PIMCO bond king Bill Gross revisits his DOW 5000 call from a few years ago. His key point, which is dead-on, is that the factors that sustained record-high profit margins and profit growth in the last couple of decades are gone (if not for good, at least for a long while).
Is the DOW going to 5,000? Probably not–and Bill Gross is not saying it is. But it wouldn’t shock us (or Gross) if it did.
The good news, as we’ve noted frequently over the past month, is that stocks are finally slightly undervalued. And unless it is completely different this time, that should eventually lead to average long-term returns.
We will not go back to what we have known and gotten used to… We are now morphing towards a world where the government fist is being substituted for the invisible hand, where regulation trumps Wild West capitalism, and where corporate profits are no longer a function of leverage, cheap financing and the rather mindless ability to make a deal with other people’s money. Welcome to a new universe stock market investors! In this rather “sheepish” as opposed to “brave” new world, here are some considerations that may affect Q ratios, P/E’s, and ultimately stock prices for years to come:
- Corporate profits have been positively affected for at least the past several decades by several trends that appear to be reversing. Leverage and gearing ratios – the ability of companies to make money by making paper – are coming down, not going up. In addition, the availability of cheap financing – absent government’s checkbook – will likely not return. Narrow yield spreads and low real corporate interest rates are gone. Last, but not least, the historical declines of corporate tax rates, shown graphically in Chart 3, will not likely continue downward in a Democratically-dominated Washington.
- Globalization’s salutary growth rate of recent years may now be stunted. While public pronouncements from almost all major economies affirm the necessity for increased trade and policy coordination, and avoiding the destructive tendencies of one-off currency devaluations as a local remedy for global problems, investors should not bank on the free trade mentality of recent years to support historic growth rates. Already we are seeing separate ad hoc policy responses with very little cooperation. Not only does the EU’s approach differ from that of the U.S., but France is in many ways an odd man out within its own community. Asia is legitimately suspicious of any U.S. endorsed approach given the failure of America’s capitalistic model.
- Animal spirits, and with them the entrepreneurial dynamism of risk-taking has likely experienced a body blow. Not only have dancers on the financed-based dance floor been shown the exit à la Chuck Prince, but those that remain have been publicly chastened and handcuffed. Golden parachutes, options, executive compensation and bonuses themselves are now at risk. Care to climb to the throne of this new world? Well, yes, egos will always dominate, but the rules will be changed and hormone levels lowered.
- The benevolent fist of government is imperative and inevitable, but it will come at a cost. The champion of free enterprise, Ronald Reagan, knew that growth of the private sector was in no small way dependent on deregulation and the lowering of tax rates. Now that those trends have necessarily come to an end, no rational investors should expect innovation and productivity to be unaffected. Profit and earnings per share growth will suffer.
My transgenerational stock market outlook is this: stocks are cheap when valued within the context of a financed-based economy once dominated by leverage, cheap financing, and even lower corporate tax rates. That world, however, is in our past not our future. More regulation, lower leverage, higher taxes, and a lack of entrepreneurial testosterone are what we must get used to – that and a government checkbook that allows for healing, but crowds the private sector into an awkward and less productive corner.
Dow 5,000? We don’t have to go there if current domestic and global policies are focused on asset price support and eventual recapitalization of lending institutions. But 14,000 is a stretch as well. One only has to recognise that roughly 20% of bank capital is now owned by the U.S. government and that a near proportionate share of profits will flow in that direction as well. Better to own corporate bonds than corporate stocks, but that’s a story for another Investment Outlook.