When I heard the Bush/Paulson measures to alleviate the mortgage mess and the ensuing proposals of the leading Democratic presidential candidates, I yearned for another time -- a time when notions such as caveat emptor, moral hazard, and sanctity of contract meant something. Unfortunately, these are becoming anachronisms and are being supplanted by the notion of "too big to fail". While government interference with the free market will, no doubt, moderate the incidence of foreclosures and the level of lender writedowns in the short run, it will, in the long run, encourage excessive borrowing in an already heavily leveraged economy and have negative implications for the U.S. dollar.
Paulson classifies the subprime mortgagees into: 1)those who would be in default even if the teaser rates were not reset, 2) those who would likely remain current on their mortgages if the teaser rates were frozen for five years but couldn't survive an immediate reset, and 3)those who are able to remain current on their payments even after the scheduled resets. He would allow the middle group to have their payments frozen for five years and then reset in hopes that the incomes of the mortgagees would have risen during that time to a level that would avoid default even at the reset rates. The Clinton approach would freeze at the teaser rate the mortgages of both the Paulson-designated group AND those who can afford all payments. I, on the other hand, would divide the universe of those who can't make their payments into two groups, those who were defrauded when they took out their loans, and those who were not. The first group should be made whole; the second should suffer the consequences of their decisions.
When a person mortgages his home, he is responsible for knowing the terms of the mortgage contract -- "caveat emptor" or "buyer beware." Ignorance of the terms of the mortgage is no reason to allow the mortgagee out of his contract unless the terms of the mortgage were not fully disclosed. If a mortgagee bets that when the interest rate is to be reset, he will either be able to sell his home for a profit or reset the mortgage at a low rate; and it turns out he is wrong, he should suffer the negative consequences of his decision -- "moral hazard." In the Clinton initiative, even those who can manage the mortgage payments after scheduled resets are entitled to a period of frozen teaser rates. If I were the mortgage lender I would expect no change in the terms. Otherwise, it would be an abrogation of the notion of "sanctity of contract". Why are these notions being suspended? Because the aggregate impact on the economy if they were strictly adhered to would be disastrous? We have seen how the notion of "too big to fail" has been invoked to "rescue" Donald Trump and Long Term Capital Management. Now subprime mortgagees can be added to this list.
How bad would the impact on the economy be if the subprime mortgagees are allowed to fail? Very bad indeed! There would be hundreds of thousands, perhaps millions, of foreclosures and forced sales of property. No one wants a foreclosure sale in his neighborhood. The negative impact on home prices and consumer confidence would be significant. A friend of mine, a highly respected economist, estimates that the historical relationship between the aggregate market value of U.S. homes and U.S. GDP has hovered around 100%, plus or minus 10%, in most years since 1950. In 2006, that relationship was 160%. An immediate regression to the norm would involve more than a 30% drop in home prices.
For purposes of illustration, let us assume that home prices nationwide decline 15% peak to trough during this cycle--a rare event indeed. The total market value of U.S. homes has been estimated at $21 trillion. The total debt against that asset is $11 trillion. A 15% hit to home prices would reduce owner equity from $10 trillion to $6.85 trillion, a decline of 31.5%. However, roughly $7 trillion of home value is in unmortgaged homes. Calculating solely for mortgaged homes, a 15% home value decline translates into a 70% reduction in equity. To put this into perspective, out of a total of 75 million U.S. homes, 50 million are mortgaged. If the owners of 50 million homes experience a 70% decline in equity, consumer confidence would plummet, which would start a vicious cycle of lower spending, layoffs, even lower confidence, etc. The probability of recession, now put at 50% by the most pessimistic Wall Street economists, would be close to a certainty, in my opinion.
There is roughly $1.76 trillion of subprime mortgage debt against roughly $1.96 trillion of home value. A 15% drop in home value would reduce equity from $200 billion to a minus $94 billion; so lenders would be on the hook for around $100 billion in writeoffs. Of course, a nationwide 15% decline in home value would result in a far greater decline in the value of homes used as collateral for subprime mortgages due to the impact of foreclosures. In this example, the total writedowns by lenders would be in the hundreds of billions, not just $100 billion.
Given this illustration, it is no wonder that the U.S. government is intervening in the free market process to try to stem the impact of falling home prices. I read that a large commercial bank has subprime mortgages at face value totaling 285% of equity. A fifteen percent writeoff of those mortgages would reduce equity by 42%. Two "venerable" financial institutions, Citicorp and Morgan Stanley, have had to shore up their capital by raising funds from Abu Dhabi and China respectively. The terms of the Citicorp deal, an 11% preferred stock convertible close to the market price of Citicorp common as of the date of issue, are those of a company in trouble. Deterioration in bank equity would mean less ability to lend unless further equity infusions were then available.
By the way, the S&P 500 Index is only off around 7% from its highs. Given the seriousness of the housing crises, I am surprised at such a limited response so far.
Why am I opposed to government intervention here? Am I a free market purist? I believe that the economy in the long run is better off when down cycles cleanse the excesses of the previous up cycles; and the housing bubble is a whopper of excess. Recessions are not pleasant; but U.S. citizens have weathered them in the past. If the U.S.intervenes and continues to bail out those who have made bad investment decisions, it will continue to have a deleterious effect on the U.S. dollar in the long run. It would encourage excesses in the future and indicate to the world that we are permissive and soft. We should remember that a significant portion of U.S. Treasury debt lies in foreign hands. A weak dollar means higher inflation and interest rates in the long run.
Friday, December 14, 2007
Wednesday, November 7, 2007
Liklihood of a bear market
Since the high in the S&P 500 Index (The "Index") of 1553 mentioned in a previous posting, the Index reached a slightly higher high of roughly 1562 recently. However, the new high was unconvincing because it occurred with unimpressive breadth and volume. The recent weakness from that high can be attributable to the confluence of a number of possible causes:
1. The problems in the financial system resulting from the mortgage mess. The ensuing writeoffs by major financial institutions may not be complete.
2. The weakening dollar, while a spur to export growth, is beginning to accelerate on the downside; and global holders of dollar assets are getting nervous. Since the Federal Reserve is worried about recession, it stands ready to continue its easing to avoid one, which would exacerbate dollar weakness. The Fed's best tactic to buoy the dollar would be to RAISE interest rates, hardly likely at this juncture. In short, the Fed is in a bind.
3. While careers have ended on Wall Street in the past due to predictions of the consumers' folding, which rarely happens, one can make a case for recession. Oil prices at close to $100 a barrel, home prices on the decline which restricts borrowing against home values to bolster consumption, and the rapid drop in financial equities could reduce consumer confidence so much that the Christmas season is a bust. That would set off a vicious cycle of lower employment, still lower consumer confidence, leading to lower employment, etc.
4. During this economic up cycle, profit margins have reached 13%, versus a historic norm of 8%. There is plenty of room for Index earnings to decline in the event of a recession.
5. If the leading contender for the Democratic Party's nominee for the Presidency, Hillary Clinton, beats the drum for protectionism loudly; and the financial markets sense that she means it rather than just trying to generate votes, the stock market could take a serious hit.
It is always difficult to identify a bear market in its early stage. After all, the stock market goes up more than 80% of the time. Bull markets die hard! However, for the above reasons, there is more than a de minimus probablity that a bear has already started.
If the recent Index high of 1562 is not exceeded before a bear market occurs, then possible Fibonacci buy points in the Index would be 1261, 1168, 1076. Tune in!
1. The problems in the financial system resulting from the mortgage mess. The ensuing writeoffs by major financial institutions may not be complete.
2. The weakening dollar, while a spur to export growth, is beginning to accelerate on the downside; and global holders of dollar assets are getting nervous. Since the Federal Reserve is worried about recession, it stands ready to continue its easing to avoid one, which would exacerbate dollar weakness. The Fed's best tactic to buoy the dollar would be to RAISE interest rates, hardly likely at this juncture. In short, the Fed is in a bind.
3. While careers have ended on Wall Street in the past due to predictions of the consumers' folding, which rarely happens, one can make a case for recession. Oil prices at close to $100 a barrel, home prices on the decline which restricts borrowing against home values to bolster consumption, and the rapid drop in financial equities could reduce consumer confidence so much that the Christmas season is a bust. That would set off a vicious cycle of lower employment, still lower consumer confidence, leading to lower employment, etc.
4. During this economic up cycle, profit margins have reached 13%, versus a historic norm of 8%. There is plenty of room for Index earnings to decline in the event of a recession.
5. If the leading contender for the Democratic Party's nominee for the Presidency, Hillary Clinton, beats the drum for protectionism loudly; and the financial markets sense that she means it rather than just trying to generate votes, the stock market could take a serious hit.
It is always difficult to identify a bear market in its early stage. After all, the stock market goes up more than 80% of the time. Bull markets die hard! However, for the above reasons, there is more than a de minimus probablity that a bear has already started.
If the recent Index high of 1562 is not exceeded before a bear market occurs, then possible Fibonacci buy points in the Index would be 1261, 1168, 1076. Tune in!
Friday, August 17, 2007
Buying into what could be a bear market
In my previous posting, I discussed buying into a bear market. In it I stated that in order to buy into a bear market, defined as a decline in the S&P 500 Index (the "Index") of at least 20%, I would need the fulfillment of two necessary conditions: 1) a sentiment indicator, Investors Intelligence Survey of Investment Advisors, must show at least 60% bulls and 20% bears; and 2) the Index must have retraced a Fibonacci number. I must admit a mea culpa. I meant to say "60% bears" and "20%" bulls. Some writers intentionally place an error like that in their texts in order to test the reader's attention span. I assure you that this was not the case.
Furthermore, I checked the percentage bears at the major market bottoms in 1974, 1982, 1987, 1990, and 2002. They were 67%, 61%, 46%, 56%, and 43% respectively. So if one were to wait for 60% bears before acting, one would have missed three of the five last major bottoms. Apparently, the "60% bears" rule isn't a good one. However, the above figures can serve as some input as to how high these figures are at major bottoms.
At this point in time, the percentage bears is 33%, well below levels of previous bear market bottoms. Furthermore, with a decline of roughly 10%, the current market action only qualifies as a "correction".
Let us assume that the high in the Index this year, 1553, is a bull market high. The bull market began in 1002 at a level of 775, and the Index has roughly doubled since then. The Index is up a total of 778 points. Reverting to Fibonacci numbers, 3/8, 1/2, and 5/8 retracements would result in levels of the Index at 1262, 1164, and 1067 respectively. I would probably begin buying at around 1200 in the Index if and only if the percentage bears was in the low to mid forties range.
Most Wall Streeters are hoping that this recent ten percent correction is all the downside we will have, and the current bull market will continue without an intervening bear. We must realize that Wall Street benefits far more in a bull market than a bear.
As bridge players say, "Let's review the bidding" with respect to where we are in the economic cycle. During the beginning of the new millenium, Alan Greenspan was worried that the U.S. economy, as a result of the internet stock market bubble, would go the way of Japan, which suffered a severe recession and a stock market that is still down more than 57% from its high EIGHTEEN YEARS ago! He wanted to let the air out of the stock market bubble slowly and cushioned the shock by lowering the federal funds rate to 1%, the lowest since the end of World War II. That policy was partially successful since the ensuing recession was mild. Unfortunately, with this low interest rate policy, he transferred the asset bubble from the stock market to the housing market. Home valuations are now about 40% higher relative to GDP than the norm.That is lower than the S&P 500 Index at its high in 2000, when it was selling at a P/E 100% higher than the norm. During the last several years, Bernanke has tried to let the air out of the housing bubble slowly by slowing raising the federal funds rate to 5.25 %.
The key question as to whether we have entered a bear market is whether the housing problem results in a recession in the U.S. If so, I am afraid that we have begun a bear.
It is possible that even without a recession, we can experience a bear if the current debt crisis results in the potential downfall of a major money center bank, investment bank, or hedge fund. The news of that problem might, in itself, create the buying opportunity that we have discussed above. Tune in!
Furthermore, I checked the percentage bears at the major market bottoms in 1974, 1982, 1987, 1990, and 2002. They were 67%, 61%, 46%, 56%, and 43% respectively. So if one were to wait for 60% bears before acting, one would have missed three of the five last major bottoms. Apparently, the "60% bears" rule isn't a good one. However, the above figures can serve as some input as to how high these figures are at major bottoms.
At this point in time, the percentage bears is 33%, well below levels of previous bear market bottoms. Furthermore, with a decline of roughly 10%, the current market action only qualifies as a "correction".
Let us assume that the high in the Index this year, 1553, is a bull market high. The bull market began in 1002 at a level of 775, and the Index has roughly doubled since then. The Index is up a total of 778 points. Reverting to Fibonacci numbers, 3/8, 1/2, and 5/8 retracements would result in levels of the Index at 1262, 1164, and 1067 respectively. I would probably begin buying at around 1200 in the Index if and only if the percentage bears was in the low to mid forties range.
Most Wall Streeters are hoping that this recent ten percent correction is all the downside we will have, and the current bull market will continue without an intervening bear. We must realize that Wall Street benefits far more in a bull market than a bear.
As bridge players say, "Let's review the bidding" with respect to where we are in the economic cycle. During the beginning of the new millenium, Alan Greenspan was worried that the U.S. economy, as a result of the internet stock market bubble, would go the way of Japan, which suffered a severe recession and a stock market that is still down more than 57% from its high EIGHTEEN YEARS ago! He wanted to let the air out of the stock market bubble slowly and cushioned the shock by lowering the federal funds rate to 1%, the lowest since the end of World War II. That policy was partially successful since the ensuing recession was mild. Unfortunately, with this low interest rate policy, he transferred the asset bubble from the stock market to the housing market. Home valuations are now about 40% higher relative to GDP than the norm.That is lower than the S&P 500 Index at its high in 2000, when it was selling at a P/E 100% higher than the norm. During the last several years, Bernanke has tried to let the air out of the housing bubble slowly by slowing raising the federal funds rate to 5.25 %.
The key question as to whether we have entered a bear market is whether the housing problem results in a recession in the U.S. If so, I am afraid that we have begun a bear.
It is possible that even without a recession, we can experience a bear if the current debt crisis results in the potential downfall of a major money center bank, investment bank, or hedge fund. The news of that problem might, in itself, create the buying opportunity that we have discussed above. Tune in!
Wednesday, April 11, 2007
Buying into a bear market
I want to discuss what to many is very scary: buying into a bear market. First, a disclaimer. There is a word to describe those who always discern the exact bottoms of bear markets, and that word is "liar." Over my money management career, which spanned twenty-seven years, I experienced the stress of at least four bear markets. (I retired at the end of 1995 and, thus, did not have to cope with the bear that started in March, 2000.) You probably have heard the expression that trying to find a bear market bottom is like "trying to catch a falling knife." What I would like to accomplish in this post is to have you look upon a bear market as an opportunity rather than a terrifying event that paralyzes you from taking action.
As an aside, the worst bear market I ever experienced was that of 1973-74, which resulted from a perfect storm of an overvalued market, recession, and high interest rates. I know one small cap growth mutual fund manager who had two consecutive down 40% years. Another person, who ran one of the few hedge funds at the time, had a terrible two years and would wake up in the middle of the night sweating and wondering whether he would soon be driving a cab. The first guy rebounded and eventually retired a couple of decades later a with a huge net worth! The hedge fund manager became a leading Wall Street pundit! The moral of these stories is "Don't despair!"
There are two necessary conditions that must occur before I would buy into a bear market: 1) a "contrary" sentiment indicator, Investors Intelligence's survey of advisory sentiment, must indicate at least 60% bears and no more than 20% bulls; and 2) the bear market must have retraced the previous bull run by a Fibonacci number.
Sentiment indicators are contrarian indicators. Those that measure investor bullishness and bearishness are valuable when there is an abnormal amount of either. For example, when there is an extreme of bullishness, the assumption is that most who want to buy are already in, and the market will soon start down. The opposite is true in the case of a very high level of bearishness. I must warn you that these sentiment indicators are only predictive at extremes. They are threshold indicators, not linear ones. In other words, a move in bullishness from, say, 48% to 50% is just noise, with no predictive value. I have been keeping the advisory sentiment figures for forty years, and have only acted on them fewer than a dozen times. This approach obviously takes discipline and patience. The publishers of these indicators sometimes recommend to readers that they taken action when the indicators haven't reached extreme levels. In my opinion, that is dangerous.
Investors Intelligence has been publishing their survey of advisory sentiment every week for decades. I find them the most reliable sentiment indicator. They used to publish their weekly findings in Barrons, but that was ended a few years ago. Their survey is, however, available to subscribers for an annual fee of several hundred dollars, a very wise investment.
The concept of Fibonacci numbers has a mystical quality to it. However, many money managers use them. For a lengthy explanation of them you might want to Google "Fibonacci numbers."
The important Fibonacci numbers for money managers are .382, .500, and .618. I look at these as percentage retracements of the previous bull market move that occurs during a down market. Thus, possible buy points might occur after 3/8, one half, and 5/8 retracements of a previous bull market move. For purposes of example, let's take the current bull market, which started at a Standard and Poors 500 Index level of roughly 775. Let's assume that the 2007 high thus far of 1460 is a bull market high. Retracements of 3/8, 1/2, and 5/8 of the 685 point bull market move would be levels of 1203, 1118, and 1032 in the Standard and Poors 500 Index. How would you determine which of these levels would be buy points? There is usually symmetry in market cycles. That is, if the amplitude and duration of the previous bull market were long, then the ensuing bear market would likely be the same, so that, under those circumstances, I would wait for the 1/2 retracement to begin buying rather than the 3/8 one. (As I have written above, this buying would only occur if the sentiment indicator had also kicked in.)
Most bear markets end in what is known as a capitulation phase, selling climax, or puking phase. They all describe a scenario where the selling accelerates on very high volume. At this juncture, there is irrational selling. Many sellers have had enough of the pain and just want out!--which provides a
great buying opportunity for those with patience and discipline. A contemporary way to time a selling climax is when the VIX indicator of option implied volatility reaches levels in the 40-50% range.
After a bear market low, usually there is a successful test of that low. The Standard and Poors 500 Index might even penetrate the former low, but there are fewer stocks within the index making new lows at that time. So even if you miss the low, there is an opportunity to get in soon thereafter.
One might ask, "Aren't you ignoring fundamental analysis"? Despite being primarily a fundamentalist, I have found that fundamentals are of no value in recognizing bear market bottoms. I have often said that if I could make only one phone call during a bear market to help me find a buy point, it would be to Investors Intelligence.
As an aside, the worst bear market I ever experienced was that of 1973-74, which resulted from a perfect storm of an overvalued market, recession, and high interest rates. I know one small cap growth mutual fund manager who had two consecutive down 40% years. Another person, who ran one of the few hedge funds at the time, had a terrible two years and would wake up in the middle of the night sweating and wondering whether he would soon be driving a cab. The first guy rebounded and eventually retired a couple of decades later a with a huge net worth! The hedge fund manager became a leading Wall Street pundit! The moral of these stories is "Don't despair!"
There are two necessary conditions that must occur before I would buy into a bear market: 1) a "contrary" sentiment indicator, Investors Intelligence's survey of advisory sentiment, must indicate at least 60% bears and no more than 20% bulls; and 2) the bear market must have retraced the previous bull run by a Fibonacci number.
Sentiment indicators are contrarian indicators. Those that measure investor bullishness and bearishness are valuable when there is an abnormal amount of either. For example, when there is an extreme of bullishness, the assumption is that most who want to buy are already in, and the market will soon start down. The opposite is true in the case of a very high level of bearishness. I must warn you that these sentiment indicators are only predictive at extremes. They are threshold indicators, not linear ones. In other words, a move in bullishness from, say, 48% to 50% is just noise, with no predictive value. I have been keeping the advisory sentiment figures for forty years, and have only acted on them fewer than a dozen times. This approach obviously takes discipline and patience. The publishers of these indicators sometimes recommend to readers that they taken action when the indicators haven't reached extreme levels. In my opinion, that is dangerous.
Investors Intelligence has been publishing their survey of advisory sentiment every week for decades. I find them the most reliable sentiment indicator. They used to publish their weekly findings in Barrons, but that was ended a few years ago. Their survey is, however, available to subscribers for an annual fee of several hundred dollars, a very wise investment.
The concept of Fibonacci numbers has a mystical quality to it. However, many money managers use them. For a lengthy explanation of them you might want to Google "Fibonacci numbers."
The important Fibonacci numbers for money managers are .382, .500, and .618. I look at these as percentage retracements of the previous bull market move that occurs during a down market. Thus, possible buy points might occur after 3/8, one half, and 5/8 retracements of a previous bull market move. For purposes of example, let's take the current bull market, which started at a Standard and Poors 500 Index level of roughly 775. Let's assume that the 2007 high thus far of 1460 is a bull market high. Retracements of 3/8, 1/2, and 5/8 of the 685 point bull market move would be levels of 1203, 1118, and 1032 in the Standard and Poors 500 Index. How would you determine which of these levels would be buy points? There is usually symmetry in market cycles. That is, if the amplitude and duration of the previous bull market were long, then the ensuing bear market would likely be the same, so that, under those circumstances, I would wait for the 1/2 retracement to begin buying rather than the 3/8 one. (As I have written above, this buying would only occur if the sentiment indicator had also kicked in.)
Most bear markets end in what is known as a capitulation phase, selling climax, or puking phase. They all describe a scenario where the selling accelerates on very high volume. At this juncture, there is irrational selling. Many sellers have had enough of the pain and just want out!--which provides a
great buying opportunity for those with patience and discipline. A contemporary way to time a selling climax is when the VIX indicator of option implied volatility reaches levels in the 40-50% range.
After a bear market low, usually there is a successful test of that low. The Standard and Poors 500 Index might even penetrate the former low, but there are fewer stocks within the index making new lows at that time. So even if you miss the low, there is an opportunity to get in soon thereafter.
One might ask, "Aren't you ignoring fundamental analysis"? Despite being primarily a fundamentalist, I have found that fundamentals are of no value in recognizing bear market bottoms. I have often said that if I could make only one phone call during a bear market to help me find a buy point, it would be to Investors Intelligence.
Thursday, March 15, 2007
The Seven Percent Solution
Before anyone reads this blog, I should warn them that I am literally a greybeard. You can assume that these are the meanderings of an addlepated geezer or reflections of someone who had spent several decades as a hedge fund manager, still retains most of his brain cells, and wishes to share his experiences and observations about the current state of financial assets. If you accept the latter, read on.
The long term growth trend of the S&P 500 Index's price is around seven percent annually. It is no coincidence that the long term growth of the Index's earnings is roughly seven percent as well. That growth rate results from the aggregate effects of labor force growth, productivity gains, and price increases.
Stocks and indices trade in channels, with an upper trend line and a lower one. I am especially interested in the lower one because it can give one a rough idea of very long term downside risk. There are seveal ways to compute where the S&P 500 would be on the lower line of the channel:
(1)Take the bear market bottoms of 1974, 1982, 1987, 1990, and 2003 and form a trendline; or take each of those lows and compound at seven percent. Seven percent doubles roughly every ten years, so this makes the computation quite easy. For example, in 1987, the Index bottomed around 205. Twenty years later, compounding at 7% a year, the Index would have quadrupled to 820. Or take the 1990 low of around 290. Compounded at 7% a year, the lower trendline would be around 914. Or the low of 775 in 2003 at becomes 1015 today. Apparently, the lower trendline is at least more than 25% below the Index's price today of around 1400.
Why doesn't Wall Street ever talk about this? The market rarely touches this downtrend line. After all, since 1974 there have been only five times the Index came close to the lower trendline. That's once every six years! Not a parameter useful in an industry that thrives on day to day activity preferably in an up market.
Implicit in this exercise is a strong belief in the concept of "reversion to the norm or mean".
For example, in aggregate, the profit margin of the Index is currently around 13%, much higher than the average 8%. The average yield to maturity of the ten year U.S. Treasury note is roughly 300 basis points above inflation. Now it is 210. If you took the $92 earnings estimate of the Index for 2007 and reduced it to reflect an 8% margin, the estimate would be $57. If you upped the inflation premium to 300 basis points, the ten year would be around a 5.4% yield to maturity. If you then took $57 of earnings and 5.4% yield and inserted them into a dividend discount model, you would probably come out with a number far below 1400 in the Index, perhaps close to the figures we arrived at using our "seven percent solution".
My conclusion is that in order to have a belief that the Index is cheap currently, you must not be a believer in the notion of reversion to the mean.
On my next blog, I shall try to explain how I used to find entry points to go long in a bear market .
The long term growth trend of the S&P 500 Index's price is around seven percent annually. It is no coincidence that the long term growth of the Index's earnings is roughly seven percent as well. That growth rate results from the aggregate effects of labor force growth, productivity gains, and price increases.
Stocks and indices trade in channels, with an upper trend line and a lower one. I am especially interested in the lower one because it can give one a rough idea of very long term downside risk. There are seveal ways to compute where the S&P 500 would be on the lower line of the channel:
(1)Take the bear market bottoms of 1974, 1982, 1987, 1990, and 2003 and form a trendline; or take each of those lows and compound at seven percent. Seven percent doubles roughly every ten years, so this makes the computation quite easy. For example, in 1987, the Index bottomed around 205. Twenty years later, compounding at 7% a year, the Index would have quadrupled to 820. Or take the 1990 low of around 290. Compounded at 7% a year, the lower trendline would be around 914. Or the low of 775 in 2003 at becomes 1015 today. Apparently, the lower trendline is at least more than 25% below the Index's price today of around 1400.
Why doesn't Wall Street ever talk about this? The market rarely touches this downtrend line. After all, since 1974 there have been only five times the Index came close to the lower trendline. That's once every six years! Not a parameter useful in an industry that thrives on day to day activity preferably in an up market.
Implicit in this exercise is a strong belief in the concept of "reversion to the norm or mean".
For example, in aggregate, the profit margin of the Index is currently around 13%, much higher than the average 8%. The average yield to maturity of the ten year U.S. Treasury note is roughly 300 basis points above inflation. Now it is 210. If you took the $92 earnings estimate of the Index for 2007 and reduced it to reflect an 8% margin, the estimate would be $57. If you upped the inflation premium to 300 basis points, the ten year would be around a 5.4% yield to maturity. If you then took $57 of earnings and 5.4% yield and inserted them into a dividend discount model, you would probably come out with a number far below 1400 in the Index, perhaps close to the figures we arrived at using our "seven percent solution".
My conclusion is that in order to have a belief that the Index is cheap currently, you must not be a believer in the notion of reversion to the mean.
On my next blog, I shall try to explain how I used to find entry points to go long in a bear market .
Sunday, March 4, 2007
Are hedge funds partially responsible for last week's decline?
The hedge fund industry, now numbering several thousands funds with
$1.25 to 1.50 trillion (unleveraged) under management has become a very powerful market force. However, the hedge funds utilize a myriad of strategies, so that the total leveraged positions are not all in the same asset classes. For example, there may be a convertible hedge fund, a short only one, a distressed securities one, etc. The only similiarity among them is that most have the same legal structure, a partnership that can go short as well as long and most have incentive compensation agreements, and most can borrow against the assets. There is one theory that hedge funds reduce volatility in the market because they sell short as well as buy long.
My opinion is that they can be destabilizing at this point in time. The amount of money now in them makes the strategies very crowded. That coupled with the need for performance to justify the enormous fees in my judgment creates pressure to go out further on the risk spectrum, which could ultimately lead to a purging of hedge funds. That happened in the 1973-1974 bear market.
A specific example is the so-called unwinding of the "yen carry" trade. Basically, the Bank of Japan has set a very low short-term interest rate, now .5%, recently raised from .25%. According to my friend, Bob Aliber, who taught currencies at the University of Chicago Business School, a hedge fund now has to pay 1.5 to 2.0% to borrow yen, which is still much lower than borrowing in the U.S. The problem is that the yen may appreciate against the U.S. dollar. One could hedge the currency by buying yen futures, but the cost of doing so would eat up the interest rate advantage. So the hedge funds have been borrowing cheap yen and buying assets in other countries. Last week, the yen APPRECIATED against the dollar by about three percent. That is one year's carry advantage gone. The quick reacting hedge funds probably sold the assets the yen purchased to pay back the yen borrowings. This put downward pressure on the prices of those assets and upward pressure on the yen since they had to buy yen to pay back the loan.
This is becoming wordy. Tune in for more ramblings.
$1.25 to 1.50 trillion (unleveraged) under management has become a very powerful market force. However, the hedge funds utilize a myriad of strategies, so that the total leveraged positions are not all in the same asset classes. For example, there may be a convertible hedge fund, a short only one, a distressed securities one, etc. The only similiarity among them is that most have the same legal structure, a partnership that can go short as well as long and most have incentive compensation agreements, and most can borrow against the assets. There is one theory that hedge funds reduce volatility in the market because they sell short as well as buy long.
My opinion is that they can be destabilizing at this point in time. The amount of money now in them makes the strategies very crowded. That coupled with the need for performance to justify the enormous fees in my judgment creates pressure to go out further on the risk spectrum, which could ultimately lead to a purging of hedge funds. That happened in the 1973-1974 bear market.
A specific example is the so-called unwinding of the "yen carry" trade. Basically, the Bank of Japan has set a very low short-term interest rate, now .5%, recently raised from .25%. According to my friend, Bob Aliber, who taught currencies at the University of Chicago Business School, a hedge fund now has to pay 1.5 to 2.0% to borrow yen, which is still much lower than borrowing in the U.S. The problem is that the yen may appreciate against the U.S. dollar. One could hedge the currency by buying yen futures, but the cost of doing so would eat up the interest rate advantage. So the hedge funds have been borrowing cheap yen and buying assets in other countries. Last week, the yen APPRECIATED against the dollar by about three percent. That is one year's carry advantage gone. The quick reacting hedge funds probably sold the assets the yen purchased to pay back the yen borrowings. This put downward pressure on the prices of those assets and upward pressure on the yen since they had to buy yen to pay back the loan.
This is becoming wordy. Tune in for more ramblings.
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