My posting philosophy when doing commentary on the news is not to do “linkfests,” much as I like them, but to try to give a little more thought behind what has been written, and try to weave them into a greater coherent whole. My career has been diverse; if I wanted to be mean I would say that I was a dabbler, a patzer, a dilettante. A jack of all trades and a master of none. The strength of my varied career is that I have insights into a wide number of areas in the markets, and how they interconnect. I have always believed that understanding multiple markets helps shed light on each one individually.
So, when I comment on the news, it is my aim to give you a broader perspective on the major factors influencing our investment decisions. That also means that I might not be commenting on what is breaking news, but on what trends are going on behind the scenes. Today’s topic is supply and demand factors in the equity market… the true technical analysis. 😉
Let’s start with Jeff Miller at A Dash of Insight. He gives the classic case of why a management would buy back stock. A management team is able to capture more of the excess returns that the business is earning by substituting cheaper debt for equity in their capital base. In moderation, this is a decent strategy; it is a strategy increasingly employed because of high profit margins and low interest rates.
Now, as you go through this discussion, you will run into the term “Fed Model.” The Fed model is a simplified version of a discounted cash flow model, where the earnings of an equity market are discounted using a common interest rate, frequently a long treasury rate, and compared to the current price, to see whether stocks are rich or cheap. (Note: this calculation does not actually prove whether stocks are absolutely rich or cheap, but only rich or cheap relative to bonds.) In practice, the calculation can come down to comparing the earnings yield of an index (earnings divided by market capitalization) to the yield on the long Treasury note.
Use of this model is controversial and can produce widely varying results depending on your assumptions. Take for example, this article over at Trader’s Narrative. It draws the conclusion that the market is “extremely undervalued” at these levels. This is true, if interest rates and credit spreads stay low, and profit margins stay high. All three data series tend to mean revert, so how long these factors remain favorable is open to question. Nonetheless, in the past, comparing treasury and earnings yields was a smart strategy. Will that continue?
John Hussman ably argues that profit margins are mean-reverting, and that the relationship of earnings yield to bond yields has been spotty at best. I agree with both of those ideas, but with some caveats:
- Profit margins could remain high for a longer time than anticipated because of increased globalization, and increased willingness to lever up.
- The relationship of earnings and bond yields has gone through eras where there has been extreme greed and fear. That earnings and bond yields do not track perfectly is not a weakness, but a strength of the model. If they tracked perfectly, there would be nothing to game here. At extreme differences the yield differential produces signals that will make money, and reduce risk to investors. (Personally, I like my models to explain half of the variation or so — a good balance between there being a signal, and having significant noise to exploit.)
I expect profit margins to mean-revert, but what if they don’t do so quickly? As an example, consider the upside surprise delivered in the first quarter. US corporations don’t just depend on the US economy anymore; they sell outside the US, and buy resources outside of the US, even labor (outsourcing). With a weak dollar, earnings in dollar terms surprised on the upside. Buybacks also increased earnings per share.
Ignore Shiller when he does the 10-year average earnings. 10-year averages are less representative of future earnings than the current year’s earnings. There has been a lot of earnings growth for sustainable reasons. Could earnings pull back significantly? Yes, but not to the 10-year average, unless we get a depression.
What of rising interest rates? Will they derail the equity market? Some think so. Some think not. My view is that at around 6.50% on the 10-year Treasury, bonds would present serious competition to stocks. Down here around 5.15%, we will continue to have the substitution of debt for equity through LBOs and buybacks. Despite the volatility, investment grade credit spreads are still tight, and the collateralized loan obligation market is still active, allowing LBOs to be more easily financed. Further, there is a yield hunger on the part of buyers that allows corporations to sell debt, even subordinated debt cheaply. This will eventually change, but we need some genuine failures of investment grade companies to demonstrate the real risks of borrowing too much.
In the short run, that IPOs are being well-received is a plus to the market. There is demand for stock. In the long run, buying at low P/Es is also a plus (ask David Dreman). That’s not true now, except relative to bonds, which are providing little competition to stocks.
So where does that leave me? My view is more complex than many of the caricatures being trotted out. Let me give you the main ideas:
- Comparing earnings yields to bond yields is useful, but must be done with discretion.
- Profit margins will mean-revert, but given globalization, and its effect in restraining wages, that may be a while in coming. How much do you want to leave on the table?
- Demographic trends should keep real interest rates low. The graying of the global Baby Boomers is one of the factors keeping interest rates low. Retirees and near-retirees want income, and that is surpressing interest rates.
- Also suppressing interest rates are those that have to recycle the US current account deficit. Until we see large currency revaluations in countries that have large surpluses with the US, rates should stay low.
- Until we get a significant set of defaults in the credit markets, credit spreads should stay low. At present, there is too much vulture capital lurking, waiting to buy distressed assets. The distressed investing community needs to be seriously scared; then maybe valuations will head south.
So, reluctantly, in the short run I carry on as a moderate bull. That said, the valuations in my portfolio are cheap relative to the market, and the balance sheets are stronger than average. The names are inclined more toward global growth than US growth. Many companies in my portfolio have buybacks on, but none are doing it to the level where it compromises their credit quality.
Trends have a nasty tendency to persist longer than fundamental investors would anticipate. So it is with the markets at present. Honor the momentum, but keep one eye on shifts in interest rates and profit margins.