Are we entering the final stage of the bull market?

[ERICOPOLY]

Eric - Attached is an excellent piece by Ned Davis himself on corporate profitability. Perhaps a good springboard for discussion on the topic...

 

Yeah that was good.  I hope I'm not distorting things by pointing out that competition won't be driving margins down if ROIC is at such low levels today.  Presumably companies are investing capital into competing with each other, but getting nowhere in their efforts?  One would tend to think that ROIC would be high if there were such fat low hanging fruits to be had.

 

Then the paper goes on to point out that profits were driven up by falling interest rates and falling labor costs.  Again, not something that Watsa sees rising on either count.

 

The only explanation left from Ned Davis is the bit about the falling rate of savings and high deficits. 

[bmichaud]

Even if labor costs and interest rates are not set to rise anytime soon, I would argue that growth will continue to be subdued since high ROIC opportunities are unavailable as you point out. As such, I would argue that PE multiples should currently be below average versus above average - so assuming current profit margins are sustainable for the foreseeable future, and run-rate S&P 500 EPS is say $95, fair value would be 1,425 at a 15X PE. Given the low-growth environment, would a 12.5X PE not be more appropriate, or 1,188 on the S&P?

 

I have no idea. Perhaps the cost of equity has now permanently dropped, and all the market will require going forward is an all-in return of 6 to 7%....

[wisdom]

There are too many variables and it is too complex for anyone to analyze correctly. I try to let history be my guide in these scenarios rather than trying to look for a particular cause. We can keep talking about it for the next 10 yrs and end up with different conclusions and still not know if they are correct.

[goldfinger]

The only explanation left from Ned Davis is the bit about the falling rate of savings and high deficits.

 

From Hussman's last weekly commentary:

"First, as job losses accelerated and household savings collapsed in order to maintain consumption, U.S. fiscal policy responded with enormous government deficits approaching 10% of GDP. Since the deficits of one sector always emerge as the surplus of another, the record combined deficit of governments and households was reflected – as it has been historically – by a mirror image surplus in corporate profit margins, which have surged to record levels in recent years. Essentially, government and household deficits have allowed consumer spending and corporate revenues to remain stable – without any material need for price competition – even though wages and salaries have plunged to a record low share of GDP and labor force participation has dropped to the lowest level in three decades. This mirror-image behavior of profit margins can be demonstrated in decades of historical data, but investors presently seem to believe that these profit margins are a permanent fixture, and have been willing to price stocks at elevated multiples of earnings that are themselves elevated over 70%, relative to historically normal profit margins."

[ERICOPOLY]

Okay, so let's throw out the PE analysis since it is easy to be misled into thinking the market is cheap when things like rising deficits can pump up profits.

 

Let's instead go with the old standby, market cap to GDP.

 

First, here is Japan:

http://www.vectorgrader.com/indicators/japan-market-cap-gdp

 

It looks like the Japanese market has traded above 80% of GDP at least once during every 5 year period dating back to 1990.  That's what a period of deflation has done to them.  Then there are those brief periods where it bounces off of 50% of GDP.  Most of the time it's in-between.

[ERICOPOLY]

I have no idea. Perhaps the cost of equity has now permanently dropped, and all the market will require going forward is an all-in return of 6 to 7%....

 

Depending on inflation, 6% or 7% earnings yields could be just as good as getting 15% earnings yields.

 

PE of 20 is a 5% yield and PE of 15 is a 6.7% yield.  So a 170 bps movement in inflation can make a large difference to market levels (a 33% increase) without having any impact whatsoever on real earnings yields.

 

[ERICOPOLY]

A non event happened this week.  A number of companies reported mark to market losses on their portfolios that lowered book value per share.  Normally, such fluctuations should be ignored as being merely noise, but a few companies took hits to their portfolio value greater than they experienced during the financial crisis because they reached into the most risky depths of the debt markets.  Allstate, in particular took a massive hit of $2.7 B on their portfolio MTM value compared to their statutory surplus of $17B.  They have started to repair their balance sheet by issuing preferred stock.

 

To the best of recollection, not one analyst on their earnings call mentioned that gaping hole as they went along with management's spin of drawing attention to their somewhat improved net earnings.

 

Has anyone else on the board noticed a suspension of critical thinking among the investing community in particular areas?

 

Bill Gross' comments:

 

Insurance companies, pension funds – all institutions with liability structures that require matched asset hedging require fixed income assets on the other side of their balance sheet. The recent several months’ experience of higher yields was, in fact, a blessing for them, as their future liabilities went down faster than the price of their bond assets did!

 

http://www.pimco.com/EN/Insights/Pages/Bond-Wars.aspx

 

 

[jay21]

A non event happened this week.  A number of companies reported mark to market losses on their portfolios that lowered book value per share.  Normally, such fluctuations should be ignored as being merely noise, but a few companies took hits to their portfolio value greater than they experienced during the financial crisis because they reached into the most risky depths of the debt markets.  Allstate, in particular took a massive hit of $2.7 B on their portfolio MTM value compared to their statutory surplus of $17B.  They have started to repair their balance sheet by issuing preferred stock.

 

To the best of recollection, not one analyst on their earnings call mentioned that gaping hole as they went along with management's spin of drawing attention to their somewhat improved net earnings.

 

Has anyone else on the board noticed a suspension of critical thinking among the investing community in particular areas?

 

Bill Gross' comments:

 

Insurance companies, pension funds – all institutions with liability structures that require matched asset hedging require fixed income assets on the other side of their balance sheet. The recent several months’ experience of higher yields was, in fact, a blessing for them, as their future liabilities went down faster than the price of their bond assets did!

 

http://www.pimco.com/EN/Insights/Pages/Bond-Wars.aspx

 

I think this is too categorical.  Wouldn't this be entirely dependent on their duration matching?

[finetrader]

S&P500 yield is what 6% and 30 year US bond is 3.75%. A 2.25% spread is not what I call extreme.

[bmichaud]

I have no idea. Perhaps the cost of equity has now permanently dropped, and all the market will require going forward is an all-in return of 6 to 7%....

 

Depending on inflation, 6% or 7% earnings yields could be just as good as getting 15% earnings yields.

 

PE of 20 is a 5% yield and PE of 15 is a 6.7% yield.  So a 170 bps movement in inflation can make a large difference to market levels (a 33% increase) without having any impact whatsoever on real earnings yields.

 

Sorry I did not see this follow-up the other day.

 

Even I look at my statement through the "real" cost of equity prism, it still stands that the market is currently implying a lower-than-historical-average cost of "real" equity.

 

So assuming $100 operating EPS for the S&P and a $1,700 price, the PE is 17X and the EY is 5.88%. Assuming average inflation of 2.5%, the "real" EY is 3.38%, which is significantly lower than the GMO-calculated historical average of 6% real.

 

A 6% real required return + 2.5% inflation implies a "fair value" PE of 11.76X, or $1,176 on the S&P 500.

 

For the current market level to be considered "fair value" while maintaining a 6% real required return, then the market is implying 0% inflation in perpetuity.

GMO_7y_Projections_July_2013.pdf

[ERICOPOLY]

I have no idea. Perhaps the cost of equity has now permanently dropped, and all the market will require going forward is an all-in return of 6 to 7%....

 

Depending on inflation, 6% or 7% earnings yields could be just as good as getting 15% earnings yields.

 

PE of 20 is a 5% yield and PE of 15 is a 6.7% yield.  So a 170 bps movement in inflation can make a large difference to market levels (a 33% increase) without having any impact whatsoever on real earnings yields.

 

Sorry I did not see this follow-up the other day.

 

Even I look at my statement through the "real" cost of equity prism, it still stands that the market is currently implying a lower-than-historical-average cost of "real" equity.

 

So assuming $100 operating EPS for the S&P and a $1,700 price, the PE is 17X and the EY is 5.88%. Assuming average inflation of 2.5%, the "real" EY is 3.38%, which is significantly lower than the GMO-calculated historical average of 6% real.

 

A 6% real required return + 2.5% inflation implies a "fair value" PE of 11.76X, or $1,176 on the S&P 500.

 

For the current market level to be considered "fair value" while maintaining a 6% real required return, then the market is implying 0% inflation in perpetuity.

 

My example was intended to show that the market isn't that expensive in real terms if we do indeed get the 0% inflation.  Yes, using historical inflation it is expensive.  The market doesn't appear to be expecting historical inflation... if it were, then why is the long term treasury yield so low?

 

Actually, P/E would be 16.66x if you assume 6% real returns and 2.5% inflation.   My numbers include the idea that if you have 2.5% inflation, you might also have 2.5% nominal GDP growth.  And if you have 2.5% nominal GDP growth, then the company earnings get this 2.5% nominal earnings growth tailwind. 

[bmichaud]

If normal nominal growth is depressed due to no inflation, then the question is what kind of real growth can companies get in aggregate? With a 2% dividend yield and a required 6% real return, the market is currently pricing in, if 1,685 is "fair value", 4% real growth.

 

With a long-term average nominal growth rate of 6% and 2% long run inflation, the long-term averag real growth rate is around 4% real.

 

But wait - don't low bond yields imply low inflation, which in turn implies a depressed real growth environment? If so, then one cannot simultaneously say that low bond yields = higher PEs while low bond yields = depressed real growth.

 

So likely the market would be more appropriately valued assuming perhaps 3% real growth + a 3% dividend to arrive at the fair value real required return of 6%, or.....$1,123 on the S&P 500.....which by pure accident almost gets me to the 11.76 "fair value" PE, or 11.23X the ridiculous $100 operating EPS number that the "Street" has been using since 2007....

[vinod1]

 

So assuming $100 operating EPS for the S&P and a $1,700 price, the PE is 17X and the EY is 5.88%. Assuming average inflation of 2.5%, the "real" EY is 3.38%, which is significantly lower than the GMO-calculated historical average of 6% real.

 

 

Isnt the earnings yield on the stock (or stock market) the real earnings yield? Earnings yield on the bonds is nominal. Most of the arguments I see aganist the Fed model is related to this. Both Hussman and Cliff Asness have written extensively on this.

 

Vinod

[ERICOPOLY]

 

So assuming $100 operating EPS for the S&P and a $1,700 price, the PE is 17X and the EY is 5.88%. Assuming average inflation of 2.5%, the "real" EY is 3.38%, which is significantly lower than the GMO-calculated historical average of 6% real.

 

 

Isnt the earnings yield on the stock (or stock market) the real earnings yield? Earnings yield on the bonds is nominal. Most of the arguments I see aganist the Fed model is related to this. Both Hussman and Cliff Asness have written extensively on this.

 

Vinod

 

A really big issue is that you don't really get to keep a large slice of what they claim they'll pay you on these Treasury bonds.

 

In my case they tell me I've got to give them 40% back.  After that 40% is gone, what's the chance of my after-tax returns beating inflation?  It's the biggest nonsense around.  The very people who claim to give you a return then take it back -- it's the Treasury in both instances!  I'm not kidding!  The 10 yr yield is really only 1.62% for such people (not the 2.7% that most believe).

 

Stocks have the advantage of getting much of the returns tax-deferred (with all capital gains forgiven upon death).  Thus, in the real world the risk premium is much wider between stocks and bonds than most people believe.

 

 

 

 

[ERICOPOLY]

If normal nominal growth is depressed due to no inflation, then the question is what kind of real growth can companies get in aggregate? With a 2% dividend yield and a required 6% real return, the market is currently pricing in, if 1,685 is "fair value", 4% real growth.

 

The P/E according to this source is 18.62.

 

http://online.wsj.com/mdc/public/page/2_3021-peyield.html

 

That's a 5.37% real earnings yield if the inflation rate is 0%.  It's not 6% real yield, but it's close.  If the market pulled back 10% then you'd be at roughly 6% real earnings yield.

 

 

As you point out, the dividend rate is 2%.  Well, if the other 2/3 of earnings were spent solely on stock buybacks, then real earnings per share would be growing at a 4% clip.  Thus, 6% real returns.

[bmichaud]

But they are not being used for buybacks - they are being reinvested to barely keep real growth above 3% real  in this depressed environment. Arguably growth is more like 2 let alone 4.

[ERICOPOLY]

But they are not being used for buybacks - they are being reinvested to barely keep real growth above 3% real  in this depressed environment. Arguably growth is more like 2 let alone 4.

 

I know they are not being used for buybacks.  I was illustrating that with a 2% dividend you can certainly have a 4% real growth rate in earnings of the S&P500 -- the easiest example for that is the one where the company just retires shares.  It's not what they are actually doing, sure, but it's to show that you can perpetually grow at a 4% rate forever without any actual economic growth.  Cutting the dividend to 0%, they could grow at 6% just by buying back shares.

 

Instead, they could pay a 6% real dividend yield. 

 

But for whatever reason they don't do that.  I'm only bringing it up because you're talking about P/E of 11 or something which is an earnings yield of 9% real if inflation is 0%.  That is far too low -- you're coming up with an earnings yield that far exceeds 6% real.

[ERICOPOLY]

But they are not being used for buybacks - they are being reinvested to barely keep real growth above 3% real  in this depressed environment. Arguably growth is more like 2 let alone 4.

 

Or they let a good portion of it sit in large, growing cash piles, or pay down debt, instead of investing it.  That would lead to poor growth as well.  But perhaps whenever that deleveraging subsides, they invest the incoming flows again (or pay it out) and earnings growth picks up.

[bmichaud]

I get to the 11x PE because I'm using the erroneous unadjusted eps figure of $100. My FV estimate of 1123 is 17.2x the GMO-calculated normalized eps of $65....for a true earnings yield of around 6% at fair value. At 1700 the earnings yield is 3.8%.

[ERICOPOLY]

I get to the 11x PE because I'm using the erroneous unadjusted eps figure of $100. My FV estimate of 1123 is 17.2x the GMO-calculated normalized eps of $65....for a true earnings yield of around 6% at fair value. At 1700 the earnings yield is 3.8%.

 

I think that sounds right in the lab but if the earnings are being goosed by the Federal deficit then it may be a long wait.  I sort of see them continuing deficits until the consumer is done deleveraging, then as the consumer picks up they can begin to cut back on the deficit.  Thus, it might be a very long wait.  In the meantime, those $100 range earnings may accumulate for years and years and years.

 

Or might not.  Just pointing out that the normalized earnings probably has something to do with fiscal responsibility.  I have tried to stay clear of things where I'd be crushed -- I know that around tangible book value BAC is not inflated.

[bmichaud]

It would be interesting to see how BAC would fare in an earnings and interest rate mean reverting environment. How sensitive will BAC be to a 4% 10 year? I believe Moore Capital is rather bearish on BAC due to rising rates. Would be interesting to hear from him.

[ERICOPOLY]

It would be interesting to see how BAC would fare in an earnings and interest rate mean reverting environment. How sensitive will BAC be to a 4% 10 year? I believe Moore Capital is rather bearish on BAC due to rising rates. Would be interesting to hear from him.

 

A 4% 10 year wouldn't make the stock go down.  It would make it go up.  The earnings potential that would unlock is very beneficial.

 

Take the interest rate increase in the most recent quarter -- completely absorbed by earnings.  A couple of more quarters like that and we're there, with no net hit to capital.  The stock would then price in the better forward earnings, and we'd come out better than if the rate movement had never occurred.

[ERICOPOLY]

I believe a major contributor to the decline of BAC's stock in summer of 2011 was the plunge in the interest rates that occurred at the same time.  The net interest margin compression, loosely translated, shrunk the size of the shovel with which BAC needed to dig itself out of it's real and perceived problems.

 

Higher rates, bigger shovel.  Bigger shovel, more resiliency.  The higher the earnings power relative to your liabilities, the lower risk.  Lower risk, better stock price.

[bmichaud]

Agree with all of that - that's why I'd be interested to hear Moore's side... I just don't see why BAC would get crushed in a rising rate environment.

[goldfinger]

I think that sounds right in the lab but if the earnings are being goosed by the Federal deficit then it may be a long wait.  I sort of see them continuing deficits until the consumer is done deleveraging, then as the consumer picks up they can begin to cut back on the deficit

 

http://thehill.com/blogs/on-the-money/budget/316015-budget-deficit-reaches-606-billion-cbo

 

The federal deficit seems to be shrinking by 368B$ this year and 100B$ of it seems to be unrelated to tax revenue increases.