Toro's Running of the Bulls Market Blog

Australia Angers God

From The Wall Street Journal.

Analysts said Russia even may cease or curtail shipments abroad. Meanwhile, other countries included in the group of the top-five wheat exporters also are facing problems. Canada's crop has struggled due to excessive rains, and Australia is battling a plague of locusts. [emphasis added]

What next, Australians turning into piles of salt?

China Costs Rising

Last week, The Wall Street Journal published an article regarding China's shift to an era of slower growth.  What was more interesting to me were the descriptions of soaring costs.

DASHIMEN VILLAGE, China—In this corn-growing hamlet in northern China, signs are emerging that the nation's supercharged economic growth may be reaching its limit.

A bottomless pool of inexpensive migrant labor has long been one of China's greatest resources, fueling its manufacturing boom. But all the able-bodied workers have left this village already, leaving mostly the elderly. "All the young men have gone out to work," says Wang Shuzhen, 58 years old, whose two sons left town, one to work in construction, the other as a driver.

Fewer migrant workers are heading to China's manufacturing zones along the coasts because villages like Dashimen are tapped out, putting pressure on wages and sparking worries about labor shortages. Job centers in the Pearl River Delta, the manufacturing heartland of southern China, had 9% more vacancies than applicants in the first quarter, according to a survey by China's labor ministry.  ...

The favorable demographics that have supplied manpower for economic growth are changing. China's working-age population, age 15 to 64, has grown continuously. But partly because most families are limited to one child, growth of this working population is slowing, according to the United Nations. The labor pool is expected to peak around 2015, and then decline, according to U.N. projections. In China, manual laborers tend to stop working before age 65, due both to the demands of the work and to employers' preference for younger workers. ...

The most anticipated problem is an end to some 35 years of steady growth of the working-age population, which fueled the expansion when China liberalized its economy. The demographic changes added about 1.8 percentage points of economic growth annually since the late 1970s, according to the Center for Strategic and International Studies, a Washington think tank. But by 2030, the CSIS predicts, the contraction in the working-age population will reduce growth by 0.7 percentage points a year.

In places like Dashimen, in the hills in northern Hebei province, everyone who can physically labor is already working in jobs in the cities. Yin Zhen, the 61-year-old husband of Ms. Wang, says he was a migrant worker himself until employers started passing him over for younger men about five years ago.

With growth of the labor force slowing, migrant workers are in a stronger position to bargain with employers. A central-bank survey this year showed average wages for migrant workers, who traditionally fill the least-skilled slots and have little economic power, rose 17.8% from a year earlier.

Those gains will improve the lives of the poorest urban workers. They also will make it tougher for Chinese exporters of low-end merchandise like apparel and toys to continue to compete mainly on price. Exporters will have to keep boosting productivity to make up for higher wages, and start making higher-end products that are less price-sensitive.

As I detailed a month ago, I believe the massive offshoring of American manufacturing is, if not coming to an end, then about to slow dramatically.  This will have an enormous affect on the composition of economic gains, which have accrued almost entirely to capital over the past decade whereas labour has seen virtually nothing.  I expect gains to labor to outpace gains to capital over the next 10 years and returns on equity to be lower. 

Perhaps I am wrong, I do not know, but seismic shifts on Wall Street usually occur when no one is expecting them.  The consensus is always wrong at big inflection points when articles of faith turn out to be illusions.  Those who see this and have the wherewithal to exploit it make fortunes.

Market Action, July 15 2010 - SEC, Machines Jam the Market

If you needed any more evidence that the market is run by machines all banging out correlation trades, look no further than today.  The TSX Composite spiked 60 points in a manner of minutes on news that the SEC would be holding a press conference to announce a deal with Goldman Sachs. 

There is no fundamental reason why the Canadian stock market should spike on news of a settlement by a foreign regulator with a foreign company, unless one believed that Goldman was threatened with collapse and would have to blow out their prodigious Canadian inventory, a dubious notion given that criminal charges were not in the cards.

Rather, the intra-day spike in Canadian stocks merely reflects what the stock market has become – a plaything for machines and algobots driving correlation trades across any and all markets. 

You, simply put, don’t matter.

You will not read many articles about market manipulation conspiracies here at Running of the Bulls.  Not because I don't think they exist.  Rather, I think they rarely exist, or at least exist much less than the conspiracy theorists - who are usually on the wrong side of the trade, either monetarily, intellectually or both - believe.

However, the timing of today’s announcement reinforces the notion that government agencies manipulate the market.  What other reason to announce a settlement at 3:30pm other than to jam the market into the close?  Legal negotiations and settlements with the government are protracted affairs.  The government does not rush to the microphone before the ink is dry.  Government agencies are slow and deliberate. This settlement was not finalized at 3pm today, with both parties feeling the need to immediately disclose material information.  

Today’s press release had the effect, at least temporarily, of halting a market slide that may have taken us to new lows for the year.  At 3pm, the market was rolling over and threatening to head to session lows.  This would have signaled a near-term top, creating a bearish formation and likely leading to more weakness in the days ahead.  Instead, the news prompted a 22 point spike in the S&P 500 in the last half hour, a 1.2% gain, and the market closed on the highs. 

Now, whether or not the announcement was timed specifically to stop a downward slide today this very minute is debatable.  What isn’t particularly debatable is that market-moving announcements by the government at 3:30pm are not coincidental and are deliberate attempts to jam the market into the close.

(Stocks were also buoyed by news that BP had stopped the gusher in the Gulf.  This news was released several minutes after the SEC announcement.  One might wonder about the coincidental timing of BP’s announcement. However, Running of the Bulls is willing to give BP the benefit of the doubt.  There is no company in the world more motivated to rush good news to the market right now than BP.)

Whether or not the machinations of the SEC will be effective remains to be seen.  But it is ridiculous that the government resorts to this type of manipulation.  If this is merely a temporary reprieve in a down-trending market, then the SEC’s timing is nothing more than a wealth transfer between market participants.

Or should I say, between market machines and algobots.

Valuation Update

I look at several valuation metrics to ascertain whether or not the market is expensive.

Median Price/Earnings Ratio

First, the median price/earnings ratio of the stocks in the Russell 3000.  The median forward operating PE ratio of the Russell 3000 is currently 14.5x.  This is a bit higher than the long-term average.

Price to Book Value

The price to book value of the S&P 500 is currently 2.1x.  This is somewhat higher than the long-term average. 

(The long-term average includes dates before 1986.  However, my graphs start in the mid-80s.) 

 

Price to Sales

Price to sales is 1.2x, which is above the long-term average. 

One reason why stocks are trading higher than historical averages relative to sales is because companies are more profitable than in the past.

Over the past 25 years, the reported profit margin has averaged 5.5%.  The "operating" profit margin - i.e. excluding "non-recurring" charges Wall Street ignores, which are inconveniently reccurring - has averaged 6.5%.  Currently, the reported profit margin is 6.9% while the operating profit margin is 7.5%.

Wall Street likes to focus on "operating earnings."  Ignore this.  It is misleading and philosophically wrong.

Normalized Price/Earnings Ratio

Because profit margins are highly cyclical, I like to use normalized earnings.  Many market commentators use next year's Wall Street forecasts to value the market, which is around $86, valuing the market at less than 13x.  Margins can stay high for a while but I do not believe that margins will remain high, partly due to structural changes within China.

If we use the long-term reported profit margin of 5.5% to normalize profits, stocks are very expensive at 21.5x.

I do think that companies are more profitable than in the past but not as profitable as Wall Street believes.  I use a 7% normalized profit margin.  At 7%, the S&P500 is trading at 17x trailing normalized earnings, expensive but not egregiously so.

Growth

Growth in earnings per share over the long-run has been about 6%.  Since 1986, per share earnings growth of the S&P 500 has actually been a little lower at 5.5%. 

Per share growth of other S&P 500 metrics since 1986 are as follows;

• Sales per share, 4.1%
• Book value per share, 6%
• Dividends per share, 4.2%.

Remember all those Pollyannas at the height of the Tech Bubble prognosticating about a glorious era of shy-high profit growth as far as the eye can see to justify even higher valuations? 

They were wrong.

Long-Term Forecast

I use a price/earnings and a dividend discount model to forecast expected returns over the next 20 years.  Currently, the models are forecasting compounded annual returns of 6.7% to 7.5% from US stocks, below the long-term average of 10% but above most other domestic asset classes.

It should be noted, however, that historically, long periods of over-valuation have been followed by long periods of under-valuation.  Stocks were under-valued during the Financial Crisis, terrifically so at the bottom.  However, over the past decade, stocks have not been under-valued for any prolonged period.  Is this time different, particularly after two of the greatest asset bubbles of all time?   Perhaps, but I would not bet the farm on it.

China Update

A few weeks ago, I laid out my thesis on how rising costs are going to create structural headwinds for corporate profitability going forward.  Jeff Matthews reinforces this argument by noting that China's one-child policy is fast creating a shortage of labour.

What is going on is this: costs in China are rising, and they will continue to rise for years to come. In fact, he said, costs will rise the rest of the decade at a rate that places China among the higher-cost manufacturing areas of the world.

And it has nothing to do with the Yuan.

What it has to do with is China’s “One-Child Policy.” ...

the demographics in China are shifting rapidly from a surplus of labor to a shortage. And by “rapidly” he means “the next three years,” when the 18-25 year old population drops by something close to one-third.

Now, the effect of this mind-boggling demographic shift was already felt, early this year.

After the Chinese New Year, a number of U.S. companies reported that an unusual number of factory workers failed to return from their inland homes, reducing their manufacturing efficiency, increasing costs-per-item, and forcing a shift to airfreight in order to get product to markets on time.

What is happening is this: as China promotes economic expansion away from the crowded south, jobs are opening up where none had been before.

To put numbers on it, according to our acquaintance, some factories were 25% short of labor after the Chinese New Year, and thus operated at as little as 75% of capacity.

And this problem for the manufacturing base in China is not going away: in fact, it will get worse as the labor surplus dries up.

Gold Underowned

Early in the week, it appeared to me that gold was topping out, at least in the short term, so I liquidated most of my GLD calls.  I blew out the rest on Thursday after the $35 plunge.  I have long-term positions that I have not touched.  I will look to re-establish positions in GLD calls in the future.

Paul Kedrosky has an excellent post on gold being underowned compared to the last big financial crisis.