Todays Links: The View from Here

October 14, 2008

Yesterday was one fo the best days ever for the stock markets:

What does it mean? I think it ultimately depends on factors unrelated to the move itself. Econompic provides us with some context:

Obviously large one day moves in and of themselves tell us little about what is to come. So, let us at least look at what the market is priced to deliver longer term.

Stocks are not cheap, they just seem so because they have been extremely expensive for a very long time (and thus we have had a decade of poor returns.)

Nevertheless, they are around fair value, which is somewhere around 1000 on the S&P 500 depending how you figure it. That should result, without any expansion in P/E ratios (adjusted for the business cycle) in returns of about 3-6% above inflation (referred to as real returns) over the next ten years. This assumes approximately a 50% earnings payout as dividends (3.3% dividend yield) plus earnings growth of between 0- 3% above inflation. For an example of this calculation I suggest this short piece from Ed Easterling (pdf.)

Assume an inflation rate of 3% and nominal returns would be 6.3%-9.3%. Not bad.

Of course a lower valuation (about 677 on the S&P 500) would result in about a 4.5% dividend yield. That means real returns of about 4.5% to 7.5% and once again assuming inflation of 3% nominal returns of 7.5% to 10.5%.That would represent an adjusted P/E of about 11. That is certainly characteristic of bear market bottoms, but that may be a few years off, or not. Either way, if we are about at the bottom then returns are reasonably attractive from here.

Of course returns could be higher if P/E ratios increase. That would reduce the contribution of dividends but increased appreciation would more than make up for it. Of course, that sets us up for lower returns once that process reverses or stalls, thus leaving us without increased appreciation and lower yields (once again, the pdf explains that very well.) They could be lower if they decrease.

Earnings are likely to decrease dramatically over the next few quarters. So further downside is very possible, but not a given.

According to Morningstar Jeremy Grantham thinks the markets is cheap and is buying in earnest. Reading the piece I don’t see him saying that. In fact this statement is completely at odds with what he actually says in the piece:

So, add Grantham to the list of sage investors who see this as a huge buying opportunity. The list includes Marty Whitman and Dan Fuss

I was actually going to do a piece comparing the views of Grantham and Whitman, both men I respect very much. Controlled Greed already noted the divergence, how did Russ Kinnel miss this? Oh, and I like Russ Kinnel, I just disagree with this characterization. I side with Grantham (and my explanation above is a simplified version of Grantham’s own method of establishing return estimates) whose views are better represented at Barron’s.

Henry Blodget likes the plan to inject capital into the banks. While not exactly how I would have designed it, it is close enough for government work. He does ask a key question, why doesn’t the plan include forced writedowns? As investors this is important for several reasons:

  • It removes the fear that banks and bank investors will be hammered by future writedowns
  • It turns the banks’ attention 100% to putting the new equity to work
  • It attracts private capital (because investors won’t worry about getting sandbagged)
  • It eliminates the death-by-a-thousand-cuts scenario that killed Japan.
  • To put some numbers on this: So far, US financial institutions have taken about $650 billion in asset writedowns. Nouriel Roubini and others have put the total expected writedowns at $1-$2 trillion.  This suggests that banks still have $350 billion-$1.350 trillion in losses to take.  Losses in this range could wipe out common shareholders, the government, and the financial institutions….unless the banks can easily raise additional equity to offset the losses.

    The government may be hoping that 1) the writedowns are done, or 2) the banks can just slowly write off the rest of their crap assets against earnings over the next several years (thanks to the elimination of mark-to-market accounting). Given the magnitude of the projected losses, this seems like wishful thinking.

    Alternatively, the government may plan to just keep injecting more and more capital until the writedowns are finally done.  If this is the plan, however, other private-market investors are unlikely to follow suit.

    So we have one remaining and important question for Messrs. Paulson and Bernanke: What about the future writedowns?


    Doug Kass is worried about Muni Bonds. I am worried about everything, but there is an answer, get a discount which reflects that. Where? Maybe this is the answer.

    Yves Smith notices Charlie Munger is in a foul mood when it comes to Wall Street. I have to agree that the financial sector needs to shrink. I have long argued that financial intermediaries should not be such a large part of the economy, and is merely a product of leverage, not a dollar for dollar addition to our nations productive capacity and wealth. By in essence increasing the money supply over and over again our financial sector increases the share of wealth they get to collect a toll from. Note, the fantastic increases in leverage has not resulted in increase in economic growth, it has resullted in the financial sector appropriating a larger and larger proportion of that wealth.

    Paul Farrell’s Lazy Portfolio’s have done better than the market:

    The Kirk Report observes:

    At a minimum, these passive lazy portfolios will provide a benchmark for you to compare your own returns to. Also, if you’ve not already proven that you can time the market effectively and consistently beat these passive strategies, then you have no excuse but to implement them until you do.

    Good advice, though our clients have done a whole lot better than that, so obviously there are better options.

    Have you suffered large losses? Sometimes misery enjoys company, especially when the other guy is in much worse shape than you. Imagine an icelander-Iceland Plunges 77% On Re-Open

    Of course you could have been advised by Nicholas Taleb, who has done even better than we have, up massively. I like this quote:

    We refused to touch credit default swaps. It would be like buying insurance on the Titanic from someone on the Titanic.

    Of course his strategy is intended as a hedge, not an entire portfolio, but I am impressed.

    Paul Kedrosky gives his view on where this is all leading. I agree with much of it, and find the rest reasonably likely:

    • We are going through a credit crisis sparked by the subprime meltdown. It is broader than that, however, really the tail end of an orgy of leverage and credit creation dating back at least 15 years
    • The unwinding of all this credit bubble will take longer than most people expect, and the damage will continue to be broader than most expect. Beyond banks and financial institutions, it will include many municipalities, some large-cap tech names reliant on major debt-financed network buildouts, a host of debt-financed non-financial companies, and some sovereign nations. Total cost: Bridgewater’s $2.7-trillion looks close enough to me .
    • S&P forward-year earnings forecasts will come down faster than at any time in recent history. We will see 20% average estimate reductions across the board, leading to a further revaluation of the markets. After all, at S&P 1010 we are trading at 19x trailing earnings, and 18x forward, neither of which are inexpensive historically speaking. Admittedly, the above is not the non-financial S&P P/E — ex- financial and consumer stocks we are more like 14x — but it is a distinction that will get blurred as we go into this recession.
    • We are already in a recession that will last well into the the fourth quarter of next year.
    • Unemployment may touch 9% in the U.S. at trough.
    • Obama will win the U.S. presidency.
    • Housing will fall 10-15% further in U.S., and we are only beginning major declines in Canada, U.K., Australia, and elsewhere.
    • U.S. consumers will become much more aggressive savers, both through debt reduction and direct saving. Similarly, future fiscal stimulus will largely be saved in service of this overdue need to fix domestic balance sheets.
    • U.S. long yields have to rise, making curve steepener trades feel appropriate.
    • Commodities will stay under pressure for the next two years,and then reverse savagely as developed countries emerge from recession at very similar times. We have newly resynchronized the global economies, which will have immense consequences.
    • Coming out the other side, we will see a barbell economy, with growth and investor interest at the mega-cap consolidator end, and at the entrepreneurial smaller end. The latter will be driven by major developments in clean technology, in particular, which was just given a two-year window to gestate before the major economies worldwide turn higher and begin driving energy prices straight up.

    David Merkel is hopeful, but skeptical. He feels that not only do we need to delever, we will. That means a lot more difficulty. This plan shuffles the issues, and maybe that is an improvement, but the issues remain. If you don’t read David regularly, start.

    Treasuries got clobbered. Many bonds seem attractive right now, except treasuries. Kind of the opposite of returns in recent weeks. Yields are low and the world is likely to be awash in them (as if it already wasn’t) in the future.

    Lastly, surprise, surprise, Nouriel Roubini is still very pessimistic. I have been with him all the way, I hope it isn’t quite as bad as he thinks:

    Nouriel Roubini, the professor who predicted the financial crisis in 2006, said the U.S. will suffer its worst recession in 40 years, driving the stock market lower after it rallied the most in seven decades yesterday.

    “There are significant downside risks still to the market and the economy,” Roubini, 50, a New York University professor of economics, said in an interview with Bloomberg Television. “We’re going to be surprised by the severity of the recession and the severity of the financial losses.”

    The economist said the recession will last 18 to 24 months, pushing unemployment to 9 percent, and already depressed home prices will fall another 15 percent. The U.S. government will need to double its purchase of bank stakes and force lenders to eliminate dividends to save them from bankruptcy, Roubini added. Treasury Secretary Henry Paulson said today he plans to use $250 billion of taxpayer funds to purchase equity in thousands of financial firms to halt a credit freeze that threatened to drive companies into bankruptcy and eliminate jobs.

    “This will be the first round of recapitalization of the banks,” Roubini said. “The government has to decide to intervene much more directly in the provision of credit and the management of these companies.”


    “The stock market is going to stop rallying soon enough when they see the economy is really tanking,” Roubini added.

    The U.S. unemployment rate stood at a five-year high of 6.1 percent last month. Home prices in 20 U.S. metropolitan areas fell 16 percent in July from a year earlier, the most since records began in 2001, according to the S&P/Case-Shiller home- price index. Bank seizures may push home prices down further, scaring away buyers in coming months, after U.S. foreclosures rose at the fastest rate in almost three decades in the second quarter, according to the Mortgage Bankers Association.

    Roubini said total credit losses resulting from the meltdown of the subprime mortgage market will be “closer to $3 trillion,” up from his previous estimate of $1 trillion to $2 trillion. The International Monetary Fund estimated $1.4 trillion on Oct. 7. Financial firms have so far reported $637 billion in losses, according to data compiled by Bloomberg.


    Stocks are not cheap, but long term investors finally have a market priced to deliver reasonable returns. Neverthess, stocks not only could become cheap, the market is facing many risks, including the possibility of much lower earnings than are now expected. Some exposure to the market may be warranted, but scaling back in over time makes more sense than going all in at this time.

    Hat tip: as always, some of this is from Abnormal Returns. Even if not, go there.

    Thanks for visiting Risk and Return. Please feel free to contact us with any questions and/or comments. Please note our disclaimer.

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