Thursday, December 13, 2012
WALL STREET'S BULLISH BIAS
On Wall Street, money is king! "Winning" is making more money than ever before and more than your peers. Wall Street in aggregate makes much more money during bull markets than bear markets. As a result, the industry has a bullish bias; it tends to inflate earnings expectations and misapply the historical average price to earnings ratio ("P/E ratio") with the result that the market appears undervalued most of the time. Stress on the word "appears."
For example, last year at this time, Wall Street's consensus 2012 operating earnings forecast for the Standard and Poor's 500 Index ("the Index") was around 107, up 10% from 2011. The actual figure for 2012 will come in at around 100. That seven percentage point overestimate, given historical annual earnings growth of 7%, is a big miss.
Furthermore, there has been little notice given to the fact that third quarter Index earnings were actually DOWN 3% from last year's earnings. Since aggregate revenues of the Index were up in the third quarter, lower earnings imply a slight DECLINE in profit margins, which have been close to all time highs of late.
Has this recent earnings decline dampened Wall Street's consensus operating earnings forecast for 2013? Nope! The estimate is 113, up 13% from 2012. How can that be with the confluence of the following: the U.S. economy is currently growing nominally at around 5% annually, profit margins have at least temporarily peaked and may be declining, there will probably be modest austerity measures put into place to start deleveraging at the federal government level, and the EU is at best going to grow moderately in 2013.
Granted, housing starts, an important engine of growth during normal times, have bottomed and have rapidly increased recently, albeit from a very low base. And car and truck sales are recovering nicely. Finally, recent statistics support the notion that China's growth rate will not decline as rapidly as previously thought. Netting these considerations out, I would be surprised if earnings were to exceed 107 in 2013.
I have tried to show that Wall Street tends to inflate earnings prospects. What about the P/E ratio? The historical average P/E for the Index is 15. Keep in mind that there have been 47 recessions in this country's history, or, on average, one every five years. (I do not remember an occasion where the consensus Index operating earnings forecast for the next year was down from the previous year.) Unfortunately, many strategists tend to forget that the historical average P/E ratio should be applied to mid-cycle, or normalized, earnings not to bottoming or peaking earnings. A lower than average P/E should be applied to peak earnings and vice versa for trough earnings. Index earnings can fluctuate violently over a business cycle. Consider recent cycles: earnings peaked at 57 in 2000, bottomed at 39 in 2001, peaked at 92 in 2007, bottomed at 40 in 2009, and are at 100 currently. A Wall Street strategist who applies a 15 P/E to peaking earnings is likely to miss the next bear phase. For example, even multiplying a more rational earnings of 107 for 2012 times a 15 multiple results in a price target during the next twelve months of 1605, a 12% appreciation from current levels. With that approach, the Index appears undervalued at this time. How does one know when earnings are peaking? One doesn't. But with profit margins near record highs and one quarter of lower margins having already occurred, one might have some concern that the peaking process has already started.
How To Adjust Index Fair Value For Earnings Cycles
To seek a better way to consider whether the Index is undervalued or not, perhaps one should visit academia, where money is important but truth more important. Yale professor Robert Shiller, whom I highly respect, has devised what he calls CAPE, an acronym for "cyclically adjusted price earnings ratio". He takes the average twelve month reported Index earnings over the last ten years and divides that by the Index, producing a P/E ratio. He then compares that with the historical average P/E to determine over, under, or fair valuation. This should be more accurate in that it takes actual earnings rather than forecast earnings, thus removing that bullish bias, and accounts for earnings over many cycles, thus removing the tendency to misapply the average P/E to peak earnings. According to this model, as of yesterday, the Index was 27% overvalued.
My approach has similar objectives, but uses a somewhat different technique. I use actual operating earnings instead of reported earnings because reported earnings are after writeoffs which can distort earnings trends. Based on a least squares technique, I try to establish an earnings trendline with an upward slope of 7% annually, which represents normalized earnings growth. Any point on that trendline could be deemed "normalized", or "mid-cycle", or "trendline" earnings. Normalized earnings will be below peak and above bottom earnings. Currently it is 79. I then multiply that by the average historical P/E of 15 to arrive at 1185, the Index fair value. According to this approach, the Index, at 1428 is 20% overvalued.
One caveat: In my approach and presumably in Professor Shiller's, I assume not only normalized earnings but normalized interest rates as well. An inflation rate of 2% annually has usually meant a ten year U.S. government treasury note yield of 5%. That is the number I use in my dividend discount model to arrive at the 15 P/E ratio. Currently, that yield is 1.65%. All things remaining equal, a lower than normalized interest rate should mean a higher P/E and a higher theoretical or fair value for the Index. I stick with my normalized method because the Federal Reserve has lowered interest rates to stimulate the economy and once our economy resumes normalized growth (reaches escape velocity) the yield on the ten year government should approach 5%. (That would mean a horrific loss of principal in long maturity fixed income instruments which would dwarf the interest income earned. As I have said on several posts, the bond market is in a bubble.)
Even with the Index's being overvalued by 20%, the Index (inclusive of dividends) should return pretax 7% a year for the next ten years with a regression to fair or normalized value during that period. That compares favorably with the meager 1.65% return on government notes. Over a five year period the Index generates a total return of 5% a year if a regression to normal valuation were to occur within that period.
The Index is significantly more attractive than bonds over the next five to ten years. This reminds me of the joke about the man who was asked to eulogize an acquaintance who was not a good guy. The eulogizer couldn't think of anything positive to say without prevaricating, so he went to the podium and said "His brother was worse!" Both government bonds and the Index are overpriced, but bonds are worse.
The sentiment indicator I follow is still neutral. Neither an extreme of bullishness nor bearishness has occurred. I remain 30-35% long equities (my core position) with the remainder in cash equivalents. If the Index goes to or below fair value, I shall increase my equity exposure by as much as 100% depending on the extent of the undervaluation.
Thursday, July 26, 2012
MUSINGS
While I have not altered my equity exposure, now 30% of financial assets, I wanted to bring you up to date on my thinking. There will be two parts: my current views on the economy and stock market; and a reiteration of how I manage my family's assets.
The latter may not be of interest to many of you. After all, there are many ways to manage money successfully, and mine may not appeal to you. However, the raison d'etre of this blog was to teach my family one person's approach to money management.
CURRENT VIEWS
My views remain the same: 1) deleveraging takes a very long time to unwind; 2) now, three years from the trough of the business cycle, the economy still seems mired in a sub-par real growth mode of 2% plus or minus one percentage point; 3) such low growth raises the probability of lapsing back into a recession, especially upon any exogenous event, such as a flareup in the Mideast, a sustained severe U.S. drought, etc.; 4) The EU's ongoing deleveraging continues to exacerbate recessions among several important members; 5) significant progress in Europe will only be triggered by some financial crisis there; 6) There is some question whether China will achieve a "soft landing," or something worse, in its attempt to quell inflation, particularly in food and housing; 7) The U.S. economy, probably soon after the election, must undergo its own austerity to stabilize debt as a percentage of GDP ( the so called "fiscal cliff"), which will dampen growth; and 8) on the brighter side, the passage of time has benefited the auto and housing industries due to the buildup of demand for those products. The housing slump has been an important inhibiting factor to resuming normal GDP growth (what I call achieving "escape velocity"), and its recent upturn may set the stage for significantly better employment numbers. If that were to occur, the stock market would stage a breathtaking rally.
My conclusion remains that, currently, most probably the U.S. economy will continue to muddle through, with recession next most probable, albeit still a low probability, and escape velocity the least probable.
The S&P 500 Index at 1360 is roughly 15% overvalued based on my normalized price to earnings ratio of 15 and normalized earnings of less than 80 (compared to estimates of 100 this year). For some time now, I have opined that, over the next ten years, the S&P 500 Index will easily outperform, on a risk adjusted basis, the 1.5% yield to maturity of the 10 year U.S. Treasury note.
However, over the next six to twelve months, the outlook for the stock market is quite murky. The rapid growth in earnings from the 2009 trough has slowed considerably. A return to normal profit margins may be starting. Economic indicators have weakened recently, and some economists feel that a recession in the U.S. may have already started.
This year, the S&P 500 Index has outperformed some European indices, the emerging markets as a whole (especially China), and Japan. However, volume has been quite low. It appears that high frequency traders/hedge funds have constituted a disproportionate share of total trading. When there appears to be progress in Europe, signs of faster growth in China, or imminent additional easing by the Federal Reserve ("QE3"), the stock market rallies. Subsequent negative news on these fronts then snuffs out the rallies.
I have a contrary view on the Fed's QE3. Conventional wisdom is that enactment of QE3 will spark a rousing and lasting rally in our stock market. In my judgment, the positive effect on our economy of each successive easing has been less than the preceding one. The Federal Reserve is running out of bullets. When QE3 is announced, there may be a one to three day rally; but, in my opinion, it will peter out much sooner than expected. It will be an example of "Buy on the rumor; sell on the news." At that time, mostly all of the good news will have been out.
REITERATION OF MONEY MANAGEMENT METHODOLOGY
My approach to managing the family's financial assets is to assign a core equity position to each family member based on how the stock market's valuation compares to its fair value, each person's age, financial needs, and other asset categories such as property. In my case, the relevant differential variables are my age, 73, and the value of the East Hampton property. That property's value correlates highly with the stock market's level because potential buyers, including Wall Street executives, will likely pay more when they are wealthier. On Wall Street, incremental wealth is primarily a function of yearly bonuses. So, to me, the East Hampton property has a greater stock market content than, say, a property in Kentucky, where I spent my youth. I currently have a core equity exposure of 30%.
To those who have read most of my previous posts, it must be apparent that I place great emphasis on a single sentiment indicator and on the relationship of the stock market's current value to what I consider "fair value." This sentiment indicator, which measures bullishness and bearishness among writers of financial newsletters, is a contrary one in that extremes of bullishness are considered a bearish signal. This sentiment indicator is only useful at extreme readings; thus, it is usually neutral, as it is now. The fair valuation measure is based on a dividend discount model. I use normalized, or trendline, earnings and earnings growth, rather than current earnings and growth in order to adjust for cyclical variations around the secular trend.
Were both an extreme level of bearishness and a significant undervaluation of the stock market to occur, then I would increase my equity exposure above the core level. For example, during the first decade of the millennium I had a zero equity exposure except on two occasions, in the 2001-2003 period and 2008 to the present. For most of that decade I believed that U.S. Treasury 10 year notes would outperform the S&P 500 Index, which, at the beginning of the decade, was a rare 100% overvalued. If we were to experience a bear market from here, I would probably double my exposure and sell that new incremental position when the stock market became significantly overvalued and the sentiment indicator reached a bullish extreme.
Once the equity exposure is determined, I then select how that exposure should be allocated among countries. After that, I decide which types of equities within a given country, such as large capitalization growth or value, small cap growth or value, etc. are the most attractive. Then I choose which no-load mutual funds best represent that category. (I do not select individual equities myself because that requires constant vigilance, which I don't want to do during my retirement.)
The latter may not be of interest to many of you. After all, there are many ways to manage money successfully, and mine may not appeal to you. However, the raison d'etre of this blog was to teach my family one person's approach to money management.
CURRENT VIEWS
My views remain the same: 1) deleveraging takes a very long time to unwind; 2) now, three years from the trough of the business cycle, the economy still seems mired in a sub-par real growth mode of 2% plus or minus one percentage point; 3) such low growth raises the probability of lapsing back into a recession, especially upon any exogenous event, such as a flareup in the Mideast, a sustained severe U.S. drought, etc.; 4) The EU's ongoing deleveraging continues to exacerbate recessions among several important members; 5) significant progress in Europe will only be triggered by some financial crisis there; 6) There is some question whether China will achieve a "soft landing," or something worse, in its attempt to quell inflation, particularly in food and housing; 7) The U.S. economy, probably soon after the election, must undergo its own austerity to stabilize debt as a percentage of GDP ( the so called "fiscal cliff"), which will dampen growth; and 8) on the brighter side, the passage of time has benefited the auto and housing industries due to the buildup of demand for those products. The housing slump has been an important inhibiting factor to resuming normal GDP growth (what I call achieving "escape velocity"), and its recent upturn may set the stage for significantly better employment numbers. If that were to occur, the stock market would stage a breathtaking rally.
My conclusion remains that, currently, most probably the U.S. economy will continue to muddle through, with recession next most probable, albeit still a low probability, and escape velocity the least probable.
The S&P 500 Index at 1360 is roughly 15% overvalued based on my normalized price to earnings ratio of 15 and normalized earnings of less than 80 (compared to estimates of 100 this year). For some time now, I have opined that, over the next ten years, the S&P 500 Index will easily outperform, on a risk adjusted basis, the 1.5% yield to maturity of the 10 year U.S. Treasury note.
However, over the next six to twelve months, the outlook for the stock market is quite murky. The rapid growth in earnings from the 2009 trough has slowed considerably. A return to normal profit margins may be starting. Economic indicators have weakened recently, and some economists feel that a recession in the U.S. may have already started.
This year, the S&P 500 Index has outperformed some European indices, the emerging markets as a whole (especially China), and Japan. However, volume has been quite low. It appears that high frequency traders/hedge funds have constituted a disproportionate share of total trading. When there appears to be progress in Europe, signs of faster growth in China, or imminent additional easing by the Federal Reserve ("QE3"), the stock market rallies. Subsequent negative news on these fronts then snuffs out the rallies.
I have a contrary view on the Fed's QE3. Conventional wisdom is that enactment of QE3 will spark a rousing and lasting rally in our stock market. In my judgment, the positive effect on our economy of each successive easing has been less than the preceding one. The Federal Reserve is running out of bullets. When QE3 is announced, there may be a one to three day rally; but, in my opinion, it will peter out much sooner than expected. It will be an example of "Buy on the rumor; sell on the news." At that time, mostly all of the good news will have been out.
REITERATION OF MONEY MANAGEMENT METHODOLOGY
My approach to managing the family's financial assets is to assign a core equity position to each family member based on how the stock market's valuation compares to its fair value, each person's age, financial needs, and other asset categories such as property. In my case, the relevant differential variables are my age, 73, and the value of the East Hampton property. That property's value correlates highly with the stock market's level because potential buyers, including Wall Street executives, will likely pay more when they are wealthier. On Wall Street, incremental wealth is primarily a function of yearly bonuses. So, to me, the East Hampton property has a greater stock market content than, say, a property in Kentucky, where I spent my youth. I currently have a core equity exposure of 30%.
To those who have read most of my previous posts, it must be apparent that I place great emphasis on a single sentiment indicator and on the relationship of the stock market's current value to what I consider "fair value." This sentiment indicator, which measures bullishness and bearishness among writers of financial newsletters, is a contrary one in that extremes of bullishness are considered a bearish signal. This sentiment indicator is only useful at extreme readings; thus, it is usually neutral, as it is now. The fair valuation measure is based on a dividend discount model. I use normalized, or trendline, earnings and earnings growth, rather than current earnings and growth in order to adjust for cyclical variations around the secular trend.
Were both an extreme level of bearishness and a significant undervaluation of the stock market to occur, then I would increase my equity exposure above the core level. For example, during the first decade of the millennium I had a zero equity exposure except on two occasions, in the 2001-2003 period and 2008 to the present. For most of that decade I believed that U.S. Treasury 10 year notes would outperform the S&P 500 Index, which, at the beginning of the decade, was a rare 100% overvalued. If we were to experience a bear market from here, I would probably double my exposure and sell that new incremental position when the stock market became significantly overvalued and the sentiment indicator reached a bullish extreme.
Once the equity exposure is determined, I then select how that exposure should be allocated among countries. After that, I decide which types of equities within a given country, such as large capitalization growth or value, small cap growth or value, etc. are the most attractive. Then I choose which no-load mutual funds best represent that category. (I do not select individual equities myself because that requires constant vigilance, which I don't want to do during my retirement.)
Wednesday, December 7, 2011
The Best House In A Bad Neighborhood?
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.
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.
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.
Tuesday, November 2, 2010
THIS TIME GRIDLOCK IS NOT GOOD!
In a post last June, I stated that further fiscal stimulus on the order of $300 to $500 billion might be necessary to keep the economy from lapsing into another recession. I also believed that Bernanke's and Paulson's success in "scaring straight" Congress into passing TARP quickly, along with later fiscal stimulus by the Obama administration, had kept the recession from morphing into a depression. Unfortunately one can't prove a negative--one can't say with certainty what would have happened without these steps. In this mid-term election, Republicans have claimed that fiscal stimulus and the Fed's quantitative easing have done little to free the economy from its Slough of Despond. After all, 2% real GDP growth in the third quarter is only a third to a half the growth that occurred when the economy emerged from the prior comparable recessions of 1973-4 and 1982. Republicans have criticized the heavy debt burden resulting from these attempts, with no apparent significant benefits. After all, unemployment still remains close to 10%. Hendrik Hertzberg of the New Yorker said it eloquently, "The presence of pain is more keenly felt than the absence of agony".
We are now faced with a Republican-controlled House, a slim Democratic majority in the Senate, and a Democratic President--what Wall Street describes as "gridlock". Wall Street has always embraced Congressional gridlock because it means less interference with Adam Smith's "invisible hand". NOT SO THIS TIME!
In previous posts, I have pointed out ad nauseam that: 1) the borrowing binge in the U.S. economy that persisted for fifteen years must be reversed, i.e. deleveraged: 2) according to the Economic Cycle Research Institute (ECRI) during the latter years of the debt binge, economic growth actually was lower than normal and recessions were more frequent: 3) during the deleveraging period, growth should be lower than during the leveraging period; and 4) no one knows WHEN deleveraging will reach a level where consumers and businesses will feel confident enough to resume normal spending, without additional government help. This return to normalcy is known in economic circles as "escape velocity." Escape velocity may take several years to happen, or could happen soon. Since the leveraging process took about fifteen years, if one believes in symmetry, then the deleveraging process still has a ways to go.
I believe strongly that some time in the future the government must reduce the deficit as a percentage of real GDP; but, and here is the rub, NOT UNTIL THE ECONOMY REACHES ESCAPE VELOCITY! Republicans want to attack the problem of increasing deficits and debt burden immediately. Until escape velocity is reached, further fiscal stimulus is likely to be necessary just to keep the economy in slow growth mode!
With a gridlocked Congress, any effort to stimulate the economy is left to the Federal Reserve. Today the Fed will announce what is known as "quantitative easing 2", which is simply printing more money to buy Treasury securities. The Fed hopes that by lowering interest rates on longer maturity Treasury debt, investors will be coaxed into buying stocks, and consumers and businesses will be persuaded to spend more. Also, the dollar might decline more than other currencies, which should stimulate our exports.
As one economist put it: if there are fifteen ways to stimulate the economy, quantitative easing ranks fourteenth or fifteenth in effectiveness. However, the others must go through Congress, thus the importance of gridlock. If quantitative easing fails, and Congress is loath to pass additional fiscal stimulus, we may face the dreaded deflationary spiral--lower prices, a consumer who reduces present spending because prices will be lower in the future, more layoffs, and an ensuing vicious cycle. If that occurs, the S&P 500 Index, now at 1193, would drop to roughly 840, a 30% decline. While normally a less than 5% probability, due to the deleveraging process and a recalcitrant Congress, I am raising that probability to 30%.
The most probable scenario is that the U.S. economy muddles through with 2% real growth until escape velocity occurs. In that case, the S&P 500 would slowly appreciate until normal growth resumes. At that point, the enormous flow of mutual fund money into bond funds over the past few years should be reversed. The ten year Treasury note would quickly jump from a yield of 2.6% now to 4 or 5%. Money would flow out of bond funds into equity funds, creating a stock buying panic or meltup! The S&P 500, which in my opinion is currently roughly 12% to 31% overvalued, depending on normalized earnings growth and interest rate assumptions, would quickly become much more overvalued.
In late 1999 I submitted an article to Barron's, which was published in the Other Voices column on December 27, the last issue before the new millennium. In it I argued that, at 29 times earnings and a 1.2% dividend yield, the S&P 500 Index, at 1435, was vastly overpriced relative to the almost 7% yield one could receive from zero coupon Treasury securities with maturities from 5 to 25 years. I suggested that pension funds sell the S&P 500 Index funds and buy the zeroes. While the current situation is not the exact opposite of 1999, I believe that over the next ten years the S&P 500 Index, even at its current overvalued level, will provide a 6% total return point to point, outperforming Treasury bonds' meager 2.6% yield -- more than justifying the incremental risk.
However, the road will be bumpy. There will be several bear markets during the period. While I want to be exposed to equities during this period with a core equity position of 30% of my financial assets, I feel that I can trade around that position. I am currently holding an equity exposure of 40%, down from 60% late last year. If the equity buying panic ensues and bullish sentiment reaches an extreme, I will sell another ten percent and protect the remaining position by buying at the money or out of the money puts. If the economy lapses into another recession with an accompanying bear market, I will take the equity risk exposure back up to 50% or more by dollar cost averaging into weakness The remainder of my financial assets are in 90 day Treasury bills, which yield zilch. Once escape velocity occurs, I plan to switch from these bills into ten year Treasury notes, hopefully with a 4% to 5% yield to maturity.
On another subject, since I started my blog in early 2007, I have written more than thirty posts. They are not equally spaced in time. I am only interested in writing a new post when I change my asset allocation or when I feel that events have occurred that are worth discussing.
We are now faced with a Republican-controlled House, a slim Democratic majority in the Senate, and a Democratic President--what Wall Street describes as "gridlock". Wall Street has always embraced Congressional gridlock because it means less interference with Adam Smith's "invisible hand". NOT SO THIS TIME!
In previous posts, I have pointed out ad nauseam that: 1) the borrowing binge in the U.S. economy that persisted for fifteen years must be reversed, i.e. deleveraged: 2) according to the Economic Cycle Research Institute (ECRI) during the latter years of the debt binge, economic growth actually was lower than normal and recessions were more frequent: 3) during the deleveraging period, growth should be lower than during the leveraging period; and 4) no one knows WHEN deleveraging will reach a level where consumers and businesses will feel confident enough to resume normal spending, without additional government help. This return to normalcy is known in economic circles as "escape velocity." Escape velocity may take several years to happen, or could happen soon. Since the leveraging process took about fifteen years, if one believes in symmetry, then the deleveraging process still has a ways to go.
I believe strongly that some time in the future the government must reduce the deficit as a percentage of real GDP; but, and here is the rub, NOT UNTIL THE ECONOMY REACHES ESCAPE VELOCITY! Republicans want to attack the problem of increasing deficits and debt burden immediately. Until escape velocity is reached, further fiscal stimulus is likely to be necessary just to keep the economy in slow growth mode!
With a gridlocked Congress, any effort to stimulate the economy is left to the Federal Reserve. Today the Fed will announce what is known as "quantitative easing 2", which is simply printing more money to buy Treasury securities. The Fed hopes that by lowering interest rates on longer maturity Treasury debt, investors will be coaxed into buying stocks, and consumers and businesses will be persuaded to spend more. Also, the dollar might decline more than other currencies, which should stimulate our exports.
As one economist put it: if there are fifteen ways to stimulate the economy, quantitative easing ranks fourteenth or fifteenth in effectiveness. However, the others must go through Congress, thus the importance of gridlock. If quantitative easing fails, and Congress is loath to pass additional fiscal stimulus, we may face the dreaded deflationary spiral--lower prices, a consumer who reduces present spending because prices will be lower in the future, more layoffs, and an ensuing vicious cycle. If that occurs, the S&P 500 Index, now at 1193, would drop to roughly 840, a 30% decline. While normally a less than 5% probability, due to the deleveraging process and a recalcitrant Congress, I am raising that probability to 30%.
The most probable scenario is that the U.S. economy muddles through with 2% real growth until escape velocity occurs. In that case, the S&P 500 would slowly appreciate until normal growth resumes. At that point, the enormous flow of mutual fund money into bond funds over the past few years should be reversed. The ten year Treasury note would quickly jump from a yield of 2.6% now to 4 or 5%. Money would flow out of bond funds into equity funds, creating a stock buying panic or meltup! The S&P 500, which in my opinion is currently roughly 12% to 31% overvalued, depending on normalized earnings growth and interest rate assumptions, would quickly become much more overvalued.
In late 1999 I submitted an article to Barron's, which was published in the Other Voices column on December 27, the last issue before the new millennium. In it I argued that, at 29 times earnings and a 1.2% dividend yield, the S&P 500 Index, at 1435, was vastly overpriced relative to the almost 7% yield one could receive from zero coupon Treasury securities with maturities from 5 to 25 years. I suggested that pension funds sell the S&P 500 Index funds and buy the zeroes. While the current situation is not the exact opposite of 1999, I believe that over the next ten years the S&P 500 Index, even at its current overvalued level, will provide a 6% total return point to point, outperforming Treasury bonds' meager 2.6% yield -- more than justifying the incremental risk.
However, the road will be bumpy. There will be several bear markets during the period. While I want to be exposed to equities during this period with a core equity position of 30% of my financial assets, I feel that I can trade around that position. I am currently holding an equity exposure of 40%, down from 60% late last year. If the equity buying panic ensues and bullish sentiment reaches an extreme, I will sell another ten percent and protect the remaining position by buying at the money or out of the money puts. If the economy lapses into another recession with an accompanying bear market, I will take the equity risk exposure back up to 50% or more by dollar cost averaging into weakness The remainder of my financial assets are in 90 day Treasury bills, which yield zilch. Once escape velocity occurs, I plan to switch from these bills into ten year Treasury notes, hopefully with a 4% to 5% yield to maturity.
On another subject, since I started my blog in early 2007, I have written more than thirty posts. They are not equally spaced in time. I am only interested in writing a new post when I change my asset allocation or when I feel that events have occurred that are worth discussing.
Monday, June 28, 2010
MORE STIMULUS OR ELSE?
With May's meager private sector employment growth, weak housing, and slow retail sales growth, the question arises whether we will just experience a slowdown in growth during the second half of 2010 or something worse--tipping back into recession-- the dreaded double dip. A lot rides on the employment report due out next Friday. If private sector employment rose 150,000 or more in June, a hopeful slow growth case lives. Alternatively, another weak report bodes ill.
What could the government do to support the economy in the event another recession looms? Short maturity interest rates are already about as low as they can get. The logical solution would be more fiscal stimulus. We might need as much as $300 to $500 billion more stimulus to maintain reasonable economic growth. We can "afford" it. After all, a lot of the TARP money has been repaid. The problem, however, is that Congress seems loath to pass any further stimulus, especially with midterm elections in November. Battling factions are those wanting austerity versus those wanting more stimulus if necessary -- the former are starting to prevail. In September of 2008, the Treasury Secretary and Fed Chairman went to the Hill and "scared straight" Congress into passing a massive stimulus bill. While it is difficult to prove a negative, had that stimulus not been passed post haste, our economy would have, in my opinion, lapsed into a Depression. It will be more difficult to replicate that tactic now.
I agree that, OVERALL, democracy is the best form of government, but sometimes it can get messy. This may be one of those times when a more authoritative form of government, such as the philosopher king in Plato's Republic, might be preferable. After all, China's leadership can introduce more stimulus to its economy without the normal lengthy legislative process we must go through.
We must avoid a deflationary, vicious economic cycle such as our country experienced in the 1930s and Japan during the last two decades.
VALUATION METRICS
Those of you who have read my posts are aware that I normalize earnings, earnings growth rates, and interest rates when calculating the fair value of the S&P 500 Index. Plugging these variables into a dividend discount model results in a rough idea of the price to earnings multiple at which the Index should be selling. That multiple is historically 15 times earnings. Annual earnings growth has, over long periods of time, been around 7%.
In a post written on June 4, 2009 entitled "What A Difference A Percentage Point Makes!" I discussed the impact a one percentage point decline in earnings growth, to 6% annually, would have on the Index's theoretical fair value. I wrote this post because the current period of deleveraging should have an adverse effect on earnings growth. Unfortunately, a 6% earnings growth assumption results in a double whammy: a lower theoretical price to earnings ratio, reduced to 13; and lower normalized earnings. You might be interested in the following table, which depicts the fair value of the Index at these two earnings growth rates.
Wall Street has a tendency to be optimistic. I do not expect the market to reflect the less optimistic earnings assumption for a long time. Based on the above table, at 1077, the S&P 500 Index is only 5% overvalued. One caveat--if the economy lapses back into recession, theoretical fair value means little because actual earnings will crater
What could the government do to support the economy in the event another recession looms? Short maturity interest rates are already about as low as they can get. The logical solution would be more fiscal stimulus. We might need as much as $300 to $500 billion more stimulus to maintain reasonable economic growth. We can "afford" it. After all, a lot of the TARP money has been repaid. The problem, however, is that Congress seems loath to pass any further stimulus, especially with midterm elections in November. Battling factions are those wanting austerity versus those wanting more stimulus if necessary -- the former are starting to prevail. In September of 2008, the Treasury Secretary and Fed Chairman went to the Hill and "scared straight" Congress into passing a massive stimulus bill. While it is difficult to prove a negative, had that stimulus not been passed post haste, our economy would have, in my opinion, lapsed into a Depression. It will be more difficult to replicate that tactic now.
I agree that, OVERALL, democracy is the best form of government, but sometimes it can get messy. This may be one of those times when a more authoritative form of government, such as the philosopher king in Plato's Republic, might be preferable. After all, China's leadership can introduce more stimulus to its economy without the normal lengthy legislative process we must go through.
We must avoid a deflationary, vicious economic cycle such as our country experienced in the 1930s and Japan during the last two decades.
VALUATION METRICS
Those of you who have read my posts are aware that I normalize earnings, earnings growth rates, and interest rates when calculating the fair value of the S&P 500 Index. Plugging these variables into a dividend discount model results in a rough idea of the price to earnings multiple at which the Index should be selling. That multiple is historically 15 times earnings. Annual earnings growth has, over long periods of time, been around 7%.
In a post written on June 4, 2009 entitled "What A Difference A Percentage Point Makes!" I discussed the impact a one percentage point decline in earnings growth, to 6% annually, would have on the Index's theoretical fair value. I wrote this post because the current period of deleveraging should have an adverse effect on earnings growth. Unfortunately, a 6% earnings growth assumption results in a double whammy: a lower theoretical price to earnings ratio, reduced to 13; and lower normalized earnings. You might be interested in the following table, which depicts the fair value of the Index at these two earnings growth rates.
Wall Street has a tendency to be optimistic. I do not expect the market to reflect the less optimistic earnings assumption for a long time. Based on the above table, at 1077, the S&P 500 Index is only 5% overvalued. One caveat--if the economy lapses back into recession, theoretical fair value means little because actual earnings will crater
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