June 15, 2009
The Outlook is Not Up, But Very Widely Sideways
Valuation Update: We estimate that the S&P 500 is currently priced to deliver total returns over the next decade in the range of 6.5-9.0%, centered at an expected total return of about 7.8% annually. Stocks are modestly overvalued here, except on metrics that assume a permanent recovery to 2007's record profit margins (which were about 50% above the historical norm).
On normalized profit margins, sustainable S&P 500 earnings are slightly above $60 on the index. That's certainly higher than the 7 bucks of net earnings that companies in the index have reported over the past 52 weeks, but unfortunately, even at current prices, the S&P 500 is near 16 times normalized earnings.
You can get that basic figure a lot of ways. Currently, book value on the S&P 500 is slightly above $500. Outside of the past 15 years, when the economy was building up to a debt crisis, the typical return on equity for the S&P 500 has historically ranged between about 10-12%. While a higher debt load raises return on equity in good times, it also leads more quickly to bankruptcy in bad times, as we've observed, and will continue to observe. The deleveraging pressure on the U.S. and global economy here is likely to be associated with a normalization in return-on-equity just as we're observing a normalization in profit margins (return on revenue, so to speak). Applying the higher end of historical return on equity to current book value, and assuming that we don't see major further writedowns in book value for the index, we again get a normalized earnings figure close to about $60. The higher earnings figures (over $80) that we observed in 2007 were based on profit margins and returns on equity far above the historical norm, and were also bolstered by unusual contributions from financials and commodity-driven companies.
Presently, the price-to-book ratio on the S&P 500 is about 1.9. If you think about the 1974 and 1982 lows, we observed price/book ratios at about 0.8, while price-to-normalized earnings multiples were at about 7. So the S&P 500 would have to drop by about 60% to match the best valuations that we've seen during the past 40 years. Investors shouldn't kid themselves that stocks are cheap - in the sense of being priced to deliver outstanding long-term returns - just because we've observed a wicked decline. We're not even close.
At the March lows, the S&P 500 was priced to deliver long-term returns in the 10-12% range. Certainly not bad, but only modestly above the norm on a historical basis, in an economy that faced (and still threatens to suffer) difficulties well outside the norm. While that might have been the final low, and we can't rule out further market gains, I still believe that it is a mistake to rule out eventual "revulsion." I don't think that we need to match valuations that existed at the 1974 or 1982 lows, but at a multiple of 16 times our current estimate for normalized earnings, suffice it to say that the market is not cheap.
What we've seen in recent weeks has been a recovery of between 25-33% of the losses that the market has suffered since its 2007 peak, putting the S&P 500 up about 6% year-to-date in total return, with the Dow up about 2%. While that sort of recovery, in this event, has implied a significant gain given the extent of the prior losses, the rebound relative to the loss is not unusual (though not easily predictable either, since such rebounds can abruptly fail early or late into the bounce). I continue to believe that it is a mistake to treat the recent advance as if it has significant information content about the economy. We are observing only smaller negatives (and even those may only be a reprieve based on a temporary lull in the mortgage reset schedule).
Until now, "less bad than expected" has been enough for investors. As a friend of mine quoted last week from a song by The Doors, "I've been down for so long, it feels like up to me." At this point, however, stocks are priced to require an economic recovery. That is a difficult bet, in my view, because as I noted last week, economic expansions are emphatically not driven by a "consumer recovery." They are invariably driven by swings in gross domestic investment - capital spending, autos, housing, factories, and other outlays that are heavily reliant on debt financing. That's why housing starts have such a strong correlation with GDP growth.
It is a very hard sell to expect a sustained recovery in debt-financed gross investment in an economy under strong deleveraging pressure. That's particularly true since the U.S. itself has not financed a penny of the growth in U.S. gross domestic investment in more than a decade - all of the growth has been financed by foreign capital inflows via a massive current account deficit. With government spending now drawing on those foreign savings to defend bank bondholders from losses, and a continuing need to shrink the current account deficit in the years ahead, gross domestic investment is likely to continue to be squeezed. We are in the midst of - and will continue to require - perhaps the largest adjustment in U.S. personal, corporate and government balance sheets that we will see in our lifetimes. This will be a very long slog. The outlook is not up, but very widely sideways.
It's nice to see consumer confidence rebound from its abysmal lows, but consumer confidence can largely be predicted from past changes in the stock market and inflation. A nice rally in stocks, coupled with soft inflation figures, has been helpful. But consumer confidence is not a useful predictive indicator of even consumer spending. Consumption is a very large, but also very stable part of GDP, and it is not the source of major variance. Indeed, except during the past year, we've never seen nominal consumer spending decline year-over-year even in recessions. The "permanent income hypothesis" of Modigliani and Friedman holds up very well in the data - investors simply do not significantly shift their consumption based on short-term fluctuations in income.
That said, it's a very negative signal that we've observed a decline in consumer spending over the past year - again - it's never happened before. The fact that it has in this instance suggests that consumers are anticipating a largely permanent downward adjustment in their overall spending ability. The lack of opportunity for continued mortgage equity withdrawals (a major source of consumer spending in recent years) explains part of that. The loss of investment and home values is another.
In typical recessions, unemployment tends to be a lagging indicator, and the employment figures themselves tend to move up and down roughly in concert with the overall economy. In the current downturn, however, the unusually high debt burden and precariousness of mortgages among households creates a dynamic that we don't usually observe. In the current cycle, as Ray Dalio of Bridgewater has correctly (in my view) pointed out, unemployment is likely to be a leading indicator of the economy. In an overleveraged economy, job losses can be expected to be followed by further delinquencies and mortgage foreclosures. While I don't expect that this will cause a violent feedback loop, I do believe that it is glib to assume that the employment markets and the U.S. economy are on a one-way track to improvement.
We've seen a nice but predictably temporary lull in the mortgage reset schedule. We've seen a nice, typical recovery of just under a third of the market's prior losses. We've seen a nice easing from the frantic pace of job losses earlier this year. All of those have been pleasant, but it is a mistake to draw information from them. There is very little information content in mean reversion following extreme moves.
Cash, Liquidity, and New Stock Issuance
I continue to be astounded by the bad analysis, misleading reporting and non-equilibrium thinking in the discussion of the bailouts, new stock issuance by financial companies, and other forms of "liquidity." This seems like a good time to review some concepts relating to "money flow" and equilibrium in order to clarify what is going on here. The upshot is that there is not a bunch of new money "looking for a home." Rather, we've observed a reallocation of risks from the private sector to the government, with the amount of purchasing power in the economy unchanged.
First, note that when the government issues Treasuries to finance the bailout of financial companies, somebody has to buy the Treasuries. The Treasury's spending is not "new" money, but is instead a redistribution. Think about it (drawing it out with pen and paper can help). In aggregate, if the government issues a trillion dollars of Treasury debt to finance bailouts, a trillion dollars of cash is taken out of the hands of the buyers of those Treasuries, and a trillion dollars of cash goes into the hands of the banks, who issue some sort of obligation (mostly preferred stock) to the government in return. So on the government's balance sheet, it has a trillion dollars of new debt as a liability, and a trillion dollars of bank stock (which may very well become worthless down the road, but is booked as an asset initially). On the private sector's balance sheet, there is a new trillion dollar asset (the Treasury bonds), and a new trillion dollar liability (the securities issued by the banks to the government). There has been a reallocation of risk, but emphatically, there is no more cash than there was before. All that is happened is that the holders of cash may have changed.
I say "may" have changed, because at present, the largest purchasers of Treasury securities have been financial companies. In effect, no net cash has been spent or received. If you add all the transactions up, the cash nets out, leaving us with a pure asset swap. The banks have a bunch of new Treasury securities on their books, and they have issued a bunch of preferred stock to the government to pay for it. They can't do any lending with that until they get somebody else to buy the Treasuries in return for cash that already exists.
Contrast this situation with what the Fed has done. The Fed has gone out and purchased commercial mortgage-backed securities from the banks, and has given them cash (in the form of bank reserves). On the Fed's balance sheet, there are new assets - the mortgage securities - and new liabilities - the cash (which is an obligation of the Fed, as is written right there at the top of the pieces of paper in your wallet). The mortgage payments previously owed to banks are now owed to the Fed, who holds those mortgage securities. Imagine the Fed holds those securities permanently, and all the mortgages are in fact paid off. Then the assets on the Fed's books (those mortgage securities) would decline as the securities are retired, and the Fed's liabilities (U.S. currency) would also decline - assuming that the Fed holds onto the payments and takes the dollars out of circulation. In actuality, these transactions are not permanent, but are repos, so banks aren't counting on that cash being actually useable for new long-term loans - they are using it as stopgap liquidity. Meanwhile however, there is a significant risk to having such a large volume of government liabilities outstanding, because it may very well cause a deterioration in the value of those liabilities over time (i.e. inflation).
On the bank balance sheets, there are fewer mortgage securities as a result of the Fed's intervention, but more cash reserves in their place. If the banks were willing to take the risk to lend this cash out, and there were borrowers with economic projects that they thought were promising enough to borrow money on the obligation of paying it back, we would get new lending and new economic projects. That is not happening, because the banks were overleveraged to begin with, and are using the cash as a cushion against further losses. Private borrowers are also generally averse to new debt and are trying to deleverage. So for now, we have very little inflationary pressure, but also very little new lending, as a result of Fed interventions.
Aside from inflation risks over the medium term (say 4-10 years out), the government's intervention will ultimately be costly to the extent that the securities it has taken from the private sector (bank equity in the case of the Treasury, commercial mortgage-backed securities in the case of the Fed) turn out to be worthless. In my view, this is a significant risk that has been understated by both the Fed and the Treasury. Time will tell.
In recent weeks, we've observed an enormous amount of new stock issuance, rivaling only the spikes that we observed at the market peaks of 2000 and 2007. Financial companies in particular are using the funds received from private investors to pay back the Treasury. Again, think in terms of balance sheets. On the bank's ledger, there is new stock being issued to private investors in return for cash. That cash then goes to the Treasury, and the stock that was issued to the Treasury is retired. In the end, there is no more cash at the banks than there was before, but instead of the Treasury owning stock, new private investors own it. From the Treasury's perspective, it now has less bank stock, but a return of the cash. The Treasury could retire the debt it incurred, but is currently fighting to hold onto that cash for further bailouts at its discretion.
My difficulty with the recent wave of issuance is that it has largely been based on misleading disclosures, not least being the government's "stress tests" that I've discussed previously. To issue stock on such assurances is like issuing stock on the basis of a fraudulent offering document. Yes, it is a free market, and investors can buy newly issued stock if they like, but my impression is that investors buying this newly issued stock have been misled about the health of the underlying institutions.
Overall then, the proper way to think of all of these bailouts and stock issues is not that new purchasing power is being created, but that ownership of existing assets and liabilities has changed in a way that reallocates risk from the private sector to the government. There is not a bunch of money "looking for a home." The overall effect of the bailouts has been to put Treasury securities and temporary bank reserves in the hands of the financial companies, in return for preferred stock and temporary repos of commercial mortgage backed securities. Let those corporate securities fail however, and that's when we have a real money creation problem, because the government will have created liabilities that it cannot buy back in using the assets it took in when it created them. That's a huge risk here.
Meanwhile, apart from the new issuance discussed above (which has, in effect, swapped bank stock out of the hands of the Treasury and into the hands of private investors), I am perplexed that people who hold themselves out as investment professionals continue to talk about "money going into stocks" as if the dollar that a buyer brings into the market doesn't go right back out in the hands of the seller.
As I noted in the March 12, 2007 comment (The Money Flow Myth and the Liquidity Trap),
"We should be very clear that there is no such thing as money going into or out of a secondary market. When stocks are issued in an IPO, or bonds are floated to investors, companies receive funds from investors and, in return, give investors pieces of paper called stocks and bonds, as evidence of the investors' claim on some future stream of cash. This is a "primary market" transaction.
"Once those pieces of paper are issued, they are traded between investors in the "secondary market." When we talk about the stock market, we're talking almost exclusively about the secondary market, because new issues make up a very small part of total activity.
"Dear Wall Street analysts and financial reporters - when investors purchase a stock in the secondary market, the dollars that buyers bring "into" the market are immediately taken "out of" the market in the hands of the sellers. It is an exchange. This is why the place it happens is called a "stock exchange." The stock market is not an air balloon into which money goes in or out and expands or contracts that balloon. Nor is it a water balloon that is expanded by pouring in "liquidity." Prices are not driven by the amount of money that buyers "put in" or sellers "take out" (as those dollar amounts are identical). Prices are determined by the relative eagerness of the buyer versus the seller.
"If a dentist in Poughkeepsie is willing to pay up 10 cents to buy a single share of General Electric, the total market value of General Electric increases by over $1 billion (GE has 10.28 billion shares outstanding - do the math). In this way, market capitalization can be created and destroyed out of thin air and on the smallest of trading volumes. So you'd better be sure that the there is a sound and fairly reliable stream of expected cash flows backing up the value of the securities you're buying.
"Cash does not ever find a "home" in a secondary market. Every time you hear the phrase "investors are putting money into…" or "investors are taking money out of …" or "money is flowing out of … and into …," it is a signal that the speaker is unable to distinguish a secondary market from a primary one.
"As I used to teach my students, if Mickey sells his money market fund to buy stocks from Ricky, the money market fund has to sell some of its T-bills or commercial paper to Nicky, whose cash goes to Mickey, who uses the cash to buy stocks from Ricky. In the end, the cash that was held by Nicky is now held by Ricky, the money market securities that were held by Mickey are now held by Nicky, and the stock that was held by Ricky is now held by Mickey. There may have been some change in the relative prices between cash, money market securities and stocks, depending on which of the three was most eager, but there is precisely the same amount of "cash on the sidelines" after that set of transactions as there was before it.
"I'm similarly convinced that Wall Street has no idea what it's talking about when it uses the word "liquidity." While using the phrase "global liquidity" lends a further element of worldly sophistication, Wall Street still hasn't the slightest idea what it's talking about. The phenomenon that's being called "liquidity" is nothing more than a combination of fiscal irresponsibility and risk blindness, and will ultimately prove itself to be the time-bomb that it is when investors begin to "re-price" that risk.
All of that is as true now as it was at the time in 2007, when the S&P 500 was above 1400. Investors hoping to ride a "wave of liquidity" may eventually discover that the wave leads to a plunge over the falls.
As of last week, the Market Climate for stocks was characterized by modest overvaluation, with stocks priced to deliver somewhat sub-par long-term returns, and mixed market action - with breadth the most favorable, and interest rate behavior the most unfavorable within that set of measures. The Strategic Growth Fund is fully hedged here, not because we are forecasting steep market losses (though we would not rule them out) but because the average return-to-risk profile of stocks has not historically been adequate under similar conditions. Moreover, if anything, economic fundamentals are far worse than other periods where we've observed similar valuations and market action, which strongly suggests that investors have gotten well ahead of themselves. On an individual stock basis, we also don't observe broad undervaluation. There are certainly pockets of what I view as strong values, which are where we've focused our individual stock selections, but the overall market is not cheap on an aggregate basis or on the basis of stock-by-stock analysis. The idea that stocks are attractive on a valuation basis is an illusion borne of the depth of the decline they suffered after being steeply overvalued, not a reality based on prices being currently reasonable in relation to the likely stream of cash flows from the underlying companies.
There have been, and there will be, better valuations and better market action on which to base significant risk taking in expectation of sustainable long-term returns. On a historical basis, current conditions would be mediocre even in a normal economy, and again, in the context of current economic fundamentals, they are a speculation - because even their mediocrity relies on economic fundamentals normalizing. I don't trust that proposition.
In bonds, yields have shot up on the combination of supply concerns, hopes of a quick return to economic growth, and to some extent, concerns about eventual inflation pressures. While I have expressed significant concerns about those eventual inflation pressures, my impression is that the depth of the selloff in Treasuries has removed the extreme risk that we saw in late December, when I wrote "Given the level of extension in yields, it would not be difficult for the bond market to generate losses of say 10% in the 10-year Treasury bond, and as much as 20-25% in the 30-year Treasury bond over a very short period of time." Presently, yields are somewhat higher than is consistent with probable nominal GDP growth here, and such deviations don't tend to persist for long. As yields shot higher last week, we extended our durations modestly in the Strategic Total Return Fund, to an average duration of just over 3 years, mostly in TIPS, but with some straight Treasuries to assist that extension (since TIPS tend to have muted durations). I expect that we'll modestly scale to higher durations if yields press significantly higher, but at present, our durations continue to be well below "market" durations, so our position is still conservative overall. The Fund also currently has about 20% of assets allocated to precious metals shares, foreign currencies, and utility shares.
The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse.
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