The peak in 2000 marked an unprecedented 160% overshooting of the trend, which is double the overshoot in 1929. The index has been above the trend for 17 years. We also see that the major troughs saw declines in excess of 50% below the trend. If the S&P 500 were sitting squarely on the regression, it would be hovering around 820. If the index should decline over the next 12 months to a level comparable to previous major bottoms, it would fall to the vicinity of 400-425.

That is a teeny bit lower than how I see it, but it is about right. However, he provides a chart which adjusts for inflation using John Williams’ shadow government stats. That shows the markets at all time lows. You can see and read the rest here.

I have one problem with that analysis. While I do think some adjustment might make it look a little better, if John Williams’ numbers are correct then stocks should be as low as they are because GDP and earnings have been horrible in inflation adjusted terms for a very long time. We have been in a recession for two decades similar to Japan. I don’t think that is true, but if so then stocks deserve every bit of the undervaluation they have experienced.

I’ll stick with the first graph being slightly overstated. It should be noted that statisticians would likely have problems with the while idea of the long term regression line having any meaning. I disagree, there are fundamental economic reasons the line makes sense as an approximation. I won’t go into the details now, I just want it noted I am aware of the issue.

Hat tip: Barry Ritholtz.

Technorati Tags chart, mean, regression, stock market, Valuation

As one of the few who saw this crisis coming and how it might play out across the board, not just in particular areas, he deserves a listen. As one of the most successful investors of the last 30 years he would warrant a listen anyway.

Watch the whole thing.

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

Technorati Tags Asset Allocation, credit crisis, Emerging Markets, equities, Housing Market, investing, Jeremy Grantham, Risk, value investing

We’re currently at a P/E around 14, a bit below the historical long-run average P/E of 16.3, meaning you could expect a slightly above-average return from buying stocks now. Specifically, if companies were to pay their shareholders all the income to which they’re entitled in the form of a dividend, that dividend would give you better than a 7% immediate return, and over the long run, the dividend would grow at least at the rate of inflation. That’s a return that proved more than sufficient compensation to investors for the extra risk they faced from stocks over the last century and a half, which included plenty of times tougher than those we’re going through at the moment. To me, a 7% real yield sounds like an attractive investment, despite the risk, and certainly dominates most other alternatives as a long-run vehicle for saving for retirement.

I agree with that, though I think most people would be surprised that attractive pricing means only a 7% yield plus inflation. In dividends are actually likely to grow 1-2% faster than inflation. Unfortunately we do not get all of that real yield because companies retain far more of their real dividend than necessary and do not distribute it to their shareholders. Much of that retained dividend is wasted. which brings me to a point of disagreement:

But isn’t it possible that the P/E will decline further, to much below the historical average, before the carnage is finished? Sure it is. But here’s another way to look at that. Companies in fact don’t turn over 100% of their profits to the shareholders as dividends, but re-invest some of those profits in the hope that future earnings will increase faster than inflation. The typical stock in the S&P 500 today is giving you a 3% dividend, which you could hope will grow 3% faster than inflation over the long run as a consequence of the reinvested profits. That again to me sounds like a very nice investment. You can buy and hold for the long term with the philosophy that it’s that stream of growing dividends that you really want and are going to get. Let the market price of the stock go up or down from here wherever the psychology of the market may take it– you’ve still received what you paid for, and it’s a reasonable deal.

Loner term those reinvested profits grow only a bit faster than inflation and trail GDP growth. Long term it is only about 1-2% above inflation. So, 3% plus 1-2% plus inflation gives us 4-5% above inflation. Still reasonable, but hardly spectacular. Of course payouts could rise and increase the dividend yield without reducing growth. So 4% dividend yield, plus 2% (let’s be optimistic) and 3% inflation. That is 9%. With some appreciation in the P/E ratio returns could be higher, perhaps substantially so.

The rest of the post is pretty good for someone who wants to invest themselves, needless to say we believe we can, and have, do much better. Not because of stock picking prowess, but asset allocation decisions, especially hedging against risk or avoiding it in many situations. The graph above over the past few years shows why that can be pretty effective. Nevertheless, sound advice.

John Hussman gives a very good way to look at the opportunities and risks in the current market as well, and some sound advice about approaching this with a long term focus but careful attention to the risks. Investing now does offer good long term returns, but you may be able to do better later. Some exposure is certainly warranted and John gives a good explanation as to why. Known by many inaccurately as a “Perma Bear” he is certainly no mindless cheerleader.

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

Technorati Tags investing, Jim Hamilton, Robert Shiller, S&P 500, stocks, Valuation

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?

Exactly.

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.

Summary:

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.

Technorati Tags bear market, bond market, bull market, Charlie Munger, closed end funds, Commodities, credit crisis, David Merkel, dividends, Doug Kass, economy, Ed Easterling, Henry Blodget, housing, Iceland, Jeremy Grantham, lazy portfolio's, leverage, markets, Marty Whitman, municipal bonds, Nouriel Roubini, p/e ratio, Paul Kedrosky, recession, Russ Kinnel, stocks, subprime, tresuries, Valuation, Yves Smith

Money tends to go where it is best treated, as measured by an asset class, hedge fund or by a traditional investment adviser. As a result, a lot of money will be shifting by year-end, and it is bound to have a disruptive market effect as well as likely to feed continued volatility.

If you delegate investing to an adviser, here are several questions that you may consider asking during a 2008 year-end review of your investment performance:

1. What were your adviser’s expectations for the stock market’s returns in 2008, and how did these expectations compare to the actual results?

2. How did your investment performance compare to that of the major indices? In what areas did you outperform, and in what areas did you underperform — and why?

3. What was your adviser’s economic and credit expectations, and how did these expectations compare to the actual events? Where and why were his assumptions wrong?

4. Did your adviser change his strategy as economic and financial events changed? If he didn’t, ask why?

5. Did you experience outsized individual stock or large specific industry or sector share price losses? Did your adviser institute a discipline to stop losses, or were your losses allowed to compound? Did your adviser “double down” on poor investments?

6. Ask your adviser whether he “eats his own cooking” — that is, did he invest along with you in the same investments, and are both of your interests aligned?

Briefly, I think I will answer for those of you who do invest with us, how I would answer the questions. Feel free to question us more closely in person. Note: While this discussion applies broadly to all of our clients, it is specifically addressed to the vast majority of our assets under management, accredited and qualified investors (those with a net worth of 1 million and up) in our model portfolio’s.

1. What were your adviser’s expectations for the stock market’s returns in 2008, and how did these expectations compare to the actual results?

In our case this discussion really should not be constrained to 2008. We believe we are in the midst of a long term bear market that began with the bursting of the tech bubble in 2000, especially for US financial assets. We participated in the cyclical bull that began in 2003, with significant allocations to international, emerging market, real estate and other high flying assets. Starting in 2006 we began to become more defensive as valuations became more and more unreasonable, allowing our portfolio to move forward based on those areas we felt were most attractive. That allocation allowed us to post strong results through the third quarter of 2007, but the portfolio was dominated more and more by assets not dependent on the general direction of the market. By 2007 we felt returns were likely to turn negative, the economy would struggle and a defensive portfolio was the most prudent path. We had by February of 2007 scrubbed nearly all exposure to financial stocks from our portfolio.

In general our expectations have been met. The markets, especially financial stocks have struggled. Following our strong showing through the first three quarters of 2007 we had a strong burst in the fourth quarter as the markets in the US fell. We weathered the storm in January with a small gain and when all was said and done had a solid first half of the year, with positive returns in each quarter, with solid gains in June to finish off the second quarter.

We began to have concerns short term with our exposure to commodity stocks, especially energy, and hedged that exposure somewhat. We assumed that some of the relationships in our hedged positions might have a short term reverse as well. Unfortunately all of our main performance drivers reversed from the middle of July to the middle of August. It was unusual that all would reverse at the same time, as opposed to being spread out. Unfortunately most, if not all, of our gains during 2008 were lost, though we were still positive since the downturn in the broader equity markets began in October. We feel that most of what we are doing now is still well positioned, with the most likely trouble spot being our unhedged positions, specifically commodity stocks and Asia. Depending on their relative performance we will have a flat to positive end to the year. Our expectation is we will finish the year with returns in the high single digits, which is what we expected at the beginning of the year.

What about surprises? The relative strength of small cap and real estate stocks stick out. We feel they will resume their under performance going forward. Commercial real estate is starting to roll over and we expect that to weigh on REITs. Small cap stocks are still very overvalued, and earnings likely to continue to disappoint. As credit markets and the economy become even more strained access to credit will hit them hard. If they struggle greatly relative to larger, higher quality stocks we could see our expected return numbers increase markedly.

2. How did your investment performance compare to that of the major indices? In what areas did you outperform, and in what areas did you underperform — and why?

We have outperformed broad market indices handily year to date, since the downturn began, and for trailing one, three and five year periods. Heck, we are positive for the year! Accomplishment enough, if unspectacular. Compared to the indices the various areas of our portfolio have performed from okay to fantastic. No major underperforming areas.

3. What was your adviser’s economic and credit expectations, and how did these expectations compare to the actual events? Where and why were his assumptions wrong?

We felt the US faced a high probability of a recession coupled with a worldwide slowdown. We felt the credit markets were the most vulnerable, due to a severe housing downturn, and inflation would be an concern. Interest rates were a bit uncertain since, with inflation an issue and growth vulnerable, the fed would be pushed in both directions. More importantly, due to the difficulties in the credit markets we felt interest rates would be relatively insensitive to the federal reserves efforts and interest rates would remain stubbornly high, with credit spreads likely to widen dramatically. Thus we felt diversifying credit exposure internationally would be prudent and bonds would not be as positive a counter to equity risk as they were in the last downturn.

That has all come true, but our moves to diversify in fixed income have not proven of much benefit. However, our emphasis on other strategies to reduce risk versus fixed income has added value, demonstrating that an over reliance on traditional fixed income to protect in a downturn would not be optimal. In fact, fixed income has been a drag on performance on both the upside and downside of the market over the last two years for us.

4. Did your adviser change his strategy as economic and financial events changed? If he didn’t, ask why?

Yes, though our change occurred before the downturn. We have made some small tactical changes as the year has progressed, though our fundamental approach we feel is still sound. We are preparing for some significant changes in the near future, especially if the equity markets weaken substantially from here and we position the portfolio for a more positive market environment.

5. Did you experience outsized individual stock or large specific industry or sector share price losses? Did your adviser institute a discipline to stop losses, or were your losses allowed to compound? Did your adviser “double down” on poor investments?

This question really doesn’t apply to us since we don’t trade individual securities, though we have hedged positions where one side or the other have struggled. That of course is the expectation for a hedged pair of positions targeting an absolute return. Nevertheless we wish some had been more successful, even if as a pair they outperformed the indices.

6. Ask your adviser whether he “eats his own cooking” — that is, did he invest along with you in the same investments, and are both of your interests aligned?

Not only do we, it is a core value at our firm, and that is exactly how we put it. “We eat our own cooking.”

Hat Tip: Barry Ritholtz

Thanks for visiting Risk and Return. Please feel free to contact us with any questions and/or comments. Please note our disclaimer. For information on our investment process see here.

Technorati Tags absolute returns, advisors, assessing performance, bonds, investment performance, markets, stocks

Earlier this year, Mr. Bush derided a modest plan to provide $4 billion to states and localities to buy foreclosed properties, saying that buying up empty homes helps only “the lenders or the speculators.” Actually, it protects entire neighborhoods and local economies from the effects of foreclosures by preventing a greater buildup of unsold homes and a further drop in prices.

This site is not about politics, but before I discuss this some disclosure is necessary. I am a fan of free markets. I do not however belong to that group of fans who believes that the market left to its own devices comes up with an optimal outcome (however one might define optimal.) There are a number of reasons to favor free markets, that isn’t one of them.

Still, one reason to favor markets, and all the pain and inequity they come with, is that even if one believes that well thought out policies could cure whatever evils (however one wishes to define them) that the market (or our world in general) afflicts us with, it is highly unlikely that we will ever get such policies. This kind of solution is exhibit 10,549 of that truth.

I only address the politics of this, because as investors we are forced to analyze things which will undoubtedly rub some peoples political beliefs the wrong way, and this is one place where I cannot avoid it, no matter how much I might wish to do so.

The absurdities

So what exactly have our leaders in Washington, and pundits on the board of the Times, come up with?

First let us deal with the absurd aspects of this plan. The government buys up a bunch of foreclosed properties that are theoretically driving down the prices of other homes. Uh, does anyone else see the big gaping hole in this logic? After the government buys them, they are still abandoned! Unless the government just takes them off the market indefinitely (thus restricting supply) rather than sell them, how does that solve the problem of excess inventory?

What it does do is allow the lenders to get a price higher than they would if the homes had to sell at a price that people could actually afford. So, bankers and other lenders get bailed out, taxpayers have a bunch of homes they have to sell at prices lower than they paid for them. Personally, I would rather have our taxes not be used to bail out lenders.

One problem homeowners are facing is abandoned homes becoming a drag due to lack of maintenance. Will the government keep all these homes up? As little faith as I have in the lenders, the profit motive will likely make them better stewards (if only marginally, given the enormity of the issue) than the state.

A Little Reality

Most important, is that we investors need to avoid falling for simple sounding solutions that will in the end not help that much. The ultimate problem with housing is not greedy lenders (greed is nothing new) or deadbeats, government policies (a personal favorite post of mine) or incompetent regulators (though all had their role in getting us to this point.) It is that housing prices are too high.

For reasons stated above this particular solution is not going to help keep prices high, but what if they could? Is that really good? Housing is extremely unaffordable in many markets. Prices will come down. Is dragging that out the best answer? I find that in isolation a dubious, and at best a marginal, good. Given the cost, in tax dollars, inflation, misallocation of resources and the moral hazard of lenders and borrowers believing that risk can be taken with some portion of it underwritten by the state, the benefits should have to be huge. As investors we should be skeptical that the end result will be good for the rest of the economy.

The same problem comes even with trying to keep interest rates low. Let us assume that these various measures, combined with low interest rates, slows, or even temporarily halts, the decline in housing prices.

Much as with claims about the “fed model” there is the belief that lower interest rates will allow people to afford a home that they could not a higher rate, ( also that lower prices will result in demand curves that shift) etc. All of these arguments miss a key point. Interest rates change. A stock price that is “justified” by todays interest rate, says nothing about whether it will be similarly “justified” in the future. Nor does a high price being “justified” by low current interest rates mean you will get a satisfactory return. It just means it will be better (actually that isn’t a given either) than a bond yielding 3% (or whatever the low rate happens to be.)

So it is with housing. Absent a speculative bubble such as we just went through in housing, low interest rates might encourage people back into the market. It might halt the slide in housing prices from going back to an economically reasonable level as fast, or temporarily. However, those buyers will not be selling to people with similarly low rates in the future. In an efficient market (stop giggling Barry and Jeremy) markets would see through temporary low rate periods and price housing at sustainable levels that vary little around interest rates. I suspect in this instance gun shy homeowners will (or even lower.) At the end of the day however it doesn’t matter even if they do not. All that means is that down the road prices will fall when interest rates go up and prospective buyers cannot afford them any longer. The same for being able to “afford” a house at a lower credit score. Prices still have to be affordable for succeeding groups of home buyers. In much of the country they just are not. This not just “gonzo” pundits beating some fantasy bear drum, but yes Jeff, “real” economists such as Martin Feldstein (who has some trenchant comments on the health of the economy and misreading of the GDP data as well)

I’ll tell you what worries me. We saw house prices overshoot by 60% relative to costs of building and relative to rents. And I worry about the possibility that they will keep falling; they will spiral downwards. In the same way that they went much too high, they could go much too low. And if that happens, then we are going to see individuals feeling a lot poorer, cutting back on their spending, defaulting on mortgages, and we’re going to see the holders of those mortgages see their assets, their capital being cut and therefore their ability to make loans being cut.

Incoherence

Bill Gross should know better, but unfortunately he doesn’t seem to realize that after decrying the destructive potential of housing prices rising faster than inflation and incomes, that keeping them from correcting that rise is destructive as well, and unlikely to work.

So let us end with one more political (if non partisan) note. If all these policies could help keep prices up, if other policies suggested are effective as well, what have we done?

Encouraging people to buy houses at prices that were economically too burdensome, and likely to eventually lose value, is what got us into this mess in the first place.

Why is it a virtue for the government to do exactly what we are criticizing mortgage companies, banks and even the fed for encouraging home buyers to do in the past? Isn’t the end result just the same thing if possibly a bit more drawn out? Investors beware.

Update: Dean Baker (another “real” economist) takes up some similar themes:

Have the NYT editorial writers not noticed this bubble or do they think the housing bubble was a good development that the government should try to foster?

The level of incoherence of the housing policy advocated by the NYT is astounding. Why on earth should Congress act to keep house prices above their market level?

House price supports will not work in the long-run. If we keep house prices high, builders will construct more houses and the over-supply will grow even larger. In this way, a house price support program is like a farm price support program, except we have a $20 trillion stock of housing. The market for most farm products is in the tens of billions of dollars annually.

A house price support program will end up costing the government billions and possibly tens of billions of dollars. Is it better for the government to spend this money (most of which will be paid to banks) supporting house prices than to pay for health care, child care or good rental housing?

Furthermore, since house prices will eventually fall to their market clearing levels, will the NYT policy even help moderate income homeowners? They will be paying far more in housing costs for the years they still in their home than they would to rent a comparable unit. This will be diverting money that they may have otherwise used for their kids health care and child care or other necessary expenses. And, since the house price will fall, they will never accumulate any equity.

Jon Henke also smells the whiff of the farm support program.

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

Technorati Tags housing, interest rates, Martin Feldstein, media, New York Times

The indicator in question focuses on corporate money-raising. Considerable research has shown that when companies turn aggressively to the equity market for their financing needs, through new issues or secondary offerings, it is a sign that the stock market is overvalued. Though there is no easy way to interpret the data, current trends in corporate finance appear no worse than neutral for the stock market’s intermediate-term prospects. And the data may actually be painting a bullish picture.

[...]

Professor Lamont, who is also a portfolio manager at DKR Capital, a hedge fund in Stamford, Conn., has calculated the new-list percentage back to 1929. Its all-time high was nearly 15 percent, at the beginning of the Depression. Its second-highest level, almost 11 percent, was in March 2000, just before the Internet bubble burst. (He published these results in 2002 in an academic working paper.)

This result doesn’t surprise me, and is intuitively reasonable. There is also this:

Two researchers who have studied these patterns are Malcolm P. Baker, a finance professor at Harvard Business School, and Jeffrey Wurgler, a finance professor at New York University. For each year from 1927 through 1996, the professors calculated the share of total capital raised by publicly traded corporations that came from issuing stock — what they call the equity share.

Over the 12 months after the quartile of years with the lowest equity shares (when this proportion was no higher than 14 percent) the stock market returned an average of 14 percent, according to the professors. In contrast, the market had an average net loss of 6 percent following the quartile of years with the highest equity shares (when this proportion was no lower than 27 percent). Their results were published in the October 2000 issue of the Journal of Finance.

This likewise makes sense that you would generally observe those conditions.

Where does the equity share stand now? In an e-mail message, Professor Wurgler said it was 6.1 percent for 2007 through September, the latest date for which data are available. Because this puts the current market solidly in the quartile of past years that were followed by above-average returns, he says the data are sending “a bullish stock market signal.”

So maybe I should be trading in my bearish hat over the next few years? I don’t think so:

In separate interviews, he and Professor Baker hastened to add that this bullish signal by no means justifies throwing caution to the wind. They pointed out that companies have had far easier access to cheap debt financing in recent years than they did in earlier decades. As a result, they argued, the current low equity share may not be strictly comparable with similarly low previous readings — and thus may not be as bullish as it otherwise would appear.

Throw in large cash reserves, record profit margins (which are reliably mean reverting) and companies hardly needed to issue equity. They already did that in extremes earlier. Much financial activity was diverted to private equity and M&A as well.

But judging from how companies have been raising new money, Professor Baker said, there was little evidence of extreme levels of speculation at the recent stock market high. At least to this extent, he said, this means that “there is less downside risk in the market today than there was in March 2000.”

Maybe so, though it seems a big risk one must account for in any decision on how to allocate assets. The problem, like with much finance theory, is that these are coincident indicators of the real problem, excessive speculation driving assets far above a reasonable estimate of their long term value. When stocks are overvalued companies do tend to issue equity, we see more companies going public, etc. However, they are not the actual driver of returns, and thus can give us a hint to check on whether the market is overvalued, but not whether it is.

Simply put, any reasonable assumption about growth in earnings, payout ratios and profit margins predicts low returns. Whether those low returns are fairly valued or not, there they are. If valuations decline to boot, we have a major decline in store.

I don’t believe investors realize how low the embedded returns in stocks are. Since I believe investors think that the US stock market can give them higher returns at these levels than is likely, when they are disappointed by declining profit margins and growth rates below their assumptions (combined with looking at their pathetic returns over the last 10 years) they will likely adjust the price. That adjustment could come fairly quickly (It would take a 30% or more drop from here just to get back to equities being priced to deliver real returns close to 5%) or by a combination of smaller declines and rallies going on for years, such as we have seen since 2002. That of course assumes inflation doesn’t become a larger issue (very much in doubt) and/or the pessimism doesn’t cause a large over shoot to the downside. When investors have been disappointed for a period of 10 years or more they have had a habit in the past of getting in very dark moods.

Hat tip: Abnormal Returns

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Technorati Tags equity, IPO's, returns, Risk, stock market indicators, Valuation

The word ‘heresy’ not only means no longer being wrong; it practically means being clear-headed and courageous. The word ‘orthodoxy’ not only no longer means being right; it practically means being wrong.

-GK Chesterton

Technorati Tags Gk Chesterton, quotes, Valuation

In the insurance business, there is no statute of limitation on stupidity.

-Warren Buffett

If only the monolines (that survive) credit default swap investors, and others could keep this in mind going forward. Risk has to be priced not on the basis of the current environment, but on what that environment might be down the road. In a mean reverting world, good times are not a reason to accept lower premiums for risk.

Technorati Tags insurance, monolines, Risk, risk premium, swaps, Warren Buffett

As I wrote in April 2000, bear market psychology typically evolves something like this:

“This is my retirement money. I can’t afford to be out of the market anymore!”

“I don’t care about the price, just get me in!!”

“It’s a healthy correction”

“See, it’s already coming back, better buy more before the new highs”

“Alright, a retest. Add to the position – buy the dip”

“What a great move! Am I a genius or what?”

“Uh oh, another selloff. Well, we’re probably close to a bottom”

“New low? What’s going on?!!”

“Alright, it’s too late to sell here, I’ll get out on the next rally”

“Hey!! It’s coming back. Glad that’s over!”

“Another new low. But how much lower can it go?”

“No, really, how much lower can it go?”

“Good Grief! How much lower can it go?!?”

“There’s no way I’ll ever make this back!”

“This is my retirement money. I can’t afford to be in the market anymore!”

“I don’t care about the price, just get me out!!”

Heh, well I don’t think I see that kind of attitude yet. He makes some other points which I have discussed before, but bear repeating:

But as I’ve frequently noted, most bear markets are not simply one-way movements. Bear markets typically comprise two, three or more separate 10-20% declines, punctuated by fast, furious rallies. It’s easy to forget that the 2000-2002 bear included three bear market advances of 20% from intra-day low to intra-day high, as well as numerous smaller advances, all of which were surrendered in subsequent plunges to new lows.

What about earnings growth? I don’t think we will see much this year, but even if I am wrong I would suggest not getting too comfortable:

At the January 1973 market peak, earnings had hit a new high, and stock prices were selling at a P/E multiple of 20, which is extreme on the basis of record earnings. Over the next 2 years, corporate earnings grew by 56%, yet the market fell by half. The 73-74 bear market teaches that stock prices can decline from rich valuations even if earnings grow dramatically:

How that worked out is gone into in detail and with a bit of sass. As I said, well worth reading. Market history does not prove what will happen in the future, but it does prove that some beliefs cannot be counted upon.

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Technorati Tags Bear markets, history, Valuation

Secondly, this occurred at a time of what I believe is the first global bubble in pretty well all asset prices, so there is a much greater degree of broad-based vulnerability.

This is why traditional, long only diversification is likely to be less effective than in the last downturn, and even tactical, long only measures will be difficult to implement. What do you over weight if everything is expensive? In 2000 it was real estate, value, especially small cap value (like home builders) emerging markets, bonds, etc. Does anyone see those as a place to hide now?

People think the Federal Reserve can stop a bear market because they can throw money at it and lower interest rates. It is even more certain we can collectively stop a bear market if some fiscal stimulus is thrown in. To which I say, ‘Oh, you mean like 2000 and 2002?’ — when they threw what I call the greatest stimulus in American history, an unparalleled series of interest-rate cuts, cumulating in two, almost three, years of negative real returns, real interest rates coupled with a really substantial tax cut, which would never have happened without 9/11.

The combination would have gotten the dead to walk, and it stopped the bear market eventually. But the Standard & Poor’s 500 was down 50% and the Nasdaq — which was all anyone talked about back then — went down 78%. And a puny five to six years later, people are saying there is not going to be a bear market because the Fed is going to lower rates and because the government is going to have a stimulus package. But we have just been there, done that, and we had a nice bear market.

As stated here before, I watched a lot of people “not fight the fed” all the way to large losses last time around. Can we learn anything?

What about places to hide?

That isn’t something we can laugh off. Last time, there were plenty of opportunities: Bonds were cheap and TIPS (Treasury-inflation protective securities) were brilliant; real estate was cheap and REITs were brilliant. Even within equities, emerging markets were much cheaper than U.S. equities, and within U.S. equities, value stocks were only a little expensive and small-caps were only a little expensive and small-cap value was actually a little bit cheap. So you could really hide and could reasonably expect to make money, which we did in each of the three years of the bear market.

Uh, already addressed this, but let us look at another couple of themes of ours:

Profit margins, the great prop to the market, surprisingly defied the laws of gravity for three years in the developed world and, particularly, in the emerging world and even in Japan. That was because the global economy was stronger than any corporation counted on and, in the U.S., consumption was always higher and our savings rate was always lower than any corporate economist would have suggested, going into negative territory. But there are a few near certainties in this business — not many, but a few — and one of them is that abnormally high profit margins will go back to normal. The timing is unfortunately shrouded in fog. The other near certainty is that house prices will go back to a normal multiple of family income. In the end, we, the people, have to be able to afford the houses and they are affordable at something around 2.8 times family income. When they peak in Boston at 6 times and nationally at 3.9 times, you know you are in for tough times.

What about the magic elixir of lowering rates boosting economic growth?

It doesn’t have that much of a powerful effect on the economy. If it had any more profound effect, there would be a positive relationship between debt increasing and GDP growth, and there is none.

It doesn’t?

I have an exhibit that shows the 30 years prior to 1982 when the debt-to-gross domestic product ratio was completely flat at 1.2 times. Total debt is defined as government debt, personal debt, corporate debt and financial debt. Then in the 25 years after 1982, the flat line goes up at a 45 degrees angle from 1.2 times to 3.1 times GDP. Massive. In the first 30 years, when debt is flat, annual GDP growth is its usual battleship, growing at 3.5% and hardly twitching. After the massive increase in debt, GDP, far from accelerating, grew at 3%. So debt in the aggregate does not drive the economy. The economy is driven by education, man-hours worked, capital investment and technology. It is not driven by what I owe you and you owe me.

Of course it could have an effect elsewhere:

It drives down the dollar, which is inflationary, and, eventually, it could be seriously inflationary.

I think we have mentioned that we aren’t too hot on private equity as a diversifier for the moment, and we suspect it is in a bubble of its own. Jeremy nails down why:

I have yet to meet a private-equity firm that put into its spreadsheet the assumption that system-wide profit margins could decline by 20% to 30%. They have taken the current, abnormally high profit margins as a given and then determined to improve them by, let’s say, 15% and assume everything works out pretty well.

But if the base declines by 20%, even if they end up improving margins by 15%, they are going backwards. And if they pay the 25% premium up front, which was normal, and if they leverage 4-to-1, which was normal, then they almost precisely wipe out all of the clients’ money, all of the 20% in equity and if, perish the thought, they don’t add 15%, but add perhaps zero to 5%, then they do more than wipe out the equity, they leave the underlying debt in ragged disarray. That is the next shoe to drop on the credit side.

Jeremy was wise enough to avoid financials like the plague, and we took his advice last year. Thank goodness. Thank goodness we not only listened, but have a significant amount of assets invested with him. That, combined with our hedges, has turned out to be a profitable move.

His prediction, which seems about right given the numbers I have been watching, on the housing market:

It has a lot to go. It still has to drop 20% to 25% to reach more normal levels, or if you prefer, it could wait five years for income to catch up, barring no big recessions. With the housing market gone, people turned to credit cards and with economic times slowing down — whether there’s a recession or not — consumers are going to slow down a lot, are slowing down or have slowed down a lot.

Update: For those without a subscription, Seeking Alpha has the beginning of the interview.

Technorati Tags Barron's, bubbles, debt, Federal Reserve, Housing Market, Jeremy Grantham, profit margins, stimulus, stock market, Valuation

On the investment merits however, stocks in general are at extreme levels only exceeded significantly by the recent tech bubble. Only by comparison to the elevated levels of the last 15 years can the S&P 500 be considered even reasonable, much less inexpensive. Unlike 2000 when many asset classes were reasonable, and only cap weighted indexes and a few components were expensive, almost all asset classes are overvalued. In many ways, from a valuation standpoint, this is a far more tenuous situation than 2000 when you could easily select assets that had not taken part in the bubble. Now there are few places to hide.

So no, the market hasn’t “discounted” a recession. Even the idea that the U.S. economy is in recession is contentious. The S&P 500 is off only about 10% from its record highs, recession concerns and a weakening of profit margins are not reflected in market prices. At best, they are discounting a slowdown based on the assumption that recent earnings growth and profit margins can be extrapolated longer term once we get past it.

John Hussman put it well (my emphasis)

Similarly, in stocks, analyst estimates reflect a quick return to record profit margins about 50% above their historical norms. If those assumptions disappoint and it becomes clear that profit margins will not be forever sustained at record highs, it doesn’t only imply near-term earnings disappointments – it implies that the whole stream of future earnings impounded into stock prices is wrong.

Since I believe this has been a long term issue, how bad has the valuation penalty been so far? Since April of 1998 the return of the S&P 500 has been below that of Treasury bills. That is almost 10 years! Since 2000 the S&P 500 has trailed inflation. In fact, the S&P500 has trailed treasury bills since Nov. of 2005 as well.

Is the market significantly cheaper than in 1998? No. Should we expect better going forward? No. The likely path is we will get similar or worse returns in an interesting way.

So, who will make money with real returns that an investor might consider satisfactory? The lucky, savvy speculators, the hedgers (I put my money on L/S guys in the vein of Julian Robertson) tactical asset allocators who hedge and protect capital (using some of the above) etc. Indexers, closet indexers and other low tracking error portfolios will disappoint.

Vitaliy Katsenelson, author of Active Value Investing: Making Money in Range-Bound Markets (Wiley Finance)points out some of the reason’s markets aren’t as cheap as they seem (and even then we are talking about p/e ratios well above “average.”)

Unfortunately, the cheapness argument falls on its face once we realize that pretax profit margins are hovering at an all-time high of 11.9%, almost 40% above their average of 8.5% since 1980. Once profit margins revert to their historical mean, the “E” in the P/E equation will decline. If the market made no price change in response, its P/E would rise from 17 to 23.8 times trailing earnings.

Maybe profit margins will stay high?

Profit margins revert to the mean not because they pay tribute to mean-reversion gods, but because the free market works. As the economy expands, companies start earning above-average profits. The competition reacts to fat margins like bees sensing sugar water. They want some, too, so they fly in and start cutting into these above-average margins. This always has happened in the past, and it will happen again and again in the future.

Let us see a chart, we all love charts:

Vitaliy deals with the most common reason’s people believe “it will be different this time.” So read the whole thing.

Let us move on to the misuse of forward operating earnings. Comparing the historical PE ratio to forward earnings estimates fails the smell test in a number of ways. The proper comparison would be to historical forward PE’s, not trailing PE’s. On that basis we end up with a lot lower forward PE to call “average.” Throw in the elevated profit margins and we get some really scary numbers for the market to get to “average.” John Hussman:

Now, to the issue of P/E ratios based on forward operating earnings. As noted above, it’s clear that forward operating earnings are generally much higher than the record level for trailing net earnings to-date, and of course, record earnings are always equal to or higher than raw trailing earnings.

Investors are used to the idea that “normal” P/E ratios are typically in the range of 14 to 16. But as Cliff Asness of AQR has repeatedly stressed, those norms are based on raw trailing earnings. If you calculate P/E ratios based on earnings figures that are higher, you clearly obtain lower P/E ratios.

As it happens, the long-term historical norm for the P/E ratio based on forward operating earnings would be about 12.

Of course, that means we get a chart:

Look closely. Exactly when has the market been more expensive on the basis of forward earnings? The mid 60’s, which led to one of the worst periods for stock returns in market history. 1987 which corrected in a day and of course the entire late 90’s to now. All periods of severe under performance.

Uh, John gives us a caveat:

Of course, that average of 12 includes the heights of the late 1990’s bubble. The historical average was just 10.6 prior to that point.

I am inclined myself to throw out the late 1990’s (we do all agree now that the valuations of that period were insane, whatever we said at the time, right? So should insanity be used to justify anything?) Your mileage may vary. Back to those profit margins (my emphasis)

It gets worse. Currently, profit margins are at the highest level in history, which further reduces the P/E multiple we observe. If investors wish to use that observed P/E ratio as their standard of value without normalizing for profit margins, they should be aware that they are implicitly assuming that profit margins will remain at current levels indefinitely.

Okay, another chart:

The following chart presents the ratio of forward operating earnings to S&P 500 revenues (net profit margins are even more volatile).

Chart: Historical Profit Margins (Forward Operating Earnings / Revenues)

You’ll notice that prior to 1995, there were only a few instances when operating profit margins exceeded 8%. At those points, prior to the late-1990’s bubble, the forward operating P/E for the S&P 500 averaged just 8. That’s not a typo.

No, I am not predicting an 8 PE down the road. I am saying that in any historical sense the markets are not, and have not, been cheap. That is why returns have been low, below that of treasury bills for a very long time, and likely to be so over any reasonably long term interval going forward.

Go ahead and read John demolish the “Fed Model” of valuing the stock market while you are at it. In fact, Go ahead and read this from John on that very subject as well.

For further thoughts, check out Barry Ritholtz’s similar demolition. He gives us another chart on the ridiculousness of forward operating earnings from the Wall Street journal:

Look at that. How do we get from 3% and 4% for the first two quarters (which I find unlikely in and of themselves, but maybe) to 16% for the year? From Barry (my emphasis)

Analysts are unflaggingly inaccurate at turning points. Example: Q3 S&P500 earnings consensus were +8% — S&P500 earnings came in at -8%. Q4 has been similarly lowered, undercutting the earlier forecasts of undervaluation.

Now let’s look at 2008. S&P 500 forward earnings over the next 4 quarters are as follows: Q1 = 3%; Q2 = 4%; Q3 = 20%; Q4 = 50%, according to UBS.

Earnings explosions like the ones above generally only occur after earnings collapses. Earnings grow reliably at about a peak of 6% over the long term, and the average is lower. In fact, the average is only around 1% over inflation depending on your point of measuring (it looks a bit higher now, it was a good bit lower at the trough of the last earnings collapse.)

Since clients may read this I want to reiterate that seeing the challenges ahead are exactly what this site, and our investment policy, is all about. The reason we have done so well, especially over the last year, is that we have expected and accounted for these, and other, factors we have been covering. The danger is for those investors, or their advisors, who haven’t faced up to the implications of high valuations.

We’ll deal with the Fed Model in more depth here at Risk and Return in the near future. John and Barry hit some of the highlights, but there are fundamental issues which I think deserve more exploration.

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Technorati Tags Asset Allocation, Fed model, indexes, John Hussman, Julian Robertson, operating earnings, return, Risk, S&P500, Valuation, Vitaliy Katsenelson

First, Jeff tackles the subject of stock buybacks and the piece echoes some of the issues I brought up in my post, The False Promise of Buybacks. Except, his version is more entertaining. So go read The Shareholder Letter You Should, But Won’t, Be Reading Next Spring which is part of his post “The Great Private Equity Cash Robbery of 2007.” I will note two interesting points he made prior to the shareholder letter:

So, was yesterday morning’s 400-point opening decline the selling climax?

[...]

Well, as far as NotMakingThisUp is concerned, the most obvious thing missing in all of yesterday’s headlines was this: no share buybacks were announced by any major company before, during or after the brief morning sell-off.

Not one.

During the panic of October 1987, grey-beards will recall, the tape was clogged not only with headlines of trading-halts amidst the worldwide rush to sell, but also with a steady stream of share buyback announcements by U.S. companies.

Coke, P&G and many others that week and in weeks subsequent to the Crash of ’87 used the substantial cash on their balance sheets to take advantage of the market dislocations that caused even the good stocks to be sold with the bad, and cannily bought their own stock back at deep discounts to its inherent worth.

Why then, were there no share buy-backs announced yesterday?

Could it be that the Great Private Equity Cash Robbery of 2007, in which previously healthy companies either “cleared” their balance sheets of cash—to use the euphemism employed by Steve Odlund, the Chief Cash Clearer at Office Depot—by buying back their own stock at bull-market peaks or faced the prospect of having it cleared for them by the Private Equity Cash Robbers?

I guess Jeff agrees with my friend Tim on this one.

My next recommendation is that you read the entire series he has put up on Warren Buffett’s purchase of Dairy Queen.

I am of course a great fan of Mr. Buffett, but like Jeff I am under no illusions about what the great hedge fund manager is doing. He is making money. He is interested in protecting his company’s shareholders interests, not those of the shareholders from whom he is acquiring his companies. Value investing means underpaying.

The series is a great introduction into looking at a transaction from multiple perspectives. It is a human story, and a financial story, with fascinating characters. Jeff’s biting wit makes it all the more enjoyable.

Part I, Part II, Part III.

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Technorati Tags Dairy Queen, private equity, stock buybacks, Warren Buffett

To paraphrase [value investing pioneer] Ben Graham, the markets seem high, they are high, and they are as high as they seem.

-Jean-Marie Eveillard

I know, I know. This isn’t what you here, but they are.

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Technorati Tags Jean-Marie Eveillard, Valuation