It’s an oldie but goodie that I’ve recounted in earlier web pieces, but it bears repeating, given the recent wave of gloomy talk about the global economy, and the supposedly dim future for stocks.
As a student at what’s now the Booth School of Business at the University of Chicago, one of my professors—it was either finance specialist James Lorie or famed statistician Harry Roberts—told the class about witnessing a PhD thesis presentation attended by Nobel Laureate Milton Friedman. The doctorate candidate had fashioned a complex model designed to forecast U.S. GDP growth over the coming years. The model consisted of sundry variables, all awarded various weights—exchange rates for the dollar, trends in U.S. consumer spending, expansion in both developed and emerging markets—that when all thrown into his magic econometric mixer, would produce a highly accurate estimate of national income.
According to this account, Friedman posed a shockingly simple challenge. “Why is this highly complex model any more reliable,” asked the tiny figure in the front row, “than adding the last five years of GDP growth, and dividing by five?”
Friedman’s point was that macroeconomic forecasts rely on numerous sub-forecasts that are extremely unreliable. So combining lots of things that are un-forecastable gives no clue whatsoever on what the future holds. Simply assuming “more of the same” is hardly foolproof, but it’s still a better guide than most of the official predictions.
But if those warnings, backed by big-name banks, foresee a looming catastrophe, they’re great for generating headlines and clicks. Witness the new media frenzy over looming doom.
In the last few days, prominent market strategists unveiled dire warnings for the world economy. Albert Edwards of Societe Generale, stated that the recent rise in the dollar will crush U.S. corporate profits, and push the U.S. into recession. Then, a rash of defaults by overleveraged companies and consumers will trigger deflation, unleashing a financial crisis on a scale of 2008 and 2009. At Royal Bank of Scotland, credit chief Andrew Roberts sounded the alarm, prophesizing a “cataclysmic year” haunted by the slump in oil below $20 a barrel, and severe slowdown in China.
Both Edwards and Roberts foresee big declines in U.S. and European stocks, with Roberts warning of a further 10% to 20% fall. Cautions Roberts, “Sell everything except high quality bonds.”
A stock market-watcher with a more balanced, Friedmanesque view is Jim Masturzo of Research Affiliates, a firm that oversees strategies for $154 billion in investment funds. “I don’t put much stock in forecasts with so many variables and moving parts that take a big macro idea and extrapolate into all these different market—then say the world is ending,” says Masturzo.
He contrasts today’s landscape with the crash of 2008, when credit evaporated, and sellers couldn’t find buyers for their junk bonds, derivatives, or office buildings, except at crisis prices. “We don’t have anything like that now,” he says. Masturzo acknowledges that the collapse in oil prices has fed turmoil and uncertainty, but it’s hardly a disaster for all but heavily petroleum-dependent exporters. In effect, most of the world’s consumers are receiving a surprise gift. When oil prices first exploded in the early 1970s, and again a few years later, the world economy sank under the weight of rampant inflation and double-digit interest rates. That was a true disaster. It can’t be a worldwide cataclysm both when oil prices soar and when they collapse. It’s far healthier for the world economy to have oil selling near its true market value than at a gigantic premium, due to conflicts, bottlenecks, or OPEC’s monopolistic practices, that brings a gigantic windfall to oil exporters that we all pay for at the gas station and toy store.
Masturzo notes that the doom scenario for emerging markets, allegedly the major impetus for the coming global disaster, is especially overstated. Although its fortunes are waning, China is still expanding in the 4% range, and India is growing briskly. In fact, all of the dour predictions on developing economies makes their stocks by far the world’s best buys. The reason is simple: they’re by far the cheapest. Sure, you’re taking a big risk concentrating in stocks of South Africa, where finance ministers keep changing, or Brazil, where the slump in revenues from commodities can no longer support reckless government spending. But buying a diversified basket of emerging market stocks is the way to go.
Today, the price-to-earnings multiple for a broad emerging market portfolio, adjusted for cyclical swings in earnings, is between 10 and 11. That’s far below the historical average of 18. The Malaysias, Indonesias, and Polands also boast a bright future: Their debt levels are far below those of the developed economies, and their workforces far younger. The current turmoil works in favor of investors since the prevailing panic makes their shares an excellent buy.
On the other hand, investors should fret about the future for U.S. stocks, though not for the big, macro, “the world is collapsing” scenario the doomsayers keep touting. Quite simply, U.S. equities are extremely expensive relative to history, and even if our economy keeps bouncing modestly ahead, will remain so. The chance of a big downward move is a lot higher than when stocks are cheap, as they are in the emerging markets. Go where the fear is greatest, the prices most inviting, and the projections of disaster probably the least justified.
So ignore the forecasters, and by the way, that appraisal also applies the ultra-optimists. Those are the Pollyannas who held sway just a year ago, and proved spectacularly wrong. Yogi Berra, according to legend, said something like “Predictions are difficult, especially about the future.” Uncle Miltie would have agreed.