Paradox of Thrift, meet Paradox of Toil

q-ratio, Enterprise Value, and more…

When Valuing Wall Street was published in 2000, it went largely un-noticed for 2 reasons: first, no one wanted to hear about the stock market being overvalued, and second, it was overshadowed by the more famous Irrational Exuberance. But I recently went back to the book to see if there were any lessons to be gleaned, either for stock selection or asset allocation for the current environment.

The study has led me to some interesting discussions and some new sources, so I’ll try to keep it coherent.

The q-ratio, also known as Tobin’s q, after the man who laid the foundations, is a simple ratio of the value of the stock market to corporate net worth. As with so many things in life, it’s simple, but extremely powerful. This ratio has some interesting characteristics. For starters, it seems (based on a few hundred years of data) to be mean-reverting. It makes sense that the ratio can’t be too extreme, for some logical economic reasons which we won’t discuss here. Second, unlike P/B, it doesn’t depend on listed cost basis, but rather can account for replacement value and inflation. Third, it appears to have been a useful tool at market turning points. So far so good. We’ll get back to some other positives in a bit, but what about issues?

The single biggest issue is one of timing. q-ratio appears to be more than a little off, making it incredibly hard to use as a predictive tool. That’s a big one. Second, we like seeing scalability in robust factors. That is, we would want the same factor to be valid for a company, an industry, and a market (fractability). Because of the disparate value of intangibles, especially across industries, q fails on the company level. Click here for a discussion of intangibles and q.

Going back to q’s positive attributes . . . I was struck by the simple logic of the ratio, and the implications for allocation that it provides. In the end, valuation metrics attempt to do the same thing: find robust ratios between current prices, assets, and earnings streams. Going back to some of the work I’ve done on stock selection and criteria, I went back to the idea of an enterprise multiple. For an academic review of EV, click here.

That, not surprisingly, took me back to Prof. Shiller’s CAPE and a look at today’s markets. Confirmatory bias? Definitely. But it also gave me an idea for our site. I won’t reveal it now, but look for an added section in resources in the next couple of weeks.

For now, I’ll leave you with this:

“On 10th December, 2009 the S&P 500 was at 1102. At this level both q and CAPE show the market to be 48% overvalued.” Definitely visit the source for this chart: http://www.smithers.co.uk/page.php?id=34

World Economic Forum Risks-Report 2010

In anticipation of this years World Economic Forum, the organization put out a report highlighting what they see as the greatest risks to the world, including political, economic, social, military, etc. Here’s an excerpt from their press release, and a link to the full report is at the bottom.

…Daniel M Hofmann, group chief economist of Zurich Financial Services said, “The events of the last year have shown that there are underlying risks within the global economy that need to be addressed. In reaction to the financial crisis, many countries have put themselves at risk of overextending their fiscal positions and being burdened with extremely high levels of debt. This could put upward pressure on real interest rates, rein back growth and lead to protracted high levels of unemployment.”

More widely, the report points to the impact of the global recession on longstanding under-investment in infrastructure, especially in energy and agriculture, and the rising costs of treating chronic disease. These “creeping” risks have not appeared overnight, but the recession has limited the ability of decision-makers to combat them effectively.

This is particularly true for energy with respect to the pressing global need to invest in infrastructure. John Drzik, CEO of Oliver Wyman, an MMC operating company, said, “The recent drop in oil prices has been good for consumers, but has also contributed to a significant cut in much-needed investment in energy infrastructure and renewable energy projects. This comes at a time when governments – as well as business and consumers – are looking for long-term security of an energy supply that is both sustainably-sourced and reasonably priced. The fragile global economy will make itself more susceptible to oil price-related shocks if this underinvestment continues.”

A massive US$ 35 trillion of infrastructure investment is required over the next 20 years, according to the World Bank. “This is particularly acute for agriculture and food security,” said Swiss Re’s Chief Risk Officer Raj Singh. “We need a vast increase in food production to feed the growing world population, and a billion people are already undernourished. Billions of dollars need to be spent on water provision, energy supply, transport and climate change adaptation measures. Governments must work together with the private sector to make it happen. Insurers can provide risk management tools that create greater financial stability for farmers and the agriculture industry.”

The report also highlights risks where the levels of awareness and preparedness are currently very low; these include transnational crime and corruption, cyber-vulnerability and biodiversity loss.

For the full report, click here.

Increasing interest rates, infrastructure, agriculture, energy, disease management. Those seem to be the big ones.

Sentiment Indicators

I’ve never been able to model these accurately and robustly, but the idea is intriguing for a contrarian (like I try to be). The question is what indicators to use, what time frame should you look at, how robust is the data, are you measuring coincident indicators/correlation/causation, how do you quantify the predictive value, etc. ETF’s have certainly given us some insight, as does watching the VIX. I was recently sent the following articles about using the Rydex levered bull vs. levered bear ETF’s. The first article looks at daily moves and the second at weekly moves. I have not tested these indicators myself and cannot attest to their validity, but it is something that is worth looking into:

http://www.zerohedge.com/article/rydex-market-timers-amazing

http://thetechnicaltakedotcom.blogspot.com/2010/01/rydex-market-timers-long-term-view.html

These articles seem to be looking at assets, not prices, but I assume you could look at prices as well. Just some food for thought for the modelers out there.

Placing speculative limits is BAD – now if only the Fed will heed it’s own research

In a recent paper published by the New York Fed, Erkko Etula shows that speculators help stabilize commodity markets. To quote:

Taken together, my results highlight the importance of speculative capital for the stability of commodity markets. In this way, the paper not only contributes to the broader literature on limits of arbitrage pioneered by Shleifer and Vishny (1997), but also shows that recent arguments in favor of speculative
trading restrictions have been starkly misguided.

Another interesting outgrowth of this research is that Etula is able to model some of the volatility of commodities based on the flow of funds report. For those trading in the options arena, especially those using quant based approaches, this might point to an interesting factor to test further. For the full report click here.

Money is made in the buying

Prieur du Plessis from “Investment Postcards” quote Richard Russell as saying:

Long-term profits depend largely on your original buy price. Today, as I write, stock valuations are extremely high. For instance, the price-earnings (PE) ratio for the Dow is now 18.02. The dividend yield for the Dow is a thin 2.67%. For the S&P 500 the PE is 86.20; the dividend yield is a mini 1.96%. In the face of these valuations, the odds of building impressive profits over the next decade are very poor (unless, of course, there’s a crash and a new bull market).

The great fortunes in stocks are made by buying stocks at true bear market lows. At today’s bloated values, profits in stock over the coming decade will probably not be any better than the percentage increase (if any) in the GDP over the same time period.

I would expand on that and paraphrase from Reminiscence of a Stock Operator: “Money is made in the waiting.” Plessis then goes on to show that even using 10-year cyclically adjusted P/E’s (CAPE), today, at 20+ we are in the upper quintile of historical CAPE’s, and should expect low single digit returns, at best.

We have written here often that returns come from dividends and P/E expansion. With dividends anemic, we have to depend on P/E expansion. Yet starting from such a high multiple, coupled with the fact that profit margins are probably at a cyclical high, we should expect even less than historical averages going forward. Namely, we will be lucky if in 10 years time we will be about where we are today.

This is not a time to put new money into the market. Are there deals out there that will outperform? Definitely! But be wary. While holding cash is not a pleasant option, sometimes not losing is not that bad.

http://www.investmentpostcards.com/2009/12/08/quote-du-jour-money-is-made-in-the-buying/

This Time It’s Different

Not so happy, but important reading. Take this with you on the train, or read this on a plane. It is important!!

“This Time is Different: A Panoramic View of Eight Centuries of Financial Crises” by Reinhart and Rogoff give us a historical context (300+ years) to analyze the current state of currency, banking, debt and defaults, etc. By looking at a much broader data set, they provide a view into the common themes across periods that has implications for our future path (if you believe that there is some predictive value in history, which, as a value-biased investor, I do).  The paper is 124 pages, which might be a bit technical for most readers, but here is the quick abstract:

This paper offers a “panoramic” analysis of the history of financial crises dating
from England’s fourteenth-century default to the current United States sub-prime financial
crisis. Our study is based on a new dataset that spans all regions. It incorporates a number
of important credit episodes seldom covered in the literature, including for example,
defaults and restructurings in India and China. As the first paper employing this data, our
aim is to illustrate some of the broad insights that can be gleaned from such a sweeping
historical database. We find that serial default is a nearly universal phenomenon as
countries struggle to transform themselves from emerging markets to advanced economies.
Major default episodes are typically spaced some years (or decades) apart, creating an
illusion that “this time is different” among policymakers and investors. A recent example
of the “this time is different” syndrome is the false belief that domestic debt is a novel
feature of the modern financial landscape. We also confirm that crises frequently emanate
from the financial centers with transmission through interest rate shocks and commodity
price collapses. Thus, the recent US sub-prime financial crisis is hardly unique. Our data
also documents other crises that often accompany default: including inflation, exchange
rate crashes, banking crises, and currency debasements.

For the full paper click here.

The conclusions aren’t pretty, but they are informative and it should give pause to the emerging markets chasers, the sovereign debt buyers, and the currency speculators on all sides.

Tough to beat the markets

Fama and French, two of the top academic researchers out there, just released a study outlining how difficult it is to identify managers who can beat the markets. For the full article click here. The highlights of the article are that after accounting for expenses, most managers (roughly 97%) can’t outperform and if they do, then it’s probably luck. Certainly a sad statement on the mutual fund industry, but I would contend a bigger hurdle for the hedge fund industry. If most managers can’t overcome a 1-2% management fee, then how would hedge fund managers justify 2 and 20 fee structures? They would probably state that because of their ability to short there are more opportunities for alpha. While it might be true, the opposite might be true as well, which is that shorting provides additional opportunities to lose alpha. As an active manager myself, my own heuristic biases compel me to believe that I actually do provide some value to my clients, either through selection of stocks, managers, allocation, etc. and so far so good, but the academic research should at least make every manager (and hopefully clients) identify where and what value they provide and question their predictive ability.

http://www.marketwatch.com/story/to-beat-index-funds-luck-is-your-only-hope-2009-12-01

I’ll put this up because people asked for it – SocGen end of world prep

But I don’t like it and I don’t think it is necessarily useful for any predictive value – if anything, I’ll use it as a contra-indicator.

From the Daily Telegraph in the UK: http://www.telegraph.co.uk/finance/economics/6599281/Societe-Generale-tells-clients-how-to-prepare-for-global-collapse.html

And if you’re looking for the full presentations…SG – Worst Case Debt Scenario and SG – Worst Case Debt Scenario 2.

Happy reading!

U.S. Share of World GDP Remarkably Constant

Good piece from “Carpe Diem” about US share of world GDP. And another reason why I’m short Euro and do not believe they will outperform mid/long-term given their structural problems.

Bottom Line: World GDP (real) doubled between 1969 and 1990, and has increased by another 60% since then, so that world output in 2009 is more than three times greater than in 1969. We might mistakenly assume that the significant economic growth over the last 40 years in China, India and Brazil has somehow come “at the expense of economic growth in the U.S.” (based on the “fixed pie fallacy”) but the data suggest otherwise. Because of advances in technology, innovation, and significant improvements in U.S. productivity, America’s share of total world output has remained remarkably constant at a little more than 25%, despite the significant increases in output around the world, especially in Asia.

http://mjperry.blogspot.com/2009/11/us-share-of-world-gdp-remarkably.html

Must Read: Mike Shedlock on unemployment

This is one of the best analyses I’ve seen on the unemployment situation. Mike Shedlock (Mish) explains why he believes unemployment will continue rising, what a recovery will look like in terms of employment, and more. This is a data heavy article, but it’s worth it! An important take-away for me was that investors should keep an eye on the hours worked by part-time workers, as those will go up before full-time employment. Secondly, employment is usually discussed as a lagging indicator, but the numbers are so large and the impact so entrenched, that I can’t see a recovery without jobs stabilizing. A sobering reflection…http://globaleconomicanalysis.blogspot.com/2009/11/mish-unemployment-projections-through.html.

The Coming Collapse of the Muni Bond Market

We have written multiple times on the lurking dangers in the municipal bond market, but this article by Phillip Greenspun articulates and summarizes the dangers even better than we have. Here are some excerpts:

…Sheehan notes that “spending is rising and revenue is collapsing” for all levels of government. Pension fund losses will require governments to double their contributions to pension plans (see my blog posting on public employee pensions). Spending is rising, e.g., in New York City from an average of $65,401 in compensation per public employee in 2000 to $106,743 in 2009. The number of full-time employees in NYC grew as well, despite falling school enrollment. The number of state and local government workers grew from 4 million in 1955 to 20 million in 2008 (5x growth, against less than 2X growth in U.S. population). Those workers receive an average of 43 percent more pay and benefits than a private sector worker…

…Without bankruptcy protection, a city that couldn’t pay bondholders would be forced to raise taxes until it could. This happened to West Palm Beach, Florida in the Depression and property tax rates rose to 42.5 percent of assessed value. Potentially bondholders might demand that the city hand over real estate to satisfy its debts. With bankruptcy protection, it is unclear what happens. Vallejo, California went bankrupt 18 months ago and their obligations have not yet been resolved (story). If courts allow municipalities to walk away from debt they’ll have every incentive to declare bankruptcy and start afresh. There are no shareholders in a municipality to wipe out and therefore the only negative consequence of a bankruptcy filing would possibly be having to pay higher interest rates for future borrowing. If on the other hand, governments are not allowed to walk away from many of their obligations, they will simply run out of cash. Are bondholders senior to pension obligations or not? It may be up to the individual judge. This is “uncharted territory for investors” as my money manager put it (he does not buy U.S. muni bonds)…

http://blogs.law.harvard.edu/philg/2009/11/03/the-coming-collapse-of-the-municipal-bond-market/

The article continues to outline statistics and implications of default, but I will take it a step further. The municipal bond market is a retail market. It is made up of mostly local (in-state) residents and diversified muni bond funds, the holders of which are individual investors. Because of the tax exemptions, public pensions and institutions tend to prefer taxable bonds. This has an interesting implication for politicians: they will have to raise taxes on the same investors that are holding the muni bonds – which is political suicide. Instead, the federal government will have to step in, along with politicians needing to find a way to influence the courts when thinking about some workouts. The question of state pensions and benefits will be addressed in the coming years, one way or the other as states face the prospect of default with limited ability to raise taxes.

If anyone has any information to counter or make me a believer in the sustainability of the currency tax and borrow regime, PLEASE forward it along, because the way things are looking now, I’m very wary of the muni market.

Hoisington: Yields could reach Japanese levels

I am not a big fan of Treasuries at these levels, but Hoisington makes some incredibly well researched points that are worth noting. If we are, indeed in a Japanese style cycle of increased government debt, crowding out of private investments, and stagnant GDP growth, we could be facing a long term deflationary environment with a decreasing per capita GDP, and falling yields. Worth reading all the way through: http://www.hoisingtonmgt.com/pdf/HIM2009Q2NP.pdf.

Supply overhang in UNG? Can natural gas rally?

I’ve been in and out of UNG and the natural gas producers at various times over the past few years. I’ve been amazed by some of the moves, and often amazed by the lack of reaction and recently decided to move out of the way completely. This article from MIT Technology review makes me more confident in that decision (talk about confirmatory bias). It’s a must read no matter what you believe: http://www.technologyreview.com/energy/23694/.

Niall Ferguson: Dollar may drop another 20%…

This came out earlier today. I’m not saying I disagree, I’m just not convinced it’s easy to know “against what”. The euro? Why? Fundamentally, the other currencies in the world don’t seem that appetizing to me, especially at these levels. Now, if you said drop 20% against specific commodities, then it’s a definite maybe, but at least we can discuss the underlying supply/demand issues. Against the Euro? They are in worse shape than we are, they just don’t understand it yet. The Chinese yuan? They’ve been keeping it artificially low for decades just to get a little export going. Do you think they can afford to let it drop 20% from here? Doubtful, or there will be mutiny on the Chinese seas.

Enjoy…

(By the way, I like Ferguson a lot and try to pick up anything he writes. Phenomenal writings on history, history of economics, and tying everything to the geopolitical landscape.)

Dollar May Drop 20% More on Deficit, Harvard’s Ferguson Says

By Cordell Eddings and Thomas R. Keene

Oct. 16 (Bloomberg) — The dollar will extend its drop versus the euro over the next two to five years, falling as much as 20 percent to an all-time low under a widening U.S. budget deficit, Harvard University’s Professor Niall Ferguson said.

Policy makers favor the dollar’s slide as a means of supporting a recovery from the worst economic slump since the Great Depression even as they voice support for a strong greenback, Ferguson said in an interview on Bloomberg Radio.

A weak dollar is “the simplest solution to most of America’s problems right now,” said Ferguson, author of “The Ascent of Money: A Financial History of the World.” “We are likely to see 1 percent to 2 percent growth unless exports take off, and that’s what everyone in Washington is quietly hoping: If the dollar keeps sliding, then maybe we can get some traction on exports.”

The dollar increased 0.4 percent to $1.4887 versus the euro today after depreciating yesterday to $1.4968, the weakest level in 14 months. The U.S. currency touched $1.6038 on July 15, 2008, the weakest since the euro’s 1999 debut.

The world’s largest economy shrank at a 0.7 percent annual rate in the second quarter, the Commerce Department reported last month. Gross domestic product contracted at a 6.4 percent pace in the first three months of 2009.

Economists forecast the current-account deficit will rise to 3.2 percent of gross domestic product in 2010 and 3.3 percent in 2011, compared with 2.9 percent this year.

‘Terrible News’

The weakening of the dollar is “terrible news for practically all of the rest of the world’s economies,” except the U.S. and China, said Ferguson. China, which manages the yuan’s appreciation, will “intervene to make sure the dollar does not weaken” relative to its currency, Ferguson added.

Treasury Secretary Timothy Geithner said on Oct. 3 after attending a meeting of Group of Seven finance officials that it’s “very important” for the U.S. to have a strong dollar.

The administration of President Barack Obama pushed the nation’s marketable debt to an unprecedented $6.78 trillion in an effort to spur economic growth and support the financial system. The U.S. government ended its 2009 fiscal year with a deficit of $1.4 trillion, the biggest since 1945, the Congressional Budget Office reported.