The Good News
The Obama economic team is excellent--a good blend of high intellect, experience and fresh faces. Prior to Friday's announcement of Geithner as Treasury Secretary, there appeared to be a leadership vacuum in Washington. Paulsen had folded up TARP. Bush was acting like a lame duck. Obama had been silent about his economic team.
Not only has Obama fleshed out and announced his team, he also has shown over the weekend that he understands the gravity of this country's economic situation and the necessity for injecting a huge dose of Keynesian fiscal stimulus ASAP to restore confidence in both the public and private sectors. He is showing a pragmatic side that is essential if our economy is going to emerge from this mess. This is not the time for ideology.
Our economy is experiencing a "liquidity trap", the severity of which has not been seen since the Thirties. Lenders are reluctant to lend and borrowers to borrow -- primarily due to lack of trust in our financial institutions and confidence in our economy's future. Monetary policy is ineffective in jump starting the economy --a phenomenon known as "pushing on a string" -- hence the need for massive fiscal stimulus.
Hopefully, the stimulus plan will address the decline in home prices, which got us into this mess in the first place. Mounting foreclosures are poison to the housing market. Furthermore, there should be no hint of protectionism. Such a path in the Thirties aggravated the downturn.
The Citicorp "rescue" plan is a de facto step toward nationalization under the guise of a "passive" investment. From my point of view, the action is constructive, but doesn't go far enough. What is needed to restore trust in banks is a secondary market for their toxic securities. Such a market would establish the clearing prices for them. At that point, the banks would know how much additional capital is needed to begin lending again; and that capital would either be raised privately or, if necessary, by the U.S. Treasury.
We have all heard the adage that "those who do not study history are doomed to repeat it". We have a Federal Reserve Chairman who is an expert on what happened in the Thirties. Let's hope that his and our study of that horrific time will prove sufficient to avoid the doom of repeating it.
The Possible Bad News
Last week the breaching of two interrelated, important trends occurred --the long-term upward price trend of the S&P 500 Index (the "Index") and the long-term rise in the consumer price index ex food and fuel. These breaches may be aberrations, but if not, are very significant because they would signal, respectively, a secular downtrend in the Index and deflation.
As you know, I have been closely watching the market's testing of the October 10 lows in order to discern whether that date constituted a major market bottom. Until last week, all tests were successful. Even now, the number of new 52 week lows and the consolidated daily volume haven't yet reached the October 10 levels. However, the Index last Thursday closed at 752. In past postings, I have said that the Index's price is the least important of the three criteria I had been observing. However, the Index at 752 is a special case because it is BELOW THE 2002 BEAR MARKET LOW OF 776. Since this secular bull market began in 1974, never has a succeeding bear market low been lower than a preceding one. This raises the specter of a secular downtrend in the Index.
The consumer price index ex food and fuel declined a tenth of one percent last month--a rare decline. Only during a few years since the Depression has modest deflation occurred, but that was nothing compared to the 5-10% annual deflation during the Thirties. If this decline persists, it may become embedded in the collective pysche of consumers--a truly dangerous development. Consumers would then expect prices to continue falling, so why buy now? The effects of lower prices and lower consumption on corporate earnings would be devastating. The Index earnings would enter into a secular downtrend, mirroring the possible secular downtrend in the Index's price alluded to above.
While this potential risk should be kept in mind, I believe "net-net" that the recent developments regarding Obama's economic team and stimulus program will trigger a very significant rally, perhaps to a level of 1100 to 1200 in the Index. At that point, I for one must decide whether or not the Index remains in a secular uptrend.
Monday, November 24, 2008
Friday, November 14, 2008
"All In!"--A Double Entendre
Yesterday, the October 10 lows survived the greatest test yet. The number of NYSE new lows Thursday was 776 versus 2901 on October 10; the consolidated volume yesterday was 7.6 billion shares compared with 11.2 billion on October 10. However, the S&P 500 Index did drop to a new intraday low of 819 versus 839 on October 10. As I have discussed in a previous posting, a slightly lower price (this was less than 3%lower) does not detract from my contention that October 10 marked the low for most NYSE stocks during this bear market. There has been at least one major bear market that ended in a similar way, with a breadth climax followed in a few months by a lower Index low but with far fewer new 52 week lows.
In a phrase well known to poker players, I am now "all in". I have completed my equity position started last March. I am also "all in" in terms of fatigue--hence the double entendre.
I want to make clear that an "all in" equity position for me, aged 69, is 40% of my total financial assets. The remaining 60% is in U.S. Treasury bills. Hopefully, I can sell those bills and purchase the 10 year Treasury Note sometime in the future when note yields exceed 5%, compared with 3.7% currently.
I was entirely in Treasury bills at the beginning of 2008, purchased half of the equity position in March and filled the other half during October and November. Basically, I have dollar-cost-averaged, but with only two tranches determined by my market timing approach laid out in my previous postings. The average cost of my position is roughly 1080 in the Index--not bad but should have been better.
Those of you who have read my previous meanderings have been saturated with my
claim that a measure of fear and greed rather than an earnings estimate is the better timing indicator of major market turns. The principal reason for that is that the stock market tends to bottom well before earnings bottom.
However, I have often touched on the "fundamentals". My last posting was a discussion of earnings estimates. In it I estimated that earnings for the next four quarters could drop from the high of $91.45 in mid-2007 to as low as $48 in mid-2009. "Normalized", or trendline, earnings at that time would be $64. Applying the 15 average historical price to earnings ratio to trendline earnings would result in a trendline S&P 500 Index price of 960.
The bears find that calculation ridiculous! They point out that the bear markets in 1974 and 1982 bottomed at ten times depressed earnings! (That would imply an Index level below 500!) My response is that you must take into account the level of interest rates during those lows. In 1974 and 1982, interest rates were much higher than now. The five-year treasury note was yielding 7.8% at the 1974 stock market bottom, 10.2% in 1982, and 2,3% today! Interest rates determine the rate at which future earnings and dividends are discounted to the present. A much lower interest rate results in a much higher present value.
For perspective, Goldman Sachs used to publish a table showing their "Justifiable Share Price for the S&P 500". I have one from 1994. The five-year note interest rate assumptions ranged in 50 basis point increments from 8.0% to 6%. At 8%, the justifiable value for the Index was 339; for 6%, it was 491, a 45% increase in value
solely due to a 200 basis point, or 25%, reduction in the interest rate assumption.
Perhaps a more relevant comparison would be with the 2001-2003 bear market when interest rates were more comparable. Earnings bottomed at $38.85 in 2001 and the Index eventually at 770, for a price to earnings ratio of just under twenty. At the recent intraday low of 819, the Index was selling for seventeen times my recession low earnings of $48. (And by the way, few, if any, have that low an estimate.)
In a former posting I suggested that the upside target would be the Index highs of 2000 and 2007. That double top is at 1565. The key question is not whether the Index will reach that price, but when? Here is a simplistic way of estimating. We can back into it. The historical average p/e is fifteen. At 1565 and a p/e of 15, earnings should be 1565 divided by 15, or roughly $104. Normalized earnings at mid-2009 are $64. Compounded at 7% annually, $64 becomes $104 in seven to eight years. So sometime in 2016 at the latest, the Index should reach the old highs. From the October 10 low of 840 to 1565 in 2016, the Index would have generated an 8% compound annual appreciation plus a 2%-3% dividend yield--a handsome total return indeed!
What the bears have to keep in mind is that, at some point, the market will begin acting well in the face of dreadful news. That may already have begun. Furthermore, the current dividend yield on the Index is around 3%, and treasury bills are yielding a mere 0.3%. Moreover,the five-year government note is yielding only 2.34%. The combination of these factors will ultimately lead to an episode of spontaneous combustion when the investment goal changes from "return OF capital" to "return ON capital". I wouldn't want to hold excess cash at that time.
201
In a phrase well known to poker players, I am now "all in". I have completed my equity position started last March. I am also "all in" in terms of fatigue--hence the double entendre.
I want to make clear that an "all in" equity position for me, aged 69, is 40% of my total financial assets. The remaining 60% is in U.S. Treasury bills. Hopefully, I can sell those bills and purchase the 10 year Treasury Note sometime in the future when note yields exceed 5%, compared with 3.7% currently.
I was entirely in Treasury bills at the beginning of 2008, purchased half of the equity position in March and filled the other half during October and November. Basically, I have dollar-cost-averaged, but with only two tranches determined by my market timing approach laid out in my previous postings. The average cost of my position is roughly 1080 in the Index--not bad but should have been better.
Those of you who have read my previous meanderings have been saturated with my
claim that a measure of fear and greed rather than an earnings estimate is the better timing indicator of major market turns. The principal reason for that is that the stock market tends to bottom well before earnings bottom.
However, I have often touched on the "fundamentals". My last posting was a discussion of earnings estimates. In it I estimated that earnings for the next four quarters could drop from the high of $91.45 in mid-2007 to as low as $48 in mid-2009. "Normalized", or trendline, earnings at that time would be $64. Applying the 15 average historical price to earnings ratio to trendline earnings would result in a trendline S&P 500 Index price of 960.
The bears find that calculation ridiculous! They point out that the bear markets in 1974 and 1982 bottomed at ten times depressed earnings! (That would imply an Index level below 500!) My response is that you must take into account the level of interest rates during those lows. In 1974 and 1982, interest rates were much higher than now. The five-year treasury note was yielding 7.8% at the 1974 stock market bottom, 10.2% in 1982, and 2,3% today! Interest rates determine the rate at which future earnings and dividends are discounted to the present. A much lower interest rate results in a much higher present value.
For perspective, Goldman Sachs used to publish a table showing their "Justifiable Share Price for the S&P 500". I have one from 1994. The five-year note interest rate assumptions ranged in 50 basis point increments from 8.0% to 6%. At 8%, the justifiable value for the Index was 339; for 6%, it was 491, a 45% increase in value
solely due to a 200 basis point, or 25%, reduction in the interest rate assumption.
Perhaps a more relevant comparison would be with the 2001-2003 bear market when interest rates were more comparable. Earnings bottomed at $38.85 in 2001 and the Index eventually at 770, for a price to earnings ratio of just under twenty. At the recent intraday low of 819, the Index was selling for seventeen times my recession low earnings of $48. (And by the way, few, if any, have that low an estimate.)
In a former posting I suggested that the upside target would be the Index highs of 2000 and 2007. That double top is at 1565. The key question is not whether the Index will reach that price, but when? Here is a simplistic way of estimating. We can back into it. The historical average p/e is fifteen. At 1565 and a p/e of 15, earnings should be 1565 divided by 15, or roughly $104. Normalized earnings at mid-2009 are $64. Compounded at 7% annually, $64 becomes $104 in seven to eight years. So sometime in 2016 at the latest, the Index should reach the old highs. From the October 10 low of 840 to 1565 in 2016, the Index would have generated an 8% compound annual appreciation plus a 2%-3% dividend yield--a handsome total return indeed!
What the bears have to keep in mind is that, at some point, the market will begin acting well in the face of dreadful news. That may already have begun. Furthermore, the current dividend yield on the Index is around 3%, and treasury bills are yielding a mere 0.3%. Moreover,the five-year government note is yielding only 2.34%. The combination of these factors will ultimately lead to an episode of spontaneous combustion when the investment goal changes from "return OF capital" to "return ON capital". I wouldn't want to hold excess cash at that time.
201
Thursday, November 6, 2008
Earnings Estimates or "Look, father, the security analysts wear no clothes!"
Prior to entering the hedge fund business in 1968, I spent my first four years on Wall Street as a security analyst. I felt that I added value to the equity portfolios of my firm's clients. However, I realized early on that most analysts parroted back what management told them. There was very little analysis. Most analysts were mere journeymen. Since then, whenever I hear what analysts in aggregate are estimating for the S&P 500 Index's earnings, the so-called "bottom up" approach, I ignore the findings. The better approach is the "top down" one, which scrutinizes macroeconomic variables.
In previous postings, I have mentioned that the aggregate profit margin of the companies in the 500 Index had reached 13% versus the normal 8%. This occurred in the year ending mid-2007, when earnings were $91.47. At that time, normalized earnings would then have amounted to 8/13 of those lofty earnings, or roughly $56.
Historically, normalized earnings have grown at a 7% compounded annual rate. (See my early posting entitled "The Seven Percent Solution".) So normalized earnings for mid-2009 would be $56 compounded for two years at 7%, or roughly $64.
I have long held the position that deleveraging the economy would cause a very serious recession. It wouldn't surprise me if earnings declined 25% from the normalized level. Reducing normalized earnings of $64 by 25% would bring earnings down to $48. The "bottom up" estimate for the four quarters ending mid-2009 is $86.95! Guess in which estimate I place more faith!
In previous postings, I have mentioned that the aggregate profit margin of the companies in the 500 Index had reached 13% versus the normal 8%. This occurred in the year ending mid-2007, when earnings were $91.47. At that time, normalized earnings would then have amounted to 8/13 of those lofty earnings, or roughly $56.
Historically, normalized earnings have grown at a 7% compounded annual rate. (See my early posting entitled "The Seven Percent Solution".) So normalized earnings for mid-2009 would be $56 compounded for two years at 7%, or roughly $64.
I have long held the position that deleveraging the economy would cause a very serious recession. It wouldn't surprise me if earnings declined 25% from the normalized level. Reducing normalized earnings of $64 by 25% would bring earnings down to $48. The "bottom up" estimate for the four quarters ending mid-2009 is $86.95! Guess in which estimate I place more faith!
Subscribe to:
Posts (Atom)
