July 12, 2010
Perhaps the best way to begin this week's comment is to note that in decades of market analysis, I can't remember a time that I've heard so many analysts quoting some support or resistance level as being "critical" for the market. Some are eyeing the 1040 "neckline" on the S&P 500 "head-and-shoulders" formation. Others are eyeing the downward trendline that connects the April and June peaks for the index. Still others point to the "death cross" between the 50-day and the 200-day moving average, near the 1100 level, as being crucial. Even Richard Russell - who deserves more respect than most - has put the full weight of his analysis, over the near term anyway, on whether or not the Dow Transportation average remains above the closing level of 3792.89. The object of discussion has increasingly turned to the implications of this particular chart formation or that, as if some magic number or another absolves investors from having to think about the big picture.
All of this suggests that this is a "rent, not own" market being driven by technical traders who uniformly and somewhat predictably pile on to the sell side or the buy side when particular levels are hit. Last week, we observed the obligatory rally to prior support, closed a "gap" in the S&P 500 chart from a couple of weeks ago, and kissed the 20-day moving average. Based on this sort of "critical level" chatter, a move above the 1100 level could trigger a powerful but short-lived burst of short-covering on the relief of the "death cross", while a move below 1040, and particularly a break in the Transports below 3792.89, would most probably cause all hell to break loose. Simply put, over the very short term, market fluctuations are likely to be driven by masses of technical traders, nearly all acting on precisely the same signals.
The key issue here is the sustainability of these moves. To the extent that an upside breakout is accompanied by a substantial relief in near-term economic concerns (e.g. a move in the ECRI Weekly Leading Index growth rate back to positive territory, or three to four weeks of plunging new claims for unemployment), one might anticipate a positive follow-through over the intermediate term. In contrast, a downside breakout accompanied by further deterioration in reliable economic indicators or poor corporate guidance would prompt a more sustained period of deterioration. Lacking such confirmation from "real" indicators of economic and corporate activity, the immediate response of breakouts or breakdowns is likely to be confined to a short burst of concerted selling or short-covering.
On a valuation basis, the S&P 500 remains about 40% above historical norms on the basis of normalized earnings. The disparity between our valuation assessment and the putative undervaluation being touted by Wall Street analysts is so great that a few remarks are in order. First, virtually every assessment that "stocks are cheap" here is based on the ratio of the S&P 500 to year-ahead operating earnings estimates, and often comes with a comparison of the resulting "earnings yield" with the depressed 10-year Treasury yield. What's fascinating about this is that this is the same basis on which analysts deemed stocks to be about 40% undervalued just prior to the 2007 top, following which the market plunged by more than half. There's a great deal of analysis regarding forward operating earnings that I published in 2007, but probably the most comprehensive piece was Long Term Evidence on the Fed Model and Forward Operating P/E Ratios from August 20, 2007.
To properly understand the price-to-forward operating earnings ratio, you have to recognize that operating earnings exclude a whole host of charges - what some observers correctly call "recurring non-recurring" charges. These include large and often quite regular losses that the companies deem, often on the thinnest basis, to be detached from their core business - even if the losses are directly related to their core business. Items like enormous asset writeoffs come to mind. Moreover, the "forward" means that these are year-ahead analyst estimates, which are typically substantially higher than trailing 12-month reported earnings.
Think of it this way. Suppose your poodle is 40% overweight. Someone sells you a scale where every pound shown on the dial represents 1.4 pounds of actual weight. Guess what? Your poodle will step on that scale, and the dial will pleasantly report that your dog is at its ideal weight. That may be comforting if you don't like to face reality, but the truth is, you've still got one sick puppy.
When you hear analysts say that the historical average P/E ratio is about 15, you have to recognize that this is the normal P/E based on trailing 12-month earnings after subtracting all writeoffs and other charges. Forward operating earnings are invariably much higher, and it turns out that the comparable historical norm, as I discuss in that 2007 piece, is only about 12. If you exclude the late 1990's bubble valuations, you get a historical norm closer to 11.5. The 1982 and 1974 market lows occurred at about 6 times estimated forward operating earnings.
A final observation is crucial. Current forward operating earnings estimates assume profit margins for the S&P 500 companies that are nearly 50% above their long-term historical norms. While we did observe such profit margins for a brief shining moment in 2007, profit margins are extraordinarily cyclical. Investors will walk themselves over a cliff if they price stocks as if profit margins, going forward, will be dramatically and sustainably higher than U.S. companies achieved in all of market history.
Bill Hester provides more insight on Wall Street earnings projections in his latest research piece Wall Street Earnings Expectations Ignore Economic Divergences (additional link below)
Economic risks continue
From our perspective, we continue to observe pointed recession risks. I'll emphasize again that our Recession Warning Composite (see the June 28 comment Recession Warning) is based on the observation of multiple conditions simultaneously, and is not driven by any single indicator. Given that I've made two, and only two, recession calls over the past decade (October 2000 and November 2007) based on this Composite, and we've always and only observed such signals during or immediately preceding other post-war recessions, I don't take the present indications lightly, and I don't like the odds.
The consensus of economists has never correctly anticipated a recession, nor have Ben Bernanke or Alan Greenspan, nor to my knowledge did any of the analysts currently assuaging investors that further economic weakness is unlikely. With regard to the ECRI Weekly Leading Index, I'll emphasize again that it nicely leads the ISM Purchasing Managers Index with a lead time of about 13 weeks. As a result, its inclusion in the composite produces more timely signals than the ISM. The WLI growth rate dropped again last week, to -8.3%, from -7.6% the prior week, which is consistent with a decline in the Purchasing Managers Index to about 44 over the next few months.
Still, it bears repeating that I am not reporting the ECRI's outlook on recession risk, but instead the implications of including the ECRI data within our broader Recession Warning Composite. The recession call by the ECRI in March 2001 admirably matched the exact beginning of that recession, but stocks had already declined precipitously by then. The call in early 2008 trailed the beginning of the most recent recession, and again followed substantial losses in the S&P 500. I note this because although the ECRI has a commendable record, and is generally decisive well before the economic consensus, it's important to recognize that deep stock market losses can precede even the best recession forecasts.
Among other views that should be taken seriously are those of Meredith Whitney, who has a much clearer understanding of credit issues than the majority of observers, and is always thought provoking. Not surprisingly, her views haven't changed a great deal over the past few months, but given that investors appear to acquire and abandon economic concerns on nearly a weekly basis, some consistency regarding the larger picture may be helpful:
"The government's involvement made the banks do really well. The government's out of the pool now, and we're on our own. The states that produced the most GDP are those that produced the most real estate, and I think we're in for a very rough second half. And here's where I would have never imagined... what happened over the past year-plus is that the government and the banks have provided a lot of mortgage modification programs, and consumers have been smart enough to say ok, if I wait, I'm going to get a better deal on a modification in 2, 3, 6 months. So I'm going to pay the things I need the most - my credit card bill, my auto bill, and even my home equity loan bill to a certain extent, and they've been not paying their mortgage bill.
"So you look at the non-performing loans on bank balance sheets, they've doubled inside of one year alone, and in terms of the top 4 banks, which control over two-thirds of the mortgage industry anyway, they stand at over one times all of the mortgages that have been charged off since 2005. So you've got this massive rotting pool of assets on bank balance sheets that have provided the consumer excess cash by not paying one big payment and being able to pay others. The thing that's happening for the first time in a year is that banks are actually accelerating their foreclosure programs, accelerating their short sale programs, so you're going to see people who weren't paying their mortgage starting to have to pay rent. Unequivocally I see a double dip in housing. There's no doubt about it. But you see a real leg down when you have the supply displacement, when you foreclose and then you have to sell, it's usually a 20% drop."
Question. Why do workers in developing nations earn a fraction of the wages American workers earn? While protective and regulatory factors such as trade barriers, unionization, and differences in labor laws have some effect, the main reason is fairly simple. U.S. workers are, on average, more productive than their counterparts in developing countries. While the gap between U.S. and foreign wages can make open trade seem very risky, it is simply not true that opening trade with developing nations must result in a convergence of wages. The large difference in relative wages is in fact a competitive outcome when there are large differences in worker productivity across countries.
The main source of this difference in productivity is that U.S. workers have a substantially larger stock of productive capital per worker, as well as generally higher levels of educational attainment, which is a form of human capital. This relative abundance of physical and educational capital has been a driver of U.S. prosperity for generations. Neither advantage in capital, however, is intrinsic to American workers, and it will be impossible to prevent a long-term convergence of U.S. wages toward those of developing countries unless the U.S. efficiently allocates its resources to productive investment and educational quality. This is where our policy makers are failing us.
There is little question that we have, for more than a decade, squandered our productive resources in the pursuit of bubbles. Almost unbelievably, real private gross domestic investment is lower today than it was 12 years ago, and much of the gross domestic investment that we have made in the interim has been destroyed in mispriced speculative activity such as residential construction and commercial real estate development.
If our only response to excess consumption is to pull out all the stops trying to "stimulate" consumption every time it falters; if our only response to reckless lending is to defend the bondholders every time their poor allocation of capital threatens to produce a loss for them, then quite simply, we will destroy our economy, our future, and our standard of living. The last thing I want to be is a cheerleader for the bears here. But quite honestly, it's difficult to envision a return to long-term saving, productive investment, and thoughtful allocation of capital until - as happens every two or three decades - the speculative elements of Wall Street are crushed to powder.
With regard to education, my impression is that the educational sector in the U.S. is about as inflexible the European labor market - the entire structure is hugely inefficient because it is detached from measures of quality and student time-on-task, undercompensating many excellent teachers and at the same time institutionalizing the employment of poor ones. Meanwhile, the failure of parents to maintain a heavy involvement in their kids' education, in the belief that the responsibility for education, personal responsibility and moral development can simply be thrust onto teachers, is a problem that money alone can't address.
If we as a nation fail to allow market discipline, to create incentives for research and development, to discourage speculative bubbles, to accumulate productive capital, and to maintain adequate educational achievement and human capital, the real wages of U.S. workers will slide toward those of developing economies. The real income of a nation is identical its real output - one cannot grow independent of the other.
One might think that as long as labor takes the hit, our misallocation of resources will still be all well and good for profits - after all, if labor is plentiful and capital is scarce, one would expect high returns to capital. Indeed, it is true that as long as we continue to misallocate capital, productive capital will continue to be scarce and profitable, but also utterly stagnant. Economies that generate high profits, weak wage gains, and low capital accumulation are like old-style monopolies that create an ever-widening distribution of income but fail to produce long-term prosperity or growth. No economy in the history of the world has tolerated that sort of situation for long without responding with prohibitively high taxation, regulatory intervention, or in some countries, revolution.
In the case of the U.S., there is actually a third, somewhat odd way in which this situation has resolved in recent years. On the surface, we observe consumers that have borrowed far beyond their actual incomes to consume output, while corporations have booked what appear to be strong profits. Financial companies, in particular, have contributed a disproportionately large share of S&P 500 profits over the past decade, and have been the primary drivers of observed profit recovery over the past year. Below the surface, however, an increasingly large fraction of reported profits has been written off as "extraordinary charges" due to credit losses and writeoffs of bad investments. Reported "operating earnings" have been substantially above the amounts that have actually been delivered to shareholders, either through dividends, increases in book value, or share repurchases in excess of grants to insiders.
Think about this for a moment. Since the late 1990's, many employees have earned paychecks for producing capital goods that did not turn out to be worth what companies spent, and consumers have received loans for amounts which they are not actually able to repay. Both of these outcomes have been the economy's way of forcing a large but rather overlooked "correction" in the income distribution back from corporate profits (and by extension shareholders) and toward the average American worker.
All of this is extraordinarily inefficient, because some people have effectively received windfalls (for example, those who sold their homes at the top of the real estate bubble, and those who have defaulted on large amounts of consumer credit), while other hard-working people have been stiffed. But one way or another, the equilibrium outcome of the economy has been to ensure - whether the transfer of purchasing power was voluntary or not - that American workers were able to purchase the output that was actually produced by the economy.
What's fascinating about this, however, is that shareholders are still ignoring it. They also ignore the large percentage of reported earnings that are actually quietly distributed to corporate insiders through the issuance of stock and options. They blindly accept that "share repurchases" are somehow a pleasant distribution of earnings, whereas the majority of share repurchases are actually made by companies to do nothing more than offset the dilution from stock shares and options granted to insiders. A good question to ask in the years ahead, immediately after profits are reported, is "how much of this figure is actually delivered to shareholders?" If you've been attentive over the past decade, the answer turns out to be much closer to the dividend yield than to the operating earnings yield that companies have reported.
For a moment, at least, it is good to be a corporate insider, particularly at major financial companies. First, you get to report productivity gains and "operating profits" - not by making smart investments in productive assets, but instead by writing up debt thanks to Treasury intervention, by misstating your balance sheet thanks to FASB changes last year, and at industrial firms, by cutting the number of workers per unit of capital. Next, you quietly write off large losses on bad investments and unrecoverable loans as "extraordinary expenses," to which investors pay no notice. And to add insult to injury, you deliver a significant portion of the remaining profits to yourself as "incentive compensation," followed by buybacks of stock to offset the dilution, which investors actually cheer because they don't realize they've been taken for suckers.
When you value stocks on the basis of the cash flows that shareholders can actually expect to have delivered into their hands over time, it's still possible to find values, but we find no support for the notion that stocks are cheap as an investment class. All of this will change eventually, but unfortunately, what investors do not learn voluntarily is inevitably taught to them against their will.
As of last week, the Market Climate was characterized by unfavorable valuations and unfavorable market action. Last week's rally satisfied some fairly "obligatory" technical expectations, but also extended far enough to clear the recent oversold condition of the market. As I've noted in the past, the most dangerous point in the stock market is where the Market Climate is negative and stocks have cleared an oversold condition, because it opens the potential for nearly vertical declines. At the same time, we do have the first wave of second-quarter earnings scheduled this week, and given the sensitivity of technical traders to various "trigger" levels, even a one-off positive report might be enough to get the market close to one trigger or another, provoking at least a brief short squeeze. Suffice it to say that the hyperfocus of traders on various support and resistance levels here makes it difficult to form any short-term views regarding market action. For now, we remain tightly hedged.
In bonds, the Market Climate was characterized last week by moderately unfavorable yield levels and favorable yield pressures. We continue to carry a duration of about 4 years in the Strategic Total Return Fund, with a small allocation to precious metals shares, utility shares, and foreign currencies. I continue to believe that the potential downside in gold exceeds the level that large holders are likely to experience comfortably, and would not be at all surprised to see a 30% loss in gold prices in the event - likely in my view - that deflation concerns emerge. For our part, the few percent of assets we've currently allocated to the precious metals sector is a sufficient hedge against the absence of fresh credit strains, but a more aggressive stance at present would require some abatement of the economic risks we observe.
NEW from Bill Hester: Wall Street Earnings Expectations Ignore Economic Divergences
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