This note was originally published at 8am on March 24, 2011. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.
“It is no other than the instinctive effort of every people towards liberty.”
It’s both sad and exciting to watch Portuguese politicians fall on their swords of Keynesian storytelling this morning. And oh the irony of Portugal’s PM bearing the name of the great Greek philosopher. Socrates’ decision certainly adds to the philosophical field of ethics. For the first time, he’s actually doing what he said he’d do – resigning.
There is, of course, no ethics in assuming that you can plunder your people with deficits and debts without the rest of the world eventually noticing. That’s why Portuguese bonds continue to crash this morning (2-year Pig Paper yields hitting new highs of 6.83%). That’s how the broken handshakes are going to be priced in this brave new transparent world of Fiat Fool Finance – with a trashing of promissory notes that were based on lies.
Instinctively, whether you are watching American Idol or a piggy politician, you know when someone doesn’t pass the smell test. While fibbing is part of any political process, flat out lying is punished with much more asymmetric outcomes. There is an Instinctive Effort of every person in this world to find the truth.
The truth about sovereign debt is that more of it is not good. At least not when your country has crossed what we have called The Rubicon of deficit and debt ratios (as a percentage of GDP). As a reminder, those 2 critical risk management levels are as follows:
If you are reading this note in America this morning, this should remind you that we will not be immune to crossing the proverbial Rubicon of Fiat Fool Finance.
Timing unknown. Fundamentals known.
As the Japanese press toward 210% Debt/GDP, if you didn’t know the Japanese Bureaucrats have already handcuffed their citizenry’s long-term liberty with these liabilities, now you know…
Socrates (the 399 BC one) was penning his thoughts about ethics 3 centuries before Julius Caesar finally crossed The Rubicon. For Caesar, that meant passing the point of no return. That was the beginning of the end for the professional politicians of the Roman Empire. On that historical score, today is a very good day for Portugal’s version of Socrates. The People refuse to be plundered.
As Bastiat predicted in 1850, in plundering The People, “in this you will not succeed… so long as the legal plunder is the basis of legislation within” (“The Law”, page 15). And behold that Instinctive Effort of The People of Portugal this morning – they refuse to let Big Government Interventionists plug them with austerity measures any longer. They’d rather see the aristocracy, who gets paid by the bond market, fail.
Back to the grind…
Not surprisingly, the immediate-term reaction in both US and European stock market futures to this “news” is that if the market isn’t going down immediately on this, well we better suit up in our BTD Gear and chase these suckers higher…
To a degree, this illustrates the continued short-term performance pressures building within the temples of the hedge fund community. For 2011 YTD, how else would you explain a stock market like Greece’s being the world’s best performer?
Drum-roll… it’s called short covering in consensus short ideas…
Been there, done that – and I’m actually still trying to do it every day. How does a “fundamental” long/short Risk Manager make money shorting Fiat Fool countries who think “This Time Is Different” (Reinhart & Rogoff, 2009) when anyone who hasn’t been living under a rock for the last 18 months knows how this movie will ultimately end? Evidently, you wait, patiently, on price.
As a refresher, there is this thing in risk management called mean-reversion. Those who subscribe to it know that what crashes, eventually bounces – and what bubbles, eventually pops…
For the year ended 2010, the 3 worst performing stock markets in the world were:
In 2011, for the YTD, the tables have turned:
So, I guess it’s a good thing we’re long China after being bearish on Chinese stocks for the last year…
Ultimately, whatever crack-pot “strategist” tells you this all means Greece, Spain, and Portugal are all systems go now probably missed proactively making the call 2 years ago that these stock and bond markets would selectively self-destruct on multiple durations.
Net net net, our long-term call on this gigantic Keynesian experiment going very bad remains as follows:
1. Crossing The Rubicon of deficits and debt ratios will ultimately result in governments and their promissory notes self destructing
2. Debauching the value of fiat moneys will result in both Price Volatility and The Inflation
3. Fiat Fools and their policies to inflate will ultimately go away
They won’t go away forever. That’s Wall Street. You always bring in a new cattle class to bank and broker commissions. But Roman history and 1970s Style Stagflation fans alike remember Caesar as well as they remember Nixon – with an Instinctively Effortless smell.
My immediate-term support and resistance lines for WTI Crude Oil are $101.78 and $106.98, respectively. My immediate-term support and resistance lines for the SP500 are 1280 and 1309, respectively. Manage your risk around these ranges.
Best of luck out there today,
Keith R. McCullough
Chief Executive Officer
“Most of those in political office, quite understandably, are firmly against inflation and firmly in favor of policies producing it.”
-Warren Buffett, May 1977
I’ve studied Warren Buffett very closely since I came to America in the mid 90’s. I wrote my Senior Thesis about him while I was an undergrad at Yale. I’ve applied many of his value-investing strategies to both the long and short side of my portfolios for the last 12 years.
Sadly, Buffett’s Politics have compromised the integrity of some of his post 2008 investment opinions. His 2010 testimony on Moody’s reminded me that if there is a transparent and accountable investment God on this good earth, it’s not him. That said, if I were in his shoes, I’d probably game these government people for my own benefit too.
If you didn’t know that Buffett’s Politics largely focus on pushing his own book, now you know. His #1 priority has been, and always will be, generating returns for the shareholders of Berkshire Hathaway. If you think this jolly looking fella has you in mind when he sits down with The President of the United States, think again…
If you go back and study the late 1970s Buffett, you’ll find a man who didn’t need the market to succeed in order for his overall invested position to. In fact, I think if you go back and read the article that we snagged the aforementioned quote from (“How Inflation Swindles The Equity Investor” – Fortune Magazine, 1977) and change the date on it to 2011, you might think it was something Hedgeye’s Howard Penney wrote last night.
Ah the 1970s…
Those were the days when Growth Was Slowing As Inflation Accelerated. Those were the days when the US Government’s heavy hand of Big Intervention tried everything from the Fed monetizing America’s debt to both Nixon and Carter signing off on a debauchery of the US Dollar. Those were the days of the 1970s – days when plenty of buy-the-dip folks went away.
My defense partner (and Columbia Business School Value Investing Program graduate) Daryl Jones, wrote an outstanding research note intraday yesterday questioning the premise of buying-the-dip on “valuation” (email if you’d like a copy). Without rehashing the note in full, the conclusion was based on my old Yale professor’s (Robert Shiller) CAPE P/E multiple whereby the US stock market looks at least one standard deviation overvalued.
We’ve been saying this since the start of the year, but it’s worth repeating. With corporate margins at 30-year highs, it’s unlikely that earnings will grow into their multiple. And while this wasn’t the topic of Buffett’s 1977 article on The Inflation, he’d be the first to remind you that you don’t buy a cyclical (the SP500) on peak earnings and peak margins of a cycle (you buy it before the cycle turns, like we did with the SP500 in March of 2009).
Back to what The Warren Buffett really thinks about The Bernank’s Inflation…
1979 Shareholder Letter:
“Our book value at the end of 1964 would have bought about one-half ounce of gold and, fifteen years later, after we have plowed back all earnings along with much blood, sweat and tears, the book value produced will buy about the same half ounce.”
“The rub has been that government has been exceptionally able in printing money and creating promises, but is unable to print gold or create oil.”
“… but you should understand that external conditions affecting the stability of the currency may very well be the most important factor in determining whether there are any real rewards from your investment in Berkshire Hathaway.”
1980 Shareholder Letter:
“High rates of inflation create a tax on capital that makes much corporate investment unwise.”
“The average tax paying investor is now running up a down escalator whose pace has accelerated…”
“As we said last year, Berkshire has no corporate solution to the problem. We’ll say it again next year, too. Inflation does not improve our return on equity.”
Back to the morning Global Macro Grind…
No matter where you go this morning, there is no “stability of the currency” in this country. The US Dollar is already down again for the week-to-date. There’s only The Bernank and The Inflation. Sure we can turn on the TV and watch the latest disciple of the Keynesian Kingdom cheer on the last leg of The Policy to inflate. But we don’t have to support them. We should fight them – out loud - and hold them accountable… before it’s too late.
Inflation is sticky. So … as Growth Slows, you end up with The Stagflation. This morning, you can see slower global economic growth being priced into many asset classes, across durations:
Now, quickly, the US-centric stock market bull should be yelling at me – “buy-the-damn-dip.” At least until month and quarter end on Thursday… (that’s when most of us get paid). But that’s not going to stop gravity. If you want to do that – and I mean stop The Inflation before you stop The Stagflation – you’ll need to have your local Central Planner in Washington re-read Buffett circa 1977.
My immediate-term TRADE lines of support and resistance for WTI Crude Oil are $100.34 and $107.94, respectively (we are long oil). My immediate-term TRADE lines of support and resistance for the SP500 are 1292 and 1323, respectively (we are short the SP500).
God bless America and a Strong US Dollar.
Best of luck out there today,
Keith R. McCullough
Chief Executive Officer
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A sequential rather than YoY look at RevPAR suggested it was only a matter of time before RevPAR disappointed.
MAR announced today that worldwide Q1 RevPAR would fall at the bottom of the 7-9% guidance range due to only 5-6% RevPAR in North America. MAR had previously guided to 6-8% for North America. Although not cited by the company, weather probably played a part. However, as we wrote about in "DISAPPOINTING JAN REVPAR" (02/28/11), we were already worried about Q1 RevPAR given that Q4 dollar RevPAR suggested close to a 10% YoY increase in the upper upscale segment.
We already thought the hotel companies would have to bring down full year RevPAR guidance. Q2/Q3 is particularly troublesome given the big spike in seasonally adjusted RevPAR in April-July of 2010 which we attribute to pent up business travel demand. As the following chart shows, RevPAR could actually go negative in June and/or July. This is not a macroeconomic call. It is a math call. Year over year comparisons are not relevant due to the extreme volatility experienced in the sector for three years.
Despite the recent fall in lodging stock prices, valuations suggest investors still believe there is upside to estimates. However, the math suggests otherwise. At best, we think the lodgers may hit the bottom end of their guidance ranges due to margin control. More likely, Q2 and Q3 estimates need to be reduced. The Q1 conference calls in late April should be telling.
Positions in Europe: Long British Pound (FXB); Short EWI (Italy), Short Spain (EWP)
Thursday and Friday saw the EU Summit in Brussels largely disappoint as a consensus decision was not reached on funding for the temporary bailout facility (EFSF) – that is to provide additional funding to increase capacity from €250 Billion to €440 Billion– nor on the permanent fund (ESM) that is set to replace the EFSF in mid-2013. Instead, a decision on both facilities is set be finalized before the end of June 2011.
In other news, last week saw Portugal downgraded by credit agencies as it failed to pass an austerity bill; now the country is without a PM who vowed to quit if the program was not voted in. Early elections could be called as soon as June as investors shake concerning the question if/when the country will receive a bailout (pegged between €50-80 Billion) from the EU and IMF.
Meanwhile Ireland is set to publish the results of its additional round of stress tests this Thursday (3/31). Estimates suggest the government will need to inject an additional €27.5 Billion worth of capital. The Irish government continues its standoff versus Germany and France to maintain its 12.5% corporate tax rate and today reiterated that it wants to impose losses on banks’ senior bondholders.
Today Reuters reported that a Eurozone central banking source told the agency on Saturday that a new facility to give troubled Eurozone banks liquidity over a longer time frame, and replace the ELA (Emergency Liquidity Assistance), is currently being worked out for a more specific release this week. The source suggests that while the facility will be tailored to Ireland’s banking crisis, it would be available to the entire Eurozone. More to come….
The spotlight has missed Spain in recent weeks; despite the uncertainty surrounding the country’s banking system, a bailout does not look imminent. That said, Spain remains on the front of our screens as an economy (far greater than Greece, Ireland, and Portugal) that would require a far larger bailout and would have significantly more impact on the common currency.
The EUR-USD continues gain amid weakness in US debt/currency policy, and due to the ECB's signal it will raise its benchmark interest rate in the coming months. Our immediate term TRADE range for the EUR-USD is $1.39-1.42.
Below we include our weekly Risk Monitor for European bank CDS. Banks swaps in Europe were mixed week-over-week, tightening for 17 of the 39 reference entities and widening for 22. Greek banks showed a notable widening.
Conclusion: Based on Shiller’s CAPE P/E multiple, the market is at least one standard deviation overvalued. Further, corporate margins are at 30-year highs, which suggest it is unlikely that earnings will grow into their multiple.
When Keith and other members of our team appear on CNBC and other major media outlets to discuss the markets and investments, it gives us a keen ability to really focus on consensus’ best ideas and the associated storytelling. A key consensus reason often given to increase long exposure to the US equity market is valuation.
As a graduate of the Value Investing Program at the Columbia University, I’m all for value, but, as always, a valuation is only as good as its assumptions. Attempting to value a stock is difficult enough given all the relevant assumptions needed, but attempting to project those earnings for an entire market, like say the SP500, only magnifies the complexity and, really, likelihood of error.
Regardless of our ability to actually project the earnings for a company or market accurately, valuation multiples themselves can provide an important gauge of investor sentiment. Simply put, in extremes of serious stock investing euphoria valuations are high. In contrast, in periods when investors are extremely concerned about the outlook for equities, stock market valuations are depressed. Thus the power of the stock market crowd in aggregate will provide us some insightful contrarian indicators.
In the chart directly below, we’ve highlighted Professor Robert Shiller’s (our neighbor across the street at Yale’s School of Management) long term Cyclically Adjusted P/E chart for the SP500. Over time, the valuation of the U.S. stock market has varied widely. Based on Professor Shiller’s work, the lowest P/E multiple for the broad market was 4.8x in December 1920, while the highest P/E multiple came in December 1999 at 44.2x.
Currently, the valuation according to Shiller’s analysis is 23.6x earnings, which is well above the long run average of 16.4x. In fact, the current valuation of SP500 composite is more than one standard deviation above its long run average. So, while this is not necessarily an extreme overvaluation, the market is clearly not cheap on this basis. The chart above shows this well graphically, as valuation is just starting to breakout above its historical range.
By way of background, Professor Shiller uses what is called CAPE, or Cyclically Adjusted Price to Earnings. In terms of the numerator, or price, Shiller uses the monthly average of daily closes for the SP500. To derive the earnings data, in this instance the denominator, Professor Shiller uses the quarterly earnings data from the SP500’s website and utilizes an interpolation to provide earnings data by month. He then adjusts both the numerator and denominator for inflation using CPI from the Bureau of Labor Statistics. Finally, the inflation adjusted price is divided by an average of ten years of real monthly earnings to determine the CAPE.
Obviously, market valuation is one of many factors to consider, but certainly the stock market is not cheap. The key push back on this call out is that future earnings growth will drive the overall P/E of the market lower, so perhaps the market is not as expensive as it appears. Our key issue with the earnings growth argument is based on slower than expected GDP growth both domestically and abroad and a limited ability of corporations to expand margins.
On the second point related to corporate margins, profit margins in the United States are at near all-time highs on various calculations. In fact, as highlighted in the chart below, our calculations using BEA data show that both EBITDA and EBIT margins are at/near 30-year highs. Needless to say, the margin expansion argument is somewhat difficult to make given that backdrop and the potential for mean reversion.
In the face of near all-time high margins, a stock market that is at a stretched valuation, and sequentially slowing domestic and global growth, it is becoming increasingly difficult to make the “valuation” argument to buy equities. That said, as long as The Bernank keeps interest rates at zero, investors are at least marginally incentivized to take some equity risk, but, to be clear, it is risky.
Daryl G. Jones
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