Opinions and observations expressed on this blog reflect the authors' individual experiences and should not be construed to be financial advice. None of the members of this blog are licensed financial advisors. Please consult your own licensed financial advisor if you wish to act on any recommendations here.

Friday, July 30, 2010

An Interesting Look Back at Economic History

GDP data revisions sometimes can have the effect of re-framing our thoughts on the nature of the business cycle we just went through. For instance, the revisions released this morning showed something interesting about 2008.

The interesting thing to me was that Q3 2008 was simply wretched and much more so than we had previously thought. An annualized 4.0% contraction is fairly poor, though not entirely surprising given that Q3 was the quarter most heavily impacted by the ridiculous levels of oil prices at the time. That effect is borne out in the finer points of the data where consumer spending declines accounted for fully 2.5 points of that 4.0. This is what you would expect given the huge hit to purchasing power consumers took.

I think this confirms what James Hamilton over at Econbrowser has argued for some time which is that the oil shock in 2008 had a much larger contribution to the severity of that recession than we give it credit for. Bear in mind, Lehman collapsed in mid-September and its full effects were not really in place until the end of the month. Lehman's effect was mainly a Q4 event, and of course Q4 and Q1 2009 were simply abysmal quarters. However, it is clear that even without the collapse of Lehman that we were in the midst of a severe recession due to the combination of the grind of the housing collapse and the oil shock in 2008.

To some extent, other data revisions reflect this as non-farm payrolls were in very steep decline in the late summer of 2008 even before the effects of Lehman. Now the picture is a little more complete.

How Big is the Chinese Property Bubble? Pretty Big

I stumbled across a bunch of charts the other day and this one in particular caught my eye: http://www.businessinsider.com/chinese-land-prices-2010-7#likewise-price-increases-are-killing-income-increases-14 (Credit goes to Jing Wu, Joseph Gyouko and Yongheng Deng at NBER)

What I have said for some time is that despite migration patterns providing a substantial level of support to real estate in China, there is a fundamental problem where price gains have far outstripped income increases. This is also the reason I don't buy the idea that all of these houses are being bought strictly with cash, or at least cash that isn't at some point supported by debt. It just isn't possible.

Just to give you some idea of what a price to income ratio of over 20.0x in Shenzhen means, here in the U.S. California had a price to income ratio of right about 10.0x before prices started plummeting to about half of their all time high. Other markets still had decent sized corrections with price to income ratios of only 4-5x. Generally, much north of 4x is considered to be on the edge of pushing it nationally here while some markets can sustain, over time, more like 5-6x. I've seen some countries that can apparently sustain near 7x, but even for those countries that seems to be the point at which prices stagnate and wait for incomes to catch up.

Returning to China, it is true that there is regional variation, but that has been true in every real estate bubble in history. Here LA, New York, Miami, Las Vegas, Phoenix, Milwaukee, Cleveland, and Detroit all had very different dynamics. In the U.K., London, Liverpool, Manchester, Brighton, and Newcastle had varying degrees of excess. The same applied in Spain in the 2000s and Japan in the 1980s. It's a very non-compelling argument to say the least. What's more is that price to income levels mask another trait of real estate excess which is that those on the bottom end of the income spectrum often get caught up in the frenzy and buy much more house than they can afford in otherwise not particularly overpriced markets such as Atlanta.

It is unclear how much further this has to go, but perhaps Alex can expand with some first hand details on what he saw there.

Wednesday, July 28, 2010

The Peculiar Allure of Gold: Part 1.1

Some time recently, we discussed here some of what seems to drive the price of gold.While all of the other arguments for owning gold are generally a pile of crap, I had noted that over time there did seem to be an inverse relationship with the value of the dollar under most circumstances. However, I would note of late that it seems that even this relationship has broken down.

This is a simple picture (click on it to enlarge):

What you are seeing there is a 3-month chart of the ProShares US Dollar Bullish Fund (UUP), which has leveraged bullish bets on the US dollar vs the SPDR Gold Trust (GLD) which tracks the price of gold. You might note that there is a positive correlation between the dollar and the price of gold. Wait... what?

Well, maybe for the past three months gold has been a bet against the Euro while over the long run it is a bet against the dollar while also being an inflation hedge while also being a crisis hedge while not doing a particularly good job reflecting any of those relationships! I think there is a simpler reason for the decline of gold recently and that is that as it is clear that there is no risk of accelerating inflation, probably the number one reason scared little Glenn Beck listeners have been hoarding gold has been undercut severely. By the way, bashing on Glenn Beck is not in violation of this blog's no political discussions rule since Glenn Beck's insanity transcends ideology. He gives investment advice and it is damn bad advice at that.

For instance, while things have gotten rough over the past few months and U.S. deficits are in the stratosphere, surely you wouldn't want to invest in worthless pieces of paper like U.S. Treasuries and instead would want the safety of gold, right? Wrong. Very wrong. Stupidly wrong.

TLT, our long term treasury proxy, kicked the hell out of GLD over the past three months while stocks, represented by SPY here, suffered as we all know. It is interesting to note that some gold bulls had maintained that stocks and gold must necessarily rise together because... um... well because they said so, that's why. Never mind that this is a relationship that has never really held except for brief periods when it seems to out of pure coincidence. Recently stocks have rebounded more sharply than many give them credit for while gold has been in a trudging decline.

Gold currently is trading in such a peculiar way that it is helpful to think about the following. Currently, gold is not trading in accordance with any clear rational relationship to, well, anything. If the rationale for investing in an asset is not clear, then you should not invest in it. I can easily spell out why equities are good buys at present levels based on well accepted empirically derived relationships. Gold, it is not so easy unless you truly believe that we are about to undergo a period of 10%+ inflation, which I do not and the markets do not either except for the gold bugs who are always and everywhere trapped in a particularly pernicious insanity.

It may well be that gold gets foisted to new highs by irrational markets, but I would wager that in the next five years gold will be beaten by just about everything, including housing.

Tuesday, July 27, 2010

Municipal Debt Worries Overblown

Now, this is outside of any official capacity I have with the State of Wisconsin and I personally own no municipal bonds, but I do think it is important not to fall victim to scare tactics. For weeks and even months, there have been numerous attempts to prompt a run on the municipal bond market. The simple truth is that worried are far overblown. This article from last week expresses the view of one firm, but I think it is correct: http://www.businessweek.com/news/2010-07-20/insurers-risk-of-municipal-debt-defaults-overblown-fbr-says.html

Neither I nor most readers of this blog have much use for municipal bonds since the tax-free status of the interest on most issues means very little to us. There are online calculators all over the place that help assess at what rates tax-free versus taxable bonds make sense at given income levels and I won't get into that now except to say that if you don't know if buying municipal bonds makes sense to you, the odds are that it doesn't. However, the issue as to whether or not there will be hundreds of billions in defaults that will cripple the balance sheets of insurance companies like Aetna (AET) and WellPoint (WLP) or possibly bank balance sheets is worth mentioning.

The simple truth is that most municipal and all state governments have very robust provisions to insure the timely payment of debt service. California proved that in spades recently. Some special districts with limited taxing authority have defaulted and many more probably will, but in terms of large scale general obligation bond defaults, that's a very unlikely scenario indeed. If you are looking for the "next shoe to drop", this is not it.

Monday, July 26, 2010

Sneak Peek at July Auto Sales

This is a bit of positive news that might indicate weak May and June consumer spending may simply be chop rather than a trend. http://www.prnewswire.com/news-releases/jd-power-and-associates-reports-july-new-vehicle-retail-sales-rebound-sharply-from-weak-june-sales-driven-by-a-multitude-of-small-wins-99012694.html

That being said, virtually any of the numbers we will be reasonably talking about here would have been considered recessionary not all that long ago. The fact that Ford (F) is making as much as it is in this environment bodes well for them going forward. Trading at below 8x earnings and possibly as low as 7x next year's earnings if they keep blowing the socks off of all estimates, it's actually not terribly priced right now. I could easily see how there's another 30-40% in it from here if not more by December of 2011. Remember, just because a stock has advanced a lot does not make it overpriced. Ford by an objective measure is cheap.

Sunday, July 25, 2010

European Bank Stress Tests vs. U.S. Stress Tests Part 2

I think that these stress tests are the equivalent of only testing what happens to a patient's heart when they walk ten feet. Bloomberg has a good article on the subject here: http://www.bloomberg.com/news/2010-07-23/eu-bank-stress-tests-fail-to-reassure-investors-wary-of-capital-criteria.html

In our stress tests, several banks were found to be in need of tens of billions in new capital, which they subsequently raised from markets that were satisfied about the stress tests' rigor. In this case, I rather doubt markets will be satisfied once they have time to digest the results.

Saturday, July 24, 2010

What's Next for Millicom (MICC)?

Several of my friends know that I am very excited about the prospects for Millicom (MICC). For the uninitiated, MICC is a Luxembourgian (though Swedish in origin) provider of cellular phone service in developing countries ranging from Costa Rica to the DRC in Africa. Africa, incidentally, is far and away the largest driver of sales growth in recent quarters. It also has a cable business in some central American countries, but that is not its predominant product line.

Most of what MICC provides is pay as you go cellular service, which fits developing markets well. Rather than having smartphones that even a middle class American might go broke on, they distribute cheap, damn near disposable phones in these markets and allow their customers to purchase however many minutes they want. In countries where landlines are almost non-existent and they went straight to cell phones this makes a lot of sense. Phones are used on a limited basis in most of these countries, often only for essential purposes. With low incomes, paying a recurring monthly charge for service you are not using makes little sense.

In any case, after a brush with bankruptcy in the early 2000s, MICC revamped and has been growing at a good solid clip ever since. Revenues have more than doubled in the last four years and will likely nearly double again in the next five. For all of the growth they have seen, the company still only had just over $3.4 billion in revenue in 2009. This isn't a great comparison, but just for the sake of something to compare to, Verizon (VZ) had revenues of $107 billion. Operating margins have also improved from 75% in 2006 to 82% in 2009. Net profits have been a little hard to interpret due to many acquisitions, divestitures, and their associated write-downs and one time profit gains. Based on operating profits though, there has been steady improvement.

The balance sheet is not overly leveraged with its cash position growing in line with its long term debt. This is important from the standpoint that if there is, God forbid, another financial shock like 2008, MICC is not vulnerable to a financing crunch. I've become more cognizant of that as an issue with companies since the crisis.

The recent earnings report, released just this last Tuesday was a thing of beauty even though on the surface it looked like a bad miss. The market realized this too, and the stock was notably higher by the end of the day after selling off in the morning. Revenue growth of 14% (11% after currency adjustments) and earnings growth of 17%. Customer base growth was near 20%, which is a promising sign for future revenue and earnings growth. All of this leads to a stock that trades at a modest 13.4x forward earnings. That's hardly steep and in normal times with their growth rates would be a steal.

As mentioned briefly earlier, the growth rates in Africa are astounding. Fully 3/4s of the subscriber growth came from Africa in the last quarter, partly driven by depressed numbers elsewhere from divestitures, but still this is an amazing thing. Africa has averaged just shy of a million new customers a quarter in the last three quarters.

Now, they do have competition for these rapidly growing markets, but market share has been steadily ticking up. It's always a good thing to have a growing portion of a rapidly expanding pie. The African numbers looked like a disappointment, but actually the market share number took a hit from entry into Rwanda since they had no presence there before. Adjusting for that, market share is growing in Africa.

All that said, the outlook for MICC looks promising and I think this is reflected by the fact that the stock has held up quite well during the recent sell off in the broad market the past few months and its gains when the market rises tend to be greater than the overall market. That said, it is a lightly traded stock at less than a million shares a day and often less than 500,000. It can be easily moved in a bad day and drop $4-6 a share. If you cannot stomach that, it might not be right for you. Still, opportunities to play growth in Africa directly are rare, even when they are a little volatile.

Thursday, July 22, 2010

Another Look at the Mortgage Bond Insurers

A few months ago, we took a look at MGIC (MTG), PMI (PMI), Radian (RDN), Ambac (ABK) and MBIA (MBI). At the time, I commented that they seemed to be coming back from the dead with the stocks posting very rapid increases in the six weeks prior to that post. Fairly shortly thereafter, they all had a rough go of it and subsequently dropped off a cliff as they, one after the other, posted fairly lousy earnings and the overall market was fairly rotten too.

At the time I commented that I wasn't entirely sold on their recovery as we are still within the wake of the vessel of death that was the mortgage crisis, however I think we can say that at least some of these companies should survive. I'm not too thrilled when I look at any of their balance sheets. They are in fairly weak positions, though debt burdens are not ruinous in any particular case so it is unlikely that even another brief credit shock would force any one of them into receivership in a hurry. Normally, this is not promising ground for starting a discussion on a stock or group of stocks, but when you are talking about companies that 18 months ago traded at fractions of their still low prices today it makes sense to do so.

Let's then turn to their earnings prospects. On the revenues side, it's fairly simple. Mortgage lenders and investors purchase insurance to cover against defaults by borrowers. Historically this was a boring business as default rates were so low that payouts were quite meager. Of course, that changed and these companies hemorrhaged money at unbelievable rates for nearly two and a half years straight. Really, it's actually a fairly simple business at its most fundamental level. There are eccentricities to the contracts I invite a more learned person to chime in on, but the basics are easy to understand.

With that in mind, what is the overall outlook? Home sales, once the plunge following the tax credit is done sorting itself out, really do have to go up. I hate to put it as simply as that, but I think it is fair. Over the next couple years, mortgage originations should increase along with the sales. This year is a little choppy and full of distortions so I don't expect miracles. What I don't know is what has happened to the premiums they are able to collect. Have they reduced them to try to grab a bigger piece of a smaller pie or have they increased them as their perceptions of risk were repriced? I can't find any data on this so I would encourage anyone to take a look at it.

On the expenses side, defaults are slowing and should top out shortly. Already we are seeing the claims paid by almost all of these companies taper off, albeit slowly. Of course, if we have a double-dip, things could get dicey, but then we have other problems. As such, I think on both the revenue and expenditure sides, we have the first true trends toward stability since the second quarter of 2007. Yeah, this mess started that long ago. However, I am speaking broadly of the sector. There is differentiation among the several firms.

As I still am not overly familiar with the companies, I won't try to be cute in what I think of their financial conditions and instead I will keep it simple. The companies that are most rapidly moving toward the break-even line are the best bets. MTG is the one most clearly moving toward profitability with claims dropping rapidly from close to $1 billion a quarter to under $500 million. I would still wait for their next earnings report to see if this trend holds. With this plunge, they are actually within sight of profitability. MBI is a little difficult to divine due to large one time charges, but they seem well on the path as well. RDN confuses me and the outlook appears unclear, even for this sector. PMI is iffy and ABK is trash and both shouldn't be touched, especially ABK for those who are attracted to penny stocks.

If I had to buy one, though I am still not inclined to buy any until I see a truly decent earnings report since the easiest money has already been made in these stocks, I would have to buy MTG. I remember when the announced in about August or September of 2007 that they didn't think they would turn a profit again until 2011 or 2012. I'll give them credit since that was probably one of the most accurate forecasts of this entire crisis and because of it they did the best job of protecting themselves and those efforts are starting to bear fruit. That said, I am still less than enthralled by the entire sector. I like value plays, but this is on the outer limits of my tolerances.

Tuesday, July 20, 2010

On Spotting Bubbles: Part 1 of Many

One of the most fascinating phenomena in financial markets is the "bubble". Defining a bubble is somewhat of a tricky art form. I think most people would agree with this quote by Justice Potter Stewart on the issue of obscenity: "I know it when I see it". We all think we know a bubble when we see it, but do we really? I have found myself looking for definitive methods for spotting bubbles before they are clearly out of control and I wanted to share some thoughts on the subject.

Broadly speaking, I would essentially define a financial asset bubble as a case where the price of an asset has far outstripped any reasonable relationship to what it should be priced off of. With stocks, this is the earnings power of a company. With housing, it is the price to rent ratio or a price to income ratio with some adjustments. Asset prices, no matter how much people may want to believe otherwise, must necessarily be constrained by their relationships to their fundamentals over long periods of time. If this was not a constraint, we could all become infinitely wealthy by speculating in financial assets. What these fundamental relationships should be (i.e. a PE of 15x vs 17x or a price to rent ratio of 1.1x 1.0x) are the province of markets to flesh out over any given time, but in the long run, certain reasonable relationships do hold.

"Ah", you might say, "You said in the 'long run'. What about the short run where I actually live?" Indeed, and this is the problem. Over short (3-5 year time spans) any particular asset class can become wildly overpriced. How wildly? Well, let's look at the NASDAQ in the span of 1996-2000:

As you can see, up until 1999, the NASDAQ held more or less in line with the S&P 500 before wildly departing and going absolutely bonkers (technical term). What's more is that the S&P 500 in this time frame was also overvalued quite considerably, though I will discuss that finer point in detail in later post. Earnings growth during this time span was good, especially for the technology-heavy NASDAQ, but not anywhere near that good. It's much like how ordering pasta at a high-end Italian restaurant may be worth $15.00 a plate, but not $30.00. At $30.00, you are just being irrational.

This takes me to a brief digression on economists. Many economists, particularly those with significant classical leanings (no, they don't sit around and listen to the finest works of Handel, though they might) feel that consumers and investors are always rational and they justify this point with a bit of twisted logic. This is that because an investor bought an asset at a certain price and expects to receive more for it in the future, they are being rational. Only if they bought an asset with the expectation that they would lose money in the future would they be irrational. If this definition of rationality strikes you as absurd, it should. If I were insane and kept drinking six cans of Dr. Pepper everyday under the expectation that would be good for my health, would that be rational? Well, it might be if I were poorly informed, but I would already have to be irrational to believe such a thing.

This brings me to how to, qualitatively, spot a bubble. You do not do so by saying "Oh, the stock market is up 50% over the past twelve months so that must be a bubble" because the market has done that plenty of times and not looked back ever again. Similarly, in individual sectors, a rapid advance does not necessarily mean that people are not in league with their senses. Steel production in the United States in the late 19th century increased many thousands of percent and did not constitute a bubble. Similarly, PC sales from 1985 to 1995 increased by such a large percent that most people wouldn't believe it if you printed it. As such, a simple quantitative rule such as "x% increase necessarily equates a bubble" is not useful.

The basic qualitative framework for assessing the likelihood of a bubble is trying to determine the amount of reliable information (broadly construed) available in a market and then assess to what extent that information is being employed rationally. There is a third variable that is unfortunately quantitative, but is easily enough assessed which is whether the asset or whole asset class in question present offer greater than typical rates of return. Bubbles do not form in assets or asset classes where there is not a truly better than typical fundamental story going on. For example, the U.S. housing bubble formed during a time of low inventories and high affordability due to low interest rates. The NASDAQ bubble occurred in the sector of the economy seeing the fastest growth.

So, to put succinctly:
1. Is the asset or asset class in question fundamentally more attractive than other alternatives?
2. Is there either little information available or is the information corrupted in some way?
3. Are market actors incorporating available information or are they doing so in a rational way?

As I hope to show in later posts, this basic framework can be used to assess not only the presence of bubbles, but also to determine the differential effects of bubbles within an asset class. Incidentally, these criteria can be used to assess what I call "fear bubbles" such as what existed in March 2009.

So Goldman Sachs is Mortal

This is an interesting little snippet I so today while perusing the headlines: Goldman Loses Money on Volatility Bet in 2nd Quarter . Goldman Sachs (GS) had one of the most astonishing win records ever prior to this point with large bet after large bet paying off handsomely. Betting that volatility would drop when they did actually struck me as a peculiar thing because in most of the second quarter we were dealing with a series of unfolding crises. Perhaps Goldman thought they would pass more rapidly.

Saturday, July 17, 2010

Quick Update of Dynamic Asset Allocation Model

The model still suggests an 80% allocation to equities in the current environment. Despite the contraction in the yield curve, the expansion of the earnings yield measure and corporate credit spreads added more than the narrowing in the yield curve took away.

On a fundamental basis, this allocation makes sense for entirely another reason. The dividend yield on the S&P 500, forgetting earnings for a moment, is just shy of 2%, so you are only giving up 1% on 10-year treasuries just there. Among those stocks that are actually paying dividends right now, the average yield is 2.54%. Further, these numbers are depressed by the fact that almost all financial stocks, normally payers of robust dividends, have pulled back over the past two years to pay virtually nothing. Case in point, JP Morgan Chase (JPM) was once a payer of a 4% dividend or better, but in order to preserve capital during the financial crisis it put that down to 0.5%.

With such a narrow differential between bonds and stocks in terms of income generation, it doesn't make long term sense to be heavily in bonds at the moment. From a trading perspective, it varies, but for those without sufficient cash to trade, it makes the most sense to be heavily in equities in the present situation.

Thursday, July 15, 2010

Bank of America to Customers: We Don't Ever Want to See You

This is an interesting trend in banking. Bank of America (BAC) is giving you a strong financial incentive never to set foot in one of their branches. Really, that is what they are doing. Even to me, with as short a time as I've been on the earth, this is hard to fathom, but I suspect that over the next five years this will be much more common than not. It's amazing to think that as recently as a decade ago, banks were still trying hard to increase their number of physical branches. That seems a quaint idea now. 

Wednesday, July 14, 2010

Are Indian Bank Stocks Good Buys Now?

For years, the Indian bank stock, principally HDFC Bank (HDB) and ICICI Bank (IBN) have traded at earnings multiples that would make even an aggressive growth investor flinch. Back in the heady days of 2006 (at least they were heady days for emerging markets), these banks often traded at 30-40x forward earnings. That compares to the general practice of only paying 15x forward earnings or less for most bank stocks. Part of this discount, regardless of growth rate, comes from the fact that banks can in fact be prone to massive calamities. Of course, we wouldn't know anything about that. Speaking of which, I haven't seen my shares of Wachovia recently. Do you know where they might be? (Disclaimer: I never owned Wachovia)

That being said, after a few years of continued earnings growth and stagnant stock prices, it might pay to see where we are here. IBN, on its surface, seems to be the better buy, trading at around 14x next year's earnings and growing earnings at a torrid pace. HDB trades at over 21x next year's earnings with a very similar growth clip, though the market may be indicating that analyst estimates might be in error. Frustratingly, I must confess I know little of the Indian banking system, being much more familiar with Brazil's among the BRIC countries. What I do know is that the central bank is currently tightening which will probably keep these stocks under pressure for some time to come as their net interest margins come under pressure. I would say then that there is little reason to nibble here for now, but in about six months time it may be fruitful to buy one or both of these banks as long term holdings. The lofty estimates for earnings growth should be obtainable so India is a country with relatively low credit utilization.

Of course, there are those that are skeptical of India's long term prospects. I am not among them and I actually favor the long term prospects of India over those of China for the reason that I believe India to have a more fundamentally sound political system. I am sure there is going to be a great difference of opinion on that point.

Monday, July 12, 2010

Medical Device Makers: A Pacemaker for Your Portfolio?

The medical device sector has been one that has seen some severe multiple compression in recent years where, instead of paying close to 20x earnings for a steady 10% annual growth rate, now the market seems content to only pay 12-14x earnings. The result is that these stocks have been cruelly punished to the point where they are looking nearly criminally cheap. Even in a time of normal interest rates it makes sense to buy stock in a company trading at 20x earnings with a 10% annual growth rate provided that it also has some dividend yield. At 3-4% interest rates when these companies are still reliably delivering strong profit growth these companies look quite cheap. Specifically, I am speaking of:

Medtronic (MDT)
Johnson and Johnson (JNJ)
Zimmer Holdings (ZMH)

One thing I like about all of these compared to pharmaceutical companies is that they are not as subject to patent risk. Medical devices are far harder to produce "generics" for as not just any mom and pop manufacturing firm can whip together pacemakers or spinal implants. Even if they did, the liabilities would be tremendous. That's not as true with generic drugs. Once you know how to do the chemical formula, it's fairly simple. Of course, I am speaking as someone who didn't do too well in chemistry, but empirically speaking this seems to be true. These companies do periodically get hit with government probes and lawsuits, but rarely have they gone anywhere.

I personally own Medtronic and it has been a source of frustration as it has delivered on its earnings growth targets, but it has seen its PE multiple shrink down to the point it now trades at 9.8x next year's forecast earnings. That's absurd for a company growing 10% a year. It once traded at close to 23x earnings when I first bought it. Similarly, Johnson and Johnson trading at 11.4x next year's earnings is also very cheap, especially as it pays a 3.6% dividend even if it doesn't go anywhere. I'll take 3.6% given that ten year treasuries give so less. Zimmer trades at 11.8x next year's earnings with a growth rate even higher than JNJ or Medtronic. Its downfall is that it doesn't pay a dividend.

If I had to recommend only one of these, I would say JNJ is the best bet for a core position. That dividend yield on top of 8-10% annual earnings growth is hard to say no to. Also, it has more diverse product lines, though medical devices provided the real oomph to the growth rate. Still, the diversity does insulate it from being hamstrung by a liability issue in any one product line.

In all of this you will note that I did not mention Boston Scientific (BSX). This is for good reason. That stock is garbage and it only brings sadness and woe to all who own it. Leave it alone to fester and decay in the pits of stock hell.

Sunday, July 11, 2010

Our new banner!

After much discussion and consultation with my artist mother, we have arrived at the above banner. I will note that the emerald tree monitor from the first banner is still there and has a stock ticker for a tongue. There may be some tweaks in the future, but I think that this is an improved design from the four images I just strung together previously.

Saturday, July 10, 2010

How do I value stocks anyway? Part 2

This will be relatively brief as a follow-up to the previous discussion and it will predominantly focus on a particular part of how price to earnings ratios (PEs) are used to value stocks. I will confess that I have not read a finance textbook in some time so the following is more what I have observed and what economic theory would dictate than any particular theory that is widely accepted.

When you look at a stock quote page on any website such as Bloomberg, Yahoo! Finance, Marketwatch, or whatever brokerage account you use, you will see an estimate of the company's PE ratio. More often than not, this is based on the earnings per share for the prior one year as reported on a GAAP basis. Often when you hear an analyst on TV talking about a stock that they like, they will either use this prior one year number or use analyst estimates of the next fiscal year. Either way, it is almost always a one year snapshot. The market in general is usually somewhere between 10 and 20 times earnings, though individual companies vary widely.

Now, you might be asking yourself "Why would I pay 10-20 times a year's worth of earnings for a company?". This, on its face, is a good question. It does seem a bit absurd. However, implicit in our acceptance of any given PE ratio is the assumption that the current year's earnings per share are a good point for estimating future years' earnings. Indeed, stocks, more or less, conform to the discounted future earnings (or the related dividends and cash flows) of a company over a number of years. Take a current year's earnings, grow them at 8% per year, appropriately discount them for inflation or a risk free rate of return (people do both), sum up, say, 10 years and you get a number that makes considerably more theoretical sense.

Now, some interesting implications of this can be found in real life examples. Take Bristol-Myers Squibb (BMY) for a moment. In 2000, it traded at about 25 times earnings, which was not absurd given its growth rate in the 1990s. This was true of nearly all pharmaceutical stocks. However, collectively, their pipelines dried up and their patents expired, leading to earnings stagnation. Despite having a reasonable PE often around 13-17 times current year earnings, the stock first plunged and then simply faltered. This was repeated across the pharmaceutical industry.

Many analysts routinely mentioned the low PE ratios of the pharmaceutical companies as being a cause to buy these stocks under the assumption that they were now underpriced. However, the only thing that makes a PE ratio of 15 or so reasonable is if that company is going to be growing earnings over the next decade by at least 7% a year. In the case of BMY, you can see in the lower panel of that chart that they have had no earnings growth for a long time. Hence, the stock has fallen well off its highs and continues to languish.

Of course, the same thing happens the other way too. Seemingly unreasonable PEs like Google's (GOOG) can be made reasonable by truly extraordinary growth rates. A company can trade at 60x earnings if it is about to grow 35% a year or more for five years straight.

Another implication of this concept is when a company is poised to have an explosive year due to a big one-time payment or government contract. It may have a very low PE ratio due to these artificially expanded earnings. However, it will be a rude surprise for you indeed if you buy based on that and the company's earnings return to earth a few years later 80% below that inflated level. The discounted sum of its earnings over ten years (or whatever interval you choose) will be far less than you might expect.

This actually also relates to my prior post on bad trend analysis. You have to do more homework than just extrapolating out the past five years' average growth rate over the next decade for a company. You need to do good qualitative analysis to determine whether or not that makes sense or else using a particular PE as a rationale for purchasing a stock will not be fruitful.

Too hot to handle

I am currently traveling so this will be short and sweet. When I was in China, I saw signs of a residential real estate bubble everywhere. So stay away from anything related to Chinese real estate unless you like juggling live grenades.

Friday, July 9, 2010

On Bad Analysis and the Chinese Real Estate Market

It's amazing how some lines of logic will never die. I saw this article from Bloomberg about the likelihood of a collapse in real estate prices in China. In it was this absolutely awful line of reasoning from Stephen Roach:

"Rogoff’s view clashes with that of Stephen Roach, chairman of Morgan Stanley Asia Ltd., who said last month the property boom isn’t a bubble. While portions of the market such as high- end apartments are overheating, residential demand will remain robust as rural Chinese migrate to cities, he said in a radio interview in Hong Kong with Tom Keene on Bloomberg Surveillance."

Well, this actually sounds familiar. I seem to recall discussions about how the U.S. faced "pockets" of overvalued real estate, though when you added up the pockets they amounted to half the entire real estate market. Also, there were discussions about the growing demographic demand for real estate as well as the fact that inventories were temporarily lean. While not discussed much in this article, the same logic has been used to defend Chinese property prices.

At the end of the day, however, the problem is that average and median sales prices here far outstripped incomes, whatever temporary supply bottlenecks existed to support prices for an instant. In China, many central city areas, from what I have read, are priced at 14x median incomes. California, at the peak, was about 8-10x before declining approximately 40%. It may still decline further. Housing prices must necessarily be a function of incomes in the long run, whatever short term trends may distort them. This is similar to how stock prices must conform to earnings eventually as they are supposed to represent the value of a company. Asset prices cannot remain entirely detached from their underlying determinants for long ("long" meaning more than several years). 

Sometimes, I think analysts forget that asset prices cannot rise independent of their determinants in the long run. This is why they fall victim to bubbles so frequently. This is part of the reason that asset managers do not truly "create" wealth. In the end, it works out to be closer to a wealth transfer. In the case of China, incomes are rising, people are moving toward the cities, and financing has been plentiful. Against the backdrop of squeezed supplies, yes, prices can rise exponentially in the short run. However, the high prices will bring more supply onto the market and they will also sap demand. In time, financing too will ease as overlending will lead to higher default rates. At that juncture, prices will drop to a level more supported by the fundamentals. 

It is odd that a man generally as bearish as Stephen Roach is would fall victim to the sort of arguments that the National Association of Realtors used back in 2005. It could be that he is talking the book of Morgan Stanley in China, but I don't want to make that accusation without evidence. In any case, this bears watching.

Wednesday, July 7, 2010

Economic Data Summary: Week Ended July 2nd, 2010

To finally play catch up, here we are. This was once again somewhat of a mixed week for economic data, though with a downward bias to be sure. It seems to be somewhat of a theme lately and one that indicates a sudden slowing of economic growth. As I discussed in another post, I don't think this signifies a double-dip, but it has come on unexpectedly fast for something that has no apparent proximate cause.

June Non-farm Payrolls

Most of the financial press called this a "mixed report", but I disagree. It was a deeply disappointing report. Of course, beneath the headline of -125,000 jobs (entirely due to Census layoffs) was the somewhat increased private sector hiring compared to May, though at less than 100,000 it was weak. I guess it's better than the job loss recovery (yes, I used job loss rather than jobless) from the 2001 recession, but that was so much shallower of a recession than what we went through. As some have indicated this is a typical recovery path from a financial panic induced recession.

More worrisome to me was that aggregate weekly hours turned down as did aggregate payrolls with declines in both hours worked and hourly incomes. Much more of this sort of performance would get me truly concerned. One little nugget in the report was that those unemployed 27-weeks or more turned down while the numbers increased down the scale a little bit. That was an interesting development and might bear watching to see if it is repeated. Down the scale makes sense from laid off Census workers, but those out 27-weeks or more should be continuing to increase. It might have just been a statistical burp.

June ISM and Chicago PMI Surveys 

Neither report was what I would call "weak" in the sense that they indicate contraction. The Chicago PMI, at 59.1, is firmly in expansion territory, indicating continued solid growth in industrial production. Granted, there is some slowing in new orders, but production actually hit new highs. In fact, the overall rate of growth was barely off from May at all.

The national ISM figures showed modest slowing, but still a broad based expansion in manufacturing activity. All major indexes are north of 55, which indicates the likelihood of average to slightly above average conditions in the manufacturing sector in the near term. Next week watch for the regional Fed surveys to get a better sense of what July might look like. If the slowing trend rapidly accelerates into a real downdraft, there is real cause for concern.

April Case Shiller House Price Index

Monday, July 5, 2010

Economic Data Summary: Week Ended June 25th, 2010

This is belated on my part and for that I apologize. Two weeks ago, we had a fairly rough raft of economic data and that situation actually only intensified the next week as we all saw. I will whip through these as gingerly as possible to keep us flowing.

May Existing Home Sales and May New Home Sales

These reports were gross and grosser. Existing home sales dropped 2.2% to 5.66 million at an annual rate from April to May, which was well well well below expectations of 6.2 million. Inventory to sales ratios have ballooned out to over 8 months again. There was almost nothing good to say here so I will not even attempt to. I fully expect that sales will be horrid in June as well as throughout the summer before beginning to pick up again, at a seasonally adjusted rate anyway, toward the end of the year. Any improvement then will be slow.

New home sales were catastrophic (watch until about the 0:30 mark for the proper visual of this report). The consensus was for a 400,000 annual rate and they came in at 300,000. I've rarely seen a miss quite that bad in any report. Inventories once again surged to over 8 months, which is a level consistent with price declines in the future. The expiration of the tax credits has had a massively negative impact on home sales. Going forward it will be hard to piece together what the real estate market is looking like, but suffice it to say that it will not be positive for some time to come.

May Durable Goods Orders

This is one of the most volatile economic numbers and it did not disappoint in that regard in May. The headline number was down 1.1% while ex-transportation they were up 0.9%. Most categories actually increased, but airplane orders caused the volatility here. For the best comparison, here is non-defense capital goods ex-aircraft:

As you can see, we are having a much more rapid recovery in business spending in this recession than in the prior recession. In this category, the fall was not actually much worse either. This is one of the very encouraging aspects of this recovery for all of the disappointments.

Richmond Fed and Kansas City Fed June Manufacturing Surveys 

Mixed bag here, but it does reflect that the manufacturing recovery might be slightly running out of gas, at least for a brief period. The Richmond Fed survey showed what still look to be solid numbers indicating a decent clip of growth. They noted that optimism is waning a bit, but I would not characterize this as a weak report.

Kansas City barely showed any growth at all, though you often have to put several of these months together to get a proper idea. It bares watching a few weeks from now when these reports come out again. If they show further deterioration, I will begin to get somewhat more nervous. Patchy regional growth is somewhat worrisome as we had seen such strong synchronized growth for a few months in a row. Still, if you look at the history of these indicators you will see a lot of chop in them. The chop only gets troubling when it coincides with other signs of weakness just as a pain in your chest may be nothing, but if your arm goes numb and you become lightheaded, then it might be time to worry.

And the rest....

GDP was revised down to a 2.7% growth rate in the first quarter. There's not much to say there except that international trade is once again becoming a persistent drain on GDP growth. China's currency manipulation along with a rebound in oil prices have done some damage.

Jobless claims for that week edged down from an earlier spike, but that has been a back and forth motion for some time now. It is very difficult to read much into these figures for now. They have been translating into weaker than expected employment reports lately so that relationship might be making sense again.

The weekly retail sales reports for that week were soft, indicating a slightly weak June, though nothing cataclysmic. I will be curious what the retailers say this coming week as they report their monthly sales. They might give us a hint into July.

Finally, MBA indicated that purchase applications and refinancings remain soft. This is no surprise, though with the recent plunge in long term bond rates, look for both of these to start increasing again some time in the future. If they don't, then consumers have really and truly turtled up.

Sunday, July 4, 2010

What do current bond yields and war bonds from WWII have in common?

They pretty much share the same interest rate. That's right. I calculated the effective compounded interest rate of war bonds sold during WWII to be 2.91% for a ten year instrument while current ten-year notes are trading at 2.98%. So, current market forces have pushed interest rates on government bonds so low that they're, well, downright patriotic allowing the government to borrow money so cheaply.

It makes me think of this WWII-era commercial for war bonds:

By the way, calculation was based on the following information. You could buy a bond that matured in ten years at $25 for $18.75. So, the calculation is ((25/18.75)^(1/10)) which is the good old fashioned compounded annual growth rate formula for those who are interested in such things.

Strategy: How to manage future transaction costs in a small portfolio

As I am not a wealthy man, nor will I likely be working for my state's government, I, like many others, must pay a great deal of attention to transaction costs when executing trades. In what follows, I try to provide a few examples, all reasonably straightforward, of how to reduce the potential for ruinous costs.

Let us take the example of a brokerage account with $5,000 in it. You have this divided among five holdings at $1,000 each because you took the advice previous mentioned on this blog and attempted to build out core, meso, exploratory, and speculative holdings. That's all well and good, but let's say that you suddenly decide that you think all hell is about to break loose and you want to shield your assets in a bond ETF, say TLT. For the purposes of this demonstration, I'll say brokerage fees are $10 per trade just because it makes the math easier. First, in your initial sales, you incurred $50. Then, in your purchase of the bond ETF you incurred another $10. When the crisis passes you sell your bond ETF, incurring another $10, and then you buy back into your original five positions at another $50. Your total fees were $120 or 2.4%.

Now, you might say that 2.4% is not so bad because you may have averted far worse in the market as a result of your move. However, even among the best portfolio managers are wrong about as often as they are right. Over time, these decisions, even executed properly, are likely to be a wash for the typical investor. I know, speaking for myself, that they have been for me. The cumulative effect of multiple swaps over several years' time can be the loss of multiple percentage points of your assets with a devastating effect on your total return over the long run.

Even in a larger portfolio, if one divides their positions too thinly, the situation repeats itself. For example, the costs as a percent of assets for a $50,000 portfolio divided amongst 25 holdings at $2,000 a piece works out to be $520 total or slightly over 1% of total assets lost via fees. If this person is an active trader and does this a few times a year on average attempting to pick each point at which the market might turn, they could rack up 3 or 4% in fees. That's to say nothing of bad capital gains management, which I will discuss at some other point.

Now, the lower proportion of fees in the second example makes the point I would like to make. If you wish to engage in more active market timing, keep your number of holdings down significantly. In the first example with the $5,000 brokerage account, if you have only two holdings at $2,500 each your transaction costs for the whole series of transactions are only $60 or 1.2% of your portfolio. It's still a steep price to pay, but with larger portfolios keeping the number of holdings down drives these costs right through the floor. In the $50,000 portfolio example, if that investor only had five holdings at $10,000 a piece, they incur $120 in transaction costs or 0.24% in fees for a whole cycle of transactions. As such, the lesson is that consolidated, larger holdings give you a greater ability to engage in market timing if you feel that's what you should be doing. The risk is that, depending on how you do it, you lose out on diversification. You can make up for this in choosing broad market index ETFs and then have both flexibility and diversification.

Now, as to whether or not market timing is a good idea, that's a tricky one. There were people who sold out after the first 10% up from the March lows of last year waiting for a correction that never came. Even with the recent rout, we are still far above the levels that these traders were waiting for. At the same time, selling in early April of this year would have been a very prudent thing to do especially if you then stuck that money in TLT. You would have a spread of something like 2600 basis points over where your money would have been otherwise. Not bad.

Saturday, July 3, 2010

Is a double-dip recession likely?

Short answer, I think, is no. It is extraordinarily difficult to think about what the impetus for that would actually be. There is certainly not an overabundance of inventories as evidenced by very low, actually historically low, inventory to sales ratios. There won't be an interest rate shock anytime soon as deflationary tendencies continue to keep the need for interest rate increases down. In fact, the plunge in long-term bond rates we have seen recently will, if sustained, prove stimulative to the housing sector.

A major economic shock elsewhere in the world is similarly unlikely to cause a recession. As I have mentioned previously, the United States is not a major exporter in proportion to its GDP. Even a 30% decline in exports to China would represent a $21 billion hit to output. If Europe absolutely cratered all at once, we might lose a percent of GDP or so. It is actually difficult to think of a time when the United States has fallen into recession due to a major financial panic elsewhere in the world in the last 100 years. In the 19th century, financial market panics in Europe did have deleterious effects here, but you would be hard pressed to find one since. The one possible exception is if Europe sustained a series of sovereign defaults and its banks absolutely buckled without assistance from the ECB or member states. It is possible to conceive of a financial contagion effect under those circumstances could cause a renewed financial crisis here. If that were to happen, a recession would be likely.

Now, then, what do the recent data suggest? This is confusing as all hell (technical term there). Jobless claims remain elevated even though these levels don't make sense given what else we know. Consumer spending, after some strong months earlier this year, seems to be flat in the most recent months. Job creation as measured by the private sector job gains has decelerated from a few good months earlier. Manufacturing still appears strong, though might be slowing now that the inventory cycle is complete (a phenomenon that we noted here earlier). All of this suggests that growth will be slow over at least the next six months. The stock market's last 5-6% sell-off I think is a reflection in this re-evaluation of conditions. One cause of this may well be that money supply has been flat for some time as the Fed has attempted to ease off some of its earlier stimulus. It has also withdrawn itself from several of the emergency programs. A tightening of money supply usually has a powerful effect and that may well be at work here.

Part of the Fed's quandary is that it did increase money supply rapidly in response to the recession and it has been nervous about a potential outbreak of inflation some time down the road. As such, when the data were more positive, they began to step off the pedal a little bit. However, the transmission mechanisms for money supply (namely the banking system and related credit markets) remain entirely broken or at least gummed up. We can see this in the absolute collapse of the velocity of money (sorry, Monetarists, this is an empirical fact that the velocity of money is not a constant). As such, the outlook for inflation is very benign. In fact, it is so benign that I think we are seeing the effects of deflationary expectations beginning to take root, particularly on the part of businesses.

One distinct possibility as a result of the fundamental deflationary tendencies in the global economy is that, led by the needless European austerity measures, we could enter a very protracted period of low growth. The principal cause of this is that nominal debt burdens still remain high and without nominal wage increases these burdens are very difficult to pay down. As such, consumer spending is going to be kept under wraps in a deflationary environment.

In this sort of environment, bonds and cash do look more attractive than they otherwise would at present interest rates. Stock prices are based off of nominal profits and those are harder to come by in an environment of non-existent inflation and weak pricing power. I have to confess that I did not expect that the European governments would so rapidly enact such massive anti-stimulus as they have, but alas, it is here.

Hopefully, the central banks will realize what the larger threat is and become far more dovish on inflation than they have been. If one is truly worried about a sovereign debt problem, the answer is higher inflation, not deflation.

In any case, recent events should give one some pause as the rate of deterioration in growth was more rapid than one could reasonably expect. A double-dip recession is unlikely (as James Hamilton at Econbrowser points out), but there is a distinct possibility that we enter a prolonged period of lackluster growth due to policy making errors in Europe and, to a much lesser extent, here.