Another year has come to a close, and another is beginning. And what a year 2008 was. 2009 will prove to be just as interesting, punctuated by more business failures amid bad economic data (and maybe even some good news). Just how bad it can get is anyone’s guess; how good it can get isn’t really on anyone’s mind at this point.
As an investor today it is more important than ever to have a macro viewpoint. For many years, it simply wasn’t necessary because the range of economic fluctuations was pretty narrow. Stability brought investors comfort and, according to popular thought, it was more or less safe to “buy on dips,” because the market would almost inevitably ratchet higher in ensuing years. Downturns were short-lived as the Fed took an aggressive stance, pumping in liquidity, but increasing the moral hazard a bit more each time. Slowly, risk aversion subsided. Investors began paying more for earnings and demanded less interest spread over Treasuries to compensate for the additional risk. Much of the returns of the past 25 years have been driven by investors’ willingness to pay higher multiples on earnings. Going back farther, though – over 100 years –stocks are up less than 5% annually, which happens to be the rate of earnings growth over that time. The rest of the roughly 9% compounded return has come from dividends, which will be back in vogue. (Some companies whose dividends may otherwise be sustainable may still have to temporarily curtail them in the current downturn, even stalwart companies.)
Fast forward to this year. We seen a broad based decline in the stock market, the first such major decline since the early 1980s. (The decline in 2001-2002 was really concentrated in a few sectors – media, telecom, and technology – and thus did not affect all sectors equally.) The market went into the year disjointed – with financials down considerably but energy, materials and industrials still holding up relatively well. Now, the market is no longer quite as disjointed, though the degree of undervaluation in the market is far from homogenous.
The most concerning issues are twofold: confidence and cost of capital. Yes, there are others, but I want to concentrate on these broad themes. Confidence underpins our whole economic system, especially with respect to its lubricant, credit. And confidence has been lost. To use a crude example, when your best friend sleeps with your significant other, it’s going to take a long time to trust either of them again. And I think that’s the case here. Trust is built up over a long period of time as confidence builds that the future will largely resemble the past. Trust in, for instance, underwriting standards, was built up over a long period of time as default rates remained low and leverage ratios were allowed to ratchet higher. The loans made late in the cycle kept it going for longer than would have normally been sustained because of the “Ponzi finance” nature of the activity. That is, new loans were used to pay interest and principal on the old loans. As long as credit was available and lenders were willing to suspend disbelief, this worked fine. Until it didn’t.
We’re going to get back to system that relies on the character of the borrower rather than purely (unreliable) quantitative measures. I’m not sure how exactly this will work, because financial innovations will remain a fact of life. But I know it will mean banks and other finance companies will retain a larger portion of their securitizations and/or provide stronger guarantees to security holders. Business models will evolve (with the help of what is likely to be heavy-handed regulation). Formerly profitable businesses will cease to be so, and the seeds of future banking problems will be planted.
The economy is a non-equilibrium, evolutionary system where feedback loops play a meaningful role. George Soros calls this “reflexivity.” The cost of capital across the system has risen quite suddenly, not just debt financing, where rates are obviously much higher and capital less available, but equity. What isn’t often considered is that higher stock prices (along with lower interest rates) bring down the cost of capital. And cost of capital has been falling since the early 1980s, which has been a tremendous tailwind for the values of financial assets. Consider the feedback loop here. At a lower cost of capital, there are more potential projects for companies to undertake. For instance, if cost of capital is 6%, projects with a return potential greater than 6% will add economic value. Adding economic value feeds back into higher stock prices, which decreases the cost of capital, and the cycle continues. And undertaking more projects means more capital spending, which feeds back into economic growth in a meaningful way and further lowers the cost of capital. But when cost of capital goes to 10% or 12% for an extended period, old projects will run off and newer ones will be made under more restrictive conditions. That is, projects with return potential higher than 10% or 12% are now needed to add economic value. (Most) companies would not undertake an 8% return project while paying a 10% capital cost since to do so would be value destroying. With the long-run average return on equity at 12-13%, there are far fewer projects when the hurdle rate is 10% than when it is 6%. Less economic value added means lower stock prices, which leads to a higher cost of capital, and the cycle continues. The longer stock prices stay low, the more likely it is we’ll be in a feedback loop that will look very different from the past 25 years.
Furthermore, when cost of capital is higher, the justified P/E ratio on stocks is lower. We’ve lived in a 15-20 P/E market for the past 20 years largely on the basis of lower cost of capital as interest rates have generally been declining and remained low over this period. The cash tax rate and growth rate do not vary much over time. Returns on capital have moved higher, too, but at least partially have been driven by the levering up, through debt, of the country. So as capital costs rise and the feedback mechanism kicks in, justified P/Es, in my view, will be much lower than we’ve been used to.
What does this mean for investors? Active management is going to be very important. Index fund investors are going to be more challenged. This last year should have proven, once again, that the efficient market hypothesis, beta, alpha, the capital asset pricing model, etc., are all garbage. Markets follow power laws, not normal distributions. Markets are open, complex adaptive systems, not closed equilibrium systems. Returns to the stock market are path dependent. They exhibit oscillations and experience periods of punctuated equilibrium that come about largely through endogenous factors that may or may not have exogenous shocks as the initial cause. Small changes can have big impacts (and do). It is not completely different this time, but it will be different for a while and investors must recalibrate their expectations for how stocks behave. We are likely to see a market, akin to the 1970s, that moves in a trading range over time. (Actually, we’ve already seen it – from 2000 forward.) Income from dividends will be more important in this kind of environment. Being willing to buy at high free cash flow yields and sell at lower free cash flow yields and being willing to hold cash at times will be key. If we get back to a market that forgets what has happened over the past year and resumes trading at its 15-18 multiple consistently, I would be very surprised. But I have been wrong in the past and will be wrong again.
Either way, it will be an interesting year, and I will make no explicit predictions regarding the markets. The economy is bound to get worse in the year ahead and geopolitical concerns will become more serious (for instance, a few countries may defect from the Euro currency), but asset prices will turn up well ahead of a recovery in the real economy.