Venezuela’s proposed “petro” cryptocurrency

the petro

Yesterday Venezuela began pre-sales of its petrocurrency, called the petro.  The idea is that each token the government creates will be freely exchangeable into Venezuelan bolivars at the previous day’s price of a barrel of a specified Venezuelan crude oil produced by the national oil company.  According to the Washington Post,  $735 million worth of the tokens were sold on the first day.

uses?

For people with money trapped inside Venezuela, the petro may have some utility, since it will be accepted by Caracas for any official payments.  For such potential users, the fact that the government determines the dollar/bolivar exchange rate and that a discount to the crude price will be applied are niggling worries.

perils

The wider issue, which remains unaddressed in this case, is that the spirit behind cryptocurrencies is a deep distrust of government, a strong belief that practically no ruling body will do the right thing to protect the fiscal well-being of users of its currency.

In Venezuela’s case, just look at the bolivar.  The official exchange rate says $US1 = B10.  But the actual rate, as far as I can tell, has fallen from that level over the past year or so to $US1 = B25000.

a little history

The more serious worry is that the history of commodity-backed currencies isn’t pretty.

Mexico

In the 1980s, for example a struggling Mexican government issued petrobonds.  The idea was that at maturity the holder could choose to receive either $1000 or the value of a specified number of barrels of Mexican state-produced crude.  Unfortunately for holders, Mexico reneged on the oil-price link.  My recollection (this happened pre-internet so I can’t find confirmation online) is the Mexico also declined to make the return of principal on time.

the US

The fate of gold-backed securities around the world during the 1930s isn’t so hot, either.  The US, for example, massively devalued (through depreciation of the gold exchange rate) the gold-backed currency it issued.  It also basically banned the private ownership of physical gold and forced holders to turn in the lion’s share of their holdings to Washington in return for paper currency.

 

In short, when the going gets tough, there’s a big risk that the terms of any government-backed financial instrument get drastically rewritten.  This recasting can come silently through inflation.  But, if history holds true, government backing of a commodity link to financial instruments gives more the illusion of protection than the reality–especially so in cases where the reality is needed.

 

 

 

going back up?

As far as US stock are concerned, I don’t know.

As/when the correction is over, however, it’s very important to look for signs of a leadership change.  At a minimum, one former hot industry/sector typically grows ice cold; at least one former laggard heats up.  Figuring this out and tweaking/reorienting your portfolio can make a big difference in this year’s returns.

inflation and stocks

wage inflation in the US?  …finally?

In my earlier post today, I didn’t mention that in the Employment Situation report from the Labor Department a week ago Friday, the annual rate of growth in wages rose from the 2.5% at which it had been stuck for a very long time, despite declining unemployment, to almost 3%.

an aside

Inflation in general is about prices in general increasing.  Deflation is when prices in general are actually falling.  Deflation is scarier than inflation both because it’s less common/harder to treat and because we have the object lesson of Japan, where a quarter-century of unchecked deflation has moved that country from penthouse to basement among world economic powers.

curing inflation

In developed countries, inflation is always about wages.

The garden variety, which seems to be what the Employment Situation may be signaling, is easy to cure.  …a little painful, but easy.

Raise interest rates.

The idea:  businesses want to expand.  To do that they need more workers.  But everyone is already employed somewhere.  So firms have to offer big wage boosts to poach workers from rivals.  Raising interest rates (eventually) stops that.  It increases the cost of expansion and also slows down demand.

Also nipping incipient inflation in the bud prevents consumer behavior from becoming all about defending oneself from it.

who wasn’t expecting this?

For years, economists have been anticipating a rise in inflation.  The first (false, then) alarms sounded maybe six years ago.

But, as they say, nothing is ever fully discounted until it happens.  In addition, Washington is arguably compounding the problem by enacting fiscal stimulus almost a decade too late–making it more likely that rates will go up sooner and more rapidly than if Washington had done nothing.  (Where did the deficit hawks disappear to?)

the state of play in US stocks

down by 12% 

From its intra-day high on January 28th, the S&P 500 dropped to an intraday low of 12% below that last Friday before recovering a bit near the close.

What’s going on?

As I see it, at any given time, liquid investments (i.e., stocks, fixed income, cash) are in a rough kind of equilibrium.  If the price of one of the three changes, sooner or later the price of the others will, too.

What I think the stock market is now (belatedly/finally) factoring into prices is the idea that the Fed is firmly committed to raising interest rates away from the intensive-care lows of the past decade.  That is, rates will continue to rise until they’re back to “normal” –in other words, until yields on fixed income not only provide compensation for inflation but a real return as well.  If we take the Fed target of 2% inflation as a guideline and think the 10-year Treasury should have a 2% real return, then the 10-yr yield needs to rise to 4%  — or 115 basis points from where it is this morning.  Cash needs to be yielding 150 basis points more than it does now.

One important result of this process is that as fixed income investments become more attractive (by rising in yield/falling in price), the stock market becomes less capable of sustaining the sky-high price-earnings ratio it achieved when it was the only game in town.  PEs contract.

Stocks are not totally defenseless during a period like this.  Typically, the Fed only raises rates when the economy is very healthy and therefore corporate earnings growth is especially strong.  If there is a typical path for stocks during a cyclical valuation shift for bonds, it’s that there’s an initial equity dip, followed by several months of going sideways, as strong reported earnings more or less neutralize the negative effect on PEs of competition from rising fixed income yields.

living in interesting times

Several factors make the situation more complicated than usual:

–the most similar period to the current one, I think, happened in the first half of the 1990s–more than 20 years ago.  So there are many working investment professionals who have never gone through a period like this before

–layoffs of senior investment staff during the recession, both in brokerage houses and investment managers, has eroded the collective wisdom of Wall Street

–trading algorithms, which seem not to discount future events (today’s situation has been strongly signaled by the Fed for at least a year) but to react after the fact to news releases and current trading patterns, are a much more important factor in daily trading now than in the past

–Washington continues to follow a bizarre economic program.  It refused to enact large-scale fiscal stimulus when it was needed as the economy was crumbling in 2008-9, but is doing so now, when the economy is very strong and we’re at full employment.   It’s hard to imagine the long-term consequences of, in effect, throwing gasoline on a roaring fire as being totally positive.  However, the action frees/forces the Fed to raise rates at a faster clip than it might otherwise have

an oddity

For the past year, the dollar has fallen by about 15%–at a time when by traditional economic measures it should be rising instead.  This represents a staggering loss of national wealth, as well as a reason that US stocks have been significant laggards in world terms over the past 12 months.  I’m assuming this trend doesn’t reverse itself, at least until the end of the summer.  But it’s something to keep an eye on.

my conclusion

A 4% long bond yield is arguably the equivalent of a 25x PE on stocks.  If so, and if foreign worries about Washington continue to be expressed principally through the currency, the fact that the current PE on the S&P 500 is 24.5x suggests that a large part of the realignment in value between stocks and bonds has already taken place.

If I’m right, we should spend the next few months concentrating on finding individual stocks with surprisingly strong earnings growth and on taking advantage of any  individual stock mispricing that algorithms may cause.

figuring out price-earnings ratios (PEs)

One part of this is easy.

PE is industry jargon.  It’s a shorthand way of expressing the value of an individual stock, an industry group or a whole stock market, in terms of how many times one year’s earnings we’d be willing to pay to own whichever it is.

On the face of it, a low PE, say, 4x, would seem to be good; a high PE, say, 50x, bad.

But how do we know?  What factors enter into determining a PE?

 

A point that I’m maybe too fond of making is that, strictly speaking, there’s no demand for stocks.  There is demand for liquid investments, though (for most people in the US, it’s so they can save to send their children to college and to retire).  Bonds and cash are the other two big categories of liquid investments.  The apparent hair-splitting distinction is important, however, because each fixed income markets is much larger in size than stocks.  They’re also less risky.  The potential returns on these alternatives have a deep influence on what people are willing to pay for stocks.  In fact, academics turn the PE upside down (1/PE) to get what they call the earnings yield on stocks.  If you make the assumption that $1 in earnings in the hands of company management is more or less the equivalent as $1 in interest paid to you by the US Treasury, then the yield on Treasury bonds should (and virtually always does) have a powerful influence on what the earnings yield, and PE of stocks should be.  Why pay 20x for stocks if bonds are yielding 10%?

As I’m writing this, the 10-year Treasury bond is yielding 2.68%.  That’s the equivalent of a PE of 37.  This compares with a PE of 26 on the S&P 500, based on current earnings.   So either stocks are cheap or bonds are overpriced.

Today’s situation is very unusual, given that the financial meltdown in 2007-08 compelled the Federal Reserve to push interest rates down to intensive-care lows.  The consensus judgment of financial professionals, which I think is correct, is that bonds are unusually expensive today, not that stocks are dirt cheap.  If the 10-year is on the way to a 3.5% yield as the Fed returns rates to normal over the next year or two, then the equivalent PE on the S&P would be 28.5x.

That’s about where US stocks are now priced vs. bonds, which suggests that stocks are fully valued if we factor in the likely course of the Fed.  This suggests that only new positive information will move the overall market higher.

Now the going gets harder.

The second important point is the the stock market is a futures market.  That is, it is always pricing in tomorrow’s prospects as well as current earnings.  Willingness to pay for future earnings ebbs and flows with the business cycle, however.  During recessions, investors play their cards very close to the chest and look at most a few months into the future when pricing stocks.  In normal times, the market begins to price in the following year’s earnings in June or July.  In a very buoyant market, investors may pay for earnings two or three years into the future.

 

A third consideration, related to the second, and applying to individual stocks, is the rate of earnings growth.  The importance of this factor changes from time to time.  But a useful general rule is that the PE based on this year’s earnings can reach as high as the long-term growth rate of the company.  In other words, if earnings per share are growing at a 50% annual clip–and will likely continue to do so for the next several years (or at least there’s no easily visible bar to growth like this)–then the PE can be as high as 50x.

 

Generally speaking, the US economy can probably grow at about 4%-5% a year in nominal terms (meaning, including inflation).  If so, publicly traded companies, which are arguably the cream of the crop, will grow earnings per share by about 8% – 10% annually.  All other things being equal, this latter figure should be the trend growth for stocks in general.Put a different way, a company that can sustain growth of 50% a year in an economic environment like this must have something extra special going for it.

This rule of thumb doesn’t work for many “value” stocks, since no growth/earnings declines would imply a zero multiple–which in most (academics would say “all”) cases is clearly wrong (Academics say every stock retains at least a kind of option value).

 

 

business line analysis and sum-of-the-parts

This is mostly a reply to reader Alex’s comment on a post from early 2017 about Disney (DIS).

The most common, and in my opinion, most reliable method securities analysts use to project future earnings for multi-business companies is doing a separate analysis for each business line.  This effort is aided by an SEC requirement that such publicly traded companies disclose operating revenues and profits for each line of business it is in.

In the case of DIS, it’s involved in:  broadcast, including ESPN; movie production and distribution; theme parks and resorts; and sales of merchandise related to the other business lines.

There is plenty of comparative data–from trade associations, government bodies and the financials of publicly traded single-business firms–to help with the analysis.  And every company has, in theory at least, an investor relations department that answers questions put to it by investors. ( My experience since retiring as a money manager for institutional clients is that many backward-thinking well-established companies–DIS and Intel come to mind–can be distinctly unhelpful to their most important supporters, you and me.  (To be fair, I haven’t spoken with DIS’s IR people for several years, so they may be better now.))

Analysis consists in projecting revenues/ profits for each business line and using the results as the key to constructing a series of whole-company income statements–one each for this year, next year and the year after that.

The trickiest part is to decide how to value this earnings stream.  The ability to do this well either comes with experience or from having worked for a professional investor who’s willing to teach.

 

More tomorrow, or in a day or two if I don’t get my film editing homework done today.