Amateur Economics

In November 2008, the top half of the cartoon seemed relevant while in April, 2009 the bottom half seemed to be more true.

Currently, the markets have been trading sideways (but still with a positive attitude towards a fast economic recovery). Yet, as mentioned in my last post, it seems like no one really knows whether we’re going up or if we’re going down. Putting aside the questions about whether the recession is over or not, or what’s going to drive the economic recovery/growth, it is important to analyze whether the current U.S. stock market is “cheap” or “expensive”. Let us look at the S&P 500 and see how it is trading relative to earnings.

Referring to the graph above, we’re at point A. If you look at the level the S&P 500 is trading relative to 2008 earnings, it’s quite over-priced.

POINT A

The graph below shows where the S&P 500 is trading relative to 2008 earnings. It has a Price-to-Earnings ratio (P/E Ratio= Market price per share/Earnings per share) of around 120. In general, a higher P/E ratio means that the a stock or market is more “expensive”. By looking at the graph, it easy to see that the market is trading at what you may consider a “ridiculous” level. Earnings in 2009 may have improved slightly, but the overall concept still stands. Additionally, from a historical perspective, the market is still expensive at 110, 90, o even 70.

Now another graph that illustrates the concept even further is the S&P 500’s actual earnings.

So, the S&P 500’s inflation-adjusted earnings is down by 90%.

I say that means it’s expensive. Nevertheless, some would claim that it is trading at these levels because the market is “forward-looking” and is discounting an economic recovery.

I understand that an economic recovery will come at some point. But should the market be rallying at a pace that would require a super-economic recovery that would bring us to $50 in earnings, or $80?

This brings me to point B.

POINT B

So, point B in the first graph of the post is where the S&P 500 peaked at the end of 2007. Earnings just about hit $90. This may or may not cause you to say, ” the market is recovering to its previous levels”. Not so fast. That 2007 peak was caused by a bubble and achieved through extremely cheap credit and leverage rather than improved productivity and reduced costs. This would mean that organic, sustainable growth to achieve those peak numbers would require a tremendous effort, especially in a short period of time. It could happen, but it’s highly unlikely; therefore, if earnings will not be growing substantially anytime soon, I would say that there is no reason why the S&P should break 1,000 or 1,200 as some people like to suggest.

SUMMARY

The moral of the story is that the market is expensive right now given its earnings potential. Second quarter earnings will start to come out in a few weeks, so we’ll see what’s happening. We also have to remember that accounting gimmicks, and stimulus money may be inflating earnings. That is, it is once again, earnings from something that is not organic and sustainable.

In order to get out this hole, we need to find a way to reach $90 in earnings through the reduction of costs and increased productivity. I’ve been beating that dead horse for quite some time now, yet I still don’t see the light that will bring us the-oh-so-desired economic recovery of fabulous 3% growth.

So, do we buy buy buy ?

Cheers.

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I don’t like to talk about any change of direction in the market by analyzing it for a two week period, but is there something for real here?

The same way I believe the “green shoots” are not all that valuable because one or two data points out of a 2 year downtrend does not tell that much, the markets starting to go slightly down and sideways for two weeks may just be noise. (Or the rally is just noise?)

Since the “March bottom”, there has been a big rally in the U.S. (and world) markets. Some people say it’s not sustainable and some claim that it is the end of the recession. Others say the gains in the markets will stay but we will have a choppy market that moves sideways (up and down with no change).

So, what to make of all of this?

First, is oil still going to break $100 and affect you at the pump? Oil has had a big rally due to the expectations of economic recovery, but with a weaker outlook, it could stay at this $70 level. You must take into account that if the dollar continues to depreciate, oil will go higher because oil is quoted in dollars. Therefore, that would be a currency effect and has nothing to do with supply and demand. Additionally, a lot of people claim that oil going past $60 has nothing to do with supply and demand but is rather just an effect from the depreciating dollar.

[Here is a link with a chart looking at the cost of an oil barrel in different currencies].

Is the recession over?

I don’t know. Nobody does. However, the people at the World Bank seem to have an opinion on the matter. Yesterday, this statement came out:

” The World Bank said the global recession this year will be deeper than it predicted in March and warned that a flight of capital from developing nations will swell the ranks of the poor and the unemployed.

The world economy will contract 2.9 percent, compared with a previous forecast of a 1.7 percent decline, the Washington- based lender said in a report today. Growth will be 2 percent next year, down from a 2.3 percent prediction, the bank said.”

[Link: Bloomberg]

So, we went from a prediction of -1.7% to -2.9%. I would not be surprised to see this number revised to -3.5% or so. Nevertheless, it seems like economic recovery is once again further than we thought. So, just because investors get hyper-happy and start buying like it’s a party again…it does not mean it’s a party again.

What about all that stimulus money?

It’s still coming! Maybe I should give an LOL for that. It will probably help us and give a boost to economic recovery. However, $787 billion is a lot of money, but relative to the size of the economy it’s trying to boost, it will cost a lot and probably only make a dent.

More importantly, should you buy and hold?

Tough question. This depends  a lot on your profile (age, risk appetite, etc) and what your outlook for the next 10? 20? 30? years is. The last ten years do not tell a good story. In the words of Jake from Econompic Data, it has been a “lost decade”.

As the chart below depicts, buy and hold and has not worked very well in the last 10 years: (Source: Econompic)

There are still 6 months left in the decade and the S&P 500 is still down some 28% for the decade. We need a 63.79% advance just to break-even for the decade. No wonder so many people are complaining that their 401(k)s are down the drain.

This does not mean you should become an active investor, but maybe a little more active than just buy and hold (especially just buying stock indexes). If the market is down 20%, maybe you should talk to your financial adviser (or yourself) and say, “maybe I should be in cash, wait a while, maybe lose some upside, think about things, and then get back in”. It’s not about timing the markets but more about realizing that if the world is tanking, you should probably liquidate a stock portfolio and wait for things to calm down.

Cheers.

And in case you missed this little commercial about the the government stimulus, you should watch it. It’s pretty funny.

Stimulis: Because all economies have performance issues

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Is Investment going to be the factor driving the U.S. economy out of the recession? In a recent post, “Road to Recovery: The Consumer ?“, I looked into whether the consumer was going to be that force; however, it seemed like the consumer was not going to be the savior this time.

What’s going to drive GDP growth? Well, the options you have are consumption, investment, government spending, and net exports. Let us dive into investment.

Investment as a whole has been reducing as businesses cut back on spending, access to credit is limited, and residential investing (as in buying homes) has dropped substantially.

The question is the following: Is there a catalyst that’s going to turn these things around?

Let’s start at residential investment/housing given that this was what fueled the recent bubble and the mess that followed. It seems like house prices are still dropping and that we have a good supply of homes for some time. Additionally, as mentioned in the previous post, credit is tight and the household sector is already carrying a high debt burden. I would conclude that residential investing (and all the benefits such as home building/lender fees, etc.) is not going to be the X-factor leading us to economic recovery and 3% GDP growth. Unless, that is, we just increase our debt even more and do more of what we did in the last 6 years or so.

What about businesses? Is there anything for businesses to invest in that will increase productivity or reduce costs and thus generate economic growth?

Sure, businesses are always investing in a variety of things in regard to their operations (buying new machines, improving infrastructure and software, etc), but is there something that’s going to improve productivity and create 3%+ GDP growth? (Think technology in the late 80s and during the 90s).

“Green Energy” seems like the buzz phrase lately. However, it seems like the technology is not advanced enough to create an impact (yet). Nevertheless, there will probably be a ton of money pouring into alternative energy (especially given the government incentives) which could lead to positive results or to a, what a surprise, bubble in the alternative energy sector.

Another question is whether the current increasing positive confidence in the economy is sustainable. The markets have been going up with many people claiming that the worst is over (the people expecting positive GDP growth by year-end or Q1 2010). However, another group of people claim that the current rally and economic recovery is further than we think (more like late 2010 or 2011).

Does it matter? Well, businesses take into account future expectations of economic activity when making investment decisions. If the attitude is that things are going to recover, businesses will likely invest more. If people think the economy will not improve, business will invest less which will negatively affect GDP growth.

As of now, confidence is increasing which is a good sign. Yet, everyone is asking what’s going to increase productivity in the mature U.S. economy. If you have any insights, feel free to share!

Cheers.

p.s. Government spending may be next!

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Inflation concerns have been a headline lately. I wrote a post on the matter a few months ago, The Fears of Inflation, but I thought this would be a good time to revisit the subject.

If you turn on CNBC, or watch say Fox News, you have quite a few people screaming out that we’re going to get hyperinflation, or very high or out-of-control inflation. I think we may get some above average inflation in the future, but nothing close to what most people would consider hyperinflation. Now that’s just my humble opinion.

On that note, this post is not to convince you about whether inflation is  a concern  or not but rather show you different perspectives on the matter and hopefully consider some things that people completely leave out yet are just as important.

To the point. There is this whole talk about how the Federal Reserve has been expanding the monetary base (or money supply) to “unprecedented” levels and how we’re going to get tons of inflation. In general, holding everything else constant, excessively expanding the monetary base would create inflation.

Link: http://research.stlouisfed.org/fred2/series/BOGAMBNS?cid=124

So, it’s true that the monetary base has expanded to “unprecedented” levels, however, what most people do when analyzing this graph is to forget that OTHER things have also changed to “unprecedented” levels. Additionally, it can be that other things have changed to such “unprecedented” levels that it offsets this increase in the monetary base.

Looking at the graph above, we can roughly say that the spike in the monetary base is equal to around $1 trillion. The question is, has there been any cash withheld in the economy that offsets this this spike?

Link: http://research.stlouisfed.org/fred2/graph/?s[1][id]=EXCRESNS

So, just in depository institutions, the level of excess reserves have reached “unprecedented levels” and gone from zero to $850 billion. That would leave a NET increase of only $150 billion in money circulating in the economy. However, what happens when you add all the non-depository institutions that are hoarding cash?

It’s food for thought, right? And some people claim that the Federal Reserve won’t be able to withdraw the money it is creating when this money seating on the sideline returns. The Fed may not be able to do a 1-for-1 perfect withdrawal job, however, it is unlikely that it will mess up to a point where we will get 15% or 30% inflation.

The second point at hand and something that has been all over the media is rising yields on the 10-year Treasury. Interest rates on Treasuries move for many reasons yet there are some that are quick to say that the rising rates is due to the market’s expectation of future inflation. (And typically, the people who are quick to reach that judgement tend to have certain political biases and have reservations about the government’s recent interventions.)

Whether it’s true or not, nobody knows. However, let us expand the number of options for rising yields.

(Aside: The interest rate of a bond moves in the opposite direction of its price, that is, people are selling Treasuries which is decreasing its price and thus increasing the interest rate/yield. Additionally, the 10-year Treasury is widely used as a benchmark for other interest rates, therefore, that is why you see people saying (as an example) that mortgages rates will go up as the Treasury rate goes up)

As of the market close today, 10-year Treasuries had a yield of 3.72%. Is that a crazy number? First, let us look at the 10-year Treasury rates since 1962.

Interesting. So, what does this graph tell us? To me, it seems that the spike back to around 4% is more like a reversal to a more natural rate. Therefore, how do the hyperinflation supporters claim that the “rising” interest rates are a sign that we’re going to get out of control inflation? Additionally, it is me or it seems that on a relative basis 4% is actually a pretty natural if not lower number than than historical levels?

Zooming in to a 2 year period, this is what we get:

As shown in the graph above, you can see that there was a big decline in the 10-year Treasury rate right in November and December 2008. Why is it so?

At the time, there were some concerns about deflation. Additionally, everyone was selling out of equities and other riskier assets and buying T-bills. In case you forgot, this was the time when most investors thought the world was going to disappear and everyone wanted to be invested in the safest securities in the world, that is, U.S. Treasuries. As a result of all the buying, the price went up and the rates went down.

In sum, this leaves us with a few possibilities to why the rate is going up again (which may be left out of the conversation on your CNBC show of choice). First, the rate was just not going to stay at 2% or 2.5% because that is just not reasonable. Second, confidence is returning and people are getting out of Treasuries (thus deflating the price to more regular levels) as the “flight to quality” phenomenon is dying down slowly and people want to take more risk. Third, you have the Fed-printing-a-lot-of-money hypothesis which can also fit the profile.

In reality, it probably is that all those things are working together to increase the rates. So, the next time someone starts telling you that the 10-year Treasury rate is going up just because of the government printing money, let them know what the real deal is.

As to what to believe, that’s your personal decision. If you’re going to invest based on that decision, I would be careful not to get on the same boat as the people who hype up anything that is thrown at them. And if you go online and watch some TV shows or read some articles from last week, you’ll see that the tone of things have already changed. As rates where about to hit 4%, it was all about hyperinflation and blah blah blah. Now, it’s coming down and the subject is thrown to the sideline. In general, don’t invest based on CNBC’s buzz phrase or topic of the day/week because they flip-flop more than you flip burgers.

Cheerssssss.

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