two common market fallacies

market cap/GDP

I was reading an article on Yahoo Finance the other day that cited what it claimed was a Warren Buffett rule to gauge whether the US stock market is under- or overvalued. The idea is that if the total market cap of US stocks exceeds annual GDP (of the US) then stocks are overvalued. If market cap is less than GDP, stocks are undervalued.

On the surface, this sounds like it might make sense, since it is the US stock market, after all. And the health of the Treasury bond market is tied to the vigor of the US economy. Also, the idea was big in the 1980s, when market cap/GDP was used by Americans and Europeans as a rationale for not becoming involved in the Japanese stock market during a decade-long domestic economy boom there.

Two issues this idea ignores:

–multinational companies. In the case of the US, a good guess is that half the earnings of the S&P 500 come from outside the US. In fact, a very simple but effective way of approaching structuring a portfolio in the US market is to ask whether the US economy will likely do better than the rest of the world in the year ahead or worse. In the first case, the portfolio should overweight domestic-oriented stocks; in the second, internationally-oriented.

–how much of the domestic economy is publicly traded. In the case of the US, big sectors like real estate and housing have little representation. Germany, whose market cap has seldom, if ever, exceeded half of the country’s GDP, is the biggest counterexample for the cap/GDP idea. Two reasons: almost nothing is listed in Germany, and German citizens have historically had little interest in stocks.

For the record, I can’t imagine Buffett thinks this.

strong stock market = strong economy

Typically, this is the case, in my experience. But there are exceptions, like Mexico in the 1980s–and Germany almost always. In today’s US, it’s easy to see, by comparing the global NASDAQ with the US-centric Russell 2000, that stocks are strong in spite of weakness in domestically-oriented issues. In fact, somewhat like Mexico back then, the US market is underpinned by the near-zero interest rates made necessary by our extreme economic weakness.

A side note: over the past three months, the R2000 (+22.7%) has held its own with NASDAQ (+24.5%). Both have far outdistanced the S&P 500 (+17.5%). Why the R2000 strength? Three possible reasons (translation: I don’t know): counter-trend rally; the worst of the pandemic is already baked into R2000 prices; anticipation that Trump will not be reelected. My guess is some combination of the first two. I think it’s too early to be trying to figure out the election, although belief in four more years of Trump dysfunction should translate into shorting the dollar and the R2000.

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.

why are higher interest rates good for banks?

There are two factors involved:

behavior of bank managements:  To a considerable degree, commercial banks are able to use changes in interest rates to their money-making advantage.  When rates are declining, banks immediately lower the interest they pay for deposits but they keep the rates they charge to borrowers high for as long as they can.

When rates are rising, as is the case in the current economic environment, banks do the opposite.  To the degree they can, and given that most loans are variable-rate that is considerable, they raise rates to borrowers immediately.  But they keep the interest rate they pay for deposits low for as long as they can.

A generation ago, banks had a much greater ability  than they do now to maneuver the interest rate spread.  That’s because money market funds were in their infancy.  There were no junk bonds to serve as substitutes for commercial loans.  There was even a Federal Reserve rule, Regulation Q, that prevented banks from paying interest on checking accounts and put a (low) cap on what they could pay to holders of savings accounts.

Nevertheless, especially as rates are rising, spreads still can widen a lot.

economic circumstances:   bank lending business tends to tail off in recession, since most companies don’t want to take the risk of increasing their debt burden during bad times–even if the potential rewards seem enticing.  The credit quality of existing loans also worsens as demand for capital and consumer goods flags.

The opposite happens during recovery.  The quality of the loan book improves and customers begin to take on new loans.

stock market effects

The market tends to begin to favor banks as soon as it senses that interest rates are about to rise.  Wall Street was helped along this time around when perma-bear bank analyst Mike Mayo turned positive on the group for the first time in ages last summer.

After the anticipatory move, banks have a second leg up when the extent of their actual earnings gains becomes clear.  It seems to me the first move has already come to an end   …but the second is still ahead of us.

Warren Buffett selling Wal-Mart (WMT)

Investment companies are required to file lists of their holdings with the SEC at the end of each quarter.  The latest such 13-F form for Berkshire Hathaway shows a buildup in Apple and airlines   …and the sale of virtually all of Buffett’s long-term holding in WMT.

WMT as icon

A powerhouse in the 1970s and 1980s, WMT has been a bad stock for a long time.  It had a moment in the sun during the market meltdown from mid-2007 through early 2009, when it rose by about 1% while the S&P 500 was almost cut in half.  Since the bottom, however, WMT has gained 40% while the S&P is up by 219%.

Wal-Mart isn’t an obviously badly run company.  It isn’t, say, Sears, or the Ackman-run J C Penney.  But it does have a number of impediments to achieving significant growth in earnings.  One is its already gigantic size.  A second is its focus on less affluent rural customers who were disproportionately hard-hit by recession and who have in many instances yet to recover.  There’s increased competition from the dollar stores.   And there’s Amazon, whose competitive threat WMT itself admits it played down for far too long.

My reaction:

old habits die hard.  Mr. Buffett built his career from the 1950s onward on the observation, novel at that time, that traditional Graham/Dodd portfolio investing techniques glossed over the considerable value of investment in intangible assets–brand names, distribution networks, superior business practices.  However, by the time I entered the business in the late 1970s, other people–me included–were beginning to adopt his methods.  So thinking about intangibles became part of the toolkit, rather than something special.  Then, of course, the internet began to erode the power of intangibles to stop newcomers from entering a business.  Mr. Buffett, like any successful incumbent (including WMT), has been slow to adapt.

WMT as metaphor for today.  WMT could become more profitable quickly if its heartland lower-income customer base could earn more money.  One way to do that would be to bar imported goods from the country, with an eye to creating manufacturing jobs in the US.  Of course, that would also destroy the WMT value proposition in the process.  So rolling the clock back to 1950 isn’t the answer, either for the health of WMT or for its customers.