"Macro" Musings

[yadayada]

I'm not good enough to do what many here do successfully

why not? Usually you post pretty intelligent stuff. I keep seeing this, but I find it hard to define what makes a good investor. If you could break it down, then you know what to  get better at no?

[Guest]

Let's say if someone became bearish in 2005 and stayed that way until 2009.  The years they missed out would've been nothing. The S&P 500, in 2009, was at virtually the same level as 1998.

 

For what it's worth, here has been my "theory" that has worked out well so far.

 

I've kept an eye on Klarman for years. I remember him starting to get bearish around 2010. I also found some of his old letters a while back, and from what I remember he started getting bearish around 1995 or 1996. I figured that he's was "wrong" for about 4 years and then was proved massively right. We're getting close to that period now. We'll see if history repeats itself! This then matches really, really well with Buffett's idea of 17 year or so market cycles.

 

As a result, I've been very aggressive and now I've been toning things down a bit. Perhaps I'll be wrong though! haha

[james22]

So better choose among 2 strategies:

1) To be an incredibly smart stock picker, a la Packer;

2) To invest in something whose future results won’t depend at all on what the stock market does, a la Lancashire.

 

3) Cash.

 

If you have continued financial repression, you want a much higher share of equities, because they are the highest performing asset, compared to bonds and cash. If you think financial repression will go on for another 20 years, you need to have equities.

 

For the scenario that the central banks will exit their policies, you will want to own cash, because that’s the only asset that does not get impaired when interest rates rise.

 

So you have two extreme portfolios: One almost fully in equities, the other almost fully in cash. So that’s what we do: We have about 50% in equities, and 50% in dry powder-like assets. That means some cash, some TIPS, and some long/short equity spread trades. But as said, we are reducing the equity part over the course of the year, to build up dry powder.

 

http://mobile.fuw.ch/article/equity-markets-are-overvalued/

 

 

[Liberty]

I'm not good enough to do what many here do successfully

why not? Usually you post pretty intelligent stuff. I keep seeing this, but I find it hard to define what makes a good investor. If you could break it down, then you know what to  get better at no?

 

Maybe someday I'll write a longer piece about my evolution as an investor, if anyone's interested.

 

But the short version is: I've only been doing this for a few years (unlike some here who have been doing it for decades), so I'm still adjusting my style and discovering what works for me and what doesn't. All this takes a while, but over the past couple year I think I might have found my sweet spot, which is different from what I thought it was maybe 4 years ago. Time will tell if I'm right. I'm 31 so hopefully I still have a lot of years to learn and improve, which is most of the fun anyway.

 

You write: "If you could break it down, then you know what to  get better at no?"

 

I find that it's more complicated than that. It would be easier if there was just one way to invest well, so you could know exactly what to aim for. The challenge is finding a good way to invest, among the promising variants, that is compatible with your personality and skillset. Not only do you have to find an approach, but you have to know yourself and not pretend you are something you're not (even if unconsciously).

[Liberty]

Let's say if someone became bearish in 2005 and stayed that way until 2009.  The years they missed out would've been nothing. The S&P 500, in 2009, was at virtually the same level as 1998.

 

For what it's worth, here has been my "theory" that has worked out well so far.

 

I've kept an eye on Klarman for years. I remember him starting to get bearish around 2010. I also found some of his old letters a while back, and from what I remember he started getting bearish around 1995 or 1996. I figured that he's was "wrong" for about 4 years and then was proved massively right. We're getting close to that period now. We'll see if history repeats itself! This then matches really, really well with Buffett's idea of 17 year or so market cycles.

 

As a result, I've been very aggressive and now I've been toning things down a bit. Perhaps I'll be wrong though! haha

 

I wish you the best of luck. I know that I couldn't invest like that, but if it works for you, that's cool.

[Guest]

hahaha

 

Liberty, I just turned 33 so I'm still learning things. too. ;)

 

I figured if super smart investors like Klarman, Burry (as a couple years ago anyway), Watsa, are bearish (heck, if Buffett's doesn't seem as positive as he was a couple years back) I think it's wise to listen to these guys. They're rich and successful for various reasons. The only guys I can think of who are bullish (that I like anyway) are Dalio and Tepper (not sure if he's still bullish though).

 

Yeah, perhaps I'll be wrong. I'm okay with that. The last few years have been much, much better than expected. I don't think anyone knows how this grand experiment will (or won't) work out. I think the opportunity cost of missing out on some upside is a chance I feel is worth taking. If the market continues to rally, I'll continue to sell down a bit at time. I'm still heavily weighted towards stocks (for now). A year from now, if the market is still higher, that number will be greatly reduced.

[wisdom]

Even Dalio has been increasing cash as of last year. He is not bullish on equities anymore.

[Rabbitisrich]

 

 

I've kept an eye on Klarman for years. I remember him starting to get bearish around 2010. I also found some of his old letters a while back, and from what I remember he started getting bearish around 1995 or 1996. I figured that he's was "wrong" for about 4 years and then was proved massively right. We're getting close to that period now. We'll see if history repeats itself! This then matches really, really well with Buffett's idea of 17 year or so market cycles.

 

 

The market rewards/punishes behavior, not reasoning, so it is probably an overstatement to say that the market proved someone to be correct for a given "big picture" statement. Klarman described the market as being "greatly overextended" in November 1995. But the S&P 500 would go on to return 7.7% over the next 8 years.

[original mungerville]

So better choose among 2 strategies:

1) To be an incredibly smart stock picker, a la Packer;

2) To invest in something whose future results won’t depend at all on what the stock market does, a la Lancashire.

 

3) Cash.

 

If you have continued financial repression, you want a much higher share of equities, because they are the highest performing asset, compared to bonds and cash. If you think financial repression will go on for another 20 years, you need to have equities.

 

For the scenario that the central banks will exit their policies, you will want to own cash, because that’s the only asset that does not get impaired when interest rates rise.

 

So you have two extreme portfolios: One almost fully in equities, the other almost fully in cash. So that’s what we do: We have about 50% in equities, and 50% in dry powder-like assets. That means some cash, some TIPS, and some long/short equity spread trades. But as said, we are reducing the equity part over the course of the year, to build up dry powder.

 

http://mobile.fuw.ch/article/equity-markets-are-overvalued/

 

I wonder what Montier has against Gold and Silver? I mean to just be 50% cash for deflation and 50% equities for inflation with no allocation to previous metals seems a little odd to me. I see Gold as a cash like investment that should respond well to financial repression providing a higher return than cash. At some point, let's say if the market goes up from here and equities go to a bubble, or say even now, equities get so over-valued that the allocation really should be zero. So by Montier's logic he should be 100% cash. But he can't because of financial repression and the timing of the burst of the bubble is unknown. In that situation, I would rather be 80% cash and 20% precious metals - that is my 100% cash equivalent at a time of financial repression and a bubble in equities.

 

I may be the only one on this board with that view.

[original mungerville]

Original,

 

I am bearishly bent as it is, so I am biased....but ur bearishness over the past 15 years is justified, IMO. Stocks have done virtually nothing with two 50 percent downturns, yet because we are right back to absurd valuations, it appears historical "overvaluation" is the new normal, since we've been at these levels for the majority of the past 15 years.

 

It's completely circular. High current valuations are required to justify 20 years of overvaluation, yet because of the high valuations for 20 years, stocks have returned hardly anything to speak of, thus nullifying the Bulls' point that "old" valuation metrics have failed to predict long term market returns.

 

I agree with Grantham that you could get an even larger bubble until the next recession.

 

Though...NDR is currently calling for a 2014 "reset" of the market similar to the 1987 crash. While not predicting a crash, they think a 2011 type decline will reset the market for a push to true bubble levels.

 

I hear you - this has been my view since I started investing in 1999. 2000 was the top of a massive bubble, reinflated again into 2007, and then now again into 2014. I made money in all the downturns, and generally took off half to 100% of the hedges coming out, but then put them on again. I think I have been hedged or semi hedged for half of the last 15 years!!! 

[Guest]

 

 

I've kept an eye on Klarman for years. I remember him starting to get bearish around 2010. I also found some of his old letters a while back, and from what I remember he started getting bearish around 1995 or 1996. I figured that he's was "wrong" for about 4 years and then was proved massively right. We're getting close to that period now. We'll see if history repeats itself! This then matches really, really well with Buffett's idea of 17 year or so market cycles.

 

 

The market rewards/punishes behavior, not reasoning, so it is probably an overstatement to say that the market proved someone to be correct for a given "big picture" statement. Klarman described the market as being "greatly overextended" in November 1995. But the S&P 500 would go on to return 7.7% over the next 8 years.

 

Good point. Though, I wonder what would have happened without Fed intervention. For instance, if LTCM wasn't bailed out in 1998. I'd imagine the story would be quite a bit different.

 

I thought this chart might be pretty telling. Though, the valuations on the bottom part suggest that things, while not cheap, aren't all that expensive either.

 

http://www.beyondproxy.com/wp-content/uploads/2014/03/2013-LAM-YEAR-END-LETTER-PDF8.jpg

 

If we use 1995 numbers on the first run up, they bull market piece would be even more dramatic. I'm of the opinion that this monkeying around of policy is great for short term uses but buries us long term.

 

On another note, I knew he was "wrong" for about 4 years. I figured it might happen again so I've been aggressive - just in case.

[vinod1]

Attached are two charts for the S&P Industrial Average:

 

1. Price to Sales Ratio going back to 1955

2. Profit Margins going back to 1955

 

Even if you conclude that margins are "permanently" higher than the historical average, the profit margin series is sharply mean reverting beginning with the '90's recession. Perhaps what goes along with a "new-age" of profit margins is more cyclicality via the "new-age" of enormous leverage. Just eyeballing the chart, an 8.5% margin is approximately 40% above call it a 6% average going back to 1990.

 

Further - would investors have not concluded in 1987 that they were in a "new-age" of permanently "low" profit margins after nearly two decades of downtrending margins? Hmmmm.....me wonders if nearly two decades of uptrending margins is just as unsustainable....

 

Same goes for the price to sales ratio - obviously a chicken and egg thing here, but would investors have not concluded they were at a permanently lower valuation plateau after two decades of below-average valuation ratios?

 

I have been worrying about profit margins since about 2000 so I understand where you are coming from. Reading Hussman every Sunday night for nearly 600 weeks and following GMO and Shiller very closely would ensure that.

 

1. P/S ratio is screwed up due to inconsistent way in how sales are accounted for. Take GM for instance, they have equity partnerships in China, their sales do not show up in the denominator. Profits however show up on their income statement and this effects the earnings that are being reported and thus the price being paid for GM. The author shows that this effect is quite big over the last several years.

 

P/S may in fact be high but the point is that it is nowhere near as high as implied by your chart due to this inconsistent data.

 

2. The same argument above also applies to profit margins. In addition, we also need to look at ROE. Just because profit margins are high does not mean they would mean revert. Say a company used to generate 10% ROE in the past with 6% margins, if the same company needs 10% margins to generate the same 10% ROE, then there would be no need to mean revert. There is evidence that this in fact had a major effect. Pzena had data around this in one of his recent letters.

 

To take a more extreme example if your profit margins are higher than the past but your ROE is say below 5%, would other companies be rushing in to get the 5% ROE due to high profit margins?

 

Vinod

[vinod1]

There are a couple of more reasons for higher net profit margins

 

1. Tax rates companies are paying is much lower compared to past.

 

2. Interest expenses companies are paying is also much lower compared to past. So some of it would revert when rates go higher but rates have to go up first.

 

Vinod

[wisdom]

http://www.bloomberg.com/news/2014-04-01/steel-defaults-seen-by-s-p-as-yuan-ruins-ore-loans-china-credit.html

 

Chinese steel companies struggles. 40% of iron-ore in Chinese ports is being used as collateral for financing. What if there are margin calls?

 

http://www.bloomberg.com/news/2014-04-02/china-s-overnight-rate-in-longest-rising-streak-since-october.html

 

overnight bank rate jumped .95% on March 27th. A large portion of the trusts are coming due later this year. Could be interesting.

 

http://www.bloomberg.com/news/2014-04-01/hong-kong-wins-from-china-credit-woes-as-lending-reaches-record.html

 

Chinese companies getting financing from HK, increasing HK's exposure to the mainland.

[james22]

I may be the only one on this board with that view.

 

I've a significant position in PME based primarily on the gold/PME relationship, but I would expect gold to rise given inflationary printing.

[bmichaud]

Attached are two charts for the S&P Industrial Average:

 

1. Price to Sales Ratio going back to 1955

2. Profit Margins going back to 1955

 

Even if you conclude that margins are "permanently" higher than the historical average, the profit margin series is sharply mean reverting beginning with the '90's recession. Perhaps what goes along with a "new-age" of profit margins is more cyclicality via the "new-age" of enormous leverage. Just eyeballing the chart, an 8.5% margin is approximately 40% above call it a 6% average going back to 1990.

 

Further - would investors have not concluded in 1987 that they were in a "new-age" of permanently "low" profit margins after nearly two decades of downtrending margins? Hmmmm.....me wonders if nearly two decades of uptrending margins is just as unsustainable....

 

Same goes for the price to sales ratio - obviously a chicken and egg thing here, but would investors have not concluded they were at a permanently lower valuation plateau after two decades of below-average valuation ratios?

 

I have been worrying about profit margins since about 2000 so I understand where you are coming from. Reading Hussman every Sunday night for nearly 600 weeks and following GMO and Shiller very closely would ensure that.

 

1. P/S ratio is screwed up due to inconsistent way in how sales are accounted for. Take GM for instance, they have equity partnerships in China, their sales do not show up in the denominator. Profits however show up on their income statement and this effects the earnings that are being reported and thus the price being paid for GM. The author shows that this effect is quite big over the last several years.

 

P/S may in fact be high but the point is that it is nowhere near as high as implied by your chart due to this inconsistent data.

 

2. The same argument above also applies to profit margins. In addition, we also need to look at ROE. Just because profit margins are high does not mean they would mean revert. Say a company used to generate 10% ROE in the past with 6% margins, if the same company needs 10% margins to generate the same 10% ROE, then there would be no need to mean revert. There is evidence that this in fact had a major effect. Pzena had data around this in one of his recent letters.

 

To take a more extreme example if your profit margins are higher than the past but your ROE is say below 5%, would other companies be rushing in to get the 5% ROE due to high profit margins?

 

Vinod

 

Regarding point #1:

 

The author goes into excruciatingly painful detail to simply conclude that DOMESTIC CORPORATE BUSINESS NET PROFIT MARGINS are 49% above the 1947-2013 average and 55% above the 1947-2002 average. Please see attached.

 

So honestly I have next to no idea what his overall point is, outside of debunking a chart that is simply one of many (even if it is wrong) pointing to the same thing.....profit margins are elevated well above historic norms.

 

I'd love to see data supporting the "JV income is so massive it is distorting NPMs across the board" argument. Most of Coke's revenue flows through its sales line versus a JV calculation. Yes GM happens to have a large JV line - but what about Parker Hannifan, Cummins, Pepsi, Mondelez etc... etc....? That's hardly a factor, and I think it comes through in the author's chart I've attached.

 

Regarding point #2:

 

It's a great point if in fact average ROEs are at or below historic norms due to lower leverage and lower asset turnover.

 

I would posit that given the exceedingly high leverage across sectors (govt, house, corp) and the low level of investment since the GFC, that leverage ratios and asset turns are higher than historic averages. Combined with above average profit margins, I imagine a broad look at ROEs would show well above-average levels.

Domestic_Corporate_Business_NPM.pdf

[vinod1]

Attached are two charts for the S&P Industrial Average:

 

1. Price to Sales Ratio going back to 1955

2. Profit Margins going back to 1955

 

Even if you conclude that margins are "permanently" higher than the historical average, the profit margin series is sharply mean reverting beginning with the '90's recession. Perhaps what goes along with a "new-age" of profit margins is more cyclicality via the "new-age" of enormous leverage. Just eyeballing the chart, an 8.5% margin is approximately 40% above call it a 6% average going back to 1990.

 

Further - would investors have not concluded in 1987 that they were in a "new-age" of permanently "low" profit margins after nearly two decades of downtrending margins? Hmmmm.....me wonders if nearly two decades of uptrending margins is just as unsustainable....

 

Same goes for the price to sales ratio - obviously a chicken and egg thing here, but would investors have not concluded they were at a permanently lower valuation plateau after two decades of below-average valuation ratios?

 

I have been worrying about profit margins since about 2000 so I understand where you are coming from. Reading Hussman every Sunday night for nearly 600 weeks and following GMO and Shiller very closely would ensure that.

 

1. P/S ratio is screwed up due to inconsistent way in how sales are accounted for. Take GM for instance, they have equity partnerships in China, their sales do not show up in the denominator. Profits however show up on their income statement and this effects the earnings that are being reported and thus the price being paid for GM. The author shows that this effect is quite big over the last several years.

 

P/S may in fact be high but the point is that it is nowhere near as high as implied by your chart due to this inconsistent data.

 

2. The same argument above also applies to profit margins. In addition, we also need to look at ROE. Just because profit margins are high does not mean they would mean revert. Say a company used to generate 10% ROE in the past with 6% margins, if the same company needs 10% margins to generate the same 10% ROE, then there would be no need to mean revert. There is evidence that this in fact had a major effect. Pzena had data around this in one of his recent letters.

 

To take a more extreme example if your profit margins are higher than the past but your ROE is say below 5%, would other companies be rushing in to get the 5% ROE due to high profit margins?

 

Vinod

 

Regarding point #1:

 

The author goes into excruciatingly painful detail to simply conclude that DOMESTIC CORPORATE BUSINESS NET PROFIT MARGINS are 49% above the 1947-2013 average and 55% above the 1947-2002 average. Please see attached.

 

So honestly I have next to no idea what his overall point is, outside of debunking a chart that is simply one of many (even if it is wrong) pointing to the same thing.....profit margins are elevated well above historic norms.

 

I'd love to see data supporting the "JV income is so massive it is distorting NPMs across the board" argument. Most of Coke's revenue flows through its sales line versus a JV calculation. Yes GM happens to have a large JV line - but what about Parker Hannifan, Cummins, Pepsi, Mondelez etc... etc....? That's hardly a factor, and I think it comes through in the author's chart I've attached.

 

Regarding point #2:

 

It's a great point if in fact average ROEs are at or below historic norms due to lower leverage and lower asset turnover.

 

I would posit that given the exceedingly high leverage across sectors (govt, house, corp) and the low level of investment since the GFC, that leverage ratios and asset turns are higher than historic averages. Combined with above average profit margins, I imagine a broad look at ROEs would show well above-average levels.

 

Point #1

 

Please see attached. The first chart shows EBIT vs GDP over the last 66 years. You would see that EBIT margin is about 12% higher than the median for the last 66 years.

 

The main point is that margins are not as higher as it is made out to be by the bears. He is not saying margins are not high. Just that they are not as high as Hussman makes it out to be i.e. something like 60% or 70% higher than average. There are lots of reasons for why margins are high today.

 

If you account for all these factors (JV income, lower taxes, lower interest expenses), margins are probably only 20% or so higher. This suggests caution not panic and abandonment of stocks which is which is what is implied by bears who suggest margins are 70% higher than historical average.

 

Margins might go down to historical averages but even if it happens, it would be a multi-decade long process.

 

Point #2

 

From the limited data that I have seen current ROE (properly adjusted as there are changes by S&P from what I heard during the late 1980s) is only modestly higher than in the past.

 

Take a look at the bottom chart in the attached. It has historical ROE for developed countries together.

 

A very kind gentleman on Fool provided some data for US when I asked this question (http://boards.fool.com/ot-long-term-averages-31148472.aspx?sort=whole#31151116). ROE for US is about 15% higher currently than the average of the past 3 decades. It does not include Financials & Utilities, so it is likely ROE is not even that high right now compared to historical averages.

 

Vinod

Charts.pdf

[vinod1]

If one is worried about high profit margins and mean reversion, why would they not invest in say the banks which have historically low profit margins over the last few years? Mean reversion is the last thing they would need to worry about in that case. GMO, Hussman and few others who are making these arguments on profit margins being high compared to history, specifically avoided this segment!

 

Vinod

[original mungerville]

I may be the only one on this board with that view.

 

I've a significant position in PME based primarily on the gold/PME relationship, but I would expect gold to rise given inflationary printing.

 

That makes two of us!

[vinod1]

What happened the last time profit margins fell from 12% to 6%?

 

From philosophical economics blog:

 

From January 1967 forward, the 20 year nominal total return (in contrast to the 10 year) was more than 10% per year–despite the domestic NIPA profit margin contracting from roughly 12% to roughly 6%.

 

Vinod

[wisdom]

http://finance.yahoo.com/news/autonation-ceo-declares-epic-winter-154620693.html

 

AN CEO says the US customer is coming back.

[bmichaud]

Attached are two charts for the S&P Industrial Average:

 

1. Price to Sales Ratio going back to 1955

2. Profit Margins going back to 1955

 

Even if you conclude that margins are "permanently" higher than the historical average, the profit margin series is sharply mean reverting beginning with the '90's recession. Perhaps what goes along with a "new-age" of profit margins is more cyclicality via the "new-age" of enormous leverage. Just eyeballing the chart, an 8.5% margin is approximately 40% above call it a 6% average going back to 1990.

 

Further - would investors have not concluded in 1987 that they were in a "new-age" of permanently "low" profit margins after nearly two decades of downtrending margins? Hmmmm.....me wonders if nearly two decades of uptrending margins is just as unsustainable....

 

Same goes for the price to sales ratio - obviously a chicken and egg thing here, but would investors have not concluded they were at a permanently lower valuation plateau after two decades of below-average valuation ratios?

 

I have been worrying about profit margins since about 2000 so I understand where you are coming from. Reading Hussman every Sunday night for nearly 600 weeks and following GMO and Shiller very closely would ensure that.

 

1. P/S ratio is screwed up due to inconsistent way in how sales are accounted for. Take GM for instance, they have equity partnerships in China, their sales do not show up in the denominator. Profits however show up on their income statement and this effects the earnings that are being reported and thus the price being paid for GM. The author shows that this effect is quite big over the last several years.

 

P/S may in fact be high but the point is that it is nowhere near as high as implied by your chart due to this inconsistent data.

 

2. The same argument above also applies to profit margins. In addition, we also need to look at ROE. Just because profit margins are high does not mean they would mean revert. Say a company used to generate 10% ROE in the past with 6% margins, if the same company needs 10% margins to generate the same 10% ROE, then there would be no need to mean revert. There is evidence that this in fact had a major effect. Pzena had data around this in one of his recent letters.

 

To take a more extreme example if your profit margins are higher than the past but your ROE is say below 5%, would other companies be rushing in to get the 5% ROE due to high profit margins?

 

Vinod

 

Regarding point #1:

 

The author goes into excruciatingly painful detail to simply conclude that DOMESTIC CORPORATE BUSINESS NET PROFIT MARGINS are 49% above the 1947-2013 average and 55% above the 1947-2002 average. Please see attached.

 

So honestly I have next to no idea what his overall point is, outside of debunking a chart that is simply one of many (even if it is wrong) pointing to the same thing.....profit margins are elevated well above historic norms.

 

I'd love to see data supporting the "JV income is so massive it is distorting NPMs across the board" argument. Most of Coke's revenue flows through its sales line versus a JV calculation. Yes GM happens to have a large JV line - but what about Parker Hannifan, Cummins, Pepsi, Mondelez etc... etc....? That's hardly a factor, and I think it comes through in the author's chart I've attached.

 

Regarding point #2:

 

It's a great point if in fact average ROEs are at or below historic norms due to lower leverage and lower asset turnover.

 

I would posit that given the exceedingly high leverage across sectors (govt, house, corp) and the low level of investment since the GFC, that leverage ratios and asset turns are higher than historic averages. Combined with above average profit margins, I imagine a broad look at ROEs would show well above-average levels.

 

Point #1

 

Please see attached. The first chart shows EBIT vs GDP over the last 66 years. You would see that EBIT margin is about 12% higher than the median for the last 66 years.

 

The main point is that margins are not as higher as it is made out to be by the bears. He is not saying margins are not high. Just that they are not as high as Hussman makes it out to be i.e. something like 60% or 70% higher than average. There are lots of reasons for why margins are high today.

 

If you account for all these factors (JV income, lower taxes, lower interest expenses), margins are probably only 20% or so higher. This suggests caution not panic and abandonment of stocks which is which is what is implied by bears who suggest margins are 70% higher than historical average.

 

Margins might go down to historical averages but even if it happens, it would be a multi-decade long process.

 

Point #2

 

From the limited data that I have seen current ROE (properly adjusted as there are changes by S&P from what I heard during the late 1980s) is only modestly higher than in the past.

 

Take a look at the bottom chart in the attached. It has historical ROE for developed countries together.

 

A very kind gentleman on Fool provided some data for US when I asked this question (http://boards.fool.com/ot-long-term-averages-31148472.aspx?sort=whole#31151116). ROE for US is about 15% higher currently than the average of the past 3 decades. It does not include Financials & Utilities, so it is likely ROE is not even that high right now compared to historical averages.

 

Vinod

 

The EBIT margin data is interesting, but without adjusting for everything Jess Livermore did, I don't know how to square your statement that NPMs are only 20% above the new norm versus the 45 to 55% Livermore came to.

 

But yes the point is taken that margins are not as high as Hussman would have you believe. I still don't know why that justifies paying such high multiples.

 

Taking the 2012 sales level of 1,495 in the chart I posted yesterday for the S&P Industrial Average, and using an 8.5% NPM, earnings are $127. At a 2,500 index level (based on 1.71 x 2013 sales of 1,464), that's 19.7X earnings. Taking 20% off as you posit, the index is trading at 24.6X earnings. If margins are 30% too high, the index trades at 28X earnings.

 

 

If in fact current earnings are "normal", then an average ROE should imply an average PE. A 12% average ROE??? Does this even justify a PE of 15X?

 

Reversion to a 15X PE from the current 19.7X on the SPX Industrial Average would be a -24% decline. Applying that to the 1,890 S&P 500 level, FV would be 1,439.

[bmichaud]

What happened the last time profit margins fell from 12% to 6%?

 

From philosophical economics blog:

 

From January 1967 forward, the 20 year nominal total return (in contrast to the 10 year) was more than 10% per year–despite the domestic NIPA profit margin contracting from roughly 12% to roughly 6%.

 

Vinod

 

For nearly 10 years the market went nowhere with two significant drawdowns. The CAPE contracted from 20 to 10. Ugh.

 

Now I think the biggest lesson to be learned from all of this - which Grantham touches on in his Barron's interview - is that you need a recession to bring all of this stuff back to the mean. So yes the market can stay overvalued for a long time.

 

Though it doesn't mean cyclical factors such as sentiment, technicals etc.... can't get out of whack and produce something like 2011, the 1987 crash, EM crisis in 1997/8.

[vinod1]

What happened the last time profit margins fell from 12% to 6%?

 

From philosophical economics blog:

 

From January 1967 forward, the 20 year nominal total return (in contrast to the 10 year) was more than 10% per year–despite the domestic NIPA profit margin contracting from roughly 12% to roughly 6%.

 

Vinod

 

For nearly 10 years the market went nowhere with two significant drawdowns. The CAPE contracted from 20 to 10. Ugh.

 

Now I think the biggest lesson to be learned from all of this - which Grantham touches on in his Barron's interview - is that you need a recession to bring all of this stuff back to the mean. So yes the market can stay overvalued for a long time.

 

Though it doesn't mean cyclical factors such as sentiment, technicals etc.... can't get out of whack and produce something like 2011, the 1987 crash, EM crisis in 1997/8.

 

Yes, but that has nothing to do with profit margins! Market went down during the first 10 years because of unexpected inflation due to oil shock. So if you had a bearish outlook based on profit margins, you would have been right for the wrong reasons.

 

If all we need is a recession to bring down profit margins, we had a pretty big recession during 2008-2009. If profit margin bears had been correct, the margins would have remained depressed after the recession has ended. But they went back right up. Cyclical factors like recessions would bring down profit margins temporarily, but we are talking more about long term margins.

 

I had been very bearish primarily due to very high profit margins and that is the principal reason I was down only 1.5% in 2008. I had invested most of my available cash during the crisis. I felt vindicated that I had been right all along. Then as recovery took hold and in 2011, much to my horror profit margins recovered all the way. Primarily due to availability of very cheap banking stocks I had been able to maintain about a 100% stock exposure.

 

See, I got bailed out of my stupidity twice entirely due to luck - first time banking crisis knocked down the market, second time making bank stocks ridiculously cheap.

 

I am worried market might not be so kind to bail me out a third time if I make another pig headed move based on worry about profit margins.

 

Vinod

[vinod1]

 

The EBIT margin data is interesting, but without adjusting for everything Jess Livermore did, I don't know how to square your statement that NPMs are only 20% above the new norm versus the 45 to 55% Livermore came to.

 

But yes the point is taken that margins are not as high as Hussman would have you believe. I still don't know why that justifies paying such high multiples.

 

Taking the 2012 sales level of 1,495 in the chart I posted yesterday for the S&P Industrial Average, and using an 8.5% NPM, earnings are $127. At a 2,500 index level (based on 1.71 x 2013 sales of 1,464), that's 19.7X earnings. Taking 20% off as you posit, the index is trading at 24.6X earnings. If margins are 30% too high, the index trades at 28X earnings.

 

 

If in fact current earnings are "normal", then an average ROE should imply an average PE. A 12% average ROE??? Does this even justify a PE of 15X?

 

Reversion to a 15X PE from the current 19.7X on the SPX Industrial Average would be a -24% decline. Applying that to the 1,890 S&P 500 level, FV would be 1,439.

 

The 20% number is just my guess. I really dont know.

 

I am not sure what index you are talking about, the russell 2500 index? Also, I can see how you can relate BV multiple to ROE but not to PE.

 

If I use S&P 500 index, sales per share are about $1100. Using preliminary 2013, Q4 data, reported earnings for 2013 are about $100 per share. Even if you believe these are not sustainable, companies are in fact generating these earnings. Put a 15 multiple then fair value is about 1500 or about 20% overvaluation from its current levels. The index trades at 19 times. Expensive, sure. But do not see  40% or 50% losses.

 

This again assumes that interest rates are going to normal levels pretty soon. If interest rates remain low for a very long time, then I can see why a higher multiple would be justified. We have to assume that most investors would stupidly earn 1-2% (after-tax) on bonds while equity investors would get to enjoy 9-10% returns in stocks. GMO also makes the same point about interest rates and valuation levels.

 

Given the uncertanity around rates, do we really have strong enough evidence that markets are vastly overvalued as in 70-80%?

 

Vinod