Note January 31,2018: Rakers of the Lost Art of Valuation – Amid gasps and contortions to justify markets without corrections (until recently), two realities seem missing. Perfect knowledge (or even efficiency) cannot be assumed, not least at any single point. Further as in the 1990s, the long term role of markets is capital allocation and not just following central bank diktat. Similarly as in the late 1970s, central banks should not be handmaidens to markets. Retrospective on monetary policy has been of paucity in depth. The January 31, 2018 FOMC would ideally have had more transparency and absorbed political blowback. Fed Funds rates unchanged seems opportunity forsaken. Other major central bank decisions loom but currency volatility is a risk. Between fixed income and equities, prior divergence in factor interpretation was not stable. Now, government borrowing is high. Fixed income vigilance seems overdue as central banks temper activity. Technology in production, logistics and services has changed. In needing funding, the U.S. State of Union $1.5 trillion infrastructure program joins others worldwide. For equities, global growth may be stronger and earnings in expansion but large P/E expansion already exists. In considerations on market behavior, M&A activity becomes pro-cyclically fervent closer to peaks. With junk bonds and concept equities particularly at risk on change, rakers of the lost art of valuation are both required and overdue. In equities with late cycle behavior in global growth amid market disdain until recently about their restructuring, valuation and delivery beckon in Energy and Materials.
Amid the gasps and contortions to justify markets that have gained without correction (until recently), two crucial realities seem missing. These realities are namely that perfect knowledge (or even efficiency) cannot be assumed, least of all in capital markets at any single point in time. Otherwise, volatility would not be a fact of life, recent low VIX levels notwithstanding. Further and as epitomized in the 1990s after the prior missteps in policy, the long term role of markets is to allocate or withhold capital as needed and not to just follow central bank diktat. Similarly and after the market misjudgments of excess valuation into the early 1970s, central banks should not be handmaidens to ever rising markets. As such, the very premise is false that there is no alternative to being fulsomely investing. After all, cash has and can be held by individuals, institutions and companies in order to invest later at the right price. This leads us to see as overdue, a requirement for more rakers of the lost art of valuation. Low valuation is in itself not indicative value but it needs at least to take into account growth and risk premiums. We highlight these aspects not as revelations but do highlight them to be wanting during massive quantitative ease now a decade old (and three decades so in Japan).
Amid change in leadership starting February 3, 2108 at the Federal Reserve, an ideal time for more transparency would have been in the January 31, 2018 FOMC statement. The leaving unchanged of Fed Funds rates seems opportunity forsaken by the Federal Reserve even if rates are increased later. Some political blowback on rate increases could have been absorbed ahead of a known transition in leadership. Other major central bank decisions also loom. Even within the European Central Bank (and overt from Germany) and the Bank of Japan, more credence has finally emerged on taming central bank ease. Retrospective on monetary policy is appropriate and of which there has been a paucity in depth.
Some fear a deliberate U.S. undercurrent exists of pressuring down of the dollar exchange rate. Volatility between major currencies is a risk as quantitative ease is tapped down. Emerging country central banks have also been tightening on credit in countries like China and India. It is not that reams of policy papers have not been published as such has clearly been the case for quantitative ease. However, when extreme policy is prescribed and then continues for a decade or more, not just conventional benchmarks like inflation, employment and growth matter. So do distortions that have been building despite the self-proclaimed long term considerations of central banks. For instance in the real world of business, prolonged easy monetary policy in Japan has also coincided with a pronounced loss of world business leadership and stagnation in many areas as well as more scandals in corporate governance. It contrasts with the prior evolution in Japan from basic production (like textiles and steel) to higher value added segments and business excellence, amid then scarce finance. Emerging countries enamored by allocation of capital on socialist principles found themselves with capital waste, lower standards of living and inferior products. Over the 1990s and beyond, emerging country change therefrom did lead to world beating growth from industry to industry, in country after country. We highlight these aspects because the Federal Reserve imminently is evolving and also other central banks need policy change, including major ones like the European Central Bank, the Bank of Japan and the Peoples’ Bank of China. After all, GDP growth in 2017 has been stronger not just in the United States but also in Europe and Japan at close to 2.5% annually. Meanwhile, both China and India appear closer to or above the 7% annual GDP growth level. Prolonged suppression of interest rates seem to us to be overdue for change from distorting capital markets and adversely affecting demographic impact (such as making real estate expensive for the young and reducing income yield for the old). Rather than detracting from it, we believe that as in the past, lessening easy money would improve the efficiency of growth by reducing zombie activity.
Within memory, one need only go to the late 1970s to recall that central banks do not invariably accommodate ever rising markets. In addition in the 1990s, the markets were not accommodating governments and in vigilance, demanded high risk premiums. One also needs to recall the mid-1970s as being asignificant example that divergence in factor interpretation is not stable between fixed income and equities. Then, fixed income yields eventually rose to reflect the same inflation conditions that had initiated the constriction of equity P/E ratios. Global country and corporate completion is currently intense. Technology in production, logistics and services has changed. Infrastructure investment needs are strong. In needing funding, the U.S. State of Union $1.5 trillion infrastructure program joins others worldwide. Today and partly reflecting less direct purchase potential from central banks, government bond yields have moved upwards, for instance with U.S Treasury 10 year Note yields at 2.72% (or twice their lows of 1.36%) and likely to move higher, even if inflation were contained. Government borrowing is high. Fixed income vigilance seems overdue.
For equities, global growth appears be stronger with earnings in expansion. Still and partly on comparisons with quantitative ease gorged low interest rates, P/E expansion took place much earlier. Up ahead, valuation benchmarks need demonstrating that long term, ( for instance 5-10 year earnings growth) can be sustained at almost twice that of a historical 6-7% annual average for the S&P 500. Separately but within market behavior considerations), M&A activity tends to be pro-cyclical in becoming fervent closer to peaks. After years of M&A activity, Healthcare is currently an indication of how change within sectors can come from competition and from government policy change. With junk bonds and concept equities particularly at risk on change, more rakers of the lost art of valuation are both required and overdue. Among equity market sectors specifically with late cycle behavior in global growth and market disdain until recently amid restructuring, valuation and delivery beckon in Energy and Materials.
Kind Regards,
Subodh
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