Bear Market?
07/15/06
The Economic Research Institute was quoted here last month and the Leading Economic Indicators (LEI) (chart on the left) are still pointing down. The growth rate (red line) has almost reached the Zero line. There is some serious weakness coming in the second part of this year. This is a negative for earnings and equity prices, positive for bonds and should (in theory) prevent further increases in interest rates. The June gain in Non-farm payrolls (right chart) of 121,000 itself was much weaker than expectations for an increase of 200,000 new jobs. The blue line represents the average of the past three months and thus takes out some fluctuations and stands now below the monthly growth in the labor force, which tends to run at about 150,000 per month. The economy needs to create about 150,000 new jobs every month for the unemployment rate to remain unchanged and to absorb new entrants that come into the labor market. Declining job creation also indicates a weakening economy. Although a weakening economy can be an indication that profit growth for companies may be slowing, the actual performance of equity prices also depends to a large extent on relative valuations. The Fed Model certainly has many flaws but it gives us at least some bearings on how expensive our market is compared to past valuations. The Fed Model (Alan Greenspan used this model as a rough estimate) calculates the "Earnings-Yield" for the S&P; 500 by dividing estimated earnings of all 500 companies ($81) that make up the index for the year 2006, into the Price of the Index (Friday's close was 1,236). In the case for operating earnings: 81/1236 = 6.55% as the S&P; 500 "earnings yield". To determine whether this is a "fair" earnings yield, we must compare this to "risk-less" investments such as 10 year Treasury Notes which currently yield 5.05%. Since in this case the earnings yield on stocks is about 30% higher than the yield on 10 year T-Notes, proponents of the Fed Model argue that the Stock Market (or at least the S&P; 500) is undervalued by that amount. The left chart assumes that yields on 10-year T-Bonds increase to 6% by June 2007 (if you asked somebody today, he would classify this event as a catastrophe) and S&P; 500 earnings increase by only 5% (if you asked somebody today, she would classify this event as a nightmare). This horror scenario would bring the market to an undervalued state of only 10%. Not bad for a horror movie. The right chart assumes profit growth of 10% for the next 12 months and interest of 5.5% by June next year. As you can see, one could argue that on a forward looking basis, we are undervalued by some 25%. Compared to the past 15 years, this market is not expensive. The charts below give us a way of measuring the value of US shares compared to other regions of the world (courtesy of S&P;/Citigroup). The U.S. ranks dead last on Price to Cash flow (left), Dividend Yield (middle) and Price/Earnings ratio (right). Does this mean that we are more vulnerable than the rest of the world ? No! The rest of the world already lost between 15% and 50% since the beginning of the year and therefore experienced a correction of previously extreme valuations. The U.S., however, was always afforded higher valuations than the rest of the world. After all, this is the country for capitalists and this is where people invest their money. Shareholders are being treated fairer, the rule of law is stronger and accounting practices are more transparent than in any other country in the world. The U.S. deserves a premium valuation. Any weakness from here should be treated as an opportunity, not as a threat. Hermann Vohs
This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities. |