This is a market comment about what is happening,
about the specifics that supply essential principles with a
This is a market comment about what is happening, about the specifics that supply essential principles with a context.
On 12/29/06 the S&P 500 closed at 1418, resulting in a total return of 15.79% for the year, and undervalued by 46% on an error correcting basis. One year ago, the undervaluation was 46%.
We are appropriately invested in equities, but cautiously with a balanced portfolio. The S&P 500 can still grow with more gradual earnings increases; if the growing chaos in Iraq can be contained. We furthermore think there are a number of lesser risks to the 2007 stock market. However, substantially undervalued markets and stocks are more forgiving of adverse events than overvalued ones.
When will the market correct a large 46% undervaluation? Our analysis suggests that this question is equivalent to asking when the problematic Mideast will right itself. The problems of the area now go beyond Iraq and Palestine. In the November/December 2006 Foreign Affairs, Richard Haass who was Director of Policy Planning in the State Department, writes that the Mideast will be very difficult, with local forces and interests ascendant. The U.S. era that began with the fall of the Soviet Union in 1991 has ended with the chaos in Iraq. The U.S. should now “intervene more in the Middle East’s affairs with nonmilitary tools” and implement domestic energy and security policies to buffer itself from the area’s problems.
The policymakers in Washington are also responsible for supplying a more stable political environment to facilitate economic growth. The environmental frame of reference, or context, matters for stock prices.
In a previous article, we found that the U.S. stock market imprecisely error corrects rather than mean reverts. This is because the stock market is a social system, and not a mathematical one. In mathematics, if y=mx, then by logical necessity, Dy = m Dx; a change in the independent variable (x) produces a predetermined effect in the dependent variable (y) at all times. In social systems, this does not always occur because human behavior is also affected by both context and threshold (Inglehart & Welzel, 2005). For instance, the short-term D response of the stock market to changes in fundamental economic variables, such as earnings or interest rates, is determined by the context in which they occur. In 1931 Keynes observed, “Just as many people were willing in the boom, not only to value shares on the basis of a single year’s earnings, but to assume that increases in earnings would continue geometrically, so now they are ready to estimate capital values on today’s earnings and to assume that decreases will continue geometrically.” 2000’s exuberance over the technical innovation of the Internet and 1977’s political problems in the Mideast caused maximum errors in our (1968-2006) model of the U.S. stock market.
A contextual analysis of the U.S. stock market provides the broader picture. As value investors, we are concerned with intrinsic value (the present value of distributable cash flow with a reasonable growth assumption) and context, integrating the normative and the conditional into an analysis requiring phronesis, or judgment.
Some investors continue with the stocks we had chosen. We refer to our portfolio note of 11/4/05 and suggest they seek other alternatives. The stocks we personally own are value stocks and long-term investments.
These two studies conclude that withdrawing to the periphery and engaging Iraq’s neighbors in a stabilization plan is the only effective remaining strategy for the United States in Iraq. They differ, however, substantially on whether the sectarian conflicts in Iraq will likely spill over into the neighboring states, with even more adverse consequences.The Council on Foreign Relations study points out that previous Mideast conflicts, between Iraq and Iran, the Arabs and Israel, have not resulted in a spillover. The Brookings Institution study describes the spread of war in Yugoslavia, among other examples. Thinking specifically, there are six countries surrounding Iraq. What are their respective capacities to cope with border problems?
We suggest reading the summaries of these studies.
The stock markets around the world are tumbling due to a large drop in the Shanghai stock market, the prospect of slower GDP growth in the U.S., and a Taliban attack on the U.S. Vice-President in Afghanistan. In a single day, the S&P 500 has dropped by 3.5% to 1399.
Since we are value investors, when to buy more stocks? Will the market become even more undervalued? We think that the latter possibility is quite likely. After a period of low volatility, the hedge funds have bet on a continuation of that state of affairs. However, as our readers know, the markets are naturally quite volatile. For structural reasons, market volatility will increase as the funds are forced to unwind their bets on low volatility. Furthermore, the events in Iraq have yet to further unfold, causing turbulence in the interim. Peter Lynch (1989) wrote that trying to catch the bottom of a falling stock (or we might add market) is like trying to catch a falling knife. Once it reaches the ground, it will vibrate and settle down before you should grasp it. We think this will be the case with the U.S. stock market.
The financial markets consist of buyers and sellers, often placing different interpretations on the same event like a large market drop. However, and this is an important point, prices eventually (to be discussed in the future) align themselves around the fundamentals like earnings and discount rates. The markets, in other words, ultimately reflect reality.
It is not likely that the U.S. will be able to set up a self-sustaining government in Iraq. The U.S. and Iraq’s neighbors can still contain the chaos to avoid a total meltdown. An effective policy will require agreement between the executive and the legislative branches.
The stock market has responded to the decreased possibilities for future growth with increased stock buybacks. According to a 4/18/07 WSJ article, “In each of the past three years, more stock has been withdrawn from the market through buyouts and corporate share buybacks than has been issued. Last year, a net $548 billion in U.S. corporate stock was taken off the market, up from $295 billion in 2005…” We point out that the investment banks would be issuing new stock if there were new areas of growth.
These problematic fundamentals call for caution at this time.
Short-term market behavior can be affected by events or by a simple momentum generated by endogenous market processes (like takeovers). The excess liquidity that the Fed created to counteract the last recession has sloshed first through the U.S. real estate market resulting in a boom, then to the export economies abroad, and has now facilitated a mania for corporate takeovers. This game of musical chairs depends upon a continuation of financial market liquidity that can furthermore be enhanced or (rapidly) de-enhanced by leverage.
The Value Line median stock appreciation potential, also comprising the smaller companies, is now at a historic low.
In spite of the undervaluation of the S&P 500 at 1525, we definitely remain cautious and think that the short-term behavior of the stock market is going to be, well, interesting.
Commenting upon recent problems in the subprime mortgage market, a 6/24/07 NYT article was titled, “When Models Misbehave.” Of course they do, since they conveniently assume – if you have a PhD in stochastic calculus - that the financial markets are mean-reverting Gaussian rather than, at best, event error-correcting. The result is a failure of mathematical models to accurately track market prices, which can be driven to extremes by emotions like fear, greed, or both at the same time, acting on events. An astute Morgan banker once said that the operations research models, “predict prices until they don’t.” This is why assumptions matter, and why you should invest around your comfort point so you won’t be forced out of your investments by events.
The concept of a margin of safety is applicable to both lending and stock investing. In lending, one of the measures of the margin of safety is the degree to which EBIT covers interest expenses. In stock investing, the margin of safety is the degree to which the conservatively calculated present value of distributable cash flow exceeds the present market price. In both cases, the aim is to avoid a permanent loss of capital.
You can control short-term risk at the asset allocation level and longer-term risk at the securities selection level.
Each business cycle is different. The last recession was caused by an overinvestment in the IT areas of the U.S. economy. Current economic imbalances are caused by broader macroeconomic factors such as the trade deficit, immanent corporate lending problems, and an overinvestment in U.S. residential real estate. A crucial question is the future trend of S&P 500 earnings. In the larger corporations, foreign earnings now comprise around 50% of the total. It is very important to determine whether foreign source earnings are independent of domestic earnings. If they are, the increasing diversification of the world economy will cushion decreased domestic earnings. If they aren’t, then a consumer slowdown in the U.S. will be translated into decreased economic growth abroad, with unfortunate consequences for the U.S. stock market.
A recent Asian Development Bank Report studies the trade linkages between the G-3 nations (the United States, The European Union, and Japan) and the economies of South and East Asia. The question that Cyn-Young Park investigates in Uncoupling Asia: Myth and reality is whether Asian economic growth is now independent of global demand trends, whether autonomous interregional trade has increased in Asia sufficiently to enable the Asian economies to weather an economic downturn in the G-3. The study, unfortunately, finds that the growth in Asian economies is now even more firmly tied to the growth of G-3 economies. The U.S. accounts for nearly 50% of the G-3 growth in non- oil imports from Asia. Furthermore, the Asian economies’ Export/GDP ratio “has continued to trend upward, reaching nearly 55% of GDP in 2005…compared with the world average of 28.5%.” This increasing trend results from the fact that intra-Asian trade is “driven by vertical integration of production chains, whose final output is largely destined for final demand outside the region.” This is similar to the respective findings of the Monetary Authority of Singapore and Goldman Sachs.
Our analysis of the U.S. stock market indicates that it has nearly discounted present problems in the Mideast, but not the possibility of a moderate recession.
A continuing financial crisis in the globalized mortgage markets points to the limits of securitization. Banks hold illiquid and unique assets like corporate and real estate loans with covenants; but since they are highly regulated, people almost always have confidence in them and are thus willing to “invest” in their liabilities. Securitization structures, an 8/10/07 NYT article points out, are the new banks. They finance illiquid corporate and real estate loans, but only on the basis of now dubious bond agency ratings. A continuing series of runs on these securities is now happening around the world, forcing both hedge fund managers and their investors to find out what they have really invested in. In some cases, they will have invested in sliced and diced financial products of dubious value. Kindleberger (2000) writes, “At a late stage, speculation tends to detach itself from really valuable objects (our note: that value investors seek) and turn to delusive ones.”
Following extensive turmoil
and the seizing up of financial markets last week, the Fed cut its interbank
lending rate from 6 ¼ to 5 ¾ in
order to reliquify the system, informing the banks that it would continue to
make loans supported by investment grade collateral. The stock market has since
rallied somewhat. This action, however, does not have a general effect upon the
economy. Changing the fed funds rate, currently at 5 ¼,
usually has a general effect because that rate affects all other interest rates
and thus the real economy.
But any cut in that rate can only be minimal, not affecting the basic problem: billions of dollars of dodgy mortgage paper spread around the U.S. and the world. A way to bail out bad debts is to inflate the economy, thus favoring debtors against creditors. We do not think that the Fed will squander its credibility in order to do so. To mention a few problems with adopting a loose monetary policy: the real U.S. economy (except the real estate industry) is still running at close to capacity, interest rates are increasing in the rest of the world, the large U.S. trade deficit requires foreign financing, and the dollar could go into a free-fall.
This market turmoil comes at an unfortunate time, when Fed policy must also take into account foreign considerations. For the above reasons, we won’t chase a short-term stock market rally, should one occur. We don’t run a hedge fund.
In testimony before Congress, Ambassador Crocker and General Petraeus said that the situation in Iraq is very difficult; competition among the different communities for power and resources will occur, whether we are there or not. The only difference will be the degree of violence. There are a few faint glimmerings of hope: mainly that some local tribal groups – and this was not anticipated – are beginning to cooperate with the U.S. to maintain local order in a very complicated war. This is happening in the Sunni Anbar province, where most American casualties have occurred. The U.S. is now working to tie these local groups to the central government that is now beginning to fund these local efforts, which will differ by province. Also, oil revenue sharing is starting to occur with the provinces without a national law, without Sunni complaints. To take an historical perspective, the warlike Arab tribes developed customs of conciliation to keep the peace (Allen, 2006). The U.S. should let these begin to operate; Iraq is a crystal clear example of what happens when political culture* is simply ignored.
The U.S. is incurring large costs to maintain a presence, measured in terms of blood and treasure. Were we to make a new decision comparing the uncertain returns of that venture against these costs, the effort in Iraq going forward would not be a good investment. Consider, however, what would probably happen if the U.S. were to leave precipitously. (Those who got us into this mess have a point, that has become quite valid.) Iraq would become a failed state in the heart of an even more turbulent Mideast, with the U.S. held directly responsible. There is no way around this. add: Carl Bildt is the Swedish foreign minister and an expert on the post-Ottoman empire. In a 9/13/07 NYT article, he “sees ‘massive parallels’ between Yugoslavia’s violent dismemberment once dictatorship ended and Iraq’s turbulent deliverance from tyranny….regional realities make an Iraqi breakup unthinkable…” In both cases, partition in some form to separate the warring parties is the only solution; and that will require more time in Iraq.
Our take on this congressional testimony is that the situation in Iraq has ceased to deteriorate; there is hope for some improvement and also the eventual development of a strategy related to reality on the ground. It is useful to ask: what is feasible and appropriate? The problem of Iraq will continue to weigh upon the stock market, with cyclical economic factors however predominating in the short-term.
* The key question concerning the present U.S. discussion about Iraq is this: what would the Iraqis do if the U.S. were to announce a large troop withdrawal on date certain? Their minds concentrated, the various fighting factions might rationally settle with each other, to form a new social compact (like the U.S. did when confronted with the lesser problems of the Confederation in 1785). On the other hand, each faction might try to find a more powerful ally in Shiite Iran and Sunni Saudi Arabia in order to survive in an environment of a war of all against all. What do you think is likely to occur in Iraq’s political culture?
The current stock market rally assumes that the residential real estate problem has an easy solution: financial institutions announce their writeoffs, balance sheets are cleaned up, and then its time to make money again. Real estate assets, however, are not like any other. Real estate loan workouts take a long time especially due to the fact that residential real estate assets are numerous, illiquid, and the loan contracts, having been securitized, are almost impossible to renegotiate.
Most current estimates indicate that real estate problems are just beginning, as housing inventories of 9.6 months in July, versus a normal 4 months, continue to increase. The problem can’t just be swept under a rug or written off. A continuing flow of bad news from the sector is very likely, and that will have an effect upon the broader real economy. Housing construction directly accounts for about 5% of annual GDP. Include now the multiplier effects of decreased housing construction and the consequences of the credit crunch. There is an increasing likelihood that the economy will dip into some sort of a recession.
The positive catalyst for the current stock market rally is decreasing short-term interest rates. However, from 5/2000-12/2001, the fed funds rate went from 6.5% to 1.75%. During that time, industrial capacity utilization dropped from 82.4% to 74.4% and the S&P 500’s total return was negative. Those interest rate decreases did not translate immediately into increased economic growth and higher stock prices. That delay is likely to be even more pronounced this economic cycle, because there are limits to how far the Fed can decrease interest rates and early cycle residential real estate investment will obviously not occur. The increased liquidity caused by the Fed’s monetary creation may rally stocks for a while, but the markets will eventually reflect an economic reality that isn’t likely to be bullish. We hope that the already deeply undervalued S&P 500 will not become acutely undervalued due to these negative catalysts. We’re favoring fixed income assets, non-cyclical stocks, and some cash.
People use stories and metaphors to handle complexities and complications. We think of the present stock market in this way: it’s a race, a race between slowing economic fundamentals and gradually accelerating financial problems, caused by bad real estate investments and overly complex, leveraged financial structures.
The short-term behavior of markets mainly provides opportunities for long-term value investors to either buy or to sell. We analyze markets out of curiosity, to get some idea about when those opportunities might occur, and to make some adjustment to our asset allocation. The goal of our analysis, however, is not market timing, that is leaping into and out of the markets. Here is an important distinction between trading and investing. If you’re leveraged 20:1, it doesn’t matter what the asset is. You have to be precisely right in imprecise markets, and your main concern will be market liquidity* rather than fundamental economic information. Investors have the resources of considered analysis and time, which they can use to good purpose.
We definitely prefer steady and growing markets, but will oblige with additional stock purchases if Benjamin Graham’s Mr. Market becomes troubled.
*Derivatives guru, Richard Bookstaber, was present at the creation, that is at the creation of the derivatives market. In A Demon of Our Own Design (2007), he describes in detail the market problems that occur when the liquidity assumptions behind the mathematical models are violated. This book leads the reader to a greater appreciation of the crucial difference between trading and investing, and shows how the markets can be used or misused.
The subprime mortgage
problem is remediable, with some time. However, a recession or foreign political
problems would exacerbate domestic credit problems. This is why we’ve
back, to a degree, on sold the preferred stock of a brokerage company. We
think that prudent caution is advisable.