It is time to start buying stocks, or is it?

There is a psychological behaviour that humans, and especially investors fall prey to. This is referred to as the 'Conservatism bias'. Under the spell of this bias, once we make up our mind or take a view on the markets, we are unwilling to change our views. On most occassions, there is enough bullish and bearish data to hold a particular view on the markets. Once we make up our mind or take a view on market direction, we can see only data that supports our views and fail to observe contradictory evidence. We do not remain neutral and do not go with the flow of the markets. We seek information in the markets that supports our views. We stick with our views even as we keep losing money, convinced that we are right (and that the markets are wrong). After deep losses we may or may not get wiser, but we definately get poorer.

No investors would want to fall prey to this bias, I certainly dont. As investors, we want to keep an open mind and respect the market for what they are telling us. We do not want to be headstrong in the face of contradictory evidence.

In my previous blog (http://shashankcurrentissues.blogspot.com/2008/12/it-is-time-to-buy-stocks.html), I had argued that perhaps it was time to start buying stocks. Lest I should become a victim of the conservatism bias, let us examine if I could be wrong (and I certainly could be wrong) and what factors could potentially lead us to that eventuality.

PE derating and valuations:
I had argued that stocks are cheap; in fact they are as cheap as they ever were in the last 17 years. But 17 years does not constitute the history of stock markets. From the early 1980s, we had a large period of credit expansion and increasing leverage across the world, which probably ended this year in the form of the credit crunch. Now with deleveraging of the financial system, the era of cheap credit might be behind us, at least for a long long time. We might see stocks as an asset class being accorded much lower valuations in terms of PE ratios and other conventional valuation benchmarks. So what looks cheap on a historical basis could actually be normal under the new paradigm. I had written a post earlier (http://shashankcurrentissues.blogspot.com/2008/09/are-we-in-watershed-moment.html) arguing how we could be in an epoch making period which we are unable to recognise. Most market participants and advisors possess experience only from the period of financial leveraging. We have not seen financial deleveraging and what it could do to valuations. Money might not flow into emerging markets are it did earlier and this could lead to secular derating of stock markets across the world. If a PE ratio of 11 for the markets might have been cheap in the past, cheap in the new era could mean a PE of 8!

Corporate Profits:
The situation on corporate profits looks dismal, though we do not know whether the markets have fully discounted them in the price already. Corporate profits might be worse than widely anticipated. Earnings might fall going ahead making current valuations not as cheap as they optically look. In addition, costlier and scarcer money would dent demand and dent corporate profits, especially for leveraged players.

Globalisation:
Globalisation had a beneficial effect on prosperity across trading member countries over the past decades. Free trade has been widely hailed in its role towards wealth creation. But I am not sure we can take free trade for granted now. Under economic stress and compulsions to keep the citizens in better shape, we could see adhoc measures that could decrease globalisation based on free trade principles. USA differs with UK, which differs with France. Asia differs with USA and China want to keep its currency weak to stimulate exports. Such competitive devaluation of domestic currencies and protectionistic measures could get destructive for the world trade, and hence to prosperity. While world leaders are well aware of this, one can never be sure of how things might evolve on this front. Perhaps an year ago, this was unthinkable and globalisation was in full swing. Now we have to consider the possibility of globalisation slowing down as well.

Greater Regulation:
There is no doubt that the financial system will be subject to greater regulation post the current mayhem. In the developed world, the iron fist of the government might get a greater share in proceedings compared to the free hand of the markets. In developing countries, it could mean an attempt to prevent incidents similar to those that occured in the west. In either case, we could see greater regulation, less freedom, especially to finance. With fiscal simuli being thrown around like there is no tommorrow, it could lead eventually to higher taxes to make up those expenses and hence could lower earnings growth.

Terrorism:
We watched with horror, shock and dismay the events of terror in Mumbai last week. This has conflagrated into a big thing, and deservedly so. We might see the negative economic consequences to flow through over time. Decreased foreign investment could be the most obvious effect. Animal spirits of entrepreneurship could be also affected. More government money might get diverted towards preventing terror attacks in the future. Taxes could be raised to gather more money for this cause. Any conflict, either direct or indirect, reduces return on capital employed and hence reduces stock valuations.


Essentially, for whatever reasons, if earnings go down or if the PE ratio assigned to stocks by the markets goes down, stocks prices could go down. In addition, if there is a structural downward shift in the valuation metrics like the PE ratio, and if business environment remains tough, stocks could stay down for a long period.

All of us need to understand that supernormal returns are not possible across all time horizons in the real world. There always will be periods of above normal returns and periods of below normal returns. What causes these cycles could vary across such cycles. The bottomline is that over time, good and bad periods get evened out to result in normal returns. An example I always like to quote: If in the year 1000 A.D, any of our ancestors had invested Re.1 at 5% per annum, the value of that rupee would today be 45 quintillion US dollars!!! (One quintillion = a million trillion). This would be about 0.86 million (8.6 lakh) times the world's annual output! The interest at 5% per annum from this would be 42300 times the world's annual output! Over long (really long) time horizons, the return from most stock investments is zero! Capitalism ensures that. Even the East India Company eventually went bankrupt after practically ruling India for more than 100 years!

Now, no one in his right mind would look at returns over a 1000 years. Lets look at century returns. The Dow Jones Industrial average went up from a value of 71 in the year 1901 to 8500 currently. This is an annual return of only 4.5% (add another 3% for dividends). Anyone for the idea 'stocks for the long run'? Noteworthy is the period from 1982-1999 where the Dow went up from 875 to 11497 generating a CAGR of 15.3%. This period coincides with the begining of proliferation of financial leverage and massive credit expansion. That might explain the above-normal return compared to history. The greatest bull market in Japan from 1970 to 1989 saw the Nikkei go up from 2000 to 40000, a return of 16%; attractive but by no means spectacular! Maybe returns are mean reverting and revert back to normal long run values.

The short of this long story is that stocks today do look cheap when valued in the context of the existance of cheap money, high leverage and low taxes. The future might look very different from the past. Stocks might not be cheap in the context of more regulation, scarce and expensive money, less leverage and higher taxes.

How would the world evolve? Only time will tell.

Happy Investing!