It is nice to know that every investment manager out there is wearing their “bubble-vision goggles” today.  In his latest weekly, John Hussman provides some hard facts to illustrate our point.  The full commentary is worth a read, but at a minimum, read the section titled, Are Corporate Balance Sheets Really the Strongest in History?  A few excerpts are below, for those not tempted by links within blogs:

 “As the following chart shows (based on Federal Reserve Flow of Funds data), the debt burden of U.S. corporations is near all-time highs, having retreated only modestly since 2009. Debt burdens are elevated regardless of whether they are measured against total assets or net worth. Certainly, corporations are presently benefiting from very low interest rates on corporate debt, which substantially reduces the servicing burden of these obligations. But the combination of high debt levels and low servicing burdens does create a potential risk to corporate health in the event that yields rise in future years. Overall, the picture is fairly stable at present thanks to low yields and high levels of cash-equivalents, but it is important for investors to keep in mind that cash can burn fairly quickly during economic downturns, and debt is not spread evenly across corporations.

 “The bottom line is that at an aggregate level, corporate balance sheets look reasonable, but are certainly not “stronger than they have ever been in history.” Cash levels are elevated, but this is at best a second-order factor (with excess cash representing only a few percent of total assets), while debt remains near record levels relative to total assets and net worth. In any event, balance sheet risks should be evaluated on a business-by-business level, rather than accepting the blanket notion that cash levels are so high that nobody needs to worry about corporate credit risk.”

“In going through the Flow of Funds data this week, I thought a few other features of the data were interesting. First, was the profound decline in tangible assets as a percentage of total corporate assets since 1980. This decline goes hand-in-hand with an increase in financial assets held by non-financial companies. At present, more than half of the total assets held by non-financial companies in the U.S. represent financial assets such as debt securities and equities. This is striking, in that we presently have a menu of prospective returns on financial assets that is among the most dismal in history. While the move toward zero interest rates has certainly been excellent for bonds when we look in the rear-view mirror, the fact that prospective rates of return are now so low suggests that a large portion of corporate assets are unlikely to achieve very much in the way of future returns, barring a decline in those asset prices. Something to think about.”

Apparently, one reason advisors believe stocks are ‘cheap’ today is the abundance of cash on the sidelines.  China bulls make a similar argument when talking about Chinese FX Reserves.  The mistake in both cases, is to ignore the other side of the balance sheet.  Yes, companies do hold  piles of cash that could potentially be used to buy back shares.  But why do they have this cash?  I would submit that there are a few reasons, none of which have bullish implications. One, low interest rates encourage managements to issue debt – in some cases a lot of debt. Note that these new claims on the business are higher in the capital structure than equity, so stockholders should not be particularly excited about high cash balances which result from selling debt.  Two, the regulatory and political environment is not exactly pro-business in case you haven’t noticed today. Companies are holding cash because it is very difficult to make long term investments when the rules of the game and their tax consequences are impossible to predict even one week forward.  Cash on the sidelines is a sign of uncertainty, and frankly, I don’t see anything on the horizon that will change this.

Finally, many advisors are excited about the potential for these companies to buy back their shares with all that cash.  But like anything else, price is the ultimate determinant of forward returns.  Companies that buy back overvalued shares are destroying capital just as they would in making any other bad investment.  On the other hand, when shares are cheap, we would encourage management to buy shares aggressively as this may be the best use of that cash.  See Berkshire’s recent announcement for a sense of what a disciplined buy back should look like.  Unfortunately, Berkshire seems to be the exception.  The chart below from Barron’s illustrates very clearly that most companies do the exact opposite – they buy back their own stock in good times and pay top dollar to do so, but rarely buy the dips when shareholders get the biggest bang for the buck.

Andy – next time someone mentions that cash on the sidelines is a bullish indicator for big stock-buybacks, show them this chart.  I look forward to their response.

Source: Barron's

Despite the harassment, I decided to take the risk and share another except from Hussman Funds Weekly Market Comment.  We’ll explore this one in detail as there is a lot of meat here.  Be forewarned – this turned out to be quite a lengthy post.  So here is a quick summary of the material to follow:

1. Denial
2. Deja Vu All Over Again
3. Europe’s Banks
4. The Fallacy of Forward Earnings
5. Bad Estimates
6. Setting the Record Straight
7. Bottom Line – Too Much Leverage

Denial

 “Last week, the financial markets mounted a striking shift back to the “risk-on” trade, as investor concerns about a recession were abandoned, and Wall Street came to believe that Europe will easily contain its banking problems. Accordingly, downside protection was largely discarded (as reflected by a plunge in the CBOE volatility index), price-volume action reflected eager short-covering, and investor interest shifted strongly away from defensive sectors to speculative ones. For defensive investors, it was admittedly a difficult week, as the markets suddenly became convinced that no defense was needed, and treated defensive investments accordingly.

“From my perspective, Wall Street’s “relief” about the economy, and its willingness to set aside recession concerns, is a mistake born of confusion between leading indicators and lagging ones. Leading evidence is not only clear, but on a statistical basis is essentially certain that the U.S. economy, and indeed, the global economy, faces an oncoming recession. As Lakshman Achuthan notes on the basis of ECRI’s own (and historically reliable) set of indicators, “We’ve entered a vicious cycle, and it’s too late: a recession can’t be averted.” Likewise, lagging evidence is largely clear that the economy was not yet in a recession as of, say, August or September. The error that investors are inviting here is to treat lagging indicators as if they are leading ones.”

Here is a picture of the most recent picture from ECRI.  The interview with Lakshman Achuthan Hussman refers to is available here. We think an important point lost on the consensus is the frequency of recessions.  John Mauldin has discussed this at length as well.  The bottom line is that during an extended deleveraging process, economic volatility is higher than “normal” which means recessions are more frequent than “normal” when you are dragging along at “stall speed.” More frequent recessions, more volatile economic growth . . . higher risk premiums, lower equity prices.  We’d also recommend taking a moment to read this interview, available at GuruFocus, with Fairfax CEO, Prem Watsa to get a feel for the possibilities here.  “That second leg can be vicious, and we might well be entering that second stage.”

Deja Vu All Over Again

“The simple fact is that the measures that we use to identify recession risk tend to operate with a lead of a few months. Those few months are often critical, in the sense that the markets can often suffer deep and abrupt losses before coincident and lagging evidence demonstrates actual economic weakness. As a result, there is sometimes a “denial” phase between the point where the leading evidence locks onto a recession track, and the point where the coincident evidence confirms it. We saw exactly that sort of pattern prior to the last recession. While the recession evidence was in by November 2007 (see Expecting A Recession), the economy enjoyed two additional months of payroll job growth, and new claims for unemployment trended higher in a choppy and indecisive way until well into 2008. Even after Bear Stearns failed in March 2008, the market briefly staged a rally that put it within about 10% of its bull market high”

In addition to the economic similarities, here’s a look at the current set-up is from a technical standpoint, compliments of The Chart Store:

Source: thechartstore.com

 Europe’s Banks

“At present, the S&P 500 is again just 10% below the high it set before the recent market downturn began. In my view, the likelihood is very thin that the economy will avoid a recession, that Greece will avoid default, or that Europe will deal seamlessly with the financial strains of a banking system that is more than twice as leveraged as the U.S. banking system was before the 2008-2009 crisis.”

Here’s a great illustration of the extent of Europe’s problems in one concise chart.  Per the folks at Credit Writedowns, “The size of the largest four banking institutions in France, for example, represents over 300 percent of the country’s GDP.”

The Fallacy of Forward Earnings

 “While many Wall Street analysts continue to view stocks as cheap on the basis of forward operating earnings (which reflect expectations of a continued economic expansion and the maintenance of record profit margins indefinitely), the use of forward P/E multiples is a valid shorthand for discounted cash flow valuation only when profit margins reflect a level that is actually likely to be sustained over several decades. Even then, the benchmarks typically applied to forward operating earnings are actually based on historical norms for price-to-trailing net earnings.”

Here’s one of the problems with “forward earnings” in a nutshell.  We will discuss the second momentarily.  For now, suffice it to say that profits are extremely high and have always reverted to trend historically.  Perhaps this time is different, but it never has been, so we’d caution those betting it is.  In fact, if indeed this time is different, we’d suggest that the major trend change ahead is best signaled by the Occupy Wall Street movement.  The largest driver of profit margins today is clearly employment – meaning there is very little of it.  The share of profits making its way to corporate balance sheets rather than their employees has been increasing for a generation.  The result is record income inequality at home and abroad.  This is precisely why we have America’s next generation unemployed and sitting outside the Financial District as if it were Tahrir Square.  Again, my bet is that if indeed “this time is different,” the difference will not be in favor of profit margins, as the pendulum is likely to swing back towards labor over time. I suspect that income inequality across the globe does not end well for any of us. This is definitely something worth monitoring.

Bad Estimates

 “Investors should recognize that P/E multiples are simply a crude shorthand for legitimate valuation calculations (specifically, the careful discounting of a whole stream of future cash expected to be delivered into investor’s hands over time). P/E multiples subsume a whole set of assumptions regarding the entire future path of growth rates, profit margins, return on invested capital, and other factors. The common practice of valuing the stock market based on “forward operating earnings times arbitrary P/E multiple” is not only misguided – it’s an utterly disappointing display of Wall Street’s willingness to dumb-down the investment process. As investors have discovered through more than a decade of zero returns, the constant abandonment of intellectual effort comes at a cost over the long-term.”

The second issue with forward earnings multiples is simply that they are WRONG.  The chart below, initially posted at The Big Picture shows S&P operating earnings (red line) and their 12-month forward forecasts shifted ahead one year. Bottom line according to James Bianco, “If the economy goes into recession, earnings forecasts are not 10% to 12% too high. Instead they might be 20% to 40% too high. In other words, if the economy goes into recession, the earnings forecasts are horribly wrong.”

Source: Bianco Research

The second chart shows the difference between the forecasts and actual releases. The shaded areas highlight official recessions. Bianco notes, “Wall Street is one of the few places where practice does not make perfect. Notice that every subsequent recession sees larger earnings error rates than the previous recession. During the 1990/1991 recession, top-down forecasters (strategists) were too optimistic by 10%. Bottom-up forecasters (adding up the 500 company forecasts) were too optimistic by 25%. During the 2000/2001 recession, top-down forecasters were too optimistic by 25%. Bottom-up forecasters were too optimistic by 23%. During the 2007/2009 “Great Recession”, top-down forecasters were too optimistic by 39.6%. Bottom-up forecasters were too optimistic by 40%. Also notice the difference between the top-down and bottom-up forecasts. Current strategists are getting significantly worse at predicting earnings than their 1980s and 1990s counterparts.”

Source: Bianco Research

Consensus expectations, particularly bottom-up, are still wildly optimistic.  Bulls continue to point to “excellent” company fundamentals to support their thesis, completely missing the fact that they are staring in the rear view mirror.  Top down forecasts are less rosy but are yet to bake in recession which I think is a given at this point.  Equity analysts rarely lower estimates, recommendations, etc. based on in-house forecasts. They wait until they are told by management, which by definition, is too late.  Company fundamentals still appeared “excellent” in H1-08 as well.  Until they didn’t. By the time management admits the economy has turned, we are typically closer to the recovery.  According to research performed by Ned Davis, the S&P has actually declined historically when earnings expectations have been this lofty.  The time to get bullish is only once consensus has baked in the drop in forward earnings.  Not before.

Setting the Record Straight

One last point on valuation that drives me mad.  This one is almost as popular as forward earnings. Take a look at the illustration below. If you can determine any relationship between the “earnings yield” on stocks and interest rates, please give me a call.  Because outside of the brief period in history that an illusion of a relationship appeared – which happens to coincide with the time period that most investment managers in the business today have operated – there is no relationship between expected returns on stocks and expected returns on bonds. The consensus would also have you believe that as interest rates and inflation come down, PE’s should go up.  Ask the folks in Japan how this has worked out for them.  The fact is, today’s models worked great in an environment of increasing leverage.  No one has thought to look at how they would perform as that leverage is unwound.  The impact on economic growth, financial asset prices, inflation, etc. is profound and few have yet to grasp this change.

Source: GMO

Consider a few simple examples to help illustrate why this is utter nonsense. First, suppose I am willing to sell you a quart of milk for $10 but offer you a gallon for $30.  Does that mean the gallon is cheap or that it is a good buy at today’s price?  If you answered yes, and you are a long-only investor, good luck. Alternatively, suppose you can buy a dollar today for 50 cents. Tomorrow, you pay two dollars for that same dollar. Is the level of the ten year treasury, or any interest rate for that matter, a significant determinant of how those investments work out for you? If you answered no, you are on your way to separating fact from fiction. Now please press mute on your remote control the next time you hear anyone comparing the yields on stocks to interest rates on bonds. Chances are anything else they have to say is not worth listening to.

Bottom Line – Too Much Leverage

 “This is a good opportunity for investors to review their tolerance for significant losses. My impression is that this may be the best opportunity to reduce risk that investors are likely to see for a while.

“As of last week, the Market Climate in stocks remains negative, but has deteriorated significantly from the more benign negative levels that we’ve seen in recent weeks. Generally speaking, the worst market plunges tend to feature three things – overvaluation, negative market action, and a short-term overbought condition.”

A quick look at just how overbought this market is in the short term.  As a general rule, overbought conditions should be sold in bear markets. In case you were wondering, this is a bear market.

Source: thechartstore.com

“You rarely see the three together, because establishing that sort of condition requires a strong rally against both overvaluation and negative internals. That’s about where we are, though we can’t rule out a modest extension for a bit – mostly because advisory bearishness is reasonably elevated as of last week. That said, the drop in the CBOE volatility index late last week suggests an abandonment of bearish views, and more generally, just as early shifts toward advisory bullishness at the beginning of bull markets are often accurate and followed by further gains, early shifts toward advisory bearishness at the beginning of bear markets are also often accurate and followed by further losses. Overall, market conditions remain negative . . . “

Contrary to popular belief, the market is NOT cheap here. There are pockets of value if you look hard enough.  But broadly speaking most major stock averages are not cheap. The chart below shows the S&P 500 trading at over 20x normalized earnings, relative to a long-term average closer to 16x. The current multiple is not that far off from where the market traded in the mid-60s prior to a bear market that lasted for almost two decades. You can feel comfortable hitting the mute button on your remote control whenever you hear someone claim that the next ten years look good for stocks, based solely on the fact that the last ten years were poor.  Will they ever learn?

While many of our indicators are pointing to excessive pessimism, which may well be supportive of further rally, it is worth noting that AAII’s measure of Bullish Sentiment has rebounded sharply back to levels last seen in July, when all was still well in the world.

Putting it all together, the immediate future is not so bright for the buy-and-hold type today.  While there are certainly values to be found in the large, multinational franchises that historically traded at premiums to the market, I am also growing concerned that this is more of a consensus belief today. Groupthink is dangerous. When everyone crowds into the same trade, the crowd is rarely right. One of the factors which made the 2008 crash so devastating was the forced liquidation driven by excessive leverage in the system. Once the crowd started selling, they all sold. We run from one side of the boat to the other, and back again. As they say, financial memory is notoriously short.  But even we are surprised by speculators’ willingness to jump back on the leverage train after being so badly burned three short years ago.  The amount of leverage in the system today is back at dangerous levels – it is declining, but prior market bottoms did not occur until these debts were entirely wiped out. I just hope this doesn’t mean that owners of risk assets and retirement plans get wiped out for the third time in ten years.  Be careful out there.

This market has now doubled from “the lows” reached in March 2009.  Unnervingly, there have been only two other times when the market has rallied so sharply over this time period.  Neither of them occurred during raging bull markets.  In fact, both of them occurred during the Secular Bear Market of 1929 to 1942.  Over this period, normalized valuations (as measured by CAPE) fell from a peak of 32.6 to a trough of 5.6.  While there were occasionally powerful rallies throughout this cycle as evidenced below, investors were well served waiting for lower valuations and/or extreme oversold conditions before dipping their toes in the water.

We find ourselves in a similarly uncomfortable position today, with the markets extremely overbought (below) and still, stubbornly extremely overvalued.  In the current Secular Bear Market which began at the turn of the millennium, normalized valuations reached 43.8 – more than 10 points better than the peak of 1929.  Even today, after a ten year bear market in stocks, normalized valuations still stand above 24x CAPE, a level significantly higher than any other market peak outside of 1929 and 2000.  Coincidentally, today’s Monster Rally (shown below), has taken us back to a similar level of overvaluation reached after the Monster Rally of 1937 (22x CAPE).

The prognosis for forward returns does not look particularly appealing.  As shown below, the market’s performance after past Monster Rallies of this magnitude has been decidedly negative 4, 8, 12, 26 and 52 weeks later. It is impossible to know exactly when the fuel will run out of Junk Ben’s Rally, but history has not been kind to those holding on for the last few percent of speculative blow-offs.  Be careful out there.

Source: Thechartstore.com

Source: Thechartstore.com

“We don’t use numerical, quantitative evaluation systems to determine people’s pay. We don’t have a formula to use for calculating pay based on so many upgrades or so many downgrades, and we don’t compute each analyst’s P&L . . . Of course, the people who work on funds that produce incentive fees for us, which is most of our business, get a share of the incentive fees. To distinguish us from other types of organizations, however, the important thing is that our managers don’t get paid for what they contributed to the incentive fees. In other words, they don’t get paid for the profits on their own deals. Everybody gets paid on the profits of the whole fund . . . I think every person should have the goal that the fund succeeds, and our system encourages teamwork. If they have that goal, they have a greater incentive to help their teammates do better . . . I think that creates a very wholesome incentive system. People are concerned whether they do well, whether their teammates do well, and whether all the funds in the company do well. It also tends to make people concerned with the long run and not the short run.”

Marks precisely portrays the essence of investment management in explaining that the number-one job of a money manager is not making a lot of money; it’s not beating the market. It is risk management.

“I believe strongly that girding for bad times, and thereby ensuring margin for error, is more essential than preparing for good times. If you prepare for and count on good times, their failure to materialize can knock you out. There’s a downside to this, however. Having a margin for safety in your portfolio means you can’t always maximize returns. The people who are sure what’s going to happen and turn out to be right—due to skill or luck— are the ones who’ll maximize. Those who aren’t sure what is going to happen and build in a margin of safety are unlikely to maximize under any single scenario. As investors, we all have to choose whether we’re going to play mostly offense or mostly defense.”

We choose defense.  Like Marks, we are worriers.  And there is no shortage of potential risks to keep us up at night.  But unlike Marks, we are not particularly excited about the prospects for long-term equity returns today.  A recent letter to Oaktree clients, titled Hemlines & Investment Styles, reviews recurring patterns, the history of stocks and bonds, and the old adage, “What the wise man does in the beginning, the fool does in the end.”  The letter is well worth a read and provides an excellent overview of the cycles of fear and greed in the stock market over the past century.  Perhaps the most important point is that investors consistently seize upon above average returns and extrapolate them, and the 17.6% compound return on the S&P 500 from 1979 through 1999 was certainly a case in point.  But rarely do they ask what gave rise to those good returns, or what it implies for the future.  Marks warns that:

“Investors consistently rail to recognize that past above average returns don’t imply future above average returns; rather they’ve probably borrowed from the future and thus imply below average returns ahead, or even losses . . . The right question to ask in the late 1990s wasn’t, ‘What has been the normal performance of stocks?’ but rather, ‘What has been the normal performance of stocks if purchased when average P/E ratio is 33?’”

Marks goes on to explain that price-earnings multiples are lower than usual today and 13% below the post-war average, while the “cash flow yield” is roughly capable of being compared against the yield on bonds.  This is where we respectively disagree.  Investors are being irresponsibly misled by countless talking heads, and quite a few respectable managers, who claim that stocks are cheap because their “earnings yield” or dividend yield is higher than the yield available on bonds, which hasn’t occurred in a number of decades.  Lots of things haven’t happened in decades.  That doesn’t necessarily mean there is anything special about them.  If these folks bothered to look more closely at history, they would see that dividend yields were higher than long-term bond yields for virtually the entire period from 1927 to 1958.  So what does that tell us?  Not a whole lot, except that this relationship was primarily driven by falling bond yields due to deflationary pressures and the extended effects of a lengthy deleveraging process. Coincidentally, these same forces are driving yields lower today and are likely to continue to do for some time.  So comparing the “earnings yield” or the dividend yield on stocks to “low” long-term bond yields, has almost zero predictive ability.  If anything, it is more helpful to look at the absolute dividend yield of the market, which still sits around 2% today, versus a historic average of 3.7% (coincidentally, around the same level seen at the market low in March 2009), and previous “bargain” levels of 5.6% or greater.

Andrew Smithers, best characterizes our frustrations, in Wall Street Revalued:

“Invalid approaches to value typically belong to the world of stockbrokers and investment bankers whose aim is the pursuit of commission rather than the pursuit of truth.  The more they achieve their aim the greater is their success at creating confusion rather than helping our understanding . . . The reason why current PEs provide no guide to value is that profits are highly volatile and rotate around their equilibrium level.  If profits are at their equilibrium level, and only if they are, then the ratio of the current to average PE will provide a valid estimate of the market’s value.”

Laymen’s interpretation: PEs calculated on one year of earnings are virtually meaningless.  It is absurd to value the stock market on current or predicted PEs when profits and margins are near peak levels.  It is equally absurd to undervalue the market when profits are depressed.  For example, at the end of 1932, after a near 90% fall in stock prices, the market PE was about 25% above average.  Anyone care to argue that stocks were expensive at this level?

There are two issues with Marks’ claim that multiples are lower today then the post-war average.  The first is a mistake commonly made by the street – the use of post-war data.  Limiting your dataset has important consequences, especially when today’s experience is likely “out of sample.”  The second is the price-earnings multiple used.  While Marks does not detail his definition of earnings, rest assured that they are not normalized.  Any attempt to normalize earnings, results in dramatically different results.  For example, a Cyclically Adjusted Price Earnings multiple, or CAPE, can be calculated by averaging the earnings per share of the stock market for each of the past ten years.  CAPE is a simple way to calculate the equilibrium rather than the current level of earnings.  The crucial assumption is that this averaging will provide a good guide to the current equilibrium level.  See the chart below for the results through Friday.

“There’s no such thing as a good idea . . . or a bad idea.  Anything can be a good idea at one price and time, and a bad one at another.  That question – at what price? – isn’t just the right question to ask about bonds versus stocks today.  It’s the right question regarding every investment at every point in time.”

To answer Marks’ question, we examine average ten-year returns based on various normalized earnings multiples.  When stocks have been priced in the most expensive quintile of CAPE ratios, as they are today, the average real return has been 2.5%.  Not exactly performance to write home about.  Sure, there are small segments of the market that are fairly priced (i.e. high quality franchises), but just because something is cheaper than the general market does not mean it won’t go down.  During abroad downward movements in the market, this segment may very well fall with the broader indices.  In our view, broad equity markets have already fully priced an economic recovery.  Consequently, downside risks should be fast and furious should the notorious double dip emerge.  Under such a scenario, government bonds would still provide a useful hedge to risk assets, as yields are likely to plunge further once economic expectations fall back to reality.  We’ll have more to say on our bullish bond call in coming weeks.  Until then, investors can revisit Ten Reasons to Buy Bonds.

We have a tremendous amount of respect for Mr. Marks and Oaktree.  But better buying opportunities lie ahead for equity investors.

“The Fed Model has been embraced by Wall Street cheerleaders as a simple and “reliable” method for estimating stocks intrinsic value.  Note that simple is the key word in that last sentence, as it conveniently takes less time to calculate which provides strategists with much more time to shake their pom-poms.  In any event, the so called Fed Model is a straightforward comparison of earnings yields (the inverse of price-to-earnings multiples) and treasury yields.  When earnings yields are higher than treasury yields, so we are told, stocks are attractive and vice versa.  Sounds intuitive and is certainly easy to grasp.”  But, “there is almost no relationship between the two data sets (earnings yields and Treasury yields) with the notable exception of the period since around 1980.  What an amazing coincidence that this is the only period that “the street” has chosen to examine.”

The “Sunshine Pumper Strategists” are out in full force today, with earnings yields on stocks spiking higher than those available on bonds.  So we were pleased to see that Ron Griess at The Chart Store provided us with a couple of charts this morning that illustrate this relationship (or lack thereof) over time.  Ron’s long term perspective is critically important here, as any monkey can easily pick out a few bananas that accurately predict the market at any given moment in time.  But we would not invest our client’s capital (or our own for that matter) based on one monkey’s bananas.  Instead, we’d prefer to focus on those few characteristics (i.e. normalized valuation) that consistently add value as a predictor of long-term returns, throughout history.  As such, I sent Ron an email this morning complaining that if one more strategist tells me that stocks are cheap because their “earnings yield” is greater than the yield on bonds, I may puke.  As Ron was concerned for my stomach, he  was kind enough to grant us permission to share this charts with our readers.  And also offered up the following colorful commentary.

“Too many of the “sunshine pumper strategists” draw their conclusion first, then look for supporting evidence. I know of one, who is a subscriber, and knew there must be others out there who were pounding the table with the earnings yield argument because I was getting requests for charts. I’m sure most of them are showing a chart of 10 or 20 years to make their “positive” case to BUY stocks. I know another portfolio-manager-type subscriber was very disappointed to learn that yet another reason to “buy ‘em” did not hold water if one looks at “the rest of the story,” i.e. far enough back in history.”

Source: Thechartstore.com

Consensus earnings estimates for 2011 and 2012 are still greater than $95 and $108, respectively, at the same time that GDP estimates are plummeting (although still don’t face the harsh economic reality).  To put these figures into perspective, analysts were forecasting a near 20% decline in earnings at the market’s trough.  Today, expectations are for 22% growth in the year ahead.

We show an example of this optimism below.  Cummins is a global leader in the design, manufacturing and distribution of engines and related technology.  The company’s engines are found in a wide range of vehicles and equipment from emergency vehicles to 18-wheelers, berry pickers to 360-ton mining haul trucks.  Management has done a tremendous job managing through the crisis.  Costs have been cut relentlessly, resulting in a leaner organization with greater operating leverage.  The balance sheet is rock solid.  Not to mention its image as a ‘safe’ play on the secular growth of emerging market infrastructure development.  It’s no wonder the street is in love with the stock.

We have a difficult time arguing any of the points above.  Our concern is that the bar is set awfully high just as we stare right into a cyclical slowdown at best and more likely, something much more problematic.  Note the company’s historic EBIT margins below.  Margins increased from 1.4% at the start of the decade to a peak of 9.4% as the global economy marched straight up through 2006 on the back of the Chinese growth engine fueled by a credit-obsessed American consumer.  Then . . . something changed.  And something changed quite quickly.  As economic growth screeched to a halt in 2008, margins followed, moving in a straight line back to 1.7% in Q3-09.  But with ‘a little’ help from the greatest monetary and fiscal stimulus in economic history, orders reappeared and a stream-lined Cummins surprised analysts quarter after quarter, in route to a magical V-Shaped Recovery.

So what’s next?  In classic fashion, consensus has basically straight-lined that v-shaped recovery over the next few years, as shown by the last piece of the chart highlighted in red and representing consensus estimates through 2011.  Wall Street bulls – of which there are plenty, as none of the analysts covering the stock are brave enough to rate it less than ‘hold’ – are now projecting that the company’s margins reach record highs above 11% over the next eighteen months.  Such levels would be nearly 200 basis points above the prior peak reached at the height of the credit-induced global growth bubble.  Possible?  Sure.  Likely?  Eh.  Not to mention that these record margins on record sales would be achieved in a global economy in the grips of an extended deleveraging process with much of the developed world entering recession or battling depression.  We can’t help but wonder, who’s buying all this stuff?

Disclosure: At the time of publication, the author did not hold a position in Cummins, although positions may change at any time.

“Economic conditions are likely to remain challenging throughout the year, but the amount of stimulus building in the pipeline makes a cyclical rally in equities increasingly likely.  We are certainly not wildly bullish today, but we believe most of the perceived threats are priced in and we have likely experienced “the point of maximum pessimism” which has historically represented a tremendous opportunity for long term investors. Lower prices and reduced risk levels, combined with exploding liquidity and extremely oversold momentum, are conditions typical of powerful advances in equities.”

Fast forward to today.  Revisions have clearly peaked and are declining sharply at the same time the bar has been moved substantially higher.  Not pictured here are valuations that have also moved steadily higher alongside the bar, meaning downside risk has increased from today’s artificially inflated levels.  Consensus earnings estimates for 2011 and 2012 are still greater than $95 and $108, respectively, at the same time that GDP estimates are plummeting (although still don’t face the harsh economic reality).  To put these figures into perspective, analysts were forecasting a near 20% decline in earnings at the market’s trough.  Today, expectations are for 22% growth in the year ahead.  The average annual gain on the S&P when earnings growth estimates have been below 4.2% has been a positive 17.2% return, consistent with last year’s monster bear market rally.  Regrettably, the average annual performance of the S&P when earnings growth estimates have been above 14.2% has been a decline of 4.6%.

The weight of the evidence clearly points to a double dip.  There are no guarantees in this business, but we put the odds at near certainty (if we ever escaped the clutches of recession in the first place).  Those that can’t see this, simply don’t want to.  The best argument we’ve heard to date against another contraction in the economy, is that ‘double dips are extremely rare.’  So are national house price declines, developed world sovereign debt defaults and the associated and extended deleveraging processes.  We’d humbly suggest that ignoring these so-called ‘rare’ risks may not be beneficial to long term returns, particularly in light of today’s elevated valuations and lofty expectations.  Caveat emptor.

In the second part of our series on various misunderstood macroeconomic relationships, we concluded that there is little correlation between economic growth and stock prices.  We think Benjamin Graham most accurately captured this phenomenon by explaining that, “In the short run the stock market is a voting machine.”  In other words, short term price movements are driven primarily by Fear (2008) and Greed (2009).  But Graham also taught us that a security’s true intrinsic value will ultimately be realized over time, “In the long run the stock market is a weighing machine.”  As a student of Graham, Warren Buffett gets it. “Price is what you pay.  Value is what you get.”  The price you pay is the single most important determinant of expected returns.  

Not unlike the unlimited combinations of flavors for Frappuccinos at Starbucks, there is no shortage of definitions for “value” today.  The most common factor is the P/E Ratio. At the most basic level, P/E is simply the price (P) of each share divided by the company’s earnings (E) per share for an individual company. Likewise, the P/E on the overall market is an aggregate of the prices and earnings of all the companies trading on the market.  The problem for investors is that because there are many ways to measure value, one can see what one wants to see.  Ned Davis recently provided us with an interesting recap of how this definition has changed over time.  

When the long-standing GAAP P/E ratios got overvalued, most on Wall Street shifted from GAAP earnings to so-called operating earnings, which added back into GAAP earnings a lot of the bad stuff that had been written off in GAAP earnings. When these operating P/E ratios got too high in the late 1990s, Wall Street shifted its focus to so-called “forward operating earnings” or predicted earnings. Sometime around 2000, they had to predict growth stock earnings three years into the future to argue that growth stocks were still reasonable. By 2007, nearly all of Wall Street had shifted to relative, forward predicted operating earnings, or the so-called Fed Model. This showed stocks deeply undervalued at the 2007 peak. Interestingly, nearly all the “Fed Models” shown only went back to around 1980. The reason is if one took them back further, they fell apart.  

Ned has a tremendous ability for calling it as he sees it.  Perhaps it’s simply the lack of investment banking biases at NDR.  Perhaps it’s something in the Florida orange juice, rather than the NY water.  Whatever the reason, we appreciate you Ned.  And we aspire to do the same.  It is in this regard that we’ll outline a few additional truths about valuation.  Specifically, we’ll discuss the relationship with inflation, the Fed Model, and forward “operating” earnings.  

Inflation  

Suffice it to say that the quality of “sell side” research has deteriorated over time, as predictably bullish biases can be proven false by anyone with a basic understanding of history and a hand held calculator.  One of our favorite Wall Street fairy tales is the popular delusion that high stock market values can be justified by low levels of inflation.  Let’s assume for a brief moment, that the intent of these strategists is not to mislead their clients in an effort to generate greater fees for their respective firms (we recognize we’re out on a limb here, but stick with us).  Making this leap of faith would then lead us to the conclusion that they are simply too lazy to do the work required.  It is true that history demonstrates a clear inverse relationship between trailing inflation and price-to-earnings multiples (i.e. lower inflation has been accompanied by higher valuations and vice-versa).  This is illustrated in the chart below.  

www.hussmanfunds.com

Unfortunately, most strategists stop here when they should be focused on the implications for expected returns.  In other words, do low rates of inflation justify high valuations and lead to attractive long-term returns despite elevated price-to-earnings multiples?  The answer is no – they do not.  Rationalizing high valuations using current levels of inflation and/or interest rates actually destroys the predictive ability of normalized valuations.  

We will concede that market history validates Wall Street’s conclusion that low trailing inflation rates have been associated with high price-to-earnings multiples, and vice versa.  But, while low inflation may help explain why stocks are overpriced, it does not alter the long term consequences associated with that overpricing.  Simply put, high valuations produce low long-term returns, while low valuations generally produce attractive long-term returns.  There is no need to overcomplicate this.  

www.hussmanfunds.com

The Fed Model  

The Fed Model has been embraced by Wall Street cheerleaders as a simple and “reliable” method for estimating stocks intrinsic value.  Note that simple is the key word in that last sentence, as it conveniently takes less time to calculate which provides strategists with much more time to shake their pom-poms.  In any event, the so called Fed Model is a straightforward comparison of earnings yields (the inverse of price-to-earnings multiples) and treasury yields.  When earnings yields are higher than treasury yields, so we are told, stocks are attractive and vice versa.  Sounds intuitive and is certainly easy to grasp.  Perhaps Wall Street had even hoped to inspire additional confidence by giving this particular measure of valuation such a strong endorsement.  Granted, they could have done worse (better luck next time Nike), but does this picture really promote confidence?  

According to work done by John Hussman, there is almost no relationship between the two data sets (earnings yields and Treasury yields) with the notable exception of the period since around 1980.  What an amazing coincidence that this is the only period that “the street” has chosen to examine.  And how convenient that the model clearly indicates stocks as being deeply undervalued for most of the decade since the market “bottomed” in 2002-2003. Unfortunately, (for investors) it turns out that the model persistently indicates that stocks are a bargain.  Although not depicted in the chart below, the Fed Model would have also implied that stocks were about as “undervalued” as they are today, just before the 1929 crash!!  

www.hussmanfunds.com

Forward “Operating” Earnings  

In recent years, price-to-earnings multiples based on forward “operating” earnings have become the new standard on Wall Street.  As we have learned, most “improvements” on Wall Street are more accurately portrayed as “distortions.”  This one is no different.  By way of background, forward “operating” earnings are based upon consensus analyst estimates for next year’s earnings, excluding “extraordinary” and “non-recurring” charges (that often recur quite predictably) and a variety of additional information that “the street” chooses to ignore.  Operating earnings are not defined under Generally Accepted Accounting Principles (GAAP) and are inevitably higher than actual earnings.  This comes in quite handy for bullish “sell side” strategists as higher earnings translate into lower valuations.  

The sell side has conditioned investors to believe that “normal” price-to-earnings ratios have historically averaged about 15 and regularly use this as a basis for comparison with valuations based on forward “operating” earnings.  What these strategists shamelessly ignore, however, is that the average they regularly quote is based on trailing earnings! Astoundingly, by using valuations based on elevated earnings, “the street” is able to once again demonstrate how “cheap” stocks are based upon “below average” price-to-earnings multiples.  Unfortunately, because data on forward “operating” earnings estimates has only been compiled since the early 80s, there is no long term historical data to even determine the “normal” level of forward price-to-earnings ratios.  And heaven forbid analysts have to dust off their HP 12C and actually build models!  Thankfully, there are a few of us that still do, and John Hussman’s estimates indicate that the average ratio based on forward “operating” earnings would be closer to 12, rather than the often-quoted 15.  Of course, this is also a period dominated by high and rising valuations, so if we exclude the extremes reached in the tech and telecom bubble, the average falls closer to 10.  

The fun doesn’t stop there either – at least for those of us with some skin in the game.  In order for investors to rely upon the current level of earnings to estimate the intrinsic value of a long term asset, those earnings must represent a sustainable level of profits; otherwise, it is imperative to normalize profit margins which are naturally cyclical.  For anyone that is incredibly curious about today’s forward earnings expectations and the assumptions for profit margins, see William Hester’s recent piece here.  

For everyone else, we’ll continue with several metrics that are actually quite good predictors of future returns after the holidays.  Happy New Year!!  

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