Good to see someone appreciates the value we bring to society…

Article from CFO.com.

I am a believer in long cycles. As part of that framwork, I believe we are in the bottoming phase of the long cycle that arose out of the Great Depression.  The changes that are happening today in the economy are not of the cyclical nature, they are of the secular nature.  We are in the midst of the final collapse and restructuring of the old "mass market" economy.  In its place, the "new economy", or what I call the "mass customization" economy, will take control.

As the tide of consumer credit that has been building since the New Deal in the 1930s washes away, so does consumer demand, leaving the industries that benefitted from that credit creation awash in excess capacity.  There are additional old economy industries that are seeing consumer tastes or technological advances leave them behind.  A list of industries with excess capacity is below:

Industries with excess capacity

Commercial and residential real estate, homebuilding, appliances, autos, retail, consumer lending, broker/dealers, airlines, media, land line telephony, pharmaceuticals, fast food

That said, there are several sectors that are dealing with capacity shortages:

Industries with capacity shortages

Data centers, developing market infrastructure, railroads, mass transit, electricity generation/transmission, oil production/refining, LNG transportation/storage, financial advisory, wireless network capacity, biotech, organic foods

Mostly, the list of industries with capacity shortages are those that require investment to complete the modernization of the old communications, energy and transportation networks. 

Given the economic shift, there should be investment opportunities in the following sectors:

Long term investment opportunities

Electrical equipment, smart grid technology, mobile platform developers, capital goods manufacturers, steel and basic materials manufacturers, very light jets, carbon fiber manufacturers, ETF providers, private equity, retail financial advisors, financial services software, software-as-a-service, solar panel developers/manufacturers, organic food packagers/distributors, railroad equipment manufacturers, wireless towers, oil field services/equipment, LNG shipping, oil & gas pipelines, machine-to-machine communications, seafood farming, developing market consumer goods companies, next gen battery developers, home automation, biotechnology

I could keep going.  The point is, there are a ton of sectors that have terrific long term prospects, and the United States is well positioned to lead in most of them.  The current crisis will pass and yield to better times, as it always does.

Investing Watch:  While my long term view is that the United States economy is actually in a much better competitive position than people give it credit for, I appear to be on a roll with my doomsday predictions.  First Bear Stearns, then the "conservatorship" of Fannie Mae and Freddie Mac, I’ve referred several times to the eventual demise of Lehman Brothers, and I poked fun at the business model of Merrill Lynch.  As of now it looks like Lehman Brothers will be liquidated and Merrill Lynch is getting swept up into the arms of Bank of America.  The shrinking of capacity in the financial services industry continues and will continue, I’m sure.  I had no idea, for example, that the venerable AIG was in trouble.  We will also get to watch the drama of what happens to Washington Mutual.  Perhaps even Morgan Stanley will lose its independence someday.

Beyond the specifics of who blows up, the important question is what it means for us regular folk.  The process of deleveraging is called deflation.  You can have deflation fast, like the great financial panics of the 1800s and early 1930s.  You can have deflation slow, like Japan for the last 15 years.  Or you can have hyperinflation, like Germany in the 1920s, where the government prints away the debt.

Given that the Treasury and Fed have been pretty adept at handling the crisis by engaging in the lender-of-last-resort role, it is unlikely that we will have deflation fast.  And given the dollar’s key role in the financial system, the US government has too much to lose geopolitically to rapidly inflate away our debts.  Thus, we will likely have deflation slow.

The gears of credit creation will have a hard time catching as the system goes through deleveraging, restructuring, and changing regulations.  Overleveraged consumers and baby boomers facing dim retirement prospects will save more and work later in life.  Consumption as a share of GDP will have to decline.  The US may even start running persistent trade surpluses.

And so after the deluge, the mailaise.  We’ll probably spend years griding sideways, with financial market participants dying of boredom and many drifting off the work in other sectors of the economy.  The debt load of the American consumer will gradually abate.  And sometime next decade, the US economy will be ready for rebirth and prosperity will return.

Just don’t hold your breath.

I’m still on summer vacation, but figured I’d post an analysis I did earlier this month on how to value the stock market relative to bond rates.  While some of the prices may have changed a bit, the point is for this to be a long term analytical framework.  I welcome comments challenging or adding to the theory, as I’m always searching for the right answers…

HISTORICAL RETURNS

From 1926 to 2001, stocks, bonds and t-bills produced the following returns:

Source: Ibbotson Associates

It is from Ibbotson’s older studies that market participants have settled in on an equity risk premium of 5-6%. This analysis would imply an equity risk premium of as high as 7%. Since the market has basically moved sideways since 2001, with relatively low dividends and a rally in bonds, I would suspect that a more recent run of Ibbotson’s analysis would have the spread come down to around the historical average of 5-6%.

The purpose of this paper is not to determine whether 5-6% is the right number. Instead I am seeking to provide a method of calculating what the priced-in return of the market is today, and then to use a "disequilibrium analysis" to determine how the market may have it wrong.

COMPONENTS OF EQUITY RETURNS

On a basic level, equity returns are driven by two things: the beginning dividend yield and the long term growth rate of dividends.

Using the Gordon growth model

P=D/(r-g)

Where P= stock price, D=dividend, r= expected rate of return and g=dividend growth rate

Rearranged to

D/P + g = r

So that the dividend yield plus the long term dividend growth rate equals the expected rate of return.

Dividend yield and payout ratio. Ok, easy enough. The problem with the dividend yield is that the payout ratio has fluctuated over time, due both to changes in management optimism and to changes in the tax code and options compensation that encourage stock buybacks. Stock buybacks are a form of dividend in that they are not reinvested in the business.

Dividend growth. We will focus on the market as a whole to determine the general valuation level of the market. Over the long term corporate profits will grow in line with Nominal GDP. There are some periods when profits’ share of GDP goes up, like the late 1990s and 2000s, and period when it goes down, like the 1970s and early 1980s, but over the long term they will grow in line with GDP. S&P 500 profits, however, grow at a rate that is about 1% slower than GDP, as that index consists of larger, more mature companies.

GDP Growth. Nominal GDP growth consists of three components: growth in the workforce, growth in worker productivity and inflation. Long term real GDP growth has traditionally been 2.5% to 3%, with workforce growth at about 1% and productivity at 1.5% to 2%. Workforce growth has slowed recently and will likely move toward 0% for a while as the baby boomers retire, and then pick back up to its historical pace in the latter part of next decade. Productivity growth, on the other hand, has been running above trend recently.

Real earnings growth. If I strip out inflation, real S&P earnings have grown at a rate of 1.74% a year since 1960, which makes sense relative to real GDP growth of 2.5-3.0%.

Inflation. Inflation has been volatile since the 1920s. It was negative in the 1930s, regulated and then high in the 1940s, moderate in the 1950s, rising in the 1960s, very high in the 1970s, falling then rising in the 1980s, stable in the 1990s, and rising in the 2000s. As of August 7, 2008, the 30-year treasury bond was yielding 4.55% and the 30-year TIPS (Treasury Inflation Protected Security) was yielding 2.05%, meaning the market expects long term inflation of 2.5%.

Below I plot out today’s yield curve relative to my "equilibrium" yield curve. As interest rates, earnings and inflation are volatile, yet mean-reverting, I need to anchor the values in reasonable, long term assumptions.

Source: PIMCO, author’s analysis

Trend real earnings. To determine whether today’s market is over- or under-valued, I calculated long term real trend earnings for the S&P. I use inflation-adjusted trend earnings to smooth out the effect of business and inflation cycles. A graph of annual S&P real earnings is shown below.

Source: Damodoran, S&P, author’s calculations

Trend earnings for 2008 are estimated to be $58.65. The S&P is currently trading at 1,266.07, which results in a PE to trend earnings of 21.6. The long term average payout ratio of S&P companies is 50%, so the implied dividend yield to trend is about 2.3%, which is about what the actual dividend yield is today, if we include stock buybacks. Focusing on dividend yield is a better way to value the market than focusing on current year PEs, because dividends are far less volatile than earnings. Corporate managers tend to only pay dividends relative to their long term earnings power, because they don’t like to have to cut dividends at a later date.

Expected S&P Return. We now have all of the pieces to calculate what return is priced into today’s S&P.

Fixed Income Alternatives. No compare this to current fixed income alternatives.

The equity risk premium is currently only 3.56% relative to the equilibrium risk-free rate. The best deal looks like investing in long term investment grade bonds, particularly if you own them in a tax deferred account. On an after-tax basis, the spread is 3.72%.

Disequilibrium Analysis. Looking at the above numbers, one could make the argument that the assumed inflation rate is below the long term trend of 3.0%. If inflation was 0.5% higher, that would accrue to stock returns (to 7%) and eat in to real bond returns. Either way, it appears the spread between stock returns and investment grade bond returns is too low. Treasury rates are either in line with, or slightly below equilibrium. Real earnings growth has more risk of surprising to the down side after the big rise over the past two decades. Taxes are likely to rise near term, with the difference between taxes on equities and bonds narrowing.

Tax-free alternatives. The above after tax rates should be compared to municipal bonds when investing in taxable accounts. The equilibrium rates are compared to treasuries on an after-tax basis. You would probably want to add a few basis points to compensate for the fact that muni bonds carry a little more risk than treasuries. And to make sure that the equilibrium rate is at least above inflation.

Here I’m assuming you are not investing in triple tax-free bonds and are paying state tax of 5%. It would appear that municipal bonds offer terrific value on an after-tax basis and are well above their equilibrium yields and are even above investment grade corporates on an after-tax basis. In addition, with tax rates more likely to rise than fall, the attractiveness of muni bonds only increases.

Sadly, it’s tough to beat inflation on an after tax basis by investing in bonds. The key is to hold bonds in your tax deferred accounts and stocks and muni bonds in your taxable accounts. I know it sounds counter-intuitive to put fixed income in your long term retirement accounts, but if you run the math, you’ll save a lot on taxes versus holding taxable bonds in a taxable account and stocks in a tax deferred account.

S&P Values at different Expected Returns. I personally believe that the current earnings yield is too low and that the stock market is overvalued. The reason the long term return of the market is 8-10% is that in starting point year 1926 the dividend yield was higher than 5%, which together with 3% inflation and 2% real earnings growth gives you a 10% return. The great returns in the market since that time have come from multiple expansion, aka yield compression. With the implied dividend yield of only 2.5% today, the potential for continued multiple expansion is diminished, and the potential for multiple contraction (a process that has been playing out since 2000, by the way) is increased.

Here is how the S&P would need to be valued to provide a range of expected returns.

                                    Source: author’s calculations

In other words, to target a long term 8% return that provides a 5% equity risk premium to the average risk-free rate, the market would need to fall 38% from today’s levels. If long term inflation ends up being 3% instead of the 2.5% that the treasury market predicts, then the market only needs to fall 29%.

Buy bonds.

UBS has decided to separate its investment bank from its asset management arm.  This step could presage UBS’ jettisoning of its investment bank.  As I said in a previous post, Merrill Lynch should do the same thing.  Apparently 247WallStreet agrees with me and throws in Citibank and Wachovia to boot.

Asset management is in inherent conflict with investment banking in that an asset management client can never be sure that he isn’t being put into an investment because its the right investment for his portfolo or because it makes money for the investment bank.  The whole auction rate security debacle is case in point.  So is the collapse and bailout of the internal Bear Stearns, Citigroup and UBS hedge funds, and the near death of Goldman’s Global Alpha hedge fund.

An investor is better off trusting a pure-play asset manager (like say a Northern Trust) than an investment bank or universal bank.

I’m not a management consultant, nor do I play one on TV.  I have worked in and around Wall Street for a little while, however.  That makes me not surprised to see a chart like this one, courtesy of the WSJ yesterday.

While I don’t have the exact numbers, if you ask me it looks like Merrill Lynch will write off in two years nearly a decades’ worth of earnings.  I haven’t gone through the balance sheet, but I would hazard an educated guess that virtually all of those losses are tied to the fact that Merrill has operated as a giant, yet conflicted, credit hedge fund for the past five years.  Conflicted in that as an underwriter and promoter of structured securities, it can’t suddenly switch and turn bearish like actual hedge funds.

As an outside director I would ask why Merrill Lynch was in that business in the first place.  Merrill’s great asset is its nationwide network of stockbrokers and its reputation as an asset manager.  Asset managers trade at higher multiples than investment banks for a good reason.  Money managers deliver in nice annuity stream of fee income, while investment banking is so volatile that…you can wipe out a decade’s worth of earnings in two years.

For big banks, investment banking is like the movie business.  It is the glamorous world of high finance drawing bank CEOs like bugs to a flame.  Like investing in the movie business, the bank’s investors are last in line behind all of the star investment bankers who take something like 2/3 of the revenue, even in the good years.

The problem is that the profitability of old fashioned investment banking, brokerage and sales and trading services has gone down over the past decade, which explains why all the investment banks increased their leverage and entered the more exotic world of structured finance.  Without all the leverage, however, the profitability comes down.

As I have been saying over and over, the capacity in the financial services industry in general, and investment banking in particular, needs to shrink to reflect the new reality of reduced profitability and leverage. (With the goal of evenutally increasing profitability, of course.)

So my advice to the Merrill Lynch CEO John Thain would be thus: focus on asset managment.  That is Merrill’s great asset.  Investment banking and structured finance have dragged down your multiple and caused massive dilution to your shareholders.  Lehman Brothers needs to be a credit hedge fund to justify its existence.  You don’t.  You actually have something valuable, a brand that resonates with retail investors.  Focus on that and leave investment banking to the suckers.

In this article from MarketWatch, we get a good summary of what’s ailing the financial system these days.  The crisis in the "shadow banking system" is likely to bring the brokerages (Lehman, Merrill, etc.) under the regulatory umbrella of the commercial banks, which means lower leverage and lower profits.  Like in London after the "Big Bang", you’re likely to see the old independent US brokerages, themselves searching for a larger capital base, get swallowed up by big commercial banks.  If this occurs, we’ll basically be seeing a transatlantic banking system dominated by large, regulated "universal banks" like Deutsche Bank, UBS, Credit Suisse, JP Morgan, Bank of America, Barclays, RBS, ING, Citigroup and HSBC.

It’s the end of an era, but not necessarily a change for the worse.  A little less exciting, perhaps, but as Bank of America CEO Ken Lewis put it, as a nation we’ve "had all the fun [we] can stand in investment banking" for a while.

Investing Watch:  Sometimes a picture tells it all. 

Where will the drop in new home sales end? 

My guess is all the way down at 400k.

Source: Calculated Risk

Investing Watch: Crossing Wall Street has a cool chart comparing how equity sectors during periods with different yield curve shapes.  For 2008, the yield curve is starting at a 10-year minue 3-month spread of 1%, with a steepening trend, maybe towards 2%.  What to invest in if the curve moves from 1% to 2% steepness: Health Care, Staples, Tech and Energy.  Makes sense, classic late-cycle and heading into recession sectors.  If the spread stays at 1%, drop tech for utilities.

Investing Watch:  I agree with Carl Icahn on breaking up Motorola.  I don’t know if his exact plan is the right one, but I do feel that MOT’s results are overly influenced by the fickle handset market, which creates a volatility that hurts the valutation of the stock.  If the handset business was sold, MOT would be a networking company, selling wireless infrastructure (which I don’t think its highly ranked at, and frankly this should probably be sold, too), cable set top boxes and home networking gear (in which it is highly ranked, but its products could use a great deal of innovation to take advatage of the coming surge in smart home applications…its primary competitor is Cisco/Linksys/Scientific Atlanta), and business mobility (not sure what that is, exactly).

The stock is basically flat from the early 1990s and the company has always seemed directionless.  I wouldn’t be surpised to see it re-test its 2003 low of under $8.00 in the next 6-12 months.  It may be a buy at that point.