Perception of Value
06/15/10
Human perception is a funny thing. We tend to process information on a weighted average basis, meaning that recent information is awarded more weight than older information. Just consider this: Only 12 short months ago the majority of investors seemed convinced that the US Dollar ought to be replaced as the leading world reserve currency. Today, the majority of investors seem convinced that the Euro belongs on the trash heap of human history. How times have changed. It is unlikely, of course, that either conviction will come true and news of the demise of either currency proved vastly exaggerated. Currencies have come under scrutiny though. People intuitively understand that sound currencies are the result of sound finances, which in turn are the result of sound policies ... or are they? Arguably Europe's financial condition has not deteriorated by 20% over the last 12 months and neither has the US financial condition improved by 20% to justify a 20% change in the value of their currencies. The only thing that did change was the perception of those currency values, that's all. In a similar vein, a recent Bloomberg poll showed 4 of 10 respondents picked the U.S. as the market presenting the best opportunities in the year ahead. That's more than double the portion who said so last October, when the U.S. was rated the market posing the greatest downside risk by a plurality of respondents. Following the U.S.'s 39 percent rating as the most promising market were Brazil, chosen by 29 percent; China, 28 percent; and India, 27 percent. What was the reason for this dramatic shift? Did Congress find the magic bullet to solve all our problems? No, perceptions changed, that's all.. And so it becomes clear that investing is not necessarily the art of anticipating future events but the art of judging the human reaction to those events. Anybody who listened to Jim Rogers and his followers and sold dollars and treasury bonds last fall based on the thesis that the US is doomed, lost money since then. For six week now stock markets were held hostage by currency markets. A falling Euro (rising dollar) threatened to destabilize the world (European) order as we know it and caused investors to take risk off the table, whereas a rising Euro (falling dollar) caused the market to rally as established relationships reasserted themselves and global risk exposure became attractive again. Last week the markets finally stabilized as the realization set in that Europe is not going to disappear even though its problems may stay with us for a long time.
The first chart above shows you the dramatic adjustment in value perceptions. The Euro currency fell from $1.50 in December to below $1.20 in June. The second chart shows the Euro weakness vis-a-vis the Yen which is even more pronounced. The red line is the S&P 500 index. Both show a high degree of correlation until October 2007. After that the S&P 500 line weakened whereas the Euro/Yen line proceeded to make a new marginal high in July 2008. Thereafter the full extent of the subprime crisis became evident and the Euro crashed against the yen in dramatic fashion, losing 30%. Risk was taken off by money managers around the world, which meant that the major funding currency (Yen) was being bought back and yen denominated loans were being repaid. The second Euro/Yen wave down started January 2010 and only began impacting the S&P500 3 months later. The correlation at this point is not very high. The Euro/Yen reached a new low whereas the S&P 500 is some 60% above its prior low. The first wave represented the global deleveraging (risk off trade) caused by the subprime crisis. The second Euro/Yen wave down represents the sovereign debt crisis and specific Euro-based weakness. The levels of Euro/Yen are not as important as the direction and the velocity of the move. A violent move down is unsettling to markets and leads to risk-averse behavior, whereas a gradual decline may not have any effect at all. So far, at least, Europe is still standing and far from breaking apart. Jean-Claude Manini, the Conference Board senior economist for Europe said on May 20, 2010: "The LEI points to a continuing, though still weak, recovery for the Euro Area. Even with the recent volatility in European financial markets, post-recession rebound effects still dominate the recovery process. The LEI has returned to a solidly upward trend, suggesting a moderate pick-up in economic activity in the second half of the year." US markets have been caught in the European maelstrom, but it seems to me that the facts on the ground continue to improve even though stocks have deteriorated severely. If one looks at the US credit markets for example the picture brightens considerably.
The first picture above shows the yields of Moody's Baa rated corporate bonds. They are trading at close to 45 year lows and show that US corporations have regained the creditworthiness. The second chart above shows the yield difference between Moody's Baa rated bonds and US T-Bonds of similar maturity. Corporate bonds yield currently about 3% more than government bonds. This is not necessarily high but is certainly not extremely low either. Let's call it "fair". Nevertheless, the interest rate environment is supporting valuations to a considerable degree. The companies of the S&P 500 are estimated to earn $82 this year. If we divide $82 into the index closing price of 1,090 we come up with an earnings yield of 7.5%. Compare that with 3% for treasury bonds and 6% for corporate bonds and we see that stocks offer some value at current prices. The trick of course is, how do we make our fellow investors understand this. Again, in a world of high uncertainty and volatility, our fellow investors may have different perception of value than we do - at least in the short run. It is for this reason that Benjamin Graham said: "In the short run, the market is a voting machine but in the long run it is a weighing machine."
Recent unemployment numbers were anything but good and doubts about this recovery have resurfaced all over. I guess the bears really never went away. If we look at just the facts though, we see that there is value in this market. That is all that matters in the long run.
Hermann Vohs
"What is madness? To have erroneous perceptions and to reason correctly from them."
Voltaire
Hermann Vohs is president of Cales Investments, Inc., a registered Broker-Dealer. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. Hermann Vohs and/or the staff at Cales Investments, inc. may or may not have investments in any of the markets cited above. Hermann Vohs can be reached at 303-765-5600.
This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities.
