Tag Archives: Goldman Sachs

Broken Record

Whilst the equity market marches on regardless, hitting highs again today, writing about the never-ending debates over equity valuations makes one feel like a broken record at times. At its current value, I estimate the S&P500 has returned an annualised rate of nearly 11%, excluding dividends, since its low in March 2009. As of the end of September 2017, First Trust estimated the total return from the S&P500 at 18% since March 2009, as per the graph below.

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Goldman Sachs recently published an analysis on a portfolio of 60% in the S&P 500 and 40% in 10-year U.S. Treasuries, as per the graph below, and commented that “we are nearing the longest bull market for balanced equity/bond portfolios in over a century, boosted by a Goldilocks backdrop of strong growth without inflation”. They further stated that “it has seldom been the case that all assets are expensive at the same time—historical examples include the Roaring ‘20s and Golden ‘50s. While in the near term, growth might stay strong and valuations could pick up further, they should become a speed limit for returns”.

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My most recent post on the topic of US equity valuations in May looked at the bull and bear arguments on low interest rates and heighten profit margins by Jeremy Grantham and John Hussman. In that post I further highlighted some of the other factors which are part of the valuation debate such as the elevated corporate leverage levels, reduced capital expenditures, and increased financial risk taking as outlined in the April IMF Global Financial Stability report. I also highlighted, in my view, another influential factor related to aging populations, namely the higher level of risk assets in public pensions as the number of retired members increases.

In other posts, such as this one on the cyclically adjusted PE (CAPE or PE10), I have highlighted the debates around the use of historically applicable earnings data in the use of valuation metrics. Adjustments around changes in accounting methodology (such as FAS 142/144 on intangible write downs), relevant time periods to reflect structural changes in the economy, changes in dividend pay-out ratios, the increased contribution of foreign earnings in US firms, and the reduced contribution of labour costs (due to low real wage inflation) are just some examples of items to consider.

The FT’s John Authers provided an update in June on the debate between Robert Shiller and Jeremy Siegel over CAPE from a CFA conference earlier this year. Jeremy Siegel articulated his critique of the Shiller CAPE in this piece last year. In an article by Robert Shiller in September article, called “The coming bear market?”, he concluded that “the US stock market today looks a lot like it did at the peaks before most of the country’s 13 previous bear markets”.

The contribution of technology firms to the bull market, particularly the so-called FANG or FAANG stocks, has also been a much-debated issue of late. The graph below shows the historical sector breakdown of the S&P500 since 1995.

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A recent article from GMO called “FAANG SCHMAANG: Don’t Blame the Over-valuation of the S&P Solely on Information Technology” tried to quantify the impact that the shift in sector composition upon valuations and concluded that “today’s higher S&P 500 weight in the relatively expensive Information Technology sector is cause for some of its expensiveness, but it does not explain away the bulk of its high absolute and relative valuation level. No matter how you cut it, the S&P 500 (and most other markets for that matter) is expensive”. The graph below shows that they estimate the over-valuation of the S&P500, as at the end of September 2017, using their PE10 measure is only reduced from 46% to 39% if re-balanced to take account of today’s sector weightings.

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In his recent article this month, John Hussman (who meekly referred to “his incorrectly tagged reputation as a permabear”!!) stated that “there’s no need to take a hard-negative outlook here, but don’t allow impatience, fear of missing out, or the illusion of permanently rising stock prices to entice you into entrusting your financial future to the single most overvalued market extreme in history”.

As discussed in my May post, Hussman reiterated his counter-argument to Jeremy Grantham’s argument that structurally low interest rates, in the recent past and in the medium term, can justify a “this time it’s different” case. Hussman again states that “the extreme level of valuations cannot, in fact, be “justified” on the basis of depressed interest rates” and that “lower interest rates only justify higher valuations if the stream of future cash flows is held constant” and that “one of the reasons why reliable valuation measures have retained such a high correlation with subsequent market returns across history, regardless of the level of interest rates, is that the impact of interest rates and growth rates on “terminal” valuations systematically offset each other”.

Hussman also again counters the argument that higher profit margins are the new normal, stating that “it’s important to recognize just how dependent elevated profit margins are on maintaining permanently depressed wages and salaries, as a share of GDP” and that “simply put, elevated corporate profit margins are the precise mirror-image of depressed labour compensation” which he contends is unlikely to last in a low unemployment environment.

Hussman presents a profit margin adjusted CAPE as of the 3rd of November, reproduced below, which he contends shows that “market valuations are now more extreme than at any point in history, including the 1929 and 2000 market highs”.

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However, I think that his profit margin analysis is harsh. If you adjust historical earnings upwards for newer higher margin levels, of course the historical earning multiples will be lower. I got to thinking about what current valuations would look like against the past if higher historical profit margins, and therefore earnings, had resulted in higher multiples. Using data from Shiller’s website, the graph below does present a striking representation of the relationship between corporate profits (accepting the weaknesses in using profits as a percentage of US GDP) and interest rates.

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Purely as a thought experiment, I played with Shiller’s data, updating the reported earnings for estimates through 2018 (with a small discount to reflect over-zealous estimates as per recent trends of earnings revisions), recent consensus end 2018 S&P500 targets, and consensus inflation and the 10-year US interest rates through 2018. Basically, I tried to represent the base case from current commentators of slowly increasing inflation and interest rates over the short term, with 2018 reported EPS growth of 8% and the S&P500 growing to 2,900 by year end 2018. I then calculated the valuation metrics PE10, the regular PE (using trailing twelve month reported earnings called PE ttm), and the future PE (using forward twelve month reported earnings called PE ftm) to the end of 2018. I further adjusted the earnings multiples, for 2007 and prior, by applying an (principally upward) adjustment equal to a ratio of the pre-2007 actual  corporate profits percentage to GDP divided by a newly assumed normalised percentage of 8.5% (lower than the past 10-year average around 9% to factor in some upward wage pressures over the medium term). The resulting historical multiples and averages are shown below.

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Based upon this analysis, whilst accepting its deeply flawed assumptions, if 2018 follows the base case currently expected (i.e. no external shocks, no big inflation or interest rates moves, steady if not spectacular earnings growth), the S&P500 currently looks over-valued by 50% to 20% using historical norms. If this time it is different and higher profit margins and lower interest rates are the new normal, then the S&P500 looks roughly fairly-valued and current targets for 2018 around 2,900 look achievable. Mind you, it’s a huge leap in mind-set to assume that the long-term average PE is justifiably in the mid-20s.

I continue to be concerned about increasing corporate leverage levels, as highlighted in my May post from the IMF Global Financial Stability report in April, and the unforeseen consequences of rising interest rate after such a long period of abnormally low rates.

In the interim, to paraphrase an ex-President, it’s all about the earnings stupid!

Crimping CDS

The post-crisis CDS market has undergone significant regulatory change including a substantial regulatory overhaul due to the Volcker Rule, requirements from reporting to central clearing under the Dodd–Frank Act and the European Markets Infrastructure Regulation (EMIR), and Basel III capital and liquidity regulations. Measuring the size of the market consistently is notorious difficult given different accounting treatments, netting protocols, collateral requirements, and legal enforceability standards. Many organisations have been publishing data on the market (my source is the BIS for this post) but consistency has been an issue. Although a deeply flawed metric (due to some of the reasons just highlighted and then some), the graph below on the nominal size of the CDS market (which updates this post) illustrates the point on recent trends.

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The gross market value (defined by BIS as the sum of the absolute values of all open contracts with either positive or negative replacement values) and the net market value (which includes counterparty netting) are better metrics and indicate the real CDS exposure is a small fraction of the nominal market size, as per the graph below.

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Critics of the regulatory impact on the liquidity of the CDS market argue that these instruments are a vital tool in the credit markets for hedging positions, allowing investors to efficiently express investment positions and facilitating price discovery. A major issue for liquidity in the market is the capital constraints imposed by regulators which impedes the ability of financial institutions to engage in market-making. The withdrawal of Deutsche Bank from the CDS market was seen as a major blow despite some asset managers and hedge funds stepping up to the mark.

The impact of rising interest rates in the coming years on the credit markets will likely have some interesting, and potentially unforeseen, consequences. With a plethora of Goldman Sachs alumni currently working on Trump’s “very major hair cut on Dodd-Frank”, amongst other regulations, it will be interesting to see if any amendments lead to a shot in the arm for the CDS market. Jamie Dimon, in his most recent shareholder letter, calls for an approach by Trumps’ lieutenants “to open up the rulebook in the light of day and rework the rules and regulations that don’t work well or are unnecessary”.

Farewell, dissonant 2016.

Many things will be written about the events of 2016.

The populist victories in the US election and the UK Brexit vote will no doubt have some of the biggest impacts amongst the developed world. Dissatisfaction amongst the middle class across the developed world at their declining fortunes and prospects, aligned with the usual disparate minorities of malcontent, has forced a radical shift in support away from the perceived wisdom of the elite on issues such as globalisation. The strength of the political and institutional systems in the US and the UK will surely adapt to the 2016 rebuff over time.

The more fundamental worry for 2017 is that the European institutions are not strong enough to withstand any populist curveball, particularly the Euro. With 2017 European elections due in France, Germany, Netherlands and maybe in Italy, the possibility of further populist upset remains, albeit unlikely (isn’t that what we said about Trump or Brexit 12 months ago!).

The 5% rise in the S&P 500 since Trump’s election, accounting for approx half of the overall increase in 2016, has made the market even more expensive with the S&P 500 currently over 60% of its historical average based upon the 12 month trailing PE and the Shiller CAPE (cyclically adjusted price to earnings ratio, also referred to as the PE10). A recent paper by Valentin Dimitrov and Prem C. Jain argues that stocks outperform 10-year U.S. Treasuries regardless of CAPE except when CAPE is very high (the current CAPE is just above the “very high” reference point of 27.6 in the paper) and that a high CAPE is an indicator of future stock market volatility. Bears argue that the President elect’s tax and expansionary fiscal policies will likely lead to higher interest rates and inflation in 2017 which will further strengthen the dollar, both of which will pressure corporate earnings.

Critics of historical PE measures like CAPE, such as Jeremy Siegel in this paper (previous posts on this topic are here and here), highlight the failings of using GAAP earnings and point to alternative metrics such as NIPA (national income and product account) after-tax corporate profits which indicate current valuations are more reasonable, albeit still elevated above the long term average by 20%-30%. The graph below from a Yardeni report illustrates the difference in the earnings metrics.

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Bulls further point to strong earnings growth in 2017 complemented by economic stimulus and corporate tax giveaways under President Trump. Goldman Sachs expects corporations to repatriate approx $200 billion of overseas cash and to spend a lot of it buying back stock rather than making capital expenditures (see graph below) although the political pressure to invest in the US may impact the balance.

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The consensus amongst analysts predict EPS growth in 2017 in the high single digits, with many highlighting further upside depending upon the extent of the corporate tax cuts that Trump can get past the Republican congress. Bulls argue that the resulting forward PE ratio for the S&P 500 of approx 17 only represents a 20% premium to the longer term average. Predictions for the S&P 500 for 2017 by a selection of analysts can be seen below (the prize for best 2016 prediction goes to Deutsche Bank and UBS). It is interesting that the average prediction is for a 4% rise in the S&P500 by YE 2017, hardly a stellar year given their EPS growth projections!

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My best guess is that the market optimism resulting from Trump’s victory continues into 2017 until such time as the realities of governing and the limitations of Trump’s brusque approach becomes apparent. Volatility is likely to be ever present and actual earnings growth will be key to the market story in 2017 and maintaining high valuation multiples. After all, a low or high PE ratio doesn’t mean much if the earnings outlook weakens; they simply indicate how far the market could fall!

Absent any significant event in the early days of Trump’s presidency (eh, hello, Mr Trump’s skeleton cupboard), the investing adage about going away in May sounds like a potentially pertinent one today. Initial indications of Trump’s reign, based upon his cabinet selections, indicate sensible enough domestic economy policies (relatively) compared with an erratic foreign policy agenda. I suspect Trump first big foreign climb down will come at the hands of the Chinese, although his bromance with Putin also looks doomed to failure.

How Brexit develops in 2017 looks to be much more worrying prospect. After watching her actions carefully, I am fast coming to the conclusion that Theresa May is clueless about how to minimise the financial damage from Brexit. Article 50 will be triggered in early 2017 and a hard Brexit now seems inevitable, absent a political shock in Europe which results in an existential threat to the EU and/or the Euro.

The economic realities of Brexit will only become apparent to the UK and its people, in my view, after Article 50 is triggered and chunks of industry begin the slow process of moving substantial parts of their operation to the continent. This post illustrates the point in relation to London’s insurance market. The sugar high provided by the sterling devaluation after Brexit is fading and the real challenge of extracting the UK from the institutions of the EU are becoming ever apparent.

Prime Minister May should be leading her people by arguing for the need for a sensible transition period to ensure a Brexit logistical tangle resulting in unnecessary economic damage is avoided. Instead, she acts like a rabbit stuck in the headlights. Political turmoil seems inevitable as the year develops given the current state of the UK’s fractured political system and lack of sensible leadership. The failure of a coherent pro-Europe political alternative to emerge in the UK following the Brexit vote, as speculated upon in this post, is increasingly looking like a tragedy for the UK.

Of course, Trump and Brexit are not the only issues facing the world in 2017. China, the Middle East, Russia, climate change, terrorism and cyber risks are just but a few of the issues that seem ever present in any end of year review and all will likely be listed as such in 12 months time. For me, further instability in Europe in 2017 is the most frightening potential addition to the list.

As one ages, it becoming increasingly understandable why people think their generation has the best icons. That said, the loss of genuine icons like Muhammad Ali and David Bowie (eh, sorry George Michael fans) does put the reality of the ageing (as highlighted in posts here and here) of the baby boomer generation in focus. On a personal note, 2016 will always be remembered by me for the loss of an icon in my life and emphasizes the need to appreciate the present including all of those we love.

So on that note, I’d like to wish all of my readers a prosperous, happy and healthy 2017. It looks like there will be plenty to write about in 2017…..

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

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The Float Game Goes Into Overdrive

The IMF today warned about rising global financial stability risks. Amongst the risks, the IMF highlighted the “continued financial risk taking and search for yield keep stretching some asset valuations” and that “the low interest rate environment also poses challenges for long term investors, particularly for weaker life insurance companies in Europe”. The report states that “the roles and adequacy of existing risk-management tools should be re-examined to take into account the asset management industry’s role in systemic risk and the diversity of its products”.

In late March, Swiss Re issued a report which screamed that the “current high levels of financial repression create significant costs and lower long-term investors’ ability to channel funds into the real economy”. The financial repression, as Swiss Re calls it, has resulted in an estimated loss of $470 billion of interest income to US savers since the financial crisis which impacts both households and long-term investors such as insurance companies and pension funds.

Many market pundits, Stanley Druckenmiller for example, have warned of the destabilizing impacts of long term low interest rates. I have posted before on the trend of hedge funds using specialist insurance portfolios as a means to take on more risk on the asset side of the balance sheet in an attempt to copy the Warren Buffet insurance “float” investment model. My previous post highlighted Richard Brindle’s entry into this business model with a claim that they can dynamically adjust risk from one side of the balance sheet to the other. Besides the influx of hedge fund reinsurers, there are the established models of Fairfax and Markel who have successfully followed the “Buffet alpha” model in the past. A newer entry into this fold is the Chinese firm Fosun with their “insurance + investment twin-driver core strategy”.

The surprise entry by the Agnelli family’s investment firm EXOR into the Partner/AXIS marriage yesterday may be driven by a desire to use the reinsurer as a source of float for its investments according to this Artemis article on the analyst KBW’s reaction to the new offer. In the presentation on the offer from EXOR’s website, the firm cites as a rationale for a deal the “opportunity to exploit know-how synergies between EXOR investment activities” and the reinsurer’s investment portfolio.

Perhaps one of the most interesting articles on the current market in recent weeks is this one from the New York Times. The article cites the case of how the private equity firm Apollo Global Management purchased Aviva’s US life insurance portfolio, ran it through some legit regulatory and tax arbitrage structures with Goldman Sachs help, and ended up using some of the assets behind the insurance liabilities to prop up the struggling casino company behind Caesars and Harrah’s casinos. Now that’s a story that speaks volumes to me about where we are in the risk appetite spectrum today.