Where was the Bubble?

One classic presentation of a equity market bubble is to show the share of market share that was represented by that given sector (look at the tech bubble around 2000).  The following chart illustrates the reality that the financial bubble was not in financial equities.  It happened on the credit side (in particular issuance).  What makes this interesting is that although financial sector earning boon-ed after 2000 the sector market cap did not gain share.  This in and off itself it not particularly interesting but it give one more data point on the nature of the ’bubble’ that crashed the system.  (I’m am becoming increasingly convinced that the collapse was by no mean inevitable but rather bad policies (read letting Lehman fail, the ‘rescues’ of the agencies, and slow response to capital problems), but I digress..

The Peversion of Better than Expected

The recent increase in the stock market has been taken by some in the media and many in the American public as an indication that the economy has or is near to a turning point.  The assumption underlying that statement is that the equity market is evaluating the current state of the economy.  Although this is part of what it is doing it is not that simple.  From a valuation perspective it evaluates the probabilisticfuture paths and assigns risk premiums to that aggregate path to create a discountable value stream.  This means that the stock market can go up or down without (necessarily) implying any changed perception in the path of the economy (in fact it could go down and imply a great growth path if the risk premium goes up at the same time).  And remember the current state is just one point along that path (albeit an important one). 

I tend to think that rally in the stock market was driven by two major factors.  (1) Breathing room for deleveraging asset managers (and buyer less afraid to step in front of that supply) and more related to this discussion (2) expectations about the future improved (not that those expectations are good).  An improvement in expectations (or performance better than expectations) is a relative concept, like a sports team covering the spread.  Covering the spread is all and good if your simply gambling on a team but you may be interested in winning.  My interpretation of the equity market movement is that the expectations of total collapse has come out of the market and we have repriced equities at a bad L-ish shaped recession. 

For a qualitative example take a look at the most recent beige book.  The markets responded fairly positively to this report (S&P rallied over a 1% from the release to the close), but what the report said what hardly uplifting (in an absolute sense): ‘Reports from the Federal Reserve Banks indicate that overall economic activity contracted further or remained weak. However, five of the twelve Districts noted a moderation in the pace of decline, and several saw signs that activity in some sectors was stabilizing at a low level.’  In English things are getting worse but not getting worse as fast as they were before.   We are still headed in the wrong direction but we’ve hit the break.  Not to downplay avoiding total collapse, which is an accomplish, but that’s not exactly the ‘green shoots’ one might hope for.

Credit and Equity

One very narrow data point that jumped out at me from the 4th quarter flow of fund was the change in security credit being extended by commercial banks.  Now the equity market fell for very fundamental reason but underneath that it seems as if there was a contraction of margin credit.  Now was it people backing away from the equity market because they needed to deleverage or was it the banks calling in margins lines.  The second seems more plausible.  This all seems to suggests that it wasn’t just a flight to safety but also a whipping out of the ability of those who wish to take risk to take it. 

I wanted to see how tight this credit line was with equity price changes.  The correlation has the right sign but isn’t overwhelming (which is what you should expect). 

The Obama Portfolio

Our president did something some what un-presidential by offering some investment advice… ‘What you’re now seeing is profit and earning ratios are starting to get to the point where buying stocks is a potentially good deal, if you’ve got a long-term perspective on it’

I actually think he is basically right and I think that the implicit approach he has suggested (‘potentially’ -> considers uncertainty and ‘long term’ -> beta – collecting risk premia- investing, which is what most people should be doing) is spot on…but as a political leader he should likely stay away from the market.  Not only could an undesired focus and expectation be built around your words but you could be blamed for (or given credit for) things that you really don’t deserve….you clearly don’t want some throwing their 16 year olds college fund all into stock now because ‘Obama said so’.

All this said…what are the chances that he called it.  It being the bottom.   Given that the market was up over 2% today and an assumption of future equity returns as 5% expected returns and 30% annualized vol (both of which are wrong but not crazy for the point I’m trying to make here) there is about a 3% chance that the equity market will not go bellow (according to my small montecarlo test) yesterday value.  We’ll that means there is a 3% chance that bad historians and bad economist will imply that (and if you open up the interpretation of bottom to a broader degree much higher) his call had something to do with a bottom. 

What does this mean?  In the grand scope not much; really just an interesting factoid.

Siegel: Weighted Earnings?

Jeremy Siegel,  a finance professor at Penn, wrote an article in the WSJ last week arguing that stocks were cheap.  I tend to agree with him – at least with respect to certain segments (cash rich, little debt) – but for different reasons. 

Siegel who is well know for at least in part for his book Stocks for the Long Run which argues that stock are good investments because they outperform all the other assets over a long period of time.  Now the evidence has been true but only if you happen to be looking at the US over those 200 years not for example Russia.  At the extreme revolutions hurt equity holder and don’t hurt gold.  Additionally Siegel seems to ignore that fact that for almost everyone draw downs matter; only the uber wealthy can be very confident that they can last out a nasty (like Japan over the last 25 years or the Nasdaq over the decade) draw down.  If you are simply saving for retirement and you really need all the money you are saving; putting it in stock is risky.  Stocks for the long run has some truth to it but it really isn’t that simple (although for it to actually be the optimal solution you have to assume a no leverage constraints and a few other assumptions that are not 100% sensible).   (Also remember it can be argue-ed that any risky asset – even as the expected return increased – is not necessarily better because the utility loss by going bankrupt is larger than the utility gained by becoming wealth (for most people)). 

His recent argument that stock are cheap rests on that fact that the S&P is a weighted index and thus the earning should be weighted too not summed (which is what the S&P does).  Now I could be off here but this seems crazy.  The S&P is weighted thus when you buy an S&P index fund you are buying the same portion of each company (market-cap weighted); so if you bought enough of the S&P 500 index you would own 1% of all the companies.  This would give you 1% of all the companies earning, not more in the large companies earnings and less in the small companies.  So weighting the earnings – seems to me – to be very odd. 

So why do I tend to agree with him? First remember that what you really care about is the futures earnings not the historical earnings.  Second when you are adding up the earning should you include negative numbers?  Think about this.  If I offered to sell you a basket with two stock each whose earnings oscillate between -10 and +10 dollars each year you would not pay me for that basket.  But if I offered a basket of companies one which earned 10 dollar per year and the other which earned -10 you would give me the present value of 10 dollar per year and ignore the negative.  So how does this relate to the S&P?  Lets imagine a fairly bad world where all the companies that had negative earning in the 4th quarter are like the negative components in the basket and that the positives in the 4th quarter (which was a rough economic quarter) continue to have those earning.  From a very hack/back of the envelope calculation based on only positive earnings the P/E ratio of the S&P is in low double digits; I calculated 11.3.  Convert this to a earning yield (1/PE) ~ 8.8%.  If you compare this to a BAA yield of ~ 8.3%; you see that that implied earning growth (remember on the sample for earnings we have: think about it, it is some what nuanced) is sort of low.  What do I take from this?  Equities are pricing in a rough economic climate (right) and high risk premiums (check) and even then are fairly cheap.  (remember typically when earnings fall, PE rise because of the expecation of higher earning growth off a low base but not this time around)  Does that mean that equities are a sure bet?  No, and certainly not in the short run – liquidation driven selling has no valuation logic to it - but I agree with Siegel that (the right) equities are somewhat cheap, but note that I’m agreeing for a very different reason.

Auto Production ala 1920

Not much commentary here just a chart after looking at the industrial production – auto numbers.  A picture is worth a 1000 words (or I’m just being lazy).

Note: I believe that this is primarly driven by investory adjustment not a shift in demand so it should snapback but it is fairly extreme.

When was the last time it was this bad?   To be honest I’m not sure if cars were a normal consumer good in 1924, I don’t think so but I’m fairly sure it wasn’t a two or three cars per household era. 

We’re retaining flexibility. But it’s on fire?

Treasury Secretary Henry Paulson let it be known that he would be leaving the remaining ammo in the financial system rescue program for use by the next administration.   He also seems to suggest that the financial system has stabilized.  Which in a way it has, things are not getting worse at nearly the rate they were, but this seems to me like a fire marshal who sees the fire has stopped spreading tell the fireman to turn off the water, even though the existing fire is still burning.

I agree with Paulson that flex-ability is a good thing; simple principle is that options have value, but they often have a cost as well.  His changing up the plan from buying assets – which was a bad idea from the beginning- to having an equity injections program was a good thing.  The cost was derision of politicians and media (he’s an adult, hopefully he can handle that), an increased likelihood that the plan would be changed again for other political reasons (ala auto bailout), and confusing the market about how it plays out (increased uncertainty thus higher risk premia).  The change to equity injections was a net positive and it is reasonable to say that it, in some ways, helped stopped the deterioration (momentarily) in the financial economy but as credit market are still functioning poorly the knock on effects to the real economy will continue.  The only place where credit market appear to be working is where the government is doing the job of the banking system.  The conforming mortgage market (Freddie and Fannie), the CP market (Federal Reserve Purchase Program), existing – not new issuance - bank debt (FDIC insurance program) appear to work. 

The outside of the governments touch – investment grade bonds, high yield bond, non conforming mortgages, and so on – are not working well.  Rates are not coming down, spreads are historic, credit is contracting, and banks are hoarding cash like a fugitive (almost 400 Billion since the end of september).  One way to illustrate the strange going ons is to look at the risky asset market and compare risk that is not being touch by the federal government directly (corporate risk) to risk that is being touch by the federal government (mortgage risk – via the agencies). The ratio shows that corporate risk is being priced as more risky than mortgages risk, this may or may not be right and there are some complicating factors, but at face value the recent movement seems to make the point that banking products that are touching the federal government are working and those that are not are still burning.  (Remember the 01/02 recession was a corporate recession the the ratio didn’t jump this much).   

The more I think about it the more I think the idea of drowning the system in capital – just like a fire crew drowns a house to make sure the fire is out – is the best option we have and at this point its not clear if the banking system has enough capital to survive never mind having an excess.

[update: 10/20/2008]

If you assume that the price return of the S&P 500 is roughly the real return (meaning that inflation equals the dividend rate, not right but not crazy - since I don’t have a way to get total return easily); the last time that I could have invested in the S&P 500 and made a real return I would have been in 6th grade…this equity market (forced selling — deleveraging) drawdown now takes the silver as the second worst.

It is important to note that this chart is not suggestive of valuation (whether or not stocks are a good value) but does give insight into the riskiness of the equity asset class. 

Buffett says to buy stocks

Decisions are a process of evaluating the relative distributions of the possible choices.  When you construct a portfolio you consider the pieces that should be put together to construct the distributive future wealth profile that you most like.  This is a challenge.  What if you just look at a simple question of if stock are expensive or not?  We’ll given the carnage of the past view months one would think that equities are cheaper are than they used to be.  I’ll argue, in a way, that is not the case. 

The cost of the equity can be converted to yield space by flipping the commonly know P/E ratio to E/P or earning yield (it makes the most sense to look at forward earnings expectations).  This measure certainly has increased (meaning stocks are cheaper than stocks used to be) by only in tandem to BAA bond spreads (remember relative choice).  Through a fairly simple process I can compare these two yields – the BAA spread and the E/P spread (Earning Yield - risk free rate) - and figure out what the implied earning growth rate is for equities (or more precisely what earning growth do I need to make me indifferent between holding a bond and holding stocks)?  If I think earnings will growth faster than what is implied I should favor stocks over bonds and visa versa. 

 

As you can see the implied earning growth rate hasn’t changed of late (the chart include data through the second week of November), the cause being that the competing asset class (bonds in this case) has also drop in price significantly.  So I think Mr. Buffett should have had a slighty different tone in his New York Times piece on why we should all buy stocks (or at least why he is).  Instead he should have suggested that we all buy risky assets (note the plural…specifcally a well diversified basket of risky assets).  Maybe he’s right (for what it’s worth I agree with him) but maybe he’s not, but if he is wrong we are in for one massive recession given what is implied by market pricing.