Tag Archives: Philosophical Economics

Sell in May and go away…

This week has been a volatile one on the markets with much of the week’s losses being regained after a “goldilocks” jobs number on Friday. Janet Yellen chipped in with the statement that “equity market values at this point generally are quite high” which resulted in the debates about market valuation been rehashed on the airwaves through the week.

My thoughts on the arguments were last aired in this post. I believe there is merit to the arguments that historical data needs to be normalized to take into account changes in business models within the S&P500 and the impact of changes in profit margins. Yield hungry investors and the lack of alternatives remain strong supports to the market, particularly given the current thinking on when US interest rate rises will begin. Adjustments on historical data such as those proposed by Philosophical Economics in this post make sense to me (although it’s noteworthy he concludes that the market is overvalued despite such adjustments).

Shiller’s latest PE10 metric (adjusted for inflation by the CPI) is currently over 27, about 38% above the average since 1960, as per the graph below.

click to enlargeCAPE PE10 1960 to May2015

I tend to put a lot of stock in the forward PE ratio due to the importance of projected EPS over the next 12 months in this market’s sentiment. Yardeni have some interesting statistics on forward PE metrics by sector in their recent report. Factset also have an interesting report and the graph below from it shows the S&P500 trading just below a 17 multiple.

click to enlargeForward 12 month PE S&P500 May2015

Recently I have become more cautious and the past week’s volatility has caused me to again review my portfolio with a ruthless eye on cutting those positions where my conviction against current valuation is weakest. Making investment decisions based upon what month it is can be justifiably called asinine and the graph below shows that the adage about going away in May hasn’t been a profitable move in recent years.

click to enlarge5 year S&P500 go away in May

However my bearishness is not based upon the calendar month; it’s about valuation and the nervousness I see in the market. To paraphrase a far wiser man than me, all I bring to the table is over 20 years of mistakes. Right now, I would far rather make the mistake of over-caution than passivity.

Goodbye 2014, Hello 2015!

So, after the (im)piety of the Christmas break, its time to reflect on 2014 and look to the new year. As is always the case, the world we live in is faced with many issues and challenges. How will China’s economy perform in 2015? What about Putin and Russia? How strong may the dollar get? Two other issues which are currently on traders’ minds as the year closes are oil and Greece.

The drop in the price of oil, driven by supply/demand imbalances and geo-political factors in the Middle East, was generally unforeseen and astonishing swift, as the graph of European Brent below shows.

click to enlargeEuropean Brent Spot Price 2004 to 2014

Over the short term, the drop will be generally beneficial to the global economy, acting like a tax cut. At a political level, the reduction may even put manners on oil dependent states such as Iran and Russia. Over the medium to long term however, it’s irrational for a finite resource to be priced at such levels, even with the increased supply generated by new technologies like fracking (the longer term environmental impacts of which remain untested). The impact of a low oil price over the medium term would also have negative environmental impacts upon the need to address our carbon based economies as highlighted in 2014 by the excellent IPCC reports. I posted on such topics with a post on climate models in March, a post on risk and uncertainty in the IPCC findings in April, and another post on the IPCC synthesis reports in November.

The prospect of another round of structural stresses on the Euro has arisen by the calling of an election in late January in Greece and the possible success of the anti-austerity Syriza party. Although a Greek exit from the Euro seems unlikely in 2015, pressure is likely to be exerted for relief on their unsustainable debt load through write offs. Although banking union has been a positive development for Europe in 2014, a post in May on an article from Oxford Professor Kevin O’Rourke outlining the ultimate need to mutualise European commitments by way of a federal Europe to ensure the long term survival of the Euro. Recent commentary, including this article in the Economist, on the politics behind enacting any meaningful French economic reforms highlights how far Europe has to go. I still doubt that the German public can be convinced to back-stop the commitments of others across Europe, despite the competitive advantage that the relatively weak Euro bestows on Germany’s exporting prowess.

Perpetually, or so it seems, commentators debate the possible movements in interest rates over the coming 12 months, particularly in the US. A post in September on the findings of a fascinating report, called “Deleveraging, What Deleveraging?”, showed the high level of overall debt in the US and the rapid increase in the Chinese debt load. Although European debt levels were shown to have stabilised over the past 5 years, the impact of an aggressive round of quantitative easing in Europe on already high debt levels is another factor limiting action by the ECB. The impact of a move towards the normalisation of interest rates in the US on its economy and on the global economy remains one of the great uncertainties of our time. In 2015, we may just begin to see how the next chapter will play out.

Low interest rates have long been cited as a factor behind the rise in stock market valuations and any increase in interest rates remains a significant risk to equity markets. As the graph below attests, 2014 has been a solid if unspectacular year for nearly all equity indices (with the exception of the FTSE100), albeit with a few wobbles along the way, as highlighted in this October post.

click to enlarge2014 Stock Indices Performance

The debate on market valuations has been an ever-present theme of many of my posts throughout 2014. In a March post, I continued to highlight the differing views on the widely used cyclically adjusted PE (CAPE) metric. Another post in May highlighted Martin Wolf’s concerns on governments promoting cheap risk premia over an extended period as a rational long term policy. Another post in June, called Reluctant Bulls, on valuations summarized Buttonwood’s assertion that many in the market were reluctant bulls in the absence of attractive yields in other asset classes. More recently a post in September and a post in December further details the opposing views of such commentators as Jim Paulsen, Jeremy Siegel, Andrew Lapthorne, Albert Edwards, John Hussman, Philosophical Economics, and Buttonwood. The debate continues and will likely be another feature of my posts in 2015.

By way of a quick update, CAPE or the snappily named P/E10 ratio as used by Doug Short in a recent article on his excellent website shows the current S&P500 at a premium of 30% to 40% above the historical average. In his latest newsletter, John Hussman commented as follows:

“What repeatedly distinguishes bubbles from the crashes is the pairing of severely overvalued, overbought, overbullish conditions with a subtle but measurable deterioration in market internals or credit spreads that conveys a shift from risk-seeking to risk-aversion.”

Hussman points to a recent widening in spreads, as illustrated by a graph from the St Louis Fed’s FRED below, as a possible shift towards risk aversion.

click to enlargeFRED High Yield vrs AAA Spread Graph

The bull arguments are that valuations are not particularly stressed given the rise in earnings driven by changes to the mix of the S&P500 towards more profitable and internationally diverse firms. Critics counter that EPS growth is being flattered by subdued real wage inflation and being engineered by an explosion in share buybacks to the detriment of long term investments. The growth in quarterly S&P500 EPS, as illustrated below, shows the astonishing growth in recent years (and includes increasingly strong quarterly predicted EPS growth for 2015).

click to enlargeS&P500 Quarterly Operating & Reported EPS

A recent market briefing from Yardeni research gives a breakdown of projected forward PEs for each of the S&P500 sectors. Its shows the S&P500 index at a relatively undemanding 16.6 currently. In the graph below, I looked at the recent PE ratios using the trailing twelve month and forward 12 month operating EPS (with my own amended projections for 2015). It also shows the current market at a relatively undemanding level around 16, assuming operating EPS growth of approx 10% for 2015 over 2014.

click to enlargeS&P500 Operating PE Ratios

The focus for 2015 is therefore, as with previous years, on the sustainability of earnings growth. As a March post highlighted, there are concerns on whether the high level of US corporate profits can be maintained. Multiples are high and expectations on interest rates could make investors reconsider the current multiples. That said, I do not see across the board irrational valuations. Indeed, at a micro level, valuations in some sectors seem very rational to me as do those for a few select firms.

The state of the insurance sector made up the most frequent number of my posts throughout 2014. Starting in January with a post summarizing the pricing declines highlighted in the January 2014 renewal broker reports (the 2015 broker reports are due in the next few days). Posts in March and April and November (here, here and here) detailed the on-going pricing pressures throughout the year. Other insurance sector related posts focussed on valuation multiples (here in June and here in December) and sector ROEs (here in January, here in February and here in May). Individual insurance stocks that were the subject of posts included AIG (here in March and here in September) and Lancashire (here in February and here in August). In response to pressures on operating margins, M&A activity picking up steam in late 2014 with the Renaissance/Platinum and XL/Catlin deals the latest examples. When seasoned executives in the industry are prepared to throw in the towel and cash out you know market conditions are bad. 2015 looks to be a fascinating year for this over-capitalised sector.

Another sector that is undergoing an increase in M&A activity is the telecom sector, as a recent post on Europe in November highlighted. Level3 was one of my biggest winners in 2014, up 50%, after another important merger with TW Telecom. I remain very positive on this former basket case given its operational leverage and its excellent management with a strong focus on cash generation & debt reduction (I posted on TWTC in February and on the merger in June and July). Posts on COLT in January and November were less positive on its prospects.

Another sector that caught my attention in 2014, which is undergoing its own disruption, is the European betting and online gambling sector. I posted on that sector in January, March, August and November. I also posted on the fascinating case of Betfair in July. This sector looks like one that will further delight (for the interested observer rather than the investor!) in 2015.

Other various topics that were the subject of posts included the online education sector in February, Apple in May, a dental stock in August, and Trinity Biotech in August and October. Despite the poor timing of the August TRIB call, my view is that the original investment case remains intact and I will update my thoughts on the topic in 2015 with a view to possibly building that position once the selling by a major shareholder subsides and more positive news on their Troponin trials is forthcoming. Finally, I ended the year having a quick look at Chinese internet stocks and concluded that a further look at Google was warranted instead.

So that’s about it for 2014. There was a few other random posts on items as diverse as a mega-tsunami to correlations (here and here)!

I would like to thank everybody who have taken the time to read my ramblings. I did find it increasingly difficult to devote quality time to posting as 2014 progressed and unfortunately 2015 is looking to be similarly busy. Hopefully 2015 will provide more rich topics that force me to find the time!

A very happy and health 2015 to all those who have visited this blog in 2014.

An ice age or a golden one?

The debate on whether the US stock market is overvalued, as measured by the cyclically adjusted price to earnings ratio (CAPE) as developed by Robert Shiller, or whether CAPE is not relevant due to weaknesses in comparing past cycles with today’s mixed up macro-economic world, continues to rage. I have posted several times on this, most recently here and here. In an article in this week’s Economist, Buttonwood outlines some of the bull and bear arguments on the prospects for US corporate growth and concludes that “America is an exception but not as big an exception as markets suggest”.

Bulls argue that, although the CAPE for the S&P500 is currently historically high at 26.5, earnings growth remains strong as the US economy picks up speed and that at a forward PE around 16 the S&P500 is not at excessive levels indicative of a bubble. The latest statistics compiled by the excellent Yardeni Research from sources such as the Bureau of Economic Analysis show that earnings, whether S&P reported or operating earnings or NIPA after tax profits from current production or based upon tax returns, continue to trend along a 7% growth projection. Jim Paulsen, chief investment strategist at Wells Capital Management, believes that “this recovery will last several more years” and “earnings will grow”. Even the prospect of increased US interest rates does not perturb some bulls who assert that rates will remain low relative to history for some time and that S&P500 firms still have plenty of cash with an aggregate cash-pile of over $1 trillion. The king of the bulls, Jeremy Siegel recently said that “If you look at history, the bull markets do not end when the Fed starts raising interest rates. Bull markets could go on for another 9 months to 2 years“.

Bears point to high corporate profits to GDP and argue that they are as a direct result of low real wages and are therefore unsustainable when normal macro conditions return. Others point to the surge in share buybacks, estimated at nearly $2 trillion by S&P500 firms since 2009, as a significant factor behind EPS growth. Société Générale estimate a 20% fall in Q2 buybacks and (the always to be listened to) Andrew Lapthorne warns that as debt gets dearer firms will find it hard to maintain this key support to stock prices as in the “absence of the largest buyers of US equity going forward is likely to have significant consequence on stock prices”. The (current) king of the bears, Albert Edwards, also at SocGen, provided good copy in a recent report “Is that a hissing I can hear?” saying that “companies themselves have been the only substantive buyers of equity, but the most recent data suggests that this party is over and as profits also stall out, the equity market is now running on fumes“. Edwards believes that an economic Ice Age is possible due to global deflationary pressures. Another contender for king of the bears is fund manager John Hussman and he recently commented: “make no mistake, this is an equity bubble, and a highly advanced one“.

One commentator who I also respect is the author behind the excellent blog Philosophical Economics. A post last month on CAPE highlighted the obvious but often forgotten fact thatthe market’s valuation arises as an inadvertent byproduct of the equilibriation of supply and demand: the process through which the quantity of equity being supplied by sellers achieves an equilibrium with the quantity of equity being demanded by buyers”. As such, the current macro-economic situation makes any reference to an average or a “normal period” questionable. The post is well worth a read and concludes that the author expects the market to be volatile but continue its upward trajectory, albeit at a slower pace, until signs that the real economy is in trouble.

For me, the easy position is to remain negative as I see valuations and behaviour that frightens me (hello AAPL?). I see volatility but not necessarily a major correction. Unless political events get messy, I think the conclusion in a previous Buttonwood piece still holds true: “investors are reluctant bulls; there seems no alternative”. Sticking only to high conviction names and careful risk management through buying insurance where possible remain my core principles. That and trying to keep my greed in check…..

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…….