(BN) ‘Dangerous Time’ to Avoid Stocks, CLSA Strategist Napier Says

By Patrick Rial
June 25 (Bloomberg) -- Stock investors can look forward to another few years of gains as central banks engineer a return to inflation, providing a tailwind for global markets, according to CLSA Ltd. strategist Russell Napier.
An acceleration in inflation from zero to 4 percent is historically associated with gains in stocks as the benefits of rising prices accrue to profits instead of labor earnings or debtholders, Napier said.
Thereafter, a bearish cycle that began in 2000 will resume as the Federal Reserve allows inflation to spiral out of control and foreign investors stop buying U.S. sovereign debt, sending the Standard & Poor’s 500 Index to an eventual bottom of about 400, Napier predicts.
"We’re likely to get strong broad money growth, and I think it’s a very dangerous time to be out of the equity markets," the Edinburgh-based strategist said in a telephone interview yesterday. After a few years of gains "the Fed will launch its final attack on inflation and it will take us into a fairly terrible situation. They’ll let go and we’ll head for inflation."
The MSCI World Index has rallied 38 percent since dropping to a more-than 13-year low in March amid signs the worst of a global recession has passed. Asset purchases by central banks have also helped drive down borrowing costs and support inflation expectations, Napier said.

Asian Equities

Stocks aren’t a good hedge against inflation, however, as accelerating prices eventually lead to a collapse in equity markets, Napier said, citing a 1977 article for Fortune magazine by investor Warren Buffett. The ideal stock market environment is when there is disinflation, a move from high to low levels of inflation, as occurred between 1982 and 2000, Napier said.
The best bets for investors remain Asian equity markets, which are likely to be driven by domestic demand-related growth and will be less affected by problems in Western countries, said Napier, Institutional Investor’s top-ranked Asia strategist from 1997-1999.
Even though the U.S. stock market is already above fair value on measures such as the Q ratio, which compares market capitalization to the replacement cost of assets, and a 10-year price to earnings ratio, equities will likely continue on the current rising trend, Napier said.

Tobin’s Q

Tobin’s Q, a mean-reverting indicator of whether the market is overvaluing or undervaluing company assets compared with the replacement cost, was 18 percent above its historic average in June, according to data compiled by U.K.-based Smithers & Co.
The 10-year price-to-earnings ratio of the S&P 500, another long-run indicator of stock values, was 15 percent above its average, according to Smithers and data compiled by Yale University’s Robert Shiller.
Napier started his career in 1989 as a fund manager for the Scottish firm Baillie Gifford & Co. As CLSA’s Asian strategist he called the bottom of Asian equity markets in mid-1998.

Quite interesting as it is commonly assumed that stocks are a good hedge against inflation.

Stocks are a good hedge against inflation? could you explain more about that? I mean its common knowledge that gold/commodities are often used for hedges against inflation, but I haven't heard about stocks being a good hedge against.

Snapman wrote:

Stocks are a good hedge against inflation? could you explain more about that? I mean its common knowledge that gold/commodities are often used for hedges against inflation, but I haven't heard about stocks being a good hedge against.

This one is a bit tough, not easy to argue what is common knowledge or not I'll try to answer with arguments i don't 100% agree :
Inflation is the sustained increase of the price of goods and services, thus it is assumed that it will increase the earnings of the companies, thus the price of their stocks. More simply said : the inflation is the increase of the prices, including the stock prices...

By the way, if you assume that commodities are a good hedge against inflation, you can assume that the increase of the price of the commodities would increase the producers stock price as well.

This being said, like all the common knowledge, it's of course not totally true... and that's precisely why I found the article interesting.
I believe that creating massively inflation is the good way to get out of the crisis (that's the idea of QE, now the question is how to restart the consumer spendings), that's one of the lessons from the Great Depression and it looks like the Economists have integrated this, but this kind of analysis are here to remind us that we tend to forget that inflation is a plague as well.

lol thats making some broad indirect connections, but as you said, one could argue such a line of thought. Though as to whether or not it is credible is a different story.

If you bring up some solid evidence of this then I would concede to this point, but other wise the connections seems quite weak to me from an economic perspective (eg. not all commodities have direct relationships with stocks, as not all stocks require commodity inputs for a majority of their production, maybe this would be the case if we were all back in the 19th century where many nations were still agrarian)

I also want to stress, one must becareful not to blur the "stock markets health" with the "economies health" as these are two very distinct things. With this context in mind, Im still not sure I follow your logic on how we get out of this crises? I follow that inflation may lead to increased stock prices, however the fundamental health of these equities haven't changed, as it would only be nominal movements in prices.

Perhaps you can clarify for me once more on how inflation will get us out of this crises? (or perhaps my logic is flawed?)

Hi Snapman, OK I owe you some more details, I was definitely too evasive on my previous post, sorry.
In this post, I will come back to my argument on inflation and stock market prices. The inflation thing will come in a later post, sorry Dear Friend, you'll need to wait more but this one takes more time to develop...

As you know, the most broadly used method for valuing a financial asset, actually any asset type from a stock to the most complex derivatives, is to assume that the price of the asset is the sum of the discounted expected future cash flows (dividends, earnings, cash flows...). This valuation formula indicates that inflated earnings and dividends lead mechanically to help the stock price increase and shows to that extent that a stock is a better hedge against inflation than "Fixed income" assets : bonds for instance. I guess now that the assumption that stock is a good hedge against inflation lies in the prospects that (I'm quoting Napier above) "the benefits of rising prices accrue to profits instead of labor earnings or debtholders". Now is it true ? : as a rough measure, I quickly looked into the correlation between the Dow and the CPI index. Those two indices show a high correlation of above 0.8 (the mathematical correlation ranges between -1 anti-correlated to 1 correlated) from 1988 and 2003 to decrease to 0.32 now (the thing is the real inflation was in the 2000s mainly in the house prices which are not reflected in the CPI)
The second component of the valuation formula, that the common prospects might neglict too much in my opinion (well, actually I don't know...), is the way the cash flows are discounted. The higher the interest rate yields are, the lower the discount factors (then mechanically the stock prices). In an inflationary scenario, this second component plays clearly against the increase of stock prices. That's precisely Napier's warning on an inflation spiralling out of control that would lead to astronomic interest rates as the bid for US sovereign debt would dry.

Like you Snapman, it's more difficult for me to buy without further analysis the argument on the weight of the commo producers in the stock indices. I need to do more homework to identify and assess those "broad indirect connections", but generally I quite like this kind of spread strategy playing correlation (long the best - short the worst) in my trading. Those hidden correlations are more difficult to detect and arbitrage so it drives to profit when you're among the first to identify them.

Sauros wrote:

Hi Snapman, OK I owe you some more details, I was definitely too evasive on my previous post, sorry.
In this post, I will come back to my argument on inflation and stock market prices. The inflation thing will come in a later post, sorry Dear Friend, you'll need to wait more but this one takes more time to develop...

As you know, the most broadly used method for valuing a financial asset, actually any asset type from a stock to the most complex derivatives, is to assume that the price of the asset is the sum of the discounted expected future cash flows (dividends, earnings, cash flows...). This valuation formula indicates that inflated earnings and dividends lead mechanically to help the stock price increase and shows to that extent that a stock is a better hedge against inflation than "Fixed income" assets : bonds for instance. I guess now that the assumption that stock is a good hedge against inflation lies in the prospects that (I'm quoting Napier above) "the benefits of rising prices accrue to profits instead of labor earnings or debtholders". Now is it true ? : as a rough measure, I quickly looked into the correlation between the Dow and the CPI index. Those two indices show a high correlation of above 0.8 (the mathematical correlation ranges between -1 anti-correlated to 1 correlated) from 1988 and 2003 to decrease to 0.32 now (the thing is the real inflation was in the 2000s mainly in the house prices which are not reflected in the CPI)
The second component of the valuation formula, that the common prospects might neglict too much in my opinion (well, actually I don't know...), is the way the cash flows are discounted. The higher the interest rate yields are, the lower the discount factors (then mechanically the stock prices). In an inflationary scenario, this second component plays clearly against the increase of stock prices. That's precisely Napier's warning on an inflation spiralling out of control that would lead to astronomic interest rates as the bid for US sovereign debt would dry.

Like you Snapman, it's more difficult for me to buy without further analysis the argument on the weight of the commo producers in the stock indices. I need to do more homework to identify and assess those "broad indirect connections", but generally I quite like this kind of spread strategy playing correlation (long the best - short the worst) in my trading. Those hidden correlations are more difficult to detect and arbitrage so it drives to profit when you're among the first to identify them.

----

Firstly Ill apologize for my previous statement about your call being broad and indirectly measured. Thank you for clarifying the idea a bit.

Im familair with the basic concept of valuing assets, though I've never taken a finance course or read up any 101 finance books. From what I follow inflation will lead to higher earnings and dividends which in turn will theoretically push up stock prices. So inflation --> higher earnings --> higher stock price = good hedge because it returns more money vs fixed income (anyway no one would in their right mind buy bonds with high inflation around; ie inflation eating away your fixed returns).

About napiers quote:

I guess he maybe right unless you get cost push inflation. The risk of cost push inflation as seen in the 2007's and early 08 is quite relevant I might say (except maybe no in the euro zone). With a weak dollar another commodity rally is indeed possible, and with higher production cost its possible labourers will demand higher wages in a recessionary enviornment as they are already are being squeezed as it is. This hits on both main points of cost push inflation.

Though, arguable demand pull inflation maybe more relevant considering the amount of government spending in fiscal recovery packages around the world.

point being, if we see cost push inflations, all those lovely inflated earnings may just go straight back in to the consumers pockets with higher commodity prices and a possible labor union movemetns ( the union lobbying power is huge in the obama adminstration, one union alone contributed 61 mil to the obama campaign) leading to wage increases.

though if we see demand pull inflation, we will only see short term growth as one has to bear tax implications in mind with huge government spending. so i guess on the demand pull side, given if sentiment is inline with expectations, a short term rally is indeed possible with the advent of inflation.


its always interesting to see an economicist view vs a financialist view...


lastly: can you explain your rationale in using 1988 as a base year? recently have you seen the CPI data and equity reactions? maybe you want to play around with that base year number.

I definitely in the future would like to work with correlations in the currency arena hopefullly I can learn lots from you master !

Hi Snapman, finally a few more details about the inflation stuff...
First a word on your comment "anyway no one would in their right mind buy bonds with high inflation around; ie inflation eating away your fixed returns". You pointed here the essence of the trading! The market is so that in most of the conditions you will find as many buyers as sellers, all is about the price.
Back to the inflation thing now! Posting here my opinion is the perfect opportunity for me to re-assess my view on the big picture and re-think of the appropriate strategy.
Actually my opinion on inflation as a solution to the current crisis may seem today without anything innovative and even outdated as it looks like that's partially the strategy the G20 leaders agreed to adopt. Having built this opinion very early this year, I managed to benefit from the Quantitative Easing with some very good calls on EURCHF and on T-bill notably. Of course, too late-too small and I partially gave the profits back shorting the stocks as maybe the market gained confidence in the global strategy and interventions much quicker than I expected....(not sure actually what triggered the rally).
Firstly, I think creating artificially inflation though massive interventions is one of the lessons of the Great Depression. Back to the 30s, most of the economists and policy makers believed that the crash of 29 was a "healthy" (OK to some extent...) process : the market went to the the top on its own, it then crashed on its own and it will recover on its own. Afterwards, it looks like that the economists now tend to agree that a more efficient solution would have been to create inflation and inject artificially money into the system. A crisis is a self fulfilling process : in a crisis, the consumers don't spend money and tend to save it, that leads to less production, less earnings and less jobs. To some extent we are in a crisis because we know we are in a crisis. Injecting money in the system (ie creating inflation) is then a way to re-launch the consumer spendings back.
Secondly, the underlying cause of this crisis was the credit bubble and the explosion of the debt (for both households and corp) and the massive over-leverage broadly granted (Greenspan !!!). Thus to me, the solution to the crisis must involve a massive reduction of the debt. To me, one of the most efficient solution to get out from debt is to inflate it out and that's probably as well the solution the US government will chose to solve the problem of their own debt at the end : we all know more or less that in the long term, the USD is doomed...
After this, you may say : "OK, Sauros, the G20 agreed that inflation is the solution to the crisis as you argue, so you should be bullish now...". That's not that easy as a few key points still need to be sorted on that side of the problem :
- The money injected in the system needs to circulate and be spent. I'm not sure the interventions we saw and the credit easing allow this easily.
- Who will pay at the end for the losses we will need one day to recognize?
but it's the matter for further discussions.
For the time being, on the inflation topic I suggest you have a look the article I found on Reuters : G20 agrees inflation is solution to the crisis and on my view on the solution at a previous post of mine : Sell the DIP

i agree this seems to be the consensus seen among central bankers. though i worry for the long term effects.

Firstly you bring up an excellent point about circulating the injected money. Sure its all great about giving liquidity and capital but its useless ifs not getting around the system.

As the old typical saying in academia goes... banking is pumping the blood (money) through the system... ok that wasn't exactly the saying but thats the jist. Which brings me to my next point.

It has been all about of sentiment and lack of confidence to loan on the consumption side over the past 1 and a half or so, which is why this inflation stuff hasn't worked and argualbly will take time. My opinion is that inflation may not be necessary but this something systemic and fundamentals need to be changed over the long term.


however what about the long term effects: huge debt for the futrue tax payers, this will be a huge drag on the economy later as our childrens childrends children will have to be paying for our current mistakes...

Also inflation may just return us to the good ole boom bust days and these credit cycle everyone complains about when they come around (im sure if you look at historty you will hear the same complaints over and over but in different scenarios)

Also, just because the government keeps pumping money into the system doesn't mean its a good thing. I point to the chinese credit growth. There are growing concerns that the government is constantly pumping money into the system and a good portion of that money is speculative either going to gambling or going to the stock markets.

If credit conditions get out of controll this can be bad for world economies as much of the capital flows are going to Asia right now!

But anyway thast my 2 cents on that

-----

I was wondering if you can explain the difference between credit easing (what the japanese gov't did in the early 90's when they were in a liquidty trap vs quantative easing (what the us fed is doing now). I woudl appreciate the clarification!

-snapman

Snapman wrote:

I was wondering if you can explain the difference between credit easing (what the japanese gov't did in the early 90's when they were in a liquidty trap vs quantative easing (what the us fed is doing now). I woudl appreciate the clarification!

-snapman

Hi, the difference between QE and Credit Easing is a bit too subtle for me, non-economist (Hey Snapman, you the economist!) , and first I have to confess it's not 100% clear to me neither. The thing it looks like Bernanke referred to FED's policy as Credit Easing to diffentiate from QE (used by the Bank of Japan and that obviously didn't work) but finally he uses a mix of the both concepts.

The idea of both is to expand the money in circulation in the system (injecting money or creating inflation artificially as I referred before). A central bank is basically a ... bank with other banks having an account with (a "reserve account"). With $1 in its reserve account, a bank can lend $10 (or print paper money), it's a kind of leverage granted. In order to create money, the central bank loads its own balance sheet with assets (government bonds, foreign currency, gold or others securities) it purchases from a bank by crediting electronically the amount of its reserve account.

The assets purchased, government bonds in the case of the QE and private securities in the case of the Credit Quantitative differ and the difference according to Bernanke sound to me like a subbtle technicality : whether the asset side (CE) or the liability side (QE) of the Central Bank, as he said at the LSE in January 09 : "Credit easing resembles quantitative easing since it involves an expansion of the central bank's balance sheet. However, in a pure QE regime, the focus of policy is the quantity of bank reserves, which are liabilities of the central bank; the composition of loans and securities on the asset side of the central bank's balance sheet is incidental."
Now the Credit Easing come under a different Credit Markets environment as well where "Credit spreads are much wider and credit markets more dysfunctional in the U.S. today than was the case during the Japanese experiment with quantitative easing," Bernanke said and the purchase private securities aims at tightening the credit spread and focus more specifically on some key sectors of the Credit markets.

Actually the Fed decided in March to adopt a mix of the policies as they Fed indicated in rather general terms that it would be buying up to $1,450 billion in mortgage-backed securities and up to $300 billion in U.S. Treasuries (and I was among those you bet on the latter ). Bernanke's testimony in July seems to indicate that Fed will keep a "highly accomodative stance of monetary policy" for "an extended period" confessing to some extent that the current policy was not enough to create enough inflation. He argued as well that the Fed had the tools to reduce or neutralize the impact of the increase in bank reserves, when it becomes appropriate to do so, to prevent the emergence of inflation pressures.

I posted in the economic forum an article I found on ft.com that is of interest in that topic :
Quantitative easing, credit easing and enhanced credit support aren't working, here's why