Valuation Matters

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 Many popular investment “gurus” advocate the Buy and Hold Strategy, yet most never discuss valuation.  We believe that valuation matters most, so before we look at anything else, we determine whether an asset class is currently cheap, expensive or fairly priced.  If you pay too much for an investment, all the time in the world won’t fix it, even if you just invest in an index fund.  The chart below shows the S&P500 adjusted for inflation from January 1, 1873 to January 1, 2010.

This chart shows that if an investor purchased the index in 1966, they would have waited until 1991 for it to return to the same value!  For twenty five years their investment was underwater.  This chart also shows that we have yet to come close to the high reach at the turn of this century.

So how can an investor know that in 1966 or in 1999-2000, the S&P was overpriced?  One way is using the price to earnings ratio (PE).  The chart below shows the PE ratio for the S&P for the same time period.  The PE ratio be thought of as how much an investor is willing to pay for one dollar of earnings.  A PE ratio of 20 means that the market in aggregate is willing to pay $12 for $1 of annual earnings.

This shows that in 1966, the PE ratio reached a high near 25 and in around 2000, the S&P again reached a high of nearly 45!  This is just one measure of valuation that we use to help us determine if the stock market in general is over-priced, under-priced or fairly priced.  The mean PE ratio is 16.35 and the median is 12.87.  The lowest PE ratio occurred in December of 1920 at 4.78 and the highest PE ratio so far was in December of 1999, when the ratio reached a mind boggling 44.20. 

On 1/1/1982, the S&P PE ratio was again at a historical low of 7.4 and the inflation adjusted S&P was at 268.62.  If an investor purchased the S&P index at this point, and kept it until the PE ratio reached 43.8 on 1/1/2000, the S&P had risen to 1,823.78, which means the investors after inflation average annual return was 11.23%.  Compare this to the 25 years it took from 1966 to 1991 for an investor to simply get a return of their initial investment and clearly, valuation matters and buy and hold provides little aid for an over-priced investment.

We don’t believe we can time the market.  There was no way to know that the PE ratio was bottoming out in 1982, nor could we know in December of 1999 that the market had peaked, but we could see that in both cases a directional change was bound to occur.  We don’t believe we can get the timing exactly right, but we do see opportunities, both for gains and losses when valuations are above or below historical norms.

By the way, we currently believe that the S&P is again relatively over-priced.  If you remove the insanity that occurred around the turn of the century, the chart above shows that the PE ratio is again near historical highs.

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Inflation, Deflation, Interest Rates… What’s going on?

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I like to keep things simple, (my wee little noggin can only handle so much) thus I generally agree with the Austrian School of Economics definition of inflation, which is simply an increase in the money supply.  As I mentioned in my piece on fractional reserve banking, an increase in the money supply, all else held constant, will result in an increase in prices across the board.   This is rather intuitive if you think of money as simply another commodity.  Imagine an economy in which the money supply is just $100 and there are only 30 apples and 20 bananas available for purchase every day.  This economy can be easily modeled as

$100 = A * 30 Apples + B * 20 Bananas (where A is the price of Apples and B is the price of Bananas)

$100 = 30A + 20B

Since Apples and Bananas are the only items available for purchase in this economy, the amount spent on apples and bananas together must be $100.  If the supply of money is doubled to $200, the equation would look like this.

$200 = 30A + 20B

Since the quantity of apples and bananas has remained unchanged, their prices (A & B) must go up.

So what’s all the talk about potential hyper-inflation these days?

Starting with the collapse of Lehman Brothers in September of 2008, the Federal Reserve more than doubled its balance sheet in only three months by financing its credit extensions using the electronic equivalent of printing money.  At the beginning of September 2008 the Fed has $894 billion in assets, by December 17th that number rose to $2.24 trillion and now stands at $2.17 trillion.  This unprecedented expansion resulted in an increase in the reserves credited to banks and a corresponding increase in the Fed’s assets.  To create these reserves the Fed essentially purchased mortgage securities from the banks for 100% of the original loan amount by giving the banks credit for those mortgages in their reserve accounts as part of the bank bailouts.

As I mentioned in an early blog post, typically in the U.S. we see a 10x multiple on reserves, meaning for every $1 increase in reserves, we expect to see a $10 increase in the money supply.  That has not yet occurred because for an increase in reserve funds to make their way into the economy, lenders need to be willing to lend against their reserves and borrowers need to be willing to borrow.  With unemployment continuing at record high levels, households shifting from consumption to savings, and paying down outstanding debts, the demand for consumer loans is lacking.  With corporations cautious about future expansions, commercial lending demands are also lower.  Once demand for loans increases and banks are more confident in their own balance sheets, we could see significant increase in the money supply, which means inflation.  The Fed claims to be watching for indications of this and have stated that they are willing to respond quickly by raising rates.  An increase in the rate the Fed pays banks decreases the supply of money in the economy because banks and more willing to leave money in their reserves, earning interest from the Fed, rather than lending it out.

Now back to the Federal Reserve’s balance sheet.  The loans the Fed “bought” from the banks are expected to be worth less than the original loan amount.  Nearly 10.7 million households, or about 23% of U.S. homeowners owe more on their mortgages than the properties are worth.  In addition, the states with the highest rate of underwater mortgages are, and most likely not coincidentally, non-recourse mortgage states, meaning borrowers are not held personally liable for more than the home’s value at the time that the loan is repaid.  It is also highly unlikely that the Federal government will go after individual homeowners to recoup losses on underwater loans.  This calls into question the quality of the assets owned by the Federal Reserve, which is of great concern to holders of U.S. debt.  As we’ve seen the quality of sovereign debt globally come into question, the interest rate at which the United States is able to issue debt could rise if the perceived quality of our debt is lowered.  With 71% of the marketable debt held by the public due by 2014 AND 40% individual income tax receipts already going to pay the interest on existing debt, an increase in interest rates on US debt could harm the economy, which puts the Fed in between a rock and a hard place when it comes to raising rates.

As of December 16th, 2009 the total outstanding public debt was $12.1 trillion while interest on the debt for 2009 was $383 billion (source Treasury Direct).  Individual income tax receipts are estimated to be $953 billion for 2009, which means interest payments accounts for 40% of individual income tax receipts.

 

Data Source:  Office of Management and Budget, Budget of the US Government FY 2010, Historical Tables, Table 7.1

Source:  November 2009 GAO Financial Audit, Bureau of the Public Debt’s Fiscal Years 2009 and 2008 Schedules of Federal Debt (GAO-10-88)

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The Markets Love Bernanke?

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The other day while I was organizing my office for the umpteenth time, (how is it that someone as obsessively organized as I am consistently has a messy desk?) I heard a reporter on the television say, “The markets love Bernanke.” I immediately glowered at the screen. After a few annoyed minutes and some distracted paper cuts, I realized, she’s right. Clearly if talk of him not getting reappointed causes the markets to drop, they must have some affection for the man. But how can this be? I come from the school of thought that increasing the bank reserves from $10 billion to $980 billion in a few months is not the best solution for an economy in turmoil and of course believe that any rational human being would agree with me, (note wry grin) so why do the markets seem to love him?

Then it dawned on me as I cleared away the seriously overused coffee mugs that hold my precious nectar of the Gods every morning. The markets love liquidity, thus Ben Bernanke. It is a bit like the love an addict has for their dealer, or me for my espresso machine. I highly recommend the Jura Capresso for those suffering from the same affliction. The recent talk that he might not get confirmed briefly sent the markets into a tizzy as their liquidity dealer might get kicked out of the neighborhood.

So why does an increase in liquidity cause asset prices to rise? You can think of it like a seesaw, with the price of money on one end and the price of assets on the other. As the price of money (interest rates) goes down, the price of assets goes up. If Bernanke is replaced with someone who is less likely to keep their side of the seesaw down, asset prices will drop.

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