Grief for Risky Investments

by Gary Shilling

To continue with my “maybe” forecasts…a renewed bear market in U.S. stocks, and grief for riskier investments, may commence this year:

As I’ve said before, the October 2002 bottom in stocks may not have been the final lows that corrects the irrational exuberance of the 1990s.I’ve also said that massive monetary and fiscal stimuli, especially after 9/11, kept the 2001 recession brief and shallow, and provided the money to keep speculation alive.It simply shifted from dot com and other new tech stocks to other vehicles like Treasury bonds, junk bonds, emerging market bonds and equities, commodities, currencies and hedge funds.

Recall that when speculation survived the big bear market, stocks never really got cheap.Sure, equities fell substantially, but they started so high that they didn’t get to bargain basement lows.Despite the rapid growth in corporate profits in the last several years, price-earnings ratios are still high.So, higher P/Es, on average, are unlikely in the foreseeable future – unless I’m right and deflation drives long Treasury bond yields to 3%, but that would present another whole new set of problems for stocks.

With no P/E expansion likely in coming quarters and dividends not even high enough to support current stock prices, earnings growth is all-important to stock performance.The recent rapid profits gains were fueled by robust productivity growth.That, in turn, resulted from business restraint on employment and wages as existing staff was stretched to handle increased production and sales.

Economic growth, however, is likely to slow, so unless productivity growth is rapid, profits will be disappointing.Continuing high levels of productivity advances are certainly possible.But productivity leaps of the size seen recently will again require severe restraint on employment and wages.That would constrain consumer incomes, which are no longer benefiting from substantial monetary and fiscal stimuli.

Sure, consumers can drive their saving rate into negative territory and continue to borrow heavily to keep on spending.But if they don’t borrow to spend, as seems more likely, earnings in 2005 might show little, if any, growth from last year.

It’s not surprising, then, that the stock market rally that commenced in late 2002 is looking weary.It’s now 27 months old and since 1954, they have averaged 40 months, by my reckoning.Also, bull markets tend to have limited life expectancies-from one to 23 more months-once the Fed starts to raise interest rates.Thus, the current stock rally could be over as of the end of last year, with the January 2005 sell-off marking the beginning of the next down phase of a multi-year, multi-step decline.Or the rally could run 23 months beyond the Fed’s initial rate increase in June 2004, which would carry it to May 2006.

This wide range is another reason I regard a renewed bear market as a “maybe” for this year.And “maybe” stocks will decline this year, but not enough to suggest they are headed for new lows, with that likelihood remaining for later years.

Maybe China will experience a hard landing this year:

China has been trying to cool her overheated economy, but with great difficulty.In the fourth quarter of last year, Chinese GDP rose 9.5% and also 9.5% for the full year, well above her leaders’ target of around 8%.Her economy is still in transition from a command to a market structure; monetary and fiscal tools are crude; and her newly minted buccaneer capitalists, including many state and local officials, are hard to control.

A recession in China would wreak havoc on the rest of Asia, even Japan, which is just emerging from over a decade of deflationary depression, and remains dependent on exports for growth.A serious recession in China would reveal the mountains of excess capacity that is now being built with the aid of direct foreign investment.A hard landing in China will also reveal the strength of her internal demand.Many believe China has developed enough domestic spending to sustain economic growth, but I don’t think that China has a big enough free spending middle class to do the job, and that domestic outlays are fueled principally by direct foreign investment and export revenues.

Revelations of excess capacity will kill direct foreign investment in China and a softer U.S. economy will curtail Chinese exports.The resulting drying up of domestic demand for cell phones, autos and computers will deepen the Chinese recession.

Coincident recessions in the United States and China would almost guarantee a global slump, given the dependence of most countries on exports to the United States for growth and the nearly-stagnant European economies.This, in turn, would no doubt reverse the rapid rise in commodity demand and prices in recent years.Furthermore, global economic weakness could well initiate the worldwide deflation I’ve been expecting-the good deflation of excess supply, unless financial crises develop to the point of chronically retarding demand.