Words ought to be a little wild, for they are the assault of thoughts on the unthinking
- J.M. Keynes

Thursday, 14 March 2013

US Stocks: Buy or Sell?



As ‘all-time-high’ euphoria builds up, is it time to buy more or start reducing exposure?

Leave aside Ben Bernanke’s financial engineering for a moment and look at some fundamental indicators. P/E ratios look reasonable compared to share of profits in national income (Graph-1). Even though corporate profits have rebounded from the crash and are near all time highs, P/E ratios haven’t followed suit. As Graph-2 shows and one would expect, the relationship between change in corporate profit and S&P500 return is fairly close.

Graph-1: P/E and Profits
Source: Bureau of Economic Analysis, www.multpl.com



Graph-2: S&P500 Return and Change in Profits
Source: Bureau of Economic Analysis

Perhaps the fear engendered by the recent crash is keeping price rises in check relative to earnings (similar to the 2003-07 period). This seems to suggest that stocks have further to go as fear dissipates and multiples expand.

However, before clicking the buy button have a look at Graphs 3 & 4 which show the share of various factors in US national income.

Graph-3: Labour vs Capital
Source: Bureau of Economic Analysis

Graph-4: Entrepreneur, Rentier and Net Taxes
Source: Bureau of Economic Analysis

Share of corporate profits is near its 60-year high in stark contrast to every other income class. This is unlikely to be sustained given the inherent cyclicality of capitalism. Even then, a falling share is not negative for equities per-se since corporate earnings can still expand albeit more slowly than other income classes. Therefore as long as national income is growing equity valuations may still be supported.

Unfortunately this is where it gets iffy. Growth is dependent on income in the current period and additional debt incurred. Repayment of debt reduces demand for goods and services and tends to act as a drag on growth. The good news is that personal savings rate has dipped back to 2.4% from a high of 8.3% in May 2008. The bad news is that the crisis had very little affect on the mountain of debt outstanding (Graph-5) which makes a debt-fuelled recovery unlikely. Household and corporate debt has gone off its exponentially rising path but the government has stepped in to take up the slack. This explains the recovery and bounce in corporate profits (consistent with Minsky's theory).

Graph-5: Non-financial Debt
Source: FRED

Unless there is a productivity surge, a higher growth trajectory demands a continuing exponential rise in debt. This would soon become untenable given the current debt burden even for the US government despite ‘reserve currency’ and ‘safe haven’ status. However, at what point will the debt barrier be hit is hard to predict. QEasy policy has made the overall debt burden more sustainable and encouraged debt growth not to mention the beneficial effect on equities. Moreover, regulation and the European Economic Disaster Area have ensured investors keep the faith. As a result equity markets are going up more because of peripheral issues than core economic factors. Profits may be near all time highs but the current situation is not stable. In this situation traders can ‘buy and pray’ and investors can wisely stay away.

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