Against the background in which the S&P 500 very much appears to be trying to break below its Growth Price (two times adjusted book value) for the second time this year, there are no end of observers that claim that the market is pretty much at about the lowest valuation that we are going to see and that the market has become fairly cheap. For those whose horizon stretches back for two and even three stock market cycles, setting back to the Growth Price is a significantly positive event. And, of course, using our Fair Market Value methodology for establishing price targets, the upside potential of the US market (and that of Canada as well) is massive, exceeding the +100% mark using analyst consensus forecast numbers together with current long term interest rates. On the face of things, with the US market this cheap, it ought to be a screaming buy, and yet the market shows more signs of wanting to break below the Growth Price than it does of trying to establish some kind of solid floor for a fresh bull market. This month, we look at the evidence for a floor versus further new lows, and conclude that we are more likely to see new valuation lows in the period ahead as the S&P returns once again to its very long term normal valuation range.

While it is somewhat early times to speculate on implications of such a major market break, we can certainly review the reasons for the S&P being as highly valued as it is today, and how we knew – and forecasted – many years ago that a new valuation regime was coming into being. We will then use this as background to try and hazard some guesstimates as to the reasons behind yet another economic regime change, for that is what it would be, and see where such changes might lead us in the longer term.

To begin, let us go back in time to the end of 1992, a momentous market event, as it turned out, as that was the moment in market history when the S&P broke out over its Growth (G) Price. Up to that time, the G Price had been a major market valuation high for such a very long time market technician and historian, Steven Leuthold, had developed a rule of thumb that stated that any time the S&P reached 2.2 times book value and a 3% yield, it was time to sell stocks and go to cash. (Note that while we mark the Growth (G) Price as being 2 times book, in point of fact, it is two times adjusted book, that adjustment factor being the element that gives the SAC Structural Valuation Analysis (SVA) Charts their predictive strength. In 1992-3, the SVA adjustment factor was roughly 10% of book value, “supporting” Leuthold’s study.) At that time, to ascertain that Leuthold was indeed correct, all that one had to do was to go back 5 years to October 1987, when the S&P did indeed get to that lofty valuation – and then promptly and disconcertingly suffered a spectacularly nasty one day collapse which saw the market drop some 26% (At that time, SAC, which was just beginning its commercial existence, observed to its then entirely institutional client base that “the market was levitating”. Little did we know that one October morning, the market would wake up at the ceiling and go to bed on the floor). Following that market event, over the next five years, the S&P slowly wended its way back to the G Price in 1992, accompanied, as it got there, by dire predictions that another market catastrophe was in the works.

But a funny thing happened in 1992. Nothing. Indeed, it was a strange sort of year, because the market oozed up against its G Price, the Leuthold and SVA ceiling, and then spent almost all of that year bumping up against it before edging out and over that ‘line’ late in the year. When the market finally did move even higher, it brought out a massive chorus from the bears and fear mongers that things were really getting out of hand. We ourselves were nervous up to the time before the breakout and very cautious on behalf of our clients as it was hard to turn our back on so many years of evidence that the G Price was “it” for the S&P. However, when the S&P did break out late in the year, we turned very bullish on the stock market. The simple reason is that once a valuation ceiling has been violated, notably a major zone breakpoint, then it is most usual for a stock – and, as it turned out, en entire market – to carry on to the next zone breakpoint. For the S&P, this was its SuperGrowth (SG) Price, or 3.5 times adjusted book value, a potential gain of 60% in price to book terms, plus whatever balance sheet growth might occur along the way as the market made its way towards this new target. In fact, the S&P did exactly as forecast, arriving at the SG price in 1998, having advanced from roughly 400 to approximately 1100. That total gain of 175% was partially the forecast gain in valuation and partly strong underlying growth in the book value of the S&P. We need to emphasize that while the market broke out, it had eased up there late in 1991, and it took all of 1992 to do so. Even then, the S&P tended to not really “want” to advance much beyond that breakpoint. After a decent run in 1993, the market set back to the G Price in 1994 before finally moving on in a “breakout” bull market which did indeed carry to the SG Price in the period from 1995 to 1998. In effect, however, it took almost a full 4 years, 1991 through 1994, to make the transition to the new and higher valuation reality.

The S&P did not, of course, just go wandering merrily into strange new valuation territory on its own hook, as it were. In retrospect, that fateful breakout up and over the G Price was the harbinger of a major sea change in corporate profitability and the massive employment of leverage in the US economy in particular which has seen the corporate share of the GDP pie increase strongly as the return on equity (ROE) of US corporations rose steadily throughout the period, leaving labour’s share in the dust. This was caused by five events which happened roughly simultaneously.

First, by the late 1980s, corporations began to examine their balance sheets and discovered that in general, they were frequently over-capitalized. The cushion of equity which had served them well during the inflationary 1970s (which had culminated in interest rates shooting to 17% in 1981-2) was becoming redundant. This began a long period in which many companies bought back stock, paid extra dividends, or took on additional debt rather than issuing new stock. As we observed at the time, and as seen in the operation of the Atrill Curve, when companies have balance sheets that are identified as “Too Strong”, if they get rid of surplus equity one way or the other (or increase their use of debt), their stock price tends to rise in the market following the price/solvency tradeoff. Indeed, that was an era in which stock selection was dead simple. Just look for companies with very strong balance sheets, as SAC defines them, and which are in the process of eliminating their excess equity and you had the perfect formula for a long rise in the stock price.

Second, the ‘internationalization’ of US corporations contributed to this ROE gain as many companies sent their production facilities to cheaper labour cost climes.

Third, there was substantially increased pressure by shareholders and more activist investor interest groups to achieve higher levels of profitability. As time wore on, and increased profitability became more difficult, a new force in the market, the hedge funds, began to push many corporations to surrender any perceived “surplus cash” on their balance sheets by way of special dividends or share buybacks.

Fourth, there was a change in the perception of financial risk itself, as an era of so-called ‘financial innovation’ erupted, devising new instruments for investment (or perhaps, more accurately, speculation) that spread out individual risks over a broader spectrum of investors than ever before.

Fifth, as a result of all the above factors, there was a huge increase in the issuance of debt by the banking institutions which radiated out across the economic spectrum and ending up with the explosion of household indebtedness by way of the mortgage market. A goodly amount of that debt increasingly consisted of securitized loans packaged up and sold to investors of all stripes but which were not backed by the balance sheets of the banking institutions. This permitted a huge increase in debt but of a much lower and riskier quality. As long as the US and global economies were expanding at a rapid pace, driven as much by the very expansion of indebtedness, aided and abetted by an accommodating US Federal Reserve Board which was entirely apparently oblivious to the long run implications of all of that debt, then risk did appear to be under control, more debt could be issued, corporations needed less working capital, and families could strap on increasing amounts of leverage.

These five events drove the return on equity to much improved levels and as a result, carried the S&P up through its Growth (G) Price and into the Growth Valuation Zone where it has remained ever since. What started out as an anomaly – the move over an historical maximum valuation – turned into a simple fact of life, a new benchmark for a new minimum valuation. Clearly – if there is anything at all clear about recent events – if the S&P is to remain in its Growth Zone, then high levels of profitability must remain in place. We would argue that this is by no means the certainty that many would prefer to believe, including the Fed.

After 15 years, it is only natural that the angst which greeted the ascendancy of the S&P to its new and lofty valuation levels should not only diminish but eventually become the perceived wisdom of the ‘new’ age. With technology providing a lift to productivity, and globalization in general, investors have simply come to accept the new and higher range of valuations as that which is right and just and normal. As for the level of US indebtedness which helped to drive all of this, beyond a few Nervous Nellys who kept raising the issue in vain, everyone in authority seemed only interested in making additional debt more possible. Unfortunately, as much as one might like to agree that this change is permanent, the stock market now appears to have other ideas, and that might well be the message that it is delivering.

While right now at this extreme present moment, the reasons that there might be a change of valuation modalities in the air are not immediately clear, what is perfectly clear from the long sweep of history is that the last 15 years were not normal. They are themselves the “unusual period” – an anomaly in market history – which contain unusual economic circumstances which we suspect may be slowly disappearing, and quite possibly reverting back to much longer term economic means. In short, it could well be that the stock market is now attempting to give us a very important message and a vital clue as the future valuation range in which the S&P is likely to trade (among many other things).

While the evidence of such changes is not dead clear, there are some strong clues as to their nature. For one thing, we note that all of the Consumer Indices in both the S&P and the TSX have themselves broken below old boundaries – “old” meaning the past 15 years. Of course, this is perfectly obvious from the collapse of the housing market in the US and the extremely low savings rate of consumers in general. It is hardly surprising that that the consumer stocks are breaking down when the consumers themselves are tapped out and possess such poor balance sheets that they are unlikely to emerge as one of the strong driving force behind the US and global economies for some time to come. If the consumer, who currently accounts for 70% of US GDP, is in the process of cooling off and starting to increase his miserable savings rate, then the growth rate of the US economy must slow down as well, and perhaps substantially so for some period of time. And cool out he is likely to do as that housing bubble is – unfortunately – still very much with us. As Gary Shilling observed recently, of households which have mortgages on their homes, the average equity in their homes is about 28%. If the folks who do the Case-Shiller real estate index work are more or less correct and housing prices fall to their target of minus 42%, then the US consumer will be in a bad way for a lot longer than into the first quarter of 2009, and therefore US growth will be affected on the downside for longer than the current consensus is looking for.

For another, US financial stocks led by the banks are in a state of disarray as the massive degree of over-leverage has caught up with them and the piper is demanding to be paid (back). The banks have been able to help US consumers over-leverage themselves and then dump the resulting low grade loans off their own balance sheets and into the portfolios of the less financially sophisticated through the magic of securitization. This has provided a massive impetus to bank profitability and has seen bank ROE’s shoot to unprecedented levels. With the consumer in disarray, so the quality of this paper has come back to haunt not only those unfortunate enough to have purchased it but also the very banks themselves. In the end, most banks appear to have believed their own myth that if you mix enough lead and other poisonous chemicals together, using financial alchemy you can get A-rated gold. You can’t, they didn’t, and that is the end of an era. (They will, of course, discover another financial boondoggle – but it will take quite a bit of time before investors become quite so gullible again). The bottom line is that the financial leverage that aided and abetted the growth of the last 15 years in the US, and hence globally, is ancient history. The banking system is paying that piper, of course, and will for some time. Bank ROE’s are likely to revert to their long term means as well. Unfortunately, at the present time, no one – and probably least of all the banks themselves – has a clue as to how deep their credit quality problems run.

No one with an ounce of common sense should expect that the “worst is behind us” in terms of bank loan write-down’s. We have only really seen the first phase, mortgage debt, and even here, the depth of the issue can only be dimly perceived. The near collapse of Fannie Mae and Freddie Mac illustrate how extremely fragile the US financial system is at the present time. Credit problems due to low quality business loans and levered buyouts are also now emerging and heaven alone knows where all of this will end. And on top of all of that, we have yet to hear from the derivative market as it begins to unwind. Maybe nothing will come out and the process will be smooth, but then again, against a general slowdown, how likely is that? Confidence in the financial system is crucial to economic recovery, and increasingly – thus far – confidence is lacking in this key sector.

Investors who rush into these two groups, consumer stocks and banks, just because they are becoming so “cheap” may well regret their impatience.

With two of the key groups of stocks sending out clear clarion calls of distress, it would be surprising if the major indices are able to maintain their current historically high valuation levels. But we could add to that the current and present danger of recession – quite possibly a severe one – if only because you cannot shut down the main driver of growth, the consumer, and the means of financing him, the banks, and expect, as the Fed is saying right now, that there is ‘only’ a 50/50 chance of recession (although Ben Bernanke did hint at mid-month that perhaps the problem might be a touch more intractable than he had thought). It would be far better if the Fed were to explain in easy-to-grasp language just how and why the US economy (and with it, that of Canada and a lot of the globe which has come to rely on the seemingly endless rapacity of the American consumer) can avoid recession, or at least help us to understand how a severe recession is to be sidestepped and/or its effects minimized. Instead, the powers-that-be have raised their expectations for economic growth in the second half of the year by ½% or so along with the outlook for 2009!

Some while ago, we alerted our clients and readers to the reality that, with the US in what we term a ‘second-order insolvent’ condition, things would change. At the time, we thought that perhaps the financial condition of the US could go either way. The first would be an entry into a sort of hyper-insolvent stage as the US Fed pumped out credit to keep the game alive but triggering high inflation and a collapsing US dollar. The other possibility was that the system would “push back” against the credit creation process and start the healing and rebuilding phase of the national balance sheet (so to speak). It now very much appears as if the system is, indeed, pushing back, and vigorously so, and in the process, shutting down the ‘lousy credit’ generation process almost entirely. The healing and balance sheet rebuilding appears to have begun; only the Fed doesn’t seem to realize it – yet. Added to that, in signaling a break back into the Normal Zone once again, the stock market, the last repository of ‘instant wealth’ generation and last hope of the Fed to create spendable wealth more or less out of thin air, will be joining the rebuilding fray as well by stopping any sort of “easy instant wealth creation solution”. This is not good news for the unaware.

While we hate to employ an over-used word which is so often applied to virtually every minor event including the Superbowl, the year 2008 may well be an historical turning point (in the accurate sense of the word). From our vantage point, we can see that the US stock market may be “coming home” to its usual long term valuation norms, thus ending a higher growth era – or at least a higher profitability era – after a pleasant run of some 15 years. It may also well be the year in which the increasing leveraging of the US economy comes to an end and the US national balance sheet (as it were) starts to be rebuilt. And here, of course, we are not just talking about the US government balance sheet, which goodness knows is in poor enough condition, but we are also talking about the balance sheets of US citizens in general – the “consumer” – as well as the end of the era of off-balance sheet leveraging of US banks. And, of course, if that pile of US liabilities deflates, then elsewhere there’s a pile of global pile as assets must also deflate, such being the operation of the balance sheet. Since a lot of those “assets” are held by foreign investors and banks, including central banks, we should well consider that there will be some changes taking place in those economies as well, and not all to the good in the shorter term.

The key important longer run consideration is that many emerging economies, including China, are quite under-leveraged and we expect that this will change. Getting the US debt problem out of the way will provide the rest of the world with the means and ability to achieve better growth for their economies and better conditions for their citizens and hence improve the political stability of the world in general as well. Contrary to Mr. Greenspan, the rest of the world are not ‘savers’ and the US is not some ‘white knight’ that uses those savings that ‘otherwise would be idle’. If we revisit the Atrill Solvency Curve once again, only this time instead of merely looking at stock price potential, then we can consider total global economic activity potential on the Y-axis. The US is in the “Too Weak” zone, and from the operation of the Atrill Curve, it is perfectly obvious that lending money to that country actually reduces global potential and by an increasingly significant degree. The rest of the world, which overall is well to the right of the peak of the Atrill Curve, has tried to accommodate the insolvency of the US and keep it afloat through infusions of cash lest the US growth rate slow and hence the rest of the world. But a look at the Atrill Curve shows that removing the US from the borrowing equation would allow those savings to be made available for much more productive use elsewhere.

Indeed, if there is a happy ending to this story, it is that the US is not the be-all and the end-all as far as the growth and financial health of the global economy is concerned, except in their own minds (and apparently the minds of the central bankers that keep trying to keep the US afloat). If the US moves from the “Too Weak” part of the curve towards the “efficient sector, there will be an improvement in the overall use of global financial resources. As the developing world learns to employ leverage, it will move from the “Too Strong” part of the curve towards the “efficient centre” as well. Both solvency trends will therefore tend to generate overall economic wealth. If there is any efficacy at all to the Atrill Curve, then future growth will be more financially healthy and quite possibly more robust once the US balance sheet is under control.

If there is a weakness in our argument, it lies in the short term. Assuming (safely) that the Fed tries to stop the US de-leveraging process and that many of the global central banks connive to help the Fed because they fail to grasp the value of the de-leveraging process, then the adjustment time will be drawn out rather longer than would be necessary if the de-leveraging were to be actively aided and abetted. From our perspective, the deleveraging will take place anyway, because it must and because the financial imperatives are now virtually unstoppable. The agony of a long period of adjustment is not worth the flickering and dying candle of hope that perhaps miraculously somehow the US will manage to muddle through and its unfortunate citizen/consumers need never face the music.

We started with the humble proposition that if the S&P convincingly cuts through its Growth (G) Price breakpoint value, then a larger bear market is likely, and we have ended up with a restructuring of the US balance sheet! That is some signal that the market is sending! Yet 15 years ago, who would have predicted the financial changes that that 1993 breakout eventually produced? The excessive wealth that the stock market created led to a sea change in how managements approached the markets. Many learned to game the system through the creation of ‘earnings’ at almost any cost, investors learned about “earnings surprise”, and a sort of circular pressure built up to push up valuations by beating forecasts, trampling on the long established principles of honesty and fair disclosure which ultimately led to Sarbanes-Oxley. If history is any guide – and we believe that it is – then a return to financial rectitude is in store, and that includes a return to personal financial prudence as well.

Already, the banks, which were at the very heart of the push to expand credit at an astonishingly massive rate, are now ‘significantly’ reducing forms of credit vital to American companies in the backlash from the subprime-mortgage crisis. That slowdown threatens to further hamper the U.S. economy. Even healthy businesses are finding it difficult to borrow money as banks, burned by the fallout from looser lending standards, overcorrect and take a much closer look at repayment ability. The banking discipline is returning with a vengeance, and with it, lower stock prices, and a more realistic assessment of risk. This will take time, and the more so should the Fed continue its feckless attempt to support current levels of over-leverage rather than setting a course to aid their demise.

We at SAC do look forward to a much brighter day but plan to keep our umbrellas unfurled for now.

 

Sector Updside Potentials

Comment

Either somebody is too optimistic or we are too pessimistic. Massive upside potential in a declining market, especially one which appears as if it is about to enter a nasty bear market, doesn’t make sense unless something is drastically wrong somewhere. Either earnings forecasts are way too high and 10-year interest rates are way too low, or this market is way underestimated – and by ourselves as much as anyone.