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 .

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.