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Buy the Market on Valuation?

This note was originally published March 28, 2011 at 15:40 in Macro

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.

 

Buy the Market on Valuation? - 1

 

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. 

 

Buy the Market on Valuation? - 2

 

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

Managing Director


TALES OF THE TAPE: PEET, DPZ, DRI, DIN

Notable news items and price action from the past twenty-four hours.

  • Goldman’s 2011 GLOBAL PROTEIN CONFERENCE (8:00am TSN, 8:45 SFD, 9:45 PPC, 10:30 SAFM)
  • PEET was raised to neutral from sell at Janney Capital.
  • DPZ UK - Sales +11.2% y/y to £132.3M; SSS +4.2% - company notes that total SSS is impacted by the performance of the Republic of Ireland stores where trading conditions have continued to deteriorate during the period; Ireland comps are (10.5%), while UK comps are +5.5% (7.8% excluding VAT increase).
  • DRI - The slowdown in The Olive Garden sales trends appear to more secular that the company may have suggested on last week’s conference call.  DRI announced today that 700 Olive Gardens will be remodeled by June 2013.  Is the company playing offence or defense?
  • DIN has seen 40 of its IHOP restaurants change hands from Quantum Management to private investment firm Argonne Capital Group.
  • The number of announced job cuts fell in March to 41,528, down from 50,702 in February. Cuts during the first quarter of 130,749 were at their lowest since 1995.

 

TALES OF THE TAPE: PEET, DPZ, DRI, DIN - stocks 330

 

Howard Penney

Managing Director


WEEKLY COMMODITY MONITOR

Coffee is down significantly week-over-week while beef and wheat were most noticeable on the upside.

 

While some of the usual suspects, such as corn and coffee, declined week-over-week, there were some significant up moves as well.  Besides the down moves in corn, rise, natural gas, and coffee, there were strong gains in the prices of live cattle, wheat, lean hogs, and chicken broilers.  Also noteworthy was the increase in gas prices.  As DRI’s CEO noted on their earnings call last Friday, gasoline prices are serving as a tax on consumption and, to the extent that this continues, it will likely tax the willingness of the consumer to absorb the price increases that are due over the next number of months.

 

WEEKLY COMMODITY MONITOR - com329

 

Beef prices are crucial to the profitability of many restaurant companies, particularly in the QSR and steakhouse categories.  Beef prices have risen by over 5% in the last week.  Below, I include commentary on beef prices from several management teams’ most recent earnings calls.

 

Arby's will also be facing very high beef prices, we think, through this year, 15% or more increase year-over-year.”

-Wendy’s

 

 

“No, sense yet on when we could try to take some contracts. We are regularly checking the market. Right now the risk premium is too high. We don't believe it's worthwhile. We're glad that we have a high quality brand where our guests are comfortable with it. But, so I would say the overall commodities probably in the high single digits and beef 10 plus percent.”

-Morton’s Steakhouse

 

 

“Beef accounts for more than 20% of our spend. For the full year, we are now anticipating beef costs to be up nearly 9% versus our previous expectations of 6% to 7% inflation. We expect beef costs to be up approximately 10% in the second quarter compared to a decrease of 9% in the second quarter 2010.”

 

“There are some Act of God provisions that will get us north of our contract bands, but at a reduced rate from what the current market pricing is ... And then also grain, corn, wheat and soybean impact, and there are input costs for a number of the proteins. And that's really what's driving up beef at this point.”

-Jack in the Box

 

 

“But let me go ahead and comment that in terms of the steak category or beef in general into 2012, I would tell you that where the futures markets are today, it would suggest that it could be fairly scary into 2012.”

-Texas Roadhouse

 

WEEKLY COMMODITY MONITOR - live cattle 329

 

 

Wheat prices continue to bounce back strongly from their low and it looks as though significant year-over-year inflation will remain through the second quarter at least.

 

WEEKLY COMMODITY MONITOR - wheat 329

 

 

Coffee prices have been on a tear since the summer of 2010 but the past week saw a decline in prices of 4.4%.  While this is a sizeable move, the chart below puts it in perspective.  Coffee concepts are under pressure from the 80%+ year-over-year inflation in their main input cost and I think it is likely that this pressure will continue and may lead to further price increases.

 

WEEKLY COMMODITY MONITOR - coffee  329

 

 

Howard Penney

Managing Director


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THE M3: FEBRUARY S'PORE VISITOR ARRIVALS; RUSSIA VISA AGREEMENT

The Macau Metro Monitor, March 30, 2011

 

 

TOURISM SECTOR PERFORMANCE FOR FEBRUARY 2011

S'pore international visitor arrivals rose 15.4% YoY to 990,000 in Feb 2011.  Indonesia (177,000), PR China (150,000), Malaysia (82,000), Japan (58,000), and Australia (58,000) were the top 5 visitor groups.  Hong Kong (+53%), Philippines, (+48%) and Japan (+43%) registered the highest growth out of the top 15 markets.

 

THE M3: FEBRUARY S'PORE VISITOR ARRIVALS; RUSSIA VISA AGREEMENT - SPORE

 

MACAU-RUSSIA VISA EXEMPTION AGREEMENT ALMOST A DONE DEAL macaubusiness.com 
Macau and Russia are close to a visa exemption agreement.  A final draft version of the agreement has already been drawn up and the signing ceremony is expected to be held within this year.

 

SHELDON ADELSON TAKES AN ILL-ADVISED SWIPE AT HIS TORMENTOR, STEVE JACOBS  Intelligence Macau

Sheldon, being himself, couldn't help making some public comments at the JPM conference regarding the ongoing investigations against LVS and the Jacobs allegations. While there is nothing really new in what was said, it was entertaining nonetheless. Our favorite quotes include:

  • "It's not a serious case... It is pure threatening, blackmailing and extortion. That is what it is all about”
  • “When the smoke clears, I am 1,000 percent positive that there won’t be any fire below it. What they  [investigators] will find is a foundation of lies and fabrications that were designed for the sole purpose of trying to make a settlement for a lot more money than what he felt he was entitled to.”
  • “One of the reasons why we fired him [was because] we told him not to get involved with direct premium players the way he wanted to. He kicked off all the junket reps. Now, we have to build back the relationship... Our policy is that the junket reps own Macau"

THE HEDGEYE DAILY OUTLOOK

TODAY’S S&P 500 SET-UP - March 29, 2011


Month end and quarter end markups look like a foregone conclusion in global equity markets this morning – never doubt the inexorable force of our profession making sure we it gets paid.   As we look at today’s set up for the S&P 500, the range is 22 points or -1.02% downside to 1306 and 0.65% upside to 1328.

 

PERFORMANCE


As of the close yesterday we have 8 of 9 sectors positive on TRADE and 9 of 9 sectors positive on TREND.  The XLF is the only sector to be broken on TRADE. 

 

THE HEDGEYE DAILY OUTLOOK - SECTOR VIEW

 

THE HEDGEYE DAILY OUTLOOK - BEST PERFORMING GLOBAL

 

THE HEDGEYE DAILY OUTLOOK - WORST PERFORMING GLOBAL

 

EQUITY SENTIMENT:

  • ADVANCE/DECLINE LINE: 1090 (+1677)  
  • VOLUME: NYSE 804.39 (+2.56%)
  • VIX:  18.16 -6.58% YTD PERFORMANCE: +2.31%
  • SPX PUT/CALL RATIO: 1.73 from 1.82 (-4.63%)

CREDIT/ECONOMIC MARKET LOOK:

  • TED SPREAD: 21.07
  • 3-MONTH T-BILL YIELD: 0.10% -0.01%
  • 10-Year: 3.50 from 3.47
  • YIELD CURVE: 2.69 from 2.66

MACRO DATA POINTS:

  • US MBA Mortgage purchase applications index (1.7%) last week; total market index (7.5%) compares to +2.7% and +2.7%; refi index (10.1%) vs. +2.7%
  • 7:30 a.m.: Challenger job cuts
  • 8:15 a.m.: ADP Employment Change, est. 208k, prior 217k
  • 10:30 a.m.: DoE inventories
  • 1 p.m.: U.S. to sell $29b in 7-yr notes
  • 1:30 p.m.: Fed’s Hoenig speaks at London School of Economics
  • 2 p.m.: Fed’s Lacker testifies at Dodd-Frank at hearing
  • 4 p.m.: Fed’s Bullard speaks at UBS dinner in London

WHAT TO WATCH:

  • Obama’s job approval hits low, with overall rating 42% late March vs 46% March 3: Quinnipiac University poll.
  • Bullish sentiment increases to 51.6% from 50.6% in the latest US Investor's Intelligence poll (Bearish sentiment increases to 23.1% from 22.4%; those expecting a market correction decreases to 25.3% from 27.0%
  • Hearing of House Financial Services subcommittee on the Dodd-Frank Act
  • Paul Allen criticizes Bill Gates in new book “Idea Man,” excerpted in Vanity Fair
  • Libyan rebels retreat under fire from Qaddafi’s troops. Insurgents driven back to the oil port of Ras Lanuf, according to reports on Al Jazeera television and the Benghazi-based newspaper Breniq

 

COMMODITY/GROWTH EXPECTATION


THE HEDGEYE DAILY OUTLOOK - daily commodity view

 

COMMODITY HEADLINES FROM BLOOMBERG:

  • Soybeans Rise to Highest Price in a Week as U.S. Farmers May Sow More Corn
  • Sushi Purchases From Japan Canceled Amid Concerns About Radiation Leakage
  • Thai Rubber Losses May Total 20,000 Tons as ‘Freak Weather' Lashes South
  • Japanese Oil Ports Still Open to World’s Five Largest Crude-Tanker Lines
  • Cocoa Falls on Speculation Ivory Coast Disruption May Ease; Coffee Drops
  • Palm Oil Advances on Speculation U.S. Farmers May Reduce Soybean Planting
  • Copper Fluctuates on Concern About Economic Growth, Prospects for Demand
  • Gold May Climb as Libyan Fighting, European Debt Concern Increase Demand
  • Vietnam to Expand Rice Areas to Boost 2011 Output by 1 Million Tons
  • Ivory Coast Rebels Advance South, Closing in on Abidjan and Key Cocoa Port
  • Japan Testing Farmland for Radiation Before Start of Rice-Planting Season

CURRENCIES

 

THE HEDGEYE DAILY OUTLOOK - daily currency view

 

EUROPEAN MARKETS


European markets rose to a 3 week high; longest winning streak since December. 

MACRO: European confidence slipped in March; 107.3 from 107.9.

 

THE HEDGEYE DAILY OUTLOOK - BEST PERFORMING EURO

 

THE HEDGEYE DAILY OUTLOOK - WORST PERFORMING EURO

 

ASIAN PACIFIC MARKTES:


The Nikkei 225 gains to the highest level since the earthquake; Japan February industrial output +0.4% m/m vs consensus (0.2%).

 

THE HEDGEYE DAILY OUTLOOK - BEST PERFORMING ASIA

 

THE HEDGEYE DAILY OUTLOOK - WORST PERFORMING ASIA

 

MIDDLE EAST

 

THE HEDGEYE DAILY OUTLOOK - MIDEAST PERFORMANCE

 

THE HEDGEYE DAILY OUTLOOK - setup

 

 

Howard Penney

Managing Director


APOLOGY OF THE PROFESSIONAL POLITICIAN

This note was originally published at 8am on March 25, 2011. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.

“Let him that would move the world, first move himself.”
-Socrates

 

Working closely with a European over the past year has been a learning experience for me.  Europe’s history has always been fascinating, of course, but the future of Europe is now highly topical as uncertainty mounts and political turmoil seems more and more likely to cross the Mediterranean and bring tectonic shifts in the power structure of the continent.  Having a European on the team helps me to get a different perspective on events over there.  It’s been educational!

 

One small thing I’ve realized is that European names often sound far more grandiose than the names I grew up around.  For instance, economist and former president of the Deutsche Bundesbank, Axel Weber, does not sound like a man you’d want to mess with.  The time has come for Portugal’s travails to garner some media attention and, with it, another interesting name has been brought to my attention.  Jose Socrates.

 

While I have a firm interest in politics in this Republic, and therefore have a passing interest in the origins of Western philosophy, I must confess that my weekend reading list is not heavily weighted towards political philosophy.  In yesterday’s Early Look, Keith referenced the Portuguese Prime Minister Jose Socrates, and his recent decision to step down.  Relative to some of his fellow eurocrats, Socrates showed a degree of humility in tendering his resignation this week in light of the escalating sovereign debt issues in Portugal. 

 

His namesake that lived in Athens over 2,400 years ago was tried and killed for disrespecting the gods and corrupting the youth of Athens.  Rather than plea for his life and compromise principles he held dear, Socrates accepted the death that preceded his death as part of the social contract between himself and society.  He refused, as a matter of principle, to pursue conventional politics.  In fact, in The Apology, he is depicted as an individual that took pride in distancing himself from public office, reflecting that he was “really too honest a man to be a politician and live”.  As the quote at the head of this Early Look indicates, Socrates’ view was that people should adjust themselves, and their views, to fit the world and its realities.  Clearly this is not a tenet that has been held by many politicians, in 400 B.C. or 2011 A.D.!  It seems that Keith, in his disapproval of Professional Politicians, is in good company.

 

We do not see 2011 as the year opacity died in Washington D.C.  It will likely survive as long as this Union does.  However, we are aware of the increasing premium Americans are placing on transparency, accountability, and trust.  Twitter, YouTube, and the general proliferation of easy-access information – and the thirst for it – underline this trend.  As a sanity check, simply observe the steady decline of self-professed leaders stepping into the political arena.  Transparency separates the boys from the men, the principled from the corrupt, and the industrious from the idle.  We believe demand-driven transparency is coming to America in a big way.  It is no longer a choice of politicians and public figures to be forthright or not; individuals are demanding it.  That was our call when we opened the doors at Hedgeye in 2008, and it remains our call today.

 

Being cognizant of the fact that our role is to help our clients make money and, more importantly, not lose any, I have applied the Socratic Method in consulting some colleagues about some of their best fundamental ideas.  The Socratic Method searches for general, commonly held truths that shape opinion, and scrutinizes them to determine their consistency with other beliefs. 

 

This Method rhymes with our modus operandi at Hedgeye: upon gaining conviction in a fundamental thesis, each vertical filters the idea through our Macro process in order for the idea to ultimately become a call we communicate to clients of the firm.  Below, I outline some broad parameters impacting our current investment approach from a fundamental perspective:

  • Job creation is a net positive, but too slow for a real robust recovery
  • Inflation is real, despite what Bernanke and everyone who is long oil/energy tells us (bullish on oil)
  • Government support for consumer income will diminish beginning 2Q11 (short large, cumbersome consumer businesses)
  • Focus on some basic consumer services that are less discretionary (eating out and/or dental needs)
  • Think local – what can consumers do to entertain themselves while not driving too far (casual dining/regional gaming)

Here are some ideas from the research team using me as a filter, with one caveat -- Keith has not signed off on them with his quantitative models as a long or short.  The ideas would all fit in the intermediate term TREND duration:

 

Financials: Today at 11am we are rolling out a Hedgeye Black Book highlighting TCF Financial (TCB) as a SHORT.  Our horizon for TCB is over the next 2-3 quarters.  Our Financials team’s core thesis is that the street is underestimating credit losses in the consumer loan book at TCB.  We think there’s downside of 20% over 6-9 months.

 

Energy: Long SUNCOR Energy (SU). As global geo-political tensions mount, particularly in the Middle East where nearly 60% of the world’s proven reserves lie buried, oil deposits in low political risk countries as Canada are increasingly more valuable.  Our favorite among these attractive Canadian Oil Sands companies is Suncor (SU) which has no exploratory risk; price and operating leverage are strong tailwinds. We consider it cheap with more upside potential than downside risk; SU is underpriced in the market by ~20%. With Brent crude oil at ~$115/bbl and SU 87% oil weighted, price momentum is a strong tailwind, as SU has a 0.69 positive correlation with Brent.

 

Gaming: This was a difficult choice given the group’s recent performance.  The Gaming team has been very positive on IGT but could not go with name today given the +5.04% move yesterday.  I like the Ameristar Casino (ASCA) story.  ASCA is a best in class operator that should be able to beat the quarter.  The MACRO environment is stable relative to other gaming operators, the company has easy comparisons, and the FCF yield offers some downside protection.

 

Restaurants: I continue to be positive on SBUX, but I’m going with Brinker International (EAT).  I recently met with management in a market where the company has recently reimaged 16 stores and they appear to be hitting the company’s hurdle rates for return on investment.  The best way to describe how the company is thinking about the remodels is that they don’t want to simply “preserve the status quo.”  Like our Gaming, Lodging and Leisure team’s view of ASCA, I think the earnings estimates are low for the current quarter.  I still like the SHORT side of MCD, and we are currently short that stock in the Hedgeye Virtual Portfolio.

 

Retail: One name that has been in and out of the Hedgeye Virtual Portfolio and a high-conviction SHORT is Carters (CRI).  What we see, that the street does not, is that margins will unravel by 400bps in 2011.  The retail team posted a note on 9/16/10 with the title “CRI: One of the Worst Stories in Retail.”  Now that is conviction.  Other SHORT names to consider are J.C. Penney (JCP) and Wal-Mart (WMT).

 

Healthcare - I’m going with DENTSPLY International (XRAY).  The Hedgeye Healthcare team has been conducting a series of calls with dentists focusing on our MACRO survey work.  The bottom line is that our demand model is forecasting rising visit volume, driven by per capita visits by age and employment status.   In FY 2011, our model suggested some improvement in US patient visits and we assumed some improvement in mix from patients signing on to “treatment plans” that dentists are selling (this is consistent with what dentists are suggesting in our calls).  EPS growth should accelerate in FY2011 as the US market improves, particularly in the second half as employment gains among younger workers accelerates.      Another long in the Healthcare space is Baxter (BAX).  BAX is insulated from much of the global macro turmoil as their IVIG business returns to price and volume growth, but it is less interesting at these levels based on our fundamental factor screens.  I would defer to Keith as to what he thinks might be a good entry point.  The fundamentals suggest the stock is in need of a catalyst or a pullback.  Lastly, their Japan exposure is not insignificant.

 

I apologize for the longevity of this Early Look.  I’ll leave you with some parting words from the Athenian Socrates ahead of the weekend:  “Enjoy yourself -- it’s later than you think”.

 

Function in disaster; finish in style,

 

Howard Penney

Rory Green

 

APOLOGY OF THE PROFESSIONAL POLITICIAN - Chart of the Day

 

APOLOGY OF THE PROFESSIONAL POLITICIAN - Virtual Portfolio


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