King of the castle

This piece was submitted by Lune on Naked Capitalism's blog. I would recommend the whole article and tracking back to the original posting as well. Here is the most germane portion, the rest of the rhetoric just supports this thesis.

Anyone who watches Congress go about its business will note a certain bipolar proclivity to its actions: it will snooze as important issues fester; then, at a seemingly random moment, it will wake up, and, after a frenzy of hearings, speeches, and negotiations, it will write and pass enormous bills faster than a harlequin ghost-writer on crack.

The public is therefore left cursing Congress for its laziness and inaction, then cursing it for its hasty decisions and rushed, poorly thought-out laws. There seems to be no in-between.

The reality is that getting a bill passed is somewhat akin to laying siege to a castle (the castle being Congress and the policy advocates being the marauders). A successful siege campaign in the Middle Ages could last years, and consisted of a slow grinding down of the inhabitants of the castle while building your siege weapons, training your forces, and probing the walls for weaknesses. Then, when a weakness was found (or created), all of a sudden, your forces would rush in, a huge, noisy battle would ensue, and very quickly, you'd either become the king of the castle, or be dead with your head proudly displayed on a pike.

For someone watching just the castle, it can appear like years of humdrum tedium interrupted by sudden, random chaos. The legislative process is a little like that (although being more civilized, we've replaced the pike with a symbolic skewering on the late night comedy shows).

History doesn't repeats it rhymes, correlations abound?

Just reading through Gluskin-Sheff's Chief Economist David Rosenberg musings on the market. The whole report is worth the read, you will have to register with the firm though.

The salient point, at least as far as this post is concerned is about how this latest burst in the S&P500 index is reminiscent of 2001 and 2002.

Then: Big 3 unleash 0% financing to bring about car sales. Annualized sales jump from 16.1 million units to 21.7 million units in just one month!

Now: Government let's Cash for Clunkers rip and car sales jump from a run rate of 9.2 million units to 11.2 million.

However, as Rosenberg points out this does little to build actual demand, while it seems that demand is increasing what occurs under the headline numbers is that sales are brought forward from the future. Say Consumer Bob was going to buy a car once he received his annual bump in salary in December. Now that the program is in force he would be wise to take the 4,500 the government was offering, plus what ever other rebates the manufacturers are offering to clear inventory for the new model year that begins in October. So his consumption from December is moved up. It did not create a new job and hence a new salaried person to purchase a car, or a recently minted 16 year old to stop riding the cheese wagon. So what happens once the demand is brought forward, it just leaves a lumpy distribution of sales.

Take this hypothetical say the new normal is for 12 million cars a year. So that is 1 million a month. With the new incentive structure fomented by the federalis instead of having a constant million a month, it instead
Jan- 1.0
Feb- 1.0
March- 1.0
May- 1.0
June- 1.0
July- 1.9
Aug- 1.6
Sept- 1.7
Oct- 0.4
Nov- 0.1
Dec- 0.3

So that all that ends up happening is that we have positive numbers now and then negative surprises later. So GDP looks good in the 3rd quarter but against all expectations worse in the 4th quarter. This leads to worry and the market falls again. But let's look and see what happened back in 2001/2

• 2001Q3: -1.1%
• 2001Q4: +1.4%
• 2002Q1: +3.5%
• 2002Q2: +2.1%
• 2002Q3: +2.0%
• 2002Q4: +0.1%

Just as it was written. The temporary boost then faded and the market lows were not reached until 2003. So will it happen again? Not sure, history doesn't repeat itself but America has placed itself into a very similar situation. Just a quick example, imagine that the government stimulus is akin to taking a child who just fell off his bike and attaching training wheels. Once the stimulus/training wheels comes off what happens, well the government and the Federal Reserve hopes that the economy/child will propel itself, but he may just end up in the hedge again.

I''l close with a direct quote from Rosenberg "The asset deflation, which included housing this time around, has been three times more intense (than 2001/2) and coupled with a broken-down credit market. It is vital as we go through this intermittent period of auto-related spending and output activity, to recall that similar period seven years ago and what we learned was that sustainability proved to be elusive."

Fun with Numbers

As the S&P 500 index races above 1,000 we have now reached a 50% re-tracement from the low of 666. The upbeat GDP report had GDP coming in better than expectations of -1.5% instead it was -1% on an annualized basis. So SPY goes wild!

However, is there more to this than meets the eye? Let us consider that also in this GDP report that the 1st quarter GDP was revised downwards from -5.5% annualized to -6.4%. 2008 had revisions in the first half with 1Q08 from 0.9% to -0.7%; 2Q08 from 2.8% to 1.5%. So taking the 3Q08 as -2.7% and 4Q08 as -5.4% we have a complete series in which to compare.

Thought experiment. Take 01/01/2008 as 100 and follow the path of the revised statement and compare it to the path of the original statement. Where is the ending point? Well 1st off all these statistics are annualized so we have to divide each by 4 and then we can grow or contract in a linear fashion.



Since a picture is worth a thousand words here is the enormous gap just exposed by the revision.



So the economy is about 4% worse than we thought and yet the rally. Baffling. But as a wise French queen once said, "let them eat cake!"

Fair Value

First, I wanted to show two charts.






Now what do they mean? Both derive from Robert Shiller's work. As a quick aside, Yale allows you to view, learn and take tests from his economics course at their website. Now what the first chart shows is the price earnings ratio, that is the price of a stock certificate to the earnings generated for that same certificate. He did this for the entire market, so for my analysis now I just use the S&P500 to continue his analysis. By analyzing his chart it becomes plain that when the P/E is low good returns on average follow. As we all know from a previous post a statistic's professor can still drown in a river that is on average two inches deep. Therefore, Professor Shiller compiled an additional chart that shows further P/E deciles with the maximum return, minimum return, spread between those two points and average return. One can see the clear correlation again, my yellow arrow almost covers all the average return bars, that as P/E's rise the total return falls.

Perfect, so let's go out and invest and be billionaires. Well, we should check to see where we are at currently before we go put a lien on the house to buy S&P Index Futures. Here is the table I generated from S&P's really helpful website.


I took the expected earnings prognosticated from S&P's staff over the next 6 quarters and for the 7th quarter I used a terminal value. The discount rate is the BBB bond yield. I put out the entire equation but as the S&P represents the entire market Beta equals one, thus causing the Risk-free rates to cancel each other in the equation. Finally, a terminal value was established by using the average earnings from March 1988 to present and it is $9.45, then I applied again the same BBB discount rate and subtracted the trend growth rate of GDP at 3%. All these earnings were discounted back and summed to equal a net present value of $141.40, which sounds great. So utilizing Professor Shiller's method I created a table of Earnings and Multiples show here:


So that's great we reached a nadir in March of a sub-five P/E ratio and we are currently at just below 7, so we can expect via Shiller's chart a maximum return off 20%, a minimum of 3% and an average of around 13% over the next ten years. Dialing the home equity underwriter.

WAIT!!!!!
As with everything even though the analysis be true the pillars it stands atop may or may not be the most secure. Now it is true that corporations have done tons for their balance sheets over the past 20 months to secure earnings power. They have cut costs, inventory, staff, R&D, etc. So there is nothing left to cut, they have the bare minimum to continue conducting business. The estimates provided by S&P seem to think that we will just snap back into "normal" corporate earnings immediately. However, what about revenue growth, the top line from which the bottom line springs, doesn't that have to grow for these titans of industry to reach these estimates that analysts have laid out? Only 23 companies show an increase in revenue in this earning season. As I said above there is only so much cost cutting before you need top line growth to propel earnings. Just changing a few items such as GDP growth at 2%, which The Economist quoted in its latest offering, and dropping earnings to 3 and growing from there would put the index at a multiple over 18, which would indicate a max growth rate of 12% an average of 7% and a minimum of -2%. A sobering thought indeed.

As always when investing one should remember "Res tantum valet quantum vendi potest," or a thing is worth only what someone else will pay for it.

Jim the Realtor

If you are not acquainted with Jim, you should be. His entire collection can be found here. Today focuses on Commercial Real Estate or CRE is how the finance types will describe it.



Now there are some caveats, Jim is a good ole boy from Southern California, he uses a hand-held digital camera and drives while shooting. He's a little dry but he has a fascinating amount of knowledge about sales tactics in commercial and residential real estate. The only problem is you have to wait for the nuggets to come, as there is no editing and this is all done via stream of consciousness. I hope you will enjoy but also be fearful of the next wave of writedowns on the banks balance sheets.

Anecdotally, I heard of a bank holding a CRE securitization pool at 95 cents on its books but through some accounting wrangling was able to sell it for 35 cents on the dollar and hold the loss of its books for a awhile, I presume it works as a lease buyback, where the bank stills own it in all but name. If I find the story I will post it.

Towards a new correlation

"recommendations affected by the changes on the 2000-2002 tapes are too optimistic, while those on the 2003-2005 tapes are too pessimistic"

Just reading a paper about sell-side analyst recommendations and how they are being affected ex-post, after the fact. So on a tip from Thompson three researchers from NYU, Harvard and UVA searched through Thompson's database. The three found that if you downloaded the data set in 2000 it would be different from 2001 and both different from 2002. Based on their research Thompson is making a move to create an un-blanched data set that will not have revisions.

Now not all the revisions were changes from hold to buy, or sell to buy which the authors deem alterations, they also found deletions, additions and anonymizations. Now in hindsight it would seem to only be a historical triviality only interesting to researchers, but any investor following a strategy of buying and selling based on changes in opinion from analysts will look at the historical record to extrapolate how much she might gain from an analyst upgrading a stock. Unfortunately, the data, as the authors put it "the historical bedrock of empirical research" would seem to have no foundation.

More darkly, for star analysts it marks a method of enhancing their record or prescience. Just imagine a golfer changing his score after the round. The justification, well I would have made par except for that nasty sand trap. In the analysts case par is the correct recommendation and the sand trap is the bear market of 2000-2002 or even worse the bull market of 2003-2007. In this new history there outstanding pay is more correlated to their "enhanced" prognostications.

Fascinating and not so fascinating

I just perused, and by perused I mean read thoroughly; not the way it is currently used in common vernacular. But I digress...

Three professors from Stanford collaborated on "Dynamical Bias in the Coin Toss" was quite a dry but worthwhile read. I had not read a paper with physics and calculus in it since I was but a lad in high school, so it took a while for the vector analysis to sink in, but I grasped the gist of the argument. But no matter, for all is provided in the abstract.

Abstract: We analyze the natural process of flipping a coin which is caught in the hand. We prove that vigorously-flipped coins are biased to come up the same way they started. The amount of bias depends on a single parameter, the angle between the normal to the coin and the angular momentum vector. Measurements of this parameter based on high-speed photography are reported. For natural flips, the chance of coming up as started is about .51.

Ahh the random coin flip is no longer. So is this just another instance where as Nassim Taleb like to point out where we are fooled by randomness, or rather we believe it to be random and we are fooled into thinking it is so. I would love to hear his thoughts on that.

However, as the abstract points out this only garners a person a one point advantage, thus the caller would need to be able to view the coin from its initial position to win on average more than he should in theory. So at the next SuperBowl or National Championship game look for the referee to cover the coin before he tosses it, otherwise Stanford, and its alumni, may be at an advantage.