Friday, September 23, 2011

Where Will the Market Go?

The S&P 500 index closed at 1136.43 and gold closed at $1642.50 per ounce today.  I said before that this is not a market forecasting or predicting blog, and I actually really have no idea where the market will go from here.  It certainly doesn't look good.

But I thought I would just highlight a thought I had in the past week or so.  There are certainly a lot of problems in the world today, one of them being way too much debt.  This debt will certainly dampen demand going forward into the future.  The Fed and Congress seem to have used up their silver bullets; interest rates are already at zero, and the budget deficit is already 10%.  The two levers of economic management can't be used now.

This has sort of been known for a few years now and is not new.  The European sovereign debt problems is not new either.  We went through this last year.

The interesting point is that now we are actually discounting the freezing up of the financial markets again just like when Lehman went bust.  More and more institutions are refusing to trade with or lend to French banks, for example.   This is sort of turning into a panic.  Of course, there is a chance that the EU will misplay this and a total disaster may happen, but I doubt that.  Europe is where the U.S. was, I think, right in front of TARP.

Strong, decisive action in Europe to draw a line on the financial instutions would put a halt to this current panic.  We can't solve the debt troubles right away, but we certainly can put a stop to the fears of liquidity disappearing.

Will the U.S. Follow Japan's Path?
This has been talked about too for many years, and more and more, it looks like the U.S. is following in Japan's footsteps.  For years, people denied a Japan bubble-like event can occur here.  Time and again, we said, nope.  Can't happen here.  U.S. regulation and disclosure is better.  The Fed is better.  The banks are better. 

But as time goes on, we seem to follow in Japan's very step.  A few years ago, if you said short term rates would go to zero like Japan, people would have thought you're nuts.   They would have said that with Greenspan / Bernanke, rates would go into the double digits with inflation.  

Nope.  We got zero interest rates.

If you said the 10-year treasury yields would go below a Japan-like 2.0%, people would have said the same thing.  Nope.  Can't happen.  Helicopter Ben would see to it that it won't happen.  He would print so much money that in fact he would cause a crash in the bond market.

And here we are with ten year treasury bond rates below 2%.

So what will happen to U.S. stock prices?  Will we follow Japan and have a 20+ year bear market taking the market down 80%?  This is certainly possible, and already, we have gone through two major bear markets in the past ten years.  We may be flat for another ten years, who knows?

I don't want to argue that we won't go down the path Japan did, because every time someone denies the possibility of something, it seems to happen. 

But I do think it's important to look at some differences too.

First of all, when the Japanese stock market peaked in December 1989, the stock market was trading at a p/e ratio of 60-80x, depending on what data you use.  Either way, that was a very, very high valuation.  Even after the popping of the bubble, the p/e ratio stayed as high as 40-50x for many, many years.  Then it drifted down to 30x, and then to 20x which I thought was still too expensive.

I think after more than 20 years and an 80% decline, stock prices are finally down to a more normal 15x p/e ratio.

So much of this stock market decline is due to a large decline in the valuation.  The U.S. stock market never got that high even during the internet bubble, and is certainly nowhere near that kind of level now.

Second, I have been looking for Japanese stocks to invest in for years and I am always baffled at how low the return on capital levels are for the listed companies.  ROE is the driver of equity/shareholder returns, so it's no wonder a market full of low ROE companies will perform poorly over time.

This is not the case in the U.S.   CEOs are very conscious of ROE and use capital much more effciently.

Also, ROE is low in Japan largely due to the fact that the Japanese capitalist system runs under what I think Canon's CEO, Fujio Mitarai once called "corporate socialism".  He said that Japanese companies cannot run efficiently because Japan doesn't have a social safety net (unemployment) like the U.S. so they can't fire people.  In the U.S. when times are bad, corporations downsize and the government's safety net takes care of the unemployed.

Since there is no such mechanism in Japan, corporations can't downsize so they have to retain their high cost base even in a shrinking industry or economy.   This is bad for the company and for the people.  As Jack Welch used to say all the time, you aren't doing anyone a favor by keeping someone employed when they shouldn't be.  The sooner you let someone go so they can find some productive work to benefit society, the better.  With this sort of inefficient labor market, is it really any wonder that Japan hasn't improved in 20 years?  You end up with many large, overstaffed corporations deploying both labor and capital inefficiently!  This is not rocket science.

Since there is no such problem in the U.S., corporations can adjust pretty quickly to the changing environment. 

(This is one reason why I am not so worried about the U.S. banks and financial institutions.  In Japan, zombie banks are left to survive for many years due to the fact they can't reorganize/restructure and become competitive, and the government won't let them fail either for fear of high unemployment and the social instability that may cause.  This is bad for the whole sector, of course.)

Also, it is interesting to notice that during the horrible years in Japan, globally competitive businesses tended to do well.  Toyota, for example, seemed to trade more in line with the S&P 500 index than the Nikkei.  This is due to their international competitiveness. 

But the retail sector, financial sector and other areas that had no global competitiveness did horribly.  (of course there are brilliant exceptions like Seven-Eleven Japan (now part of Seven and I Holdings), Fast Retailing among others. ).

What does that teach us about the future of the U.S. market? 

For one, I think as long as U.S. stocks are bought at reasonable prices, they should perform well over time.  Second of all, if they have presence globally and are competitive, that's also very good.  A good way to play global growth, or diversify away from what may be slow growth in the U.S. is to invest in the best global companies based here.  Of course, the usual suspects are Coca Cola, Proctor and Gamble and the other usual American global blue chips.

A company like Goldman Sachs tends to be pretty competitive internationally, unlike most Japanese financial institutions. YUM Brands and McDonald's have great global presence and is very competitive.   Most of these businesses are available here for reasonable prices.

Bottom Line
So to me, the bottom line tends to be that if you invest at a reasonable price in a business that is globally competitive with decent returns on capital, you should do fine.   The Japan problem, at least in terms of stock market investing can be avoided by not paying ridiculous prices for any business, and staying away from low ROE, uncompetitive companies.

At the end of the day, it's not really about trying to predict what will happen in the U.S. economy in the next ten years and worrying about the Japan scenario.  It's about finding good businesses at reasonable prices (which was hard to do in Japan over the past 20 years, and I argue it's not so hard here in the U.S. now).

Instead of trying to figure out where the markets will go, I think it's more important to understand that good stocks will go up and bad stocks will go down (over time).  And that will always be the case no matter the macro scenario.


  1. And now, end of May 2014, S&P 500 is at 1900,53, up 67% from the day you sent this post. And Buffett says it is fairly valued:).


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