Tuesday, November 25, 2008

Equities are so undervalued it's hard to believe

Today the government released third quarter data on after-tax corporate profits. Profits fell, but only modestly relative to the second quarter, and profits were down only 7.8% over the preceding 12 months. Profits were 7.8% of GDP, way above their mean-reverting average of just over 6%. This chart takes the NIPA profits (which are distinct from GAAP profits, in that NIPA profits are based on actual tax filings by companies and are adjusted for inventory valuation and capital consumption allowances—thus making them similar to economic profits, whereas GAAP profits are accounting profits and can be quite different) and uses them as a proxy for corporate earnings. It divides those earnings by the yield on 10-year Treasuries to get the capitalized value of all U.S. corporations (blue line). It then uses the S&P 500 index as a proxy for the price of all corporations (red line). The model is similar in construction to the "Fed Model" of equity valuations, and is my version of a similar model that Art Laffer has used profitably for decades.

What jumps out at you is the unprecedented degree to which stocks are undervalued today. The gap between these two lines has never been so huge. It's enough to make you question whether the model makes any sense at all, or whether there is something horribly wrong with the data. Or whether the stock market is just simply in the grips of a massive deleveraging panic that has driven valuations to absurd levels. Or maybe the 10-year Treasury yield is so artificially low due to panic conditions that it is inflating capitalized profits? To test whether the latter explanation is reasonable, it would take a 10-year Treasury yield of 10.4% to make the model say that stocks were fairly valued today. That's a big stretch.

I'll stick with the conclusion that stocks are incredibly undervalued today for a variety of reasons, but even the sum of those reasons fails to fully explain what is going on. The financial market is still in the grips of panic, deleveraging selling; liquidity in the bond market is dismal; the ability of anyone to reliably quantify the risk of subprime-backed, asset-backed, and commercial real estate-backed securities is highly questionable; our government is in a state of flux; the threat of higher taxes on capital is real; the threat of protectionist policies is real. But even if Obama makes a series of blunders, one big thing distinguishes the current period from the Depression, and that is monetary policy. The Fed today is simply not going to allow the monetary contraction that crippled the economy in the 1930s. And although I dislike Obama because of his socialist instincts, I seriously doubt he is going to blindly make every mistake in the books.

So I'm left with the conclusion that stocks are cheap.


Tom said...

Two things, Scott. One is that your valuation model showed stocks being undervalued for most of this decade. Other models, such as John Hussman's, seem to be more useful -his showed the market overvalued until the recent plunge, but now undervalued.

Secondly, this idea that avoiding monetary contraction avoids the damage doesn't make sense to me. The Austrian School thinking shows that the damage happens during the credit expansion boom -- an abnormal number of people make investments that turn out to be in error and liquidation of those investments is both inevitable and necessary once they are made.

How will it help the economy to have the Fed and the Treasury preventing bad businesses from failing? All of these insane liquidity moves are aimed at preventing price corrections in the economy. How is it that a market-oriented economist can accept these developments as appropriate and helpful?

We've talked about the 1930s before. The depression didn't continue because of a monetary contraction. It continued because FDR tried to control prices, production, wages -- everything. It continued because of higher taxes, higher tariffs, and escalating threats to private property.

The extreme liquidity "operations" today amount to a theft of trillions of dollars for the purpose of fighting price changes in the economy and propping up failed institutions. These actions strike me as coming directly from FDR's play book.

Tom Burger

CDLIC said...

Scott wrote:

"And although I dislike Obama because of his socialist instincts, I seriously doubt he is going to blindly make every mistake in the books."

But then again he is a socialistic; spread-the-wealth; tax-the-rich; free-markets don't work; Government is the savior of society; give the less fortunate their fail share; universal “voluntary” civilian service; regulate the producers; universal healthcare for all kind of guy. Other than that, I’m comfortable.

Mark Gerber said...

It seems to me that right now it is all about whether the central banks can and will fill the black hole of debt (perhaps better described as dollar amount of lost leverage) created by dropping asset prices and the collapse of the shadow banking system. If they can and will fill that hole, I think stocks can recover substantially in the next few months. If we can't or won't, deflation will take hold, more deleveraging will occur, unemployment will go much higher, and earnings (stocks) will drop much further.

We all seem to have a reasonable handle on the current mortgage backed security losses, but as housing continues to drop, projections of future losses will keep going up. Even though the shadow banking system has collapased, and the losses have moved onto the real banking system, it is still not clear how big of a hole was created for the banks. I've heard estimates of $10T, but it seems nobody really knows. It sure would be nice to know the size of the existing hole so we can get certainty on whether they CAN do it.

I have generally believed the Fed/Treasury CAN fill the hole, especially with creative emergency Fed creativity, but I've been unsure whether they WILL. They have been behind the curve, and it has felt like they don't get it so they won't step up in time. Paulson's speech last week about abandoning the asset purchase part of the TARP felt as though they were trying to convince the market they had already done enough and nothing more would be needed until the new administration took over.

Now, it seems that Paulson's "we've done enough and the system is stable" statments were a bluff, and the subsequent selloff in banks, especially CITI, and the new stock/corporate bond market lows late last week was a call on Paulson's bluff. Now, with the aggressive action over the weekend with CITI, and aggressive $800B action over the past couple of days, especially the Fannie/Freddie mortgage purchase program by the Fed which should help stop the housing decline, it finally feels like they are ready to play catch up. It finally feels like they are finally willing to do what it takes and fast. Based on these qualitative observations, I think the odds have now shifted away from continued deflation and toward a more probably stock/corporate bond market bottom being behind us for now -- at least a few months as long as the Treasury/Fed continue to at least indicate they will keep filling the hole. Gold also seems to be confirming this shift in likely outcomes.

Now, if someone could just show me the figures on how big the hole really is so I could know with certainty when we have done enough to fill it. Looks liek the Fed has shoveled about $3T so far, has programs in place to shovel another $2T, and is willing to do more.

t said...

Tom, Would like to take a look at the Hussman model, would appreciate if you could post web address. Not much of a top down mkt analyst, look more at individual companies but even old dogs can learn new tricks. Have been buying aggressively since Oct 10th, BRK,JNJ,KO, BNI, CB,GE,UPS.

Have been watching CVX and COP, thinking crude may drift into the low 40s this winter.

Scott Grannis said...

Mark: excellent comments. I don't know how big the hole is but I have a high degree of confidence in the Fed's ability to fill it. I've always believed that you can never underestimate the Fed's ability to get what it wants.

Scott Grannis said...

CDLIC: ;-). But he's also a politician, and you can never trust politicians to do what they say.

Scott Grannis said...

Tom: isn't Hussman now bullish? I have to believe that all model valuations are showing stocks to be some degree of cheap. I admit my model has been wrong for years, and questioning its validity is entirely reasonable.

The Depression was caused by monetary contraction AND FDR's stupidity: a lethal combination that we don't have today.

SpeakToMe said...

Stocks are cheap at the moment, no doubt about it. Looking forward, I'd expect those lines to come together more from the earnings dropping and rates rising (intrinsic value lower) rather than stocks going up.

In the past, where there have been large discrepancies, I note that the market has proven to be more right than the model -- the intrinsic value moved to the stock price rather than the other way around.

Scott Grannis said...

Speak: Those are valid points. But to close the gap on the earnings side alone would require a decline in profits of two thirds. On the rate side, it would require Treasury yields of 10%. Or some combination of the two, leaving you with a scenario very difficult to describe.

I can believe that profits will decline some more and that rates will rise. But that still leaves me with cheap stocks unless prices rise meaningfully.

Tom said...

"t" is looking for John Hussman.

Here is the link address: http://www.hussmanfunds.com
A google search on John Hussman brings his site right to the top.

Hussman is a data-driven analyst. His valuation model is based on Price to Peak Earnings ratios with what he calls normalized profit margins. He looks at long-term data history and calculates the average expected 10 year rate of return for existing parameters. Hussman is also a stock picker, and his team hopes to pick stocks that do better than the market.

Read many of his weekly commentaries; he does an excellent job of defending his methodology. Incidentally, the projected ten year return as of now was right on the money -- just about zero percent. He has also posted several commentaries over the years showing what he believes is the problem with the so-called Fed Model of stock valuations -- well worth taking a look at.

Before this market crash, his model had him hedging his fund 100%. Now Hussman says that for the first time in this decade stocks are priced to deliver good 10 year returns. He says he is most emphatically "not bullish" and is "not calling a bottom" -- his argument is more subtle than that. He says it is time to start slowly and carefully building a portfolio on days of market weakness. I like what he has to say.

By Hussman's model, valuations are attractive but well within historical experience. My only concern is that the impending recession could, in my opinion, become an outlier relative to Hussman's data -- and thereby fail to deliver expected returns. But, it is clearly a probability game and I too am buying selectively.

Tom Burger

LetUsHavePeace said...

From Peter Fisher at the New York Fed: "Stress testing alone, however, -- if it is only a theoretical, number-crunching exercise divorced from the messy reality of trading and settlements -- may create its own problems. I am sure most portfolio managers know the potential impact of one- or two-standard-deviation moves in their asset values and of simultaneous one- or two-standard-deviation moves in previously-uncorrelated assets. Some portfolio managers may have contemplated the potential impact of three- and four-standard-deviation moves on their assets. But even if one had run stress tests of the impact of three-, four-, or five-standard-deviation moves, what assumptions were made about the bid-ask spreads that would exist in markets after they have experienced such outsized shocks? We know that the bid-ask spreads will not be "normal" and in the last few weeks we have some experience that the thinning out of markets will lead to further movements in the asset prices themselves.

This is really just a fancy way of saying that we are learning again the lesson that markets are subject to liquidity illusions; that each trader may be able to exit a position when he or she wants, but that all traders cannot exit their positions at the same time.

As a practical matter, no one can be expected to manage a portfolio on the assumption that a Russia will default once a month. As Chairman Greenspan recently noted, returning to the 30-percent-plus capital ratios of the 19th century might make financial institutions stronger, but it would also have consequences on rates of growth and standards of living that we might find less agreeable.

But we all probably need to study the distribution of outcomes a little more carefully to understand the structure of the tails--whether fat or thin. A common assumption is that thin tails should not worry us; but perhaps, for example, a thin tail may tell us that a six-standard deviation move is as likely as a three-standard deviation move. This is something that should give us pause.

My main point, however, is that the discipline of stress testing needs to encompass both the outlandish and the practical: outlandish in pushing the bounds of the unexpected and practical in relating "what if" scenarios back into the real world of trading and bid-ask spreads."

Tom said...


When it comes to markets and the economy, it seems to me that we are making unwarranted assumptions about underlying probabability distributions. You can't even talk about "standard deviations" without assuming a particular mathematical form -- and that is quite likely wrong.

The Austrian School economists have argued all along that mathematical models in that field are a fools game. They say that not because they don't like or understand mathematics, but because they understand the nature of Human Action. In his book, Human Action, Mises has a discourse on the different meanings of "probability" -- it's well worth reading if you haven't seen it.

Tom Burger

Scott Grannis said...

Peace: your comments are very insightful. You can't manage a portfolio if you assume that markets like we have today will happen every so often--the risks would leave you frozen in cash, and even cash can be risky as some holders of MMFs found out. How to avoid another disaster like this? I don't know, but I suspect that risk spreads will be higher than normal for quite some time.

LetUsHavePeace said...

Tom: I think Mr. Fisher was making a comment about standard deviations from the historical record of volatility, not about the shape of future uncertainties. I think we Austrians overreach when we absolutely reject the efforts of professional managers like Scott to develop norms and rules for the design of prudent portfolios. The existence of rogue waves that can swamp any vessel does not "prove" that naval architecture is an exercise in pure folly. I think Mises is right to argue that, because of human action, we can never know what is the shape of the roller coaster of risk we are riding on, but that does not mean that we can't take measures that reduce the chances of our fatally crashing. Measured against the educated guesses about future earnings by owners and managers with real stakes in their businesses, current equity prices are at an extreme low in the range of historical forward P/Es. That provides no certainty that prices will not go lower, but it does suggest that the risk curve (whatever its exact shape) is offering far greater potential rewards to owners of property than to owners of government IOUs.

Your comparison with the Depression is an appropriate one, but I think China is the country that is now in the position the U.S. was then. In 1932 the U.S. had the current account surplus. That is why Keynes was right when he urged the U.S. to increase domestic consumption through the use of deficit spending; the rest of the world could not pick up the slack. That is the dilemma the Chinese face right now. The U.S. by contrast needs to adjust to a slightly lower rate of consumption and an increased level of domestic savings. To the extent that the TARP operations represent assets swaps rather than outright Keynesian spending, they are a bumbling step in the right direction.

Tom said...


I agree there is nothing wrong in using mathematical models to better understand history and therefore gain a little insight into likely future conditions. It's when you take it too seriously that problems emerge: LTCM and our recently failed "quant" funds, for example.

These guys had models that said a certain event would happen only once in (what?) a thousand years, so they put on 50-1 leverage. That is using the mathematics inappropriately, I would say.

Tom Burger