Thursday, May 07, 2009

You Get What You Pay For

Another day, another rip higher in equities. Despite the dodgy leg, Macro Man is starting to harbour a desire to visit Pamplona this July. For someone with his relatively bearish disposition, that running of the bulls would appear to be considerably less dangerous than trading equities at the moment.

Fortunately for Macro Man, he by and large isn't trading equities. But given the extraordinarily high cross-asset correlations, it feels like just about everything boils down to getting the S&P 500 right.

To be sure, the weight of money trumps all; indeed, this is how bubbles form. So while the fundamentals may or may not be rubbish, if there are lots of marginal buyers and no marginal sellers, the price will rise until equilibrium is restored. Trying to sell the top-tick is a game for suckers.

That having been said, it is worth checking one's biases every so often. This is why Macro Man runs a medium term equity forecasting model that takes emotion out of the equation and attempts to provide an unbiased assessment of the factors that typically drive medium-term equity trends.

And in the latest run, the 12-month forecast has turned down again. This is partially a function of the recent rise in prices, but also an acknowledgement that earnings quality is pretty execrable, recent beats notwithstanding.

There is a lot of talk about how 'cheap' stocks are, but frankly, Macro Man just doesn't see it. Oh sure, it you look at operating earnings- particularly the operating earnings expected from bottom-up analysts- you can convince yourself that equities don't look too pricey. But this ignores the record divergence between operating and reported earnings, the latter of which contains the "one off", "extraordinary" write-downs (that seem to occur with quarterly regularity) known affectionately in this space as "turds."

Source: S&P

It is frankly ridiculous to look at earnings with the turds stripped out, not least because the continued presence of the turds is what has put the monetary framework in place that allows banks, etc to "earn" their way back to health.

And while there's no guarantee that equity analysts of any stripe are going to be right, Macro Man places a great deal more faith in the top-down folks (who forecast both operating and reported earnings) than the collective wisdom of the bottoms-up crowd, all of whom seem to live in Lake Wobegon.

Looking ahead to the end of next year, at current pricing the SPX is looking like a 20-25 P/E on 2010 earnings. That puts the earnings yield roughly in line with 30-year Treasuries, and well below yields offered bv investment grade credit.

Those markets appear to offer superior investment opportunities at current pricing. Macro Man understands the importance of money flow in driving short-term price action, which is why (despite his frequent bearish mutterings), he has largely refrained from trying to strap on the bear trade.

But those managers and allocators who are throwing in the towel and buying stocks should remember: at the end of the day, you get what you pay for.


H(oratio) said...

'earnings quality is pretty execrable, recent beats notwithstanding'

Not to belabor the obvious, however let us note that the beats have been at the expense of the 'expense' side of the ledger, and the attendant effects such as salaries.

Once again, my admiration goes to you London chaps. Ten point bump on the spies as soon as I took a nap. Any longs want to pay me to sleep?

Anonymous said...

I have worked with a lot of people who, thanks to MM, i now know come from Lake Wobegon....For this titbit, i'm forever thankful...Yours, IB

SFOT said...

Hi MM, agreed with the fact that trading anything else now is about getting the S&P right. And spot on re weight of money trumping everything. Seems like this applies to commodities very much at this juncture, Gold and Oil in particular. U r still a happy camper in long mid curve oil? My 2 cents worth here. Really seems like the price action this time of the year in 2007 and 2008.

Anonymous said...

Agree. Referring to your last video on GC heres one explaining the last rally. Great show.

dblwyo said...

MM - credit where it's due. One of you best posts imho. Clean, clear, simple, logical and right.

Consider this - outyear earnings and PEs are also likely envisioning a more robust recovery than the Fed, CBO, OECD, IMF, World Bank, are AND those PE ratios are outrageous when you look at history.
Right now we're trapped in a s.t. sucker's rally where fantasy feeds fantasy,again imho.

For the record, on a YoY basis,ADP employment was down -4.3% vs -3.9% last month. There is NO data point in the last three weeks where the level isn't abysmal even if the rate of decrease has slowed.

Macro Man said...

SFOT, yes I am still happily ensconced in midcurve oil; the possy is small enough that I can run it no matter what the price does. I have augmented it with the occasional foray into prompt; I was long earlier this week, but sadly took profit yesterday morning and missed out on nearly $4/bbl. grrr.

hopefully anon said...

che guevara actions on chrysler changed secured lenders priorities and the wall of money scouring for credit deals poured on equities instead. better to bet on the certainty of inflation. that's my story and i'm stickin to it.

Anonymous said...

Interesting. I am out of equity now. What is the story behind the long term treasury? Is the current yield sustainable if the fed wants to support the recovery?

PPM said...

Personally, I find this rally deeply disturbing because it demonstrates the extreme shallowness with which most market participants make their investment decisions. A few months ago the world was ending. Now, there is nothing but optimism to the most distant horizons.

People are buying because the fear missing the leg up. This is nothing more than "monkey see, monkey do." "Everyone else is jumping in, so I should too" type thinking. If this is the level of intellectual analysis that goes into capital allocation decisions, the world, in the long term, is in even more trouble than I first thought.

prophets said...

how do you get 2010 earnings BELOW 2009 earnings? that doesn't make sense and I run the same bottoms up/top down model.

I get fair value of S&P500 in the 700-900 range, even using BBB as a baseline compare.

Anonymous said...

the numbers in the charts are PEs not quarterly earnings.

They are the publicly available numbers from the S&P Homepage.

Macro Man said...


wcw said...

Yeah, top- and bottom-ticking is for suckers. That said, while I am still net long, I have been selling this week's rally. Bear-market rallies are wonderful things, but it's my thesis that the Geithner feelgood bankstravaganza we call "stress tests" were a sell-the-news opportunity.

We'll see, but I now equities are going to have to earn out their new valuations.

Anonymous said...

we've discussed before...but if dividend futures market is right. then 70 euro of dividends to come from eurostoxx next calendar year, 2010. thats a 3% yield based on current spot level. i think that is too pessimistic, eurostoxx will yield more. i'd be willing to be that companies maintain or grow dividends in 2010. this year eurostoxx companies will pay 110 euro of dividends. if this is the true trough in earnings and payout ratio are maintained....then equities to me don't look bad value versus the 1 year risk free rate which in Europe currently 82bp according to my screen. money will naturally flow into higher yielding assets even if growth is dull in my view. it is this allocation story that will dampen the equity sell off in my humble opinion. we could go into boring low return world where yields matter. analyst earnings whether observed at the operating or reporting line can never be trusted. They are sheep. and this earnings season they were too low. even if you look at sectors that were not full of hocus pocus. i.e ex-financials.

laabla said...

great stuff!

Anonymous said...

MM. Any chance you could provide high level details on your equity models. Type - regression, factor analysis, inputs - macro variables, technical, sentiment..... Just a general idea to see how the pro's do it.


theoddone said...

I look much more at P/S and EV/S now as the contraction has been so sharpe it destroys earnings. Trusting the forward looking earnings is basically trusting analysts (your call). I have basically just taken 30% off topline for P/S and EV/S to gauge priceness of equities.

Macro Man said...

Anon @ 8.46: sorry, but my little models and indicators help put food on the table, so they must remain a secret!