Toro's Running of the Bulls Market Blog

What I Have Learned

An investment program or a trading system must be specifically tailored to each and every individual.  Risk tolerances, return targets and cash flow needs are critical in structuring a program of capital allocation for investors. All programs and systems are unique based upon our own biases and requirements.

I do believe, however, that there are broad-based investing maxims that can assist individuals in navigating the financial markets.  These are the investment maxims I follow.

Human nature never changes. 

My favourite investment quote is from Jesse Livermore who said

Wall Street never changes.  The pockets change, the suckers change, the stocks change but Wall Street never changes because human nature never changes.

Knowing human behavior is a critical to successful investing.  It does not matter if one is trading short-term or investing long-term, any trade or investment is an explicit or implicit bet on human behavior. 

Understand history. 

History is a guide.  It is a road-map to the future.  It does not predict what is going to happen exactly because structural shifts occur, but the forces of economic history shift slowly over time.  I first read Reminiscences of a Stock Operator in 1998, and I was amazed at how accurately Livermore (through Edwin Lefevre) was describing our time.  In the same way that officers are taught military history to understand the mistakes of past battles and the evolution of strategy, investors should understand financial history to understand the mistakes and context of financial markets.  Mark Twain said history doesn’t repeat itself, but it rhymes.  Karl Marx said history repeats itself, first as tragedy than as farce.  Twain and Marx could have been talking about financial markets.

Hubris kills. 

The words I cringe the most upon hearing are "can't" and "won't."   When people say something "can't" or "won't" happen as it pertains to investments, I become very wary.  In investing, anything can happen.  Do not think in certainties.  Think in probabilities.  Banish the words "can't" and "won't happen" from your investing vocabulary.  People with a high degree of certainty about the future are the ones most likely to get wiped out.  Confidence is good.  Hubris is not.

Most people cannot invest successfully.  You are probably one of them. 

You are hardwired to fail at investing.  Literally.  Your brain and neurological system are wired in such a way to separate you from your money.  It is why your feel euphoric when your stocks are rising and why you feel revulsion when your stocks are falling. It is why you feel you have to buy something when it appears to be running away from you, and why you feel fearful when stocks are falling.  Learning to deal with your natural instincts may be the single most important aspect to investing success.  Fortunately, there have been significant advances in understanding behavioral finance and neuroeconomics over the past decade.  I have listed books on the subject in my book log.  Read those books ASAP.

This is not a part-time job.

It is difficult to do well investing and trading over the long-run without being dedicated to it.  It is difficult to invest profitably by dedicating a half hour of study in the evening.  Investing and trading is not a hobby.  Investing is a profession, a craft, a systematic pursuit.  If you are not willing to put the time and resources needed to be successful, you should not do this yourself.  Pay someone else who does this for a living to invest for you.  Or give the professional most of your money and invest in small amount yourself.

Protect your capital.

You cannot play the game if you have nothing to play with.  For an investor, that means buying a stock with a significant margin of safety.  For a trader, that means cutting your losses quickly.  An investor can average down if they have purchased a stock with a significant margin of safety, a trader cannot.  A trader must cut his losses.  An investor must be certain there is a margin of safety in his investment. Otherwise, capital could become permanently impaired.

Be patient.  You do not always have to be involved.

I am an impatient person.  I do not like waiting for a minute.  I get bored easily and want to do something.  Plus, I am greedy and feel that if I am not doing something, I am not accomplishing anything.  But this works against me.  Patience is a virtue when investing.  I have found that I have done really well being patient, and I do much less well being impatient.  You do not always have to be involved. Sometimes it is best to just step aside and not buy or sell anything.

Do not invest or trade something you do not understand.

Is this not obvious?  You do not need to know Microsoft’s code to invest in Microsoft, but you should know what Microsoft does.  If you are trading symbols, know your process cold.

Have a process and keep an open mind.

All great investors and traders have a process.  Some great investors are great visionaries with nerves of steel.  Some great traders flit in and out of markets successfully.  However, all have a process.  Different processes are often a function of differing emotional temperament and intellectual curiosity.  Everyone is different and different processes will appeal to different people.  But the important thing is to have a process.  Your process will evolve over time.  You will not do things perfectly.  Thus, keep an open mind on what works for you and what does not.  If there is a weakness in your process, be willing to change it.

Process and strategy are a function of time.

Whether a trade or investment is right or wrong is often a function of time.  I both trade and invest.  When I trade, I look out a few months.  When I invest, I look out a few years.  How each strategy plays out is dependent upon time.  In the short-term, what matters most is momentum.  In the long-term, what matters most is economics.  In the short-term, news flow, sentiment and emotion are all the matters.  In the long-term, what you pay for a stock relative to the long-term prospects for a stock is all that matters.  If you are an investor, the crowd is usually wrong in the long-run.  If you are a trader, the crowd is usually right in the short-run. 

Time frames matter.

Wall Street tells its retail clientele that stocks are for the long-run.  This is true, over generations.  If you start methodically and systemically investing in stocks when you are 20 or 25 years of age, you can weather the volatility of the market and buy at almost any valuation and end up with a nice nest egg when you retire.  But this is not necessarily true for most people.  Most people do not start saving significantly until their mid-40s or later.  If someone starts a saving plan at 45 with the goal of retiring at 65, plowing money into the stock market expecting to earn the historical return to equities of 10%, the results can be devastating if stocks bought at the wrong valuation.  A 10% annual return over 10 years equates to a 159% gain compounded.  But the US stock market has declined since the beginning of 2000.  For the 55 year-old who started investing in stocks a decade ago, this is a huge hole in his retirement account compared to what he expected. 

Do not base your actions on the opinions of others.

There are a lot of smart people doing stupid things in the world.  Simply because someone sounds smart does not mean they are necessarily correct.  I can remember just starting out as a portfolio manager, reading an extensive industry analysis by a well-respected Wall Street analyst, thinking “That doesn’t make sense.”  I liked the thesis but could not get around this aspect regarding inventory that kept nagging me which the analyst had brushed off.  I thought “Well, he knows more than I do,” and invested despite my reservation because everything else sounded good.  Turns out, I was dead right, and I lost money because I trusted someone else's argument rather than my own instincts. 

Take more risk when you are younger.  Take less risk as you get older. 

When you are younger, you rely primarily on income from your job.  When you are older, you rely primarily on income from savings.  Thus, you can take more risk with your savings when you are younger and less risk when you are older.  When you are older, a sustained dip in the value of your savings can significantly alter your lifestyle.  Thus, your primary goal should be to avoid losses.  Conversely, a mistake many young people make is not taking enough risk.  The corollary in investing is that, over time, higher risk means higher returns.  Since younger people have more time before needing to draw on retirement savings, they should take more risk, and vice-versa.

Risk is however you define it.

Risk is usually defined in two ways – volatility and loss of capital.  Academics, quantitative investors and consultants tend to define risk solely as volatility.  Investors, usually value investors, tend to define risk solely as the loss of capital, particularly the permanent loss of capital.  In truth, the answer depends upon your own circumstances.  Some people do not want to see their capital fall, ever.  To them, they do not care if an investment they purchased is worth 60 cents on the dollar that falls to 30 cents on the dollar.  They care that it fell, period.  To someone living off savings, volatility can be devastating, given that a fall in savings means relatively more capital is drawn down when savings are being tapped.  This same affect occurs with an endowment or a pension fund that is required to disburse funds at periodic intervals, whereby volatility in itself can result in the permanent loss of capital to the fund.  However, if one does not need to draw on capital for an extended period of time, and one has the fortitude to withstand the ups and downs in the market, volatility is irrelevant, and the only thing that matters is the permanent loss of capital.

The only thing that matters is how much money you make.  Or, the only thing that matters is how much risk you take. 

We do not trade nor invest to test dogmatic philosophies.  We trade and invest to make money.  In the end, what matters is the size of your account.  Having the most logical or most elegant system means nothing if you cannot make money from it.  Making money, however, is a matter of taking risk.  Over time, the more risk you take, the more money you will make.  At times, you want to take lots of risk, at other times, you want to take no risk at all.  Understanding your risk profile and managing risk is perhaps the most important aspect of all in money management.

The only (other) thing that matters is price.

You invest and trade to make money.  You should not invest or trade for any other reason.  For example, you do not invest or trade a stock because it is a great company.  I do not know how many times I have heard an investor say that they were investing in a stock because it was a great company.  Cisco was a great company in 2000 when it was trading at 118x earnings.  It was a great company when it was trading at 7x earnings.  Investors who bought at 118x earnings lost 90% of their money top to bottom.  A great company can make you great losses if you buy at the wrong price.  For traders, if the price is working against you, get out!  Get out now!  If the price action is poor, the market is telling you are wrong.  In the short-term, arguing against the market is a losing proposition.  Do not do it.

Focus on what is going to happen, not what has happened.

This may sound trite but investors are often focused on what has already happened, not what is going to happen.  People want to focus on what has made them money in the past.  Nobody cared about homebuilders before the housing bubble, but you still see a disproportionate amount of commentary on homebuilders today, even though they have been crushed.  After the tech bubble collapsed, investors focused on tech stocks for years and ignored, at least initially, basic materials and industrial stocks.  And when the bull market inevitably ends in commodities, investors will focus on commodities for years afterwards.

Do not ignore the macro environment.

One does not have to be a macro trader to understand that the macro environment matters.  Self-avowed stock pickers often brush aside macro issues, stating that no one can forecast the economy so you should not pay attention to the macro economy but instead focus on valuation and quality of the company.  However, if one looked at the banks in 2006, one would have seen many great companies with stocks that appeared reasonably valued.  But the edifice upon which the banks had built their businesses was dependent upon housing prices.  Having a view on the banks meant having a view on housing prices.  If one was bearish on the banks, one was bearish on housing prices and the concurrent collapse of the financial system, which was a macro call.  The KBW Bank Index (the BKX) fell 86% peak to trough, which was greater than the Nasdaq’s decline of 78% after the collapse of the Tech Bubble.  High quality banks like Wells Fargo and US Bancorp fell 75% or more.  Yes, they have recovered, due in large part to government largesse - a political call even more disconnected from individual company fundamentals - but the volatility has been enormous, and most bank stocks have returned nothing over the past seven years.

It is much easier to make money in a bull market than a bear market.

It should be obvious that it is much easier to make money in a market that goes up 200% over a decade than one that is flat during that same time.  For example, you would have been much better investing in commodities over the past decade than stocks, just like you would have been much better investing in stocks rather than almost everything else over the prior two decades. 

Things can go on for longer than seems reasonable.

I remember thinking that technology was getting nutty in 1996. I thought housing was getting stupid in 2003.  Boy, was I wrong.  Both were just beginning.  Trends tend to last a long time.  Do not underestimate the strength of a trend.

Eventually, all bull markets and all bear markets end.

It is difficult to know exactly when bull and bear markets begin and end.  However, they eventually do.  You might be late in making that determination but understand that the end is an eventual certainty.  Structural bull markets tend to last 10 to 20 years, so you have time in determining whether or not a bull market has begun or ended. 

All Quantitative Easing, All the Time

Earnings have been good this quarter, but earnings are not the primary driver of the recent stock market strength.  If earnings were driving the market higher, one would expect interest rates to firm.  But that is not happening as rates have collapsed and the dollar gets whacked every day.

What would cause stocks to rise, bonds to rise (and concurrently interest rates to fall) and the dollar to fall?  That would be quantitative easing (QE).

There is anticipation in front of the Fed meeting on Tuesday that the Federal Reserve will announce further quantitative easing to counter-act the deflation that is seeping its way into the economy. 

The first round of quantitative easing ended in March after the Fed finished purchasing over a trillion dollars of mortgages and government bonds.  Since then, a mere four months later, the economy is threatening to dip back into recession.

Economists are forecasting economic growth of 2.5-3% this year.  I think that will be wrong.  A favorite economic index of mine is constructed by a money manager who uses 22 leading and concurrent economic indicators.  It was remarkably prescient at predicting both the Great Recession and the subsequent recovery.  Today, it is in contraction mode, implying negative growth in the second half of the year.

I am loathe to rely on one sole indicator to make investment decisions. However, the Fed is also worried about the economy slipping back into recession, hence the noise about the need for further quantitative easing.

The effects of quantitative easing on asset prices is as follows.  The central bank purchases securities from banks (or the market), injecting cash into the financial system.  Cash earns nothing, so banks and investors turn around and use that cash to buy something else, bidding up asset prices.  Hopefully, for the Fed, interest rates fall and asset prices rise. 

In the last round of quantitative easing, the Fed primarily bought mortgages.  This time, the Fed is primarily going to buy – allegedly – government debt.  This explains, at least in part, why interest rates are collapsing and stocks are rising – the market is anticipating that the cash injections will lead to higher prices.  If deflationary fears were driving the market, stocks should also be falling.  But they are not.  At least not yet.

The dollar goes down every day because QE is the monetization of government debt, which is inherently inflationary.  The goal of the Fed is to create enough inflation to counter the forces of deflation in the economy.  However, that inflation also bleeds into asset markets.

It would certainly surprise me if the Fed did nothing.  Currently, the political environment is leaning heavily towards deflation.  Governments in Europe are talking about reducing budget deficits while it appears that the Republicans are poised to make significant gains in the November elections.  If the Fed opts not to being a new round of QE, I would expect a sharp correction in asset prices.

Of course, another round of QE is enormously bullish for gold.  Gold is correcting as fears about European sovereign default dissipate.  Investors have been comforted by the actions of European governments to address the Greek situation, the increased focus on budget deficits, and the so-called stress tests for European banks.  However, deflation is enormously bearish for the European financial system, which is in worse shape than the financial system in America.  I am afraid that the Extend-and-Pretend policies of the European governments are merely kicking the can down the road.  Ultimately, I believe European governments will also act to counter deflation.  If ultimately deflation wins out, gold is going down, but I am betting on the guys with the printing presses.  I have no exposure to gold at the moment but am watching carefully for entry points.

I am currently 80% in cash, my highest allocation ever, and my equity exposure is completely hedged out. (As regular readers of this blog know, I can change my mind in a heart-beat and get aggressively long or short tomorrow, and I won't tell you about it.)  Over the near term, it appears to me that the market wants to go higher.  Chart formations suggest such and the typical intra-day trading pattern over the past two weeks has been the market trading strong into the close, which is bullish.  However, volume is on fumes – Monday was the lightest volume day of the year – and the machines are pushing markets around as correlations between different asset markets are at or near all-time highs.  Thus, I remain on the sidelines, watching and waiting.

The Bond Market Has Lost It's Mind

The Wall Street Journal published this story regarding the recent high volume of bond issuance on Friday. 

The global corporate-bond boom is gathering steam as companies rush to take advantage of some of the lowest borrowing costs in history.

Companies from global giants McDonald's Corp. and Kimberly-Clark Corp. to Indonesian telecommunications company PT Indosat Tbk are rushing to sell debt.

This month has been the busiest July on record for sales by U.S. companies with junk-credit ratings. Asia's debt market is on pace for a record year, and European companies are also raising money apace.

The low borrowing costs are the culmination of an unprecedented bond-market rally that began in the depths of the credit crisis in late 2008 and early 2009 and has defied every prediction that it would soon run out of steam. But individual and professional investors continue to plow money into the bond market, giving companies a constant source of funds to tap.

With each new leg higher, the bond market gets more expensive and interest rates, which move in the opposite direction of price, fall even lower. If the economy heats up and rates rise, investors gobbling up bonds will get burned as bond prices fall. ...

Companies big and small are taking advantage of the low rates to bolster their balance sheets and lower their interest costs by millions of dollars for years to come. "I think we are accessing the market at precisely the right time, and a very opportune time," said Stephen De May, senior vice president for investor relations and treasurer of Duke Energy Corp., whose subsidiary in Indiana borrowed $500 million at 3.75% in early July, the fourth-lowest rate on record for a large U.S. corporate borrower, according to Bank of America Merrill Lynch.

McDonald's this week raised $450 million in 10-year debt at 3.5%, a record low yield for a large batch of debt issued by a U.S. corporate borrower. The U.S. government paid more than 3.5% for its 10-year debt as recently as May.

Now, if you have been paying attention, you will see that those yields are comparable to the dividend yields on the equities of those same companies.  The following is a comparison between dividend yields and yield-to-maturities of a select group of companies that have issued a significant amount of debt.  The bonds all expire in eight to twelve years.

The dividend yields of some of the highest quality companies in the world are comparable to or exceed the bond yields of the debt of those same companies.

Frankly, that's nuts.

There was a time when dividend yields consistently exceeded bond yields.  The thinking then was that since equities were riskier than debt, stocks should yield more than bonds.  But eventually, investors came to understand that stocks contain a growth element, unlike a bond, which is a contract to pay a fixed amount of interest and a return of principal at a given date.  For bonds, the total return if held to maturity is the yield.  At best, the bondholder can only be made whole.  However, for stocks, the owner of equity has, in theory, limitless profit potential.  Because profits grow, dividends grow, and the total return to stocks is the yield plus the rate of growth.  Thus, a little more than 50 years ago, the market began to price stocks at a lower dividend yield compared to bond yields for all but the most financially distressed firms.

If one looks at the table above, one could argue that the pharmaceutical and telecommunication companies face structural problems in their core businesses - pharmaceutical companies are not replacing products that are going off patent fast enough while fixed phone lines are in secular declines.  Thus, pharma and telecom companies will inevitably have to cut their dividends. 

But what about global multinational companies with fantastic brands, such as Coke, McDonald's and P&G?  These are some of the greatest companies in the world.  Why are their bonds yielding less?  Or regulated utilities?  I posted just a few utilities, but there are many utes with dividend yields that are comparable to or greater than the yield paid on their debt.  That's ridiculous, given that regulated utilities have targeted returns on equity embedded in the rate structures set by state utility boards, i.e. their profits are pretty much guaranteed.  For energy companies, stock prices have been hurt by the Gulf disaster, and yes, replacement of reserves is an issue, but it is bizarre to me that the securities further down the capital structure of some of the biggest energy companies on the planet yield more than up the capital structure.

In other words, the bond market has lost it's mind.

I am not one to say that stocks are table-pounding cheap here.  I think that certain stocks are attractive, particularly high-quality, big-cap multinational companies that are trading at 11x-12x earnings and sporting dividend yields of 3%-4%.  A basket of inexpensive, high-quality stocks is likely to earn an investor a return of 10%+ per annum over the next 10 to 20 years.  However, cheap stocks can get cheaper, and in the early 80s, similar high-quality big-cap stocks traded at 6x-8x, and paid dividends that yielded 6%-7%.

But I would rather buy stocks than bonds.

So what accounts for the bond market's current state of collective madness?  I can think of three reasons.

First is ZIRP, the Fed's zero interest rate policy.  Corporate bonds trade off the Treasury yield curve.  As the curve has shifted downward, corporate bonds have followed.  This is, at least in part, a rational response by investors to government policy.

Second is fears of deflation.  In deflation, profits fall and dividends are cut.  Of course, debt payments are fixed, increasing the financial strain on a company.  However, a little bit of deflation may have more of an affect on equity holders than bond holders, especially when companies are hoarding cash.

Finally, there is fear.  Retail investors were crushed during the Financial Crisis.  Many who sold at or near the bottom never bought back.  Having watched their savings cut in half, the Crisis has seared an indelible imprint on the psyche of the investment public, scaring investors out of stocks and into bonds.  This can be seen in the massive inflows into bond funds over the past 18 months and the continuing outflows from US equities.  Also, companies are holding record amounts of cash on their balance sheets, fearful of being cut out of the commercial paper and bond markets yet again.  This cash could be used to buyback stock, but that is not happening.

A rational investor would short the debt and buy the stock of the same companies.  However, given that this is an unprecedented time in American financial history, and the market is doing unprecedented things, one should greatly heed Keynes's saying that "the market can stay irrational longer than you can stay solvent."

However, in the long-run, rationality will win out, as it always does, and this will not end well for the owners of corporate bonds. 

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 – Rising Costs, Lower Returns

I am seeing all sorts of commentary regarding the de-pegging of the RMB to the dollar as being positive for risk assets.  And it is, long-term.

Over the long-term, a floating Chinese currency is enormously positive as it will help alleviate the enormous imbalances in the world economy.  Simply put, the imbalances are that the US consumes too much and China produces too much, which has led to an unstable build-up of foreign currency reserves in China.  China must consume more and the US must produce more.  A rebalancing of the Chinese currency will help do both by making imported goods into China cheaper while making exported Chinese goods more expensive, leading to lower growth in Chinese currency reserves.  But over the short and intermediate term, this could produce headwinds for US stocks.

There will be pressures on businesses other than a rising Chinese currency, however.  Labor costs are rising in China, which means labour costs will start rising again in the developed world.  Because Chinese labour costs are rising, offshoring will become less ubiquitous and profitability will fall.

I believe that we are witnessing an inflection point in the construct of the global economy that could have enormous ramifications for how the spoils are divided up between capital and labour.  Over the past decade, those spoils have accrued primarily to capital whereas labour has lived off crumbs.  I believe that we are shifting to a more equitable distribution of wealth. And though I doubt we will see a reverse of the past decade such that all the gains accrue to labour and capital gets little, the gains will be more evenly distributed.

More to labour, less to capital

The biggest benefactors of the opening of China over the past decade have been the owners of capital.  The opening of China has shifted global cost curves down.  Companies have been able to shift productive capacity overseas, which has increased profitability and returns on equity.  Many measures of corporate health during the 00s hit either all-time highs or multi-decade highs – profit margins soared, return on equities skyrocketed, profits as a percentage of GDP exploded, etc.

Labour, on the other hand, experienced stagnant income growth, at least in the developed nations.  Productive capacity shifted offshore, pressuring wages.  Consumption growth was often financed by debt and home equity extraction, not by growth in income.

Even in China, which has seen enormous gains accrue to labour over the past decade, there is widespread discontent amongst the have-nots as income disparities have raised significantly over the past 10 years.  There have been several high profile reports coming out of China lately about worker discontent at plants and factories.  Workers have gone on strike and have received significant wage gains.

Wages are going to rise in China relative to capital as Beijing attempts to create more internal consumer demand within the country to rebalance the economy and to keep the social peace.

This cannot be overstated enough – if the cost structures of global corporations are rising, as accelerating wages in China and a higher RMB implies, there will be headwinds for corporate profitability growth, and gains to the owners of capital will be lower.

Rising costs in China will mean fewer options for corporations to lower costs by moving production offshore.  Costs for corporations are going to rise at the expense of profitability as companies pay their employees more domestically.  Profit margins are going to fall, return on equities will be lower and the percentage of profits to GDP will decline.  Good for labour, bad for capital.

Over the long-term, the developments in China are extremely positive as they assist in the rebalancing the enormous imbalances in the global economy.  Over the short and intermediate-term, however, they will slow aggregate profitability growth.

Less demand for dollars

Perhaps the most destabilizing imbalance is the enormous amount of currency reserves held by the People’s Bank of China.  Over the past decade, the Chinese currency peg has kept interest rates in the United States lower than they otherwise would have been.  To keep the RMB low, the PBOC purchased US dollars and used those dollars to buy US debt, primarily Treasury and agency bonds.  This demand for US government bonds kept a lid on interest rates.

A rising RMB means there will be less imperative for the PBOC to buy US bonds to keep the RMB low.  Less demand for US bonds will mean higher interest rates.  Higher interest rates means lower valuations for risk assets, which means lower returns for equities.

Less liquidity

The downward shift in global cost curves kept interest rates low as the opening of China was deflationary.  Central banks don’t like deflation, they like price stability.  To counter deflation, central banks created money, which is inflationary.  The money supply grew at a faster rate than economic growth. 

Much of this liquidity found its way into asset prices, particularly real estate prices but also commodities, credit and other more esoteric assets such as wine and sports teams.  A rising cost structure in China will reduce deflation, which means there will be less money creation to counteract deflation, thus less liquidity.  Less liquidity will mean less fuel for assets.  Less demand for assets will mean lower returns for risk assets.

The end game

The effects of a rebalancing Chinese economy towards more consumption will mean lower aggregate profitability growth, higher interest rates and less liquidity in the financial system, all of which are negatives for stocks over the intermediate-term.  This does not mean that stocks are going to fall but it does mean that returns to equities will probably be substandard.  Over the long-term, the effects will be positive as they will strengthen an unhealthy global system.

Of course, over the intermediate-term, there will be winners and losers.  Obviously, corporations selling to the burgeoning Chinese consumer will benefit.  However, companies that relied on offshoring are going to see lower profitability.  Profit margins are likely to be lower over the next decade than the past decade as less offshoring will mean less pressure on wage growth in the developed world.  This will alleviate (though not eliminate) the pressure on the American consumer caused by deleveraging, thus benefiting the American consumer.

I believe this shift in trend will occur over the next 10 years, and will happen slowly and subtly.  The opening of China has been and will continue to be one of the most significant economic events of the past 100 years.  However, the composition of wealth distribution caused by the opening of China is changing, I believe, which is going to have a significant effect on asset returns.

 

Ignore Analysts' Forecasts

We here at Running of the Bulls pay some attention to analysts' forecasts for company earnings, but not a whole lot because forecasting is less of an exact science than handicapping football games and predicting the weather.  Via Paul Kedrosky, the green line is analysts' forecasts of future earnings while the blue line is actual earnings.

Valuation Update

The median price/earnings ratio of the Russell 3000 is currently 16.6x 2010 earnings.  The median forward PE for the Russell 1000 is 16.8x.  The median forward PE for the Russell 2000 is 16.5x.

The long-term average forward PE is 14x.  Thus, the average stock is somewhat expensive but not egregiously so.

However, profit margins are above long-term averages.  If profit margins revert to mean, then stocks are more expensive than they appear. 

Margins matter more in the long-run than the short-run, though.  Thus, over the near-term, valuation is not worrisome.

China's Currency Peg and Bubbles

The global economy is characterized by enormous imbalances, particularly the $2 trillion or so in reserves parked at the People’s Bank of China.  This build-up of reserves is one culprit of the asset-driven economy.

Make no mistake, our problems are not because of China.  Our problems are because of ourselves.  But China’s currency peg has dramatically exacerbated the problems of the global economy.

The past decade has been characterized by two of the most deflationary forces of our time – the Internet and the inclusion of China as a major player in the global economy.  The Internet is deflationary because of dis-intermediation – it cuts out the middleman, lowering costs for consumers.  The opening of China is deflationary because its wages are low, effectively lowering the global cost curve for corporations.

In a balanced economy, these deflationary forces should have caused prices to fall.  However, prices did not fall.  The Federal Reserve would not allow that to happen.  To keep prices from falling, the Fed injected money into the economy to keep prices stable.  That money had to go somewhere, and it went into asset markets.

China supplied us with cheap goods and ran a massive trade surplus.  The yuan should have risen against the dollar, but the Chinese government would not allow that to happen, and China built up a ridiculous amount of reserves.  Had the yuan risen, Chinese labor would not have been so cheap, and the deflationary forces emanating from China would have been less.  With less deflation, less money would have been created and less liquidity would have flowed into asset markets.

With trillions of dollars in reserves, China had to put that money somewhere.  Much of China's reserves were recycled back into the US Treasury market, increasing demand for Treasuries which lowered interest rates.  Lower interest rates allowed people to finance purchases of assets cheaply – from homes to CDOs  – fueling the housing bubble.  Had China not pegged its currency to the dollar, it would have had fewer dollars to recycle into the US bond market, demand for bonds would have been less and interest rates would have been higher. Had interest rates been higher (and the Fed could have kept rates higher regardless of what China did) then there would have been no housing bubble, or at least the housing bubble would not have grown as large as it did. 

(This criticism can also be labeled at Japan and other Asian countries whose economies were geared towards exports to the American consumer.  They too ran up enormous currency reserves.)

Over the long run, a floating yuan is good for the global economy.  It will clear out many of the destabilizing structural imbalances.  It is good for China as well.  A rising yuan will increase consumer spending in China as imports become cheaper, re-balancing the Chinese economy away from its heavy (and unhealthy) reliance on exports and capital spending.

In the near and intermediate-term, however, it is bad for our asset markets.  A rising yuan means less demand for Treasuries, which means higher interest rates, which means less support for asset markets such as stocks, bonds and housing.   In our asset-driven economy, less liquidity is bad for our markets.

In the long-run, a floating yuan is positive for the US economy.  Our heavy reliance on asset markets is unhealthy.  Less trading things and more making things is ultimately good for America.

Stocks are Expensive

I look at a variety of stock market valuation methodologies.  Below are several, but I look at many others as well to get a sense of valuation.  Of course, valuation means absolutely nothing in the near-term.  It is, however, the single biggest determinant of long-term returns in the stock market. 

Assuming, of course, we do not go the way of Argentina.

One model I use is a forward price/earnings model.  I calculate normalized earnings by multiplying a normalized profit margin by sales per share, assume 6% profit growth for the next 20 years – which is the long-term growth rate for earnings – apply a multiple of 15x –  which is the long-term average PE of the market – then discount this 20-year expected S&P 500 target back to the present to calculate the expected capital gain.  I then add the current dividend yield to get my total expected return.  Currently, this model is forecasting a total return to equities over the next 20 years of 6.7%, well below the long-term average of 10%.

Another model is a dividend model.  I forecast normalized earnings one year out and multiply it by an expected payout ratio – which is higher than the actual current payout ratio.  I then add the long-term growth rate in dividends.  This model is forecasting expected equity returns of 6.3%.  (For the record, the current dividend yield of the S&P 500 is 1.8%.  The dividend yield for the S&P 500 never went below 2% before 1997, around the time when markets started going bonkers.)

Modeling has its problems, of course.  Just like all valuation methodologies, I use models for approximation, not precision.  I’m not trying to hit a hole-in-one.  I’m just trying to hit the green.  (He can’t keep the ball on the fairway. – ed.)  And the approximation is that stocks are expensive.

I also use a normalized PE.  Normalized earnings is calculated in the same way as above.  Sales per share of the S&P 500 is currently $905.  Assuming a normal profit margin of 7% - the average of the past 20 years has been 5.5% - normalized earnings per share is currently $63.  Thus, the market multiple on normalized earnings is 18.5x, well above the long-term average of 15x.

Trailing earnings are currently $53, forward “operating” earnings are $77.  Wall Street consistently over-estimates operating earnings relative to reported earnings by 10% to 20%.  If you adjust for Wall Street’s excessive optimism, forward earnings are $62 to $70.  Using these two numbers, the market is trading at 16.7x to 18.8x forward earnings.  While the trailing historical PE multiple has averaged 15x, the forward PE has averaged 14x.  That means the market is 19% to 34% over-valued.

If one looks at analysts’ estimates for individual companies, the median forward PE of the Russell 3000 is 15.9x.  Since this is operating earnings, we have to adjust by 10% to 20% to obtain reported earnings. Thus, the median PE for companies in the Russell 3000 is 17.7x to 19.9x.  Given that the historical forward PE has been 14x, the market is 26% to 42% over-valued.

In the asset-driven economy, where the Fed has unleashed oceans of liquidity, none of this matters.  The market is riding a rising wave.  But when the wave starts to break – when the liquidity starts being withdrawn – it will matter greatly.

NonFarm Payrolls Suggest Higher Market

There are two reasons why the market is screaming higher – enormous liquidity and an improving economy.

An ocean of liquidity has flooded the markets, thanks primarily to the Federal Reserve and government programs.  One can either surf the ocean (by going long) or drown in it (by going short).  The tricky part is getting safely to shore on the surfboard when the tide goes out. 

The economy is undoubtedly expanding.  Economists are expecting the nonfarm jobs report for March to be 200,000.  I am hearing the print could be as high as 300,000. 

Generally, the market moves higher when nonfarm payrolls turn positive.  At the end of the previous six recessions, the average gain of the S&P 500 a year after NFPs turned positive for good has been +5.7%.  In only one instance was the market negative a year later, which was in 1981.  Not coincidentally, nonfarm payrolls turned negative in September 1981 as the economy plunged back into recession.  The highest one-year return was +9.5% in 1976. 

This pales in comparison to buying the market at the depth of the recession.  At the nadir of job losses, when job losses are at their worst, on average the market was 43% higher a year later.

Contemporary history suggests that the market is headed higher from here, though most of the returns have most likely occurred.  The question is whether or not this time period is contemporary?