Edge and Odds

The enemy of knowledge is not ignorance, it’s the illusion of knowledge (Stephen Hawking)

It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so (Mark Twain)

Edge and Odds

Invest with smart knowledge and objective odds

EQUITY VALUATION

TRUMP CARDS

The Trump story has been remarkable, not really on its impact on the bull and bear population, but mainly on the denizens of the “correction camp” as these Yardeni charts illustrate. Bullish investors (per Investors Intelligence) are back at their usual high number of hopefuls but they have been joined by a significant number of short-term nervous willies who suddenly decided that the odds of a correction vanished the morning of November 9. That has left the few bears still growling with barely anybody to share any notion of cautiousness on the forthcoming renewal of American Greatness.

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Factset tells us that during the first two months of the fourth the Q4 bottom-up EPS estimate for the S&P 500 Index dropped by 2.0% (to $30.91 from $31.55).

During the past year (4 quarters), the average decline in the bottom-up EPS estimate during the first two months of a quarter has been 3.8%. During the past five years (20 quarters), the average decline in the bottom-up EPS estimate during the first two months of a quarter has been 3.4%. During the past ten years, (40 quarters), the average decline in the bottom-up EPS estimate during the first two months of a quarter has been 3.9%. (…)

One of the sectors contributing to the below average decline in the bottom-up EPS estimate for the S&P 500 over the past two months is the Information Technology sector. This sector has recorded an increase in the bottom-up EPS estimate of 0.8% (to $13.26 from $13.15) during the first two months of the quarter. This 0.8% increase is well above the average decline of 4.0% over the past year and the average decline of 3.6% over the past five years in the bottom-up EPS estimate for this sector during the first two months of the quarter. (…)

The Energy sector has recorded the largest increase in expected earnings growth since the start of the quarter (to 3.4% from -1.3%). (…)

Of the 108 companies that have issued EPS guidance for the third quarter, 73 have issued negative
EPS guidance and 35 have issued positive EPS guidance. The percentage of companies issuing negative EPS guidance is 68% (73 out of 108), which is below the 5-year average of 74%.

As a result of the downward revisions to earnings estimates, the estimated year-over-year earnings growth rate for Q4 2016 is 3.3% today. On September 30, the expected earnings growth rate was 5.3%. (…)

Analysts currently expect earnings and revenue growth to continue in 2017.
For Q1 2017, analysts are projecting earnings growth of 11.5% and revenue growth of 8.0%.
For Q2 2017, analysts are projecting earnings growth of 10.7% and revenue growth of 5.7%.
For all of 2017, analysts are projecting earnings growth of 11.4% and revenue growth of 5.7%.

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On the Rule of 20, the only positive is that the Rule of 20 “fair value”, which reflects trends in trailing earnings and inflation (yellow line below) has bounced back after reaching a 12-month low in July, thanks to a 2.9% rise in trailing EPS and stable inflation.

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Based on Q4’16 estimates, trailing earnings could reach $118.19 (TR) by mid-March. The Rule of 20 P/E is thus 20.8x trailing EPS three months hence. This elevated number leaves little room for a strong upward move unless investors get so giddy to venture higher into overvalued territory. There have been 17 major market peaks since the Great Depression. The average Rule of 20 P/E at these peaks has been 21.7 (median 22.0).

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Here are other ways to look at the risk/reward ratio at this point:

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With such poor odds, Mr. Market better have solid trump cards in his hand.

If you prefer more conventional valuation measures, Goldman has them lined up in this table:

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Corporate insiders don’t seem to trust their own hand as they see it.

(…) A total of 3,500 insiders at Russell 3000 companies have unloaded their own stock in the last three weeks, while 467 purchased shares, according to data from The Washington Service, a Bethesda, Maryland-based provider of insider trading data and news. The number of sellers was higher than the monthly average of 1,832 sellers this year through October. Sellers have also increased from the comparable year-ago period, and buyers have decreased. (…)

Insider buying and selling doesn’t necessarily presage gains or declines in a given firm’s shares, of course. But Wall Street watches the data because insiders are understood to have the best information about their companies’ prospects, and are also typically veterans of their industries with longer-term horizons.

While they have historically tended to sell more than buy, their behavior since the election diverges from investors, who have exhibited a rapid shift in sentiment and poured money into equities. (…)

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“The big increase in insider selling makes sense because we’ve been making all-time market highs,” said Aaron Jett, the Los Angeles-based vice president of global equity research at Bel Air Investment Advisors, which oversees about $8 billion. “A huge portion of their wealth could be tied up with that one stock so they could want to sell to diversify.”

It is normal for executives to sell into market strength, according to Mr. Jett. That said, a prolonged period of outsize selling by insiders would be concerning, he noted.

(…) in the last month, 891 insiders of U.S. financial companies sold shares, compared with 425 executives who added, data from The Washington Service show.

Both Mr. Clissold and Mr. Jett said it is more valuable to pay attention to a pickup in executive buying rather than selling, since sales can occur for personal, idiosyncratic reasons, while stock purchases tend to indicate confidence in the company. (…)

Punch Where the big increase in insider selling makes much less sense is that it is occurring at the end of 2016:

  1. why not wait just a few weeks to defer tax payments by 12 months to April 2018?
  2. why not wait just a few weeks to potentially avoid the 3.8% Obamacare’s net investment income tax which the Trump camp wants to eliminate?
  3. why not wait just a few weeks to potentially benefit from lower capital gains tax rates promised by Republicans?

Insiders’ use of the trading window following quarterly earnings reports has been rising as the year progressed. Sellers steadily increased while buyers became fewer and fewer. Note that the November data on the chart only includes trades after the election.

Only fools and bourses – The ‘CAPE’ ratio can be useful but do not take it at face value

In November 2012, I entered the debate (The Shiller P/E: Alas, A Useless Friend) on the usefulness of the CAPE or Shiller P/E as an adequate valuation tool for the U.S. equity market with the following reasons:

  • “Operating” earnings are a better gauge of index profits;
  • Assessing current indices against the last 10-year earnings is flawed;
  • Looking at past evidence, the Shiller P/E is simply useless as a market valuation tool;
  • There is at least one alternative.

One of the main problems with the Shiller P/E approach has not been discussed by any other pundit until today. In 2012, I explained why the CAPE was not a fair valuation tool since 2008 given that

many of the companies that recorded huge losses in 2008-09 either went bankrupt or were substantially restructured or acquired. A conceptually valid valuation method like the Shiller PE, measuring 10-year average earnings against a current index, is thus including in its denominator, during 10 years, the huge losses recorded by companies that are no longer included in its numerator, these companies having in fact been replaced by other, profitable, companies.

Humongous or very large losses were recorded in 2008 by companies such as AIG, GM, Merrill Lynch, Marshall & Ilsley, MBIA, Wachovia, all companies then part of the S&P 500 Index but no longer. As to the dot.com bubble, everybody remembers the infamous Enron and Worldcom, just to name a couple. Their losses still impact the 10 year average earnings even though they have no contribution to the actual index value.

The losers are long gone but their losses remain!

This is like assessing a baseball team’s current batting line-up using 10-year data that includes the dismal stats of now deceased players. How useful is that?

Finally, somebody has awaken to this reality. Kevin Murphy, fund manager at Schroders, last week published the headlined article in which he used other examples to illustrate why CAPE is distorting valuations:

The British girl group Sugababes may not seem an obvious starting point for any discussion on the merits of value investing but please do bear with us. Sugababes started life in 1998 with a founding line-up of Keisha Buchanan, Mutya Buena and Siobhán Donaghy but one by one, over the course of the next 11 years, all three left the group – each time to be replaced by a new singer. 

Go to a Sugababes concert now and you would hear the group’s repertoire being performed by Amelle Berrabah, Jade Ewen and Heidi Range while, curiously enough, the original three members have reconvened under the eponymous banner of Mutya Keisha Siobhan, which Wikipedia helpfully informs us “is often shortened to MKS”. So – which would you consider to be the real ‘Sugababes experience’? 

Keen students of popular culture may recognise a similar philosophical conundrum cropping up in an episode of ‘Only Fools and Horses’ where the road-sweeper Trigger wins an award from the council for having owned the same broom for 20 years. He goes on to reveal it has had 17 new heads and 14 new handles, but insists it is still the same broom. Does Trigger have a point? 

Genius that he was, Plutarch foreshadowed both these vexing questions with his ‘Ship of Theseus’ paradox. Can a ship that is restored by replacing every single one of its wooden parts, the First Century historian and philosopher asked, remain the same ship? At the same time, we sense you asking, what has any of this to do with value investing? 

Well, here on The Value Perspective, we often refer to a metric known as the cyclically adjusted price/earnings ratio – ‘CAPE’ for short – which encapsulates the average earnings generated by a business, sector or market over the preceding 10 years, adjusted for inflation. And of course, over time, the constituents of sectors and markets can and do change. 

The peripheral eurozone is a topical enough example, with many companies that would have featured in the benchmark indices of Greece, Ireland, Italy, Portugal and Spain before the 2008 financial crisis now no longer with us due to insolvency. As it happens, at the start of 2015, all five markets featured among the cheapest in the world on a CAPE basis in a chart we ran in Cape of good hope.

Focusing in on Greece then, a comparison of the constituents of the Athens Composite index in 2006 and 2015 reveals just three of the 10 largest companies from nine years ago can still make that claim today. At a sectoral level, meanwhile, financial companies make up just a third of the Athens Composite at present, compared with half the index back in 2006. 

However, even though they may no longer exist, the constituents of the Athens Composite in 2006 are frozen in time as the profits or earnings power of Greece. Of course, given some of those stocks are no longer in the index, it would be foolish to work on the basis that that level of profits or earnings power is likely to come back any time in the near future. 

What this means for us as investors is that, when we are valuing stockmarkets, we need to recognise there are reasons those markets may not necessarily end up performing as strongly as the superficial headline ratio would suggest. Indeed, when we dig deeper, it can quickly become apparent there are nowhere near the number of opportunities within ‘cheap’ markets as the headline ratios might suggest. (…)

The point of our Ship of Theseus analogy (and the two shamelessly more populist variations on the theme) is that markets and sectors change and evolve. As a result, investors need to be careful about taking headline ratios at face value and so being fooled into buying an index that may not necessarily provide the returns that history would suggest. (…)

Back to U.S. equities, the main reason why the Shiller P/E has remained elevated throughout the last five years’ bull market is that its numerator has changed significantly while its denominator continued to include the huge losses incurred in 2000-2001 and in 2008-2009 by companies no longer in the Index. Losses incurred by the Enron’s of the internet bubble years are now out of the Shiller denominator but those of the financial crisis will keep knocking the denominator for another 3-4 years.

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We are not talking about trivial numbers. In 2008, some eighty S&P 500 companies recorded $240 billion in losses, subtracting over $27 per share from the index earnings even though they accounted for only 6.4% of the index weight. Incidentally, the S&P Financial sub-index recorded “operating” losses in each and every quarter of 2008 for a yearly total of $21.24 (-$37.96 “as reported”). Many of the big losers are no longer, but CAPE still carries their losses.

CAPE 10-year earnings are currently $77 (rounded), some $36 (31%) lower than the current S&P 500 trailing operating earnings. It is not a mere coincidence that the difference between S&P’s normalized operating earnings and Shiller’s earnings peaked at $38 in March 2009. This gap will continue to artificially and deceivably inflate the Shiller P/E until December 2019.

Meanwhile, the Rule of 20 P/E, almost totally unknown or neglected by most pundits, continues to provide investors with dependable assessments of the risk/reward ratio for U.S. equities. This orphan valuation tool has not been endorsed by a Nobel laureate and is likely too simple to be used by economists and strategists in need of justifying their forecasts with circumvoluted formulas and thesis. Nonetheless, there is no better and dependable friend around.

Contact: edgeandodds [at] gmail.com