Tuesday/Thursday Market Commentary

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Why Cyclically-Smoothed Earnings Make Sense
7/10/14 7:30 PM



Almost all professional investors look at the P/E ratio of the stock market, but rather than smoothing the earnings as we do, they look at either the past 12 months of earnings or the estimates of earnings over the next year.  We can’t believe how many sophisticated investors use the P/E ratio based on the past year or following year.  The reason we attempt to smooth the earnings is to dampen the volatility that one year of earnings has had over the past decades.  This will make it easier to make longer term decisions.    

An example of the volatility of one year of earnings over the past 14 years would be that “reported earnings” (or GAAP—Generally Accepted Accounting Principles) were $50.00 in 2000, $24.69 in 2001 and came back to $48.74 in 2004.  The earnings “estimates” over that period of time also had tremendous volatility and it boiled down to almost a guess.  So how could you possibly base an intelligent investment decision during that time?  Also earnings were $66.18 in 2007, $14.88 in 2008, and $50.97 in 2009.  Earnings are among the most mean-reverting statistics in investing, and therefore there has to be a better way of determining the “true” earnings.  Earnings always return to the trend and the long term trend of earnings growth over time has consistently averaged about 6% despite the year-to-year volatility.

The idea of smoothing earnings over a period of more than a single year was first proposed by Graham and Dodd in their classic book “Security Analysis” published in the early 1930’s.  Cyclically—smoothed earnings have proven to be a much more accurate predictor of long-term market returns than any method that uses earnings over the past year or following year.  In fact, we used this method in late 1999 when we published a report forecasting that the normalized S&P 500 would be about 1260 ten years from then.  That was significantly below the then prevailing price.  It was a projection we made near the peak of the dot-com bubble.  Almost everybody thought the forecast was crazy although it eventually proved to be highly accurate.

What we do to smooth reported S&P 500 earnings over a longer period of time is to calculate an average of the past 9 years (which usually includes at least one and often two business cycles) .  We then take that average of the 9 years and place it in the 5th year, the exact mid-point of the 9 years.  We then increase that number by 6% per year to the last of the nine-year period and use that number as our normalized earnings for the most current period.  Using that method our normalized earnings for the 12 months ended March 2014 is $90. Then we divide the S&P 500 level of 1970 by the normalized earnings of $89 and come up with a PE of about 22..  This represents a very expensive level for the stock market, and was exceeded only in 1929, 2000 and 2007. 

There are others in the investment community that also normalizes earnings such as Robert Shiller, John Hussman, and Ned Davis.  They each actually use a longer time frame than we do, but each of them comes to the same conclusion that the stock market with normalized earnings is expensive and overvalued. 

Note: From this point, we will issue our comments on the first Thursday of every month, rather than every Thursday, although we may sometimes do additional commentary when it is appropriate.



Happy July 4th Weekend
7/03/14 12:30 PM

There will be no comment this week.  We wish all of our readers a happy July 4th weekend.

The Fed's New GDP Forecast Is Already Badly Out of Date
6/26/14 5:30 PM



In the last several years the Fed has been overly optimistic about economic growth prospects. Fed officials have had to repeatedly mark down their forecast and then revise down the initial and subsequent readings.  In fact, yesterday the real GDP for the first quarter of 2014 was revised down to -2.9% from -1.8% recently, and -1.0% in April of this year.   This is the lowest real GDP reading in 5 years. The consumption segment (by far the largest) was reduced from the original forecast of 3.1% to just 1% yesterday.  This latest release lacked both consumption and capital expenditures

Moreover, with the release of the report for 1st quarter GDP, the Fed’s new downwardly revised forecast for the year, issued only last week, is already badly out of date.  The latest Fed GDP forecast for 2014 is for a central tendency of +2.1% to +2.3% growth.  However, given the 1st quarter growth, a simple arithmetical calculation shows that GDP would have to grow at an annualized rate of about 4.4% for each of the next three quarters to reach its new projection.  We regard this as highly improbable, and are surprised that we have not seen or heard anyone comment on this.   

To get significant growth we need more consumer spending  in order to offset the weak capital expenditures by most of corporate America.  We have discussed the consumption problem in many of our comments.  The largest problem with consumer spending is the enormous debt taken on by the household sector during the period of the mid-1980s to 2007 when the “great recession” hit.  The percentage of household debt as a percentage of both GDP and personal disposable income more than doubled over that period of time.  Since 2007 the consumer has been paying down the debt and deleveraging.  To get good growth we need the deleveraging to end or wages to rise in order to turn around the weakness in consumption.

After 5 years into a recovery real consumption has been growing at only 2% in real terms while the long-term average is closer to 3.5%.  If the deleveraging slows down it will all come down to wages increasing.  While job growth has been barely satisfactory over the past 5 months, and the unemployment rate has declined, the lack of wage growth and a declining Labor Force Participation Rate  to multi decade lows (back to1978 levels), have reinforced the fact that there is still a lot of spare capacity.  We believe, the continued household leverage and spare job capacity will continue to disappoint the Fed and probably force them to reinstate the QE-3 before the tapering ends.

In fact, last week’s comment summarizes our QE point of view with the following statement--  “However, we believe the market will correct significantly before the Fed ends the tapering of the bond purchases and this will result in a delay of further tapering, and maybe even reverse the tapering altogether, and actually increase the amount of bond purchases made each month.  What will be interesting is how the markets handle it.  Will investors continue to believe the Fed will bail the markets out again by buying more bonds?  And will investors go back to the buying of risky assets on the news of more QE purchases, or will they start losing confidence in these policies?  Eventually, we believe it will be the latter”. 

What Happens When the Fed Unwinds Their Balance Sheet?
The Manager of QE-1 Agrees that the Fed Has Lost Perspective
6/19/14 1:00 PM


  Here we are, almost six years from the financial crisis of 2008 and yet the Federal Reserve is still printing money--Quantitative Easing (QE).  At the beginning, it was explained that these policies were necessary to stop us from going into another “great depression” (after entering the “great recession”).  That was with QE-1 starting in late 2008, and QE-2 starting in November 2010 until June 2011. With the start of QE-3, the Fed did not use any time limit which started the description “QE-3 to Infinity”.  The latest “QE-3 to Infinity” starting in September of 2012 was also driven by much larger purchases of bonds.  Under this QE the Fed purchased $45 bn. /month of Treasury securities, $40 bn. /month of mortgage-backed securities, while keeping the Fed Funds at a range of zero % to .25%.  This strategy was used by the Fed to create a “wealth effect” so consumers felt wealthier as asset prices rose.  They expected this “wealth effect” to help stimulate the economy.  Presently, the Fed has decided they want to stop QE-3 since their balance sheet skyrocketed from $800 billion (bn.) to $4.3 trillion (tn.) as the S&P 500 rose close to 300%. 


Here’s the problem.  The hope of the Fed has been that the economy would improve to such a point that stimulation would no longer be necessary.  But, although there has been some improvement, many important sectors such as capital expenditures, strong growth in well-paying jobs, housing, and retail sales, have all been disappointing, which accounted for a negative GDP in the 1st quarter, and probably will stay with a 2 handle for the year.


The Fed has tried to stop QE strategies before but were unsuccessful.  During the first two QE programs, they set a date when the programs would end.  Once those dates were announced, the markets began to unravel which resulted in the Fed starting another QE.  They essentially had to start a new QE in order to keep the “wealth effect” alive.  Apparently, they noticed that stopping their programs at a specific date was not working, so they came up with the idea of getting out gradually (“tapering”) as if no one will notice and everything will go back to normal.


Our hope is that the “tapering” actually works and the Fed will no longer meddle in the markets, but realistically, how can it end differently this time?  After all, the Fed has never had to taper bond purchases or raise interest rates with a balance sheet of over $4.3 tn.  As the Fed continues to taper the bond purchases, it will eventually strike a nerve in the capital markets just like the earlier programs. And if not, it will definitely strike a nerve when they decide to raise interest rates. They may decide to try other techniques before they raise interest rates, like pay interest on bank reserves, issue Certificates of Deposits for excess reserves, or “repo” bank securities by giving the banks securities while they pay the Fed cash. 


However, we believe the market will correct significantly before the Fed ends the tapering of the bond purchases and this will result in a delay of further tapering and maybe even reverse the tapering and actually increase the amount of bond purchases made each month.  What will be interesting is how the markets handle it.  Will investors continue to believe the Fed will bail the markets out again by buying more bonds?  And will investors go back to the buying of risky assets on the news of more QE purchases or will they start losing confidence in these policies?  Eventually, we believe it will be the latter.  


The Manager of QE-1 Agrees that the Fed has Lost Perspective


Andrew Huszar is a senior fellow at Rutgers Business School and was the former manager of the Fed’s $1.25 tn. Agency mortgage-backed security purchase program (QE-1).  In an interview recently Andrew questioned the enormous build- up of the Fed’s balance sheet.  He stated, “You can’t spend $4 tn. in the financial markets and not see benefits.  First of all, I should say that while I feel the Fed has lost perspective, I believe the people working there are smart, well intentioned people.  I just don’t believe it flies, and whatever benefit you get from this program is being outweighed dramatically by the negative distortions that QE is creating.  There’s the question of how the Fed unwinds its unprecedented operational expansion.  This is an unwinding that will have to be invented on the fly, and it could have huge downside risks for the U.S. economy.  Note that even the Fed’s suggestion of a minor taper this summer led to the beginning of a substantial stock market  selloff.  What if the Fed ever has to sell off bonds?  You can imagine far greater risk and volatility in the markets.  The longer the Fed waits, the greater the risk gets.”

The Reason for Interest Rate Declines
Bullish Sentiment is a Problem
6/11/14 1:00 PM

Last week we published the special report, “Deflation vs. Inflation”. That topic has become the subject of ongoing debates on the financial news about why the bonds and notes, here in the U.S. and Europe, were declining so much this year. As our report was being distributed the European Central Bank (ECB) met and Chairman Mario Draghi released an onslaught of anti-deflationary policies. The ECB hopes these policies will reverse the spreading deflation throughout the Eurozone.

Deflation is caused by onerous debt collapsing on the system, resulting in less credit extension and less spending, followed by a severe recession or depression. This is what took place in the “Great Depression”, Japan starting in 1989, and it looks to us like the Eurozone and U.S. could be headed for the same scenario.

There have been several debates among the financial gurus in the media attempting to explain why interest rates dropped so sharply this year, after rising last year. Some would argue the lower rates are reflecting weaker economies over the next few quarters or years. Clearly, we believe that these lower rates in Europe and the U.S. are reflecting disinflation presently, (that has a good chance of turning into deflation). The U.S. inflation is running about 1.6%, which is about 1% higher than Europe, which is running about .5%. The U.S. money supply rose over 6% during the past year while Europe grew only 0.8%. The U.S. 10 year Treasury is still trading at about 2.6% while the French 10 year bonds are at 1.7%, Italy 2.8%, Spain 2.6%, and Germany 1.4%. The UK is also under the blight of deflation since their average hourly earnings growth has slowed to just 0.8% while their 10 year bonds are trading at 2.7%.

The anti-deflationary policies that Mario Draghi revealed last week were a reduction of 0.1% in its main rate (similar to our Fed Funds rate), and lowering the interest rate on reserves the banks hold with the ECB. Additional steps were taken to provide banks with low cost long term funding to make loans. These ECB headline policies are not as significant as the policies for their banks to loan out Euros to small and medium sized businesses at the same rate they charge to the large companies. Before this policy they were charging small and medium sized companies almost double the rate they were charging their larger corporate clients.

As much as the ECB went with deflationary policies, they did not go as far as our Fed and the Bank of Japan (BOJ) in initiating quantitative easing (QE). We suspect that they could see the corner we painted ourselves into and didn’t want to wind up with the same dilemma we have presently. They could see that it will not be easy to wind down a $4.3 trillion balance sheet that started at $800 billion just 5 years ago.

In fact, in the past, every time we ended a QE program the stock market declined. We will end the purchases of government securities and mortgage backed securities if we stay on the Fed plan this year. We suspect strongly that before we end the QE program, the Fed will see enough weakness in the economy to reverse the “taper” and begin purchasing more bonds (essentially start another QE). However, even if they complete the “taper” they will still have a problem with the stock and bond markets as they attempt to raise rates. And after that, they still have an enormous balance sheet to wind down eventually. Just yesterday the Fed officials stated that they are concerned about having to sell bonds from their balance sheet (since that could crush the U.S. recovery).

The World Bank cut its global growth forecast for this year from 3.2% in January to 2.8% now - amid weaker outlooks for the U.S., Russia, Brazil, India, and China economies.  The U.S. forecast was lowered from 2.8% to 2.1%.  They also called on emerging markets to strengthen their economies before the Fed raises interest rates. 

Another problem the bulls have got to deal with is the fact that “Investors Intelligence” just reported the results of their weekly poll of financial advisors. The percentage of bulls just jumped to 62.2% from 58.3% a week earlier. This marks the 5th straight week this indicator has been above the key 55% level. This current level exceeds last year’s high-water mark of 61.6% at the end of December. Prior highs came in August 1987 (60.8%), October 2007 (62%), and December 2004 (62.9%). All of those peaks occurred after large rallies and prior sizable corrections.


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