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 :-).

You Can Handle Greed, But Can You Handle Fear?

In my normal market value reviews, of late I have found myself noting that the SP500 is very cheap relative to valuations investors have been willing to pay over the last decade. I do occasionally note, that what investors have been willing to pay over the last decade, is higher than what investors have been willing to pay over the last several decades.  Since 1871, investors have been willing to pay median multiple of 15.82 times median 6 year as reported earnings (Cyclically Adjusted PE or CAPE); in the post war period (1945 onwards), a median CAPE of 18.19 has been paid by investors. The single year model median PE has been 14.68 and 16.32 for all periods since 1871 and all periods since 1945 respectively.  So it is clear the last decade valuations have been dear, but the market remains cheap even when viewing present valuations in the context of what investors have been willing to pay over multiple decades.

The other thing I do, is use SP500 Operating Earnings instead of As Reported Earnings.  I do this as it makes the market look even cheaper than it really is, thus influencing my readers to buy, while I am selling - only joking - I use operating earnings, which excludes only M&A related expenses, Goodwill impairment, litigation settlement and the gain or loss on asset dispositions, because (a) this provides a better guide on future earnings potential and (b) eliminating M&A related expenses and Goodwill impairment makes the number more comparable with as reported earnings in the olden days, before the accountants took control of the world.  

But I will admit that while valuation viewed in the context of operating earnings works well most of the time, during periods of distress, as reported earnings provides the better guide. I do publish the Quant Report based on as reported earnings on my website; its up to you to read it.

Now let me try and terrify you! 

A Grouse Against Obama

The problem with Obama is what he gives with one hand, he takes away with the other. What is really disappointing, is that the risk is clearly recognized and the solutions with the best chance of success identified.  Yet, Obama back tracks even as he extends his hand.  It looks like he wants the Republicans to deny him, so that he can blame failure on the Republicans.  And use that to win an election. The alternate would be to try for a true bipartisan plan, for there are good ideas on both sides of the aisle, and to win on evidence of a successful turnaround.  Maybe he lacks confidence in success, and if he does, the best outcome would be for him to step down, to let those who believe they can succeed lead. 

Germany Recognizes Risk - A Turning Point?

Ms. Merkel is now on record discouraging chatter of an orderly or disorderly default for Greece.

Germany may soon become aware that a Greek default, whether orderly or disorderly, will cost Germany more in absolute terms than Greece. First, there is the crippling impact of default on already weakly capitalized European banks - this raises systemic risks. But more than that think of negative real interest rates, deflation and a soaring Euro. Once EZ is smaller and stronger, I'd fully expect the Euro to appreciate in a flight to safety, much like the Swiss Franc did.  This will totally destroy German exports and cripple growth; in fact it will likely cause a significant contraction.  And a severe contraction in the Euro Zone which accounts for 20% in global trade, will contaminate global growth causing a severe global recession.  Merkel has finally grasped it; she now needs to convince partners of the folly of a fall-out. 

What is a Bear Market?

Their is no clear definition of what constitutes a Bear Market.  Our friends at Wikipedia say:  "A Bear Market is a general decline in the stock market over a period of time.  It is a transition from high investor optimism to widespread investor fear and pessimism. According to the Vanguard Group, while there’s no agreed-upon definition of a bear market, one generally accepted measure is a price decline of 20% or more over at least a two-month period."

I do not like the supposed Vanguard Group definition.

Does US Tax Code Cause US Structural Unemployment?

I spend a lot of time trying to convince people that America is where the true value opportunities lie. As Winston Churchill said "Americans can always be counted on to do the right thing...after they have exhausted all other possibilities.". The process of exhausting all other possibilities is on, and it's creating huge investment opportunities, the fruit of which will be borne once the right thing is done. America was built on industrial roots, it was built on management capability, human ingenuity and the ability to innovate; all created by the best educational systems in the world - that has not changed. A significant reason for the problems America faces today is the war America is waging against Americans; and this is a war that Americans will win – it must not be fought.

For the record, I am not an American; but as a citizen of the world, the laws, systems and processes in US sometimes fascinate and sometimes bewilder me. There is the Constitution which is an absolutely amazing piece of work, especially when you look at the deep sense of fairness with which it has been interpreted over the centuries; and then you have the tax code, which a child could tell you is not fit for the global world within which we live. How can you not recognize that America's unemployment problem is structural? Structural unemployment needs to be addressed by major reform of some laws and regulations. You need to incentivize value creation in America. Instead, today America has laws which put its corporations at a competitive disadvantage globally; it's crazy to do this at a time of globalization. And today America all but forces its corporations to create value outside America, even where the value would be best created in America; how crazy is that? The tax code was acceptable during an era where globalization was not the norm, for it allowed America to increase tax revenues without harming America's corporate houses. At that time the American corporate had little competition and major competitive advantages; this is no longer true.  A quick measure such as reduction of tax on foreign profits at a rate of half the normal US tax rate with full credit for all foreign tax paid will help as in interim measure; but longer term the tax code needs to be re-written.  Over the years, the tax code, together with its million amendments and regulations, has evolved into a complete mess which no longer meets the national needs; it needs to be thrown out and re-written in a form which accepts that the world has changed beyond recognition over the decades this unwieldy monster was created.

The mile high view says:

• US Companies are at a competitive disadvantage versus US subsidiaries of foreign companies operating in America. Innovative American response – Corporate Inversions.
  
• US Companies are at a competitive disadvantage versus foreign companies in respect of global operations outside America. Innovative American response – Super Holding Companies.
  
• US Companies are incentivized to create value outside US instead of within US, leading to structural unemployment in US. Innovative American response – Excessive Off-shoring & Outsourcing.
  
  

Market Snapshot - SP500 & Sensex 9 Sep 2011

Sensex & SP500 Valuation August 2011 - Stay Balanced!

Updated Quant Report is available for

1.  India Portfolio Allocator with relative value against SP500 As Reported Earnings

2.  Sensex with relative value against SP500 Operating Earnings

3.  SP500 Operating Earnings

4.  SP500 As Reported Earnings

Have the Yield curve and M2 Obscured Reality?

M2 and the yield curve are important indicators of the health of an economy.  Slowdowns are often seen through inversions in the yield curve and M2 contributes to leading indicators too.  

This time, chances are that these two indicators are sending false signals to leading indicators.  Many leading indicators, including the Conference Board's Leading Economic Index, include the yield curve and M2 as an important component of forward expectations.  At present, a steep yield curve & M2, will signal a positive contribution to forward expectations but it is a false positive; in other words - a lie.