Tell Me Lies, Tell Me Sweet Little Lies

Tuesday, July 28, 2009

The summer rumbles on with the risk-on orgy intact. After a brief wobble earlier in the day, the SPX closed on its highs of the years, and a welter of bullish strategists send missives with 4-digit price targets and dreams of a sustained V-shaped recovery.

Now, Macro Man is surfing the risk-on wave, especially after jettisoning the non-performing player yesterday who had harshed his smooth since late last week. In the short run, a steady flow of funds into equities and other risky assets will drive prices higher, assuming such flow materializes.

The problem that some so-called perma-bears have is is recognizing the temporary importance of such asset flow, and how far it can push asset prices. By the same token, the problem that some of the flow-of-funds, risk-on crowd have is is failing to recognize that buying something just because other people do is nothing more than an exercise in greater fool theory. And while the market may well be a voting machine in the short run, as Benjamin Graham observed it is a weighing machine in the long run.

Macro Man was debating the long-run outlook for stocks with an FX-only punter yesterday who asked him what he thought "fair value" was. This raises on of the critical issues that a macro punter like your author has with equity markets. It's gotten to the point that the stock market is so rife with misrepresentation and lies that it's very, very dificult to get a firm idea of what's priced in.

Now, the high-lighting the fact that the stock market is full of misrepresentation is hardly breaking new ground, even for this space. But Macro Man does wonder....when Barrry and Gordon take a break from fingering your wallet to try and build a better (financial) mousetrap, why they don't do anything to address the web of lies, sweet little lies, that surface every reporting season.

Misrepresentation in corporate earnings statements is rife; according to S&P, of the 197 SPX companies to report this quarter, only a quarter have actually earned the number reported in the headlines. Fully 63.5% stuffed "one-off" or "extraordinary" items in their income statements, while only 24 of the 197 had reported earnings that were higher than headline operating earnings. Interestingly, some of the latter were quite sizeable, courtesy of some of the worst performers of the whole crisis: Z-list financials, Ford, etc. The dispersion graph is shown below.

So in valuing equities moving forward, what concept of earnings should we use? Pick a number, any number. Looking at 2010 earnings estimates yield an incredibly broad range of forecasts. If you believe the crack-smoking bottom-up guys who strip out everything that could be construed as a "loss", you get a resounding $74 pr share. Not bad!

Taking the same approach (stripping out the quarterly "one offs"), but from a top-down framework, yields a substantially less rosy result: earnings of just $46 per share. And actually counting all the turds for what they are on a top-down basis yields 2010 EPS of just $37 per share.
Source: S&P

Remarkable! On this basis, equities are either pretty darned cheap or bum-clenchingly expensive based on 2010 earnings. Gee, thanks. Now obviously, trusting analysts' forecasts is a treacherous endeavour at the best of times, but it's small wonder that you have some people screaming "buy buy buy buy buy!!!!" whole others mutter "you guys are frickin' morons" under their breath (or not, as the case may be.)

The chart below shows the appropriate valuation for the SPX based on a) the 3 sets of earnings estimates listed above and b) a range of multiples, none of which is completely unbelievable.
This little exercise yields a range of values for the SPX from 300 to 1480. So regardless of where you fit on the bull/bear continuum, there's probably a forecast here that fits your view. (Macro Man cannot help but observe, however, that all of the top-down valuations are well below current levels.) It's also a pretty good indication that if someone tells you that they "know" what fair value is for the SPX or equities generally, they're almost certainly lying.

Posted by Macro Man at 9:41 AM  


Interesting post MM, but let me ask you this. Is this phenomenon confined to the equity market? How do you "know" what the fair value is for any financial instrument? And, more importantly, how does that help you trade it. Fair value is irrelevant if the market decides to push itself 50% away from that fair value in the opposite direction to which you are positioned.

thetrader said...
10:57 AM  

I'm just waiting for a bond auction fail a la China, or, for some genius at the Fed to work out that we have yet another asset bubble in the making. So long as rates are zero punters will use their brokerage account as an ATM.

Nemo Incognito said...
10:58 AM  

The trader, you never "know", of course. In fixed income, there is usually a policy-rate anchor, though as punters found last year, the strength of the link between LIBOR rates and that anchor isn't always as firm as they might like. FX ostensibly has valuation metrics like PPP, but frankly those are only appropriate for people whose time horizon is best described as "geologic."

At least currency punters know this, however, and don't generally use rationales like valuations as a reason for trading. My impression is that equity folk tend to have more of a false sense of confidence in therir valuation metrics. Just one (macro) outsider's opinion...

Macro Man said...
11:11 AM  

MM, you are absolutely right. But if you want to see real intellectual arrogance you need to spend more time with high yield credit guys. I've only heard of one guy pushing another on a trading floor saying "f you, I know this x better than you ever will." X was Countrywide, and the guy saying it was a high yield guy.

Nemo Incognito said...
11:40 AM  

A dangerous time to be chasing momentum

Anonymous said...
12:24 PM  

MM, given that you are able to spot the sleight of hand tricks of moving one offs to the income statement (when they are positive) does that not mean that disclosure is adequate? If monkeys want to ignore that and buy buy buy that is their problem - and such people are can always find a number to "justify" what they "know".

Oh, and the word verification captcha I'm getting when writing this is "troll" - excellent!


Anonymous said...
12:28 PM  

A more appropriate position is to be out of this market completely. I think it is too unstable. Look at the % swings in this broadening formation.

Anonymous said...
12:32 PM  

There are a number of commentaries emerging, primarily from those away from the market hothouse and who manage portfolios, who regard the equity rally as all fizz that will pop. The burden of these discussions is that (a) it is going to be a long "L" experience, and (b) that as far as exit strategies are concerned central banks don't have any - not any that add up. Their panties are in a twist.

Donlast said...
12:46 PM  

Mornin MM - as always a good post indeed. Have you done any regression to see which valuation metric has the most predictive power 3, 6, 12 mos out?

Apart from that, I'm seeing my most ardently bearish friends and confidants one by one peeling away and turning bullish. While I agree that you can't "fight the tape", I see them increasingly as counter-indicators, something you may be at risk of becoming MM!

The true bottom of this secular equity bear, IMHO, will be seen when simply nobody cares about equitie anymore, or investing at all for that matter - and at that time you, MM, may find fewer eyeballs hitting your blog too! (perish the truth!!) :O

birds eye view said...
12:58 PM  

The 'greater fool' theory requires that pension funds start diving into equities with vigour - something that I don't believe is happening yet. The sheer neediness of that lot will set up a lovely crash.

Charles Butler said...
1:26 PM  

Nemo, as far as I can make out, the only 2 requirements to become a hig yield guy are a) a very short term memory, and b) a basic ability to identify which in a series of numbers is the largest (and then to buy those issues with the largest numbers in the 'yield' column of the spreadsheet.)

LFY, given that we live in a world where governments have evidently decided that they need to tell people that a) you actually cannot get something for nothing, b) that you really oughtn't to lie on your mortgage app. really! and c) if you lost money in anything, it's because someone lied to you, I am neverthless surpised that they allow such widespread misrepreanetation of results. A simple solution would be to mandate that the official earnigns number from a company be the same one that it puts on its quarterly tax return. (Oh, and I have no control over the captchas, but that is awesome!)

birdseye, I've actually had one of my better months of the year this month precisely by remaining flexible and following the price action. As observed yesterday, my style of portfolio construction is to create a group of positions that will work in multiple environments, with some working best during an equity rally, others doing better during a sell-off, etc. While I may well be a reverse indicator intellectually, at the end of the day I am more interested in making money then being "right."

As for readership, it's been sadly stagnant since last November after scaling the heights in September/October 2008.

Fortunately, the contribution from the comments remains entertaining and informative, so I'm still deriving plenty of utility (and the odd trade idea) even though traffic's no longer increasing.

Macro Man said...
1:30 PM  

ok, so one way of looking at it is that fair value then is (300 + 1480) / 2 = 890 which fwiw is pretty close to jeremy grantham's recent estimate of fair value at 880.

So, just wondering... keeping it simple, do I buy equities as long as we are above 880-890 for now?

btw, what are the chances that the relentless rally has been fueled by short covering by hedge funds? Similar to the liquidation of late last year/early this year?

God, I hate yield chasing, inflation, etc - why can't we have some deflation for a while so I don't have to worry about my investing and can go about living instead! I want to be shorting FXI soon.

jbr said...
1:51 PM  

jbr, my sense is that while macro has been leaning short stocks, directional equity funds (who are, after all a much bigger group in terms of stock trading firepower) have been leaning long (with a beta below 1 but greater than zero.) I think the rally from 870 to 930 or so was probably short covering from some segments, but thereafter it seemsd as if it has been hot money longs.

Macro Man said...
2:01 PM  

Well, first time post over here for me, so it can't be all bad (having said that, I guess you will make your owm minds up after you hear what I have to say...)

re: earnings - using the top down inc. items for Q3Q4Q1Q2, the Fed model puts the SPX at about "fair" (!) where it is now, with the earnings more likely to outperform to the upside than dissappoint.

So while the 2010 earnings puts the spoos wherever one wants, there are others who see only potential upside...

Personally, I belong to the sideways brigade, just food for thought.

Awesome blog.

blah said...
2:05 PM  

Thank you for an excellent post. I agree that many income statements are misleading, since the whole purpose is to let the public (not just pros) get a "true" picture of the health of a company. Also, IMHO, mark-to-market should be replaced by something like mark-to-lowest-value-of-last-business-cycle to reduce the pro-cyclicality of managers marking up assets along with the inflating bubble.

Re jbr: from my corner it seems that equity hedge funds have been fairly well positioned for this rally, with a bit of overweight in equities and thus fewer short positions to cover.

Vasastan said...
2:10 PM  

MM: Appreciate your views in your follow up post.

Also, wanted to say that I've been following your posts for a while now and have always found them to be very informative and thought provoking. Many Thanks!

Vasastan: thanks for your thoughts.

jbr said...
2:20 PM  

MM et al., in case you guys haven't seen this, this 80s documentary featuring Tudor Jones came online... gotta love the pet turkey:

SD said...
2:22 PM  

MM, you clearly haven't spent that much quality time with the Goldman SSG crowd or anyone who has ever managed a CLO. "My new tranche slicing technique is unstoppable (cue rinky dink kung fu flick movie)". Its not the yield hogging, its the plain old belief that you can project cashflows out accurately for 5 years, just like a PE muppet.

Nemo Incognito said...
2:22 PM  

Hot money longs is right. Short interest in US stocks was down 72% in the first 2 weeks of July, and outstanding interest in short ETFs fell sharply. So by 930 or so most shorts had covered.

I think the rally has topped. Only bad news on the horizon. So many have bought into this Q3 recovery idea, when it collapses the market will have a fast 10% drop.

Anonymous said...
2:23 PM  

Nemo, after the last 2 years, are these guys still talking about their models? I'd thought that they had been discredited long ago. In any event, I see that it's almost August, so presumably we're due for another blow-up soon....

Macro Man said...
2:31 PM  

I sir am hoping for such a thing and spending an awful lot of time working out how to defray the cost of waiting.

Nemo Incognito said...
2:47 PM  

can't remember who it is that keeps predicting a withering trade war but here you go


Anonymous said...
4:29 PM  

Oh dear....dodgy consumer confidence and it's all looking suddenly wobbly. Meanwhile, The EU's fixin' to slap some tarriffs on Chinese steel....let the games begin, baby!

(erroneously posted in yesterday's to the story is in melki's post above.)(

Macro Man said...
4:37 PM

Raise your swords..... I told you it was coming.

Nemo Incognito said...
4:47 PM  

MM - as always, spot on today. The commentary about earnings and suggestion that the reported number must match the tax number is a fabulous idea which might cure a number of ills. Thus, certainly, is unworkable, but fabulous nonetheless.

Thanks for the great blog.

k1 said...
5:08 PM  

SD, thanks for linking to the PTJ video, I have been wanting to see that for a long time. Nice one.

Anonymous said...
5:59 PM  

Since we're on the subject of fair value, how about a smashing MM expose' on all the chit chat about "the new fundamental drivers of FX" from the emerging "new world order."

None of which have I been able to wrap my drunken, sweaty and formerly nicotine stained fingers around.

Professional Gringo said...
6:40 PM  

PG, I wrote an exhaustive list of everything that I currently understand about G10 FX on Sunday.

Macro Man said...
6:42 PM  

That very subject consumed me this weekend and I can't seem to connect the in "new" dots. I thought maybe you or the anon guys here might have an interesting idea or two.

Professional Gringo said...
7:09 PM  

Well, the story with EUR/USD (and, to a lesser degree, cable) is that Voldemort has gone from hoovering euros to selling strength and buying dips....i.e., he's enforcing a pretty excruciating range.

All the while, he's accruing FX reserves, so presumably at some point (after the SED?), the dam will burst and he'll come to market with a vengeance. Unoless, of course, the world implodes first, in which case EUR/USD will drop. Easy!

As for yen, pass. Ditto scandis. Commodity currencies are basically just trading like EMFX, except by and large they're not as good.

Overall risk budget to FX is smaller than usual...risk budget to G10 is more or less nonexistent.

Macro Man said...
7:21 PM  

The market still wants to rally on everything. it just does. One canary-in-a-coal-mine trash spec position is up another 25% today. The news on which it is up, best I can tell, are the headlines inaccurately asserting that house prices advanced in May (seasonally adjusted prices are down on the month, real prices down more)

I have stayed dollar neutral, but a don't-fight-the-tape long gamma, net long beta position is starting to sound like a reasonable way to participate.

wcw said...
7:38 PM  

"He's enforcing a pretty excruciating range." It's mind numbing. The lack of volume is a major issue and the Usd will be under extreme pressure to drop in value if it can just draw in an extra flow of the global drivers of the Usd are building into a solid long mode, and the neutral momentum reads on equity and commodity markets can make this thing swing either way.

In other words, this sucks. We need strong equity moves to easily break the ranges and hold.

Professional Gringo said...
7:56 PM  

my 2nd comment to your blog.
thanks for posting this. And for your excellent commentary and explanations within.
Most helpful.

index fund investor said...
9:00 PM  

macroman -- if your traffic is holding constant over the past 3ms (or even past 6ms) after the boost provided by the mother of recent financial crisis, you are doing extremely well! and the quality of the comments is well above the web average/ econ/ financial blog average.

interesting re Voldemort selling as well as buying EUR. Has Voldemort's appetite for commodity currencies grown recently, in line with the Chinese SOE push to go forth and Chinese stockpiling? Or is Voldemort trading a range there too?


Anonymous said...
12:26 AM  

Long time reader, first time poster and all that.

Great post. I have always wondered why estimates are not always for S&P earnings of -100, then any beat would be huge and the markets could go crazy, liek they are now.

On a somewhat related note, if the banks are going to have to buy much of the US debt sales this week, they may be a little light to push stocks up as well. Still, the late date pumps are done on minimal volume, so they can probably swing both.

1:54 AM  

China said to be tightening credit, HSI down 600+ pts, Shanghai down 5%, spoos off...... I think I just jizzed in my pants.

Nemo Incognito said...
7:45 AM  

Is this you, old boy?

Macro Man said...
7:52 AM  

Pretty much.

Nemo Incognito said...
8:21 AM  

Brad, I haven't heard much about V doing anything in the commoeity complex other than the odd trade here and there...certianly no suggestion that he's been accumulating steadily.

Inciedntally, he's been seen buying EUR/USD this morning off the lows in the wake of the Shanghai Comp-related sell-off...

Macro Man said...
8:22 AM  

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