INVESTMENT INTELLIGENCER

Jason Trennert Responds: High Profit Margins ARE Sustainable

2007-05-30T09:49:51-04:00

A few weeks ago, I took issue with Jason Trennert's argument in Barron's that today's P/Es were "low." I felt that, like many other analysts, Jason had not taken into account the likelihood that today's record-high profit margins would eventually revert to the mean. Here, Jason responds directly to that criticism:

I very much enjoy this website but I hope you don't mind, as one of its subjects, my posting a comment or two on your critique. Your point on margins is well-taken, but your readers should understand that that there is limited time and space to discuss all the nuances of one's views in such interviews, especially when speaking about something as broad as the stock market. I was unfortunately not asked about profit margins in my interview with Barron's but, as any one of our clients knows, we have written extensively about the subject.

There are many astute market observers that have rightfully pointed out that profit margins have been mean-reverting in the past. Although it's always dangerous to say it's different this time, it seems clear to us, after nearly three years of profit bears claiming that the end was nigh, that something has changed.

In our view the the double-barrelled secular changes of technology and globalization have made margins stickier, longer than the consensus would have ever thought possible. This is simply because companies have a better chance of arbitraging unit labor costs today than they have ever had in history. Labor costs comprise about two-thirds of total costs for the average company. With a seemingly limitless supply of labor in India and China, there has never been a better time to be an owner of a business or for companies to maintain margins. This has also been true, to a remarkable extent, in the service sector. Goldman Sachs' third largest branch office, as an example, is now in Bangalore. The greatest risk to profit margins, therefore, is not labor unrest, as it might have been in years past when labor markets were less fluid, but political efforts aimed at slowing the forces of globalization.

In the hope of prompting an additional thoughtful response from Jason (or another reader), my concern with the argument above is that it doesn't explain why companies won't begin to pass through these labor savings to customers, in the form of lower prices. For a temporary period, the companies that are the first to exploit lower labor costs will benefit from higher margins and lower prices than their competitors, but over time, the competitors should follow suit--until outsourcing labor to Asia and India becomes not a competitive advantage but a competitive necessity. Also, companies should begin to take market share by reducing prices, which will also put pressure on margins.

So, bottom line, I agree that the massive reduction in labor costs from globalization should drive temporary margin gains (which I think we're seeing), but I don't understand why this should be expected to continue indefinitely.

Siegel Rebuttal, Part 1:

2007-05-07T14:36:56-04:00

As described in the prior post, Jeremy Siegel made several arguments intended to refute the theory that U.S. corporate profit margins will soon regress to the mean, taking stocks down with them. One of these arguments was that the percentage of overall U.S. profits captured by corporations vs. private entities is very high, so overall U.S. profitability is not, in fact, extreme. The following email (from an independent analyst) suggests that this argument, at least, is a hallucination:

It’s hard to know where to begin with Siegel, but I have to start someplace, so I’ll pick his point that looking at corporate profits alone gives an inflated picture of overall profit growth, since capital has shifted to corporate ownership. Here’s a useful chart from the Federal Reserve Bank of St. Louis (click here and see the second row down: Selected Component Shares of National Income. Also note the third row, which contains the data everyone else is focused on Corporate Profits as a percent of GDP):

Yes, proprietor’s income has grown more slowly than corporate profits. But looking at the two together, it’s clear that overall profit (as Siegel defines it) is at or close to a high, at least since 1981.

Siegel Fires Back: Bullish And Proud Of It

2007-05-07T08:33:39-04:00

Jeremy Siegel's latest column in Yahoo Finance responds to John Hussman and others, who argue that Siegel's irrational bullishness is setting him up to be come a modern-day Irving Fisher. Siegel's response: The critics are wrong, profit margins are fine, valuations should be higher, and stocks are going up.

Siegel's main arguments are these:

The hand-wringing about "record-high profit margins soon reverting to means" is misplaced because 1) a greater percentage of U.S. corporate profits are coming from international operations, which aren't affected by U.S. GDP, and 2) a greater percentage of overall U.S. profits are now captured by public U.S. companies instead of private ones.

Innovations in the financial system, namely lower trading costs and smarter central banks, have reduced the equity risk premium. Thus, stocks should now trade at an average P/E of about 20-times, instead of the long-term average of about 14-times.

Siegel, in other words, believes that "it's different this time." And that's reasonable--because sometimes it is different this time (the most salient example being a permanent change in the relationship between bond yields and dividend yields after the U.S. went off the gold standard--a change that cost many "prudent" investors to miss decades of gains). Of course, more often than not, it's NOT different this time, and those who argue that it is end up with egg on their faces (believe me--I know).

I'll wait for Hussman, Grantham, Smithers, DeLong and others to respond to Siegel's arguments before taking a strong stand here. I will simply suggest that the big lesson from most major bull markets is this: anytime someone argues that "it's different this time," the burden of proof ought to be on them (as opposed to on bears who appear to be "wrong" because the market keeps going up). With this in mind, I'd like to see more data from Siegal backing up his profits argument--a chart showing the percentage of U.S. profits generated from international operations over time, for example, as well as a chart of global profits relative to global GDP (are profit margins at record highs globally, as well?).

The "risk premium" argument obviously won't be settled until after the fact, but in my mind there's an easy counter to that one: Today's risk premium is low because stocks haven't been that risky recently--even with the crash of 2001-2002, global equities are sharply higher than they were 10 years ago. Go through a couple of decades of stagnation, meanwhile, like the periods that followed market highs in 1929 and 1966, and investors won't give a damn about low transaction costs or more enlightened central banks. Instead, because stocks will seem like the worst investment idea anyone ever thought of, investors will once again demand a huge equity risk premium.

Warren Buffett: Buy Low-Cost Index Funds

2007-05-06T21:54:35-04:00

The Oracle delivered some secrets of intelligent investing in a press conference following the Berkshire Hathaway annual investor meeting:

Buy low-cost index funds, which will outperform the majority of other investors (the vast majority).
Avoid hedge funds.

Buffett also said he hoped that Berkshire would outperform the S&P by a couple of percentage points (which wouldn't be surprising, given the value effect). He added that he would be "amazed" if Berkshire did any better than that.

Jeremy Siegel: The "Irving Fisher of the 21st Century?"

2007-05-01T21:36:05-04:00

In his latest weekly letter, fund-manager John Hussman posits that Jeremy Siegel, the famous finance professor known as the "wizard of Wharton," is well on his way to becoming the Irving Fisher of this era. Fisher, you may remember, was the well-regarded economist who opined in early September 1929 that stocks had "reached what looks like a permanently high plateau." As Siegel himself noted in his excellent Stocks for the Long Run, Fisher made this remark two weeks before the start of The Great Crash. Soon thereafter, his reputation was forever destroyed.

Siegel hasn't said that stocks will never again fall, but in Hussman's opinion, he's now stretching his bullish interpretations so far that he's making methodological errors. Hussman cites a Financial Times piece in which Siegel argues that "Real returns can be estimated from the earnings yield, the reciprocal of the more popular price-earnings ratio. Since stock earnings are based on real assets, the earnings yield provides a good estimate of the real return on the stock market.” Siegel then uses this logic to suggest that stocks may produce even higher returns in the future than they have in the past.

Hussman, also a finance PhD, has a number of problems with this logic, starting with the fact that Siegel is equating earnings with dividends. He also ignores that 1% of stock performance over the past 80 years has come from multiple expansion, compares apples with oranges by conflating trailing and forward P/Es, and ignores that profit margins are at currently at record highs (thus producing artificially low P/Es).

This latter omission is the part of Siegel's bullish argument that I find inexplicable. As Jeremy Grantham has observed, earnings are "one of the most dependably mean-reverting series in finance." It would be one thing if Siegel were to acknowledge today's record profit margins and then argue that this time they won't revert to historical means. But he doesn't even acknowledge them! Instead, he just takes a simple current P/E and compares it to a century average based on average profit margins.

If Siegel weren't so smart and well-informed, this omission might be understandable. In fact, he is one of the world's foremost market experts and a good friend of Yale professor Robert Shiller who popularized the "cyclically adjusted P/E". So the only conclusions that one can draw are either that 1) Siegel doesn't think profit margins will drop (an argument radical enough that it deserves to be made explicitly), or 2) he is now so wed to his bullishness that can't let it go (wouldn't be the first time this has happened to a market guru...). A third, more negative interpretation is that now that Siegel is an advisor to ETF vendor WisdomTree, he can't afford to be publicly bearish because it would be bad for business. I'll give him the benefit of the doubt on that one.

DeLong: Hedge Fund Comp Fine for Top 20, Silly For Everyone Else

2007-04-27T15:54:21-04:00

Brad DeLong concludes that the top hedge-fund managers--Simons, Soros, Lampert, Cohen, etc.--who took home an average of $240 million apiece last year (per the New York Times) may have earned their money, but that the average hedge-fund Joe who banked, say, $500,000 to $50 million, almost certainly did not. No argument here.

The average hedge-fund Joe is a brilliant 25-40 year old with great breadth of knowledge, great information, great speed, and a proven ability to out-trade his or her competition more than, say, two-thirds of the time. Unfortunately, beating the competition two thirds of the time doesn't come close to offsetting the costs of this trading and the gigantic sum (two and twenty) that said hedge-fund Joe will take home at the end of the year. Although the hedge-fund Joe's clients, therefore, will likely be impressed with his/her insights, they are also likely to be made poorer by the deal.

DeLong:

Not at the top, further down the food chain, however... it is a mystery how the hedge funds staffed by very smart and hard-working people who nevertheless do not seem to have much of a risk-adjusted edge over the market indices nevertheless collect fees of 2% of assets and 20% of returns each year:

One theory is that is is a disequilibrium phenomenon, and that market entry by those who promise to produce whatever alpha the typical hedge funds achieves and to produce it with lower fees will drive down the compensation structure:

A second theory is that the 2-and-20 fee structure is a sociological fact embedded in the social network of midtown Manhattan and the City of London, and will stick--a modern-day equivalent of Fidelity Investor Services. For a generation, investors in Fidelity funds received net annual returns of S&P - 2.5% + noise, as high fees plus the price pressure that Fidelity generated against itself by herding with the Wall Street crowd took their toll. By contrast, investors in Vanguard received net annual returns of S&P - 0.6%. The gap compounds: Over 35 years Vanguard investors double their relative wealth. This gap drove John Bogle insane. But it did persist.

A third theory, related to No. 2, is that most hedge-fund investors just don't know how to evaluate the services they are receiving and/or are so focused on near-term performance that they are willing to trade away pots of long-term money for a chance to outperform during the next downturn. My money's on No. 2 and No. 3.

Sky-High Prices, Overrated Japan

2007-04-25T14:44:18-04:00

An advisor submits: Regarding Jeremy Grantham's apocalytic view, here's how I explain the current environment to clients. Back in 2000, the investment landscape looked like the Alps, with stunning peaks (technology and some other large-cap growth) and deep valleys (REITs, small-cap value, energy, emerging markets). Today, the investment landscape looks like the Tibetan Plateau, with high valuations in every direction, as far as the eye can see.

I had an interesting meeting recently with a portfolio manager for international equities. When I asked him to describe a couple of recent portfolio additions, he said that he has been struggling to find anything new to buy at acceptable valuations. He pointed to the run-up in value, the run-up in small caps, the run-up in emerging markets. He noted that international markets were up 30% in the last 18 months in dollar terms, up 20% in local currency, and that "obviously" stocks aren't worth that much more now than they were then.

I then asked him how he justified his substantial overweight in energy stocks. He has something like 22% of his portfolios in energy, vs. 7% for EAFE, and he acknowledged he would overweight even more except that the funds have a policy limiting sector overweights. Hasn't energy had the same kind of run-up, I asked, as small-caps and emerging markets?

"Can you think of any other industry," he replied, "where prices have tripled?" He said he assumes $50 oil, which he thinks is conservative, and even with that many energy stocks still appear to be much better values than anything else around.

I also asked him about his substantial underweight in Japan. The explanation: He looks for high return on capital combined with low valuation -- shades of Joel Greenblatt -- and return on capital is pathetically low in Japan.

Personally, I continue to have a hard time making sense of Japan as an investment opportunity. Bulls emphasize that Japan is much cheaper than other developed markets on price/book and price/sales; bears emphasize that Japan is more expensive in P/E terms and that return on capital is awful. In effect, bulls say, "You can buy assets cheap," while bears ask, "Why throw good capital after bad?"

Grantham: Short the World

2007-04-25T08:09:42-04:00

Jeremy Grantham's Q1 letter (www.gmo.com) paints a startlingly gloomy picture, even for him: For the first time in history, every major asset class is experiencing a bubble at the same time. Globally, economic conditions have gotten so good, credit has gotten so accessible, profit margins have gotten so high, and investors have gotten so diversified, that risky assets no longer provide any expected premium over safer ones and there is nowhere to hide. Even forestry, Grantham laments, has become a mainstream asset class. The resulting race to scarf up the world's trees has reduced expected timber returns to a paltry 5%-6%.

As before the 2000 crash, Grantham is convinced that it's NOT different this time--and, therefore, will end badly. He dismisses the idea that, in order for the markets to correct, we will need a catalyst (and, because we don't know exactly what it will be, we're safe). He ridicules the theory that "private equity" will drive up stock prices indefinitely (and suggests that, in hindsight, this latest bubble will be called "The Private-Equity Bubble"). He acknowledges that predicting the timing of such a correction is impossible and, therefore, that all asset classes might get even more expensive for years (this was what happened in the late 1990s: Grantham and other value-driven forecasters called the top too early and suffered years of predictable ridicule and scorn. Then the market crashed, and they were heroes.).

Grantham's less-gloomy colleagues point out that bubbles usually peak in a final orgy of excitement, in which markets rocket to levels that previously seemed unimaginable (e.g., 1999 and 2000 for tech, 2005 for housing) and that, globally, we haven't seen such a blow-off yet. So perhaps, Grantham admits, the party will go on for a while longer. But, he adds, "bubbles always burst."

Hedge Funds: Are They For Everyone?

2007-04-24T06:51:31-04:00

I'm speaking on a panel today at Lipper HedgeWorld with Ed Easterling of Crestmont Research and Ron Geffner of Sadis & Goldberg LLC. "Are Hedge Funds For Everyone?" My answer is "no."

I should say upfront that I am viewing this question from the perpective of those who invest in hedge funds. From the perspective of those who own or work for hedge funds, they are probably the best business in the history of the world (and I would have said this even before today's New York Times reported how much the top 25 managers took home in 2006).

On the investor side, if one could consistently identify the top hedge funds in advance and be confident that performance that looked fine in one market environment (up) would persist in another (down), the answer would be "Yes--hedge funds are for everyone." The trouble is that the top funds are hard to identify in advance, even for those with the necessary time, money, and expertise, and many of the best ones are closed to new investors (especially small investors). This means that most hedge-fund investors will likely be choosing from funds that are merely above-average, average, or below average. And, there, the picture isn't so pretty.

Recent academic research suggests that, on average, hedge funds generally produce lower returns and have higher risk than most people think. Gross performance is blunted by high fees and increasing competition: So much brainpower competes in the hedge-fund industry these days that even brilliant managers often can't overcome the drag of 2-and-20 fees (2% of assets and 20% of gains). Average hedge-fund risk, meanwhile, is harder to measure than, say, average mutual fund risk, and research suggests that, on average, the likelihood of "extreme negative events" is higher than a standard mean-variance analysis would suggest. The same research suggests that hedge funds' diversification benefit is often overstated.

The primary drawback of hedge funds, in my opinion, is that the compensation structure often rewards managers who produce results that are no better than one would receive in a low-cost passive strategy: many investors pay 2-and-20 for gross performance they could have bought for 20 basis points. Currently, some hedge funds do offer investors the ability to invest in risks and opportunities that aren't accessible with passive products. Within a few years, however, I think it's likely that Wall Street will develop passive products that can replicate (or track) the returns of all but the best hedge funds at far lower cost. At that point, hedge funds might be "for everyone."

Until then, however, Jack Bogle's logic holds: the net return to investors equals the gross return minus costs. And, historically anyway, most hedge funds managers have not produced performance strong enough to overcome their fees.

I discussed these points in some detail in the Wall Street Self-Defense Manual and this recent Slate piece. Below are links to some of the recent research on the topic:

Hedge Funds: An Industry in its Adolescence, by William Fung and David Hsieh, 2006. Excellent overview. Fung and Hsieh have written numerous papers about the performance and risk-characteristics of hedge funds, many of which can be found here.

Hedge Funds: Risk and Return, by Burton Malkiel and Atanu Saha. Argues that hedge funds have lower performance and higher risk than is commonly thought. This article was immediately attacked by the hedge-fund industry, but, in my opinion, most of the counter-points were not persuasive.

10 Things Investors Should Know About Hedge Funds, by Harry M. Kat. Explodes some of the myths about hedge funds (great diversification!) and discusses the challenges of correctly assessing risk, portfolio impact, etc.

Hedge Fund Benchmarks: A Risk-Based Approach, by William Fung and David Hsieh, 2004. An examination of hedge-fund returns using "style-based factors". Shows that most hedge fund returns can be explained by the performance of the particular strategy, rather than the manager's unique skill.

Hussman Bangs The Bearish Drum. No One Listens.

2007-04-16T22:45:31-04:00

John Hussman of the Hussman Funds keeps banging away on the impending-market-crash drum, this time in a long interview with Kathryn Welling of welling@weeden. Hussman's points won't come as any surprise to Investment Intelligencer readers, but they are so rare in the larger world of market commentary today that I'll keep repeating them. (And when the market doubles from here and stays there for a generation, you can throw both of us to the dogs):

The market is trading at 19-times "peak earnings" (Hussman's equivalent of the cyclically adjusted P/E). The common bullish arguments that the market's P/E is 15-times (or less) have no basis in theory or historical fact. Today's valuation is similar to that of many historical peaks, such as 1929.

Profit margins have always been mean-reverting, and none of the theories floated to suggest that they will forever remain at today's nosebleed level (50% above their historical average) make sense. These theories, moreover, are only floated by a handful of thoughtful bulls--the rest don't even bother to try to account for today's high profit margins.

The long-term profit growth trend line in the U.S. is 6% a year. The reason everyone thinks (and says) profits will grow at least 10% a year forever is because profits have grown that fast for five years (a.k.a., eternity).

"Fair value" on the S&P is at least 40% below current levels, even if one makes allowances for the (unlikely) possibility that cheap labor in China and India have permanently improved the profitability of U.S. corporations.

The market might go up another 10% before it has a typical 10% correction. From now until after this 10% correction, however, the market will have been outperformed by T-bills.

Hussman does not go so far as to make a forecast, but, for him, he comes awfully close. And given these data points, who can blame him? He also notes that rising interest rates usually suggest that mean-reversion will come sooner rather than later (which it certainly did in 2000).

After having lived through the 1990s, and been on the opposite side of this argument, I can confirm that long-term valuation metrics are worthless at predicting near-term market movements: In the late 1990s, bears like Hussman were not "cautious," they were "wrong," and year-after-year they were carried out on stretchers. This said, after the market finally collapsed, they looked pretty good.

Flawed Logic: Jason Trennert Barron's Interview

2007-04-16T08:08:06-04:00

This week's Barron's interview featured Jason Trennert of Strategas Partners. Jason is bullish about the U.S. market and bearish about emerging markets. Much of his logic is sound, and his conclusion is fine--the U.S. market goes up about two-thirds of the time, so predicting it will go up this year is rarely a dumb bet. One of Jason's points is flawed, however:

We expect $93 for S&P 500 operating earnings in '07, and that puts the market at roughly 15 times earnings...The downside risk is low because P/Es are so low.

P/Es are not "so low." In fact, they're not even "low." To get to "15-times earnings", Jason is looking at "forward operating earnings" (an estimate). He's then comparing it to last-twelve-months earnings. Cliff Asness has written in detail about the folly of this apples-to-oranges comparison. According to Cliff, the average "forward operating earnings" P/E is about 11-times, not the 15-times that Jason and other contemporary bulls throw around. This 11-times, moreover, is an average--so half the time the market's P/E has been below this level.

And then there's the profit-margin problem. As discussed often in this forum, profit margins are 50% above their long-term average and at 50-year highs. To compare today's P/E multiples to historical average multiples, you have to believe that today's profit margins will stay where they are. Anything's possible, but this seems extremely unlikely. At the very least, the profit-margin question is deserving of 1) acknowledgement, and 2) an explanation. In Barron's, anyway, Jason didn't have either.

The market may go up, but, if so, it won't be because P/Es are low.

Easterling: Earnings Do Not Grow 6% Every Year In Perpetuity

2007-04-13T17:50:52-04:00

The seemingly prudent consensus these days is that corporate earnings growth will slow from the torrid double-digit pace of the last few years and settle in at a more normal rate of, say, 6% per annum (the long-term average). Alas, this consensus is anything but prudent.

As fund-of-funds' manager, analyst, and SMU adjunct professor Ed Easterling writes, earnings just don't behave that way. Yes, they average about 6% a year (6.6% in Ed's 80-year model). But they achieve this average by shooting up for 3-5 years, collapsing for 1-2 years, shooting up for another 3-5 years, and so on. In other words, for all of recorded history, earnings have followed a 3-steps-forward, 2-steps-back pattern, not safe, smooth trend-line growth.

So, what's the problem? Well, as previously discussed, profit margins--"one of the most mean-reverting series in finance" (Jeremy Grantham)--just hit a 50-year high of 14% of GDP, as compared to the 9% average. As Ed Easterling points out, profits have also now grown strongly for 5 years in a row. According to Ed's data, there has been only one business cycle since 1950 in which profits grew for more than 5 years in a row (in the late 70s). In the sixth year of that expansion, moreover, growth was miniscule, and in the following two years, it collapsed--taking the stock market to a 16 year low.

As of this writing, meanwhile, "prudent" forecasters are expecting profits to continue to grow for not only 2007 but 2008--what would be the 7th year in a row. Is this possible? Anything's possible. Is it likely? A review of the business cycles of the past half-century suggests the answer is an emphatic "no."

If, instead of setting a record for consecutive years of impressive growth, earnings behave the way they normally do--collapse for a year or two--what is the stock market likely to do? Happily deliver another two years of low-volatility, near-double digit growth? We could do that math, but then we might be accused of always being the bearer of bad news.

Mauboussin: Why the Market is Smarter Than You Are

2007-04-13T08:34:48-04:00

Most people who write about the wisdom of crowds offer colorful anecdotes about crowd intelligence but don't explain why groups are smarter than individuals. In a recent piece, Explaining the Wisdom of Crowds, Legg Mason strategist Michael Mauboussin solves this mystery.

Drawing on a book by Scott Page (The Difference) and some of his own experiments at Columbia Business School, Mauboussin first observes that, in order for crowd wisdom to prevail, several conditions must be met:

The group must be cognitively diverse (the individuals in the group must have different approaches to analyzing and solving problems).
There must be a way to aggregate each individual's opinion into a collective view (such as a stock market).
There must be incentives: rewards for being right, punishment for being wrong.

In most cases, the stock market easily satisfies all three conditions. (Mauboussin has argued in the past that part of what happens during bubbles is that there is reduced cognitive diversity, as most investors begin to think and invest alike).

Mauboussin then describes three distinct types of situations in which groups are wiser than individuals. In the first, the "needle-in-the-haystack," a subset of the group knows the correct answer, but the majority does not (Mauboussin uses the example of the audience on Who Wants to Be a Millionaire). Here, the crowd's "best guess" is superior because the subset of people who know the answer ensure that the correct answer is the most popular choice (everyone else's guess is random).

In the second and third cases, which are closer to the situation in the stock market, no one in the crowd knows the correct answer, so it must be estimated. (In the stock market, no one knows what stocks are worth because the valuation process is subjective and because the key variable--future cash flows--is unknown). In these cases, Mauboussin attributes the crowd's wisdom to Page's "diversity prediction theorem," which states the following:

Collective error (the difference between the correct answer and the group's average estimate) = average individual error minus prediction diversity (the dispersion of the individual estimates).

Mauboussin invokes his Columbia experiments--"guess the number of jelly beans in the jar" and "predict the Oscar winners"--to show how this theorem works. He also summarizes the theory's implications, all of which apply to investing:

A diverse crowd will always predict better than the average individual. Not sometimes. Always.
Collective predictive ability is driven by average individual accuracy and diversity. In other words, a crowd composed of simpletons who think the same way will be less intelligent than one composed of independent-minded geniuses or experts.
The group is often smarter than not only the average individual, but the smartest individual.

The last point is critical for investors. Because of our innate overconfidence, we quickly dismiss the fact that a diverse crowd is always smarter than the average individual. (Most of us think we're above average). What is far harder to dismiss is the fact that the crowd is often smarter than all individuals.

In instances in which the crowd is not smarter than all individuals, moreover, the individuals who beat the crowd usually change with each successive prediction (which gives the investment media a parade of new gurus and "fallen stars" to write about). Just because you are occasionally right when the market is wrong, in other words, doesn't mean you usually will be.

Kasriel Blasts Rose-Goggled Economist, Defends LEI

2007-04-10T21:43:43-04:00

Nothern Trust's Paul Kasriel, whose recession-warning indicator is flashing yellow, devotes an entire eContrarian to poking fun at another economist, Michael Lewis, who scoffed at Kasriel's advocacy of the LEI as a decent recession-predictor.

Lewis appears to have taken the same position as most economists: The LEI isn't a perfect recession predictor, so even though it is suggesting that there will be a recession, there probably won't be one. Kasriel argues that this interpretation is bass-ackwards: The LEI is a pretty darn good predictor of recessions, so there probably will be one. (For good measure, Kasriel throws in his personal Kasriel Recession-Warning Indicator, which, when combined with the LEI, has never given a false signal.)

Who's right? Time will tell. But of the two economists, Kasriel appears to be deriving his thesis from the data, while Lewis appears to be doing it the other way around.

Costs Matter: Vanguard Wins Again

2007-04-06T18:34:20-04:00

Low-cost fund leader Vanguard had another strong year in 2006, with 78% of its funds beating their peer-group averages. Over longer periods--three, five, and ten years--the percentage is even higher: more than 80%.

This performance, of course, has nothing to do with superior stock-picking and market timing--and everything to do with costs. The industry-wide average mutual fund expense ratio was 1.27% of assets in 2006. The average Vanguard fund expense ratio was 0.21%. Since 1975, moreover, Vanguard's average expense ratio has dropped to one-quarter of its original level--while the industry-wide average has risen.

Given Vanguard's consistently strong performance, it is no wonder that it now manages more than $1 trillion of assets and is the second largest fund firm in the world. What is a wonder is why more fund companies haven't copied Vanguard's "secret formula."

Actually, it's not a wonder. Most other fund companies are for-profit corporations, many of them publicly held. For-profit corporations, especially publicly-owned ones, have impatient shareholders to please. And for impatient shareholders, even a three-to-five year time horizon is eternity.

Hussman: "Fair Value" on S&P 40% Below Today's Level

2007-04-04T22:06:26-04:00

Not to keep beating the same drum, but John Hussman seconds Andrew Smithers's points about the U.S. stock market's overvaluation. Hussman's bete-noire is the common use of "forward operating earnings" as a means of concluding that the market is cheap--a practice whose many flaws merely start with the fact that the historical average P/E multiple on "forward operating earnings" is about 11-times, not the 15-times that many investors use (Hussman cites Cliff Asness here). Hussman is quick (and wise) to say that this condition doesn't mean that stocks will tank--just that future returns for the S&P 500 won't look anything like 10% a year.

After triangulating with a variety of valuation methods, including the dividend discount model, Hussman puts the fair value of the S&P 500 at 850, 40% below today's level. So anyone counting on U.S. stocks to appreciate at 10% a year for the next decade had better 1) scale back expectations, and/or 2) pray that it's different this time.

Smithers: P/Es and Fed Model Are "Nonsense"

2007-04-04T21:34:25-04:00

Andrew Smithers, of London-based Smithers & Co., has published another free lecture, this one entitled "Behavioural Thoughts on Equity Valuation." In it, Smithers takes aim at two of his betes-noire: the use of standard P/Es and bond-yield ratios to determine whether the market is cheap or expensive. Such metrics are "nonsense," Smithers says, and have no predictive value. He then produces the charts to prove it.

As previously discussed, the trouble with standard P/Es (based on Price/Current Earnings or Price/Forward Earnings) is that they don't take into account the business cycle: When profit margins are fat, as they are today, P/Es look artificially low, and when margins are thin, they look artificially high. The trouble with bond-yield ratios, Smithers says, is threefold:

They have no theoretical justification.
They don't work.
Their apparent predictive capability is the result of data mining.

The bogusness of these valuation metrics, of course, doesn't stop dozens of Wall Street strategists (and Fed governors and financial journalists) from using them--a fact that Smithers attributes to Wall Street's need to always conclude that stocks are cheap.

As in other reports, Smithers argues that the only two valuation metrics that are valid are cyclically adjusted P/Es (CAPE), which take into account the business cycle, and Tobin's Q, which is a measure of price to replacement cost. These metrics, Smithers says, meet the five key tests of validity:

The "fundamental" is measurable and relatively stable, and the price ratio to this fundamental is mean-reverting.
The measure must make economic sense.
The measure must tell you something (but not too much) about future returns.
The measure must have been predictive in the past.
If there is more than one measure, they must generally agree.

At the end of the lecture, Smithers uses CAPE and Q to show that the U.S. market is significantly overvalued, but notes that this tells us little about what it will do in the next year or two. He observes that intelligent fund managers, whose jobs depend on not missing big bull moves, would be dumb to bet on an intermediate-term decline, even when it has a 70% chance of occurring. Why? "Because a 30% chance of ruining your business or career is too high."

In Search Of: A New Name For "Passive"

2007-03-31T09:57:42-04:00

One of the many reasons "passive" investing gets dissed is that its name--"passive"--is both misleading and deflating. Who wants to be "passive"? The folks who do well in life are active, the ones who have gumption, the ones who get up off the couch and make things happen. "Passive" investing, moreover, isn't passive--it's active. Smart passive investors actively determine which types of stocks they want to invest in, actively screen the market to find such stocks, and actively manage their portfolios to make sure they contain only such stocks (and in the proper proportion).

So smart passive investors, the ones who wouldn't mind earning some respect in addition to superior returns, are forever searching for a new term to describe what they do. Alas, to date, none has been found.

"Indexing" doesn't work, because "indexing" suggests that the passive investor is simply trying to match the performance of the S&P 500, Russell 2000, or other index. And now that such strategies are popular, the style suffers from herding, index-reconstitution, and other problems (even thought it still outperforms most active strategies).

"Rules-based investing" doesn't work because...well, because it's boring and vague.

"Factor-based investing" doesn't work because it's mystifying.

"Dimensional investing" doesn't work because...ditto.

"Quantitative" doesn't work because it has already been coopted by "quants."

The latest suggestion, "Equilibrium-based investing", put forth by DFA's Weston Wellington in a recent article, doesn't work because it doesn't mean anything that couldn't just as easily apply to the "active" world. (Although it is arguably better than "passive").

So the search continues. One thing is certain, however. If passive investing continues to be called "passive," those who advocate the strategy will continue to operate at a major marketing disadvantage to their "active" competitors. In fact, given the inherent connotations of the words "active" and "passive," it is almost certain that the nomenclature was devised by a traditional stockpicker.

Housing Market Still Getting Worse

2007-03-26T21:52:22-04:00

Henry Blodget submits: According to Asha Bangalore, new home sales declined again in February and are now running at a pace not seen since June 2000 (see March 26 Daily Global Commentary) The supply of new homes, meanwhile, rose to 8.1 months, a level not seen since 1991. And the number of completed homes for sale in February set an all-time record.

Asha's previous commentary, on existing home sales, was slightly less discouraging: the pace of price-declines has moderated. For three reasons, however, Asha still considers the relatively good news of the past few months in existing home sales to be temporary: tightening mortgage lending standards, less availability of subprime financing, and rising delinquencies. She also notes that, despite a pick-up in February in the number of houses sold, the total inventory also increased.

So it seems as though those jubilant shouts about the housing market having stabilized may have been premature.

Kasriel Recession-Warning Indicators Flashing Red

2007-03-26T21:39:35-04:00

With the exception of Messrs. Roubini and Roach, the vast majority of Wall Street economists are still whistling Dixie. Another exception, previously noted here, is Northern Trust's Paul Kasriel. Kasriel hasn't gone so far as to forecast a recession, but he is at least willing to conclude that, when our boat's instruments say we're heading for the rocks, that's probably where we're headed.

In the March 22 eContrarian, Kasriel observes that the LEI is en route to its first quarterly-average year-over-year decline of this expansion. Barring a miraculous turnaround in March, the quarterly average LEI will produce a "signal" that has preceded every recession since 1960 (and yielded only one "false positive.") Kasriel notes that Wall Street loves to diss the LEI--but suggests that this is because it outperforms almost every proprietary economic model on the Street.

Kasriel's bearishness, moreover, doesn't stop with LEI. He also invokes the Kasriel Recession-Warning Indicator: the combination of an inverted yield curve and a year over year contraction in the real money supply. The KRWI has missed only one recession since 1960 and has given no false signals. So far in the first quarter, the KRWI is performing about in line with the LEI.