With the current low rates available on treasury bills, and the current low inflation rate, what is an appropriate P/E ratio for stocks. Now excepting variations based upon growth and individual stock expectations, if we assume that the additional risk in the stock market requires twice the returns you can get in a 10 year t-bill, that would be 7%. Now, that is a P/E of 14. However a 3.5% premium over the 10 year is a very high risk premium and generally we would expect a premium of 1.5 to 2% for stock returns or a resulting p/e of 18. Based on what I believe profits in the next quarter are going to be for the S&P 500, that would result in a level of at least 1200. Now if growth is greater, the valuation would be higher.
As I hear analyst after analyst talking about how the market has gotten ahead of itself, the only justification I ever hear is that current profits are based on cost cutting and without revenue growth, they are unsustainable. I fail to understand why if everything stayed the same the profits would go down. The only real likelihood is that if top line growth appears, and it will, that profits will be greatly higher.
Showing posts with label valuation. Show all posts
Showing posts with label valuation. Show all posts
Saturday, September 19, 2009
Sunday, August 9, 2009
S and P valuation
I'd like to return to a theme I've addressed in prior posts and talk about the market valuation. Now, we have seen that interest rates have stayed low and for the 10 year treasuries are still below 4%. Since they are considered extremely safe investments they are a good starting point. If you are going to invest in a stock, you are taking on risk that simply doesn't exist in a treasury bond. Because of this risk, you probably want to get at least 50% more in earnings (not dividends but earnings) from a stock investment. So that would mean a return of about 6%, or a P/E of 16. Even if you use 15 instead of 16, this means that if you multiply the S&P earnings by 15 you should get an approximate valuation.
Now we have had a surprisingly good earnings season. Now as of Aug 4th, the current S&P estimate for 2009 and 2010 is 54.28 and 73.18 respectively. If you look at the current year estimate (and note the estimate shows earning increasing each quarter) you would come up with a market valuation in the low 800s. If you consider 2010 projected earnings you would get to about 1100.
Based on recent data, I believe there is sentiment that the earning may increase faster than the projections. After Friday's rally the S&P is just a little over 1000. If the market actually looks 6 months ahead, we would be about 20 points higher than the first quarter of 2010 estimate would indicate. Of course if you think the estimates are low, the market may be undervalued. However, since earning estimates are projected to go up each quarter in 2010, unless there is some specific bad news, I would expect the S&P to go up to 1061 next quarter.
A lot of commentators think the S&P has gone up to far and too fast and expect a pull back. The numbers don't support that position and in fact say the S&P is almost exactly where it should be. Now, if you don't believe the earnings or the estimates, that is a different story.
Which brings me to my next point. I hear commentator after commentator make a comment similar to the following :
"These earnings are due to cost reductions and are a one time event"
I think the people making these comments are intelligent but I simply can't figure out what they are trying to say. Cost reductions are not restructuring events, they are in fact ongoing. Once you eliminate cost and achieve earnings at a particular revenue level, you will continue to earn at that rate if the revenue level stays the same. Now if the revenue grows, you may or may not have to reintroduce cost and if we have any kind of recovery at all, I would think cost will be introduced at a lower rate than revenue will increase, leading to very good earnings growth.
I have heard some analysts say something that does make sense to me. Companies have used this downturn to eliminate jobs that they perceived to be of limited value. I believe many of the jobs cut will never be replaced, no matter how fast the economy grows, because companies will use this opportunity to either outsource them or replace them with automation.
I have discussed the need for the country to get behind the renewable energy growth engine to create jobs, but that is a different post.
Now we have had a surprisingly good earnings season. Now as of Aug 4th, the current S&P estimate for 2009 and 2010 is 54.28 and 73.18 respectively. If you look at the current year estimate (and note the estimate shows earning increasing each quarter) you would come up with a market valuation in the low 800s. If you consider 2010 projected earnings you would get to about 1100.
Based on recent data, I believe there is sentiment that the earning may increase faster than the projections. After Friday's rally the S&P is just a little over 1000. If the market actually looks 6 months ahead, we would be about 20 points higher than the first quarter of 2010 estimate would indicate. Of course if you think the estimates are low, the market may be undervalued. However, since earning estimates are projected to go up each quarter in 2010, unless there is some specific bad news, I would expect the S&P to go up to 1061 next quarter.
A lot of commentators think the S&P has gone up to far and too fast and expect a pull back. The numbers don't support that position and in fact say the S&P is almost exactly where it should be. Now, if you don't believe the earnings or the estimates, that is a different story.
Which brings me to my next point. I hear commentator after commentator make a comment similar to the following :
"These earnings are due to cost reductions and are a one time event"
I think the people making these comments are intelligent but I simply can't figure out what they are trying to say. Cost reductions are not restructuring events, they are in fact ongoing. Once you eliminate cost and achieve earnings at a particular revenue level, you will continue to earn at that rate if the revenue level stays the same. Now if the revenue grows, you may or may not have to reintroduce cost and if we have any kind of recovery at all, I would think cost will be introduced at a lower rate than revenue will increase, leading to very good earnings growth.
I have heard some analysts say something that does make sense to me. Companies have used this downturn to eliminate jobs that they perceived to be of limited value. I believe many of the jobs cut will never be replaced, no matter how fast the economy grows, because companies will use this opportunity to either outsource them or replace them with automation.
I have discussed the need for the country to get behind the renewable energy growth engine to create jobs, but that is a different post.
Saturday, July 4, 2009
Happy 4th of July!
Certainly hope everyone has a safe and happy holiday!
I've been reading about how the SEC is considering putting restrictions on short selling. Now it seems likely they will reinstate the uptick rule, a requirement that you can only short a stock after an uptick, but it made me start thinking about short selling.
I guess the more I think about it the greater problem it seems to be. Yes, short selling has been around for a very long time but the capability for short selling and the amounts involved have exploded with the growth of hedge funds. Its easy enough to find how much short interest there is on any individual stock but not as easy to see the amount of short selling in total. I did see one old chart that showed the amount of short selling increasing exponentially between the early 1960s and the early 1990s. Based on some more recent data, short interest on the NYSE was said to be about 4% of total shares which would support that the increase has continued.
So what about short selling? Short selling is a way to bet that a stock will go down without actually owning the stock. Yes, the stock will eventually need to be purchased to cover the short position and it can be a risky strategy but the other impact is that it has some impact on the supply and demand of a stock. Now, when the amount of short interest is negligible it can be absorbed by normal market conditions. The situation that concerns me is when short positions become a significant factor in the number of shares outstanding.
Assuming stocks reach a supply and demand equilibrium because the number of buyers and sellers at a particular level are approximately equal. You can increase the number of sellers by taking short positions. Now, the impact of this clearly depends on the amount of short sellers. Now the number of short positions is not spread evenly across all stocks. Certain stocks either because they have had recent run-ups or because they have some negative news, attract a great number of short sellers. In those situations they have a multiplier impact on the stock, meaning that more shares are on the market than would have been otherwise.
This increases volatility of the stock price. Now if you think of the stock market as something akin to a casino, this is OK. However, if you think the fundamental purpose of the stock market is to provide for a fairly orderly place to raise capital, it may not be a good thing. However, there are clearly times when short sellers become so numerous for a particular sector or stock that they endanger companies. Near the end of 2008 the SEC banned short selling of financial stocks for a 2 week period, Britain banned it for financial stocks for a longer period and Australia banned it altogether. Whether these actions helped or not may be debatable. There is also a theory that if a stock has a large short interest, it has a built in demand level since all these short holders will eventually have to buy the stock to cover their positions.
So what should the SEC do? As I said earlier they will probably re institute the uptick rule. Should there be additional restrictions? One possibility would be to restrict the amount of short interest that could exist on any particular stock. Since there are other ways to bet that a stock will go down or up, puts for example, is short selling a good idea at all? It is clearly a speculative position that generates fees for the brokerage. It does provide a way for hedge funds to "hedge" but do we care about that?
I'll wait and see what the SEC decides. I will say that with the amount of retirement funds tied up in the stock market, the American people don't want it to be a crap shoot. Prices should not be inflated, but selling shares you don't own is gambling, plain and simple. It may expose overvalued stocks or it may depress values below where they should be. Either way it is not an investment.
I've been reading about how the SEC is considering putting restrictions on short selling. Now it seems likely they will reinstate the uptick rule, a requirement that you can only short a stock after an uptick, but it made me start thinking about short selling.
I guess the more I think about it the greater problem it seems to be. Yes, short selling has been around for a very long time but the capability for short selling and the amounts involved have exploded with the growth of hedge funds. Its easy enough to find how much short interest there is on any individual stock but not as easy to see the amount of short selling in total. I did see one old chart that showed the amount of short selling increasing exponentially between the early 1960s and the early 1990s. Based on some more recent data, short interest on the NYSE was said to be about 4% of total shares which would support that the increase has continued.
So what about short selling? Short selling is a way to bet that a stock will go down without actually owning the stock. Yes, the stock will eventually need to be purchased to cover the short position and it can be a risky strategy but the other impact is that it has some impact on the supply and demand of a stock. Now, when the amount of short interest is negligible it can be absorbed by normal market conditions. The situation that concerns me is when short positions become a significant factor in the number of shares outstanding.
Assuming stocks reach a supply and demand equilibrium because the number of buyers and sellers at a particular level are approximately equal. You can increase the number of sellers by taking short positions. Now, the impact of this clearly depends on the amount of short sellers. Now the number of short positions is not spread evenly across all stocks. Certain stocks either because they have had recent run-ups or because they have some negative news, attract a great number of short sellers. In those situations they have a multiplier impact on the stock, meaning that more shares are on the market than would have been otherwise.
This increases volatility of the stock price. Now if you think of the stock market as something akin to a casino, this is OK. However, if you think the fundamental purpose of the stock market is to provide for a fairly orderly place to raise capital, it may not be a good thing. However, there are clearly times when short sellers become so numerous for a particular sector or stock that they endanger companies. Near the end of 2008 the SEC banned short selling of financial stocks for a 2 week period, Britain banned it for financial stocks for a longer period and Australia banned it altogether. Whether these actions helped or not may be debatable. There is also a theory that if a stock has a large short interest, it has a built in demand level since all these short holders will eventually have to buy the stock to cover their positions.
So what should the SEC do? As I said earlier they will probably re institute the uptick rule. Should there be additional restrictions? One possibility would be to restrict the amount of short interest that could exist on any particular stock. Since there are other ways to bet that a stock will go down or up, puts for example, is short selling a good idea at all? It is clearly a speculative position that generates fees for the brokerage. It does provide a way for hedge funds to "hedge" but do we care about that?
I'll wait and see what the SEC decides. I will say that with the amount of retirement funds tied up in the stock market, the American people don't want it to be a crap shoot. Prices should not be inflated, but selling shares you don't own is gambling, plain and simple. It may expose overvalued stocks or it may depress values below where they should be. Either way it is not an investment.
Tuesday, June 23, 2009
Deflation
Two years ago if you wanted to buy a house the amount you would have paid would certainly be higher than the price you would pay today. If you wanted to put gas in your car, you would have paid as much as $2 more than today. In most retail stores, while there were items on sale, the sales were neither as broad nor as deep as they would be today. It is also likely that the salary or starting pay you could get would be higher than you could get today, however there are a lot of variables there.
So have we experienced Deflation? One of the things that is worrisome about deflation is that since the currency is worth more, debts become more expensive. Also, since prices are declining there is a disincentive to buy since there is an expectation that whatever it is you want to buy will be cheaper tomorrow.
This may sound sort of like the situation facing us today, yet you hear a lot of talk about the return of inflation because the Government is creating money. Is it really? When the bank reserve requirements increase, you are taking money off the street. If you don't replace this money somehow, you have less money, not more. So is more money being created than has disappeared?
When you consider the idea that the Government is creating money, some seem to think they just turn on the presses and print a bunch. They actually create money by borrowing with a promise to repay. The money created this way can be considered as a "dilution" of the money supply but that is only true if the amount of money in use is greater than it was before the borrowing. It should also be noted that when banks use assets to loan money at multiples of those assets, they also either create or remove money from circulation. So is the value of those assets go down and therefore less loans can be made, there is less money. In fact, as we move more and more to electronic transactions, the need for money to ever get printed diminishes.
So, if we have had trillions of assets lost because of falling valuations in housing, stocks, inventory and commodities, isn't that a whole lot of money that went out of circulation since the banks had to reduce loans and replace the lost assets used as the basis for future loans. Has the Government borrowed enough to replace all this lost money? One problem in measuring this is that the money supply measurement that would be meaningful here includes the value of the assets on the banks books. While it looks like it has increased, that depends on whether the bank assets are properly valued. Since we dropped the "mark to market' rule it is more likely these assets are valued at hopeful amounts. This is of course why the reserve requirements have been increased, and is assets recover value, the hopeful valuations may end up being correct, but it is doubtful to me that there is really more money available.
I think worrying about inflation right now is a bit premature, we should be worried about deflation.
So have we experienced Deflation? One of the things that is worrisome about deflation is that since the currency is worth more, debts become more expensive. Also, since prices are declining there is a disincentive to buy since there is an expectation that whatever it is you want to buy will be cheaper tomorrow.
This may sound sort of like the situation facing us today, yet you hear a lot of talk about the return of inflation because the Government is creating money. Is it really? When the bank reserve requirements increase, you are taking money off the street. If you don't replace this money somehow, you have less money, not more. So is more money being created than has disappeared?
When you consider the idea that the Government is creating money, some seem to think they just turn on the presses and print a bunch. They actually create money by borrowing with a promise to repay. The money created this way can be considered as a "dilution" of the money supply but that is only true if the amount of money in use is greater than it was before the borrowing. It should also be noted that when banks use assets to loan money at multiples of those assets, they also either create or remove money from circulation. So is the value of those assets go down and therefore less loans can be made, there is less money. In fact, as we move more and more to electronic transactions, the need for money to ever get printed diminishes.
So, if we have had trillions of assets lost because of falling valuations in housing, stocks, inventory and commodities, isn't that a whole lot of money that went out of circulation since the banks had to reduce loans and replace the lost assets used as the basis for future loans. Has the Government borrowed enough to replace all this lost money? One problem in measuring this is that the money supply measurement that would be meaningful here includes the value of the assets on the banks books. While it looks like it has increased, that depends on whether the bank assets are properly valued. Since we dropped the "mark to market' rule it is more likely these assets are valued at hopeful amounts. This is of course why the reserve requirements have been increased, and is assets recover value, the hopeful valuations may end up being correct, but it is doubtful to me that there is really more money available.
I think worrying about inflation right now is a bit premature, we should be worried about deflation.
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