Cataclysm postponed, temporarily
How inflation, population, and developing countries could take us back to the ‘70’s
You have to watch this two part video interview with Russell Napier on the FT site earlier this month:
If you do, come back, because I rang Mr Napier last week asking him to clarify his prophecy of doom. It starts with a chart like this one:
I’ve explained Tobin’s Q and the cyclically adjusted price earnings ratio (CAPE) before. Napier is a fan of both measures of stockmarket value, because they accurately describe the four great US bear markets, 1921, 1932, 1949 and 1982, he studied in his book Anatomy of the Bear.
Smithers & Co plot them, but their latest chart only goes up to the end of 2008. Not surprisingly, everybody wants the June chart, which should just about show March’s lows, and that this bear market has yet to measure up to the ‘greats’. Napier thinks the final bottom, the end of a cataclysmic US bear market, has yet to come.
But before you think this is a US problem, he says the forces driving his predications are at work in the UK, and unlike the US, we don’t have the luxury of a guaranteed buyer for our currency. While the dollar lasts as a reserve currency, the US can use other nations’ savings to finance its borrowing, and borrowing is at the heart of Napier’s bearish case.
So, noting that:
- We may be in a worse position than the US, and…
- Napier’s more confident, the further ahead he’s predicting
What does he think will happen?
The bear-market rally could last two years, and it could be as impressive as the bull market of 2003-2007. Rising commodity prices and falling bond prices indicate that the prospect of a prolonged period of deflation, which could wipe out investors, is diminishing and the prospect of mild inflation, is mildly reassuring.
He doesn’t think we’ll get mild inflation, though. Nothing about his genial telephone manner indicates that he knows this first hand, but if you put a frog in warm water, he says, it stays there, enjoying the pleasant temperature. If you keep heating the water, the frog stays put right up until it’s boiling, and it’s too late. Inflation is similar, it creeps up on investors, governments and central banks, who go on thinking it’s benign until the economy’s boiling.
Only the economy won’t be boiling, just prices. The two big trends of the twenty-first century will see to that:
- In 2007, a retired school teacher from New Jersey, like millions before her, applied for social security benefits. She is the first American baby boomer, representing the post-war population bubble that is now at, or approaching retirement age. Challenged with caring for their aging populations, Napier thinks Western governments will issue more debt, rather than politically troublesome measures like cutting entitlements or raising tax.
- 2008 is the year 40% of the World’s population realised it can’t get rich selling to 14% of its population. The first stage in the development of the former communist economies, where they bought dollar reserves, held their currencies down and ensured their exports were cheap in developed markets is over because the West cannot consume at an ever increasing rate. Now the 21st century can begin, as China and Russia switch their attention to their own markets.
The combination of more government debt, and less foreign demand for it will lead to a terrible bear market in government bonds. Like the frog, we won’t notice it at first because bond yields have fallen to very low levels and rising yields feel like ‘normalisation’, but once government bond yields reach the historically significant level of 6%, we’ll be boiling.
The 6% level is significant for the stockmarket for two reasons. At that level stockmarket returns are unattractive compared to the ‘risk-free’ rate on government bonds so investors switch out of shares. Secondly, high interest rates make business more expensive and could be indicative of inflationary economies in serious trouble.
Nothing is ever the same, says Napier, but the closest parallel is the decade between the mid-1960’s and mid 1970’s. Britain’s economy would have changed from high growth, low inflation mode to low growth and high inflation.
I’ve been reading my Littlewood. We really don’t want the 2010’s to resemble the 1970’s. Inflation peaked at 27% in 1975 and although the All Share Index rose from 107 to 280 between October 1964 and May 1979, shares lost a third of their real value.
People genuinely thought capitalism faced collapse, fears that only began to recede after the UK had accepted a loan from the IMF, the last Western European country to do so until Iceland, last year. Unfortunately that part of history could repeat itself, says Napier.
Here’s my own modest contribution to the measurement of markets. A plot of the nine-year ‘cyclically adjusted’ PE ratio of the UK stockmarket.
A PE of 10 is cheap, and my chart would have to go back a lot further to show it much cheaper, but historically PE ratios have fallen as low as five in extreme bear markets.
Regardless of what happens to the economy, though, and even the stockmarket, shares are a lot more attractive on aggregate prices of ten times earnings than twenty.
Buying shares now may seem irrational, but I take the view that it’s a lot more rational than buying shares was say in 2007. I’ve done both, of course, but I always try not to pay too much.
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When will the London School of Economics start videoing its lectures? It's difficult watching a small grey ball traversing a thin grey line for an hour. But if you can bear it, you can catch up with Robert Shiller on Animal Spirits, the economy, and how 'the only thing to fear, is fear itself'.
Charlie Munger explains why Warren Buffett’s buying capital-intensive utility companies when his favourite investments are companies with ‘wide moats’ that use little capital and make loads-a-money. Moats have been filling up with sand lately, particularly newspapers and TV stations.
Wide Moat, a blog and homage to Buffett, points us to Damodaran Online, a treasure trove of spreadsheets, data, and papers from Professor Aswath Domodaran, an expert on company valuation. He writes a blog too. Here he is buffeting Buffett.
Mad about the mess we’re in? Punish someone :-)
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