Monday, December 8, 2008
Motion vs. Movement
In a Mid-October Insight we offered the following prediction:
I believe we have now entered purgatory. Valuations are low enough, but we have too much uncertainty to expect an immediate up-trend. Government action has been announced, but not deployed. Until the markets get a chance to assess the impact of the programs, skepticism will act as a governor. While entering a trading range may not seem cause to celebrate, it’s certainly preferable. We could all use the rest.
I wrote that on October 17th when the S&P traded for 918. Since then it has climbed as high as 1008 and fallen as low as 741. We ended last Friday, November 28, at 896 and closed Friday, December 5, at 876, 18% off the low point and 13% off the high point. While all of this motion has provided few opportunities for rest, it hasn’t produced any meaningful directional movement. In fact, of the 33 trading days since that email, there have been 16 up days and 17 down days. With a power vacuum in Washington, blackmail from Detroit, paralyzed credit markets, cascading jobs losses, municipal distress and the Titans loss to the Jets, one might expect these markets to be trading significantly lower. Why haven’t they?
The Investors, Lenders, and Consumers of Last Resort
Clearly the capital markets are not functioning normally. Volatility in the stock markets rivals levels not seen since the 1930s, and the lending rates in the bond markets exhibit historic risk aversion. In the absence of private capital, only public capital remains. The Federal Reserve, the Treasury and Congress each have roles to play, with the Federal Reserve as the lender, the Treasury as the investor and Congress as the consumer.
The Federal Reserve has implemented a cornucopia of programs to liquefy frozen markets. While historically acting as a lender of last resort to banks, they have also announced lending programs for money markets, commercial paper, mortgages, longer-term corporate borrowing, and consumer based asset backed securities. With the effective Fed Funds rate at zero, they have exhausted their traditional ammunition and are now using policy to force down interest rates in non-banking related markets. This is very significant in my view.
The most obvious manifestation has been the dramatic reduction in mortgage rates. 30 year fixed rate mortgages have fallen from 6% to 5.5% in the last week, inspiring record mortgage activity. This subtle shift tripled mortgage refinancing and increased home purchase activity by 38%, not to mention the immediate interest savings for those with floating rate mortgages. This action lowers payments which increases affordability and purchasing power. New overtures suggest that the Fed won’t stop until rates fall to 4.5%. Wow.
Remember, too, that the Fed can borrow money at today’s Treasury rates, meaning that any income they receive from entering frozen markets above 2% or so will actually provide a positive carry and earn them a profit. Think of the Fed as a REALLY big investment bank.
The Treasury has one singular purpose at this point, and that is to maintain the solvency of the financial system. Worldwide, we have written down $850 billion or so in assets on financial services balance sheets. These write-downs amount to eroded capital that must be replenished. The TARP program has provided $250 billion, another $250 billion or so has been provided to European banks, with the remainder coming from private sources or eternally written off. Total write-downs may end up climbing into the region of $1.5 trillion, which means we may need to double the amount of injections we have already made. That would consume another $250 billion of TARP funds, taking us to $500 billion, with $200 billion to spare.
In other words, Treasury’s $700 billion appears to be enough to re-capitalize the US financial system. For that they will receive 5% interest payments and warrants on equity purchases. Think of the US Treasury as an opportunistic private equity firm.
Congress will ultimately vote on a significant fiscal stimulus package. With US GDP running around $14 trillion, a 5% package would amount to $700 billion. Figuring out how that money will be allocated will be tricky, but let’s assume that it will be a mix of tax cuts, spending programs and tax rebate checks. With the previous stimulus checks, it appears that 50% of the money was spent (higher consumption) and 50% was saved (higher bank deposits). Effectively, this was good for GDP growth and good for banks. The downside of Congressional spending is that the returns are more diffused. Higher economic activity should mean higher tax receipts, but this equation is dynamic and complex. In reality this deficit spending will simply have to be repaid down the road by the taxpayer, in effect borrowing future GDP for GDP today. Think of Congress as a credit rich shopaholic.
The governmental combination of lender, investor and consumer creates an economic juggernaut worth respecting. Betting against its effectiveness at this point seems risky, providing the first of our two stabilizing forces.
The Math Be Good
Now that the lion’s share of the hedge fund forced selling for 2008 has passed, markets have begun exhibiting more normal characteristics. With 2009 S&P 500 earnings expectations ranging from $40 on the low side to $100 on the high side, earnings are anyone’s guess. The real question we should be asking is what multiple (Price/Earnings) should we apply to these earnings to come up with a fair value for the S&P 500? The largest influences on P/E multiples are inflation and longer term interest rates. High inflation requires higher multiples, and low inflation supports lower multiples. Higher long-term interest rates require lower multiples and lower long term interest rates support higher multiples. We have no inflation currently (just see the price of oil), so that affords higher multiples. Because of the Fed’s action, long term interest rates are falling, so that should support higher multiples. Let’s look at previous market bottoms, the yield on the 10 year Treasury bond and the associated stock market multiple (p/e ratio) to see if we can draw any conclusion about what an appropriate multiple might be.
Bear Market Ten Year Expected Actual
Bottom Dates Treasury Yield P/E Ratio P/E Ratio
6/26/1962 3.97% 25 16
10/7/1966 5.02% 20 14
5/26/1970 8.22% 12 13
10/3/1974 8.04% 12 7
8/12/1982 13.55% 7 8
12/4/1987 8.94% 11 14
10/9/2002 3.61% 28 27
12/05/2008 2.67% 37 ???
While expected and actual P/Es may deviate some, the relationship is clear – low interest rates support higher multiples. So with today’s 2.67% 10 year Treasury yield, a mathematical case can be built for a 37x multiple (1/2.67%). That multiple seems optimistic, so let’s cut it in half to 20 (which mathematically would correlate with a 5% Treasury bond yield). Now…if you are still with me…let’s take the most pessimistic earnings assumption of $40 for 2009 earnings and apply our multiple of 20 for a worst-case scenario of 800 for the S&P 500. If 800 is worst case scenario and we are trading 9.5% above those levels, what might a best case scenario look like? Using realistic earnings expectations of $60 a share and applying our 20 multiple gets us to 1200 on the S&P or roughly 37% higher from here. Remember, we are not reaching this level because earnings are rising – indeed, they are falling – we are reaching this level because multiples are rising as long term interest rates are falling. Earnings down = bad. Earnings down and multiples up = good!
I asked a client at lunch on Friday when the last time was that I sounded optimistic to him, and he said late September. That’s true. I fully expected the government to pass the $700 billion bailout package and maintain some crisis-fighting credibility. Unfortunately, they did not, and markets fell dramatically in the subsequent two weeks into October 10th, and have been treading water since then, albeit violently. The setup I am seeing now, with the Fed, Treasury, and Congress positioned appropriately and the long term interest rates affording much higher multiples, makes me optimistic at a time when the economic data has been most horrendous. This may not result in terrific gains from here, but I think you can take the threat of substantial losses off the table for now.
Have a great weekend!
David S. Waddell
Senior Investment Strategist
David S. Waddell quoted, Memphis Daily News , December 2, 2008
David S. Waddell quoted, Commercial Appeal , December 3, 2008
Click here for more information on Waddell and Associates.
**This blog represents the opinion of W&A and is for informational purposes only. It is not intended to be construed as tax or legal advice by the recipient. Past returns of investment are no guarantee of future results.
***Any data reported in this blog has been compiled from the Wall Street Journal, Morningstar, Investors Business Daily, or various other informational internet sites.