Is it the top for stocks?
In mid April 2007, the International Monetary Fund produced what Morgan Stanley’s perennial bear, chief economist Steve Roach, described as “the single most optimistic official forecast I have ever seen for the global economy”.
It was the IMF’s twice-yearly World Economic Outlook (see link below), the centrepiece of which was a forecast that the global economy would grow by 4.9% in each of the next two years after four years of actually growing by an average of 4.9% a year.
In the modern era of the world economy (that is, after the end of Bretton Woods monetary system in the early 1970s following the US balance of payments crisis and collapse of the dollar) there has never been a six-year period of such strong economic growth.
The only four-year period that has exceeded the past four was 1970 to 1973 (world GDP growth 5.4% pa), and that was followed promptly by a global recession sparked by the 1972 oil shock. The IMF is now forecasting another two years of the same, an extraordinarily optimistic outlook.
The IMF’s economic counsellor and research chief, Simon Johnson, is not some sparkling toothed private equity fund salesman. He and the very large team of economists at the IMF have a record of conservatism and, if anything, of getting it wrong on the downside.
Their global GDP forecasts come from “bottom up” work on each country; that is, the IMF economic research department makes detailed forecasts of each country then adds them up and adjusts for risk, to oversimplify the process.
So what are we to make of this? And how should it affect our investing?
I have no reason to doubt the IMF’s forecasts, although it is worth dwelling on the two main risks to this scenario highlighted by the IMF’s economists: the US housing downturn; and the risk of protectionism, especially from US Congress (I’ll do that below).
I feel secure being fully invested, with about half my share portfolio in good resource stocks and the rest in low private equity (at least they were when I bought them!) industrials. But I’m worried about the rest of this year and not for the reason you might think.
I’m worried the market will disconnect from reality and take off.
The euphoria brigade doesn’t need a lot of encouragement, and right now they’re getting it from the official source. In fact the IMF’s growth forecast is slightly higher than what is being discounted by financial markets at present.
That’s not surprising. Valuations are not euphoric at present: the forward price/earnings multiple of the Australian market is 17 times and for the resources sector it’s 11 times. These are not the sort of valuations that assume the four-year boom will become a six-year boom, as the IMF suggests.
To be clear about it: the IMF outlook confirms to me that the stockmarket is not euphoric at present and that the conditions are not in place for even a short bear market. It is not a time to sell good stocks (it is always the right time to get rid of bad ones) and I think you can still buy well-priced, well-run companies with confidence.
Corrections of up to 10% are a normal part of bull market life. We thought the one that started in late February would be a 10% but it wasn’t only 6.5%, all of which has already been recovered.
That means the 10% reversal is still to come and if we have another “up 7%” month like March, that correction will be more certain, more severe and less relevant (a 10% correction after a 7% up-month is obviously net 3%.
In fact, there is no reason to think the stockmarket will finish the second quarter of 2007 down for the year. It closed the first quarter up 9%, which should not be repeated in the second but nor should it be lost, given the strength of corporate profits and the economy, as well as the cash inflow from takeovers and superannuation.
Which brings me back to the “risk that dare not speak its name” that the market will actually go nuts and take off, that investors will really become euphoric about the combination of liquidity and economic conditions.
That’s been made a little more likely by last week’s IMF outlook and the four big takeovers going on at present: Coles, Qantas, Rinker and Alinta. These three transactions alone will put more than $50 billion in the hands of investors. In addition to that is the normal flood of superannuation money.
It is quite conceivable we will see a buying panic over the next few months as fund managers attempt to place this money.
This might sound like a splendid prospect, but it’s not. If average P/E valuations get above 20 times, as they have before other crashes, investing will become difficult and dangerous. There will be very little to buy; more of you will be inclined to let go of discipline and go with the flow, with disastrous consequences.
Charlie Aitken already thinks we are at or close to that point, but I fear we ain’t seen nothin’ yet.
Leaving aside the risk of a market spike and crash, as a result of the combination of the IMF boom forecast and massive liquidity, there are two more fundamental risks identified by the IMF in its report in mid April..
They are: the risk of a severe US downturn and the risks inherent in growing protectionism in the US, against China.
To boil down two 40-page chapters, the IMF basically says a serious spill over from the US housing downturn into a cutback in consumption expenditure would have a significant effect on the global economy, but in the end discounts this, saying that American consumers are likely to keep spending.
On protectionism versus globalisation, the IMF spells out in detail the declining share of labour income in the developed world, which is behind the push in the US for tariffs down 8 percentage points of developed world GDP since the early 1980s but in the end Simon Johnson and his team reject the idea that this will lead to a renewal of the sort of protectionism that led to the Great Depression.
The International Monetary Fund a creature of globalisation would say that, but I agree. However, either you believe in robust globalisation and free trade or you don’t; if you think it’s fragile, and able to be subverted by American and European agrarian socialists, then you will think the strength of the boom in the developing world, led by China, is also fragile.
I’m a bit more worried about American consumers than that, but I think that if the US housing bust was going to feed into a consumer spending retrenchment we would have seen more signs of it by now.
In my view the struggles in the housing and automotive sectors in the US will continue to put a cap on US growth but not produce a recession. In that case I am happy to believe the IMF’s forecasts and to remain fully invested in stocks that are exposed to the world.
My only concern is that with all the money around they will get stupidly expensive, in which case I will stop buying for a while, and sell into stupidity.