June 1, 2004
Do Valuations "Feel" About Right?
“This really blew my mind; the fact that me – an overfed, long-haired… leaping gnome – should be the star of a Hollywood movie. Hmmm. But, there I was.”
- Spill the Wine, Eric Burdon & War, 1970
The last time we saw a bad decade for stocks, I was growing up in Chicago, listening to “hippie” songs like that on the radio, and stocks were selling about the multiples they're selling at today (a bit lower then, but sometimes bad is bad). Well, thirty years later, some of those hippies have cut their hair and have taken their stations at major Wall Street firms. You can still identify them from the way they analyze the market by talking about what “feels” right. As in, “A P/E of 20 times operating earnings feels about right,” or “It feels like this economy is entering a real expansion phase.”
The problem with this sort of analysis-by-feeling is when those subjective feelings are simply contradicted by objective facts. It's like saying “It feels like this bond is going to deliver a 6% yield to maturity” when the bond is objectively priced to deliver 4%. The same is true of stocks. If you pay 18 times peak operating earnings at a time when there is an unusually wide gap between operating earnings and free cash flow, and when the historical norm has been closer to 12 times operating earnings, you can say all you want about valuations “feeling right.” The fact is that you're going to earn unusually low long-term returns.
So the argument gets bolstered by the claim that inflation and interest rates are low, so P/E multiples ought to be higher. But if you're going to compare the rate of return on stocks to the rates of return on other assets, you'd better be talking about securities of similar duration. As I've noted before, the duration of stocks is over 60 years here (at normal historical valuations, the duration has been closer to 25 years). The duration of a 10-year bond is about 8 years. Unless the argument is that interest rates and inflation are likely to remain low for the indefinite future, it's absurd to argue that present levels of inflation and interest rates are relevant to setting the valuations of stocks.
Not that inflation is even low anymore, if anyone would bother to check. The year-over-year rate for the CPI has now climbed to 2.3%, with a year-over-year rate of 3.7% for the PPI. With little doubt, the upcoming comparisons will be even higher, given that recent energy price increases will largely hit the May numbers when they are released later this month. Then add this fact: increases in short-term interest rates have a strong tendency to increase monetary velocity, accelerating the inflationary effects of the prior monetary ease. That's analytical shorthand for saying that inflation surprises are likely to be firmly to the upside in the months ahead.
As I noted last week, output growth has a tendency to reduce, not increase the rate of inflation. In fact, periods of higher output growth are consistently associated with lower rates of inflation (simply, prices are a reflection of scarcity – greater output supply implies less price pressure). So without the fairly rapid growth we've seen in GDP over the past few quarters, inflation rates would have been even higher. The difficulty here is that the underlying measures of capital and labor demand – capacity utilization, help wanted, bank lending, commercial paper issuance – are all still very tepid for this point in an expansion. (With regard to the help wanted index, online advertising may have some effect on the level of the index, but it should still be trending higher, which it is not).
While I don't place too much emphasis on econometric models or forecasts, it's of at least some concern that our inflation models are now more hostile than they've been at any time since the 1970's.
So on the inflation front, it seems about time to pull out the bell bottoms, tie-dye shirts and vinyl 45's… maybe go for some Deep Purple, Grand Funk Railroad, Bachman Turner Overdrive and The Guess Who.
The Market Climate for stocks remains characterized by unusually unfavorable valuations and unfavorable market action. The Strategic Growth Fund remains fully invested in a broadly diversified portfolio of stocks, with an offsetting hedge intended to remove the impact of overall market fluctuations from that portfolio.
After the deeply oversold status that the market achieved a few weeks ago, we've seen the standard “fast, furious, and prone to failure” rally to clear that. It's important to emphasize how dangerous it is to attempt “playing” these rallies. In a negative Climate like this, stocks can remain deeply oversold for some time, so oversold conditions in and of themselves make poor buy points. Similarly, the subsequent rallies tend to end without notice, and often without hitting “standard” resistance points such as moving averages, Bollinger bands, or prior resistance levels. It's possible, when interest rates are falling, to construct certain favorable “sub-Climates” within what would commonly be viewed as bear markets. But in decades of research, I've still not found a reliable means to capture brief “bear market rallies” that don't include falling yields as a requirement. We don't have that here, so all rallies in this Climate should be viewed as suspect.
In bonds, the recent rally in straight bonds provides a reasonable opportunity to reduce portfolio duration. In the Strategic Total Return Fund, our present duration of about 3.5 years is solidly in Treasury Inflation Protected Securities, which I continue to view as useful investments here. The Market Climate for precious metals also remains favorable, while the U.S. dollar continues to appear vulnerable. The markets continued to re-evaluate the risks of inflation last week (correctly, in my view), so we've seen a nice recovery in many inflation-linked assets. Overall, the Strategic Total Return Fund remains positioned primarily to benefit from downward pressure on real interest rates and the U.S. dollar, but our overall exposure to risk is relatively conservative in all of the asset classes we hold – TIPS, precious metals, utilities, U.S. agency notes, and foreign government securities.
New from Bill Hester: Valuing the Fed's Inflation Fighting Credibility
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