BLIND THRUST

A blind thrust earthquake is an earthquake along a thrust fault that does not show signs on the Earth’s surface. Such faults, being invisible at the surface, have not been mapped by standard surface geological mapping. Although such earthquakes are not amongst the most energetic, they are sometimes the most destructive, as conditions combine to form an urban earthquake which greatly affects urban seismic risk.

The vast majority of research reports essentially focus on the corporate, economic and financial environments, the investment background that I call “the story”, and precious little time on valuation. Look at any brokerage report, you will find 2, 4, 8, even 28 pages on “the story” and generally less than a page on what that story is really worth and why.

I prefer to do the opposite. I spend a lot of time trying to value securities, seeking to unearth the really attractive securities where the absolute risk/reward equation is very favourable. Then I try to assess the probability for an appropriate “economic and financial background” to unfold to justify buying, selling or shorting the thing and in what quantities.

The truth is that valuation is a more exact science than economic and financial forecasting. The risk (i.e. the probability), and consequences, of being wrong on a very attractively valued security are not big if the economy goes against your forecast. The value is there and time is on your side. In effect, you may end up being too early, but if the value calculation is well done, you have a sound investment and not a torpedo.

However, if you primarily invest based on expectations of a positively developing “story”, like most strategists and analysts suggest, the risk and consequences of being wrong are significant if you were not careful and disciplined on valuation. The “story” risk is always greater than the “valuation” risk if you spend enough quality time on the latter.

Since early 2009, even though the investment background (the story) was complex, murky and volatile, equity values were such that being long U.S. equities was generally a good risk/reward proposition. In fact, the complexity of the story helped as it kept investors wary, and valuations low, while earnings cyclically recovered. As a result, with the exception of two periods when equities came close to “fair value” (springs of 2010 and 2011), the valuation risk was low enough to justify staying long equities even if the background was almost unreadable.

In March 2013, I flagged a yellow light on equities because valuation was no longer attractive enough to fully offset the risk associated with the continued complexity of the story while earnings were stalling. After three great years, it seemed prudent to manage the equity exposure which meant, for me, to reduce straight equities, increase the emphasis on revenue (high dividend payers, good quality preferred shares) and improve overall portfolio quality. Since valuation was not outstanding, prudence was required at least until earnings would begin to display a clear upside pattern. Here’s how I phrased it in February 2013:

Much like a windless sailboat seeking strong currents to move along, equity markets now need higher multiples to advance, a bigger bet than when earnings are fuelling the engine.

And higher multiples we got, courtesy of the world central bankers. Trailing P/Es rose from 14.4 in December 2012 to their current 17.2, 25% above the historical median (and average) of 13.8. Trailing P/Es rarely rise above 20 (click on charts to enlarge).

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Two other important benchmarks are also at or near their highs.

The Price to Sales ratio for the median Morningstar/CPMS database of 2185 stocks is at a 20-year peak and the gap between the median P/S and profit margins is nearly as wide as it was in 2007, suggesting that expectations are for a continuation of record high margins (see below on margins). Keep in mind that “sales” are barely growing, meaning that the denominator offers little upside to the P/S ratio.

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The next chart looks at balance sheet values. It plots the Price/Book Value against the ROE for the median company in the CPMS universe.

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The median P/B is near its 20 year high but this is not supported by the eroding ROE (return on book value), unless you want to buy forecasts for 2014 which see ROEs jumping 200 bps to 12.8% (red dot), a rather heroic assumption in today’s environment.

Finally, the dependable Rule of 20 valuation tool currently stands at 18.9 (17.2 + 1.7% inflation), a mere 6% below fair value. Investor enthusiasm has often lifted the ratio to the 23-24 range but not during the present cycle when 19-20 has been a strong barrier.

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As of October 31, 356 company had reported their Q3 results. The beat rate rose to 69% from 67% the previous week. Factset calculates that

In aggregate, companies are reporting earnings that are 1.4% above expectations. Over the last four quarters on average, actual earnings have surpassed estimates by 3.7%. Over the past four years on average, actual earnings have surpassed estimates by 6.5%. If 1.4% is the final surprise percentage for the quarter, it will mark the lowest surprise percentage since Q4 2008 (-62%).

Q3 earnings are now expected at $26.77, down from $26.94 the previous week and $26.81 on Sept. 30.

At this stage of Q3 2013 earnings season, 79 companies in the index have issued EPS guidance for the fourth quarter. Of these 79 companies, 66 have issued negative EPS guidance and 13 have issued positive EPS guidance. Thus, the percentage of companies issuing negative EPS guidance to date for the fourth quarter is 84% (66 out of 79). This percentage is well above the 5-year average of 63%.

But the average of the last 3 quarters is 79.5% at the same stage, not terribly different.

Q4 estimates keep being tweaked downward. They are now $28.38 compared with $28.52 on Oct. 24 and $28.89 on Sept. 30. Nothing major, so far. In fact, according to Factset

the decline in the bottom-up EPS estimate recorded during the course of the first month (October) of the fourth quarter was lower than the trailing 1-year, 5-year, and 10-year averages.

The fact is that EPS growth has accelerated sharply from the 2% range in Q4’12 and Q1’13 to +8.7% in Q2’13 and +11.5% in Q3’13. Importantly, Q4’12 official S&P earnings were negatively impacted by many companies boosting their pension fund expense which S&P rightly treated as operating costs (unlike many other aggregators). The fact that analysts are not meaningfully cutting their Q4 estimates at this stage could mean that companies are not inclined to repeat last year’s funding boosts. In particluar, Telecom profits were particularly depressed in Q4’12 and they are expected to bounce back this year, providing a big lift to total S&P 500 earnings.

On the other hand, Financials are currently expected to grow Q4 EPS by 25%, a big jump, especially considering that their Q3 EPS will be down 0.8%, contrary to expectations of +8.9% only one month ago.

Overall, there is some substance to Q4 earnings reaching the $26-27 range, +12-17% YoY. Trailing 4Q EPS would thus rise from $102.05 expected after Q3 to $105-106 after Q4. This is not insignificant, being a 6-7% sequential advance in trailing earnings since Q2’13 and a clear break out above $100.

The risk remains high on 2014 earnings as analysts continue to assume that margins will rise from 9.6% on average in 2013 to 10.3% in 2014 on a 4% gain in sales. It is not clear how sales growth would accelerate in the present economic context, it is even less clear why margins would start rising again when productivity has stalled, capacity utilization is not rising and the big windfall from low interest rates is behind us. image_thumb[9]

Another major uncertainty is the eventual impact of central bank experiments with QEs of all kinds. How they will end it and how it will end remain to be seen. In reality, we are all clearly in uncharted territory, nervously watching Fed officials blindly trying to find their ways out of their maze.

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Private employment keeps slowing in spite of the Fed’s extraordinary stimulation. The 3-month change in employment was 40% lower in September than it was in April, right when the Fed began mumbling about tapering!

And as soon as the taper balloon was launched, fixed income markets reacted, mortgage rates jumped 120bps and the long awaited and much needed housing recovery stalled (Facts & Trends: U.S. Housing A House Of Cards?).

The only obvious Fed success is the rise in equity prices during the past year when earnings stalled. The intended wealth effect may have boosted consumer spending by the wealthiest Americans but that effect is obviously waning seriously, just as we approach the all important holidays period.

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In September 2012, I wrote What If the Fed Has It All Wrong?, arguing that QEs would be inefficient:

The problem with Bernanke’s wealth effect thesis lies with the new reality in America. Income and assets have lately been so significantly redistributed that only a tiny few actually feel a wealth effect from rising equity prices. (…)

Keep in mind that it is these wealthy people who run American corporations, keeping them lean and mean and flush with cash. They remember how profits literally disappeared in 18 months in 2007-08. They remember how financial markets totally froze in 2008. They see the humongous budget deficits and the debt piling on, and the not-so-distant day of reckoning. They realize that all the QEs in the world can’t offset inept and irresponsible politicians on either side of the Atlantic. Yet, they are the ones targeted by the so-called wealth effect!

Lacy Hunt (Federal Reserve Policy Failures Are Mounting) offers another angle:

Perversely, (…) a rise in stock prices generated by excess reserves may sap, rather than supply, funds needed for economic growth.

It is difficult to determine for sure whether funds are being sapped, but one visible piece of evidence confirms that this is the case: the unprecedented downward trend in the money multiplier.

The money multiplier is the link between the monetary base (high-powered money) and the money supply (M2); it is calculated by dividing the base into M2. Today the monetary base is $3.5 trillion, and M2 stands at $10.8 trillion. The money multiplier is 3.1. In 2008, prior to the Fed’s massive expansion of the monetary base, the money multiplier stood at 9.3, meaning that $1 of base supported $9.30 of M2.

If reserves created by LSAP were spreading throughout the economy in the traditional manner, the money multiplier should be more stable. However, if those reserves were essentially funding speculative activity, the money would remain with the large banks and the money multiplier would fall. This is the current condition.

The September 2013 level of 3.1 is the lowest in the entire 100-year history of the Federal Reserve. Until the last five years, the money multiplier never dropped below the old historical low of 4.5 reached in late 1940. Thus, LSAP may have produced the unintended consequence of actually reducing economic growth.

Stock market investors benefited, but this did not carry through to the broader economy. The net result is that LSAP worsened the gap between high- and low-income households. When policy makers try untested theories, risks are almost impossible to anticipate.

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To summarize, here’s where we are on valuations:

  • Absolute P/E ratios are clearly extended, being 25% above their long term median. They are nonetheless 16% below the rarely breached “20” level. 
  • The P/S ratio is at a 20-year high and expectations of higher margins are nothing but heroic.
  • The P/B ratio is also near its historical highs which is not validated by rising ROEs.
  • The Rule of 20 ratio is 18.9, also close to fair value.

Stretched as we are on valuations, we desperately need a great story.

Yet, investors seem to be merely pegging their hopes on the Fed staying put. To the point where bad economic news is good market news.

This is not a great story.

One, the story writer is blind. He is lost in his story. He is trying to find his way to the finish but he can’t even understand his own narrative. His friends are trying to help but each has his own version of the story with his own conflicting conclusion. A new writer is coming along, however. Is this the new J.K. Rowling of economics arriving with a magic wand that will eradicate all the Dark Wizards? Fantasize all you want, I am but a muggle when my own money is at stake.

Two, bad economic news can’t be good for very long. American consumers drive 70% of the economy. They are not driving blind, but most of them have little or no fuel to go anywhere. If they were to completely stall…

Three, the plot thickens and gets very muddy when politicians enter. So far, the Fed and the ECB have barely countered the ineptitude of politicians on both sides of the pond. Yet, they don’t understand that their backstop is full of holes and is all rusted. How long can it save them, … and us all?

As Ben Hunt wrote in Epsilon Theory: The Koan of Donald Rumsfeld, it is one thing to make decisions under risk, dealing with the known unknowns of the traditional economic and financial cycles. But it is something else to make decisions under uncertainty,

the unknown unknowns, where we have little sense of either the potential future states of the world or, obviously, the probability distributions associated with those unknown outcomes. This is the decision-making environment faced by a Stranger in a Strange Land, where traditional cause-and-effect is topsy-turvy and personal or institutional experience counts for little, where good news is really bad news and vice versa. Sound familiar?

Ben goes on:

We are enduring a world of massive uncertainty, which is not at all the same thing as a world of massive risk. We tend to use the terms “risk” and “uncertainty” interchangeably, and that may be okay for colloquial conversation. But it’s not okay for smart decision-making, whether the field is foreign policy or investment, because the process of rational decision-making under conditions of risk is very different from the process of rational decision-making under conditions of uncertainty. The concept of optimization is meaningful and precise in a world of risk; much less so in a world of uncertainty.

That’s because optimization is, by definition, an effort to maximize utility given a set of potential outcomes with known (or at least estimable) probability distributions. Optimization works whether you have a narrow range of probabilities or a wide range. But if you have no idea of the shape of underlying probabilities, it doesn’t work at all.

As a result, applying portfolio management, risk management, or asset allocation techniques developed as exercises in optimization – and that includes virtually every piece of analytical software on the market today – may be sub-optimal or downright dangerous in an uncertain market. That danger also includes virtually every quantitatively trained human analyst!

(…) We should be far less confident in our subjective assignment of probabilities to future states of the world, with far broader margins of error in those subjective evaluations than we would use in more “normal” times.  (…)

Ben Hunt is totally right. We are all, in fact, blind investors hoping that our blind leaders, clueless as to where we are in the “cycle”, will shortly safely guide us to some unknown promised land that remains to be landscaped by the never tried before QE experiments.

YELLOW OR RED LIGHT ON EQUITIES?

The fault lines may be invisible and undefined but they are very present. However, I may be blind but I am not seeing a blind thrust striking in the near future.

We should flee equities when a recession and/or a bear market are looming. In spite of all the uncertainties discussed above, there are no signs of a recession in the U.S. As to the bear market risk, while earnings growth could disappoint, an outright decline is not apparent at this time. The main risk is valuation given that multiples of all kinds are in extended territory, although not in bubble area as many contend. Central bankers remain determined to keep the U.S. and the Eurozone economies growing, even if it is at very slow speed. The financial heroin will continue to flow.

The yellow light stays for now. I remain moderately invested although I keep managing my exposure down and my quality and liquidity up. From 1767 on the S&P 500 Index, the upside to the Rule of 20 fair P/E of 18.3 (20 – 1.7 inflation) is 1866, only 5.6% above current levels. Downside to the 200 day moving average (1626) is 8% but it is 13% to the average of the two Rule of 20 corrections of 2010 and 2011. In any cases, the risk/reward profile remains unattractive. That is unless one wants to bet on an overshooting. No blind thrust, and no blind trust either.

 
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2 thoughts on “BLIND THRUST

  1. Hi Denis – thank you for your valuable insights and analysis – as usual :-) I am glad I am not the only one who is ‘dazed and confused’ right now. It is a very tough time to invest and I was reviewing my portfolio yesterday and also just finished Mauldin’s latest book. Your comments helped me a lot.

    Thank you again.

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