Reader Chris sent the following comment regarding a Russell Napier Interview on Financial Sense:
Hi Mish if you get a chance, I highly recommend this Russell Napier interview with Jim Puplava. I think Napier is incredibly rational and knowledgeable, with a very interesting perspective on things. This is the best interview I have heard for a while.
Napier seems reasonably aligned with your own views on deflation and what you have been saying on stock market valuations.
Napier sees the scary prospect of a slumping economy and higher bond yields something that has not happened for a long time, as usually bonds do well when the economy sinks. Napier likens it to 1931 when the UK came off the gold standard.
I concur with Chris and would also like to add that Jim Puplava is one of the best interviewers around. Here are a few select quotes from the Financial Sense audio Russell Napier Discusses the Failure of QE2 and the Coming QE3
Puplava: For stocks to continue to do well, don’t we need to see mild inflation and sustained economic growth, and do you see that as a possibility? The leading economic indicators would probably tell us otherwise.
Napier: I think we need to see more than that. The cyclically adjusted PE does not forecasting this level [of GDP] or associated with this economic outcome, it has been associated with very good economic outcomes. That is why I don’t buy the story here.
Many people say that equities are cheap. Well they are cheap based on current earnings but current earnings are at an all-time high. We have a reasonable measure of this going back to 1929. You find that corporate profit as a share of GDP is the highest it has been since 1929.
This is a very mean-reverting figure.
So this stock market is pricing in more than a median economic recovery. Yet as you say, even asking for an average economic recovery is a big ask at this stage. The Fed has distorted two asset prices: treasuries and equities, but they have not yet produced a rise in fundamental economic activity to support these valuations.
Puplava: If I look at your analysis, so far you would argue that QE2 has failed, and a lack of broad money growth will mean that growth and inflation expectations are too high. That implies, likewise that equity prices should fall, and yields rise which you believe could lead to deflation and a bad environment for equities.
Napier: Equities are overpriced and bonds overpriced. But the thing I am saying that is really quite different is normally when the economy slows bonds do well, that is the normal relationship. That’s what everybody expects. What I am saying is a much more frightening scenario, where the economy slows and bond yields go up. And the reason I am suggesting they go up is the matters underpinning their path of huge inflows of foreign central bank capital simply stop coming or slow very dramatically. You might say that this just does not happen. You just do not get scenarios like this. But what springs to mind is 1931 when falling Britain’s exit from the gold standard and people panicked that America would do the same, and when they realized that money they lent to America the American government would be paid back in pieces of paper that would be worth less than gold, then suddenly bond yields went up into a depression as people reassessed the quality of the paper they would be paid back with.
I think that is where we are going, not just for the United stated but the developed world markets.
If the Chinese find a Paul Volcker, we all better be very careful.
Puplava: If some event like that happens, in 2009 the S&P; 500 touched 666, could we go back to those levels again, or in fact lower?
Napier: In my 2005 book “Anatomy of the Bear” I forecast the S&P; would bottom in 2014 and the S&P; would get to 400. I do not have a strong feeling as to the particular year it happens, but 400 number is looking at the low points over the last 100 years, of cyclically adjusted PEs, and also the Q-Ratio which is measuring equities to the replacement value of assets, and if the valuation measures continue to mean-revert, then we are not talking 666 but a number near 400.
The bottoms I talked about in the book are not about business cycles, they are about things much bigger than that: the first world war, the great depression, the second world war, and the collapse of the Bretton Woods agreement. And this is right up there with the collapse of the Bretton Woods agreement.
This is an emerging market that says we no longer think the developed world has good credit quality and we refuse to back developed world governments with our capital. If we begin to question the credit of governments of the developed world then this  is where we go to.
In Austrian terms, the Austrians always tell us we have creative destruction. We have had several business cycles governments have refused to permit creative destruction of the private sector. They threw their balance sheets and the balance sheets of the central banks on the line to stop creative destruction.
So the ultimate situation we have to get to is the creative destruction of the government.
Puplava: Given this forecast that seems highly likely, what would it take to turn you more positive on the equity environment?
Napier: As a historian, the one thing that can always come along is technology that permits much higher level of productivity growth. Cheap energy is something that could transform long-term growth forecasts. There may be many others, but I can’t see them on the horizon.
That concludes the Financial Sense audio excerpts.
Here is a link to the much shorter Financial Times video Long View: Historian sees S&P; fall to 400
Stock market historian and CLSA consultant Russell Napier discusses with head of Lex John Authers his warning that the real bear market in the S&P; has yet to come and could push the US equities index down to 400, plus he explains how emerging markets could trigger a leap in US Treasury yields. (11m 16sec)
Stocks Tremendously Overpriced
In 2007 people might even have thought Napier was a bearish fool. He clearly wasn’t. The S&P; 500 fell to 666 and there is no reason why that level cannot be tested again.
I made the case recently in Negative Annualized Stock Market Returns for the Next 10 Years or Longer? It’s Far More Likely Than You Think
As a follow-up, please consider Anatomy of Bubbles; Negative Returns for a Decade Revisited; Is Gold in a Bubble?
Overvalued is Not a Price Target
Stock prices are tremendously overpriced. However, I do not know if we see Napier’s targets or not.
Overpriced can be worked off by a stock market that goes nowhere for 10 years or a stock market that takes another plunge. It can even be worked off by a bigger rally now before a plunge. I seriously doubt the latter, but it is certainly possible.
What’s Different Now?
The big difference that I see now vs. 2008 and early 2009 is corporate cash levels. Cash levels are much higher today thanks to a certifiable bubble in corporate bonds.
Google, which does not even need cash raised billions in a 10 year blended offering at 2.33%. Google will not default but that is ridiculous . Why lend money at 2.33% for 10 years when such a paltry yield does not possibly compensate for the risk of much higher rates a few years from now, possibly even next year?
Who knows what interest rates will be 5 years from now? I don’t. Nor does anyone else.
Regardless, corporations from total junk to top-tier are flush from with cash from debt offerings. Unless corporations blow it on stock buybacks or acquisitions at absurd prices, corporations have a chance to sit on cash (debt really), for a long as the terms permit.
Thus, corporations can weather a cash-crunch storm today better than a couple years ago.
In the midst of the decline in 2008-2009 there was a genuine fear corporations in need of cash could not raise that cash. Now they have cash-on-hand in advance. It sits on the balance sheet as debt (it is debt), but it is spendable.
The best use for that cash is to let it sit there. If instead, corporations blow it on absurd buybacks at silly prices we will be back in the 2008 crash scenario. For reasons Napier suggests the markets could crash anyway.
Not knowing what corporations or the Fed will do (or in what time-frame), I see no need to make a prediction other than to say history suggests that stock market outcomes from here are highly unlikely to be favorable even if corporations avoid serious mistakes.
Mike “Mish” Shedlock
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