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Review and outlook: Valuations and refrigerators

Gordon Fowler Jr.

8 January 2007

Views on 2007 come down to your view of the sustainability of global growth. Gordon Fowler Jr. is CIO of Glenmede Trust Company, an independent wealth advisory based in Philadelphia.

Summary The relatively compressed valuations in the world's global markets make forecasting this year's capital-market returns a real challenge. It is hard to say there's much in the way screaming buys. Global growth, however, is still relatively strong, and this growth has created plenty of capital for investing. We weigh the arguments for weak versus healthy capital markets for next year and, on the margin, come down on the side of optimism. I also consider the object of my son's heartfelt desires.

Review and outlook

Guessing what will happen to the world's capital markets this year depends on two important factors. With global capital markets on a steady uptrend for the past four years, the first factor that has driven markets up has been steady economic growth fueled by India and China, Asia's largest economies. Their ability to produce goods and services at substantially lower costs and the willingness of the world's developed economies, particularly the U.S., to purchase them, should continue to support the current trend.

The second factor is closely related. As the world's wealth has grown through the rapid emergence of two very large economies, a surplus of savings has been created. Excessive savings may not be a familiar concept to most Americans, given our tendency to spend money rather than sock it away, but the savings glut is a global phenomenon. Part of the reason that the typical Goldman Sachs executive will earn enough money to put food on the family table is because the capital markets have become so well developed, this money gets easily recycled around the world, driving up global asset prices.

In the process of driving up asset prices, risk premiums (the rate investors get for taking risk beyond a "risk-less" asset like Treasury bills) have become very compressed. Corporate, junk and emerging-market debt yields are extremely low. Stock valuations based on normal or "trendline" earnings or profits are quite expensive.

How investors view these two factors -- global growth and valuation compression -- skews their view of this year.

The bullish camp is perhaps best represented by Wall Street's investment strategists. This group seems uniformly optimistic about 2007, seeing the benefits of global growth and liquidity. A recent Barron's article has nine out of nine strategists predicting higher levels for the S&P 500 this year. Members of this group tends get performance evaluations every year -- some would say every day, so there's some career risk associated with taking a longer-term view. They also sit near capital-markets traders, and so they see massive cross-border flows of that help drive up asset prices.

The bearish camp is led by long-term investors, such as pension-fund managers, endowment CIOs, consultants and wealth managers. This group must invest for some very long-term liabilities. They see relatively low and unattractive bond yields, stock dividend yields, and real-estate investment-income yields that are being offered in the market, and recoil from them in horror.

Which side is going to be correct? Let's look at their arguments.

Bull side

There are three components to the bull view of 2007. Global growth led by Asia's rapid ascent to a developed modern economy continues. We have seen the transformation like those in India and China before. After World War II, Europe and Japan took their economies to levels that rivaled the U.S. There is a misconception that this rapid growth was attributable solely to a bounce back from the devastation of war. Growth and development went way beyond rebuilding. This "miracle" occurred by opening these economies to the world and letting a well-educated and industrious populace take advantage of the world's capital, technology, and consumer demands. By throwing off stifling socialism, India and China have stopped the assault on their own economies. What is happening in these countries now is not an economic miracle. It's the repeat of the same time-tested formula. Growth begets wealth and liquidity. Quite simply, the money available for investment increases as the world becomes wealthier. Much of the Asian world has saved their increasing incomes. This money needs a home. As the world's investment portfolios become more diversified, the level of acceptable yields falls to reflect a lower level of portfolio risk. This is not a temporary effect. This is important, because it suggests that low yields on investments are not a temporary phenomenon but the result of a permanent secular shift. The basic idea is that when you price an asset (or determine an acceptable yield as a buyer), you should be less concerned about the risk of the asset on its own and more concerned about the risk it adds to your portfolio.

The development of the U.S. mortgage market is a good example of how this works. Once upon a time, you got your mortgage from your local bank, which only operated in your home town or state. The bank had to charge an interest rate that recognized the possibility that the local economy might go through hard times and that all of their borrowers could have a hard time paying back their loans at the same time.

Over the last thirty years, mortgage markets have become national, and mortgage lenders now hold portfolios diversified by region. Since the risk of holding a portfolio of mortgages is lower, the interest rates charged by lenders have fallen. In today's more developed market, the Dutch Public Employee Pension Fund portfolio holds not only loans to homeowners in the U.S. but also home loans from around the world. Because this portfolio is internationally diversified, the overall risk of the portfolio is still lower, and the rate that the investor will receive has gone down even further.

In short, we may be seeing the results of investment portfolios around the world becoming better diversified and the yields needed to justify holding these assets have shrinking -- and maybe staying shrunk.

Bear side

The arguments for lower returns in 2007 come down to a several key points. Equity values and income yields have compressed to dangerously low levels. Investors always take good news about growth and value compression too far. Remember the Internet bubble? Remember how the Japanese were supposed to take over the world's economy and the collapse in Japanese equity and real-estate prices that followed their prodigious run-up? Remember the collapse of the junk bond market in the late 1980s and the emerging-market debt crisis in 1998? All of these events were preceded by very low yields or high price-to-earnings ratios on assets. How many times do we need to listen to this record to know how the song goes? There are limits to growth that eventually bring an expansion to a close. Under this Malthusian scenario, raw materials prices rise faster than a replacement can be found. The world runs out of existing energy supplies before a substitute can be discovered. Industries run out of skilled labor. The current transportation infrastructure can no longer handle the flow of goods or services without massive investments. There is a populist backlash against pro-growth economic policies. A side effect of growth is, generally, change which some will inevitably see as change for the worse. It's relatively easy to make a list of all of the ways a backlash could manifest itself. Protectionism takes a bite out of trade. Aging baby boomers look to secure Social Security and Medicare payments through higher marginal tax rates. A growing middle class in Asia demands a higher quality of life instead of greater growth opportunities. The world concludes that rapid growth is causing too much environmental damage. Parts of the globe, including Latin America and the Middle East, determine that they are not seeing sufficient benefits from global growth and use whatever leverage they have to demand their fair share or to take us back to the "good old days."

On which hand?

Economists and strategists are famous for saying "on the one hand" such-and-such might happen while "on the other hand" the complete opposite might occur. So which hand do we favor for 2007?

Given the magnitude of the recent run-up and the emergence of the nearly perfect economic scenario as the consensus -- weak enough to create inflation but strong enough to keep hope alive for reasonable growth -- it is hard not to think that we are due for some sort of mild reversal in the first half of next year. Henry McVey of Morgan Stanley argues that the historic January stock market rally has shifted into the fourth quarter. He attributes this to relatively lower 401(k) inflows and the tendency of hedge fund managers (who are paid as a percentage of absolute returns) to use their market power to boost returns.

However, if we have to choose between the arguments outlined above, we would rather tilt toward the more optimistic argument for three reasons. The first reason stems from the knowledge that optimists generally get rewarded since higher risk assets (equities) generally do much better than low risk assets (cash and bonds).

The second reason we would tend to favor the more optimistic case is that the bear case involves rapidly reaching limits. It's not clear that we have actually a roadblock.

Let's take each of the different bear points. Equity values and income yields have compressed to dangerously low levels.It's certainly true that many measures of the stock market value have compressed and that long-term yields are historically unattractive. It is worth lending some credence, however, to the idea that the "global portfolio effect" has compressed yields and risk premiums. It is also true that they could compress further, and they probably won't expand until the world's economy faces a serious negative event like a severe recession in the U.S. In fact, barring a negative event, equity prices will probably continue to grow with equity earnings. In essence, he investment markets are playing a global game of "chicken." There are limits to growth that eventually bring an expansion to a close. Humankind is remarkably resourceful when it comes to working around shortages of natural resources. Running out of labor and the resulting wage inflation can be more of a problem. As is typical for later in an economic cycle, we are beginning to see real growth in incomes as well as a very low unemployment rate. For now, however, the developing world's ability to supply the developed world with adequate labor supplies seems to have slowed down the wage inflation process. There is a populist backlash against pro-growth economic policies. Despite a fair amount of success, there appears to be a small but growing trend running against "liberal" free market economic policies around the world. These trends, however, can take a long time to develop. Greater globalization may have strengthened the resistance to change, but it has also developed some very powerful advocates in the Americas, Europe, and Asia who are willing to find ways to work out the issues of the discontented.

The final reason we would cite for taking risk relates to our tendency to tilt toward assets with the most attractive valuations. While there is a limit to how much protection buying cheap will give you when a shock hits the system, it's a policy that over time tends to favor assets that will hold up better in a disappointing market. Right now we like large-capitalization stocks cap over small-cap stocks. We'd still hold a fair amount of international market equities, although it is possible that U.S. dollar gains will work against international investing for a bit here.

We would also suggest initiating strategic positions in hedged equities or absolute return strategies, given relatively high cash yields. Finally, we are inclined toward private-equity investing that takes advantage of low borrowing costs and some fairly opportunistic management capabilities.

Object of desire

My son 11-year-old Michael says he has a girlfriend at school. I suspect that she may only be a trifling fancy for I believe that I know from recent observation the object of my son's true desires.

By way of introduction, this observation involves obsession with sports and sporting events. It is only fitting that the nerd father gives birth to super jock. My eleven year old son lives for sports: he likes to play them, he likes to watch them on television, and he absolutely loves going to games.

As we are now in Philadelphia, he has become a rabid Philadelphia sports fan with one exception. (He clings to rooting for the Yankees in order to spite his Red Sox-loving parents and older sister.) This means supporting the hapless 76ers, the pitiful Flyers, and the underachieving Phillies. But in Philadelphia, only one sport -- professional football -- truly matters, and that means the Eagles. The crowd that the Eagles games attract is both highly vocal and very "passionate."

After he came back from his first game sitting in the end zone, he proudly announced, "Guess what, Dad, I learned two new swear words." Imagine my excitement.