NORFOLK, VIRGINIA (The Borowitz Report) – Eleven indicted Somali pirates dropped a bombshell in a U.S. court today, revealing that their entire piracy operation is a subsidiary of banking giant Goldman Sachs.

 There was an audible gasp in court when the leader of the pirates announced, “We are doing God’s work. We work for Lloyd Blankfein.”

“There are lots of laws that could bring these guys down if they were, in fact, pirates,” one government source said. “But if they’re bankers, our hands are tied.”

“The Fed Model has been embraced by Wall Street cheerleaders as a simple and “reliable” method for estimating stocks intrinsic value.  Note that simple is the key word in that last sentence, as it conveniently takes less time to calculate which provides strategists with much more time to shake their pom-poms.  In any event, the so called Fed Model is a straightforward comparison of earnings yields (the inverse of price-to-earnings multiples) and treasury yields.  When earnings yields are higher than treasury yields, so we are told, stocks are attractive and vice versa.  Sounds intuitive and is certainly easy to grasp.”  But, “there is almost no relationship between the two data sets (earnings yields and Treasury yields) with the notable exception of the period since around 1980.  What an amazing coincidence that this is the only period that “the street” has chosen to examine.”

The “Sunshine Pumper Strategists” are out in full force today, with earnings yields on stocks spiking higher than those available on bonds.  So we were pleased to see that Ron Griess at The Chart Store provided us with a couple of charts this morning that illustrate this relationship (or lack thereof) over time.  Ron’s long term perspective is critically important here, as any monkey can easily pick out a few bananas that accurately predict the market at any given moment in time.  But we would not invest our client’s capital (or our own for that matter) based on one monkey’s bananas.  Instead, we’d prefer to focus on those few characteristics (i.e. normalized valuation) that consistently add value as a predictor of long-term returns, throughout history.  As such, I sent Ron an email this morning complaining that if one more strategist tells me that stocks are cheap because their “earnings yield” is greater than the yield on bonds, I may puke.  As Ron was concerned for my stomach, he  was kind enough to grant us permission to share this charts with our readers.  And also offered up the following colorful commentary.

“Too many of the “sunshine pumper strategists” draw their conclusion first, then look for supporting evidence. I know of one, who is a subscriber, and knew there must be others out there who were pounding the table with the earnings yield argument because I was getting requests for charts. I’m sure most of them are showing a chart of 10 or 20 years to make their “positive” case to BUY stocks. I know another portfolio-manager-type subscriber was very disappointed to learn that yet another reason to “buy ‘em” did not hold water if one looks at “the rest of the story,” i.e. far enough back in history.”

Source: Thechartstore.com

Consensus earnings estimates for 2011 and 2012 are still greater than $95 and $108, respectively, at the same time that GDP estimates are plummeting (although still don’t face the harsh economic reality).  To put these figures into perspective, analysts were forecasting a near 20% decline in earnings at the market’s trough.  Today, expectations are for 22% growth in the year ahead.

We show an example of this optimism below.  Cummins is a global leader in the design, manufacturing and distribution of engines and related technology.  The company’s engines are found in a wide range of vehicles and equipment from emergency vehicles to 18-wheelers, berry pickers to 360-ton mining haul trucks.  Management has done a tremendous job managing through the crisis.  Costs have been cut relentlessly, resulting in a leaner organization with greater operating leverage.  The balance sheet is rock solid.  Not to mention its image as a ‘safe’ play on the secular growth of emerging market infrastructure development.  It’s no wonder the street is in love with the stock.

We have a difficult time arguing any of the points above.  Our concern is that the bar is set awfully high just as we stare right into a cyclical slowdown at best and more likely, something much more problematic.  Note the company’s historic EBIT margins below.  Margins increased from 1.4% at the start of the decade to a peak of 9.4% as the global economy marched straight up through 2006 on the back of the Chinese growth engine fueled by a credit-obsessed American consumer.  Then . . . something changed.  And something changed quite quickly.  As economic growth screeched to a halt in 2008, margins followed, moving in a straight line back to 1.7% in Q3-09.  But with ‘a little’ help from the greatest monetary and fiscal stimulus in economic history, orders reappeared and a stream-lined Cummins surprised analysts quarter after quarter, in route to a magical V-Shaped Recovery.

So what’s next?  In classic fashion, consensus has basically straight-lined that v-shaped recovery over the next few years, as shown by the last piece of the chart highlighted in red and representing consensus estimates through 2011.  Wall Street bulls – of which there are plenty, as none of the analysts covering the stock are brave enough to rate it less than ‘hold’ – are now projecting that the company’s margins reach record highs above 11% over the next eighteen months.  Such levels would be nearly 200 basis points above the prior peak reached at the height of the credit-induced global growth bubble.  Possible?  Sure.  Likely?  Eh.  Not to mention that these record margins on record sales would be achieved in a global economy in the grips of an extended deleveraging process with much of the developed world entering recession or battling depression.  We can’t help but wonder, who’s buying all this stuff?

Disclosure: At the time of publication, the author did not hold a position in Cummins, although positions may change at any time.

“Economic conditions are likely to remain challenging throughout the year, but the amount of stimulus building in the pipeline makes a cyclical rally in equities increasingly likely.  We are certainly not wildly bullish today, but we believe most of the perceived threats are priced in and we have likely experienced “the point of maximum pessimism” which has historically represented a tremendous opportunity for long term investors. Lower prices and reduced risk levels, combined with exploding liquidity and extremely oversold momentum, are conditions typical of powerful advances in equities.”

Fast forward to today.  Revisions have clearly peaked and are declining sharply at the same time the bar has been moved substantially higher.  Not pictured here are valuations that have also moved steadily higher alongside the bar, meaning downside risk has increased from today’s artificially inflated levels.  Consensus earnings estimates for 2011 and 2012 are still greater than $95 and $108, respectively, at the same time that GDP estimates are plummeting (although still don’t face the harsh economic reality).  To put these figures into perspective, analysts were forecasting a near 20% decline in earnings at the market’s trough.  Today, expectations are for 22% growth in the year ahead.  The average annual gain on the S&P when earnings growth estimates have been below 4.2% has been a positive 17.2% return, consistent with last year’s monster bear market rally.  Regrettably, the average annual performance of the S&P when earnings growth estimates have been above 14.2% has been a decline of 4.6%.

The weight of the evidence clearly points to a double dip.  There are no guarantees in this business, but we put the odds at near certainty (if we ever escaped the clutches of recession in the first place).  Those that can’t see this, simply don’t want to.  The best argument we’ve heard to date against another contraction in the economy, is that ‘double dips are extremely rare.’  So are national house price declines, developed world sovereign debt defaults and the associated and extended deleveraging processes.  We’d humbly suggest that ignoring these so-called ‘rare’ risks may not be beneficial to long term returns, particularly in light of today’s elevated valuations and lofty expectations.  Caveat emptor.

An Evening with Dennis Gartman:

A Trader’s Perspective on the Capital Markets

Tuesday, September 21, 2010 – 5:30 p.m.

The Grandover Resort and Conference Center

Greensboro, North Carolina 27407

Dennis Gartman, Publisher, The Gartman Letter

Mr. Gartman has been directly involved in the capital markets since August of 1974, after his graduate work at the North Carolina State University. He was an economist for Cotton, Inc. in the early 1970′s, analyzing cotton supply/demand in the US textile industry. From there he went to NCNB National Bank in Charlotte, North Carolina where he traded foreign exchange and money market instruments. In the late 70′s, Mr. Gartman became the Chief Financial Futures analyst for A.G. Becker & Company in Chicago, Illinois.

Mr. Gartman was an independent member of the Chicago Board of Trade until 1984, trading in treasury bond, treasury note and GNMA futures contracts. In 1984, Mr. Gartman moved to Virginia to run the futures brokerage operation for the Sovran Bank, and in 1987 Mr. Gartman began producing The Gartman Letter on a full time basis. He continues to do so today.

Click here for registration information

For additional information, please contact Sheri Gillette, Executive Administrator of the CFA North Carolina Society.

Please click here for information and directions to the Grandover.

Price: Members $25  -  Non-members and Guests $50

We’ll be interested in what Raiford Garrabrant has to say next week, particularly as our short position in the industry appears to be playing out.  While we do not have a position in CREE, recent data points indicate that we are approaching a peak in orders as LCD panel vendors have begun cutting orders at Taiwan LED makers.  The “street” still expects robust earnings growth to continue next year, as evidenced by JPMs recent report encouraging investors to “buy on weakness.”

The following is an excerpt from a report issued by Simon Hunt included in John’s letter:

The scale of speculation in real estate is enormous. There is a total of 64.5 million apartments and houses lying purchased but vacant in urban China, about five times the surplus in the USA, according to an economist from the Chinese Academy of Social Sciences.

A report written by the National Bureau of Economic Research in July this year provides interesting data on China’s housing market. Real housing prices have risen by 140% since the first quarter of 2007. In the first quarter of this year, house prices rose by a record 41%, since when it appears that prices have stabilised but not fallen. Price increases have not been driven by any shortage in housing.

In Beijing, there has been an almost eight-fold increase in land values since 2003, but since the end of 2007 land prices have nearly tripled. The impact of rising land prices on home and apartment prices has been equally great. From 2003 to 2007, the ratio of land-to-house values hovered between 30% and 40%, but since then it has doubled to just over 60%. The report also found that when a central government state-owned enterprise (SOE) was a winning bidder for land, prices rose by about 27% more than if they had not been involved, thus showing the influence that SOEs bring to bear on land values, an influence that grew in 2009 when they became more active. A separate report shows that so far this year 82% of Beijing’s land auctions have been won by SOEs.

Price-to-rent values in Beijing and seven other large markets across the country have increased from 30% to 70% since the start of 2007.

In summary, against a background of cheap money and plenty of credit, house prices across the country have become unaffordable to most first-time buyers. In Beijing, for instance, average house prices have been between 14 and 15 times incomes for the past three years, but rose to 18.5 times in the first quarter of this year.

The evidence appears to be stacking up against the few remaining property bubbles around the globe.  As we’ve stated previously, an economic hiccup in China is not a prerequisite for a bursting Australian property market, as bubbles of this magnitude often collapse under their own weight.  But we certainly don’t mind having multiple potential catalysts when evaluating the risk/reward of investment themes.  In this case, our Chinese Pin appears to be pointed directly at the Land of Oz.  The potential consequences are alarming . . . even to Jack Burton!!

The populations of the developed world are getting older and, as they age, they need more medical attention. The march of medical science means that an increasing number of expensive helpful treatments are available. The problem is that they are mostly very expensive and only a little bit helpful. Yet it is hard to limit or ration their use. A symptom of this is that almost 25% of total medical expenses occur in the last year of life, while equivalent spending in prenatal and child care would yield multiples of the payoff to society. The result is that total medical costs rise rapidly, and in the U.S. are handsomely in first place globally, with the percentage of GDP going to medical care at one-third more than the average developed country. With progress in the study of the human genome, we will soon see breathtakingly expensive ways to reduce the incidence of very rare diseases and much more that will be hard to ration or resist. And a great leap in life extension drugs although desirable (where can I buy it?) would result in a terrible extension of the age profile problem.

The plain truth is becoming more obvious by the minute. Almost all developed countries are overcommitted to retirement benefits, especially health care. Even without severe aging problems, health costs alone would be a major economic challenge. With an aging population, though, health costs and retirement costs balloon and put an intolerable burden on younger workers. We in developed countries are on a collision course with budgetary integrity: given our current policies on health costs we simply cannot afford the commitments we have made.

In the developed world, which choice is made will depend on the country’s history and on the strength of its concept of the social contract: how much personal disadvantage is the individual willing to accept in the interest of the social good?  Under current stresses, the Europeans seem ready to extend the retirement age (never waste a good crisis!), which can fairly be seen as involving a degree of reneging, received with varying degrees of kicking and screaming.  Here the possibility of rationing health benefits to the level society is willing to pay is so anathema that it cannot be talked about sensibly and, if at all, the language must be tortured in order to talk around the point. Our culture demands the best that money can buy, combined with unlimited legal liability (courtesy of the legal lobby and all those lovely lawyers in Congress), and friendly conditions for the drug and insurance industries (courtesy also of their effective lobbies). Nobody gets treated badly except, of course, the ordinary user. That is to say, the ordinary taxpayer, who pays a third more for mediocre or worse aggregate health results, lower life expectancy, etc., etc., etc.

Our cost-laden health system is perhaps fine if you are willing to pay for it. But the same people who scream “death panels” at the concept of sensible rationing also reach for their revolvers, of which they insist on having plenty, at the prospect of having a tax structure nearer the average of the rest of the rich world. Now, this is a non-compute. It has to be one or the other, either rationing or taxes. Presumably we will hunker down, wait for a crisis, and then respond. In my opinion, this refusal to make painful choices puts the U.S. fairly high up the list of countries with longer-term financial problems.

Unfortunately, it is difficult for us to visualize today’s administration proactively addressing this issue until they are forced to.  Cutting healthcare benefits for largest constituency is not exactly a roadmap to reelection, which is why we continue to kick the can down the road.  Much easier to let the next guy worry about it I suppose.  Reading GMO’s letter reminded us of a recent BIS Working Paper which further put our unfunded liabilities into perspective.  The authors, Stephen G Cecchetti, M S Mohanty and Fabrizio Zampolli, conclude that:

Fiscal problems confronting industrial economies are bigger than suggested by official debt figures that show the implications of the financial crisis and recession for fiscal balances. As frightening as it is to consider public debt increasing to more than 100% of GDP, an even greater danger arises from a rapidly ageing population. The related unfunded liabilities are large and growing, and should be a central part of today’s long-term fiscal planning. 

It is essential that governments not be lulled into complacency by the ease with which they have financed their deficits thus far. In the aftermath of the financial crisis, the path of future output is likely to be permanently below where we thought it would be just several years ago. As a result, government revenues will be lower and expenditures higher, making consolidation even more difficult. But, unless action is taken to place fiscal policy on a sustainable footing, these costs could easily rise sharply and suddenly.

The chart below illustrates the extent of the problem at home.  The authors examine three scenarios, all of which are built upon the wildly optimistic projections that real interest rates remain constant at their long term average (not a chance), and real GDP growth is set to the “post-crisis rate” (estimated using the OECD’s stimulus-driven, recovery in 2009).  The results are disastrous in every scenario, even using cheery assumptions.  In the base case (red line) Debt/GDP ratios rocket beyond 150% in just the next decade.  The second scenario (green line) examines the long-run implications of fiscal adjustments similar to the policies being proposed today.  Although debt accumulation slows, we are still faced with substantial increasing debt ratios.  The blue line shows the consequences of a third scenario that combines gradual fiscal adjustment with a freezing of age-related spending at 2011 levels.  While the consequences of such a draconian policy result in a reversal of debt ratios in several economies, the US is not one of them.  Even this policy is not sufficient to bring rising debt under control.

In our Q4-09 Broyhill Letter, we stated: “We are not yet at the end of the road, although we can hear the fat lady singing more clearly today. Our problems are not insurmountable, but they require immediate attention. Simply hoping that we will grow our way out of the remnants of crisis will cost us dearly. The key conclusion policymakers should learn from the work of Reinhart and Rogoff is that seldom in history have countries grown their way out of deep debt burdens. Reversing a crisis of confidence and strengthening sovereign balance sheets requires smart policies from strong leaders. Sadly, we have neither. Perhaps Paul Broyhill was on to something when he suggested it would take a “one-term” president willing to make unpopular short-term decisions to restore the long term health of our great nation. I’d still like to believe that America would appreciate such character when they saw it and re-elect him for a second term, but I recognize that this is wishful thinking, particularly as we have yet to find him.”

Smart policies from strong leaders.  The best advice we’ve heard to date was eloquently stated as, “Stimulus in the front . . . austerity in the rear.”  In other words, our economy is badly in need of smart, productive investments today.  Without appropriately directed stimulus (which we’ve seen little as of yet), the probability of Dancing towards Depression increases each day.  We’d hate to see what the state of the economy looked like without government intervention, although we may find out if those in DC don’t learn to play nice.  Since we can’t spend to infinity (we realize some disagree), today’s spending must be accompanied by tomorrow’s austerity.  Someone must address the 800 pound healthcare and social security gorilla.  Preferably, before a crisis as it will be too late otherwise.  And if you are looking for an example of a smart, productive investment, see Grantham’s thoughts below from the same letter.  Needless to say, Cash for Clunkers (or appliances for that matter) does not qualify.

The amount of carbon dioxide (CO2) in the atmosphere, after at least several thousand years of being quite constant, started to rise with the advent of the Industrial Revolution. It has increased by 40% and is rising each year. This is certain and straightforward. One of the properties of CO2 is that it creates a greenhouse effect and, other things being equal, causes the temperature to rise. This is just physics. Skeptics argue that this wide range of uncertainty lowers the need to act: “Why spend money when you’re not certain?” But since the penalties rise hyperbolically at the tail, a wider range implies a greater risk (and a greater expected value of the costs). This is logically and mathematically rigorous and yet is still argued.

Pascal asks the question: What is the expected value of a very small chance of an infinite loss? And, he answers, “Infinite.” In this example, what is the cost of lowering CO2 output and having the long-term effect of increasing CO2 turn out to be nominal? The cost appears to be equal to foregoing, once in your life, six months’ to one year’s global growth – 2% to 4%, or less. The benefits, even with no warming, include: energy independence from the Middle East; more jobs, since wind and solar power and increased efficiency are more labor-intensive than another coal-fired power plant; less pollution of streams and air; and an early leadership role for the U.S. in industries that will inevitably become important. Conversely, what are the costs of not acting on prevention when the results turn out to be serious: costs that may dwarf those for prevention; and probable political destabilization from droughts, famine, mass migrations, and even war. And, to Pascal’s real point, what might be the cost at the very extreme end of the distribution: definitely life changing, possibly life threatening. The biggest cost of all from global warming is likely to be the accumulated loss of biodiversity. This features nowhere in economic cost-benefit analysis because, not surprisingly, it is hard to put a price on that which is priceless.

A special word on the right-leaning think tanks: As libertarians, they abhor the need for government spending or even governmental leadership, which in their opinion is best left to private enterprise. In general, this may be an excellent idea. But global warming is a classic tragedy of the commons – seeking your own individual advantage, for once, does not lead to the common good, and the problem desperately needs government leadership and regulation. Sensing this, these think tanks have allowed their drive for desirable policy to trump science. Not a good idea.

Keith R. McCullough
CEO, Hedgeye Risk Management 

After 17 consecutive months of solid growth, dwelling values across Australia’s capital cities recorded their first monthly decline of 0.7 per cent in June, according to the RP Data-Rismark Hedonic Home Value Index. This was the largest monthly fall in home values since April 2008. The June outcome follows on from a clear trend in the decline in monthly seasonally-adjusted growth rates in Australia’s capital cities, RP Data said. This represents a striking deceleration in the quarterly rate of increase in home values.

According to RP Data, dwellings in Sydney (+0.5%), Melbourne (+0.2%), Brisbane (-1.3%), Perth (-2.5%), Darwin (-0.1%) and Canberra (-0.8%) all experienced a marked reduction in growth rates in the June quarter from the 3 per cent per quarter pace witnessed since the beginning of 2009.

We’d remind our readers that the Case Shiller Home Price Index experienced its first monthly decline in August 2006 just as the year-over-year change in home prices began to slow dramatically, turning negative in January 2007.  No need to remind home-owners what transpired from that point forward.  With variable mortgage rates at a steep 7.4% in Australia, and a median home price of $465,000 in the nation’s capital cities, our hearts go out to the first-time home buyers of Oz.  They’ll need a lot more than the lion’s courage to make that leap of faith.