Tag: davidson

Had a post from “Davidson” yesterday regarding inflation and bond vs equity returns. It illicited several responses on twitter that many folks, contrary to the results of the post would rather own equities in an inflationary environment than bonds.

True, and not. It goes to degree. In a low inflationary environment, asset inflation favors equities at the expense of fixed income bonds. BUT, as the post yesterday demonstrated, in times of “hyper-inflation” ie: The 1970’s, inflation’s destructive effect systematically reduces equity values, making the fixed income bond and its guaranteed return of principle more valuable.

My fried on twitter @zippertheory provided the following statistics:

Of the he stated:

As you suspected stocks get crushed in hyper inflation due to P/E compression (as you know discount rate increases dramatically killing all terminal values). I can only presume that if CPI is above 7% commodities/Gold and anything that resembles a natural resource would flying.

I’ve as included a handy chart from the book Unexpected Returns by Easterling that better illustrates my aforementioned point.

The chart (click to enlarge):

So the evidence is pretty clear that 4% inflation seems to be the magic number at which a weighting from equities to bonds ought to take place in one portfolio. The question then remains to be answered, “what effect will the unprecedented monetary expansion have on inflation”?

If you believe it will cause hyper inflation, it it time to begin researching bonds. With corp. bonds currently yielding 7% to 9% for very safe companies, it does put pressure on the return you need from equities when you consider the additional risk.

Note: A bond/stock hybrid can be also accomplished with high dividend paying stocks, for instance, a stock yielding 4% need only appreciate 3% to 5% to equate to the bond yields. Just make sure the dividends are safe….we have had a score of cuts the last year although it would seem the worst of them has passed

Personally I find it hard to believe the actions taken recently leave us with the rather benign 2% long term inflation rate the Fed predicted yesterday. It doesn’t match up with history.

That being said, for me it looks like 2%+ which means down the road I am going to be looking at some bonds….

Disclosure (“none” means no position):

“Davidson” submits:

First Read the following story from the WSJ:

China’s Iron Hand Comes Up Against Market

By CHUIN-WEI YAP

For China, there’s just seven points between national pride and market savvy.

Some of the bluest of China’s blue-chip steel mills have struck deals with major iron ore suppliers, accepting a provisional 33% cut to last year’s price.

This is the beginning of the end of an annual closed-door ritual that sets sale terms for one of the world’s most important industrial commodities.

This year, the negotiations have become particularly tortuous as China, the world’s biggest iron ore consumer, squared off with heavyweight miners, in hopes of getting a discount of 40%.

The acceptance of the smaller cut signals a fissure between the country’s steelmakers and the Chinese government, which together with the steel association heading the iron-ore price negotiations, has resisted any compromise.

The steelmakers say the latest deals are just temporary, and any difference will be refunded once China’s terms are set.

But their message is clear: Those who negotiated on their behalf miscalculated.

Analysts say the Chinese should have a struck a deal in February when the domestic economy was weak enough to warrant steeper discounts from miners. Steel prices in China have been rising for more than two months.

Certainly, Beijing’s decision to arrest four employees of the Anglo-Australian miner Rio Tinto hasn’t helped the country’s cause. The arrests are now widely accepted as linked to the iron ore price standoff.

As far as prices are concerned, Chinese officials are already softening their stance, saying they are willing to settle for a discount between 33% and 40%.

Now all the miners have to do is stand pat.

Craving certainty the Chinese market has spoken out — it is willing to settle for 33%.

Of the news, “Davidson” opines:

Free Market Continues to Take Control in China

This speaks volumes. The command economic tactic, i.e. dictated by political leaders, to negotiate iron ore discounts of 40% from suppliers has had to make way for the free market which dictated a 33% discount. Rather than following government guidelines the top steel makers seeing prices rise with world demand decided to take contract decisions back into their own sphere of influence and ignore the bureaucrats and the top down instruction.

This is what brings about democracy and free markets. That this happened in China speaks volumes as to the sea change which began in 1979 when Deng Xiaoping launched his economic reforms and continues. See the attached BusinessWeek article of September 27, 1999, “China’s New Capitalism”

BW 1999

Stories of single events such as this one which details the transfer of power from the political sphere to the free market have enormous impact to building free markets and democracy around the world for the long term.

For those who question the viability of the global economy, fear the future and the next bank failure, this report if read in the context of the BusinessWeek article should generate much enthusiasm for the future. When investing, I advise having both a “Top Down” and a “Bottom Up” methodology with the goal of grasping an understanding of as much of the global market as possible and with this the critical investment themes.

Disclosure (“none” means no position):

“Davidson” submits:

First Read the following story from the WSJ:

China’s Iron Hand Comes Up Against Market

By CHUIN-WEI YAP

For China, there’s just seven points between national pride and market savvy.

Some of the bluest of China’s blue-chip steel mills have struck deals with major iron ore suppliers, accepting a provisional 33% cut to last year’s price.

This is the beginning of the end of an annual closed-door ritual that sets sale terms for one of the world’s most important industrial commodities.

This year, the negotiations have become particularly tortuous as China, the world’s biggest iron ore consumer, squared off with heavyweight miners, in hopes of getting a discount of 40%.

The acceptance of the smaller cut signals a fissure between the country’s steelmakers and the Chinese government, which together with the steel association heading the iron-ore price negotiations, has resisted any compromise.

The steelmakers say the latest deals are just temporary, and any difference will be refunded once China’s terms are set.

But their message is clear: Those who negotiated on their behalf miscalculated.

Analysts say the Chinese should have a struck a deal in February when the domestic economy was weak enough to warrant steeper discounts from miners. Steel prices in China have been rising for more than two months.

Certainly, Beijing’s decision to arrest four employees of the Anglo-Australian miner Rio Tinto hasn’t helped the country’s cause. The arrests are now widely accepted as linked to the iron ore price standoff.

As far as prices are concerned, Chinese officials are already softening their stance, saying they are willing to settle for a discount between 33% and 40%.

Now all the miners have to do is stand pat.

Craving certainty the Chinese market has spoken out — it is willing to settle for 33%.

Of the news, “Davidson” opines:

Free Market Continues to Take Control in China

This speaks volumes. The command economic tactic, i.e. dictated by political leaders, to negotiate iron ore discounts of 40% from suppliers has had to make way for the free market which dictated a 33% discount. Rather than following government guidelines the top steel makers seeing prices rise with world demand decided to take contract decisions back into their own sphere of influence and ignore the bureaucrats and the top down instruction.

This is what brings about democracy and free markets. That this happened in China speaks volumes as to the sea change which began in 1979 when Deng Xiaoping launched his economic reforms and continues. See the attached BusinessWeek article of September 27, 1999, “China’s New Capitalism”

BW 1999

Stories of single events such as this one which details the transfer of power from the political sphere to the free market have enormous impact to building free markets and democracy around the world for the long term.

For those who question the viability of the global economy, fear the future and the next bank failure, this report if read in the context of the BusinessWeek article should generate much enthusiasm for the future. When investing, I advise having both a “Top Down” and a “Bottom Up” methodology with the goal of grasping an understanding of as much of the global market as possible and with this the critical investment themes.

Disclosure (“none” means no position):

“Davidson” submits:

Below is a chart of the SP500 Index and that of Barclay’s Intermediate Term Corporate Bond and Long Term Corporate Bond Indices. The simple answer to which did better was bonds. This because 1) when investors panicked they sold stocks and went to bonds thus keeping values high/yields lower than the rate of inflation and 2) bonds have maturity dates on which principal is returned. Bonds preserved value.

Stocks’ response to inflation was to fall till the earnings yield rose to compensate.

During the ‘70’s stocks earnings yields rose to 14% causing stocks to fall from the 20 P/E level of the ‘60’s to 7 P/E. This equated to a 67% decline in valuation and thus stocks under-performed bonds throughout the ‘70’s. See chart.

Disclosure (“none” means no position):

Davidson is back with more data and commentary inferring the worst may indeed be over. He has provided the charts at the end of his commentary.

“Davidson” sumbits:

The point to observe in all this is that market psychology went from cautious to panic on the Lehman failure Sept. 15th, 2008. Corporations experienced an almost immediate freezing of short term cash accounts which cascaded into Money Market funds as a literal “run on the bank” and an almost complete halt to credit based import/export and capital transactions in the US and around the world.

The reason the global financial system works is that all participants trust that certain rules will be followed and that terms in contracts will be honored. When it became clear that marginal participants had gamed the system and infected it with contracts that had violated the accepted standards of conduct, trust in exactly which contractual arrangements would be honored experienced a dramatic decline for all contracts.

The psychology of trust is elemental to a global financial system. With trust the system works! Without trust the system fails!

The system requires rules that all understand and that cannot be arbitrarily changed.

At the moment trust in the global financial system is returning as is reflected in The Conference Board’s reports of the past few days. Declaring victory, declaring the “End of the Recession” as many would like to do at this time is always subject to continuing trust in the system.

I have just finished Amity Shlaes’ “The Forgotten Man” a new and refreshing look at the Great Depression. I highly recommend it. While many previous authors have focused on policy issues, legislation errors, banking errors and the like, Shlaes’ focus is centered on the intangible quality of “Trust in the System” and how when trust is lost the system fails to function. Corporations and individuals hold on to cash not knowing who or what to trust. Just as we recently experienced!

Trust is returning, but if someone again games the rules, then trust can be lost. Market participants are working through the issues one at a time.

Risk to trust is always present.

Disclosure (“none” means no position):

The Baltic Dry Index tracks the cost to ship dry bulk goods, i.e. grain, metal ores, coal and etc.(see chart 1) Baltic Capesize Index tracks the shipping costs on the largest of the dry bulk vessels, i.e. vessels that are in excess of 80,000 dwt.(see chart 2) Capesize vessels are viewed as primarily carry coal and iron ore vessels. The Baltic Capesize Index tends to fluctuate with the amount of steel being produced and reflects global economic activity. Over the last two weeks the Baltic Capesize Index has increased over 80%. The same two weeks the broader Baltic Dry Index has increased 21%. The Baltic Dry Index has increased over 470% from its low of 663 in Dec 5, 2008 to 3164 on May 27, 2009.

Most assume that speculators are not driving up the cost of vessels as the result of some speculative market activity and that these indices provide an untarnished view of world business activity. But, with the history of oil at $147bbl in 2008 still sharp in memory, it should always be considered that speculation could be playing a part in these indices. Regardless of the all the sources of these price increases, these indices are in line with the Port of LA activity regarding loaded containers which provides another reference point.(see chart 3)

That these charts reflect a substantial turn upwards in global business activity and psychology is a point that should catch the attention of all investors in my opinion.

Disclosure (“none” means no position):

Now this chart is either really good news or dark storm clouds on the horizon…

Scott Grannis says of it:

Treasury yields are heading skyward, as the bond market begins to realize that a) the economy is improving, b) monetary policy is incredibly expansionary, and c) fiscal policy is creating massive financing needs. This is a perfect storm for the Treasury market, and it could send yields far higher in short order.

The silver lining to this thunderstorm cloud is that it may cause our politicians to rethink their plans to spend money like a drunken sailor. It would be great if Obama came to have the same respect for the bond market as Bill Clinton did.

“Davidson” says of it all:

This piece by Scott Grannis begs the question: “Would Bernanke reigning in stimulus boost market confidence?” There are many indications that confidence in the credit markets have improved. It is understood that if lender’s confidence levels continued to improve as has been apparent then many of the looming refinance issues for commercial real estate would ease. The effect on lender’s confidence in the auto loan and home loan market could continue to improve which would go a long way towards easing fears of the after-effects of a GM bailout or easing the fears of Alt-A mtg rollovers.

If Bernanke declares that now is the time to reduce the stimulus, would this rein in the fears of pending inflation, boost lender confidence and stimulate economic improvement?

Confidence in our financial system is crucial to our society. It is the lack of confidence which causes deep recessions as everyone retrenches at once. It is the excess confidence that produces bubbles as many over extend themselves.

A boost to confidence would be welcome.

My two cents:

“Davidson” submits:

When you are a value investor you are really an asset buyer with an expectation on ROE on those assets over an anticipated future period. The “science” that Ian Cumming references in his quote, “The science is in the “In”. The poetry is in the “Out”.”, is in the means that a value investor assesses the potential that the expected returns are likely to be realized. It is important to be cognizant of financial history, Hamilton, Fed Reserve history, economic philosophy of Hayek and etc as well as how this has played out since the 1871.

A powerful record of the effect of the Federal Reserve acting as a financial shock absorber has been in effect since 1933-see chart 1 (click to enlarge).

With all the manipulations of govt., war, high taxation, excess govt. spending leading to inflation and the recovery and disinflation under Reagan and Volcker, one can build a great deal of confidence in US society and the its economic underpinnings that can serve to let one see thru the current fog of issues clouding our economic future.

If one measures BV (the productive assets of public cos) growth of the SP500 (I see this as quite steady at ~6.2%) (see Chart 2, click to enlarge) and then when one examines the ROE on these assets and measures that regression analysis produces a quite steady 14.2%.

Between 1978 to Present, one can produce a forecast for SP500 earnings and convert this to an earnings yield. This earnings yield is compared to the Real US GDP trend which is 3.16% and the current core inflation rate which is 2.3%; the combination of these 2 rates becomes the benchmark against which all investments are compared. The market has priced the SP500 against this benchmark return since 1978 in a fairly close relationship with allowances for market psychology which is an important factor at all times (see Chart 3, click to enlarge).

The current relationship is that the SP500 is priced at an estimated 8.08% earnings yield while the Market Cap Rate (MCR) is 5.4%. For the SP500 to return back to a normalized rate of return, this means that it needs to rise by 49.6% to roughly 1,350 from 900 currently. This is how a value investor converts assets to future returns by assuming that a historical trend with many periods of in which problems like those we fear today will eventually be resumed and return to trend.

Can value investors be wrong? Absulutely!! But, there is a very strong trend of economic history that supports these assumptions and the Fed is easing like it has done in the past. The cry, “But, but, but…it is different this time!!!” has be uttered at every major low in our financial history, i.e. 1974, 1982, 1987, 1990, 1998, 2002-2003 and 2008-2009. The odds greatly favor recovery, strong recovery which few are forecasting.

Our greatest problem today is fear and a complete lack of perspective. Historical perspective is how value investors look across the valley.

A constant theme here and really for any value investor is “price always meets value”. They just do. It is the “when” that we cannot predict but we know eventually it does. For that reason we buy when the value is above the current price and sell when it reaches or exceeds it. Easy right? Well, not really, it is the determination of what that value is that trips folks up and causes mistakes.

Thus is the dilemma of the current market. By any valuation it is way over valued. The S&P 500 last Friday after another quarter of reduced earnings (most are in now) sat at an stratospheric 122 times earnings. For those who are not sure what “normal” is, it is about 20 times earnings.

Here is the whole thing visually (from Chart of the Day):

So, that must mean the market is headed for a big fall, right? Well, there are two parts to the equation. The “P” or price and the “E”, earnings. In order to get the ratio down to a normal level the “P” must fall and the “E” must rise. Q1 earnings numbers were smacked by a -6% Q1 GDP. We know Q2 will be better and Q3 three ought to show even more improvement (both may still be negative but less so). That means we can expect the “E” part of the equation to increase.

With S&P earnings as of last Friday at $7.21, it will not talk much improvement for the PE ratio of the market to be brought down by even a modest earnings improvement. For reference, last year at this time the S&P had earnings of $62 and sat at 1400 vs 888 today. For the market to sit where it is and have its PE fall to around a more “normal” 20 times earnings, they  must increase 485% to $45. 

Again, visually, this is what has happened to earnings:

So, what happened to Q1? Companies wrote off billions in Q1 and used it as a “kitchen sink” quarter. We all expected it to be bad so they wrote down everything that had or might deteriorate in value. Q2 ought to show improvement if for no other reason the massive Q1 writedowns ought to be just about over. Even if operating earnings stay flat, we will see overall earnings improve.

Again, visually (click to enlarge): This is the S&P operating earnings.

Notice Q4 was the worst operationally and improvement is expect through the year. This is what to watch going forward. As long as this continues upward, the rest will wash out in the end.

It is fairly safe to say that the decline in earnings is or is near over and we ought to begin to see improvement. Note: this does not mean the overall economy improves immediately or dramatically, just that the decimation in earnings is done. Because of that, there is a very real scenario where the market just pauses and waits for earnings to catch up. Then, depending on the Q2 results as they come in, the next move in the market is defined. If they are as or better than expected the market will feel justified at its current level. Should they begin to come in worse, the high levels it currently sit at will indeed appear irrational and we could see a decent sized sell off.