The risk trade marches on. It’s another day and another high in the DOW. What have investors learned from this?
Alan Hartley writing for Morningstar explores that question in A Potent Brew for a Tall Glass of Regret
While it is clear economic data has improved, we must be conscious of the risks that remain.
For starters, our recent economic growth has required unconventional and unprecedented monetary policy. The purchase of trillions of dollars of securities by the Fed in the hopes that “higher stock prices will boost consumer wealth and help increase confidence” has thus far worked wonders in bolstering equity markets. But such involvement with a seemingly tepid growth response should cause one to ponder the economy’s stand-alone strength and growth sustainability.
As Bill McBride of Calculated Risk noted, the December figure was “the largest year-over-year increase in [housing] inventory since January 2008 and … is something to watch closely over the next few months.”
Rising inventories would likely lead to additional price declines that would affect consumer sentiment, consumer spending, and ultimately bank balance sheets.
Other concerns are more exogenous, but no less real, and include European sovereign funding troubles, rising commodity prices, and tightening requirements in emerging economies to tame inflation. All these risks could be contentedly borne at the right price, but unfortunately for investors, valuations offer no solace.
The cyclically adjusted price-earnings ratio, developed by Yale professor Robert Shiller, stands at 23, a level 40% above its mean. The ratio of the total market capitalization to gross national product, a measure used by Warren Buffett, is almost 50% above its long-term average. Total market capitalization to corporate profits, which can function as an economy-wide P/E ratio, is 10% above its long-term average, despite current near-peak profit margins. In fact, take any valuation method that doesn’t rely on next-year earnings estimates that imply ever-expanding profit margins, and you’ll find elevated valuations and the lack of a margin of safety in broad equity markets. Yet, analysts’ target prices for the S&P; 500 still point to significant market upside.
Why do analysts come to such different conclusions when analyzing the same data? Differences in opinion of overall valuation can exist because of most analysts’ over-focus on one year of earnings, instead of what is likely to occur on average. To make sense of this discrepancy, it might help to think about investing in the stock market as if you were buying one large company. The first thing to remember is that this “company” is quite cyclical. Its earnings vary over the business cycle, from having profit margins of less than 4% in tough times and greater than 8% at the peak of the cycle. On average, the company delivers 6% profit margins during the course of a full cycle, which includes great, terrible, and average years (think 2001-10).
Analysts expect 2011 S&P; 500 sales to breach $1,000 per share with earnings of $87.50, or an 8.5% profit margin–a margin level eclipsed by only the year 2006. Put a long-term average multiple of 15 on those earnings, and you get a price target of $1,313, or 2.3% above Friday’s close. But assume the average occurrence of 6% profit margins, and you’ll find $60 per share in earnings and a current P/E over 21.
Such disregard for average occurrences is also evident in other corners of asset markets. Fixed-income securities have seen spreads compress to pre-crisis, below-average levels while historically low interest rates remain held in their place. Implied volatility, which is the key driver of option pricing, recently closed at low levels not seen but prior to the onset of the financial crisis. Elevated valuations, limited yield opportunities, tight credit spreads, and complacency are a potent brew for a tall glass of regret.
It seems that market participants have learned the wrong lesson: that the Fed can have an enormous effect on the market, “keeping asset prices higher than they otherwise would be”, and not that the Fed’s largesse always ends in tears.
Why Wildly Differing Conclusions?
Hartley hits the mark with his analysis and even more with his conclusion “the Fed’s largesse always ends in tears.” However, he misses one key point:
Most analysts, money managers, and broker-dealers are perpetually bullish because they have a vested interest to be perpetually bullish.
Just as real estate salesman do not sell houses if they tell potential clients houses are too expensive, broker-dealers don’t make commissions if people are not buying. Moreover, most money managers earn no fees at all if their clients sit in cash.
Conflicts of Interest in “Stay the Course” Advice
In January of 2009 before the final 20% plunge in the stock market, an investment advisor from Wachovia Securities called me up and stated “Mish, I am sitting on millions because I see nothing I like”.
I told the person I did not like much either and that Sitka Pacific was heavily in cash and or hedged. His response was “Well, I do not get paid anything if my clients are sitting in cash”.
I called up a rep at Merrill Lynch and he said the same thing, that reps for Merrill Lynch do not get paid if their clients are sitting in cash.
Massive Conflict of Interest
Notice the massive conflict of interest possibilities. Reps for various broker dealers have a vested interest in keeping clients 100% invested 100% of the time, even if they know it is wrong. And so during every recession and every boom alike, bad advice permeates the airwaves and internet “Stay The Course”.
By the way, that person at Wachovia mentioned above did the right thing. He did not see investment opportunities he liked, so he kept client funds in cash. Such action is not the norm.
The fact that managers do not get paid if clients sit in cash accounts for a great deal of the long-term-buy-and-hold mentality you see. The rest of it comes from analysts who have a vested interest via relationships to broker-dealers to be optimistic.
Moreover, clients never want to hear that stocks are going down, that valuations are stretched, or that risk is high. The industry capitalizes on that by seldom saying such things.
History shows that no matter how stretched valuations get, analysts invent new metrics to justify stock prices. Remember the concept of tracking “click counts” instead of revenues for dot-com companies? How about the “Gorilla Game” and Pro-Forma earnings?
Now its “stocks are cheap relative to bonds”.
For further discussion, please consider The Question “Are Stocks a Screaming Buy Relative to Bonds?” Creates False Premises
We also see the old-standby regarding “forward PE’s”.
Analysts do not care how ridiculous those PE’s are or that earnings are a function of $trillions in stimulus. Nor do analysts care that bank earnings are blatantly fraudulent and based on mark-to-model fantasies not marked-to-market reality; nor do analysts care about the sustainability of those earnings.
Note that rating agencies fraudulently marked pure garbage “AAA” because the more garbage they rated AAA, the more business they got.
This all boils down to a simple statement of fact: Analysts do not care about sustainability of earnings, about valuations, about mark-to-fantasy, about currency risks, about risk in general, or about anything at all because they make more money by not knowing and by not caring if they do happen to know.
Mike “Mish” Shedlock
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