Back To The Basics... And Beyond
Long suffering Daily Reckoning readers deserve a break.
Today, they will get one. I will not once, not once – I promise – mention the “J” word (the world’s number 2 economy, where people eat raw fish and refuse to buy things they don’t really need with money they don’t really have…thus putting the entire planet in danger of a deflationary shrivel).
Instead, we will go back to basics…and beyond.
Readers with long memories and excess mental storage may recall our new philosophy here at the Daily Reckoning – conjured up over at the Caf? Paradis across the street after a few glasses of wine. It is called “essentialism” and is sure to take its place alongside marxism and dadaism in the dustbins of pseudo-intellectual history.
Essentialism is a creed founded on two very important insights:
That most people are blockheads most of the time.
And that, if you think you are not a blockhead, you are a bigger blockhead than they are.
We are blockheads because we don’t really know nearly as much as we think we do. Will the price of gold go up? Will the man sitting in front of us suddenly go mad? Will the Afghanis hold a peaceful election and live happily ever after?
We can know what will happen when we throw a bucket of water on a camp fire…but not what will happen when we do the same thing to a gendarme. Unable to know either the cause or effects of events, we essentialists rely upon tried and true rules of conduct to guide us.
We do not kill…
We do not steal…
And we do not buy stocks that are expensive.
In either of the three instances above, we recognize that the world might be a better place – for us at least – if we were to ignore our own rules. But we don’t know for sure.
The person we kill could have vengeful relatives. The expensive stock could become less expensive. So, we stick to the essentials.
Buy low, sell high. No more essential rule of investing has ever been formulated. So, now…as the Dow heads towards the 10,000 mark…we turn to it for guidance. Are stocks “low”, we ask?
“Over long periods of time, stock prices are a function of two things,” writes Bill Gross, who runs the Pimco fund, “(1) corporate earnings, and (2) the price/earnings (P/E) multiple investors are willing to pay for those earnings.”
“That’s it,” he continues, “…pure and simple folks. All you ever really needed to know about the stock market.”
Over extended periods of time, corporate earnings grow at a rate slightly lower than the rate of GDP growth in the economy. If stock prices rise faster than the increase in GDP – as they did throughout the ’90s – they can only do so by increasing P/Es. People have to be willing to spend more for each dollar of earnings. In the 1990’s, average P/Es rose from the long-term average of about 14 to over 30. They had to do so. Because with earnings and GDP rising at less than 5% annually…there was no other way to get stock prices up 18% per year!
Why might investors be willing to pay more for the same dollar of earnings?
“Inflation goes up – as in the ’70s and early ’80s – P/Es go down,” explains Gross. “Inflation comes down – as in the late ’80s and ’90s – P/Es go up. Theorists would quarrel with the logic of this, claiming that companies can ‘pass through’ inflationary costs when they need to and that ‘real’ earnings growth should be unaffected by the inflation rate – if so P/Es should be more stable.
Perhaps, but history suggests otherwise and indeed bond yields – which are directly impacted by inflation – are stock’s primary competitive investment alternative. If Treasury bonds are yielding 15% like they did in 1981, then stock P/Es seem likely to be affected. They have been…”
According to Gross’s logic, P/Es are not necessarily too high. “P/Es are just about where they should be in a 1%- 2% inflationary world. P/Es are fairly valued, but importantly – not going much higher. They can’t…
Inflation isn’t going much lower than zero and if it does, we enter a deflationary spin zone [such as we are seeing in “J”…] which knocks earnings for a giant negative loop…P/Es of 25-30x are close to the max bull market P/Es…”
In this regard, Gross is probably too optimistic. Real P/Es are probably much higher. Because American companies typically overstate their earnings. In August, the Wall Street Journal attempted to recalculate P/Es using GAAP – generally accepted accounting principles. The author of the study found the average P/E ratio of the 250 S&P companies to be 36.7.
Since August, earnings have fallen sharply. The Levy Institute, for example, says that earnings of the S&P 500 are 67% below those of a year ago…the largest drop in history. “This is not a common profit squeeze,” writes Dr. Kurt Richebacher in his latest letter. “We are witnessing something that belongs to a completely different category [i. e. “J”…]; it is a profits carnage of extraordinary severity.”
Dr. Richebacher estimates that given the collapse of earnings an “honest” P/E ratio is now over 50. We are ignorant of the real current average P/E as we are of so many other things. But whatever it is, it is not likely to go higher…unless it is driven there by earnings.
Lower earnings will send P/Es higher – but without an increase in stock prices. The only way stock prices can go higher – assuming P/Es remain at the top of the known range – is by multiplying increases in earnings. “Stock appreciation from here depends not on an expansion of P/E multiples – which provided a good portion of the double-digit returns for the past 20 years,” says Gross, “but on earnings growth.”
But how fast can earnings grow? They are not growing at all now, but falling. But, again putting the best light on the little we know, the economy could recover from its current slump and resume growth of 4%…maybe even 5%. This would put earnings growth at maybe, 4%. Plus, there are dividends.
Bull markets usually begin when dividends are high. They were 7% at the end of the ’40s and 6% in 1982. But now, they are only 1%. Not only does this tell us that stocks aren’t cheap and a new bull market is unlikely, it also tells us what our total return might be.
In addition to the 4% annual growth…assuming the economy grows at 4-5% and earnings keep pace…investors will get a 1% dividend yield…giving them a total return of about 5%…they would be better paying off a mortgage.
“A stock investor expecting double-digit returns over an extended number of future years is dreaming,” Gross concludes. “Your return from stocks over the next decade is going to be 5% or so…”
If we are lucky, and don’t go the way of “J”…
November 20, 2001
What do we see when we look around the investment world?
“Mixed signals,” says the Financial Times. The Dow has recovered nearly half the ground it lost since its top last year. Polls show investors more bullish than ever. But earnings continue to drop.
Mortgages are about as cheap as they’ve ever been. In real, inflation-adjusted terms, consumers are paying only about 4% interest for the privilege of living in houses they can’t afford to buy. But new home sales are falling.
Car sales from October were remarkably strong. But automakers spent billions on incentives – including zero financing, effectively lowering prices and shaving profits.
And despite the lowest interest rates since the Kennedy Administration, “Suddenly, Paying Down Debt Makes Sense,” says a NY POST headline. Where else can you earn 18% on your money – except by paying off credit card debt? Accountants at Grant Thornton also estimate that if the stock market returns less than 6.39% per year – and you’re in the 27% tax bracket – you’re better off paying down your mortgage.
What do you do in such a mixed up, confusing world? See Back to Basics…and Beyond…Below!
Eric, what’s up on Wall Street?
– Don’t even think about telling Mr. Market to take a rest! There’s just no stopping this guy. He’s a man on a mission.
– It’s like he looked at himself in the mirror one day, didn’t like what he saw and decided, “Gosh darn it! It’s high time I got back into shape.” No more drooping averages for him, no sir; no more slumping indices; no more chubby “new lows” lists.
– Well, Mr. Market’s back and he’s in fighting trim. He could probably take down Lennox Lewis in a couple of rounds.
– On day one of Thanksgiving week, the Dow gained more than 100 points to within a whisker of 10,000. Meanwhile, the Nasdaq rose 36 points, or nearly 2%, to 1934.
– “Is this the second coming of the bubble?” asked Merrill Lynch technology strategist Steve Milunovich (apparently reading the mind of one or more of the Daily Reckoning’s authors).
– “The tool of choice during crisis? Liquidity – or ‘reflation’,” writes John Myers of Outstanding Investments. “Expect the United States and Western governments to pump up the world’s financial system by making money more available. This may create a short- term benefit, but it is not likely to overcome the recession or the bear market. In addition, an increase in the money supply could stoke inflation in the years to come. The result then could be a doubled-edged sword: a slowing economy and a pumped up money supply.”
– The current rally on Wall Street, while not quite bubble-like, certainly feels very “retro”. Most stocks are flying high, but tech stocks without earnings are flying highest of all. It’s just like old times.
– Yesterday, ScreamingMedia jumped nearly 20% because it cut a deal with Verizon. Remember when every NASDAQ stock was named ScreamingMedia…or something like that?
– Palm and Handspring both soared yesterday just because a report in the Wall Street Journal said the two companies might work together somehow.
– Most retro of all, the beleaguered Nortel Networks leapt 7 percent after the company announced winning a contract to supply an “optical metro backbone network.”
– No doubt about it, plus signs and bullishness are back in vogue on Wall Street. And forecasting an imminent economic recovery is also part of the latest fashion. Almost every investment strategist on Wall Street predicts the U.S. economy will rebound next year.
– Very well then. It’s official. There’s nothing much left to do except to keep buying stocks and wait for a recovery.
– Of course, Wall Street’s highly paid “seers” don’t see the future perfectly each and every time. But even if they are on target this time, even if the economy bounces a little, does that mean that a new bull market in stocks has begun?
– Should investors pay absolutely any price for stocks?
– Maybe we should be asking ourselves, “Are stocks too expensive relative to their growth prospects, or do today’s rich valuations merely anticipate a robust earnings recovery in 2002 and 2003?”
– To justify the current rich valuations, we might need to see a robust earnings recovery continuing into 2010. If hopes for economic recovery are driving the stock market, what’s driving the economic recovery? Well, curiously, ISI suggests it might be the stock market. Hmmm, sounds a little like circular reasoning.
– “Let’s not lose sight of the supposed NASDAQ-effect,” says Moody’s John Lonski, “where consumer spending tends to vary directly with the performance of the NASDAQ stock price index.” Lonski explains that retail sales fell 2.2% in September, lock-step with the falling stock market. But when share prices recovered 12.8% in October, retail sales jumped 7.1%. Of course, 0% financing didn’t hurt.
– Lending support to Lonski’s findings, the ISI Group observes that there is an extremely high correlation between fourth-quarter changes in the Wilshire 5000 index and holiday sales. “So far this quarter,” says ISI, “the Wilshire has increased 8.8%, which is close to 1996’s 8.5% increase when retail sales rose a solid 6.6%.”
– Certainly a strong stock market helps to fill Christmas stockings. But this year, there’s a new Santa in town – mortgage refinancings.
– Year-to-date, the Mortgage Bankers Association’s (MBA) index of refinancing applications has skyrocketed more than 500 percent over last year’s volumes. “Consumer spending topped expectations throughout 1999 and early- 2000 partly because of 1998’s steep +232% annual surge in applications from mortgage refinancings,” says Lonski.
– Astonishingly however, Lonski points out that mortgage applications for home purchases has actually fallen 8.6%.
– In other words, folks are borrowing against their houses as fast as they can, but they’re not buying houses. Ho! Ho! Ho! Merry Christmas!
Back in Paris,
*** “Japan’s consumers stop spending,” a BBC headline tells us. What’s the matter with those Japanese? Don’t they know that spending money you don’t have on things you don’t need is the key to prosperity? Must be the raw fish…
*** Also from that part of the world comes news that Taiwan’s President Chen Shui-bian won the 2001 Prize for Freedom. He was supposed to attend a ceremony in Strasbourg to receive the honor. But France – bowing to pressure from China – wouldn’t give him a visa.
*** Maria, 15, dropped out of her French Catholic school this year. It interfered with her budding career in showbiz. So, we let her switch to a U.S.-based home schooling program and worried how it might turn out. She got her first results yesterday – all A’s.
*** “How is it possible,” I asked her, “that you struggled to get C’s in the French school…and always seemed on the verge of a nervous breakdown…and now, you seem to have not a care in the world, yet you’re getting A’s?”
*** “Dad,” replied the hopeful model, “I just don’t have those awful teachers yelling at me all the time, telling me what to do…and American schools are just a lot easier.”