Fair Value is Very Different from Normal Market Values

Beware of the loose use of terminology. I have started reading many professionals calling the market fairly valued. That is wrong; and far wrong. 

With the Sensex at 19.7k, markets are trading at "normal" levels; that means that

• multiples of current year earnings are between the 50^th and 75^th percentile of decade levels, and
• multiples of prior year earnings are between the 50^th and 75^th percentile of decade levels, and
• multiples of forward year earnings are at the 50^th percentile of decade levels, and
• multiples of current year 6 year median earnings are between the 50^th and 75^th percentile of decade levels, and
• multiples of prior year 6 year median earnings are at the 50^th percentile of decade levels and
• multiples of forward year 6 year median earnings are between the 50^th and 75^th percentile of decade levels.

Greed, Fear & Asset Allocation

Since 1953, the 10-Year Treasury Constant Maturity Rate has yielded 5.88% at median levels; 7.75% at the 75^th percentile and 4.15% at the 25^th percentile. In March the rates were at 3.41%, which is the 10^th percentile. Since 2001, the 10-Year Treasury Constant Maturity Rate has yielded 4.18% at median levels; 4.67% at the 75^th percentile and 3.72% at the 25^th percentile. In March the rates were at 3.41%, which is the 15^th percentile. Treasuries are not cheap on a multi decade or a single decade basis. It's not time to be greedy as yet. Equities too are trading at a premium to fair value. So again, it's not time to be greedy.

US Credit Downgrade – S&P says AAA Negative

SP shifted US rating to negative, with a 1 in 3 chance of a cut in rating over the coming two years. Part of the reason is the belief that the politics will not allow the process of cutting the deficit to begin.

It will be interesting to see how markets react to the SP downgrade; rising interest rates at the mid and long end of the yield curve must be expected. But some of it should be priced – after all common sense says that the cost of debt must rise as the proportion of debt in the capital structure rises; and there has already been a rise in long rates and much debate on rampant over valuation in treasury markets, led by the abandonment of treasuries by PIMCO's Gross. In a situation where expectations of interest rate differentials rise between currencies, in theory, the $ should strengthen – but where the rising rates represent substantially higher risk, it is unlikely that the $ will strengthen. In addition, the rate differential also needs to build in expectations of rate increases in alternative currencies which have not suffered rating changes as yet - fiscal despair is deep and wide spread, the risk of downgrades in other jurisdictions and the downgrade impact on interest rates in those jurisdictions must be considered.  At the outset of the 2008/2009 crisis, the $ strengthened due to a flight to safety, now with that very safety challenged, we have potential for $ weakness despite rising rate expectations; but again the safety of alternative currencies yet to suffer a downgrade also needs consideration.  Of interest to me is to observe how the yield curve will behave; it will flatten, but will it invert.

So much of what will happen is very perceivable, and therefore partly priced, but events that crystallize expectations are ever so important. Is this the start of formal recognition of fundamental problems which will lead to risk aversion? Or will it trigger political action and cause an increase in risk taking as the start of repair process start getting priced? I am bearish because valuations are at a level higher than at which markets are in a position to respond positively to a show me the results question. But I am always an early bear and an early bull, which is why I eliminate my personal bias by following a strict value adjusted portfolio allocation strategy!

Cutting the deficit is a must; it is the first step in reducing total public debt to manageable proportions. But how it's done is more important. The only way out of the present situation is via growth (preferably unleveraged {i.e. falling deficit to arrest growth of total public debt}), which increases the GDP (denominator) and inflation (which reduces the real value of debt and also grows nominal GDP faster compared with a low inflation scenario, which reduces total public debt as a percentage of GDP).

Deleveraging is a deflationary force which is very counter-productive for an indebted nation as the real value of debt rises in times of deflation - policies which will encourage growth and inflation to counter this force are a must. For it to work, strong export markets and a weak $ offer the best chance. Higher tax is okay, provided that it is not so high that the marginal propensity to create wealth is breached (i.e. if taxes are so high so as to discourage risk taking to earn the extra $, it is bad).

What US has to hope, is that a weak $ with moderately higher domestic inflation tolerance will lead to slower imports and domestic growth, offset by stronger export markets, allowing surplus capacity in US to be utilized, thus keeping unemployment in check, while creating a trade surplus, which will help further reduce public borrowing. It will take time but the process needs to start now. For years, inflation in US has stayed low because of cheap imports, now that trend needs to reverse.

Ultimately, the answers to developed economy problems, rests in emerging markets. For success, the US consumption must fall and savings rise, while consumption in emerging markets must rise and savings fall. Today, there is demand for investment, consumer goods and capital goods in emerging markets. For developed markets such as the US, the $ needs to stay weak; and for this to happen, emerging economy currencies need to be allowed to strengthen. One way for this to happen is continued de-basement of the $ with large capital outflows strengthening emerging economy currencies; but this will be countered by trade barriers and capital controls; both of which would be counter-productive. Strengthening emerging economy currencies backed with open global markets will be beneficial for the US in terms of exports; at the same time, with falling import costs in emerging economies, there will be much relief from lower inflation in emerging economies. In the long term, the emerging economies will also benefit greatly from reducing reliance on export markets and developing demand in country. The problem of course is that weak export markets in the short term can be counter-productive to growth in emerging markets – this reduced dependence on export markets can be managed over a long period of time; another reason why de-leveraging in US will need to be gradual.

The talks on spending cuts and rising taxes are all very well and good; but it's not where the solution will be found. In some ways, US problems will probably require more focus on foreign policy than economic policy. Growth (exports) will only be possible with open markets, which in turn require global consensus on climate change, carbon emission control, currency controls (including on capital flows), farm subsidies and food shortages - all areas where compromise is needed to open global markets to trade. The solution will come from export growth and domestic inflation tolerance – and this needs good foreign policy and serious compromise and consideration of needs of emerging economies.

Political Risk & the Risk of Bad Policy Management in US Soars

Did the world just climb out of a hole to fall back in deeper?

During December 2007 through June 2009 the United States and indeed the world suffered a great recession. It was brought about by the bursting of the real estate bubble which inflated as a result of excessive leverage amongst consumers. Following the binge, the pain of the hangover had to be suffered, for following excesses there is always a price to pay. The intensity and duration of pain is important. With proper rehydration and some medicine, the pain can be less intense, and yes, even the duration shorter.

Bad management caused a disorderly disruption and a severe and long crisis. With Lehman Brothers on the brink, the solution was to let it sink. Was it right? A better solution might have been to save the company, without saving the shareholders. Inject capital to dilute existing shareholders ownership to nothing would have saved the company and perhaps the recession would have been shorter and less severe.

This brings us to today. The rescue of the economy ultimately resulted in huge national deficits. Much debt was reduced in the private sector and this was offset by increased governmental leverage. The fact that the balance sheet needs to be restored is unquestionable. The matter of how it is done remains important; we still have a patient in intensive care. There are three options, ignoring the problem, bad medicine, good medicine. Ignoring the problem is not a solution; the patient will die. Then there is bad medicine, which will have the same result. The only solution is good medicine taken over an extended period of time.

And I fear that bad management is a significant risk at this point in time. The Republican plans for deficit reduction using cuts in government spending with no tax increases can work well if done over an extended period of time. The Democrat plans for deficit reduction using cuts in government spending together with tax increases can work well too if done over an extended period of time. But neither plan has a chance if the debt ceiling is not raised – in consensus and immediately. Not raising the debt ceiling, in consensus and immediately, will lead either to a US debt default and soaring interest rates, or to a perception of high risk of a debt default and soaring interest rates. If the debt ceiling is raised after markets build in an expectation that it will not be raised, the damage is done. Once the damage is done, we will be on the verge of another deep and lasting recession; one from which recovery will be problematic because unemployment going in so high and injecting liquidity into the system in a high rate debt default environment not easy. Low interest costs due to flight to safety is out of the question in an environment where default risk is high.

As recent past has shown, this is not the first time a deep and lasting recession would be caused by bad management. And it certainly looks like we are heading in the direction of bad management again. The action required is to raise the debt ceiling and it has to be bi-partisan, in consensus and immediate. This matter of concessions required for a bi-partisan action, needs to be discussed amongst Democrats, Republicans and the Tea Party activists behind closed doors, outside of the public domain. The Democrats must recognize that this is too important to use as a tool to gain political mileage; and realize also the need to stop spending what they have not. Republicans & Tea Party activists need to recognize that if consumers don't have the confidence to spend, governments must; and to spend, they must ultimately get the spending power through taxation. The answer as always lies between two extremes and must be found.

In the present circumstances, the Republicans and the Tea Party activists are the greater risk - I hope better sense prevails for there is no answer other than to raise the debt ceiling, in consensus and immediately. A debt default must be avoided; the cost of failure will be too heavy to carry.

Sensex FY12 Outlook

We are into FY12! Have a look at the various economic, risk taking and market valuation indicators on the Quant Report.

Using valuation as the prime basis for portfolio allocation gives the Sensex a score of 4 out of 12; see Sensex Value Grid on the Quant Report. With Sensex earnings expectations for FY11 at 1,067; a market trading at 19,687 is at 18.45X prior year earnings; that is higher than decade median levels of 17.45, but lower than 75^th percentile levels of 20.72; this indicates moderate over valuation. For FY12, a conservative estimate of earnings, after considering the impact of rising interest rates, would be 1,210; market trading at 19,687 is at 16.27X current year earnings; that is higher than decade median levels of 15.39, but lower than 75^th percentile levels of 17.24; this indicates moderate over valuation. And looking ahead to FY13, a conservative earnings growth which is in line with decade average nominal GDP growth rates, would take us to 1,373; a market trading at 19,687 is at 14.34X forward year earnings; this is very close to median forward year multiples of 14.6X; this indicates in-line valuation. Using multiples based on six year median earnings, which can be viewed on the Quant Report, we arrive at the same conclusions – moderate over-valuation considering current and prior year PE 6 and in line valuations considering forward year PE 6 multiples. So, this is not a market for buy and hold investors to be buying. For cycle investors it is a market to hold market in line with preferred equity portfolio allocations.

For shorter horizon investors, it is not a buy low sell high market; however economic and risk aversion levels can certainly make for a buy high, sell higher market. An expensive market is not necessarily one to sell; in fact considerable profits can be made until risk aversion rises to unacceptable levels, or the global economy turns. But remember, a buy high sell, higher strategy is fraught with risk!

So let's look at the economy. We are doing just fine. GDP growth is strong, earnings growth is decent. The reverse repo rate has only just moved to a level where it is no longer accommodative. At 5.75% it is now only just above decade median levels of 5.35%. Corporate debt is 9.3% for Aa ratings and 8.9% for Aaa rating companies; this too is in line with decade median levels of 9.02 and 8.28% respectively. The market has squealed at rising rates, but so far all that has happened is a normalization of rates to a level consistent with decade averages. Now further rate rises could hurt late FY12 and FY13, but how much will it hurt? Earnings growth would come down to decade medians of 15.8%; or decade median nominal GDP growth rates of 13.5%; with growth in DM's languishing at 4% nominal, this is still strong. The Indian yield curve is also looking good; normal, not inverted, in fact the real interest rate yield curve continues to look steep which indicates continuing economic expansion potential.

The thing to watch out for is whether growth expectations run ahead of fundamentals and that is best assessed by looking at risk aversion indicators. Investor appetite for risk has come off considerably over the past few months. Precious metals Gold continue to do quite nicely; not bearish, which may indicate rising risk taking. It is true that commodity prices have strengthened; this is normally indicative of rising risk appetites; but presently, it represents a fear premium due to elevated risks in MENA, as well as natural disasters and weather phenomena. The DM over EM trade, which came into fashion a few months ago, reduced rising risk aversion to more normal levels. This trade will now likely reverse and lead to more risk taking. With $1=Rs45, the Rs is not indicating excess risk taking; at Rs 42 it would be more worrying. Using the Rs as an indicator on risk aversion has become a bit problematic; capital inflows which would drive Rs lower are now being offset by demand for $ to pay for oil; nonetheless, I would get uncomfortable at Rs 42/43 levels. Domestically, the spread of Aa rated bonds is 130 basis points over the 10 year GoI bonds; for Aaa rated bonds it is 90 basis points; decade median levels are closer to 184 and 110 basis points respectively – risk taking is still well under control. The 10 year GoI bond is at 7.99%, which is over 7.18% decade median; a demand for higher interest rates until strategy on reducing deficits is visible is also indicative of conservatively priced risk. And when you look at the Aa bond vs Aaa bond risk premia; it is still below historic decate median levels; also indicating neutral risk aversion. Finally, while large cap valuations are moderately high relative to historic decade medians, non Index large caps, mid caps and small caps remain cheap; until values in these zones are buoyed by risk taking, sufficient risk aversion exists. The biggest risk is how deterioration in DM's effect the real Indian economy and of course, how rising risk aversion impact Indian valuations. Over-all, I view risk aversion as neutral; when its high, as it was a quarter ago, it may be time to sell.

The broad range should be 15.5k at the lower end and 21.4k on the higher end, with a central tendency towards 18.6k. On the downside, as a buyer, I'd get really excited if the market gets to 14k, and would be ecstatic if it hits 11.5k. On the upside, all said and done, short term anything can happen, but over a period of 12 to 24 months, provided that a Goldilocks scenario prevails, we could see the Sensex at 22,750 levels by March 2012. This is a 15% return from present, but it carries risk, for the bear may turn on Goldilocks! Is the risk worth it, with short term income bonds funds capable of delivering over 9%, post tax? I'll leave it to you to decide. I'll stay with a 2% underweight on equity and a 2% overweight on short-term (1-1.5 year maturities) bond. On long term bond funds – not yet, wait for more clear visibility on a deteriorating economy; with short term bond funds yielding well the rate risk on longer maturities is not worth it.

Back Testing Past Buy Calls for US Listed Stocks Published on Seeking Alpha

Many have asked why I blogged furiously between September 2008 and October 2009 and have been silent since. My answer is that those were interesting times when markets were mis-priced; it made sense to buy. Since then, it's not been so exciting; it's been a market to hold - for a long only investor during such times there is not much to say.

Now it is different. With the SP500 at 1,332, the markets are trading at 16X prior year EPS, 14X current year EPS and 13X forward year estimates. The single year valuation model says the market is not expensive; but it's not ridiculously cheap either.

The PE6 (SP500 Value divided by Median 6 Year Earnings) is my preferred valuation measure, because it measures median earnings over a typical economic cycle (66 months is the average length of an economic cycle; I round it up to 72 months or six years). It's similar to Schiller's Cyclically Adjusted Price Earnings ratio with two differences.

First, PE 6 measures over the duration of 6 years compared with Schiller's CAPE which measures over a decade. In my view, six years provides a better reference to cycle earnings because it is closer to the average length of an economic cycle.

Second, PE 6 uses median earnings compared with Schiller's CAPE which uses average earnings. In my view median earnings are better than average, because median's express where earnings have been most of the time, instead of an average over the period of time. For example, real earnings of 1.2, 1.2, 1.2, 0.0, 1.2, 1.2 gives a six year average of 1.0 and a median of 1.2. A one year break-down, does not imply the economic potential to create real earnings has fallen; the median, which tells you where earnings are most of the time, is a better reflection of the earnings potential.

On a PE6 basis we are trading at 17X 2010 6 year median earnings, and 16X 2011/2112 6 year median earnings. These are well below median levels over the past decade. However, valuations are in line with PE 6 measured over several decades. It is most definitely time to eliminate equity over-weights; a reversion to multi decade PE 6 levels is complete after a fall to well below multi decade PE 6 levels. The next step is likely to be a falling PE 6. A falling PE 6 does not necessarily mean that the markets will go to hell; markets can stay at present levels even with a falling PE 6, provided that median 6 year EPS continues to rise. A PE 6 fall may occur in 3 months or 18 months, but occur it will, and I personally expect markets to fall rather than remain stable. The depth of a future fall depends on future events, but the impact of recent history will not help.

So, book your profits to return to your preferred allocation to equity and be patient for the next buying opportunity.

I went back and measured what would have happened to an investor who put $100 on each stock I disclosed as being a long position on US markets between September 2008 and October 2009. I may have made some mistakes since there are 72 posts to slog through, but it should be roughly correct. The result is on 55 long disclosures, $5,500 would have been invested; and the present market value of stocks purchased would be $9,374.

 

Date	Ticker	Cost Price	Price 1 Apr 2011	Shares	Cost	Value	% Gain/(Loss)
22-Sep-08	PFE	16.01	20.38	6.25	100.00	127.30	27.30%
14-Oct-08	Satyam	14.86	3.03	6.73	100.00	20.39	(79.61%)
17-Oct-08	INTC	14.29	19.72	7.00	100.00	138.00	38.00%
24-Oct-08	Dell	11.5	14.34	8.70	100.00	124.70	24.70%
07-Nov-08	MT	20.75	36.28	4.82	100.00	174.84	74.84%
10-Nov-08	PFE	14.96	20.38	6.68	100.00	136.23	36.23%
17-Nov-08	AXA	15.2	21.53	6.58	100.00	141.64	41.64%
17-Nov-08	NOK	11.61	8.55	8.61	100.00	73.64	(26.36%)
17-Nov-08	SI	48.56	140.48	2.06	100.00	289.29	189.29%
17-Nov-08	VOD	17.58	29.08	5.69	100.00	165.42	65.42%
17-Nov-08	MT	19.4	36.28	5.15	100.00	187.01	87.01%
17-Nov-08	BP	39.25	45.66	2.55	100.00	116.33	16.33%
17-Nov-08	CCL	18.24	38.25	5.48	100.00	209.70	109.70%
02-Dec-08	BP	41.13	45.66	2.43	100.00	111.01	11.01%
02-Dec-08	SLB	42.55	93.7	2.35	100.00	220.21	120.21%
29-Mar-09	RIO	32.39	71.7	3.09	100.00	221.36	121.36%
29-Mar-09	BHP	41.07	96.84	2.43	100.00	235.79	135.79%
29-Mar-09	MT	18.1	36.28	5.52	100.00	200.44	100.44%
29-Mar-09	AAUK	7.63	26.12	13.11	100.00	342.33	242.33%
29-Mar-09	VALE	12.46	33.44	8.03	100.00	268.38	168.38%
29-Mar-09	BP	36.07	45.66	2.77	100.00	126.59	26.59%
29-Mar-09	SLB	40.04	93.7	2.50	100.00	234.02	134.02%
29-Mar-09	NOV	28.51	80.68	3.51	100.00	282.99	182.99%
29-Mar-09	RIG	60.1	78.82	1.66	100.00	131.15	31.15%
29-Mar-09	CAT	25.87	113.12	3.87	100.00	437.26	337.26%
29-Mar-09	DE	31.13	98.6	3.21	100.00	316.74	216.74%
29-Mar-09	SI	52.1	140.48	1.92	100.00	269.64	169.64%
29-Mar-09	INTC	13.83	19.72	7.23	100.00	142.59	42.59%
29-Mar-09	NOK	10.31	8.55	9.70	100.00	82.93	(17.07%)
29-Mar-09	DELL	9.49	14.34	10.54	100.00	151.11	51.11%
14-Jul-09	INTC	15.95	19.72	6.27	100.00	123.64	23.64%
15-Jul-09	NOK	14.9	8.55	6.71	100.00	57.38	(42.62%)
16-Jul-09	DELL	12.75	14.34	7.84	100.00	112.47	12.47%
20-Jul-09	CAT	35.32	113.12	2.83	100.00	320.27	220.27%
21-Jul-09	SLB	55.7	93.7	1.80	100.00	168.22	68.22%
22-Jul-09	BP	46.23	45.66	2.16	100.00	98.77	(1.23%)
22-Jul-09	MT	34.4	36.28	2.91	100.00	105.47	5.47%
23-Jul-09	NOV	35.25	80.68	2.84	100.00	228.88	128.88%
24-Jul-09	SI	74.66	140.48	1.34	100.00	188.16	88.16%
27-Jul-09	DE	41.32	98.6	2.42	100.00	238.63	138.63%
27-Jul-09	RIG	81.73	78.82	1.22	100.00	96.44	(3.56%)
28-Jul-09	VALE	18.4	33.44	5.43	100.00	181.74	81.74%
28-Jul-09	AAUKY	15.08	26.12	6.63	100.00	173.21	73.21%
29-Jul-09	RIO	37.04	71.7	2.70	100.00	193.57	93.57%
30-Jul-09	BHP	59.57	96.84	1.68	100.00	162.57	62.57%
29-Sep-09	VOD	20.9	29.08	4.78	100.00	139.14	39.14%
09-Oct-09	INFY	46.61	73.11	2.15	100.00	156.85	56.85%
11-Oct-09	TTM	12.01	27.78	8.33	100.00	231.31	131.31%
04-Nov-09	HDB	115.84	172.39	0.86	100.00	148.82	48.82%
04-Nov-09	IBN	34.94	50.08	2.86	100.00	143.33	43.33%
04-Nov-09	WIT	10.47	14.93	9.55	100.00	142.60	42.60%
05-Nov-09	RIG	85.83	78.82	1.17	100.00	91.83	(8.17%)
05-Nov-09	SLT	16.93	15.53	5.91	100.00	91.73	(8.27%)
20-Nov-09	DELL	14.29	14.34	7.00	100.00	100.35	0.35%
					5,400.00	9,374.40	73.60%

 

By the way, this is not a sell call; I am a buy, hold and rebalance kind of person. Just cautioning, because many I speak with, who were terrified of buying when markets were dirt cheap, are becoming aggressive buyers now.