Russell Napier, consultant to stockbroker CLSA and author of the popular Anatomy of the Bear, talks to our editor in chief about what investors can expect next from stockmarkets.
Merryn Somerset Webb: You’ve said that you think stockmarkets are due another low.
Russell Napier: Yes. Investors tend to think they lose most money in a short, sharp shock – let’s say the 2008 experience. But history shows that’s the exception, not the rule. Real destruction of wealth comes in a different way.
People talk about 1929-1932 as if that’s the archetypal bear market. But the actual archetypal bear market is a low, slow grind from a very high valuation to a major undervaluation (sometimes over 20 years), times when prices didn’t go anywhere, even as nominal earnings went up. Anybody who was involved in the 1964-1982 market knows that.
The market bounced around and ended up nearly to where it was in 1964 by 1982. Even accounting for dividends, real returns were dire over that period.
Merryn: And markets are expensive now?
Russell: Yes. The cyclically-adjusted p/e, one of the few valuation methods with any track record, is very high, not far off its historical peaks. Over long periods, CAPE, like the Q ratio (see box below), can tell you a lot about where markets will go. The problem is that it can’t tell you where they’ll go shorter term.
If you look at it in 2003, you will see that the market was grossly overvalued, as overvalued as 1968, 1937, and pretty close to 1901. The stockmarket then doubled, went up 100% from 2003 to 2007. Try and judge markets in the short term and you can make some significant errors. Selling equities in 1995 as GMO’s Jeremy Grantham did, for example, costs short-term performance, but was clearly the right thing to do in the long term. Still, look at Q and CAPE and they can tell you about the future price in the long run.
That’s good, because at least it gives us some of the right questions to ask. The problem in this business is that every morning you walk into the office, you switch on the Bloomberg machine and there are 57 obvious questions. Only three of them actually count. But which three? If you can go back and explain anything in financial history, you rarely find more than two or three variables that really drove prices. Yet every morning at your desk, you’re worrying about Greece; about inflation; about China – you’re worrying about something else. You’re worrying about 57 different things.
Merryn: What’s the other question to ask?
Russell Napier is the author of Anatomy of the Bear, the definitive guide to how real bear markets work. He is also a consultant to Asia-based stockbroker CLSA, where he writes about the issues facing the global markets; and he is the creator of ‘A Practical History of Financial Markets’ – a particularly brilliant course on offer at Edinburgh Business School.
Russell: Ask about inflation. I’ve looked at what happens at the peaks and it seems extreme valuation peaks are usually driven by the same thing: the market starting to believe in high levels of growth with low levels of inflation. In 1901, inflation was low and technological innovation was coming along. The run up to 1929 was typified by electrification, which, along with the automobile, seemed to lift the non-inflationary growth rate in America onto a higher plain.
In 1968, post-World War II, we had the rise of the consumer and the rise of the computer and very high levels of non-inflationary growth in America, which people began to project into the future.
In 2000 it was the internet. In fact, if there were one phrase you want to put at the top of all these extreme CAPE numbers, it would be ‘the New Economy’. One in which a dis-inflationary technology of some kind creates a high-growth, low-inflation illusion that can be extrapolated indefinitely. If simultaneously you think that the growth rate has gone up but inflation isn’t moving, then you get a low discount rate, and hence a higher valuation. Rising inflation – and government reaction to it – then ruins everything.
Merryn: So inflation illusion can define a top. What about a bottom?
Russell: Well, if you look at stockmarket lows you’ll see they always coincide with deflation, or a belief in deflation. Equities are not an asset. They are a fine sliver of hope between assets and liabilities. Firms have assets and liabilities. But if the value of their assets adjusts downward, and those of their liabilities does not, you can wipe out their equity pretty fast. Deflation is awful on a cash-flow basis too, if they have fixed-cost debt, for example. Equities are not a pure asset and that makes them particularly susceptible to deflation; when deflation comes along, the chance of them going to zero doesn’t rise in a straight line – it leaps up.
That’s exactly what happened in 2008. Once there was a real risk of a debt deflation, markets began to discount bankruptcy. None of us had really seen that in our investment lifetimes, but now we see how when there is even a sniff of deflation, things collapse. Then, of course, in 2009, as the deflation risk disappeared with quantitative easing (QE), markets leapt. So all of the bottoms coincide with either deflation, a belief in deflation, or a significant banking crisis, which can result in deflation.
Merryn: So are you expecting to see deflation again in the next few years?
Russell: I’m expecting a deflation shock followed by serious inflation. Let me give you a scenario of what could happen in the next five years. Bond yields start going up, partly because of inflation and partly because governments meet a kind of tipping point in their finances where they just have to pay more to borrow.
But if that happens, even as growth is slow and the banks are still in trouble, we get another deflationary shock. Take the Fed. Heading for deflation in 2008, it printed money and bought bonds. They got away with it that time because everyone else was at it and the currency didn’t collapse. But when it happens again, they’ll know it will just crush the exchange rate.
So maybe they hold back for a year, creating a great deflationary scare and a collapse in valuations. Then they won’t have any choice but to go back to money printing and, eventually, inflation. The question then will be how far they can go down the money-printing road without destroying the exchange rate.
Merryn: You say governments may reach a debt tipping point. How might that play out?
Russell: Via capital controls that will effectively force private savings to fund governments via the debt markets. The general belief is that markets discipline governments. But if you’ve read any financial history you know that governments like to, and can, discipline markets. Given the tower of public debt out there, investors are all going to want to drive up the yield for government bonds. But governments aren’t going to like that. And there are a couple of easy ways they can stop it just by manipulating markets. One would be capital controls, which is what we had the last time we had government debt levels this high.
The other one would be high transaction taxes on equities. Let’s say tomorrow I invented a tax of 4% on all transactions in equities and of zero on government bonds. That might force you into government bonds. Let’s not forget that for a decade in the 1970s, real yields on government bonds were regularly negative in Britain. Why? Because we had capital controls, so there were a limited number of assets you could buy. You just had to choose between the best of a bad bunch. That kept yields down.
The same thing happened in World War II. There was a huge debt alongside price controls that kept the money in the country, forcing private savings into public debt, protecting the exchange rate and heading off inflation (alongside price controls and rationing) at the same time. The American economy in 1944 was as close to a command economy as it has ever been and I hope is ever likely to be.
Merryn: Do you see the euro surviving?
Russell: There is one period I think is useful in terms of the euro: the creation of the dollar. If you think that went smoothly, you’re ignoring 1861 to 1865 – the Civil War. The North wanted the South to give up slavery. To which the South replied, if we give it up we’re bankrupt. But if they had had independent currencies, this needn’t have turned into a war. The South could just have depreciated and offered a market wage to everybody who wanted to come.
When your currencies are flexible – like those of America and Britain – there are ways around things. The point is that the euro is actually a political, not an economic, thing. The economists may sit there and say, ‘well if Greece can get its wages down 20% then everything is fine’. That may be absolutely right. But have they ever tried reducing wages by 20% in a democracy? It doesn’t work. It’s a political impossibility. The only way the euro can survive is as a weak currency that suits all its constituents – it cannot survive as a strong currency. Democracies don’t deflate – there is not the political will to make it happen.
It has been said that if we have a combination of youth unemployment over 30%, deflation and temperatures over 30°C, that’s when you get serious social unrest. That’s what this summer holds. But I don’t think it will end with break up. Just with easy money, growth in the core (Germany), and inflation. Is that really such a bad solution, given the alternative of huge structural disruption on a break-up of the euro?
Merryn: There is clearly a bubble building in emerging markets though?
Russell: Yes, one so obvious even the governments can see it. But the thing to watch for here is inflation. If Asian economies are going to head for domestic-driven growth – as they have to, given that 40% of the world’s population can’t get rich selling to the other 14%, they are going to need to control their own currencies. They’ll want stronger currencies to help deal with inflation, not lower ones to boost exports.
That means they’ll need entirely independent monetary policy, not exchange rates pegged to the US dollar. That’s why the situation a few weeks ago, when Singapore said it was to revalue its exchange rate up by 1.5%, might turn out to be so important. This may augur a new structure for emerging-market monetary policy that will be a major structural change. That’s got knock-on effects for the US dollar and, more importantly, for America’s Treasury market.
Sure, it might remain the world’s reserve currency, but if you aren’t trying to control your currency against it, you don’t need to keep accumulating dollars and Treasuries. So as the links to the dollar go, so will demand for US government bonds – something that would also push up yields and help precipitate the crisis I mentioned before. Of course, Asia might go for capital controls too as a response to too much money coming in and over-heating risks. You’ve got to watch this.
Merryn: So what do we buy now?
Russell: A basket of Asian currencies. I have read all the biographies of the great American capitalists of the 19th century and about how they made their money. All of them are slightly different, but one thing they all have in common is that they were able to mobilise cash to buy things when they were cheap.
Asian currencies may not be offering a fantastically high return, but it’s the only buy-and-hold asset I can think of for now. Over the long term, the real return from equities is around 6%. A basket of Asian currencies could produce similar, or even higher, returns for sterling investors over the next few years. That may seem low to some investors, but preserving wealth with very reasonable returns is the order of the day as we wait for equities to become cheap.
We are waiting for one more deflation scare to pass, very probably driven by a crisis in the Western sovereign debt markets. When this occurs, investors need to watch the cyclically-adjusted p/e and Q ratio. It seems likely that some time in the next five years, equities could become very cheap indeed on those measures. Then would be the time to become the new Mellon, Carnegie, or Rockefeller, and buy high-quality corporations when they are very cheap.
Of course, it will seem madness to do so as question marks over the solvency of governments – and even social stability – will be raised, but the most important thing about equities is to buy them when they are very cheap.
Equity prices have recovered from world wars and depressions and hyperinflation, so they will recover again – even when it will appear that the sky is falling down. But having the courage to buy them when they are cheap will not be easy.