I have recently discovered Ben Hunt and his web site Epsilon Theory. Ben uses game theory, history and behavioral analysis to assess investment risk. Using a poker game analogy,

Game theoretic analysis is the equivalent of “playing the player”, where decisions are based on a strategic assessment of the likely behavior of other players relative to the informational signals provided by bets.

In financial markets, we refer to the monitoring of changes in conventional wisdom. Understanding, evaluating, and anticipating the investment decisions of other investors is paramount to investment success. A cheap stock, or a cheap market, can stay cheap for a long time until the narrative changes. Ben goes on:

The secret of effective market game-playing, whether you were an investor 100 years ago or you are an investor today, is to recognize that the market game hinges on the Narrative, on the strength of the public statements that create Common Knowledge. These are the core concepts of Epsilon Theory. (…)

The financial news media has to say something, and they have to be saying something all the time. So they will. (…) But it’s critical to recognize a Narrative for what it is and not imbue it with superfluous attributes, such as Truth. To be effective, it is only important for a Narrative to sound truthful (this is what Stephen Colbert calls “truthiness”, which is actually a very interesting concept, not to mention a great word), not that it be truthful. A Narrative may in fact be quite truthful, but this is an accident, neither a necessary nor a sufficient condition of its existence. (…)

The link between Narrative and behavior is Common Knowledge, which is defined as what everyone knows that everyone knows. This is actually a trickier concept than it might appear at first blush, because as investors we are very accustomed to evaluating the consensus (what everyone knows), and it’s easy to fall into the trap of conflating the two concepts, or believing that Common Knowledge is somehow related to your private evaluation of the consensus. It’s not. Your opinion of whether the consensus view is right or wrong has absolutely nothing to do with Common Knowledge, and the consensus view, no matter how accurately measured or widely surveyed, is never the same thing as Common Knowledge.

Common Knowledge is, in effect, a second-order consensus (the consensus view of the consensus view), and it is extremely difficult to measure by traditional means. You might think that if a survey measures a consensus, then all we need to do is have a survey about the survey to measure a consensus view of the consensus view and hence Common Knowledge, but you would be wrong. What would the second survey ask? Whether or not the second-survey individuals agree with the first-survey individuals?

Common Knowledge has nothing to do with whether the second-survey individuals think the original consensus view is right or wrong … that would just be an adjustment of the original survey. What you’re trying to figure out is the degree to which everyone believes that everyone else is relying on the original survey as an accurate view of the world, which has nothing to do with whether the original survey does in fact have an accurate view of the world. It has everything to do, however, with how widely promulgated that original survey was. It has everything to do with how many influential people – famous investors, famous journalists, politicians, etc. – made a public statement in support of the original survey. It has everything to do with the strength and scope of the Narrative around that original survey, and this is what you need to evaluate in order to infer the level of Common Knowledge in play regarding the original survey. (…)

What you want to know is what everyone thinks that everyone thinks about the Fed statement, and you can’t find that in the Fed statement, nor in any private information or belief. You can only find it in the Narrative that emerges after the Fed statement is released. So you wait for the talking heads and famous economists and famous investors to tell you how to interpret the Fed statement, but not because you can’t do the interpreting yourself and not because you think the talking heads are smarter than you are. You wait because you know that everyone else is also waiting. You are playing a game, in the formal sense of the word. You wait because it is the act of making public statements that creates Common Knowledge, and until those public statements are made you don’t know what move to make in the game.

As Keynes wrote, you are devoting your intelligence to anticipating what average opinion expects the average opinion to be. And there is nothing – absolutely nothing – in the standard model of modern portfolio theory or the fundamentals of the market or any alpha or beta factor that can help you with this effort. It’s not that the standard model is wrong. It’s just incomplete, both on its own terms and, more importantly, in that it was never intended to answer questions of strategic behavior. You need an additional tool kit, one designed from the outset to answer these questions. That’s what Epsilon Theory is intended to be, and I hope you will join me in its development.

Ben has decided to soon make his web site available only on a subscription basis and I wish him well. If you can afford it, you should consider subscribing.

What struck me when I discovered Epsilon Theory was that, in a different and very personal and humble way, News-to-Use is built as as a layman’s version of epsilon theory. My monitoring, choosing, structuring and presenting of the news for the daily New$ & View$ is meant to help me, and hopefully you as well, understand the narratives and their evolution and how common knowledge is likely to evolve. All the “ ***.WATCH” segments I create from time to time are meant to help us monitor how a particular narrative is changing and likely to change and how these changes might eventually change common knowledge. Being ahead of the curve in order to anticipate changes in the curve.

All this in the context of the evolving risk/reward profiles for various financial assets.

Overlaying the narratives, their evolution and the anticipated changes thereon over the risk/reward relationships of various financial instruments is the essence of New$-To-Use.

That said, I have no plans and no intentions to copy Ben into a subscription site. I cherish my sovereignty too much for even thinking about considering that, even if my readership were to grow exponentially. New$-To-Use is growing nicely and I find it very rewarding that, being into its fifth year, many of you have been reading me regularly for quite some time meaning that NTU fills a need for many people across the world.

Some readers even gratify NTU with donations. Some are small, others are larger, but all are extremely appreciated and totally reinvested in research material. The reality is that many info sources are doing like Ben and require payments. Donations allow me to afford subscribing to some of these.

This post was meant to introduce you to Ben Hunt’s web site and his approach to investing because it is good stuff that is worth some of your time. If you can’t subscribe, you should at least visit his site and read some of his articles while still freely available.

His most recent email is very interesting in the present context (my emphasis):

Epsilon Theory: Increased Instability in US Markets

The Credit Suisse Equity Derivatives group put out this chart in their weekly note today, and I thought it was worth forwarding to the Epsilon Theory list.

The chart shows the spread between the 1M implied volatility (taken from 1-month forward option prices) and the current realized volatility (taken from historical price changes) in the S&P 500. The greater the spread, the more expensive options are on the SPX relative to the actual volatility that is occurring. Basically, it’s an indication that expectations or fears of bad things happening in the short term future have increased, even if those bad things haven’t actually materialized yet.

Chart: S&P 1M Implied-Realized Volatility Spread Widens to 90th Percentile High

hunt_thumb[1]Source: CS Equity Derivatives Strategy

My interest is less in whether the spread is at the 99th percentile high or the 1st percentile low (both of which have occurred in the past 12 months), but in the violence and rapidity of moves between very high percentile spreads and very low percentile spreads. This is what an unstable market looks like from an information or game theoretic perspective. Realized volatility is relatively stable, but expectations of short-term volatility swing from pillar to post. In the absence of a strong Common Knowledge structure for the US market, investor behavior becomes unmoored, and that’s what we’re seeing here. An unstable market is like a marble on a glass table … it takes very little “news” to make the marble roll for a long way in *either* direction.

The Common Knowledge structure around the US market has weakened in the past few weeks. That’s NOT the same thing as saying that sentiment has grown more negative, although in terms of the US growth outlook it happens to be true. What I’m saying is that a few weeks ago everyone knew that everyone knew that the US economy was on a self-sustaining growth trajectory. Even if you believed privately that growth was likely to be weak, you believed that everyone else thought otherwise because there was a monolithic media Narrative telling you that everyone else thought otherwise.

But then the Fed talked down growth after their July 30-31 meeting (without talking down the Taper), and since then more and more opinion leaders have joined the chorus on slower-than-expected growth. I have no idea what the “truth” is regarding US growth, and my private opinion is not particularly useful in any event. But I do think it’s useful to be aware of increased instability in the US markets, because it makes the risk/reward assessment of ALL exposures — both long and short — less certain.



Ben Bernanke’s gambit has succeeded. Bringing interest rates through the floor, he left investors with no alternative, forcing them into equities, hoping to create a wealth effect to fuel consumer spending. He may have gone too far as the WSJ reports (my emphasis):

Individual investors are pouring tens of billions of dollars into a new generation of complex investment products, and regulators are raising concerns that not all buyers understand the costs and risks. (…)


A total of $59 billion poured into alternative mutual funds this year through July, according to Morningstar, making it by far the fastest-growing mutual fund category. (…)

The jump in those seven months was bigger than any previous full-year increase. The alternative mutual funds attracted $25.6 billion in additional assets in 2012. (…)

The number of alternative mutual funds has grown to 402 from 77 in 2003, and assets soared to $216.47 billion as of July from $11.2 billion at the end of 2003, according to Morningstar. (…)

Part of the surge in popularity of such investments is due to a push by hedge-fund firms and buyout groups to offer new retail products as part of a search for new growth as sales to their traditional institutional clients slows, according to a report last year by McKinsey & Co.

Why that push into retail?

Hedge funds have a performance problem. Since the turn of the decade, Wall Street’s master stock pickers have spectacularly failed to beat the market.

The crisis of performance comes as the industry is under intense scrutiny over the source of past returns, with SAC Capital facing criminal insider trading charges that threaten to undermine the record of one of the world’s most successful hedge funds. The firm says it has done nothing wrong.

Since January 2010 the average equity hedge fund has produced profits for its investors, after fees, of just 14.5 per cent, according to the research group HFR.

Over the same period an investor in the S&P 500 earned, with dividends, a 55 per cent return: a total which 85 per cent of equity hedge funds have failed to match, finds HFR. (…)

The comparison may be unfair to some funds which do not aim to beat the market. Some within the industry argue that hedge funds are behaving as they should, performing better as markets plunge, but lagging behind as they steadily rise. (…)

This idea that hedge funds protect investors, and just almost everybody, from down markets, even from financial crisis, is not supported by facts.

In a 2005 article published in the Financial Analysts Journal, Princeton U. professor of economics Burton Malkiel, after analysing hedge funds returns since 1995, concluded

(…) that the practice of voluntary reporting and the backfilling of only favorable past results can cause returns calculated from hedge fund databases to be biased upward. Moreover, the considerable attrition that characterizes the hedge fund industry results in substantial survivorship
bias in the returns of indices composed of only currently existing funds.

Correcting for such biases, we found that hedge funds have returns lower than commonly supposed. Moreover, although the funds tend to exhibit
low correlations with general equity indices—and, therefore, are excellent diversifiers—hedge funds are extremely risky along another dimension: The cross-sectional variation and the range of individual hedge fund returns are far greater than they are for traditional asset classes. Investors in hedge funds take on a substantial risk of selecting a dismally
performing fund or, worse, a failing one.

The Economist provided more up-to-date data in a Dec. 2012 article titled Going nowhere fast:

The S&P 500 has now outperformed its hedge-fund rival for ten straight years, with the exception of 2008 when both fell sharply. A simple-minded investment portfolio—60% of it in shares and the rest in sovereign bonds—has delivered returns of more than 90% over the past decade, compared with a meagre 17% after fees for hedge funds. As a group, the supposed sorcerers of the financial world have returned less than inflation. Gallingly, the profits passed on to their investors are almost certainly lower than the fees creamed off by the managers themselves.

The WSJ looks at returns since the beginning of the financial crisis:

Yet the poor performance of the last three years now far outweighs hedge funds’ resilience through the worst of the crisis. Over the past five years the S&P 500 with dividends has delivered average annual returns of 7 per cent, while equity hedge funds have produced just 1.7 per cent, according to HFR.

But it goes beyond performance numbers. The hedge fund industry is so large and so powerful with brokers, banks and politicians that it now has a huge economic and financial impact. Scott Patterson’s “The Quants” is a good read on that. The industry has recently successfully lobbied to get access to smaller investors just when the larger ones are finally discovering the real “truth”.

Adding to some of the regulatory worries was the Securities and Exchange Commission’s decision in July, in response to legislation passed by Congress, to permit hedge funds to advertise for the first time, which could increase the visibility of the products.

And now:

Heath Abshure, Arkansas’s securities commissioner and president of the North American Securities Administrators Association, said alternative investments are “one of our biggest investment problems, and all our members are looking at them.”

The Economist suggest alternatives to alternative investments…

Defenders of the industry maintain that even a small allocation to hedge funds can diversify a portfolio away from turbulent markets. Perhaps, but long-term institutional investors should be well-placed to ride out market turmoil. And there are other ways to diversify. Exchange-traded funds allow investors to gain exposure to anything from gold to property to Indonesian firms, and they charge investors just a few basis points (hundredths of a percentage point) on the money they put in. That compares with fees of 2% of assets and 20% of profits (above a certain level) typically charged by hedge funds. In a low-interest-rate environment, where returns are unlikely to hit double digits, a 2% annual management charge seems particularly steep. Institutions have put pressure on fees, but with only mixed success so far.

The hedge-fund industry’s trump card is that a handful among them have delivered stellar returns over the long term. But the same is true of any sort of investment.

…agreeing with Malkiel:

The average hedge fund is a lousy bet, and predicting which will thrive and which will disappoint is a task that would tax even a Nobel prizewinner.

To finish dispelling the myth around hedge fund managers, Jon Sundt, President & CEO of Altegris Advisors, hits on two characteristics of hedge fund returns: high dispersion and attrition rates in a recent note titled “All Managers Are Not Created Equal”

The accompanying chart compares performance dispersion of traditional, long-only mutual funds invested in large cap value stocks with three types of alternatives investments—managed futures funds,
long/short equity hedge funds and global macro hedge funds. (…)


To illustrate the importance of performance dispersion among
alternative investments, compare the dispersion of the large cap mutual funds with long/short equity hedge funds in 2012. As the chart shows, in 2012, large cap value mutual funds all performed relatively similarly. The bottom 25% gained an average of 10.68%, while the top 25% gained 18.57%. The dispersion was less than 8%. (…)

By contrast, long/short equity hedge funds had a much wider range of performance. The bottom 25% lost 6.94% while the top 25% gained 26.12%. The dispersion was 33%. (…)

(…) Picking the right manager matters immensely where dispersion is high. It’s a similar phenomenon with managed futures and global macro funds. In both cases, the performance dispersion was also greater than for large cap value mutual funds.

Dispersion shows the range of results of existing managers but it omits the results for managers who have left the business, resulting in what statistics experts call “survivor bias.”

Performance dispersion tells only part of the story. Attrition tells another part. Figure 3 shows the attrition rate for managed futures funds. When the number of “attrited”—or dissolved—programs are added to the picture, the risks of picking an underperforming manager become more clear.


Thus, even though 2008 was a stellar year for managed futures—they gained 15.4% versus the S&P 500 TR’s 37% loss—more than 20% (166 dissolved out of a total of 772 programs) of the managers dissolved their funds.

In other words, despite being a winning strategy in 2008, it was possible for managed futures funds to lose money. The year 2012 further illustrates the importance of manager selection. As Figure 3 shows,
the number of managed futures programs declined by 30% in 2012.

Understand that many return stats published on the hedge fund industry omit many or all the “attrited” losers. Since 2008, there have been 376 new “managed futures funds” while 700 were dissolved. The birth/death rate trend for other types of hedge fund is likely similar.

Hedge funds as an asset class? Only if you can find the right managers. And then hope that they have class!


The Equity Drumbeaters Are Out

(Note: my good friend I. Bernobul just published this post on his blog)

Now that equity prices have more than doubled and that it has become fashionable to be bullish, the gurus are out with their often convoluted theories and the media are all too happy to act as megaphones. However, one would expect the more serious media to be a little critical and choosy.

James W. Paulsen, chief investment strategist at Wells Capital Management, was given front page exposure in Monday’s Financial Times to trumpet the arrival of ‘the second
confidence-driven bull market of the postwar era”. Unfortunately, his facts and figures are not what one would expect from the FT. Some excerpts with my comments (my emphasis):

(…) But while many investors have turned cautious, the bull market has probably not ended. This is because the primary force driving the stock market is not earnings performance, low yields or quantitative easing; rather, it is a slow but steady revival in confidence, a trend that is just beginning.

In this scenario, investors need not be overly concerned about slower earnings growth. While earnings are obviously important, stock prices have frequently diverged from earnings trends. In fact, for the third time in the postwar era, stock prices and earnings are repeating a remarkably similar three-stage cycle.

Here’s Paulsen’s recipe:

First, earnings surge while the stock market remains essentially flat (the earnings production cycle). Second, earnings performance flattens while the stock market surges (the valuation cycle). Finally, both stock prices and earnings move in tandem (the traditional cycle). It appears the contemporary bull market has just entered the second phase, making earnings growth less important. (…)

So, for the third time in the postwar era, we would be in a “remarkably similar” three-stage cycle which apparently begins with an earnings surge accompanied by a flat market. Mr. Paulsen does not divulge when exactly his first stage began, but the fact is that the stock market has doubled along with surging earnings between March 2009 and May 2012.

Nonetheless, “it appears the contemporary bull market has just entered the second phase”, when “earnings performance flattens while the stock market surges”. If there is such a “second phase”, it began in the spring of 2012 when equity prices rose 30% on flat earnings.

So much for the “remarkably similar” three-stage cycle. But there’s more:

In both the 1950s and the 1980s, the earnings cycle was followed by an explosive stock market run despite almost flat earnings performance. Between 1952 and 1962 the market rose about 3.5 times, while from 1982 to about 1994 it surged almost fourfold.

Here’s the chart for the 1952-62 period during which we can see five periods when earnings and equity prices moved pretty much in tandem. Based on monthly closes, the S&P 500 Index actually tripled between January 1952 and the December 1961 peak.


There were actually two broad stages between 1952 and 1962:

  • between 1952 and September 1958, earnings grew only 18% while the S&P 500 Index doubled from extremely undervalued levels after going through highly volatile times following the end of WWII. Inflation went from 2% in 1945 to 20% in 1947 to -3% in 1949, to 9% in mid-1951, to -0.7% in mid-1955 and to 3% at the end of 1957. Understandably, investors were totally uncomfortable with this extreme volatility. As a result, P/Es on trailing earnings plummeted from 22 times in June 1946 to a deeply undervalued 6 times in June 1949. By January 1952, P/Es had recovered to 10x but were still very undervalued based on the Rule of 20 formula which then called for P/Es around 17-18x.
  • Multiples reached 19 in December 1958 as inflation decelerated from 3.6% in the spring of 1958 to less than 1% 12 months later. Between September 1958 and the end of 1962, equities rose 26% while earnings rose 20%, not a meaningful discrepancy.

The same can be said of the 1982-1994 period which is Paulsen’s second “remarkably similar period”.

Inflation reached 14.8% in March 1980 when the U.S. economy was in recession. Inflation receded to 8% in early 1982 but a second recession had begun in July 1981. Equity prices troughed in July 1982 at 7.7x earnings as 10Y Treasury yields reached 14%. Earnings bottomed in December 1982 and doubled by June 1989. Meanwhile, the S&P 500 Index more than tripled as P/E ratios reached 14.5 in June 1989 right where the Rule of 20 stated since inflation was then 5%.

The U.S. entered a mild recession in July 1990 but the sudden 170% jump in oil prices between July and October 1990 created a severe margins squeeze which brought earnings down 25% by the end of 1991. The successful Operation Desert Storm and the subsequent rapid decline in oil prices led investors to expect a rapid restoration of profit margins which brought P/E ratios to 21x by the spring of 1992.


In brief, Paulsen’s characterisations of the 1952-1962 and the 1982-1994 periods to fit his theory are far fetched and certainly not even close to the present circumstances.

But on with more recent data:

In the contemporary era, since autumn 2012, despite earnings growth slowing to low single-digit rates, the price-earnings multiple has risen from about 13 times to about 16 times. If this means the stock market just entered its third “valuation cycle” of the postwar era, is slower earnings growth really that worrying?

We are obviously nowhere near the extreme undervaluation levels of the so-called “remarkably similar periods”. Actually, using trailing earnings rather than Paulsen’s forecast, the S&P 500 Index is currently selling at 17x earnings. With inflation at 1.8%, the Rule of 20 P/E is 18.8x, a mere 6% below the “20” fair value level. If there was a “third valuation cycle”, we’ve just had it.

As to the question whether “slower earnings growth is really that worrying?”, the chart below, covering 1946 to the present, is a clear reminder of the importance of profits in equity valuation.


Yes, equity markets can, and sometimes do, for brief periods, rise in spite of slow or even negative earnings growth. When it is not to correct extremely low valuation levels, such advances inevitably bring markets to overvalued levels which significantly raises investors risk.

Mr. Paulsen does address some of the risks:

One concern is that the recent rise in US bond yields will abort the stock market bull run. But rising bond yields reflect improving economic confidence, rather than increasing inflation expectations or concerns about the creditworthiness of the US government. A rise in bond yields predicated on a growing belief the “world will not soon end” hardly seems bad for the stock market. Indeed, since 1967, when bond yields have risen in tandem with consumer confidence, the stock market has advanced at almost 12 per cent a year. (…)

Hmmm! Never heard that one. It would have been nice to get the details, especially given that, during the 45 years since 1967, only the first 14 years have seen a marked rise in long term interest rates.


Just for fun, however, I checked Paulsen’s assertion since 1977, the last year I have data on the Conference Board Consumer Sentiment Index. I only found 3 periods when interest rates rose in tandem with consumer confidence:

  • April 1983 to July 1984. S&P 500 down 7.9%.
  • January 1987 to October 1987: down 8%.
  • September 1998 to February 2000: +34%. The dot.com bubble years!

You might want to scratch that last one. But there is more:

Since 1900, there have been three major bull markets, in the 1920s, 1950s-60s and the 1980s-90s. Both the first and the third of these were driven by a persistent decline in interest rates, an option not feasible today. However, the 1950s-60s bull market was characterised by a simultaneous rise in both stock prices and bond yields, driven by rising confidence. (…)

May I just mention that earnings have grown at a 5.0% compound annual rate of growth between 1950 and 1969. As to rising confidence, read the above comments on the 1952-62 period once again.

Mr. Paulsen’s conclusion:

Certainly earnings, bond yields and Fed actions will create some turbulence along the way. But beware of becoming too myopically focused on these mainstream issues lest you miss what could be the second confidence-driven bull market of the postwar era.

Now, how confident are you?


(Thanks to news-to-use.com for the charts)


Inflation And The Rule of 20

Many pundits currently fear the return of inflation. It is therefore appropriate to verify how the Rule of 20 behaved during years of rising inflation. Could it be that since the market multiple is believed to anticipate changes in inflation, the Rule of 20 would tend to be “behind the ball” in a rising CPI environment?

The first chart sets the challenge. Inflation has been well contained and reasonably stable since 1982, unlike during the 1968 to 1982 period.


As a reminder, the Rule of 20 states that fair P/E on trailing earnings equals 20 minus inflation. Since the Rule of 20 uses trailing inflation, there is the risk it might lag rising inflation expectations and fail to give the right signals as a result.


looking at the longer period of Jan. 68 (CPI +3.7%) to March 1980 (CPI + 14.8%), the Rule of 20 P/E (trailing P/E + inflation) crossed the 20 “fair value” line into the rising risk yellow zone in July 1967 (S&P 500 Index at 95). It remained into the riskier zones pretty much until September 1975 (S&P 500 at 84, CPI +2.9%). The Rule of 20 P/E then dropped deep into the lower risk zone, troughing at 14.2 in February 1978 when the S&P 500 Index began a 23-month rise from 87 to 114 in January 1980 when the Rule of 20 P/E reached 21.5. Equities kept rising for another 11 months to peak at 150 in November 1980 when the Rule of 20 P/E reached 22.2, only to crash 33% to 100 in July 1982 when the Rule of 20 P/E got back into extreme low risk again at 14.1.

During all those years, inflation fluctuated tremendously but always in a rising trend of higher highs and higher lows until Paul Volcker and Ronald Reagan got really serious about it.

These blowout charts help appreciate how the Rule of 20 kept investors prudent until late 1975 amid a roller-coaster equity market. During the following 4 years, corporations adapted to higher inflation, particularly to higher oil prices, and earnings rose rapidly enough to offset rising inflation. Rising earnings, combined with generally flat equity markets, brought the Rule of 20 P/E well into the low risk zone, reaching a 23-year low of 14.2 in February 1978 at 87 on the S&P 500 Index, a level never seen again.



However, the 14-month period between December 1976 and February 1978 was not favourable as equity markets declined 18.7% even though the Rule of 20 P/E was in very low risk range (16) at the end of 1976. It took 2 years to get back on side but, as mentioned, the lows of February 1978 were never revisited.

To conclude, the Rule of 20 worked just as well when inflation was high and rising rapidly, perhaps a suggestion that investors are not as adept at anticipating inflation as generally believed. In any event, investors should realize how much better it is to deal with real, trailing, data on earnings and inflation, rather than trying to crystal ball them.


Understanding The Rule Of 20 Valuation Tool

Many readers ask that I better explain the Rule of 20 and how to read the The Rule Of 20 Barometer Chart.

Briefly, the Rule of 20 states that fair P/E on trailing operating earnings equals 20 minus inflation. For more on that see S&P 500 P/E Ratio at Troughs: A Detailed Analysis of the Past 80 Years and THE “RULE OF 20” EQUITY VALUATION METHOD.

With total CPI of +1.4% YoY, fair P/E should thus be 18.6x on trailing EPS of $98.35 yielding 1829 as fair value for the S&P 500 Index. At its current level of 1640, the Index is thus 10.4% undervalued.


The yellow line on the chart is that “fair value” while the blue line is the actual Index level. The trend in the yellow “fair value” line provides a visual of the trend in “fair valuation”. A rising trend generally results from rising earnings, but sometimes from falling inflation, rarely both. The recent sideways pattern in the yellow line reflects stalling earnings during the past 12 months.

The gap between the yellow and the blue lines provides a visual of the degree of under or over-valuation of the Index versus “fair value”. Lately, stocks have advanced against stalled valuations resulting in a decline in the market undervaluation, which is reflected in the rise of the thick black line towards the “20” red horizontal line which delineates under and over valuation. The background colors indicate where current valuation (the black line) stands on the risk barometer.

The thick black line is the Rule of 20 value itself (not “fair value”). It plots the sum of the actual P/E on trailing EPS plus inflation. Since “fair value” equals 20 minus inflation, it follows that current P/E plus inflation will equal 20 at fair valuation. So current P/E plus inflation, the “Rule of 20 P/E”, is undervalued when below 20 and overvalued above it. The Rule of 20 P/E historically fluctuates between 15 and 25. Readings below or above that band reflect periods of extreme investor greed or fear.

At the current 1640 on the S&P 500 Index, trailing P/E is 16.7. Add inflation of 1.4 = 18.1 which is 10% below 20, or 10% undervalued.

Understand that the Rule of 20 is not a forecasting tool. A quick glance at the chart reveals that markets rarely trade at “fair value” (the “20” line). It is rather a risk/reward measure providing a totally objective reading of where equity markets trade versus objective fair value. Investors can thus calculate the upside/downside to fair value, thereby appreciate whether this fits their own individual risk profile.

Understanding where markets trade on an objective risk/reward scale enables investors to structure their portfolios dispassionately and rationally. They can monitor economic trends and better appreciate how these can modify investors sentiment and move valuation closer or further away from fair value.

This is one of the goals of News-To-Use: objective monitoring of pertinent economic trends in order to better utilize the Rule of 20, the most useful tool to constantly gauge the risk/reward equation for U.S. equity markets.

I hope that helps. Please let me know otherwise.


Margins Calls Can Be Ruinous In Many Ways

Bearish calls based on mean-reverting profit margins may be missing important points.

I generally avoid using forward earnings in valuing equities. I have therefore not spent much time writing about profit margins and whether or not they are about to mean-revert, one of the main points of the equity bear population.

Also, I tend to avoid forecasting future equity levels, preferring to concentrate on evaluating fair market values and monitoring the risk/reward equation along with economic momentum in order to assess whether equities should be favoured or not.

This blog began in early 2009 and rapidly advocated buying equities on the basis of very attractive valuations based on a detailed analysis of P/E ratios over the previous 80 years (S&P 500 P/E Ratio at Troughs: A Detailed Analysis of the Past 80 Years). During the following 4 years, using unbiased economic analysis and the objective Rule of 20 valuation tool, I modulated my general bullishness along with the fluctuations in the risk/reward ratio provided by the Rule of 20’s factual analysis (black line in chart below). Managing risk is what this blog is all about.


In DRIVING BLIND, I recently highlighted the facts that S&P 500 trailing earnings peaked one year ago and that revenue growth has decelerated to +1.3% in Q1’13 with most indicators pointing to more weakness in coming quarters. This suggests that maintaining profit margins will be a real challenge for corporate managers, unlike the past several years when rising revenues combined with sharply decelerating costs boosted margins to all-time highs even though world economies remained pretty sluggish.

(Gavyn Davies in FT)

Wondering what is the downside risk in profits, I recently started to look into profit margins and the reasons for their admittedly elevated level. Among the many straight line forecasters and the several astute and patient mean-reverters, few seem to have done a thorough analysis to support their thesis, other than posting charts like the one above and ridiculing people who say “this time may be different”. I wonder what such people were saying back in 1995. While margins have been pretty volatile lately, the two recent lows never went back near previous lows while new highs were recorded in each of the last 3 cycles. Patience is an essential investment virtue, but there is a limit. As Keynes said, in the long run, we’re all dead.

The relationship with wages is most interesting and obviously revealing of some secular trends. The slow declining long term trend in the share of wages observed since the 1960s clearly accelerated during the last 10 years. The easy explanation is that high unemployment allowed corporate America to squeeze labor as the caption on the chart above suggests.

This may be true of the last 4 years but productivity gains have been accelerating for much longer. The huge advances in technology since 1995 coupled with accelerating globalization have strongly contributed to the more recent productivity gains. Previously, these gains eventually transpired into lower prices, keeping margins pretty constant over time. The fact that profit margins have kept rising since 1995 may have more to do with the changing complexion of the economy than with the evil side of capitalistic corporate America. In fact, Gavyn Davies’ next chart shows that the same phenomenon is observed in all advanced economies.

Raj Yerasi, a money manager, wrote a guest post for Greenbackd to show how rising foreign earnings have helped boost American corporate profit margins. Importantly, he explained how the quirks of the national accounts can distort the reality:

To understand this, it is important to note that current analyses do not directly measure profit margins per se (meaning, profits divided by revenues). Rather, they measure corporate profits as a percentage of GDP, which captures not total revenues but the total value addition of corporations (along with other components). While there are multiple potential data issues in comparing profits to GDP, it nonetheless stands to reason that profits as a percentage of GDP should generally correlate with profit margins.

However, one big source of error is that the most widely known NIPA corporate profits data series, which the analyses referenced above appear to be using, represents profits generated by corporations that are considered US residents. As such, this data series includes profits generated by US companies’ international operations (e.g. Coca-Cola India, Coca-Cola China) and excludes profits generated by foreign companies’ US operations (e.g. Toyota USA). GDP, meanwhile, captures all economic activity within US borders, whether undertaken by US companies or foreign companies, and it excludes any economic activity abroad. It should be clear that one cannot compare these two metrics, since the corporate profits data series introduces profits generated by other economies and excludes profits generated by the US economy.

US companies’ profits from abroad have grown tremendously over the last 10 years, much more so than foreign companies’ profits from US operations:

This skews the calculated profits level upwards and by an increasing amount over time, making profit levels today look exceedingly elevated.

To do the analysis correctly, we need to use data that are more apples-to-apples. Fortunately, the NIPAs do include a data series of corporate profits that simultaneously excludes US companies’ profits from abroad and includes foreign companies´ profits from US operations, called “domestic industries” profits. Comparing these profits to GDP, profit levels still appear elevated but now not as much as when using the prior “national” profits data series:

He then tackles another important factor:

It is also worth noting that effective corporate tax rates are lower today than in the past. Per the NIPA data, tax rates have decreased from about 45 percent in the 80s to 40 percent in the 90s to 30 percent in recent years. Using pre-tax “domestic industries” profits as a percentage of GDP, profit levels today may be closer to 20 percent elevated relative to historical norms. (…)

National accounts are one thing but, in reality, we invest in equity markets. The composition of the S&P 500 Index is different than that of the corporate component of the national accounts. Importantly, the industrial complexion of the Index fluctuates over time. To the extent that certain industries have very different structural operating margins and effective tax rates than other sectors, changes in industry weightings within the index will impact the total.

This chart from the American Petroleum Institute (note the typo, they meant 2012) shows how net margins vary by industry. Pharmaceuticals, tobacco and technology enjoy much fatter margins than most other sectors.


Part of the reason is found in the respective effective tax rates, likely the effect of R&D expensing and foreign earnings:

Bespoke Investment plots historical sector weightings of the S&P 500 Index. The 15% increase in Technology stocks’ share of the Index over the last 20 years, reflective of the huge advances in technology referred to above, no doubt has had an impact on total Index margins. The strong rise in importance enjoyed by Tech and Heath Care companies, combined with the decline in Industrials’ weight, phenomena observed in all advanced economies and supported by normal evolutionary and demographic trends, surely explain much of the secular growth in Index margins.

Another factor for currently elevated margins is historically low interest rates which have substantially reduced financing costs in recent years, boosting margins more so than in previous cycles. Obviously, this will succumb to higher rates later in the cycle.

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.

I don’t have the resources nor the time to try to thoroughly explain why margins have increased over time. It would be useful if large organisations like GMO and Hussman Funds did and shared thorough research on this non-trivial matter. 

The following charts from CPMS Morningstar plot a proxy for net margins for various market sectors since 1993. Current margins are in effect high and have been rolling over. Note how margins and trends can vary significantly over time. Also, cyclicality varies meaningfully between sectors. Importantly, note the volatility at a high level for the CPMS average during the 1990s.

Forecasting aggregate margins is a perilous activity, especially if done without a good understanding of the root causes for trend changes. Making investment decisions on the basis of such forecasts can be very frustrating.














From New$-To-Use large and busy marketing department: Winking smile

NEW$-TO-U(SE) was launched on January 2, 2009. In addition to providing readers with investment-pertinent facts, trend analysis and other expert views and opinions, NTU makes regular assessments of U.S. equity markets, offering detailed and unbiased valuation analysis and clear investment stances taking into account both risk and reward potential. Here’s the record (click on chart to enlarge in new window):


And the details if you want to do due diligence (for all Equity Valuation comments, click on green light in the sidebar):

Pointing up   On March 3, 2009, when the S&P 500 Index was below 700,  NTU explained and documented why U.S. equities were extremely cheap and offered a very attractive risk/reward ratio. NTU also introduced The Rule of 20 method of valuing equity markets. NTU’s detailed and rigorous analysis concluded that equity markets were clearly undervalued with very little downside risk. (S&P 500 P/E Ratio at Troughs: A Detailed Analysis of the Past 80 Years)

Pointing up   On December 8, 2009, NTU explained and documented that, at 1100, caution was now warranted given that

“This is the first time since March 2009 that the Rule of 20 gives such downside against so little upside”. (…) “Given the fragility of the economy, of the banking system (housing and CRE remain dangerous), of the US dollar and the US budget deficit, equity markets that are merely fairly valued are not particularly attractive.

In conclusion, US equities are fairly valued using annualized Q3-2009 eps and 2% inflation. They could rise another 8% to 1200 (S&P; 500) if Q4-2009 reach the expected $67 level but the risk/reward ratio has become unfavorable for the first time since March. (US EQUITIES VALUATION ANALYSIS: DUCK, YOU (HAPPY) SUCKERS!)

Pointing up   On June 2, 2010, NTU posted that U.S. equities had become undervalued again at 1090 and that, barring deflation, they could rise to between 1240 and 1320:

Equities are thus currently 9-16% undervalued depending on whether one uses current trailing EPS or “normalized trailing EPS” using Q2 2010 estimates. Using 1.0% inflation, fair value would rise another 5% but such a low inflation rate may be too low for comfort unless monthly core inflation strengthens. (US Stocks Are Cheap But Beware of Deflation).

Pointing up   On November 7, 2010, still positive at 1225:

(…) On that basis, the S&P 500 Index at 1225 sells at 15.5 times, right on the historical median, pleasing both bears and bulls. However, the more appropriate Rule of 20 says fair value is at 19x EPS (20 minus inflation of 1%), or 1500 on the Index, a big 18% undervaluation. (…) investors might have the best of all world: a very cheap equity market, rising earnings, no double dip, very low interest rates for as far as the eye can see, reduced probabilities of deflation and, just in case, the Fed unlimited QE puts in the back pocket. (SO! WASSUP? Cheap Markets)

Pointing up   On January 28, 2011, even though valuation remained reasonable, the risk/reward ratio turned less attractive at 1285. Economic trends were suggesting  muddling-through at best, right when economists were becoming more positive.  “Even notable bears have mellowed their stance” and risks of negative surprises were now pretty high.

From a valuation standpoint, the Rule of 20 continues to point to 1500 on current trailing earnings of $79-80, for a 15-20% upside potential to fair value. This remains a good target for this year. However, the risk of a technical correction towards the 200 day m.a. (1170, -10%) is not insignificant, skewing the risk/reward ratio and raising a yellow flag for the shorter term. (YELLOW FLAGS ON EQUITIES)

Pointing up   On March 29, 2011, NTU published US EQUITIES: APRIL PEAK?, realistically warning that apparent undervaluation was being threatened by rising inflation and dangerous groundhogs:

While the Rule of 20 provides a rigorous mathematical and time-tested approach to PE multiples on US equities, it does not account for external risks. While many external factors are at play at any given time, it is fair to say that the current environment has more than its fair share of known unknowns (see KNOWN AND UNKNOWN UNKNOWNS (GROUNDHOGS)), many of which are potential game changers (list followed).

Liquidity is currently flowing liberally in the US economy and into its stock market. Yet, many of the above noted groundhogs could quickly change the outlook significantly. In addition, the era of excess liquidity could well end abruptly on June 30th or, more likely, fade away gradually during the summer months.

It is therefore likely that high uncertainty will keep PE ratios below what they would otherwise be in a more “normal” environment.

This is why caution is warranted here. It will be psychologically very difficult for investors to bid stocks up when PEs are no longer terribly attractive and given the number and dangerousness of the groundhogs out there.

Pointing up   On August 15, 2011 as politicians on both sides of the pond were playing Russian roulette with already sick economies, NTU pondered whether it was time tp take advantage of the significant undervaluation in U.S. equities at 1180:

Although rare and appealing from a value stand point, the current 21% undervaluation is not a guarantee of positive returns. In the last 90 years, similar undervaluation levels have not been followed by positive returns in the following circumstances:

  • Major war.
  • Deflation.
  • Rapidly rising inflation.

US inflation has been rising at a fast clip in 2011, from 0.8% in January to 3.6% in June (July CPI to be released Aug. 18). This very rapid rise in the deflating component of the Rule of 20 has been a major factor in my downgrading of equities during the early part of 2011. In effect, the S&P 500 Index went from a 21% undervaluation in November 2010 (1185) to a much less appealing 7% undervaluation last June (1320). The rise in the inflation rate cut the Rule of 20 fair PE by 2.8 points, offsetting the 14% jump in trailing earnings during the period.

(…) the way the economy is going, a total surprise to the Fed and to the economist community in general, who also used “transitory” to qualify the spring’s soft economic data. Fortunately, my readers have been repeatedly warned that the world was actually not transiting to anything pleasant (THE ECONOMIC AFTERLIFE (June 6),EQUITIES: TIME TO GO FISHING but NOT BOTTOM FISHING!(June 13), THE US ECONOMY NEEDS ANOTHER “MIRACLE” (June 17), EQUITIES: CAREFUL OUT THERE! (July 7).

I then offered 3 scenarios and took side this way:

For my part, given that we are only in mid-August (see SEASONALITY OF EQUITY MARKETS) with so little visibility and such high volatility, I remain on the sidelines for a while longer even though my fishing season is over (sigh).

Pointing up   On November 8, 2011, right in the middle of the Eurozone crisis I began my post (TIME TO INCREASE EQUITY EXPOSURE) with:

I have been very cautious on US equities since April 2011, warning that good apparent valuation would be overwhelmed by the significant macro risks. Recently, the US economy has distanced itself from recessionary risks, at least for the shorter term, and US inflation has started to recede, providing relief to consumers and a more solid background for valuation.

I then explained and documented the reasons why the Euro-scare had reached its high, concluding:

This is a binary situation and Angela Merkel will not want to go down in history as the euro sinker. The writing is on the wall and that German wall will also fall.

Then, I proceeded to explain and document the fact that the U.S. economy was not double dipping and that, in fact, it was doing surprisingly better:

Economic forecasts are more upbeat while inflation is tapering off.

US employment is slowly recovering The U.S. labor market is edging forward, with fresh data suggesting October’s modest job gains are continuing into November.

The US LEI keeps rising, gaining 0.9% in October after 0.1%in September and 0.3% in August. The October advance reflected gains in many areas that have been lagging in the recovery so far.

With the economic background more positive, highly attractive equity valuation levels became irresistible:

At 1221, the S&P 500 Index is selling at 12.9x trailing EPS. The last time the trailing PE fell below 13 was in March 2009. Prior to that, one has to go back to 1989 to find PEs below 13, a period when US inflation was in the 6% range.

The Rule of 20 takes inflation into account when assessing equity valuation. Under the Rule of 20, the appropriate PE should be 16.5 (20 – 3.5) which, using $94.75 trailing EPS gives a fair value of 1563 for the S&P 500 Index.

(…) Of course, risks remain, particularly from the political side. This is why valuation is so attractive. However, the Euro risk has entered its “terminal” phase and while US politicians continue to act … as mere politicians, the resiliency of the economy and the easing of inflation, coupled with extraordinarily low interest rates promised for “an extended period” and ample liquidity, provide a good background for US equities.

Pointing up   On March 19, 2012 (EQUITIES: IT’S SPRING AGAIN!)

The big difference with the current situation compared with last year’s is that the risk is currently centered on earnings while in both 2010 and 2011 rising inflation was the reason for valuations getting less attractive. Changes in inflation rates are more gradual than earnings movements which can, at times, be sudden and violent. Thus, risk is more significant at this point than last year, something which we must integrate into the risk/reward analysis.

The 18% upside to fair value remains superior to the downside but not much. A more balanced risk/reward equation would be reached near the 1450 level, only 3.3% above current the current level.

Many commentators are reminding investors of the fact that equities peaked in the spring of both 2010 and 2011. So the next 8 weeks will be challenging because everyone, all mindful of left tail risk and knowing everyone might want to “sell in May and go away”, might want to get ahead of the pack and sell in April.

In 8 weeks, Q1 earnings season will be almost over. Let’s see how it goes. Meanwhile, assess your equity exposure, manage your risk and watch the technicals.

Pointing up  On April 5, 2012 (EQUITIES: MIND THE GAP!)

Given the state of the Eurozone, the continued weak trend in China and my relatively pessimistic analysis on the U.S. consumer (FACTS & TRENDS: The U.S. Consumer About to Retrench), I expect economic news to err on the negative side during the next several months, prompting investors to remain cautious, even more so with the U.S. elections approaching, and the U.S. fiscal cliff just on the other side.

For these reasons, I sense that it is unlikely that markets will reach “fair valuation” (1650) within this complicated context. A repeat of last spring is more likely: in April 2011, the S&P 500 came within 10% of the Rule of 20 fair value before correcting (18%!). If 90% of fair value is all we can hope for, that’s 1485, less than 10% above the current level.

Given the “technical gap” which might get aggravated by disappointing earnings, 10% upside does not provide a good risk/reward ratio.

The yellow flag if raised.

Pointing up  On April 30, 2012 (EQUITIES: YELLOW FLAG WAVED HIGH)

Given the 9% “technical gap” which might get aggravated by disappointing earnings, 10% upside does not provide a good risk/reward ratio.

Pointing up  On June 6, 2012 (BANKING (BETTING) ON BANKERS?)

The S&P 500 closed at 1278 last week, down 8.7% from 1400 when I raised the yellow flag on April 5 (EQUITIES: MIND THE GAP!) and again on April 30 (EQUITIES: YELLOW FLAG WAVED HIGH). We are now right on the 200 day m.a. (1286) which is still rising. More importantly, equities are now 27% below fair value (1765) under the Rule of 20, slightly worse than in the summers of 2010 and 2011.

(…) fair value has continued to rise along with trailing earnings and declining inflation rates. Seems like perfect timing. (…)

We could well be about to get a big equity rally. Fear is extreme and visibility is very low, explaining the very attractive valuation. Normally, this is the time to close your eyes, pinch your nose, take a deep breadth and buy stocks.

It may be my age, or the fact that the salmon fishing season begins shortly but, for now, I’d rather be safe than sorry. I am sticking with an income and return of principal theme, not increasing equities overall.

Here’s why:

  • The game of chickens being played in Europe is too complicated with stakes and repercussions beyond understanding.
  • There is clearly a general bank run in Europe, not only from South to North but now from Europe to Switzerland and the U.S. Where and how that ends up is impossible to forecast.
  • The Eurozone economy is shrinking at an accelerating pace and complicated politics is in the way of most solutions.
  • This eventually has to impact corporate America which derives 45% of its revenues (S&P 500) from abroad.
  • American politicians are playing their own game of chickens. Based on recent experience, investors are unlikely to enjoy the spectacle of these headless hens fighting their ways towards stupidity supremacy before taking everybody down the fiscal cliff they have created.
  • All this while the U.S. economy is weakening, never having recovered from the previous downturn.
  • China has its own political intricacies while its economy is “surprisingly” weaker than expected.

Central bankers are watching the games of chickens, shouting advices in ways never heard before, warning the chicks that the Banks are running out of tricks to meet the swelling challenges. Should we bet on Bankers being heard, and listened too?

If this is the only hope, I’d rather go fishing peacefully. Bankers often also require visions of Armageddon before acting.

I have bought equities in March 2009, and in the summer of 2010 and again in August 2011 when undervaluation was also extreme due to the difficult economic and financial environments. This time, the economic challenges around the world are amplified by the complex (Europe), self-centered (U.S.) and intricate (China) political complications.

Stocks are very attractive, but the environment is too toxic. This chicken is willing to leave money on the table until he feels safer. Better be safe than sorry.

Pointing up  On November 27, 2012 (The Shiller P/E: Alas, A Useless Friend)

U.S. equities are very cheap currently. While Q3 earnings were down somewhat (-4.2% Q/Q, -3.6% Y/Y), they are not in free fall like in 2007 when they dropped 13.2% in Q3 2007 from their Q2 peak level. Also, inflation remains contained in the 2% range and oil prices, a big driver of inflation, are behaving reasonably well currently. Inflation was rising rapidly in the U.S. between August 2007 and July 2008 which, combined with declining earnings, caused a sharp 18% decline in the Rule of 20 fair value (yellow line in the Barometer chart above) between August and November 2007.

The U.S. economy has been showing encouraging signs lately. The Fed is printing money like there is no tomorrow (literally) and is actively keeping interest rates to the floor, the ECB is taking care of the Eurozone fat tail risk and China seems to have stabilized its economy and could be about to re-stimulate more aggressively. Normally, such an environment is quite enough to unlock a cheap equity market and justify a green light on equities.

Yet, I am keeping a yellow light for now, essentially because of the looming fiscal cliff which, with odds no better than 50-50, would cause a U.S. recession as early as Q1 2013. This would most likely axe 2013 earnings by 10-20%, eliminating most if not all of the current 25% undervaluation. Betting one’s own money on politicians is generally not without peril. The current undervaluation is so large that I would rather wait to see if politicians deliver or not. This has been a wise approach in Europe.

On December 18, 2012 (GREEN LIGHT ON EQUITIES)

I am partly re-committing to equities after having been cautious since April 2012.

  • The S&P 500 Index is 25% undervalued based on the Rule of 20.
  • Earnings have peaked but are not collapsing like in 2007.
  • Inflation has slowed and seems unlikely to re-accelerate soon.
  • The U.S. economy remains ok. Avoiding the fiscal cliff removes a big short term threat. Christmas sales look ok.
  • Oil prices are not a big threat although Middle East tensions remain.
  • The Fed keeps pumping.
  • China is not hard landing, actually showing signs of re-acceleration.
  • Europe remains in poor shape but the ECB will act as a backstop if things get worse.
  • Technically, U.S. equities look good with stocks above the rising 100-day and the 200-day moving averages. Technical downside is 1390 on the S&P 500, -3.3% from the current 1438 level.
  • Not a slam dunk but, all in all, the risk/reward ratio is very favorable and many catalysts are turning positive.


Tracking all pertinent news and stats, NTU is often among the first to detect trend changes. A few examples:

  • On June 6, 2011, NTU posted THE ECONOMIC AFTERLIFE which argued that Bernanke and most economists’ reassuring comments that recent poor economic stats were merely a “soft patch” and “transitory” were only wishful thinking and that the transition would in fact be toward a tougher life. By mid-summer, most economists got worried of a double-dip.
  • NTU was among the first in the fall of 2011 to document that the double dip risk was declining as the U.S. economy was in fact reaccelerating.
  • NTU was among the first to warn, late in 2011, of a significant slowdown in China.
  • NTU was among the first to warn that U.S. inflation was peaking in mid-2011.
  • NTU was among the first, in November 2011, to post about THE AMERICAN MANUFACTURING REVIVAL
  • NTU was among the first to spot GREEN SHOOTS IN US HOUSING? in mid-October 2011, following on January 3, 2012 by FACTS & TRENDS: U.S. Housing Mending
  • NTU was among the first, on October 18, 2012, to post about Facts & Trends: The U.S. Energy Game Changer

This is what New$-to-U(se) is all about:

  • NTU publishes (and archives) all pertinent economic facts objectively and dispassionately.
  • NTU analyzes trends and confronts them with conventional economic wisdom and the flavor of the day in the media.
  • NTU carefully analyzes and monitors equity market valuations using all appropriate tools but placing significant weight on The Rule of 20 which values equities using actual trailing earnings and inflation rates.
  • NTU assesses equities based on their risk/reward ratio as upside potential needs to always be measured against the downside risk.
  • Contrary to most people who let their assessments of the economic and financial environments dominate and dictate their valuation work, NTU starts with valuation, then assesses if the economic and financial environments are favorable to a closing of the valuation gaps if any.
  • NTU also offers competing views and opinions from other analysts and commentators, to challenge and verify my own initial ideas.


NTU is a personal site used for my personal investments but open to everybody. If you ever invest on the basis of NTU’s analysis, do it at your own risk and peril since there is no guarantee whatsoever about anything, including my own sanity. Remember that past performance is no guarantee for the future, even though I work very hard at it since our personal lifestyle totally depends on it.


The Shiller P/E: Alas, A Useless Friend


The high level of the Shiller P/E is one of the bears’ main arguments against equities. Bulls claim that the 10-year average earnings it uses to measure P/Es is unduly depressing earnings because it includes not just one but two of the worst profit recessions in history, the dot.com bust and the financial crisis. They also generally prefer to use “operating” earnings as opposed to the “as reported” profits that the Shiller P/E approach favors. Three articles on that debate:

Shiller P/E advocates strongly dispute the more bullish arguments. Professor Shiller admits that “corporate earnings have been unusually volatile in the past decade” but he argues that this is more reason — not less — to use normalized earnings in calculating the market’s P/E.

Others simply dismiss the bulls’ arguments with more dogmatic, almost religiously radical statements such as:

  • What about the fact that the past 10 years include two major earnings anomalies that skew the market’s CAPE? “I’m grateful that there are people who believe that, who can be on the other side of my trades,” Mr. Arnott says.
  • In short, if you don’t like what Shiller is telling you, it is because you are a bull who thinks “this time is different”.

And the ultimate:

“What alternatives do people have?”

I am entering the debate because:

  • “Operating” earnings are a better gauge of index profits;
  • Assessing current indices against the last 10-year earnings is flawed;
  • Looking at past evidence, the Shiller P/E is simply useless as a market valuation tool;
  • There is at least one alternative.

When I began as a financial analyst, back in 1975, our clients were essentially conservative pension funds and wealthy businessmen. When companies reported year-end results, one of the first questions clients asked was “What are the operating earnings?”.

In those and previous years, accounting rules and regulations were so loose that accountants had much leeway in presenting results. Investors were shown but one set of results, often highly manipulated, which may or may not reflect previous years methods and/or competitors’ standards. You had to wait 4-8 weeks after the initial release for the annual report to be mailed. Only then could you delve into the details and the notes in order to decipher what were the “operating results”, pruning out of the “as reported” all the accounting noise that, more often than not, contributed positively to the reported results.

This annual exercise helped us better appreciate and adjust the quarterlies which often came on a small folded carton with no details other than revenues, certain cost items, if any, depreciation charges and taxes. The quarterly cash flow statements were “very useful” in providing total non cash charges that may, or may not, have arisen from normal operations.

One could then approximate how companies were performing on their basic operations in order to better evaluate their stock.

“Those were the days, my friend”.

Nowadays, many investors and “observers”, often in the name of conservatism, totally dismiss “operating earnings”, advocating the exclusive use of “as reported” earnings when valuing equities.

“The times, they are a-changin’”!

Accounting “principles” changed frequently throughout the 20th century. A case in point, the treatment of unusual or extraordinary items has been fraught with difficulty. Generally,  companies had preferred to place extraordinary bad news in the earned surplus statement, and extraordinary good news in the income statement. APB Opinion 9 in 1967 endorsed the SEC’s preferred all-inclusive income statement, although it said that extraordinary items should be reported separately. Under APB Opinion 9, companies simply began rationalizing good news as ordinary and bad news as extraordinary. In 1973, APB Opinion 30 established a “Discontinued Operations” section of the income statement and defined extraordinary so narrowly that the classification no longer existed as a practical matter. In 1974, FASB’s SFAS 4 designated gains and losses on the premature extinguishment of debt as extraordinary. In 2002, SFAS 145 rescinded SFAS 4.

Other contentious issues involved inventory costing (FIFO, LIFO, etc.), goodwill recognition and amortization, foreign exchange translation, pension costs, consolidation, just to mention a few.

Here’s how the American Institute of Accountants saw its role in 1933.

Within quite wide limits, it is relatively unimportant to the investor what precise rules or conventions are adopted by a corporation in reporting its earnings if he knows what method is being followed and is assured that it is followed consistently from year to year.

When advocates of “as reported” earnings claim that “operating earnings” are manipulated and that historical stats are purer, they take little account of the fact that historical earnings were themselves positively manipulated, often much more so, than modern “operating earnings”. At least, the latters are now much better defined and consistent and are more openly displayed.

It is only in 1973 that an independent FASB became the first full-time accounting standards-setting body in the world and began to gradually improve and standardize accounting rules.

Standard & Poors has data segregating “operating” and “as reported” earnings going back to 1988.

As Reportedincome, sometimes called Generally Accepted Accounting Principal (GAAP) earnings, is income from continuing operations. It excludes both discontinued and extraordinary income. Both these terms are defined by Financial Standards Accounting Board (FASB) under GAAP.

Operating income then excludes ‘unusual’ items from that value. Operating income is not defined under GAAP by FASB. This permits individual companies to interpret what is and what is not ‘unusual’. The result is a varied interpretation of items and charges, where same specific type of charge may be included in Operating earnings for one company and omitted from another. S&P reviews all earnings to insure compatibility.

Adjusted operating earnings may exclude non-recurring expenses such as restructuring charges, asset sales gains, major litigation charges, goodwill write-downs and other write-offs.

Having an independent body to ensure compatibility and continuity adds credibility to the “operating” earnings time series. S&P effectively prunes out, when it deems appropriate and consistent, non-recurring expenses such as restructuring charges, asset sales gains or losses, major litigation charges, goodwill right downs and other write-offs that are unlikely to recur in the future and are thus regarded as one-off items that distract from the recurring earnings stream and true operating results. S&P does not only adjust earnings upwards. For example, Q3 2012 “operating” earnings were reduced below “as reported” for 50 of the S&P 500 companies.

While it is advisable to take account of “recurring non-recurrings” when analyzing individual companies in order to assess management, the notion becomes preposterous when used for an index such as the S&P 500.

The chart below shows how trailing 12-month “operating” earnings diverged from “as reported” since divergence began in 1982.


Between 1982 and 2000, the average spread was 7.4% with a 7.2% median within a stable 0-17% range. Since 2001 however, the average has shot up to 20.4% with an 11.8% median. The internet bubble and, particularly, the financial crisis have both resulted in huge “unusual” charges, substantially larger than what we had seen in the previous two decades. At its current 11.5%, the spread is back within its past normal range.

In both these truly exceptional periods, many companies, large and small, reported losses, some significant, others simply humongous. To appreciate the uniqueness of the 2008 debacle, consider that for Q4 2008, 140 S&P 500 companies, nearly 1 in 3, reportedlosses, 97 of which also recorded “operating” losses per S&P.

As a result of the carnage, trailing 12-month earnings for the S&P 500 Index collapsed to a trough of $6.86 in March 2009, down 92%from their June 2007 peak of $84.02. The last time trailing earnings were below $7.00 was in April 1973, 35 years before! “Operating” earnings, meanwhile, troughed in Q3 2009, declining 57% from their $91.47 peak of June 2007 to $39.61.

Many investors, strategists and economists have missed the March 2009 market trough because they blindly used the “as reported” data. Had they done a little more thinking and research they would have realized that:

  • While reported earnings had cratered 92%, the value of corporate America could not have shrunk anywhere near that.
  • Importantly, a very large part of the losses were in financial companies due to the  collapsing housing market and the Lehman failure. Many recorded humongous losses while their stock price sank as bankruptcy loomed. This extraordinarily unique combination of sky-high losses and stock prices diving towards zero created a very unique situation for stock indices: companies with then almost negligible market weights were recording humongous losses.

Here’s what Wharton professor Jeremy Siegel wrote in a Feb. 25, 2009 WSJ article:

(…) As the fourth-quarter earnings season draws to a close, there are an estimated 80 companies in the S&P 500 with 2008 losses totaling about $240 billion. Under S&P’s methodology, these firms are subtracting more than $27 per share from index earnings although they represent only 6.4% of weight in the index. (…)

I added these details in my March 3, 2009 post S&P 500 P/E Ratio at Troughs: A Detailed Analysis of the Past 80 Years:

At the extreme, and we are admittedly in an extreme period, a large company with a tiny market capitalization could incur losses so large as to wipe out most of the S&P 500 earnings (AIG lost over $60 billion last quarter alone). As a result, the Index PE would skyrocket even though the other 499 stocks’ valuation would actually not change at all. In effect, a casual or superficial observer looking at the Index would conclude that equities are expensive or overvalued when, in fact, 499 stocks would be cheap or undervalued.

Incidentally, the S&P Financial sub-index recorded “operating” losses in each and every quarter of 2008 for a yearly total of $21.24 ($37.96 “as reported”)

  • Another important and overlooked consideration is that many of the companies that recorded huge losses in 2008-09 either went bankrupt or were substantially restructured or acquired. A conceptually valid valuation method like 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. As to the dot.com bubble, everybody remembers the infamous Enron and Worldcom, just to name a couple. 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?

Cliff Asness, a Ph.D. turned hedge fund manager (AQR Capital) recently wrote a long note “An Old Friend: The Shiller P/E” which was extensively disseminated by the media and, particularly, the bear population . The notorious quant statistically looked at most arguments against the Shiller P/E and categorically ended the debate:

Those who say the Shiller P/E is currently “broken” have been knocked out.

Unfortunately, Asness did not stumble of the truth this time since nowhere does he mention that his current roster has little to do with that which generated the 10 year record.

While the internet is filled with Shiller supporters, I failed to find a good analysis of the actual track record of this valuation method. It may be because the record leaves a lot to be desired.

The long term average of the Shiller PE is 16.5 and the median value is 15.8 which most people seem to use as the dividing line between cheap and expensive. I will let you judge by yourself based on your own personal needs and risk aversion, only to point out the following (click on charts to enlarge):

  • Post WWII investors using the Shiller P/E would have had very few buying windows, to say the least.
  • The 20-year period between 1955 and 1975 was a very long one to stay on the sidelines.
  • One could have bought the 1974 low, only to be back on the fence in early 1976, buying again during the next 10 years but sell out in 1986, only to watch equities appreciate 2.5 times to 1996 (I am excluding the internet bubble years).


Cliff Asness computed 10-year forward average returns from different starting Shiller P/Es since 1926:image

(…) while not near its prior peaks, today’s Shiller P/E is high versus history. In fact, it’s higher than it has been 80% of the time since 1926.

The media and the bears loved that last sentence and the supporting table! Asness continued:

(…) Ten-year forward average returns fall nearly monotonically as starting Shiller P/E’s increase. Also, as starting Shiller P/E’s go up, worst cases get worse and best cases get weaker (best cases remain OK from any decile, so there is generally hope even if it should not triumph over experience!).

In particular, in the ninth bucket (where we are today at 22.2) the average real stock market return over the next decade does not break 1%. The worst case is a horrendous -4.4% real return per annum (those who think the disappointing post-2000 decade-long results can only happen from super high P/E’s are mistaken), and the best case is very good, though less wonderful than the much better best cases from lower starting Shiller P/E’s.

Asness then goes on listing some caveats but never mentions that readings below 15.8 occurred mainly before 1950. He does, however, confess that

(…) I would, if trading on a tactical outlook, give the Shiller P/E some small weight, particularly when it’s above 30 or below 10.

There you go! Cliff Asness shared the Truth with us. Since 1927, that is over some 1,030 months, the Shiller P/E registered below 10 thirty-seven times (3.6%), all but two months being pre-1942, and was over 30 eighty-nine times (8.6%), all but 2 being between 1996 and 2007.

The Shiller P/E may be an “old friend” to Cliff Asness (although he was born in 1966), let’s hope it is not his best friend.

“What alternatives do people have?” This authoritative question is from Professor Shiller himself.

Here’s an alternative: my personal old friend the Rule of 20 which says that fair P/E is 20 minus inflation. When the actual P/E on trailing EPS plus inflation is below 20, equities are undervalued. Above 20, risk increases as overvaluation rises.


Admittedly not perfect but, in my book, substantially more sound and useful than the Shiller P/E. I must admit that I was actually hoping to find another friend in the Shiller P/E that would complement the Rule of 20. Alas, this is not my kind of friend.

The Rule of 20 is a risk management tool, enabling investors to measure the downside against the upside in order to decide whether the risk/reward profile fits their own personal needs.

Most strategists tend to analyze the economy and the market fundamentals before assessing if the market P/E fits their scenario. I prefer the opposite approach. First, I objectively measure the risk/reward ratio, paying particular attention to trends in the 2 components of the Rule of 20: earnings and inflation.

When equities are expensive, I work on my golf game or go salmon fishing. When  equities are cheap, I then assess the economy and the fundamental trends to see if a trigger is near that might unlock values. Here’s the Rule of 20 barometer since 1980.


I have been blogging since January 2009, providing my readers with balanced, objective and detailed views, caring more about preserving than increasing capital (the return of capital concept vs return on capital). I have generally been positive on U.S. equities since March 2009 with three interim periods where I advised caution. The Rule of 20 has been very useful helping me objectively measure risk vs reward during these very volatile years. However, a disciplined following and objective analysis of the economic and financial environment is always needed to supplement the mathematical risk/reward equation (detailed track record).


U.S. equities are very cheap currently. While Q3 earnings were down somewhat (-4.2% Q/Q, -3.6% Y/Y), they are not in free fall like in 2007 when they dropped 13.2% in Q3 2007 from their Q2 peak level. Also, inflation remains contained in the 2% range and oil prices, a big driver of inflation, are behaving reasonably well currently. Inflation was rising rapidly in the U.S. between August 2007 and July 2008 which, combined with declining earnings, caused a sharp 18% decline in the Rule of 20 fair value (yellow line in the Barometer chart above) between August and November 2007.

The U.S. economy has been showing encouraging signs lately. The Fed is printing money like there is no tomorrow (literally) and is actively keeping interest rates to the floor, the ECB is taking care of the Eurozone fat tail risk and China seems to have stabilized its economy and could be about to re-stimulate more aggressively. Normally, such an environment is quite enough to unlock a cheap equity market and justify a green light on equities.

Yet, I am keeping a yellow light for now, essentially because of the looming fiscal cliff which, with odds no better than 50-50, would cause a U.S. recession as early as Q1 2013. This would most likely axe 2013 earnings by 10-20%, eliminating most if not all of the current 25% undervaluation. Betting one’s own money on politicians is generally not without peril. The current undervaluation is so large that I would rather wait to see if politicians deliver or not. This has been a wise approach in Europe.