Thursday, March 24, 2011

Whiskey Tango Foxtrot

I write this today after looking at the S&P 500 stay around 1,300 or so.

Fundamentally speaking, I do not understand how equities can keep these valuations. Under classic valuation methods, a stock should be worth the net present value of its future projected cash flows. Let's keep this simple and put the time period for projecting cash flows as the next ten years.

First we need a macroeconomic view. As we are in the midst of a massive 30 year credit bubble imploding, we need to look at previous credit bubbles for guidance. If we look at the great Depression, the 1907 banking panic, the Kansas land bubble of the 1840's, etc - what we learn if after a credit bubble, we should expect deflation from depressed demand as consumers de-leverage from high debt levels. The past 30 years of debt fueled consumption has brought future consumption into the past - whether it be houses, cars, or other goods. The consumer (especially the American consumer - who has single handedly developed the Asian export market), spooked by too much debt and fearful of his employment prospects, curtails spending in order to pay off debt and save. This will curtail demand for goods - whether it be housing, electronics, cars, or any other discretionary good. All the money printed by the government will not stimulate demand. All this reflating is doing for now is increasing the national debt; when the consumer is done saving and paying off debt, he will have more taxes to pay in order to pay off government debt. All of this will keep demand suppressed and will exacerbate the deflationary cycle. Only after years of deflation from the aftershocks of the credit bubble will rapid inflation come with a vengeance.
This means that corporate earnings will remain weak going forward. Yes, companies will still restructure and increase productivity, but will be continuously cutting prices in order to maintain capacity. Couple this with expected tax increases and earnings will not be strong going forward.

Until this credit bubble is finally resolved (which will take years to unravel as the central banks and financial institutions of the world continue their "extend and pretend" strategy), stocks cannot keep up this valuation for the foreseeable future. I see the S&P 500 challenging the early 2009 lows of 800-900 range.

I think that this will pop when people finally realize that the other shoe hasn't dropped yet. It will be the banks taking massive write-downs on commercial real estate loan portfolios and a flurry of corporate defaults. But once people realize that we're not through this mess by any stretch, the stock market will eventually tank.

2 comments:

Realist Theorist said...

Good post. Have you read Koo's book "Holy Grail". He's a Keynesian, wringing his hands about deflation and the need to government deficits.

If you can ignore his recommendations and focus on the info about deflation, it is worth reading. I blogged about it here.

Hershblogger said...

Right on, Mitch. Welcome back.