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Even If Stocks Are Expensive, Are They Still A Good Relative Value? Not So Sure . . .

On Monday we wrote a research note on the valuation of the SP500 using the Shiller CAPE P/E, which suggested that the market was overvalued by at least one standard deviation.  Not surprisingly the note elicited a fair amount of feedback, some positive, some negative, but mostly constructive and all worth contemplating.  Below I’ve categorized the main areas of feedback and attempted to address them appropriately.


1. On a relative basis aren’t equities still a good buy? 

Clearly, money managers need to make allocation decisions between stocks, sectors, and asset classes.  Therefore, one could argue, looking at U.S. equities on purely a valuation perspective and saying they are expensive only makes sense in the context of the investment alternatives, and the relative after-tax returns.


It is hard to disagree with that.  As investors, we have various options of asset classes from which to consider allocating our clients’ heard-earned capital.  On a very basic level, then, we should consider the relative value of bonds versus equities as an indicator of whether equities are truly expensive.  (The one caveat here is that we also don’t have to be fully-invested when there are as few opportunities for true value as there are today.)


To examine this relative valuation, we’ve taken a look at the earnings yield of the CAPE P/E versus the average yield of a 10Y AAA corporate bond going back to 1954.  In this analysis, a lower yield implies a more expensive asset class which is less appealing from an asset allocation perspective, in theory.  Currently, bonds, based on this proxy, are a cheaper asset class as they have a 5.2% yield versus equities with a 4.23% yield.


Interestingly, on a standalone basis, while bonds are expensive versus their historical standards, not surprising given the current interest rate policy of the Federal Reserve, they are not as expensive as equities versus their historical average.  In fact, 10Y AAA corporate bonds are currently only 0.74 of one standard deviation more expensive than their long run average yield of 7.2% going back to 1954 versus more than one standard deviation for equities.


Even If Stocks Are Expensive, Are They Still A Good Relative Value? Not So Sure . . . - dj chart bond yield


2. The CAPE P/E is based on historical earnings and equities are based on future estimates, so aren’t equities still cheap? 

While we would agree with this to a point, in aggregate it is important to remember that analyst estimates of future earnings are typically wildly disparate versus future actual earnings.  So, while the valuation of a stock, and equities broadly, will eventually reflect their future earnings or cash flow, looking at the broad forward earnings of a market is rarely a great gauge of the valuation of the market and whether it is cheap or expensive.


Simply put, forward earnings estimates are typically inaccurate and usually too high.  To highlight this, we’ve attached a chart below from McKinsey Consulting that emphasizes our point that EPS forecasts for the broad market are consistently grossly off their mark.  We would submit that the primary driver of this disparity is that the bottoms up earnings projections rarely include accurate economic forecasts.


Even If Stocks Are Expensive, Are They Still A Good Relative Value? Not So Sure . . . - 1


Obviously, we also have a negative view on future earnings based on corporate margins being very close to cycle highs as growth slows while inflation accelerates, so we have a hard time making the case that earnings will grow into their multiples. In addition, it is somewhat dangerous to make a “valuation” call on the collective sell-side’s earnings projections, particularly given their preponderance for inaccuracy.


3. The CPI is not a great gauge of inflation since it has changed over time, so how would CAPE P/E look with real inflation?


The calculation of CPI has changed many times over the last few decades with significant changes coming in 1983 when housing prices were replaced with owners’ equivalent rent and in 1999 when the Bureau of Labor Statistics stopped using Laspeyres indices in its calculation.


In the chart below, we have an estimate from shadowstatistics.com of what CPI would look like from 1980 onwards if the calculation of CPI hadn’t changed. The obvious take-away is that inflation would be substantially higher.  


Whether we agree that CPI should be calculated the same now as it was 30+ years ago is not the point, but rather the point is that markets, commodities prices, and basic goods are indicating quite clearly that CPI understates inflation.  So, the question is, if we use a more realistic, and presumably higher measure of inflation, how would the CAPE P/E for the SP500 look?


Even If Stocks Are Expensive, Are They Still A Good Relative Value? Not So Sure . . . - 2


Shiller’s methodology for accounting for inflation is to use a CPI-adjusted S&P500 index and to then divide that by a 10-year average inflation-adjusted (using CPI) earnings to impute his CAPE P/E. Absent being able to actually recreate these numbers for a constant measure of inflation, which would presumably be higher than CPI, another way to look at this market valuation is on a nominal basis, which would at least normalize the valuation for changes in CPI calculations and allow us to compare apples to apples historically.


This analysis was actually done by Chris Turner (email me at if you’d like a copy of the paper with hat tip to a certain subscriber for pointing it out).  He found that by using nominal numbers, for both the index and earnings, that nominally speaking (which really only makes the measure of inflation constant) the market trades at a higher multiple historically (no surpise) and is about as overvalued as it is currently without such adjustments.


We would further submit, that in a period of higher inflation the inflation-adjusted valuation of the market would be higher since the price is based on current inflation, while the earnings is based on cycically smoothed inflation. Thus, if you believe, as we do, that inflation is higher than reported today, than the market is likely more expensive.  This is disconcerting because in periods of high inflation market multiples decline dramatically.


To the last point, the table below shows that as inflation accelerates, earnings multiples decline.  This occurs due to a combination of margin compression due to higher input costs, which slows earnings growth and naturally leads to lower multiples; as well as, to the point highlighed earlier, the relative value trade: as inflation goes up, interest rates will as well and bonds will likely become more appealing from total-return perspectve (so “The Flows” will follow).


Daryl G. Jones

Managing Director


Even If Stocks Are Expensive, Are They Still A Good Relative Value? Not So Sure . . . - 3

Buffett's Politics

This note was originally published March 29, 2011 at 07:59 in  

“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 sales@hedgeye.com 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:

  1. Asian Growth Slowing – Thailand reported an industrial production growth number last night of -3.4% (year-over-year) for the month of February versus a +4.1% growth report in January. While growth slowing on the East Side of this world isn’t new news (we’ve been calling for it since November), it’s scary to think that the slowdowns were this sharp BEFORE Japan’s quake.
  2. European Growth Slowing – Germany, which has been our favorite Western Economy for the last 2 years, is starting to show the first signs of high-frequency growth data slowing in March. This is not good. Neither is all of the Pig Paper countries falling down on the sword of GDP “growth” promises for 2011 (Portugal revised expectations to negative y/y GDP growth last week).
  3. Dr. Copper Slowing – Copper prices are getting pounded again early this week, trading down -2.3% so far for the week-to-date. Critically, the price of copper is now broken on 2 of our 3 core risk management durations @Hedgeye with TREND line resistance now at $4.36/lb.

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


Buffett's Politics - Chart of the Day


Buffett's Politics - Virtual Portfolio


The Macau Metro Monitor, March 31, 2011




Sands China said it’s being investigated by the Hong Kong Securities and Futures Commission for alleged breaches of regulations. 


Economic Services Bureau (DSE) director Sou Tim Peng said authorities from both Mainland China and Macau have agreed to implement measures to smooth the issuance of visas for MICE events.  Local authorities have already sent a list of MICE events being held in Macau this year and 40 of those events have been recognized by the Chinese authorities as relevant for mainland enterprises and businessmen, he added. 

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Initial Claims 

The headline initial claims number fell 6k compared to last week's revised claims to 388k. Last week's number was revised up 12k to 394k, so this week's headline is 6k higher than last week's headline print. Rolling claims rose 4k to 391k. On a non-seasonally-adjusted basis, reported claims were flat WoW.  


We have been looking for claims in the 375-400k range as the level that can begin to bring unemployment down.  If this level is held, we expect to see unemployment improve. We consider unemployment to be ~200 bps higher than the headline rate due to decreases in the labor force participation rate. In other words, if the labor force participation rate were at the long-term average level of the last decade, unemployment rate would be 10.9% rather than 8.9%. So when we say that claims of 375-400k will start to bring down the unemployment rate, we are actually referring to the 10.9% actual rate.








One of our astute clients pointed out the relationship between the S&P and initial claims shown below.  We show the two series in the following chart, with initial claims inverted on the left axis.




Yield Curve Remains Wide

We chart the 2-10 spread as a proxy for NIM. Thus far the spread in 1Q is tracking 40 bps wider than 4Q.  The current level of 266 bps is tighter than last week (271 bps).






Financial Subsector Performance

The table below shows the stock performance of each Financial subsector over four durations. 




Joshua Steiner, CFA


Allison Kaptur


Notable news items and price action from the past twenty-four hours.  Today, we are adding a column on the right hand side of our price table with our fundamental views on select names. 

  • MCD is having to boost imports to Japan to counter supply-chain disruption in the wake of the recent earthquake and resulting tsunami.  A number of the company’s processing plants and a distribution center were damaged by the tsunami, Simone Hoyle, VP of Supply Chain for McDonald’s Asia, Pacific, Middle East and Africa region told The Wall Street Journal.
  • SBUX CEO is set for a mixed reception at Harvard on Friday as a protest is being planned for his appearance at Harvard Business School, according to The Harvard Crimson.  Organizers of the event, including employees of Starbucks and Harvard, hit out at Shultz’ “phoniness” in this new book and the reality of conditions for workers at SBUX being bad and getting worse.
  • Roberio Silva, Brazil’s candidate to head the International Coffee Organization told Bloomberg that “coffee prices will stay “firm” in the next two years as producing countries such as Colombia and Vietnam recover from harvest damage.
  • COSI traded down on massive volume yesterday.  Our conviction on this name remains high and we view this pullback as a buying opportunity.
  • BKC’s exodus continues.  Burger King’s manager for product innovation, Robert Thomas, stepped down Wednesday, making him the latest of several executives to leave the burger company.
  • HSY on Wednesday said it raised wholesale prices by 9.7 percent.
  • Dunkin' Brands is considering an IPO in the second half of 2011. Reuters reports, citing sources, that the IPO could be in the range of $500-750M. The company is still in preliminary discussions regarding the IPO and has not yet selected underwriters.
  • Dunkin’ is going to be sold as “growth” story…  Continuing its steady expansion around the world, Dunkin' Donuts, the world's leading baked goods and coffee chain, today announced the opening of its 3000th restaurant outside the United States




Howard Penney

Managing Director

CHART OF THE DAY: Until Ben Blames Himself, Stay Long of The Inflation



CHART OF THE DAY: Until Ben Blames Himself, Stay Long of The Inflation - Chart of the Day 4

Hedgeye Statistics

The total percentage of successful long and short trading signals since the inception of Real-Time Alerts in August of 2008.

  • LONG SIGNALS 80.51%
  • SHORT SIGNALS 78.32%