Saturday, September 18, 2010

Is This Time Different?

In a past issue of Forbes Magazine, Gabriel Wisdom wrote an article titled “The Four Phases of Market Cycles”. Phase I: Pessimism and Abject Fear; Phase II: Skepticism; Phase III: Optimism; and Phase IV: Euphoria.

I wrote last month that “Our economy is clearly “recovering” from a financial crisis, but we have not yet “recovered”. The trip is not over, and we are not there yet.” I think that it can be safely said that for the most part we are in Phase II: Skepticism. Markets have risen dramatically from their lows, but recent declines in June and August had caused some to even fear that we had fallen back into Phase I.

According to Mr. Wisdom, “If you wait for optimism, you missed it.” This is sort of like Warren Buffet’s quote: “If you wait till you see the Robins, Spring has already arrived.”

The important point to remember, is that your investment strategy must ANTICIPATE the movement from one phase to another. If you wait until the markets enter Phase III: Optimism—then you will have missed most of the upside. The time to be fearful is during Phase IV: Euphoria.

Many investors are rightly disturbed by the negative uncertainty of high unemployment, a terrible real estate market, excessive debt, government deficits, and potentially rising tax rates. Even though corporate profits have risen back to pre-crisis levels, the market is skeptical that the numbers are wrong, rigged, or that they are not sustainable. (See graphs in 09/17/2010 weblog entry.) Few investors or pundits can clearly indentify the catalyst that will cause the whole thing to “turn around”.

Corporate Profits Recover

Time for a review of the basics of how equity prices are determined. Let’s start with the question, “How much would you pay for a security that promised to pay you $2500 per year, forever?” The answer for most people is that it would depend on the credibility of the institution making the promise, so let’s assume that probability of the promise being kept is very good. Most people would also need to know the rates of returns being offered by comparable investments.

So, for this example, let’s assume that comparably “safe” investments are currently paying 5% which is comparable to a price equal to 20 times the earnings or a 20 P/E ratio. So, most people would consider paying $50,000 for the security promising to pay $2,500 annually. (Based on current US Treasury Bond rates, buyers are paying more than $60,000 for 30 year bonds with a similar annual return.)

Next, how much would you pay for a security where the annual payment is likely to grow or increase over time? Let’s assume that the payment grows by only 3% per year—in 24 years the annual payment would have doubled to $5000. Since the “average” annual return over 24 years would be $3750, most people would be willing to pay 20 times $3750 or $75,000 for this security with a growing return. This would translate to a current 30 P/E ratio.

So, for a security with a stable return, a 20 P/E or price to earnings ratio is acceptable, and for one with a growing rate of return, a 30 P/E might be reasonable. The only reasons the P/E offered would be reduced is fear or belief (hence the risk) that the return or annual payment will be less or less certain in the future. The price of the “market” is clearly Earnings multiplied by Price/Earnings Ratio (P/E). The lower the P/E Ratio, the higher the perceived risk.

During Phase I, both Earnings and P/E Ratios (based on future earnings) fall, causing dramatic market declines. Typically, during the first stage of recovery, Corporate Earnings improve—as has been the case in this recovery. But during Phase II: Skepticism, even though earnings have improved, P/E ratios have not yet risen. Historically, the big market moves have been when earnings become stable (steady gradual growth) and P/E ratios expand dramatically. This will indentify the move to Phase III: Optimism. Essentially the P/E Ratio is a measure of Investor Sentiment.

The problem with trying to predict market movements is that one must predict or “guess”: Average Annual Earnings, Growth Rate and Relative Certainty (Risk). Then the P/E must be determined based on prices for “comparable” investments. When interest rates are low, then P/E Ratios for stocks tend to be higher. Finally, in order to predict market movements one must predict or “guess” likely changes in Sentiment which indicates how others (the market) have processed the same data.

As I wrote last month, “It seems that we are in a bubble of pessimism.” Without a doubt, there are many legitimate reasons for pessimism, but history teaches us that things will get better. As Jeremy Siegel, Wharton Professor and Author has written: “Over the past 200 years, we’ve gone through a Civil War, the Great Depression, two World Wars, and double-digit inflation in the 1970’s. There’s a long list of tragic events, but we always come back to the same trend of long-term stock returns.”

It seems likely that in the long run, Sentiment improves and P/E Ratio’s rise, creating an attractive rise in the market and a move to Phase III: Optimism. When it will happen is unknown. For those who have a long term perspective of 5 years or more—be prudent but start to get ready. “If you wait for optimism, you missed it.” And, “If you wait till you see the Robins, Spring has already arrived.”

In other words, markets will continue to fluctuate, and while one must always consider unknowable geo-political or natural disaster risks, the probability that markets will be significantly UP three to five years from now is significantly higher than the probability that they will be down.

Our economy may be slowing but it is very unlikely that we are making a U turn. Corporate profits may fail to meet analyst’s expectations, but the trend is still likely to be UP. The best assets to own during a time when corporate profits and sentiment improve are stocks.

Market recoveries are never a straight line up, and at each dip, fear will return. (Remember that September and October tend to be very volatile.) Chicken Little types will yell “Double Dip” and declare bizarre warnings of things like the “Death Cross” and the “Hindenburg Omen”. The media uses this hyperbole to entertain—not to inform.

While we are clearly not there yet, and may be moving slower than hoped, as corporations hoard cash and consumers pay off debts, we are clearly also increasing our potential for growth. Be patient, those delayed rewards may be better than we expect. We are in the middle of the Skepticism Phase, but Optimism is coming, sooner than later.

I suggest that you review my January 31, 2009 posting: “Early is on time, on time is late, and late is unacceptable”. Since then, the S&P500 is up about 5%, corresponding to a 7.5% annualized return.

This paper is for educational purposes and for the sake of discussion. It is not a sales presentation and not a recommendation or personal investment advice. Opinions provided are exclusively those of Wayne Strout and are not the opinions by any financial institution. All investing involves significant risk of loss and there is no proven method to eliminate that risk. No investment should be made without a complete due diligence process, fundamental analysis and a discussion with your personal financial advisor.

Friday, September 17, 2010

Corporate Profits Show "Recovery in Aggregate"

Anemic Real Estate is affecting and is affected by Sentiment

Unemployment, like housing is affected by and is affecting Sentiment

Corporate Profits Show "Recovery in Aggregate"

Along with sentiment regarding the future, corporate profits are fundamental in determining the value of corporate equities.