Tuesday, March 13, 2012

Does the Drop in Monetary Aggregates Spell Doom for Stocks?

It goes without saying that regular readers of Random Glenings are a pretty savvy lot.

I was reminded of this again today, when I received an email from a client who is also a regular reader.

The client noted that I have written on numerous occasions that I am a pretty big fan of Ambrose Evans-Pritchard of the London Telegraph - which is absolutely true.

So, my client wrote, how do I square the basically bullish stance of Random Glenings with yesterday's Evans- Pritchard column, which rang a very loud warning bell against getting too excited about stocks or any other risk assets:

Data collected by Simon Ward at Henderson Global Investors shows that M1 money supply growth in the big G7 economies and leading E7 emerging powers buckled over the winter. 

The gauge - known as six-month real narrow money - peaked at 5.1pc in November. It dropped to 3.6pc in January, and to 2.1pc in February. 
This is comparable to falls seen in mid-2008 in the months leading up to the Great Recession, and which caught central banks so badly off guard. 
“The speed of the drop-off is worrying. This acts with a six months lag time so we can expect global growth to peak in May. There may be a sharp slowdown in the second half,” said Mr Ward. 
If so, this may come as a nasty surprise to equity markets betting that America has reached “escape velocity” at long last, that Europe will scrape by with nothing worse than a light recession, and that China is safely rebounding after touching bottom over of the winter.


 Good question.

Moreover, my client noted that Ben Graham - the father of modern security analysis - was fond of buying stocks only when they offered a sufficient margin of safety.  With the most recent market rise, my client asked, would Ben Graham be a buyer of stocks?

Mr. Evans- Pritchard may be right - a rapid drop in monetary aggregates could spell difficulties for the economy and stocks - but I believe that any drop in stocks would be on the order of -5% to -10%, which would in fact present a buying opportunity.

Here's how I responded in part:

Yes, I saw the Evans- Pritchard note yesterday.  And, as you say, I am a big fan of his, so his thoughts are definitely worth considering.

However, your portfolios here are only a portion of your overall financial picture.   I estimate your ultimate stock exposure is only about a third of your total finances, with the rest in CD's and bonds.  Significant, yes, but I would argue that having two-thirds in less volatile investments gives you a pretty good cushion.

The way that I am thinking about the market now is as follows:  It would not be surprising to see the market “correct” after a strong start to the year.  However, analysts are beginning to raise earnings forecasts for this year, as business trends slowly begin to improve (especially in North America).

Consensus estimates for the S&P for 2012 are for around $105 per share.  If we assume EPS growth of +6% to +8% for the next couple of years – I can walk through my assumptions in another email if you would like – this would bring earnings by 2014 in the $120 to $125 range.

If you throw a 14x multiple on these earnings (conservative when you consider the low level of interest rates), you come up with the S&P trading in the range between 1,700 to 1,750 in 2 ½ years, or about +25% to +30% higher than current levels, not including dividends.

Bears would argue that my assumptions are too Pollyannaish, and that I am ignoring, among other things, the continued problems in the euro zone and the huge debt overhang from the last decade.  


On the other hand, it seems unlikely that we will be revisiting the credit crisis of 2008-09, given the recent actions of the Fed and ECB. 

In other words, while a near-term correction is always possible, I would think that 1700 on the S&P is at least as likely as 1000. 

After all, the S&P traded at 1550 twice in the last 12 years.  Once, in 2000, when S&P earnings were around $50.  Second, in 2007, when earnings were $90.  If we end this year without any major hiccups, the market will be trading on 2013 earnings, which could reach $115 or so.  Why couldn’t the market trade higher?

Ben Graham suggested that investors have their allocations to stocks range between 25% to 75% at all times.  I agree that Graham advocated buying stocks when they were cheap, but I would suggest that compared to cash earning 0% and bonds mostly less than 2% that stocks are more attractively priced than the alternatives.

In other words, based on Graham’s criteria, you  are already at the lower end of your allocation to stocks

One final point:

In constructing an investment portfolio it is important to consider your overall exposure to various asset classes.  Too often, in my experience, we all will focus on a piece of the overall picture that is not doing as well as expected, and ignore the rest of the assets that are doing just fine.

But I appreciate the feedback!