Revising my stock valuation model

In my first quarter market update, I arrived at a target S&P 500 level of 541 to target an 8% long term return.  Certain of the data points have been bugging me, though.

First, the data set I had access to excluded the 1950s, when earnings growth was strong.  I backed into some earnings data for that period (by dividing the dividend yield data into the index value and assuming a 55% earnings payout).  This raised my assumed long term real earnings growth rate from 1.2% to 1.6% and raised the trend earnings value to $54.70 per share from $50.37.

The other wild card is inflation.  Inflation from 1947 to 2008 averaged 3.7% per year (geometric mean), which included the inflation plagued late 1960s and 1970s.  Bernanke uses 2% as an implicit target and Greenspan averaged 2.5%-3.0% during his reign.

I have been using a 2% assumption, because (1) that is what Bernanke is targeting, (2) I hope we've learned something since the 1970s, and (3) I think the natural undertow is a deflationary one given the high debt levels in the US.  Given the aggressive actions the Fed has taken to date, it is tempting to assume a higher rate of inflation for the future.  FYI the treasury market (distorted somewhat by assumed Fed purchases) is pricing in LT inflation of 1.8%.

Assuming 2% long term inflation:  The current S&P level is pricing in an annual return of 6.8%.  To arrive at a 7% return, we need a S&P level of 818, and to arrive at an 8% return we need a level of 630.

Assuming 2.5% long term inflation:  The current S&P level is
pricing in an annual return of 7.3%.  To arrive at a 7% return, we need
a S&P level of 964, and to arrive at an 8% return we need a level
of 714.

Assuming 3% long term inflation:  The current S&P level is
pricing in an annual return of 7.8%.  To arrive at a 7% return, we need
a S&P level of 1173, and to arrive at an 8% return we need a level
of 822.

Assuming 3.7% long term inflation:  The current S&P level is
pricing in an annual return of 8.5%.  To arrive at a 7% return, we need
a S&P level of 1685, and to arrive at an 8% return we need a level
of 1044.

In other words, the model is incredibly sensitive to the assumed inflation rate.  If you think long term inflation is going to be high, the stock market is reasonably valued or even cheap.  If you think long term inflation is going to be low, the stock market is somewhat expensive.  Of course, if inflation is going to be low, interest rates will remain low and perhaps the required return for equities will come down as well.

Figuring out the path of long term inflation is the pivot upon which your investment permormance will depend.

Crony Capitalism still Reigns Supreme

Joel Kotkin has posted a good piece that hits on a theme that I have been hitting on at the Dynamist for some time, particularly here and here.  The theme is that Obama has probably achieved a political realignment in favor of the northern blue states and the Democratic Party.  Mr. Kotkin has written that, in reality we have traded one form of crony capitalism, the Sun Belt "cowboy capitalism" of Nixon, Reagan and Bush, with that of the "collusive capitalism" of Obama…still driven by a well-connected elite, but just a different elite than that which dominated politics under the Republicans.

"Cowboy Capitalism" holds the free market supreme, but contradicts itself with direct and indirect subsidies for agribusiness, pharma, health insurers, big energy, aerospace, suburban homebuilders and consumer lenders.

Obama's "collusive capitalism" punishes the beneficiaries of cowboy capitalism while supporting hedge funds, venture capitalists, information technology, academia, green energy and urban landowners, with support from Hollywood and the media.

Mr. Kotkin hypothesizes, correctly I think, that the threat to the domination of the Blue State economic elite comes not from the Republicans, who are currently flailing, but from the "non-gentry" left, who will become disappointed by weak job creation and a continued concentration of wealth into the hands of the New Economy elite.

These are not “unprecedented” times

It is common for those in and out of the financial industry to refer to the current crisis as "unprecedented".  It may be the worst financial crisis since the Great Depression (which had two downturns, the one from 1929 to 1932 and 1937-38), although in some respects the 1980-1982 crisis exceeds the current economic downturn.  If your lens of history is the post World War II era, then yes, the current crisis is unprecedented, but of course as we learned with our assumptions that housing prices always rise, using the post war period as you only lens is a grave mistake.  As far as history goes, the current crisis rhymes with many crises in the past.  In fact, a student of historical cycles would have known this was coming, in some form, all along.

There is a long 50-70 economic cycle known as the Kondratiev Cycle.  Google it and you will find plenty of charts and books that talk about it in detail.  I'm not one to put my faith in prescice cycles as a way to time the market or predict the future with iron-clad certainty.  Nevertheless, the K-Cycle provides a good set of guidelines for understanding the larger forces as work in the economy.  You can break the K-Cycle up into "seasons":


The last 30 years were a classic Autumn in the cycle, but with a major difference that I will explain later.  Autumn is the season of the "monetary bull".  It begins with a stagflationary peak following a war.  In the late 1970s, the inflationary spike followed the Vietnam War, and inflation and interest rates were in the double digits.  Previous stagflationary peaks were in 1920, following World War I, 1865, at the end of the Civil War, and 1820, after the War of 1812.  A conservative government gets elected that brings down inflation (which since the Civil War has meant the Republican Party).  As inflation falls, interest rates fall.  Falling interest rates results in rising asset prices.  Rising asset prices result in rising speculation and leverage.  The great bull markets in American history occur during these periods: the Era of Good Feelings (1820-1836), the Gilded Age (1865-1882), the Roaring Twenties (1920-1929), and of course the recent, yet unnamed bull market (1982-2006).  Autumn is a great time to own stocks and bonds, and sometimes, but not always, real estate.  These are the times that a great "New Economy" rises: the steam, cotton and textile economy in the Era of Good Feelings; the railroad, coal and steel economy of the Gilded Age; the mass market economy of autos, oil, appliances, and broadcasting in the Roaring Twenties; and the technology, health care and communications economy of today.  Eventually, however, interest rates fall as far as they can, asset prices rise as high as they can, and leverage increases to as high as it can, and the edifice comes crashing down.


A great financial panic then pops the bubble: the Panic of 1837 (after the Jacksonian wildcat banking and real estate boom), the Panic of 1873 (after the Greenback and railroad boom), the Great Depression (after the financial boom of the 1920s) and, apparently, the panic of 2007-2008.  During the transition between Autumn and Winter we usually have a transition from conservative to populist government.  The Jacksonians and Whigs in the 1830s and 1840s, the agrarian populists of the 1880s and 1890s, the New Dealers in the 1930s and 1940s, and the right-wing and left-wing populists that seem to dominate both parties today.  Winter is known as a "real bear", where deflation of balance sheets dominates the economy, there is a major restructuring and consolidation of businesses, the economy runs at a large "output gap" for an extended period of time.  These periods can last anyehere from 10-20 years and the best investment from start to finish is typically cash and high-quality bonds, although usually the nominal stock market bottom will occur relatively early in the Winter season, rebound strongly, and then languish, trading sideways for years.  These periods usually end with a war of some sort, which serves to reflate the economy: the Mexican War in the 1840s, the Spanish-American War in the 1890s and World War II in the 1940s.  The end of the deflationary bear market has also coincided with an increase in money supply caused by a gold strike: the California gold rush of 1849, the Klondike gold rush of the 1890s, although now that can be conjured by running the printing presses.


After Winter is Spring the "real bull".  Debt levels and prices in the private economy are low after a long period of deflation.  The overcapacity built up during the investment boom of the the Autumn has been worked off and business profitability is high.  There is a moderate, positive level of inflation that lifts profits, wages and asset prices at a reasonable pace.  Sometimes these periods are short and unsatifying, like in the 1850s, but often they are great periods for the average American: the late 1890s and 1900s and the 1950s and early 1960s.  These are also periods of rising warfare around the world.  Usually this is a period of progressive, high-minded governance.  Stocks and real estate do well during these periods and bonds to relatively poorly as inflation rises.  These periods usually end when a war and rising inflation tip the scales into Summer.


Summer is the period of the "monetary bear", where war and rising inflation lead to rising interest rates and falling asset prices.  The economy can do ok during these periods but it is masked by the terrible asset markets.  In these periods, real estate and commodities are the best investment.  The late 1850s and early 1860s, the late 1900s and 1910s and the late 1960s and 1970s were Summer seasons.  There can be some vicous bear markets during these periods: the Panic of 1857, the Panic of 1907, and the bear market of 1974.  These are usually periods of cosmopolitan governance.  Eventually, the people tire of war and/or inflation and they elect a conservative government and the cycle starts over.

What does this mean for us?

We are almost certainly in the transtion between Autumn and Winter.  We had the most outrageous Autumn in American history because we have let the dollar float.  In previous Autumn periods, the dollar was eventually re-fixed to gold at the value that prevailed before the war.  Thus inflation during the Autumn period was slightly negative as prices fell back to their levels before the war.  The dollar has since fallen from $35 per ounce to $900 per ounce.   Inflation has slowed, but stayed positive, with prices today perhaps 10 times higher than they were before the Vietnam War.  This meant that asset values could rise more than usual because the value of the currency in which they are denomiated has fallen.  The huge asset bull market, which included real estate because inflation stayed positive, meant overall leverage could rise far more than usual.  Now that interest rates can not fall any further, asset valuations can't rise any more, and debt levels, which have risen to unsustainable highs on the belief that asset prices would keep rising, can now only decline.  Only a period of dollar inflation and/or balance sheet deflation can work off the debt overhang.  It took us 30 years to create the balance sheet mess we're in, and it will likely take us 20 years to work it off.  Just ask the Japanese.

The closest historical parellel is likely the Winter period of 1880-1896, which resulted in more of a consolidation rather than a collapse.  Contrary to what some have been saying recently, there is not a strong, rising, anti-capitalist ideology like there was going into the Great Depression.  The elites of the US are generally in the pro-market camp to at least some degree, and most reform impulses are evolutionary, rather than revolutionary, in nature.  The "New Economy" will emerge as the dominant part of the economy, the "Old Economy" of manufacturing will be important but will not employ many people (much like agriculture today), and will likely be focused around hgh-value capital goods.  The new populists (like the agrarian populists of the 1880s and 1890s) will likely be (or already are) disaffected blue collar manufacturing workers from the Midwest and Piedmont, subject to swing their votes between cultural populism on the right and economic populism on the left.

Good news on the Trade Deficit

The trade deficit continues to fall.  As I outlined in Part II of my economic series, moving to a trade balance is the easiest way to at least limit the overall indebtedness of the United States.  (The more painful way is debt destruction via deflation.)

If the massive fiscal deficits coming down the pike aren't offset by equal increases in private savings and/or Fed purchases, we risk undoing some of these gains in our trade position.  The good news about Obama's spending plans are that they focus on domestic spending (health care, education, alternative energy) and not on consumer spending which has a higher marginal propensity to import.  Not that I don't think alot of those stimulus dollars will be wasted, because I do.

A combination of suppressed consumer spending (caused by suppressed consumer borrowing), a shift toward a more domestically-oriented energy mix (which should include more nuclear power if we want to be realistic about it), less borrowing from abroad and more US savings directed abroad should help dig us out of our national balance sheet hole.

On autos and tech company dividends

Two quick things:

Barron's does a great job analyzing the shape of the auto industry to come, which is in line with what the Dynamist has been saying all along.

I was also glad to see the Obama Administration adopt my plan for rescuing Detroit.  (Now we'll see if it actually works!)

Second, I totally agree with the Sanford Bernstein analyst that says Google should pay a dividend instead of even thinking about paying $300MM for Twitter.  If I had to guess, if you look at the actual value today of the acquisitions made over the years by Google, Yahoo, AOL and eBay and other acquirers of early-stage internet content companies, it can't be more than 10 cents on the dollar.

"a deal for Twitter would continue the cycle of big Web companies
basically subsidizing the pursuits of Silicon Valley venture
capitalists, the analysts asserted — all at the expense of shareholders." – NY Times

Tech shareholders of the world unite!