I Worry About "The Shot Heard Around The World"

[Parsad]

Here is the interview just before Berkshire weekend.  He says that stocks are a better investment than other asset classes, but that doesn't make them cheap...just cheap in the current low interest rate environment.  Cheers!

 

http://www.cnbc.com/id/100515743

[giofranchi]

I think using since 1980 is not misleading because it includes both inflation and declining inflation periods and increasing (1982 to 2000) and flatline periods (2000 to 2012).  If we have a large amount of inflation the period does not make sense but I think the deflationary forces are such that inflation will not become an issue for awhile.  The only other issue is that if you think flatline will continue but I think at some point flatline will breakout to the upside I just don't know when and his period includes both periods.

 

I think Greenblatt's observation is what many of us have seen here.  There are alot of undervalued securities folks have found despite the market averages appearing to be high.

 

Packer

 

Packer,

I don’t really get either one of the bull arguments…

 

1) Stocks in general are not overvalued: the P/E of the S&P500 is 19, that is to say we enjoy an earnings yield of 5.3%… How many businessmen do you know who would even get out of bed in the morning for a 5.3% return? Not a single one. And earnings are also inflated, because margins are at an all time high! So, actually, you cannot even count on a 5.3%... You don’t have to look at Shiller PE Ratio, or Q Ratio, Market Cap / GDP Ratio, or Regression to the Mean Growth Trend, to get to the conclusion that stocks in general are overvalued. It is enough to think about what gets a businessman out of bed in the morning! :)

It is enough to think about what will happen to the market, if the Fed stops buying…

 

2) I don’t even get Mr. Greenblatt’s argument: because a cautious businessman is not refraining from buying undervalued stocks; instead, he is just heeding Mr. Baruch 9th rule of investing: Always keep a good part of your capital in a cash reserve. Never invest all your funds.

 

giofranchi

 

[JBird]

Here is the interview just before Berkshire weekend.  He says that stocks are a better investment than other asset classes, but that doesn't make them cheap...just cheap in the current low interest rate environment.  Cheers!

 

http://www.cnbc.com/id/100515743

 

This interview took place in 2012, not 2013. This year's interview took place in a aircraft hangar.

[Parsad]

Here is the interview just before Berkshire weekend.  He says that stocks are a better investment than other asset classes, but that doesn't make them cheap...just cheap in the current low interest rate environment.  Cheers!

 

http://www.cnbc.com/id/100515743

 

This interview took place in 2012, not 2013. This year's interview took place in a aircraft hangar.

 

??? Did you look at the date...March 4, 2013?  I think I may have confused you because I said just before Berkshire weekend.  I should have said a couple of months before Berkshire weekend.  Cheers!

[giofranchi]

Great quote from today’s market commentary by Mr. John Hussman:

 

For as long as I can remember, veteran businessmen and investors – I among them – have been warning about the dangers of irrational stock speculation and hammering away at the theme that stock certificates are deeds of ownership and not betting slips… The professional investor has no choice but to sit by quietly while the mob has its day, until the enthusiasm or panic of the speculators and non-professionals has been spent. He is not impatient, nor is he even in a very great hurry, for he is an investor, not a gambler or a speculator. The seeds of any bust are inherent in any boom that outstrips the pace of whatever solid factors gave it its impetus in the first place. There are no safeguards that can protect the emotional investor from himself.”

-- J. Paul Getty

 

giofranchi

 

[Packer16]

My point and Greenblatt's as well is there is a disconnect between the micro (high bottom's up FCF yields) and the macro (the average or weighted average earnings yield being low).  I think you and others are more than 50 to 75% right?  That would imply that you believe the micro over the macro.  If both were occurring (low FCF yields and low average earnings yields), then there would be an issue.  As a to margins regressing to the mean, there again I think you have a micro (firms with alot of IP, defendable positions and not much fixed assets) versus the macro (averages).  I think averages can be useful but also misleading.

 

 

Packer

[giofranchi]

My point and Greenblatt's as well is there is a disconnect between the micro (high bottom's up FCF yields) and the macro (the average or weighted average earnings yield being low).  I think you and others are more than 50 to 75% right?  That would imply that you believe the micro over the macro.  If both were occurring (low FCF yields and low average earnings yields), then there would be an issue.  As a to margins regressing to the mean, there again I think you have a micro (firms with alot of IP, defendable positions and not much fixed assets) versus the macro (averages).  I think averages can be useful but also misleading.

 

 

Packer

 

Yes! Of course, you are right! My point is simply that also the micro is traded in the market (unless you own a private business). And market behavior as a whole will somehow affect also our micro picks. Therefore, when I think that in the future the probability of averaging down in my investments will be high, I tend to build up cash and I reluctantly put it to work. That’s all.

Imo, this is much more important, because my circle of competence is currently limited to just a few dozen companies, and I don’t see extreme bargains among them. Your circle of competence, instead, might be made up of hundreds or even thousands of companies, and the probabilities of still finding great bargains among them might be very good indeed.

So, I guess, it depends a lot on the situation: you could afford to completely disregard the averages, while at the same time it would be imprudent for someone like me to do so.

 

giofranchi

[mcliu]

How does it work when yields are high on a company by company level, but when you average them, it's low in aggregate?

[Packer16]

It is due to only small portion or weighted portion having a high yields but many larger or larger weighted firm having lower yields.  Averages are useful but also can be misleading if you don't understand their composition.

 

Packer

[mcliu]

So you're saying large caps are overvalued and are dragging down the average yield? Not sure I buy that..

[merkhet]

 

No one said imminent crash...just that prices are getting more and more speculative.  And yes, the Reuters quote was out of context, but do you really need to know that, or can people figure that out rationally and what is quoted becomes irrelevant.

 

 

When I mentioned "imminent crash," it wasn't directed at you, Parsad. There are in fact a few other posters who have alluded to the fact that they are in anticipation of a correction coming soon.

 

Additionally, I asked for context because I just assumed that Warren was looking at his measure of Market Cap to GNP, which I believe is currently at around 100%. Neither cheap nor expensive. Of course, interest rates act as gravity (Munger mentioned this on May 3rd as well) but it's difficult to know which one Warren is referring to without context.

 

[matjone]

I wonder what the pe of the dow or s&p is if you strip out excess cash?  That could be part of the reason why a businessman might pay more than what he should according to shiller.  Also, Hussman keeps saying profit margins are abnormally high, but people on the other side of the argument have countered that that is sustainable because the mix of industries has shifted to more high margin stuff.  I haven't seen anyone refute that - not saying they haven't because I don't follow that kind of thing too much.

 

[giofranchi]

Also, Hussman keeps saying profit margins are abnormally high, but people on the other side of the argument have countered that that is sustainable because the mix of industries has shifted to more high margin stuff.  I haven't seen anyone refute that - not saying they haven't because I don't follow that kind of thing too much.

 

The problem with that kind of thinking is simply that, if it were true, we would have finally find a way to earn a higher return on our capital. On average, though, the return on capital is a sort of “social contract”. A too high return on capital for too long a time will not be easily accepted today, as it has never been accepted throughout history.

What is for sure is that, as long as the consumer saves only 1%-2% of income, and as long as the government runs large deficits, the “new era” of permanently higher returns on capital cannot be proven: If we don’t save, like we used to do, and the government spends, like never before, profit margins MUST be higher!

And the fact this spending binge has been going on for almost 30 years doesn’t mean it is sustainable forever, certainly not if, to sustain it so far, we have progressively run into heavier and heavier debt!

 

giofranchi

 

[bmichaud]

Attached are some charts relevant to this conversation, courtesy of Ned Davis Research.

 

The market cap to gdp chart is as of 4/30/13. Updated for the current SPX level of 1,635, the cap to gdp ratio is 116%. I've added the various interest rate levels in red boxes (interest rate source is the Schiller PE data spreadsheet)...which I might add largely debunks the notion that below-average interest rates automatically mean above-average PE ratios.

 

The long-run average since 1925 is 61.4%, which would require a -48% drop to 856.

 

Using the trend-line 92% as "fair value", the market would need to drop -22% to 1,283.

 

Using a more realistic say 80%, the decline would be -32% to 1,115.

 

 

EDIT:

 

Might I add - if the S&P Industrial average price to sales were to revert to its 59-year average, the implied fair value on the S&P 500 would be to 1,106.

 

Using the S&P 500 price to sales, the market would be fairly valued at 1,229.

 

I like using the industrial average for valuation and margin analysis purposes, as it removes the odd accounting nature of financials.

Stock_Market_to_GDP.pdf

SP_Industrials_Net_Profit_Margins.pdf

SP_Industrial_Average_Price_to_Sales.pdf

SP_500_Price_to_Sales.pdf

[Parsad]

I wonder what the pe of the dow or s&p is if you strip out excess cash?  That could be part of the reason why a businessman might pay more than what he should according to shiller.  Also, Hussman keeps saying profit margins are abnormally high, but people on the other side of the argument have countered that that is sustainable because the mix of industries has shifted to more high margin stuff.  I haven't seen anyone refute that - not saying they haven't because I don't follow that kind of thing too much.

 

I agree Matjone, I think excess cash on the balance sheet is what is making investors pay up right now.  But if you cannot distribute the excess cash, then your ROE is going to be lower.  Corporate net profit margins are high...probably not sustainable at current levels, but that doesn't mean they will revert to the historical 6% range either.  I think as rates start to rise, inflation creeps into input costs, you will see a reduction in corporate net profit margins as interest costs will also escalate. 

 

Presently, I think markets are enjoying a golden era in net profit margins...low interest expenses, no real inflation, low labor costs due to excess workforce, high profit margin businesses dot the landscape in another era of technological innovation, solid balance sheets...you name it, things are good for Corporate America.  But not sustainable long-term!  Cheers!

[giofranchi]

Attached are some charts relevant to this conversation, courtesy of Ned Davis Research.

 

The market cap to gdp chart is as of 4/30/13. Updated for the current SPX level of 1,635, the cap to gdp ratio is 116%. I've added the various interest rate levels in red boxes (interest rate source is the Schiller PE data spreadsheet)...which I might add largely debunks the notion that below-average interest rates automatically mean above-average PE ratios.

 

The long-run average since 1925 is 61.4%, which would require a -48% drop to 856.

 

Using the trend-line 92% as "fair value", the market would need to drop -22% to 1,283.

 

Using a more realistic say 80%, the decline would be -32% to 1,115.

 

Thank you very much! ;)

 

giofranchi

[txitxo]

Attached are some charts relevant to this conversation, courtesy of Ned Davis Research.

 

The market cap to gdp chart is as of 4/30/13. Updated for the current SPX level of 1,635, the cap to gdp ratio is 116%. I

The long-run average since 1925 is 61.4%, which would require a -48% drop to 856.

 

  Great plots, bmichaud.

 

  However, things never fall to their average and stay there. If the cap/gdp ratio falls to levels close to the last bottom, ~40%, the market needs to fall by 66%. This is similar to what you get from Tobin's Q, and from the Shiller P/E (current CAPE~24 vs CAPE~8 at bottoms). Therefore, if markets keep behaving in the same way as they have done during the last century (which is the only real dataset we have to study), stocks have to go down by ~2/3 from the current levels. 

 

  I really don't have a narrative to explain how that will happen. I can speculate that once QE-infinity is baked in, and the economic numbers disappoint, the Fed will run out of rabbits to pull out of the hat. Or that Japan, or China will implode and drag the rest of the world down with them or that yadda, yadda, yadda.  But the numbers are crystal clear, unless, of course,  this is time is different...

 

 

 

 

 

 

 

 

[bmichaud]

To your point txitxo -

 

Given the similarities between: the 1929 and 2007 credit-induced peaks, the deflation-induced 2007-2009 and 1929-1933 declines, and the debasement-induced 1933-1927 and 2009-2013 rallies, the 1937 peak appears to be a very relevant comp to the current period.

 

1937/2013: Schiller PE well over 20 with interest rates at multi-year lows and falling.

 

Schiller PE falls from well over 20 to around 15X in 1940 where interest rates bottomed at around 1.90%. Interest rates begin a multi-decade climb in 1940, but the market falls to under 10X, back up to 15X, then back under 10X in 1950 before initiating a huge secular bull run.

 

Would not at all be a surprise to see the 10-year rate bottom below current levels, given the massive amount of debt still outstanding (see the chart attached - yes there is a clear step up in the ratio, but the post-1929 deleveraging went on far longer than the current cycle).

 

We shall see if this time is truly different  8)

Shiller_PE_Ratio_-_multpl.pdf

10_Year_Treasury_Rate.pdf

Credit_Market_Debt_%_of_GDP.pdf

[jay21]

Pabrai raising cash as well?  He sold GM last quarter.

 

http://www.dataroma.com/m/holdings.php?m=PI

[hyten1]

folks forgive my ignorance, i was wondering what everyone's thoughts are on this topic, in regards to "market cap vs nominal gdp" ratio

 

i am puzzle on why we don't adjust the nominal gdp part to consider for globalization? does anyone have this info?

 

as we know market cap is how much a companies worth given by the market, a company like KO which makes half of its profit overseas (i think that is the number) naturally would have a large market cap than a KO that doesn't make that part of the profit overseas. however in this scenario the GDP would not be affected in the calculation.

 

am i missing something? please forgive my ignorance

 

EDIT: i am not argueing that market is high or low, just like to have more accurate data. if you look at this ratio over time (http://www.cornerofberkshireandfairfax.ca/forum/general-discussion/i-worry-about-the-shot-heard-around-the-world/?action=dlattach;attach=1738) it seem like its trending up for decades, how do you explain that? does that mean we have some sort of overvaluation that have a cycle of centuries or multi centuries? please forgive my igorance.

 

base on the chart we have been overvalue since early 1990's (except for 2008/2009). obviously i have no been investing for that long, i guess this entire thing make be pause a little.

 

also i wonder, what about before 1920's what does the data look like way back. i would beat the ratio is even lower in the past? obviously this is just a hunch.

 

[bmichaud]

This graph of the Schiller PE is far better, IMO - it automatically takes into account globalization etc... as that will flow through the "E" part of the equation. It appears there is a slight step-change upward in 2000, but for the most part, going back to before 1890 the market appears to want to revert to around 15X, give or take.

Shiller_PE_Ratio_-_multpl.pdf

[hyten1]

be careful

 

http://www.sec.gov/Archives/edgar/data/1549575/000154692713000077/dalalstreet132013q1v3.txt

 

it looks like he has swap GM common for GM warrants

 

which is something that i done a little while ago

 

GM'B warrant is a long long term option, it a better way to leverage your GM shares, most of my GM investment are in warrants

 

EDIT: GM is pabari's second largest holding by value

 

 

 

Pabrai raising cash as well?  He sold GM last quarter.

 

http://www.dataroma.com/m/holdings.php?m=PI

[Kraven]

For all you budding Elaine Garzarelli's out there, tell us when the market will crash within one week of your prediction - and do it twice in a row - and I will be impressed.  The rest, to borrow a line from the one of the classic films of the past 30 years, Road House, is like putting an elevator in an outhouse.  It don't belong.

[hyten1]

i think this discussion is interesting, but if you follow it you would have been out of the market since early 1990's

 

we all already get a since of the valuation by how easy/hard it is to find ways to put to work our money

 

its definitely interesting and as a sanity check

 

still looking for great investments, anyone got any GREAT ideas? i can find a bunch of reasonable ideas :(

[bmichaud]

Isn't one of the long standing rules if investing that you can either predict what or when something will happen....but not both? Why should we care when?