Less Bang For The Buck

June 17, 20918

by Steve Stofka

There are two types of inputs into production, human and non-human. Over a hundred years ago, Henry Ford realized that he had to invest in his human inputs as well as his equipment, land and factories. Once he started paying his employees a decent wage, they were able to buy the very cars they were producing on Ford’s assembly line.

The total return on our stock investments depends on two inputs: dividends and capital gains, which is the increase in the stock price. Both are dependent on profits. Dividends are a share of the profits that a company returns to its shareholders. Capital gains arise from the profits/savings of other investors who are willing to buy the shares we own (see end for explanation of mutual funds).

In the past three decades, a growing share of total return has come from capital gains. Because of that shift from dividend income to capital gains, market corrections are harsh and swift.

In the 1970s, stocks paid twice the dividend rate that they do today. It took an oil embargo and escalating oil prices, a continuing war in Vietnam, the impeachment of President Nixon, a long recession and growing inflation to sink the market by 50% beginning in early 1973 to the middle of 1974.

In 2000, the dividend rate or yield was a third of what it was in 1973. Total return was much more dependent on the willingness of other investors to buy stocks. In 2-1/2 years, the market lost 45% because of a lack of investor confidence in the new internet industry, a mild recession and 9-11. Dividends act as a safety net for falling stock prices and dividends were weak.

In 2008, the dividend yield was about the same as in 2000. In 1-1/2 years, the market again lost 45% of its value because of a lack of confidence brought on by a financial crisis and a long and deep recession.

Other bedrock shifts have occurred in the past three decades. Corporate debt is an input to production. In the post-WW2 period until 1980, corporate debt as a percent of GDP was a stable 10-15%. $1 of debt generated $7 to $10 of GDP. Following the back-to-back recessions of the early 1980s until the height of the dot-com boom in 2000, that percentage almost doubled to 27%. Each $1 of corporate debt generated less than $4 of GDP.

CorpDebtPctGDP

Today $1 of corporate debt generates just $3 of GDP. Debt is a liability pool. GDP is a flow. That pool of debt is generating less flow. It is less efficient. In 1973, $1 of corporate debt generated 46 cents in profit. Now it generates just 30 cents.

To hide that inefficiency and make their stocks appealing to investors, companies have used some of that debt to buy back their own stock. This reduces the P/E ratio many investors use to gauge value, and it increases the leverage of profit flows.

Here’s a simple example to show how a stock buyback influences the P/E ratio. If a company makes a $10 profit and has 10 shares of stock outstanding, the profit per share is $1. If the company’s stock is priced at $20, then Price-Earnings (P/E) ratio is $20/$1 or 20. If that company borrows money and buys back a share of stock, then a $10 profit is divided among 9 shares for a per-share profit of $1.11. The P/E ratio has declined to 18. When the company buys stock back from existing shareholders, that often drives up the price, and thus lowers the P/E ratio further.

The P/E ratio values a company based on the flow of annual profits. A company’s Price to Book (P/B) ratio values the company based on a pool of value, the equity or liquidation value of the firm. If we divide one by the other, we get an estimate of how much profit is generated by each $1 of a company’s equity, or Return On Equity (ROE).

1982 was the worst recession since the Great Depression. Stocks were out of favor with investors and were at a 13 year low. In 1983, $8.70 of equity generated $1 of profit for companies in the SP500. Seventeen years later, at the height of the dot-com boom in 2000, companies had become more efficient at generating profits. $6 of equity generated $1 in profit. In the last quarter of 2017, companies have become less efficient. $7.30 of equity generated $1 of profit.

Let’s look at another flow ratio, one based on the flow of dividends. It’s called the dividend yield, and the current yield is 1.80, about the same as a money market account. I can put my $100 in a money market account or savings account and earn $1.80. If I need that $100 a year from now, it will still be there. I could use that same $100 and buy a fraction of a share of SPY, an ETF that represents the SP500. I could earn the same $1.80. However, if I wanted my $100 back in a year, it might be worth $120 or $50. A stock’s value can be very volatile over a short time like a year, and the current dividend rate does not compensate me for that extra risk.

Why don’t investors demand more dividends? After the early 1980s, economists at the Minneapolis Federal Reserve noted (PDF) that, on a global scale, companies’ profits grew at a faster rate than the dividends they paid to shareholders. The dividend yield of the SP500 companies fell from 6% in the early 1980s to 1% in 2000 (chart).

Those extra profits are counted as corporate savings. The same paper showed that global corporate savings as a percent of global GDP increased from 10% in the early 1980s to 15% this decade. Each year companies were adding on debt at a faster pace than during the post-war decades, but undistributed profits were growing even faster. The net result was an increase of 5% in the rate of corporate saving. Companies around the world were able to shift dividends from the savings accounts of shareholders to the savings of the companies themselves.

From the early 1980s to the height of the dot-com boom, stock prices increased more than ten-fold. Investors that had depended on company dividends for income in previous decades now depended on other investors to keep buying stocks and driving up the price. The source of an investor’s income shifted slightly from the pocketbooks of corporations to the pocketbooks of other investors. Investors adopted a shorter time horizon and now look to other investors to read the mood of the market.

The bottom line? If investors rely on each other for a greater part of their total return, price corrections will be dramatic.

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Notes: Price to Book (P/B) ratio was 1.5 in 1983 (article).
P/B graph since 2000
When mutual funds sell some of their holdings, they assign any capital gains earned to their fund holders. This amount appears on the mutual fund statements and the yearly 1099-DIV tax form.

A November 2017 article on share buybacks at the accounting firm DeLoitte

 

Dance of Debt

April 9th, 2017

Last week I wrote about the dance of household, corporate and government debt. When the growth of one member of this trinity is flat, the other two increase. Since the financial crisis the federal debt has increased by $10 trillion. Let’s look at the annual interest rate that the Federal government has paid on its marketable debt of Treasuries. This doesn’t include what is called interagency debt where one part of the government borrows from another. Social Security funds is the major example.

In 2016, the Federal government paid $240 billion in interest, an average rate of 1.7% on $14 trillion in publicly held debt. Only during WW2 has the Federal government paid an effective interest rate that is as low as it today. World War 2 was an extraordinary circumstance that justified an enormous debt. Following the war, politicians increased taxes on households and businesses to reduce the debt. Here is a graph of the net interest rate paid by the Federal government since 1940.

InterestRate

In 2008, before the run up in debt, the interest rate on the debt was 4.8%. If we were to pay that rate in 2017, the interest would total $672 billion, more than the defense budget. Even at a measly 3%, the interest would be $420 billion.  That is $180 billion greater than the interest paid in 2016.  That money can’t be spent on households, or highways, or education or scientific research.

The early 1990s were filled with political arguments about the debt because the interest paid each year was crippling so many other programs. Presidential candidate Ross Perot made the debt his central platform and took 20% of the vote, more than any independent candidate since Teddy Roosevelt eighty years earlier. Debt matters. In 1994, Republicans took over Congress after 40 years of Democratic rule on the promise that Republicans would be more fiscally responsible. In the chart below, we can see the interest expense each year as a percent of federal expenses.

PctFedExp

Let’s turn again to corporate debt. As I showed last week, corporate debt has doubled in the past ten years.

CorpDebt2016

In December, the analytics company FactSet reported (PDF) that the net debt to earnings ratio of the SP500 (ex-financials) had set another all time high of 1.88. Debt is almost twice the amount of earnings before interest, taxes, debt and amortization (EBITDA). Some financial reporters (here, for example ) use the debt-to-earnings ratio for the entire SP500, including financial companies. Financial companies were highly leveraged with debt before the crisis. In the aftermath and bailout, deleveraging in the financial industry effectively hides the growth of debt by non-financial companies.

What does that tell us? Unable to grow profits at a rate that will satisfy stockholders, corporations have borrowed money to buy back shares. Profits are divided among fewer shares so that the earnings per share increases and the price to earnings (profit), or P/E ratio, looks lower. Corporations have traded stockholder equity for debt, one of the many incidental results of the Fed’s zero interest rate policy for the past eight years.

Encouraged by low interest rates, corporations have gorged on debt. In 2010, the pharmaceutical giant Johnson and Johnson was able to borrow money at a cheaper rate than the Federal government, a sign of the greater trust that investors had in Johnson and Johnson at that time.

Other financial leverage ratios are flashing caution signals, prompting a subdued comment in the latest Federal Reserve minutes ( PDF ) “some standard measures of valuations [are] above historical norms.” Doesn’t sound too concerning, does it?

Each period of optimistic valuation is marked by a belief in some idea. When the bedrock of that idea cracks, doubts grow then form a chasm which swallows trillions of dollars of marketable value.

The belief could be this: passively managed index funds inevitably outperform actively managed funds. What is the difference? Here’s  a one-page comparison table. In 1991, William Sharpe, creator of the Sharpe ratio used to evaluate stocks, made a simple, short case for the assertion that passive will outperform active.

During the post-crisis recovery, passive funds have clearly outperformed active funds. Investors continue to transfer money from active funds and ETFs into index funds and ETFs. What happens when a smaller pool of active managers make buy and sell decisions on stocks, and an ever larger pool of index funds simply copy those decisions? The decisions of those active managers are leveraged by the index funds. Will this be the bedrock belief that implodes? I have no idea.

Market tensions are a normal state of affairs. What is a market tension? A conflict in pricing and risk that makes investors hesitate as though the market had posed a riddle. Perhaps the easiest way to explain these tensions is to give a few examples.

1. Stocks are overvalued but bond prices are likely to go down as interest rates rise. The latest minutes from the Fed indicated that they will start winding down their portfolio of bonds. What this means is that when a Treasury bond matures, they will no longer buy another bond to replace the maturing bond. That lack of bond purchasing will dampen bond prices. Stocks, bonds or cash? Tension.

2. Are there other alternatives? Gold (GLD) is down 50% from its highs several years ago. Inflation in most of the developing world looks rather tame so there is unlikely to be an upsurge in demand for gold. However, a lot of political unrest in the Eurozone could drive investors into gold as a protection against a decline in the euro. Tension.

3. What about real estate? After a run up in 2014, prices in a broad basket (VNQ) of real estate companies has been flat for two years. A consolidation before another surge? However, there is a lot of debt which will put pressure on profits as interest rates go up. Tension.

In the aftermath of the financial crisis, we discovered that financial companies, banks, mortgage brokers and ordinary people resolved market tensions through fraud, a lack of caution, and magical thinking. Investors can only hope that there is enough oversight now, that the memories of the crisis are still fresh enough that plain old good sense will prevail.

During the present seven year recovery there have been four price corrections in the Sp500 (Yardeni PDF). A correction is a drop in price of 10 – 20%. The last one was in the beginning of 2016. Contrast this current bull market with the one in the 2000s, when there was only one correction. That one occurred almost immediately after the bear market ended in the fall of 2002. It was really just a part of the bear market. From early 2003 till the fall of 2007, a period of 4-1/2 years, there was no correction, no relief valve for market tensions.

Despite the four corrections and six mini-corrections (5 – 10%) during this recovery, the inflation adjusted price of the SP500 is 50% higher than the index in the beginning of 2007, near the height of the market.  Inflation adjusted sales per share have stayed rather stable and that can be a key metric in the late stages of a bull market. The current price to sales (P/S) ratio is almost as high as at the peak of the dot com boom in 2000 and that ratio may prove to be the better guide. In a December 2007 report, Hussman Funds sounded a warning based on P/S ratios.  Nine years later, this report will help a reader wanting to understand the valuation cycles of the past sixty years.

Stock and Housing Valuations

March 1, 2015

There are several popular methods to evaluate stocks.  The P/E ratio is probably the most quoted metric.  This is a stock price divided by its current earnings.  A conservative variation of this popular methodology is Professor Shiller’s Cyclically Adjusted Price Earnings (CAPE) ratio.  The basis for this metric is the observation that all data reverts to its mean.  Professor Shiller’s method adjusts the past ten years of reported earnings for inflation, then averages those earnings and divides the current price by that average to get a CAPE ratio.

Any well-regarded valuation method has its detractors. This Economist blog points out objections to the Shiller CAPE ratio. In a 2014 blog I tackled an objection to Shiller’s methodology: a ten year average can include a severe downturn in earnings that does not reflect current conditions. I massaged away the 2008 to 2010 downturn to show that Shiller’s CAPE ratio was little changed by the downturn.

Some object that the CAPE ratio uses reported earnings, which includes depreciation (lowers earnings) and interest (increases or decreases earnings).  Operating earnings exclude these items and more accurately reflect the profits generated by ongoing operations.   Operating earnings may be a valid basis for evaluating a single company and Warren Buffet uses this method, among others, to get a sense of sustainable earnings.

Some prefer to use forward operating earnings, which are estimates of profits for the next twelve months.  These estimates come in two varieties: top down and bottom up.  Top down estimates are calculated by estimating a growth percentage of profits for the coming year and applying that percentage to the sum of current profits.  Bottom up estimates are painstakenly compiled by taking the forward earnings guidance given by each company.  Top down estimates tend to be optimistic and are usually revised downward with the passage of time.

I prefer Shiller’s method as a more realistic approach for a long term investment in a stock index like the SP500.  Successful businesses should be able to generate enough profit in their operating margins to account for depreciation, which is included in reported earnings.

Another valuation method is the flip side of the Price Earnings or P/E ratio – an E/P ratio, or earnings yield.  As of a week ago, the current earnings yield was 5.02%.  This is then compared to the 10 year Treasury rate, 2.13%, as of Feb. 20, 2015.  The difference between the earnings yield of stocks and a risk-free investment like U.S. Treasuries – currently about 3% – is called the risk premium for owning stocks.  Often, this risk premium is quoted in basis points, which are 100ths of a percent.  So 3% = 300 basis points.  In 2007, the risk premium was over 4%.  The average from 2002 – 2006 was about 2% as stocks climbed out of a prolonged slump following the dot com bust and 9-11.  So, using this method, we could say that stock valuations are somewhere in the middle, neither frothy or pessimistic.

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Housing

Sales of New Homes remained brisk at just under 1/2 million.  The supply of new homes on the market indicates historically strong demand.

The latest Case-Shiller home price index increased 4.3% year-over-year, below the 4.7% growth curve of the past forty years.  From 1975-2000, home prices increased 5.5% annually.  During the boom years of the 2000s housing prices surged above that growth curve only to fall swiftly in the crash of 2008.  The bust in the housing market has more than taken out the excess, bringing the forty year growth curve to 4.7%.

The home price index does not take into account the larger homes being built over the past two decades.  The median square footage of new homes has grown from 1555 SF in 1975 to 2457 SF in 2013. (Census Bureau data)

A greater percentage of today’s homes include air conditioning, extra bathrooms and other amenities that the homes of forty years ago did not have, skewing the long term effective growth curve even lower.  While some metropolitan areas on both coasts may be overvalued, national averages suggest that housing prices are fairly valued.

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Economic Summary

Twice a year the chair of the Federal Reserve testifies before the Senate Banking Committee.  Chair Janet Yellen’s testimony this past week was a concise distillation of economic trends.  Investors bombarded with an avalanche of articles and blogs may sometimes find it difficult to synthesize all the information they absorb.  Ms. Yellen’s initial summary cuts through the clutter:

The unemployment rate now stands at 5.7 percent, down from just over 6 percent last summer and from 10 percent at its peak in late 2009. The average pace of monthly job gains picked up from about 240,000 per month during the first half of last year to 280,000 per month during the second half, and employment rose 260,000 in January. In addition, long-term unemployment has declined substantially, fewer workers are reporting that they can find only part-time work when they would prefer full-time employment, and the pace of quits–often regarded as a barometer of worker confidence in labor market opportunities–has recovered nearly to its pre-recession level. However, the labor force participation rate is lower than most estimates of its trend, and wage growth remains sluggish, suggesting that some cyclical weakness persists. In short, considerable progress has been achieved in the recovery of the labor market, though room for further improvement remains.

At the same time that the labor market situation has improved, domestic spending and production have been increasing at a solid rate. Real gross domestic product (GDP) is now estimated to have increased at a 3-3/4 percent annual rate during the second half of last year. While GDP growth is not anticipated to be sustained at that pace, it is expected to be strong enough to result in a further gradual decline in the unemployment rate. Consumer spending has been lifted by the improvement in the labor market as well as by the increase in household purchasing power resulting from the sharp drop in oil prices. However, housing construction continues to lag; activity remains well below levels we judge could be supported in the longer run by population growth and the likely rate of household formation.

The Gathering

February 14, 2015

In January of this year, the SP500 finally rose above the inflation adjusted high set in 2000.  Here is a chart from multpl.com that I have overlaid with a few boxes.  Long term market trends are dubbed “secular” to contrast them with the shorter cyclical swings in valuation.  A secular bear market is a prolonged market downturn in which the inflation adjusted price of the SP500 never gets above a certain historical peak.

These long term periods are easier to define in hindsight.  They have begun with some peak and ended at some trough.  Years after the trough when the market has made a new inflation adjusted high price, market watchers get out their crayons and set the end of the bear market just after that trough.  Based on that historical rule, we would then say that the secular bear market that began in 2000 ended in 2009 at a market low six months after the onset of the financial crisis.

If history is any guide, an investor could expect further price increases for another 2 years (as in the late 1920s), or another 10 years (as in the late 1950s to late 1960s), or another 8 years (as in the 1990s).  In other words, history may not be much of a guide.

If the market tanked in 2017, two years after setting a new high, some sages would nod soberly and say it was just like the 1920s and was to be expected.  If the market continued rising another eight years before falling, ah yes, just like the 1990s.  The signs were all there if you knew where to look.

Secular bear markets share characteristics other than long term price swings.  During past prolonged downturns there have been five recessions within each period.  We have had two recessions since 2000.  Price to earnings, or PE, ratios went really low – about 6 – at the lowest trough of past downturns.  This is also the approximate low in the Shiller CAPE ratio.  Since 2000, the PE ratio has fallen to 10; the CAPE ratio to 13.  The current PE ratio based on the trailing twelve months earnings is almost 20, about 25% above the average. The number of years from peak to trough has been 19.  2000-2009 would be only 9 years, the shortest secular bear period on record.  The number of years from peak to peak has been about 26 years, much longer than the current 15 year period.

 This has led some to predict a further final crushing decline in the market to end the secular bear.  If the doomsayers are correct and we are only two-thirds through a secular bear market, we would expect market prices to plateau this year.  Then will come some shock – China’s real estate market implodes, or its regional banks collapse.  The so called PIGS – Portugal, Ireland, Greece, and Spain – could exit the euro.  There could be a major armed conflict with Russia or Iran that causes investors to abandon equities in droves.  The stronger dollar can put strains on countries whose currencies are pegged to the dollar. Such strains can cause a financial crisis similar to the one in Mexico in 1995 and the Asian and Russian crises of 1997 – 1998.  In the summer of 1998, the SP500 fell 15% in one month as fears grew that regional monetary imbalances would infect the economies of the entire world.

Secular bear markets come in types.  The two that started in 1929 and 2000 arose from what I call discovery shocks.  Investors lose conviction in their own hopes of future gains and leave the market.   The bear market that began in the late 1960s was a series of conflict shocks that spurred erratic changes in inflation.   As the country borrowed money to fund the Vietnam war, inflation rose above 3%, peaking at 6% in the spring of 1970.  The 1970s was marked by domestic and international conflict: the Watergate scandal and the oil supply wars with OPEC drove inflation to a high of 12% in late 1974.  As oil prices quadrupled through the 1970s, inflation spiked at almost 15% in the spring of 1980.  Through most of the decade, inflation stayed above 5% – a low that was almost double the historical average.

The SP500 made new records again this week although FactSet notes that the blended earnings growth for the fourth quarter of 2014 was only 3.1%.  The forward P/E of the SP500 is 17.1%, substantially above both the five and ten year averages (see paragraph below for illustration of changes in forward P/E). FactSet reports that nine out of ten sectors have forward P/E ratios that are above their ten year averages.  Only the telecom sector is selling slightly below its ten year average.  The forward P/E of the SP500 is based on projected earnings over the next year and volatile oil prices have made such earnings estimations difficult.  First quarter earnings by energy companies have been revised downwards by 50%, resulting in a 7.4% decrease in earnings estimates for the SP500.

Small changes in earnings estimates are multiplied 10 to 30 times to reach an evaluation of fair market price.  If 2015 earnings for SP500 companies are estimated at $100, an index price of 2000 is a forward P/E of 20.  If estimates are revised upwards to $110, then an index price of 2000 reflects a forward P/E of 18.  If the forward P/E of the SP500 is above the five and ten year averages as it is today, it means that investors and traders are betting that estimates of forward earnings will be revised upwards, resulting in a lower forward P/E ratio.

Long-term Treasuries (TLT) rose up 11.5% in the five weeks from late December to the end of January – too much, too fast.  After falling back in the last two weeks from their peaks, they are priced at the same level as in July 2012.  In 2014, traders who bet against long term bonds in anticipation of rising interest rates got slaughtered as long term Treasuries rose 25%.  Investors who moved out of long term and into shorter term bonds were disappointed as well.

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Retail Sales

Investors regard the monthly employment report and the retail sales report as the most important barometer of a consumer driven economy.  As an example of the correlation, consider a graph of inflation adjusted retail sales and the SP500 index.

Retail sales in January declined slightly from December.  Investors were somewhat heartened by the 2.4% annual gain, at least 1% above inflation, but remember that last January was particularly poor and was an easy benchmark to beat.  On the other hand, lower gasoline prices lowered this year’s total,  offsetting the comparison with a weak benchmark.

Sales at food and drinking establishments rose more than 11% y-o-y in January.

Large y-o-y gains in food and drink usually occur in the winter months.  January 2000, 2001, 2004, 2006, December 2006, January 2012, and these past two months all peaked at more than 8% y-o-y gains.  Eating and drinking out are largely discretionary for most of us.  A change in the pace of growth in this behavior signals  changes in consumer attitudes that are more real than a consumer confidence survey.  Changes in this discretionary budget item is a survey of wallets. In the past year, the growth of food and drink sales has accelerated, indicating a more confident, less fearful consumer.

While the various consumer sentiment surveys indicate what we tell interviewers, the wallet survey indicates what we really think.  In early 2009, the U. of Michigan Consumer Sentiment Survey showed a rebound of confidence.  What the survey indicated was more a rebound of hope, not confidence.  Consumer spending on eating and drinking out was still declining.

2011 is an indication of the opposite – plunging sentiment according to a survey but growing spending at food and drink establishments, indicating that the volatile drop in sentiment might be short lived.  The plunge in confidence was a response to the budget battles between the Republican House and the President.

Low inflation, relatively low gasoline prices, strong employment and retail sales gains all point to steady moderate growth.  Judging by the PE (19.7) and forward PE (17.1) ratios, the market may have already priced in that growth.

How Much Is That Doggie In the Window?

June 22, 2014

This week I’ll look at interest rates and various models of evaluating both the stock market and housing.

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GDP Growth Revised

This past Monday, the International Monetary Fund (IMF) cut estimates for this year’s economic growth in the U.S. to 2% from 2.8%.  IMF cited a number of headwinds: the severe winter, weakness in housing, some fragility in the labor market.  It recommends that the central bank keep rates low through 2017.  Expectations were that the Federal Reserve would begin raising interest rates in mid 2015.  Some recommendations in the report will be met with antipathy or a polite “thanks for letting us know”: raising the minimum wage and gasoline taxes.

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Fed Don’t Fail Me Now

As expected, the Federal Reserve decided to leave the target interest rate at the extremely low range of 0% to .25% that it has held in place since the beginning of 2009.  Congress has given the Fed a dual mandate:  keep inflation reasonable and promote full employment.  It is this second half of the mandate that presents some problems as the FOMC looks into their crystal ball.  The Labor Force Participation Rate is the percentage of those working to those old enough to work.  It has declined from 66% at the beginning of the recession to less than 63% today.

As economic conditions improve and job prospects brighten, how many of those who have dropped out of the labor force will return?  If workers return to the labor force, actively seeking work, that increased supply of labor will naturally curb wage increases and reduce upward pressure on inflation.  However, if the decline in the participation rate is more or less permanent for several years to a decade, then a stronger economy will create more demand for workers, who can demand more money for their labor, which will contribute to inflation.

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401K Retirement Plans

The Financial Times reported projections  of negative cash flows in 401K plans by 2016 as boomers convert their pension plans to IRAs when they retire.  Retirees tend to have a much more conservative stock/bond allocation and may force institutional money managers to liquidate some equities to meet the outgoing cash flows.  An ominous speculation at the end of the article is that regulations could be put in place to slow the conversion of 401Ks to IRAs.  Whenever the finance industry needs a friend in Washington, they can be sure to find one.

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Stock Market Valuation

It has been 32 months without a 10% correction in the SP500 market index.  The post World War 2 average is 18 months. Is the stock market overvalued?  I will review a common metric of value and develop an alternative model of long-term value.

Probably the most widely used metric of stock valuation is the Price/Earnings, or PE, ratio.  If a stock sells for $100 and its annual earnings are $6, then the P/E ratio is 100/6, or a bit above 16.  The average PE ratio is 15.5 (Source).  Companies do not pay all of those earnings in the form of dividends to investors.  That is another metric, called the Price Dividend, or P/D ratio, that I wrote about last year.

Fact Set provides an analysis of the past quarter’s earnings of the SP500 companies, as well as projections of current  and next year’s earnings. Earnings growth estimates for this year range from 30% (yikes!) for the telecom sector to a bit over 3% for utilities. The health care sector tops estimates of revenue growth at about 8%, while the energy sector is projected to have negative growth.  The basic materials sector tops the 2015 list of earnings growth at 18% and the utilities sector again takes the bottom rung on the ladder with almost 4% growth.

The SP500 is priced at 15.6x forward 12 months earnings, which is above the five year and 10 year averages of less than 14x (Fact Set Report page)  but just about the 100 year average of 15.5.

Robert Shiller, a Yale economist and co-developer of the Case-Shiller housing index, uses a smoothing technique for calculating a Price Earnings ratio and makes his data spreadsheet available.  His team calculates the 10 year average of real, or inflation-adjusted, earnings and divides the inflation adjusted price of the SP500 by that average to arrive at a Cyclically Adjusted Price Earnings, or CAPE, ratio.

Using this methodology, the market’s CAPE  ratio is 25, above the 30 year ratio of 22.91 and the 50 year ratio of 19.57.  In 1996, the market was trading at this same ratio, prompting then Fed Chairman Alan Greenspan to make his infamous comment about “irrational exuberance.”  The market continued to climb till it reached a nosebleed CAPE ratio of 43 in early 2000.  It took another 7 months or so before the SP500 began its descent from 1485 to 900, a drop of 40%, over the next two years.  There is no automatic switch that flips when a market becomes overvalued.  People just get up from their seats and start to leave the theater.

In most decades, this methodology works well to arrive at a longer term perspective of the market’s price.  However, some argue that when severe downturns occur, this methodology continues to factor in the downturn’s impact long after it they have passed.  In 2008 and 2009, SP500 index annual earnings crashed from above $80 down to $60, a precipitous decline that is still factored into the ten year framework of the CAPE method.

So I took Mr. Shiller’s earnings figures and did some magic on them.  I took away most of the downturn in earnings during a 3 year period from 2008 – 2010.

Bye, bye earnings dive.  Hello, stagnating earnings.  The chart shows a slight downturn in earnings, then flat-lines in the pretend world of 2008 – 2010, where the steep recession never happened.

Instead of a deep crater formed in the markets by the financial panic in late 2008, the stock market slid downward over several years before rising again in early 2012.  Can you hear the soft sounds of flutes echoing in the mountain meadows of this pretend world?

Using this pretend data, I recalculated today’s CAPE ratio at 22, below the actual 25 CAPE ratio.  What should be the benchmark in this pretend world?  The 100 year average includes the Great Depression of the 1930s and World War 2, which naturally lowered PE ratios.  A 50 year average includes the Vietnam War and high inflation, particularly during the 1970s and early 1980s.  As such, it is less comparable to today’s environment marked by low inflation and the lack of major hostilities.

So, I ran a 30 year average of our pretend world, from 1984-2013, and calculated a 30 year average of 23, close to the real 30 year average of 22.9!  It shows the relatively small effect that even momentous events have on a long term average of the CAPE ratio, which is why Robert Shiller advocates its use to calculate value and establish a comparison benchmark within a longer time frame.  In the real world, the market’s CAPE ratio of 25 is above that 30 year average.

Let’s put aside the world of soft market landings and mountain meadows and look at what I call the time value of the market.  I picked January 1980, a point almost 35 years in the past, as a starting point.  Then I divided the SP500 index by the number of months that have passed since that starting point.  This gives me a ratio of value over time. If an investor buys into the market when its value is above a long-term average of that ratio, we can expect a lower long-term rate of return.

The 20 year average is 3.98, just a shade above the 20 year median of 3.91, meaning that the highs and lows of the average pretty much cancel out.  Note also that it is only in the past year that the market value has risen above the 20 year average of this ratio.

But we cannot look at a time value of any investment without considering inflation, which erodes value over time.  When we add the Time Value Ratio and the Consumer Price Index (CPI), we find that the current market is priced slightly lower than both the 20 year and 30 year averages.

Historically, as this ratio has risen more than 25 – 30% above its long-term average,  the market peaked.  Today’s ratio is just about average.

So, is the market overvalued?  Based on CAPE methodology, yes.  Fairly valued?  Based on expectations of earnings growth this year and next, yes.  Undervalued?  Probably not.

Common Sense recently published the best and worst 10 and 20 year returns on a 50/50 stock/bond portfolio mix.  This balanced approach had a 2 – 3% annualized gain even during the Depression years when the stock market lost 80 – 90% of its value.  It should be a reminder to all investors that trying to assess the true value of the stock market is perhaps less important than staying diversified.

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The P/E of Housing

Home builders broke ground on almost 1.1 million private residential units in April, a 13% increase over last year.  Called Housing Starts, the series includes both multi-family units and single family homes. The pace slowed a bit in May but still broke the 1 million mark.  As a percent of the population, we just aren’t building as many homes as we used to.

For most of us, our working years are about 60% of our lifespan.  Hopefully, our parents took care of our income needs for the first 20% of our lifespan. During our working years, we hope to save enough to generate a flow of income for the last 20% of our lifespan.  Those savings, which include private pensions and Social Security, are like a pool of water that we accumulate until we start turning on the spigot to start draining the pool.    We turn a stock or pool of savings into a flow of income.

The Bureau of Labor Statistics uses a metric called Owner Equivalent Rent (OER) in their calculation of the Consumer Price Index.  This concept treats a home as though it were generating a phantom income equivalent to the rents in that local real estate market.  We can use this concept to value a house.  The future flows from a stock can be used to generate an intrinsic current value for the house.

As an example:  a house which would generate a net $12000 a year in income, whether real or phantom, after taxes and other expenses, is worth about 16 times that net income, according to historical trends calculated by the ratings agency Moodys.  In this case, the house would be worth about $200K.

Coincidentally, this is the average P/E ratio of the stock market.  Historically, stocks have been valued so that the price of the company’s stock has been about 16 times the earnings flow from the company’s activities.  If a primary residence generates 6% in tax free income and 3% in appreciation, the total annual return on owning a house free and clear is more than the average annual return of the stock market.  The housing boom and bust may have given many younger people the impression that home ownership is a debt trap.  It may take a decade for the housing industry to recover from this perception.

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Takeaways

The Fed is likely to keep interest rates low past mid-2015 but is watching the Labor Participation Rate for early indications that rising wage pressures will spur rising inflation.
The stock market is slightly overvalued or fairly valued depending on the metric one uses.
On average, a house has a value multipler that is similar to the stock market but generates a higher after tax income.

Next week I’ll take a look at some long term trends in education spending and tuition costs.