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4/12/17: The Federal Reserve says one thing, the yield curve the other.  

Final 4th quarter GDP came in at 2.1% leaving the 2016 growth rate at 1.6%.  The Atlanta District of the Federal Reserve is predicting less than 1% growth for the 1st quarter of 2017.  That is not good.  Despite this, the Board of Governors of the Federal Reserve in Washington has begun raising short-term interest rates, citing indications of a stronger economy ahead.  However, the yield curve (which plots the interest rates of bonds maturing from now to 30 years out) is telling a different story.  While the short term rates on CD’s and money market rates move with the Fed’s decisions, the interest rate on the 10-year Treasury bond is very important and is driven by real world activity.  This is the one to watch.  Mortgage rates and other important benchmarks key off of this rate more than the Fed’s position on short-term rates.  The interest rate on the 10-year Treasury bond has risen from a very low 1.4% about a year ago to 2.6% in the past month (remember, the current price of a bond goes up when the interest rate goes down and vice versa). However, the interest rate on the 10-year Treasury bond has started to stall and may well roll over and head back down ... not an encouraging sign for increasing economic activity (but good for the current price of many bonds).  Long-term interest rates typically rise with stronger economic activity, but they are lagging.  The yield curve showing longer term interest rates vs. short term rates remains somewhat flat.  

The stock market still sees things differently. Stock prices have risen despite years of disappointing earnings (see below “5/16/16: Is Fair Value Obsolete?” ). President Trump’s election has further boosted stock prices due to a hopefully optimistic outlook. 

A great deal depends on the effectiveness of our new President's economic policies and whether they will be implemented or not.  While the stock market may be optimistic, the bond market has not been so inclined to follow suit at this time.  Should the economy continue on its slow growth path similar to the last 8 years or so, interest rates may stay low (or even go lower) perhaps, making bonds a safer place to invest (remember, the current price of  bonds goes up when interest rates go down and vice versa).  Interest rates going  lower when they are already near historic lows seems implausible but possible.  

 

10/26/16: Italy, Again, Still

“……the bad-loan problem is mainly due to a 25 percent plunge in industrial output in the six years through 2014.

Italy’s GDP remains about 8 percent below its pre-crisis peak reached in 2007.” (link)

Back in 2012 and 2013, I wrote that the European common currency, the Euro, would fail. I wrote that a Europe strapped into a common currency designed for political reasons would prove itself to be unworkable for economic reasons.  Countries like Italy could not be locked into the same currency as Germany. I wrote that Italy needs its own currency so it can continuously devalue to keep the cost of its goods competitive with those from Germany (devaluing a currency makes everything in a country cheaper for everyone outside of that country). Before the Euro, Italy was able to devalue its currency, the Lira, and thus keep the price of its goods relative to the price of German goods and services. However, the Euro locked Italy and Germany into the same currency. While the cost of Italian goods rose, Germany’s cost held steady. Instead of facilitating trade, Italian industries were outcompeted and hollowed out.  Italy began to import more and export less. (Un) Fortunately, because Italy’s currency was now the Euro and devaluation was not possible; banks everywhere were willing to lend Italy money without abandon . While exports (earnings) and their industries declined, the government  bloated up with debt/spending to fill the void left by their declining productive sector.  Government expansion (and government debt) maintained the illusion of economic activity. The problem was solved (or better, put off) for a while. Government did what government does best; it makes things worse.

Then the European Central Bank (ECB) stepped in and, you guessed it, made things worse. The ECB decided to buy massive amounts of bonds from all the European nations and flood the system with money with the intention of reviving these economies. This has put off the inevitable default of the massive amount of debt Italy found itself in.  Of course, this has not worked. Italy has not defaulted, but it’s economy is sick because political forces are strapping it to the death grip of the Euro. In order to compete, Italy must lower its costs. Instead, the current plan is to remain in the Euro and grind down wages, benefits and everything else (austerity). This is not working and will most likely end in a popular revolt. On the other hand, if Italy was to leave the Euro and pursue its own currency, Italy’s new currency, the Lira would devalue. Devaluation would immediately realign relative prices. The cost of Italian goods and services would become cheaper while the costs of creditor nations goods and services such those from Germany would become more dear.  Floating currencies adjust to keep countries competitive and thus working without grinding ‘austerity’.

Today, Italy is sick. The economy has not grown in years, government debt has exploded, and the banks are full of defaulted loans. Italians are increasingly holding cash and/or gold because their banks are failing. Non-performing loans are approaching 20% of total gross loans; and under the current European Laws, the Italian government is not allowed to bail out the banks. So many depositors could lose their savings.

Watch Italy. As I wrote about several years back, the Euro is a failed experiment. The partial breakup of the Euro is not the end, it is the beginning.  The immediate pain of going back to a devalued Lira will free Italy from past mistakes and reset its economic path to future growth. Currency exits have happened before and devaluations are commonplace. It is inevitable. A devalued Lira will make vacations in this beautiful country a bargain and a flood of tourists will put Italy on a road to recovery.


6/27/16: Britain Exits

Sixty years ago, the nations of Europe began uniting under one European union.  The first goal was to define themselves as Europeans instead of separate nationalities which repeatedly started a war with each other. The second goal was to integrate their economies to achieve greater prosperity for everyone. The European Common Market was formed and it worked for a while. Over time a total of 28 countries joined. The next major step was the creation of one common currency called the Euro. 19 of these countries discontinued their currency and adopted the Euro (the Eurozone).  The goal here was to further simplify financial transactions across Europe by using just one currency. While Britain was the second largest economy within the European Union, it never joined the Eurozone and kept its own currency known as the Pound. 

Each European nation not only had its own national government, but also the new supranational government created by the European Union. Unfortunately this additional layer of government formed by the European Union grew and metastasized into an overreaching giant that regulated, interfered, and constrained all aspects of activity.  Due to this and many other reasons, the European economies are in decline.  This, in addition to the unmanageable flood of immigration mandated by the European Union’s open border policy, brought Britain to the edge. Last week the British voted to leave the European Union and all of its rules. 

The question now is, will Britain leaving the European Union for the sake of self-determination bring economic calamity or long term prosperity? And what effect will that have on the rest of the world?

 

5/6/16: Is Fair Value Obsolete?

The Fair Value concept holds that stocks, and the market in aggregate, have a value based on past, current, and future estimates of earnings. To oversimplify, when you buy a stock, you buy a piece of a business. The questions to ask when buying a stock are what has the business earned, and what is the business expected to earn in the future?  The stock’s fair value is then determined by the current and expected earnings. This is measured by the Price/Earnings (P/E) ratio.

For the S&P 500, which consists mostly of the country’s 500 largest corporations, the average historic P/E ratio has been about 15 times its GAAP (see previous entry) earnings. But in the last 20 years or so, the P/E ratio has started to vary wildly, reaching extremes in 2000 and 2007. Today it is 24 times its GAAP earnings. The S&P 500’s price is overvalued compared to what Fair Value would suggest.

Is the concept of Fair Value obsolete? Why is the market’s P/E ratio significantly higher than the historic average? Is it that our government now has a policy of supporting the stock and bond markets? Is it that the introduction of new computerized trading programs by hedge funds has raised the level of Fair Value? 

To return to Fair Value’s historic average either stock prices must retreat or corporate earnings must rise. Currently, the market is up while our economy has not yet delivered strong corporate earnings. Hopefully, earnings will rise rather than stock prices dropping because over the long run, I suggest Fair Value will ultimately prevail.

 

4/13/16: 2015, Just The Numbers

Earnings for the 500  largest U.S. companies; the S&P 500 are reported in two ways. First is reported or GAAP (Generally Accepted Accounting Principles) earnings. This number is what is reported to the SEC. The second is operating or non-GAAP earnings.  Companies often report both operating or non-GAAP earnings along with required GAAP earnings.  The non-GAAP earnings are what analysts follow because it adjusts for one-time events and is said to more actually reflect their business.

Reported or GAAP earning for 2015 were about $87 (the total of all 500 companies in the index), depending on how and when they were measured. This compares to about $102 for 2014, and about $100 for 2013.

Operating or non-GAAP earning for 2015 were about $100, depending on how and when they were measured. This compares to about $113  for 2014, and about $107 for 2013.

In 2015, the major  U.S. corporations earned substantially less. Much, but not all, of this was due to the decline in the price of oil hurting the energy companies.

The S&P 500 started the year at 2,059 and closed at 2,044 paying out an approximate 2.15% dividend for a total return of about 1.4%.   

 

2/25/16: ZIRP, QE, NIRP

Sounds boring, but wait, read on. These terms are behind much that matters. First is ZIRP or Zero Interest Rate Policy. The developed world (Europe, Japan, USA) dropped interest rate to zero save the economy from the 2008 crash. Unfortunately the economy stagnated while bank savings rates to dropped to almost nothing. It did however fuel the stock market beyond fair value (see post below). Next is QE or Quantitative Easing. The central banks bought bonds from the public and flooded the system with cash. The plan was to force the banks to lend out that idle cash and start up the economy? That did not work either.

With interest rates now near zero, there is NIRP or Negative Interest Rate Policy. The central banks will force interest rates down through to zero the point where the consumer will be charged to keep their money in the bank, forcing the depositor/consumer to spend it instead and revive the economy. Right? Well, maybe not. The smart choice may be to withdraw the cash and keep it under the mattress. But this would cause bank runs as depositors cash out the accounts. So first, cash must be outlawed. No $100, no $50, no bank runs, nowhere to go. This sounds ridiculous but read the news. Negative interest rates are raging in Europe and Japan, and a “cashless society” is being proposed everywhere.

Perhaps the next step is Direct Monetary Fiscal Policy. The way things currently work is when our government needs money beyond what it collects, they issue debt in the form of Treasury bonds. So far that comes to $19 Trillion in Federal Government debt, $9 trillion of which was just borrowed by the Obama administration. Fortunately, our Federal Reserve Central Bank has soaked up trillions of that through the above mentioned QE program. So, to over simplify, our government owes itself trillions. Again, ridiculous. So what may be coming are that laws will be changed so the Federal Reserve can create money to pay for massive government programs directly without the U.S. Treasury issuing any new debt. Traditionally, this would be highly inflationary, but we are not in traditional times.

Being an optimist, I hope it works.

 

1/8/16: China is a Mirror

This stock market sell off is being blamed on news that China’s economy is weakening, but it is important to note that China’s news is a mirror on what is going on in the rest of the world including the U.S.  China is an industrial powerhouse built on exports and the global economies are just not buying Chinese exports like they used to. Furthermore, raw material economies like Brazil and Australia depend on China to import huge quantities of their raw materials to manufacture finished goods which China then sells to the world. So when China doesn’t sell to the developed world, it doesn’t buy from the raw material economies.

Many attribute this to what changed in 2008. They call it ‘peak debt’. The pillar of aggregate demand (the middle class) maxed out on the money/credit they could or would borrow and spend. So demand for Chinese goods began to falter and the demand for raw materials began to taper off. This effect was delayed as the Chinese government injected stimulus to support their economy;  building even more capacity hoping demand for their exports would return. It didn’t. 

Compounding this was the cure the developed world’s central banks undertook only made the problem worse. To reinvigorate economic activity or ‘aggregate demand’ they dropped interest rates to 0% (Quantitative Easing, or Zero Interest Rate Policy). Corporations worldwide used these low interest rates to expand even more capacity to meet the expanding aggregate demand they thought would soon appear.  But it didn’t happen. The American and European middle class was under pressure and not willing or able to continue  their  borrow and spend splurge. The expected resurgence in demand for Chinese exports never happened.

China’s economy is cooling because the world’s economies cannot increasingly import their exports. Without the world’s need for China’s exports, they have less need for the raw materials to manufacture those exports. Hence, a concurrent collapse in commodities prices, and not just oil, but iron ore, copper, zinc, etc. This lack of demand for exports from raw material economies then boomerangs back on less demand for Chinese exports, and so on.

It is not just China’s economy that is weakening, it is worldwide.

 

9/30/15: Back to the Future

I have been around for a while now; decades.  I remember when investing was done by stock picking.  A stock’s value is mostly the current value of its future cash flow. A good stock picker analyzes the future prospects of the underlying company, buys its stock, and rides the price appreciation as the analysis hopefully unfolds. However, today the Federal Reserve openly states that it targets the level of the stock market as a policy tool to change the "mood" of the economy and thus stimulate economic activity.  The plan has been/is to boost asset prices, revive the economy's animal spirits, which then will start to create jobs. It worked in their mathematical models, but not so much in the real world. The markets are way up, the economy not so much.

Add to this how massive pools of money have developed complicated formulas implemented rocket fast with massive computers jerking markets hundreds of points back and forth with reckless regard.  These moves have little to do with underlying value, or future cash flows.

How does one cope? One way would to not yield to this at all; to ignore it. Ultimately, all that matters is Fair Value. Fair Value is like gravity. What a company is and will be determines its stock price. This is Fair Value and over the long run, it always wins. So buy quality and only at a good price. Sometimes it involves a great deal of patience.  Trade the euphoria of runaway advances for confidence in scary declines as computers run the markets to short run extremes. Go back to traditional stock picking to deal with the future of seemingly crazy markets.

It can be easy to do. Some of the best stock pickers are readily available through tried and true mutual funds. 

 

6/22/15 Stock Buybacks

Not discussed enough is the effect stock buybacks are having on the stock market over the last several years. The concept is simple. Corporations buy shares in the open market the same way ordinary investors do, however, when corporations do it, they ‘retire’ these shares leaving fewer shares outstanding. Each remaining outstanding share then represents a larger piece of the corporation. Therefore, when total earnings are reported a smaller number of shares divide into them. This increases earnings per share more than total profit of the corporation would indicate. Share prices then rise accordingly with the increase in earnings per share. Additionally, buying shares in the open market  provides a further boost to share price. 

However, this may be sacrificing long term growth for short term gains.  Corporate cash used for stock buy backs is diverted from investing in additional opportunities,i.e. of buying plants and equipment, and employing more people to create more profits over the long run.  Corporations are even borrowing to finance stock buy backs; putting more and more debt on their books for future managers to deal with. Activist investors concerned only with immediate gain are forcing the issue. Managers who do not implement buybacks are soon unemployed.

Stock buybacks are a major component of what is driving the stock market to  record valuations. It also helps explain why the market is soaring while full time jobs have not recovered to pre-recession levels.

(link)

 

11/13/14: Gold, Silver, and Japan

Another deflationary impulse hit the global economies. Japan announced shocking news.  After several decades of no economic growth, the Japanese government has piled up massive debt. They desperately need to get their economy going and just announced a desperate plan. After the Bank of Japan (their Federal Reserve) copied our grand growth experiment of flooding the economy with vast quantities of newly created money (QE), they are going all in. While our Federal Reserve tapered money creation, Japan is boosting their efforts to the equivalent of three times that of our Federal Reserve.  Moreover, the Bank of Japan will be indirectly investing in the stock market (governments creating cash to buy stock ... what next?). Of course, the Japanese yen crashed on this news.

So what does this mean for the U.S. economy?  In a word: deflation.  A cheaper yen means they will try to undercut their Chinese, American, and German competition and export more. They are debasing their currency to steal business from other nations. Competing economies will be forced to retaliate by cheapening their currencies.  In a currency war, when everyone tries to fix their slow economy problems at each other’s expense, everybody loses.  Currency debasement leads to the inevitability of instability and/or eventual inflation.

Therefore, for now, there is worldwide deflation.  The price of gold and silver, which traditionally hedges against inflation and instability, has stagnated. However, in a world of currency debasement or, in other words stuffing the world with more and more currency from nowhere, precious metals are the last stable currency. Governments cannot create gold. Citizens of developing economies know this. That is why they are buying gold and silver at record rates. Even some of the foreign central banks are buying gold and building their gold reserves.   

In the past, gold has held its value. Currencies run by desperate governments have not.   

 

10/21/14: The Iron Law of Valuation

The discipline which holds that stocks and the market in aggregate have a fair value based on past, current, and estimates of future earnings. This method is calculated through exhaustive mathematical analysis and statistical back-testing.  Through this methodology, a current fair value can be derived.  The Iron Law of Valuation is that, while actual prices will fluxuate, the inevitable pull of fair value will win over the long run. This analysis compares the current price to what is historically normal and can further demonstrate the degree of the difference; whether this market is under or overvalued.

Furthermore, by assuming, what has been true will continue to be true and comparing the current price to an expected future fair value, the probability of an expected future average annual return can be derived. Therefore, history gives a fair value: an average, a mean, a best fit. In addition, because stocks are no more than the present value of future earnings, these earnings can be anticipated, then assigned a current value discounted at some function of the Federal Reserve’s ‘neutral policy’ interest rate. It becomes a simple matter to determine whether the current price of the stock market is above or below fair value; whether it is under or overpriced.

Right now, the current price of the stock market is higher than this discipline would expect. But reality often turns theories about the appropriate value of the stock market into junk. Recent history is full of instances where the stock market continued to make substantial gains long after these theories stated otherwise. No one better documents this divergence than Laszlo Birinyi, and he is still bullish. 

However, I believe knowing fair value is very important. The Iron Law of Valuation is like gravity.  Over the long term, it wins.

10/10/14: Jobs

It has recently been argued by a leading economist  that the Federal Reserve's great financial experiment of buying massive amounts of bonds (QE), dramatically dropping interest rates (ZIRP), and flooding the system with newly created money was not about bailing out the big banks, it was about Main Street jobs. That, in order to restart the economy the Fed’s began a policy of targeting not just bonds prices, but stock prices as well.

Too many people taking on too much debt caused the 2008 financial crash.  Debt they could not pay back.  After 20 years, the economy topped out and went bang. In the aftermath, Americans were choking on debt and unable/unwilling to continue spending at binge rates.  Economists call this a Liquidity Trap.  Dropping interest rates did not encourage us to borrow more and spend. Someone who already ate too much is not interested in free hamburgers.

The argument continues that it is not the level of debt, but rather the amount of debt relative to equity that matters.  A $300,000 mortgage on a house worth $250,000 is not good.  However, the same mortgage on a $500,000 is another story. Price influences behavior.  A homeowner with $200,000 equity in their house behaves differently than a homeowner that is underwater….they spend. Furthermore, corporations are run by people, so by lifting their equity (their stock price), they would also behave differently. Expansion plans would be undertaken, plants built, orders made, and finally, people hired. Therefore, by boosting the stock market, middle class jobs are created.

In this way, the level of the stock market became a policy tool of our Federal Reserve. Their plan to escape this Liquidity Trap was to lower interest rates, flood the system with money, and thus run the stock market to change the "mood" of the economy. The plan is to boost asset prices, revive the economy's animal spirits, which then will start creating jobs.

So, here we are. The Fed has fully implemented its Grand Experiment of Zero Interest Rate Policy and Quantitative Easing (QE). They are now one of the largest holders on U.S. Treasury bonds. Their policy of driving stock prices higher worked. The market is up. However, the economy has yet shown little response.  Consumer expenditure has remained weak.      

The "fair value" of proper asset prices so important to capitalist systems was no match for the determined will of the central planners of our government.  The price of the stock market is now a policy tool of the Federal Reserve and freed from the Iron Law of Valuation, freed from fundamentals of the underlying economy.

So, there it is.  Government policy intentionally rallied the stock market to kick-start our anemic economy. Now it is time to see if it worked.

This brings me to last quarter’s positive GNP report:

Gross domestic product, the broadest measure of goods and services produced in the U.S., grew at an annual rate of 4.6% in the second quarter.

http://online.wsj.com/articles/u-s-economy-grew-at-4-6-rate-in-second-quarter-1411734858

 

5/21/14: Bonds and then Bonds.

The Federal Reserve responded to the financial crisis by dropping interest rates to zero (ZIRP) and by buying massive quantities of bonds and thus flooding the banks with newly created cash. We were told it would short lived. However, five plus years later it is still mostly with us because we are told that the economy is fine but only by a little. Therefore, faced with a banking system flush with cash and the average investor desperate for yield, there has been a multiyear rally in bonds. This rally was interrupted last spring but has since remained calm at marginally higher rates. While this calm lasts, it is important to review what are bonds, and what are bonds.

Bonds have a credit rating. The credit rating is based on the ability of the lending organization to repay the money lent to them. Standard and Poor is a leading bond rating service. Their ratings run from AAA to CCC or lower. AAA are the highest quality bonds. BBB and up are referred to as ‘investment grade’. Investment grade bonds have adequate to extremely strong capacity, depending on their rating, to both meet their dividend payments and return your capital. CCC’s are considered “vulnerable”.

Link to Standard and Poors

This is important because the recent years of yield chasing have dropped the yield on BB and lower bonds to record lows. In addition, these ‘junk’ bonds command a higher premium over their investment grade brothers. Investors rightly required a much higher dividend yield to compensate them for their higher risk. However, this premium is now near historic lows. This makes them vulnerable on two fronts. First, all bonds suffer a decline in current market price if interest rates rise. Second, their current market price will decline if the outlook for their financial stability worsens. So, you have to ask yourself; “Is the extra dividend yield worth the risk?”.

Link to the SF Fed

So there are bonds and there are bonds. It is important that you know which ones you own.  

5/14/14: Time Will Tell.

While the stock market continues to remain orderly, there have been some recent changes. The prices of many of the momentum stocks, which are long on promise and short on earnings, are down 50% or more so far this year. The iron law of valuation always wins.  Fortunately, the stock prices of large traditional companies are holding (keeping many stock index returns slightly positive for the year). This could be a return of rationality, which bodes well going forward.  While the valuation of the broad market is still rich, it is still well below previous extremes. It looks like it is headed higher.

Recent numbers on the state of the economy are mixed at best. The early report on first quarter GDP came in flat. The unemployment rate has improved substantially, but this is due to a decline in the U.S. labor-force participation rate. The stock market advance continues without much support from the economic fundamentals. Perhaps stock investors are looking ahead, optimistic about what they anticipate.  For example, new technologies in natural gas production are boosting the oil & gas industry. These technologies are increasing domestic supplies, dramatically lowering energy costs and therefore potentially igniting a domestic manufacturing renaissance. Other technologies, too numerous to itemize, are also changing the world for the better. Innovations have become commonplace and, in past, solutions from seemingly nowhere have solved the challenges we faced.  Why not this time, again. 

Then there are bonds. Last year the interest rate on the 10-year Treasury spiked to 3% at year-end from an epic low of 1.75%. This left the Bloomberg U.S. Treasury Bond Index with a loss of 3.4% and the Barclays U.S. Treasury Inflation Protected Securities Index with a loss of 8.6%. So far this year, the interest rate of the 10-year Treasury has dropped back down to about 2.6%, resulting in higher year-to-date bond prices.  The Bloomberg U.S. Treasury Bond Index is up about 2.6% and Barclays U.S. Treasury Inflation Protected Securities Index is up almost 3.8% this year. This is not something that normally happens in an improving economy. Rates should be going up and bond prices down; especially with the Fed’s Quantitative Easing bond buying program pulling back. However, rates are so far stable to down and bond prices are up.  Perhaps higher bond prices are the result of the shortage caused by the years of the Fed’s bond buying.  Or perhaps it is because our bonds look attractive relative to those globally.  U.S. Treasuries are still seen by the world as a safe haven.  Therefore, bonds look attractive for now despite interest rates remaining near historic lows.

The markets remain orderly. However, as always, participate with caution. 

12/30/13: The Other Market.

It seems we have forgotten about bonds with the stock market in full boil. The bond market is almost twice the size of the stock market and it is about to post one of its worst years in a long time. Over the last decade, interest rates have dropped below the long-term average of 5% to 1.4% for the 10 year Treasury.  Furthermore, short-term rates on money market funds and C.D.s are almost zero due to the Zero Interest Rate Policy of our Federal Reserve. Of course, when interest rates go down, the price of bonds goes up and the long trend of lower interest rates since 1981 made bonds a good investment. However, this trend has hit bottom.

Like holding a ball under water, interest rates are popping upwards. The interest rate on the 10 year Treasury has almost doubled off of the May low to the current 3%, and this is still below what many consider normal. Therefore, the price of bonds has now been declining due to rising interest rates. Their meager interest payments have not been enough to compensate for the damage. Leading bond funds are sporting total returns of 0 to minus 10%.

The dilemma is that bonds and money market funds are an important theoretical part of any proper portfolio. This is especially true for the investor concerned about what the extreme volatility of the stock market can do to one’s life savings.  

12/30/13: Deja Vu.

THE social media stock, which everyone has been atwitter about, became a public company last month. A lucky few were able to get it at its initial public offering price. Opening price for the rest of us was about 70% higher. Since then it has risen another 64%. There is no Price/Earnings ratio because there are no earnings. Even the Price/SALES ratio is obscene. The market capitalization of this company now makes it bigger than most of the companies in the S&P 500. We have seen this sort of price action before, 15 years ago during the Internet bubble. *

“History doesn't repeat itself, but it does rhyme.” - Mark Twain

*Since I wrote this 2 days ago, the stock is off almost 20%.

11/22/13: Properly Pricing a Stock.

In the past writings below, I referred to the concept of a fair value for stocks. However, I skipped a step. I did not define what I meant by fair value. So here goes...

To start, let us assume that we are not in extraordinary times (link). Assume that we are in normal times, that the economy is fine.

The first concept is the Price/Earnings ratio. It compares a stock’s 12-month trailing earnings over the current price. For example, currently a major U.S. car company’s P/E is 12x and a cell phone equipment company is 18x. The P/E difference is due to the expected future earnings growth of the cell phone company being higher than the car company’s. Therefore, the higher the future prospects for a company, the higher the P/E ratio of its stock.

Next is the PEG ratio. The PEG ratio is the P/E ratio over the expected growth rate in earnings. A company that is 15x earnings which is expected to grow earnings at 15% has a PEG ratio of 1 (This is considered fair value, some would argue for a higher number). Below 1 (or 2), the stock is cheap, above …expensive. Yahoo finance is an excellent webpage to find this out and more on almost all stocks.

Lastly, because earning can be volatile, a leading economist, Robert Shiller developed the Cyclically Adjusted Price Earnings ratio (CAPE10). This ratio is based on average inflation-adjusted earnings from the previous 10 years instead of just the last trailing 12 months. It is believed to be a more accurate measure.

Of course, due to a cornucopia of various factors, the CAPE10 ratio is a poor predictor of short-term movements in stock prices (and there is certainly no shortage of various factors lately). Lazlo Birinyi well documents this (he continues to call for higher prices). However, over the longer term, I believe the inevitable gravity of fair value pulls on prices (link).

What is the current CAPE10 ratio on the S&P 500 you ask?

9/3/13: Stocks, Value, and the Economy.

There has been a historic intervention into the economy by the central government. Huge deficit were incurred. The U.S. Treasury and its partner, the Federal Reserve engaged in massive money-creation, buying (QE) all this debt. Essentially, the government loaned itself money; as much as it wanted and more. Interest rates collapsed to never seen before levels (0%). We were told this would find its way into the real economy and economic prosperity would return. So far, it has not. The financial sector and their cabal have benefited from this debt/financed binge of cash flowing to them but high unemployment remains and wages are downs. Trickle-down economics has yet to take hold this time. Clearly, the economic backdrop is not good.

Yet the U.S. Stock market is up. Reasons vary. Government deficit spending has replaced the tapped out consumer’s borrow & spend binge. This has maintained corporate revenues. Lower than low interest rates allowed corporations to refinance debt and add to earnings.  The central banks newly created money has flowed into the stock market; boosting prices.

However, up is up. Although valuations are rich (link), especially given the economic backdrop, they may not be in bubble territory. Lazlo Birinyi still firmly holds that the time proven rhythm of the U.S. stock market points up. And this is America. Great technological strides are being made; such as Apple’s harnessing and slick packaging of personal digital devices, Ford’s remarkable progress manufacturing fuel efficient EcoBoost engines, the dramatic reduction of electricity used by LED lighting, or direction drilling reducing carbon emissions and making us energy independent to name a few.     

Therefore, as we go into the Fall, U.S. growth stock funds are up about 16.0%, but emerging market funds are down about 13%, Intermediate term bond funds are down about 4.0%, and money market funds pay next to nothing. This leaves a diversified portfolio up maybe about 6.0%. This is a respectable return, but not what the headlines lead the average investor to believe.

Now, all eyes are on what our government will do with interest rates (QE and its tapering) and how this grand experiment will end.

8/6/13: Bonds Got Hit.

I have been writing, talking, and even ranting about duration, ultra-low interest rates, and the inevitability of higher rates and thus, lower bond prices (link).  However, rates kept driving down to historic lows. But maybe it is finally time.

The interest rate on the 10-year Treasury rose off the bottom of 1.7% in May and broke through a 7-year trend line to 2.7%, as of this writing. Bonds prices dropped dramatically (link).

Our government needs to hold interest rates down to avoid the compounding effects of higher interest payments on the existing debt. In addition, our government needs to hold interest rates down until growth is strong enough for the economy to stand on its own. Their plan is to create new money, buy bonds, and keep interest rates low until the economy revives (Quantitative Easing). Inflation will then pick up along with higher wages. Deficits will subside due to higher taxes from a growing economy. Total debt will shrink in real terms due to controlled inflation, and interest rates will rise slowly. That is the plan.

They will do whatever it takes….which is to print money and buy bonds. The Fed simply cannot stop. Interest rates must stay down. But so far, little of this money has found its way past the stock market into wages. Hence, there is no growth. Their plan is not working.

GDP is growing at about an anemic 1.5% so far this year (link).

The July employment report confirms (as follows): link

I see no economic strength driving rates higher. The unemployment reports have not been positive. Full time, breadwinner jobs ($35,000+) are scarce and other employment measures are not good. The economy does not point to higher interest rates. The Fed has no reason to stop its Quantitative Easing maintenance of low interest rates.

However, the risk of principal loss has shown itself. Maybe something else is at play. Maybe with dividend yields so low, it is not worth the risk.

As always, it is not easy to see forward.

5/16/13:  Up is Up

The stock market is running. The economy ... not so much.  So what is going on?

A quote I wrote down months ago (but not the author).  It sums it up:

“we expect robust flows ... to dominate fundamentals.”

In a perfect world one invests in the stocks of well-managed companies that are growing sales and earnings in a sound and strong economy.  However, this bull market is not that.   Yes, well-managed companies are growing sales and earnings.  Yes, the price of the stock market relative to its underlying earnings, although rich, is not excessive.  However,  it is not a sound and strong economy.

What is driving this market is: liquidity.

“Credit is super-abundant and stock market behavior is conditioned not so much by the fundamental performance of its underlying companies but by increasing doses of monetary Ritalin.” (link)

Our Federal Reserve is pushing a reported $85 billion of newly created cash in the banking system every month and dropping interest rates to near zero.  Much of this new cash is buying stocks.  Also, savers that are faced with near zero CD rates, are searching for some return and buying dividend stocks.

Furthermore, the European Central Bank appears to be no longer backstopping their citizen’s bank deposits.  Money is moving out of Europe and finding a home here (Link). Japan with its aggressive yen devaluation plan is also a benefit to our stock market (Link).

Robust inflows of cash are driving this stock market higher without concern for the economic uncertainty all around us.  The psychology of Birinyi’s bull market cycle is in full swing (see below).  The stock market is running. Up is up.

 

2/28/13:  What is behind the Italian elections?

The introduction of a common currency, the Euro, created a potent cocktail for the less industrialized nations involved, especially the Mediterranean countries (including France). It allowed the highly efficient industries of the northern European powerhouses countries (Germany) to compete with their southern brothers on equal footing. The southern nations, with their relaxed lifestyles and less than robust industrial infrastructures, were unable to compete. Before the Euro, they were able to devalue their currency and thus lower the price of their goods (in terms of their competitors currencies). However the Euro locked them in. Instead of facilitating trade, industries in the south were outcompeted and hollowed out.  Imports grew while exports shrank. Goods imported from Germany were increasingly being financed with more and more debt, not earnings.

(Un) Fortunately, because the southern brother’s currency was now the Euro and devaluation was not a concern; banks everywhere were willing to lend these nations money with abandon. While exports (earnings) and thus their private productive sectors declined, governments of these southern nations bloated up to fill the void left by their declining productive sector. Government, which of course earns nothing, financed itself by borrowing even more money. Government expansion maintained the illusion of economic activity. The problem was solved for a while.

So here we are now. The southern Euro nations have a shrunken and uncompetitive productive sector burdened with a huge government, and an enormous debt which cannot possibly be paid back. Austerity, or ‘internal devaluation’, is being pushed on them by the northern banking/political class. They want their southern brothers to start ‘living within their means’. However, as Milton Freedman proved, it is easier to spend more than it is to spend less. A gradual devaluation used to keep things in check, no longer. Now the northern Eurocrats are trying to hold back the inevitable by forcing their southern brothers to cut wages, employment, and benefits to kept the euro intact. The Italians are pushing back.

Watch Italy. I think Europe may devolve into class warfare. The Euro is a failed experiment.

Furthermore, it is a warning to others that a debt financed, bloated government is not the solution.

2/5/13:  Part II: What's going on

The preliminary Gross Domestic Product for the 4th quarter of 2012 printed minus .01%.  That is not good. True, looking at the individual components shows some upside.  Consumer spending grew 2.2%. Housing advanced off a low bottom. Tech spending was up. Inventories and exports fell while government spending, which needed to decline, did. However, our Government still borrowed a huge amount; $312 billion in the fourth quarter alone. (link).  Overall, 2012’s GDP was about 2.2%. That is not good (link). 

Yet the stock market looks to continue to rally.  Is the market wrong?  No.  Up is up. 

Lazlo Birinyi, a veteran market historian to be respected, argues that bull markets have cycles.  He breaks these cycles into four stages: Reluctance, Consolidation, Acceptance, and Exuberance.  These cycles are driven by psychology and play out despite other factors.  Of course, a major event will dominate. However, desperate U.S. Government policy and the failing economic recovery, the debt tsunami in Europe, or the Arab spring have not broken this cycle.

Birinyi remains positive for 2013.  He believes the fourth stage of Exuberance began last July. Furthermore, his analysis shows that, historical bull markets he sees as similar to todays resulted in a 38% average gain.

“History never repeats itself, but it often rhymes”  – MARK TWAIN

Heady stuff.

1/9/13: Part I: Ignoring the Fundamentals?

Is The Fiscal Cliff is now behind us?

“…$620 billion in tax increases is spread over 10 years, so it is only $62 billion in 2013. To put this in perspective, the Federal budget deficit in 2011 was a whopping $1.089 trillion. This amounts to only 5.7% of the 2011 budget deficit!” (link)

Not 6% of the total debt, not 6% of the Federal Budget, but just 6% of the $1 trillion plus deficits to be incurred in each of the following years. Moreover, this assumes that revenue (taxes) meets projections. Remember that the rich are also the successful and have proved adept at changing behavior to manage their tax bill.

So, the answer is: no. The Fiscal Cliff is still very much unsolved.

Furthermore, a measure of how expensive stocks are relative to earnings is the Shiller Price/Earnings ratio. It is above historic averages at 22x’s. This generous premium surely signals good times are soon to appear. Or are they? Chart after chart of economic data still shows little sign of this. So what’s up?

This stock market is on a liquidity-driven rocket ride as the U.S. Federal Reserve mints new dollars from nowhere to accommodate the massive debt binge of our Government. Currently, our Federal Reserve is purchasing $85 billion of bonds per month to maintain our record low interest rates. This is $1 trillion per year compared to U.S. GDP of about $16 trillion. It is estimated that 42 cents of every dollar spent by our Government is borrowed (link).  All this liquidity pumped into the system by not just our Federal Reserve but, by the Bank of Japan, and European Central Bank, is driving stock prices with no apparent end in sight. This market is on a rocket ride.

This news is not new. It was the case a year ago when I was recommending caution. It seems nothing has changed. Our government is still irresponsible, the economy is still mired down, the Euro is still a bankrupt idea, and the stock markets continue to go up.

After proofing the above for me, one of my managing partners sent me a copy of a the Daily News dated 11/29/1949 titled “Ode To The Welfare State”. This article foretold the end of American prosperity. It reminded me that our Country has been here before and survived to scale to new heights. He also reminded me that there are currently many highly successful companies driving their stock prices higher.

Laszlo Birinyi, a veteran market historian to be respected, was right last year and is still bullish. His recommended portfolios were up 3%, 7%, and 15% for 2012. He chooses his words carefully and, is very positive for 2013 (link). Birinyi’s newsletter is provided to me by my other managing partner.

Gee.

11/20/12:  Duration Duration Duration

Duration is a very important concept for bondholders in today's world of
low dividend yields. It measures the degree of risk of principal loss
should interest rates rise from our current historically very low
levels. For example, a leading investment company offers an exchange
traded fund (ETF) which I believe they correctly state is
"representative of the broad, U.S. investment-grade market."  It has an
SEC yield of 1.6% and a duration of 5.0 years. Simply put, if the
relevant interest rate rises by 1%, the current market value should drop
about 5%. Given a meager 1.6% SEC yield, that is not much reward for
that much risk.  

It is no secret that our Federal Reserve is 'managing' interest rates in
an effort to generate economic growth. Many argue that this policy is
unsustainably suppressing interest rates and that the free market or
'correct' level of interest rates is much higher.

Predicting and timing moves in interest rates is a "fool's errand". The world is
full of turmoil. U.S. interest rates could remain low for an extended
period. However, government policies often fail and interest rates could spike upward. This would leave many investors with unexpected losses.   

One must consider that current dividends may not be
sufficient pay for the potential risks. Caution is recommended. 

9/11/12:  Is It Safe? Stocks: Pro, Con, and the Dividend Bubble

The U.S. stock market is at post -crash highs in the middle of domestic and world economies optimistically seen as struggling. Does it make sense? Is the market reasonably priced? Is it safe?

Well, it depends who you talk to:

Pro: The S&P 500 is currently about 16 times earnings on a 12 month trailing basis. This is about average on a historical basis (link). Additionally, we are in the recovery stage of the business cycle where earnings slowly improve. Furthermore, price/earnings multiples are inversely related to interest rates and interest rates are extraordinarily low. The average dividend alone on high quality stocks is paying far more than what C.D.’s offer. Lastly, the charts are pointing up; as the saying goes, “the trend is your friend”.

Con: Shiller’s methodology for calculating the S&P 500’s price earnings ratio is based on average inflation-adjusted earnings from the previous 10 years (link). It is currently at 23 times earning with a historic average of about 17. The S&P 500’s current dividend is currently substantially below the historic average meaning prices are high (link). Additionally, corporate profits as a percent of GDP are not as high as some claim, but high none the less (link). Profits could decline as a percent of national income as wages start to reestablish themselves. Lastly, the end of borrowing the difference between what is spent and what is earned is here. Politicians call it ‘austerity’. It is inevitable and will depress economic activity.

The Dividend Bubble: The Federal Reserve’s Zero Interest Rate Policy (ZIRP) intervention has forced normally conservative savers into the stock market looking for yield. Dividend stock has been bid up distorting their price (a bubble). The resulting elevated P/E of these stocks has raised the overall multiple of the market. The other side of this is many other stocks remain at more traditional P/E multiples.

For example, a currently popular dividend stock is now priced at 18 times earnings and a 4.3% dividend yield. According to Valueline, its historical average P/E is 14x and its average dividend yield is 5.0%. This implies a ‘fair value’ of over 15% below its current price.

With the stock market at post-crash highs it may be a good time to do some math.

8/2/12:  Getting There

What is the greatest technological advancement of the last ten years? Most would probably say the smart phone, or perhaps social media sites. I think it is directional drilling and what is referred to as ‘fracking’. Vast reserves of natural gas through this new technology have become economically producible throughout the Midwest. Further west, rich oil reserves can now be accessed.

“…energy resources are primarily a function of technology, not of geology. Technology unleashes resources, resource wealth creates capital, and capital is reinvested in new technology that, in turn, unleashes resources.” Link

“So dramatic are America’s finds, analysts talk of the US turning into the world’s new Saudi Arabia by 2020, with up to 15m barrels a day of liquid energy production…” Link

This technology has the potential to change America’s future. It has the potential to drive our GDP out of recession and return us to full employment. We could dramatically cut both our trade and fiscal deficits.  Cheap energy could also revitalize other American industries. Lower electricity bills could help every homeowner. Tax receipts could expand painlessly.

In addition, while natural gas is still a carbon-based fuel, it is far cleaner than what is currently in use.

“...the biggest advances have been in power generation. A technological breakthrough, the combined-cycle gas turbine, a spin-off from the aviation industry, has transformed the economics of the industry. Not only has it made it cheaper to generate electricity from gas, but the process releases up to 50% less carbon dioxide than does coal. As governments strive to cut greenhouse-gas emissions, replacing coal with gas will bring fairly swift results.” Link

Billions of consumers are coming on line around the world. This reality demands that clean, renewable energy technologies be developed. But for now….    

5/25/12:  Niall doesn't get it

Niall Ferguson is one of the best historians of our time and was recently quoted saying that the Euro must hold and Greece should not leave the currency. ” I am not a federalist," said Ferguson, "But the costs of the single currency disintegrating are really so high and would impact so many people, that the only responsible thing for me to do is to argue urgently for the next step to a federal Europe. I see no alternative at the moment that isn't a great deal worse." Link 

Mr. Ferguson is not an economist and I believe he misses the point. This is not a debt crisis, it is a current account crisis. The debt is a result of southern European nations being unable to compete with their northern neighbors. To over simplify, the Greeks have been buying everything German while no one was buying anything Greek. To finance these purchases with no international earnings coming in the Greeks borrowed, and borrowed, and borrowed some more. Since Greece is part of the Eurozone, lenders mistakenly lent, and lent, and lent some more.

“So the problem for the euro is the capital flows between the creditor nations and the debtor nations. What caused the problem? The culprit is the current account imbalances.” Link 

Europe is strapped into a common currency designed for political reasons which is totally unworkable for economic reasons. Federalizing Europe would create one nation out of many countries. This would lock in the current uncompetitive reality. Germany would be forever sending transfer payments to their unproductive southern brothers.

In order to compete, the south must lower their costs. The current plan of remaining in the Eurozone and the accompanying ‘austerity’ of grinding down wages, benefits and everything else will not work and will most likely end in revolt. On the other hand, if Greece left the Euro and had its own currency, it would devalue. Devaluation immediately realigns relative prices. The cost of goods and services of debtor nations such as Greece becomes cheaper while the costs of creditor nations goods and services become more dear. Thus Greeks buy less German goods and services while Germans buy more from Greece. Debt too revalues. Creditor nations and their banks are forced to write down what is owed to them to the new currency.

Creditor nations and their banks face huge losses when their debtor devalues. This is where we are now. The creditor will do everything it can to hold off devaluation and deny the realization of huge losses.

“…financial panics do not cause the destruction of wealth, financial panics merely tell you the extent to which wealth has been destroyed...” link 

Further loans, massive injections of newly created money, and whatever it takes to ‘kick the can down the road’ will be done to avoid the pain of a solution. While this may not solve the intended problem, It will probably keep interest rates low and markets high for an extended period.  

5/10/12:  The Great Reset: Europe

The Euro was the child of politicians, not economists. It was seen as huge, allowing trade with each other free of restrictions as an integrated Europe no longer subject to internal wars. The unintended consequence was a clash of different non-homogenous cultures strapped into one currency, into one monetary policy. The low interest rates of Germany became available to all and the enormous stockpiles of capital flowed freely into the easy lifestyle of the Mediterranean countries.  

“The Euro triggered a tsunami of wasteful fiscal spending in Greece and Portugal, the loss of export markets for family owned Italian firms dependent on lira devaluations and an epic construction bubble in Spain whose denouement has devastated its banking system and cajas. Ireland has mirrored Spain." Read here for more

Now the southern economies are strapped with a mountain of unpayable debt and unsustainable budgets. Production costs need to drop up to 30% to be competitive with the northern counterparts. Internal adjustment though wage cuts, pension reductions, and benefit cutbacks will not work.  The populace is turning increasingly and inappropriately socialist while those responsible for the financial mismanagement seem to go unscathed. A coordinated exit from the euro and an immediate devaluation is inevitable. Those institutions that benefited so greatly from the old order need to face the inevitable losses.

“Exit is the cleanest way to "re-balance Europe" and end the deflationary bias in the system. This may mean "crystalising losses" but they already exist in any case.”

“Unilateral exit states would spring a "Saturday surprise", suddenly reverting to the Drachma, Escudo, etc. Euro notes would be stamped with national insignia. Capital controls would be imposed, with a bank holiday.”

“Local jurisdiction debt would be switched to the new currency under Lex Monetae. More than 90pc of Greek, Portuguese and Spanish state debt is under national law.” Read here for more

The partial breakup of the Euro is not the end. It is the beginning. The history of capitalism is full of panics. Currency exits have happened before and devaluations are commonplace. Quick and immediate pain and a reset to growth is the answer. The current path of denial and grinding agony is not. Read here for more

 

5/8/12:  Too Good Not to Share

Mohamed El-Erian, the head of PIMCO, recently delivered this lecture at the St. Louis Fed. Here are two passages from his conclusion:

“After diffusing a material threat of a global depression, central banks in the advanced economies did a good job in maintaining a certain status quo in the midst of too much debt, too little growth, too much inequality, and an historic global economic realignment. Critically, they succeeded in their overwhelming priority of avoiding an economic depression.” 

“Where the global economy goes from here will depend less on the actions of central banks and more on whether others, including other government agencies and private sector participants that have the ability to act but lack sufficient willingness to do so, finally step up to the plate. Only with the supportive actions of others can central banks pivot – away from using the unsustainable to sustain the unsustainable, and toward a better equilibrium for them and for the global economy (i.e., sustainability).”

View the complete transcript

He believes it is possible that our country’s leaders can put us on a ‘sustainable fiscal trajectory’ of manageable debt and modest economic prosperity. It is refreshing to read some guarded optimism from an informed and honest scholar such as Dr. El-Erian.