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

NEW$ & VIEW$ (27 MAR. 2015): Nominal sales vs labor costs; Japan; Oil.

More Signs of Wage Inflation

Via The Big Picture

From Torsten Sløk of Deutsche Bank:

The first chart below shows that over the past year employer costs have risen significantly. The second chart shows that the rise is driven partly by a significant increase in bonuses. The third chart shows that the uptrend in wages can been seen across all parts of the services sector. And the fourth chart shows that wages are rising faster for unionized workers. This data, the Employer Costs for Employee Compensation (ECEC), is created using the same raw data that goes into the Employment Cost Index (ECI). The difference between the ECI and the ECEC is that the ECI controls for changes in the industrial-occupational composition of jobs. In other words, the ECI is intended to indicate how the average compensation paid by employers would have changed over time if the industrial-occupational composition of employment had not changed from the base period. The ECEC data on the other hand, does not control for the effect of a change in the composition of jobs. For example, if a company goes from hiring fewer customer services workers to hiring more R&D workers then it would show up in the ECEC data as higher wage inflation (because R&D workers generally have higher wages than customer services workers).

This happens to be consistent with the data showing that employment growth has been stronger for high-wage occupations and it is also consistent with the recent strong uptrend seen in private sector R&D spending. In the 1990s we saw the opposite, with the ECI above the ECEC because more lower paying jobs were created. For more discussion of this and the differences between the ECI and the ECEC see also this BLS article here:http://www.bls.gov/opub/mlr/cwc/explaining-the-differential-growth-rates-of-the-eci-and-ecec.pdf. The bottom line remains that there are several ways of measuring wage inflation and although average hourly earnings remains flat, several of the other measures of wages are showing signs of broad-based wage pressure.wage inflation3

A slower economy, slower overall inflation with deflating retail prices, and a rising dollar against rising labour costs means lower margins and potentially lower earnings. Here’s another illustration from Moody’s:

image

BTW this a.m.: Q4 Corporate Profits: -1.4% vs. +5.06% prior.

EMU Trends Turn Up for Credit and Money

The EMU is showing a clear pick up in credit and money growth trends as of February 2015. It is beginning to look as though the ECB’s special efforts to stimulate credit growth are starting to pay off. The QE effort is too recent to have its direct effect included in the data, but QE has been expected and other programs appear to be having some impact too.

Japan’s Zero Inflation Is a Setback for Abenomics Japan drifts back toward deflation, two years after launching a radical monetary policy experiment to cure the affliction.

imageThe government said Friday the core consumer-price index hit 0%, the lowest level since May 2013 and far from the 2% target that the central bank had pledged to hit by this spring. The index excludes fresh food prices and effects of a tax increase. (…)

To be sure, the economy has some bright spots, according to other data released Friday. As a shrinking working-age population and growth in construction work—in part fed by fiscal stimulus—tighten the labor market, the jobless rate fell to 3.5% in February from 3.6% in January, while the jobs-to-applicants ratio rose to 1.15, its highest level since March 1992. That means there were 115 jobs available for every 100 job seekers.

That, however, hasn’t translated into more spending by consumers. Household spending fell 2.9% from a year earlier in February, marking the 13th consecutive decline. Retail sales fell 1.8% from a year earlier. (…)

Despite the weak yen, exports have been slow to rise, in part because many Japanese companies have opted not to use the new currency advantage to cut prices on world markets, but rather maintain sales at current levels and book higher yen profits. And despite sharp earnings gains, multinationals have continued to sit on cash, rather than invest it in new equipment, as they remain unsure of Japan’s longer-term growth prospects. (…)

In the FT:

The advance inflation reading for the Tokyo area in March stayed positive at 0.2 per cent year-on-year, suggesting Japan will not dip into deflation next month, but it could still happen by summer.

“Electricity and gas charges are expected to start declining from April onwards, putting larger downward pressures on the core CPI inflation rate going forward,” noted analysts at Credit Suisse in Tokyo.

Elsewhere in the WSJ:

(…) The worries are overdone. The Bank of Japan has clearly missed its target, declared at the start of its easing campaign two years ago, to hit 2% inflation in two years. But this is due to factors largely beyond its control—sharply falling oil prices and last year’s increase in the consumption tax.

Oil prices have in fact been a positive for the Japanese economy. The tax increase has been negative. Both will be temporary in their effects on prices.

That said, zero isn’t the lower bound for Japanese inflation. Prices could turn negative in the coming months, as utility companies cut charges after a lag. But lower energy costs will be a boon to the country’s economy in the long term, putting more cash in the pockets of consumers and businesses.

Of course, even the so-called “core-core” CPI, which also excludes energy and food, was up just 0.3% from a year earlier in February. This likely reflects the lingering effects on demand from last year’s three-percentage-point increase in the consumption tax.

The concern is that these temporary disruptions could conspire to keep Japanese people trapped in a “deflationary mindset.” To head that off, some speculate that the Bank of Japan might ease policy again as soon as next month.

But a deflationary mindset takes more than just CPI turning briefly negative. Other recent data show demand strengthening. Household consumption rose 0.8% from a month earlier in February. The labor market is tight, with the unemployment rate falling to 3.5% from 3.6% a month earlier. The ratio of job postings to applicants, already at its highest in decades, climbed further. And Japan’s largest companies have just agreed to the biggest wage increases in many years.

And besides consumer prices, asset prices, from stocks to land, are rising. Export volumes are picking up. This isn’t what deflation looks like.

Japan may have laid a goose egg on inflation. But with so much else going in the right direction, the BOJ is unlikely to ramp up the stimulus just yet.

U.S. Oil Output Not Even Slowing Let Alone Falling

Another week, another record high for U.S. oil production, now topping 9.4 million barrels per day, or about 1 to 2 million barrels more than the nation needs each day. Moreover, despite a collapse in drilling rigs, the rate of increase (15% y/y) hasn’t even slowed. Shale producers are simply pumping more oil out of their best
performing wells. While supply will eventually ebb as these wells run dry, the short-term risks for oil prices are clearly on the downside. (BMO Capital)

image

BMO looks at the YoY rate of change. Others have noted that last week’s production rose only 3000 barrels, down to a trickle… 

EQUITY VALUATION

Posted yesterday:

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

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.

cotd distressed sp 500 companies

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.