Congratulations is due to Warren Buffett and all others who stood up against the foolishness of market timing during the short period between 1982 and 1999, and focus only on US stocks. The mere act of selecting this time and place is a fairly spectacular act of market timing. But if you look at any other period of time or practically any other market, failing to time the market turns out to a bad idea. Just to take one example, during the 53 years between September 1929 and July 1982, stocks, adjusted for inflation, declined 37%. Of course, that’s just an arbitrarily selected time period, but stocks are not always good investments.
In fact, right now, they suck. The naked analyst is short stocks. Stocks are massively over-valued and the recession is about to get worse, not better.
The Stock Market is Naked Too
Actually, since roughly 30% of the movement in the average stock is directly related to movements in the market, the naked analyst wonders: if you can’t analyze the market, what makes you think you can analyze a stock?
The market has earnings, and it has a price. The earnings growth of the market is in fact a lot easier to forecast than the earnings of any individual company. The price has a beta of 1.0 and an alpha of 0. This is not only better than most fund managers achieve, it also never changes. I like things that never change because it’s pretty easy to forecast them. Finally, like any other stock, there is an infinite amount of bullshit pretending to be an explanation for the current price. So you see, there’s nothing special about the market at all. It’s completely naked, just laying there in bed, waiting for me to analyze it.
Since 1872, earnings have grown at an average rate of 5.9% + inflation. Stock prices during the same period, rose at, would you believe, 5.9% plus inflation. Stock prices never diverged more than about 50% from that trend until 2000, and earnings never did until 2009.
In theory, stocks compete with interest-bearing securities, so the higher the interest rate, the lower the P/E multiple should be. Unfortunately, the data proves otherwise. There is zero correlation between interest rates and stock prices. This is not so surprising if you think about the standard equation for discounting the value of a stream of cash flows.
P = E / (( Rf + rb )-g)
Where P = price, E = earnings, rf=risk free rate, rb = expected rate of return * beta, and g = growth rate.
The overly simplistic Fed model measures the P/E against interest rates, which is simply: P = E/Rf. This formula completely neglects to account for the possibility of changes in growth rate or expected rate of return. The funny thing is, these two items turn out to be a lot more important than interest rates and, wouldn’t you know it, are most often inversely correlated to interest rates. Interest rates tend to go up when the economy is strong, which is the exact same situation that tends to cause risk aversion to go down and growth expectations go up. Because these other considerations have a very strong tendency to cancel each other out, we can construct a model that is far simpler than the fed model and at the same time more accurate.
Where En = normalized earnings.
This model has an r2 with the market of .75, which isn’t perfect, but it beats getting poked in the eye with a hot fork.
Based on normalized earnings of $62.26, our 13.8x model suggests the fair price for the S&P500 is 649.5. If you can buy the index at less than this, your long term return swill be greater than 5.6% + inflation + dividends, but since the current share price is more than 2 standard deviations above this normal level, good luck with that.
What Makes a Really Bad Short
Those who use valuation to set target prices will consistently be disappointed – stocks rarely trade at their fair value. Valuation can tell us something though, if we break stock market history in to quintiles according to the level of prices relative to the fair value. From this exercise, we can determine that buying at high quintiles is significantly less profitable than buying at lower quintiles. The current price is in the 4th quintile. Investors who bought the index at prices within this quintile, on average, lost money in the subsequent year. The odds of losing money are 45.2%. Interestingly, the odds of still being in the hole even 3 years later are still 19.5%.
But short sellers lost money too! On average, the market was down only in the first year, and even then, not by enough to pay the interest rate on the borrowed stock. The odds of a short-seller making more than 10% are only 23% in the first year, and diminish to 19% by the third year. That is not statistically different than the average for all times.
To make a good short, we would have to have good reason to expect some sort of similar catalyst in the near future that would force these brave short-term investors to retreat or even disappear. Here are the top possibilities:
1. Every recession in the last four decades has had at least one positive quarter-to-quarter GDP reading, only to be followed by a renewed downturn. This recession might be different, but I don’t see why.
2. Almost all of the apparent 3.5% growth in the third quarter’s GDP came from non-recurring contributions: cash for clunkers; first-time home buyers’ tax credits, and involuntary inventory buildup.
3. My contacts in the real-estate business tell me about 45% of transactions they are seeing are bank-controlled, and prices of homes in this category are still falling. Any change in bank policy could drastically change the outlook for housing.
4. Employment surveys have apparently been missing 200k job-losses per month and these will be corrected with revised data in February. Those who lost their jobs will stop spending money long before the data is released.
5. A study by Societe General shows that between 2000 and 2008, the S&P performance outside the reporting season was 7% lower than inside the reporting season, and that more than 100% of the reporting season gains occurred in the first three quarters.
6. A good reason for number 6 above is that the first three quarters reports are not audited. The fourth one is, and fourth quarter earnings are always below trend established in the previous three quarters. That’s not surprising, given the standard of ethics on most American boards. What’s surprising is that the market hasn’t figured this out yet.
7. According to Bloomberg, consensus forecasts indicate earnings growth for the average company of 31% to 25% in each of the next 7 quarters. Nice try.
8. Consensus forecasts for operating earnings indicate that analysts believe margins will exceed record levels by the end of 2011 – exceeding the previous records set in the years leading up to 2007, when leverage was preferred over balance sheet strength and a political climate that was hostile toward labor, causing the naked analyst to wonder, “Are they all just stupid? Or just lazy?”
9. The second wave of re-sets for Alt-A and Option ARMs has just begun, following a lull since last March.
10. Major credit losses are continuing unreported as a result of FASB change last spring. The naked analyst feels this change will eventually prove disastrous.
11. Despite massive increase in M1, broad money continues to contract.
OK, I lied. I have only come up with 11 reasons so far, but you get the point.
