Bailouts, bailouts and more bailouts. How much money is getting pumped into the economy? Trillions and trillions. (I'll try to find some good numbers on this.) Will this result in more inflation? Absolutely.
When? Ah, there's the hard part. For now, inflation is still the biggest risk as the price of everything from oil to plasma TVs is collapsing.
In the meantime, what should we do about it? Well, TIPS (Treasury Inflation Protected Securities) are the traditional way of protecting a fixed-income portfolio from inflation. Now, Treasury yields are at historic lows, so this probably isn't a good time to buy, but let's run the numbers now and then keep an eye out when things turn. (How bad of a time is it to buy Treasuries? The government recently auctioned some Treasury bills for 0%. That's right, zero. People were actually ready to pay the government to look after their money.)
TIPS pay interest every six months. The catch is, every six months, the government adjusts up the principal value of the debt based on the CPI. So although TIPS will yield a fixed interest rate, the principal amount will change based on inflation. So far so good.
Now, when is a good time to buy? Well, 10-years TIPS are yielding about 2.4%. Meanwhile, the regular 10-year Treasury bond is yielding 2.65%. We can't directly calculate that expected inflation is only 0.25%, but, we can safely say that the market is expecting inflation over the next ten years to be less than 1%. That I don't believe, and therefore wouldn't be a buyer of TIPS right now (or of Treasuries, for that matter).
Now if I were a hedge fund, I'd think about buying TIPS and shorting Treasuries, or just shorting Treasuries outright. I'm not a hedge fund guy, and I won't, but it's an interesting thought. But for now, it's time to sit tight.
Tuesday, December 9, 2008
Tuesday, December 2, 2008
Profits and GDP
Another interesting barometer of the market is what percentage corporate profits make up of total GDP. In a nutshell, when corporate profits are too high above the long-term average, look out.
The BEA (Bureau of Economic Analysis, part of the Department of Commerce) publishes both GDP and corporate profit statistics. A long-term chart of corporate profits/GDP shows the ratio at about 5% during the bad times, and around 6% during the good times. (For a good long-term chart, look at PIMCO's February 2007 Investment Outlook by Bill Gross.)
How about recent history? Well, profits/GDP ranged between 5%-6% from 1998-2002. Then things got out of line - 7.7% in 2004, all the way to over 10% in 2006 and 2007. (These figures from the BEA website, http://www.bea.gov/national/index.htm.)What did this mean to astute observers? (And I don't count myself as one, because I didn't realize this until after the crash!) Corporate profits were too high, were unsustainable, and had to fall - by as much as 50%, in order to return to historical norms. Ouch!
(As an aside, if we did some further math, we could probably have calculated that the excess corporate profits came from low interest rates and too much debt.) The moral of the story - watch the corporate profits/GDP ratio, and when it gets out of line, be careful.
The BEA (Bureau of Economic Analysis, part of the Department of Commerce) publishes both GDP and corporate profit statistics. A long-term chart of corporate profits/GDP shows the ratio at about 5% during the bad times, and around 6% during the good times. (For a good long-term chart, look at PIMCO's February 2007 Investment Outlook by Bill Gross.)
How about recent history? Well, profits/GDP ranged between 5%-6% from 1998-2002. Then things got out of line - 7.7% in 2004, all the way to over 10% in 2006 and 2007. (These figures from the BEA website, http://www.bea.gov/national/index.htm.)What did this mean to astute observers? (And I don't count myself as one, because I didn't realize this until after the crash!) Corporate profits were too high, were unsustainable, and had to fall - by as much as 50%, in order to return to historical norms. Ouch!
(As an aside, if we did some further math, we could probably have calculated that the excess corporate profits came from low interest rates and too much debt.) The moral of the story - watch the corporate profits/GDP ratio, and when it gets out of line, be careful.
Monday, December 1, 2008
Other valuation indicators
Today, a few other old-school but useful metrics for whether it's a good time to buy.
Corporate yield spreads: At the lowest, Baa corporate bonds were trading only 150 basis points over 10 year Treasuries. (Data from Bloomberg: .BAA10Y INDEX GP) They've shot up to 500 basis points now, going from extreme optimism to extreme pessimism. What does this tell us? That market is way out of whack - no surprise.
U.S. Treasury TIPS give us a sense of inflation expectations - right now they've plunged off a cliff, from pricing in ~2.5% inflation down to ~1%. (Data also from Bloomberg: USGGBE10 INDEX GP)
Another oldie but goodie: comparing dividend yields with the 10-year government bond rate. The 10-year government bond rate is 2.7% according to the Wall Street Journal - very low - while the dividend yield on the S&P 500 is 3.4%. (The 2008 expected dividend is $28.05, according to S&P's "S&P 500 Payers vs. Non-Payers" table. Dividing that into the 12/1/08 closing price of 816 gives us the 3.4% yield.) This is a return to a very long time ago, when the dividend yield on stocks was higher than interest rates due to the risks associated with stocks. Of course this was long forgotten in the 80s, 90s, and post-2000 in the long boom, but the fact that we're back here is telling indeed - the market is expecting a very, very, very bad ten years.
Corporate yield spreads: At the lowest, Baa corporate bonds were trading only 150 basis points over 10 year Treasuries. (Data from Bloomberg: .BAA10Y INDEX GP) They've shot up to 500 basis points now, going from extreme optimism to extreme pessimism. What does this tell us? That market is way out of whack - no surprise.
U.S. Treasury TIPS give us a sense of inflation expectations - right now they've plunged off a cliff, from pricing in ~2.5% inflation down to ~1%. (Data also from Bloomberg: USGGBE10 INDEX GP)
Another oldie but goodie: comparing dividend yields with the 10-year government bond rate. The 10-year government bond rate is 2.7% according to the Wall Street Journal - very low - while the dividend yield on the S&P 500 is 3.4%. (The 2008 expected dividend is $28.05, according to S&P's "S&P 500 Payers vs. Non-Payers" table. Dividing that into the 12/1/08 closing price of 816 gives us the 3.4% yield.) This is a return to a very long time ago, when the dividend yield on stocks was higher than interest rates due to the risks associated with stocks. Of course this was long forgotten in the 80s, 90s, and post-2000 in the long boom, but the fact that we're back here is telling indeed - the market is expecting a very, very, very bad ten years.
Saturday, November 29, 2008
How crazy was real estate?
Just how big was the real estate bubble? Unprecedently big.
As we discussed in prior posts, low interest rates and high overseas savings led to a credit-and-debt bubble, which fed the mortgage markets and, in turn, real estate prices.
Robert Shiller, author of "Irrational Exuberance," developed the now widely used Case-Shiller home price index. Looking at his numbers, the ridiculous heights the bubble reached become obvious. (They're available at standardandpoors.com, at the somewhat ridiculous URL http://www2.standardandpoors.com/portal/site/sp/en/us/page.topic/indices_csmahp/0,0,0,0,0,0,0,0,0,1,1,0,0,0,0,0.html.)
Here are some charts based on his indexes (now owned and published by Standard and Poor's.)
The chart above show home prices from 1987 to September 2008 (ten city index). As you can see, home prices from 2000 onward (after Greenspan lowered rates to fight the 2000-2001 recession), were way out of line from the historical trend. That just sounds too depressing though...let's take the (very) optimistic assumption that the 1990s were a bad time for home prices, and that the 2000 level was the "right level." Here's the chart below.
What does this chart tell us? Well, for one thing, home prices were still way out of whack recently. The National Association of Realtors tells us that U.S. median sales price of existing single-family homes peaked at about $220,000 in 2006. (Data available here: http://www.realtor.org/research/research/ehsdata). Remember the guideline that home prices should be about 3 times a family's income? Well, the median household income was about $50,000 in the 2006-2007 time period (Data available from the U.S. Census Bureau at http://www.census.gov/hhes/www/income/incomestats.html.) So, home prices were over 4 times the average household's income - no wonder homes were unaffordable!
The big question now of course is, where are home prices going? Well, to reach the 3x level of affordability, home prices would have to drop to $150,000, a further 18% drop from the $183,000 level calculated by the National Association of Realtors for October 2008. Using the Case-Shiller indexes, it depends on your interpretation. I personally don't expect home prices to drop all the way to their historical averages - it would be too painful (and, we should build in a "natural" rate of home appreciation that includes inflation). Rather, I'd expect them to bottom out somewhere slightly above the historical average, and then inflation would eat away the remaining ~10% of home values. So, given an index value of 173 (10-city index) in September 2007, a fall to index values of 130-150 would imply anywhere from a 15%-25% further decline in home prices.
So in a nutshell, the news is really bad. #1: Home prices are not done dropping. #2: Even when they bottom out, they're likely to be above the historical average. #3: They're unlikely to bounce back once they've bottomed out. And as a corollary, all the talk of stabilizing home prices buy having Treasury but mortgage-backed securities doesn't make any senese - home prices need to be lower, and trying to prop them up is only delaying the inevitable. Yes, we should try to make mortgages available once again; yes, we should try to help consumers at risk of foreclosure re-negotiate loan terms; and yes, we should try to bail out banks with bad mortgages so our financial system doesn't melt down.
But, we should be aware that home prices have to fall further to reach a sensible point (i.e. historical affordability ratios), and that the road ahead will be very, very painful.
As we discussed in prior posts, low interest rates and high overseas savings led to a credit-and-debt bubble, which fed the mortgage markets and, in turn, real estate prices.
Robert Shiller, author of "Irrational Exuberance," developed the now widely used Case-Shiller home price index. Looking at his numbers, the ridiculous heights the bubble reached become obvious. (They're available at standardandpoors.com, at the somewhat ridiculous URL http://www2.standardandpoors.com/portal/site/sp/en/us/page.topic/indices_csmahp/0,0,0,0,0,0,0,0,0,1,1,0,0,0,0,0.html.)
Here are some charts based on his indexes (now owned and published by Standard and Poor's.)
The chart above show home prices from 1987 to September 2008 (ten city index). As you can see, home prices from 2000 onward (after Greenspan lowered rates to fight the 2000-2001 recession), were way out of line from the historical trend. That just sounds too depressing though...let's take the (very) optimistic assumption that the 1990s were a bad time for home prices, and that the 2000 level was the "right level." Here's the chart below.
What does this chart tell us? Well, for one thing, home prices were still way out of whack recently. The National Association of Realtors tells us that U.S. median sales price of existing single-family homes peaked at about $220,000 in 2006. (Data available here: http://www.realtor.org/research/research/ehsdata). Remember the guideline that home prices should be about 3 times a family's income? Well, the median household income was about $50,000 in the 2006-2007 time period (Data available from the U.S. Census Bureau at http://www.census.gov/hhes/www/income/incomestats.html.) So, home prices were over 4 times the average household's income - no wonder homes were unaffordable!
The big question now of course is, where are home prices going? Well, to reach the 3x level of affordability, home prices would have to drop to $150,000, a further 18% drop from the $183,000 level calculated by the National Association of Realtors for October 2008. Using the Case-Shiller indexes, it depends on your interpretation. I personally don't expect home prices to drop all the way to their historical averages - it would be too painful (and, we should build in a "natural" rate of home appreciation that includes inflation). Rather, I'd expect them to bottom out somewhere slightly above the historical average, and then inflation would eat away the remaining ~10% of home values. So, given an index value of 173 (10-city index) in September 2007, a fall to index values of 130-150 would imply anywhere from a 15%-25% further decline in home prices.
So in a nutshell, the news is really bad. #1: Home prices are not done dropping. #2: Even when they bottom out, they're likely to be above the historical average. #3: They're unlikely to bounce back once they've bottomed out. And as a corollary, all the talk of stabilizing home prices buy having Treasury but mortgage-backed securities doesn't make any senese - home prices need to be lower, and trying to prop them up is only delaying the inevitable. Yes, we should try to make mortgages available once again; yes, we should try to help consumers at risk of foreclosure re-negotiate loan terms; and yes, we should try to bail out banks with bad mortgages so our financial system doesn't melt down.
But, we should be aware that home prices have to fall further to reach a sensible point (i.e. historical affordability ratios), and that the road ahead will be very, very painful.
Friday, November 7, 2008
The economic outlook, Part 2
Picking up where we left off, what was the ratio of Debt/GDP for other sectors of the economy?
Using the same sources as before (BEA and the Fed), we can calculate Debt/GDP ratios.
For households, Debt/GDP was 47% of GDP in 1977, skyrocketing to 100% in 2007, for a total of $14 trillion.
For the financial sector, Debt/GDP was 17% of GDP in 1977, also skyrocketing to 116% by 2007, for a total of $16 trillion.
Both of these figures are absolutely shocking. Ultimately, it is these extreme leverage numbers that caused today's financial crisis. With debt levels like these, households and financial institutions were basically insolvent - that is, not making enough money to pay off their debts (well, maybe when times were great, but the slightest problem, and then everything crashes). Also, the ridiculous leverage versus the equity base meant that both households and financial institutions could see their net worth wiped out - which is exactly what we're seeing happening now. And finally, it's also likely with extreme leverage like this that most of it was wasted - buying houses in Phoenix or Miami that are no longer wanted, or buying super-senior ABS CDOs that are now called "toxic securities."
Why calculate these ratios? First, to understand what went wrong; second, to understand how we can watch out for problems in the future; and finally, to figure out what we need to fix to heal our economy. The news here is not good - we need to return leverage ratios to what they used to be, which would be trillions of dollars lower than where we are now. The problem is, the assets that households and financial institutions bought with all that debt are worth 20%-40% less now.
In the short term, the multi-trillion loss caused by the sharp declines of late are cascading through the system now, and the main reason why the government has already committed over $1 trillion to fix this problem.
In the long term, only saving, by businesses, household and government alike, will reduce these debt ratios. That reduced amount of consumer spending and business investment will likely lead to sluggish economic growth for a long time to come. Yet, like the Fed-induced recession in the early 1980s that Paul Volcker introduced to squash the inflation of the 1970s, this may be the only way we can wash our hands of this extreme leverage. I wish I had happier news - I really do.
Next up...real estate...
Using the same sources as before (BEA and the Fed), we can calculate Debt/GDP ratios.
For households, Debt/GDP was 47% of GDP in 1977, skyrocketing to 100% in 2007, for a total of $14 trillion.
For the financial sector, Debt/GDP was 17% of GDP in 1977, also skyrocketing to 116% by 2007, for a total of $16 trillion.
Both of these figures are absolutely shocking. Ultimately, it is these extreme leverage numbers that caused today's financial crisis. With debt levels like these, households and financial institutions were basically insolvent - that is, not making enough money to pay off their debts (well, maybe when times were great, but the slightest problem, and then everything crashes). Also, the ridiculous leverage versus the equity base meant that both households and financial institutions could see their net worth wiped out - which is exactly what we're seeing happening now. And finally, it's also likely with extreme leverage like this that most of it was wasted - buying houses in Phoenix or Miami that are no longer wanted, or buying super-senior ABS CDOs that are now called "toxic securities."
Why calculate these ratios? First, to understand what went wrong; second, to understand how we can watch out for problems in the future; and finally, to figure out what we need to fix to heal our economy. The news here is not good - we need to return leverage ratios to what they used to be, which would be trillions of dollars lower than where we are now. The problem is, the assets that households and financial institutions bought with all that debt are worth 20%-40% less now.
In the short term, the multi-trillion loss caused by the sharp declines of late are cascading through the system now, and the main reason why the government has already committed over $1 trillion to fix this problem.
In the long term, only saving, by businesses, household and government alike, will reduce these debt ratios. That reduced amount of consumer spending and business investment will likely lead to sluggish economic growth for a long time to come. Yet, like the Fed-induced recession in the early 1980s that Paul Volcker introduced to squash the inflation of the 1970s, this may be the only way we can wash our hands of this extreme leverage. I wish I had happier news - I really do.
Next up...real estate...
Wednesday, November 5, 2008
The economic outlook, Part 1
So what's the economic outlook going forward?
Well, first, let's start with the big question - what got us to this point of crisis in the first place? In a word, debt.
A combination of low interest rates from Alan Greenspan, excess Chinese savings, and Wall Street securitization led to investment banks, consumers, and government alike taking on too much debt. How much? Absolutely unprecedented amounts.
Let me show you why. At the level of a country, debt is usually expressed as a percentage of a country's GDP. At 100% Debt/GDP, you should start to get worried; Japan is in the worst debt situation of any major country, at over 150% Debt/GDP.
Let's calculate Debt/GDP for the US. According to the Bureau of Economic Analysis "National Income and Product Accounts" table, GDP was $14.4 billion in 2008 (nominal annualized rate as of the third quarter). According to the United States Treasury Department's "Treasury Direct" site, total federal debt is $10.6 trillion, less than 100% of GDP.
Not so bad, right? You know where this is going...there's a lot more, and the numbers are scary. According to the Fed's "Flow of Funds Accounts for the United States" (Q2 2008), total United States was nearly $50 trillion. Households accounted for $14 trillion of this, with $11 trillion coming from mortgages. Financial firms accounted for another $17 trillion. (Non-financial businesses made up the remainder.)
Of course, debt in itself is not a bad thing. It's when assets and liabilities are mismatched, and a borrower becomes insolvent, that debt becomes a problem. Even a federal debt of 100% Debt/GDP wouldn't be terrible if the federal government can pay that debt (and it can, because of its taxing power).
Obviously, as we learned in September-October 2008, it's an entirely different matter for households and financial institutions that can't work their way as easily out of excess leverage. Tomorrow we'll look at ratios of those entites' debt to GDP, which was totally out of control relative to historical standards.
Well, first, let's start with the big question - what got us to this point of crisis in the first place? In a word, debt.
A combination of low interest rates from Alan Greenspan, excess Chinese savings, and Wall Street securitization led to investment banks, consumers, and government alike taking on too much debt. How much? Absolutely unprecedented amounts.
Let me show you why. At the level of a country, debt is usually expressed as a percentage of a country's GDP. At 100% Debt/GDP, you should start to get worried; Japan is in the worst debt situation of any major country, at over 150% Debt/GDP.
Let's calculate Debt/GDP for the US. According to the Bureau of Economic Analysis "National Income and Product Accounts" table, GDP was $14.4 billion in 2008 (nominal annualized rate as of the third quarter). According to the United States Treasury Department's "Treasury Direct" site, total federal debt is $10.6 trillion, less than 100% of GDP.
Not so bad, right? You know where this is going...there's a lot more, and the numbers are scary. According to the Fed's "Flow of Funds Accounts for the United States" (Q2 2008), total United States was nearly $50 trillion. Households accounted for $14 trillion of this, with $11 trillion coming from mortgages. Financial firms accounted for another $17 trillion. (Non-financial businesses made up the remainder.)
Of course, debt in itself is not a bad thing. It's when assets and liabilities are mismatched, and a borrower becomes insolvent, that debt becomes a problem. Even a federal debt of 100% Debt/GDP wouldn't be terrible if the federal government can pay that debt (and it can, because of its taxing power).
Obviously, as we learned in September-October 2008, it's an entirely different matter for households and financial institutions that can't work their way as easily out of excess leverage. Tomorrow we'll look at ratios of those entites' debt to GDP, which was totally out of control relative to historical standards.
Monday, November 3, 2008
Is it time to buy? Part 3
Let's try to get a little more clarity on the earnings question. In our last post we noted that S&P operating earnings were still forecast at $97.32 for 2009, but almost sure to come down. The question is, how much?
Professor Robert Shiller (of "Irrational Exuberance" fame) has compiled some helpful statistics for us at http://www.econ.yale.edu/~shiller/data/ie_data.xls. What does his data show us?
It looks pretty scary. From 1917-1921, the S&P index's earnings fell from 29 to 4, a 90% drop. Let's hope that doesn't happen again.
What if we try something more familiar? In 1989, earnings were $45; in 1992, $26, a drop of 40%. More recently, from 2000-2002 earnings declined from $69 to $31, a 55% drop. By comparison, the 1974-1975 drop from $40 to $32, a decline of 20%, was downright mild.
How bad will it be this time? Profits were high for a prolonged time. Costs were kept low by cheap labor from China. And there's massive deleveraging that needs to happen throughout the economy. Sounds like this is more of a 40% drop scenario rather than a more benign one. I hope I'm wrong, but I'm afraid I'm right.
So, if we take 40% off of $97.32, we get $58.39. If we apply a P/E ratio of 12, which gives me a comfortable cushion versus the long-term P/E of 15 (though still well higher than the truly rock-bottom P/E range of 6), that gives me a price target of 700 on the S&P 500. Ouch!
Finally, a note on the rock-bottom P/E of 6. If we take out the Great Depression, the lowest P/Es of the early 1980s happened during the super-high interest rates brought on by Paul Volcker's fight against inflation. The math gets complicated, but basically, why hold stocks when bond interest rates are high? So I think we would only see a sustained P/E below 10 if long-term rates rise. How likely is this? Not that likely, I think - there's still a lot of liquidity in the world (if on the sidelines), though there are some serious imbalances ahead that will reduce available savings even as national expenditures rise - i.e. the retirement of the baby boomers. But as long as that doesn't cause an extreme rise in interest rates, P/Es shouldn't go super-low.
But even so, these calcluations make me nervous looking at today's S&P 500 of 966. We'll see. Like I said, I hope I'm wrong, but fear I'm right.
Professor Robert Shiller (of "Irrational Exuberance" fame) has compiled some helpful statistics for us at http://www.econ.yale.edu/~shiller/data/ie_data.xls. What does his data show us?
It looks pretty scary. From 1917-1921, the S&P index's earnings fell from 29 to 4, a 90% drop. Let's hope that doesn't happen again.
What if we try something more familiar? In 1989, earnings were $45; in 1992, $26, a drop of 40%. More recently, from 2000-2002 earnings declined from $69 to $31, a 55% drop. By comparison, the 1974-1975 drop from $40 to $32, a decline of 20%, was downright mild.
How bad will it be this time? Profits were high for a prolonged time. Costs were kept low by cheap labor from China. And there's massive deleveraging that needs to happen throughout the economy. Sounds like this is more of a 40% drop scenario rather than a more benign one. I hope I'm wrong, but I'm afraid I'm right.
So, if we take 40% off of $97.32, we get $58.39. If we apply a P/E ratio of 12, which gives me a comfortable cushion versus the long-term P/E of 15 (though still well higher than the truly rock-bottom P/E range of 6), that gives me a price target of 700 on the S&P 500. Ouch!
Finally, a note on the rock-bottom P/E of 6. If we take out the Great Depression, the lowest P/Es of the early 1980s happened during the super-high interest rates brought on by Paul Volcker's fight against inflation. The math gets complicated, but basically, why hold stocks when bond interest rates are high? So I think we would only see a sustained P/E below 10 if long-term rates rise. How likely is this? Not that likely, I think - there's still a lot of liquidity in the world (if on the sidelines), though there are some serious imbalances ahead that will reduce available savings even as national expenditures rise - i.e. the retirement of the baby boomers. But as long as that doesn't cause an extreme rise in interest rates, P/Es shouldn't go super-low.
But even so, these calcluations make me nervous looking at today's S&P 500 of 966. We'll see. Like I said, I hope I'm wrong, but fear I'm right.
Monday, October 27, 2008
Is it time to buy? Part 2
Valuations
One key factor in assessing whether it's time to buy - if not THE factor - is the market's valuation. But how do we determine that?
Let's start by figuring out the market's P/E ratio. Where do we get that information from?
One source is from the S&P 500's namesake, Standard and Poor's.
www2.standardandpoors.com/spf/xls/index/SP500EPSEST.XLS
From this worksheet, we can see that the S&P's 2009 earnings are forecast as:
-Operating earnings per share (bottom up): $97.32
Is that the best estimate to use? I honestly don't know - the news media make reference to Thomson Financial's IBES database, but it looks like that's a paid database. Please write to me if you know a better source!
Meanwhile, the S&P 500 closed at 850 on October 27, 2008. This implies a P/E of only 8.7 for 2009. The sounds like a screaming buy, given that the market normally trades at a P/E ratio of 15.
But, how solid is that earnings number? The asset management firm GMO has put together a timely analysis for our purposes at http://www.gmo.com/websitecontent/JGLetter_ALL_3Q08.pdf. Here the news is bleak: profit margins are still 20% above average, but typically fall to fall to 20% BELOW average during severe recessions.
That suggests a floor of $58 to the S&P 500's 2009 (or 2o10) earnings, earning the S&P 500 index a less-appealing valuation of 14.6.
Add to that the fact that P/E ratios typically drop below 10 during really bad bear markets. To be generous, let's use that 10x ratio (yes, it can go even lower, all the way down to 8 in the 1970's, but let's hope that doesn't happen again) and our trough earnings of $58. That would imply an S&P 500 index level of 580 - scary stuff. (And, not coincidentally, the bottom end of GMO's forecast range).
So what? Well, at "normalized" levels - earnings of $78 and a P/E of 15 - the market would be fairly valued at 1168. But these are not normal times, since bear markets often overshoot. I'm not going to give any financial advice here, but let's just say I'm comfortable buying with a P/E of 12 at earnings 70% of today's - with both P/E and earnings below long-term trend, I can be more confident in a solid long-term return. That, in turn, implies a price target of 817, so I'll start buying sometime soon.
And if you buy, too, good luck to us all!
One key factor in assessing whether it's time to buy - if not THE factor - is the market's valuation. But how do we determine that?
Let's start by figuring out the market's P/E ratio. Where do we get that information from?
One source is from the S&P 500's namesake, Standard and Poor's.
www2.standardandpoors.com/spf/xls/index/SP500EPSEST.XLS
From this worksheet, we can see that the S&P's 2009 earnings are forecast as:
-Operating earnings per share (bottom up): $97.32
Is that the best estimate to use? I honestly don't know - the news media make reference to Thomson Financial's IBES database, but it looks like that's a paid database. Please write to me if you know a better source!
Meanwhile, the S&P 500 closed at 850 on October 27, 2008. This implies a P/E of only 8.7 for 2009. The sounds like a screaming buy, given that the market normally trades at a P/E ratio of 15.
But, how solid is that earnings number? The asset management firm GMO has put together a timely analysis for our purposes at http://www.gmo.com/websitecontent/JGLetter_ALL_3Q08.pdf. Here the news is bleak: profit margins are still 20% above average, but typically fall to fall to 20% BELOW average during severe recessions.
That suggests a floor of $58 to the S&P 500's 2009 (or 2o10) earnings, earning the S&P 500 index a less-appealing valuation of 14.6.
Add to that the fact that P/E ratios typically drop below 10 during really bad bear markets. To be generous, let's use that 10x ratio (yes, it can go even lower, all the way down to 8 in the 1970's, but let's hope that doesn't happen again) and our trough earnings of $58. That would imply an S&P 500 index level of 580 - scary stuff. (And, not coincidentally, the bottom end of GMO's forecast range).
So what? Well, at "normalized" levels - earnings of $78 and a P/E of 15 - the market would be fairly valued at 1168. But these are not normal times, since bear markets often overshoot. I'm not going to give any financial advice here, but let's just say I'm comfortable buying with a P/E of 12 at earnings 70% of today's - with both P/E and earnings below long-term trend, I can be more confident in a solid long-term return. That, in turn, implies a price target of 817, so I'll start buying sometime soon.
And if you buy, too, good luck to us all!
Is it time to buy? Part 1
You know the saddest part about the credit crisis? The fact that it was predictable. Warren Buffet called derivatives "financial weapons of mass destruction." Many times in the past decade, more clear-eyed regulators called for greater financial regulation, only to be turned down by high officials entranced with free-markets ideology. But by 2007, some of the smartest investing minds in the world, like Warren Buffet, Bill Gross, and Jeremy Grantham, had put their money where their mouths were, holding tens of billions of cash, waiting for the crisis to unfold. I wouldn't give as much as credit to Nouriel Roubini, who really does seem like a perma-bear, clearly anyone who had listened to him over the past few years would be in much better financial shape for it.
So that said, since the data was there for all to see, how do we cut through the clutter in the future to make sure we really know what's going on? There's really only one - look at the data yourself. And that's what we're going to do.
So that said, since the data was there for all to see, how do we cut through the clutter in the future to make sure we really know what's going on? There's really only one - look at the data yourself. And that's what we're going to do.
Monday, October 13, 2008
Is this a good time to buy stocks?
This is the question one everyone's mind, after the gut-wrenching decline of last week and the equally shocking rally on Monday.
I think there is a good opportunity to buy stocks here, but it really depends on your time horizon. No one knows if the market will come back in 5 years, but if you can wait 10 years, then this may be a good time to buy.
Here are the reasons why the market could come back in 5 years:
1. The normal fundamental drivers should be strong in 5 years. We would need corporate earnings to be good, inflation to remain low, and interest remains to remain low/moderate. Corporate earnings will decline in the near term, but global growth should resume in the medium term. Inflation has been driven by rising commodity prices lately, but that has proven to be temporary, with oil falling back below $100. More importantly, wage inflation has not occurred, meaning the inflationary expectations remain stable. Finally, interest rates are likely to go up, which is bad for stocks, but they should remain moderate.
2. Price/earnings valuations are low. Earnings will have to be cut, so valuations are not as good as they first appear, but, they're still below average (currently closer to 10 than the historical average of 15, and much better than the 2001 bubble of 30). While there are some bear markets in which P/E ratios reached the single digits, this did not happen in most bear markets.
3. The typical bear market goes down less than 40% , and we've already reached that point. For some historical context, look at:
http://www.nytimes.com/2008/10/12/business/12stox.html?em
http://www.nytimes.com/interactive/2008/10/11/business/20081011_BEAR_MARKETS.html
But, there is a possibility that the market won't come back for 10 years. If you want to put more money in now, you have to be prepared for that possibility. Here's are the reasons why the market might not come back quickly:
1. There have been 10-year periods when stocks did nothing. The 1930s and 1970s are good examples of this. However, the 1930s was the Great Depression, which shouldn't happen again since government authorities are trying everything they can to fix the economy, unlike in 1929-1933. And in 1970, earnings growth was low and inflation and interest rates were high, so it was not a good time for stocks.
2. The "credit crunch" is the really unique part of what's going on. Beyond the stock market crash, the fact that banks have stopped lending to each other will eventually crash the economy if not fixed. The rapid bank failures have scared all lenders and all banking and credit-related activity has stopped, which is unprecedented - this has not happened since the Great Depression. Will the recently announced bank recapitalizations in the U.S. and Europe get banks lending again? No one honestly knows.
3. If the government can't get banks lending again, then the economy is in for an extremely bad time, for a long time - like what happened to Japan in the 1990s. This is the single biggest question about the crisis. If the government can get the bank lending going again, then there's a good possibility the economy will be back to normal in 5 years. If not, then we're looking at 10 very painful years before a full recovery.
So which it be? Stay tuned.
I think there is a good opportunity to buy stocks here, but it really depends on your time horizon. No one knows if the market will come back in 5 years, but if you can wait 10 years, then this may be a good time to buy.
Here are the reasons why the market could come back in 5 years:
1. The normal fundamental drivers should be strong in 5 years. We would need corporate earnings to be good, inflation to remain low, and interest remains to remain low/moderate. Corporate earnings will decline in the near term, but global growth should resume in the medium term. Inflation has been driven by rising commodity prices lately, but that has proven to be temporary, with oil falling back below $100. More importantly, wage inflation has not occurred, meaning the inflationary expectations remain stable. Finally, interest rates are likely to go up, which is bad for stocks, but they should remain moderate.
2. Price/earnings valuations are low. Earnings will have to be cut, so valuations are not as good as they first appear, but, they're still below average (currently closer to 10 than the historical average of 15, and much better than the 2001 bubble of 30). While there are some bear markets in which P/E ratios reached the single digits, this did not happen in most bear markets.
3. The typical bear market goes down less than 40% , and we've already reached that point. For some historical context, look at:
http://www.nytimes.com/2008/10/12/business/12stox.html?em
http://www.nytimes.com/interactive/2008/10/11/business/20081011_BEAR_MARKETS.html
But, there is a possibility that the market won't come back for 10 years. If you want to put more money in now, you have to be prepared for that possibility. Here's are the reasons why the market might not come back quickly:
1. There have been 10-year periods when stocks did nothing. The 1930s and 1970s are good examples of this. However, the 1930s was the Great Depression, which shouldn't happen again since government authorities are trying everything they can to fix the economy, unlike in 1929-1933. And in 1970, earnings growth was low and inflation and interest rates were high, so it was not a good time for stocks.
2. The "credit crunch" is the really unique part of what's going on. Beyond the stock market crash, the fact that banks have stopped lending to each other will eventually crash the economy if not fixed. The rapid bank failures have scared all lenders and all banking and credit-related activity has stopped, which is unprecedented - this has not happened since the Great Depression. Will the recently announced bank recapitalizations in the U.S. and Europe get banks lending again? No one honestly knows.
3. If the government can't get banks lending again, then the economy is in for an extremely bad time, for a long time - like what happened to Japan in the 1990s. This is the single biggest question about the crisis. If the government can get the bank lending going again, then there's a good possibility the economy will be back to normal in 5 years. If not, then we're looking at 10 very painful years before a full recovery.
So which it be? Stay tuned.
Friday, May 9, 2008
Why Inflation Is Not The Big Problem
What's the biggest risk to the global economy today? There are so many choices - the credit crisis, the housing slump, skyrocketing food and oil prices, and more. The trickiest of these problems, though, is inflation.
Why inflation? For starters, many countries are trying to strike the right balance in terms of monetary policy, attempting to choose benchmark interest rates high enough to reduce rising inflation, without slowing growth more than necessary. Were inflation not a problem, monetary policy choices would be much simpler.
In addition, the likely consequences of inflation are unclear. Most traditional inflation measures strip out "volatile" food and energy prices, which makes sense under normal circumstances - but does it make sense today? Increasing food and energy prices are putting serious pressure on incomes and discretionary spending. However, economists usually worry most about inflationary expectations . If wages do not rise, will we see an increase in inflationary expectations in the overall economy? And what if oil and food prices stabilize at their current (if high) levels? It's hard to say.
This Fortune magazine article touches on some of these questions. Some of the economists Colin Barr has spoken too think the inflation risk is overstated - they argue that the credit crunch has only started to be felt in the real economy, and that housing prices will continue to decline, unemployment rise, and American consumers, after all these years of spending, will finally start to pull back. And slower economic growth - a true recession, which we aren't technically in yet - will constrain inflation.
Did Bernanke and the Fed take these considerations into account when cutting interest rates? It's quite possible that they did, and that these factors made them more comfortable with steep cuts in interest rates. Without a doubt, though, the risk of rising inflation is as high as we've seen in the last 30 years.
http://money.cnn.com/2008/05/08/news/inflation_crunch.fortune/index.htm?postversion=2008050903
Why inflation? For starters, many countries are trying to strike the right balance in terms of monetary policy, attempting to choose benchmark interest rates high enough to reduce rising inflation, without slowing growth more than necessary. Were inflation not a problem, monetary policy choices would be much simpler.
In addition, the likely consequences of inflation are unclear. Most traditional inflation measures strip out "volatile" food and energy prices, which makes sense under normal circumstances - but does it make sense today? Increasing food and energy prices are putting serious pressure on incomes and discretionary spending. However, economists usually worry most about inflationary expectations . If wages do not rise, will we see an increase in inflationary expectations in the overall economy? And what if oil and food prices stabilize at their current (if high) levels? It's hard to say.
This Fortune magazine article touches on some of these questions. Some of the economists Colin Barr has spoken too think the inflation risk is overstated - they argue that the credit crunch has only started to be felt in the real economy, and that housing prices will continue to decline, unemployment rise, and American consumers, after all these years of spending, will finally start to pull back. And slower economic growth - a true recession, which we aren't technically in yet - will constrain inflation.
Did Bernanke and the Fed take these considerations into account when cutting interest rates? It's quite possible that they did, and that these factors made them more comfortable with steep cuts in interest rates. Without a doubt, though, the risk of rising inflation is as high as we've seen in the last 30 years.
http://money.cnn.com/2008/05/08/news/inflation_crunch.fortune/index.htm?postversion=2008050903
Wednesday, May 7, 2008
Is Foreign Capital a Luxury That Poor Countries Can Live Without?
Another pillar of free-market orthodoxy is re-examined in this article from the Economist. Developing countries abandoned the "Washington Consensus" almost a decade ago, in the aftermath of the Asian economic crisis, but its central principles - free trade, open capital markets, privatization and deregulation, have still been the core assumptions guiding U.S. foreign economic policy.
Yet all this time, academic researcheres have not conclusively shown whether or not it "works." The economic theory of liberalization is certainly sound, and still taught as such in universities, but the evidence in the real world is unclear - for instance, serious questions persist on whether free trade lowers wages or makes workers worse off (beyond the effects predicted by theory). The Economist article assess a longer research piece by Professsors Dani Rodrik of Harvard and Arvind Subramanian of the Peterson Institute, which raises similar questions around the assumption of open capital markets.
Their question is a timely one, since the breakdown in U.S. credit markets and the rise of dynamic economies elsewhere may well lead nations to rethink their need for capital market liberalization. Their central point is that, despite the best efforts of researchers, no clear link has been found between freer international capital flows and economic growth. They point out that while open capital markets can provide cheaper capital or discipline policymakers, they can equally lead to overborrowing, capital flight and upward pressure on the local currency.
Advocates of open capital markets assume that countries will simultaneously reform property rights and improve contract enforcement, which are needed to reap openness' full benefits. Yet it is precisely these weaknesses that make investing in developing countries difficult, and in Rodrik and Subramanian's view, it is these constraints on the "supply" of available investments that is the problem, not the "demand" for investments from foreign capital.
In the end, like almost all policy prescriptions for developing countries, adopting economic openness and liberalization works best when domestic systems, regulations and supervision are already sound. It's the classic chicken-and-egg problem - figuring out whether the greater problem is a shortage of investment that foreign sources can fix, or poor investment infrastructure, in which case opening up to foreign capital may do more harm than good. "It depends" is always an unsatisfying answer, but Rodrik and Subramanian conclude that “depending on context and country,” they write, “the appropriate role of policy will be as often to stem the tide of capital flows as to encourage them.”
Economist link: http://www.economist.com/finance/economicsfocus/displaystory.cfm?story_id=11016324
Full article: http://ksghome.harvard.edu/~drodrik/Why_Did_FG_Disappoint_March_24_2008.pdf
Yet all this time, academic researcheres have not conclusively shown whether or not it "works." The economic theory of liberalization is certainly sound, and still taught as such in universities, but the evidence in the real world is unclear - for instance, serious questions persist on whether free trade lowers wages or makes workers worse off (beyond the effects predicted by theory). The Economist article assess a longer research piece by Professsors Dani Rodrik of Harvard and Arvind Subramanian of the Peterson Institute, which raises similar questions around the assumption of open capital markets.
Their question is a timely one, since the breakdown in U.S. credit markets and the rise of dynamic economies elsewhere may well lead nations to rethink their need for capital market liberalization. Their central point is that, despite the best efforts of researchers, no clear link has been found between freer international capital flows and economic growth. They point out that while open capital markets can provide cheaper capital or discipline policymakers, they can equally lead to overborrowing, capital flight and upward pressure on the local currency.
Advocates of open capital markets assume that countries will simultaneously reform property rights and improve contract enforcement, which are needed to reap openness' full benefits. Yet it is precisely these weaknesses that make investing in developing countries difficult, and in Rodrik and Subramanian's view, it is these constraints on the "supply" of available investments that is the problem, not the "demand" for investments from foreign capital.
In the end, like almost all policy prescriptions for developing countries, adopting economic openness and liberalization works best when domestic systems, regulations and supervision are already sound. It's the classic chicken-and-egg problem - figuring out whether the greater problem is a shortage of investment that foreign sources can fix, or poor investment infrastructure, in which case opening up to foreign capital may do more harm than good. "It depends" is always an unsatisfying answer, but Rodrik and Subramanian conclude that “depending on context and country,” they write, “the appropriate role of policy will be as often to stem the tide of capital flows as to encourage them.”
Economist link: http://www.economist.com/finance/economicsfocus/displaystory.cfm?story_id=11016324
Full article: http://ksghome.harvard.edu/~drodrik/Why_Did_FG_Disappoint_March_24_2008.pdf
Tuesday, May 6, 2008
The Rise of the Rest
The always insightful Fareed Zakaria has another great article out, The Rise of the Rest. The trends reshaping the global economy Zakaria talks about have been visible, but scattered - many data points whose direction is as yet unclear. Trends like the astonishing economic development, and wealth creation, in formerly sluggish or even dysfunctional countries around the world; the growing challenge to American power from China; and the increase in intra-Asian trade that makes the United States less critical, though still an incredibly important trading partner. It's easy to try to make sense of these forces by saying the U.S. is in decline, but that doesn't really capture what is happening in the world.
Zakaria brings a greater narrative to the breathless "Flat World" hype that Tom Friedman gives us. Zakaria's view is that the United States has actually been very successful in spreading the ideas of capitalism, open markets, and economic reform, and that we are now witnessing the fruits of these efforts throughout the 1980s and 1990s. And as these countries generate their own multinationals and billionaires, their attention naturally begins to focus more and more on what's happening within their countries, and with Lakshmi Mittal, Carlos Slim or Ratan Tata rather than with Donald Trump, Bill Gates or George Bush.
Of course, as other countries rise, the United States declines on a relative basis. The U.S. will be the world's largest economy for a few more decades, and most likely the world's most important country for yet longer, but relative decline seems unavoidable, and a source of anxiety for Americans. Zakaria's view? Things aren't all that bad. Outside of Iraq and Afghanistan, despite all the negative reporting, the world is as peaceful as it has ever been, even including hotspots and conflicts in Nigeria, Somalia, Darfur, etc. And the major countries? While they are happy to have a greater say, even occasionally troublesome China and Russia prefer a stable, orderly, and smoothly functioning international system, and are not likely to rock the boat (yet).
Therefore, Zakaria concludes that the "Rise of the Rest" is a good thing (and inevitable), and that the U.S. still has the opportunity to be the "indispensable country" and chief architect of the new international system. The question, of course, is whether the U.S. can rise to that challenge given its completely dysfunctional politics of the last eight years. Zakaria concludes here, but the question of whether the U.S. will align itself better with the rest of the world is a huge question. Why haven't we fixed our health care system? Why aren't we adequately funding research into newer and cleaner energy sources? Why is our foreign policy so myopically focused on terrorism, ignoring the most powerful countries and forces at work today? These problems are all solvable. I, for one, am hopeful that Americans will recognize and be galvanized by these trends, and/or that better political leadership can tackle the nation's problems. "The Rest" will be watching.
Rise of the Rest (Foreign Affairs):
http://www.foreignaffairs.org/20080501facomment87303/fareed-zakaria/the-future-of-american-power.html
Rise of the Rest (Newsweek):
http://www.newsweek.com/id/135380/
Zakaria brings a greater narrative to the breathless "Flat World" hype that Tom Friedman gives us. Zakaria's view is that the United States has actually been very successful in spreading the ideas of capitalism, open markets, and economic reform, and that we are now witnessing the fruits of these efforts throughout the 1980s and 1990s. And as these countries generate their own multinationals and billionaires, their attention naturally begins to focus more and more on what's happening within their countries, and with Lakshmi Mittal, Carlos Slim or Ratan Tata rather than with Donald Trump, Bill Gates or George Bush.
Of course, as other countries rise, the United States declines on a relative basis. The U.S. will be the world's largest economy for a few more decades, and most likely the world's most important country for yet longer, but relative decline seems unavoidable, and a source of anxiety for Americans. Zakaria's view? Things aren't all that bad. Outside of Iraq and Afghanistan, despite all the negative reporting, the world is as peaceful as it has ever been, even including hotspots and conflicts in Nigeria, Somalia, Darfur, etc. And the major countries? While they are happy to have a greater say, even occasionally troublesome China and Russia prefer a stable, orderly, and smoothly functioning international system, and are not likely to rock the boat (yet).
Therefore, Zakaria concludes that the "Rise of the Rest" is a good thing (and inevitable), and that the U.S. still has the opportunity to be the "indispensable country" and chief architect of the new international system. The question, of course, is whether the U.S. can rise to that challenge given its completely dysfunctional politics of the last eight years. Zakaria concludes here, but the question of whether the U.S. will align itself better with the rest of the world is a huge question. Why haven't we fixed our health care system? Why aren't we adequately funding research into newer and cleaner energy sources? Why is our foreign policy so myopically focused on terrorism, ignoring the most powerful countries and forces at work today? These problems are all solvable. I, for one, am hopeful that Americans will recognize and be galvanized by these trends, and/or that better political leadership can tackle the nation's problems. "The Rest" will be watching.
Rise of the Rest (Foreign Affairs):
http://www.foreignaffairs.org/20080501facomment87303/fareed-zakaria/the-future-of-american-power.html
Rise of the Rest (Newsweek):
http://www.newsweek.com/id/135380/
Monday, May 5, 2008
China Needs Old Boys With MBA's
A lack of management talent is one of the key constraints on China's otherwise astonishing economic growth. This article looks at this problem from the point of view of managers in China today, and also raises the old question of whether "Western" or "Chinese" management practices are needed in China. It seems like both are needed - Chinese practices most importantly (like guanxi), to navigate the uncertainty, corruption and lack of trust.
But for companies that seek to be come dynamic global competitors (remember, China has virtually zero homegrown multinationals so far), and especially for founders that want their companies to continue growing once their unique relationships and resources are gone, professional "Western" management seems to be an absolute necessity. Can China pull it off?
http://www.nytimes.com/2008/04/19/business/19nocera.html?hp=&pagewanted=print
A few excerpts:
But for companies that seek to be come dynamic global competitors (remember, China has virtually zero homegrown multinationals so far), and especially for founders that want their companies to continue growing once their unique relationships and resources are gone, professional "Western" management seems to be an absolute necessity. Can China pull it off?
http://www.nytimes.com/2008/04/19/business/19nocera.html?hp=&pagewanted=print
A few excerpts:
One evening in Beijing, I wandered into a local bookstore. I couldn’t read a thing, of course, but I had been told that Chinese urbanites are voracious readers, and that I could get a feel for that in any decent bookstore. The place was enormous; its five floors of wall-to-wall books made your typical suburban Barnes & Noble look puny by comparison. Shoppers sat on the floor, reading.
On shelf after shelf, I could see copies of Jim Collins’s “Good to Great,” Jack Welch’s “Straight From the Gut,” Tom Peters’s “Re-Imagine!” and just about everything the late Peter Drucker ever wrote. There was no management topic, no matter how arcane — the science of H.R. anyone? — that didn’t have its own section.
Can the Cellphone Help End Global Poverty?
This is an interesting New York Times article on a "consumer anthropologist" who photographs and documents human behavior for Nokia, in order to design more usable and relevant cell phones - especially for the global poorest, who are the last untapped market for otherwise ubiquitous cell phones. Maybe this is an approach that can be used to design other useful products for the proverbial "Bottom of the Pyramid"?
http://www.nytimes.com/2008/04/13/magazine/13anthropology-t.html
Some excerpts:
This sort of on-the-ground intelligence-gathering is central to what’s known as human-centered design, a business-world niche that has become especially important to ultracompetitive high-tech companies trying to figure out how to write software, design laptops or build cellphones that people find useful and unintimidating and will thus spend money on.
The premise of the work is simple — get to know your potential customers as well as possible before you make a product for them. But when those customers live, say, in a mud hut in Zambia or in a tin-roofed hutong dwelling in China, when you are trying — as Nokia and just about every one of its competitors is — to design a cellphone that will sell to essentially the only people left on earth who don’t yet have one, which is to say people who are illiterate, making $4 per day or less and have no easy access to electricity, the challenges are considerable.
http://www.nytimes.com/2008/04/13/magazine/13anthropology-t.html
Some excerpts:
This sort of on-the-ground intelligence-gathering is central to what’s known as human-centered design, a business-world niche that has become especially important to ultracompetitive high-tech companies trying to figure out how to write software, design laptops or build cellphones that people find useful and unintimidating and will thus spend money on.
The premise of the work is simple — get to know your potential customers as well as possible before you make a product for them. But when those customers live, say, in a mud hut in Zambia or in a tin-roofed hutong dwelling in China, when you are trying — as Nokia and just about every one of its competitors is — to design a cellphone that will sell to essentially the only people left on earth who don’t yet have one, which is to say people who are illiterate, making $4 per day or less and have no easy access to electricity, the challenges are considerable.
The BRIC Road
The BRIC Road
A blog on international economics, finance, and the macro trends shaping the world as we know it. If you're here, you probably know that Goldman Sachs coined the term "BRICs" in 2003 to describe the most important emerging markets of the 21st century - Brazil, Russia, India, and China, which are on track to overtake the US, Japan and Europe as the largest economies in the world - if they can stay on the BRIC Road!
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