the stock market cycle–where are we now?

As I wrote yesterday, stock market price-earnings multiples tend to contract in bad times and expand during good.  This is not only due to well-understood macroeconomic causes–the effect of higher/lower interest rates and falling/rising corporate profits–but also from psychological/emotional motivations rooted in fear and greed.

(An aside:  Charles McKay’s Extraordinary Popular Delusions and the Madness of Crowds (1841) and Charles Kindleberger’s Manias, Panics and Crashes (1978) are only two of the many books chronicling the power of fear and greed in financial markets.  In fact, the efficient markets theory taught in business schools, which denies fear and greed have any effect on the price of financial instruments, was formulated while one of the bigger stock market bubbles in US history, the “Nifty Fifty” years, and a subsequent vicious crash in 1973-74, were taking place outside the ivory tower.)

Where are we now?

My take:

2008-09  PEs contract severely and remain compressed until 2013

2013  PEs rebound, but only to remove this compression and restore a more typical relationship between the interest yield on bonds and the earnings yield (1/PE) on stocks.

today  The situation is a little more nuanced.  The bond/stock relationship in general remains much the way it has been for the past several years, with stocks looking, if anything, somewhat undervalued vs. bonds.  But it’s also now very clear that, unlike the situation since 2008, that interest rates are on an upward path, implying downward pressure on bond prices.

In past plain-vanilla situations like this, stocks have moved sideways while bonds declined, buoyed by an early business cycle surge in corporate profits.

Since last November’s presidential election, stocks have risen by 10%+.  This is unusual, in my view, because we’re not at the dawn of a new business cycle.  It comes from anticipation that the Trump administration will introduce profit-boosting fiscal stimulus and reforms.  The “Trump trade” has disappeared since the inauguration, however.  Our new chief executive has displayed all the reality show craziness of The Apprentice, but little of the business acumen claimed for the character Mr. Trump portrayed in the show–and which he asserts he exhibited in in his long (although bankruptcy-ridden) career in the family real estate business.

Interestingly, the stock market hasn’t weakened so far in response to this development.  Instead, two things have happened.  Overall market PE multiples have expanded.  Interest has also shifted away from business cycle sensitive stocks toward secular growth stocks and early stage “concept” firms like Tesla, where PEs have expanded significantly.  TSLA is up by 76% since the election and 57% so far this year–despite the administration’s efforts to promote fossil fuels.  So greed still rules fear.  But animal spirits are no longer focused on beneficiaries of action from Washington.  They’re more amorphous–and speculative, as I see it.

Personally, I don’t think we’re at or near a speculative peak.  Of course, as a growth stock investor, and given my own temperament, I’m not going to be the first to know.  It does seem to me, however, that the sideways movement we’ve seen in the S&P since March tells us we are at limits of where the market can go without concrete economic positives, whether they be surprising strength from abroad or the hoped-for end to dysfunction in Washington.

 

discounting and the stock market cycle

stock market influences

earnings

To a substantial degree, stock prices are driven by the earnings performance of the companies whose securities are publicly traded.  But profit levels and potential profit gains aren’t the only factor.  Stock prices are also influenced by investor perceptions of the risk of owning stocks, by alternating emotions of fear and greed, that is, that are best expressed quantitatively in the relationship between the interest yield on government bonds and the earnings yield (1/PE) on stocks.

discounting:  fear vs. greed

Stock prices typically anticipate or “discount” future earnings.  But how far investors are willing to look forward is also a business cycle function of the alternating emotions of fear and greed.

Putting this relationship in its simplest form:

–at market bottoms investors are typically unwilling to discount in current prices any future good news.  As confidence builds, investors are progressively willing to factor in more and more of the expected future.

–in what I would call a normal market, toward the middle of each calendar year investors begin to discount expectations for earnings in the following year.

–at speculative tops, investors are routinely driving stock prices higher by discounting earnings from two or three years hence.  This, even though there’s no evidence that even professional analysts have much of a clue about how earnings will play out that far in the future.

(extreme) examples

Look back to the dark days of 2008-09.  During the financial crisis, S&P 500 earnings fell by 28% from their 2007 level.  The S&P 500 index, however, plunged by a tiny bit less than 50% from its July 2007 high to its March 2009 low.

In 2013, on the other hand, we can see the reverse phenomenon.   S&P 500 earnings rose by 5% that year.  The index itself soared by 30%, however.  What happened?   Stock market investors–after a four-year (!!) period of extreme caution and an almost exclusive focus on bonds–began to factor the possibility of future earnings gains into stock prices once again.  This was, I think, the market finally returning to normal–something that begins to happens within twelve months of the bottom in a garden-variety recession.

Where are we now in the fear/greed cycle?

More tomorrow.

results from Disney (DIS): a lesson in how the market works nowadays

DIS and ESPN

A relative in the movie business called my attention to Marvel Entertainment a few years ago.  When it was acquired by DIS in late 2009, I held onto the stock I got and added more in the mid-$20 range Marvel, of course, has been pure gold for DIS, even though DIS initially went down on fears that DIS had overpaid.  Naturally I sold the stock way too early, in the mid-$60s–acting more like a value investor than a growth stock fan.

My first thought on reading the DIS 10-K, as I acquainted myself with the company,was that the company really should have been named ESPN, since at that time the cable sports network accounted for 2/3 of DIS’s overall operating profit and virtually all of its earnings growth.

red flags about ESPN

Over the past several years, a number of key warning signs have popped up about ESPN, however:

–ESPN decided to expand into the UK, signalling to me that it considered its US franchise on the cusp of maturity

–but ESPN was outbid for soccer rights by locals and effectively terminated its international expansion ideas–not good, either

–DIS began to shift cash flow away from ESPN and toward the movie and theme park business, which I took to be a sign of corporate worries about ESPN’s growth potential, rather than simply diversification for diversification’s sake

–serious discussion has begun over the past year about the demise of cable system bundled pricing, which likely benefits ESPN substantially (I suspect we’ll find out how substantially sooner rather than later)

–since ESPN.com’s recent format change, I find myself almost exclusively using Time Warner’s Bleacher Report for sports information

–personally, although this isn’t the most crucial part of my analysis, I think the progressive dumbing-down of ESPN coverage, in imitation of sports talk radio, to gain a wider audience will backfire.

To sum up,, there has been an increasing collection of evidence that ESPN probably won’t be the same growth engine for DIS that it has been in the past.

Yet…

…DIS shares were down by about 10% in Wednesday trading (in an up market) on the first signs in the earnings report of the factors I’ve just listed.

discounting?

Where was the market’s discounting mechanism, which in the past has been continuously evaluating corporate strategy and factoring worries like the long list I’ve mentioned above into the stock price?

…only on the earnings report, not before

To my mind, DIS trading yesterday is another indicator that information isn’t flowing on Wall Street as fast as it once did.  That’s neither good nor bad;  it’s just the way the game is being played in today’s world.  What we as investors have got to figure out is how to adjust our own behavior to fit altered circumstances.

My initial thought is that it may be riskier than it has been to dabble in down-and-out industries like mining or oil until the final bad news has hit income statements.

 

more on discounting

In actual practice, judging what the market has already discounted in the price of an individual stock or the prices of stocks in general, is a tricky thing.  Even seasoned professionals are often wrong.

There are trends in overall market direction that are relatively easy to spot.  In a bull market, investors tend to ignore bad news and respond strongly to good.  In bear markets, the opposite happens.

Perhaps the main reason for professionals that technical analysis is more than a curious practice of a more primitive time is that watching for deviations from the usual daily price action of individual stocks can give clues to what other investors are thinking/doing.  Rises on unusually high volume, for example, can suggest that others are figuring out what you already know and have acted on.  On the other hand, failure of the stock to react positively to news that supports your positive thesis suggests that what you thought was a new, investable insight actually wasn’t.

The reality that investors only act piecemeal, or the idea that we act differently when infused with greed than when in the vise grip of fear are both much too untidy for the statisticians who formulated the Efficient Market Hypothesis/Capital Asset Pricing Model that arose in the 1970s (and which–mind-bogglingly–is still taught in business schools).

These theories have no place for observation/practical experience.  They assume that everyone has the same information and that the market factors new information into prices instantaneously.  What’s particularly ironic is that they were formed during the early 1970s.  How so?

–1972 was the peak of the “Nifty Fifty” or “One-Decision Stocks” speculation.  Investors believed that a small number of stocks–Kodak, Xerox, National Lead, for example–would grow rapidly forever.  Therefore, they should never be sold, and no price was to high to pay to acquire them.  The result was that this group of names traded at as high as 110x earnings–in an environment where the 10-year Treasury yielded 6% and the average stock traded at 11x.

–this high was immediately followed by a vicious bear market in 1973-74 that saw stocks trade in mid-1974 at discounts to net cash on the balance sheet–and still go down every day, on the theory that money in the hands of management scoundrels wasn’t worth 100 cents on the dollar.

How is it that these guys didn’t notice?

discounting and today’s equity market

Discounting is the term Wall Street uses for the idea that investors factor into today’s prices, to a greater or lesser degree, their beliefs about the future (I wrote a detailed post about the process in October 2012).

 

Two of the major macroeconomic factors the market is wrestling with now are the timing and extent of the Fed’s future moves to raise interest rates from their current emergency lows, and the possibility that Greece will default on its debts and exit the euro.

 

My experience is that almost nothing is ever 100% discounted in advance.  There’s always some price movement when the event actually happens.  Having said that, the coming rise in interest rates in the US has been so anticipated–and talked about by the Fed–for such a long time that there may even be a positive market reaction to the first rise.  This would be on the idea that Wall Street would give a sigh of relief when there’s no more anticipatory tension to deal with.  More likely, there’ll be a mild negative movement, for a short period, but that’s all.

The Greek financial crisis has also been in the news for a long time.  But we don’t have the same extensive history of behavior during past economic cycles to draw on, the way we do with the Fed.  We do have Argentina as a case study in what happens to the defaulting country (personally, I expect the consequences of default for Greece would be pretty terrible for its citizens).  But the focus of investors’ concern is what damage might be done to the EU by Greece’s leaving.  In addition, lots of non-economic factors are involved in this situation.  There’s Greece’s central role in Europe’s beliefs about its own exceptionalism.  There’s the Greek portrayal of the EU’s requirement that Greece implement structural economic reform as a condition for debt relief as 21st-century Nazism.  There’s the status quo in Greece that has benefited from the country’s profligate borrowing.  There’s fear of the unknown that must be urging politicians to paper over Greece’s problems.

In addition, my sense is that the markets’ overriding emotion so far is denial–hope that the whole situation will go away.  Current thinking seems to be that the parties will arrange for some sort of default, along with capital controls to restrict the flow of euros out of Greece, that will allow Greece to stay in the EU.  Still, I find it very hard to calculate odds or even to anticipate what the worst that can happen might be, or the best.  This makes me think that very little of the possible negatives of “Grexit” are factored into today’s prices.

More tomorrow.

the equity discounting mechanism: how it’s working today

Happy Halloween!

discounting at work today

My previous post was about what the equity discounting mechanism is. Today I want to give my take on how discounting is working in today’s US stock market.

The US market has been rising since June, despite the evidence of widespread global slowdown. How can this be?

economic slowdown, but uptrending market??

Several macro reasons:

  1. After five years of decline, the US housing market has been giving strong signs of bottoming for some months and is recently beginning to rise. Housing is important in the US, not only for the construction jobs it brings, but because it’s the largest source of wealth (or potential wealth) for most Americans.
  2. Around mid-year the leadership of the EU seems to have stopped living in denial about the Eurozone’s structural problems and begun to take positive action to address them. Yes, resolution may take a half-decade. Yes, Greece may get tossed out and the UK may voluntarily withdraw. But the basic direction of government policy appears to have changed.
  3. Beijing has already taken a number of measures to reinvigorate its economy. Yes, any dramatic steps will probably await the installation of new top leadership in the Communist Party there. But, again, the basic stance of government economic policy appears to be reversing itself from contractionary to expansionary.
  4. The US Fed has announced that it intends to keep the current extraordinarily-low level of short-term interest rates in place for at least the next 2 ½ years. Ultimately, rising interest rates will be a threat to world bond, and to a lesser extent, stock markets. But that’s not likely to be anytime soon.

two discounting judgments

Two qualitative discounting judgments are involved in the upward move of global indices over the past five months:

–the first is that there’s no longer any percentage in betting that conditions will continue to deteriorate. That’s already been fully, or very close to fully, discounted by the prior price declines.

–the second is that the three macro forces listed above are powerful enough for investors to begin discounting potential future good news into today’s stock prices.

 unusual?

In my view, there’s nothing unusual about this. It’s the standard macro-based anticipatory discounting that has occurred at business cycle turning points over the thirty years or so that I’ve been involved in global stock markets.

To my mind, what is unusual, though, is the apparent disconnect between the macro discounting judgment that the worst is behind us and the very violent micro discounting being done as companies report 3Q12 earnings results.

two separate judgments

In theory, these are two separate kinds of judgments–how benign or hostile the overall economic environment is likely to be vs. what earnings prospects are for individual companies. But in practice, investors, in my experience, tend to ignore poor company results during a transition period between macro trends. The bad numbers are usually dismissed as “old news,” the last artifacts of a trend that has already been relegated to the scrap heap (or, if you prefer, the recycling center).

Not this time, though. Companies that disappoint are being aggressively sold off.

Why should this be?

More important, should this strong micro-related discounting undermine confidence that the macro trend has indeed reversed?

I can think of a couple of reasons macro and micro discounting could be following different paths:

–the most likely, in my view, is the current valuations of business cycle-sensitive stocks. Typical market turning points in the past have been 2009-like affairs. Not as ugly, but conceptually similar. Those bottoms occur at the end of extended bear markets, when overpowering fear is rampant and all stocks have been sold down to levels which—in hindsight—will appear ludicrously low. The most cyclically sensitive will often be crushed, priced as if they’re going out of business.

In the quarters immediately following these market turns, the negative effect of earnings disappointment on individual stock prices is offset by the positive of extremely low valuations.

That’s not the case today. We’re more than three years past the 2009 bottom, and about 100% higher than the absolute lows. So disappointing stocks don’t have the valuation cushion they normally do.

If I’m correct, the selloffs of cyclical stocks on bad earnings doesn’t undermine the macro case that the overall market trend has changed in a favorable way. It just means this upcycle is different and will be more muted than the standard pattern.

–it may also be that both buy-side and sell-side firms are no longer integrated, having both macro and micro researchers, as they have been in the past. In the integrated model, either the chief investment officer or a committee of senior staff would set an overall investment policy. To a significant extent, the overall investment stance, bullish or bearish, would be coordinated with, and reflected in, recommendations about individual stocks.. In an up market, portfolios wouldn’t sell cyclical stocks; disappointing earnings would be ignored. On the sell side, cyclical stocks would continue to be recommended, not downgraded.

In today’s world, in contrast, brokerage firms have dismantled their research departments. Many hedge funds specialize in macro research only. Others run highly concentrated portfolios that hold only a handful of names. There are many more short-sellers, as well.

So it may be that the market for individual stocks is becoming much less uniform in its thinking—and thereby much more volatile–than it has historically been.

–there are other possibilities, but less probable and not worth mentioning here.

the equity discounting mechanism: what it is

SF Giants–World Series Champions!!!

discounting

I’m going to write about this topic in two posts.  Today’s will cover the basic idea.  Tomorrow, assuming Hurricane Sandy has left the cable and electric power lines alone, I’ll apply them to the current situation in world equity markets.

Here goes:

Discounting” is a piece of Wall Street jargon.  It refers to the process in which investors factor into current stock prices their expectations about future events. It’s also used to describe the degree to which this process is complete.

Although most pople don’t think about it that much, the stock market is in many ways a futures market.  For example:

Based on trailing twelve months’ earnings, AMZN trades at a PE multiple of more than 3000x.  That’s over 200 times the PE of the average US-listed stock, which is trading at about 14x.  True, to some degree this is because AMZN uses extremely conservative accounting principles.  But it’s mostly because buyers are basing their purchase decisions on strong positive beliefs about AMZN’s future growth prospects.

In contrast, Seagate Technology (STX) is currently trading at 3.4x eps, implying that investors don’t hold high expectations for its future profits.  If we look at current earnings as a percentage of the current purchase price, a buyer is earning at a current rate of almost 30% of cost per year.  I don’t want to get into valuation metrics in this post but, believe me, but 30% is a lot, if you expect the current earnings level to be sustained or increase.

a qualitative term

Discounting isn’t a quantitative term.  It’s an expression of judgment.  I think the AMZN price is crazy high.  I’d express my reaction a bit more elegantly by saying that I think the AMZN quote already discounts much more profit growth than I can see the company ever achieving.

My impression isn’t worth very much, however.  I haven’t done any careful analysis of the company for years.  It may be that other researchers have, say, recast AMZN’s financials into a more conventional format that shows the PE multiple to be much, much lower than 3000.  The same people may also be envisioning a very sharp growth trajectory for earnings over the next five-ten years–and have a reasonable basis for doing so.  Such researchers would likely  express their judgment by saying that the market has not yet fully discounted AMZN’s prospects.

two forms

Discounting has two general forms:

–macroeconomic, where investors take conclusions about the overall economic environment and use them to draw inferences about the profit prospects for stock market sectors, industries and individual stocks, and

–microeconomic, where investors base their conclusions principally on their analysis of the individual companies they are focused on without much regard for the macro environment, other than as a mild head- or tailwind.

For very mature companies, which are so large that their growth can’t be much different from that of nominal GDP in the areas where they operate, investors typically use a blend of both forms.

For what it’s worth, Americans typically favor a bottom-up micro style for almost everything; Europeans typically prefer a top-down macro style.

two stages

Discounting begins to happen far in advance of facts.  Call this sort of discounting anticipatory.  It can be most easily seen in turns in the business cycle.  Wold stock markets bottomed in March 2009.  World economies reached their nadirs about six months later.

AAPL shares bottomed in relative performance terms in early 2005 at a price of about $40 (Note from April 2015:  this price is adjusted for the stock’s 2/1 split in February 2012, but not for the 7/1 split in 2014)..  During that year it traded at about 30x earnings, or about twice the market multiple.  I remember that one of my then colleagues would visit my office daily urging me to sell, on the argument that every possible future favorable event was already discounted in the price.

In reality, the opposite was happening.  The market was beginning to sense the changes that were occurring in the firm and were bidding up the stock as a result.  It’s up over 17x since.

A second kind of discounting, call it adjusting, happens when an event where opinions about possible outcomes have already been factored into a stock’s price actually occurs.

What follows is a period of recalibration, as expectations are adjusted in light of new facts.  If the actual results are surprisingly good–that is, better than have been already discounted–the stock typically quickly goes up.  If the results are surprisingly bad, the stock typically drops over the following few days–and then usually continues to drift downward over the following weeks and months.

The existence of two stages of discounting is what leads to Wall Street’s Yogi Berra-esque belief that “nothing’s ever fully discounted until the event occurs.”

Tomorrow (Hurricane Sandy willing):  using these ideas to assess the current stock market situation.