Bulls Versus Bears


Stocks are in a bubble and will crash, say the bears.

Stocks can’t be in a bubble if ‘everyone’ says they are, the bulls retort.

So what is it? Are we in a bubble and on the verge of a crash…or is the bubble just getting started?

If only we knew! We’re in the bearish camp, and have been for a while. Which means we’ve been wrong about the recent market surge, driven largely by ‘multiple expansion’ rather than an increase in company earnings.

Multiple expansion means investors are prepared to pay a higher price for the same level of earnings, expanding the ‘multiple’ that the earnings trade for. So instead of paying 10 times earnings for a company as investors would in a bear market, they’ll pay 15 or 16 times earnings.

The difference is significant, adding 50% or 60% to a company’s market value.

Usually, it is the emergence of good economic times that encourages investors to pay up for a stock. Paying a high price for earnings is always risky but if you have an expanding economy and rising earnings, growth can diminish those risks.

But is that what we have? Good economic times? Well, the top 1% of the population might think so, but the rest are probably struggling to see what all the fuss is about.

At the moment there seem to be constant reminders that Australia is undergoing long term economic change as it tries to cope with its high cost structure…courtesy of a China driven commodity boom.

But now the boom is receding. Except for iron ore, high commodity prices are no longer. But they have left a legacy of high costs, and many companies are struggling to cope.

On Friday, Rio Tinto announced the closure of its Gove alumina operations in the Northern Territory for the loss of 1,000 jobs. Apparently it was running at a loss of around $200 million per year. It won’t be the last casualty of the commodity boom turned bust.

More on Australia’s high cost economic structure in a moment…

But first, let’s get back to the market, and try and work out what investors are thinking. Are they thinking?

Well, they’re paying increasingly higher prices for stocks not because of rising earnings, but because of falling interest rates. Falling interest rates encourages investors to take more risk. They want to achieve a certain return on their investments and can no longer get it in cash or fixed interest, so they move into equities.

This movement of capital pushes up prices and simultaneously lowers the future return on investments. That’s because without an increase in earnings (because the economy is rubbish) a higher price automatically means a lower future return.

So the bears see this and think it can’t go on…that it must end in a crash. The bulls see it as perfectly rational behaviour, and believe that as long as interest rates stay low then the market will keep on moving higher.

And that’s the question, isn’t it? How long can interest rates stay low, fuelling asset bubbles that clearly have no impact on the real economy? How long will central bankers keep flogging the interest rate dead horse?

Well, we think the tide is turning. Or more accurately, the glacier might be thawing on the effectiveness of monetary policy. Last month’s minutes of the US Federal Reserve meeting showed the most important central bank in the world is having second thoughts about the efficacy of QE.

David Wessel, writing in the Wall Street Journal, says, ‘The world economy needs a new strategy to generate faster growth‘ and…

…monetary policy by itself cannot solve chronic growth problems. Both US Fed Ben Bernanke and his designated successor, Janet Yellen, have said as much, though they have not shouted it.

Indeed, they’re explicitly using monetary policy to compensate for short-sighted fiscal policy that is pre-occupied with cutting this year’s spending.

That doesn’t mean we’re going to see higher interest rates in 2014…or even 2015. But it does suggest that the market’s unyielding faith in low interest rates and easy money may come under closer scrutiny next year.

Which might not be a comforting thought for the stock bulls, because it’s faith in low interest rates that is levitating stocks prices. If that faith subsides…look out below.

We discussed why low interest rates can’t produce a sustainable economic recovery in the recent issue of Sound Money. Sound Investments. It’s all to do with the ‘economic structure’, we argued.

That is, over-reliance on monetary policy creates a very rigid economic structure. The structure evolves to a point where it constantly requires lower and lower rates just to sustain it. 

We argued that Australia’s economic structure is the result of a combination of a long term fall in interest rates (which created a house price and consumption boom) and an historic surge in our terms of trade, which sustained the house price boom but has left us with a high cost base.

But now the terms of trade are starting to recede. That means we’re left with falling interest rates alone to sustain economic growth. It is the great hope of policymakers that housing investment will replace the inevitable drop off in mining related investment.

But as David Bassanese writes in today’s Financial Review 

…despite a lift in building approvals and strength in housing auction clearance rates in key cities such as Sydney and Melbourne, last week’s construction survey suggests actual home building activity failed to rise again last quarter, and has shown no growth in 2013 so far.

Speculating on ever rising house prices does not lead to sustainable economic growth. It doesn’t even promote housing investment. But that’s what easy money does in a structurally challenged economy…it just promotes short term inflationary growth that eventually subsides, in need of even cheaper money to keep the momentum going.

Here’s what we wrote in a report to members last week, in an attempt to explain why the recent surge in bank profits and house prices was unlikely to be sustainable:

Lower interest rates merely reinforce the existing economic structure, rather than promote structural change. That’s why attempts by monetary policy to generate economic growth will only generate short term, inflationary growth, with the inflation showing up in property prices and bank profits.

Which brings us back to the bullish/bearish argument. How long can low interest rates levitate prices and maintain investor confidence? And if central bankers are starting to have second thoughts, how long will it take the market to think the same?


Greg Canavan+
for The Daily Reckoning Australia

Read the rest of this article at The Daily Reckoning

Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.

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