Assessing US equities

One of the frustrations about being short stocks in the current environment is that one hears a constant refrain of how "cheap" they are. Indeed, Macro Man saw a US equity strategist from a C-list house a couple of weeks ago, and this guy was ashamed to admit that his analysis of the numbers would allow him to envisage "only" a 30-40% rally over the next year.

Now, eighteen months ago, Macro Man took a look at US stocks and liked what he saw. And so he remained constructive on equities through the end of last year. Early in 2008, however, he changed his mind on the fate of the US consumer, and thus his opinion on equities. Ever since, he's been biased towards neutral to short positioning in indices. Still, when in an introspective mood the other week, he realized that it was time to get cracking with trying to develop a more robust version of his old equity beta portfolio. In 2006, his work prompted him to go long despite his underlying suspicions about the sustainability of earnings. Would 2008 generate the same result?

Now, at first glance, US equities don't look particularly cheap at all. Punching up the SPX on his Bloomberg, Macro Man finds that it has a trailing P/E ratio of around 23...that hardly has "buy of the century" written on it, does it? The man from the C-list shop showed Macro Man a chart suggesting that the P/E was actually about 14 if you strip out all the writedowns, and that this level represented good value.

Uhhh...OK. Presumably if we strip out the writedowns, we should also strip out the accounting profits in 2005-2007 that were caused by the securities that were written off? And if we're stripping out the writedowns, surely we also need to strip out the "profits" generated by the fall in the financials' liabilities? Finally, Macro Man's friends at Merrill Lynch and Citi might also take issue with the notion that writedowns should be stripped out because they are a "one off."

Regardless, perhaps trailing P/Es don't tell the whole story. We also need to look forward, not back. And absent the kind of failsafe crystal ball that Macro Man has yet to locate in his 15 years in this business, that means relying on analysts. Now, simply looking at expected earnings growth isn't going to cut it, because of the Panglossian cloth from which equity analysts are cut: they almost always expect earnings growth. However, we can look at how their optimism changes over time; the chart below shows the six month momentum on analysts' rolling 12 month forward EPS estimates for the SPX. And what we observe here is that analysts' expectations have only slowed this much during recessions. And in each of the previous two recessions, downgrade momentum troughed before equities broke out to the topside. Chalk one up for the "not so cheap" camp!
Now granted, SPX earnings yields (the inverse of the PE) look pretty attractive relative to bond yields, even when using trailing data. This was the metric that Macro Man used in his old beta plus portfolio. But using that metric to evaluate equities carries the implicit assumption that bonds are fairly priced. And if there's one lesson of all that's happened since last July, it's that bonds of all description have not been fairly priced for quite some time. Comparing the S&P's earnings yield with another metric, the cost of living, yields a less satisfying result; the real earnings yield is less than 1%, down sharply from the levels in excess of 3% that prevailed this time last year. Again, not exactly compelling, is it?
Macro Man took these factors, and a couple of other fundamental inputs (no sentiment or momentum data allowed), and developed a couple of simple models to determine the attractiveness of US equities. Now, one thing that he found, which backed up his prior results, was very clear: just because stocks are not a buy does not make them a sell. In fact, he could find no consistent signals to market time the stock market from the short side without torturing the data to the degree that he violated the Geneva Convention.

So the output of his efforts is basically a signal that says "go long" or "stay flat." The first of these was a scorecard approach, wherein each of his factors provide a positive (+1) or negative (-1) signal, and the sum of the factors is totted up, much like in an investment manager's scorecard. Gratifyingly, Macro Man found a strong positive correlation between his scorecard reading and subsequent market returns. And it was pretty clear from sifting through the data that for any reading below +3, you might as well go to Vegas and put all your money on red, as equities are not a winning proposition.
Macro Man was quite pleased to see that his intuition was mirrored by his research result; after a long period in which US stocks looked very attractive, the scorecard recently fell through the key threshold and actually registered a negative reading in April.


He also took a different approach, taking the same basic factors but using regression analysis to generate a forecast market return over the next twelve months. The r-squared of this analysis was high enough to suggest statistical significance but low enough that Macro Man could be pretty sure he wasn't over-fitting what were, after all, a pretty simple set of factors.

He then compared this return forecast with a measure of trailing volatility (though perhaps VIX would be better) to get a "forecast Sharpe ratio." The benefit of this methodology over the scorecard one is that it accounts for the magnitude of the signal from each of the factors, rather than simply assigning a binary rating. It should provide an idea of just how good or bad the outlook for stocks is. And currently, the outlook is, ahem, less than rosy, with negative returns forecast for the next twelve months. Macro Man found that it's really only worth being long equities when the forecast Sharpe is in excess of 1; over the past 20 years, a strategy of being long the market when this ratio is above 1 and flat when below has delivered a risk-adjusted return of....err...1.0.

Now, this methodology has been kept deliberately simple to avoid the traps that many of the equity quants found themselves in last summer. But Macro Man approached it with a tabula rasa; he was more than prepared to accept a signal that the US market was a buy, to implement it, and then trade around it. But he can't make the numbers lie. On the basis of what's worked since 1988 (and indeed since 1970, on the basis of a stripped-down model that excludes analyst expectations), US stocks may be cheap, they may be expensive; but one thing they are clearly not is a buy.
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May 29, 2008 at 10:46 AM ×

A beta components is helpful for two things, because you need positions when you don't know what to do and because stocks in long term growth, so if you have also a filter it could be better.. but i tried this morning to see if there is some correlation with real yields (simple 10yr nominal less cpi yoy, it's a proxy) and I'm asking now: is the real bubble in bonds?? and we know the role of yields into pricing equities..
your beta model modified in a binary +1;0 probably is the right thing to do.
Inflation now is roaring harder, firms are passing their costs, so my question is: is demand curve really insensitive to price as analysts expect?
And: central banks have to adjust their inflation targeting to higher levels or they hike, now??
I've just come back from an inflation conference and the big trend is that no one wants to pay inflation!!!!

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Anonymous
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May 29, 2008 at 12:53 PM ×

Casual observation suggests S&P earnings can be driven by sectors e.g. energy, right now. Would buying a sector (e.g. via ETF)improve the results?

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Anantha
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May 29, 2008 at 3:26 PM ×

I am pleased that your rigorous analysis did not lead to a BUY decision. American housing is in the dumps and hence all attempts are being made to ensure that the other shoe of "asset prices" does not drop too.

If analysts/economists look at profits ex-financials, then the bond market yield ex-financials (i.e., but for financial sector woes) would be at 5% or more and perhaps the price of crude oil would already be at USD160?

Also, profits excluding energy sector are very poor and hence multiples are even more indefensible, excl. energy

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Anonymous
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May 29, 2008 at 9:30 PM ×

Great work as usual, MM.

Quick comment about your last chart "Forecast Sharpe Ratio":

Last time it was this low was April '03, when the SP500 was just a bit over 900 and on its way higher.

On the other hand, the June '01 call was prescient, as the SP500 was comfortably in the 1200s back then.

Gosh, speculating ain't easy..

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Anonymous
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May 29, 2008 at 10:57 PM ×

Hi MM - love the blog! trying to reconstruct the first chart here - what is the Bloomberg ticker for that index? and any chance you can share the other factors you arre using for this model - i love the top-down ideas.

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Macro Man
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May 30, 2008 at 8:37 AM ×

No, speculating ain't easy. The July 2003 miss is one example of why the alternative to being long is going flat, not short.

The IBES data comes from a special subscription on Datastream, and sadly isn't available via Bbg. As for the other factors, I'd rather not reveal, but suffice to say they are both fairly simple and, I think, fairly intuitive.

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Mr. Prop
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May 30, 2008 at 7:46 PM ×

M-squared I have some good news for you. Stocks have little upside, and if the stars align they may get anihilated in H2. I see the current bullish argument as a reflection or shall I say hope that Q2 is the bottom of the cycle and given the forward looking nature of stocks if the current fixed income forwards are correct they imply above trend growth in 2009.

Also, there is a strong recored of positive equity returns when real rates are negative. This has held up for 49-years even during the stagflation days of the 1970s.

Now, why will stocks go down? First, the string of positive economic surprises are poised to turn south as soon as consensus works out that the drags on economic growth are substantial enough to reassess the view that Q2 is not the bottom. This view implies that rebate checks are not enough to save the consumer.

The growth scare plays out for 3 reasons. Non-residential investment which has held up well collapses. Asia slows, finally, and the shock of recoupling is a nasty hit for sentiment.

Finally, and this may be the most important factor, the real cost of capital is soaring, just see what is happening to global bond markets. Again blame Asia. They were the reasons it was so low, and now they are withdrawing support from bond markets and are recycling less. Why?

Inflation means they have no interest in weak currencies. External balances are weakening, thanks to higher energy costs. Finally, speculators are not in love with the Asian carry trade. All puts currencies in the region on the precipice. They may actually be forced to buy their currencies to slow the decline. To do that they must sell Treasuries, Bunds, Gilts.

When will the higher cost of capital impact stocks? Soon, baby soon. My guess is that this along with some clarity on weakness in the economy in 2h is what is needed. Oh by the way higher bond yields is not going to help those hoping the US housing market is going to bottom. I am long stocks, playing for a squeeze here, but I am a longer term bear.

Asia, recoupling, less flows, higher cost of capital, higher financing rates for housing, and too many bulls are a recipe for disaster...

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Yaser Anwar
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May 31, 2008 at 3:20 PM ×

Hey MM,

When you stated, "Comparing the S&P's earnings yield with another metric, the cost of living" - by cost of living you meant inflation right? Just clarifying, thanks.

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Macro Man
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May 31, 2008 at 5:56 PM ×

Mr. Prop, I too am bemused by the resilience of stocks to the the butchery of fixed income....though in many gays, one could argue that govvys are just becoming more fairly priced, given the inflationary dynamic.

Speaking of which, inflation is indeed what I was referring to, Yaser.

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Mickson
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June 1, 2008 at 1:09 AM ×

Loved your Jibe at the C-Lister's.
LOL.

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Lammert
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June 2, 2008 at 3:01 AM ×

The United States Dollar's Quantum Valuation Pattern


Relative to other leading economic nations, America's governments, corporations, and citizens have borrowed proportionally more. Under this primary GNP growth through debt pushing on the proverbial string parameter and to a correlative and accompanying measure - under the conditions of inappropriately low interest rates and imprudent lending terms which fueled that borrowing - the US dollar has fallen - in a relatively precise fractal manner - against a basket summation of other leading currencies. While the dollar has fallen nearly 50 percent against basket currencies in the last 12/30/24/18 :: x/2.5x/2x/1.5x months, it has fallen to less than 15 percent below its lows from 1987 to 1994. The world requires inflation of all currencies for growth in order to service debt and population growth. in spite of the 2 percent US interbank lending rates and US treasury rates which directly foster malinvestment speculation in stocks and commodities, the latter of which is killing the pay check to pay check surviving middle class, a necessary saturation curve mathematical fractal correction of the US dollar to the summation basket fiats is now and will occur.df

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