What is the SP500 Worth?

S&P recently published its buyback report which provides details of money returned to shareholders via buybacks.

On a trailing 12 months to 30 September, 2011, SP500 companies have returned per share amounts $25.18 in dividends and $44.30 for a total of $69.48.  For the full year, I expect SP500 companies will have returned per share amounts $25.65 in dividends and $47.60 for a total of $73.25.  If we assume that SP500 companies can grow this value returned at a real growth rate of 2%, an investor who has a long term real rate of return expectation of 6.5%, should have been willing to buy the SP500 at 1,575 at end September and at 1,660 at end December, for this is the discounted value of future cash flows expected to be returned to shareholders.  There are 3 major problems with the calculation above; 

Europe: A Tail Risk No More

What is a tail risk?  Put simply, it is a future risk event that has a low likelihood of occurrence in the absence of sheer stupidity.  In Europe, we have seen sheer stupidity flow forth from Germany.  And that leads me to believe Europe is no longer a tail risk; it is a very real risk.

This week we saw Germany scoff at the immediate need to provide funding to IMF; we also heard that none might be provided if the rest of the world does not chip in.  We also saw Troika not closing on the Greek debt deal.  We also saw Monti pushing back.

Now Papademos and Monti are both technocrats.  And given that what Germany demands makes no sense; in the long term it is likely that they will conclude that it would be better to leave the EZ, gain control over their own currency, restructure their debt and move on.  The alternative imposed by Germany is far worse as it has a deeper depth to suffering and a longer duration too.

SP500 2012 Outlook

In Europe Storm clouds continue to gather.  A recession has likely already started.  In emerging economies, rates of growth have slowed down considerably.  In US Q3 GDP was first estimated at 2.5%.  The second estimate came in at 2%.  I expect the final estimate to come in at 1.5%.  Corporate America has started warning on expectations by giving initial signals of slowing growth during Q4 2011 and Q1 2012; the earnings downgrade cycle which is in an advanced stage in EM's is only just beginning in US.  A slow down in EM's and a recession in Europe more or less assure that US will enter recession during Q1/Q2 2012, if not in Q4 2011.  The fiscal drag from a potential loss of the stimulus provided from payroll tax cuts, could result in a sharp contraction, but if the payroll tax cuts are extended, any contraction could be fairly mild.

What Did the EU Summit Achieve?

Merkel rightly believes that Europe's problems will take years to solve; but she translates that into meaning that she has time to act. The luxury of time is just not there; if Italy or Spain go from being illiquid to being insolvent, the problems that are manageable today, become unmanageable. What is required, or rather desired, is something credible; something decisive; something substantial; something quick; something comprehensive. This was not achieved and so risks remain elevated. Something giving a few months or quarters visibility would help; but we remain in an environment where we watch the story unfold one day at a time. 

Sensex Upside Potential - 2012 Outlook

Fiscal Year 2011 (Year end 31/3/2011), earnings came in at 1,013.  Late last year, estimates for FY12 were centered around 1,275 and for FY13 at Rs 1,500.  Estimates have now been cut down to size; with FY12 estimates coming in at 1,125 plus or minus 50, and FY13 estimates coming in at 1,275, plus or minus 50.  And there is an expectation that this downgrade cycle will continue a while longer; for FY13 some like Bank of America are speaking of further downward revisions to 1,200.  In my view, just as there was too much optimism late in 2010, there is now too much pessimism built in to the numbers.  This opens up upside for FY13.

Good Week; What Next - Merkel Part of the Problem not the Solution

Markets moved up strongly.  But why? Nothing remotely resembling a solution for EZ came up. The waffling has just continued.  There is no progress; and what is worrying is that all solutions are clearly identified and on the table on which Merkel, Sarkozy and Monti dine. Merkel & Germany are clearly part of the problem not the solution; like a spoilt child she cries for treaty amendments as the only solution and accepts nothing else - a solution which does not buy time is no solution at all and while treaty amendments and debt reduction are the desired end outcome, in the interim a more proactive ECB and Stability Bonds are a must.

Global Central Banks responded to the rising TED Spread this past week; but TED continued to rise anyway.  Without something real on the table out of EZ we could see big trouble accompanying a spike from 53 bps to 75 bps initially and then higher as terror sets in.  A rising TED means a withdrawal of liquidity from markets; that is bad news for equity.  It also indicates fear of inter bank lending; this indicates a great degree of stress in the finacial system.  TED tends to be a very good short leading indicator of trouble; but it is quick to respond to changed circumstances, which means good policy could result in slowly narrowing spreads - that would be market positive.  When the TED spread is at 50 bps, a lot of very clever people are worried - you have to be watchful.  When TED spread is at 10 bps, a lot of very clever people are complacent, you got to be watchful.  In the middle, every mostly alright!

Risks have risen considerably; EZ bond yields and the TED spread need to be driven up, and equities need to fall sharply for markets to signal their lack of conviction and confidence in EZ policy.  And of course, gold and US-T as safehavens will rise.  That perhaps is the only thing which might force some policy action; and if it does not be prepared for a serious meltdown.

News in India over the week-end is possibly worrying with Mamta Banerjee claiming that Pranab Mukerjee has indicated that recent policy reform on FDI in retail is shelved pending consensus; see ET article here.

I wish Sarkozy and Monti had more influence in EZ, but they do not, for it would appear that the EZ is Germany.  I hope, that Geithtner will be able to offer insights and suggestions to EZ, but I doubt it; now a days Merkel hears only her own voice.

Bottom line, I think next week will be ugly, ugly, ugly.  Whether ugly evolves to a major meltdown depends on policy.  We remain at the mercy of policy makers and unfortunately they are not delivering. 

The Weak That Was - W/E 25 Nov 2011

Weak, week say what.  Down on the week, down on the year, down from the peak, languishing well below all key moving averages.  Indian Rs at a lifetime low, EZ on the verge of falling apart; the world as we know it looks like its about to end.

The Storm, The Butterfly & The Rupee As a Measure of Risk Aversion

The Rs did prove a good measure of risk aversion during the US led 2008-2009 crisis.  This time around, the main risk stems from the EZ.  And the Rs may prove to be a good measure of risk aversion once again; sometimes it is better to look for the Butterfly and away from the Eye of the Storm to watch a crisis unfold or resolve.

The Glitter of Gold

Gold Prices a Bubble?

This chart shows the nominal annual average price of gold and the nominal annual return from gold.  Gold is more expensive than ever before.  But this says nothing about whether it is a bubble; almost everything is more expensive.  The nominal annual return on gold are high, but certainly not at a level where a bubble at the point of implosion is evident.

Super-Committee Failure - Big Deal?

What does Super-Committee Failure Mean?

Well, looks like the super-committee is set to fail.  Is it bad, and if yes, why?  Its bad, because starting 2012, there are some small cuts in discretionary spending; payroll tax cuts will expire; extended unemployment benefits will go.  These cuts could hit GDP by 0.5% to 1% next year, thus ensuring that the US is at stall speed or in recession during 2012.  But what is really bad is that the nation is not able to rally around a common purpose; in the US, the magnitude of the problem is still not acknowledged by our political masters.

Bottom line; super-committee failure is nothing more than a disappointment.  Markets will ultimately move past this event. The political jostling for position will be interesting to watch; Obama will need some money to stimulate 2012 to protect recession downside and I suspect the might of the market is strong enough to ensure he gets it.

Presidential Cycle - Election Year

This is a brilliant chart from Ned Davis Research which shows the Dow has performance during the election year.  The data looks at the previous sixteen cycles.  Put it this way, the prognosis is not good for Obama unless the market has already bottomed, or will bottom no later than late November.  A decline through mid December would be bad news for Obama & indeed for markets during 2012.

I am hoping that we have seen the bottom for this bear; but the time wise correction required to mark typical bottoms does point towards a July 2012 bottom.  Throw Europe into the mix and the uncertainty rises further.

Blast From the Past

This video is all about happy memories - a memoir of the happy times 50 years ago when my uncle passed out of school.  I passed out some 24 years later.  We have long memories and despite a 26 year gap, the memories are amazingly similar.  Hear the words of the school prayer; very simple, but in some ways it covers everything that matters.  And it ends with Auld Lang Syne; we sung it to a completely different tune! More martial, perhaps more emotional; mostly a toast for those golden years now past.  The present is but an instant which flashes into the past; the future is cloudy, perhaps more now than ever before; but the past - that belongs to us it cannot change and we must learn and build upon that foundation.

The Austerity Trap W/E 11/11/11

Where are we in the business cycle? I would say near the bottom of the vicious phase on a secular basis.  And near the start of a vicious phase on a cyclical basis.  Good policy matters if the vicious secular phase is to be turned up into the virtuous secular phase.  Good policy to address the vicious secular phase would also shorten the vicious cyclical phase we are presently in.  Bad policy now would extend the duration of the vicious secular phase as well as the vicious cyclical phase.  Neutral policy would permit continuance of the vicious secular phase, while helping with the vicious cyclical phase.  At present, I believe policy is heading from bad to neutral.

Since steps are being made in the right direction, an optimist would hope for policy to progress to good; but the hurdles are monumental.  To make policy good, we would need to see far better global co-operation.  We would need to see solvent Europe embrace spending.  We would need to see a more substantial EFSF.  We would need to see a changed ECB; one willing to consider balancing growth and inflation risk and one expanding balance sheets and money supply to support illiquid but solvent markets.  We would need to see a good plan out of the US super-committee.  We would need to see the House & Senate vote yes to the plan.

All in all, the cyclical position is encouraging, while the reversal of the adverse secular trend needs more support.

Next Up - Super Committee - Week End 29 October, 2011

We had a good week. Markets rose solidly for the week.  Market technicals have improved with price over the one year MA and with the one month MA rising over the one quarter MA.  This was in response to the European plan and US GDP first estimate coming in at 2.5%.

The good news is that Europe came up with an action plan.  Much remains to be done, but it is an incremental positive.  Draghi's coming on board will also be an incremental positive; I'd expect to see a more balanced approach to the growth and price stability balance, in addition to the commitment to continue buying sovereign debt.  The likelihood of an interest rate cut has risen and this is positive.

I'd look for the markets to spend a few weeks consolidating with a downward bias (75 to 100 points on SP500).  After that a breakout or breakdown would depend on how the US handles economy and how markets digest the recent European action.  The French & German commitment to austerity and their pledge to provide no further support, together with the Republican's & Tea Party activists remain the greatest risks.  The markets are a very efficient & powerful leading indicator; now that Europe's plan is out, the markets should indicate the trajectory of the economy some six months out within the next couple of weeks.  Initial response is a relief rally in stocks, but the bond markets responded with rising Italy yields. A breakdown at the one year MA is a distinct possibility. 

I remain short term (6 months) optimistic since expectations are low and we need to test the theseus that enough has been done.  It will be positive if we see US markets trending in a range (even with a mild downward bias) to work of its overbought condition with falling volatility and EM's outperforming DM's; this is what I expect for November.  A rise into March and a subsequent decline in recognition of continued bad policy is in my view the highest probability event.  A helping hand from the G20 could be a powerful rally source - if the Europeans wont help themselves, perhaps someone else will.

Benefit of $ Cost Averaging a Myth?

One of the methods of investing commonly propagated by the financial services industry is $ cost averaging.  SP500 closed Friday at 1,238.  The annual average cost over the last six years was 1,227 - you could have stuffed your wealth in your mattress and used the it to buy the SP500 at pretty much the same level as a $ cost average investor. If you had bought debt or even invested in low yielding deposits, you would have outperformed a $ cost investor over the past six years.  A a portfolio allocator would have owned less equity over the first half of the six year period for the markets were expensive, and more equity during the second half when equity was cheap.

Do Earnings Matter - Weekly Snapshot 14 October 2011

Technicals deteriorated week before last, but the repair over the last week has been considerable.  

SP500 shows a weekly gain of 5.98%, a year over year gain of 4.33% and Friday closed at over the monthly and quarterly moving average with the index just 3% below the one year moving average.  Current index levels are also over the two and three year moving average and a mere two points below the six year moving average.

Sensex shows a weekly gain of 5.24%, a year over year loss of 16.66% and Friday closed at over the monthly and quarterly moving average with the index 7.8% below the one year moving average.  Current index levels are also over the three and six year moving average and somewhat below the two year moving average.

SP500 is now pushing against resistance at its 38.2% retracement of 1,228, though it does have place to run to 1,263.  Sensex has place to run to 18k levels.

How Cheap is the Market? Weekly Snapshot 30 September 2011

Markets technicals continue to look ugly, but not ugly enough. Valuation continues to look very appealing when viewed in the context of decade valuations.  But looking at valuations in the longer term the market will be priced for buying at lower levels:

Valuations investors have been willing to pay 1871 onwards says markets are attractive at 891.

Valuations investors have been willing to pay 1945 onwards says markets are attractive at 890.

Valuations investors have been willing to pay 1980 onwards says markets are attractive at 812.

Valuations investors have been willing to pay 1945-65 says markets are attractive at 940.

Valuations investors have been willing to pay 1929-45 says markets are attractive at 665.

Valuations investors have been willing to pay 1919-45 says markets are attractive at 805.

 Valuations investors have been willing to pay 1960-80 says markets are attractive at 884.

Valuations investors have been willing to pay 2001 onwards says markets are attractive at 1,143.

Sectors, Relative PE's & the Economic Cycle

Relative PE is the PE of a stock divided by the PE of the SP500.  The relative PE 6 is the price of a stock divided by six year median operating earnings for the stock, divided by SP500 Index level stock divided by six year median operating earnings for the Index.

The relative PE & PE 6 indicates how expensive or cheap the stock is relative to the SP500.  A relative PE of 50% tells you that the stock trades at half the PE of the SP500, a relative PE of 200% tells you that the stock trades at double the PE of the SP500.

In this post when I speak of a contraction, I mean a period of contracting growth rates and/or an outright contraction.

Please remember that these are relative values; absolute values can continue to fall even when relative values are attractive. This post is about allocations across sectors which should not be confused with the total amount allocated to equity as an asset class.

Gold's Message - Weekly Snapshot Sensex & SP500 23 Sep 2011

Money is first and foremost a medium of exchange.  It also serves a useful purpose as a store of value and a unit of account.

Gold no longer serves as a medium of exchange; because all goods and services are denominated in & trasacted using modern day money.  However, gold can be sold to buy modern day money, which in turn can be used to purchase goods and services.  Thus gold, as a derivative of modern day money, retains some characteristics of money.  

Gold still acts as a store of value; I don't understand why, buts its long history as the basis of money makes it gain acceptance as a store of value.

Gold does not act as a unit of account anymore.  Value and wealth is now measured in modern day money.  Modern day money is quite inefficient as a unit of account simply because a unit of value today, need not the equal to tomorrows unit value, simply because of forces of inflation. Take a ruler and measure a rod; its six inches today and will be six inches tomorrow, for an inch is an inch and remains an inch.  If the size of the inch were to halve, your  rod would measure twelve inches tomorrow.  And that would make some very happy.  But in reality your rod, would remain unchanged both in absolute and relative terms.  

It is the real value that matters, and a discrepancy between nominal & real values makes it more difficult to measure using modern day money.  Over long periods of time, the value of gold relative to other assets also varies; so it has no great advantage over modern day money as a unit of account.  But because it serves as a store of value, during period of distress, people turn to gold.  And so it becomes important to value gold.

Bill Clinton Speaks – Listen Up

This problem can be solved the Republican way, which is really very simple. The Tea Party caucus demands austerity. The Republicans demand that long term interest rates are not lowered. These two brilliant ideas set the stage for a great leveler. A Great Grand Depression will occur, and wealth will be destroyed. Since wealth is owned by the Rich Guy, the inequality problem will be solved; easy.

With deficits & austerity, we have to remember, that what we need to do today, ought to have been done yesterday and can only be done tomorrow.

Market Snapshot - Sensex & SP500 16 September 2011

RBI Rate Hikes Reverse Repo to 7.25% - A Minor Policy Error?

Central Bankers have an important job. They need to balance inflation, growth, unemployment and financial stability. In India, since we spend little time monitoring unemployment, we are left with inflation, growth and financial stability as key policy objectives. With the 0.25% hike in the reverse repo rate to 7.25%, in my view the RBI has committed a policy error. If further rate hikes continue, it would appear that the RBI effort is directed towards creating a situation where a hard landing is the most likely outcome, setting up an opportunity for a rate cut next year. But as of now, because real interest rates continue to be negative, the policy error is minor, and may prove to be a good policy action, if the growth cycle resumes and upward trajectory.

Fib & the Sensex in $ Terms

Sensex 6 year high was at 21,207 on 10 Jan 2008 when the exchange rate was Rs 39.29 to the $.  Expressed in $, Sensex was 540. 

Sensex 6 year low was at 7,656 on 28 Oct 2005 when the exchange rate was Rs 45.09 to the $.  Expressed in $, Sensex was 170. 

Fib retracement levels are at 453 (23.6%), 399 (38.2%), 355 (50%), 311 (61.8%), 257 (76.4%), 170 (100%).

The Sensex is at 16,934 with the exchange rate at 47.47; 367 when expressed in $.  Recent lows have been 15,765 on 26 Aug 2011 when the exchange rate was 46.052; Sensex at 342 in $ terms.

So, the Sensex has successfully tested its 50% retracement in $ terms, much as the SP500 has tested its own 50% retracement.

The chances of a market bottom rise as we move up the retracement percentage levels and successfully test those levels; so based on the $ Sensex, the chances of the markets bottoming are higher than when looking at the Sensex.

I thought this was interesting little factoid. 

Dare You Dream, as Others Wont? Dow 100,000!

On 1 Oct 1945 Dow traded at 192. It rose five fold to 969 over 20 years ending 1/10/1965.  This too was a period of post war deleveraging.

For the next 15 years the market went nowhere.  On 1/10/1980 it languished at 963. 

The Dow then rose eleven fold to 10,788 over the next 20 years to 1/10/2000.

Will we still be at 10,788 on 1/10/2015?

More importantly, by 1/10/2035:

Will the Dow be at 54,445 with a five fold return not unlike the 1945 to 1965 return?  This implies an annualized return of 8.43% plus dividends.  During this period, dividend yield averaged 4.42%; a person who bought early would have seen dividends grow by about 7.2% annually and would enjoy a rather nice yield to cost.  Payout ratios averaged 63.5% during this period.

Or

Will the Dow be at 120,852 with an eleven fold return not unlike the 1980 to 2000 return is delivered?  This implies an annualized return of 12.83% plus dividends.  During this period, dividend yield averaged 3.16%; a person who bought early would have seen dividends grow by about 5% annually and would enjoy a rather nice yield to cost; though not quite as nice as the 1945 to 1965 period.  Payout ratios averaged 50.6% during this period.

US De-leverage - Process Road Map

US have surplus capacity. Unemployment causes aggregate demand to fall. Deleveraging in both public and private sector also places a downward pressure on aggregate demand. Falling aggregate demand, coupled with high unemployment and surplus capacity are disinflationary and potentially deflationary. Deflation is a grave risk. Both monetary & fiscal policy are needed and the leverage situation should get worse before it gets better.  This is what I think might work; it is the kind of action I will be watching for as it will help figure whether we will plunge into an abyss (hopefully ahead of the crowd :-) or rise like the Phoenix (hopefully ahead of the crowd :-).