The Dow Jones Industrials Average is down roughly
20% from its peak in 2007 and fears of recession (or worse)
are rampant. Bearish sentiment on equities is elevated and
as is typical in fear-filled environments, opportunity exists.
Not only are fears of recession overblown, but earnings
continue to surprise analysts to the upside. The bottom-line
is that the US equity market is at least 35% undervalued.
And when we survey the entire investment landscape it is
clear the equity market is the only broad market category
where significant future gains can be reasonably expected.
Equities are the most undervalued asset class.
Consider the alternatives – real estate, commodities, and
bonds. Although there are regional pockets of resilience, on
a national average, residential real estate is still in the
process of adjusting to a Fed-induced “bubble.” We still do
not see home prices hitting bottom until mid-2009.
While commercial real estate is faring much better than
residential, and REIT prices are down significantly from
their peaks, if bond yields rise as we suspect, the returns in
this asset class will face strong headwinds.
In the past few years commodity markets have provided
all the excitement and entertainment one could ever ask for.
And in the process have provided significant profits for
investors. This success has attracted even more money to
the sector, but in the process has driven prices well above
fundamental value. And despite recent sharp declines,
commodities are still priced as if the Fed is not ever going to
try and reign inflation back in again. We highly doubt this
will be the case. Fed Chairman Bernanke is a keen student
of monetary history and does not want to become the Arthur
Burns of his generation – a highly respected academic
economist whose policies in the 1970s gave the US our
worst persistent bout of peacetime inflation ever.
Interestingly, while commodities are overestimating
inflation, the bond market is underestimating inflation.
Consumer prices are up 5% in the past year, but the 10-year
Treasury yield is roughly 4.1%. What is important to realize
is that it takes 18-24 months for changes in monetary policy
to affect inflation. Eighteen to twenty-four months ago the
federal funds rate was 5.25%; now it’s 2%. So the Fed is
looser today than it was when its policy was generating the
high headline inflation we see today. The underlying
inflation trend will be up in the next two years, not down.
Some Treasury investors have already experienced
negative real returns, and – with inflation at elevated levels –
this should spread throughout the maturity spectrum in the
year ahead, as interest rates rise across the yield curve.
Meanwhile, US stocks appear substantially undervalued.
Even if we discount earnings with a 6% rate (which is well
above market rates) and use earnings depressed by “paper”
losses at financial firms due to “mark-to-market” accounting
requirements, historical relationships between stocks, profits,
and interest rates suggest a fair value of at least 15000 on the
Dow by the end of 2008. As a result, stocks are not the
contrarian investment, but the only one where there is a true
chance of outsized gains in the years ahead.