Markets(1Jun08): It Ain't Over til...EPS, Profits and What Next
Well the markets seem to be experiencing some adjita...which way do we go, which way do we go ? In the long-run that answer tends to follow EPS which follows real profits which, in turn, follow the business cycle. Contrary to most popular opinion and talking head discussion. You know if the markets really were a future cash flow discounting mechanism we wouldn't see much uncertainty..except that today's news is extrapolated to "infinity and beyond". At least until the next round of infinity shows up. So we're going to focus on those long-term relationships this post and let the markets gyrate as they may from hour to day to week and so forth. The last post had some key sections on corporate profits and their outlook - which wasn't very sanguine to say the least. Or it was in the old sense of bloody :) !
To build a little machinery let's start by looking at the l.t. relationship between GDP, Profits and the SP500. The top chart here shows annual changes in the three since 1950 and the bottom shows quarterly changes since 1980. Perhaps the most prominent conclusion we'd offer is that they're synchronous. At least until the late 1950s when the SP bubbled up over the economic trends. Which in our book means two things - GDP => Markets for one. And then we wonder can the S&P stay where it is or grow even if we get 1% economic growth for the next several years ?
Or put that another way can profits be sustained at their current levels ? Which in turn makes one ask what are those levels and how do they compare to historical norms ? These two charts start in 1947 with the top chart showing profits, capex and dividends from the national income accounts. Notice that capex and dividends followed profits up until the '90s when profits flattened off a bit before just booming since '00. More interestingly capex flattened off while dividends skyrocketed. If you look at the bottom chart, which shows profits, capex and wages as % of GDP, that profits are at historically very very high levels while again capex has flattened. And after jumping during the tech boom wages have continued a long-term downtrend. Bottomlines here are that companies are neither hiring nor investing. Instead they appear to be being extraordinarily tight-fisted and putting those fund flows into dividends (& buybacks). Good in the short-run for investors but one has to wonder about both sustainability in the long-run. AND the organic nature of economic growth - with below par hiring and investing clearly no executive suite sees much opportunity to grow; at least in the US. One also has to ask what about mean reversions ?
Which then leads to asking how is all this reflected in the markets ? Judging from this 4-year chart of the SP500 EPS has kept growing significantly, as you'd expect. But PE ratios have undergone enormous compressions relative to the implied growth rates. Moreover after the 10% decline from Jan to mid-March and the subsequent recovery they markets are still basically in their long-run uptrend. In other words as far as the markets are concerned all the prior postings assessments on the economic outlook are so much unsinn. We're soon going to return to earnings growth.
So what earnings growth ? And more importantly what's it worth ? We happen to like an ancient Graham-Dodd valuation formula for at least putting in a floor on valuations vs. growth estimates. That formula is PE = [8.5 + 2*G] X 4.4/Y where G = earnings growth rates and Y = AAA bond rates. In other words earnings are worth a basal growth of 8.5% plus/minus a growth adjustment adjusted for the real interest rate for risky investments. Or something like that. Well according to the previous chart PE has been in the range of (16,18). What's the implicit growth rate required to make that accurate according to these very conservative valuation rules ?
We ran the formula in reverse and looked at it two different ways in this chart. In the first it's EPS growth verses PE's and in the second it's observable PE ratios vs. implicit growth. Two ways of saying the same thing. The different lines represent different interest rates. Now if 10YR Treasuries approach, say, 5% for the next several years as we might expect does 6% for AAA corporates make a lot of sense ? What about inflation and economy/market/industry/company risk factors ? For which one might want a bit of premium. So the question then becomes how much premium, i.e. what risk factors impact your decision-making. With PEs in the 16-18 range that implies earnings growth in the 7-8% range and an interest rate of no more than 5%. If you start bumping up that interest rate you start looking at growth rates in the 10-20% range. Whee....and historically that would require Profits to maintain their seriously anomalous character for a long time in the future. AND that somehow we get outstanding earnings growth where even the Fed sees years of ~2% GDP growth.
Even if you believe a) that we've seen the last of the "so-called recession" and b) that GDP will get some growth and c) that corporations will keep not hiring and not investing you've still got a very...very aggressive valuation built into the markets.
Profits & Markets
That Was The Week That Was “That Was The Week That Was” was the title of a television program many years ago. This was a week that many investors would like to forget. What happened to the stock-market rally? Did it fade together with hopes of a second-half economic rebound? Consider the following chart. The stock market (S&P) peaked at roughly the same level in 2007 as it had in 2000, but earnings per share (EPS) improved by more than half in those years. Since the Price/Earnings (P/E) ratio = S&P divided by earnings per share, and earnings per share increased from 2000 to 2007 while the stock market didn’t, the P/E is now back to the normal range it enjoyed before the late 1990s dot.com boom and bust. The P/E had risen to speculative levels during the dot.com frenzy, but has receded from those irrational heights. Note, however, that the P/E ratio is still closer to 20 than to 10 and higher than the post-WWII average of 15 that prevailed before the dot.com boom. If the stock market is to improve, earnings per share or the P/E - or both – will have to rise. How likely is that? The financial crisis may or may not be over, but the damage done to the economy by the housing bust is not over. It seems that most days carry another report of housing’s woes. Home prices have a ways to fall. There are also more reports of the automobile industry’s difficulties. It’s hard to see how the economy can go north if housing and autos continue south.
Profits drop by record amount Before tax profits of domestic companies dropped by $167 billion this quarter. Eclipsing the old record of decline of $104 billion set last quarter, that's $272 billion in just six months an astounding drop in profits that is being excused away by many experts. By contrast the worst decline in profits during the 6 months of the 2001 recession was $105 billion, placing today's experience in stark contrast. In percentage terms the profit loss this time is very similar to the profit drop in 2001. Today profits are down more than 20% from the peak. What else is similar? Profits always lead the stock market. Back in 2000, profits hit a peak exactly 9 months before the S&P 500 hit it's peak, and 2007 that was repeated, profits peaked exactly 9 months before the stock market did. Of course the same is true for market bottoms. Profits rebounded a year and half before the stock market. What will happen this time around? Hard to say of course, but a 20% drop in profits last time equaled a 40% drop in the stock market. Today's 20% drop in profits will not see an equal 40% decline in the stock market but a 20% sell off in stocks is certainly possible. So most likely the stock market still has a ways to drop. And the economy will follow stocks.
Leverage vs Credit Markets
Long View: When it’s time to ask for whom the bell curve tolls The problem is that VaR has become ubiquitous. Regulators and ratings agencies allow banks to decide how much capital they should have using VaR models. Since the credit crisis started, VaR has come in for criticism. One problem is that it is backward looking. If the past sample of investment returns was gleaned from a period of low volatility and strong stock returns, as we had from 2003 to 2007, they will not be much use in navigating the current situation. VaR also does not take account of what are now known as “black swans” – extreme events that have not happened in the past. These can lead to extreme results, or change the shape of the bell for the future. The unprecedented fall in US national house prices may be such a black swan. Still another argument is that if everyone moves to the same place on the bell curve – where they expect a good return for little risk – they will change the shape of the curve. If everyone crowds into the same investments, they will create the conditions for sudden reversals and extra volatility. That inflicted bad losses on many fund managers last summer. Even if we do follow a bell curve, VaR can lead to excessive risk. David Einhorn, a New York hedge fund manager, offers the following example: you are offered odds of 127 to one on $100 that when you toss a coin, heads will not come up seven times in a row. The chance that you will win is 99.2 per cent. So you can say with 99 per cent confidence that you have no value at risk. Using a VaR model, a bank could hold no capital to guard against a loss on this bet. But in fact there is a 0.8 per cent chance (not an unimaginable black swan) that they will lose $12,700. What risk managers need to know, according to Mr Einhorn, is what will happen in the “tail” – the 1 per cent of the time when things go wrong. By ignoring the tails, he says, “it creates an incentive to take excessive but remote risks”. It also “creates a false sense of security”. Where does this leave us? Risk managers have made horrible mistakes in the past year.
Slow road to recovery for credit markets If the credit markets improve from here, expect it to take some time. Conditions have improved somewhat in the past two and a-half months. Back in mid-March -- the height of the credit crisis -- the near collapse of Bear Stearns (BSC, Fortune 500) sent debt buyers running for the hills. But last week, the amount of outstanding commercial paper - a key source of short-term funding for companies - increased for the first time in two months, growing by $23 billion to $1.757 trillion, according to the Federal Reserve. At the same time, both high-grade corporate debt and junk bonds have come roaring back to life as investor appetite for these riskier investments has returned. Even the overhang of financing for corporate buyouts, which hovered around $200 billion towards the end of last year, has dwindled to about $83 billion, according to Standard & Poor's. But despite these signs of improvement, today's environment still remains a far cry from the heady days of the recent credit boom when investor demand for any type of debt, risky or otherwise, was virtually insatiable. The amount of high-yield debt issued in 2008, for example, is down nearly 77% from a year ago, while interest spreads remain sharply wider, making borrowing that much more expensive.
Moody's Implied Ratings Lab Reveals Transformation of Ambac, MBIA to Junk Moody's Investors Service has created a new unit that surprises even its own director. The team from Moody's Analytics, which operates separately from Moody's ratings division, uses credit-default swap prices as an alternative system of grading debt. These so-called implied ratings often differ significantly from Moody's official grades. The implied ratings frequently show that swap traders think debt is in more danger of defaulting than Moody's credit ratings signify. And here's the kicker: The swaps traders are usually right. The credit quality of bond insurers, which have been at the center of the subprime storm, differ dramatically. The official ratings of these companies say the insurers are in great shape; the alternative ratings say they're in dire danger of defaulting on their debts.
S&P Downgrades $34 Billion of Bonds Backed by Alt-A Mortgages Standard & Poor's cut or may lower ratings on almost $34 billion of securities backed by Alt-A mortgages, the firm's largest downgrade for the type of debt. Ratings on 1,326 classes of the bonds created in the first half of 2007 were reduced, New York-based S&P today said today in a statement. S&P put another 567 similar bonds with AAA ratings under review. Based on the balances of the bonds at issuance, 14 percent of the total from the period were either cut or placed under review. Late payments of at least 90 days and defaults among Alt-A loans underlying bonds issued last year rose to 6.64 percent as of April bond reports, up 65 percent since January, S&P said. Defaults on all types of home loans have surged amid record U.S. property-price declines. Fitch Changes Method of Rating Alt-A Mortgage Bond
Previous Posts on Valuations
Value, PE and Mr. Benjamin
Markets, Earnings and PE
Earnings, Valuations & Business Analysis (II): Resources and Approaches
Long-term Market Performance: It Sure Ain't What You Thought !