Skip to main content

Monthly commentary October 2011

By October 5, 2011No Comments

SUMMARY  George Soros blames the markets for the woes of indebted economies, but the reality is that the world (at least a large part of it) has fundamentally changed, and markets and economies are going through a period of adjustment, sometimes painful. This will create new opportunities.

Far be it from us to argue with the likes of George Soros, but a recent piece in the FT was a touch bizarre. “Markets are driving the world towards another Great Depression” he proclaimed. Let’s explore that.

Imagine a world where, for 25 years, the bulk of the population is at its peak earnings potential; saving, spending, paying tax. Interest rates also steadily fall, so as the years progress it is made easier to go into debt and buy now, rather than save and buy later.

The Government enjoys a tax bonanza, and it’s increasingly cheap for them to borrow as well, so they do. And in this increasingly confident environment, promises are made on future pensions and social security entitlement and much more.

All of this (not just increasing use of debt) helps inflate the economy, imagine air blowing up a balloon. There is a sense of confidence, not surprisingly, and stock markets also reflect this.

So it was from 1980-2005, with the technology crash from 2000 giving a warning about over-confidence.

Now imagine a world where the taxpayers and spenders are increasingly past their best years, where Government promises are increasingly difficult to keep, and the debts of consumers and Governments now have to be reduced. This is, roughly speaking, the story of 2005-2030. The air is slowly but surely being let out of the balloon, and there is less exuberance.

Stock markets have to adjust to this new reality. This isn’t necessarily because company profits will fall – on the contrary, there are and will continue to be many outstanding and consistently profitable businesses. What will change, in a less confident world, is the price that investors are prepared to pay for that business. Whereas a confident investor might have been prepared to buy shares in a business valued relatively expensively (say a price earnings (PE) ratio of 20), a less confident investor will only be attracted by a lower valuation (say a PE ratio of 10 or less).

The latter doesn’t mean share prices (the P bit of the ratio) have to halve in coming years to become attractive. The same thing can be achieved by rising company profits or earnings (the E of the ratio) not being reflected by a share price rising in tandem. This has been going on since 1999/2000.

Back to George Soros. Markets can’t drive an economy into depression. Markets simply reflect the view of investors who live in a less confident world, and markets will ebb and flow with changing levels of confidence.

Sadly, so long as politicians fail to grasp the nettle of debt defaults volatility will remain extreme.The good news is that s

Dennehy Wealth