The Aftershock Investor: A Crash Course in Staying Afloat in a Sinking Economy (18 page)

Stock analysts and cheerleaders naturally assume (almost unconsciously) that there is a natural economic growth rate. That means an economic growth rate that always goes up no matter what, and that means a stock market that always goes up. We discussed earlier why there is no such thing as a natural economic growth rate—there is simply no theoretical or historical basis for a natural growth rate in any country at any time. All economic growth is basically derived from productivity improvements, and those happen only when people make changes to improve their productivity. Even during periods of high-productivity growth, like the twentieth century, the growth rates can change dramatically because productivity improvements are not being made all the time. Just look at China over the past century or even the United States over the past century. It’s hardly been one solid straight line of growth.

The second assumption is harder to refute since we are still living in a multibubble economy and it is very hard for people to see bubbles until they pop—especially people who don’t want to see it. We made the case for the multibubble economy quite a while ago in
America’s Bubble Economy
in 2006, but don’t expect the cheerleaders to see it. It’s simply not in their stock and bond salesmen’s interest.

Aftershock wisdom is clearly different from conventional wisdom on stocks. It looks at some basics. As discussed in Chapter 3, GDP grew 260 percent between 1980 and 2006, yet the stock market grew over 1,000 percent. That just doesn’t make economic sense. Big growth that is not firmly based on real fundamental economic drivers adds up to a bubble. Research by the eminent economist Milton Friedman showed that over a longer period of time, company earnings don’t outpace growth in GDP. That’s because any excess company earnings above economic growth are eliminated.

As we mentioned earlier, if you look at a longer-term historical perspective, the stock market grew 300 percent from 1928 to 1980—a period of more than 50 years of massive economic growth and population growth—whereas in just 20 short years, from 1980 to 2000, it grew more than
1,000 percent
. We think you will agree that
Figure 4.3
even looks like a bubble. Why else would there be so much growth in the stock market so quickly, compared to the past? And, economic growth was stronger in the past, not weaker.

Figure 4.3
Growth of the Dow, 1928–1999

The stock market had modest but reasonable growth until the 1980s and 90s when growth just exploded.

Source
: Bloomberg.

Also, it’s not just the rocket rise of stocks, it’s the whole rising multibubble U.S. economy and the rising multibubble world economy that makes an even greater case for calling this a stock market bubble. We discussed this in Chapter 1 and in more detail in
America’s Bubble Economy
and
Aftershock
, Second Edition, so we won’t go over it again here. Suffice it to say that Aftershock wisdom calls this a stock market bubble. And as you already know, bubbles eventually pop.

But if this is a bubble, how big is that bubble and how much of it is nonbubble? In other words, how much do stocks have to fall to be more properly valued? Another way to look at it is what is the correct way to value stocks?

The problem with the way CW currently values stocks (as described earlier in this chapter) is that all the CW valuations rely heavily on assumptions about the future economy, future earnings, future interest rates, and other variables that are highly subject to optimistic and bubble-infused interpretation.

So how can we get a valuation method that isn’t so easily influenced by bubble-think?

Aftershock wisdom gives us an effective and realistic method for valuing public companies on a nonbubble basis. We call this method the leveraged buyout model of valuation. It’s not a perfect name because it conjures up an image of the outrageously overpriced LBOs that drove up the private-equity bubble of 2007. However, we still use it because it is technically correct.

Unlike the LBOs that drove up the private-equity bubble of 2007, which essentially relied on private-equity firms paying the highest possible price for a company fueled by incredibly stupid bank loans and then hopefully flipping it for an even crazier public price down the road, the LBO valuation model we are talking about is entirely different.

What we are talking about here is the leverage that would be used for purchasing a normal private company where a bank lends money for the purchase and that loan is paid back to the bank out of the company’s earning over a period of several years. The assumption is that the entire price of the company is determined by
what a bank is willing to lend
to buy the company, assuming the bank is paid back entirely out of the company’s earnings. In this model, there is
no
assumption that the bank loan will be paid off by the sale of the company. The loan can only be paid back to the bank
out of future company earnings
; therefore, the bank will lend only the amount that can be paid back in this way. That really limits the potential for false bubble valuation.

By definition, a company’s LBO valuation will be a low valuation by today’s standards. However, we believe this is correct now and later it will be the
only
valuation for any company in the Aftershock. This is the “how low it can go” valuation below which the stock market will not go. If the stock market values it for less, investors can then buy the company for the LBO valuation amount and make money by buying the company at a low price. They pay back the bank loans in a few years and keep any profits to be had after that time. In the Aftershock, the payback time banks will require will be very short, probably no more than two to three years, because the uncertainty of earnings is great enough that many banks won’t want to take the risk of loaning more money than can be paid back easily in a short period of time.

For example, if the stock market values a company at $40 million dollars and its earnings are $20 million dollars a year, a bank (or other group of lenders) will likely be willing to make a loan of $40 million to buy the company under the assumption that it is quite likely it will recoup the $40 million in a short period of time (two years). Hence, the value of any public company has a floor, and that floor represents the
nonbubble
valuation of the company, which is the amount a lender will lend to purchase the company over a short period of about two to three years. Any value above that LBO valuation is a bubble value.

This method of valuation will produce very low valuations of companies, but they will be nonbubble valuations. This will be the model used once the Aftershock hits. It’s also where potentially a lot of money will be made by those few investors who are still active enough to participate in the market. Needless to say, banks will want hefty equity on the part of the buyer for any of their loans, and when the Aftershock is at its worst, there will be very few loans of this type. The point is that in order to correctly value companies on a nonbubble basis, this method will be the only reliable way of accessing a company’s worth. There has to be enough future earnings to pay off a loan in a reasonable amount of time, otherwise the loan is not justified—and neither is the company valuation.

As discussed earlier, the normal valuation methods are highly subject to economic and financial assumptions that are changing and are about to change even more. What matters now is bubble-think and the ability of various economists and financial analysts to make people feel more comfortable believing that bubble valuations are real valuations.

Investor attitudes are key to stock market valuations today. However, investor attitudes can and will change. Bubble blindness, after all, is only a temporary condition. All bubble blindness has a cure:
time
. Over time, it becomes increasingly obvious that we really are in a multibubble worldwide economy and there is no “natural” economic growth rate to save us. Over time, it will also become increasingly obvious that the government cannot borrow enormous amounts of money that is enabled by enormous amounts of money printing without creating inflation.

Most importantly, bubble blindness is quickly cured by others who lose their blindness. If only 20 percent of the investing public loses their blindness, that is enough to pop the bubbles. As with all bubbles, only a few investors will get out the door before this bubble pops. Most investors will stay blind until the bubbles pop and their money suddenly goes to Money Heaven.

So, bubble blindness is always temporary. The only question is whether it is cured before the bubbles pop or it is cured when the bubbles pop.

Investors will not all run out and stay out of the stock market at the first signs of trouble. That’s why the stock market will not fall all at once but will decline in stages, leading up to the Aftershock, before the biggest crash. Here is our best approximation of how that will happen.

During the global financial crisis of late 2008, stock markets around the world fell 40 percent and more. Since then, massive money printing by the Fed and massive borrowing by the U.S. government have been helping to boost and support the stock market. But the fact that stock investors are generally still trusting current stock valuations doesn’t mean those valuations are worthy of that trust. Lots of things can temporarily sell at the “wrong” price for a while until investors figure it out. But at that point, investors’ views of trustworthiness can change very quickly.

Stocks will likely not fall dramatically in the immediate future, although investors are getting more skittish and the Dow could easily drop 100 to 200 points or more in a day, depending on the news. However, in the recent past, it seems that even very negative news does not always create as big a drop as one might expect. When stocks do fall, prices will not drop in a straight line. In the short term, each time stocks fall a bit, there are some investors who see bargains rather than a falling bubble, and they begin to buy those “bargains,” which prevents a deeper fall. Also, there is some reason to question whether this market is occasionally manipulated to some extent.

As long as the Fed is able to continue massive money printing without significant inflation (yet) and as long as the government is able to continue its massive borrowing, the United States will continue to be viewed as a relative safe haven, especially compared to Europe, U.S. stocks still have appeal for both foreign and domestic investors. Remember, these people are in love with stocks, and it will take some time to give that up.

Over time, as inflation and interest rates rise, the bloom of love will begin to wilt. Certainly, rising inflation and rising interest rates will not be good for companies or their stocks (or for any of the other bubbles). That’s because massive stimulus is not the same thing as massive growth. And, increasingly, the stimulus will have less of an impact, over shorter and shorter periods. “Green shoots,” if any, will turn brown faster and faster. Without a real recovery, there will be lots of stock market oscillations.

Even if the Fed were to stop all money printing today (and they certainly will not), we have already increased the money supply threefold since March 2009. That is more than enough to give us plenty of future inflation and rising interest rates to damage the future economy and the stock market. High inflation and high interest rates are not going to occur overnight. It will happen over time. So the more time that goes by, the greater the risk to stocks.

However, time is not the only risk factor. There are a number of other potential triggers that could push things along sooner. Among these possibilities are further problems with the European debt crisis, an economic downturn in China, or a potential Israeli strike on Iran. These were discussed in more detail in Chapter 2.

Because so much of any bubble is driven by investor psychology (both on the way up and on the way down), bubbles can pop very, very quickly. Please see Chapter 11 for details about how the stock market may crash.

Before the Aftershock, the federal government can, and will, ease the pain of this for as long as it can with more money printing. But as we’ve said, eventually this medicine becomes a poison, and there will be little the Fed or anyone else can do without just making things worse. Right now, the Fed can put money into the system with very few short-term consequences, as any potential inflation will lag at least by a couple of years behind money printing.

But once inflation gets going (in the 5 to 10 percent range), the lag time behind any new money printing will get shorter and shorter, and investors will become increasingly concerned. Once enough investors, particularly foreign investors who now own so many dollar-denominated assets, begin to exit, the bubble will suddenly burst as more and more investors try to flee.