I have not changed my equity exposure, which is 30% of financial assets. However, several developments merit discussion.
The deleveraging in Europe has reached a critical stage. Often when very difficult decisions have to be made, they are postponed until forced upon them by the markets. "Necessity is the mother of invention!"
Two unpleasant steps have to be taken. To keep the EU intact, the strongest nation, Germany, ultimately must pay a price in order to absorb the effects of the weakest nations' profligacy. Such action lets these nations off the hook and encourages future bad behavior, which is anathema to the German psyche. But at the same time, the EU has been a boon to German exports, and perhaps Germany can suspend their antipathy toward bailouts for their own better economic well being -- a calculated cost-value decision. In the Fall of 2008, two anti-moral hazard leaders, Paulson and Bernanke, persuaded the U.S. Congress to enact TARP, essentially bailing out profligate U.S financial institutions. I wrote about this in a post entitled "Scared Straight!"
The second step is setting up a fiscal governing body for the EU or EC, one with teeth. Such a body could force fiscal discipline on any member until desired levels of budget deficits and debt are reached and maintained. If a member doesn't comply, the penalties must be severe--with expulsion from the community a possibility. Chauvinism runs high in Europe. Getting seventeen nations to agree on this may be extremely difficult.
If the European Central Bank is satisfied that movement toward resolution of this crisis conveys both sincerity and a sense of urgency, it is likely to lower interest rates.
For certain, even the best outcome entails austerity. The European economies in aggregate are larger than our economy. Europe is teetering on recession, and may already be in one.
With respect to China, the Central Committee is attempting to dampen inflation without causing too great a slowdown in growth--a "soft landing." Whether such an outcome can be achieved is yet to be determined.
The U.S. is now the "best house in a bad neighborhood." Our aggregate equity market is up slightly for 2011 thus far, while all other major equity markets are down significantly. While our growth continues to be subpar, recent economic stats, particularly a lower trend in unemployment claims and a gradual increase in private employment, point to no imminent recession. While real incomes remain flat, consumers apparently are dipping into savings during this Christmas season, with retail sales surprisingly robust so far. When asked, as many as 40% say they will spend less this Christmas and 70% plus don't plan to borrow more to pay for Xmas gifts. However, one should never underestimate the U.S. consumer's propensity to spend. Watch what they do, not what they say!
In any event, the risk of outright recession in the fourth quarter has receded. Whether our economy can decouple from the rest of the world for much longer is questionable. The highest probability is that the U.S. economy continues to muddle through with subpar growth. The next most probable event would be recession, with the imminent attainment of "escape velocity" the least probable.
An interesting question is whether the U.S. economy can reach escape velocity before our own austerity measures kick in. The passage of time favors resumption of normal growth because pent-up demand for new cars and new homes is building. At some point these factors will overwhelm deleveraging effects. On the other hand, after the November 2012 elections, we must deal with our own federal debt and deficit issues. Like Europe, this entails austerity, or lower GDP growth.
Achieving escape velocity would mean 3% to 3.5% real growth in GDP over several quarters without the aid of additional fiscal or monetary stimulus. The discounting of that event would trigger a massive rally in the S&P 500 Index, regardless of its overvaluation at that time.
At this juncture, the S&P 500 Index is slightly overvalued at 1260. Fair value for 2012, based on normalized earnings growth and interest rates, is 1150 to 1200. For those of you unfamiliar with my methodology, I suggest you read my posts entitled "The Seven Percent Solution", written March 15, 2007, and "More Stimulus Or Else" with the subheading "Valuation Metrics", written June 28, 2010.
Wednesday, December 7, 2011
Monday, August 1, 2011
Escape Velocity?--DEFINITELY NOT YET
Last Friday's horrific GDP revisions should have overshadowed the circus surrounding the debt extension debate. Not only was the recession from December 2007 to mid 2009 harsher than previously reported, the recovery from it has been at half the normal growth rate. And to make things worse, the first half of 2011 has grown at less than an annualized 1% rate. In the latest quarter ending June 30, consumption, thanks in part to rising gasoline prices, barely advanced, at a 0.1% annual rate.
Those of you who have managed to read my past postings without nodding off realize:1) that the secular deleveraging now occurring will take a lot of time, (2) it is highly uncertain how much time it will take because there are very few recent observations to analyze, 3) pundits who claim to have "insights" into when "escape velocity" will happen are speaking with the "authority of ignorance," 4) the gridlock in Congress is not good because further significant fiscal stimulus may be needed to avoid lapsing back into recession and such stimulus would be difficult to pass, particularly with an election looming, and 5) while Bernanke might embark on another round of quantitative easing (QE3), the effect of such an undertaking would probably be akin to "pushing on a string." We are now two years into an economic recovery. A normal recovery and expansion lasts twice that long. To quantify my current feeling, at this stage during a normal expansion, the probability of an imminent recession would be no more than 20%. However, due to the above factors, I would put that probability at 30 to 40%. Perhaps the economy can soon reach escape velocity, or normal growth without additional governmental fiscal and monetary stimulus. But based on the above, my assessment is that such a belief is the triumph of hope over experience.
Currently, the chief positive is aggregate corporate earnings growth since the recession. S&P 500 Index earnings have already surpassed the previous cycle high, primarily due to the combination of: 1) sales growth without additional employees (profit margin expansion), and 2) forays into the high growth areas of the world.
At 1292, the S&P 500 Index is selling for 14 times last twelve months earnings. Bulls argue that, historically, the average P/E ratio for the Index has been 15, and the ten year U.S. Treasury note is yielding only 2.8%, way below normal, which argues for a higher than normal P/E ratio because future dividends are discounted to the present at a lower rate. Thus, according to the bulls, the Index is slightly undervalued.
My approach has been to value the Index based on normalized earnings and normalized interest rates. Normalized earnings, I assume, will grow at the old 7% a year rate. Despite an over-leveraged domestic economy with an aging population, this could happen because of rising business in the high growth areas abroad. Trendline earnings in 2011 are roughly $74, so, in my view, at 1292 the Index is selling at more than 17 times normalized earnings -- overvalued by 16%.
As an aside, Wall Street, with its bullish bias, insists on applying the historical average 15 multiple to peaking earnings. This is an anomaly I have never understood during a half century following the stock market. Doesn't it make more sense to apply the average multiple to average or trendline earnings, a lower multiple to peak earnings and a higher multiple to trough earnings?
As most of you know, I have already reduced my equity exposure from a high of 60% of financial assets to the current 30%. I feel comfortable with that although the market is somewhat overvalued. A purist might argue that my holding any equity exposure is a variant of the "Bigger Fool" theory--that is, I am a fool holding overvalued stocks and expecting to sell them at a higher price to a bigger fool. If the economy lapses into recession soon, I will be able to reinvest the sidelined cash at much lower prices--perhaps as low as the 840 to 1000 area. If the economy gains escape velocity, interest rates should rise sharply, which should allow me to invest in the ten year Treasury note at a 4 to 5% yield to maturity versus 2.8% now.
Those of you who have managed to read my past postings without nodding off realize:1) that the secular deleveraging now occurring will take a lot of time, (2) it is highly uncertain how much time it will take because there are very few recent observations to analyze, 3) pundits who claim to have "insights" into when "escape velocity" will happen are speaking with the "authority of ignorance," 4) the gridlock in Congress is not good because further significant fiscal stimulus may be needed to avoid lapsing back into recession and such stimulus would be difficult to pass, particularly with an election looming, and 5) while Bernanke might embark on another round of quantitative easing (QE3), the effect of such an undertaking would probably be akin to "pushing on a string." We are now two years into an economic recovery. A normal recovery and expansion lasts twice that long. To quantify my current feeling, at this stage during a normal expansion, the probability of an imminent recession would be no more than 20%. However, due to the above factors, I would put that probability at 30 to 40%. Perhaps the economy can soon reach escape velocity, or normal growth without additional governmental fiscal and monetary stimulus. But based on the above, my assessment is that such a belief is the triumph of hope over experience.
Currently, the chief positive is aggregate corporate earnings growth since the recession. S&P 500 Index earnings have already surpassed the previous cycle high, primarily due to the combination of: 1) sales growth without additional employees (profit margin expansion), and 2) forays into the high growth areas of the world.
At 1292, the S&P 500 Index is selling for 14 times last twelve months earnings. Bulls argue that, historically, the average P/E ratio for the Index has been 15, and the ten year U.S. Treasury note is yielding only 2.8%, way below normal, which argues for a higher than normal P/E ratio because future dividends are discounted to the present at a lower rate. Thus, according to the bulls, the Index is slightly undervalued.
My approach has been to value the Index based on normalized earnings and normalized interest rates. Normalized earnings, I assume, will grow at the old 7% a year rate. Despite an over-leveraged domestic economy with an aging population, this could happen because of rising business in the high growth areas abroad. Trendline earnings in 2011 are roughly $74, so, in my view, at 1292 the Index is selling at more than 17 times normalized earnings -- overvalued by 16%.
As an aside, Wall Street, with its bullish bias, insists on applying the historical average 15 multiple to peaking earnings. This is an anomaly I have never understood during a half century following the stock market. Doesn't it make more sense to apply the average multiple to average or trendline earnings, a lower multiple to peak earnings and a higher multiple to trough earnings?
As most of you know, I have already reduced my equity exposure from a high of 60% of financial assets to the current 30%. I feel comfortable with that although the market is somewhat overvalued. A purist might argue that my holding any equity exposure is a variant of the "Bigger Fool" theory--that is, I am a fool holding overvalued stocks and expecting to sell them at a higher price to a bigger fool. If the economy lapses into recession soon, I will be able to reinvest the sidelined cash at much lower prices--perhaps as low as the 840 to 1000 area. If the economy gains escape velocity, interest rates should rise sharply, which should allow me to invest in the ten year Treasury note at a 4 to 5% yield to maturity versus 2.8% now.
Monday, February 28, 2011
Sell Down To Your Sleeping Point
The turmoil in the Middle East has sent oil prices soaring. If this persists for several months, its negative impact on other consumer spending would nullify the positive impact from the modest incremental stimulus package approved late last year. Since I have believed that additional fiscal stimulus has been needed to offset the restrictive effect of deleveraging, this situation could derail the fragile economic recovery.
There are two ways (or a combination of the two) to deleverage, or reduce debt relative to underlying assets and income-- 1) write off debt and reduce asset values accordingly; or 2) inflate asset values. Conservatives prefer the former; liberals the latter. When the Democrats controlled both the House and Senate, the Obama Administration could pursue the latter strategy. Now that the Republicans control the House, additional stimulus is more problematic. A student of the 1930s Depression, Bernanke is concerned that removal of stimulus prematurely could send the economy back into recession, as happened in the late Thirties.
Recent economic statistics indicate a strengthening of the economy perhaps to "escape" velocity, or an economy able to sustain normal growth without additional governmental monetary or fiscal stimulus. Convincing evidence of this would require several months of employment gains in excess of 200,000 persons a month. If that happens, then there is probably another leg up in our stock market. Otherwise, there is a likelihood of a severe stock market correction or worse.
The events in the Middle East are of great concern to me. Years later the ultimate outcome of this may be a more stable, democratic environment there. But the near term effect is uncertain, and the equity market hates uncertainty.
There is an old stock market adage, "Sell down to your sleeping point!" If you feel so uncomfortable with your long equity position that you are losing sleep, more often than not it is wise to pare down your position to the point where you can resume normal sleep. Several days ago I did just that. I reduced my equity exposure from 40% of financial assets to 30%. To put this in context, I initially took a 40% equity position in 2008, rebalanced it from 60% back to 40% in late 2009, and reduced it to 30% late last week.
There are two ways (or a combination of the two) to deleverage, or reduce debt relative to underlying assets and income-- 1) write off debt and reduce asset values accordingly; or 2) inflate asset values. Conservatives prefer the former; liberals the latter. When the Democrats controlled both the House and Senate, the Obama Administration could pursue the latter strategy. Now that the Republicans control the House, additional stimulus is more problematic. A student of the 1930s Depression, Bernanke is concerned that removal of stimulus prematurely could send the economy back into recession, as happened in the late Thirties.
Recent economic statistics indicate a strengthening of the economy perhaps to "escape" velocity, or an economy able to sustain normal growth without additional governmental monetary or fiscal stimulus. Convincing evidence of this would require several months of employment gains in excess of 200,000 persons a month. If that happens, then there is probably another leg up in our stock market. Otherwise, there is a likelihood of a severe stock market correction or worse.
The events in the Middle East are of great concern to me. Years later the ultimate outcome of this may be a more stable, democratic environment there. But the near term effect is uncertain, and the equity market hates uncertainty.
There is an old stock market adage, "Sell down to your sleeping point!" If you feel so uncomfortable with your long equity position that you are losing sleep, more often than not it is wise to pare down your position to the point where you can resume normal sleep. Several days ago I did just that. I reduced my equity exposure from 40% of financial assets to 30%. To put this in context, I initially took a 40% equity position in 2008, rebalanced it from 60% back to 40% in late 2009, and reduced it to 30% late last week.
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