There is no better title than Josh Brown’s post title of January 12 to express the capitulation of the CAPE Ratio (Shiller P/E) advocates.

When I wrote QUIBBLES on January 7, I was not aware that John Hussman was in fact reacting to a December 2013 post in Philosophical Economics. Josh Brown explains:

Over the last few months, there’s been a radical rethinking of the utility of CAPE and a huge battle has been taking place in the financial blogosphere as a result, sucking in nearly every thought leader and serious investment writer in the process. Jesse Livermore, a pseudonymous blogger writing at Philosophical Economics, has really blown the debate wide open, beginning with what I consider to be one of the most notable financial blogposts of 2013 (see Fixing the Shiller CAPE from December 13th).

Nobody should be surprised that after having totally missed the fourth longest and fifth most powerful bull market of the last 100 years, the bears draped into professor Shiller’s CAPE would decide to do a more thorough inspection of the fabric that made them so comfortable and confident during the past several years but which is making them feel totally naked now. Analytical help is also coming from many sources which, now that the evidence is so clear, are coming out of the closets to expose to the world the hidden flaws of the CAPE approach.

These are much more than mere quibbles.

Too bad for all the investors who missed this generational bull because of religious beliefs of these well mediatized disciples. Religions can often blind the smartest people, making them so confident that they possess the Truth that they see no reason to dig below the  surface to better understand the inner workings of their formula.

I don’t agree with each and every specific “flaws” now attributed to the CAPE, finding that the digging may be getting too “accountingly” complex. We should not get over-zealous and totally dismiss what is after all a valid valuation concept that may eventually, but not very soon, become useful again. I also don’t agree with al the ways and means by which the data could be “adjusted”. Once you take this path, there’s no ending.

The most important problems with the CAPE now being exposed are essentially the same one I have been mentioning for many years and detailed in my 2012 post The Shiller P/E: Alas, A Useless Friend:

  • “Reported earnings” are not as “pure” as people believe and are far from providing the long-term consistency that the CAPE advocates pretend.
  • Notwithstanding the above, one has to question the relevance of the CAPE considering that upon close analysis (some people finally objectively did this), its long-term helpfulness in investment decision making leaves a lot to be desired.

Funnily, another important flaw in the current readings of the CAPE remains elusive to everybody. It is important since it will impact the CAPE ratio for another 5 years. To repeat myself:

Many of the companies that recorded huge losses in 2008-09 either went bankrupt or were substantially restructured or acquired. As a result, a conceptually valid valuation method such as the Shiller PE, measuring 10-year average earnings against a current index, is thus including in its denominator, during 10 years, the huge losses recorded by companies that are no longer included in its numerator, these companies having in fact been replaced by other, profitable, companies.

Humongous or very large losses were recorded in 2008 by companies such as AIG, GM, Merrill Lynch, Marshall & Ilsley, MBIA, Wachovia, all companies then part of the S&P 500 Index but no longer. Their losses still impact the 10 year average earnings even though they have no contribution to the actual index value. The losers are long gone but their losses remain!

This is like assessing a baseball team’s current batting line-up using 10-year data that includes the dismal stats of now deceased players. How useful is that?

It will be very interesting to see how the exodus from CAPE town will impact demand for equities. Can we expect that investors who up to now religiously refused to sin will get back into equities as they undrape? Some wavering CAPE priests have been preparing their followers for their possible defrocking in the advent of a market correction. In fact, some have already capitulated, conveniently blaming the central banks for rendering their religious beliefs useless, possibly just as these turncoats’ own business began to be impacted by their unfortunate asset mix of the past 5 years.

Interestingly, as a result, a new wave of cash-rich equity investors could prevent the still useful Rule of 20 to correct as much as during the previous two major corrections since 2009 when the S&P 500 Index fell 13% (2010) and 15% (2011) as the Rule of 20 P/E failed to cross the 20 level and retreated back to 15-16. You might want to read TAPERING…EQUITIES before betting too much on this possibility.


Note: The link to Josh Brown’s post will lead you to several interesting articles on this fascinating matter if you have time for that.



This bull is getting old.

The answer is from The Short Side Of Long:

Stock Bull Market Length

Stock Bull Market GainsPunch The old bull in me is tiring. Time to taper…equities.

Hmmm, I hear you, yes, you may be right, the Fed is taking care of us this time with all this financial heroin. And, yes, Super Mario will do whatever it takes and Abenomics are rewriting economic Japanese history.

Plus, the U.S. economy is clearly reaccelerating, inflation is minimal, we’re about to get Janet’s “new and improved” forward guidance, the GOP finally learned its lesson and President Obama’s golf game is improving by the day.

Blue skies forever!

I am only playing the odds here, not really knowing what markets will actually do in 2014. Honestly, that’s all one can do, no?

  • Ok, let’s be objective here: we are into the fourth longest bull market since the Great Depression. The only three bulls that lasted longer ended in a speculative frenzy that eventually led to a catastrophe for their riders.
  • The only thing blue skies tell me is that it would be nice going out, walking, golfing, fishing, hiking…Investment wise, blue skies are no reason to buy, or sell. If anything, if the skies are so blue, then everybody must feel great. The contrarian in me does not really like that.
  • Trying to find a positive narrative, I looked at each previous market peak and I could not find any combination of GDP, inflation or profit trends that could signal anything in a consistent manner. Equities have peaked in any kind of trends, positive, negative or flat.


  • The only consistency is the Rule of 20 valuation, currently at 19.7, when the average at the 16 previous market peaks was 21.7. Excluding the two internet bubble peak readings of 1998 (27.1) and 1998 (27.1), the average is 20.7 and the median 21.5. Charts of the actual P/E on trailing EPS and of the Shiller P/E at market peaks are provided below for those who care.

image_thumb[32] image_thumb[33]

Not a bear, but an old bull that feels the need to be careful for a while. Let’s see how Q4 earnings stand and what kind of guidance we get. Let’s see how corporate inventories finished the year. Let’s see how inflation behaves and how interest rates trend.


Better be safe than sorry!



The Q3 earnings season is now behind us. S&P calculates the beat rate at 66% and the miss rate at 23%. However, only Health Care (73%) and IT (83%) truly beat the average. In fact, 7 of the 10 S&P sectors came in below the average beat rate. Excluding Health Care and IT, the beat rate is 62% and the miss rate is 27%. On that basis, the Q3’13 earnings season looks rather uninspiring.

Factset suggests that companies have nearly exhausted their ability to surprise us:

In aggregate, companies are reporting earnings that are 1.7% 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%.

imageBut overall results are in fact pretty good. Quarterly earnings totalled $26.86, up 11.9% YoY, which brought trailing 12- month EPS to $102.14, finally breaking the $$98-99 range of the previous 6 quarters.

Revenues grew 4.2% YoY while margins rose from 8.92% in Q3’12 to 9.58% last quarter, just shy of the Q3’06 record of 9.60%, thanks primarily to large jumps in margins at Financials (+2.7%), IT (+1.8%), Telecoms (+1.4%) and Utilities (+1.2%). Notice that the more economy-sensitive sectors did not enjoy higher margins last quarter.

Q4 estimates are now $28.08, a 21% YoY increase against a quarter which included charges related to unfunded pension liabilities. Estimates continue to trickle down but at a very slow pace, even after the end of the Q3 season and all the conference calls. Yet, Factset warns that

(…) 101 companies in the index have issued EPS guidance for the fourth quarter. Of these 101 companies, 89 have issued negative EPS guidance and 12 have issued positive EPS guidance. Thus, the percentage of companies issuing negative EPS guidance to date for the fourth quarter is 88%. This percentage is well above the 5-year average of 63%.

One of the reasons for the high percentage of negative EPS guidance is the unusually low number of companies issuing positive EPS guidance. Over the past four quarters (Q412 – Q313), 86 companies on average have issued negative EPS guidance and 26 companies on average have issued positive EPS guidance. Thus, the number of companies issuing negative EPS guidance for Q4 is up only 3% compared to the one-year average, while the number of companies issuing positive EPS guidance for Q4 is down 54% compared to the one-year average.

While 20% of S&P 500 companies have issued negative guidance for Q4, that ratio jumps to 38% for IT and 24% for Consumer Discretionary companies.

This corporate cautiousness has not (yet) transpired into more cautious analyst estimates. In fact, analysts continue to forecast sharply rising margins throughout 2014 as this Factset chart reveals:


Morgan Stanley illustrates the apparent exuberance with this chart (via ZeroHedge):

Is this realistic or pure wishful thinking?

Thomson Reuters provides useful insight in this debate (my emphasis):

(…) looking at growth in net income shows the increase in the profits of a company as a whole, which is not affected by share repurchases. The difference between EPS growth and net income growth is the result of changing share counts. For the third quarter, net income growth for the S&P 500 is 3.5%, more than two percentage points below the EPS growth rate of 5.7%, meaning that declining share counts have boosted earnings growth. As Exhibit 1 shows, lower share counts have boosted earnings per share growth in the index as a whole, and in each sector except for utilities.

Exhibit 1. S&P 500 Q3 2013 Growth Estimates: Net Income and Share-Weighted Earnings
Source: Thomson Reuters I/B/E/S

Exhibit 2 depicts the components of share-weighted earnings growth. The revenue growth component shows what portion of earnings growth is due to top-line growth of the business, assuming constant profit margins. The benefit from share repurchases, discussed above, represents the part of earnings growth due to changes in share count. The remainder, other factors, includes any other reasons for higher earnings growth, such as operating leverage, efficiency improvements and cost-cutting.

For the third quarter, this segment is small, with only 0.3% coming from other factors, meaning that the 5.7% earnings growth is primarily due to top-line growth and share repurchases, with minimal help from cost-cutting.

Exhibit 2. S&P 500 Components of Earnings per Share Growth

ER_1125_chart2Source: Thomson Reuters I/B/E/S

Looking ahead to Q4, analysts expect revenue growth of only 0.6%, while earnings are expected to increase 8.1%. With a 1.9% expected boost from share repurchases, current earnings estimates are implying large increases in other factors. This means that companies are either going to realize far more efficiencies than they did this quarter, or that current earnings estimates are too optimistic.

Margins don’t simply fluctuate randomly. Scotia Capital uses capacity utilization as a proxy for corporate margins. This sure get the trends right but margins have recently exceeded the level suggested by capacity utilization, most likely due to labour cost controls.


SoGen’s Albert Edwards has another sensible approach, plotting unit labour costs against corporate output prices, a proxy for selling prices, which suggests that the tight labour cost control era is near its end and that margins are currently getting pressured by slow revenue growth, validating Thomson Reuters’ earlier comments (chart via ZeroHedge):


Zacks Research shows that Q4’13 downward estimates revisions have in fact accelerated lately.


Using S&P data, trailing 4Q EPS should grow from their current $102.14 to $107.07 after Q4’14, a 4.8% QoQ improvement and an acceleration from the 2.9% gain after Q3’13. The margins risk lies mainly with 2014 estimates when analysts are forecasting margins rising a large 0.9% to a record 10.4% by Q4’14.

Such a rise in such a short period would be truly outstanding and I would not bet on it. Neither, however, would I want to bet on a meaningful decline in margins as many bears are loudly suggesting based on the irresistible mean-reversion phenomenon. I have posted last June on profit margins (Margins Calls Can Be Ruinous In Many Ways), warning that avoiding equities on the basis of an expected collapse in margins was not sensible in the current environment.

In brief, arguing that margins are historically high and assuming they will necessarily mean revert appear to be too simplistic analysis, at least until we begin to see a real trend toward tax rates normalization across the world.

The reality is that the S&P 500 is no longer a direct reflection of the U.S. economy but rather a global index. Currently, 45% of its revenues are recorded abroad, a proportion that has been rising over time. Foreign revenues seem to attract higher margins and one of the main reasons for that is lower foreign tax rates.

Warren Buffett’s 6% peak margin may be an appropriate benchmark for domestic profits but American corporations have shifted a meaningful part of their profits to lower tax jurisdictions in the past 2 decades. ISI calculates that there are 135 S&P companies where the foreign effective tax rate was less than 20% in 2012 (52% of which were in the Tech and Health Care sectors) and that the effective tax rate on the foreign earnings of S&P 500 companies was 25% in 2012, down significantly from 29% in 2008 and substantially lower than the 35% U.S. statutory rate.

Unsurprisingly, Heath Care and IT companies enjoy the lowest foreign tax rates. According to ISI, these two sectors have seen their foreign tax rate drop from 21% to 12% for Health Care and from 28% to 10% for IT since 2003. These two sectors account for nearly 33% of the S&P 500 capitalization, up from 13% twenty years ago, greatly contributing to the rise in aggregate S&P 500 profit margins. Will foreign margins mean-revert anytime soon?

On November 19, Senate Finance Committee Chairman Max Baucus tabled a proposal to overhaul the U.S. tax system.

The LIFT America Coalition, which includes major technology, pharmaceutical and consumer-products firms, termed some aspects “punitive against globally engaged American headquartered companies.”

Other U.S. firms, particularly those with a domestic focus that worry more about the high U.S. corporate-tax rate, cheered the proposal as a needed step. The RATE Coalition, which includes major retail, defense and telecommunications firms, said “we welcome a process that leads toward…comprehensive tax reform that will encourage economic growth and create jobs for American workers.”

The “LIFT RATE” (!) coalitions not seeing eye to eye on this major issue, it seems highly unlikely that anything major will be done in 2014, at the earliest.

The Baucus plan would impose a temporary corporate tax on that money at a rate of up to 20%, below the current 35% top rate. That would raise more than $200 billion for the government. Next, the plan would begin moving the U.S. to a system that would no longer seek to impose U.S. tax on some types of overseas income. That would put the U.S. closer to the mainstream of developed nations.

The back-and-forth underscored how tricky it will be to reach consensus even among big businesses on overhauling the U.S. tax system. Domestic firms care more about the posted corporate-tax rate while multinationals care more about what the world-wide tax system would look like. (WSJ)

So, don’t hold your breadth! And don’t expect a substantial decline in profit margins any time soon, unless the U.S. economy enters in recession (chart below from Doug Short). Given the Fed’s determination to keep the financial heroin flowing and the absence of any significant warning signs of an approaching recession, it seems sensible to stay cool on profit margins for a while longer.


The Rule of 20 suggests that fair value on the S&P 500 Index is 1869, a mere 3% above current levels. Since 1956, the Rule of 20 P/E (actual P/E + inflation) has gone through the 20 fair value level 9 out of the 13 times it rose to “20”. Another way to look at it is to say that every time the Rule of 20 P/E rose to “20”, it kept rising into the “higher risk” area except between 1963 and 1966 and since 2009.


Between 1963 and 1966, equity markets rose in sync with earnings while inflation remained stuck between 1% and 2%. Equities subsequently quickly lost 17% when inflation spiked from 2% to 3.6% in less than 9 months.

Since 2009, traumatized investors refused to get carried away, nervous and uncertain as they were about the world economy, U.S. politics and Fed behaviour, all these fears being amplified by generally negative media narratives.

Little has really changed other than the capitulation of most of the bears as the most recent equity rally silenced most of them and revived greed instincts supposedly extinct forever after the financial crisis. The last 55 years history suggests that the odds that equities will soon trade through fair value into the “rising risk” (yellow) area are 69% (9/13). A rise to the yellow-red boundary (Rule of 20 P/E of 22) would take the S&P 500 Index to 2070 (trailing EPS of $102 and inflation of 1.7%= P/E of 20.3), 14% above current levels. If trailing EPS reach $107 by March 2014, fair value would rise to 2172, 20% higher than the current 8010 level.

The downside can be assessed in two ways:

  1. Investor confidence disappears for some reason and the Rule of 20 P/E drops to the 16-17 lows seen in the past 4 years. The S&P 500 Index could thus drop 15-20% to the 1500 range.
  2. Markets simply “technically correct” to either their 100-day moving average (-5.5% to 1710) or their 200-day m.a. (-8.8% to 1650). The former light correction occurred in June, August and October 2013. The latter more brutal correction was experienced in November and December 2012. Importantly, both moving averages are still rising smartly, implying that this technical downside risk diminishes with time.

The best that could happen is a repeat of the 1963-66 ride along fair value. Earnings would keep rising but the remaining mean-reverters and Shiller P/E fans (The Shiller P/E: Alas, A Useless Friend) would keep fear high enough to prevent equity markets from getting overvalued.

In all, this is the objective, measured and dispassionate risk/reward lay of the land:

  • Current fair value is 1869, only 3% above current levels. By March, assuming inflation stays at 1.7%, rising trailing earnings would boost fair value to 1960, 8% above current levels.
  • With 70% odds of equities selling through fair value, upside rises to 2070-2172 by March, +14-20% or 10-14% risk-adjusted.
  • Technical downside is 5-10% but resumption of fear could set us back 15-20%.

Equity investors are about to enter the dark side where the tilt is gradually getting unbalanced towards higher risk. The Force, energized by greed instincts and the Fed’s ZIRP, will suck increasingly hard at the Jedi within each of us. The latest II survey shows the extent of the decimation of the Ursid specie by the bulls. Bears may not be the most popular but, when in sufficient quantity, they serve to keep us away from the dark side. Beware Luke Skywalker, you could lose your hand, even worse, an arm and a leg.




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).


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.


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.


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.


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.


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.


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.


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.


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.


NEW$ & VIEW$ (24 OCTOBER 2013)

Japan says exports almost flat as shipments to Asia slow down

Japan’s government downgraded its assessment of export performance for the second consecutive month in October on slowing shipments to Asia — suggesting external demand may now contribute less to Japan’s growth than initially anticipated.

The government left its overall assessment unchanged, saying the economy is set to recover at a moderate rate as high corporate profits fuel capital expenditure, which then spurs labor demand.

Domestic demand, boosted by increasing public works and consumer spending, has largely driven Japan’s recovery from recession last year, but signs of weakening exports may mean Japan having to rely even more on domestic demand to continue growing.

“Exports are almost flat,” the government said in its report for October. “Exports are expected to pick up in the future, because overseas economies are stable and because the yen has weakened, but we must be mindful of downside risks to overseas economies.”

That assessment marked a further downgrade from last month, when the government noted recent gains in exports had started to slow.

It was also the first time in three years that the government downgraded exports for two consecutive months.

A decline in export volumes due to lower shipments of cars to the United States, India and Southeast Asian countries prompted the downgrade in October.

The government left unchanged its view that industrial output is slowly increasing and that business investment is showing signs of picking up — mainly among non-manufacturers.

On deflation, the government’s view was unchanged from September, saying Japan is approaching an end to deflation as consumer prices, excluding fresh food and energy, were firming up.

LA area Port Traffic in September

On a rolling 12 month basis, inbound traffic was up 0.4% in September compared to the rolling 12 months ending in August.   Outbound traffic decreased slightly compared to August.


Showing a steady increase in the demand for design services, the Architecture Billings Index (ABI) continues to accelerate, as it reached its second highest level of the year. As a leading economic indicator of construction activity, the ABI reflects the approximate nine to twelve month lead time between architecture billings and construction spending.

The American Institute of Architects (AIA) reported the September ABI score was 54.3, up from a mark of 53.8 in August. This score reflects an increase in design services (any score above 50 indicates an increase in billings). The new projects inquiry index was 58.6, down from the reading of 63.0 the previous month.

Bank of Canada Drops Bias to Lift 1% Policy Rate

Bank of Canada Governor Stephen Poloz surprised investors by dropping language about the need for future interest rate increases, a move that’s leading to investor speculation about possible rate cuts.

Poloz removed the language, which had been in place for more than a year, citing greater slack in the economy, while keeping his benchmark rate on overnight loans between commercial banks at 1 percent for the 25th consecutive meeting today. The country’s currency and government bond yields fell after the announcement.

The Canadian dollar fell 1 percent to C$1.0385 per U.S. dollar at 4:16 p.m. in Toronto. One dollar buys 96.29 U.S. cents. Government bond yields fell, with the five-year security declining to 1.73 percent from 1.79 percent. (Chart from BMO Capital)



U.S. Equities: Lift-Off

The short-term resolution to Washington’s folly ignited stocks last week, kicking off what looks to be an equity overshoot phase. Even a soft earnings season is unlikely to derail the budding positive momentum in the broad market: investors may award a ‘free pass’ to the business sector, as uncertainty and modest order book softness is expected given the U.S. government shenanigans.US Equitites - Lift Off

More importantly, lost in the shuffle has been the simultaneous easing in three main reflationary variables.

  • First, the U.S. dollar is drifting lower, reflecting the official nomination of noted policy dove Janet Yellen as the new Fed Chairperson, and the expectation that liquidity settings will remain extremely generous.
  • Second, Treasury yields are moving sideways, digesting this year’s rapid advance. Prospects for another budget battle in the coming months suggest that the Fed may well delay tapering further. Thus, another sudden surge in yields is not imminent.
  • Third, oil prices are easing, reducing a drain on global consumer and business purchasing power, especially in the developing world where weak currencies have exacerbated the impact.

The reflationary push from these three natural economic stabilizers will add to the positive economic momentum that has been slowly but steadily building all year. Our profit model has hooked back up, and capital spending indicators are accelerating, implying that the transition to a self-reinforcing economic expansion remains intact. With reduced fiscal drag next year, growth could surprise on the strong side.

That said:


The Rule of 20 valuation barometer is approaching “fair value” which it has not exceeded during his bull market. The risk return ratio is getting unfavourable to investors based on trailing earnings and inflation. Equities do occasionally reach into overvalued territory and sometimes pretty high into it and for extended periods (click on charts to enlarge).


The Rule of 20 is not a forecasting tool, it is a risk measurement tool enabling investors to objectively measure the potential reward vs the risk of owning equities at any point in time.

Other than the Rule of 20, I also look at some basic absolute valuation parameters on U.S equities. CPMS is a Morningstar software that I have profitably been using since 1985. The charts are not fancy but the data is reliable. The first chart plots Price/Sales for the median U.S. company in the CPMS database (2185 stocks) against net profit margins on the CPMS median.


The median P/S is at its 20 year peak but so is the median profit margin. The gap between both lines is nearly as wide as it was in 2007, suggesting that expectations are for a continuation of record high margins. In fact, the red dot on the top right corner is the bottom up forecast for margins in 2014, a jump from 8.2% to 10%. Obvious irrational exuberance. Keep in mind that “sales” are barely growing, meaning that the denominator offers little upside to the P/S ratio.

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


The median P/B is near its 20 year high but this is not supported by the median ROE, unless you want to buy analyst forecasts for 2014 which see ROEs jumping 200 bps to 12.8% (red dot), a rather heroic achievement in today’s environment. Note that the median ROE has been declining steadily since early 2012!

This is not my definition of “Buy low, sell high”. We are clearly defying gravity here. How lucky to you feel?


We now have 181 companies representing 42% of the S&P 500 Index having reported so far. The earnings beat rate is now 61% (56% yesterday) while the revenue beat rate is 28% (unchanged from yesterday) as per RBC Capital’s calculations.


Reset Switch: Is the Can Coming to the End of the Road?

From The Institutional Risk Analyst:

We invented an early warning operating bank stress indicator (BSI) in 2004 that was based on what were then the optimistic visions of Basel II and the global economy. (…)

We tracked the comings and goings the U.S. banking industry through the 2008 crisis and subsequent recovery. We started giving speaker presentations on the journey this systemic stress showing how as a whole, the banking industry population today has a stress profile similar to where it was just prior to the 2008 crisis. (…)

Since the beginning of 2013, we’ve seen a number of banks drop from what were steadily improving BSI scores in the A to A+ range back down to F’s. The subset of the population doing this is small but statistically significant enough to warrant us putting the pattern into exception analysis follow up. What reveals so far is that the time has come to recognize asset value degradations.

Some banks look to have carried loans at book value hoping that the economy would improve substantially before rules on revaluation triggered and the clock seems to have run out on the bet. Aggregate 1-4 residential lending on bank balance sheets is still around 14 percent below a beginning of 2008 baseline and current property valuations dictate that the write down process needs to begin recognition. Similar stresses also seem to be manifesting in some banks’ commercial real estate lending books.

(…)  From years of observation, we note that banks typically do their write downs as part of their 4th quarter end of year filings. At the moment we do expect most will survive the pain but do worry a little that the regulatory and counterparty burden on what will be materially weaker institutions could cause secondary effects to a still jittery market. (…)


NEW$ & VIEW$ (21 OCTOBER 2013)

Today: update on earnings and market valuation.

Euro Zone May Not Have Emerged from Recession

An influential group of European economists that calls periods of expansion and recession said Friday it is too early to declare that the euro zone has emerged from recession, and the single-currency area’s return to growth in the second quarter may prove temporary.

The Centre for Economic Policy Research, a network of more than 700 economists primarily based in European universities, dates periods of expansion and recession. Its Euro Area Business Cycle Dating Committee provides judgments on the currency area’s entry into and emergence from recession that is independent of policy makers in much the same way as the National Bureau of Economic Research’s Business Cycle Dating Committee in the U.S. (…)

“While it is possible that the recession ended, neither the length nor the strength of the recovery is sufficient, as of 9 October 2013, to declare that the euro area has come out of recession,” the committee said. (…)


Cheap U.S. Gas Attracts Norway Interest

Norwegian fertilizer producer Yara International said it and BASF would decide next summer whether to build a world-scale ammonia plant along the U.S. Gulf Coast, a potential $1 billion investment.

(…) “If you look at the U.S. now, the cheapest area to construct something in is actually the Gulf [Coast]. If you get up in the middle of the Bakken [Shale] area, there is a peak, and farther north, in Canada, [costs are] even higher,” Mr. Haslestad said.

Yara recently postponed expansion plans at its Canadian Belle Plaine plant due to rising construction costs. The Regina, Saskatchewan, plant has a capacity of 700,000 tons of ammonia, as well as 1.2 million tons of urea and urea ammonium nitrate a year.

Construction costs are higher in Canada than along the U.S. Gulf Coast partly due to less competition, cold weather, and a lack of infrastructure, Mr. Haslestad said.

The U.S. has a huge potential to establish more chemical plants amid low energy prices, Mr. Haslestad said, while in Europe high energy prices prevent companies from investing in activity that would create jobs. (…)



Top Bear’s Bullish Tilt Has Followers Growling

One of Wall Street’s leading bears has turned more bullish, riling some longtime clients. (…)

Lately, though, Mr. Rosenberg has changed his tune, a rare turn for a Wall Street strategist with a large following and a high-profile market stance. This past spring, he upgraded his outlook for the U.S. economy, urging investors to buy more stocks and dump Treasury bonds, citing an improving labor market, among other things. (…)

Mr. Rosenberg hardly has been telling investors to bet it all on stocks. He simply has toned down his usual caution, recommending that investors put just over half of their portfolios in stocks, up from about 35% in early 2012, while urging them to flee from bonds, which usually do well in difficult times.

Mr. Rosenberg switched to the more-bullish camp this year after he saw unemployment dropping, detected early signs of wage inflation and observed more workers leaving the workforce for reasons beyond their frustration over job prospects. He also viewed deflation as no longer a concern, as the Federal Reserve aggressively eased policy, and saw other signs of economic improvement for the U.S. (…)

Fiscal Crisis Leaves Stocks in a Sweet Spot

Despite the market disruptions Washington’s mess caused over the past few weeks, analysts who have studied past market behavior say that the current backdrop—moderate economic growth with low inflation and strong central-bank backing—is excellent for stocks.

(…) ‪Analysts who have studied past market behavior say that backdrop—moderate economic growth with low inflation and strong central-bank backing—is excellent for stocks. That may help explain why financial markets remained fairly calm throughout the crisis and how the S&P 500 stock index finished Friday at 1744.50, a record high. The S&P 500 is up 22.3% this year.

“This is the best environment for stocks right now. You don’t have rising interest rates becoming a problem. You don’t have inflationary pressures. You do have earnings growth,” said Tim Hayes, chief global investment strategist at Ned Davis Research in Venice, Fla. ‪The firm has studied stock performance in a wide variety of economic environments going back decades.

Stocks also do better when earnings growth is below 5% on a year-over-year basis than when it is above 5%, according to the Ned Davis studies. That is because moderate earnings growth is less likely to spur inflation or push interest rates higher.

‪Another big boost for stocks is the growing hope that low inflation and worries about economic growth will induce the Federal Reserve to keep stimulating the economy by holding down long-term interest rates. (…)

Fed stimulus helps stocks because low interest rates hold down corporate costs, and the stimulus money itself leaks into the stock market, fueling investment there. (…)

A big question for the future, he said, is how and when central banks around the world unwind their financial stimulus. ‪Mr. Hayes thinks how that is handled could determine when stocks next face a bear market, most commonly defined as a 20% decline from a high. ‪While he is optimistic about the immediate future, he said he wouldn’t be surprised to see stocks pull back by next summer.

Such a decline is common after stocks have risen strongly for years, Mr. Hayes said. That is especially true when stock prices are above average when compared to corporate earnings, as they are today. The S&P 500 trades at more than 18 times its component companies’ earnings for the past 12 months, above the historical average of about 16. ‪(…)

Earnings and inflation, that’s the recipe.


A quarter of the way into the Q3 earnings season, many aggregators have released their tally. Remember that there is no “common consensus estimate” and no unique way to assess earnings among aggregators so that beat rates, as well as growth rates, can vary. I try to compare beat rates against each aggregator’s own history. S&P remains the official data provider, giving both operating and “as reported” earnings in a consistent manner..

It is interesting to note that the narratives during this earnings season are clearly tilting on the negative side (my emphasis).

We’re now a week and a half into earnings season, and 190 US companies have reported their third quarter numbers so far.  By the end of earnings season, more than 2,000 companies will have reported, so we’re still in the very early stages of this quarter’s reporting period.

Below is a look at the historical earnings beat rate for US stocks by quarter since 2001.  As shown, 60.5% of the companies that have reported so far this season have beaten consensus analyst EPS estimates.  This is a mediocre reading compared to the average beat rate of 63% that we’ve seen since the bull market began in March 2009.

Top-line numbers have also been mediocre so far this season.  As shown below, 50.9% of the companies that have reported have beaten revenue estimates, which is 9 percentage points below the average of 60% that we’ve seen since the bull market began.

The picture emerging from the 2013 Q3 earnings season is far from inspiring or reassuring. There hasn’t been much growth in recent quarters and not much was expected from Q3 either, particularly after the sharp estimate cuts in the run up to the reporting season. But companies are struggling with meeting and exceeding even those lowered expectations.

Total earnings for the 99 S&P 500 companies that have reported results already, as of Friday October 18th, are up +1.0% from the same period last year, with 62.6% beating earnings expectations with a median surprise of +2.1%. Total revenues for these companies are up +2.1%, with 43.4% beating revenue expectations with a median surprise of +0.0%.

All of the growth is coming from the Finance sector. Excluding Finance, total earnings growth for the companies that have reported falls in the negative category – down -6.2%. This is a weaker performance than what we have seen from the same group of companies in Q2 and the 4-quarter average.

Total Q3 earnings for all S&P 500 companies, combing the 99 that have reported with the 401 still to come, are expected to be up +0.2%, which reflects +0.8% revenue growth and modest gains in margins. Estimates have come down sharply over the last few months, with the current +0.2% growth down from +0.5% last week and +5.1% in early July.

  • S&P’s tally gives a 59% earnings beat rate and a 26% miss rate. Q3 estimates are currently $26.72, down $0.12 from Sept. 30. Q4 estimates dropped from $28.88 to 28.67.

Pointing up At about the same time during the Q2 earnings season, the beat rate on S&P’s tally was 63% and the miss rate 27.5%. All of the deterioration comes from Financials. At that time, the beat rate from Financials was 80% vs 63% this season. Non-Financials’ beat rate is about the same at 57%. Miss rates have been relatively high among Industrials (31%), Consumer Discretionary (36%) and Financials (33%).

Overall, 97 companies have reported earnings to date for the third quarter. Of these 97 companies, 69% have reported actual EPS above the mean EPS estimate and 31% have reported actual EPS below the mean EPS estimate. Over the past four quarters on average, 70% of companies have reported actual EPS above the mean EPS estimate. Over the past four years on average, 73% of companies have reported actual EPS above the mean EPS estimate.

In aggregate, companies are reporting earnings that are 2.3% below 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%.

In terms of revenues, 53% of companies have reported actual sales above estimated sales and 47% have reported actual sales below estimated sales. The percentage of companies beating sales estimates is above the percentage recorded over the last four quarters (48%), but below the average over the previous four years (59%).

In aggregate, companies are reporting sales that are 0.6% below expectations. Over the previous four quarters on average, actual sales have exceeded estimates by 0.4%. Over the previous four years on average, actual sales have exceeded estimates by 0.7%.

At this early stage of Q3 2013 earnings season, 18 companies in the index have issued EPS guidance for the fourth quarter. Of these 18 companies, 14 have issued negative EPS guidance and 4 have issued positive EPS guidance. Thus, the percentage of companies issuing negative EPS guidance to date for the fourth quarter is 78% (14 out of 18). This percentage is well above the 5-year average of 63%.

Using S&P’s numbers, trailing operating earnings are now expected at $102 after Q3, down 1% from what was expected on Sept. 30 and 1.6% from June 28. Nonetheless, trailing earnings would be 2.7% higher than their level after Q2 and cross the $98-99 wall that they have been hitting since March 2012.

imageThe next 2 weeks will be crucial for market sentiment, not only for Q3 results but importantly for company guidance into Q4 since estimates for the last quarter of 2013 have held up reasonably well so far. The current $28.67 estimate remains nearly 24% above Q4’12 ($23.15) which was impacted by big pension fund provisionings which S&P rightly treated as operating expenses but which is a highly discretionary management decision often made after yearend (see below).

If analysts are right, trailing 12-month EPS would jump to $107.52 after Q4, 8.3% above their level after Q2.

The chart below uses $102 as trailing EPS and 1.5% as trailing inflation. On these basis, the Rule of 20 P/E fair P/E of 18.5 means 1887 for the S&P 500 Index, 8% above its current level. We will get the September CPI on October 30.



Assuming Q4 estimates hold, the ensuing jump in trailing earnings would bring the Rule of 20 fair value to 1980 (+13.5%) if inflation stays at 1.5% (1926 at 2.0%). As I said, the next 2 weeks are crucial.

Pointing up BTW, from this weekend’s FT:

US corporate defined benefit pensions gain some lift

(…) Funding ratios for the 100 largest DB pension plans at US companies, which boast close to $1.4tn in combined assets, rose to an eye-catching 91.4 per cent last month, having climbed from just 74 per cent in September 2012, according to Milliman, the actuarial firm. The improvement was largely due to shifting projections for interest rates, changes in strategy and stronger investment returns.

It marks the highest funding ratio for US DB schemes since the collapse of Lehman Brothers in October 2008.

The improvement has mainly been driven by a rise in market interest rates. This has reduced the estimated value of pension scheme liabilities, as these liabilities can be discounted at a faster rate in the future.

This process may have further to run. Actuaries at Milliman forecast that pension managers at the aforementioned 100 US companies will see their funding ratios rise to an impressive 98.1 per cent by the close of next year. Their deficits should drop from $132bn at the end of September to as little as $29bn over the same period, Milliman predicts.

John Ehrhardt, a principal and consulting actuary at Milliman, explains: “As interest rates come up, it will reduce the cost of maintaining these plans.”

He adds: “If the Federal Reserve takes its foot off the floor on interest rates, rates could go up significantly.

Confused smile  What will happen to pension asset values when rates rise? Bond losses could far exceed past equity losses given current excessively low interest rates. And I am not so sure the pension funding problem is near the end:

(…) However, there are a number of corporate stalwarts in the US whose DB plans are still open to further accrual by existing members, such as Boeing (which has a pension funding ratio of roughly 74 per cent), General Electric (70.6 per cent), AT&T (76.5 per cent), Lockheed Martin (67.2 per cent), ExxonMobil (63.4 per cent), UPS (78.1 per cent), Pfizer (71.8 per cent), Johnson & Johnson (80.3 per cent) and Federal Express (78.1 per cent). (…)

And this from Pensions & Investments:

This slide lays out year by year the allocations to fixed income. Starting in 2008, you can see a dramatic change to fixed income by corporations. Numerous corporate plan sponsors now have allocations to fixed income of more than 75%. Intel’s DB plan, for example, has an 85% allocation to fixed income.

FIxed income allocations of corporate and public pension funds

Ford's asset allocation


S&P 500 funded status in $ bil.


Back to Financials:


Banks Facing Profit Squeeze

The nation’s biggest banks are getting squeezed from almost every direction, quarterly reports show, from slumping mortgage demand to a sluggish economy and tumultuous bond markets.

The 10 largest traditional commercial banks and securities firms in the U.S. that have reported earnings thus far posted a 6.9% decline in combined adjusted net income, to $17 billion. Adjusted revenue totaled $116 billion for the quarter, a 4.8% decrease from the same period in 2012. (…)


There are pockets of strength in the banking sector. Commercial real-estate loans are picking up, and consumer banking has been healthy. But plunging mortgage lending is weighing heavily on banks’ results. (…)

Among the six biggest banks and securities firms in the U.S., Morgan Stanley was the lone bright spot, in part because of its smaller fixed-income operation. It swung to a third-quarter profit, outpacing Goldman in total revenue for the first time in two years. (…)


Thomson Reuters writes:

Tracking the Top 50 Global Financials for our third consecutive quarter of TRust Index metrics, Q3 saw a continuation of several trends that we’ve been observing throughout 2013. According to our media sentiment analysis, trust in global financial institutions remains negative overall, but regional differences have shifted. For the first time since January, European financials have moved higher than US financials, while US financials have remained flat but have the lowest levels of confidence overall. Q3 data also shows the continued proliferation of regulatory activity, essentially double since the introduction of the Dodd-Frank Act.

Interesting, but my money would rather buy the view of Chuck Clough, CEO of Clough Capital Partners on European banks:

We think Europe’s banks are not as healthy as they claim to be. Many pledged much of their risk weighted assets as long-term refinancing operation collateral and the improvement in capital ratios is ephemeral in our opinion. Eventually these assets must be repurchased and that is the difference between what the European Central Bank (ECB) and the US Federal Reserve have done in efforts to resuscitate their respective banking systems.

Via the quantitative easing programs and troubled asset relief program the Fed outright purchased troubled assets. That passed the cost onto shareholders and taxpayers but cleared balance sheets so banks could renew lending. Nothing of the sort is happening in Europe. Europe’s banks still own the toxic assets they hypothecated with the ECB and time
worsens the state of those assets.

In an op-ed article in the Financial Times, Wolfgang Munchau cited a report which estimated that the size of any bad bank which might be set up to absorb losses would have to be capitalized at more than 1 trillion Euros (out of a total Euro bank balance sheet of 27 trillion Euros) and reportedly that does not include hidden losses from loans about to default but which were rewritten to make them good, the “pretend and extend” strategy. Even German banks are not free of issues since Germany’s
current account surplus has forced its banks to take on a lot of peripheral debt. Recapitalization will likely occur at much lower equity . If they are low enough we could be buyers.

Thomson Reuters continues:

image(…) the aggregate changes to recommendations over the quarter by sector analysts on the Top 50 Global Financial institutions show that downgrades outnumbered upgrades across all regions. While the Asian institutions scored the highest number of upgrades in Q2, these were outpaced by the number of downgrades in Q3 – again, increasing concerns about Chinese banks appears to be having a particularly strong influence.

This next comment was before the Q3 earnings season:

In Q3, earnings growth estimates for the U.S. Financials sector regained their top spot (having slipped to second in Q2) based on high expectations by analysts for financials. At 9%, earnings growth estimates for the sector are lower this quarter, but still well ahead of the other S&P 500 sectors.

And here’s Factset after 30% of S&P Financials have reported Q3 (including the largest ones):

The Financials sector has the second lowest earnings growth rate (-2.1%) of any sector. Four of the eight industries in the sector are reporting or are expected to report a decline in earnings for the quarter, led by the Diversified Financial Services (-32%) industry.

Factset drills down:

At the company level, Bank of America and Morgan Stanley are the not only the largest contributors to growth for the sector, but for the entire S&P 500 as well. Bank of America reported actual EPS of $0.20, relative to year-ago actual EPS of $0.00. Morgan Stanley reported actual EPS of $0.50, compared to year-ago actual EPS of -$0.55. If both of these companies are excluded from the index, the growth rate for the Financials sector would fall to -11.9%, while the growth rate for the S&P 500 would be -0.5%.

On the other hand, JPMorgan Chase is not only the largest detractor to growth for the sector, but for the entire S&P 500 as well. The company reported actual EPS of -$0.17, compared to year-ago actual EPS of $1.40. If this company is excluded from the index, the growth rate for the Financials sector would improve to 14.0%, while the growth rate for the S&P 500 would rise to 3.8%.

S&P differentiates between “operating” and “as reported” earnings. In JP Morgan’s case, S&P treated most of Q3’s “extraordinary costs” (mainly litigation expenses) as non-operating (or at least “non-recurring”, hopefully!). JPM’s Q3 “operating” EPS are thus $1.43 vs $1.41. Using only operating EPS, the 22 Financials that have reported Q3 so far are showing average EPS growth of 18.1%. But that is heavily influenced by BAC’s and SLM’s respective +211% and +87% jumps. The median growth rate is a more modest +4.1%, so far.

Finally, Thomson Reuters keeps track of regulatory activity worldwide:

The proliferation of regulatory activity over the past two years (and its clear implications for the financial sector in terms of managing compliance) can no longer be considered a post-crisis tsunami (which would imply a surge and then receding level) but must be seen as the growing and permanent conditions under which the global financial industry will rebuild.



expandBARRON’S COVER Return of the Bulls 

America’s money managers expect stocks to rise 7% from now through the middle of next year.

The managers’ subdued forecasts reflect the fact that 71% of poll participants now regard stocks as fairly valued, compared with 58% in the spring. Only 15% consider the U.S. market undervalued, down from 26% last April.

Just over half of the Big Money managers expect the price/earnings multiple to expand in the next 12 months, while 11% see a contraction, and the rest see no change.


71% say equities are fairly valued and 68% are bullish. Personally, I tend to be less bullish when stocks are fairly value.


52% expect higher P/Es.



Condos Go Back Up for Sale

Many condominium developers who rode out the real-estate downturn by renting out their units are reverting to for-sale housing, in another sign of the market’s continued recovery.

(…) Now, in big markets from San Francisco to South Florida, “Condos for sale” signs are popping up at a steady pace as the improving housing market creates an opening for landlords to sell off rental housing. That hot market also is spurring new construction of condo buildings. (…)

Reversions are being driven by a supply shortage in the single-family-home market, which has sent prices upward. There were 2.07 million existing homes for sale at the end of August, up 5.1% from January but still down about 6% from a year ago, according data from the National Association of Realtors and Trulia, a real-estate listings site. The data include both condos and single-family homes. (…)

Few places have seen as big of a turnaround as South Florida. As of the second week of October, there were about 21,000 condos and townhomes for sale across Miami-Dade, Broward and Palm Beach counties. That was down 66% from the fourth quarter of 2008, according to multiple-listing-service data compiled by Condo Vultures Realty, but up about 14% from a June low of about 18,000 listings. (…)

We put our South Florida condo for sale in mid- August. We received 5 offers in 8 weeks. We signed yesterday for closing in 3 weeks! A hair below the ask price. All but one all-cash offers.




When I was managing money, after our group had discussed and explored all economic scenarios based on available data, we often concluded with the wishful expression “next month things will be clearer”. We kept repeating it month after month…

What we got last week:

  • Q2 GDP

Thumbs up The U.S. economy entered the second half of the year on firmer footing than previously estimated, with stronger growth, an uptick in corporate profits and consumers feeling better amid a rebound in housing. (WSJ)

The good news is, the U.S. economy grew more than initially expected a month ago. The first stab at the Q2 real GDP on July 31st was 1.7% a.r. Then the trade numbers came out and wow, the view changed and it looked like GDP grew in the neighborhood of 2½% a.r. Then, as the
days went by, more data on inventories and consumer spending caused estimates to be trimmed, leaving consensus and us at around 2.2%-to-2.3% for the second quarter. Now, gentle reader, it looks like we should’ve stuck with the trade data as real GDP did rise 2.5% a.r. in Q2, the largest increase in nearly one year. That and the fact that consumer spending wasn’t revised at all (still 1.8% a.r.) is encouraging. Exports were revised up nicely, and inventories added more to the bottom line. (BMO Capital)

A 2.5% growth is not particularly impressive, but when one takes into account (a) the fiscal drag of lower government spending and higher payroll taxes and (b) the financial drag of retaining revenues to rebuild private balance sheets, the results are beating expectations. Moreover, it is interesting to note that the current recovery has come about despite a declining trend in the velocity of money. (Palos Management)

Curb your enthusiasm:

Thumbs down The latest GDP update shows the current data point is lower than the onset of all recessions except the one that started in January 1980. (Doug Short)

Click to View

Thumbs down But domestic final sales, which strip away swings in the trade deficit and inventories, actually were revised slightly lower, to a 1.9% annual pace from 2%. Over the past 12 months, domestic final sales are up 1.5%, which is more in line with GDP year-on-year growth of 1.6% per annum. (WSJ)

Thumbs down We get a similarly weak picture in the YoY Real Final Sales (which excludes changes in private inventories). (Doug Short):

Click to View

Notice how current levels are indicative of recessionary conditions. (Note to Ian M.: thanks for the heads up on the ZH post. Doug’s chart is just so much better)


Thumbs down July Consumer Spending Up 0.1% Americans spent more cautiously in July as income growth slowed, signaling a potential risk for the economic recovery in the second half of the year.

Overall incomes improved slightly, but wages and salaries fell 0.3%, pushed down by federal spending cuts that spurred furloughs across the government. Government wages were reduced by $7.7 billion in July and $700 million in June due to the furloughs, the report said.

The weak growth of overall spending was partly due to falling demand for durable goods. The category fell 0.2% in July after rising 0.9% in June, marking the first decline since March.

Real disposable income was up 0.8% YoY and is really not growing enough to sustain the recent spending trends…

Click to View

…unless the consumer keeps dissaving. Bold call!

Click to View

Doug Short continues:

As the chart above illustrates, the US savings rate had generally declined since the early 1980s, a trend no doubt supported by the psychology of the secular bull market from 1982 to 2000. After stabilizing for a couple of years following the Tech Crash, a new surge in asset-growth confidence from residential real estate was probably a factor in that trough in 2005. But in 2008 the Financial Crisis reversed the trend … for a while.

Doug is absolutely right. Savings are the residual of income minus spending. When people borrowed against their house to pay for their third car and new boat, the savings rate collapsed, a phenomenon unlikely to be repeated for quite a while.

Thumbs down Several economists lowered their growth estimates for the third quarter after Friday’s weak report, which offered the first major gauge of consumer spending in the third quarter. The forecasting firm Macroeconomic Advisers now expects a 1.6% annualized growth rate, down two-tenths of a percentage point from its earlier estimate. Barclays economists lowered their estimate 0.3 percentage point, also to 1.6%. (WSJ)

Snail  What about August? Weekly chain store sales have been on the weak side so far (to Aug.24). Slow back-to-school sales generally herald sluggish Christmas sales.


Wait, wait:

Note: The automakers will report August vehicle sales on Wednesday, Sept 4th.
From Kelley Blue Book: Crossovers, Pickup Trucks Lift August Sales Nearly 14 Percent, According To Kelley Blue Book

In August, new light-vehicle sales, including fleet, are expected to hit 1,460,000 units, up 13.6 percent from August 2012 and up 11.0 percent from July 2013.
The seasonally adjusted annual rate (SAAR) for August 2013 is estimated to be 15.6 million, up from 14.5 million in August 2012 and down from 15.8 million in July 2013.

Press Release: J.D. Power and LMC Automotive Report: August New-Vehicle Sales Reach Highest Level in Seven Years

With consistency in the fleet environment, total light-vehicle sales in August 2013 are also expected to increase by 12 percent from August 2012 to 1,495,400. Fleet sales are expected to account for 15 percent of total sales, with volume of 225,000 units.
PIN and LMC data show total sales reaching a 16 million unit SAAR in August, which is the highest since November 2007, with actual unit sales the highest since May 2007.

From TrueCar: August 2013 New Car Sales Expected to Be Up 14.4 Percent According to TrueCar; August 2013 SAAR at 15.75M, Highest August SAAR since 2007

For August 2013, new light vehicle sales in the U.S. (including fleet) is expected to be 1,464,214 units, up 14.4 percent from August 2012 and up 11.8% percent from July 2013 (on an unadjusted basis).
The August 2013 forecast translates into a Seasonally Adjusted Annualized Rate (“SAAR”) of 15.75 million new car sales

The analyst consensus is for sales of 15.8 million SAAR in August.

July sales were 15.7M annualized.

After a six-month stretch where the headline index saw some extremely volatile month to month swings, the Chicago PMI has settled down over the last two months with back to back increases of 0.7 points.  To top things off, the headline reading also came in right in line with forecasts.

Thumbs up New orders at 57.2 from July’s 53.9. Impressive!

Thumbs up Overall prices rose just 0.1% in July from June, according to the Fed’s preferred inflation gauge, the Commerce Department’s price index for personal consumption expenditures, released Friday. Core prices, which exclude volatile food and energy costs, also nudged up 0.1%. Both rose at a slower pace than in June. Compared with a year earlier, overall prices were up 1.4% while core prices rose 1.2%. (WSJ)

In effect, the U.S. economy looks like a building seemingly pretty solid from the outside but actually resting on weak foundations.

Fingers crossed And while the charts above showing that current readings on YoY growth in GDP and final sales generally reflect recessionary conditions, the Conference Board’s LEI charts keep hopes alive (more great Doug Short charts):

Click to View

Click to View

It may well be that the YoY change in key GDP numbers were unusually distorted by the “temporary” sequester. In fact, quarterly trends are not indicative of a coming recession . Last 3 quarters:

  • GDP: 0.1%, 1.1%, 2.5%;
  • Final sales of domestic product: 2.2%, 0.2%, 1.0%;
  • Final sales to domestic purchasers: 1.4%, 0.5%, 1.9%.
  • These while federal government spending was: –13.9%, –8.4%, –1.6%.

Palos’ Hubert Marleau:

We have noticed that the private sector has started to slightly lower its preference for cash and equivalents. Should the trend in the velocity of money turn upwards as theory would suggest, the US economy would certainly gather steam. It would either bring about an increase in growth or inflation or both. Given the existing slack in the economy, it is more likely to first have an increase in growth than inflation. This leads us to believe that the Fed is about to reduce its bond-buying program this Fall.

Confused? Pity the FOMC in a couple of weeks. But don’t worry, it will be clearer next month…Winking smile



Wait, wait:

Thumbs up (…)Yet investors aren’t exactly dumping their riskiest, priciest bets, notes Justin Walters of Bespoke Investment Group, who divided the 500-stock benchmark into 10 groups of 50 stocks based on various criteria. He found, for instance, that the 50 stocks with the richest price/earnings valuations had declined just 3.4%, the least among the 10 deciles. The 50 stocks paying no dividend lost just 3.9%, versus 4.9% for the 50 proffering the most generous yields. Heavily shorted stocks outperformed. Says Walters: “This is the type of relative performance you would see during a market rally, and not a market decline.”

Individuals also seem to be doing more of the selling, and the 50 stocks most heavily held by institutions fell just 3.5%, versus 4.9% for the 50 with the least institutional ownership. Bulls are rethinking their infatuation with U.S. exposure: The 50 stocks with the most foreign revenues fell just 3.2%, versus 5.2% for those with the most U.S. sales. Meanwhile, economically sensitive sectors continue to hold up. More than half of all industrials, materials and technology stocks hovered above their 50-day averages—a feat managed by less than 15% in the utilities and consumer-staples camps. (Barron’s)

Thumbs up expandFall Market Forecast Looks Sunny  With the economy growing and earnings on the rise, stocks could head higher in coming months. Market strategists like technology and industrials, but not utilities. Who’s afraid of the Fed?

The market, as represented by the Standard & Poor’s 500, has risen 14.5% year-to-date, and Wall Street’s investment strategists see more gains ahead both this year and next.

Barron’s recently checked in with 10 Street seers, whose consensus view is that the S&P will reach 1700 by year-end, 4% above Friday’s close. If these prognosticators are right, the market will log a 19% gain for the full year, compared with last year’s 13.4% advance. Unperturbed by rumblings of rising interest rates or another budget brawl in Washington, some strategists see the S&P hitting 2000 or more in 18 to 24 months. (…)

The S&P currently trades for 14 times the next 12 months’ estimated earnings, up from 13 times earnings at the end of last year. That’s not dirt-cheap, but nor is it rich; the market historically has averaged a P/E of 15 times future earnings, and much more in the past 20 years.

For the record, the average and median P/E on trailing earnings have been 13.3 since 1927, 1945 and 1983 (13.5 actually). Referring to the past 20 years is, shall I say, irrational exuberance. But let the sunshine in:

Corporate-earnings growth, stalled around 5% in the year’s first half, hasn’t been a big driver of stock-market gains this year. But that could change, the strategists say, as profit growth accelerates sharply in the fourth quarter. Our forecasters look for stronger growth in U.S. gross domestic product to boost company-earnings growth to 8% toward year end. The strategists expect full-year S&P earnings to total $107.85, rising to $116.50 next year. (As usual, the consensus view of industry analysts is higher, with estimates of $110 for this year and $123 for 2014.)

Obviously, the strategists are not confused about the economy. Sun SunSun

Thumbs up The bull case


(…) Knight says consumers have “hung in,” with annual spending growth of almost 2%, despite paltry wage gains and the expiration of the 2% Bush payroll tax cut early this year. Businesses continue to hire new workers at a steady but not stellar rate of 150,000 to 200,000 per month. The fiscal head winds caused by sequestration and government contraction could ease as the government’s automatic spending reductions are lapped early in 2014, he says.

Auth looks for investment and capital expenditures to pick up, and notes the U.S. housing market has worked through excess inventory. Rising home prices will add to the wealth effect, and nonresidential construction—which hasn’t moved yet—will increase, he says. Commercial rents are stabilizing, and in prime markets such as New York City, they are rising. That is a prelude to greater construction activity, he says.

In the past, construction accounted for 9% of GDP, but it has contributed only 5.5% in the past few years. Construction is “where all the missing middle-class jobs are,” Auth says.

And the “Earnings Math”

With many companies in the S&P 500 reporting near-peak profit margins, “you need sales to come through” to propel earnings growth, Goldman’s Kostin adds.

Barclay’s Knapp is looking for S&P revenue to grow at a rate of up to 5% in the second half, possibly more than doubling the year-to-date growth rate. The drivers, he says, will be higher capital expenditures, steady consumer spending, and continued strength in the U.S. housing industry. Steady growth globally also will help.

Wait, wait,

For more, and better earnings math, read the “EARNINGS WATCH” segment of my Aug. 5 New$ & View$.

For good measure, Barron’s cites a few negatives for its thorough readers:

(…) the litany of negatives, including the widespread expectation of the Federal Reserve’s taper of its $85 billion-a-month bond-buying program, which threatens to stall the housing recovery; weaker-than-expected data, especially on the part of consumers’ income and buying; the potential for renewed upheavals in Europe once the Sept. 22 German elections are safely out of the way, including the recognition that Greece will likely need a third bailout; and the resumption of U.S. fiscal follies, including the need to pass a continuing resolution to keep the federal government from shutting down when the new fiscal year starts on Oct. 1; and yet another debt-ceiling fight when the Treasury reaches its borrowing limit in mid-October.

And add to that we’re heading into historically the worst month for stocks,  one frequently marked by currency and other financial crises (which seem to be brewing in the emerging markets), and there’s the potential for a September to remember. Or maybe one the bulls might want to forget, especially if things heat up in the Middle East.

(Bespoke Investment)


99% of S&P 500 companies have reported Q2:

  • Q2 EPS are $26.36, up 3.7% YoY.
  • Trailing 12 months EPS are $99.28, up 0.9% from 3 months ago and +0.6% YoY.
  • Estimates are now $27.04 (+12.7% YoY) for Q3 and $29.04 (+25.4%) for Q4. These estimates have essentially stopped declining in recent weeks (again, see the “EARNINGS WATCH” segment of my Aug. 5 New$ & View$ before buying these estimates).

Thomson/Reuters says that there have been 105 pre-announcements for Q3: 88 negative and 17 positive. During the past month, we have had 28 pre-announcements for Q3, 27 of which were negative. By comparison, at the same time after the Q1 earnings season, there had also been 28 pre-announcements, 24 of which were negative. Post the Q4’12 season, again comparing similar periods, we had 54 pre-announcements, 41 of which were negative.

Another way to look at pre-announcements, one month prior the end of the quarter, 78.2% of pre-announcements were negative for Q1’13, 80.6% for Q2 and 83.8% for Q3.

NoteSummer has come and passed
The innocent can never last
wake me up when September ends
(Green Day)

The objective Rule of 20 barometer, based on trailing earnings and inflation, closed August 9% undervalued from its 1787 fair value. Downside from the current level of 1633 to the Rule of 20 P/E of 16 (trailing P/E of 14 + 2% inflation)  -15% (1390). We hit these levels during the mid-2010 and mid-2012 retreats.


Technically, the S&P 500 Index is now at its 100 day m.a. (1640), a level that held in June, and downside to its 200 day m.a., last touched in December 2012, is 4.5% (1563). At that level, the upside potential would be roughly in line with the downside risk, providing a more attractive investment proposition. Importantly, both moving averages are still positively sloped, as is the 50 day m.a. for that matter.

  • Patience is bitter, but its fruit is sweet. (Aristotle)
  • Patience is power.
    Patience is not an absence of action;
    rather it is “timing”
    it waits on the right time to act,
    for the right principles
    and in the right way
    . (Fulton J. Sheen)

Just kidding  The Seven Deadly Sins of Investing Financial crisis be damned—investors are still making the same mistakes the always have. Here are their biggest blunders and how to avoid them.

Lust: Chasing Recent Performance The belief investors feel that recent performance will dictate future performance—known as “recency bias” in psychology—is one of the biggest investor pitfalls, experts say. (…)

Pride: Being Overconfident (…) Investors, especially ones new to the game, frequently believe they know far more than they actually do about a particular investment, say psychologists and financial advisers. (…)

Sloth: Overlooking Costs Investors often just don’t pay attention to details. (…) “The expenses are much more predictive of future performance because there’s so much randomness in past performance,” he says.

Envy: Wanting to Join the Club  (…) The desire to be part of an exclusive offering often drives people to throw money into an investment that doesn’t fit into the overall goals of their portfolio, against their better judgment.

Wrath: Failing to Admit Failure People hate to lose money. (…) Loss aversion, as it is called by psychologists, isn’t hard to spot. (…)

Gluttony: Living for Today Let’s face it: (…) Fifty-seven percent of U.S. workers surveyed by the Employee Benefit Research Institute earlier this year reported less than $25,000 in total household savings and investments, not counting their house or defined-benefit retirement plans. The lack of preparedness has led experts to deem it a crisis. (…)

Greed: Following the Herd (…) To battle the fear that inevitably comes with a market decline or other adverse events, financial advisers say it is crucial that investors have a detailed portfolio plan that they stick with regardless of short-term events. The plan should outline investors’ targeted holdings in bonds, stocks and other investments, and be based on their retirement goals. (…)

Don’t think investment pros are immune from the above. BTW:

According to JPMorgan’s strategists, nearly three out of five fund managers are trailing their benchmarks this year, including 32% who lag behind by 2.5 percentage points or more.



Pointing up Lessons From an Investing Giant

Filings with the SEC in March and again this month show the extraordinary gumption of Charlie Munger, Warren Buffett’s business partner and vice chairman of Berkshire Hathaway.

Mr. Munger, who will turn 90 years old next Jan. 1, is a model for individual investors who wonder how they can possibly beat the professionals at their own game. The pros have more information than you, and their trading machines are faster. But you still have an edge over them—so long as you play a different game by your own, more sensible rules.

You can be patient; the pros can’t. You don’t have to be part of the herd; they do. Above all, you can be brave; they almost never are.

What makes Mr. Munger a model for individual investors?

In the first quarter of 2009, during the most desperate days of the financial crisis, Mr. Munger took 71% of the cash at Daily Journal, a small publishing company he chairs, and poured it into the bank stocks that so many other investors were fleeing. By March 31, 2009, his bet already had gained 60%. With other purchases he made later, Mr. Munger invested $49.7 million into stocks and bonds that today are worth $128.4 million, according to financial statements Daily Journal filed on Aug. 20.

At Daily Journal’s annual meeting in February, Mr. Munger discussed the move briefly. According to an online transcript and an attendee, Alexander Rubalcava of Los Angeles-based Rubalcava Capital Management, Mr. Munger said “we behaved pretty sensibly” by moving boldly out of cash when stock prices got “ridiculously low.”

The Daily Journal investment wasn’t the only bold move Mr. Munger made during the crisis. (…)

Where does Mr. Munger get his gumption?

In the late 1980s, he recalled in a magazine interview, a guest at a dinner party asked him, “Tell me, what one quality accounts for your enormous success?”

Punch Mr. Munger’s reply: “I’m rational. That’s the answer. I’m rational.”

Trained as a meteorologist at the California Institute of Technology, Mr. Munger thinks in terms of probabilities Light bulb rather than certainties, say those who know him well. (…) Decades of voracious reading in history, science, biography and psychology have made him an acute diagnostician of human folly.

“Charlie has such a deep sense of stoicism,” says a long time friend, Christopher Davis, chairman of New York-based fund manager Davis Advisors. “He seems to be able to invert emotions, becoming uninterested when other people are euphoric and then deeply engaged when others are uncertain or fearful.”

Mr. Munger favors what he calls “sitting on your a—,” regardless of what the investing crowd is doing, until a good investment finally materializes.

In the panic that typically produces such an opportunity, Mr. Munger ruminates. If he likes what he sees, he pounces.

“Charlie knows exactly what he thinks, and the fact that other people don’t agree has no impact on him,” says his friend John Frank, managing principal at Oaktree Capital Management in Los Angeles. “He doesn’t get confused about the difference between an emotional feeling and an intellectual understanding.”

Many money managers spend their days in meetings, riffling through emails, staring at stock-quote machines with financial television flickering in the background, while they obsess about beating the market. Mr. Munger and Mr. Buffett, on the other hand, “sit in a quiet room and read and think and talk to people on the phone,” says Shane Parrish, a money manager who edits Farnam Street, a compelling blog about decision making.

Pointing up “By organizing their lives to tune out distractions and make fewer decisions,” he adds, Mr. Munger and Mr. Buffett “have tilted their odds toward making better decisions.” (…)

Mr. Buffett declined to comment other than to say, “Charlie is indeed rational.”

This unsolicited and unpaid advertising was presented to you by New$-to-Use Winking smile.

This is what NTU attempts to help us do. Be well informed with relevant, unbiased info, think rationally and independently, and act rationally based on sound probabilities.

John Mauldin “hates” this market. His latest weekly note, always a good read, shares his “reasons to head for the sidelines”. One of these is this chart with these comments:

One of the first market aphorisms I learned was that copper is the metal with a PhD in economics. While you can get into a great deal of trouble regarding that as a short-term trading axiom, it is definitely a longer-term truth. Copper is a metal that is closely associated with construction, industrial development and production, and consumer spending. One can argue that the price of copper is falling today because of a fundamental increase in supply, but for those of us of a certain age, the following chart is nervous-making. Unless the long-term correlation has disappeared, the data would indicate that either the price of copper needs to rise or the market is likely to fall.


Something inside me screeched when I read “Unless the long-term correlation has disappeared”. John is younger than me so his “long term” must differ. Here’s my “long term” which does not correlate copper with equity prices very well (sorry, I do not have John’s means to quickly combine both series on the same chart but the time frames are the same).



John’s long term seems to begin with China and QEs. It likely includes a lot of hype in copper which is now deflating thanks to China’s slowdown and the coming tapering. My sense is that copper prices, and those of most other commodities, are on their way back to their real long term trend which is dismal and little (!) correlated with other asset classes (chart from SoGen).  image_thumb[1]

One day, I will explain why I essentially never invest in commodity-related stuff but the chart above provides a good starting point.

Copper Rally Loses Steam as China Demand Falters


(…) One leading indicator of waning appetite is that stocks at metal at warehouses in Shanghai have stabilized around 400,000 tons after falling from as high as a million tons earlier this year. Manufacturers are easing up on using stocks after robust buying over the past few months depleted inventories, according to the manager of a warehouse who declined to be named as he isn’t authorized to speak to the media. (…)

Another sign is that the premium for copper in China is falling, which analysts say also bodes badly for futures. (…)

“We’re not very bullish on copper prices going forward,” said Liu Jiang, a purchasing manager at a Zhejiang-based power-cable maker that supplies China State Grid Corp., the world’s biggest utility. He sees demand from power cable producers, which account for half of copper consumption in China, remaining flat until the end of the year after a flurry of activity in the first half.

Mr. Liu said his company’s order books have been thin since July, as some urban infrastructure projects have ended, with most of the orders placed and filled in the first half.

Investment in power grids rose 19% in the first six months from the same period a year earlier to 165.9 billion yuan ($27.1 billion), far exceeding the 4% growth target set by China State Grid. That means there is little room for growth from the power sector for the rest of the year, according to Yang Changhua, chief copper analyst at state-owned metals consultancy Beijing Antaike.

“We’re unlikely to see any surprise in copper demand from China this year,” Mr. Yang said. (…)

Plus, a potential glut from rising copper supply may also add to the metal’s woes, says Barclays, who forecasts prices will fall in the fourth quarter. The U.K.-based investment bank estimates there will be a 418,000-ton global copper surplus in the second half of this year compared with a 307,000-ton market deficit in the first half. (…)

Chinese Home Prices Outpace Construction

Chinese home prices climbed 8.6% in August from last year and soared in major cities, but didn’t lift construction, or the wider economy.

Prices nationwide climbed 8.6% year-over-year in August and soared in major cities, according to data provider China Real Estate Index System on Monday. Housing prices are up 22.5% year-over-year in Beijing, CREIS said. In Guangzhou, the rate is 24.2%. Other cities are seeing more modest increases, with prices in Shanghai up 7.7%

(…) developers are sitting on a large amount of unsold inventory. With builders preferring to pare down their existing supply rather than take on new projects, housing starts are returning to life only sluggishly—up 7.1% in the first seven months of the year, according to the government. Sales rose 27.1% to 547.3 million square meters over the same period. (…)

The backlog in unsold housing is formidable. At the end of 2012, China had more than 4 billion square meters of residential property under construction, enough to satisfy demand for more than four years without a single new project started. The bloated inventory is the result of China’s last go-round with slowing growth, in 2009. To recharge the economy, Beijing unleashed bank lending and loosened its controls on the property sector. Sales and construction soared. (…)

Surprised smile Chinese workers lock out US bosses

Cooper Tire factory hit by tri-national $2.5bn M&A dispute

Chinese factory workers in eastern Shandong province have turned a traditional management weapon – the lockout – back on their American bosses, by denying them access to a tyre plant at the centre of a controversial $2.5bn cross-border deal.

The sustained Chinese industrial action that erupted in June after the deal was announced is the first to target a major offshore acquisition involving two foreign companies, and exposes a new risk for multinationals operating in China with local partners.

Ohio-based Cooper Tire, which has accepted a buyout offer from India’s Apollo Tyres, admitted for the first time on Friday that workers at its joint venture with the Chengshan Group had taken “disruptive actions”. These included “denying access to certain representatives of the company and withholding certain business and financial information”. (…)

Unlike most other high-profile disputes between foreign manufacturers and Chinese workers, Cooper’s Shandong employees are not demanding higher wages.

The workers have instead complained they were not adequately consulted over Apollo’s offer for Cooper. They also fear the deal will burden their prospective Indian owner with too much debt and result in a clash of corporate cultures.


Kerry praised the support of France—”our oldest ally,” which supported the new United States in the Revolutionary War against Britain—in a pointed barb following the vote by the House of Commons. That, of course, also was the reverse of those nations’ stances regarding the U.S. invasion in Iraq, for which former Prime Minister Tony Blair was a vociferous supporter and France was opposed. Left hug Martini glass Right hug

Note Oh, I get by with a little help from my friends
Mmm, I get high with a little help from my friends
Mmm, gonna try with a little help from my friends



The earnings season is almost complete. S&P reports that of the 446 S&P 500 companies that have reported, 65% beat estimates and 27% missed. As expected, the beat rate has diminished slightly throughout the season and the miss rate has gradually edged up to 27%. The miss rate has been rising steadily from 23.7% in Q3’12 to 24.8% in Q4’12 and 25.9% in Q1’13.

Q2 earnings are now seen at $26.43, in line with the $26.40 estimated at the end of June, and up $1.00 or 3.9% YoY, a deceleration from the 6.3% YoY growth rate recorded in Q1’13. Trailing EPS should thus come in at $99.35, up $1.00 or 1.6% from the previous quarter, a slight advance from the $96.82-98.69 range since March 2012, a period during which the S&P 500 Index rose 20.7%.

This is in contrast with the March 2009-March 2012 time span when equity prices doubled, pushed ahead by the strong tail wind of a doubling in operating earnings. The latest advance was purely a valuation increase toward the 1800 level, a level which the Rule of 20 has been qualifying as “fair value” since May 2012 (yellow line on chart). Notice how the Rule of 20 Value (P/E + inflation), the black line on the chart, has risen from 15.1 in May 2012 to its current 18.8, only 6% shy of the 20 fair value level.


During the next 6 months, investors will be confronted with the following:

  • Trailing earnings have barely advanced during the last year and Q2 EPS only grew 3.9% YoY, thanks primarily to Financials. Ex-Financials, Moody’s calculates that Q2 earnings declined 1.3% YoY.
  • Ex-Financials, the YoY gain in quarterly earnings has averaged 1.4% since Q2’12. It has averaged +0.3% during the first half of 2013, down from +1.5% for the whole of 2012.
  • Revenues of non-Financials have grown 1.7% in Q2’13, up from +0.3% in Q1 but down from +2.1% for all of 2012.
  • Such a context makes it pretty difficult to readily accept analysts projections for the next 6 months. In fact, analysts keep shaving their second half estimates. Estimates are $27.17, +13.2% YoY, for Q3 and $29.13, +25.8% YoY. Please, don’t bet your life savings on these numbers. Earnings pre-announcements continue to be primarily negative. Factset reports that of the 85 companies that have pre-announced Q3 results, 68 companies have reduced guidance.
  • Moody’s says that revenue estimates for non-Financials are +3.5% for Q3 and +8.8% for Q4. This combination of expected accelerating revenue growth with rising operating margins makes the next 6 months highly prone to downward revisions.

All this in the context of a pretty sluggish economic background which keeps confounding most pundits, including the pundit in chief.

So, unless something resembling a magic wand helps boost earnings, equity investors will be navigating the present economic, financial and political cross-currents with no earnings tail wind while facing equity valuations that are only 6% shy of fair value.

This is the third time we get to this valuation wall since the bull market began in March image2009. Retreats were sudden and painful in spite of rising earnings and fairly stable inflation. As we approach the dangerous month of September, it seems appropriate to assess the gaps: A set back in the Rule of 20 P/E to 16, assuming stable inflation, would bring equities down some 15%. Technically, the 100 day m.a. is only 4% lower at 1625 but the 200 day m.a. is at 1545, 9% below.

What’s the upside against these risk measures?

Plus 6% to the Rule of 20 fair P/E of 20 (trailing P/E of 18.0 + 2.0% inflation). Beyond 1800, we get into the twilight zone where gurus of all sorts will no doubt find contextual or esoteric justifications for valuation levels which, while potentially lasting, inevitably lead to deep sorrows, unless, of course, key fundamentals such as earnings and inflation, start supporting higher prices again.


Can extremely low interest rates support higher valuations?

Equities are not priced based on short term interest rates which are what the Fed normally controls. Longer term rates, used as a discount factor for cash flows and generally competing with equities for investor favour, do impact equity valuation. To the extent that long term rates reflect inflation expectations, using inflation as a proxy for a discount factor is appropriate in as much as it eliminates fluctuations in real interest rates and provides a more stable valuation tool, free of investor mood swings.

This time around, it seems even more appropriate to use inflation rather than long term interest rates. In effect, Bernanke’s gambit was to bring long term rates low enough to force investors out of fixed income into equities. During the last year, Bernanke’s bet paid off as reflected by rising P/Es during QE3 while profits stalled.

But as the market has begun to prepare and adjust to an eventual tapering by the Fed, long term interest rates have been rising toward more “market-derived” levels, more in line with “normal” real rates levels.

How this normalization process will take place is unknown, even to Fed officials. It is thus better to continue to use inflation as a discount proxy if one wants to keep investing based on solid fundamentals rather than on artificially set rates, the unwinding process of which is more akin to dice throwing than to educated guessing.