Inflation And Stock Market Valuations

``A prediction, which makes judgments which are qualitative only and not quantitative, is practically useless even if it is eventually proved right by the later course of events. There is also the crucial question of timing. Decades ago, Herbert Spencer recognized, with brilliant perception, that militarism, imperialism, socialism and interventionism must lead to great wars, severe wars. However, anyone who had started about 1890, to speculate on the strength of that insight on a depreciation of the bonds of the Three Empires would have sustained heavy losses. Large historical perspectives furnish no basis for stock market speculations which must be reviewed daily, weekly, or monthly at least.- Ludwig von Mises, The Causes Of Economic Crisis

It’s been repeated here that inflation has been emerging as the most pivotal factor in driving the pricing and real returns of equity investments[1] or for that matter all other investment activities.

That’s because monetary policies shape the incentives of entrepreneurs in the allocation of resources on the marketplace. Monetary policies also help determine consumption habits of the consumers. Low interest rates, for instance, entice consumers towards an increase in time preferences by indulging in “conspicuous consumption” financed by credit. On the other hand, low interest rates beguile investors to take upon long horizon projects in the expectations of the constancy of such environment which should provide them attractive returns.

Therefore, by influencing price signals, monetary conditions from central bank policies drive business conditions, which influence all other factors including, capital inputs, operating costs, wages, earnings, revenue streams, consumption patterns and etc. Importantly, such falsified pricing signals propel malinvestments which leads to boom bust cycles.

Yet monetary policies have relative effects that creates conflicts over the flow of funds relative to production and to stock markets,

According to Mr. Ludwig von Mises[2], (bold highlight mine)

``Another case, when control of the money market is contested, concerns the utilization of funds made available to the market by the generous discount policy. The dominant ideology favors “cheap money.” It also favors high commodity prices, but not always high stock market prices. The moderated interest rate is intended to stimulate production and not to cause a stock market boom. However, stock prices increase first of all. At the outset, commodity prices are not caught up in the boom. There are stock exchange booms and stock exchange profits. Yet, the “producer” is dissatisfied. He envies the “speculator” his “easy profit.” Those in power are not willing to accept this situation. They believe that production is being deprived of money which is flowing into the stock market. Besides, it is precisely in the stock market boom that the serious threat of a crisis lies hidden.”

Here Mr. Von Mises speaks from the empirical operating conditions during his period, where agriculture remains a large part of the national economy. Although current conditions would reverse the ‘ideological’ priorities, i.e. favouring higher stock markets than higher commodities prices given the larger share of financial industry to the economy, the important message here is that the stock market and production are both highly influenced by monetary conditions and compete in placement of funds.

Therefore it would be misguided to presume that stock markets operate independently from business conditions, or that business conditions are inherently stable so as to narrowly focus on micro barometers such as price earning ratios, book value, debt to equity, return on assets or etc...

Aside from monetary policies, there are massive differences in the structural composition of a political economy that affects real returns (see figure 6)

Figure 6: World Economic Forum[3]: Enabling Trade in Greater Asia

An example can be found on the chart above (higher window), based on imports procedures (or bureaucratic red tape) and irregularities (or corruption) the Philippines ranks as the most bureaucratic and most corrupt among the ASEAN contemporaries. Note the differences of bureaucracy and level of corruption.

In addition, based on the quality of infrastructure (lower window), the differences of the stages of development is noteworthy.

And the nuances are not limited to these, there are many other variables at work, such as degree of market access, regulatory environment, tax regulations and tax rates, access to financing, access to labor, access to communications, foreign currency regulations, labor regulations, policy instability, security, legal framework, efficiency of social institutions, respect for property rights, degree of economic freedom and etc...

Therefore, the greater complexity of regulations translates to lesser efficiency in the marketplace. Alternatively, this means greater complications in establishing the cost-and-return tradeoffs. So why the heck would these economies suffer from lack of investments and high unemployment, if not for the lack of clarity on returns?

Yet the most important factor would be the political spectrum, which ultimately determines how resources are distributed in an economy. For instance, in a closed and highly regulated economy (I am thinking Venezuela), where the distribution of economic opportunities is channelled mainly through politics, returns are determined NOT by market forces but by political connections or concessions. Hence it would be naive and highly erroneous to oversimplistically apply PER, Book Value, debt equity or etc... simply because political privileges determine returns, and at worst, risk money could be arrogated out of political considerations because of the despotic tendencies of the leaders.

So an applicable rule of thumb--micro barometers are dependent on the degree of the market economy, where the more open an economy is, the more reliable these tools are and vice versa.

Bottom line: Oversimplistic assumptions based on equal application of models can be fatal because each markets, like individuals, has their own thumbprint.

MacroAsia Corporation and the Machlup-Livermore Model

MacroAsia Corporation (MAC) is likely to be a good example of what I have been talking about. Figure 7 accounts for the financial highlights of MAC along with the stock price performance.

Figure 7: MacroAsia Corporation[4]

The reason I chose MacroAsia (MAC) is due to its pleasant updated presentation of the financial highlights. As disclosure, I presently don’t own any MAC shares, although it has been part of my watchlist.

MAC is owned by one of the entrenched economic elite, tycoon Lucio Tan. The company is into what we call as “pick and shovel” play or secondary exposure to the airline industry.

Its main business is in-flight catering, ground handling, airline repair and maintenance services, property rental, supply chain management and charter services. The company has also major mining Nickel Lateral claims or concessions in Palawan which currently is undergoing exploration.

The company has one impressive balance sheet; it is very cash rich, has minimal debt, has steady top and bottom line growth, which has virtually been unscathed by the 2008 crisis, issues regular dividends and has a great moat (a monopoly (?) in its industry).

Yet if one looks at the financial graph all indicators have been pointing upwards, since 2005.

However the stock prices seem to be saying differently, MAC has seen a 50% collapse on a peak-to-trough basis even when financial conditions have NOT been affected!

And importantly, since the trough of 2008, MAC’s stock prices has traded for over one year at virtually the same level when the Phisix has jumped by nearly 100% since the 2008 nadir!

Does MAC’s corporate fundamentals reflect on the stock prices? The answer is NO. What has driven MAC’s prices has been the boom bust cycle. MAC belatedly boomed at the near climax of the bull market of 2007 and consequently fell when market sentiment collapsed along with all the rest. Hence, it is safe to discern that MAC’s financial and corporate conditions and stock prices have basically been disconnected.

One would object that, if inflation drives stocks why has MAC’s prices been stagnant? Well the answer to that is that inflation does not impact every issue simultaneously nor does it impact all issues to the same degree. Inflation’s impact is always relative.

Also, since inflation has a psychological aspect, applied to stock markets, stock prices are likely to be driven by fancy storytelling, rationalization, jockeying, the chase for yields and operating rotational effects within the market.

This implies MAC will surely rise sometime in the future, in condition that the advances of Phisix will continue. MAC will then be a beneficiary of the rising tide phenomenon (but perhaps at a much later date?).

Therefore, we have another proof that validates our Machlup-Livermore model.

Finally, from the storytelling department, of course MAC has a great future. If tourism will boom in Asia, as we expect, considering the wealth transfer dynamics from the West to the East, then MAC will definitely be a major beneficiary, since there hardly has been any competition. Let me add that I’m not sure why there hasn’t been a competitor, I would suspect that perhaps political concession could be a factor. Lastly, there is another bonus, the mining department, but full operation will probably commence sometime in the future.

Yet none of this glorious tale is new.

---

[1] See Why The Philippine Phisix Will Climb The Global Wall Of Worries

[2] Mises, Ludwig von Mises The Causes of Economic Crisis, p.165

[3] World Economic Forum Enabling Trade in Greater Asia

[4] MacroAsia Corporation Corporate Website

Tenuous Relationship Between Presidential Approval And Stock Market Returns

In our July post, Presidential Approval Ratings and Stock Market Returns we argued that stock market returns have little causal relationship with the popularity ratings of the incumbent President.

We said ``popularity measures seem to be an inaccurate way to evaluate, gauge or predict stockmarket activities, trends or returns. That's because popularity is mostly about superficiality and inherently fickle."

In contrast to certain analysts who say that Presidential approval has important contributions in determining spending and investment choices which gets filtered into the stock market valuations, it would seem to us that the attribution of a causal link, instead, represent as a heuristic or cognitive bias known as "clustering illusions" or the tendency to see patterns where none exists (wikipedia.org).

Gallup's recent article seems to validate our thesis.

Some of the presidential approval-stock market performance correlationship charts per administration during the last two decades...

Barack Obama

George Bush Jr.

Bill Clinton

George Bush Sr.

Ronald Reagan

Jimmy Carter

In conclusion, the Gallup says, (all bold highlights mine)

``In any case, Gallup trends suggest no systematic pattern by which Democratic presidents (who may be viewed on Wall Street as more anti-business than Republicans) find their job approval ratings inversely related to job approval, nor a consistent pattern by which Republican presidents find a positive correlation.

``More generally, from president to president, and from time period to time period within presidencies, the market and job approval ratings have moved in widely varying directions, displaying no systematic relationship."

It's the policies employed that should matter more than simple popularity.

Why Stocks Could Outperform Bonds Over The Next Decade

``The investment world has gone from underpricing risk to overpricing it. Cash is earning close to nothing and will surely find its purchasing power eroded over time. When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early 2000s. But the U.S. Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary."-Warren Buffett, annual letter to Berkshire shareholders

Despite the surfeit of available information via cyberspace, much of these do not necessarily account for as knowledge, since pieces of information could be irrelevant or just plain rubbish or built around flawed presumptions.

In last week’s Should We Follow Wall Street?, we disputed the idea of a universally accepted technical wisdom from Wall Street.

We made as one of our example the polemics about the equity premium or the comparison of the returns of bonds versus stocks.

Nitpicking over hundreds of years of data, for us, would seem like another exercise of vanity.

Unless humanity will reach a state of human-machine convergence or Singularity soon, from which futurist Ray Kurzweil predicts that ``our intelligence will become increasingly nonbiological and trillions of times more powerful than it is today—the dawning of a new civilization that will enable us to transcend our biological limitations and amplify our creativity,” looking at an investment horizon of 100 years or more is downright impossible or impractical to put in practice.

Moreover, given the rapidly evolving dynamics, largely supported by technological innovation, such devotion to interpret a mountain of market historical data defeats Wall’s Street’s basic mantra of “past performances doesn’t guarantee future outcomes.”

So even if bonds have been proven to outperform stocks in the longest run, it doesn’t necessarily translate to the same outcome over the next coming decades.

Lastly, it’s about data mining too. Advocates of one particular cause tend to use time reference points that support their underlying bias, as different time periods yield different results.

However, over the next decade or so we believe that stocks should outperform bonds.

Here are the reasons why.

One, global government in an attempt to reflate the markets has imposed policies, such as massive stimulus spending, a cheap money environment as shown by the steepening of the yield curve [see Steepening Global Yield Curve Reflects Thriving Bubble Cycle] and quantitative easing, that has indirectly been supportive of the equity assets.

Second, under the onus of over indebtedness, afflicted governments have been tacitly inflating away these burdens through inflationary policies. And since inflation erodes a currency’s purchasing power, higher inflation thereby reduces real gains on fixed income.

Third, as governments take on more debt to substitute for declining private sector demand, inflationary policies serve as an indirect way to default on debts.

Fourth, global supply of debt will transcend available capital.

Fifth, the mercantilist inclinations of global governments will employ measures to prevent the necessary adjustments in the values of their respective domestic currency so as to protect “export markets”.

Hence, inflation will likely be a global phenomenon than one limited to debt scourged nations.

Sixth, even in the US, financial asset pricing has increasingly been influenced by inflation more than capital gains.

In fact, it is nearly catching up with dividends. [see our earlier discussion on Worth Doing: Inflation Analytics Over Traditional Fundamentalism!]

Figure 6: Economagic.com: 10 Year Treasury In A Bond Bull Market For 27 years!

Seventh, bonds have been in a bullmarket since the early 80s [see Figure 6], hence ``it would be almost impossible for bonds to generate the same amount of capital gains as they did in the past” argues Peng Chen, Ph.D., CFA, and Roger Ibbotson, Ph.D. (HT: Gully)

This suggests too that the US treasury bearmarket could likely be as long as the last bullmarket (27 years) or the previous bearmarket (30 years).

Figure 7: Manual of Ideas’ Instablog: Tobin’s Q

Lastly, in an inflationary environment the cost of replacing company’s assets would increase, hence stock prices should also adjust to reflect on this changes, based on the Tobin’s Q ratio, or a measure defined by wikipedia.org, ``comparing the market value of a company's stock with the value of a company's equity book value. The ratio was developed by James Tobin (Tobin 1969). It is calculated by dividing the market value of a company by the replacement value of the book equity.”

If the derived value is greater than one then this suggest of overvaluation [as market prices are greater than the company’s assets] and if the value is less than one then it is an indicator of undervaluation.

Notice that during the stagflationary decade of the 70s to the early 80s the Tobin’s Q had largely been undervalued or that stocks were priced below their replacement costs, although stocks and bonds had marginal differences in returns, according to Shawn Allen of Investor’s Friend ``The 20 years from 1966 through 1985 were ugly all around. Stocks came out slightly ahead but were the best of a dismal lot.”

As a caveat, since inflation impacts asset prices relatively, stocks won’t likely perform in a uniform manner and would likely be distinguished based on the industry.

So yes, like Warren Buffett, we think stocks will outperform bonds over this cycle.

Presidential Approval Ratings and Stock Market Returns

An interesting insight by Bespoke Invest on the correlations of Presidential approval ratings and stock market returns.

This from Bespoke Invest, (bold highlights mine)

``When looking at the complete history of approval ratings, it was hard to believe that even though he left office as one of the most unpopular Presidents ever, at one point George W. Bush's approval rating was higher than any other President in the post-WWII era. Ironically, the prior record appears to be held by his father, whose popularity also hit its lowest levels near the end of his first and only term. Likewise, while Reagan has been viewed positively by both Republicans and Democrats, he and Nixon (and Obama so far) are the only post-WWII Presidents who never saw their approval ratings break above 70%.

``Taking the USA Today's look at Presidential approval ratings one step further, we added a chart of the S&P 500's year over year (y/y) performance during each President's term to see how a President's popularity was tied to the stock market. Not surprisingly, there is a strong relationship between the stock market's performance (which reflects the economy) and how a President is viewed. Presidents who were in office while the stock market was strong typically have been more popular and vice versa."

``In recent history, however, the relationship has been less consistent. For example, George W. Bush's popularity peaked when the market was weak, and as the stock market improved up until 2007, his popularity continued to decline. Likewise, while it's still early in his first term, President Obama came into office with an approval rating of 64%, but even though the markets have shown considerable improvement, his approval rating has seen a decline to 55%."

Think of it, the last paragraph suggests that falling popularity for President Obama has been coincidental with rising stock markets so there seems to be a loose connection.

Aside from the attractively colored chart which are meant to amuse, popularity measures seem to be an inaccurate way to evaluate, gauge or predict stockmarket activities, trends or returns. That's because popularity is mostly about superficiality and inherently fickle.

For instance, a popular president who undertakes populist policies may generate short term gains, but reap long term pains and vice versa.

What seem to matter more is the substance and direction of the policies employed.