Sign up with your email address to be the first to know about new products, VIP offers, blog features & more.

All Posts By Cliff Jarvis

Is It Safe? Stocks: Pro, Con, and the Dividend Bubble

The U.S. stock market is at post-crash highs in the middle of domestic and world economies optimistically seen as struggling. Does it make sense? Is the market reasonably priced? Is it safe?

Well, it depends who you talk to:

Pro: The S&P 500 is currently about 16 times earnings on a 12-month trailing basis. This is about average on a historical basis (link). Additionally, we are in the recovery stage of the business cycle where earnings slowly improve. Furthermore, price/earnings multiples are inversely related to interest rates and interest rates are extraordinarily low. The average dividend alone on high-quality stocks is paying far more than what C.D.’s offer. Lastly, the charts are pointing up; as the saying goes, “the trend is your friend”.

Con: Shiller’s methodology for calculating the S&P 500’s price-earnings ratio is based on average inflation-adjusted earnings from the previous 10 years (link). It is currently at 23 times earnings with a historic average of about 17. The S&P 500’s current dividend is currently substantially below the historic average meaning prices are high (link). Additionally, corporate profits as a percent of GDP are not as high as some claim, but high none the less (link). Profits could decline as a percent of national income as wages start to reestablish themselves. Lastly, the end of borrowing the difference between what is spent and what is earned is here. Politicians call it ‘austerity’. It is inevitable and will depress economic activity.

The Dividend Bubble: The Federal Reserve’s Zero Interest Rate Policy (ZIRP) intervention has forced normally conservative savers into the stock market looking for yield. Dividend stock has been bid up distorting their price (a bubble). The resulting elevated P/E of these stocks has raised the overall multiple of the market. The other side of this is many other stocks remain at more traditional P/E multiples.

For example, a currently popular dividend stock is now priced at 18 times earnings and a 4.3% dividend yield. According to Valueline, its historical average P/E is 14x and its average dividend yield is 5.0%. This implies a ‘fair value’ of over 15% below its current price.

With the stock market at post-crash highs it may be a good time to do some math.

Getting There

What is the greatest technological advancement of the last ten years? Most would probably say the smartphone, or perhaps social media sites. I think it is directional drilling and what is referred to as ‘fracking’. Vast reserves of natural gas through this new technology have become economically producible throughout the Midwest. Further west, rich oil reserves can now be accessed.

“…energy resources are primarily a function of technology, not of geology. Technology unleashes resources, resource wealth creates capital, and capital is reinvested in new technology that, in turn, unleashes resources.” Link

“So dramatic are America’s finds, analysts talk of the US turning into the world’s new Saudi Arabia by 2020, with up to 15m barrels a day of liquid energy production…” Link

This technology has the potential to change America’s future. It has the potential to drive our GDP out of recession and return us to full employment. We could dramatically cut both our trade and fiscal deficits. Cheap energy could also revitalize other American industries. Lower electricity bills could help every homeowner. Tax receipts could expand painlessly.

In addition, while natural gas is still a carbon-based fuel, it is far cleaner than what is currently in use.

“…the biggest advances have been in power generation. A technological breakthrough, the combined-cycle gas turbine, a spin-off from the aviation industry, has transformed the economics of the industry. Not only has it made it cheaper to generate electricity from gas, but the process releases up to 50% less carbon dioxide than does coal. As governments strive to cut greenhouse-gas emissions, replacing coal with gas will bring fairly swift results.” Link

Billions of consumers are coming online around the world. This reality demands that clean, renewable energy technologies be developed. But for now….

Niall doesn’t get it

Niall Ferguson is one of the best historians of our time and was recently quoted saying that the Euro must hold and Greece should not leave the currency. ” I am not a federalist,” said Ferguson, “But the costs of the single currency disintegrating are really so high and would impact so many people, that the only responsible thing for me to do is to argue urgently for the next step to a federal Europe. I see no alternative at the moment that isn’t a great deal worse.” Link

Mr. Ferguson is not an economist and I believe he misses the point. This is not a debt crisis, it is a current account crisis. The debt is a result of southern European nations being unable to compete with their northern neighbors. To over simplify, the Greeks have been buying everything German while no one was buying anything Greek. To finance these purchases with no international earnings coming in the Greeks borrowed, and borrowed, and borrowed some more. Since Greece is part of the Eurozone, lenders mistakenly lent, and lent, and lent some more.

“So the problem for the euro is the capital flows between the creditor nations and the debtor nations. What caused the problem? The culprit is the current account imbalances.” Link

Europe is strapped into a common currency designed for political reasons which is totally unworkable for economic reasons. Federalizing Europe would create one nation out of many countries. This would lock in the current uncompetitive reality. Germany would be forever sending transfer payments to their unproductive southern brothers.

In order to compete, the south must lower their costs. The current plan of remaining in the Eurozone and the accompanying ‘austerity’ of grinding down wages, benefits and everything else will not work and will most likely end in revolt. On the other hand, if Greece left the Euro and had its own currency, it would devalue. Devaluation immediately realigns relative prices. The cost of goods and services of debtor nations such as Greece becomes cheaper while the costs of creditor nations goods and services become more dear. Thus Greeks buy less German goods and services while Germans buy more from Greece. Debt too revalues. Creditor nations and their banks are forced to write down what is owed to them to the new currency.

Creditor nations and their banks face huge losses when their debtor devalues. This is where we are now. The creditor will do everything it can to hold off devaluation and deny the realization of huge losses.

“…financial panics do not cause the destruction of wealth, financial panics merely tell you the extent to which wealth has been destroyed…” link

Further loans, massive injections of newly created money, and whatever it takes to ‘kick the can down the road’ will be done to avoid the pain of a solution. While this may not solve the intended problem, It will probably keep interest rates low and markets high for an extended period.

The Great Reset: Europe

The Euro was the child of politicians, not economists. It was seen as huge, allowing trade with each other free of restrictions as an integrated Europe no longer subject to internal wars. The unintended consequence was a clash of different non-homogenous cultures strapped into one currency, into one monetary policy. The low-interest rates of Germany became available to all and the enormous stockpiles of capital flowed freely into the easy lifestyle of the Mediterranean countries.

“The Euro triggered a tsunami of wasteful fiscal spending in Greece and Portugal, the loss of export markets for family-owned Italian firms dependent on lira devaluations and an epic construction bubble in Spain whose denouement has devastated its banking system and cajas. Ireland has mirrored Spain.” Read here for more

Now the southern economies are strapped with a mountain of unpayable debt and unsustainable budgets. Production costs need to drop up to 30% to be competitive with the northern counterparts. Internal adjustment through wage cuts, pension reductions, and benefit cutbacks will not work. The populace is turning increasingly and inappropriately socialist while those responsible for the financial mismanagement seem to go unscathed. A coordinated exit from the euro and an immediate devaluation is inevitable. Those institutions that benefited so greatly from the old order need to face the inevitable losses.

“Exit is the cleanest way to “re-balance Europe” and end the deflationary bias in the system. This may mean “crystalising losses” but they already exist in any case.”

“Unilateral exit states would spring a “Saturday surprise”, suddenly reverting to the Drachma, Escudo, etc. Euro notes would be stamped with national insignia. Capital controls would be imposed, with a bank holiday.”

“Local jurisdiction debt would be switched to the new currency under Lex Monetae. More than 90pc of Greek, Portuguese and Spanish state debt is under national law.” Read here for more

The partial breakup of the Euro is not the end. It is the beginning. The history of capitalism is full of panics. Currency exits have happened before and devaluations are commonplace. Quick and immediate pain and a reset to growth is the answer. The current path of denial and grinding agony is not. Read here for more

Too Good Not to Share

Mohamed El-Erian, the head of PIMCO, recently delivered this lecture at the St. Louis Fed. Here are two passages from his conclusion:

“After diffusing a material threat of a global depression, central banks in the advanced economies did a good job in maintaining a certain status quo in the midst of too much debt, too little growth, too much inequality, and a historic global economic realignment. Critically, they succeeded in their overwhelming priority of avoiding an economic depression.”

“Where the global economy goes from here will depend less on the actions of central banks and more on whether others, including other government agencies and private sector participants that have the ability to act but lack sufficient willingness to do so, finally step up to the plate. Only with the supportive actions of others can central banks pivot – away from using the unsustainable to sustain the unsustainable, and toward a better equilibrium for them and for the global economy (i.e., sustainability).”

View the complete transcript

He believes it is possible that our country’s leaders can put us on a ‘sustainable fiscal trajectory’ of manageable debt and modest economic prosperity. It is refreshing to read some guarded optimism from an informed and honest scholar such as Dr. El-Erian.