Here is a Bloomberg piece. At a glance, it seems to make sense when you just compare the multiples of today and those around 1982. But if you think about it, even at the same multple, S&P is valued a lot higher today than 1982 because the discount rate now is lot lower than 1982. Today, fed fund rate is almost zero and 10-yr T is about 2%. In 1982, fed fund rate was about 20% and 10-yr T was about 15%. What do you guys think? ----------------- By Inyoung Hwang - Aug 29, 2011 Investors are paying less for equities than they have during every recession since Ronald Reagan was president amid growing concern that the economy is on the edge of another recession. The Standard & Poor’s 500 Index has lost 13 percent in the past five weeks, sending its price-earnings ratio down to 12.9. That’s 3.5 percent less than the average multiple during the 10 contractions since 1949 and a level last reached in 1982, according to data compiled by Bloomberg. Bears say valuations show the U.S. remains in the slowdown that began in 2007. Unlike under Reagan, when U.S. Federal Reserve Chairman Paul Volcker raised borrowing costs as high as 20 percent to combat inflation, interest rates are already near zero, leaving policy makers fewer tools to boost the economy, they say. Bulls say the ratios are so low because they reflect indiscriminate selling by investors convinced that any slowdown will turn into a repeat of the 2008 credit crisis. “There are truly some terrific values out there in companies, but it’s a question of timing,” John Massey, a Jersey City, New Jersey-based fund manager who helps oversee $13 billion at SunAmerica Asset Management, said in a telephone interview on Aug. 26. “Right now, the market is very short-term sighted. Every day the market is up or down, and it’s much more of a macro call than anything else.” $2.3 Trillion Drop About $2.3 trillion has been erased from the market value of U.S. equities since the S&P 500’s recent high on July 22 after reports on housing and manufacturing trailed estimates, Europe’s debt crisis worsened and S&P stripped the U.S. of its AAA credit rating. The last time stocks in the index were cheaper on average during a recession was the early 1980s, a decade when the index surged 227 percent, or 403 percent including reinvested dividends. At the Aug. 26 close of 1,176.80, the S&P 500 traded at 10.8 times analysts’ forecast for profits in the next 12 months of $109.12 a share. For the P/E ratio to reach its five-decade average of 16.4 without shares appreciating, earnings would have to fall to about $71.76 a share, 22 percent below the last 12 months, data compiled by Bloomberg show. Should companies meet analysts’ profit estimates, the S&P 500 must advance to about 1,790 to trade at the average multiple of 16.4 since 1954, according to data compiled by Bloomberg. That’s more than 50 percent above its last close. The S&P 500 gained 1.8 percent at 9:55 a.m. in New York today. Worst Performers Energy, financial and industrial companies have performed worst out of 10 groups in the S&P 500 in the past month, falling more than 16 percent, as investors fled so-called cyclical stocks that are most tied to economic growth. Utilities and makers of household products posted the smallest losses. The index rallied 1.5 percent on Aug. 26, for the first weekly gain since July, after Fed Chairman Ben S. Bernanke said Aug. 26 during a speech in Jackson Hole, Wyoming, that the economy isn’t deteriorating enough to warrant any immediate stimulus. Optimism the U.S. will avoid a recession helped offset a Commerce Department report showing gross domestic product climbed at 1 percent in the second quarter, down from a 1.3 percent estimate. The economy grew at a 0.4 percent annual pace in the first quarter of 2011, the slowest since the second quarter of 2009, when the recession had yet to end, according to data compiled by the National Bureau of Economic Research. Reagan Inflation Runaway inflation at the start of Reagan’s presidency in 1981 spurred Volcker to lift the Fed funds rate, pushing the U.S. economy into a recession until November 1982. The S&P 500’s multiple sank to an average of 8 times earnings as record-high interest rates and 10-year Treasury yields above 15 percent reduced the appeal of equities. Rates dropped through the decade, helping fuel the equity rally. Bernanke has held the target rate for overnight loans between banks near zero since December 2008 and pledged this month to keep it there through mid-2013. “The Fed’s used up a lot of their big ammunition already,” Bruce Bittles, who helps oversee $85 billion as chief investment strategist at Milwaukee-based Robert W. Baird & Co., said in an Aug. 26 phone interview. “With earnings expectations coming down, P/E ratios are likely to remain lower than anticipated as well.” Cheaper Valuations During the credit crisis, the world’s largest economy shrank the most in any recession since the 1930s, according to the Commerce Department. Quarterly earnings among S&P 500 companies have almost doubled since ending an eight-period decline in September 2009. Valuations declined as the stock prices advanced at a slower rate, with the index climbing 11 percent since Sept. 30, 2009, data compiled by Bloomberg show. For TCW Group Inc.’s Komal Sri-Kumar, valuations must be lower to be attractive because the economy is stagnating. The S&P 500 has declined 10 percent since the start of June, the last month of the Fed’s second program of quantitative easing, known as QE2, data compiled by Bloomberg show. “Stocks have been at very high levels compared with a very weak economy,” Sri-Kumar, the chief global strategist at TCW, which oversees about $120 billion, said in a phone interview on Aug. 24. “When QE2 was introduced last August, you got a rally in equities prices for several months, but you didn’t get a big push up in economic growth.” Sri-Kumar recommended defensive stocks in the consumer staples, utility and health-care industries. Consumer Products Procter & Gamble Co. (PG), the Cincinnati-based maker of Gillette razors, has slipped 2.6 percent since July 26, compared with a 13 percent decline by the S&P 500. This month, the world’s largest consumer-products company said 2011 revenue topped analysts’ estimates and reported a 15 percent increase in fourth-quarter profit on sales from emerging markets. For Blackstone Group LP’s Byron Wien and Gamco Investors Inc.’s Howard Ward, the decline in valuations will prove temporary as investors buy back shares they sold in a panic after the U.S. lost its AAA credit rating at S&P. General Electric Co. (GE) has fallen 15 percent this year even after reporting profits that topped analysts’ estimates in the first two quarters. CEO Jeff Immelt said last month that industrial earnings and sales should increase in the second half of 2011 and accelerate into 2012. While analysts estimate profit at the Fairfield, Connecticut-based company will jump 21 percent this year, shares are trading at their lowest valuation since 2009. Market Decline “Too much has been read into the stock market’s decline,” Ward, who helps oversee $35 million in Rye, New York, wrote in an Aug. 24 e-mail. Corporate earnings are growing fast enough to boost equities, he said. Per-share profit at S&P 500 companies will rise 13 percent in 2012, the fourth straight year of increases, according to analyst estimates compiled by Bloomberg. Alcoa Inc. (AA), the country’s largest aluminum producer, and Caterpillar Inc. (CAT), the world’s biggest maker of construction and mining equipment, were among the worst performers in the Dow Jones Industrial Average in the last month, falling 25 percent and 19 percent through Aug. 26, respectively. Analysts estimate earnings will jump 21 percent in 2012 at New York-based Alcoa and 33 percent at Peoria, Illinois-based Caterpillar. “The market’s anticipating economic growth will slow and earnings estimates are going to have to come lower,” Mark Bronzo, who helps manage $26 billion at Security Global Investors in Irvington, New York, said in a telephone interview on Aug. 24. “My gut is the stock market is attractive at these levels and we won’t go into a recession. We’ll be in a sluggish growth environment and eventually stocks will do better.” To contact the reporter on this story: Inyoung Hwang in New York at ihwang7@bloomberg.net
AlphaSeeker Wrote: ------------------------------------------------------- > Here is a Bloomberg piece. At a glance, it seems > to make sense when you just compare the multiples > of today and those around 1982. > > But if you think about it, even at the same > multple, S&P is valued a lot higher today than > 1982 because the discount rate now is lot lower > than 1982. > > Today, fed fund rate is almost zero and 10-yr T is > about 2%. In 1982, fed fund rate was about 20% and > 10-yr T was about 15%. > > What do you guys think? I think you have the math backwards unless I am reading your post wrong. Mathematically, lower discount rate should imply a higher multiple not a lower multiple. Higher discount rates for future profits lower present values. Stocks are cheap by pretty much any metric. I have yet to see a compelling argument otherwise. The one that comes the closest is the Shiller CAPE mean reversion argument for profit margins coming down, however margins going down to me implies that overall economic growth must pick up (competition/wages drives margin pressure) which would help top line growth. The problem is there are very few true long term investors left out there to hold stocks anymore. Fund flows have been out of equities for 4 years and correlations are extraordinarily high. You have a market that functionally is a bunch of high frequency traders bouncing ETFs back and forth rather than a decent pricing mechanism. Risk aversion is extraordinarily high, and people are flocking to assets that they mistakenly perceive are risk free: deposits, treasuries, gold, Swiss Frank, etc. http://jerrykhachoyan.com/the-majority-of-america-does-not-care-about-stocks/
Dwight Wrote: ------------------------------------------------------- > AlphaSeeker Wrote: > -------------------------------------------------- > . > The one that comes the closest is the Shiller CAPE > mean reversion argument for profit margins coming > down, however margins going down to me implies > that overall economic growth must pick up > (competition/wages drives margin pressure) which > would help top line growth. > > I disagree with this. Here are some reasons margins will come down: 1. Input costs: The price of virtually everything has gone up, and in this economy, the ability to pass this through to consumers is going to hit a wall at some point. I think it shows up in the 3Q numbers to an extent. 2. Companies have cut themselves so lean that they have driven margins to unsustainable levels. Growth will pick up, but companies are going to have to hire in order to foster the growth. Sales will have to grow at a much higher rate in order to outpace costs in order to sustain margins. Ain’t happenin’.
Dwight Wrote: > I think you have the math backwards unless I am > reading your post wrong. Mathematically, lower > discount rate should imply a higher multiple not a > lower multiple. Higher discount rates for future > profits lower present values. I think we are looking at the same subject from different angles. Yes, multiples today should be a lot higher given the low discount rate. At the same time, the discount rate can only go up from here, which will work against the mulitple expansion… I wonder what this Stepember will bring us. Hisotirically, it’s the most volatile month of the year. For this Stepember, we will see the ugly econ numbers compiled in the aweful August… Unless investors expecations have been adjusted, this Stepember could be an interesting.
HighYielder Wrote: ------------------------------------------------------- > 1. Input costs: The price of virtually > everything has gone up, and in this economy, the > ability to pass this through to consumers is going > to hit a wall at some point. I think it shows up > in the 3Q numbers to an extent. I disagree. Wages are the largest input cost and they are roughly stagnant, and cuts have driven labor costs down. Commodity prices have bubbled up a bit but are generally volatile and have come off their peaks now - besides the US economy is over 70% service based - little commodity cost pressure there. Please point out where margin pressures show up in the 3Q numbers as corporate profits are at all time highs even as GDP growth is very sub par. > 2. Companies have cut themselves so lean that > they have driven margins to unsustainable levels. > Growth will pick up, but companies are going to > have to hire in order to foster the growth. Sales > will have to grow at a much higher rate in order > to outpace costs in order to sustain margins. > Ain’t happenin’. So economic growth is bad for company profitability? I disagree. I think companies will be easily able to hire for a while when they need to expand. The unemployment rate is not going to plummet any time soon. Margins will come back down if and when the economy starts to near capacity again.
^^ I have yet to have anyone convince me how it is possible that margins dont mean revert from here. You are welcome to try, but the following is evidence enough for me. http://www.valuewalk.com/wp-content/uploads/2011/03/us-corporate-profit-margins-1980-2010.png
Dwight, >>The problem is there are very few true long term investors left out there to hold stocks anymore. Fund flows have been out of equities for 4 years and correlations are extraordinarily high. You have a market that functionally is a bunch of high frequency traders bouncing ETFs back and forth rather than a decent pricing mechanism. This is something I have been thinking about quite a bit lately. With less discernment between good companies and bad (high correlations due to proliferation of ETFs, etc), it is a challenge for fundamental managers to stand out, particularly in the short term. However, this should lead to more mispricings, and hence better opportunities for active managers, but it will require more patience and time to get through the noise.
I didn’t say that profit margins won’t revert, just that they very likely won’t revert without economic growth/competition. Please do not put words in my mouth. I subscribe to valuewalk as well. Good blog.
Chi Paul Wrote: ------------------------------------------------------- > Dwight, > > >>The problem is there are very few true long term > investors left out there to hold stocks anymore. > Fund flows have been out of equities for 4 years > and correlations are extraordinarily high. You > have a market that functionally is a bunch of high > frequency traders bouncing ETFs back and forth > rather than a decent pricing mechanism. > > > This is something I have been thinking about quite > a bit lately. With less discernment between good > companies and bad (high correlations due to > proliferation of ETFs, etc), it is a challenge for > fundamental managers to stand out, particularly in > the short term. However, this should lead to more > mispricings, and hence better opportunities for > active managers, but it will require more patience > and time to get through the noise. Absolutely. Also will require very good salesmanship though… you can be the best portfolio manager in the world and it won’t matter if no one listens to you. Seth Klarman says rule number 1 for managing money is to never lose money, and rule number 2 is never to forget rule number 1. Fundamental equity analysis is a strategy that can lose money unfortunately, particularly in the current environment, even if the calls are eventually right.
^^ wasn’t intending to put words in your mouth. You might have read something into that, or it the classic internet speak that didnt come through. My bad.
HighYielder Wrote: ------------------------------------------------------- > ^^ wasn’t intending to put words in your mouth. > You might have read something into that, or it the > classic internet speak that didnt come through. > My bad. True I can see how it’s ambiguous. My main point was that I think the political and economic environment is actually great for the large cap multinationals because they can squeeze profit out of any meager economic growth because they do not have to pay more and can actually cut costs given their relative bargaining strength. For this to no longer be the case my thinking is that the economy must be closer to capacity again such that there are not 5 qualified people lining up for every job opening. At the same time those very same factors are extremely bad for consumer confidence, investor optimism, etc. So in rough terms you have a P/E ratio where the E continues to benefit because of the strong position companies are in, but the P is depressed for a variety for reasons related to sentiment and market structure. That’s my case.
I look at things from a global economic view…guess CFA likes to call it “top down” or whatever. Basically the environment is unstable right now. Somewhere between “not that great” and “really freakin’ dangerous”. I think the S&P should be about half the current value.
purealpha Wrote: ------------------------------------------------------- > I look at things from a global economic > view…guess CFA likes to call it “top down” or > whatever. Basically the environment is unstable > right now. Somewhere between “not that great” and > “really freakin’ dangerous”. I think the S&P > should be about half the current value. Why? Why about half the current value? I don’t see how a top-down view that things are unstable concludes with the S&P being 50% over valued. Care to share some facts or evidence?
You don’t understand how global movements impact a local market? I don’t know that I don’t care to, it is just that I don’t do “facts” or “evidence” or quantification so there is nothing to share. I do intuition and common sense, I also realize that is beyond the CFA program and not the way people of this profession tend to work. Things follow natural patterns, for awhile (centuries) things were coming together, and now things are falling apart. It is overvalued because of denial. That’s my analysis, no spreadsheets. —E
Sure, of course I understand how global movements impact a local market, I’m just wondering how you get to the figure of 50%? Could it be 75%? Or 15%? I just wonder how people discuss qualitative and subjective events and issues, some of which are ephemeral, yet arrive at a quantitative clonclusion like 'the market is 50% overvalued". Intution and commonsense can sure help you figure out the market is overvalued, but I don’t see how it tells you the market is 50% overvalued (or 45%, or 33.2% etc etc).
purealpha Wrote: ------------------------------------------------------- > You don’t understand how global movements impact a > local market? > > I don’t know that I don’t care to, it is just that > I don’t do “facts” or “evidence” or quantification > so there is nothing to share. I do intuition and > common sense, I also realize that is beyond the > CFA program and not the way people of this > profession tend to work. > > Things follow natural patterns, for awhile > (centuries) things were coming together, and now > things are falling apart. It is overvalued > because of denial. That’s my analysis, no > spreadsheets. > > —E In other words “it’s different this time”. There are an awful lot of simplistic narratives out there about the end of the world and how bad things are. The problem is they are never supported by data or facts, only this generic feeling that “things are falling apart”. The world has problems today as it has throughout history, but we should resist the temptation to believe we are able to predict the future based on our gut intuition, because predictions are often wrong and subject to a number of biases (the most important is overconfidence). The present is difficult enough to keep up with. There will always be naysayers and purveyors of negativity. People will listen to them when the market is going down and ignore them when the market is going up. It’s just the way the industry works.
HighYielder Wrote: ------------------------------------------------------- > ^^ > > I have yet to have anyone convince me how it is > possible that margins dont mean revert from here. > You are welcome to try, but the following is > evidence enough for me. > > http://www.valuewalk.com/wp-content/uploads/2011/0 > 3/us-corporate-profit-margins-1980-2010.png I agree with this. When you look at this time series going back for the last 100 years, it is very clearly mean-reverting. This can be explained rationally as when profits are high, new companies will enter the market until margins fall. In practice this might not always happen in sectors which have a monopoly or oligolopy market but in aggregate for the economy overall I think it remains the most reasonable working assumption. Nominal GDP growth in the US won’t be much above 4% over the next 3 years I’d say. So if corporate profit margins revert to the 30 year mean over that timeframe, even allowing for some growth in revenues in line with GDP, you are looking at a fall in profits in the region of 30%. If you look at sell-side forecasts for corporate profits for the next two years, you will see many pricing in double-digit growth. We’ve just had two years of really strong earnings growth. That won’t last indefinitely. Consumer spending is going to be restrained for the next few years as consumers pay down debt and the government is forced to cut spending and/or increase taxes. Overall I’d say its a pretty poor outlook for corporate earnings. Here’s an article from 6 months ago suggesting equity markets were overvalued then: http://amarginofsafety.com/2011/03/08/tobins-q-ratio-and-shillers-price-to-trailing-10-year-earnings-ratio/ Anyone got more up to date versions of those charts? The S&P 500 is down around 10% since that was written.
Unfortunately all the stocks I want to buy refuse to fall in value…lame…
Yes. This website updates Shiller PE10 daily. http://www.multpl.com/ Carson Wrote: ------------------------------------------------------- > I agree with this. When you look at this time > series going back for the last 100 years, it is > very clearly mean-reverting. This can be explained > rationally as when profits are high, new companies > will enter the market until margins fall. In > practice this might not always happen in sectors > which have a monopoly or oligolopy market but in > aggregate for the economy overall I think it > remains the most reasonable working assumption. Will these new companies you speak of have to hire anyone? Where is this competition going to come from? My argument is that capitalism/competition are part of economic growth. With a stagnant economy companies can maintain the high margins because they can cut costs and don’t have to hire/pay more. The current environment is very conducive to collecting economic rent (high margins).
Thanks for the link. So we are at relatively elevated levels for the Shiller PE10 against the long-run historical mean. Also, earnings are high relative to their long-run historical mean as discussed. Both negative indicators for future stock returns. The main positive I would see is that long-term interest rates are near historical lows (lowest since around 1950) which will tend to increase share prices. The equity risk premium is higher than normal and that is also mean reverting. Is the ERP more likely to converge to mean through higher bond yields or higher stock prices in the medium term ? I’d suggest the former although the Fed could easily keep short-term rates at very low levels for the next 3 years +.