Projecting the future of any economic entity, whether an individual company, an index of companies, or a nation's economy, can be mind-numbingly complex. Sometimes it is better to just look at past averages on a few items of information, project them forward, and then ask yourself if the results are reasonable. I think of it as a generic projection.
Generic projections - For an individual stock, I take annualized revenue growth for 5 years, net income as a percentage of revenues, again a five year average, and apply them to TTM revenues and existing share counts to develop an EPS projection. The results can be compared to company guidance/outlook and/or analyst consensus, and any differences are food for thought. This type of default projection can be built into a spreadsheet, and if the investor intends to use something different he owes it to himself to explain why.
Ben Graham advocated an approach along similar lines. A trainee or clerical type was to do the menial work and produce a mechanical projection. The senior analyst would then do his thing. But he was obligated, if he did not accept a rote or mechanical projection, to produce a written report stating his reasons.
Spreadsheets and on line databases do most of the drudge work. That leaves the individual investor to decide for himself whether he has insights sufficient to over-ride generic projections. He can lean back, place the tips of his fingers together, gaze out the window, and think deep thoughts. Reading the 10-K, 10-Q and checking for conference calls and presentations also helps.
Ratio of S&P 500 to GDP – A similar approach can be applied to GDP information in order to project future values of the S&P 500. This computation is easy, can be done on a quarterly basis, and provides a good starting point for thinking about the future trajectory of the markets and the risk/reward of being in them.
Since 1990, the average ratio of S&P 500/GDP is .093. The average growth of unadjusted GDP has been 4.79%. To look ahead one year: GDP 14,463.4 x (1 + .0479) = 15,155 X .093 = 1,409, round to 1,400.
S&P 500 at 1,400 within one year, when divided by Friday's close of 1,074, yields 30% growth. That is a generic or default projection: others are possible. As an investor making a serious effort to proceed along logical lines, I have to ask myself whether that is realistic, and what the other possibilities are?
Cutting it in half – If I assume that growth will be ½ of average, and that it will take two years instead of one for the S&P/GDP ratio to revert to the norm, a similar computation comes up with a 14% annual return.
Cutting it in half again – if I assume growth will be ¼ of average, and that it will take four years to revert, I get 7% annual return. That's quite a bit better than what you can get from CDs these days, 1% if you're lucky. Years ago, in a different era, they used to say the long term return on any of the indexes worked out to 8%. Those were the good old days. 7% is pretty near to 8%. The point is, after cutting a generic projection in half twice I wind up looking forward to 4 years of the good old days.
Things can go past the midpoint – The above lines of thought all stop at the midpoint. Past experience of irrational exuberance tells us it is possible to go quite a bit higher than that. How about an heroic assumption, that the present pessimism will give way to optimism and that future markets will go as far above the midpoint as they are below it now? Using 4 years and ¼ average growth rates, if by then optimism gets to where pessimism is now the S&P 500 will hit 1,650, returning 11% annualized.
Chasing the train out of the station - Investors who are standing around with bags in hand will be extremely disappointed if the train pulls out before they get on board. Once that gravy train gets rolling it really barrels down the line, just like Old 97.
There were some very sad folks who watched the train pull out of the station in March last year; they stood there, inconsolable, praying for the correction that never came. But praying, prophesying doom and even throwing tantrums was of no avail – the market went up. So if an investor is going to go against a generic projection, he will be happier in the long run if he has cogent reasons for doing so.
Now the train has backed up to the station again.
Political concerns – The issues that can tip over the apple cart are well known. Solutions are very slow in developing, due to difficulties in the operation of the political system and the interplay between politicians and financiers. A previous version of this post contained a long rant on the topic, which has been cut and saved for later delectation.
But this article is about generic projections, and requires a simple statement of a most likely outcome to the present political impediments to meaningful financial reform. Briefly, if the status quo ante is restored on regulation, and reasonable additions made to compensate for the current state of financial innovation, the economy and financial system will heal in due course.
Looking back through our history, the Populist and Progressive movements of the 1890s to WWI dealt with problems that were strikingly similar to what we face today. While controversial, both worked within the existing political system, advanced the cause of the middle class, and made significant changes to political, economic and financial systems that were not serving the interests of a very large majority of the population. Adherents of these two parties were absorbed back into the Democratic and Republican parties and retained a voice in the politics of the country.
The historical exercise is not about laying a chart of the Dow Jones during the Depression against a chart of the current market episode. It's about looking at the ideas and modes of thought that developed successful solutions to analogous problems in the past. As the Pecora Commission went about its work, the Securities and Exchange Act of 1934 and Glass-Steagall became law, laying the foundation for many years of well-regulated markets.
This country has solved these same problems in the past, albeit with considerable controversy, and the most likely thing is that we will solve them again in the present instance. While this plays out, the authorities will use great care to avert deflation, which is the most significant cause of economic hardship. In due course it will become safer for those who work, save and invest than it has been for the past twenty years.
Black swans - Those who possess the same skills as Ackman, Paulson, Goldman Sachs, or others who clearly identified the causes of the meltdown in advance can of course achieve similar success in the future with more detailed and specific projections and trading positions.
For those less prescient, that would include me, the methods outlined in this article would have suggested that the market was well above its midpoint in 2007 and there was little reason to be in equities: or, given very low volatilities, appropriate hedging was indicated for those who preferred to stay in.
Bill Gross warned in advance that CDS were going to cause trouble. Nobody could predict that Lehman would be permitted to fail, very nearly taking the system with it. In the past, the authorities always intervened, as in the case of LTCM. Who could have predicted Congress would fail to pass TARP on the first effort? For that matter, who could predict that Tim Geithner would develop an effective method to shore up the banking system, but would present it so poorly that the market would tank?
Investment implications – Getting back to the original point: the individual investor, if he is going to over-ride the indications of a generic projection, will be happier in retrospect if he has cogent reasons for doing so.
From my point of view, there is every reason to be in equities, given the S&P 500 is well below a midpoint on its ratio to GDP. Many professionals have observed that very high quality stocks are trading at discounts to their historical multiples. This coincides with my own observations on stocks I follow personally. Earnings so far this quarter have been encouraging.
There are good reasons to be cautious, given the poor political and regulatory climate and existing vulnerabilities in the economic and financial system. When I am doing what I think works best I hold about 20% cash. Based on bad vibes and decreasing volatility I started to accumulate a hedge with SPY puts but stopped when the market headed down.
By Thursday and Friday last week I was buying in dribs and drabs, mostly cases where under-valued stocks sold off after good earnings reports. Backed up by my hedge, I sold puts to convert a few long calls into synthetic shares, something I had planned in advance. From here, I will be buying in small amounts on a daily basis. If the market goes down, I keep buying and waiting for the bottom. If it goes up, that was the correction, at least for now, and I will continue to buy in small quantities.
Disclosure: Author is long US equities with a trivial hedge via SPY puts