Markets Manias: Thinking About the Year Ahead
The alternative title for this post might have been "Still Inside the Box" since recent market action
could be taken, as we are tending to do, as being still trapped into a sideways trading range. In fact one could make a pretty good case that our last two market-related posts (The 1,000 Yard Stare: Beyond Terminal PTSD in the Markets, Time for Triage: What Bear Rally ?) - despite some of the most tumultuous markets in six decades - have held up amazingly well. Just for the record you might want to skim back to check up on us. We think we're "in the box" because the markets are wrestling with a) the continuing credit crisis and it's implications, b) the earnings outlook and c) valuations, i.e. PE ratios. While the V-shaped recovery is has gone the way of the dodo as our last two econ posts discuss, there's still a more sanguine outlook than there should be IOHO. In that case the questions become where away - which in turn means what are the earnings outlooks based on economic realities, what are valuations appropriate to this brave new world and now what do we do ? We say inside the box because when you look at the Sept collapse, the Lehman bankruptcy, we see the sudden grasping of the truth of how bad it is. The mid-Nov collapse when Citi almost bought the big one was apparantly worse but when you change the scale from days to weeks (and note that the timelines changed as well please - read carefully) you can see the LEH cliff was much bigger and never recovered from while the Citi bump was just that. Which also tells us that the markets have a lot of confidence in systemic risks being better under control. Which is also reflected, BtW, in the credit markets. A detailed discussion for another time and place however.
On that latter question two observations/suggestions. After the break you'll find a collection of 
reading excerpts wrestling with those same questions that we've carefully culled over the last several weeks. We recommend diligent attention to them all. And we draw your attention to the accompanying chart on investment returns from the AAII. Back around '01 we suggested that buy-n-hold wasn't going to be viable and instead careful strategic picking plus cycle-based trading was going to be the new "black". We think the case is now well established.
Speaking of Earnings
Analysts have frantically been pulling down their earnings estimates for '08 and '09 but we're still not sure they've entirely got it right. The composite graphic at right puts two charts from John Mauldin's newsletter together to show how this has been working plus a table built from S&P's running on-line earnings updates. Note Mauldin is drawing from S&P but getting the reported (after-tax) estimates while the other table is operating earnings, so they aren't directly compareable. Directionally however it's very...very revealing. Based on our assessments the earnings estimates have further to drop. The other interesting thing to note is what's the implicit PE Valuation ? At $42/share and Friday's close of 950 that's a PE of 22+. Now tell me the market is still over-valued !!!
Speaking of Valuations
We've spent quite a bit of time before on relating earnings to the economy and that outlook to appropriate PE measures so we won't repeat all the arguments and machinery. Feel encouraged to skim the archives for more details and explanations. We do want to repeat a key chart from those discussions and link them to the last couple of posts on the domestic and worldwide economic outlook however. The composite graphic at right provides two tables built around the Grahm-Dodd valuation formaula so you can zoom in as you like while the chart translates it into earnings growth. Pick your area and check the details in the tables. For example at a 5% interest rate and a 22+ PE we'd need to see earnings growing at 10%. That's not next year btw, that's sustainably for at least the next five and preferably 10. Now what in either of the last two posts (pointing at Roubini, the Fed or the IMF) suggests economic growth consistent with 10% earnings growth ? In the long-run earnings and economies have to and do grow together -except for this last abberational period when profits were historically high because of under-investment and very weak hiring.
One More Nail: Shiller's LT PE Estimates
Prof. Robert Shiller of Yale (he of "Irrational Exuberance" and other prescient punditry fame) has put together some long-run estimates of financial data since the 1870s, including PE ratios. And he makes his results, papers and data available on-line in case you want to check up on either of us. Which we've taken the libery of re-producing here and adding two PE averages to - one with and the other without the Tech Bubble influences. With the average is 16.3 and without it's 14.9, so let's say 15 all around. Rather a far cry from 22, wouldn't you say ? That would suggest quite a bit of correction to go (btw - Shiller gets his estimates from looking at trailing 10 year data). His chart would also seem to indicate that long-term secular bear markets are accompanied by drops in PE far below the mean as well.
So put all the pieces together. At a 15 PE ratio and earnings of $42 we get an appropriate SP500 target of around 650. But is a 15 PE still optimistic according to the G-D analysis ? IF interest rates stay around 5.5% and profit growth is in the range consistent with the economic outlook of 2-4% then a PE in the 10-12 range would be more appropriate. Sadly and scarily that would put the appropriate SP500 reading in the 400-500 range. Which is not at all out of the question as we've shown in the earlier posts taking long-term looks at the technicals.
Markets Readings
The market's crystal ball is broken I can't remember a time when views on the short- and long-term direction of stocks, the financial markets and the global economy were so thoroughly at odds. One of these views is going to turn out to be very wrong. Either the next 10 years will look much like an attenuated version of the current crisis, or they will show this crisis to have been just that, a crisis, and the major investing themes of the past 10 years will reassert themselves as the drivers of the global economy and financial system. I'd bet the short-term view of the long-term future, which is so dominant right now, will turn out to be, well, shortsighted. If I'm correct, then long-term investors are going to see a huge pop when the crowd swings in their direction. All they have to do is survive until then. Not an easy task when the turn is so unpredictable and the day-to-day punishment is so unrelenting. Normally, bear markets are punctuated by rallies that suck investors in from the sidelines before failing and inflicting more losses. Not this bear market. It just goes down and down and down. From Oct. 1 through Nov. 24, the Dow has managed back-to-back daily gains just twice. Long-term investors -- and not just Warren Buffett -- see the current market collapse as a buying opportunity. On Nov. 19, a day the S&P 500 dropped more than 6%, Norway's $300 billion sovereign wealth fund announced that it was increasing its allocation to stocks to 60% from 40%. "These market circumstances suit us very well," Executive Director Yngve Slyngstad said. "We are a large buyer in a market with more sellers than buyers." The fund, which invests Norway's oil and gas revenue for the day when the oil and gas run out, is the second-largest sovereign wealth fund next to that of the United Arab Emirates. But the short-term money is selling, which in this case means hedge funds and their investors. Hedge fund investors pulled a record $40 billion out of the funds in October, the most since Hedge Fund Research started compiling figures in 1990. Hedge fund managers have been selling, too, and some of the industry's biggest funds are now 50% in cash. How's that for divergence? Of course, you could argue that that kind of divergence is exactly what you'd expect in a bear market. It's just business as usual in these unusual times.
10 picks for income investors, The 10 best stocks for 2009
Company woe To look ahead, look back to 2002. NO MATTER what happens in 2009, financial markets can surely not be as turbulent as they have been in 2008. The virtual demise of the independent investment bank, the rescue of Fannie Mae and Freddie Mac, the halving of global share prices—these were sufficient shocks to last investors for a decade. If 2008 was dominated by a financial crisis, 2009 seems likely to be the year when the bad news comes from the economy and from the non-financial corporate sector. All the forward-looking surveys, such as the purchasing managers’ indices, have been gloomy for months. The surprise indicator compiled by Dresdner Kleinwort, an investment bank, indicates that both European and American data have been a lot worse than expected. On the corporate side, everyone expects profits to fall but analysts’ forecasts do not yet reflect that likelihood. And everyone expects the default rate on bonds (and loans) to rise, but nobody yet knows which companies will fail. All this leaves investors with a big dilemma. The equity market has made several attempts to rally during this crisis, dating all the way back to August 2007. On each occasion, the rally petered out because the “climactic event” (for example, the collapse of Bear Stearns) proved to be a false dusk. Investors may have decided, like the Who, that they won’t get fooled again. Valuations have now reached levels that proved to be bargains in the last 30 years. The London market, for instance, is trading on a single digit price-earnings ratio. The question that has been raised, however, is whether the last 30 years are a good yardstick. In the 1940s and 1950s, it was common for equities to yield more than government bonds, as they now do in Europe and America. Perhaps we have gone back to that era. If we have, then current valuations may not be cheap at all.
Dow 5,000 Redux What is fair value for stocks? Are they now cheap? You can certainly make that argument by comparing valuations based on past performance. But repeat after me, 'Past performance is not indicative of future returns.' The investment climate of today is almost certainly going to be quite different than that of the 80's and 90's. Thus, to expect stocks to repeat the performance of the last bull market in a climate of government intervention, deleveraging and increased regulations may not be realistic? This week Bill Gross, the Managing Director of PIMCO (and one of my favorite analysts) moves away from his familiar neighborhood of bonds and offers a few thoughts on stock market valuations. This is not a lengthy read, but it is one you might want to read twice, as the concepts are important. And not just for stocks but for investments of all types. Let me first announce a fundamental premise with which I think all rational investors would agree: I believe in stocks for the long run – but only if purchased at the right price. That statement packs a real punch. It says that capitalism is and will remain a going concern, that risk-taking – over the long run – will be rewarded, but only from a starting price that correctly anticipates the economy's growth and its share of after-tax corporate profits within it. Acknowledging the above, let's look at a few basic standards of valuation that historically have stood the test of time, to see if at least the price is right. My transgenerational stock market outlook is this: stocks are cheap when valued within the context of a financed-based economy once dominated by leverage, cheap financing, and even lower corporate tax rates. That world, however, is in our past not our future. More regulation, lower leverage, higher taxes, and a lack of entrepreneurial testosterone are what we must get used to – that and a government checkbook that allows for healing, but crowds the private sector into an awkward and less productive corner. Dow 5,000? We don't have to go there if current domestic and global policies are focused on asset price support and eventual recapitalization of lending institutions. But 14,000 is a stretch as well.
The Ugly: P/E Multiple Assuming a 5% earnings growth rate for the next five years (I do not think we will have 5% growth for the next five years for reasons detailed later), the current AAA corporate yield predicts a 15x P/E multiple, much lower than the current P/E ratio implied by either backward or forward looking earnings (roughly 19x and 22x each based on S&P earnings estimates). But what annualized earnings growth should we expect over the next five years? Not 5% according to dblwyo for the following reasons:
If the economic outlook is for 2-2.5% growth on average over the next five years (IMF) at best and we presume a 5% yield a PE multiple of 10-12 becomes appropriate. Given that the markets were held up by leverage applied in one form or another (buybacks, housing ATM,et.al.) consider a go-forward regime where a 15 historical average PE is inappropriately optimistic!
Agreed, but I'll let each of you use any figure you want... the next chart shows what inputs are needed for the model to spit out the "inappropriately optimistic" 15x P/E multiple or the unreal 22x forward P/E. With the current 5.2% AAA Corporate Bond Yield, earnings need to be at least 5% to justify a 15x P/E multiple (as detailed above), which would still imply equities are currently overvalued by 30%. For current equity valuation (22x), we need 9% growth... FOR EACH OF THE NEXT 5 YEARS. A more likely outcome that gets us to our current market valuation is for AAA corporate bonds to continue the recent rally. However, based on a 2.5% earnings growth rate, the rate needs to approach a measly 2.5% AAA yield. Highly unlikely...
10 investing basics from Buffett Last year's market madness didn't just flush away $7 billion in wealth. It also washed away a lot of investors' confidence and left them stumped about the best position to take now. "Somewhere between cash and fetal," quips one pessimist. In such downbeat times, let's consider a dose of optimism, wisdom and insight: the basics as taught by that perennial investing Yoda, Warren Buffett. For new investors or those now starting over, there's good news here because Buffett's investment success comes from some easy-to-grasp human qualities as much as sophisticated expertise in balance sheets. Buffett would be the first to say his homespun and positive philosophy played a big role in his becoming the richest person in the world (before he gave most of his loot away). Changing your basic psychology can be tough, so new investors may have a leg up here because they don't have ingrained bad habits. But for anyone, a psychological makeover is worth the effort if you hope to recover your losses in the market's next leg up -- and then make the right moves for the rest of your life. My tour of the essence of Buffett's wisdom starts with the simple psychological lessons taught by the master, many of which are applicable in life outside investing.
This is the year to buy ETFs We don't know who the winners will be in the end, but exchange-traded funds will let you catch the (eventual) gains after another tough year. This year is not going to be a pretty one. There is going to be a lot more bad news.The markets won't get better, though they probably won't get much worse. Bad news has already depressed the markets, so I really don't feel there is a lot more downside for the market as a whole. A friend of mine described the current economy as a plane crash from three feet. Last year, when we were flying at 30,000 feet, the ride down was gut wrenching. But now we are flying three feet off the ground at almost stall speed with full flaps; how bad could a crash be? Among individual stocks, expect a slew of mergers, acquisitions and bankruptcies. Many of the companies you may have been following won't exist at the close of business December 2009. The credit markets, meanwhile, won't really be lending until late in 2009. Companies will be cutting payrolls, and every round of layoffs will result in another round of home foreclosures, since no one seems to keep a six-month emergency fund any more. Housing inventories will swell to record levels, and new housing starts will fall. Travel budgets, inventories and work in process will be cut to the bone, and only goods already sold or under contract will be produced. Look for a lot of bad debt write-offs, and expect a lot of defined benefit pension plans to announce they are underfunded and cannot meet their obligations to those who have already retired. Many city and county governments will become insolvent, and even some states may be in trouble. Property tax defaults will increase. Sales tax revenues will decrease. But where does that leave the average investor? You have lost faith in the brokerage research departments. Mutual funds and money managers didn't protect you. Your defined contribution plans have taken a big hit. These are the very reasons I think investors will flock to broad-based and broad-sector exchange-traded funds, or ETFs. If you invest in an S&P 500 Index ($INX) fund and 20% of the companies merge or go bankrupt, then 100 growing companies from an S&P 400 mid-cap fund will be elevated to take their place. Buy the indexes and you can buy the growth wherever it is found. If you can't decide who will survive in the financial sector, you don't buy individual companies. You buy a financial sector ETF and let the sector shake itself out. ETF's can be judged on their raw performance.
10 Outrageous Claims 2009 True to Saxo Bank’s now annual tradition, we in Strategy and Research are delighted to present our “10 Outrageous Claims” for 2009. The primary reason for doing this “Black Swan” exercise every year is to counter-balance human psychology, which is usually skewed towards optimism. We tend to be somewhat more pessimistic in our Yearly Outlook than the average analyst in the market, and believe that it is important for the investor to always factor in the less likely scenarios (as perceived by the market). Please keep in mind that this is more of a thought exercise than a set of outright predictions – we do not consider the chances are better than 50-50 for all of these claims.
Ten Non-Predictions For 2009: Part 1 1) Last year's lows in the S&P will NOT hold. Consensus looks for 2009 earnings to be roughly the same level as 2008. This looks too high. The economic environment in the US and the world is not the worst since the early 80's, it's the worst since the 1930's. And while the end of the Great Moderation will bring with it the end of the uber-leveraged business model, that model will go out with a bang rather than a whimper. The growth of leverage in US corporation can be seen in the chart below; observe how during the period of relative macroeconomic stability (1982-2006), each recession brought about a steeper drawdown in corporate earnings from the cyclical peak. Macro Man expects a substantially deeper drawdown than during the previous recession, both because of the continued unwinding of leverage in certain sectors and because of the execrable macro backdrop. Ultimately, this should lead to 2009 equity lows modestly below 2008's.
10 key trends for investors in '09 If you hope to make any serious money in 2009, you're going to have to beat the stock market. After netting out a grim first half of the year and a recovery in the last quarter, the major indexes will be lucky to show a 6% gain for the year. That kind of number will be a huge disappointment for investors looking to recover from what Wall Street has begun to call the lost decade. Over the past 10 years, the returns from investing in a stock market index, such as the Standard & Poor's 500 ($INX), have been squat. No, make that negative squat. The overall stock market lost money in that period. Fortunately, you don't have to go to the ends of the earth to beat the index. I'm going to tell you about a strategy to do just that in this column. It's not complicated. You can do it at home. And it's been shown to work over the past 11-plus years. It's the strategy that I've used for the Jubak's Picks portfolio, and it's the strategy I explain in my new book, "The Jubak Picks," which hits bookstores today. As of Dec. 22, the Jubak's Picks portfolio was beating the total return on the S&P 500 over 10 years by 184 percentage points. It's simple: Put more money into the hot sectors of the market as they heat up. Sell those sectors when they get too hot. And put very little money into the sectors that are cold or cooling.