Bearish News

Guest Post: Grey Owl Capital Management’s Q4 2009 investment letter. A good read, especially the sections on market valuations.

“Anyone who isn’t really confused doesn’t understand the situation”
-Edward R. Morrow

Reports concerning unemployment and housing show economic conditions continued to worsen in the fourth quarter. While corporate profits (as measured by the S&P 500) have improved from the significant losses of -$23.25/share reported in the fourth quarter of 2008, they are nowhere near their peak annual rate of $85/share experienced between the third quarter of 2006 and the second quarter of 2007. Importantly, much of this improvement can be attributed to financial firms which, while repaying TARP funds, are at the same time receiving another (lightly-disguised) subsidy as they borrow from the government at a Fed Funds rate under 25bps and lend that money right back to the government at close to 4%. Yet, “the market” (the S&P 500 is at 1140 as we write) is up over 70% from its 666 March low.

The cover of last week’s Economist read “Bubble warning” and we could not agree more. By our estimation, the S&P 500 is now 20-30% overvalued. However, with a no-end-in-sight loose monetary policy this rally could continue for quite some time. We will spend the rest of this letter discussing our process for investing in this climate. First, a review of our performance compared to investable options for the major market indices:

Our overall investment process is quite simple . We spend most of our time looking at individual investment ideas trying to find five to seven ideas each year that meet very specific criteria. For us to invest your capital (and ours), we need to believe that the idea has a very low probability of losing money and multiple ways (depending on how the uncertain future evolves) of providing a better-than-market return over a several-year time period. Given our generalist approach (we do not focus on a single sector or market cap), we are able to be very meticulous and look at lots and lots of ideas before committing to one. In other words, we can wait for the “fat pitch” Warren Buffet so frequently discusses. We then try to build a portfolio that diversifies factor risks. That is, we try to build a portfolio that diversifies exposure to changes in inflation or consumer behavior or global trade, etc.

In a “normal” environment, our approach works fine. Today, there are two (somewhat related) forces, exogenous to the above process, that create complications. The first concerns the structure of the overall economy. It is unclear how the significant national debt, increased government involvement in the economy, and unorthodox monetary policy will broadly affect corporate profits and real (after subtracting inflation) returns. Second, most valuation approaches conclude that equities are overvalued. Additionally, we have yet to experience a real “revulsion” bottom in the current market cycle – investors have yet to “give up” on equities, a behavior that typically marks market troughs. Therefore, we are concerned that even if we make investments that we believe are undervalued, they may be subject to a broad re-pricing lower along with the rest of the market. While their intrinsic value may remain sound (or even grow), these investments could get cheaper during a broad market correction. Our last two letters addressed point one – the economic issues – in depth. Please refer to these letters for more on that topic . In this letter, we will briefly touch on valuation and then describe a thought exercise that helps us frame the key issue we now face: how much capital do we invest in opportunities we believe are cheap today and how much dry powder do we keep available for potentially cheaper opportunities that the market may afford us in the future?

Current Market Valuation

Valuing a broad market index like the S&P 500 is actually straightforward. One way to approach the process is to work backwards from the return investors expect. The return from owning equities can only come from three places: 1) earnings growth, 2) dividends, and 3) re-pricing (i.e. a change in the earnings multiple – price-to-earnings or PE ratio) .

Since 1900, earnings growth has averaged 6% nominal (i.e. including inflation). If we expect a return greater than 6%, we will need either a dividend yield that makes up the difference or a re-pricing higher. Over this same period from 1900, the forward PE ratio on the S&P 500 has averaged 14. With a 50% dividend payout , this has allowed for the close-to-10% average returns most investors equate with equities. The return from 1982 through the end of 2009 was higher than 10% because the market started from a PE ratio of 86. The return since 1999 was well worse than 10% (actually negative) because the market started from a PE ratio of 30.5 .

As of this writing, Standard & Poor’s lists expected “as reported” (i.e. GAAP) earnings for 2010 at $58.71. This equates to a forward PE ratio of 19.4. The dividend yield on the S&P 500 is currently just under 2%. We believe “fair value” is closer to the historic average PE ratio of 14 and a dividend yield closer to 4% as this is the only way a broad market index can provide investors with the return they have consistently required for holding risky equities.

There are only two strong arguments for higher valuations. The first argument is that we are experiencing an economic shift to sustainably higher corporate profit margins and/or profit growth. Profit margins have been mean reverting over long periods. Basic economics provides the rationale. Excessively high profit margins engender competition, which eventually drives profit margins down. The second argument for higher valuations is that investors have permanently changed their expected return for holding risky equities. Like the mean reverting profit margins, the mean reverting earnings multiple over very long periods tells us this is unlikely. Those two arguments notwithstanding, we believe the stock market is 20-30% overvalued.

Three well-regarded investors, who (like us) warned of pending doom well before the recent credit crisis and market correction, agree with us again. John Hussman of the Hussman Funds says the S&P 500 is currently priced to deliver total returns averaging just 6.1% over the coming decade. Jeremy Grantham of GMO believes fair value on the S&P 500 is 860. David Rosenberg of Gluskin Sheff says the market is 25% overvalued. So what is a value investor to do?

Buy 80-cent dollars or wait for 50-cent dollars?

In investor parlance, we refer to a security that we believe trades at 80% of fair value as an “80-cent dollar.” Likewise, an investment that trades at 50% of fair value is a “50-cent dollar.” With the market 20-30% overvalued, through our research process we are able to identify a sufficient number of 80-cent dollars but few 50-cent dollars. This leads us to the question: do we buy the 80-cent dollars or wait for 50-cent dollars?

If we assume that an 80-cent dollar will accrete to fair value over a three-year period, we can expect an 80-cent dollar to provide us with a 7.7% annualized return . A 50-cent dollar that accretes to fair value over a three-year period would provide a 26% annualized return. The question then becomes, how long can we wait for the 50-cent dollar so that our average return over a longer period improves from waiting. It turns out that in this simple construct, we can wait six years making no investments, then buy 50-cent dollars that take three years to accrete to fair value and still achieve an annualized return over the full nine-year period of 8%. This modestly beats the alternative, which is three consecutive rounds of buying 80-cent dollars and allowing them to accrete to fair value over three years.

Unfortunately, the real world is more complicated than the above scenario. If we remove the simplifying assumption and include increases in intrinsic value, the 80-cent dollars look a lot better. After all, not only do we have two extra rounds of 80-cent dollars accreting to fair value, we also have six extra years of increases in intrinsic value. Additionally, we have no way to gauge if or when the overall market will correct and present us with 50-cent dollars.

Fortunately, we can again look to history for guidance.

Range-bound Markets

Two hundred years of US stock market history paints a remarkably consistent picture of (approximately) twenty-year bull markets followed by (approximately) twenty-year sideways or “range-bound” markets. We would contend that we are ten years into a sideways market.

Investment manager and author, Viataliy Katsenelson, describes range-bound markets this way, “range-bound markets are the bear markets of price-earnings (P/E) ratios (they decline), whereas bear markets are the bear markets of P/Es and earnings (they both decline). Range-bound markets are so-called payback markets – investors are paying back in declining P/Es for the excess returns of the preceding bull market.” Importantly for our above analysis, he demonstrates that range-bound markets have shown significant volatility and approximately as much downside volatility as upside volatility.

Thus, if history were any guide, we would expect the next several years to provide sufficient (downside) market volatility, which will allow us to increase our exposure to equities when more 50-cent dollars are available. As these securities recover to fair value, we will again tune our equity exposure based on the overall market’s level and the availability of new 50-cent dollars. Ideally, we will repeat this process until PEs decrease to well below their historic average of 14.

There is one caveat to the range-bound market theory. In past letters, we have discussed the potential for inflation (or at least a very unstable monetary unit of account) given the dramatic recent Federal Reserve actions, as well as the significant (and ongoing) increase(s) in the federal debt. We also described the historic correlation between inflation (documented by Crestmont Research) and inflation volatility (documented by William Hester of Hussman Funds) and shrinking earnings multiples (PEs). They show that multiples have expanded during periods of low and stable inflation and multiples have contracted during periods of high and volatile inflation. If inflation and/or inflation volatility is a necessary requirement for multiple contraction, we must consider the possibility that the Federal Reserve will be able to keep the value of the dollar stable, thus managing inflation and allowing the stock market to keep its elevated multiple for another cycle.

Katsenelson’s analysis makes a broader argument for multiple contraction based on human psychology: “They [range-bound markets] follow [bull markets] because excess optimism feeds on itself and drives stock market valuation to one extreme, and then unmet expectations turn into disappointment, driving stock valuations to the opposite extreme. Long excesses require lengthy corrections.” There just are not enough data points to provide us conviction that Katsenelson’s broader explanation is sufficient nor to show that inflation is necessary to create a range-bound market. Both explanations are possible.

Therefore, we choose to make decisions based on a range of outcomes. In other words, in today’s market we will buy some 80-cent dollars, but also leave some dry powder for the 50-cent dollars we expect (but are not certain) will appear. This will allow us to protect capital and provide the opportunity for satisfactory gains if we (and history) are wrong. It will also provide the opportunity for substantial gains if we (and history) are right. As the opening quote from Edward R. Murrow warns, there are no clear paths, only probabilities and ranges of outcomes. We aim to be prepared whatever future unfolds.

As always, if you have any thoughts regarding the above ideas or your specific portfolio that you would like to discuss, please feel free to call us at 1-888-GREY-OWL.

Visit Grey Owl Capital for more. Republished with permission. You can find their disclosure statement here.

Home sales often dip in December, but 2009′s finish was especially nasty. The first-time homebuyer credit was scheduled to expire at the end of November (almost nobody believed that was gonna happen). That explains some of the drop — as demand was pulled forward — but 16% is ugly no matter how you spin it.

Here’s the NAR’s spin-job for any who are interested. I honestly feel for them, tasked with finding the silver lining in this dismal RE market.

Chart via Rolfe Winkler.

Guest post by Mac of SHTFplan.com

There’s a lot of buzz hitting the contrarian financial news circles around the web regarding recent market weakness and the possibility for the end of the rally which began in March of 2009.

Many contrarian investors have been waiting for the crash that is inevitably to follow the largest US market rally in modern history, and this may be it. We caution our readers, however, that over the last year there have been various false signals, and rather than seeing a crash in the Summer of 2009 or Fall of 2009, stock markets continued to push up, despite abysmal economic fundamentals.

Is it the real thing this time?

Bert Dohmen, publisher of the Wellington Letter, says “This is the time for the bears to make money. Sell short any rally attempts.”

Dohmen, who suggested in December 2009 that early January would see a continued rise in stocks, anticipated a down-turn in late January. In his most recent letter, dispatched to subscribers January 21, 2010, Dohmen says that we can forget about the theory that “hyperinflation is right around the corner,” and that deflation and debt implosion is the major problem:

“Market analysts expect 2010 to see a rise in corporate earnings and sales. They are probably correct. But that will be met by further market weakness. You see, that’s what the stock rise of the prior 10 months was all about. Stocks are already priced for the best news that could possibly develop this year. When all the fund managers are positioned for this “good news,” there is no further money to go in. And that’s when the selling gets serious.

The recent news out of China is just what we have been warning about: tighter lending and monetary policies! Economic growth in the last quarter was a blistering 10.7% (officially), which obviously creates worries about inflation. Tighter money dampens speculative fever. And all the sins of the speculative bubble of 2009 will surface.

As a result, the US dollar is now in demand and is soaring. That kills the most important reasons for buying commodities. The dollar rally will be a lot stronger than even the few dollar bulls imagine. There will be a massive rush to close out short positions.”

In our earlier post this morning, Chinese Fed Shuts Down Lending, Capital Flees to Dollar, we suggested that the pullback in Chinese bank lending and stimulus, may force capital speculating in Asian stocks back to safety in the US Dollar. Dohmen seems to agree with this assessment.

J Derek Blain, of Investopedia, also thinks the stock markets may be turning. His view is that not only will the dollar rebound, but we will see equities prices, commodities, and precious metals turn to the down-side in the near term, as more capital flows into the US Dollar. Blain is quite bearish on short-term precious metals prices, so if you haven’t stocked up on gold and silver, perhaps you’ll have yet another opportunity in the near future because Blain says The Big One Could Finally Be Here:

“But here’s the interesting thing – finally, after 5 weeks of watching gold top and begin its bear market decline, and the major stock indexes make new highs, we might have just witnessed the turning point in all “risk assets”.

And that is really one of the keys, and one thing we have been saying for several months now.   Whenever the precious metals are treated as risk assets for the purposes of capital gains, they are not in a bull market but in a false rally.  The psychology that drives this sort of rally is hope-based, completely mood-driven, and ultimately comes unwound like the thread in a poorly knit sweater.

What we are looking for, here at Investophoria, is despair.  Until we see such a thing in the precious metals we cannot recommend buying them.  If we did without it, we would be advising you to get in line and be “the sucker” who is willing to pay a higher price.”

—

“The next leg down in both gold and silver should be very fast and will take many more by surprise who have run to them seeking to make back the losses they sustained in stocks in the last bear-market leg.”

If the global stock markets start to pull back, gold and silver are going with them. While gold is a safe haven asset in times of distress, it is important to note that the broader picture for the time being is that gold has not decoupled from the stock market in general and remains closely tied to the inverse movement of the US Dollar, as was evidenced by gold’s reaction to the Dubai stock market collapse in November 2009.

For traders (not investors) looking to make short term profits, precious metals are just as dangerous as the stock market right now. If you are a long-term precious metals investor, turn off the news and stop watching daily price movement in precious metals, you should be fine when gold does finally decouple from other assets and becomes a safety asset, not because of inflationary fears, but because instability in the public (government) sector.

When this will happen is anybody’s guess, but there should be a floor for gold, because as the price collapses, it will become attractive for large buyers, especially central banks in China, India and Russia. So, there really is no need to run out and sell all your gold bullion to Cash4Gold at 60% less than it is worth. The longer trend for gold is still entact.

The dollar seems to be the beneficiary of recent market mini-panics, as evidenced by corrections in US markets last year, Dubai and now the shift in capital out of Chinese assets.

How can this be, you ask? Isn’t the dollar supposed to be on an unstoppable collapse to a value of exactly zero? Well, yes, it is on a collapse trajectory, but it is important to note that this will not happen in one fell swoop. There are gyrations in the markets, and since the US Dollar remains the world’s reserve currency, regardless of talk from Russia and China, this is where the money will go when everything else is collapsing. We strongly believe that this trend will eventually end and the ultimate safety asset class will become precious metals, but in a paper world, when the SHTF, capital flees to the safest paper around, which ironically, is the US Dollar.

Considering that the US Treasury needs to fund roughly $1.5 Trillion in new debt via Treasury sales in 2010, a global stock market collapse could be the US government’s saving grace, as Graham Summers recently pointed out:

“So how do you create interest? [In US Treasuries]

Simple, let the stock market collapse. The “flight to safety” that would follow would push billions if not hundreds of billions of dollars into Treasuries, soaking up the debt issuance and roll-over with little difficulty.”

It sounds mad scientist sinister, but quite realistic when you give it the consideration it deserves. The Fed, Treasury, Congress and the administrations have continually taken ridiculous, if not criminal, actions over the last several years. What’s to stop them now? It’s really a quite simple plan – pull back on stimulus in the US and China, have the big investment banks rip their profits out of equities and shift into US Treasuries, and leave panicked investors who thought the economic recovery was sustainable scrambling for the exits.

Theoretically, this all sounds quite feasible, but how are we looking from a technical perspective? Tyler Durden of Zero Hedge weighs in on the argument for the dollar:

“The DXY is about to break the 78.449 high last achieved on December 22: at 78.320 we are very close. Greece is helping. When that resistance is breached, look for Europe to start panicking and also all those who still have the dollar short trade on to start rushing through the exits.”

Though it may still be too early to tell, the technical signals suggest that the ingredients for a crash seem to be in place and conditions for a serious down-turn are now more likely than anytime in the last ten months.

Thanks to Mac Slavo of SHTFplan.com for the submission.

After a short dip, this ratio is on the rise again. So while there may have been less firing in December, the hiring hasn’t materialized yet.  Via Econompic.