My primary work is to find good individual investments: be it bonds, equities or other investable financial securities. The value school of thought has heavily influenced my approach. Hence valuation is an important risk factor for me.
However, I believe some appreciation of the macroeconomic environment helps determine asset allocation, and to some extent, position sizing of individual investments.
Assuming the macro environment is mean reverting, hence ignoring it in countries where democracy, peace and the rule of law works, has allowed company focused, value equity investors to be successful since the post war era (it was not particularly useful during the depression from what I have studied).
However, I express concern over the debt burden many developed countries have accumulated, new political regimes in large, important economies (i.e. the European Union), current monetary policy and its effect on the aggregate demand function of an economy, demographic structure of many developed countries, and the displacement of power between developed and emerging countries as the latter contribute an ever-greater amount of global GDP (now 50% split between developed and emerging markets).
As a result I have developed a simple framework to allow me to periodically consider macro factors by connecting them to micro factors (my primary domain of research). The aim of such a framework is to allow me to have a basic grasp of the macro environment, and not to be swayed too strongly by the market noise. It also allows me to appreciate where I was wrong when I make mistakes (been very useful here with hindsight).
In essence, as all models should do, it allows me to assess the data coming in factually rather than have a strong emotional reaction to the data flow.
The framework is laughably simple. It is based on the simple assumption that equity markets are primarily affected on a top level by only two factors: EPS (earnings per share), and the multiple on those EPS. I then proceed to appreciate the factors that determine the higher-level factors. I only take 4 steps to keep it simple. Below I present the framework schematically.
|LEVEL 1 FACTOR||LEVEL 2 FACTOR||LEVEL 3 FACTOR||LEVEL 4 FACTOR|
|Capital Equipment/software (tools)||Demand/supply|
|Earnings yield v borrowing cost|
|Where conduct business|
|LEVEL 1 FACTOR||LEVEL 2 FACTOR||LEVEL 3 FACTOR|
|Govt budget (DEFECIT/SURPLUS)|
|Where is new money being placed|
|Who are the dominant portions of the population|
I should first raise some controversial points that some readers will disagree with. That's fine. This is not meant to be precise - I see it as a topographical map. Not to scale - but useful in providing reference.
- You will note I indicate that macro factors determine the aggregate multiple for the market. Some companies grow, others decline, and hence I assume the growth rate and other idiosyncratic factors for individual companies cancel out. You may agree, or disagree with this. I find historically the model under this assumption provides useful information.
- I use EPS as my starting point rather than free cash flow (FCF) per share. This is simply because it seems most people that surround me focus on EPS than FCF/share. I admit focusing on both.
Lets apply the model to today's world. What output do I take from it (you will have a different output if you make different assumptions). Let's start with the multiple.
Assessing the multiple 's role in determining value today
Since monetary policy has become aggressive from 2008 in developed economies, market participants have discussed the massive inflation that will be surely unleashed as a consequence. This can of course still happen. But waiting 10 years for it to occur will not lead to a lucrative career in finance if you are investing assets. What we can clearly see is that money has been created in the financial markets, and has not spilled over to the consumer [measuring consumer inflation by the consumer price index (NYSEARCA:CPI)]. Hence, financial markets have experienced strong inflation/appreciation, but consumer prices have been subdued. Inflation always occurs closest to where new money is unleashed. Credit growth, the transmission mechanism that connects the financial markets and the real economy, has been subdued for consumers, and for corporates has been primarily spent on share buy backs rather than large capex projects. This is due to the onslaught banks have had to suffer from toxic balance sheets and increasing regulatory costs and scrutiny. Corporates have access to the bond markets - individuals don't.
Inflation for me is about the demand/supply of everything. Some factors that express this include:
- Capacity utilization (demand of industrial equipment relative to its capacity to be produced)
- The ability of companies to increase pricing depending on the demand and supply of that product (as well as market dynamics)
- The evolution of wages expressing the demand/supply of labor markets
- Price competitiveness of consumer facing industries (i.e. retail) as consumers spend each dollar with increasing care, or service focus as consumer buying power is increasing
- The evolution of commodity prices that aggregate information on the demand and supply of each material
- Demand and supply of credit - which affects the buying power of consumers, corporates and governments
- Higher growth regions like EM are currently experiencing lower growth. This is likely to translate into lower demand in general for the global economy. If as a result of this environment more money is invested in reducing debt - unless banks funnel these funds to consumers, rather than buy low risk weighted assets in the financial markets, it will not help propel growth in the short term
None of these factors have been signaling greater demand than supply - so why should we conclude there would be a great inflation. If money enters the hands of consumers than it is likely to increase CPI (consumer price index), meanwhile the newly created money it will inflate the areas where it is held - mainly fixed income instruments, and a spillover effect to equities.
How does this affect our assessment of value? If CPI inflation remains at a region of 1 to 1.5% p.a. in the USA, why should the S&P 500 trading at a x17 multiple be seen as expensive in today's world?
- Historically CPI inflation has been around 2.5% p.a.
- Equities have historically averaged a multiple of around 15. This suggests an earning yield of around 6.6%
- Hence equities, on average, offer a 4% premium to CPI
If CPI today is 1.5%, a reasonable multiple should be around x18. Just like if CPI today was 7%, a reasonable multiple for the market should be around x9, all else equal.
The difficult question, of course, is what do you assume inflation will be over a period of time? Unfortunately I don't know the answer to that so I just look at the different level factors for EPS and assess what inflation is likely to tend towards. This combines knowledge of the company-focused investor with a framework to make some simple macroeconomic readings.
The big factor that can change the current situation in the USA is higher wage pressure - which we are seeing from large, low skill employers such as Wal-Mart (NYSE:WMT). If this trend strengthens it can put mild pressure on the equity multiple. Continued credit growth can also help drive further consumer spending - that can help increase consumer demand. Banks are now lending to consumers at more normalized growth rates. Combining this with capacity utilization around its historical average level, higher consumer spending could tip the US inflation environment into a more normalized regime. No consistent evidence yet to confirm this is the case. A strengthening housing market as a result of a stronger consumer would clearly also benefit the economy, and help reduce slack in industrial businesses.
If you were to take the step to assume that throughout the next business cycle CPI is unlikely to be higher than current inflation rates because you felt demand would not grow faster than supply, than the current multiple acts as a strong support for the S&P 500 index. Simply put, buying "risk free" assets offering 0.5% is not as attractive as getting a 5.5% earnings yield on the equity holding of a company you make like the future of. Large corrections in equity markets may therefore find strong support from the multiple - which does not seem inaccurate considering current data flow.
In reality the four factors for assessing the multiple are not mutually exclusive. Interest rates and money supply should fall under inflation. However, considering their prominent role in current markets I have separated them out.
Assessing EPS role in assessing value today
We have stated we feel the equity multiple currently offers strong support for the S&P 500 due to subdued CPI at the moment. However, let's look at how EPS could evolve focusing only on the much-discussed context of a weakening EM environment.
We assume international sales are approximately 33% of US corporate sales. A third of that is assumed to be to EM. Implying an exposure of around 11% of S&P 500 sales. Margins are usually lower in EM countries than in the home market, and other DM economies. Hence EM profits are assumed to be closer to 7 - 9% of the S&P 500.We feel it is not aggressive to assume greater than 11% of current capex is to EM regions.
- Many US corporates sell and invest to increase their exposure to China. It's understandable, it's a large economy with a stronger growth rate than the USA. However the economic transition being undertaken in the country could slow growth during this business cycle to increase its quality for several business cycles later. This is affecting demand from corporate, government and consumer customers, and therefore affecting volume, and affecting price as supply was built extrapolating past growth rates. We are seeing this happen in a range of sectors
- Weaker currency in China, and other EM could affect the USD valuation of sales from these regions
- Wages are increasing in China to help develop a consumer society. This is opposite to the beneficial effect that has happened in the US market over the last several years, which has allowed corporate margins to increase to record highs
- Raw material prices are decreasing as large commodity consumers like China experience lower growth rates, and invest in alternative projects to fixed asset, infrastructure projects that are capital intensive and raw material rich
- Single government state that is very involved in market policies, and can help local companies at the cost of international ones to assist creating national champions. This can distort the risk/reward and ownership dynamics of the investment, feeding in companies sacred search of growth (GAAP - growth at any price)
- Weaker global demand could reduce the probability of a US rate hike in 2015, which could provide temporary support for US companies as the USD may decline versus an international basket of currencies
- Large oversupply of capital equipment in China demonstrated by several years decline in PPI (purchaser price index). A clear signal demand at the wholesale level is severely impaired
- It is not new news that US corporates have been buying back stock aggressively taking advantage that borrowing costs though the bond markets are consistently below earnings yields, even with the current x17 multiple as the market average. When this condition is met share buybacks are value adding to shareholders
The list is longer than I originally intended to make - but I was going through the list. To conclude, I estimate EM alone put at risk 5% of S&P 500 aggregated profits. As a reference, a 15% decline of the USD versus a basket of currencies would probably offset the majority of that EM EPS risk.
The difficult question however is how weaker EM demand could translate to weaker domestic demand for Europe or the USA - as less imports from EM countries, fewer tourists, or less confidence can affect home market demand.
Again, I don't know the answer. One just keeps going through the list looking for clues. As an example, positive earnings growth for retailers on aggregate during Q2 2015 in the USA suggest consumer demand from lower unemployment, some small wage inflation and increasing credit from banks is dominating decreasing EM demand for the moment. We continue to assess the data flow.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.