Monday, March 29, 2010

The Fox and the Price of a Chicken Dinner

In looking at markets and economies there are really a number of subjects which although interconnected are not moving in lockstep. The fear of two years ago that the financial system was on the precipice of Armageddon has abated. Whether that sanguine attitude is justified is another issue.

The palpable fear of the autumn of 2008 was clearly lessened. The eyes fixed on the coming tsunami have adjusted their gaze. Although the impending violence of the imminent implosion has passed, have the deep and stiller waters receded? I think not. The underlying issues of nonfeasance still exist. There is no more oversight into the activities financial institutions and risk assets than before.

Derivatives, what Warren Buffet called the “financial weapons of mass destruction” are still without serious oversight. The Commodity Futures Modernization Act of 2000 (CFMA), mandated that derivatives were completely exempt from ALL regulation. Whether it was Collateralized Debt Obligations (CDOs) or Credit Default Swaps (CDSs) that single act required that the fox run the chicken coop. How? The CFMA mandated it. No supervision was allowed, no reserve requirements for potential future payouts were mandated, no exchange listing requirements were put into effect, all capital minimums were legally ignored, there was no required disclosures of counter-parties. Derivatives were treated differently from every other financial asset — stocks, bonds, options, futures. They were uniquely unregulated. (And we rail about welfare to the poor?!) Our grade for dealing with the systemic problems that was the Petri dish of the breakdown is a “D.”

The second stool leg would be the investment markets. Clearly the blast off from a year ago to the current stock market levels has been impressive. It has fueled a collective sigh of relief while 75% of the public missed it. While the gnomes of Wall Street enjoyed trillions of dollars of investment liquidity, bailout funding and friendly accounting standards those on Main Street continued to focus on unemployment, diminished retirement funding by employers and fiscal panic in local economies.

This has been a trader’s market with the mantra, “the trend is your friend,” leading the charge. Our grade for market evolution over the past year is clearly a resounding “A”. The market is telling us that the economy is right behind and ready to swing into action creating jobs and profits in a typical post war recession recovery.

The final issue is value. Separating the idea of price from that of value is difficult. Ask those in the hot housing markets of the early part of the last decade. Real estate was priced at the last sale plus a profit. In most markets it delinked from such value parameters as the rental market or the cost of materials. The sky was the limit and living (and lending) was easy.

Today the stock market is again delinking from traditional historical valuation measures. With the exception of the period from 1997 and 2007 the cost of “the market” is back in bubble territory. But it is hard to be analytically cold blooded when the streets are running with soup instead of blood.

Economists are forecasting modest growth of the next several years. Although corporate earnings generally grow more quickly than the economy coming out of a recession, the aggressive forecasted earnings growth is utterly detached from historical precedent. Equity analysts are expecting earnings to grow 25% in 2010, 20% in 2011 and 14% in 2012.

Corporate sales are forecast to 5.5% this year and 7% next year which will mean record profit margins. If we assume that corporate profit margins reach unprecedented levels, the market is already at a valuation far above the norm. If profit margins revert to more historical average levels of slightly above 6% instead of the projected 10% the market would be VERY overvalued at the current level.

Regardless of mood and sentiment and trend, this is not a time to underestimate risk in investment markets.

John Barnyak
Stonehouse Asset Management