Tag Archives: David Bianco

One Direction

Goldman Sachs says “we have more potential for shocks right now”. Deutsche Bank and Bank of America Merrill Lynch predict a pick-up in volatility to hit equities. The ever positive Albert Edwards of Socgen points to a recent IMF report on debt and trashes the Fed with the quip “these dudes will never identify an asset bubble at least before the event!

In the IMF report referenced above, and other reports published by the IMF this month, there is some interesting analysis and a sample of the accompanying graphs are reproduced below.

All of these graphs show trends going inexorably in one direction. Add in dollops of (not unrelated) political risk particularly in the UK and across Europe, and that direction looks like trouble ahead.

click to enlargeimf-gross-global-debt-as-of-gdp

click to enlargeimf-private-debt-during-deleveraging-periods

click to enlargeimf-decomposition-of-equity-valuations-october-2016

click to enlargeimf-global-real-rates

click to enlargeimf-report-sovereign-bond-yields-and-term-premiums

click to enlargeimf-report-banking-sector

click to enlargeimf-report-pension-deficits

Patience on earnings

With the S&P500 up 100 points since last week’s low of 1882, the worry about global growth and earnings has been given a breather in the last few days trading. Last weeks low was about 12% below the May high (today’s close is at -8.6%). Last week, the vampire squid themselves lowered their S&P500 EPS forecast for 2015 and 2016 to $109 and $120 respectively, or approximately 18.2 and 16.6 times today’s close with the snappy by-line that “flats the new up”.

The forward PE, according this FACTSET report, as at last Thursday’s close (1924) was at 15.1, down from 16.8 in early May (as per this post).

click to enlargeForward 12 month PE S&P500 October2015

Year on year revenue growth for the S&P500 is still hard to find with Q3 expected to mark the third quarter in a row of declines, with energy and materials being a particular drag. Interestingly, telecom is a bright spot with at over 5% revenue growth and 10% earnings growth (both excluding AT&T).

Yardeni’s October report also shows the downward estimates of earnings and profit margins, as per below.

click to enlargeS&P500 EPS Profit Margin 2015 estimates

As usual, opinion is split on where the market goes next. SocGen contend that “US profits growth has never been this weak outside of a recession“. David Bianco of Deutsche Bank believes “earnings season is going to be very sobering“. While on the other side Citi strategist Tobias Levkovich opined that there is “a 96 percent probability the markets are up a year from now“.

Q3 earnings and company’s forecasts are critical to determining the future direction of the S&P500, alongside macro trends, the Fed and the politics behind the debt ceiling. Whilst we wait, this volatility presents an opportune time to look over your portfolio and run the ruler over some ideas.

Reluctant Bulls

There was a nice piece from Buttonword in the Economist where he concluded that despite all the indicators of the equity market being overvalued that “investors are reluctant bulls; there seems no alternative”. This seems like a rationale explanation for the relatively irrational behaviour of current markets.

He highlighted indicators like the high CAPE, figures from the Bureau for Economic Analysis (BEA) on the profit dip in Q1, high share buybacks, figures from SocGen’s Andrew Lapthorne that the ratio of corporate debt to assets is close to its 2009 peak, and a BoA Merrill Lynch poll which shows that 48% of institutional investors are overweight equities whilst a net 15% believe they are overvalued.

Despite the bearish indicators everywhere, investors seem frozen by central bank indecision on whether economies still need help by remaining accommodative or that the recovery has taken hold and monetary policy needs to start to tighten.

Andrew Lapthorne released some analysis earlier this month highlighting that a significant amount of the previous year’s earnings growth was down to M&A from Verizon and AT&T and concluded that EPS growth by M&A and from share buybacks is a classic end of cycle indicator. Lapthorne produced the graph below of historical peaks and troughs in the S&P500 and noted that the average historical 1% down days is 27 per year since 1969 an the S&P500 has only had 16 in the past 12 months and that we have gone through the 4th longest period on record without a market correction of 10% or more.

click to enlarge
SocGen peak to through

Albert Edwards, also at SocGen, points to the difference in the BEA profit statistics and those reported being down to the expiration of tax provisions for accelerated depreciation and he concludes that “the bottom line is that the U.S. profits margin cycle has begun to turn down at long last“.

Even the perma-bull David Bianco of Deutsche Bank has cautioned against overvaluation calling the market complacent and moving into mania territory using their preferred measure of sentiment, namely the PE ratio divided by the VIX. The graph below from early June illustrates.

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DB Price Earnings VIX Ratio

From my point of view, I think the chart of the S&P500 for the past 10 years tells its own story about where we are. As Louis Rukeyser said “trees don’t grow to the sky“. Nor do equity markets.

click to enlarge

S&P500 Past 10 Years

Carry on CAPE

The debates on the cyclically adjusted PE (CAPE), developed by recent Nobel Prize winner Robert Shiller, as a market valuation indicator continue to rage. My last post on the subject is indicative of where I left the arguments.

A variation on Jeremy Siegel’s arguments against CAPE was put forward in an interesting post on the blog Philosophical Economics (hereinafter referred to as PE), centred on the failure of CAPE to mean revert through the ups and downs of the past 23 years and the need for a consistent measure for earnings in the PE calculation across historical reference periods.

The first point essentially relates to the time period over which CAPE is relevant for today’s global economy. Shiller uses available S&P reported GAAP earnings dating back to the 1936 and has supplemented them with his own GAAP earnings calculations from 1936 back to 1871. PE makes the point that historical periods which are “distorted by world wars (1914-1918, 1939-1945, 1950-1953), gross economic mismanagement (1929-1938), and painfully high inflation and interest rates (1970-1982)” may not be the most appropriate as a reference period for today (as reflective of the changed macro-economic period covering the so called great moderation). In essence, PE is saying that structural changes in the economy and investor sophistication may justify a shorter and more relevant time period (yes, PE admits it is a flavour of the “this time it’s different” argument!).

On earnings, PE repeats many of Siegel’s arguments. For example, the point is again made about asymmetric accounting changes to intangible write downs from FAS 142/144. In addition, PE also highlights the lower dividend payouts of 34% over the past 18 years compared to 52% over the 40 year period between the mid-50s and mid-90s. PE argues that lower dividend yields indicate higher investment by firms and therefore support the argument that historical comparisons may not be as relevant.

PE uses Pro-Forma (non-GAAP) S&P earnings from 1954 as reported by Bloomberg for earnings (as opposed to Siegel’s use of National Income and Product Accounts (NIPA) earnings for all approx 9,000 US corporations) and stresses that these earnings may not necessarily be more applicable but they are at least consistent. PE shows that using these earnings since 1954 the market (as at December 2013) was only modestly above the geometric mean and further supports the use of Pro-Forma earnings by back testing this metric against CAPE as an indicator of value through the financial crisis.

A counter-argument (in a December paper) from Bill Hester of Hussman Funds centred on differences in the Bloomberg Pro-Forma earnings used in PE’s calculations, arguing that from 1988 to 1998 the earnings reported by Bloomberg are a mixture of reported & operating earnings and that from 1998 they are akin to operating earnings. The argument highlights the problem of data quality in many databases which are commonly used in the market creating a source of systematic risk. [As an aside, on an individual stock basis, I have found issues with data from commonly used databases and that is why I always take my historical figures from published accounts – not that they are without any issues, just try reconciling some of AIG’s historical financial statements given the almost annual restatements!]. On earnings, Hestor uses work done by Andrew Smithers in his book “The Road to Recovery” which suggests that executive compensation tied to short term results has been a factor in earnings volatility.

PE counters Hester’s counter argument in another post that after adjusting the Boomberg data pre-1998 and applying an adjustment for the change in dividend payout ratio the ProForma earnings based CAPE still signals a less overvalued market that Shiller’s CAPE. PE also rubbishes the contention from Smithers that volatility is as a result of executive remuneration saying that low volatility is in the executive’s interest to maximise their options which vest over time and that investment is currently low due to the uncertainty around unprecedented macro- economic risks.

PE cites arguments similar to those of other bulls such as Siegel who content that US corporate profits as a percentage of GDP (or GNP) is high compared to historical levels due to increased foreign contributions to profits, lower corporate taxes and a higher S&P concentration of globalised technology and energy firms with fatter profit margins. PE points to stability in statistics such as S&P 500 net profit margins for non-financials (excluding energy & technology) produced by BoA Merrill Lynch and analysis of David Bianco from Deutsche Bank on firms with a high level of foreign sales showing higher profit margins (see graph reproduced below). To be fair to Bianco, he recently maintained his year-end 2014 S&P500 target of 1850 and warning of volatility in 2014 stating “buy the dips, but I’m also saying in advance, wait for the dips“.

click to enlargeDeutsche Bank Foreign vrs Domestic Profit MarginsIn a December note, the extremely bearish John Hussman stated that “in recent years, weak employment paired with massive government deficits have introduced a wedge into the circular flow, allowing wages and salaries to fall to the lowest share of GDP in history, even while households have been able to maintain consumption as the result of deficit spending, reduced household savings, unemployment compensation and the like”. In another note from John Hussman out this week on foreign profits, based upon a range of valuation metrics (see graph reproduced below) he puts the S&P500 at a 100% premium to the level needed to achieve historical normal returns (or indicating a negative total return on horizons of 7 years or less). He also rubbishes the higher contribution from foreign profits, saying they have been decreasing since 2007 and that they “do not have any material role in the surge in overall profit margins”.

click to enlargeHussman S&P500 Valuation March 2014The (only) slightly more cheerful folk over at GMO also had an insightful paper out in February by James Montier on the CAPE debate. One of the more interesting pieces of analysis in the paper was a Kalecki decomposition of profits which indicate that the US government deficit is a major factor in replacing reduced investment since the crisis (see graph reproduced below). As we know, this US deficit is in the process of being run down and the knock on impact upon profits could result (save a recovery in investment or a significant re-leveraging of households!). The Kalecki composition also seems to support the larger contributions from foreign earnings (albeit a decreasing contribution in recent years).

click to enlargeGMO Kalecki DecompositionDepending upon whether you use the S&P500 PE, the Shiller PE or the NIPA based PE since 1940 the market, according to Montier, is 30%, 40% or 20% overvalued respectively.  Using a variety of metrics, Montier estimates that the expected total return (i.e. including dividends) for the market over the next 7 years ranges from an annual return of 3.6% from Siegel’s preferred method using NIPA to a negative 3.2% per annum from a full revision Shiller PE (using 10 year trend earnings rather than current trailing 10 year earnings).  The average across a number of valuation metrics suggests a 0% per annum return over the next 7 years!

Ben Inker also has a piece in the February GMO letter on their strategy of slowly averaging in and out of the market. Inker calls it slicing whereby you take account of historical forecasts as well as your current “spot” view of valuations. Their research shows that you capture more value through averaging purchasing or selling over time by benefiting from market momentum. GMO currently are in selling mode whereby they “are in the process of selling our equity weight down slowly over the next 9 to 12 months”.

So, where do all of these arguments leave a poor little amateur investor like me? Most sensible metrics point to the S&P500 being overvalued and the only issue is quantum. As I see it, there is validity on both sides of the CAPE arguments outlined above. Earnings are high and are likely to be under pressure, or at best stable, in the medium term. I am amenable to some of the arguments over the relevant timeframe used to calculate the mean to assess the mean reverting adjustment needed (I do however remain wedded to mean revision as a concept).

To me, the figures of 20% to 40% overvaluation in Montier’s note based on calculations back to 1940 from different CAPE calculations feel about right. A 30% overvaluation represents the current S&P500 to a mean calculated from 1960. The rapid bounce back in the S&P500 from the 5% January fall does show how resilient the market is however and how embedded the “buy on the dip” mentality currently is. GMO’s philosophy of averaging in and out of the market over time to take advantage of market momentum makes sense.

In the absence of any external shock that could hit values meaningfully (i.e. +15% fall), the market does look range bound around +/- 5%. Common sense data points such as the Facebook deal for WhatsApp at 19 times revenues confirm my unease and medium term negative bias. I have cut back to my core holdings and, where possible, bought protect against big pull backs. In the interim, my wish-list of “good firms/pity about the price” continues to grow.

They say that “the secret to patience is doing something else in the meantime”. Reading arguments and counter argument on CAPE is one way to pass some of the time…….

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”.