The Pain in Spain and Implications for Global Equity Markets

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May 24, 2012

If you don’t already subscribe to John Mauldin’s Thoughts from the Frontline, I highly recommend that you do so. Not only does he publish every week, but he also has the unique ability as a writer to break down complex issues into more easily digestible pieces. In a recent e-letter, he states the following:

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Spain is too big to save and too big to fail. The only way for Spanish debt to remain at 6% is for the ECB to basically buy it (or lend to Spanish banks so they can buy it, or whatever creative new program Draghi and team can think up). When Spain goes, it is just a matter of time before we lose Italy and then, yes, even France. The line must be drawn with Spain. And the only outfit with a balance sheet big enough that can also do it in a politically acceptable manner is the ECB, and the only way they can do it is with a printing press.

Will it buy time? Yes, but time for what? To fix government deficits? To deal with bank debts? Sovereign debt? To somehow solve the massive trade imbalances between Germany and the European periphery? To force voters to accept a fiscal union? In the midst of a crisis? If there is some conspiratorial cabal that has a secret plan, they have kept it well hidden. Because from here it looks like they are making up the “plan” as they go along.

Their actual intentions are no secret. They will do whatever it takes to keep the European Union and eurozone together. And whatever it takes is a very open-ended plan. But it is going to cost them trillions of euros.

Someone is going to have to pay that bar bill. And there’s going to be one helluva hangover.[/content_box_light_blue]

The hangover that he’s referring to will be the large increase in inflation that will be the result of the ECB becoming the money printer of last resort. Similarly, the Federal Reserve facing a slowing US economy will also begin a new round of quantitative easing if the US markets enter into a correction, which I think is likely. Thus, the developed world is clearly headed for higher inflation but only after a brief deflationary scare. I believe that most investors mistakenly believe that this new inflationary environment will be positive for stocks. Fortunately, investors can look back in history to another period marred by stagflation and find out whether equities were able to truly able to achieve positive inflation adjusted returns. In his book, Anatomy of the Bear, Russell Napier mentions:

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The 1970s saw inflation averaging 7.1% and a threshold of inflation seemed to have been passed, beyond which equities could not provide positive real returns…In real terms, the S&P Composite Index declined 63% from December 1968 to July 1982. This long decline was punctuated by dramatic swings in the market.[/content_box_light_blue]

Thus, it’s clear that the stagflation of the 1970s produced horrible returns for equity investors. In addition, it appears that the volatility experienced in that period is similar to the violent swings in market sentiment we’re seeing today.

I think we are still in the middle of the bear market that began in 2000. It’s unlikely it will end anytime soon given current valuation levels based on Robert Shiller’s CAPE (cyclically adjusted P/E). Ultimately, I think the only way to make reasonable returns will be to find individual stocks that have dividend yields and trade cheaply on an absolute basis. No longer can you rely on a buy and hold strategy to generate decent returns in the market. The key to investing success in the next decade will be to adopt two distinct game plans, one for defense, to protect assets in market corrections, and one for growth, by investing in great franchises at low absolute valuation levels.


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