December 1, 2008
Wheat from Chaff
One of the features of market panics is that selling tends to be indiscriminate, with only modest regard to the particular features of individual companies or even industries. Over the next few months, investors will begin to pick the wheat from the chaff, and I am hopeful that this will be a particularly good environment for value-conscious investors in individual stocks, even if the general movement of the market is contained within a very wide trading range.
The reason that market panics are indiscriminate is that panic is rarely about long-term cash flows. Market panics are invariably driven by a spike in risk premiums and "index-level" selling of anything liquid. From the standpoint of individual stocks, investing is largely an inference problem where the object is to interpret what portion of a price movement is related to cash flows and what portion represents a change in valuation. This is not a simple problem, particularly because movements in one price are taken as a signal about the prospects for others. In a panic, the market develops a sort of "everything-will-affect-everything" contagion where imaginations run as wild with pessimism as they did with optimism at the top. Contagion allows good companies to become mispriced with the bad ones, and as a bear market proceeds, there is usually a great deal of wheat (consistent cash flows, well-accepted products, strong balance sheets, reasonable valuations, strong return on invested capital) to be picked from the chaff (volatile margins, rapid product obsolescence, weak balance sheets, speculative valuations, poor return on invested capital).
With regard to the market as a whole, if the long-term record is clear on one point, it is that most of the fluctuaton in the stock market is due to changes in risk-premiums, not major variations in the long-term stream of cash flows delivered by U.S. corporations over time. Just as driving down the price of a bond raises the long-term yield to maturity on that bond, stock market plunges also increase the long-term return that stocks are priced to deliver. This was true even in the Great Depression.
Despite this regularity, many investors believe that a decline in stock prices must reflect expectations for a similar decline in long-term earnings power. Worse they may believe that short-term declines in earnings will inevitably lead to a similar decline in stock prices. The fact is that stocks are not simply a claim on next quarter's earnings, and it is absurd to value them on that basis. Stocks are a claim on a very, very long-term stream of future cash flows. The main source of variation in the stock market is not variation in those long-term cash flows, but variation in the long-term rate of return used to discount them. Even several years of bad earnings does very little to the fundamental value of stocks that have sustainable business models and reasonable balance sheets.
Take S&P 500 earnings back even to the Great Depression and you'll find that despite enormous volatility in year-to-year earnings, the growth rate from peak-to-peak across market cycles has been remarkably steady at about 6% annualized. Cyclical variations in the rate of inflation have had very little effect on this long-term growth rate. Alternatively, you can approach the S&P 500 as the discounted value of a very long-term stream of future dividends (blue), and you'll find that the actual index (red) has reliably traded around that value for over a century. The chart below is based on real dividends and real returns (see Don't Discount Discounted Dividends for details)
The chart above is based on the actual dividends at each point in time, including during the Great Depression. The blue valuation line declines on the basis of this methodology because actual dividends were cut during the Depression, and the model gives full weight to that cut.
As with earnings, however, the stream of income that is realized over time tends to be far better behaved than year-to-year fluctuations might suggest. The value of that stream is particularly well behaved. The chart below shows the price that an investor would have paid for the S&P 500 in order for the actual, realized, subsequent dividends paid on the index to deliver a long-term total return of 10% annually (the current valuation assumes a growth rate of about 6% on normalized dividends from here).
The main lesson of the above charts is that the long-term fundamental value of stocks is far smoother than either prices, earnings or even dividends. The other lesson is that stock prices fell in the late 1920's and over the past year – as well as the past decade – because they deserved to fall.
After over a decade of strenuous overvaluation, stocks are now undervalued. Not ridiculously cheap, but undervalued and likely to deliver satisfactory long-term returns to even passive investors. It's certainly possible that stock prices could fall further by the time that the current market downturn is over, but to some extent, the profound depth of the recent selloff has given value investors something of a “freebie.” Investors have already priced in a worst-case scenario – treating a near-Depression with unemployment north of 10% as a certainty. Yet even in the Great Depression, the market didn't reach the current price/peak-earnings multiple until late 1931, when unemployment was already pushing past 15%. In 1974 and 1982, valuations were lower, but largely because interest rates (commercial paper in 1974 and long-term Treasury yields in 1982) surged to 12-15%. Yes, the economy and earnings will probably continue to weaken, but value investors can observe the evolution of the economy here with reasonable comfort that the market has already discounted a good amount of bad news already.
An interesting aspect of the current environment is that the low levels of interest rates here, particularly on Treasury securities, have prompted concern that the U.S. might be the “next” Japan. Over the past 20 years, the total return on Japanese stocks has been dismal, at -2.75% annually even including dividends. The concern is that somehow these poor long-term returns are attributable to the near-zero interest rate policies of the Bank of Japan, and that the U.S. appears to have embarked upon the same course.
Beyond clear structural differences between the Japanese and U.S. economy, differences in the extent of central planning, savings rates, consumption patterns, dependence on export-driven growth, and other factors, the simple response is that the U.S. market has already experienced in 10 years what the Japanese market has experienced in 20: a massive retreat from hypervaluation to what is now fair and even attractive valuation. The U.S. is not the next Japan. From a stock market perspective, it has already been Japan for the past decade, as the price/peak-earnings multiple of the S&P 500 has plunged from a high of 34 to a recent trough of about 9.
As a refresher on what caused 20 years of -2.75% annualized total returns for investors in Japanese stocks, the chart below shows the price/peak-earnings multiple of the Japanese market, which reached the mid-50's two decades ago and now stands at less than 10. One might think that at the peak, those high valuations must have been justified by observed earnings growth, but one would be incorrect. From 1970 to the highs of the Japanese market in the late 1980's, earnings growth in Japan averaged only 6% annually measured from peak-to-peak across market cycles.
As for low Japanese interest rates, investors constantly make the mistake of believing that low interest rates “justify” high stock market multiples, without recognizing that those high multiples in turn ensure that stocks will achieve comparably low subsequent returns. Paying high multiples of peak earnings, regardless of the level of interest rates, is rarely rewarded by anything but sorrow.
The bottom line is simple. Stocks are a claim on a long-term stream of future cash flows. Even if one allows for a terrible and surprisingly deep continuation of the current recession, stocks appear reasonably priced or undervalued based on a careful analysis of long-term cash flow prospects.
There will of course be failures, largely among recidivists with poor balance sheets (which is why Circuit City went under, and a few of the weaker department stores will follow). I do think there is reasonable potential for the market to reach further new lows after an advance or consolidation. Be aware - a dividend yield in excess of 4% on the S&P 500 was generally the rule, not the exception, for bear market lows prior to the past decade. The low we saw just over a week ago was slightly short of that, and we shouldn't rule out an even higher (if short-lived) yield spike at the very low. If we do observe new lows, I would consider them to be more likely in early 2009 rather than as an extension of the recent selloff. In any event, after more than a decade of careless overvaluation, diversified investors – even passive ones – have the prospect of achieving reasonable long-term returns.
As of last week, the Market Climate for stocks was characterized by favorable valuations and tentative market action – still unfavorable on measures that develop slowly, but with a fresh improvement in “early” measures of market internals. A variety of measures of risk aversion are retreating fairly quickly here (the most obvious being implied volatility). With that stabilization, I expect that pressure is growing on short-sellers to cover their positions and for investors who abandoned stocks near the lows to re-evaluate their exit. On the other side, however, the market has not recovered enough for value-driven investors to have much eagerness to abandon their positions. All of that is why a combination of retreating risk aversion coupled with favorable valuations tends to produce quite strong risk-adjusted returns, on average. I wouldn't want to be net short here because there are few natural suppliers of stock in the event the shorts are forced to cover. The doomsday club is already out, value investors are in no hurry to sell, and the trend-followers aren't even in yet.
That said, we observed some amount of early improvement in market internals a few weeks ago, followed by a market decline back below our strike prices, so we can't rely on such improvement enough to warrant removing our hedges. We do have enough evidence to warrant a more constructive “local” exposure, but we've already achieved that somewhat passively - we bought a cheap but now increasingly valuable “contingent” position in far-out-of-the-money index call options when the S&P 500 was plunging into the 700's.
Though I believe that another reversal to new lows is unlikely, the Strategic Growth Fund continues to carry index put option protection against about 70% of its holdings. These represent primarily out-of-the-money put options – not full long put / short call hedges – so they will not hedge much in the way of local movements of several percent, where the Fund should participate to a significant extent in both market advances and declines. Rather, our index puts can be expected to act as a “brake” on large and extended market declines. Overall, our investment position is intentionally constructive here, but we continue to be hedged against any major unexpected market decline toward fresh lows.
In bonds, the Market Climate last week was characterized by unfavorable yield levels and generally positive yield pressures. Credit spreads remain generally wide and economic risks remain, so there is no particular pressure for investors to abandon the safety from default risk that Treasury securities provide. Inflation pressures have also turned down, with much of the apparent “deflationary” pressure tied to oil prices. I continue to view the real yields near 4-5% available on TIPS as very favorable even in the event that oil, apparel and other price declines produce negative near-term inflation readings on the CPI. Precious metals shares have strengthened significantly from their lows, despite strength in the U.S. dollar on expectations of an ECB rate cut. Even with that cut, however, the U.S. dollar is overextended here, and a pullback is likely to benefit both precious metals and, at least temporarily, oil prices. For now, the Strategic Total Return Fund continues to have the majority of its assets invested in TIPS, with about 30% of assets invested in precious metals shares, foreign currencies, and utility shares.
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