I wanted to share some outstanding reading material that I came across in the last little while regarding stock market valuations, the state of the world economy, and US tax reform.
Chris Leithner runs a private investment company in Australia that is geared towards professional and sophisticated investors. The company follows a value investing approach similar to that used by Benjamin Graham and Warren Buffett. An approach that I also try to use.
About three or four times a year, Leithner puts out an investment letter that discusses topics including investing, the state of the global economy, psychology and philosophy. I recommend reading his letters as he provides great insight on some of today’s more pressing issues. His letters are thoroughly researched and he provides great wisdom on the topics discussed.
I found two of his more recent letters especially interesting.
In Issues 200-204, Leithner outlines various stock market valuation ratios. This letter was published in July 2016. He specifically covers the Schiller P/E ratio, Q ratio, and ratio of market cap to GDP. He came to the conclusion that these three ratios indicate that stocks are greatly overvalued. While at the same time, the 1-year forward P/E ratio shows that stock valuations are okay – but we know that analysts are optimistic about their earnings estimates so that the 1-year forward P/E ratio is likely understated. Since this letter was published, stock markets are even higher! So these ratios have further deteriorated. This shows how long stock markets can be irrational and why it is so important to be patient.
In Issues 209-212 (his most recent letter), he looks at political uncertainty and stock market volatility. What he finds is that in Canada, Australia, and the US, there is significant political uncertainty at this time. The volatility has been above average since 2008. Much of it has increased lately with the election of Donald Trump. However, while this political uncertainty exists, stock market volatility is well below average which shows investors are becoming complacent. All of this is happening while stocks (and bonds and real estate) are significantly overvalued. The conclusion that I reached from the letter is that stock market volatility is likely to rise and stock prices are likely to go down in the future. The decline is likely to occur until volatility and valuations return to more normal levels. The alternative would be for policy uncertainty to go down significantly but this is not likely.
John Mauldin is an advisor to hedge funds and money managers. He also has his own website, Mauldin Economics. I find he has great commentary on the most important macroeconomic issues that the world is facing.
I found his most recent write up on US tax reform to be enlightening. He focuses on the proposed border adjustment tax (the “BAT”) by the Republicans in the US. If the BAT were implemented, it would deny US companies a deduction for imported goods from outside the US, while companies that export goods to other countries would not have to count the exports as revenue. Before getting into the BAT, Mauldin believes tax reform is necessary in the US to help drive economic growth. I agree with him, particularly bringing down the US corporate tax rate to levels more in line with the G20 countries.
However, Mauldin thinks the BAT would be a disaster for the US and world economy. He raises some interesting points in coming to this conclusion. The companies that import and export goods are often not the same companies and are not located in the same areas. So you would have winners and losers. The importers would likely be losers as their income tax burden would rise – this may lead to layoffs. The exporters would likely be winners as their export revenue would not be taxable. This would lead to the same situation we are in today where cities with tech industries are booming while the traditionally manufacturing areas are hurting (but different industries may prosper while others suffer).
The BAT would also hurt the US consumer. For example, the US economy does not have the capacity to manufacture goods that are currently imported (think of the things you get at Walmart and Amazon). So initially, the additional cost (probably 20% or so) would be passed onto US consumers. US wages would not rise to meet the increase in costs. Thus, likely triggering a downturn in spending.
In addition, the BAT may set off currency and trade wars. For example, a 20% BAT may drop the Canadian currency by 20%. A 20% drop in the Canadian currency relative to the US currency would substantially increase inflation in Canada since Canada imports a significant amount of goods from the US. This would hurt Canadians (Canadian exporters would do okay). So Canada would likely implement a tax on imported US goods.
The spike in the US dollar would also hurt countries that carry US dollar debt. This is the case because it would become more difficult for these countries to repay the debt since they would need more of their own currency to pay it back in US dollars. These countries are usually those in emerging markets.
Due to all of these concerns, I do not think the BAT will be implemented but the US government does have to come up with something else to make up the lost tax revenue from corporate tax rate cuts, personal tax rate cuts, and the estate tax repeal.
At the end of the letter, Mauldin discusses the investing conference he just attended, “This has been an extremely interesting conference. The attendees are generally institutional and family office investors, and the conversations this year were remarkably candid. There is a concern about how long the current status quo can continue and what these institutions, which generally have mandates that limit their flexibility, can actually do to protect themselves from what everybody agrees will eventually be a crisis.” I found this interesting as he acknowledges that there is an economic crisis down the road that we should be prepared for. I agree with his comment as stock, bond, and real estate markets are significantly overvalued, countries are awash in debt, individuals are awash in debt, and most countries are experiencing little economic growth. Sooner or later the ball will drop.
I also ran across an interesting study a few weeks back that looked at how the Shiller P/E ratio impacts future returns. For example, what eventual returns does a low starting Shiller P/E ratio result in? What I found interesting in the study is that when the Shiller P/E ratio is around 29 (which it is today), the Shiller P/E ratio 10 years later is around 20 on average. So a large compression. This can only happen if companies grow earnings in excess of inflation over the next 10 years, if stock prices fall, or a combination of the two. So this tells me that the Shiller P/E ratio should compress over the next 10 years and I think it will because of risings earnings in excess of inflation coupled with falling stock prices.
My thoughts on the commentary above are that there is quite a bit of economic and political uncertainty in the world. This at a time when stocks, bonds, and real estate are all greatly overvalued. To me this signals that I should be saving my dividends and employment income – building cash reserves to use when stocks become cheaper. This has been an ultimate test of patience as my cash balances grow. Note that I still not have sold any stocks. Now is also not a good time to have excessive debt.