The Rebalancing

Financial analyst John Mauldin hops onto the “death of equities” bandwagon along with PIMCO CEO Bill Gross:

The business cycle has endured for well more than a century. It generally delivers two to five years of above-average EPS growth before experiencing a year or two of pullback. We have had a dramatic run over the past two years, and the forecast for the next two years now positions profits well above their historical relationship to the economy.

Several factors now indicate that a period of EPS decline may be upon us. It does not necessarily portend a decline in the market, although that vulnerability clearly exists. Beware nonetheless! For investors, this means that portfolios should be positioned through diversification and active risk and return management.

You may recall that I linked to Mr. Gross’s plaint several days ago. Mr. Mauldin’s letter is chock-full of graphs if you’re interested in that sort of thing.

Henry Blodget concurs (and reproduces a number of the graphs):

When earnings “correct,” by the way, so do stocks–often violently.

Don’t look to stock analysts and strategists to tell you when this correction is going to happen, though. They don’t know. And, in the meantime, the message will be: Don’t worry, be happy.

So, let’s recap. Bonds are going to earn less going forward. Stocks are going to earn less going forward. Bad news for investors. The ray of sunshine, I suppose, is that with the advent of new approaches for connecting people looking for investors to people who want to invest the traditional instruments for investment just aren’t as necessary as they used to be.

For me the preferred outcome of all of this ferment would be a sharp decline in the size (and influence) of the financial sector. There are some signs that’s already under way. In my opinion it is simply untenable for so many people to be making so much money without being involved in direct or even indirect production.

However, I think another likely scenario is a tremendous thrashing, the result of financial types desperate to maintain their incomes and way of life and flushed with their rent-seeking victories of the last few years, into ever riskier and dodgier pseudo-investments, with plenty of people, equally desperate for retirement income, following right after them.

Update

Arnold Kling weighs in to the discussion with a neat analysis:

The point of this algebra is that for the value of the stock market to rise faster than GDP, one or both of the following has to happen: the price/earnings ratio has to rise, meaning that people are willing to apply a lower discount rate to earnings; or the ratio of corporate earnings to GDP has to rise, meaning that profits of shareholder-owned corporations increase as a proportion of overall income.

The historical return on stocks has been high in large part because P/E has trended upward. Past performance is not necessarily predictive of future returns.