Monthly Archives: November 2013

Then again, always look on the bright side……

To recap on the bear case for the US equity market, factors highlighted are high valuation as measured by the cyclically adjusted PE ratio (CAPE) and the high level of corporate earnings that look unsustainable in a historical context. I have tried to capture these arguments in the graph below.

click to enlarge50 year S&P500 PE CAPE real interest rate corp profit&GDPCurrently, the S&P500 PE and the Shiller PE/CAPE are approx 10% and 30% above the average over the past 50 years respectively.

On earnings, Andrew Lapthorne of SocGen, in an August report entitled “To ignore CAPE is to deny mean reversion” concluded that “mean-reversion in earnings, though sometimes delayed, is as undeniable as the economic cycle itself. That peak profits typically accompany peak valuations only reinforces the point. When earnings revert back to mean (and below), the valuation will also collapse.” The graphic below from that report highlights the point.

click to enlargeSocGen Mean Reverting ProfitsThe ever bullish Jeremy Siegel, in a recent conference presentation, again outlined his arguments raised in the August FT article (see Shiller versus Siegel on CAPE post). The fifth edition of his popular book “Stocks for the long run” is out in December. Essentially he argues that CAPE is too pessimistic as accounting changes since 1990 distort historical earnings and the profile of S&P500 earnings has changed with bigger contributions from foreign earnings and less leveraged balance sheets that explain the higher corporate margins.

Siegel contends that after-tax profits published in the National Income and Product Accounts (NIPA) are not distorted by the large write downs from the likes of AOL and AIG. The changing profile of NIPA versus S&P reported earnings through historical downturns illustrate that historical S&P reported earnings are unreliable, as illustrated in the graph below.

click to enlargeNIPA versus S&P reported

However, even using NIPA data, a graphic from JP Morgan in late October shows that currently the S&P500 is approx 20% above its 50 year average.

click to enlargeS&P500 CAPE with NIPASiegel even proposed that current comparison should be against the long term average PE (1954 to 2013) of 19 including only years where interest rates were below 8% (which incidentally is only slightly higher than the 8.2 5o year average used in the first graph of this post).

The ever insightful Cliff Asness, founder of AQR Capital Management, counteracts such analysis with the recent comment below.

Does it seem to anyone else but me that the critics have a reason to exclude everything that might make one say stocks are expensive, and instead pick time periods for comparisons and methods of measurement that will always (adapting on the fly) say stocks are fair or cheap?

However, nothing is as black and white in the real world. The rise in corporate net margins has been real as another recent graphic, this time from Goldman Sachs, shows.

click to enlargeGoldman Sachs S&P500 net margin

Earnings from foreign subsidiaries have increased and S&P500 earnings as a percentage of global GDP show a more stable picture. Also leverage is low compared to historical levels (104% debt to equity for S&P500 compared to a 20 year average of 170%) and cash as a percentage of current assets is also high relative to history (approx 28%). Although there is signs that corporate leverage rates are on the rise again, future interest rate rises should not have as big an impact on corporate margins as they have historically.

JP Morgan, in another October bulletin, showed the breakdown of EPS growth in the S&P500 since 2010, as reproduced below, which clearly indicates a revenue and margin slowdown.

click to enlargeJP Morgan S&P500 EPS Annual Growth Breakdown October 2013David Bianco of Deutsche Bank has recently come up with a fascinating graphic that I have been looking at agog over the past few days (reproduced below). It shows the breakdown of S&P500 returns between earnings growth, dividends and PE multiple expansion.

click to enlargeDeutsche Bank S&P500 Growth BreakdownBianco, who has a  2014 end target of 1850 and a 2015 end target of 2000 for the S&P500, concluded that 75% of the S&P500 rise in 2013 is from PE expansion and that “this is the largest [valuation multiple] contribution to market return since 1998. Before assuming further [multiple] expansion we think it is important that investors be confident in healthy EPS growth next year. Hence, we encourage frequent re-examination of the capex and loan outlook upon new data points.

David Kostin from Goldman Sachs, who have a 2,100 S&P end 2015 target, stated that “multiple expansion was the key U.S. equity market story of 2013. In contrast the 2014 equity return will depend on earnings and money flow rather than further valuation re-rating.

Even well known pessimists like David Rosenberg and Nouriel Roubini are positive albeit cautious. Dr Doom has a 2014 target for S&P500 of 1900 (range 1650 to 1950) although he does give the US equity market an overall neutral rating. Rosenberg, who describes the current rally as “the mother of all liquidity rallies“, cites the US economy’s robustness over the past year as a sign that 2014 should see a further strengthening of the US economy.

So clearly future growth in the S&P500 will depend upon earnings and that will depend upon the economy and interest rates. Although I am still trying to get my head around a fascinating article from 2005 that shows negative correlation between equity returns and GDP growth, that brings me back to the macro-economic situation.

I know this post was to have represented the positive side of the current arguments but, as my current bear instincts can’t be easily dispelled, I have to conclude the post with the comments from Larry Summers at a IMF conference earlier this month that the US may be stuck in a “secular stagnation” and that the lesson from the crisis is “it’s not over until it is over, and that is surely not right now”.

Something is not right

An article on inflation from the Economist two weeks ago has been freaking me out. By now, with the biggest experiment in loose monetary policy the world has ever known, we should be happily inflating our way out of the overleverage aftermath of the 2008 crisis. Yet here we are with core inflation at 1.4%, 1.2% and 0.8% for the G7, US and the Euro zone respectively.

It seems like the air is coming out of the balloon faster than the central bankers can fill it. An article in today’s FT pointed out that real incomes in the average US family are less today than they were in 1989. No matter how much the central bankers want us to go back to the Mall and shop our way out of the current climate, there is something that just doesn’t add up.

Against the background of loose monetary policy and weak underlying fundamentals, I am becoming more convinced that the stock market is overvalued today (which doesn’t mean it will necessarily stop going up!) with the Dow topping 16,000 and S&P500 nearing 1,800 at a PE of 20 (& 15 times 2014 estimated earnings) and the Shiller PE at 24.7.

With my thanks to Fast Eddie, here are some articles on valuations that I have been reading which provide food for thought:

GMO November letter by Ben Inker & Jeremy Grantham

Chumps, Champs, and Bamboo by John Hussman

and the thought provoking

The paradox of wealth and the end of history illusion by William Bernstein

Latest thoughts on AAPL valuation

In my previous post on AAPL in April, when the stock was trading around $400, I presented an analysis of three possible scenarios – Apple loses it’s cool, Apple matures gracefully, and Apple keeps on rockin’. Each of these scenarios involved some fanciful assumptions on the trajectory of Apple’s products which I clearly highlighted as likely to prove well off the mark in reality. I did say however, that “the purpose here is not to predict the future but to get an idea of Apple’s valuation given the views prevalent today”.

Well, although a fair amount has happened to AAPL over the past 6 months in relation to an iPhone/iPad/Mac product refresh, a new music steaming service and a number of shareholder friendly actions on buybacks, the hoped for visibility into AAPL’s medium term future remains somewhat elusive and will likely remain so in the short term. The speculated China mobile deal remains a possible short term catalyst.

The three opening observations in my April post do, in my opinion, remain valid: namely, that the iPhone is core to Apple’s future with no new “product category” currently envisaged having the potential to replace the dominant contribution that iPhone makes to profits in the medium term, that gross margins are likely to continue to fall in the face of increased competition, and that a Nokia/Blackberry rapid fall from grace is unlikely given Apple’s ecosystem and loyal customer base (for now!).

There is little point trying to redo the scenarios by replacing one set of assumptions with another so I have simply updated the current share price in the exhibit below.

click to enlargeAAPL DCF Scenario Projected Valuations November 2013

By way of disclosure, I did establish a small position in AAPL 6 months ago around $420, as my April post suggested. Against my expectations outlined in that post, market sentiment on AAPL has clearly moved around the “Apple matures gracefully” valuation from an “Apple loses its cool” bias firmly towards an “Apple keeps on rockin” bias. The exhibit below shows the most recent results from AAPL.

click to enlargeAAPL 2010 to 2013 Operating Metrics

The degree to which the change in market sentiment on AAPL over the past 6 months is due to underlying fundamentals or simply a function of general market bullishness is open to debate. One factor that cannot be underestimated is Apple’s own buyback programme with approx. 40 million shares repurchased over the past two quarters.

The iPhone and iPad product refreshes have no doubt had an impact on the short term perspective of AAPL. One factor that doesn’t seem to be discussed in the market is whether the product refreshes impact positively or negatively upon Apple’s brand or tests the loyalty of its customer over the longer term.

Market hype from the likes of Carl Icahn should be ignored (my view on the leech that is Mr Carl Icahn is expressed in a previous telecom post) and I don’t understand why Mr Cook is entertaining such distractions.

My own estimates for the holiday Q1 2014 quarter were blown away by Apple’s revenue projections. Based upon recent trends, I was coming up with revenue of $53-55 billion so the $55-58 billion suggest buoyant iPhone and iPad sales. If the China mobile deal comes through, Apple could also bring home a positive Q2.

The valuation graph below uses brokers’ estimates on earnings for 2014.

click to enlargeAAPL Multiples November 2013

So, overall, I am content to sit on my limited AAPL position to see what happens in Q1. Adding to the position (or establishing a new position) in AAPL is not advisable, in my opinion, given the current fair valuation, the still uncertain medium term prospects and the overall frothiness in the market right now.

Trick or treat: AIG Q3 Follow Up

Well, I’d put AIG’s Q3 results firmly in the trick basket. The big surprise for me was the nearly $1 billion income tax benefit item in Q3. I wasn’t expecting that.

Income before tax was distinctly lacklustre. The P&C technical result was only marginally worse whilst P&C investment income added just over $1 billion of incremental income before tax. Life & retirement only added $400 million of incremental delivered income before tax. The hodgepodge of the other segment had a negative impact of over $1 billion of incremental income before tax due to the marginal increases in GCM and DIB lagging interest, corporate & legal expenses. Updated graphs for net income and the other segment for YTD to Q3 are below.

click to enlargeAIG Net Income Breakdown Q3 2013click to enlargeAIG Other Segment Q3 2013

Overall then, I wouldn’t materially change my estimates for a “normal” 2014 (although I may need to reconsider my tax assumptions) and would stick to a book value target of $70 by year end 2014 as being achievable, save any large catastrophes or unexploded bombs. One small treat from the results was the reduction in share count which should continue.

Although the risk/reward is getting more attractive after the price drop to just above $48, I will stay on the side-line as the overall market looks very frothy to me and, as a result, I am currently in risk reduction mode. The uncertainty around the other segment and the lack of clear improvement in the P&C segment may justify the AIG book multiple discount for a while yet.