Blog: Investors Beware, Sugar Rush Is Fading

There is currently a comfortable consensus on Europe at present that, in the final analysis, Germany will stand behind the euro come what may, and that the EFSF is an effective tool to achieve this.

The problem with this analysis is that it ignores a couple of uncomfortable facts. First, the German public is becoming increasingly opposed to the continued bail-out of indebted "Peripheral" countries.


The strength of this feeling was evidenced in the results of the Hamburg regional elections in which Angela Merkel's ruling CDU Party received only 21 percent of the vote, the lowest since 1945.

Second, the EFSF is simply not big enough to cover capital needs of the periphery countries. They have outstanding debt of €3.1 trillion ($4.3 trillion) versus the EFSF's €440 billion, which also includes contributions from nations most likely to be in need of emergency financing. To us this mechanism is similar to a super-sized CDO.

Furthermore, the current mechanism, as devised by the EU, simply targets the symptoms (ever-spiraling financing costs) rather than the cause of the general underlying malaise (too much debt).

It remains to be seen whether the problem of excessive debt can be solved with issuing more debt, in the absence of radical reform.

French and German banks hold approximately €1 trillion worth of peripheral sovereign bonds, a considerable proportion of which will have to be restructured. Along with other concerns, this explains why "investing" in European banks remains a gamble with a binary outcome.

In sum, investors should be cautious and not just "buy the market"; many companies perform better in changing and changed economic circumstances and therefore as the sugar rush initiated in the first quarter of 2009 fades, this is the discipline that investors should once more return to.

Be Careful in the US Markets

The starting point for any investment is the price paid. If US stock valuations are any guide, investors should be very careful right now. The US cyclically-adjusted PE ratio is currently 23.7X, 45 percent above the 16.4 percent average of the past century.

This ratio has only twice been higher; in 1929, and during the TMT bubble at the start of the century. The most plausible explanation for this is that central banks are flooding the system with liquidity, the effect of which has been to lift all asset prices. In the US, movements in the S&P 500 and the Federal Reserve's balance sheet are 86 percent correlated.

>> Click here for a chart of the US national debt from 1940 to the present

Furthermore, when operating margins are at record highs, as they are now, many analysts assume that they will remain at these elevated levels indefinitely. This has the effect of making stocks look cheap on earnings forecasts. For example, on this basis, US stocks are currently on 13.5x 2011 earnings, far more reasonable than the cyclically adjusted measure that many prefer.

Profit margins are by definition mean-reverting, simply because, first, super-normal profits attract new industry entrants and secondly, greater profit margins lead to the labor force demanding a greater slice of the economic pie. Lastly, greater production leads to upwards pressure on input costs.

The biggest single risk to valuations is an end to the easy monetary policies pursued by Bernanke and his central bank acolytes around the world. The cacophony that is now questioning the efficacy of current monetary policy and its side-effects grows louder, particularly in light of the rise in the price of commodities and the effect that this is having on both the Western consumer and political stability abroad.

Within the FOMC itself, such discord can be seen through the recent resignation of Kevin Warsh from the Board of Governors.

Time To Roost?

The fact that asset prices are so buoyant is not a sign that the risks outlined above have passed. Stimulus measures have merely "kicked them down the road". Chickens are, however, slowly coming home to roost.

History seldom repeats itself but often rhymes; the 1970s saw similar ultra-loose policies unleashed on the world by the Fed, leading to asset bubbles, and market and geopolitical instability. The search for yield pushed investors further up the yield curve than "normalized" real interest rates would have done, leading to disastrous results (and geopolitical instability as typified by events in Iran).

OECD countries are mostly in a similar position; ultra-loose interest rate policies combined with fiscal stimulus (funded by yet more borrowing) have created a "recovery" which may yet prove to be little more than a short-term sugar rush of policies designed to buy time, driven by tactics and compromise rather than strategic economic and fiscal reform.

The author is Julian Pendock, Senior Partner, Senhouse Capital.