Fundmastery Blog

Kurt Brouwer December 2nd, 2008

I enjoy reading master bond manager Bill Gross’s monthly columns.  His comments on the economy and the bond markets are generally right on target and, in particular, he has been excellent on the whole subprime lending mess and its resultant financial panic.

When it comes to the stock market though, he has not been quite so prescient.   In the latest Pimco Investment Outlook, Gross offers a mea culpa for suggesting six years ago that the Dow would plunge from 8,500 to 5,000.  Instead, it went the other way and, by October 2007, the Dow had risen to 14,000.  So, he was off by a little bit.

Following his confession, Gross points out that stocks are now either really, really cheap or only just pretty cheap by historical standards.  Somehow though, he uses that information to lead to his conclusion, which is a stirring appeal to buy corporate bonds rather than stocks.

Along the way, he did produce an interesting theory that we are in a whole new paradigm for publicly-traded corporations in which taxes will be going up, leverage would be going down and the heavy hand of government would be much more active.  Let’s dig in to his theory about stock market valuations:

Dow 5,000 Redux (PIMCO Investment Outlook, December 2008, Bill Gross)

…Let me first announce a fundamental premise with which I think all rational investors would agree: I believe in stocks for the long run - but only if purchased at the right price. That statement packs a real punch. It says that capitalism is and will remain a going concern, that risk-taking - over the long run - will be rewarded, but only from a starting price that correctly anticipates the economy’s growth and its share of after-tax corporate profits within it. Acknowledging the above, let’s look at a few basic standards of valuation that historically have stood the test of time, to see if at least the price is right.

One of them is what is known as the “Q” ratio, or the value of the stock market relative to the replacement cost of net assets. The basic logic behind “Q” is that capitalism works. If the “Q” is above 1.0, then the market is valuing a company at more than it costs to reproduce it; stock prices should fall. If it is below 1.0, then stocks are undervalued because new businesses can’t be created at as cheap a price as they can be bought in the open market. In the short run, this ratio is volatile as shown below but it tends to be mean reverting, which is critical. As long as capitalism is a going concern, “Q” should mean revert to 1.0. If so, then oh, oh what a “Q”! Today’s Q ratio has almost never been lower and certainly not since WWII, implying extreme undervaluation, as seen in Chart 1.

Source: Pimco

This Q Chart is interesting and the concept of it makes sense because it deals with replacement cost.  Replacement cost is a pretty normal valuation tool, not just for stocks, but for real estate and many other assets.  If you can buy a home for less than it would cost to buy the land and build the house, then you are probably getting a good value.  Similarly, if you can buy shares in a corporation for less than it would cost to replace that company and the assets it owns, then you are probably getting a good deal, particularly if you buy a whole portfolio of such companies.

Gross goes on to review other stock valuation methods such as price/earnings ratios, which also are at historically low points.  But, he draws an interesting conclusion: It’s different this time.   He continues:

…Welcome to a new universe stock market investors! In this rather “sheepish” as opposed to “brave” new world, here are some considerations that may affect Q ratios, P/E’s, and ultimately stock prices for years to come:

1. Corporate profits have been positively affected for at least the past several decades by several trends that appear to be reversing. Leverage and gearing ratios - the ability of companies to make money by making paper - are coming down, not going up. In addition, the availability of cheap financing - absent government’s checkbook - will likely not return. Narrow yield spreads and low real corporate interest rates are gone. Last, but not least, the historical declines of corporate tax rates, shown graphically in Chart 3, will not likely continue downward in a Democratically-dominated Washington.

Source: Pimco

…4.  The benevolent fist of government is imperative and inevitable, but it will come at a cost. The champion of free enterprise, Ronald Reagan, knew that growth of the private sector was in no small way dependent on deregulation and the lowering of tax rates. Now that those trends have necessarily come to an end, no rational investors should expect innovation and productivity to be unaffected. Profit and earnings per share growth will suffer.

 

I agree with most of his points made above.  Certainly, corporate profits have been helped by the ability to borrow easily and cheaply.  And, I agree that government interventions will hurt free enterprise because many regulations do not restrain the bad guys, but they inevitably add to the cost of most solid and law-abiding businesses.

The point on which I disagree with Gross is in the arena of corporate taxation.  I think there is very little chance that U.S. corporate tax rates will go up.  Why? It’s not because many politicians wouldn’t love to raise corporate taxes, but rather it is because our corporate tax structure is already one of the highest in the developed world.  When you are #1, it’s hard to go much higher:

Source: The Tax Foundation and KPMG

As you can see from this chart, when you add up Federal and state corporate taxes, we are at the top.  And, in this case, being #1 is not good.  Other countries such as Ireland and even Russia are actively cutting corporate tax rates, so we are engaged in a global competition and that is why I think we will maintain or even lower our corporate tax rates.

Bill Gross continues:

…Dow 5,000? We don’t have to go there if current domestic and global policies are focused on asset price support and eventual recapitalization of lending institutions. But 14,000 is a stretch as well. One only has to recognize that roughly 20% of bank capital is now owned by the U.S. government and that a near proportionate share of profits will flow in that direction as well. Better to own corporate bonds than corporate stocks, but that’s a story for another Investment Outlook.

In all fairness to Bill Gross, corporate bonds are priced at very attractive yields right now.  So, investors are faced with a target rich environment in which corporate bonds and stocks are somewhere between really, really cheap and just cheap. Let the buying begin.

See also:

Bill Gross: Potential Returns Are Very Attractive

Bond Markets Pricing In Armageddon

Warren Buffett: I May Soon Be 100% Invested In U.S. Stocks

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