February 14, 2005
One of the interesting aspects of the S&P 500's return to 21 times record earnings is the gradual reemergence of bad finance. Various late 90's valuation models that properly vanished during the 2000-2002 plunge are being pulled out of the dirt like artifacts from an archaeological dig.
The central feature of these models is the attempt to demonstrate an assertion that has been routinely brutalized over history: “Former measures of valuation are no longer valid, because this time it's different.”
The Fed Model
The Mother of bad finance is the Fed Model – the notion that the prospective earnings yield on the S&P 500 should be equal to the 10-year Treasury bond yield. Here is a model with appealing simplicity, the downside being that the model has no finance content at all.
First, it's a model developed over the period from 1980-2000, when interest rates and stock yields were persistently declining. Statistically, if you take any two variables which trend in the same direction over time, you'll estimate a correlation between them of roughly 0.99, and you'll assume far too much causality in the relationship. The 1982-2000 period featured a steady decline in bond yields and a steady increase in stock valuations (falling earnings yields), but it's absurd to conclude that there's a one-to-one causal relationship. At best, one can conclude that both stocks and bonds both benefited from an extended period of disinflation that was relatively unique in U.S. financial history. If you examine data prior to 1980 however, particularly long-term data prior to 1965, you'll find no clear or reliable link between 10-year interest rates and earnings yields. This isn't to deny that there's some relationship between interest rates and stock valuations. It's just that the relationship is far more complex than “this yield should equal that one.”
Indeed, the Fed Model gives no consideration to factors like earnings growth, risk premiums, or the relationship between operating earnings and the cash flows that investors actually can claim. “Operating earnings” are themselves the pacifiers that corporate America hands to Wall Street analysts – earnings minus anything that reduces the predictability of earnings – and are not even defined under GAAP. While the inclusion of both an earnings yield and an interest rate make it appear that some sort of appropriate discounting is occurring, this is an illusion. It takes numerous odd and counterfactual assumptions to map the Fed Model into a proper model of discounted cash flows.
Further, the model rests on the unbaked assumption that the yield on a 10-year Treasury bond – having a duration of about 8 years – is the appropriate benchmark with which to value a stock index that currently has a duration of over 60 years. (For more on the concept of duration, see the February 23, 2004 comment).
Finally, if the proof of the pudding is in the eating, the simple fact is that there is no correlation between over- or under-valuations based on the Fed Model and subsequent returns for the S&P 500. The belief to the contrary is based on a handful of seemingly “prescient” calls by the model in 1982 and 1987, for example. All of these were achievable with a much simpler model: buy stocks when earnings yields are high and interest rates are falling, and avoid stocks when earnings yields are low and interest rates are rising.
That said, however, there is an interesting use for predictions from the Fed Model (other than to line a bird cage). Remember that the Fed Model indicates that stocks are undervalued when the prospective earnings yield on the S&P 500 is higher than the yield on 10-year Treasury bonds. It turns out that when the Fed Model registers a strong “undervalued” signal and the earnings yield on the S&P is itself very low, the signal is still meaningless for stocks, but is a fairly reliable sell signal on bonds . In effect, when the S&P 500 earnings yield is low, and the 10-year Treasury yield is lower still, it's a good signal that bond yields are probably too low to be sustained. Trouble for the bond market often follows.
“But it's different this time”
As the S&P has approached 21 times record earnings, investors have also become emboldened to revive “new era” arguments as to why some fundamental or another is no longer valid. One we received last week cited a paper published several years ago near the top of the bubble by an economist from the Philadelphia Fed (staff papers always include a disclaimer that they do not necessarily reflect the views of the Federal Reserve). The basic argument is that companies began investing in, and explicitly expensing more of their cash flow on “intangibles” after 1990, so reported earnings are misleadingly low and therefore price earnings ratios appear misleadingly high, since intangibles like research and creativity are obviously wonderful things. To support this line of argument, the paper notes that 1.3% of corporate GDP was spent on research & development from 1953-59, while 2.9% was spent between 1990-97.
Unfortunately, a 1.3% difference in R&D outlays is an exceedingly slim difference relative to total investment of about 15-16% of corporate GDP. More importantly, the bulk of the increase in “intangibles” investment during the 1990's wasn't R&D anyway – it was “goodwill” generated by the buyout of other companies at prices far in excess of their book values. Many of these “investments” proved to be exceedingly bad in the subsequent years, and “goodwill” assets reported by S&P 500 companies have been shrinking from writedowns ever since.
Still, new era arguments like this die hard when you're trying to justify high valuations.
A similar argument, but targeted at dividends, is that the dividend yield is no longer meaningful, because companies are now repurchasing stock instead of paying a dividend (as if companies never repurchased stock prior to the past few years).
In order to get at this argument, you've got to follow the money a little bit. Notice, for example, that the bulk of stock repurchases made during the 1990's did not represent net repurchase of stock. Rather, companies repurchased their stock simply in order to offset dilution from stock and option grants to employees and management. This sort of repurchase doesn't confer any benefit to shareholders at all. Meanwhile, attempts by analysts to correct repurchases the impact of option grants were also flimsy, because analysts generally netted out the cost of options at the date of issue , not the value of these grants at the point of exercise (which is where the rubber hits the road in terms of dilution).
Aside from dilution considerations, it should also be clear that companies can and often do finance stock repurchases with money they borrow by issuing debt. Again, there's no sense in which this sort of repurchase represents an investment return to shareholders. At best, a fraction of these repurchases might benefit shareholders to the extent that the stocks are undervalued and the interest on the debt is low. But at 21 times earnings, that argument is a stretch.
There is, however, a kernel of truth with which “new era” investors sow their field of dreams. If repurchases out of earned income actually exceed stock issuance to employees and management, they do represent compensation to shareholders, because they concentrate future cash flows into the hands of fewer owners without increasing other liabilities of the company.
So let's look at the data. If you take operating income before depreciation, then net out interest, taxes and capital spending, you'll find that S&P 500 companies have generally retained about 4% of revenue for distribution to shareholders as dividends or indirectly through stock repurchases. At a price/revenue ratio of 1.0, this would support a dividend yield of (0.04/1.0 = ) 4%, or some combination of dividends and repurchases having the same effect (assuming that the repurchases weren't offset by option grants and the like).
Presently, however, the price/revenue ratio of the S&P is about 1.6. That implies that if companies made no grants of stock or options to employees or management, one might expect that S&P 500 companies could sustainably provide (0.04/1.6 = ) 2.5% in dividend yield or combined dividends and stock repurchases to investors. Given that the dividend yield on the S&P 500 is actually 1.7%, it appears that a marginally higher dividend yield could be supported by sustainable cash flows if companies were to discontinue option and stock grants (which is a poor bet).
You'll notice the word “sustainably” in the preceding paragraph. The reason is that over the past four quarters, operating income (before depreciation), less interest, taxes and capital spending has represented nearly 7.5% of revenues, which would be a nice margin if it could be sustained. Unfortunately, that apparently high amount of distributable cash earned by S&P 500 companies is explained by the fact that capital spending over the past year has dwindled to just over 4% of revenue (it's normally over 6% of revenue). This level of capital investment does nothing but keep pace with depreciation. Meanwhile interest expense – thanks to unsustainably low interest rates – briefly narrowed to just 2.8% of revenue (it was normally closer to 4% during the past decade).
As I've noted before, the huge U.S. current account deficit virtually ensures a tough time for capital spending in the coming years. Indeed, to the extent that corporations earn excess cash flow, a good portion of it is likely to be drawn to finance huge government deficits for the foreseeable future. This can happen indirectly, of course. For example, if a company uses cash flow to retire its bonds, the former bondholders then have the funds to purchase new Treasury securities issued by the government to finance ongoing deficits. If that cash flow was not available from domestic sources, it follows that the U.S. current account deficit would have to deepen, or interest rates would rise to the point where investment funds devoted to other uses (such as capital spending and housing) would be diverted to bond purchases. A fiscally profligate government cannot help but sabotage the growth prospects of the nation.
In short, if investors assume that we're in a new era where growth doesn't require investment, and also assume that profit margins can be sustained indefinitely by downsizing and offshoring U.S. workers, and that the Fed actually hasn't been raising rates recently, and that negative real interest rates are sustainable in the long-term, I suppose those investors could argue that stocks are reasonably priced here.
We wish those investors the best of luck.
As of last week, the Market Climate for stocks remained characterized by unusually unfavorable valuations and still modestly favorable market action. We are already observing a tenuous character to this market action, with numerous elements in market action showing initial deterioration. For that reason, the Strategic Growth Fund remains well hedged against downside fluctuations using either long put / short call combinations (which replicate an interest-earning short-sale on major indices) or put options alone. Still, the fact that part of the Fund's holdings are hedged with puts alone means that we continue to expect some benefit to the Fund should the market advance further. That also means that a market decline would be expected to result in at least modest losses for the Fund until our defensive put options were firmly in-the-money. Overall, our exposure to market fluctuations remains modestly positive here.
In bonds, the Market Climate remained characterized by unfavorable valuations and modestly unfavorable market action, holding the Strategic Total Return Fund to a limited duration of about 2 years, mostly in Treasury Inflation Protected Securities, with the most significant additional exposure being about 19% of assets invested in precious metals shares.
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