Regardless of the claims made by the multitude of pundits and prognosticators on CNBC and elsewhere, no one knows what the stock market will do tomorrow, or next week, or next month (unless they have inside information, which seems to be disturbingly common judging by the headlines lately). The best an honest investor can do is to know that he doesn’t know.
What we do know, however, is that in the long term the market can not go crazy in one direction forever. If the economy grows an average of 4% every year, then the stock market can not forever grow at 8%, nor will it forever grow at 1%. It can do either of those things for years at a time, but as it does it gets more and more disconnected from economic reality. You might say that the market is tethered to the economy with a rubber band – it can stretch the rubber band in either direction for a while, but eventually it snaps back (and usually overshoots in the other direction).
Similarly, the economy itself has, for a very long time, trended to a fairly steady growth curve. It also gets stretched above or below this trend growth for years at a time, but (so far at least) it has consistently reverted to the trend line, again as if tethered by a rubber band.
Some very smart guys at an outfit called Crestmont Research have done a lot of work on this. They have calculated a trend line for S&P500 earnings that has proved to be extremely robust over time. In fact, the trend line in 1975 predicted that 2013 trend earnings would be $79.59, and now with 24 more years of data the trend line is basically unchanged, trending to 2013 earnings of $80.01. You can get all the details at http://www.crestmontresearch.com/pdfs/Financial%20Physics%20Presentation.pdf.
This research also looks at average P/E’s for the market, and finds that when the pricing environment is benign (i.e. there is neither severe inflation nor deflation) then market P/E’s have historically averaged approximately 16x. (Deflation or severe inflation both drive average P/E’s meaningfully lower.) A 16x P/E multiple implies a return of about 6% (1/16) for stocks, which seems reasonable when inflation is low and under control.
We can utilize this knowledge of these trends to craft a successful investment strategy. We can have some comfort level that when inflation is contained then over time the S&P500 will tend to revert back to a price level of around 16X trend earnings. When the S&P500 falls significantly below that, it is a long term buying opportunity, and when it rises significantly above that level it is likely a good time to sell. Of course this does not guarantee stocks will go up after you buy them, since the rubber band could stretch even further to the downside, but over time this approach should outperform the market’s trend line.
So where are we today? Trend S&P500 earnings for 2009 are about $65, and around $68 for 2010. A 16x multiple of these earnings implies an S&P 500 price range of 1040 to 1090. Friday’s closing level was a hair under 1080, so for the long run at least stocks appear to be fairly valued. My gut is that in the short-term the rally will extend upward for a while longer, but every time I think something like that I have to remind myself that in the short run, the best an honest investor can do is to know that he doesn’t know.
Monday, October 26, 2009
Monday, October 19, 2009
Forget all the screaming about socialism. Have we fixed anything?
My good friend Jayson Bales' most recent investing newsletter really got my attention because he used (brace yourself)… the S word! That’s right, SOCIALISM! It reminds me of that musical where the musical instrument salesman warns the town they’ve “got trouble, right here in River City!” (Jayson and many of you are probably too young to get that reference.) “Socialism” is a very polarizing word that is getting thrown around a lot these days. No one in the U.S .says they support socialism, and yet millions of people are passionately fighting to stop it from becoming our new system of government. While the whole ideological debate may be interesting (if you can call the screaming matches a “debate”), as a practical investor it doesn’t do me much good. I want to know what it all means for my portfolio, now and in the future. (WARNING: Even though I have put most of the really hard core academic and economic materials in a longer and more technical Appendix at the end – which I expect most people will skip – I am going to make you suffer through one slightly academic and boring paragraph here at the start. Trust me, it’s not that bad and it will be worth it. Here goes…)
Broadly speaking, every boom and bust is caused by the same factors, both economic and human, and our recent boom and bust was no different. On the economics side, all through the boom monetary policy was very loose (the Fed kept interest rates very low for a very long time) and fiscal policy was very stimulative (massive deficit spending). These factors fueled the boom to absurd and unsustainable levels. On the human side, the optimism fed on itself as rampant speculation and excessive leverage by both individuals and corporations became the order of the day. History shows us that not only will the free market eventually correct this situation on its own, but left alone it will brutally overcorrect. As was seen in the Great Depression (and many other lesser known busts in the 1800’s and early 1900’s), without government intervention the money supply plummets and government spending shrinks (if limited by tax revenues) which feeds on itself on the way down just as the bubble did on the way up. Investors lost their life savings held everywhere, even in banks, and the economy sharply contracted. The Depression lasted a decade with unemployment of 25%, shantytowns in every city, and soup kitchen lines stretching for blocks.
So call me a socialist (I dare ya! Besides, I think I look in good in a beret) but I can’t fault the government this time around for saying we couldn’t let that happen again. They saved the banking system at all costs, the Fed printed huge sums of money and we have instituted massive government spending. We can talk about whether each of these actions has been good or bad for America, but as an investor it is hard to argue with a 50%+ rebound in the stock market. And unemployment of 10% doesn’t seem that bad compared to 25%. Clearly it wasn’t perfect, but doing nothing would have been a disaster for our investment portfolios and the economy.
But now, as an investor, I am worried. Because the same conditions that led to the “roaring ‘20’s” and the Great Depression, and that led to our recent boom and bust, are still in place. The whole debate now raging about whether the government is doing too much (we’re all becoming socialists!) is dangerous because it risks distracting our elected officials from some really important things that need to be addressed. The reality is we don’t need the government to do more, and we don’t need them to do less, we need them to do some different things (quality, not quantity).
Unlike today (so far at least), in the 1930’s meaningful changes were made to the conditions that caused the whole mess. It was unnecessarily painful and harsh and awful, but the severe contraction of the money supply and the failure of the banking system forced individuals and companies to eliminate their excessive leverage and speculation. And the length and severity of the Depression burned this lesson into people’s consciousness. Those who survived the Great Depression NEVER forgot. But just in case they might forget, the government went several steps further and in the 1930’s passed a variety of regulatory reforms to prevent the recurrence of such financial speculation and leverage (and even outright fraud). Basically, in the 1930’s the government did little to alleviate their then-current pain and suffering, but focused a lot of effort on how to prevent a recurrence of it in the future.
Compare that to our current situation, which is the exact opposite – we fixed the short term pain but have done nothing to prevent its recurrence. To lessen the short term pain, we did not allow the money supply to contract, government spending increased, and the banking system was rescued. Those were all good things (at least for the short run), but as a result no one has learned any permanent life lessons. Give the stock market another big up year in 2010 and we’ll all be partying again like it was, well… 1999! (or 2006). This makes it even more troubling that the government has put nothing in place to address the CAUSES of the boom and bust. So far we have gone for the quick and easy pain relief without addressing the root causes (so surprising in a country where liposuction and stomach bands are more popular than healthy eating and exercise).
The implications for an investor are clear. If the government does not take action to address the conditions that caused the boom and bust (conditions that still exist today – loose money, deficit spending, and ineffective to nonexistent regulation of financial firms, financial products, and financial markets) we will have another bust, and the next one will be worse (more like the 1930’s). If the government can gradually tighten the money supply and cut back on spending as the economy strengthens, and also reinstate and update the regulatory reforms made in the 1930’s (Congress actually repealed many of these in the last decade) then the markets will be a safer place, and we may be able to have a sustained period of very slow economic growth. The astute investor will watch the news closely, ignore all the ranting about socialism, and see what, if anything, the government does to prevent the next crash. Anyone who is really hard core can read the appendix below to see what, specifically, to watch for.
APPENDIX (for the truly hard core investor or economics buff):
This appendix lists the specific steps the government needs to take to address the causes of the boom and bust and prevent its recurrence. Watch for them in the news. If most of them happen we can all start sleeping better. If not, then vigilance is the watch word as we embark on another boom and bust cycle, and this time the bust will be even worse.
1. As the economy strengthens, the Federal Reserve needs to begin tightening the money supply.
The Fed must do this quickly enough (to avoid fueling another boom that will lead to another bust), but not too quickly (to avoid sending us back into another recession before we really get out of this one). This is as much about the Fed shrinking its balance sheet as it is about higher interest rates – both will be required. This will be a tough needle to thread, but Ben Bernanke understands what must be done. I am reasonably confident he will pull it off.
2. As the economy strengthens, the Federal Government needs to begin reducing deficit spending.
Just as the Fed must do with monetary policy, the Federal Government must do with fiscal policy, reigning in deficit spending quickly enough to prevent the next boom and bust, but not so quickly as to squash the current recovery. Sadly, neither Democrats nor Republicans have much of a record for reducing government spending over the last couple of decades, so success here seems more difficult.
3. Congress needs to reinstate and update the regulatory reforms made in the 1930’s.
The Securities Act of 1933, The Banking (Glass-Steagall) Act of 1933, and The Securities Exchange Act of 1934 were designed to ensure that there would never be another Great Crash and Depression. These reforms worked for many decades, but in the past decade some important provisions were repealed by Congress. Of the reforms that remain, new technologies and clever traders have enabled financial firms to legally circumvent most of them. Congress’ success in fixing this could go either way, since the changes below would be popular among individual investors and the population as a whole, but most would be vehemently opposed by the big financial institutions and other entrenched interests. If the Fed gets step #1 (above) right, and the Congress fails on #2 (above), then the implementation of the changes and reforms listed below could be the deciding factor that determines whether we manage a period of relative safety for investors, or we face another boom and bust that makes the pain and suffering of 2008-2009 pale by comparison. Here is what to look for:
a. Reinstate the Uptick Rule: Enacted in 1938, repealed by Congress in 2007, this rule prevented speculators from driving stocks of sound companies down to such absurdly low levels that it caused their lenders to panic, which can lead to bankruptcy for the company.
b. Prevent Financial Institutions from Getting “Too Big to Fail”: In 1933 the Glass-Steagall Act enacted a prohibition on banks owning Wall Street brokerage and trading firms that was quite effective… until Congress repealed it in 1999. There are many different ways to accomplish this, but one way or another we need to prevent financial institutions from getting so large that they can bring down the whole system.
c. Regulate Hedge Funds: The Securities Act of 1933 contained a variety of registration and disclosure requirements designed to prevent the “blind pools” and shady operators that were doing serious damage to the markets and to real companies. But by the start of this decade hedge funds and some companies (some legitimate, some just plain frauds) had figured out how to exploit certain exemptions (some might say loop holes) in these regulations. They need to be re-tightened, and any remaining exemptions based on dollar thresholds should be indexed to inflation so they don’t become obsolete over time. At a bare minimum, far more disclosure should be required from hedge funds and financial and operating companies that act like hedge funds.
d. Regulate or Prohibit Dark Pools, Naked Access and High-Speed Trading: Without going into all of the complicated details, these are new ways in which the big boys (or more accurately, the big boys’ computers) trade massive amounts of stock in a matter of milliseconds based on information and market access that is not available to the general public. These practices, currently completely legal and unregulated, are not only dangerous but are just plain unfair.
e. Implement Meaningful Margin Requirements for Derivatives: Margin requirements for stocks were as low as 10% in the 1920’s, and that was a major contributor to the problems, but since the 1930’s they have generally been set at 50% or greater. The problem is that in the 1990’s and 2000’s, trading technologies and clever traders developed a variety of new products that let you play the market with low (<10%) or even no margin requirements. Products like Credit Default Swaps and other derivatives let investors bet against a company for pennies on the dollar. These new products need meaningful margin requirements, just like stocks.
f. Increase Margin Requirements on Leveraged ETF’s or Prohibit Them Completely: ETF’s have become popular enough to move the entire market, but an ETF with three-to-one leverage and the current 50% margin requirement effectively allows investors to bet on $6 of stock for every $1 invested.
g. Put Some Teeth in the Prohibition on Naked Shorting: Normally, when you sell a stock short (sell a stock you don’t own) you must actually borrow it from someone who owns it before you can sell it. To borrow it, you need collateral (cash or securities worth at least 50% of the value of the securities you are borrowing). But big players often sell short (again, often computers do the dirty work, not humans) and then cover (re-buy the stock) in massive amounts and over very short time frames. As a result, they never have to actually show that they borrowed the stock before they sold it, because they re-buy it so quickly. This allows them to make massive short-term bets against a stock without putting any hard cash on the line up front. While in theory this practice is prohibited, this prohibition currently lacks meaningful teeth and enforcement.
h. Increase Financial Institutions Capital Requirements: Perhaps the most obvious lesson of the last boom was that banks and other financial institutions did not have nearly enough capital (basically equity) to survive the write-downs they were required to take when asset prices collapsed, hence the need for so many government bailouts. One of the simplest and most obvious reforms needed (and the one fought most vehemently by the big banks) is to increase the capital requirements so that next time, things can go a farther south without blowing up the entire financial sector.
i. Increase Deposit Insurance Levels: Because they aren’t indexed to inflation, the limits on FDIC-insured bank accounts have become so low that they no longer effectively prevent runs on the bank, as was the original intent back in 1933. Increased bank capital requirements would offset the liability increase to the government from doing this.
j. Stiffen Regulation and Disclosure Requirements for Consumer Credit and Residential Mortgages: No discussion of how to fix this would be complete without addressing the absurd levels of leverage that individuals incurred through mortgages, home equity loans, and credit card debt. First, disclosure requirements on all forms of consumer debt should be increased so that no one, no matter how uneducated, can ever claim that they signed up for a loan that turned out to be completely different than they expected. Every lender should be required to provide easy-to-read disclosures in big print saying “Here are all the fees we can charge you” and “Here is how much and how quickly your interest rate and payments can change,” and every borrower would have to read and sign those disclosures before they get the loan. Furthermore, some practices are just so toxic that perhaps they should be banned altogether, such as loan-to-value ratios of 110% on mortgages or absurdly low “teaser” rates of interest.
Broadly speaking, every boom and bust is caused by the same factors, both economic and human, and our recent boom and bust was no different. On the economics side, all through the boom monetary policy was very loose (the Fed kept interest rates very low for a very long time) and fiscal policy was very stimulative (massive deficit spending). These factors fueled the boom to absurd and unsustainable levels. On the human side, the optimism fed on itself as rampant speculation and excessive leverage by both individuals and corporations became the order of the day. History shows us that not only will the free market eventually correct this situation on its own, but left alone it will brutally overcorrect. As was seen in the Great Depression (and many other lesser known busts in the 1800’s and early 1900’s), without government intervention the money supply plummets and government spending shrinks (if limited by tax revenues) which feeds on itself on the way down just as the bubble did on the way up. Investors lost their life savings held everywhere, even in banks, and the economy sharply contracted. The Depression lasted a decade with unemployment of 25%, shantytowns in every city, and soup kitchen lines stretching for blocks.
So call me a socialist (I dare ya! Besides, I think I look in good in a beret) but I can’t fault the government this time around for saying we couldn’t let that happen again. They saved the banking system at all costs, the Fed printed huge sums of money and we have instituted massive government spending. We can talk about whether each of these actions has been good or bad for America, but as an investor it is hard to argue with a 50%+ rebound in the stock market. And unemployment of 10% doesn’t seem that bad compared to 25%. Clearly it wasn’t perfect, but doing nothing would have been a disaster for our investment portfolios and the economy.
But now, as an investor, I am worried. Because the same conditions that led to the “roaring ‘20’s” and the Great Depression, and that led to our recent boom and bust, are still in place. The whole debate now raging about whether the government is doing too much (we’re all becoming socialists!) is dangerous because it risks distracting our elected officials from some really important things that need to be addressed. The reality is we don’t need the government to do more, and we don’t need them to do less, we need them to do some different things (quality, not quantity).
Unlike today (so far at least), in the 1930’s meaningful changes were made to the conditions that caused the whole mess. It was unnecessarily painful and harsh and awful, but the severe contraction of the money supply and the failure of the banking system forced individuals and companies to eliminate their excessive leverage and speculation. And the length and severity of the Depression burned this lesson into people’s consciousness. Those who survived the Great Depression NEVER forgot. But just in case they might forget, the government went several steps further and in the 1930’s passed a variety of regulatory reforms to prevent the recurrence of such financial speculation and leverage (and even outright fraud). Basically, in the 1930’s the government did little to alleviate their then-current pain and suffering, but focused a lot of effort on how to prevent a recurrence of it in the future.
Compare that to our current situation, which is the exact opposite – we fixed the short term pain but have done nothing to prevent its recurrence. To lessen the short term pain, we did not allow the money supply to contract, government spending increased, and the banking system was rescued. Those were all good things (at least for the short run), but as a result no one has learned any permanent life lessons. Give the stock market another big up year in 2010 and we’ll all be partying again like it was, well… 1999! (or 2006). This makes it even more troubling that the government has put nothing in place to address the CAUSES of the boom and bust. So far we have gone for the quick and easy pain relief without addressing the root causes (so surprising in a country where liposuction and stomach bands are more popular than healthy eating and exercise).
The implications for an investor are clear. If the government does not take action to address the conditions that caused the boom and bust (conditions that still exist today – loose money, deficit spending, and ineffective to nonexistent regulation of financial firms, financial products, and financial markets) we will have another bust, and the next one will be worse (more like the 1930’s). If the government can gradually tighten the money supply and cut back on spending as the economy strengthens, and also reinstate and update the regulatory reforms made in the 1930’s (Congress actually repealed many of these in the last decade) then the markets will be a safer place, and we may be able to have a sustained period of very slow economic growth. The astute investor will watch the news closely, ignore all the ranting about socialism, and see what, if anything, the government does to prevent the next crash. Anyone who is really hard core can read the appendix below to see what, specifically, to watch for.
APPENDIX (for the truly hard core investor or economics buff):
This appendix lists the specific steps the government needs to take to address the causes of the boom and bust and prevent its recurrence. Watch for them in the news. If most of them happen we can all start sleeping better. If not, then vigilance is the watch word as we embark on another boom and bust cycle, and this time the bust will be even worse.
1. As the economy strengthens, the Federal Reserve needs to begin tightening the money supply.
The Fed must do this quickly enough (to avoid fueling another boom that will lead to another bust), but not too quickly (to avoid sending us back into another recession before we really get out of this one). This is as much about the Fed shrinking its balance sheet as it is about higher interest rates – both will be required. This will be a tough needle to thread, but Ben Bernanke understands what must be done. I am reasonably confident he will pull it off.
2. As the economy strengthens, the Federal Government needs to begin reducing deficit spending.
Just as the Fed must do with monetary policy, the Federal Government must do with fiscal policy, reigning in deficit spending quickly enough to prevent the next boom and bust, but not so quickly as to squash the current recovery. Sadly, neither Democrats nor Republicans have much of a record for reducing government spending over the last couple of decades, so success here seems more difficult.
3. Congress needs to reinstate and update the regulatory reforms made in the 1930’s.
The Securities Act of 1933, The Banking (Glass-Steagall) Act of 1933, and The Securities Exchange Act of 1934 were designed to ensure that there would never be another Great Crash and Depression. These reforms worked for many decades, but in the past decade some important provisions were repealed by Congress. Of the reforms that remain, new technologies and clever traders have enabled financial firms to legally circumvent most of them. Congress’ success in fixing this could go either way, since the changes below would be popular among individual investors and the population as a whole, but most would be vehemently opposed by the big financial institutions and other entrenched interests. If the Fed gets step #1 (above) right, and the Congress fails on #2 (above), then the implementation of the changes and reforms listed below could be the deciding factor that determines whether we manage a period of relative safety for investors, or we face another boom and bust that makes the pain and suffering of 2008-2009 pale by comparison. Here is what to look for:
a. Reinstate the Uptick Rule: Enacted in 1938, repealed by Congress in 2007, this rule prevented speculators from driving stocks of sound companies down to such absurdly low levels that it caused their lenders to panic, which can lead to bankruptcy for the company.
b. Prevent Financial Institutions from Getting “Too Big to Fail”: In 1933 the Glass-Steagall Act enacted a prohibition on banks owning Wall Street brokerage and trading firms that was quite effective… until Congress repealed it in 1999. There are many different ways to accomplish this, but one way or another we need to prevent financial institutions from getting so large that they can bring down the whole system.
c. Regulate Hedge Funds: The Securities Act of 1933 contained a variety of registration and disclosure requirements designed to prevent the “blind pools” and shady operators that were doing serious damage to the markets and to real companies. But by the start of this decade hedge funds and some companies (some legitimate, some just plain frauds) had figured out how to exploit certain exemptions (some might say loop holes) in these regulations. They need to be re-tightened, and any remaining exemptions based on dollar thresholds should be indexed to inflation so they don’t become obsolete over time. At a bare minimum, far more disclosure should be required from hedge funds and financial and operating companies that act like hedge funds.
d. Regulate or Prohibit Dark Pools, Naked Access and High-Speed Trading: Without going into all of the complicated details, these are new ways in which the big boys (or more accurately, the big boys’ computers) trade massive amounts of stock in a matter of milliseconds based on information and market access that is not available to the general public. These practices, currently completely legal and unregulated, are not only dangerous but are just plain unfair.
e. Implement Meaningful Margin Requirements for Derivatives: Margin requirements for stocks were as low as 10% in the 1920’s, and that was a major contributor to the problems, but since the 1930’s they have generally been set at 50% or greater. The problem is that in the 1990’s and 2000’s, trading technologies and clever traders developed a variety of new products that let you play the market with low (<10%) or even no margin requirements. Products like Credit Default Swaps and other derivatives let investors bet against a company for pennies on the dollar. These new products need meaningful margin requirements, just like stocks.
f. Increase Margin Requirements on Leveraged ETF’s or Prohibit Them Completely: ETF’s have become popular enough to move the entire market, but an ETF with three-to-one leverage and the current 50% margin requirement effectively allows investors to bet on $6 of stock for every $1 invested.
g. Put Some Teeth in the Prohibition on Naked Shorting: Normally, when you sell a stock short (sell a stock you don’t own) you must actually borrow it from someone who owns it before you can sell it. To borrow it, you need collateral (cash or securities worth at least 50% of the value of the securities you are borrowing). But big players often sell short (again, often computers do the dirty work, not humans) and then cover (re-buy the stock) in massive amounts and over very short time frames. As a result, they never have to actually show that they borrowed the stock before they sold it, because they re-buy it so quickly. This allows them to make massive short-term bets against a stock without putting any hard cash on the line up front. While in theory this practice is prohibited, this prohibition currently lacks meaningful teeth and enforcement.
h. Increase Financial Institutions Capital Requirements: Perhaps the most obvious lesson of the last boom was that banks and other financial institutions did not have nearly enough capital (basically equity) to survive the write-downs they were required to take when asset prices collapsed, hence the need for so many government bailouts. One of the simplest and most obvious reforms needed (and the one fought most vehemently by the big banks) is to increase the capital requirements so that next time, things can go a farther south without blowing up the entire financial sector.
i. Increase Deposit Insurance Levels: Because they aren’t indexed to inflation, the limits on FDIC-insured bank accounts have become so low that they no longer effectively prevent runs on the bank, as was the original intent back in 1933. Increased bank capital requirements would offset the liability increase to the government from doing this.
j. Stiffen Regulation and Disclosure Requirements for Consumer Credit and Residential Mortgages: No discussion of how to fix this would be complete without addressing the absurd levels of leverage that individuals incurred through mortgages, home equity loans, and credit card debt. First, disclosure requirements on all forms of consumer debt should be increased so that no one, no matter how uneducated, can ever claim that they signed up for a loan that turned out to be completely different than they expected. Every lender should be required to provide easy-to-read disclosures in big print saying “Here are all the fees we can charge you” and “Here is how much and how quickly your interest rate and payments can change,” and every borrower would have to read and sign those disclosures before they get the loan. Furthermore, some practices are just so toxic that perhaps they should be banned altogether, such as loan-to-value ratios of 110% on mortgages or absurdly low “teaser” rates of interest.
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