Sunday, December 26, 2010

Investment Outlook 2011

2010 in review

The US stock market spent the better part of 2010 in mildly overvalued territory. As of December 2010, the S&P is hovering around 1200, and the overall market capitalization is around USD 14.2 trillion. The market capitalization ratio is around 100%. As we've seen in our post in October 2008, the fair value of the US market is around 70-80% of GDP, which in todays terms corresponds to the S&P at 960. (A good place to get an update of the market valuation is here at GuruFocus:

History also suggests that market values will correct towards fair value, often overshooting in the process. But there is no guarantee that the past will repeat itself, and we must be careful not to drive forwards while using only the rear view mirror to guide us. The nature of the market and investor participation prior to the 1960s is different in some fundamental ways from today's market. Nonetheless, my bet is that the market is still overwhelmingly driven by human mob psychology, and that is something that has not changed throughout human history.

Market mob psychology has historically demonstrated the ability to allow:
- the market to fall to 50% of GDP. This would imply the probable lowest the S&P may fall to is approx 600. That's a 50% drop from here.
- the market to rise to 150% of GDP; this occurred very briefly during the 1999 dot com mania, and was an unprecedented all-time valuation high for the market. This would imply the S&P at being 1800, which is a 50% rise from here.

Wildly overvalued markets are often challenging for value investors, because almost all stocks can be overpriced. Similarly undervalued markets present a feast for value investors as the majority of stocks drop to fire-sale prices. Mildly overvalued or undervalued markets would typically present fewer investing opportunities, as individual stocks and assets become cheap because of poor investor sentiment arising from events such as bad press and unexpected (transient) earnings surprises.

However the market in 2010 did not manifest many such opportunities, because it demonstrated an interesting characteristic: a very high level of correlation across all stocks. This has commonly been referred to as the "risk-on, risk-off" behavior of investors. All stocks move up and down in unison, and individual stock picking thus becomes a very challenging task as every stock pick becomes a bet on the overall market movement. There are fewer opportunities to practice investing, the art of buying undervalued stocks whose prices then go up as their value gets realized in the market. One of the few opportunities that came up were the few times when high quality blue chip companies were trading at fair value.

Looking forward : 2011

The economic environment is 2011 is likely to continue to be subdued as we continue working through the mis-allocation of resources during the bubbles between 2000 and 2008. The high levels of obligations to retirees and government employees (manifested as debt and unfunded obligations) will likely be a drag on the economy, as either (1) working people adjust to reduce their standard of living to make good on these promises made by the government to other sectors of society by transferring the results of their production to these other sectors, or (2) society adjusts to inflation which comes from monetizing the debt to break those promises made. The drag on the economy comes from the psychological effect on people who discover that their plans based on past promises or projections now have to be changed. As they feel poorer and/or find less rewards in production, they may reduce their level of economic activity (production and consumption).

But does the underlying economy really matter for investors? Stock prices will go up if everyone gets whipped up into a frenzy, whether or not the underlying economy is sound. How it matters is that the degree of activity in the underlying political economy can increase or decrease the probability that investor psychology will be triggered in one direction or the other.

What is 2011 likely to present to us: what are the known risks this coming year?
  1. The risk of people recognizing that massive central bank money printing will lead to inflation.

  2. The risk of people recognizing that private and sovereign debt will default explicitly or implicitly via inflation, either way leading to inflation or increasing yields; because of the large amounts of debt.

  3. The likelihood that economic growth continues to be slow, as we work through the continuing economic readjustment from the housing and financial asset bubble.
The underlying longer term trends, that we have observed earlier, continue to play out:
  1. reduction in availability of low cost resources (energy, commodities)

  2. demographic trends: aging in the vast majority of developed countries, and China

How investor and mass psychology plays out over the coming year is uncertain, though the triggers for a market correction seem to be there.

Investing Playbook

Given the underlying economic landscape, and what seems to be latent triggers for a change in investor psychology leading to a fall in equity prices, we look towards investing in companies which have strong business positions and growth ahead of them. Their downturn resistant earnings streams should support their stock prices to some degree, and even driving a growth in prices once correction-psychology stabilizes. The key is to buy at fair prices, as it is highly unlikely that companies seen as low-risk, durable and world-leading will sell for cheap prices for too long, irrespective of how much the market corrects. It is unlikely for example, that WMT would go for less than 10 times earnings for any prolonged period of time. A study of the bear market in the 1970s would suggest this belief.

Other more transient, or in-the-moment approaches are likely to be tricky this year. The recent erratic risk-on risk-off nature of market psychology makes it difficult to make money by playing transient shifts in changing asset preferences. It also makes it difficult to make the traditional value investing play of buying assets below their fair prices, in the hope of markets recognizing their true value.

The one shift in preference that seems a possibly good bet is the shift away from debt instruments. Rising recognition of sovereign default would likely trigger a shift away from bonds and resulting in rising yields. This has been expected for several years, and it is still anybody's guess whether this will happen this year. But when it does, it is likely the shift will be swift and decisive, providing an opportunity to place a bet on the continuance of this shift after it has started.