Sunday, October 25, 2009

Are Stocks Overvalued? - Alpha

Are Stocks Overvalued?
by Alpha and Vega, an Investor and a Trader
October 24, 2009

In this issue:

1) Historically, Stocks Were Considered Risky

2) Attitudes Towards Stocks Change after 1950

3) How to Value Stocks Today

4) The Witch of Wall Street

Dear Friends, Colleagues, and Investors,

Are stocks overvalued? How should we value stocks and allocate our capital between stocks, bonds, and real estate? Are stocks the best asset class “for the long run?”

1) Historically, Stocks Were Considered Risky

Until the 1920s, most American investors considered bonds to be safe and stocks to be speculative investments. This attitude developed for two reasons:

First, contractually bonds are a superior investment because repayment is far more certain. As a bond investor, you get a guarantee that your principal will be returned and you get a guaranteed rate of return as interest. You may even get a guarantee that if the borrower/debtor defaults you can take and keep the corporate assets, which act as collateral. Stocks, on the other hand, promise “what’s left over,” the residual profits. By law, a company’s management and board can, at their discretion, choose to pay out some of the profits or hoard them indefinitely. Also, it’s nearly impossible to liquidate a company as a stockholder. This reality is evident for companies whose stock market value is less than the cash on the books (management would rather get paid money to do nothing or pursue windmills). All else equal, it’s common sense for what a rational, risk-averse investor should choose:

a) An uncertain expectation of an 8-14% annualized non-contractual total return (dividends plus capital appreciation), with the risk of losing 50% of your principal in any given bad year (US common stocks from 1900-2009), or;

b) A 6-12% contractual return every year for 5-10 years with a guarantee to get your money/principal back (investment grade and high yield bonds – the riskier bonds offer higher returns –from 1970-2008).

Second, the experience investors had from 1870-1920 suggested bonds were the safer and better path. The first major American industries which issued securities were railroads and mining/resource companies. Often stock investors and even junior debt holders were fleeced. Only senior debtholders (with collateral) and shrewd entrepreneurs made any money. For a great historical overview, see these books on the railroads about E.H. Harriman, Cornelius Vanderbilt, and Leland Stanford, and these about the resource kings William Sharon, John D. Rockefeller, and Andrew Carnegie. One of the biggest lessons was that local entrepreneurs in the “Wild West” of the US took foreign capital, both equity and debt, and created wealth as the US grew fabulously. Their foreign investors frequently got nothing, as they were fleeced in elaborate legal scams (NOTE: Western investors in China are due for yet another rude awakening from 2013 onwards). Generally, the senior debt holders could recover something, but junior debt holders and equity holders often got a big fat zero for their money and effort (China today is worse, since debtholders can barely collect pennies on the dollar).

From 1860 to 1940, conservative investors and bankers, like Moses Taylor’s City Bank and James Stillman’s National City Bank weathered numerous economic depressions by holding one hundred percent of their assets in government bonds (see Jim Grant’s “Money of the Mind”, chapters 2 and 3, for their stories). This would have been the best strategy for 2007 and 2008 as long duration US government bonds outperformed everything else - “a panic exposes the essence of banking as no lecture, book, or diagram can do.”

Attitudes toward stocks changed in the 1920s.
JP Morgan singlehandedly helped to make investing in bonds and stocks more compelling. His firm consolidated many companies in an industry into trusts, with bankers on the boards looking out for securities holders. The US had superb real economic growth after WWI due to many technological innovations and adoptions (cheap motor cars, radio, nylon, plastics and rubbers, household appliances, etc.). Stocks started appreciating and offering mid-teens to low-twenties returns. Where hard-minded businessmen started, fools followed. Investors, day traders, and waiters threw caution to the wind and started to speculate on the momentum. Joe Kennedy famously liquidated his long portfolio and went short when a shoe shine boy gave him a tip in 1929; he reasoned that the foolishness had peaked.

The best intellectual argument to “push” stocks came from Edgar Lawrence Smith in his
Common Stocks as Long Term Investments and John Burr Williams’ The Theory of Investment Value. Their basic idea was the value behind a stock was left internally in a company, and investors could get their gains from capital appreciation and not payouts (dividends, asset distributions, etc.). Williams was more honest and acknowledged that at some point investors would have to get paid cash or assets (the basis of a dividend discount model) – not earnings, which are a made-up accounting number. Otherwise a stock was just a long Ponzi scheme, with one sucker selling a piece of paper to another sucker at a higher price with a final fool at the end.

The 1920s’ excesses continued and were fueled by cheap and easy debt, until the clock struck midnight in 1929. Margin lenders called their loans. Stock investors were burned with a loss that went as high as 89% from the peak to trough for the Dow. To put this in perspective, investment grade bonds only went down 20-30%, and government bonds stayed good near par. Hence 1922 to 1932 was a rollercoaster. Stocks came into favor and then fell out of it. Bankers were shown to be some of the biggest speculators and many had neglected their fiduciary duties.
John Kenneth Galbraith offers the most illuminating history of the Great Crash, with many of its lessons applicable to 2008.

2) Attitudes Toward Stocks Change after 1950

For the next twenty years till 1950, investors held bonds, especially government bonds. Stocks were for scoundrels and speculators. The markets even expected the Depression would continue after WWII ended in 1945, and bond yields went to ridiculous lows. See Sidney Homer’s History of Interest Rates, “Europe and North America since 1900”. Ben Graham published the first edition of his “Security Analysis” in 1934 to help investors analyze bonds - a few final chapters dealt with those highly speculative investments called “common stocks.” Investors then viewed stocks similarly to how investors today see hedge funds investing in RMBS and subprime - crazy. So stock prices and P/E ratios fell as investors avoided them; dividend yields rose till stocks were a bargain by 1945. 1950 would have been a great time to start picking stocks since stocks were cheap compared to bonds. In fact, that’s roughly when Warren Buffett got started and this is how he describes it:

The news was very good indeed in, the 1950's and early 1960's. With bonds yielding only 3 or 4 percent, the right to reinvest automatically [a stock’s] portion of the equity coupon at 12 percent was of enormous value. . . On their [stock’s] retained earnings, investors could earn 22 percent. In effect, earnings retention allowed investors to buy at book value part of an enterprise that, in the economic environment than existing, was worth a great deal more than book value. (“How Inflation Swindles the Equity Investor,” Fortune, 1977.)

In the second half of the 20th century, attitudes towards stocks changed dramatically. Instead of comparing a stock’s dividend yield to a bond’s yield-to-maturity (or usually coupon yield), investors bought stocks based on “good news” and “earnings.” Howard Marks of Oaktree Capital has a thoughtful section about “Attitudes Regarding Equities” after 1950 in a recent memo, on pages 10-12. Marks writes that “until the 1950s, equities always provided higher current yields . . .for the simple reason that they had to. People invested primarily for yield, and riskier securities – stocks – would attract buyers only if they promised higher yields than bonds.” That changed after 1950 as investors piled into stocks for numerous reasons, but mostly strong salesmanship with some theoretical underpinnings. Marks’ conclusion is that:

Equities’ higher historic average [from 1950-2000] and potential future returns should be viewed as nothing more than compensation for their inferior status and greater volatility. They’re not magic, just securities that can perform well when they’re priced right for the coming profits. If sluggish growth lies ahead for the economy in the next few years, it’s no given that common stocks will outperform corporate bonds.

From 1950 to 2008, the US experienced three secular bull markets (1950-1966, 1981-1990, 1992-2000) and two secular bear markets (1966-1981, 2000-2009). In general, stocks tended to track business cycles, the latter defined ex post by NBER here. But the big cycle was a bull cycle – the US kept getting richer and corporate profits kept rising until 2000, which was a peak for equities. Stocks in 2009 are still lower than the 2000 peak.

One interesting point is that the 1982-2008 superbubble that Soros pointed out didn’t just lead to the overvaluations of stocks. Rather, as credit was easy, too many companies got funding even through bonds and there was a secular rise in corporate issuer default counts, as the chart from Moody’s below shows. Notice how it took until 1940 for the 1920-1929 bubble to clear out. Then, chastened lenders didn’t let the purse strings loose again till the 1980s and defaults increased by 1986 onward.

One alternate explanation for the boom in stocks is due to life cycle demographics and the savvy marketing of stocks to boomers. As the baby boomers reached peak saving years from 1980 to 2006, they had to put their money someplace. Their advisors suggested stocks (given historical returns from 1950 to 1970), so the boomers piled money in regardless of valuations, yields, and expected long-term returns. This wave of cash fueled a massive and long lasting equities boom and bubble. New generations of investors and advisors saw that stocks only go up, faster and better than bonds, so they kept piling into stocks.

One paper on demographics suggests that the boomers outflows to fund their retirement would pick up in 2006 or 2007, and in fact, outflows did pick up.
By 2007, American stocks were ripe for another drop.

Japan seems to bear up this point as it has already crossed the line of dis-saving. As its population gets older, stocks in Japan (and even government bonds!) seem to be less safe bets as citizens liquidate securities to pay for retirement. Japan’s stock market is about 45% lower now than it was 19 years ago, and fund managers are still bearish on it. So much for the long run!

The key point from this historical discussion is that stocks are not naturally better than bonds. What matters are prices relative to underlying cash flows, actual future inflation rates, and investors’ liquidity/consumption preferences.

When the WSJ’s Jason Zweig asked Warren Buffett whether he believed stocks are sure to beat all other investments over the next 20 years, Buffett stated:

I certainly don't mean to say that. I would say that if you hold the S&P 500 long enough, you will show some gain. I think the probability of owning equities for 25 years, and having them end up at a lower price than where you started, is probably 1 in 100.

When Zweig pushed further by asking about the probability that stocks will beat everything else, including bonds and inflation, Buffett replied:

Who knows? People say that stocks have to be better than bonds, but I've pointed out just the opposite: That all depends on the starting price.

3) How to Value Stocks Today

We come to the relevant questions: How should an investor value stocks, and are stocks overvalued today? Two important notes: First, the questions deal with stocks in aggregate as an asset class, which investors can hold through indexes or diversified equity funds, not individual companies. If you can identify the next Google or Microsoft at IPO time, you will do well in that stock. Good luck finding it. The other note is that we only have historical experience to go by, especially the historical experience of equities in the US from 1850 to 2009. And past performance is often not a good guarantee of future performance.

The key question is how to value stocks as an asset class. One way is to go back to the old principle of comparing yields. This is similar to the Fed Model, which has its supporters and its opponents here and here. As boomers pull out of stocks over the next decade, don’t count on capital appreciation (in fact, you might want to factor in capital depreciation and hence demand a higher yield from stocks).

The basic idea behind comparing yields between asset classes is that one must look at opportunity costs (comparative yields). If you don’t hold stocks, you can hold cash, bonds, or real estate. Forget real estate for now, as it complicates the analysis.
Today, cash yields next to nothing, as money markets and 3-month to 12-month Treasury bills offer from 0.06% to 0.32%. 5 and 10-year government bonds offer 2.4% to 3.4%. Investment grade bonds offer about 5%, and high yield bonds offer about 9%.

The stock market’s yield (specifically the yield of an index like the S&P 500) can be estimated in many ways. One can consider the operating earnings yield, the net earnings yield, or the dividend yield.

Operating earnings yield: This is the S&P 500’s earnings before special charges, interest, and taxes. It’s a silly analysis that many equity analysts use because of convention and not thoughtful or rational thinking. Basically, as a stock investor you only get what’s left over after the payment of taxes, interest, and special charges (which are often recurring). Many S&P analysts calculate the P/E ratio of the S&P 500 using estimated 2010 and 2011 operating earnings. This is foolish, like using EBITDA, because a business can only ever pay out net earnings, not the made-up operating number. Operating earnings has its place as one metric to use for an individual company or industry’s profitability - it is not a good metric for the stock market as an aggregate. Beware P/E ratios where analysts say the S&P 500 is trading at a fair place because they use operating earnings (and worse,
completely moronic, lemming-like estimates of 2010 earnings, as William Hester of the Hussman Funds points out).

Net earnings (GAAP) yield: This is a better estimate of a “yield” but still imperfect. Usually depreciation understates the actual replacement cost of assets and capital expenditures, so what a company can actually sustainably pay out is lower than its GAAP net earnings (or it can choose not to replace its plant and just break down one day). For most companies, the actual sustainable yield (which is the theoretical free cash flow yield) is somewhere between the net earnings yield and the dividend yield. For mature companies, free cash flow can be approximated by the sum of dividends, share repurchases, and discretionary expenditures.

Dividend yield: This is the most conservative possible estimate of what a company’s yield is. It’s what a mature company actually pays out without scrimping or borrowing to make a payout. Until 1950, a company’s dividend yield to stockholders had to be higher than bond yields. Otherwise, investors would prefer safer bonds. After 1950, companies tended to re-invest free cash flows, so dividend yields have fallen from about 4% to under 2% from 1955 to 2007 (but have risen above 2% after the 2008 crash). Whether an investor prefers a dividend-paying stock or a bond depends on her views about inflation. In an inflationary environment, the common stock of a company with pricing power and low capital expenditures can pay dividends and do well. In a deflationary environment, the bonds of the same company will do better. Today the S&P 500’s dividend yields are near historical norms.

From December 1936 through March 2009 the average yield for the S&P 500 was 3.814% vs. 3.815% for December 2008. The current 12-month dividend yield is 3.42% vs. the 3.14 yield for December 2008.

Yet bond yields, for both government bonds and corporate bonds, are better (from 3.4% for 10-year Treasuries to 9% and above for high yield bonds). Score one for bonds.

There are other ways to value stocks as an asset class. One can look at the cyclically adjusted P/E ratio (the normalized P/E ratio over one or more cycles) or Tobin’s Q, a measure of market values to asset values.
Both indicators suggest US stocks are 30-40% overvalued. Or one can consider what GDP growth rate is implied by the current stock market valuations, and compare that to predicted GDP growth rates from expert forecasters. Gluskin Sheff’s David Rosenberg suggests the S&P 500 currently prices in a 5% growth rate. This is much higher than the 3% average from a WSJ poll of economists, and lower than skeptics who expect even less. Rosenberg presents the valuation in a second way too:

The stock market is expensive. According to Ned Davis, the median P/E ratio is 20x versus the average of 17x dating back nearly 40 years. Another nifty way to look at the situation (see page B2 of last Thursday’s NYT) is to go back to 1995 after the Fed had engineered the era of multi-year price stability and when Alan Greenspan hinted at the FOMC meetings that the stock market seemed to be fairly valued. At that time, the Dow was trading around the 4,000 mark. If you were to inflate that figure by the increase in GDP since that time and tack on a little more to account for margin expansion, the Dow would be trading around 8,000. As the NYT concluded, “against that hypothetical level, the Dow appears to be in bubble mode.”

The analysis for stocks boils down to this: What will net earnings for the S&P 500 be in 2010 and going forward? What is your best estimate of a sustainable free cash flow from the earnings? Then, at what multiple of that earnings or cash flow should stocks trade? Is it appropriate to use the 15x median for earnings that was common when boomers were saving and inflation was low? Or should we use a lower multiple as boomers liquidate their assets and the threat of inflation hangs over us? Will attitudes toward stocks change once again?

One reason some investors give to justify stock valuations and P/E ratios above 20 is that “interest rates are so low” so stocks should be priced higher. Yes, the Fed funds rate is nearly zero (for the select group of large “too big to fail” banks that can borrow close to that rate). All else equal, when all rates are low, stocks are more attractive. Yet as the above analysis shows, corporate bonds and even high yield bonds are priced much more attractively than stocks – their rates are high. They also offer much more downside protection in case of a second collapse.

4) The Witch of Wall Street

Hetty Green was a frugal American investor and businesswoman, often known as “the Witch of Wall Street” by her envious male counterparts. She borrowed a Manhattan office from her banker (for free), lived in a cheap New Jersey apartment (to avoid New York taxes), and walked within the city (to avoid paying the nickel for a tram car). Hetty stuck to conservative investments, holding much cash, lending money with extra collateral to back up her loans, and buying distressed real estate and mortgages for ten cents on the dollar. From 1870 to 1916, despite numerous depressions, bank failures, and a 20-year deflationary period, her wealth rose from $8mn to $200mn. This was a 7% annualized return, which may sound low. But remember that for two decades of her lifetime the rate of inflation was negative, so Hetty’s real rate of return was closer to a steady 9% for half a century - during turbulent times. And Hetty rarely ever lost money.

Hetty’s main advice was to wait for the foreclosures. “I regard real estate investments as the safest means of using idle money… I would advise any woman… to buy at an auction on occasions when circumstances have forced a sale… [where] she can buy a parcel of land at one-third its appraised value.” She also shrewdly avoided stocks, saying “I don’t much believe in stocks. Wall Street is no place for a woman.” Or, it seems, for any outsider, as the Street seems to continually fleece both retail and sophisticated investors, while CNBC constantly plays trash about the latest hot common stock or the daily fluctuations of stock markets. Hetty was also a shrewd investor in mortgage bonds and city mortgages, but that takes more sophistication than most investors today have (certainly more judgment than the real estate lenders and securitizers who issued all the junk CMBS, subprimes, CDOs, and such). In a deflationary environment, Hetty’s strategy works. In a massively inflationary one, look to precious metals, agricultural and energy companies, and *productive* real estate (not subprime homes sitting empty and rotting in depressed areas).

In summary, the point of this piece is that perhaps stocks are high today because of the repetition of a saying, “BUY STOCKS,” for the last fifty years (or “BUY ON THE DIP” or “BUY ON THE ECONOMIC RECOVERY”). This advice came from the experience of two great bull markets, 1950-1966 and 1981-2007. It also came from the demographic surge as boomers had excess savings and took mindless investment advice: “Keep a 60/40 portfolio” or “Stocks are cheap when trading below 15x earnings” (What measure of earnings? Why?). Today stocks don’t look cheap anymore. An economic recovery isn’t assured and savers need their cash to meet basic expenses. A sober analysis shows stocks aren’t cheap or fair, but quite dear. Investors will need to be burned again before they reject their advisors’ pap.

Your Cautious Investor,


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