Does Gross expect that US population will shrink, productivity gains will disappear, and inflation will remain quiescent forever? That is what needs to happen for long-term nominal GDP growth to be as low as 4%. The scenario is possible, but hardly likely. Just assuming that inflation runs at a relatively tame 3% with below-normal real GDP growth of another 3%, we’d have nominal equity returns of 6% or so. That looks quite attractive when you get just 2.7% for holding long bonds to maturity.

In our recently published paper “The Case for the 20,000 Dow,” we show that with reasonable assumptions we can get returns in the 6% to 7% range and that the Dow hits that target in five to 10 years. We will also lay out our argument in an upcoming blog post.

Most investors today are very concerned about equity volatility, and for good reason. But there is another risk that should concern investors: the risk that their investments will not keep up with inflation and meet their goals. As investors balance short-term market risk against the long-run risk of falling short of their objectives, we think an appropriate allocation to equities continues to improve the likelihood for success.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Seth J. Masters is Chief Investment Officer of Asset Allocation and Defined Contribution Investments at AllianceBernstein and Chief Investment Officer of Bernstein Global Wealth Management, a unit of AllianceBernstein.

Tags: Alliancebernstein, August 1, Bill Gross, Bonds, Equity Return, Fairness, GDP, GDP Growth, Government Labor, inflation, Investment Outlook, Productivity Gains, Real Gdp, Recompense, Seth, Stock Returns, Treasuries, Wall Street Journal, Wealth Creation
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Can Stocks Avoid Another Bear in Spring?

Thursday, May 3rd, 2012

Can Stocks Avoid Another Bear in Spring?

by Francis Gannon, Royce Funds

After back-to-back double-digit return quarters, the equity markets paused in April. Uncertainty and volatility returned on renewed concerns about a slowdown in economic growth in the United States and China, and the never-ending debt crisis in Europe. Interestingly, these are the same issues that unsettled investors during the spring of 2010 and 2011, and there remains widespread fear that this year could play out the same way. After falling close to 30% in the first quarter, the CBOE Volatility Index (VIX) spiked 20% and the Russell 2000 Index fell -1.54% during April.

Many investors remain spooked by the last two cruel Aprils. They can easily recall how well stocks, especially small-caps, did during the early months of the past two years, only to peak in 2010 on April 23 before dropping 20.3% through July 6, 2010, and then peaking on April 29, 2011 before plunging 29.1% through October 3, 2011.

Whatever the combined reasons for the change in the market’s fortunes, we have been struck by the consistently optimistic tone we are hearing from corporate managements following first-quarter earnings. From our perspective, while many are once again questioning the sustainability of earnings and fear that peak margins are at hand in the face of renewed economic concerns, we think there is a long way to go.

It’s probably not surprising that, lost among today’s uncertain macro headlines and the seemingly endless fear of equities falling (as measured by sustained actively managed equity mutual fund outflows), is the reality that high-quality smaller companies not only have strong balance sheets, but also continue to expand in what can only be described as an anemic economic growth environment.

While popular opinion seems to be calling for margins to reverse, we have been hearing about continued productivity gains, expanding profit margins, and sound capital allocation in many of our recent conversations with corporate management teams. In fact, for many companies, the spread between the cost of capital and return on capital has never been wider, which should continue to drive capital formation and therefore growth and margin expansion.

Remarkably, small-cap operating margins remain significantly below prior peaks, and there is ample room for continued expansion. According to Chip Miller of UBS, “S&P SmallCap 600 operating margins are roughly 180 basis points—or 20%—below last cycle’s high.” To be sure, smaller-company margins in general have been solid, but we think they have room to improve.

The immediate issue, then, is whether or not the market can avoid a third consecutive bearish spring. Will the third time be the charm? For the moment, the market is caught in a tug of war between better first-quarter corporate earnings and a string of disappointing economic news. Could this be the beginning of another economic growth scare and equity correction? We are not sure. We do know, however, that corrections happen. From our perspective, they are part of the small-cap landscape and occur on a regular basis. They are neither unusual nor unprecedented.

“Price corrections serve an important function
in our investment process, allowing for the accumulation
of well-run companies at attractive prices.
After all, total return is a function of entry price.”

Using the Russell 2000 as an example, the small-cap index has experienced 18 downturns of 10% or more since its 1979 inception, including the most recent one in 2011. While calendar-year declines have occurred about every third or fourth year, downturns of 10% or more have happened about every other year. Without a doubt they are unpleasant, but in our view they remain a key component in building higher long-term returns.

Price corrections serve an important function in our investment process, allowing for the accumulation of well-run companies at attractive prices. After all, total return is a function of entry price.

We have always believed in the old adage that “great companies create their own success,” which is especially true today as many smaller companies position and prepare for better economic times in the not too distant future. It is also true, from our perspective, that there is an abundance of high-quality small-caps trading at a discount not only to their fellow small-caps but to their larger-cap siblings as well.

Stay tuned…
FDG

Important Disclosure Information

Francis Gannon is a Portfolio Manager of Royce & Associates LLC. Mr. Gannon’s thoughts in this essay concerning the stock market are solely his own and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above, will continue in the future. The historical performance data and trends outlined are presented for illustrative purposes only and are not necessarily indicative of future market movements.

The CBOE Volatility Index (VIX) measures market expectations of near-term volatility conveyed by S&P 500 stock index option prices. The S&P 500 is an index of U.S. large-cap stocks selected by Standard & Poor’s based on market size, liquidity and industry grouping, among other factors. The Russell 2000 is an unmanaged, capitalization-weighted index of domestic small-cap stocks. It measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 index. The S&P 600 is an index that covers roughly the small-cap range of stocks selected by Standard & Poor’s based on market size, liquidity and industry grouping, among other factors.

Tags: April 29, Balance Sheets, Capital Allocation, Cboe Volatility Index, Debt Crisis, Economic Concerns, Endless Fear, Fortunes, Francis Gannon, Growth Environment, Optimistic Tone, Popular Opinion, Productivity Gains, Profit Margins, Quarter Earnings, Royce Funds, Russell 2000 Index, Slowdown, Small Caps, Smaller Companies
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Cheap China Transitions to Luxury

Thursday, April 26th, 2012

April 25, 2012
by Michelle Gibley, CFA, Director of International Research, Schwab Center for Financial Research

Key points

• After a decade of double-digit gains in wages, China may be poised for a manufacturing slowdown—and the price of goods may rise globally.
• China’s export-market share may decline slightly, but an increase in the Chinese consumer’s buying power could help the economy in other ways.
• European luxury-goods companies will likely benefit from the influx of Chinese consumers into the luxury market.

Cheap labor costs helped make China a global manufacturing powerhouse. So what happens after a decade of double-digit gains in wages for Chinese workers?

Growth is likely to slow, but we believe it will aid the transition of China’s economy to a more balanced, sustainable growth model. In fact, China and the globe could benefit as Chinese consumers gain buying power, creating opportunities for luxury-goods companies that can cater to this influential new market.

China may lose export share, but no catastrophe

Wages in China have risen at a double-digit rate in recent years, but so has productivity, resulting in little change to the end price of goods exported. Meanwhile, the manufacturing sector in China shows the following signs of maturity:

• Productivity gains are getting harder to come by.
• Wage differentials with other countries are growing less favorable.
• Exports are steadily moving away from lower-end goods such as clothing and toys, and toward machinery and electronics.
• Advances in technology, in particular the move toward flexible automation in upper-end manufacturing, are reducing the role of labor in manufacturing.

The less human labor that’s involved in manufacturing, the smaller labor’s effect on the final price of goods—which means that even if Chinese labor costs were to decline, they wouldn’t be much help in holding down the price of exports.

We believe China may lose some export market share and export growth will likely slow in the near-term and coming years. We’ve written before about how the changing cost equation has contributed to a manufacturing renaissance in the United States, where the smaller labor cost differential has been particularly helpful for makers of goods with high logistics costs. In terms of low-end exports, countries such as Bangladesh and Vietnam have already increased their market share.

That said, it’s unlikely China will lose significant market share. With its large base of both skilled and unskilled workers, extensive infrastructure, and supply networks, China will probably remain the global manufacturing hub for some time. Additionally, it would likely take competitor countries of low-end goods many years to duplicate the highways, rail systems and ports that China already has.

Slower but more balanced Chinese economy

In addition to exports, infrastructure and housing construction have helped propel the growth of China’s economy. But construction can’t grow indefinitely, and over time, continued investment into building more factories becomes an inefficient use of capital.

This is part of why China needs consumers if its economy is going to continue growing. Private consumption plays a much smaller role in the Chinese economy than in the American economy. The Economist Intelligence Unit notes that, during the five years ending in 2011, private consumption accounted for roughly 30% of gross domestic product (GDP) in China. In the United States that figure was nearly 70%. To help foster consumer spending, the Chinese government is targeting a 13% growth in the minimum wage over the five-year period ending 2015.

China’s growth is likely to slow during the transition toward a consumer-led economy. However, this could result in an economy that is less reliant on exports and construction, and therefore more balanced. As a result, China’s next phase of growth could be more sustainable—to the benefit of both China and the world.

Chinese consumers seek luxury

Rising wages may temporarily slow economic growth, but they increase the buying power of domestic consumers. A large number of wealthy Chinese now have ample discretionary income and a newfound affinity for luxury goods.

The Asian luxury market is booming

Source: Bain & Company, Fondazione Altagamma. Luxury Goods Worldwide Study, October 2011.

Measures of the size and growth of China’s luxury market are astounding. McKinsey & Company believes the market can double over the five years ending 2015. By some estimates, China may have exceeded Japan as the second largest luxury market in 2011, when including purchases made in Hong Kong and Macau¹.

Greater China overtakes Japan as second largest global luxury market

Source: Bain & Company, Fondazione Altagamma. Luxury Goods Worldwide Study, October 2011. Greater China includes Hong Kong, Macau and Taiwan.

Chinese luxury buyers tend to be younger and less wealthy than their overseas counterparts, and they’re generally male. According to CLSA Research, Chinese buyers are 15 years younger than their peers in other markets, while McKinsey & Company notes that consumers further down the income ladder are purchasing luxury goods. In addition to the desire for status, the primary reason for purchases is “self-reward,” while business gifts are also an important part of luxury spending. As in many emerging markets, most luxury purchases are made by men.

Lastly, despite the perception of China as having a large counterfeit market, Chinese consumers increasingly want the real thing and are willing to pay a premium for globally recognized luxury brands. Consumers associate European brands most strongly with luxury², a status earned over decades of consistently producing high-quality goods with cachet.

European companies dominate the luxury segment

Investors may have trimmed their exposure to Europe due to concerns about low economic growth and the continued eurozone sovereign debt crisis, but there may be a way to invest in Europe while reducing exposure to the region’s risks. Europe has the largest share of luxury companies, producing the highly sought-after luxury brands that Chinese consumers are clamoring for.

What are the risks?

The law of large numbers tells us that the torrid pace of luxury sales should slow eventually. In fact, luxury spending in China already shows some signs of slowing, possibly due in part to a slowdown in exports and the housing market. Additionally, some high-profile corruption cases have highlighted individuals’ purchases of luxury items, which may cause some people to moderate overt displays of wealth.

While established luxury brands remain the most popular, they could see declines in market share. Newer luxury consumers and more price-sensitive buyers have shown some interest in local Chinese brands made in Europe. Even the government has funded a luxury clothing company that will manufacture Chinese designs in Italy. This could undermine the size of opportunity for European luxury companies.

Lastly, changes in Chinese import taxes could alter the landscape for retailers. According to ISI Research, the combination of custom duties and taxes currently account for roughly 50% of the price of many luxury goods, making prices in China much higher than elsewhere globally. As a result, over 50% of Chinese luxury spending occurs outside mainland China. China’s Ministry of Commerce has proposed reducing import taxes for consumer goods, although disagreements among Chinese ministries means that changes have delayed a decision.

While the pace of growth and individual companies that benefit could evolve as the market matures, the rising incomes of Chinese consumers are likely to generate investment opportunities in coming years.

1. Bain & Company, December 2011.
2. Luxury experiences in China, A KPMG study, May 2011.

Schwab resources

You can invest in the Chinese luxury trend through individual international stocks, but you need to have a high risk tolerance and time to devote to in-depth research before making investments. We’ve published a guide titled Managing an International Equity Portfolio Using Schwab Equity Ratings, which details our recommended research process for creating and managing an international stock portfolio.

Schwab clients can get the Schwab Equity Ratings International Report on a particular stock. This is an individual stock research report that guides you through our recommended method for researching a stock. It includes insights into a stock’s rating along with valuation, earnings and fundamental metrics. With this report, you should have most of the information to help you evaluate the investment potential of a particular stock. This report can be found in the Ratings Summary box on a stock’s summary page under the Research tab. To help interpret it, there’s a user’s guide which you can find directly under the report.

Investors trading foreign ordinary shares in the US over-the-counter (OTC) market using our online and automated trading platforms can contact Schwab’s Global Investing Services team at 800-992-4685 for more information.

Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

International investments involve additional risks, which include differences in financial accounting standards, currency fluctuations, political instability, foreign taxes and regulations, and the potential for illiquid markets. Investing in emerging markets may accentuate these risks.

Tags: Advances In Technology, Cfa, Chinese Consumer, Chinese Consumers, Chinese Labor, Chinese Workers, Electronics Advances, Export Market, Export Share, Flexible Automation, Growth Model, Influx, Luxury Goods, Luxury Market, Manufacturing Sector, Productivity Gains, Signs Of Maturity, Slowdown, Sustainable Growth, Wage Differentials
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BRIC Country PMI, New Business, Employment, Exports, Mfg Import Purchases

Friday, April 20th, 2012

by Richard Shaw, QVM Group

HSBC Emerging Markets PMI Index rises to 53.4 from 52.4 for 2012 Q1

Stephen King, HSBC’s Chief Economist, said:

“The latest HSBC EMI underlines the relative immunity of emerging nations to the economic permafrost of the developed world. Emerging nations still have many years of economic “catch-up” ahead of them, suggesting that their growth rates – driven by continuous urbanisation alongside productivity gains linked to improved access to global capital – should remain significantly higher than in the west. They also have considerably more policy ammunition to deploy, including rate and reserve ratio cuts and, if necessary, fiscal stimulus.

Despite two successive quarters of strength, EMI remains at a relatively low level, thanks largely to further deterioration in Chinese export orders but also domestic demand as a result of attempts to tame inflationary pressures through quantitative tightening. Emerging market inflation has generally eased outside India, despite the return of higher oil prices, and policymakers are returning their focus to promoting growth over limiting inflation.

Emerging nations still have to balance the risks of too little growth against the threat – if not yet the reality – of commodities-driven inflation. But the outlook remains encouraging with China, India, Brazil and Mexico all set to be top ten global economies by 2050.”

click images to enlarge

source: HSBC Emerging Markets Index 2012 Q1

Tags: Business Employment, Chief Economist, Chinese Export, Emerging Market, Emerging Markets, Export Orders, Fiscal Stimulus, Global Capital, Global Economies, Inflationary Pressures, Level Thanks, Markets Index, Oil Prices, Permafrost, Productivity Gains, Qvm, Relative Immunity, Reserve Ratio, Richard Shaw, Urbanisation
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Doug Kass: Ten Questions for the Bears

Wednesday, October 12th, 2011

Isn’t it amazing after a frantic run up in the first hour, we have sat in a +/- 2 point range on the S&P around that 1188 level I mentioned  for hours on end?  Ahh, computers….

Last week hedgie Doug Kass asked 10 questions for the bulls; this week he has 10 for the Bears… and not just how they expect to stop Detroit’s offense tonight on Monday Night Football. (duu duh duu duu)

1. Pace of domestic economic growth: Third-quarter 2011 GDP (in real terms) will likely expand by over 2.5%, well above 2011′s first-half growth of less than 1%. This pace of growth is stronger than the consensus forecast was as recently as a month ago, as business fixed investment, personal consumption expenditures and the improving trade deficit will all be positive contributors to growth. As well, third-quarter S&P 500 corporate profit growth (aided by a still-weak jobs market, strong productivity gains and rising production) should advance to a near $100-per-share annualized rate. Sure, beyond the current results, visibility is limited, as the manufacturing orders less inventory mix produced the third negative reading in four months and the household sector labors under a decline in stock and home prices, a contraction in government jobs and stagnating wages and little progress in real incomes.
   Nevertheless, both the residential real estate and the U.S. automobile industries are deeply depressed, represent historically low percentages of GDP and pent-up demand will be unleashed at some point. Almost all of the other recent domestic economic releases (e.g., jobless claims, the national ISM and lower food and energy prices) signal that the U.S. will muddle through into 2012. Meanwhile corporations have already proven that they are positioned to prosper even in a relatively sluggish backdrop — for instance, in the first half of this year, earnings exceeded expectations despite sub-1% GDP growth. Corporate balance sheets are liquid, inventories are conservatively aligned relative to sales, and profits are at record returns in third quarter 2011 (as profit margins having benefited from, among other factors, years of cutting fixed costs).
2. Europe and China: While Europe is a wild card, it rarely ever pays to bet on catastrophe. European leaders, though slow in response, no doubt have a full understanding of the consequences of not addressing their debt crisis. As I mentioned recently on “Fast Money,” the eurozone and its banks are now experiencing a La Dolce Vita moment — in the same way in which Marcello Mastroianni struggled between the allure of the cafe life in Rome and the responsibilities of living with his girlfriend. This was exactly what the U.S. and our financial institutions experienced three years ago — as a country, we were forced to find our way back to recovery and our banks were forced to accept responsibility (and recapitalize) for their misdeeds.
   My expectation is that the eurozone will become domesticated and accept the consequences of its actions (and recapitalize). Indeed, on Sunday, Merkel and Sarkozy agreed to a eurozone bank recapitalization.
   As to China, the September Chinese HSBC Markit Service PMI climbed back to 53.0, a blow to those who believe in a hard landing.

Read the other 8 here.

Tags: Automobile Industries, Contraction, Corporate Balance Sheets, Corporate Profit, Doug Kass, Duu, Economic Releases, Energy Prices, GDP Growth, Government Jobs, Household Sector, Inventories, Inventory Mix, Monday Night Football, Personal Consumption Expenditures, Productivity Gains, Profit Growth, Real Incomes, Residential Real Estate, Trade Deficit
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Paulsen: Could Declining Productivity be a Catalyst for Jobs???

Wednesday, August 11th, 2010

This article is a guest contribution by James Paulsen, Chief Investment Strategist, Wells Capital Management.

Just a quick thought to noodle over this morning…..

After rising by its strongest annual growth rate since the early 1 960s during the first quarter of this

year, nonfarm productivity declined in the second quarter. Could this be a catalyst for the job market?

The accompanying chart overlays the productivity index with the level of nonfarm private payroll employment. In each of the last two economic recoveries, job creation was a no show “until” productivity growth slowed. Although the early-1990s recession ended in March 1991, it was not until the beginning of 1993 (once productivity growth waned) that job creation finally took off. Similarly, the early 2000 recession ended in November 2001 but job creation was absent until the latter part of 2003 when productivity growth finally slowed.

As occurred during both the 1991 and 2001 recessions, productivity surged during the last recession as companies raced to “rightsize” their organizations to a new reality. Also similar to the past, this survival mentality has persisted in the last year even though the recession has ended. While rising productivity certainly plays an important role in recoveries helping restart the profit cycle, replenish business cash flows, and improve company balance sheets, it has also tended to be a job destroyer in the early part of the last few recessions.

Could the second quarter represent the beginning of a downshift in the pace of productivity gains which, like it has in the last two recessions, also finally mark the beginning of a healthy period of job creation? Just something for investors to ponder…………………………………………………………………………

Copyright (c) Wells Capital Management

Tags: Business Cash, Cash Flows, Catalyst, Chief Investment Strategist, Company Balance Sheets, Destroyer, Downshift, First Quarter, Job Creation, New Reality, Payroll Employment, Productivity Gains, Productivity Growth, Productivity Index, Profit Cycle, Recession, Recessions, Second Quarter, Survival Mentality, Wells Capital Management
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Japan: Land of the Rising Debt

Friday, July 23rd, 2010

This post is a guest contribution by Vitaliy Katsenelson, portfolio manager/director of research at Investment Management Associates in Denver, Colorado.  He is also the author of “Active Value Investing: Making Money in Range-Bound Markets” (Wiley, 2007).

Investors are understandably scared of the sovereign debt crisis unfolding in Europe. Amid their angst, however, they are ignoring a more likely, and significantly larger, debt catastrophe that is about to hit the nation with the second-largest economy in the world — Japan. Two decades of stimulative, low-interest-rate fiscal policy have made Japan the most indebted nation in the developed world, and as new Prime Minister Naoto Kan recently said, in his first address to Parliament, that situation is not sustainable. Japan has little choice but to raise interest rates substantially, with dire consequences far beyond its shores.

The prelude to the current crisis began in the early 1990s, after Japan’s housing and stock market bubbles burst and its economy slipped into recession. For the next 20 years, using flashy names like Fiscal Structural Reform Act, Emergency Employment Measures and Policy Measures of Economic Rebirth, the government cut taxes, increased spending and borrowed money to finance itself. Today, Japan’s ratio of debt to gross domestic product stands at almost 200 percent, more than twice that of the U.S. and Germany and second only to Zimbabwe.
A country with ballooning debt needs to have an expanding economy to outgrow the burden. Economic growth is driven by two factors: productivity and population growth. Although the Japanese economy may continue to reap the benefits of productivity gains, population growth is not in the cards.

Japan has one of the oldest populations in the developed world — every fourth person is 65 or older — and its number is on the decline. The Japanese birth rate is one of the lowest in the world, a meager 1.2 children per woman. To maintain its current popu­lation level, the average woman in Japan would need to give birth to 2.1 children. (Of course, only economists know how a woman can give birth to a fractional child.)

The severity of the debt problem in Japan has been masked by the fact that government spending on interest payments has not changed over the past two decades, as the average interest rate paid on the country’s debt declined to 1.4 percent in 2009 from more than 6 percent in the 1990s. This is about to change. Historically, more than 90 percent of Japan’s government-issued debt has been consumed internally by its citizens, directly or through its pension system. But the savings rate in Japan, which was in the midteens in the 1990s, today is approaching zero and will likely go negative in the not-so-distant future.
The Japanese economy operates on the assumption, soon to be proved false, that the government will always be able to borrow at low interest rates. As internal demand evaporates, the government will have to start hawking its debt outside Japan — in a more realistic world, where interest rates are a lot higher. Japanese ten-year Treasuries currently yielding 1.3 percent will not stand a chance against U.S. or German bonds of the same maturity, which yield 3.5 percent and 3 percent, respectively. Japan will have to offer rates far in excess of its U.S. and German counterparts. Although they have their own set of problems, the U.S. and Germany still have much lower indebtedness and superior demographic growth profiles.

Higher taxes and the austerity measures that undoubtedly will follow, combined with higher interest rates, will further slow Japan’s economy and drive the country toward insolvency. Unlike Greece, which because of its size could be bailed out by Germany and friends — with a little help from the ever-willing International Monetary Fund — Japan is too big to be bailed out. Defaulting on its debt, especially when the majority of it is held by its own citizens, is a political impossibility. But unlike European nations that socialized their currencies and cannot print euros on their own, Japan has complete control over its currency printing press. And print it will! Decades of deflation will turn into hyperinflation, which will destroy the purchasing power of Japanese citizens’ savings and collapse the yen.

The consequences of the economy’s slow but sure unraveling in Japan will spill over to the rest of the world. Japan is the second-­largest holder of U.S. government debt, and most likely it will start selling Treasuries. To make matters worse, Japan will start competing with the U.S., not just in cars and electronics but for buyers of sovereign debt. As Japan exports inflation, interest rates around the globe undoubtedly will rise.

Timing bubbles — and Japan is in the late stages of an enormous debt bubble — is very difficult. They tend to last longer than rational observers expect. But as Japan’s debt continues to swell, the eventual bursting of the bubble grows more catastrophic.

Japan is proof that a country cannot borrow itself to prosperity. The U.S. and other developed nations still have a chance to make the politically difficult but right decision to cut fiscal spending and stop looking for government to be the source of sustainable growth — which it never is.

Tags: Birth Rate, Curren, Debt Crisis, Economic Rebirth, Emergency Employment, Government Cut, Gross Domestic Product, Investment Management, Japan Land, Japanese Economy, Management Associates, Manager Director, Naoto Kan, New Prime Minister, Policy Measures, Population Growth, Productivity Gains, Sovereign Debt, Stock Market Bubbles, World Japan
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Will Earnings Expectations Be Met?

Wednesday, April 7th, 2010

The Q1 earnings reporting season is upon us and expectations, based on the stock market’s recent behavior, are lofty.

While gallivanting through South America, let’s turn to David Rosenberg, chief economist and strategist of Gluskin Sheff & Associates, for a few comments on valuation levels.

“The earnings outlook is bright and even our regressions suggest that we will get 15% EPS growth in 2010 (the consensus is at 36%), which is completely normal for the type of nominal GDP growth we are going to see.

“Keep in mind that we are not going to get the intense expense cutting we have seen in the past year, which has seen unit labor costs decline at a record 4.7% rate, or are we going to see an unprecedented string of productivity gains, which have averaged at a 7.4% annual rate over the past three quarters. So, that would bring us closer to $68 on earnings than the $78 consensus view – a view that Sam Stovall from S&P uses to come up with a Goldilocks 15x forward multiple to then apply to a median (since 1988 no less!) of 19x to come up with the view that this market is still dirt cheap. Well, if you are willing to assume that there was a stock market before 1988 and use a real historical average (back to 1980, for example), then the average is closer to 14x. And if our EPS projection is closer to the mark, then the market is trading at a 17.3x forward multiple or is 20% more expensive than what would ordinarily be considered normal.

“As for 2011, the consensus is looking for $97 on S&P 500 operating EPS — we did $95 at the peak of the last cycle when the unemployment rate was at 4.5%, the industry CAPU rate was 81%, private sector credit expanding at a 16.2% annual rate and nominal GDP at a 4.9% YoY pace. So the consensus believes that barely two years into the second weakest post-recession recovery in the past six decades we will actually get back to peak profit levels seems to be a tad outlandish.”

The chart below, courtesy of The Big Picture, saves you to do the maths and provides a useful table for reading off S&P 500 levels implied by different price/earnings (PE) ratio and operating earnings combinations.

Source: Standard and Poor’s, Compustat, FactSet, J.P. Morgan Asset Management.

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Tags: Chief Economist, Consensus View, David Rosenberg, Eps Growth, Gallivanting, Gluskin Sheff, Gold, Goldilocks, Nominal Gdp Growth, Productivity Gains, Profit Levels, Q1 Earnings, Recession, Regressions, Reporting Season, Sam Stovall, Stock Market, Strategist, Three Quarters, Unemployment Rate, Valuation Levels
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