Valuation Analysis: Why Multiples May Not Expand

Since September of last year, I have posted numerous comments re why stocks are and will remain undervalued. The central point of my argument deals with risk. The valuation tools used are forward looking and are best and simply viewed in a modified Fed Model (see May 23 posting below). There is another aspect of valuation, however, that bears noting (or is it what the bears are noting?): Is the current and expected level of various valuation metrics above, at, or below their respective long term averages? To shed some light on the subject, an interesting piece of valuation work has been produced by sector expert, Merrill's Brian Belski.

From an historical perspective (which is not always the best way to make valuation decisions), an argument can be made that stocks are not undervalued. Using the average of the past 16 years as the centerpoint, the two above charts (Brian Belski, Merrill Lynch, May 9, 2007) paint a picture of a market that is already more than fairly valued.

The first chart makes it clear that on a P/E basis, stocks are just slightly undervalued. However, on a Price to Cash Flow basis (second chart), stocks are actually quite overvalued.

Investment Strategy Implications

Using such historical data neglects other important valuation inputs, most notable of which is interest rates*. Nevertheless, the past can be a useful guide, particularly as an indicator of cycle ranges. In the current cycle, a US market that trades at or below fair value is appropriate.

While more than a handful of investment strategists believe multiples can and should expand, I beg to differ. Considering risk in all its forms (geo political, liquidity induced bubbles, over extended US consumer, untested decoupling, profits deceleration, high global growth dependence on immature emerging countries, etc.), the above noted historical data for the current market cycle suggests multiples may not expand.

*The charts also invite other questions and further analysis, such as: for the current market cycle, why has the price to cash flow levels consistently been above their long term average?

Note: Conclusions reached on this blog entry are solely those of Vinny Catalano and should not be construed as being those of Mr. Belski or Merrill Lynch. Additionally, Belski employs different methods for determining the long term average for each indicator. For a further description of the methodologies used, please see the Belski report "Sector Valuations - May 2007"

Just How Smart is the “Smart Money”?

“The availability heuristic is a rule of thumb, heuristic, or cognitive bias, where people base their prediction of an outcome on the vividness and emotional impact rather than on actual probability.”*

"Are US individual investors more cautious in this bull market due to their recent experience with the bursting of the tech bubble? Does that help explain why individual investors appear to be less ebullient than the “smart money”?

Behavioral finance teaches us that investors tend to overweight those events that are most vivid over events that are less so. This is known as the “availability heuristic” (defined above). Events that are most vivid tend to be those that are (a) most dramatic and (b) most recent. The more dramatic and recent the event, the more vivid in the mind it will be and, therefore, the more likely it will overweighted in the minds of investors.

One current application of this behavioral tendency is the aforementioned US individual investor who experienced the tech bubble bursting, and appears to be more cautious than they might otherwise be. In this regard, two questions come to mind:

1. Will individual investors stand their ground and, due to their absence from the bull market party, cause an eventual (and substantial) contraction in equity prices? Or

2. Will their resolve to not join the bull market party eventually give way (capitulation) and, therefore, become the necessary final push of liquidity for the “smart money” to sell to?

In other words, just who is the smart money?..."

"There is another aspect to consider, however, one that involves the subject being described in this report – the behavioral tendencies of investors. And for that, it's worthwhile to take a look back at the last period investors had to deal with the aftermath of a real bear market – the mid to late 1970s.

The bear market of 1973-74 had its roots in..."

Investment Strategy Implications

"This bull market may not experience the “dumb money” bailing out the so-called smart money crowd. The experience of the last US equity bubble is still vivid in the minds of many investors. Whether this results in a capitulation or not remains to be seen. Nevertheless, it is advisable to remember that stocks can remain undervalued for an extended period of time. Particularly when risk is as abundant as liquidity.

If the “smart money” is waiting for the “dumb dough” to show up, they may be disappointed. Investor behavior is a sticky tendency. Besides, if the “smart money” wants to find where the “dumb money” is, perhaps a trip across the Pacific is a better place to look. Can you translate this?: 泡影"

Note: To view the entire report (including the all-ETF Model Growth Portfolio) and for information regarding our subscription service, please click on the Blue Marble Research services link to your left.

* Wikipedia

Quotable Quotes

on a lighter note:

"When I was young I used to think that money was the most important thing in life. Now that I am old, I know it is."
Oscar Wilde

"Gentlemen prefer bonds."
Andrew Mellon.

"Don't gamble; take all your savings and buy some good stock and hold it till it goes up, then sell it. If it don't go up, don't buy it."
Will Rogers

"When shit becomes valuable, the poor will be born without assholes."
Henry Miller.

"We have two classes of forecasters: Those who don't know--and those who don't know they don't know."
John Kenneth Galbraith


Have a good weekend.

Technical Thursdays: 4 Reasons Why a Market Correction is Imminent

Setting aside seasonal factors (sell in May and go away; the long Memorial Day weekend ahead), I have identified four reasons why a market correction of some consequence is imminent. The four reasons noted are encapsulated in the chart to your left and are all of a technical analysis nature.

They are as follows:

1 – Rising Wedge – while a rare occurrence, chartists will tell you that a rising wedge is a bearish pattern. History shows that the narrowing of the spread between the highs and lows of the trend lines, with the lower end rising dramatically (the rising wedge), usually results in a serious reversal.

2 – Momentum Divergence – one of the most reliable short term trading indicators I have found is when price advances are not matched by momentum. The second area of the chart to your left shows an unmistakable decline in momentum as the market marched ahead to new highs.

3 – MACD – moving average divergence is another area of concern. Here MACD (third area of the chart) has gone flat, confirming momentum’s weakening of market strength.

4 – Price to 200-day Moving Average – at 9%, the gap between the current level of the S&P 500 and its 200-day moving average (arrow) matches the most recent gap (end of February) that preceded a minor (yet dramatic) market correction.

Investment Strategy Implications

Common sense dictates that market corrections are a normal, healthy aspect of a bull market. And, while it is risky business to try and be so precise in calling market turns, when equities run up in nearly a straight line, it is not exactly a low risk environment.

Note: This call is strictly in a market correction vein and not a major market top call. For that to occur, other, more substantial factors must come into play. Despite clear signs of market bubbles and highly risky this-time-is-different new era thinking, a major market top has still not been formed.

Fed Model - Fair Value Update

As of today's close, the concurrent rise in stocks and interest rates has lowered the Blue Marble Research Fed Model expected return for US equities (S&P 500) to 4.98%*.


*average of 6.80% and 3.15%

What to do, what to do?

“…with almost 100 million stock accounts now open -- including 310,000 opened just this past Friday -- any panic selling might test the limits of the system.”

"China's Bubble is Defying Beijing"
Wall Street Journal
May 22, 2007

To the Chinese leaders meeting with their US counterparts I say: Welcome to world of capitalism.

The Chinese economic model threatens to spin out of control, a nightmare scenario if there ever was one for a communist country trying to transition to a free market-based economy and not experience the chaos of the pre-Putin Russian model nor the near global financial debacle of the Asian contagion of the late 1990’s. Yet, the baby steps taken thus far by the Chinese government toward cooling an overheated and increasingly speculative economy and stock market are clearly not working. What to do, what to do?

Obviously, stronger action needs to be taken by the Chinese central authorities. The problem lies, however, in the fact that the Chinese economic and banking system is not like the US and other developed countries. As noted in yesterday’s Financial Times, “It might be more accurate to liken the Chinese economy to a flotilla of large and small boats, all steaming ahead at full bore, with little regard to the direction of the fleet or the diktats of its commanding officers in Beijing.*” No central control is evident here. What to do, what to do?

Well, if the central authorities can’t get the job done, then the market will do the dirty work for them – and let the consequences fall where they may. Ironically, should such a development happen, it may occur during the tenure of Mr. Market Discipline himself, Henry Paulson – the host of the current round of meetings here in the US.

Investment Strategy Implications

The nightmare scenario for stock market bulls and advocates of laissez-faire/cowboy/American-style capitalism is to have both ends of the global growth train – the US and China – go off the rails simultaneously. While this is a low probability, either event occurring is not. Nevertheless, given the interconnected nature of our globalized world, the odds of a negative feedback loop are not zero either. What to do, what to do?

Wait. I know. More liquidity!!!

*China’s Unbalanced Economy
Richard McGregor

MTA Market Forecast Notes: Liquidity Risks and Connecting the Dots

excerpts from this week's report.

“It is now the consensus of most practicing central bankers that monetary policy can’t do much preemptively to correct an existing substantial asset price misalignment. But if monetary policy is calibrated appropriately to keep aggregate demand growing roughly in balance with aggregate supply and to keep inflation low and stable, this reduces the risk that such misalignments will emerge and expand.”

Timothy Geithner
“Liquidity Risk and the Global Economy”
May 15, 2007
Remarks at the Federal Reserve Bank of Atlanta's 2007 Financial Markets Conference—Credit Derivatives, Sea Island, Georgia

Having moderated more than a half dozen Market Technicians Association (MTA) events over the past five years, I have noticed two distinctive features – market technicians tend to have a nearly unanimous perspective on the overall market (there were some differences around the edges) and audience participation is very lively.

Unlike fundamental analysts, market technicians utilize similar tools in their craft and, therefore, often end up coming to largely the same conclusions – at least at it pertains to the overall market. In the current case, the four panelists on last Friday’s panel – Acampora, Bartels, deGraaf, and Roque – were firmly in the bullish camp. However, the topic of liquidity came up during the audience Q&A segment and, in my opinion, it stood out on two levels – one in the form of question posed by Phil Roth, the other in form of an insightful observation made by Merrill’s Chief Market Analyst, Mary Ann Bartels.

Phil essentially raised the question, “When isn’t a bull market the product of ample liquidity?” This self-evident question is both simple and profound. And it cuts to the heart of all bull markets. Earnings can be as terrific as one could hope for. But without liquidity flowing through the bloodstream of the economy and markets, stocks can easily fail to produce favorable returns - which brings us to Mary Ann’s comment on a measure of liquidity – MZM – and how it connects to the above quote by NY Fed President Geithner.

Merrill’s Chief Market Analyst, Mary Ann Bartels, provided her usual terrific points on hedge funds. But it was her comment on MZM (money supply) that I found especially insightful. Mary Ann stated that the high growth in MZM was attributable in part to...

...The recent comments by Fed speakers make it crystal clear that financial shocks cannot be anticipated and a market discipline is the “first line of defense”. The Fed will play its liquidity supportive role proactively and preemptively...

...In my opinion, stocks should always reflect this uncertainty and not be priced to fair value (1650 for the S&P 500). Things are much too dynamic for such complacency. To help punctuate this point, Mr. Geithner states,“…we do not have the capacity...

Note: Access to Blue Marble Research reports (which includes our all-ETF Model Growth Portfolio) require a modest subscription. To view the entire report and for information regarding our subscription service, please click on the Blue Marble Research services link to your left.

Wrath of God

Due to a storm related two-day power outage plus out of office events (moderated the Market Technicians Association "Market Forecast" and New Delhi TV appearance) as well as several client meetings, no posts were made for Thursday and Friday.

Will be back on track on Monday.

Why Stocks Are (And Will Remain) Undervalued

“Risk can now be sliced and diced, moved off the balance sheet, and hedged by derivative instruments.”

Remarks by Chairman Ben S. Bernanke
May 15, 2007: Regulation and Financial Innovation

Chairman Bernanke’s remarks yesterday to the Federal Reserve Bank of Atlanta's 2007 Financial Markets Conference highlight an issue that I have written about on numerous occasions – the degree of uncertainty brought about by financial innovation. As with Globalization, financial innovation has produced many benefits. However, what is often ignored is the downside, the risks that accompany our brave new world. As Mr. Bernanks goes on to say:

“Indeed, the need for better risk sharing and risk management has been a primary driving force behind the recent wave of innovation. But in some respects, new instruments and trading strategies make risk measurement and management more difficult. Notably, risk-management challenges are associated with the complexity of contemporary instruments and trading strategies; the potential for market illiquidity to magnify the riskiness of those instruments and strategies; and the greater leverage that their use can entail.”

A major component of the Fed’s plan to deal with this complexity is a reliance on what is known as market discipline. Harry Paulson cites it often and Mr. Bernanke referred to it in yesterday’s speech as follows:

“…part of an effective risk-focused approach is the promotion of market discipline as the first line of defense (emphasis added) whenever possible.”

Investment Strategy Implications

Isn’t the first line of defense the one that bears the greatest risk? If credit derivatives and other financial innovations that have sprung up over the past years have become so complex that most professional investors have little full knowledge of their consequences (a point referenced time and again at the hedge fund seminars that I have conducted), then shouldn’t stocks always reflect that enhanced risk* and, therefore, never close the valuation gap to fair value (see Fed Model to your left) thereby remaining undervalued for the foreseeable future? I think so.

*Along with other macro risk factors such as the unknown consequences of Globalization as well as geo political issues.

Note: Chairman Bernanke’s remarks can be found at http://www.federalreserve.gov/boarddocs/speeches/2007/20070515/default.htm

IVE – An ETF for a Contagious Market

As the US equity markets struggle to keep pace with their Asian bubble counterparts, concerns of an overheating appear to be justified. Yet, M&A activity has never been frothier. A market melt-up can just as easily develop (as if China wasn’t already there) as yet another seemingly out-of-the-blue nasty correction. For reasons noted in yesterday’s weekly report (modest subscription required), Large Cap Value (IVE) appears to be very well suited for either occurrence.

In the melt-up scenario, hedge funds may be pressured into shifting more funds out of the underperforming Smids and into the better performing large cap value sector (see 1 year chart above). Contrarily, in a meltdown environment, the lower beta/higher quality sectors (IVE’s beta is .93) should weather the storm better than higher risk issues (again, see chart).

Investment Strategy Implications

Whether there is a market melt-up or another spring market swoon, IVE appears to have the odds tilted in its favor regardless of which contagion sweeps over the markets.

Disclosure note: IVE is owned in accounts under Blue Marble Research management. No shares are owned by Vinny Catalano nor any members of his family.