It’s been a weird three days as far as portfolio management goes. Each day I outperformed the S&P 500 by 10-20 basis points. It’s been too regular, and it has to shift, but which way?
Cement names hurt me today, including Cemex and Lafarge SA. Barclays plc also hurt. On the plus side were SABESP and Grupo Casa Saba. On net, the results were nearly breakeven to me.
There may be other exogenous discontinuous events ready to smack the market around, but after early panic yesterday, the market became very rational in aggregate. The panic is over. Time to adopt a normal posture of moderate bullishness.
Moderate bullishness should be the posture of most investors because absent famine, plague, war on your home soil, and aggressive socialism, markets tend to appreciate over the intermediate term.
As I have pointed out at RealMoney, it is important to avoid non-prime lenders and homebuilders for now. Short them?! Well, that is for gamblers, not investors.
long SBS SAB CX LR BCS
I question how much real panic there was on Tuesday. I track Rydex asset levels in every one of there funds and the $ value in their money market fund actually went down Tuesday, as people bought the dip. Assets in their leveraged S&P fund WENT UP! Europe and Japan funds also saw increases in asset levels. Personally, I see widespread complacency and IF the market resumes its decline over the next 2-3 trading days I think it could get quite violent as the psychology transitions from denial to migration and eventually to panic. I think the Rydex data, along with anecdotal observations I’ve made, clearly show that most are still in denial about the possibility of a larger correction.
I think part of the issue on Tuesday was the systems glitches, which exacerbated the move down. The breadth of the decline was notable. Not much went down a ton, aside from some of the subprime related names… but almost everything went down. As you pointed out to me, the correlation level between various stock prices was high. It often is in a panic.
But look at the VIX — it was a big percentage move, but when have we ever hada significant crisis where the VIX didn’t go over 20? Or, for the old VIX, over 25?
I think there are a number of destabilizing factors that can hit the market. But so long as those remain quiet, there will be the continuing push to lever up public companies through buybacks and LBOs. There is still a lot of willingness to take risk whether through CDOs, private equity, or public equity. Short run those are bullish factors, as Ken Fisher would say. The intermediate term is less bullish, because leverage is a two-edged sword. Eventually the slowdown, or exogenous event hits, and the risks get revealed for what they are.
Thanks for the response. I have worked hard to view markets as a complex system and not in linear terms. I believe that the current market environment is in a critical state. I am using that phrase in the same spirit as a scientist would. Randomness and chaos often ensue throughout nature once a critical state has been reached. I am not necessarily saying the market will break lower. I am simply saying that IF it does, there is enough leverage in the system (the critical state is at a very extreme level) that I don’t believe most are respecting the elevated probability that the decline could be explosive.
All of those things you cite are linear in nature and I’m sure similar things could have been stated in August of 1987. Again, I am not saying we are going to have another 1987-type crash – only that once a critical state has been reached, the size of the chaotic unwind is difficult to predict. Whether it be an earthquake or an avalanche, these principals are fairly uniform throughout all complex systems. Whether or not the VIX stops at 25 or 250 is impossible to know – all I am saying is that the factors are in place so that the probability of a fat tail is MUCH higher than normal. In fact, I would argue the fact that many of the market internals from Tuesday haven’t been seen since 1987 is supportive that a chaotic event may have started. Just like an earthquake, the 1st tremor may be a warning sign that a bigger event is coming. Most 1st tremors turn into nothing – unless a critical state has been reached!
In 1987, earnings yields were way below corporate bond yields. Today, earnings yields are above corporate bond yields, but not by much. Before the crash in 1987 the earnings yield on the S&P 500 was 447 bp below the 5 year T-note. On average over the past twenty years the earnings yield on the S&P 500 was 106 bp below the 5 year T-note. At present, the earnings yield on the S&P 500 is 139 bp above the 5 year T-note. Valuations are favorable at present; they weren’t in 1987.
I know about the complexity that lies behind the wall of liquidity. I’ve written about it. Not everything written has to go into the depth of what could go wrong. It’s easy to look at the possible troubles, and not take the risks that get rewarded in an ordinary environment.
But I invite you to explain why you think the system has gone critical. I work with a bunch of bears; I’m a bear as well, but I control my emotions and my investing so that I rarely act on it.
I understand non-linear systems theory, and I try to apply it where it makes sense. I’d just like to know why you think the crisis is coming now and not several months or years from now?
Earnings yields are only above corporate bond yields because of record high margins. I don’t have the data, but I would guess that if you applied a comparable margin to 1987 earning the picture then may have been different. Regardless, my point is that that kind of relative valuation analysis is linear and nothing to do with what causes outsized market corrections. I believe these occur because of a violent shift in aggregate risk preferences, as the pendumlum shifts back to fear from greed. I too use linear valuation methods, but not to try and assess the chances of a sharp correction for trading purposes.
I think if you re-read what I wrote it is clear that I did not state that I expect “now” to be the moment. Simply, I am stating that the markets are in a critical state. Crashes have occurred at various levels of valuations as well as differing points in the valuation cycle. I believe that the compression of risk premiums in nearly every risk asset class as well as the incredible levels of leverage as well as the long period of low volatility creates an environment where risk preferences could adjust violently.
The drop on Tuesday is a tremor in the same way as the first area of snow begins to fall in a possible avalanche. I already have a blueprint for an avalanche if it triggers, but I am not saying that it has yet. My methods indicate that a definitive SPX close below 1398 will set up a correction at least to 1336, with 1274, 1211 and 1159 as potential terminal levels for a correction.1274 is the most likely destination according to my work IF the avalanche triggers Lets wait to see what happens and if things trigger and things play out in this way we can discuss further!
Oh – and I do valuation work as well! I have to take serious note with your statement that valuations are favorable right now. In general, my work shows that major risk assets classes are more overvalued as a group than they have been in years. Using normalized profit margins the SPX is trading at a P/E of 25. Price-Book and Price-Sales ratios are 30-40% above long term averages.
When margins are normalized P/E’s are also about 35% above average. I don’t have the data, but I would venture to guess that the SPX was cheaper at the peak in 1987 on a P/B and P/S basis compared to today – and probably by a decent amount.
That is not why I think a correction could happen – but it is why the SPX is likely to generate low single digit average annual returns for anyone who buys it now and sells it at the peak of the next cycle.
I did ask ISI Group for valuation work on price/sales ratios. You can read about it here, along with other complexities of my views on the markets. That’s below the 11-year average as well, and doesn’t rely on profit margins. I don’t have P/S or P/B for 1987 for any major index.
Profit margins are high for a good reason, though. Wage rates are under pressure because of globalization, and imported goods and services with cheaper embedded labor help keep margins high. There is still excess labor to employ. Profit margins could stay at a higher level, and not revert to mean for a while, unless globalization gets derailed.
More later; I appreciate your comments.
First off I enjoy and appreciate the intellectual debate. I think that ISI’s data is data mining – why use a trailing 11 year period in which half of those years included the largest valuation bubble in US market history. The P/S for the SPX has averaged below 1% over the past 100 years with the median even lower. The factors you site – largely globalization – have been in force for a long time. The Berlin wall fell 18 years ago and outsourcing to Asia has been a progressive development – not some explosive move in the past 4 years. The reality is that margins are not just high, but about 15% above any other historical precedent. The timing of this explosion above what had capped margins historically just happens to coincide with the explosion in debt and derivatives after the Fed lowered rates to 1%. With 50%+ of SPX profits being financial in nature, one must ask the question how much of these “profits” are real. As you know, the accounting behind these “profits” is a mile wide but an inch deep. Just look at HSBC and how the subprime operators are restating – oops their earnings models were off just a little!
Did you see the story this week about the rigging of trades that appears to be systemic at the wirehouses? One of the insiders squealed to reduce his sentence and implicated many of the major firms. He explained that he did what he did to achieve higher bonuses. As you my or may not know, most of these exotic derivatives that are being manufactured are priced by the same traders whose bonuses depend on those values. Buffett just stated this week that they finally finished digging out from under General Re’s derivatives mess….after 10 years! All of these “profits” that are being stated based on these derivatives arrangement are only “real” in fantasy land based on models put in place by people who have a self interest in being aggressive.
So we have almost everyone being aggressive in loan loss assumptions and derivatives accounting. Non-financial margins are not above historical peak norms. This tells me that along with energy (which may very well be more sustainable if peak oil is real), the financials are distorting current profits via aggressive accounting based on explosive debt growth.
Finally, I encourage you to go to http://www.GMO.com and read Jeremy Grantham’s latest quarterly letter. In it is a white paper by Ben Inker addressing the issue of higher margins and why GMO thinks the globalization argument doesn’t carry water (my phrase not their’s). I agree that the timing of mean reversion is not knowable but to state that the market is cheap is empirically wrong using any kind of long term valuation data. When someone needs to rationalize valuations with new era-type arguments (like profit margins will remain permanently higher), I cringe.
Oops – one more thing. If we use what used to be the level that peaked profit margins and apply it to current earnings, the Value Line Median P/E would be about 21. That is about 5% higher than the peak reached in early 1998 right before margins/earnings began to contract and the P/E contracted to 15 during the fall of 1998 – time when the Value Line index suffered a 29%+ correction from peak to trough.
James, the reason ISI used 11 years is an accident — that’s all they had; they are generally moderate bulls, but they are intellectually honest. It was at my request that they did the calculation. Do you have a source on your P/S ratio claims?
Yes, globalization has gone on for a long time, but it has not been linear. It has picked up dramatically in the last six years. Part of that has been the need for China and India to develop, but also simply the need to recycle all the dollar claims that the US produces. I have an article in the back of my mind called, “They don’t need us anymore.” Ex-US trade has grown even more rapidly, with China trading in many places where it only had a modest presence previously. The world is getting close to the point where it may not need the US to provide demand.
Financial profits, by their nature, are always shadowy, and lower quality. Accruals are always less certain than cash flows. But though Merrill Lynch is noting some deterioration in the ratio of earnings to cash flow from operations, we are not near the territory where we were in early 2000.
I agree that accounting for derivatives books is a joke, and we have yet to see the day of reckoning there. I’m not sure how much impact that makes on the system as a whole. It all depends on how well capitalized the party is who is called on to bear the risk in an adverse situation. Also, I have no argument with you over bad loans — I have written extensively about that.
I don’t think that profit margins will remain permanently higher. I think that they will remain higher for another 5 years or so, and grade down over the next five. That said, political calculations can change things, as can the willingness for governments to allow parties to trade freely.
I could be wrong here, but I am not as certain about my views as you seem to be about yours. I see the current troubles. I’ve written about them for a long time. But I also see some reasons for hope. I am not a bull or bear by constitution. I’m generally bearish now, but I understand the bull case, and can’t dismiss it. I am presently on the bearish side of my positioning in my mandates. But I never get so bearish that I make big negative bets.
Actually we agree on most things – my bone was simply with your contention that valuations are “favorable”. I agree that the timing of mean reversion is uncertain, but it will happen. I don’t believe that is bullish or bearish – simply empirical. Any basic algebra can tell you that assuming the SPX grows sales at 6% from here, if profit margins just revert back to average in year 10 avg annual returns will be less than 4% including dividends. I don’t know when it will happen over the next 10 years – the sooner it does the worse the performance between now and then. My certainly is not in the timing of all of this but simply in what current valuations suggest about future returns. A similar statement could have been made at the end of 1998 and the SPX has not outperformed T-Bills since then – though it sure did in 1999 and into 2000!
My question for you would be what rationale or empirical basis are you basing your assumption as to the timing of the margin adjustment? Seems to me it is inherently speculative and that is the crux of my criticism. I am not averse to speculating – I do it often with my own money. However, to speculate and rationalize it as investing is dangerous in my opinion.
You’ve made a number of good points here, and yes, I feel that we agree more than not. With respect to valuations, all valuations are by their nature relative. What do I like better, this or that? Eventually, by asking questions like that a bunch of times, I can come up with a full ranking of any portfolio.
I’m not crazy about US bonds relative to US stocks at present. What bonds I hold are typically high quality, and with short durations or foreign denominated. I am carrying a decent slug of cash as well. I have 1/3 of my portfolio in foreign equities, and have tilted away from areas that I think are prone to systemic risk. My median PE is around 12, and PB around 180%.
So, I’m playing it safe-ish. I like equities better than mid-to-long duration fixed income, but to the extent that I have discretion, I am leaning away from both.