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Archive for September, 2008

Thinking Long Term About the Equity Premium

Posted by Rob Weigand.

One of my favorite blogs, Abnormal Returns, recently linked to a post at the blog Zero Beta regarding the Equity Premium “Puzzle.” I’ve published a few papers on this topic recently (Journal of Portfolio Management, Journal of Investing and Journal of Financial Planning — forthcoming in October), so the literature remains fresh in my mind. Here’s the perspective I’ve cultivated after reading over 100 papers on the Equity Premium:

The only way to properly conceptualize risk premia is from a very long term perspective (as in Siegel’s Stocks for the Long Run). US equity markets have set the long term real return on equities at just under 7%. But egg-headed professors look back on the data — with the benefit of perfect hindsight — and say 7% was too large, AS IF EVERYONE KNEW STOCKS WOULD EARN 7% REAL RETURNS. Duh! The equity premium has been that large because people were extremely unsure how compelling global events would play out — at the time those events were occurring.

Try to appreciate the incredible uncertainty associated with two World Wars, the Great Depression and the Cold War. All of these events eventually worked out for the best — and thank goodness for that — but investors didn’t KNOW they would when those events were playing out. Moreover, the US economy was closer in time to regularly-recurring bank panics than we are today (I would assert that we currently suffer from a false sense of security that regulation and Fed monetary policy is better than it used to be).

As if in response to all this contrived thinking about the equity premium being too large historically, the equity premium is smaller today — any way you measure it. Yet, as we’ve seen with the subprime banking crisis, the world is just as uncertain as it used to be. Russia and the Middle East have most of the oil — and we’re no closer to independence from foreign oil than we were under Jimmy Carter. The Chinese have a work ethic that would make the average American faint — just THINKING about it. And we have witnessed a pronounced decline in the value of the US dollar in recent years (the recent rally notwithstanding). Residential real estate is in a protracted bear market and the credit creation system is gummed up beyond all recognition (GUBAR). We’re as up against it as we’ve ever been. And we may very well prevail, just as we always have — but we don’t know that with the type of perfect certainty that warrants real expected returns on stocks of 3-5% (or lower).

When you look at the P/E ratios (use 10-year smoothed earnings as suggested by Graham & Dodd, Shiller and others) and dividend yields on the major indexes, however, these metrics don’t reflect the expected returns necessary to fully compensate for the real risks going forward — at least as those risks appear to a rational person TODAY. (That’s why the super-rich are hoarding cash and cash equivalents and, as the Forbes crowd always loves to do, hoarding gold.)

One of the major factors holding up equity values in the current bear market (and keeping relative valuation high compared to this point in bear markets historically) are all the “jocks” that have migrated into professional money management. You know who they are — they’re lined up a mile deep to get their 5 minutes on CNBC and say things like “Stocks have always paid off and I’m really bullish on America,” or “Stocks look really cheap to me right now,” etc. Of course, they never back up their forecasts with any metrics — they just spout pro-market “feelings.”

Now, all this doesn’t mean that equity values can’t rise from current levels as soon as the news turns more positive than negative, but if they do, we’ll just be perpetuating the rolling global asset bubble that’s been hanging over markets since the latter 1990s (read Jeremy Grantham’s Barron’s interview on the global bubble and credit crisis from February, or his more recent post on the global competence meltdown). Therefore, after reading 100+ papers and publishing 3 myself, my perspective is that markets have set the LONG TERM equity premium just right historically, and this premium remains too low today when considered alongside the financial, economic and political risks that prevail in the current environment.

You can email Rob Weigand at profweigand@yahoo.com or find him on the web at Rob Weigand’s Home Page.

Peak Oil Theory and the Energy Crisis: Not Just for SUVs Anymore

Posted by Jessica Collins.

Consumers grumble about rising gas prices.  The price of goods – inputs, outputs, intermediates – escalates; businesses struggle.  As the price of oil steadily climbs to an all-time high and U.S. currency, markets, and overall economy are left to suffer in its wake.  You think it’s bad now? The situation may be getting worse.   

In addition to being the backbone of the global economy, oil is a non-renewable commodity whose demand curve has increased steadily over the past two decades. 

Lead by population supergiants China and India, the world has embarked on an unmatched boom in global industrialization (read: oil consumption) that has forced the price of oil up 56 percent to-date in 2008 and over 365 percent over the last decade. [1] 

 

Source.

In addition, analysts estimate combined global demand will exceed 120 million barrels per day (bpd) in 2030, an astonishing 41 percent increase from current production levels. [2] 

The problem?  The world may not have enough oil to go around.  Will we completely run out of oil?  Not likely.  Many have dismissed the idea that the global community could ever completely deplete the world’s oil supply.  However, it’s not extracting that last drop of oil that will send the world into its biggest energy crisis in history.  Not even close.  The true turning point occurs when the gap between the demand for oil and its accessible supply becomes so great that the resulting price brings the world economy to a grinding halt.  Unlike previous energy shocks of past decades, this unprecedented energy crisis is based on accelerating global demand, rather than sudden, short-term interruptions of supply.  The result?  “A long period of significant hardship worldwide.” [3].

Don’t think it could happen?  Assuming a daily consumption of 21 million barrels per day, at $135 per barrel, the U.S. alone spends approximately 15 percent of its $6.8 trillion net income on oil.  Increase the price to $200 per barrel and the percentage of take-home income spent on oil increases to 22 percent.  “In other words, the U.S. [could be] broke long before oil prices hit $200 per barrel, and the rest of the world is sure to follow.” [4]

This is not just a problem for our children’s children.  Several key figures in the oil and gas industry, including the CEO of France’s Total Petroleum and the CEO of Royal Dutch Shell, have recently expressed concern about the situation. [5],[6].  Even ExxonMobil, which continues to post strong financial performance, recently reported a 6 percent decline in production and have readjusted long-term reserve projections. [7]        

Think this is only a problem for SUV owners and Big Oil executives?  Think again.  Every aspect of modern life depends on oil.  Never mind that virtually every type of good is brought to market using oil-based transportation – food, water, modern medicine, and all technological devices rely on oil and oil byproducts.  As explained by commentator Robert Wise:   

Nearly all the work done in the world economy, all the manufacturing, construction, and transportation, is done with energy derived from fuel. … And, the lion’s share of that fuel comes from oil and natural gas, the primary sources of the world’s wealth. [8]

While higher oil prices will stimulate the development of additional oilfields, the remaining oil is difficult to produce, expensive to extract and refine, and is owned by a small majority of the world that seems to hate everyone else – or, at least, the U.S.  Moreover, while new production may slow the decline in production, it cannot completely prevent it. 

What about ‘alternative energy’?  Some alternatives, like natural gas, have showed promise, but it too is a limited-supply fossil fuel. [9]  Further, all of the current ‘viable’ sources of alternative energy (e.g., wind, solar, biofuels, biomass, hydrogen, and even nuclear) are extracted, collected, generated, or otherwise based, in whole or in part, on oil and oil-based fuels. [10] In addition, not one alternative energy technology is currently suitable for wide-spread commercial implementation.  Even if the technologies themselves were ready to be implemented, the necessary infrastructures are primitive, if present.  Implementing alternative energy sources is, at best, daunting:  it requires massive short- and intermediate-term investment and represents a massive drain on the dwindling pool of global capital.

The global shift to alternative energy sources is inevitable.  The challenge, then, is to execute the transition seamlessly and efficiently by appropriately allocating capital to winning sustainable alternative technologies thereby permitting the global economy to maintain reasonable growth levels.  On the other hand, inefficient execution of this crucial transition will almost certainly result in a severe depletion of global capital, leaving little or no financial resources for investment in other areas of the world economy.