After three quarters of grinding lower, it’s not clear the ultimate loss of wealth at the bottom of this market cycle will be the most painful aspect for investors.  Instead it could very well be the time it takes to get there.

We all expect the market to go up and the market to go down.  We’re conditioned to follow the well-worn mantra - “Investing isn’t about timing the market, but time in the market”.  That’s a great catch phrase for a logical philosophy but perhaps better suited to boom, rather than bust, times.  After all, how much time are we talking about - 5 years, 10 years, 50 years, or 100 years?  Here we are 75% of the way through the decade with a stock market that has delivered 14.3% cumulatively (as defined by the Russell 3000 index); or 1.8% annually – before taxes and before fees.  Perhaps we should have invested in Twinkies, canned apricots, frozen vegetables or cases of motor oil as the consumer price index (even arguably under-reported) has advanced 24.5% over the same time period.

What we’re not conditioned for, as families or as a country, is the prospect of reducing our long-term dreams based on diminished expectations.  Rethinking what it means to “retire”, or live a convertible life in old age as individuals and recalibrating our role in the world economy as a nation. Yet before this downturn’s run its agonizingly slow course, that’s what many citizens, and the United States as a nation, will have to face. 

Unfortunately this realization doesn’t come quickly for our leaders who are more apt to provide short-term props ad hoc to keep the inevitable at bay.  Ultimately, what purpose do the taxpayer rebates in the president’s “Economic Stimulus Plan” really serve?  Or accounting rules and guidelines that allow investment banks to defer financial losses on instruments that can’t be sold by terming them “tier 3” assets?  Far better to take our lumps and clean our closets today, even if it means stock prices decline a further 20-30% from today’s levels.  Over the long-term the end result may remain the same, but perhaps by taking our punishments now, opportunities for the long-term investor would be enhanced and increasing optimism for a prosperous future would instill confidence - resulting in higher stock market valuations.

Just a thought – but hey, what do we know anyways? 

In the meantime all eyes remain glued to this slow motion train wreck we call the U.S. economy and to the marvelous feats of frivolity administered by those in control.

An interesting article published about a week ago by James Montier of Societe Generale in London made its way to my inbox via the weekly John Mauldin’s “Outside the Box” e-Letter.  I thought I’d share it with you and provide a few thoughts of my own.

Before we get started though, John Mauldin’s free pieces – “Outside the Box” (published Monday) and “Thoughts from the Frontline” (on Friday) are really worthwhile readings for those wishing to stay up on non-traditional thinking and analysis as it applies to the financial markets.  Very focused, opinionated, and to the point. You may not agree with everything written, but I assure you it will make you think.  I encourage you to sign up if you have an interest.

In Mr. Montier’s commentary, he makes a strong case that Wall Street stock analysts are behind the curve with regards to earnings revisions for corporate America in this downturn.  It’s not the first time – in fact Wall Street analysts have routinely lagged reality.

“They only change their minds when there is irrefutable proof they were wrong, and then only change their minds very slowly.”

Mr. Montier goes on to make two additional points.   Most fundamental stock analysts base their assessments, at least in part, on corporate guidance.  Unfortunately companies themselves have a hard time recognizing reality. Instead they’re consistently more optimistic about their own companies than the overall economy.

Finally, in all likelihood the market hasn’t gotten anywhere close to pricing in the severity of this unfolding recession – we’ve likely a good deal further to go, and a good deal more pain to endure, for that to happen.

Our opinion precisely.  It’s simply astonishing to hear analyst after analyst present their views that the worst case has already been priced into the market.   Hello – earth to McFly! 

To think we slide right through without significantly lower earnings is simply laughable.  Facts to consider:

·        For all the talk of delinquencies and foreclosures over the past few months, we’re just now entering the high-season of increased resets among adjustable-rate mortgages.

·        The consumer has little in the way of savings, having become reliant on the “Home as ATM” phenomenon to maintain an extended lifestyle over the past few years.  Simply removing this increased spending without additional savings will drop GDP noticeably.

·        Financial services companies have a long way to go before their balance sheets are back in order.   Think many, many quarters.   While there is growing concern over Sovereign Wealth funds buying stakes in many of these concerns, they’ll likely look less like geniuses and more akin to the Japanese Real Estate investors of the 1980s in a few years.

·        Non-financial companies are just beginning to feel the pinch of higher input prices and reduced demand.  If one hasn’t noticed layoffs, and good sized ones at that, are a daily occurrence in the financial press.

So, the stock market is already pricing this in, huh?  We’ll continue to take the other side of that bet.

Gaining Insights From a Flawed Model

Pariveda’s quantitative S&P 500 fair market value model arrives at an interpretation of fair value based on the aggregate operating earnings of the companies that make up the index over the prior 1-year.  While we don’t rely solely on this model in making investment decisions it does provide insight on aggregate value investors ascribe to the market and raises important questions that we should address in understanding market psychology from time to time.

The model continues to signal a strong buy signal with fair value for the market as a whole at 2330, some 58% higher than where it currently trades.  Our confidence in the model remains low for the reasons pointed out below.

The primary reason we don’t ascribe more weight to the quant model in making our investment decisions is that the data-set used to construct it, historical quarterly data going back to 1988, is really too short to provide statistically significant results.  We can get index valuations going back before this, but operating earnings weren’t reported, or re-constituted, prior to that time.

Prior to 2004 the model did a good job of estimating fair value and providing longer-term buy and sell triggers.  Since then however we’ve seen a major divergence between our estimate of fair value and the market’s willingness to pay up for this “value”.

It’s impossible to say exactly why this deterioration has occurred, but it has happened as “value stocks” have been out-performing growth by a significant margin – and within the 20 years of data we’ve used, that simply hadn’t happened before.  In our opinion, it’s likely that investors are unwilling to value cyclicals, with the volatile nature of their earnings streams, at similar multiples to more stable growth counter-parts.  What this means is that the model is apt to continue over-estimating fair value until growth stocks rotate back into favor (which is now beginning).

It’s also interesting to note that financials have made up a large and growing percentage of the index’s total earnings over the past 4 years – but haven’t been rewarded for these earnings.  Look at any money center bank one or two years back and they were being valued at 10-13 times earnings, a much lower valuation than in times past.  Could it be that in aggregate the market was already pricing in, or anticipating, that these earnings weren’t sustainable?

So, while we aren’t wedded to our quantitative model, we can and do gain insights by what it shows us on a quarterly basis.

When compared with 10-year U.S. treasury yields, corporate earnings yields confirm investor skepticism, as stock investors continue to demand a healthy premium to bonds in order to take on stock market risk. 

Corporate earnings of the stocks that make up the S&P 500 continue to grow at rates above that of their respective stock prices, further boosting “fair value” for the S&P 500 index over the intermediate term, based on our quantitative valuation model.  In fact, at present fair value remains more than 50% higher than the index’s current price of 1526.

Even given the fact that corporate profit margins remain at historically wide levels, the disparity between our model and the market’s current trading range suggest that investor hesitancy remains a strong head-wind for stock prices. 

There are two ways in which the discrepancy between current stock levels and our fair value estimate can come back in line.  Clearly the market could rally sharply to make up the difference.  As noted above, it would take an immediate spike of better than 50% to close the gap, or a move of better than 70% over the coming year, given today’s expectations for one-year forward earnings levels. 

Second, corporate profit’s could either stagnate, or outright fall.  Either of these scenarios would likely be caused by increasing employee wages & benefits and/or supply costs that can’t be passed onto buyers – thus negatively impacting profit margins.

In our opinion, the resolution will likely be a combination of higher stock prices, coupled with tighter profit margins.  Supporting this view, the September employment report released on October 5^th, points to a tight labor market (unemployment rate of 4.7%) and moderately rising wages (0.4% month-over-month).

When compared with 10-year U.S. treasury yields, corporate earnings yields confirm investor skepticism, as stock investors continue to demand a healthy premium to bonds in order to take on stock market risk.  As we’ve noted in previous valuation write-ups, a sea-change in stock-market risk-premium occurred late in 2002 as value stocks began to significantly out-perform their growth counter-parts. As growth continues to rotate back into favor it will be interesting to see whether, and to what extent, this risk premium is removed.

With S&P 500 earnings continuing to grow at double-digit rates, though at a slowing pace, our valuation model continues to point to considerably more upside in the market at the start of Q3-2007.

Profit margins remain quite wide, at close to record levels, as companies have only reluctantly increased capital spending.  Instead management teams in all sectors have been deploying capital through increased dividends and stock buybacks – both which should continue to support share prices.  Bearish interpretation is that today’s near-record profit margins are unsustainable and that long-term profit margins of roughly 40% lower are just a matter of time.  In this case, today’s P/E ratios would look substantially under-stated.

With interest rates beginning to drift upwards, the spread between 10-year treasury rates and stock earnings/price ratios tightened moderately over the quarter.  Still, with earnings yields superior to treasury yields, and corporate bond spreads at extremely tight levels, opportunities remain for private equity investors to initiate corporate buyouts – and these transactions have been frequent and well-received by the broad market.  As private equity firms race to go public, look for buyout opportunities to remain at a heightened level.

Based on our work, fair value for the S&P 500 currently remains 55% higher than current index levels – suggesting ample upside for today’s investors.  Recognize that as of today, earnings for the S&P 500 index are roughly 57% higher than at their highest level in 2000.  Since its peak in early 2000, the index itself has risen a mere 0.3%.  From this perspective investor enthusiasm has remained in check throughout this market rally.

Assuming earnings come in as currently expected by Wall Street analysts over the next year, fair valuation 1-year forward would be roughly 69% higher than current levels.

Nothing new to report on the stock valuation front – as S&P earnings continue to expand at a robust clip, our valuation model remains pegged to a very under-valued reading.  According to our work, fair value resides some 60% higher.

There are a number of reasons why our model may be flawed and we’ve expended a good deal of time writing about them in the past.  But let’s run through them quickly:

1)      Operating earnings provide a warped sense of reality.  They’re easy to manipulate and susceptible to management tinkering.  Possibly, but then so are net earnings.  And of the different shades of earnings we’ve explored, the fact remains that over the past 18 years, historical operating earnings, lagged one month prove the best predictor of stock market returns going forward.

2)      Unusually high profit margins are apt to disappear over the long-term.  OK, we’ll buy that.  Let’s say profit margins move from an unsustainable 8.5-9% of revenues to a historically appropriate 6% of revenues.  That would imply that pre-tax earnings would fall 30%.  In that case, fair value would be about 1525 based on this model.  So perhaps the market is pricing in the fact that today’s profit margins are un-sustainable.

3)      Low interest rates are being biased downward by exogenous factors.  Again perhaps, but our model doesn’t take interest rates into account.  We’ve looked at interest rates, but found little in the way of additional explanability.

4)      Too short of time frame for reliable results.  Again, perhaps we’d find “better” results through a more robust data set (By “better” I mean more consistent and easier to accept).  Clearly there is a historical precedence of lower multiples.  But there are also strong arguments to be made against lower multiples.  One? The demographics of the United States have changed - an aging population with more responsibility for retirement savings simply skews the investment landscape to favor sellers over buyers.

Of the points noted above, we’re most apt to believe that the market is discounting a return to historical profit margins.  We’ll need to look into historical profit margins a bit more.

The spread between the S&P 500 earnings yield and 10 year treasuries remains close to 20 year highs.  From a statistical perspective that’s interesting and supports the idea that markets are under-valued.  But from a practical perspective it’s more than interesting - it’s actionable.  And private equity firms have been the ones taking action.  They’re been plenty busy taking companies private over the past two years and it’s likely they’ll continue to do so as long as their cost of capital remains lower than corporate earnings yields.

So, from a quantitative perspective, we find ourselves remaining uncomfortably in the bullish camp at this juncture, with a buy signal on the market and expectations for further support from private equity buyers.

It’s no wonder many investors have been lagging the indices badly in this market – as others have noted, the move has been extremely concentrated favoring the largest large-caps over pretty much everything else.  So, what's behind the big move and does it make sense to join the party?

From Birinyi Associates Ticker Sense, via the Wall Street Journal: 

“The third quarter enjoyed a good, but narrow, advance. The S&P 500 rose 5.7%, but Birinyi analysts point out that half that gain came from 13 stocks, making picking winners critical.”

Source: Wall Street Journal (MarketBeat: 10/12/06)

Our own analysis of the Russell 3000 3rd quarter capitalization sector returns turned up the following:

If you weren’t invested in the top 50 stocks, it’s likely you under-performed the broad market.  So don’t feel too bad if you’ve been trailing the market’s advances.  You’re not alone.

What’s driving this move?  A couple of thoughts:

A slowing economy generally favors large-caps.  Any way you slice it, the economy is showing signs of slowing, precipitated by declining housing activity on the consumer side and restrained capital spending on the corporate side.

In the late 1990’s prior to the last two market corrections in1998 and 2000, small-caps peaked ahead of large caps.  In 1998 small caps led large caps by three months, in 2000 by more than five.  More interestingly, for each capitalization sector, value stocks each peaked ahead of their growth counterparts by between 10 months (mid-caps), and 23 months (small-caps). 

So, as the economy begins to slow, market participants rotate out of more speculative small caps into larger offerings believing that these company’s earnings should be more resilient to a slowdown.  Additionally, a rotation from value to growth often occurs, as in a slowing economy, investors tend to “bid up” companies with a proven ability to deliver consistent earnings growth.

Lower oil and commodity prices coupled with lower bond yields.  The argument made is that all else being equal, lower oil and commodity prices, reduce inflation and free up money that would otherwise be spent on necessities for additional consumer discretionary spending.  They act like a tax cut – spurring the economy over the short-run. 

On the bond side, lower bond yields imply lower expected returns for bondholders in the future, inducing operating companies to undertake more speculative capital projects and investors to risk a larger portion of their capital into the stock market.

For investors, large cap stocks, due to their deep liquidity, often represent the most frictionless way to re-deploy assets efficiently.

That said there is an equally valid argument in the bearish camp which postulates that the rapid deterioration in commodity prices coupled with a prolonged inverted yield curve signal that the economy is in for a noticeable slowdown in the not-too-distant future.  Professor Nouriel Roubini of the New York University School of business argues this case extensively in his global economics blog.

Fast capital and the search for returns.  In our opinion, one simple reason for the dramatic sell-off in commodities coupled with a “melt-up” in large cap stocks the past few months, though rarely discussed and hard to quantify, is the market impact of hedge funds, proprietary trading desks and other “fast capital”. 

It’s no secret that hedge funds have proliferated over the past decade and with estimates of over 8,000 individual funds controlling up to $1.3 trillion in assets, the group has become the marginal buyer and seller for a wide variety of assets.  Increasing competition, leverage, and monthly performance reporting all promote a bias towards short-term trading over long-term investing. 

Momentum strategies, which key off the assumption of “what has worked in the past should continue to work going forward”, have performed well over the past few years signaling opportunities in small caps, emerging markets and the natural resources sectors that more than a few hedge funds have enjoyed. Furthermore, futures markets for many of the energy, minerals and metals complex commodities have facilitated leverage as well as frictionless entry and exit.

In contast, U.S. large caps have been dormant for the past two years, though analysts have been calling for their rebound for at least the past three!  Returns for the largest 200 stocks in the Russell 3000 in 2004 and 2005 were 8.3% and 3.8% respectively - lagging the broader market roughly 3% per year and small caps by 10% annually.

In our opinion, the breakdown in natural resources, emerging markets, and small caps occurring soon after the Fed signaled a pause in their interest rate increases, isn’t co-incidental.  It’s the result of a race for the exits from speculative sectors by the fast money crowd, regardless of fundamentals.  Still, they have to put that money to work, and what better than the sector of choice in a maturing market.

A point to consider – if the demand for commodities were truly waning, would the commodities under-represented in the futures market, namely the CRB Spot Index, be testing all-time highs?

We're skeptical of the longevity of this large-cap move, believing it to be more technical than fundamentally motivated.  Somehow we just can't bring ourselves to delve into stocks such as GM, Verizon and Boeing given their weak stories (in the case of GM and Verizon) or the multiples they command (Boeing).  That said, momentum-driven rallies can last for quite awhile, and with the end of the year approaching it wouldn't be suprising to see quite a bit more buying before the fat lady sings.

The quantitative valuation model we use to assess fair value for the S&P 500 index remains solidly in “buy” territory again this quarter suggesting that the index is more than 55% under-valued based on trailing operating earnings.

Last quarter we discussed our thoughts on why the model might be over-estimating fair value at this stage of the economic expansion, and why it might not be as good of predictor in a market whose earnings have been so strongly driven by a few key cyclical industries.  Our thoughts haven’t changed, but work by John Hussman points to another idea which may be of relevance.  His research shows that operating earnings margins, currently at an all-time high, aren’t sustainable over the full market cycle.  While historic operating earnings, which we use to drive our model, market participants, in aggregate, may be imbedding a risk-premium into stock prices to account for this.

From the perspective of operating earnings yields versus treasury bond yields, stocks remain attractive as well in our opinion.  Specifically, investors are getting paid roughly 2% more per annum for bearing stock market risk.  Over the past quarter, the effects of lower bond yields have more than offset the appreciation in the stock market and the growth in earnings delivered by the S&P 500 companies.

For now, our “buy” rating stays in place, though our confidence in it remains low.

The Terrain Just Got More Challenging

Our quantitative model that uses historic results over the past 17 years to signal the relative attractiveness of the broad U.S. market remains solidly in “buy territory”, yet it has clearly broken down.  Given the rise in operating earnings over the past four years we would expect the S&P 500 to trade between 1800 to 2150, some 45-70% higher than current levels.

What has led to the model’s recent loss of explanatory power is the change in earnings leadership over the past 3 years.  S&P 500 earnings have been growing at a rate of better than 15% but the only sectors to achieve superior earnings growth have been energy, industrials, basic materials and information technology.  All but information technology are considered “cyclical industries” that are perceived as realizing explosive earnings growth in the early stages of a recovery but less dynamic profitability as the recovery ages. 

Because of their expected earnings variability, investors have traditionally penalized cyclicals with lower price/earnings ratios than alternative industries.  While technology concerns may trade at P/E ratios of 20 or more, most cyclicals languish between 8 and 12 – even with earnings growth of 20-30%.

The table above makes our case.  Growth in the S&P 500 has been strongest within the cyclical industries (highlighted in blue).  Analysts expect a slowdown in these industry’s earnings growth rates in 2007.  Even with a strong multi-year advance in the price of cyclical shares, both P/E and P/E to Growth ratios for these industries remain lower than alternatives.

At the end of 2003, cyclical industries made up about 20% of the S&P 500 based on market capitalization.  Yet from 2004 through today they’ve contributed a full 45% of the entire earnings growth of the S&P 500.  While cyclical shares have been well-rewarded over the past few years, they still comprise just 25% of the S&P 500.  The interesting point, and what has caused our model to falter, is that strong relative performance of cyclical shares actually drive the P/E ratio of the entire index down, not up. 

Our model is not unique.  In fact, many Wall Street firms use similar gauges to estimate the attractiveness of the overall market and most continue to point to the market’s being undervalued by 20%+.  We’d suspect they’re suffering from the same phenomenon. Until earnings growth becomes more uniform across sectors, we’d expect most quantitative valuation models to perform poorly.

While we’re highly skeptical of the signals currently being sent by our model, we’ll continue to publish the results.  As always, we advise against using the model’s assessments as stand-alone short-term trading indicators however, especially in the current environment.