Market Value – A Historic Perspective

GMO & Goldman Sachs recently opined that they saw fair value for the SP500 at 900/950 range.

The obsession with 6 year moving averages, which you will see in my notes below, is because 6 to 7 years is the average length of an economic cycle. The six year moving average for as reported earnings works out at $57.36. Average market six year moving average multiples since 1929 is 16.61; while the median multiple is 15.46. In that sense a fair value between 887 and 953 makes sense.

If you look at six year moving average multiples since 1929, selecting only those years when the long interest rates lay between 1.25%and 3.25%, the average and median multiples are 18.84 and 17.77. Indicative fair market values for the SP500 are 1019 to 1081.

Looking at the 22 year operating earnings history, we get a 6 year moving average of real operating earnings of $72. The average 6 year multiple during this time is 22 which gives a valuation of 1590. At 7 years we have a 7 year moving average of 70.98 together with an average multiple of 20.7; indicative value is 1470. In my view, the risk premiums demanded by equity investors during 1988 - 2006 were ridiculously low; as a result the multiples during the 22 year period for which I have been able to gather operating earnings data is too high. In my view a sensible multiple on operating earnings should be no more than 16 to 18. At these multiples, the value range is 1150 10 1300.

Presently the SP500 trades at sub 800 levels. At 666 the market was discounting average as reported earnings of $40 for the next 6 years. In my view this is possible but not at all probable. In the short term, as clouds continue to gather the market can go anywhere, though I suspect not below 550.

A close at 550 would be bizarre. Look at it this way. The GDP in 1929 restated at a CPI of 213, would have been 1,132. A forward GDP expectation of 5,500 at CPI 213 would mean GDP grew at 2% per year since 1929. Now if we assume that corporate America grew in line with GDP, an index close at 550 would deliver real index returns of 1% annualized. This real index return together with a 1% real dividend return makes for a total return of 2%. The odd number in this story is the GDP forward expectation at 5,500; not something I expect on a worst case scenario.

In the long term, since 1929 through 2008, GDP (historic restated at 213 CPI) has grown at an annualized rate of 3.25%. During this period, dividends have returned just over 1%. For the index to have returned 2.25% (which takes the total market return to an amount equaling GDP growth), the market needs to trade at 1400. In my opinion, a worst case scenario would see GDP at 11,500 to 12,500 before returning to growth. To reflect equivalent returns for the market and GDP, the index should trade at 1150 to 1250 levels.

The extent of uncertainty over future earnings needs to clear before multiples can begin to expand. As of now, my view is that the future is somewhat less dark. Forward looking indicators are beginning to look less bad than a few months prior; backward looking indicators continue to deteriorate. The final quarter of 2008 also saw significant talking down of expectations. It also saw massive write downs, corporate actions and restructuring cost recognition; these actions will likely not be recurring - upside surprises in Q1 2009 can be expected in several economic sectors. Q1 2009 ought to be a trough earnings quarter for energy, basic materials and industrials.

Bottom line - as the clouds gather, expect a worst case scenario of 550. As clouds lift, expect a fairly sharp recovery to 1000. As the clouds clear, expect index level of 1400. Short term risks are high, long term risks are low; on a point basis, from 787 to 550 is 237 points or 30%. On the upside 787 to 1400 is 613 points or 78%.

Data is available on http://www.maxkapital.com/SP500Data.pdf.

Get on Your Bike - The Cycles Are A Changin

The recession marking the end of the era of consumer discretionary has been painful. Like all things, good and bad, it too shall come to an end. The question is what next? Economic cycles are rational. Late contractions start with a recovery in financial services and information technology; the economic expansions which follow are driven by consumer discretionary, industrials, basic materials and energy; then comes the time for defensive sectors such as health care, staples, utilities & telecom, which gain popularity during contractions. No one can deny that since the devils low of 666; financials, information technology and discretionary have tried to tell us that the next cyclical expansion might soon begin; they have outperformed. It might be a false reversible outperformance, but for now outperformance it is; and it is coming at a time when the future while far from bright, is looking less dark. The expansion whenever it starts is very important; it marks the onset of a new economic cycle lasting typically 6 to 7 years. This one is even more important because it marks the end of a secular trend in financials and discretionary sectors; this secular change-over is a significant event occurring no more than once each 18 to 20 years. This particular secular age, is even more important, for it marks the end of a group of 3 distinct secular cycles [financials, information technology & discretionary; basic materials, industrials & energy; health care, staples & utilities and telecom] - a once in 60 year event.

The economic cycle is simple, it is rational, and it rarely varies other than in sector intensity. Predicting the out performers for the next several market cycles is important; for this is what dictates the intensity within the sectors; financials, information technology and discretionary may well signal the impending start of the next cyclical expansion, but it is highly unlikely they shall lead the next bull.
The leader of the next bull needs a secular story, not a cyclical one and the secular expansion of the financials & discretionary sector is done. Both financial and consumer balance sheets are in agony; de-leveraging is necessary and de-leveraging will take time. Assume that the $50 trillion peak property market could support debt of $40 trillion. A fall in property values of 40% from peak to trough indicates new asset values of $30 trillion; that supports sustainable debt levels of $24 trillion. The $16 trillion debt gap is the extent of de-leveraging necessary and it will play out over many years; some will be written off, some is over-estimated as it goes without saying that not all consumer debt was created at peak property values, some will reduce as debt gets serviced and paid down by borrowers, some will disappear as sustainable debt levels rise once property prices start rising sometime in the future. While this process unfolds, both financial institutions and consumer balance sheets remain at risk; they cannot lead on a secular basis, so who will?
It is my view that the past decade and a half saw great strength in financial services, information technology and consumer discretionary. That era has drawn to a close. The era now starting, has several very visible pointers. America needs to restore financial discipline; America needs to de-leverage; America needs to save more; America needs to restore its primacy as a producer. So financial services as a multi market cycle leader is out. Consumer discretionary is out too. Information technology will remain important because it plays an important role for all economic sectors; but it is no longer a secular star. Who will be the next secular winner?
Industrials, basic materials and energy have all had a strong past economic cycle. I expect this group to see strong outperformance on a multi market secular cycle basis. The rise in the US saving rate will mean lower demand for discretionary goods. The hard lessons now learned will change habits for well over a decade. These savings will be invested for what is saved must be invested; you can either consume it, or save it - if it is saved, it is invested. Even if it simply deposited in a bank; it will be invested since what a deposit does is gives the bank access to cheap capital to lend. And yes, what is saved can also be used for paying for past consumption; de-leveraging consumer debt is what I expect most savings to go towards initially. Do keep in mind that as savings rise and de-leveraging continues, balance sheets get repaired and result in an increasing ability to expand credit; particularly with the kind of monetary stimulus in the system.
Capital will be needed for investment in industry to restore America's lost producer status; energy demand will elevate as industrial production rises and before industrial production rises, basic materials will be necessary - without raw materials, industrial growth is but an illusion. The strength in this sector has strong secular support from China and India; both economies with huge industrial and infrastructural needs. These are capital intensive sectors (both extraction and capacity expansion require high levels of capex and opex) and availability of credit in a de-leveraging economy is tight. Yet, the demand fundamentals together with supply constraints will mean strong cash flows. This coupled with the massive monetary stimulus will mean incremental credit flows to the sectors; much will come from debt diversion from prior popular credit markets (the consumer) to these sectors.
For financial investors; commodities provide a high degree of interest during periods when elevated inflation is expected; more so when a $ devaluation is possible. In my view, the large monetary stimulus injected into the global economies the world over will prove inflationary for the consumer and will result in a weakening $ as risk aversion reduces with the efflux of time.
While there is no doubt that extensive de-leveraging will be necessary following the recent and ongoing collapse in asset prices, it must be noted that deflation & de-leveraging do not always go hand in glove. Take for example the last 15 years; we have seen low levels of consumer price inflation, together with high asset price gains. Now it is likely that high consumer price inflation will come with restrained (not absent) asset price gains. The commodities area will no doubt have subdued asset price increase because the speculative premium caused by financial investors will be absent. Yet, do bear in mind that asset prices will rebound strongly from where they are today once demand re-surfaces - the speculative premium makes for a small part of the total price increase witnessed prior to the crash, not all of it.
For an investor; Australia, Canada, Brazil and Russia provide compelling basic material and energy opportunities. West Africa (Angola, Equatorial Guinea, Nigeria) all provide strong energy plays - these are best entered via the oil majors. These countries all have secular bull themes. China and India provide strong industrial and infrastructure opportunities and shall remain in secular bull formation.
Within the United States, strong outperformance in industrials, energy and basic materials can be expected. United States corporations remain amongst the best in the world in terms of access to capital, ability to create intellectual property, access to equipment and access to talented management - this is a huge competitive advantage. These corporations can and will succeed in a globalized world despite a potentially subdued home market.
In terms of capital structure; today leveraged entities are shunned. They also offer some excellent valuations. Look at Arcelor Mittal or Rio Tinto. Both are excellent companies with the ability to generate long term cash flows to service and pay down existing debt levels. Both have the ability to dispose non- core assets, cut costs, capex and dividends to pay down debt. While leveraged companies are shunned by equity investors, the debt investor interest in corporate debt is rising; Arcelor Mittal has already taken advantage of this to change its debt maturity. Both are capable of raising equity to pay down debt and yet being under-valued post dilution – this extreme step (new equity) could be an option if this period of dis-location continues for an additional two years (2009 & 2010). In a future period of inflation, debt embedded in the capital structure can be powerful as the value of debt falls in real terms. All in all, leveraged entities are valued with risks priced and then some. Shun the leveraged players if you have a high conviction of deflation going ahead; shun them if you do not see long term cash flows to service and pay down debt; but do not shun them simply because debt is unpopular today – remember that interest in the corporate debt market comes from investors traditionally more conservative compared with equity investors – today interest in corporate debt is rapidly rising - tomorrow it will spread to equity investors.
Author is long RTP, BHP, MT, AAUK, RIO, BP, SLB, NOV, RIG, CAT, DE, SI, INTC, NOK, DELL.

A Terrifying President

Obama is a terrifying President. Somehow, he strikes me as a person lacking confidence seeking constant approval from the electorate. Somehow, he strikes me a person still on the campaign trail; the cup brimmeth over with rhetoric; the actions do not feel like those of an elected President.

Yet, as of now, I like his all of his plans - including plans for energy, healthcare, withdrawal from Iraq, tax cuts for middle and lower income Americans and rises for the rich. I like his approach to the financial services sector too. Helping homeowners is important for it restores confidence; it also goes a long way in improving the damaged and over leveraged consumer balance sheets.


It remains my view, that private money leveraged through the use of government funds and guarantees buying impaired assets, is something which will go a long way in restoring a semblance of health to the financial services sector. Banks and financial institutions can be better capitalized following stress tests with lower risk, only once the bad assets are off their books. The other big plus of the Obama approach is that when private investors buy impaired debt, with an element of downside protection through government guarantees, they can work with both corporate and individual borrowers to restructure debt, thus nurturing severely damaged balance sheets back towards health. Banks and institutions can have all the money supply/liquidity in the world and yet no progress will be made until there are borrowers - both individual and corporate; and the borrowers will emerge only once they have confidence together with credit worthy stronger balance sheets. Large tranches of debt simply must be written down.

In my view, President Obama is doing what needs to be done and doing it well; but his presentation is adversarial. And it is destroying the one essential ingredient for recovery. Without confidence an economy cannot recover; the adversarial Presidential style is undermining exactly what it should seek to strengthen. Who will have the nerve to go out and buy a house or a car while the President seeks to fight a battle between rich and lower/middle income America in the public domain.

Action not words win; some battles are best won in privacy through policy and action; transparency takes you so far, but there comes a point where over-communication is damaging.

Take for example the Saturday Whitehouse blog titled "Keeping Promises" says

"I promised to bring down the crushing cost of health care – a cost that bankrupts one American every thirty seconds, forces small businesses to close their doors, and saddles our government with more debt. This budget keeps that promise, with a historic commitment to reform that will lead to lower costs and quality, affordable health care for every American.".

What does it say to the American people - are you being promised lower cost and quality healthcare? Or is the comma simply misplaced with a promise of lower cost quality affordable health care.

Over communication is dangerous; it digs a deep grave - climbing out is then a challenge.

In the same blog he says

"I realize that passing this budget won’t be easy. Because it represents real and dramatic change, it also represents a threat to the status quo in Washington. I know that the insurance industry won’t like the idea that they’ll have to bid competitively to continue offering Medicare coverage, but that’s how we’ll help preserve and protect Medicare and lower health care costs for American families. I know that banks and big student lenders won’t like the idea that we’re ending their huge taxpayer subsidies, but that’s how we’ll save taxpayers nearly $50 billion and make college more affordable. I know that oil and gas companies won’t like us ending nearly $30 billion in tax breaks, but that’s how we’ll help fund a renewable energy economy that will create new jobs and new industries. In other words, I know these steps won’t sit well with the special interests and lobbyists who are invested in the old way of doing business, and I know they’re gearing up for a fight as we speak. My message to them is this:

So am I."

Would it not be better for the President to win his wars in the corridors of power - in boardrooms, the House and the Senate? How does escalation within the public domain help anything? There is a time for politics and a time for policy; this is the time for policy.