From his 2008 shareholder letter:
On Private Equity:
"Some years back our competitors were known as “leveraged-buyout operators.” But LBO became a bad name. So in Orwellian fashion, the buyout firms decided to change their moniker. What they did not change, though, were the essential ingredients of their previous operations, including their cherished fee structures and love of leverage.
Their new label became “private equity,” a name that turns the facts upside-down: A purchase of a business by these firms almost invariably results in dramatic reductions in the equity portion of the acquiree’s capital structure compared to that previously existing. A number of these acquirees, purchased only two to three years ago, are now in mortal danger because of the debt piled on them by their private-equity buyers. Much of the bank debt is selling below 70¢ on the dollar, and the public debt has taken a far greater beating. The privateequity firms, it should be noted, are not rushing in to inject the equity their wards now desperately need. Instead, they’re keeping their remaining funds very private."
On quant / models:
"The type of fallacy involved in projecting loss experience from a universe of non-insured bonds onto a deceptively-similar universe in which many bonds are insured pops up in other areas of finance. “Back-tested” models of many kinds are susceptible to this sort of error. Nevertheless, they are frequently touted in financial markets as guides to future action. (If merely looking up past financial data would tell you what the future holds, the Forbes 400 would consist of librarians.)"
"Investors should be skeptical of history-based models. Constructed by a nerdy-sounding priesthood using esoteric terms such as beta, gamma, sigma and the like, these models tend to look impressive. Too often, though, investors forget to examine the assumptions behind the symbols. Our advice: Beware of geeks bearing formulas."
On Investing:
"Approval, though, is not the goal of investing. In fact, approval is often counter-productive because it sedates the brain and makes it less receptive to new facts or a re-examination of conclusions formed earlier. Beware the investment activity that produces applause; the great moves are usually greeted by yawns."
"When forced to choose, I will not trade even a night’s sleep for the chance of extra
profits."
On Derivatives:
"Derivatives are dangerous. They have dramatically increased the leverage and risks in our financial system. They have made it almost impossible for investors to understand and analyze our largest commercial banks and investment banks. They allowed Fannie Mae and Freddie Mac to engage in massive misstatements of earnings for years. So indecipherable were Freddie and Fannie that their federal regulator, OFHEO, whose more than 100 employees had no job except the oversight of these two institutions, totally missed their cooking of the books."
"The ridiculous premium that Black-Scholes dictates in my extreme example is caused by the inclusion of volatility in the formula and by the fact that volatility is determined by how much stocks have moved around in some past period of days, months or years. This metric is simply irrelevant in estimating the probabilityweighted range of values of American business 100 years from now. (Imagine, if you will, getting a quote every day on a farm from a manic-depressive neighbor and then using the volatility calculated from these changing quotes as an important ingredient in an equation that predicts a probability-weighted range of values for the farm a century from now.)"
Saturday, February 28, 2009
Must Read
Off to read Buffett's latest annual shareholder letter. I like and share his optimism:
"Amid this bad news, however, never forget that our country has faced far worse travails in the past. In the 20th Century alone, we dealt with two great wars (one of which we initially appeared to be losing); a dozen or so panics and recessions; virulent inflation that led to a 211⁄2% prime rate in 1980; and the Great Depression of the 1930s, when unemployment ranged between 15% and 25% for many years. America has had no shortage of challenges.
Without fail, however, we’ve overcome them. In the face of those obstacles – and many others – the real standard of living for Americans improved nearly seven-fold during the 1900s, while the Dow Jones Industrials rose from 66 to 11,497. Compare the record of this period with the dozens of centuries during which humans secured only tiny gains, if any, in how they lived. Though the path has not been smooth, our economic system has worked extraordinarily well over time. It has unleashed human potential as no other system has, and it will continue to do so. America’s best days lie ahead."
"Amid this bad news, however, never forget that our country has faced far worse travails in the past. In the 20th Century alone, we dealt with two great wars (one of which we initially appeared to be losing); a dozen or so panics and recessions; virulent inflation that led to a 211⁄2% prime rate in 1980; and the Great Depression of the 1930s, when unemployment ranged between 15% and 25% for many years. America has had no shortage of challenges.
Without fail, however, we’ve overcome them. In the face of those obstacles – and many others – the real standard of living for Americans improved nearly seven-fold during the 1900s, while the Dow Jones Industrials rose from 66 to 11,497. Compare the record of this period with the dozens of centuries during which humans secured only tiny gains, if any, in how they lived. Though the path has not been smooth, our economic system has worked extraordinarily well over time. It has unleashed human potential as no other system has, and it will continue to do so. America’s best days lie ahead."
Friday, February 27, 2009
CDOs vs. Gigabit Ethernet
The Economist compares crashes: banking vs telecoms. "Just like banks, telecoms had imperial bosses, kamikaze deals and incomprehensible jargon—if collateralised-debt obligations troubled you, try gigabit Ethernet routers. In telecoms leading firms were reduced to indebted objects of ridicule. The consequences were bankruptcies, huge job losses, fraud, trashed reputations and, eventually, a clean-up".
They draw the following lessons: gradualism will most likely fail, "back to basic" focus on core business may lead to disappointing acquisitions, a new culture needs to be fostered as bubbles corrupt firms' intellectual capital (away from exclusive focus on ROE, cost income ratio and from giving cheap capital to high-risk units) and conclude:
"For most others, the decade since the bubble has been a slog against competitors and reinvigorated regulators. That is the lot of most firms in most industries. They face a constant battle to protect pockets of high profits and have few chances to grow. For telecoms, the glamour and infamy were followed by mediocrity. Banks are still staggering about in the limelight, but the same fate surely awaits them."
They draw the following lessons: gradualism will most likely fail, "back to basic" focus on core business may lead to disappointing acquisitions, a new culture needs to be fostered as bubbles corrupt firms' intellectual capital (away from exclusive focus on ROE, cost income ratio and from giving cheap capital to high-risk units) and conclude:
"For most others, the decade since the bubble has been a slog against competitors and reinvigorated regulators. That is the lot of most firms in most industries. They face a constant battle to protect pockets of high profits and have few chances to grow. For telecoms, the glamour and infamy were followed by mediocrity. Banks are still staggering about in the limelight, but the same fate surely awaits them."
Wednesday, February 25, 2009
Home Price to Income by State
Following up on CalculatedRisk's recommendation I have built this chart of home price to median income for different states and cities. Quite a bit of datacrunching. I used the following sources:
Median Income in Current Dollars:
http://www.census.gov/hhes/www/income/histinc/h08.html
For 2008 I grew 2007 incomes by 2%.
Home Prices:
http://www2.standardandpoors.com/spf/pdf/index/CSHomePrice_History_022445.xls
Charts and data available for review if needed!
What's going on in Portland?
Median Income in Current Dollars:
http://www.census.gov/hhes/www/income/histinc/h08.html
For 2008 I grew 2007 incomes by 2%.
Home Prices:
http://www2.standardandpoors.com/spf/pdf/index/CSHomePrice_History_022445.xls
Charts and data available for review if needed!
What's going on in Portland?
Tuesday, February 24, 2009
Monday, February 23, 2009
Valuation Update
First: Prof Robert Shiller from Yale actually provides online the data he uses for his long term PE chart. You can access it here. His PE chart is "real", ie both S&P levels and earnings are adjusted for inflation. Very useful, no need to play around with S&P data anymore!
The dataset also contains info on dividends and interest rates that got me started on a simple Dividend Discount Model. Here is a first chart on the implied cost of capital assuming growth of 5.5% (3% real and 2.5% inflation). On this metric the market does not seem that cheap at least compared to the 82 low.
Second: John Hussman from Hussmanfunds has an excellent market comment where he proposes "Property Appreciation Rights" as part of the solution to the current mortgage problems. He also discusses these great long term valuation charts:
(1) Earnings Growth Channel:
(2) PE based on Earnings Channels
(3) 10 year total return projections
Thursday, February 19, 2009
Worst Post WWII Slump in Industrial Production
Econbrowser compares recessions
Industrial production:
Manufacturing production (since 1973):
The current cliff diving is impressive. 1973 had a similar drop.
Angry Bear's chart shows the average trough happening three months from now.
The current drop does not seem of the "average kind" though.
Bank Solvency
Arguments are raging for or against nationalizing part of the banking system. John Hempton at Bronte Capital (H/T econbrowser) has a long but excellent post on the topic.
His main points are: we first need a proper diagnosis, second solvency can be defined various ways (regulatory solvency, positive networth under GAAP, positive liquidation value, etc) hence the solvency meant needs to be specified and clarified by the arguing parties and finally the right policies may involve some selective nationalization after due process.
Diagnosis:
Bank's assets sits on banks' balance sheets with a value after markdowns or provisions (90 cts/$) that is higher than both market value (50cts/$) and "held to maturity" basis (75cts/$). Banks are hence under-reserved.
For the United States he then explains:
"Reasonable numbers are that:
The system starting capital (ie pre-crisis) was 1.4 trillion dollars
Banks have raised about $500 billion along the way
Financial institutions have passed say 300-700 billion in losses outside the banking system (such as to defaulted bonds on Lehman or to hedge funds that have blown up) or to non bank holders of junky CDS
That end cumulative losses (the 25 cents in the dollar not recoverable in the above illustration) total maybe $1.5 to 2 trillion and
That mark-to-market losses (where the assets are marked down to what the market price for those assets) is about 3 to 4 trillion dollars. The current Nouriel Roubini number is 3.4 trillion."
He then notes the various definitions of solvency and goes about testing the system against these:
Definition 1: Regulatory Solvency. Does the bank have adequate capital to meet the solvency tests imposed by regulators? (his answer: not likely)
Definition 2: Positive net worth under GAAP. Does the bank have positive net worth under GAAP accounting (ie yield to maturity with appropriate provisions when YTM is required or mark to market otherwise)? (his answer: a bare pass)
Definition 3: Positive economic value of an operating entity. If the bank is allowed to continue to operate it will be able to pay all its debt and replace its capital? (his answer: definite yes)
Definition 4: Positive liquidation value. If you liquidated it today at current market prices it would have positive value. (his answer: no way)
Definition 5: Liquidity. Does the bank have adequate liquidity to operate on a day to day basis? (tough to answer as it depends on government policy, hence the importance of a consistent plan)
His conclusion overall "if you believe these numbers - and he does - then there is no need to nationalize the banking system in the US provided you can get the confidence back" and adds that it can't be done without a strong plan.
His main points are: we first need a proper diagnosis, second solvency can be defined various ways (regulatory solvency, positive networth under GAAP, positive liquidation value, etc) hence the solvency meant needs to be specified and clarified by the arguing parties and finally the right policies may involve some selective nationalization after due process.
Diagnosis:
Bank's assets sits on banks' balance sheets with a value after markdowns or provisions (90 cts/$) that is higher than both market value (50cts/$) and "held to maturity" basis (75cts/$). Banks are hence under-reserved.
For the United States he then explains:
"Reasonable numbers are that:
The system starting capital (ie pre-crisis) was 1.4 trillion dollars
Banks have raised about $500 billion along the way
Financial institutions have passed say 300-700 billion in losses outside the banking system (such as to defaulted bonds on Lehman or to hedge funds that have blown up) or to non bank holders of junky CDS
That end cumulative losses (the 25 cents in the dollar not recoverable in the above illustration) total maybe $1.5 to 2 trillion and
That mark-to-market losses (where the assets are marked down to what the market price for those assets) is about 3 to 4 trillion dollars. The current Nouriel Roubini number is 3.4 trillion."
He then notes the various definitions of solvency and goes about testing the system against these:
Definition 1: Regulatory Solvency. Does the bank have adequate capital to meet the solvency tests imposed by regulators? (his answer: not likely)
Definition 2: Positive net worth under GAAP. Does the bank have positive net worth under GAAP accounting (ie yield to maturity with appropriate provisions when YTM is required or mark to market otherwise)? (his answer: a bare pass)
Definition 3: Positive economic value of an operating entity. If the bank is allowed to continue to operate it will be able to pay all its debt and replace its capital? (his answer: definite yes)
Definition 4: Positive liquidation value. If you liquidated it today at current market prices it would have positive value. (his answer: no way)
Definition 5: Liquidity. Does the bank have adequate liquidity to operate on a day to day basis? (tough to answer as it depends on government policy, hence the importance of a consistent plan)
His conclusion overall "if you believe these numbers - and he does - then there is no need to nationalize the banking system in the US provided you can get the confidence back" and adds that it can't be done without a strong plan.
Wednesday, February 18, 2009
"Getting Off Track"
Prof John B. Taylor from Stanford University just authored an excellent short new book on the crisis:
Getting Off Track. How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis.
See the author summing up his points in the wsj here. A review of the book by his colleague from the Hoover Institution can be found in Forbes.
Prof. Taylor is the economist who gave his name to the "Taylor Rule" which says "the interest rate should be one-and-a-half times the inflation rate plus one-half times the GDP gap plus one. (The GDP gap measures how far GDP is from its normal trend level)". (Am not sure what the rule says when the result of the above equation is negative!)
The book is a short read and answers the following questions rather convincingly.
What caused the financial crisis?
What prolonged the crisis?
Why the crisis worsened dramatically a year after it began?
What caused the financial crisis?
Too loose monetary policy (interest rates lower than the above rule would have suggested and for longer than necessary) contributed to the housing boom.
"Queen of Spades Problem": complex securitization ensured that people didn't and still don't know where the bad mortgages are.
What prolonged the crisis?
According to the author the problem was at first wrongly diagnosed. The rise in spreads that seized market in August 2007 was first attributed to liquidity problems rather than a counterparty risk problem. The policies that followed were then mistaken and ineffective(TAF, 100bn US$ checks to households, aggressive cut in rates that led to higher oil prices)
Why the crisis worsened dramatically a year after it began?
In this chapter the author questions the conventional wisdom according to which letting Lehman Brother go bust led to a worsening of the crisis. Mr Taylor makes an interesting detailed event study to prove his point (basically the surge in Libor-OIS spread happened more than a week after that event and just after the TARP announcement). For the author the wrong diagnosis and the lack of a predictable framework for intervention were big contributors to the worsening of the situation.
Getting Off Track. How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis.
See the author summing up his points in the wsj here. A review of the book by his colleague from the Hoover Institution can be found in Forbes.
Prof. Taylor is the economist who gave his name to the "Taylor Rule" which says "the interest rate should be one-and-a-half times the inflation rate plus one-half times the GDP gap plus one. (The GDP gap measures how far GDP is from its normal trend level)". (Am not sure what the rule says when the result of the above equation is negative!)
The book is a short read and answers the following questions rather convincingly.
What caused the financial crisis?
What prolonged the crisis?
Why the crisis worsened dramatically a year after it began?
What caused the financial crisis?
Too loose monetary policy (interest rates lower than the above rule would have suggested and for longer than necessary) contributed to the housing boom.
"Queen of Spades Problem": complex securitization ensured that people didn't and still don't know where the bad mortgages are.
What prolonged the crisis?
According to the author the problem was at first wrongly diagnosed. The rise in spreads that seized market in August 2007 was first attributed to liquidity problems rather than a counterparty risk problem. The policies that followed were then mistaken and ineffective(TAF, 100bn US$ checks to households, aggressive cut in rates that led to higher oil prices)
Why the crisis worsened dramatically a year after it began?
In this chapter the author questions the conventional wisdom according to which letting Lehman Brother go bust led to a worsening of the crisis. Mr Taylor makes an interesting detailed event study to prove his point (basically the surge in Libor-OIS spread happened more than a week after that event and just after the TARP announcement). For the author the wrong diagnosis and the lack of a predictable framework for intervention were big contributors to the worsening of the situation.
Nationalization / Preprivatization / Receivership AGAIN!
Academia weighs in on the above topic.
Prof. Mankiw from Harvard University mentions as well the language issue regarding bank nationalization but believes there is more to it than semantics:
"The search for alternative names can be amusing at first, but I think there is more here than mere semantics. Why are people scared about the idea of nationalization? One reason is that it is a sign of the depth of our problems. A second, more substantive reason is that it seems to point in a bad direction. I certainly do not want the government deciding who deserves credit and who does not, what kind of investments are worthy of financing and what kind are not. That is a big step toward crony capitalism, where the politically connected get the goodies, and economic stagnation awaits the rest of us. If the government is to intervene in a big way to fix the banking system, "nationalization" is the wrong word because it suggests the wrong endgame. If banks are as insolvent as some analysts claim, then the goal should be a massive reorganization of these financial institutions. Some might call it nationalization, but more accurately it would be a type of bankruptcy procedure. Bankruptcy could become, in effect, a massive bank recapitalization. Essentially, the equity holders are told, "Go away, you have been zeroed out." The debt holders are told, "Congratulations, you are the new equity holders." Suddenly, these financial organizations have a lot more equity capital and not a shred of debt! And all done without a penny of taxpayer money" ... "But there is one thing I am sure of: If this is the route we go down, the government had better get in and out as quickly as possible. If it is done right, nationalization will be the wrong word to describe the process."
Paul Krugman via his blog points to Greenspan's view on the subject as reported in the FT. Elsewhere he argues "Focus just on the big four money center banks: Citi, B of A, Wells Fargo, JPMorgan. According to this estimate, they need around $450 billion. Meanwhile, their combined market cap is only about $200 billion — and part if not all of that market cap surely represents the “Geithner put,” the hope that stockholders will in effect get a handout from the feds. Given these numbers, it’s extremely hard to rescue these banks without either (a) giving a HUGE handout to current stockholders or (b) effectively taking ownership on the part of we, the people. Of these, (a) would be politically unacceptable as well as bad policy — but the Obama administration isn’t ready to go for (b), because it’s not in our “culture”. Hence the perplexity of policy. Our best hope right now is that the “stress test” will make (b) inevitable — that Treasury will declare itself shocked, shocked to find that the banks are in such bad financial shape, leaving government receivership unavoidable."
Prof. James Hamilton from UCSD writes about the Prospects for the U.S. banking system and proposes a way to frame the problem: "Figure out what are the possible parameters for the capital loss that is to be allocated among the various parties-- specifically, a loss that must be borne by some combination of stockholders, creditors, managers, employees, and the taxpayers-- and try to reconcile those numbers with the current liquidation value of the banks." He remains unsure of the solution though: "For myself, I don't know the true value of the assets, but I suspect it's well below 90 cents on the dollar. And I fear that the debt-for-equity swap, though attractive in principle, could prove to be quite a destabilizing process. It would be nice if there were a painless way out of this, but I don't see one. What we need is not a painless resolution of the crisis, but rather a plan that puts the pain behind us."
Mr Hamilton also refers to a great piece by John Hempton from Bronte Capital that I will have to come back to in a next post.
Prof. Mankiw from Harvard University mentions as well the language issue regarding bank nationalization but believes there is more to it than semantics:
"The search for alternative names can be amusing at first, but I think there is more here than mere semantics. Why are people scared about the idea of nationalization? One reason is that it is a sign of the depth of our problems. A second, more substantive reason is that it seems to point in a bad direction. I certainly do not want the government deciding who deserves credit and who does not, what kind of investments are worthy of financing and what kind are not. That is a big step toward crony capitalism, where the politically connected get the goodies, and economic stagnation awaits the rest of us. If the government is to intervene in a big way to fix the banking system, "nationalization" is the wrong word because it suggests the wrong endgame. If banks are as insolvent as some analysts claim, then the goal should be a massive reorganization of these financial institutions. Some might call it nationalization, but more accurately it would be a type of bankruptcy procedure. Bankruptcy could become, in effect, a massive bank recapitalization. Essentially, the equity holders are told, "Go away, you have been zeroed out." The debt holders are told, "Congratulations, you are the new equity holders." Suddenly, these financial organizations have a lot more equity capital and not a shred of debt! And all done without a penny of taxpayer money" ... "But there is one thing I am sure of: If this is the route we go down, the government had better get in and out as quickly as possible. If it is done right, nationalization will be the wrong word to describe the process."
Paul Krugman via his blog points to Greenspan's view on the subject as reported in the FT. Elsewhere he argues "Focus just on the big four money center banks: Citi, B of A, Wells Fargo, JPMorgan. According to this estimate, they need around $450 billion. Meanwhile, their combined market cap is only about $200 billion — and part if not all of that market cap surely represents the “Geithner put,” the hope that stockholders will in effect get a handout from the feds. Given these numbers, it’s extremely hard to rescue these banks without either (a) giving a HUGE handout to current stockholders or (b) effectively taking ownership on the part of we, the people. Of these, (a) would be politically unacceptable as well as bad policy — but the Obama administration isn’t ready to go for (b), because it’s not in our “culture”. Hence the perplexity of policy. Our best hope right now is that the “stress test” will make (b) inevitable — that Treasury will declare itself shocked, shocked to find that the banks are in such bad financial shape, leaving government receivership unavoidable."
Prof. James Hamilton from UCSD writes about the Prospects for the U.S. banking system and proposes a way to frame the problem: "Figure out what are the possible parameters for the capital loss that is to be allocated among the various parties-- specifically, a loss that must be borne by some combination of stockholders, creditors, managers, employees, and the taxpayers-- and try to reconcile those numbers with the current liquidation value of the banks." He remains unsure of the solution though: "For myself, I don't know the true value of the assets, but I suspect it's well below 90 cents on the dollar. And I fear that the debt-for-equity swap, though attractive in principle, could prove to be quite a destabilizing process. It would be nice if there were a painless way out of this, but I don't see one. What we need is not a painless resolution of the crisis, but rather a plan that puts the pain behind us."
Mr Hamilton also refers to a great piece by John Hempton from Bronte Capital that I will have to come back to in a next post.
Monday, February 16, 2009
Pre-privatization / Nationalization / Receivership
InfectiousGreed makes an interesting point on the importance of language in the raging debate for / against nationalization. CalculatedRisk was the first I saw proposing the word "pre-privatization".
Prof. Nouriel Roubini explains why nationalization may be needed and uses the word "receivership". Basically his company's estimates "suggest that total losses on loans made by U.S. banks and the fall in the market value of the assets they are holding will reach about $3.6 trillion. The U.S. banking sector is exposed to half that figure, or $1.8 trillion. Even with the original federal bailout funds from last fall, the capital backing the banks' assets was only $1.4 trillion, leaving the U.S. banking system about $400 billion in the hole."
Slightly less sanguine Martin Wolf opines "The correct advice remains the one the US gave the Japanese and others during the 1990s: admit reality, restructure banks and, above all, slay zombie institutions at once. It is an important, but secondary, question whether the right answer is to create new “good banks”, leaving old bad banks to perish, as my colleague, Willem Buiter, recommends, or new “bad banks”, leaving cleansed old banks to survive. I also am inclined to the former, because the culture of the old banks seems so toxic."
Prof. Nouriel Roubini explains why nationalization may be needed and uses the word "receivership". Basically his company's estimates "suggest that total losses on loans made by U.S. banks and the fall in the market value of the assets they are holding will reach about $3.6 trillion. The U.S. banking sector is exposed to half that figure, or $1.8 trillion. Even with the original federal bailout funds from last fall, the capital backing the banks' assets was only $1.4 trillion, leaving the U.S. banking system about $400 billion in the hole."
Slightly less sanguine Martin Wolf opines "The correct advice remains the one the US gave the Japanese and others during the 1990s: admit reality, restructure banks and, above all, slay zombie institutions at once. It is an important, but secondary, question whether the right answer is to create new “good banks”, leaving old bad banks to perish, as my colleague, Willem Buiter, recommends, or new “bad banks”, leaving cleansed old banks to survive. I also am inclined to the former, because the culture of the old banks seems so toxic."
Finally Andrew M. Rosenfield, the CEO of Guggenheim Investment Advisors concludes his Forbes commentary Why We're not Socialsits with "The present practice of subsidizing shareholders and debt holders of large insolvent bank holding companies is unprecedented, improper and unwise. It is time to take strong capitalist action--and that requires wiping out the existing owners of the insolvent banks and giving the system much needed new equity capital, which, at this time, can come only from the government."
Financial Crisis for Beginners
Recommended by Nobel Price Paul Krugman: http://baselinescenario.com/
An other economics professor with a great quality blog.
An other economics professor with a great quality blog.
Sunday, February 15, 2009
Art as an investment
Cassandra has an interesting post on the recent sale of a painting by Claude Monet that sold for less than the price fetched 20 years ago. Made me think of the various investment outlooks by Pimco's boss on his stamp collection. Here they are in reverse chronological order.
- Stamps and what to expect for asset prices inflation from November 2006.
- CAPM and stamps from November 2005
- He mentionned his hobby in this 2001 outlook with great longterm charts and lessons.
- Stamps and what to expect for asset prices inflation from November 2006.
- CAPM and stamps from November 2005
- He mentionned his hobby in this 2001 outlook with great longterm charts and lessons.
Earnings and valuation
The drop in earnings animates the discussions. See Barry Ritholz first with a very provocative target for the S&P500 and the response by Peridot Capitalist.
I created below a long term chart based on 10 year rolling earnings for the S&P500. The chart shows the PE, the average and a one standard deviation band. To discuss the findings further I added as well the YoY change in CPI.
Key findings:
(1) The 48 year average is roughly 22x 10 year rolling earnings.
(2) The current level of 15x is ca one standard deviation below the average. The last time it was so low was in the 70's.
(3) Indeed in the 70's this metrics was lower fluctuating between 15 and 10x. Note though that during that period inflation was much higher than currently.
(4) The market bottomed in 82 at 10x 10 year rolling earnings
(5) The Internet bubble is clearly visible. Interestingly the recent bull run from 2002 to 2007 happened at a valuation ca one standard deviation above the long term average.
(6) Interpretations of the apparently low level of valuation based on 10 year rolling earnings?
(a) Past 10 year earnings were inflated
(b) Future earnings will remain lower for longer
(c) The market is cheap
Saturday, February 14, 2009
Earnings
The downturn is taking its toll on earnings. Marketwatch recently reported that quarterly earnings for the S&P500 will be negative for the first time ever. Here is a chart tracking the S&P500 and 12 months rolling earnings based on the monthly PE ratio reported by S&P. (The S&P500 closed in Dec at 903.25, for that month S&P then reported a monthly PE on 12M rolling earnings of 19.59 implying 12MrE of 46. Note however that earnings get revised after the monthly PE has been published and hence for recent data this earnings series differs from the bottom up estimates that S&P reports here)
12 months rolling earnings are now ca 46 down 46% from the peak of 85 reached in June 2007.
The current correction in earnings is already among the most severe as the following chart of log earnings illustrates and it does not yet consider the latest revisions. Using the last reported bottom up estimates of ca 30 the drop would be even larger.
An old post from Bespoke shows how drastic the cuts to earnings have been. At the end of Ocotober 2008 they wrote: "So where are earnings likely to come in next year? One of the more bearish forecasts making the rounds is that earnings for the S&P 500 will come in at $60 per share next year." This has now been reduced drastically, S&P sees 2009 reported earnings to be roughly 42. S&P also reported its bottom up earnings estimates for 2008. Here they are by sectors:
2008E
S&P 500 29.64
S&P 500 Consumer Discretionary (8.63)
S&P 500 Consumer Staples 15.37
S&P 500 Energy 38.62
S&P 500 Financials (25.39)
S&P 500 Health Care 19.72
S&P 500 Industrials 19.05
S&P 500 IT 13.43
S&P 500 Materials 1.92
S&P 500 Telecom 7.60
S&P 500 Utilities 12.55
12 months rolling earnings are now ca 46 down 46% from the peak of 85 reached in June 2007.
The current correction in earnings is already among the most severe as the following chart of log earnings illustrates and it does not yet consider the latest revisions. Using the last reported bottom up estimates of ca 30 the drop would be even larger.
An old post from Bespoke shows how drastic the cuts to earnings have been. At the end of Ocotober 2008 they wrote: "So where are earnings likely to come in next year? One of the more bearish forecasts making the rounds is that earnings for the S&P 500 will come in at $60 per share next year." This has now been reduced drastically, S&P sees 2009 reported earnings to be roughly 42. S&P also reported its bottom up earnings estimates for 2008. Here they are by sectors:
2008E
S&P 500 29.64
S&P 500 Consumer Discretionary (8.63)
S&P 500 Consumer Staples 15.37
S&P 500 Energy 38.62
S&P 500 Financials (25.39)
S&P 500 Health Care 19.72
S&P 500 Industrials 19.05
S&P 500 IT 13.43
S&P 500 Materials 1.92
S&P 500 Telecom 7.60
S&P 500 Utilities 12.55
"Understand Crude Oil Price"
I finally finished reading Prof Hamilton's paper on crude oil prices. A must read.
Key Take-aways:
(1) The real price of oil appears to follow a random walk with no drift.
(2) The current spot price is most likely the best forecast one can make. It is however unlikely to be a good one as the standard deviation of quarterly log price changes is high at 15%. Prof Hamiltion makes the following example: at the end of Q1'08 the price of oil was 115USD, four years from then one should not be surprised to see the oil price within a range of 34USD to 391USD.
(3) Speculation does not explain the oil price behaviour well. A point made by EDHEC in a recent position paper as well (see "The true role of speculation")
(4) Demand: Price elasticity are hard to estimate. Short run elasticities for gasoline demand are low and have been declining (from -0.25 -0.34 over 1975-80 to -0.034 -0.077 over 2001-2006). The author provides an intermediate-run price elasticity for crude of -0.26 based on 1980's data.
(5) Income elasticity: numerous studies at ca 1. But it has been declining as well over time and the poorer the country the higher the income elasticity.
(6) China: demand increased by 7.2% annually between 91 and 2006. Extrapolate the trend and China will consume as much oil as the US in 2020. In 2006 it consumed 2 barrels of oil per person vs. 6.6 for Mexico and 25 for the US. Ie China's oil consumption could triple and it would still be less per person than in Mexico today.
(7) Supply: the largest private producer Exxon has a 3.1% share of daily production and the five biggest private companies have a 12% share. This is close to Saudi Arabia's share of 12.1%. OPEC-10 had a 37% share of world liquid production in 2007. Overall global production has stagneted over the past three years.
(8) Effectiveness of cartel behaviour of OPEC is hard to prove empirically. Alternative hypothesis is of Saudi Arabia using its monopoly power to influence price while others operate on a more competitive basis.
(9) Very long lead time between discovery of a new oil reservoir and actual delivery of oil to a refinery imply very low short term price elasticity of supply.
(10) Ballpark estimates of the "average" or "typical" decline rate to apply to global production is ca 4% per year. Many large fields are now in decline (Texas, Prudhoe Bay, North Sea, Mexico’s Cantarell, and China’s Daqing) and Saudi Arabian production appears stable in spite of the large increase in rigs.
The author concludes: "...if demand growth resumes in China and other countries at its previous rate, the date at which the scarcity rent will start to make an important contribution to the price, if not here already, cannot be far away".
Key Take-aways:
(1) The real price of oil appears to follow a random walk with no drift.
(2) The current spot price is most likely the best forecast one can make. It is however unlikely to be a good one as the standard deviation of quarterly log price changes is high at 15%. Prof Hamiltion makes the following example: at the end of Q1'08 the price of oil was 115USD, four years from then one should not be surprised to see the oil price within a range of 34USD to 391USD.
(3) Speculation does not explain the oil price behaviour well. A point made by EDHEC in a recent position paper as well (see "The true role of speculation")
(4) Demand: Price elasticity are hard to estimate. Short run elasticities for gasoline demand are low and have been declining (from -0.25 -0.34 over 1975-80 to -0.034 -0.077 over 2001-2006). The author provides an intermediate-run price elasticity for crude of -0.26 based on 1980's data.
(5) Income elasticity: numerous studies at ca 1. But it has been declining as well over time and the poorer the country the higher the income elasticity.
(6) China: demand increased by 7.2% annually between 91 and 2006. Extrapolate the trend and China will consume as much oil as the US in 2020. In 2006 it consumed 2 barrels of oil per person vs. 6.6 for Mexico and 25 for the US. Ie China's oil consumption could triple and it would still be less per person than in Mexico today.
(7) Supply: the largest private producer Exxon has a 3.1% share of daily production and the five biggest private companies have a 12% share. This is close to Saudi Arabia's share of 12.1%. OPEC-10 had a 37% share of world liquid production in 2007. Overall global production has stagneted over the past three years.
(8) Effectiveness of cartel behaviour of OPEC is hard to prove empirically. Alternative hypothesis is of Saudi Arabia using its monopoly power to influence price while others operate on a more competitive basis.
(9) Very long lead time between discovery of a new oil reservoir and actual delivery of oil to a refinery imply very low short term price elasticity of supply.
(10) Ballpark estimates of the "average" or "typical" decline rate to apply to global production is ca 4% per year. Many large fields are now in decline (Texas, Prudhoe Bay, North Sea, Mexico’s Cantarell, and China’s Daqing) and Saudi Arabian production appears stable in spite of the large increase in rigs.
The author concludes: "...if demand growth resumes in China and other countries at its previous rate, the date at which the scarcity rent will start to make an important contribution to the price, if not here already, cannot be far away".
Wednesday, February 11, 2009
Solar Energy - Suntech Power
A short piece on Suntech Power in Fortune and some of the challenges faced by the solar panel manufacturers.
0vercapacity:
"The rapid success of Chinese solar companies such as Suntech has spawned lots of imitators. And that's why the market is now plagued by overcapacity. A new report from research company iSuppli says 11.1 gigawatts of panels will be produced in 2009, up 62% from 7.7 gigawatts in 2008. However, iSuppli says just 4.2 gigawatts are expected to be installed in 2009, up from 3.8 gigawatts in 2008. "
Reaching the wholy grail of grid parity:
"What is grid parity? It means getting the cost of producing solar energy down to the point where there is no difference between it and competing fossil fuels like natural gas or coal. For Suntech that means about 14 cents per kilowatt-hour. Currently, Suntech's cost is about 35 cents, yet Shi says that by 2012 his production line will reach his target.
0vercapacity:
"The rapid success of Chinese solar companies such as Suntech has spawned lots of imitators. And that's why the market is now plagued by overcapacity. A new report from research company iSuppli says 11.1 gigawatts of panels will be produced in 2009, up 62% from 7.7 gigawatts in 2008. However, iSuppli says just 4.2 gigawatts are expected to be installed in 2009, up from 3.8 gigawatts in 2008. "
Reaching the wholy grail of grid parity:
"What is grid parity? It means getting the cost of producing solar energy down to the point where there is no difference between it and competing fossil fuels like natural gas or coal. For Suntech that means about 14 cents per kilowatt-hour. Currently, Suntech's cost is about 35 cents, yet Shi says that by 2012 his production line will reach his target.
How, exactly? For one thing, the scale that the solar industry has reached gives it new pricing power over suppliers. Explains Shi: "We were a parasitic industry relative to the semiconductor industry, which was the main user of silicon." Now that's no longer true: The solar industry uses more silicon than the chipmakers. Also, the world economic slump has driven silicon prices down sharply.
But far more important, analysts say, is increasing conversion efficiency - the amount of electricity derived from the silicon used. The rule of thumb is that every 1% increase in efficiency results in a 6% cost reduction. And in the past year, Suntech has cut costs by about 20%. In time, he says confidently, "solar will be cheaper than coal or gas."
Not all industry analysts are as sanguine. "Obviously the efficiency gains get harder the more efficient you get," says Pavel Molchanov, an alternative-energy analyst at Raymond James & Co. "Shi has made impressive gains so far, but grid parity by 2012 is pretty ambitious - though plausible.""
Madoff - A Long List of Red Flags
Prof. Greg N. Gregoriou and François-Serge Lhabitant just published an interesting EDHEC position paper on the Madoff scam highlighting a long list of red flags worth noting:
Operational Red Flags:
Lack of segregation amongst service providers
Obscure auditors
Unusual fee structure
Heavy family influence
No Madoff mention
Lack of staff
SEC registration
Extreme secrecy
Paper tickets
Conflict of interest
Investment Red Flags:
A black-box strategy
Questionable style exposures
Incoherent 13F filings
Market size
They mention that early sceptics (see Mar/Hedge and Barrons' articles from 2001) were ignored and had no impact and conclude: "Let us hope that this will serve as a reminder that the reputation and track record of a manager, no matter how lengthy or impressive, cannot be the sole justification for investment."
Operational Red Flags:
Lack of segregation amongst service providers
Obscure auditors
Unusual fee structure
Heavy family influence
No Madoff mention
Lack of staff
SEC registration
Extreme secrecy
Paper tickets
Conflict of interest
Investment Red Flags:
A black-box strategy
Questionable style exposures
Incoherent 13F filings
Market size
They mention that early sceptics (see Mar/Hedge and Barrons' articles from 2001) were ignored and had no impact and conclude: "Let us hope that this will serve as a reminder that the reputation and track record of a manager, no matter how lengthy or impressive, cannot be the sole justification for investment."
Monday, February 9, 2009
A Tale of Two Charts
Barry Ritholz and CalculatedRisk trade charts:
(1) Job Losses in post WW2 recessions
(2) Slightly more reassuring, the same with job losses as a % of peak employment
Both note that it has taken longer and longer for jobs to recover with the last three recessions taking the longest to recover from.
(1) Job Losses in post WW2 recessions
(2) Slightly more reassuring, the same with job losses as a % of peak employment
Both note that it has taken longer and longer for jobs to recover with the last three recessions taking the longest to recover from.
Saturday, February 7, 2009
"Exxon: Juggernaut or Dinosaur?"
Good piece by Steve Levine on Exxon in Business Week. Exxon is the most profitable company in World's history, raking in 45bn USD in profits in 2008. It produced ca 1.5bn barrels in 2007 and slightly less in 2008.
Worst 10 year stretch ever for real S&P500 returns
Floyd Norris explains that the 10 years ending January 2009 have been the worst ever for annual real returns of the S&P500: "Over the 10 years through January, an investor holding the stocks in the S.& P.’s 500-stock index, and reinvesting the dividends, would have lost about 5.1 percent a year after adjusting for inflation, as is shown in the accompanying chart. 
Mr Norris adds "Many things influence stock prices, of course, and there is no guarantee that continued economic and financial woes will not drive the market down from here. But long-term investors may be able to take comfort from the fact that bad decades are often followed by 10-year periods that are better than the long-term average, which shows a gain of 6.2 percent a year." Looking at the chat above confirms this. In the past keeping stocks for 10 years after a negative 10 years streak usually provided positive real returns.
Until now, the worst 10-year period, by that measure, was the period that ended September 1974, with a compound annual decline of 4.3 percent.
That decline was strongly influenced by inflation. Ignoring inflation, stocks over that decade returned half a percent a year, not a very good showing but not a loss. But with inflation taking off, the real, inflation-adjusted return was negative.
For the current period, the total return was negative, at minus 2.6 percent a year, even before factoring in inflation."
Mr Norris adds "Many things influence stock prices, of course, and there is no guarantee that continued economic and financial woes will not drive the market down from here. But long-term investors may be able to take comfort from the fact that bad decades are often followed by 10-year periods that are better than the long-term average, which shows a gain of 6.2 percent a year." Looking at the chat above confirms this. In the past keeping stocks for 10 years after a negative 10 years streak usually provided positive real returns.
Friday, February 6, 2009
Thursday, February 5, 2009
"Buffett's metric says it's time to buy"
Mr Buffett has been buying stocks of late. According to Fortune here is one of his metrics:
They quote the Sage of Omaha as saying "If the percentage relationship falls to the 70% to 80% area, buying stocks is likely to work very well for you."
Wednesday, February 4, 2009
Historical sector weights in S&P500
Great long term chart on the sector allocation of the S&P 500 found at Zerohedge. The latest data is here. It seems that once a sector deflates it does so for a long time and does not come back for a while. See energy in the late 70's and tech in the 90's. Will the same apply to financials?
This white paper from GMO on "Our Financial House of Cards" explains why the recent heavy weight of financials was most likely unsustainable.
This white paper from GMO on "Our Financial House of Cards" explains why the recent heavy weight of financials was most likely unsustainable.
Banking Crises
Monday, February 2, 2009
Hedge Funds - Paulson & Company
Thanks to DealBook for providing its readers with Mr Paulson's year-end shareholder letter. Mr Paulson has had a fantastic run with his various funds capitalising very nicely on his bearish views on subprime, credit and financials. The letter is definitely worth a read. It illustrates first why some hedge funds will for sure stay in business as some of the opportunities they foresee need specialists' know-how: "Distressed mortgages, distressed debt, debt restructurings, bankruptcies, strategic mergers, etc...". Their 2009 outlook may be of interest as well. "We remain bearish on the outlook for the U.S. economy and believe the recession will extend into late 2009 and likely into 2010. The sharp contraction in the global economy, the instability of the global financial system and the ongoing credit contraction are unlikely to be resolved in the first half of 2009".
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