Comparisons


With little economic data on the calendar, and the Fed speakers back-loaded at the Chicago Fed conference later in the week, there is time to reflect on other questions (unless, of course, the Israel/Syria back-and-forth turns into something more than the last couple of jabs have produced).

It is interesting to me that analysts and journalists truly enjoy finding comparisons between present situations and actors, except when the comparisons suggest unpleasant conclusions. This is at a time when there are really no comparable periods in history to compare to, at least with respect to major global policy initiatives!

I read comparisons between Shinzo Abe’s pressure on the Bank of Japan and Fed Chairman Bernanke’s campaign to resurrect the American economy with ever-greater monetary policy shocks. Somewhere, I saw an analyst ask “isn’t Abe taking note of the failure of U.S. monetary policy to goose the economy?” But the comparison is not apt because the two men, and the two economies, face very different challenges. Abe doesn’t need to increase consumer spending and reinvigorate the economy with monetary policy. While that might be nice, the main goal of Japanese monetary policy now is to raise the price level and the rate of inflation. They are using exactly the right tool to do so: lots of monetary easing. On the other hand, Bernanke is trying to kick-start the real economy with a monetary tool, while at least in principle avoiding an inflationary outcome. That’s like trying to hammer a nail with a fish. It might work, but it’s the wrong tool for the job. So the comparison doesn’t work: one man knows how to use his tools, the other does not.

Here is another useless comparison: “Bond Buyers See No 1994 as Bernanke Clarity Tops Greenspan.” The myth that transparency really helps markets in the long run is sort of silly: is there any sign that the crises caused by monetary policy have become less frequent since the Greenspan glasnost than they were before? I know that’s the belief, because the Fed has told us that’s the way it is. But my scorecard tells a sorry tale of bubbles and crashes since the early 1990s. It isn’t a lack of transparency that causes routs. It’s leverage, and negative gamma. Mortgage hedgers are more active now than they were in 1994, and they have larger books. Hedge funds are orders of magnitude larger. And Wall Street is smaller, and is able to provide less liquidity – partly because they are more levered (which they think is okay because of “Fed transparency”), and partly because the government doesn’t want them to take bets with the leverage they have (which, since they’re paying for failures under the current system, isn’t wholly absurd).

So will the next bond selloff not be as bad as in 1994, because the Fed will give more warning? Remember that no matter how transparent the Fed is, there is still a transition point. Somehow, the market goes from a state of thinking there will be no tightening of policy, to a state of thinking that there will be a tightening of policy. That requires a re-pricing, whether it occurs because the Fed signaled it in a speech or a statement, or because they signaled it by doing Matched Sales for the SOMA account with Fed funds already trading above target (as was the old way of telling us something had changed). There is no way to go from “not knowing” to “knowing” without a moment of realization. And when that phase change ultimately occurs, the greater leverage inherent in the market and the diminished role of market makers will cause the selloff (in my view) to very likely be more dramatic than in 1994.

One place where we cannot prevent comparisons – nor should we want to – is in the asset markets. Stocks are doing well, despite absurd valuations, because most other markets are either more-absurdly valued (e.g., Treasury bonds) or have horrible momentum that means they’re not popular right now (e.g., commodities). I have no doubt that equity performance over the next 10 years will be very uninspiring, because equity markets that start from this level of valuation never produce inspiring returns. But when people ask me what the trigger will be for a selloff, I have to shrug. There have been plenty of “reasons” for that to happen. But I think the ultimate reason is probably this: equities are perceived as the “only game in town.” I have read several articles recently that echo this one: “Bond Fund Managers are Loading Up on Stocks.” When there is some other asset class, or some other world market, that starts doing appreciably better, perhaps investors will decide to allocate away. Unfortunately, the candidates for that market are pretty few, given the general level of valuations. Could it be commodities, which is one of the few genuinely cheap markets? Or perhaps real estate, which is still only fair value but has some pretty striking momentum? I don’t know – but I am also not sitting around waiting for a “trigger event.” There may well be a selloff without such a trigger.

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  1. Mark B. Spiegel
    May 6, 2013 at 7:59 pm

    >> Stocks are doing well, despite absurd valuations…<<

    I don't necessarily agree that valuations are "absurd." The S&P had RECORD earnings for the quarter just reported, coming in at $26.20 which is nearly $105 annualized… At tonight's close that's 15.4x earnings. I do understand that this is only due to Bernanke's unsustainable policies (I was going to use the phrase "Potemkin Village" economy as I've been doing for at least a year, but as David Rosenberg used it today I feel that it's no longer mine.) So within the context of this "village" (there, I sort of used it) stocks are fair value-ish if not a bit cheap:

    If Japan managed to pull off the "unsustainable" for at least 15 years, who's to say that we– currently only in "year 4"– can't? When guys crack open their spread sheets and do their various analyses to figure out the value of a company, at what point do they term out? Seven years? Eight? Ten? Within this context, I'm not so sure that stock prices are "absurd." (And yet I have a large percentage of my fund in cash because I'm not willing to bet that they AREN'T absurd. But I wouldn't be broadly short here, either, because I don't think there's enough downside– 20% or more– to make it interesting)

    • May 6, 2013 at 11:50 pm

      Yes, this isn’t a trading view. I don’t believe in valuing on 1 year of earnings, especially the S&P earnings (although if you use the ones from S&P that have the negative earnings in them, it’s at least arguable as long as you are sure you’re in an “average” year rather than a “peak” year…Bloomberg reports the S&P P/E using only positive earnings). My estimator of the total return of the S&P for the next 10 years will be about 1.9%+ inflation, which is basically just the dividend – the growth of 10-year earnings will be offset by a compression of the multiple of 10-year earnings. But if we are 25-40% or whatever overvalued, it doesn’t tell you we’ll get there QUICKLY. But we will get there eventually.

      I wouldn’t touch stocks with a ten foot pole here, not because I think a crash is imminent but because there’s almost no chance of getting 4%+inflation for the next ten years, and there’s little point taking 20x the TIPS risk if you’re getting that little increment of return (but that’s a personal risk decision that not all will share).

    • May 7, 2013 at 12:00 pm

      Here’s an example…for the Russell 2000 index (I just noticed this b/c I was looking at something else:

      Both from the Bloomberg FA page:
      “Price/Earnings: 54.87 Current
      Price/Earnings, Positive: 18.41”

      Which do you think gets reported if you do RTY Index in Bloomberg, under “Price/Earnings”? The latter number of course! That’s simply a lie.

      • Mark B. Spiegel
        May 7, 2013 at 1:37 pm

        Well, the S&P numbers I’m using definitely include losses, as for Q4 2008 the number was slightly negative. Of course, these are “operating earnings” rather than “GAAP,” but the “operating” number is the one that market participants care about.

      • May 7, 2013 at 2:40 pm

        …incorrectly, since although operating numbers with respect to any given company may be a good predictor of future earnings, the earnings with bad stuff included is a better predictor of index earnings.

      • Mark B. Spiegel
        May 7, 2013 at 2:46 pm

        Yes, I do generally agree with this Michael, but what what you or I think really doesn’t matter if stocks are priced the other way! I mean it would be one thing if using “operating” rather than “GAAP” were a ‘bubble” in and of itself, but this has now been the practice for a pretty long time and that didn’t change following either the crash of 2000/2001 or the one in 2008, so I’m not sure why it would now..

  2. HP Bunker
    May 7, 2013 at 3:10 pm

    Yes, but Mark the reasoning you’re applying (value stocks on operating earnings since everyone else does) is essentially ponzi logic, to coin a term. Once you’ve lost sight of anything like intrinsic value, you truly might as well be investing in tulip bulbs or beanie babies. Lots of “investments” are profitable for a little while using that sort of herd-following logic, but you are supremely vulnerable to sudden, sharp principal losses whenever you hold assets that are valued not on the income stream they provide, but rather the expectation that a valuation system you acknowledge to be deeply flawed will continue to be favored by investors.

    • Mark B. Spiegel
      May 7, 2013 at 3:19 pm

      HP,

      I do understand your point, but I think that the PE ratio accounts for this; after all, on GAAP the average PE multiples would have been considerably higher. Also, I think that “operating” has been the accepted metric for at least 20 years now; if that changes it won’t happen overnight– i.e., it won’t be a game of “musical chairs” where you need to grab one before the other guy.

      • May 7, 2013 at 4:02 pm

        Well, that’s true if you happen to understand that that’s what is changing. Of course, no one will say that is happening; the market will simply decline, and we’ll come up will all sorts of other reasons that it is declining. It is only 20 years later that we’ll look back and say “hey, it looks like they’re not valuing on all earnings, not just positive, operating earnings.”

        I am a little agnostic on whether GAAP or operating earnings is the “right” measure. But the fact that the market uses it carries exactly zero weight with me. This may be because I am a bond guy at heart, but I want the most conservative measure, not the more aggressive one – call it a “margin of safety,” which is something some other investor once referred to! However, I may be wrong. But the consequences of my being wrong are a lower positive performance, not a big negative performance, so I’m okay with that type of error.

      • HP Bunker
        May 7, 2013 at 6:26 pm

        I think there are two reasons to favor GAAP over operating earnings:

        1) “GAAP” has a relatively clear definition, whereas “operating” appears to be rather loosely defined as “always a bit more than GAAP” (at least when applied to a broad market index like the S & P), and

        2) “GAAP” reflects the amount that you, the shareholder who is a joint owner of the corporation, is actually entitled to, whereas “operating” denotes an amount that is a theoretical construct and generally based on what turn out to be rosy assumptions of future performance

      • Mark B. Spiegel
        May 7, 2013 at 6:41 pm

        Well, since I (and, presumably, you) buy “companies” and not “the market” we can adjust from GAAP to “operating’ at our own discretion. Personally, I wouldn’t touch with a ten-foot pole (from the long side) a company that ALWAYS has a variance between the two, but there is of course such as thing as a “period of restructuring” and a good turnaround situation often offers a great opportunity. To your point about “rosy assumptions of future performance,” well, that’s how most stocks are priced when they reach full value so the trick (of course) is to sell them when they get there.

      • May 7, 2013 at 7:19 pm

        I agree that for individual companies, you want to choose the more stable (and predictive) earnings. But that doesn’t generalize to an index, where actuarially-speaking the gap between operating and GAAP is fairly steady from year to year. Thus, the only reason to favor one over the other is because of the stability of the definition or because it gives a prettier number for the lemmings to buy. 🙂

  3. HP Bunker
    May 7, 2013 at 3:16 pm

    It was also the case in, for example, the late 90s that many .com companies with little or no earnings were valued based on stats like page views or subscriber additions. Many “experts” made the same sort of argument then (ie “traditional” valuation metrics don’t adequately capture the “value” in these stocks), and if you had simply joined the herd back then, you would have been run right off the NASDAQ cliff at the turn of the century and never regained those nominal highs. This is a more extreme example than simply using operating earnings in place of GAAP, but the same reasoning holds; once you step away from GAAP earnings, there are no longer any standards at all. You are granting corporate management complete discretion in reporting earnings, a blind faith in total strangers that is seldom justified.

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