Thursday, August 4, 2011

Valuation & Gold

America is starting to have a problem that long dogged comedian Rodney Dangerfield, who often complained: “I don’t get no respect.” On Monday according to Reuters, Vladimir Putin had the following to say about the recent debate in Washington between the Democrats and Republicans about raising the debt ceiling and reducing the deficit: “Thank god that they had enough common sense and responsibility to make a balanced decision.” He added, “They are living beyond their means and shifting a part of the weight of their problems to the world economy.” To add insult to injury, he complained: “They are living like parasites off the global economy and their monopoly of the dollar.”

China’s official news agency, Xinhua, which often voices the true feelings of the country’s political elite, described the recent battles over the Washington debt deal as a “madcap farce of brinkmanship.” The commentary, published in many Chinese newspapers, went on to warn the US that it must implement more responsible policies if it is going to solve its problems. And it warned that the emergency debt bill thrashed out between Democrats and Republicans “failed to defuse Washington’s debt bomb for good, only delaying an immediate detonation by making the fuse an inch longer.”

It has been my view for some time that the stock market’s valuation multiple is directly related to the geopolitical stature of the United States. The US certainly wasn’t standing tall during the late 1970s when Jimmy Carter was the President. The P/E of the S&P 500 hovered between 7 and 8 times forward earnings as inflation and interest rates soared during the second oil crisis. In Iran, the Shah was deposed by Islamic revolutionaries who held 52 Americans as hostages for 444 days from November 4, 1979 to January 20, 1981.

The P/E rose during the 1980s under President Ronald Reagan, who supported Paul Volcker’s tough anti-inflationary monetary policies, while stimulating economic growth with lower tax rates. President Reagan along with President George H. W. Bush pursued foreign policies that led to the collapse of the Soviet Union, marked by the removal of the Berlin Wall during 1989, when the P/E was over 10.

The US won the Cold War and emerged as the world’s sole superpower during the 1990s. The P/E spiked up to 15 after the end of the first Gulf War in early 1991. It then soared under President Bill Clinton to finish the 1990s around 25. America was the epicenter of the high-tech revolution, and had an entrepreneurial economy that was widely admired. Inflation was low and so were interest rates. Congress held a hearing in February 2001 to discuss what to do about huge projected federal government surpluses!

Then the tech bubble burst. Enron imploded in late 2001. Terrorists attacked the US on 9/11, and the P/E was down to 22.1 by the end of 2001. During July 2002, Worldcom filed for bankruptcy, and the P/E fell to 15.3 by the end of that month. These companies and others were brought down by accounting scandals. The federal budget outlook deteriorated rapidly when President George W. Bush pushed for tax cuts to stimulate the economy while launching wars in Iraq and Afghanistan. That was the beginning of the end of Pay-Go and fiscal discipline in Washington.

The P/E continued to decline during the bull market from 2003 through 2007, led by a steady drop in the valuation multiples of large-cap tech stocks. Investors learned from the 1990s tech bubble to pay less for rising earnings. Then, the financial crisis hit. Lehman blew up during September 2008. The P/E dropped to a low of 9.3 during October 2008. It was back up around 14 during the second half of 2009 and the first four months of 2010, as the economy recovered from a very severe recession. It then dropped again to just below 12 on mounting concerns about a double dip in the US and a sovereign debt crisis in Europe during the spring and summer of 2010, before rising back up to 13.

The budget situation only got worse under President Barack Obama as he resorted to a massive Keynesian fiscal stimulus program to revive economic growth. It didn’t work. In July of this year, the P/E was back down to 12. After Monday’s selloff, it was down to 11.7. Investors are fretting that the economy is stalling and that Washington is too politically paralyzed and too deep in debt to help. Washington may actually worsen the situation as the Republicans push for spending cuts, while the Democrats push for tax increases.

Could the P/E drop back below 10? Unfortunately, it could if more investors see more similarities between Jimmy Carter and Barack Obama. Thirty-two years ago on July 15, 1979, Carter delivered his depressing “crisis of confidence” speech, in which he berated the way of life of Americans and questioned our values. In his mind, the oil shock of that year and soaring inflation were our fault. The speech was later dubbed the "malaise speech," even though Carter never used that word. Here is a link to a remix,” showing the extraordinary similarities between Carter’s speech and numerous similar preachy statements made by Obama in some of his speeches to the nation.

In the chart above, you can see that there is a long-term inverse correlation between the P/E versus the inflation-adjusted price of gold, which is approaching the record high of $866 per ounce during January 1980, when Carter was President. This does not bode well for the valuation multiple. The real price of gold was $682 during June. To match the 1980 peak on an inflation-adjusted basis, it would have to rise over $2,500 in current dollars. If it gets there, odds are that the P/E will be lower.


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