March 16, 2009
Lowering The Sights for Profit Margin Recovery
Last week's advance gave us a good chance to “buckle-up,” and we closed out some near-term call options that benefited from the market's advance. Overall, the Strategic Growth Fund remains tightly hedged. As I noted last week, “While the stock market is extremely compressed, which invites the typical ‘fast, furious, prone-to-failure' rallies to clear this condition, my larger concern is that market action and credit spreads are demonstrating very little investor confidence, risk-tolerance or commitment to stocks.” With that “clearing rally” largely out of the way, my concerns are strongly focused on defending capital here.
The absence of appropriate policy responses to the credit crisis has made me much less optimistic about the potential for sustained recovery in profit margins toward anything near the levels we saw in 2007. Those profit margins were about 50% above the historical norm, thanks to significant balance sheet leverage, as well as relatively depressed labor compensation as a proportion of GDP. Had we responded to the credit crisis by forcing bondholders to take appropriate haircuts (which I've advocated ever since the Bear Stearns crisis), and focusing efforts on restructuring mortgage and debt obligations, the add-on effects of the recent downturn would have been much less severe than they are, and appear likely to become.
As geeky as the following argument will sound, the fact is that profit maximizing firms try to operate on the “elastic” portion of their demand curve. That is, they operate at a point where cutting prices will predictably increase revenue, and the only thing that will stop them from cutting prices is if the (positive) marginal revenue from doing so falls below their marginal cost of producing an additional unit. Unfortunately, that microeconomic consideration is important here, because the defensive and structural (probably long-term) shift of consumers and businesses toward less borrowing and more saving, combined with aggressive competition to preserve market share, creates a situation where we can expect lower profit margins per unit of production for the foreseeable future.
In plain English, that means that backward-looking profits of recent years are not a good benchmark by which to gauge the valuation of U.S. stocks. Last October, my view was that the 600 level on the S&P 500 would represent deep undervaluation. Since then, however, it has become clear that we are observing a larger structural shift in the U.S. economy than seemed likely or necessary at that time. Presently, assigning a somewhat increased likelihood of normal profit margins in the future (rather than the elevated ones of recent years) results in a 10-20% lowering of future valuation benchmarks. Investors will do particular harm to themselves if they gauge valuations on the basis of the elevated profit margins that we observed in 2007.
We will continue to observe larger dislocations than necessary until our policy makers get the response right, which is to approach the bondholders of distressed and undercapitalized financial institutions, and tell them that the companies will (appropriately) go into government receivership unless a portion of those bondholder claims are moved lower in the capital structure (essentially swapping some of the debt and giving them equity instead, which can then be counted as “Tier 1” capital). Why should the American public (and eventually our children) foot the bill to protect the full interests of corporate bondholders? Has everybody gone completely insane, or is it simply not clear that the sum total of the government's response to-date has been to squander public funds to defend private bondholders?
Remember that roughly 30% of even Citigroup's liabilities represent debt to its own bondholders. Less than two-thirds of its obligations are to depositors and other customers. You could literally wipe out 30% of Citigroup's assets without customers or taxpayers losing a dime if bondholders were appropriately held accountable for the hit through the receivership process. With $600 billion in bondholder liabilities, why should the U.S. public be putting up funds to defend Citi's bondholders? You could swap a fraction of those bondholder liabilities into equity capital, let Citigroup continue to operate, and there's a good chance that the bondholders would be made whole over time anyway (especially if the mortgage obligations were restructured using property appreciation rights, which are essentially debt-equity swaps on the mortgage side).
Why aren't the bondholders doing this voluntarily? Simple. Why should they, when Geithner is promising them your money and mine to defend 100% of their claims? Meanwhile, the excitement of investors last week about Citigroup posting an operating profit in the first two months of the year simply indicates that investors may not fully understand the term “operating profit.” Citigroup could burst into flames while Vikram Pandit sells lemonade in the parking lot, and Citi would still post an operating profit. Operating profits exclude what happens on the balance sheet.
On the valuation front, this week Bill Hester offers some historical perspective on stock market valuations during recessions (additional link at the end of this comment), emphasizing metrics that are not skewed by the abnormally high profit margins of the past few years. To expand on those, I've included dividends to the list of “smooth fundamentals” below.
As with S&P 500 earnings, S&P 500 dividends have historically followed a reasonably consistent growth trend of about 6% annually.
Recently, dividends on the S&P 500 have been plunging due to dividend cuts among major financials. As of last week, the dividend yield on the S&P 500 was 3.2%, versus a historical median of about 3.8%. From a dividend standpoint, that would imply that the S&P 500 is still about 20% above even median historical valuations.
A somewhat more constructive picture emerges if we normalize the dividend yield by using “trend” dividends (the red line in the chart above) rather than actual dividends. On that basis, the present dividend yield rises to 4%, while the historical median drops to about 3.4% (thanks to the omission of high yields based on above-trend dividends from the calculation). Unfortunately, even with this adjustment, 40% of historical yield observations are still above that 4% level.
A normalized dividend yield of 4%, coupled with long-term growth of 6% in normalized dividend yields, produces an extremely straightforward result, which is that at current levels, the S&P 500 is probably priced to deliver long-term returns of about 10% annually. To the extent that investors become comfortable with yields well below 4%, the returns from now until that point would tend to exceed 10% annually. To the extent that investors demand yields above 4%, the returns from now until that point would tend to fall short of 10% annually. In any event, it is difficult to view stocks as being extremely undervalued unless we assume a sustained return to the unusually elevated profit margins of recent years.
On the basis of a wide variety of evidence, my own impression is that the S&P 500 is moderately undervalued, at about the level that is likely to produce total returns on the order of 10-12% annually over the coming decade. That is a reasonable rate of return, and could reasonably be considered as attractive relative to the returns likely from bonds of similar maturity. The difficulty, from my perspective, is that investors remain measurably averse to risk, even after last week's “clearing rally.” To the extent that the current economic downturn is outside the norm, we should also be prepared to observe risk premiums and valuation extremes that are outside the norm. We will be attentive to improvements in market action that suggest a fresh, robust willingness of investors to accept risk. Presently, we don't have that evidence.
As of last week, the Market Climate for stocks remained characterized by favorable valuations and unfavorable market action. Having experienced a “fast, furious” (and possibly prone-to-failure) advance to clear the recent oversold condition, we no longer observe the compressed conditions of recent weeks, which opens up some potential for fresh losses. At the same time, we have to allow for a further squeeze to short-sellers, since new sellers may not be inclined to liquidate stock until we move a few percent higher. In any event, the overall combination of valuations, market action, economic evidence, and credit conditions suggests that the market's likely return/risk profile remains muted. Further improvement in market internals would be helpful, but meanwhile, it is difficult to envision a quick reversal in the economy. More likely, increasing defaults are ahead.
In bonds, the Market Climate was characterized last week by modestly unfavorable yield levels and relatively neutral yield pressures. There is little pressure in the bond market for yields to drive higher at the moment, given the continued demand for safe-havens. For our part, TIPS provide competitive yields with straight Treasuries, less volatility, and better long-term prospects in the face of probable inflation pressures several years out (though probably not in the next couple of years). The Strategic Total Return Fund continues to have most of its assets in Treasury Inflation Protected Securities, with about 30% of assets still allocated between precious metals shares, foreign currencies, and utility shares.
New from Bill Hester: Market Valuations During U.S. Recessions
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