Profiting Over Lunch
If I can pull this off, I’ll pay for lunch on this one.
I admire two organizations: the Hussman Funds and CrossingWallStreet.com. Both live near me. They have different views on whether the market is overvalued or undervalued.
Take these two posts:
The first was Eddy’s post indicating that the market is cheap on a forward earnings basis. After I read this, I prompted my Bloomberg Rep to show me data on market-wide Price-to-Sales ratios, because profit margins could be unsustainable. While I did that, William Hester, who I have met at a BCFAS meeting, commented on the very item I was looking for — if the profit forecasts occur, profit margins will be unusually high.
Having been burnt on unusually high profit margins before, I am inclined to be more conservative about future profit margins now.
But for fun, Eddy and William (and if you can bring along your bright boss John), I am willing to have a lunch discussion of these issues at a nice restaurant in Howard County. Let me know if you have interest.
October 6th, 200912:07 pm at
Can i come David? I am in Bethesda…
October 6th, 20096:09 pm at
I fear that Wall Street remains too optimistic in its expectations regarding profit margins. For too long, corporate margins kept expanding and expanding beyond what people thought was imaginable. There’s a real danger that we could see a similar effect on the downside once the Fortune 500 runs out of expenses to cut.
October 6th, 20098:26 pm at
I don’t buy Eddy’s argument. The problem IMO is that 15x multiple for 2011 is pretty much pulled from thin air.
If one reads the Hester piece you linked, this is the part that should jump out:
“On that measure, the price to forward operating earnings ratio is 13.7. John Hussman has estimated that the long-term price to forward operating earnings ratio is about 12 in data that includes the late 1990’s bubble, and 10.6 in data prior to that (see Long-Term Evidence on the Fed Model and Forward Operating P/E Ratios ). So assuming that analyst expectations for strong margin recovery are correct, the P/E is already at least 1.7 points above the long-term average. Assuming a 7 percent profit margin on next year sales, the P/E ratio would currently sit about 3 points above the long-term average. And at the long-term average profit margin of 6 percent, the P/E ratio on forward operating earnings would sit 5.5 points (nearly 50%) above the long-term average.”
What I find flabbergasting, almost just surreal, is this line of valuation reasoning that Eddy is utilizing (and he isn’t the only one by any means) is THE EXACT SAME ARGUMENT used by many to boldly proclaim stocks were “cheap” in October 2007 right before the carnage of Oct 07-Mar 09.
Fool me once, shame on you, fool me twice, shame on me. Anyone using this metric to justify a full allocation/overweight position to equities does so at their peril, and if they are a professional investment advisor I would argue it borders on incompetence after what has just transpired.
October 6th, 200910:09 pm at
Hello David,
I’d like to challenge critical assumptions made by both Mr. Hester and Mr. Elfenbein. Hester’s analysis de facto assumes that nominal GDP will come in at a tepid pace, as that is the current consensus among economists – and in reading Hussman’s weekly commentary he appears to be an economic skeptic.
However, ECRI’s long leading index and WLI are forecasting the most robust economic bounce since the early 1980’s recession…at least. In addition, their FIG has now moved in a pronounced, pervasive and persistent fashion. I think these developments make it possible, if not likely, that nominal GDP could come in around 7-9% next year. Of course, the key word is “nominal”. Sales could surprise on the upside and result in higher earnings without margins returning to record levels. I agree with most of Hussman’s long term reservations, but think his short to intermediate concerns are in George Costanza land – i.e. the exact opposite.
This brings me to Elfenbein’s argument. As Hester points out, a 15 multiple is very high on forward operating earnings, yet Elfenbein and many others rationalize it by obfuscating forward operating with trailing net earnings. Even if nominal GDP surprises and sales follow, a $75 earnings number could still result in an SPX at 800 or below if the multiple simply reverts to the mean. Why would this happen?
I think the most likely scenario, and currently the least discussed as far as I’ve observed, is a growth shock developing in the 1st half of 2010. GDP could print in the high single digits in Q1 2010 and send the bond and currency markets into chaos. While unemployment is likely to improve (at least in the service sector) late this year and early next, the political machine will already be too far in motion with another round of “something” – call it stimulus, pork or whatever. The initial stimulus is just now starting to kick in.
The bond market is NOT prepared for this – the futures markets don’t price in higher rates for some time. What does the Fed do if we have a GDP print of 8% or 9%? What happens to the 10 year? The dollar?
So I think the broad market averages are likely to trade in a broad range over the next few months as market leadership shifts to commodity related industries. I think Hussman has it wrong – the economy is likely to shock with its headline strength (at least statistically which is all bond traders seem to care about). The reaction to a growth shock in bond and currency markets may very well kick off the next financial and economic crisis and end up where the Hussman’s and other skeptics expect us to go. I just think the path to get there is going to confound the most people possible!
And David – I’m in Harrisburg, PA and would be happy to buy you lunch any time!
October 7th, 20091:45 am at
James,
Interesting thoughts. Certainly a variant perception. Something for me to think about as I know from your past comments you bring strong insight to the table.
Re ECRI, I’m not going to pretend I’ve got a better economic forecasting model, but I think the skeptical counterargument would be their models are built on a typical post WW2 inventory type recession, and not a balance sheet/credit contraction/”bursting of the debt bubble” recession we’ve had.
Unless the federal government is going to provide a ton of stimulus, and do Cash for Clunkers 2, cash for refrigerators, cash for furniture, cash for home improvement, I just don’t see where the spending is going to come from. Unemployment is still rising, wages are stagnant to falling, credit availability and access and the willingness of consumers to borrow is declining month after month (see Meredith Whitney article and Rosenberg commentary).
http://www.jugglingdynamite.com/blog/_archives/2009/10/5/4342355.html
Hussman isn’t the only skeptic on this front.
From Rosenberg’s report today:
“New York Fed President Bill Dudley is on the wires saying the Fed will keep rates low “indefinitely”. This combination of dramatic fiscal and monetary stimulus and pledges for even more largesse is absolutely generating a high degree of excitement in the stock market, but the question remains one of sustainability and what the economy really looks like without all of this medication.
El-Erian
http://www.pimco.com/LeftNav/Viewpoints/2009/El-Erian+FT+Return+of+Old+9-28-09.htm
We are at the point of maximum confusion in the multi-year transition of the global economy, markets and policymaking. We have left the global growth regime that was driven primarily by debt-financed consumption in the U.S., but we have not as yet reached a position of more balanced, albeit anemic, growth. Those who lack a robust anchoring framework, be they investors or policymakers, risk being misled and backtracking to outdated ways of thinking.
The signs of inappropriate reversion are multiplying. Confusing temporary factors for sustainable ones, a growing number of analysts have extended the ongoing stimulus/inventory bounce to a V-like recovery next year and beyond.
Last month, the governor of the Bank of England stated bluntly: “It’s the level, stupid – it’s not the growth rates, it’s the levels that matter here.” Investors have not yet accepted his insight that the absolute levels of income, debt, wealth and unemployment, not just the rates of change, are what matter today. They need to, and soon.
If I understand the implications of your bond comments, you seem to be maintaining that right now, the stock market has it right and the bond market has it wrong. How often in the past when they disagree has the bond market usually been the correct one?
Certainly interesting times with no easy, clear-cut answers. I’m just somewhat dismayed that some of the same crowd that led people to the slaughter in 2006/2007 by saying it was safe to load up on equities are at it again saying it is once again time to back up the truck before one misses any more “gains”.
http://www.jugglingdynamite.com/blog/_archives/2009/9/17/4324378.html
I’m about 50% invested in equities here with a clear plan for defense if it looks like this rally starts to break down.
October 7th, 20096:26 am at
Hello Mike C,
There is certainly MAJOR intellectual horsepower on both sides of the argument – which makes its exceptionally difficult to have any real conviction!
As for ECRI, I think I have a pretty good grasp of their models and the long leading index collapsed following a brief bounce in 1930 -it did pick up the credit contraction.
ECRI is as close as I’ve seen that is a non-linear forecasting firm, which is what I try to focus on as relates to financial markets – complex systems analysis. John Maudlin’s recent commentary referenced this area of analysis.
As for the stock market, I’m no “blind bull”. We currently have only about 30% net risk exposure heavily weighted to commodities. If we get a 5-10% correction from here we would likely lift our hedges a good bit. We have a barbell portfolio with commodities and related equities on one end and high quality high dividend yield mega/large cap on the other end. I think a correction could shift leadership to these market segments for the “last phase” of the cyclical bull market.
October 8th, 20095:32 pm at
There is certainly MAJOR intellectual horsepower on both sides of the argument – which makes its exceptionally difficult to have any real conviction!
James,
Not trying to be disagreeable here for its own sake, but outside of ECRI which no doubt has a good track record, who else is the major intellectual horsepower on the V-shaped recovery theme?
I’m genuinely curious. I can think of Jim Grant, but outside of him who else? The rest of the V-shaped crowd is the EXACT same “cast of characters” who maintained in 2007 we would just have a mid-cycle slowdown, and were in “recession denial” until it became an absurdity to deny it any further. I could name names with various strategists and bloggers but no point in embarrasing them.
Meanwhile, Hussman, Roubini, Rosenberg, Grantham, Gross, El-Erian, just about every guy who saw some level of problems/imbalances in the economy while most still thought it was Goldilocks don’t believe in this “sustainable” recovery theme.
That said, I must respect the message of the market. I have no intention of trimming any equity exposure until at least 1100-1120 which is the 50% retracement of the bear, and you would have to be nuts to short this market if you are a practical investor:
http://www.thestreet.com/story/10608278/1/kass-staying-practical.html
Around 1200, we completely “fill the gap” of the fall 2008 crash, the Shiller P/E will get back to around 20 which usually marks tops, and is consistent with the magnitude of rallies coming off secular bear crashes:
http://www.ritholtz.com/blog/2009/10/the-most-hated-rally-in-wall-street-history/
Definitely confusing times, and with valuation IMO making little to no sense with the backdrop of economic fundamentals as I believe they exist, I find myself primarily relying on technicals and historical cycles to make decisions about where to trim/sell.
FWIW, here are a few comments from Rosenberg today:
“STATE CAPITALISM
It is next to impossible to really gauge the health of the U.S. and the global economy in view of the massive doses of medication that have been administered by governments everywhere. In the U.S., the situation has been particularly acute because it is so apparent that domestic demand falls off a cliff once the freebies from the unknown taxpayer expire. We saw this with the end to cash-for-clunkers, and wouldn’t you know it, but the 2.7% slide in the S&P homebuilders index yesterday was pinned on a Deutsche Bank report concluding that the U.S. government is not going to extend the first-time homebuyer tax credit, which is due to expire at the end of November.
ONGOING CREDIT CONTRACTION
The big story yesterday was the further massive $12 billion decline in outstanding consumer debt in August — the consensus was looking for an $8 billion contraction. This was the seventh month of debt retrenchment in a row. In other words, the tidal wave of the credit collapse continues unabated,
The real question is that if we in fact do have this sustained reflation trade going on, which is actually necessary to justify the earnings expectations embedded in equity valuation, why it is that the yield on the 10-year T-note isn’t north of 5% already. Instead, it is 3.3%. History shows that when bonds and stocks do diverge, as was the case in the summer of 1987, the fall of 1994, the summer of 1998, the winter of 2000 and the summer of 2007, it is the former that proved to be prescient.
October 9th, 200911:38 am at
Good luck putting this together, David. You should video tape if it happens and post the lunch conversation online.
October 9th, 20097:40 pm at
David,
This is my first visit to your blog compliments of Abnormal Returns. I’m impressed with both the quality of your writing & analysis as well as the caliber of the accompanying comments. With regard to Mr. Hussman’s piece, he notes in the tease for the essay that “At these levels it seems that a full-blown V-shaped recovery is being priced in.” Therefore, if the lunch occurs could you ask him what his view of fair value is if the recovery is U-shaped (a-la Roubini), L-shaped or, lest we forget still another option, not a recovery at all?
October 9th, 200911:46 pm at
Tom and all, I have not been contacted by Dr. Hussman — I hoped but did not expect that he would reply. I am thinking of having an Aleph Blog lunch somewhere between Baltimore and DC. Everyone pays their own way, but we can have some good conversations.
October 9th, 200911:55 pm at
Oh, as an aside, if this is not a V-recovery but a U, I could see the market down 20%. L? We would test the 666 low on the S&P.
Just remember, though it hurts, there are limits to how far markets can fall, absent plague, pestilence, rampant socialism, and war on your home soil. I called high yield in November 2008 when the panic was thickest, because yields were discounting too many companies failing, around half, with poor recoveries.
In the same way, assets have intrinsic value, even if earning power has temporarily been diminished. Look at more stable measures than earnings during a panic like price to book or sales. And, focus on strong balance sheets.
October 10th, 20097:36 pm at
Hello Mike C,
ECRI is not forecasting a “sustainable” recovery. They have simply said that the initial stages of the recovery will be the steepest since the early 1980’s double dip recovery. In fact, ECRI is the 1st to admit that their indicators are really only highly effective 6-9 months out. They have consistently stated that the long term structural problems do not de facto preclude the possibility of a cyclical recovery.
As for the sides in the intellectual horse race, I am speaking more about the inflation/deflation debate versus the shape/slope of an economic recovery. It is this debate that has true heavy weights lined up on both sides. Inflation “believers” include Jim Rogers, Julian Robertson and many others. Deflationists include Rosenberg and Gross. I view Hussman as a “tweener”, as he sees inflation pressures mostly 3-5 years out.
I don’t believe a sustainable v shape recovery is likely. However, I do think that GDP prints in Q1 and Q2 of next year could shock many and lead to significant market disruptions – particularly in currency and fixed income markets. Such prints could cause people to get more optimistic at just the wrong time, as any significant uptick in rates is likely to be a death nail for our still over leveraged economy.
You’ll get no valuation argument from me, but valuations can be ignored for some time. I don’t see much more upside for the average stock during this cycle – the Value Line index has already retraced about 75% of the bear market. But I do think a top will likely take months to form with some market segments providing ample rewards as the broad indexes churn.
Personally, I think the ag space – particularly the commodities – are gearing up for a MAJOR move higher in the next 1-2 years and that is where we are over weight significantly.