The Float

Words of Wisdom

Two useful items from two of our favorite participant-observers: Mohamed El-Erian and John Hussman. Frist, from El-Erian's interview with Advisor Perspectives (bold text in original):

Another principle you advocate is the separation of alpha and beta in portfolio construction (something we have written about in our publication). Why has this principle gained in importance and how can advisors best implement it?

The dispersion of returns among actively managed strategies has become very large. In the old days, the dispersion resembled a "fan chart." It started with relatively small dispersion in fixed income classes, to larger ones in public equities and very large ones in illiquid asset classes. Today, we are seeing much more dispersion across all asset classes. The result is, unless you are absolutely confident of your active management choices, it is better to go passive.

The cause of this greater dispersion is that markets are more volatile. We came from a period (until the middle of 2007) that was very good to investors. Risk premia across all asset classes were compressing, delivering high returns and declining volatility. As long as investors were exposed and levered they did well. Now investors can get easily caught with the wrong position in a highly volatile environment. The hurdle for active management has gone up. You have to be sure you are actually getting something. You are paying higher fees and being exposed to more risk.

And here's Hussman, on the intertwined roles of government and Wall Street in the unwinding of the credit bubble:

As with the stock market bubble of the late 1990's, it is generally true that bad investments tend to go bad. There is little to prevent that from occurring. The only question is who bears the cost. Essentially, the Federal government issued hundreds of billions in debt, much of the proceeds which tax cut beneficiaries invested in mortgage bonds, without concern about loan quality because the debt had been tied to the good faith and credit of Uncle Sam, and now we've got to issue more government debt to bail out the losses from the bad investments.

One of the reasons that the recent credit crisis has been so wrenching is that the losses are being borne by institutions that have the explicit or implicit backing of the U.S. government, so it feels like the things that ought to be safe really aren't safe. But that is no accident -- bad credit sought out those institutions and their government backing, as the inevitable result of the swap markets (as described above). In the end, the implicit and explicit backing of the U.S. government -- which allowed all of this to occur -- is also what will be called upon to clean up the mess.

Read the whole Hussman comment, especially for his take on the making of the credit bubble. We think it's one of his best efforts.

El-Erian on Squawk Box

As we've noted in this space (here and here, for example), we think PIMCO's Mohamed El-Erian is one of the sanest voices on Wall Street. So when he appeared on yesterday's Squawk Box, we put the DVR to work so we could pass along a few of his most incisive observations. Here's our collection of El-Erian's highlights:

• "Things are bad because the credit crisis has morphed into an economic crisis. Things are bad because policymakers don't have easy solution. No matter how well-intentioned they are, they will create collateral damage."
• "As long as you can underwrite the volatility, there are major bargains out there...things high up in the capital structure."
• "If you're going to recapitalize the financial system, which has to be recapitalized, you're going to dilute somebody. And who are you going to dilute? You're going to dilute existing shareholders."
• "It takes time to recapitalize the financial system. It doesn't happen overnight."
• "You need to be able to hold on when it gets bumpy, because this is not a linear journey."
• "If you get an unexpected rise in prices that people are not ready for, the next move will be up. It's what economists call perverse [unintelligible]. When prices go up, people demand more rather than less; when prices go up, people supply less rather than more. It builds on itself, it feeds on itself, until it exhausts itself. The big question is: Do you break something in the process. It will exhaust itself at some point, but what is the collateral damage?"
• "It's been a puzzle to many of us how 2-and-20 has lasted so long, given that most hedge funds don’t do that well. There are a few hedge funds that deserve it, but many that don't. And at some point investors will wake up and investors will realize that they can get the same service from more conventional providers of investment services. And I think another few quarters of disappointing returns, that will be the wake-up call."
• "There are times, as they say, when you work about the return on your capital, and there are times when you worry about the return of your capital. These days you should worry about the return of your capital."

Wise stuff from Mr. El-Erian.

David Rosenberg on Corporate Earnings

Whatever the squiggly lines look like in the short run--and they're plenty squiggly today, now up sharply on some sort of financials-driven rally--the medium-term prospects for equities are driven by two things: corporate earnings and market multiples. On those all-important questions, here's Merrill's David Rosenberg, a confirmed member of the reality-based community:

Prospects for a profit plunge are palpable

In the final analysis, only two things go into the forecast for the S&P 500 -- earnings and the multiple that investors are willing to pay for that future earnings stream. While it is normal to see corporate profits decline 30% in a recession, what makes the current and prospective backdrop more sinister is that we headed into this recession with profit margins at sky-high levels. The ratio of pretax profits to nominal GDP has already started to recede from its nearby 55-year high of 14% as we headed into recession to 12.2% currently, but consider that recession troughs usually occur just south of 7% on this metric. If we overlay this with S&P 500 earnings per share, what we are then talking about is the strong possibility that profits end up being cut in half during this bear market -- which would mean an ultimate low of around $45 on operating earnings (in other words, we are only one-third of the way through the earnings turndown at a time when the consensus seems to priced for the bottom being right about now!).

Now to put this into some sort of perspective, the 4-quarter trailing EPS in the 2001 recession hit a trough of around $38 and in 1991 the trough was jut over $18 so we are not talking about Armageddon here but rather offering up some analysis highlighting the what the risks are the outlook. We will bottom at levels much higher than the troughs in the past, that is the good news. The not-so-good news is that the level of the S&P 500 in the past that tended to coincide with $45 earnings was right around the 1,000 mark; and if we were slap on a typical trough multiple of 10x-12x on that earnings stream, then...well, you do the calculation. Either way, as economists judging the earnings landscape, it is extremely difficult for us to be calling for a bottom in this market outside of the intermediate oversold lows that are the domain of technical analysts and generally prove to be very temporary as we saw back in January and March of this year. One of the biggest fundamental hurdles to the market, we're afraid, is going to be the risk of continued negative earnings surprises, especially with the consensus predicting earnings growth of 13% the second quarter and 59% in the fourth.

Source

David Rosenberg, "Morning Market Memo," Merrill Lynch, July 7, 2008

Earnings: The Next 12 Months? Or the Last?

As Barry Ritholtz noted over the weekend, certain media outlets seem determined to find reasons for optimism in equities' recent breakdown. Not that there's anything wrong with that! Who knows. Maybe these will turn out to be "attractive levels."

One of these efforts to find a glimmer of short-term hope--Greg Zuckerman's weekend piece in the Wall Street Journal--revealed one of the stubborn realities of current market conditions.

Here's Zuckerman:

On Thursday, the Dow fell below the level reached in March, when brokerage firm Bear Stearns was fighting for its life, and now stands at levels not seen since September 2006.[*]

The good news is that the overall market now is beginning to look more attractive based on any number of metrics. For example, the S&P 500 now trades at a price-earnings multiple of about 15 times this year's expected earnings.

The 10-year average is 18.7, covering a period of investor exuberance, as well as the 2000-2002 market downturn. The 24-year average P/E ratio is 15, and that includes a period of much higher inflation than now. That all suggests that the market is reasonably priced, though not yet at bargain-basement levels.

Yes, but...

Other measures are more ambiguous. Because future earnings are harder to get right, some look at profits over the past 12 months. On that basis, the price-earnings ratio of the S&P 500 is 21, compared with a long-term average of about 16, according to Birinyi Associates.

This is the big question, at least for equities' medium- and long-term prospects: Where are earnings headed?** What of the potential gap between actual and reported earnings? If corporate earnings fall, will traders and investors take the market multiple lower as well, resulting in a double blow to equity prices?

From where we sit, the probabilities aren't especially bullish. But Zuckerman's reveals just how important one's perspective is at times like these. If backward-looking valuations aren't cheap, and forward-looking estimates are too rich...well, you get the picture.

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* Some perspective: As of Friday, the S&P 500 had returned to the level it reached at the beginning of 1999, 2001, and 2006.

** In the short run, the market will be, as ever, a function of animal spirits, fiscal and monetary policymaking, and a grab-bag of pure contingency.

Source

Gregory Zuckerman, "Snatching Bargains From Bear's Jaws," Wall Street Journal, June 28, 2008

Random Thoughts on Market Conditions

Amid this morning's sideways action, traders and investors* would be well-served to take a deep breath and evaluate market conditions. Not so much to guess what'll happen in the very short run, but to gain some perspective on the broader lay of the land.

Over the last few days, it has become almost cliché to note that sentiment-based measures of market anxiety have not spiked as they did at the last few intermediate bottoms in the equity markets (see the followning two charts of the CBOE's equity put-call ratio and the VIX, both through yesterday's close).

Note that current measures of the put-call ratio, both the single-day numbers and the 21-day exponential moving average, remain well off their March peaks. Though the 21-day EMA is in the neighborhood of its August, November, and January tops, the daily readings themselves have seen only one spike up to 0.9, and none to 1.0 or higher. So the picture here is a bit muddled. Or, to be precise, more muddled than it is even in its least-muddled configurations.

There's a similar story in the VIX chart, with daily readings moving back into the 20s, but the 21-day EMA lingering well below the levels associated with market bottoms over the last year. And we haven't had any single-day readings above 24 since March. Here, too, we have a relatively muddled picture, one that does not scream market bottom. But we live in a (Bayesian) probabilistic world--not a deterministic one--so we'll keep updating our "priors" along with all of you.

Here's another miscellaneous thought prompted by yesterday's action. In Thursday's "Four at Four," MarketBeat editor David Gaffen quoted a money manager saying this: "We're very much in a declining market...People have to realize that the returns in the market, or expected returns, are going to be lower." The point here isn't to indict the guy who said this, but we think the opposite is closer to the truth. As asset prices decline, expected returns actually improve.

Now, it's certainly true that this is walking and talking like a declining market, and near-term returns could well be negative. We aren't making any particular claim about near-term market action. But, again in good Bayesian fashion, we now have new data in the model: lower prices for long-term assets. And lower current prices imply higher future returns. That doesn't do much to salve investors' short-term pain, but it's true nonetheless.Those of us who speak to the investing public should work to clarify these counter-intuitive subtleties, popular understanding of which would help rank-and-file investors make fewer big mistakes.

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* Now that we mention it, this distinction could make a good addition to "Things We Don't Like About CNBC." Too frequently to count, CNBC's talking heads talk about what "investors" might want to do in the next few hours. At the risk of being a little picky, investors aren't especially concerned about what happens in the next few hours. In fact, they'll be better off if they totally ignore what happens in the next few hours.

Stuck on the 50-Day

Toward the end of Wednesday's weak action, we posted an item on the challenge faced by the broad equity market as the S&P 500 sagged just below its 50-day moving average. We suggested that the short-term burden of proof (to say nothing of the long term!) remained with the bulls...just in time to see the market rocket higher yesterday in a mildly strange session. Oil moved up sharply, bond insurers were downgraded (good grief...was that still in question?), questions about Lehman persisted, &c. But a few decent retail prints and some good ol' fashioned animal spirits were enough to take 'em higher.

The trading action yesterday was unusually robust, with solid volume, and a classic open-at-the-low, close-at-the-high move to the upside. Looking back over the last few months, we've seen a few days with similar action, just after marking (and re-testing) the March lows, twice in April, and again yesterday. All but the mid-April case were followed by some sort of non-trivial pullback, the sort of moves that can whipsaw investors into and out of the market in all the wrong ways.

The Battle Continues

So far so bad for the S&P 500's test of its 50-day moving average. As we noted yesterday, the developing squeeze between the 50- and 200-day MAs was going to resolve itself one way or the other, perhaps decisively. And so far, the bulls can't take much solace in the market's action around the 50-day line. This story isn't over, and, as always, investors can reverse field in a hurry.

Stripping away all the caveats, and pending this last hour of trading, the last couple days haven't been especially bullish. After closing below the 50-day yesterday (on above-average volume), and remaining there after rolling over early in the afternoon today, the burden of proof remains squarely on the bulls.

The big question is whether this downside breach of the 50-day line will prove short-lived (as the most recent such instance did in mid-April) or whether they'll take 'em lower from here...yet again. 

Unstoppable Force or Immovable Obstruction?

We've noticed an interesting development in the S&P 500 over the last several days, with a declining 200-day moving average providing overhead resistance...and a rising 50-day moving average providing support. See chart below, with data through yesterday.

Assuming those two trendlines continue to converge (and a close look at the 200-day shows that it's flattening out, so a renewed uptrend in the index could well have the lines crossing while both are rising), the big question is which way the tension resolves itself: to the upside with a decisive breach of the 200-day or to the downside with yet another move below the 50-day?

We have little faith in esoteric technical patterns, but simple trends tend to have underlying motives that matter, that give them substantive weight and meaning. And when major trends collide, things can get very interesting indeed. 

Trading Range?

This weekend's Wall Street Journal featured excerpts from an interview with Barton Biggs, a former chief investment strategist at Morgan Stanley. Here's a classic Wall Street hedge (emphasis added in bold):

Conventional wisdom is that the market will test its lows, and go lower again. A really serious bear like George Soros thinks we've seen just the first part of the bear market. I'm nervous, but my intuition tells me that after this consolidation is over, the next move will be up, not down.

Psychology is involved here. I like the fact that the market is worried. I like that The Wall Street Journal runs articles about that. That's all good. But the puke point has been reached, in March. Because of the problems we're living under, the market should be in a trading range for the rest of the year, between 1250 and 1550 in the S&P 500.

Ummm...a trading range between 1250 and 1550? What kind of trading range has a upper limit that's 24 percent higher than its lower limit? By our lights, that pretty much drains any meaning from the term.

Source

Larry Light, "One Bold Analyst's Latest View: Worst is Over for Economy, Stocks," Wall Street Journal, May 31, 2008

More on Earnings Expectations

In the aftermath of Friday's employment report, we posted an item on earnings expectations, passing along a chart from Societe Generale's James Montier that showed the lagging nature of equity analysts' earnings projections. At key turning points higher and lower, analysts tend to be led by earnings reports, not the other way around.

Which leads us to this item in today's Journal, in which Tom Lauricella wonders whether projections for the third and fourth quarter of 2008 might be a bit lofty. As the adjacent chart indicates, projections for the fourth quarter of 2008 have risen since January. The expectation being, at least in part, that the fiscal and monetary caffeine unleashed by the federal government will then be flying through the economy's bloodstream.

In the short run, all that stimulus will matter. There's no way--or reason--to deny that. But we expect the underlying fundamentals of the economy to remain extremely challenging. Here are a couple relevant excerpts from Lauricella:

First-quarter earnings-per-share are on track to post a 15% decline from a year earlier, according to Thomson Reuters. Yet analysts still expect earnings to be up 10% for the full year. That translates into a slight loss in the second quarter, solid earnings growth in the third quarter and a fourth quarter that would be the most profitable in history.

Thomas Lee, equity strategist at J.P. Morgan Chase & Co., thinks expectations for the fourth quarter are too high. The consensus forecast of roughly $93 a share for the Standard & Poor's 500 stock index as a whole would amount to "unprecedented profitability," he says. Meanwhile, the only two sectors that have posted record profits are energy and materials, which combined contribute just one quarter of all the profits from companies in the S&P 500.

Brian Belski, U.S. sector strategist at Merrill Lynch, says Wall Street stock analysts have a track record of being overly bullish about earnings rebounds amid economic downturns (and too bearish when earnings fall.)

Following the periods of declining earnings in 1991 and 2001, results four quarters after the trough of the downturn came in 50% below what had been expected when the economy was bottoming out, Mr. Belski notes. He expects that pattern to hold true this time around.

...

Stock-market strategists at Goldman Sachs Group Inc., who have been arguing that earnings expectations have been too high, said they were surprised that more companies aren't lowering earnings outlooks.

"It is hard to imagine that the current economic landscape was entirely incorporated in prior guidance," they wrote last week. "A more cynical interpretation is management will be the last to know when the proverbial 'other shoe' drops."

Related: Vitaliy Katsenelson's piece in Saturday's Financial Times. Katsenelson argues that the key to the "e" in "p/e" is profit margins, which are at or near historic highs. And ohbytheway, profit margins tend to be very serious mean-reverters. Here's Katsenelson:

Many people describe the stock market as cheap. After all, at 18 times earnings, p/e's are half of what they were eight years ago (those bubbly valuations are not coming back anytime soon) and only three points above their long-term average of 15. However, the "e" is temporarily inflated by all-time high (pre-tax) profit margins, which are at 11.5 per cent, or about 35 per cent higher than their multi-decade average of 8.5 per cent.

Historically, every time profit margins have become overextended, they have reverted towards the mean (that is, declined). This is because capitalism works. One company's excess profits are another's potential opportunity -– increased competition puts pressure on profit margins.

This time round is no different. If profit margins fell and stopped when they reached the average level -- an aggressive assumption as historically they have overshot and gone lower –- the market's p/e would rise from 18 to 22.

This is important stuff. As always, these cautionary notes do not constitute short-term forecasts of market direction. In the short run, animal spirits drive things higher and lower with only a loose connection to the underlying fundamentals. In the longer run, mean reversion remains a fact of life in the capital markets, and investors would be well-served to recognize as much.

The reality of mean reversion in profit margins might not precipitate big changes in investment strategy; indeed, for those who are appropriately invested, it shouldn't. But it should lead to relatively modest expectations for the coming months and years. And grounding one's expectations in a pragmatic sense of what's possible (and likely) will help keep short-term emotions out of the mix.

Source

Tom Lauricella, "Bulls' Optimism May Be Premature," Wall Street Journal, May 5, 2008

Vitaliy Katsenelson, "Look to the margins when using the price/earnings ratio," Financial Times, May 3, 2008