Friday, February 27, 2009

The 10-year PE ratio

One good valuation technique is the 10-year PE ratio. That is the current real price of the S&P 500 divided by the average of the last 10 years of real earnings per share. This is better than the trailing twelve month PE since it smooths over periods of excessive profitability or un-profitability. The following chart (from Robert Shiller's data) shows this ratio back to the 1880s. The red line shows the median value 15.68 and the blue line is at 10 which appear to be around where the troughs occur. Some were worse than this for example in 1921. Right now we are at 12.95 (S&P 500 = 745) which is somewhat below average but somewhat higher than most troughs. To reach PE(10)=10, the S&P 500 would fall to 575 or another 23%. To reach the lowest ever PE(10)=4.78, it would drop to 275 or another 63%. Lets hope that doesn't happen.

There is another way to look at this however. It is possible that the inflation correction is incorrect. There is an alternative inflation measure which claims to be closer to what was used for most of US history. This is from Shadowstats . The Shadowstats inflation measure is much higher than the government reported inflation rate, especially for the past few years. The following plot is the same as above but with the alternative Shadowstats CPI inflation correction applied to both earnings and price. The effect of this is that it makes stocks look cheaper since the correction to the current price is larger than the correction to 10-year earnings.

Which is correct if any? I don't know but would guess that the best measure is probably somewhere in between.

Conclusions: stocks are probably approaching their lows and buying solid blue chip companies is likely the right thing to do. Certainly, selling now look like the wrong thing to do.

Saturday, February 21, 2009

The TALF. What hath God wrought?

The New York times has a fascinating article on the Fed's new program. The Term Asset-Backed Securities Loan Facility or TALF is an attempt to jump-start lending in the economy. The reason for the credit crunch is not that traditional banks like Bank of America are not lending. The Fed has a fairly firm grip on the balls of the CEOs of these banks since all are on the verge of government takeover. If the Fed says lend, they say "How much?".

The trouble is that over the past few decades a new banking system has arisen. This so called "Shadow Banking System", a term coined by PIMCO's Paul McCully, is just the network set up to securitize credit instruments and move them off bank balance sheets and onto the balance sheets of hedge funds, insurance companies, pension funds and any other investors looking for fixed income type investments. Many but not all of these loans are made by commercial banks. There are also finance companies like AIG's American General Finance or GE's GE Capital. Hedge funds and investment banks were also involved in credit creation and securitization. Someone willing to start a small business could go directly to a hedge fund for capital rather that to Bank of America.

This shadow banking system has collapsed. More accurately, it still exists but has dramatically reduced the amount of credit that it is willing to extend. Insurance companies and pension funds are saying "thanks but no thanks" to those BBB rated tranches of securitized auto loans. They will stick with US Treasuries, thank you very much.

The Fed has concluded that growth cannot resume while this major source of lending has been shut off. So its solution is to try to get it going again by subsidizing it.

It works basically like this. From the New York Times.

"Under the program, the Fed will lend to investors who acquire new securities backed by auto loans, credit card balances, student loans and small-business loans at rates ranging from roughly 1.5 percent to 3 percent. Depending on the type of security they are borrowing against, investors will be able to borrow 84 percent to 95 percent of the face value of the bonds. Investors would not be liable for any losses beyond the 5 percent to 16 percent equity that they retain in the investment."

So in essence, the Fed is creating a new system of unregulated or lightly regulated banks from the stock of hedge funds and private equity investors around the world. To a hedge fund, it might look like this. You borrow at 2% and buy assets yielding 12%. Maybe your loss rate on these would be 6% so your final yield is 6% with a Net Interest Margin of 4%. Now you get to leverage this by a factor of 10. Now you are making 40% return on invested capital before expenses and taxes. Expenses for running a large fund are small. A team of 20 hot-shot hedge fund guys might run a fund with $10B of capital taking on $100B in assets making $40B on profits per year. They might pay themselves 2% of assets and 20% of profits which is $2B/year + $8B = $10B/year leaving $30B/year in pretax profits for the investors which is a 30% return. The 20 hedge fund guys each make half a billion per year if it is divided equally. If something goes horribly wrong and these credit instruments result in massive losses, the investors lose all of their invested capital but are not on the hook for the losses. The Fed (or maybe the taxpayer) is on the hook for the losses. If the hedge fund makes their expected profit for say three years before the shit hits the fan, they still make $1.5B each and then need to look for new jobs.

Some would say that the cause of the crisis was too much borrowing, too much leverage and too much greed. The Fed's solution appears to be more borrowing, more leverage and more greed. Somehow, I don't think the American people are going to like that plan.

Friday, February 20, 2009

Who owes who what

The Federal Reserve publishes their quarterly flow of funds report. It is a fascinating document with all kinds of interesting figures.

One table shows the assets and liabilities in the US credit markets. So it shows you who owes who what.

Here are some statistics. Everything is in Trillions of dollars.

The total credit markets $51.80T. The following table shows who owes the debt and who owns those same credit market instruments as assets. Categories less than $1T are not shown.

Borrower 2009 2004
Household and Non-profit $13.92T $9.50T
Non-farm, non-financial, corporate $7.01T$4.97T
Federal Government $5.80T$4.03T
Issuers of asset-backed securities $4.21T 2.21T
Government Sponsored Enterprises $3.15T $2.60T
Non-farm, non-corporate, business $3.75T $2.20T
State and local government $2.22T$1.57T
Rest of World $1.96T$1.25T
Commercial Banks $1.46T $0.66T
Fianance Companies $1.28T $1.00T
Total US credit market debt $51.80T $34.60T
Rest of world $7.85T $3.84
Commercial banks $7.85T $5.99
Domestic non-financial sectors $6.15T $4.79
US Agency and GSEs total mortgages $4.89T $3.32
Issuers of asset-backed securities $4.11T 2.12T
Households and Non-profits $4.09T $3.04
Insurance companies $3.79T $3.11
GSE credit and equity instruments $3.02T $2.56
State and local governments $1.48T $1.12
Pension funds $2.37T 1.51T
Mutual funds $2.37T $1.51
Finance companies $1.621T 1.201T
Savings Institutions $1.32T $1.29

One thing that is trivially true but also something that most people don't think about is that debt nets to zero. All debts or liabilities are someone else's assets. The net debt of the world is zero. This table above shows that the net debt in the US is $7.85T-$1.96T = $5.89T. This is the difference in the gross amount that we lend to them minus what we owe to them. The rest, $45.9T, is debt that we owe to ourselves. That is it nets out to zero inside America. But who are the borrowers and who are the savers?

Basically it breaks up into three groups. There are the net debtors: households, non-financial businesses and government. Then there are the net savers, banks, pension funds, insurance companies and mutual funds. You can also include "rest of world" here. Then there are what you can call arbitrageurs. These are entities that have large gross debt but little net debt. That is, they borrow from the capital markets but invest in other debt instruments. These are: GSEs, issuers of asset backed securities and finance companies. This would also include hedge funds, investment banks and the like.

So do we have too much debt? Remember debt is a gross measure. Much of this debt is just due to the rise of the arbitrageurs. Whether that is good or bad is hard to say. All of this extra leverage helps with liquidity. It makes it easier to borrow and therefore probably lowers interest rates and lubricates the wheels of industry. Whether or not it does anything else useful is hard to say. It also of course adds complication to everything and we have been paying the price for this over he past few years.

There is clearly too much household debt. As you can see from the table above, household debt grew from $9.50T to 13.92T from 2004 to 2009. Most of that is mortgage debt but is also made up of credit card debt, home equity loans, student loans, auto loans etc. During that time, average salaries did not increase. People simply over-consumed. Now their assets, homes and stocks, are falling in value and so they are getting poorer and they will have great difficulty servicing this large debt load.

Businesses also borrowed heavily. Corporate and non-corporate together increased their borrowing from $7.17T to $10.76T. Earnings may have increased over that period but they are now dropping at the fastest pace since ... well maybe ever. They won't be able to service this debt either. According to Standard & Poor’s, nearly 66% of nonfinancial companies have below investment grade ratings. They are predicting a default rate for this group of about 14% in 2009.

We may have about $7T of unserviceable debt which is roughly the increase from 2004. Much of that will be restructured, foreclosed on etc. Maybe only 30% of that will becomes losses. But even still that is $2.1T. We can see above where those losses will show up - with the savers: banks, pension funds, insurance companies and mutual funds and the "rest of world".

So in total, it looks like this. Savers who wanted to accumulate more wealth loaned money to people who bought either consumables (e.g. steak dinners), over-priced assets (e.g. houses) or unproductive capital assets (e.g. steak house restaurants). These tuned out to be bad loans. All that principal will not come back to the savers. But the wealth that was lost by the savers didn't all go up in smoke. All the extra steak dinners might be gone but the houses and commercial real estate and businesses are not. They might have less value than everyone thought but they are not valueless. So part of the loss in wealth is just a realization that it wasn't real wealth to begin with. We as a country are really no poorer than in 2002. We just thought we got rich in between. There has of course been a transfer of wealth between many individuals but not much in the way of real net loss.

This isn't quite right though. We did increase our US net debt by about $3.3T since 2004. That works out to be about $33,000 per american family. We have assets in return however even if we might have over-paid for some of them (like houses). With our assets falling in value and wages falling due to unemployment we have to spend much less. We need to save more. This will be the main dynamic of the next few years. The world will have to adjust to a US consumer which is spending a lot less. This adjustment is likely to be very painful. Our economy is out of balance. We have too many of somethings like restaurants and retail stores and too little of other things like factories for exporting goods. Since the economy is out of balance much of the investment will be required to restructure it to the new reality. This is likely to sop up any actual economic growth for a few years.

There are some groups that are likely to benefit. Poorer people who had no or negative equity to begin with may now have large negative equity especially if they bought a house with no money down that has plummeted in value. If they walk away and declare bankruptcy, their net worth goes from a large negative number to zero. It has increased. Since they will no longer have to service this debt, they will have more discretionary income. They will be richer. Their creditors however will take the loss. This is a rather direct transfer of wealth from rich to poor. This commonly happens in depressions.

Sunday, February 15, 2009

It is official: Obama is a tool

Ok, I was admittedly excited when Obama was elected. Finally, there was someone who would help reverse the plight of the middle class in America. It has taken less than a month for me to decide that his presidency will be a failure. It is not that he lacks good intensions. It is that he is not a strong leader. He is another Jimmy Carter. He is too impressionable, too willing to keep the status quo, too willing to try to please everyone. What we need right now is someone willing to be confrontational and make hard decisions. He is not that person.

Foremost is his handling of the economic crisis. For a while there was some hope when he hired Paul Volcker. The hard nosed former Fed chairman is exactly the kind of person that should be leading the handling of banking crisis. Unfortunately Paul seems to be losing favor in the administration. Larry Summer seems to be in charge. Summers, the protege of Robert Rubin was one of the chief proponents of deregulation and free markets. In other words, he is one of the people that caused all the mess to begin with. The foxes are guarding the hen house. Goldman Sachs in firmly in control.

We are already seeing some of the bad policies that will come out of this administration. The right thing to do is to nationalize the insolvent banking systems like Sweden did in the 90s when they had a financial collapse. However, that is not the Obama plan. He said in an interview that this would not be possible due to the "different culture" in the US. Different culture? What does culture have to do with whether a bank is insolvent? I assume that he is saying that Swedes are pinkos and that we in America believe in capitalism. But taking over the banks is not socialism. It is capitalism. In a capitalistic system, when a company becomes insolvent, it's equity is wiped out and ownership is transferred to it creditors. Usually this is what happens in bankruptcy court. The banks are insolvent and they should be handed over to their creditors which are the depositors. Propping up banks with government money is socialism, not the other way around. For banks, this is done by putting them into receivership. This is what needs to be done.

Today in the Wall Street Journal there is an article saying that Obama's aid David Axelrod says Obama has a solid plan on housing. His plans will prevent foreclosures and "put a floor under house prices". Now preventing some foreclosures makes sense. It is in the interest of both the homeowner and the banks. However "putting a floor under house prices" is absurd. House prices like everything else are set by supply and demand. Houses are still over-valued which is why people are not buying them. They were in a bubble. The huge demand for houses was primarily due to two things 1) Speculators hoping to flip houses for a profit and 2) a huge group of people that got fooled into believing that they could afford a house when the really could not. Clearly neither of these two sources of excess demand are coming back and there is more supply than ever. Houses prices will continue to go down regardless of what Obama does. But the fact that he is trying to prop up housing prices shows that he is an imbecile. When house prices have fallen to the point where the price-to-income ratio is normal, people will buy them and they will have more money left over to spend in the economy. It does not do any good if we keep house prices unaffordable. High house prices is one of the reasons why people could only afford to live by running up lots of consumer and home equity debt. The sooner house prices fall to normal levels, the sooner we can come out of this recession. If the government tries to manipulate house prices upward, it will only prolong the pain.

Thursday, February 12, 2009

Credit problems ahead

Here is a nice slide from a great (but scary)

by T2 partners.

If you go through and apply reasonable loss rates to these categories, it isn't hard to get $3 trillion dollars in total credit losses.
(note: agency double counts prime loans). Maybe half of that is concentrated in US banks. The total capital of the US banking system is roughly $1 trillion which basically makes the banking system insolvent.

HERE is another estimate from Nouriel Roubini.

Sunday, February 1, 2009

A theory of boom bust

  • Anti-progressive policies allow wealth to accumulate more quickly at the top of the economic spectrum.
  • The wealthy save most of the money and much of the wealth gets lent to the middle classes keeping interest rates low.
  • The middle classes have less income but are able to borrow cheaply to support the same standard of living.
  • Higher amounts of leverage, profit growth and more capital accumulation pushes asset prices higher leading people to believe their wealth is higher than it really is. This creates a wealth effect which supports debt-supported spending.
  • Eventually, the debt cannot be serviced and the process goes into reverse. Asset prices fall. Debt goes bad. The middle classes stop consuming beyond their income.
  • Ultimately the wealth accumulation reverse as social unrest forces the government to adopt more progressive policies and wealth redistributes more equally.