Value Expectations'  Instablog

During the Applied Finance Group’s 6th annual Research Summit at the Encore in Las Vegas in mid-June, the mood was quite somber. Though the stock market had rallied from its March lows and turned positive for the year, the over arching feeling was one of worry that the rally would not last. In the weeks subsequent to our conference, economic news continued to worsen, as jobs were being lost at an increasing rate in June relative to May, which led to a new round of discussions regarding a 2nd stimulus package. Indeed there was and continues to be much to worry about, as inflation, growing national debt, and an overall weak economic environment made it difficult to enjoy the stock market gains achieved to date. This sentiment is consistent with the results of AFG’s first Market Forecast Project conducted in mid July, which shows a significant amount of unease in the investment community regarding the economy and various fiscal and regulatory policies currently being proposed. For example, 90% of the respondents felt we should not have another federal stimulus, while 80% felt the currently proposed cap and trade legislation to curb carbon emissions was not a good idea for the economy.

On the topic of the stimulus program, we were early and loud skeptics of its potential effectiveness in our February and March letters. Sadly, the program’s results to date are making oracles of us. Unemployment has materially worsened since the stimulus program was rammed through congress without being properly debated, or made available for public review. It is likely that unemployment will surpass 10%, possibly hitting 11% next year, with the latest projection being the July unemployment rate has risen to 9.7% from 9.5% in June. Further, while there are signs that the economy will register some growth in the 2nd half of the year, it may very well be a jobless recovery. All this makes us go back to the first principles regarding economics and human nature. In general people tend to want less of something as it gets more expensive, and people have no incentive to conserve something that is free and seemingly endlessly available. These two principles have led to the time tested result that government is very efficient at expropriating and redistributing wealth by force, but consistently incompetent as a wealth creator. Therefore it is no surprise that as the tax code will shift rates upward on labor and capital next year, the cost to invest and take personal risk increases and results in less economic activity. As a result we concur with the view that the coming economic expansion is likely to be less robust than exits from past recessions. Further, since the current fiscal strategy is to stimulate economic growth through government spending, the capital allocation process is likely to be less efficient than private sector actions. Free markets allocate treasure to individuals or firms that can create customers by offering them goods and services that they voluntarily purchase. That voluntary exchange of value is the critical ingredient, which leads to wealth creation. It is the pursuit of such treasure that drives innovation and ultimately leads to the betterment of society. However, as the government can fund itself freely by inflating its way out of debt, and can create customers by decree, it does not face the discipline imposed by voluntary exchange. This critical missing component results in government having few incentives to innovate, either via new products or more efficient processes, to serve its customers fittingly. Moreover, because government in the short run has unlimited access to capital, it has little discipline to make accurate cost forecasts or even utilize the public’s treasure efficiently - as recently evidenced by the Cash for Clunkers program running out of money 90% sooner than expected. Thus, it is not surprising that as the stimulus program continues to unfold, it will likely overspend and under deliver.

While the debate concerning another stimulus program seems to have died down, during July the debate over revamping the nation’s health care system kicked into high gear. In what was a fascinating month of politics, the Congressional Budget Office (CBO) essentially lobbed a live nuclear warhead into the debate with an estimate of the leading house plan costing approximately $1 trillion and adding approximately $200 billion to the federal deficit over the next 10 years. Not surprisingly, Republicans and Democrats have significantly increased the rhetoric on this issue, with each side claiming to be on the side of angels and advocating approaches that will likely reduce costs and increase consumer choices. This month we will not explore the competing claims made by each party, as we will save that for September when Congress resumes debate on proposed legislation. But one interesting point from a market perspective is that the public seems to be very engaged on this issue, especially the cost aspects of the program and its likely effect on the government’s deficit and the national debt. Entering July, the public generally favored health care reform, but today most polls show the opposite. As we have mentioned many times before, higher taxes and inflation lead to lower real stock returns. To the extent that such a government expansion increases the national debt and leads to an accommodative Federal Reserve, it is likely that taxes and inflation would increase in the near to mid term, reducing the long term attractiveness of equity investments. In fact, 60% of our survey respondents expect moderate inflation risk. In addition, further confirming our view regarding likely tax increases, on the Sunday talking heads circuit, neither Geithner nor Summers would rule out a middle class income tax hike when talking with the press.

So why has the market done so well this year, given all the bad news and the prospects of a growing government role in the economy, higher taxes, and likely higher inflation? We believe there are both fundamental and political reasons for the market rally, especially in July. These dual concepts are reflected in a combination of questions we asked in our recent survey. First, most respondents felt the US economy was headed in the wrong direction, yet simultaneously 80% believe the economy will be stronger in the coming year. Studying the commentary provided with the answer to these questions, it was clear that the majority of investment professionals feel the economy has started adjusting to the post “real estate boom” economy, but feel current fiscal policies will not allow the economy to expand to its full potential. Therefore, one interpretation of July’s market performance is that the declining popularity of the current programs, namely Cap & Trade and Universal Healthcare Reform, creates a relatively more attractive future macro environment. Again, when thinking of why the market would react favorably in the midst of a deep recession, we are reminded of the story of two buddies (Buddy 1 and Buddy 2) camping in the woods. As the buddies prepared their camp and started to cook dinner, Buddy 1 mentioned that he heard a black bear can run at 25 miles per hour for spurts of time. Buddy 2 just shrugged his shoulders and continued to cook dinner not worried about the prospects of having to outrun a ferocious black bear. Buddy 1 was really bothered by the thought of a bear chasing him down and tearing him to shreds, so he had to ask Buddy 2 how he could be so calm and see if he could gain some peace of mind from his good friend. So Buddy 1 asked, “Why aren’t you worried about being chased down by a bear?” Buddy 2 just shrugged his shoulders and said, “I don’t have to outrun a bear. I just need to outrun you”. In the same way that while having to escape a Black Bear is a crappy situation, if you only have to outrun the person next to you, your prospects improved significantly. In a similar vein, the prospects of lower government spending and smaller deficits as a result of citizen protests holds the long term promise of a more responsible government and a better economic outlook. So as the popularity of these programs decline, the market may be reacting to prospects of a smaller, less taxing federal government, which is long term bullish on the market. Put another way, if the market tends to view the government as a negative Economic Margin (EM) firm, having the public demand a restructuring, is similar to a negative EM firm that begins to divest its losing business units and return capital it cannot invest above the cost of capital back to share holders.

The other reason stocks did so well in July, is that companies are finally outperforming the pessimistic expectations embedded in their market valuation. At the start of the second quarter, the consensus estimate was that S&P 500 earnings would be down 35% from a year ago. With 50% of the S&P 500 reporting second quarter numbers, the collective EPS change has been just -24.8%, much better than expected. (Bloomberg report as of July 29, 2009) Amid optimism of corporations’ ability to control costs despite generally lower than expected sales, several analysts raised estimates on the S&P500, calling for 2009 EPS to be $51-56 and 2010 EPS to be $65-75. This is consistent with the data we have seen regarding Economic Margin Momentum. This variable essentially converts the change in analyst EPS estimates into a cash flow revision. During the market trough in March, negative cash flow revisions outpaced positive cash flow revisions by a factor of 4 to 1. This was an incredibly negative outlook on the analysts’ part, and in retrospect it is not surprising such extreme negativity marked the market bottom. Conversely, in the last week positive and negative cash flow revisions were approximately equal. This resulted from a dramatic decline in analyst calls for negative revisions, and a near doubling of the companies receiving positive revisions, indicating a dramatic change in the market mindset. One thing is for certain at today’s market prices – the easy money has been made. Again comparing the market in March versus today, we see that back in March, companies with greater than 10% upside to AFG’s determination of their intrinsic values approximately outnumbered those with 10% downside by a factor of 2 to 1. The subsequent market run confirmed our view that companies were priced at a significant discount to their intrinsic value. Obviously, pulling the trigger to capture those gains in the midst of such economic uncertainty is what makes money management such a difficult job. Today, the ratio has reversed. Companies with 10% downside, relative to their intrinsic value, outnumber those with 10% upside by a factor of 2 to 1. We believe the current situation is not as risky as it may first seem, because analysts are likely to continue revising their EPS estimates upward and such revisions will lead to higher intrinsic values, although there is obvious risk with such a scenario. Again making the point that money management is a hard way to make an easy living.

We look forward to our next Market Forecast Project Survey taking place during the month, and encourage each of you to get involved – it only takes 5 minutes and our questions will stimulate your mind. Your views will add to the overall effectiveness of our results that you can put to work in your client communications and market strategies.

Lastly, the following are the returns for July, 2009:

In our article  Has GM Earned A Bailout? and many others , we incorporate the use of AFG's Economic Margin  because of it's powerful insights on measuring shareholder value and calculating intrinsic values. As the demand for AFG's unique valuation and corporate performance insights has grown globally, so has the research. 

 
This year, April showers brought happy portfolios along with May flowers. Despite a few nay-believers stressing their belief that this is a bear market rally and February was A Bottom not The Bottom, the US equity market continued the momentum started in March, sending S&P500 up by 9.4% in April. Those impressive results materialized in spite of the fact that the month’s economic data was mixed.
 
April brought plenty of negative news to keep rational people wondering if things will indeed improve later this year, or at least make them question the sustainability of the current market rally. The big headline statistic was unemployment, which reached 8.5% and is expected to continue climbing well into 2010. The Service sector continued to shrink for the 6th straight month in March according to the Institute for Supply Management, with its index showing the contraction accelerating to 40.8 from 41.6 in February, much worse than the 42 Economists expected.The U.S. federal budget deficit rose to a record $956.8 billion in the first six months of the fiscal year by March, and is well on its way to the $1.75 trillion -- or 12.3% of GDP -- for the full fiscal year, which ends in September 2009. US foreclosure filings rose to a record in the first quarter with a total of 803,489 properties receiving a default or auction notice or were seized, 24% more than a year earlier. The Conference Board's Leading Economic Index declined 0.3% in March, steeper than the 0.2% analysts were expecting.
 
On a positive note, home prices in 20 cities were down 18.6% in the 12 months ending in February, compared with a 19% drop in the 12 months ending in January, the first time in 16 months that the decline in prices did not set an annual decline record. The US economy shrank 6.1% in Q1, much bigger than what Wall Street expected and hardly different from the 6.3% plunge in the fourth quarter. However, investors liked the components of the GDP decline, which suggested that the decline was driven by plunging business investment as firms drew down inventories at the fastest pace since the start of the decade. Excluding the drop in inventories, ultimate demand in the economy fell at a 3.4% annual rate, compared with 6.2% in the fourth quarter. Investors are now hopeful the depressed inventory level could lead manufacturers to ramp up production later in the year. In addition, U.S. factory orders increased more than expected in February, the first time in seven months that the indicator turned positive. Retail sales showed signs of hope as well. February sales were revised up to increase 0.3% instead of dipping 0.1% as originally reported. January sales were revised up to an increase of 1.9% from an increase of 1.8%. On the credit side, about $70 billion of corporate bonds were issued in February, up from $21.4 billion in October, and while still only about half the level of last May, it shows debt markets are starting the journey towards normality. Lastly, April showed an uptick in M&A activity indicating some corporate buyers see bargins out there and are in the mood of seeking non-organic growth again. Operationally, the market is in a difficult spot to handicap. While we felt it was undervalued when the Dow was trading in the 6,000’s, (see our Then and Now report), its current levels have clearly priced in a more normal economic environment. Over the next year, we believe the trend will continue to be towards an improving economy and likely with it a rising equity market. Primarily this view is premised on the inordinate government spending and incredibly accommodative Federal Reserve. It is hard to believe with the amount of money entering the economy that business indicators will not continue to improve in the short term. The question, however, is at what cost?
 
Our longer term view is much more cautious as a result of an exploding budget deficit, a rising tax environment on personal and business income, as well as business activities through a proposed carbon tax scheme. In addition, the massive growth in the Fed’s balance sheet has laid the foundation for significantly higher inflation in the years ahead. Further, there are big question marks regarding how this administration will treat the businesses it interacts with to achieve its policy goals. We have already seen how financial firms that accepted TARP funds have started to regret their decision, as agreements with the government seem to last as long as public opinion polls. Further, the government’s treatment of Chrysler’s senior debt holders is concerning. Despite having a very well established bankruptcy law in America, the public bullying and favoritism of one group of pensioners versus those represented by the senior debt holders is very troubling. This does not bode well for private firms that cross paths with the administration. As a group, these are troubling indicators about the economy in the future.
 
While we believe the short run will be dictated by a “missing the run” versus “protecting for downside” mentality, it will be important to think about these issues in the months to come and properly position portfolios to minimize the damage from what may be a “double dip” recession. We will reprint a chart and a discussion from last month, as we think its implications are not fully absorbed in today’s “miss the rally” mentality.
 
"Just for fun, we did a quick exercise. We consolidated the current S&P500 companies excluding Financials and Utilities, and calculated their leverage. To be conservative, we included every piece of liability and debt for those firms including operating leases. The S&P500 industrials generated revenues approximating $7.5 trillion in 2008 vs. total debt of $3 trillion, suggesting a debt/revenue ratio of 40%, comparable to our current national debt to GDP ratio. As equity investors we know excessive leverage is a dangerous thing as we will be the first one in line to see our investment wiped out. As a nation, exorbitant leverage will be devastating to the economy as it will devalue our currency, allow foreign debtors to dictate our agenda, and we the tax payers will be the first in line to be hurt, seeing our assets worth less, our income taxes rising, and our future shaky. We do not suspect corporate America will ever consider increasing its leverage to 82%, and we don’t understand why the Federal government thinks it is a great idea.”