"We are in uncharted territory."

excerpts from this week's report:
Gary Crittenden
Chief Financial Officer, Citigroup

"For those who may be inclined to go along with the recent optimistic comments from the heads of several major investment banks (see last Thursday’s blog posting, “News Flash: Credit Crisis End in Sight”) and for those who might construe that last week’s impressive counter rally in the equity markets signals an end to the credit crisis and a resumption of the bull, the quote by Mr. Crittenden should put some real world perspective on the current situation. For the credit crisis and economy are intertwined a far greater degree than many investors may appreciate."

Investment Strategy Implications

"An undervalued market rally is one matter (see Expected Return Value Model in the report for more commentary on this point). But when it is accompanied by a return to complacency in the form of a lower VIX**, it behooves investors to take note, particularly when so much remains unclear.

Mr. Crittenden is right. And his comments are not exclusively related to Citigroup. The transformation of the credit creation machine at the core of the financial system (commercial and investment banks), within the “shadow” banking system (nonbank financial institutions, such as insurance companies, hedge funds and private equity), and the originate-to-distribute business model (not to mention the degree to which other securitized instruments..."

also in this week's report:

* Expected Return Valuation Model
* Moving Averages Scorecard
* Model Growth Portfolio
* Sectors and Styles Market Monitor
* Key US Economic Indicators

*To gain access to this week's report (and all reports), click on the newsletter subscription information link to your left.
**click on image to enlarge.

All Bad is Not Good

“At the moment the media remains firmly on gloomwatch, which is mildly encouraging. The credit crunch will be over long before the press has finished dissecting it.”
Jonathan Davis
“How investable knowledge got scarce”
Financial Times, February 10, 2008


The flip side of early 2007 is in full force in early 2008. A year ago, goldilocks was all the media rage. Now her evil sister, gloomdilocks is running amuck in media land. Yet, as Mr. Davis implies in his recent excellent FT commentary, a little objectivity wouldn’t hurt. Take for example, the credit crisis.

I recently noted two separate pieces of information from two distinct and unrelated sources re the current credit crisis that should help put things in some perspective.

First, the remainder of the credit crisis is likely to be more of a slow rolling event. This point was noted by two of my Market Forecast panelists in Denver (see blog posting, “Wait ‘til Next Year, Feb. 1, 2008). Why? The answer to this question comes from my interview with S&P’s Chief Economist, David Wyss (see blog posting, “Beyond the Sound Bite: An Interview with David Wyss”, Feb. 6, 2008). In the interview, David points out that most of the must be published data re credit related losses (by the banks and other publicly traded entities) has already been done. One third of the write-offs by his reckoning. However, and this is key, the remaining two thirds sits with those entities who do not have to mark to market every credit derivative product they have on the books as their reporting requirements are significantly different from the high profile, publicly traded ones*.

Who are these entities? The very same ones that are providing liquidity to the high profile, publicly traded entities; the ones that have lots of cash to on hand – foreign entities (including sovereign wealth funds), hedge funds, and private equity.

Investment Strategy Implications

My bet is that three months from now, the media focus will shift from the gloom watch it is currently obsessing on to how resilient the US (and global) economy is turning out be as tax rebates, rate cuts, and a more robust global growth story help bring equities back to some semblance of fair value. Moreover, the credit lock up at the core of the banking system will likely begin to loosen up thereby producing some semblance of a return to credit generating normalcy enabling corporations to function more normally.

With a stock market that is in undervalued and oversold territory, the downside from the low 1300’s appears limited. Should the environment look brighter this spring (as I suspect it will), investors may regret getting too swept up in the media moment of extreme pessimism.

*Moreover, for those private entities who do experience credit related blow ups, the odds that their pain will extend to the larger financial and real economy is significantly less likely than in the banking and publicly traded company domain.

Where Are the Bodies Buried?

Whatever your views on yesterday’s Fed action might be, a disturbing question is emerging that few seem to be paying much attention to – How long does it take for the financial system to identify who owes what to whom?

CDOs of CDOs of CDOs of CDOs cannot stand unaccounted for indefinitely. Knowing where the bodies are buried is a vital component to putting an end to the uncertainty risk premium that has elevated the fear factor among many investors, which, in the process, has sucked the Fed into reverting to the Greenspan playbook of more liquidity. But will more liquidity alone do the trick?

The Bank Credit Analyst’s thesis, “The Debt Supercycle”, says liquidity will work its magic, provided inflation remains relatively tame. Massive amounts of money can be pumped into the system to help reflate assets and preemptively avoid a severe economic downturn. All well and good, but a reflating system that contains untold amounts of hidden toxic paper may end up producing unintended and unforeseen consequences. A true manifestation of the expression, “You don’t know what you don’t know”.

Therefore, as we approach the six-month anniversary of the great awakening, the moment when complacent investors woke up from their Goldilocks stupor and came to recognize that all was not kosher, the question of who owes what to whom still remains unresolved.

The longer it takes bankers to identify the toxic paper on and off the books, the more damage to the global economy they will incur as trust erodes both within and without the core of the financial system thereby exacerbating an already tenuous credit situation.

With bankers still unable (unwilling?) to identify where the bodies lie and horde their precious capital, the far less than transparent New Power Brokers (Petrodollars, Asian Central Banks and their Sovereign Wealth Funds, Hedge Funds, and Private Equity) have stepped into the breach to save the day. However, their rescue efforts come with a price – opacity. And opacity is precisely what is not needed at a time when so much remains unknown and trust hangs in the balance.

Investment Strategy Implications

Equities are undervalued and yesterday’s Fed action certainly helps improve everyone’s valuation model. Equities are undervalued in a scenario that overstates the downside risks to global growth and corporate profitability (see “Here Comes the Global Depression”). Equities are not undervalued, however, in a world of endless undisclosed toxic paper and new capital opacity.

It’s high time we all learned where the bodies are buried.

The Enduring Bull Market

excerpts from this week's report:

“Quite a few people have been asking lately why on earth the equity market is so high, but I make no apology for joining them. If the Dow can rise 540 points in two days - as it did last week - something rather odd is going on.”

So writes Tony Jackson in today’s FT commentary, “Glum conclusion is equity investors are still in denial”. And herein lies the problem with viewing the equity markets solely through the prism of the real economy.

For while nearly all the references in Mr. Jackson’s commentary today cannot be disputed, one can be correct in factors pertaining to the real economy yet wrong when factors pertaining to the financial economy (the markets) are at odds with or offsetting the real economy issues noted.

Yes, there are ample reasons to be concerned re the credit crunch. Yes, there are many causes for concern re the credit crunch and its potential effect on emerging markets and the damage that can be done to the decoupling argument. And, yes, the markets may be foolish to be “starting to price in a return to more normal profitability after a long and exceptional bonanza.”

All true, all logical, and all flawed if one chooses to ignore the counterbalancing factors of valuation, equity market liquidity (as in the hands of hedge funds and private equity players), and the conditions favorable for decoupling.

Moreover, while fundamentally oriented investors may choose to, I believe that ignoring the technical analysis factors is done at one’s own financial peril.

Here are a few comments on each of the positive points noted..."

also in this week's report:

* Expected Return Valuation Model
* Model Growth Portfolio
* Investor Sentiment Data
* Chart Focus: ISM Indices
* Sectors and Styles Market Monitor
* Key US Economic Indicators

To gain access to this and all reports, click on the subscription info link to your left.

Searching For The Magic Formula

To some, the powerful two-day stock market rally was all about the prospects of the Fed cutting rates. While this no doubt was a contributing factor, the larger issue that may have been lost in the noise of rate cuts is the attempt by the Fed and other interested parties to secure the core of the financial system (i.e. big banks). Those at the periphery of the system can break down (hedgies, private equity, mortgage bankers and brokers, even investment banks), provided their problems do not metastasize inward toward the core of the system.


What seems to also be lost in all the noise re rate cuts and traditional real economy stuff is the concurrent effort of the Fed and other interested parties in fixing what got broke. Specifically, the financial model that gave us the Great Moderation (lower rates, low inflation) and all the wonderful real economy benefits complements of Globalization.

Perhaps it is the street kid in me but I find it rather curious that earlier this week the Fed pumped $8 billion into the system followed by ADIA (Abu Dhabi Investment Authority) pumping $7.5 billion into Citigroup (a core of the system entity) at the same time Fed Vice Chairman Kohn gives a speech widely interpreted as communicating the Fed’s intention to do whatever it takes to maintain the monetary boat. Random events? Reactionary decision-making? Maybe not.

In my view, what is happening is an attempt by the Fed and other interested parties to find that magic formula that can both secure the core of the system and invent a new and improved financial model, one that will enable the Great Moderation to live another day.

The core of the system cannot break down. The Fed has stated as such many times over (read just about any speech by Bernanke and other important Fed heads and you will hear this theme stated explicitly or implicitly). Now, this is not to say too big to fail is part of the policy solution currently being orchestrated the Fed and other interested parties with its attendant moral hazard implications. However, failure in the core of the system has very different meaning as in a managed transition to another entity that can ensure the system functions effectively. Think ADIA and Citigroup.

Investment Strategy Implications

The big equity markets' hurrah of the previous two days was about more than a simple rate cut. It was about the perception that the Fed and other interested parties seem to be making progress toward reestablishing a secure core of the financial system and reinventing the magic formula of economic peace and stability to the system, the markets, and the real economy.

To be sure, more pain is headed the markets way. Yet, unless one believes that the mark-to-market pain will aid and abet a US recession, which will precipitate a global slowdown or worse, which will thereby produce a double-digit decline in corporate earnings (see the Expected Return Valuation Model in my reports*) while at the same time the Fed and other interested parties are too dumb and lack the innovative wherewithal to work their way out of this mess, the credit derivatives problems of yesterday and today are fast becoming old news. And old news does not move markets. New news does. And the new news is the progress made toward reinventing the magic formula.

*subscription required

Hedge Fund Seminar Data Points - Day 2: The Power to Exploit

Sometimes the deeper you dig the more you get to appreciate the many nuances and special wrinkles that make up a given complex subject such as alternative investments. Such is the case with yesterday's hedge fund seminars that I conducted. To my ear, two points among the many superb and often insightful comments made by my excellent expert panelists stood out and I share them with you here.

At my luncheon session, Rob Blabey with Jim Hedges' firm noted that there are no secrets among hedge fund players, particularly the equity players who are reasonably well informed. As with traditional positions (say long only) taken by your typical portfolio manager, the positions taken by most hedgies are fairly well known among those who make it point to know their markets. This occurs despite the opacity that is part and parcel of a largely unregulated business because the information network can be rather porous in areas. Nothing new here. However, where this gets most interesting is when things go wrong.

During such times, the Darwinian approach to money management kicks in and those that are in difficulties are left to twist in the wind until the pain can be taken no more. The pack then swoops in and makes the most hay out from the residue of the bad bet made.

I suppose none of the above should come as a surprise. It is, after all, the nature of the free market system. You place your bets, you take your chances. I guess I just never gave it much thought as to how ruthlessly it all plays out, especially during times of market stress.

The dinner session produced a piece of actionable information for all investors.

As this year wraps up in a couple of months, there is likely to much window dressing conducted by the hedgies. Given the summer experience of the pre Bernanke put era ("we didn't bail anyone out", wink, wink) and the fact that so much remains to be uncovered (including the real value of the assets on the books), it is quite reasonable to assume that many market-related cross currents will continue to occur and will likely intensify as the year comes to a close. For with the end of the year comes the auditors and audited investor reports as well as the performance fees "earned". Since mark to the market is still absent from many alternative investment instruments, alternative pricing methods (mark to model, to ratings, to marketing, and/or to myth) set the stage for a number of potentially suspect "transactions". With so much money (and careers) at stake, the free market system operating in a largely unregulated space could produce a number of, shall we say, interesting "transactions".

Investment Strategy Implications

There will be additional points in next Monday's weekly report (subscription required). For now, the central issue is the exploitative mindset that the rest of us, the more traditionally-oriented investor should develop. When it comes to thinking about the alternative investments space, much like the Darwinian example above, it is what an investor can do to exploit the situation that matters most.

With knowledge comes power. From an investment perpsective, that power is expressed in the ability to exploit the situation.

For despite the once in a century storm that actually occurs every five years*, alternative investments (hedge funds, private equity, structured products, etc.) are here to stay. An investor's mission, therefore, is not to bemoan the situation but to exploit it. The power to exploit is in the ears and minds of all investors attuned to changed game of investing.

*With the implications for equity valuation models via the destruction of the normative bell curve distribution of returns. A point made before and one that I will return to in future reports and blog entries.

Hedge Fund Seminar Data Points - Day 1

Every Hedge Fund/Alternative Investments seminar I conduct produces a wealth of useful and insightful information. Last night’s kick-off event in Tampa was no exception.

The first points of value I wish to share comes via Tim Hayes the highly regarded Chief Investment Strategist from the equally highly independent research firm, Ned Davis Research. In Tim’s excellent handout are three data points (among many) that I found particularly interesting:

* Of 7,300 hedge funds, the largest 200 account for 75% of hedge fund assets. 40% of hedge funds don’t last five years. (source McKinsey & Company)
* A Greenwich Associates survey indicates that during the next three years, 34% of U.S. institutional investors plan to increase their investments in private equity, 22% to increase investments in hedge funds.
* At the end of September 2007, monthly dollar flows into Exchange Traded Funds by hedge funds reached a record $19.9 billion, eclipsing August’s record at just over $14 billion.

Three initial conclusions reached by all three of my seasoned and well experienced expert panelists (which included D. Scott Luttrell of LCM Group and Daniel O'Conner of M&I Investment Management) is that high end, high quality hedge funds will weather the storm quite well, with many exploitig the misfortunes of their lesser talented peers; for most investors, sticking with the better run, better disciplined fund of funds managers is superior to selecting individual hedge fund managers (the data supports this view); and that the effects of the recent credit crunch will be felt more on existing deals and private equity.

I will provide today's two events and their insights and comments in tomorrow's blog entry.

Showing Us The Money

Attending yesterday’s Lipper/HedgeWorld conference in New York City provided a wealth of detailed information re hedge funds. As someone who produces and conducts such events for CFA Societies throughout the US, I am always interested in breakout sessions that go into considerable detail re the inner workings of hedge funds and private equity, the two opaque behemoths of the unregulated money world. Such was the case with the two breakout sessions I attended, one titled “Strategy Focus: Credit Derivatives/Structured Products”, the other “Strategy Focus: Looking Abroad and Beyond the BRICs”.

Here are a few comments on each:

The first session on credit derivatives and structured products provided an amazing example of the risks inherent in complex, customized deals. The story, described by one of the panelists, was from the last 1990’s and dealt with a structured product for Russian treasury obligations created and marketed by a major investment bank. The deal had two component pieces to it.

The first piece was the return produced by the yield on the core instrument. The second piece was the return expected from the currency translation. Two interrelated returns – yield and currency – that together would counterbalance one another should one part of the equation, say the yield, go against the investor. Rates rise, price goes down, currency goes up. Sounds like a normal bond/currency transaction, right? It was except for the fact that when yields rose dramatically during the Russian debt crisis of the late ‘90’s, guess who had stripped out the currency return from the structured product? None other than the investment bank who put the deal together. In other words, the investor(s) was left holding the bag on a highly risky investment simply because they did not have the proper risk management systems in place (lawyers, in this case). Sounds like a one off? Not really.

From my previous hedge fund seminar experiences, many if not most mid and small sized hedge funds lack the rigorous risk management talent necessary to play the high-risk games that they do. Now, when you combine this fact with five other facts - huge sums of money under management, limited practical investment experience of many of the managers, many, many players in the game, a limited number of unique strategies, and the pressure to perform, things can and do get quite sloppy. Moreover, correlations go up as the momentum lemmings have little choice but to play the game to stay in the game.

The second session on emerging markets provided yet another story of the abundant liquidity in the global financial economy. It’s a story that comes straight out the current news, as reported by Reuters this past Thursday: “Ghana sold a $750 million Eurobond Thursday, with order books testifying to abundant appetite for the debut bond from the West African country and possibly for future issues from the continent. The 10-year dollar bond was sold at par to yield 8.5 percent, the tight end of the guidance given on Wednesday, lead managers Citi and UBS said.”

Tight end of the deal! Try 10 times oversubscribed, according to one of the panelists at yesterday’s emerging markets session. And this was no small deal for the B+ rated paper. According to the Reuters article, “The book size was almost $3 billion with about 40 percent placed to U.S. investors, 36 percent with UK investors and the rest in Europe, officials with the banks said.” For those who may not recall, Ghana, is a country that was “part of a historic 2005 $40 billion debt relief effort for Highly Indebted Poor Countries”. That’s two years ago. And in two years time, all is forgiven and forgotten. Bye, bye fear, hello risk appetite.

Investment Strategy Implications

The Ghana story, whose “success comes a day after Turkey sold $1.25 billion in 2018 Eurobonds, which were three times oversubscribed”, along with the structured product story noted above, provide two clear examples of the need to understand the $3 trillion (not including leverage) hedge fund/private equity players better.

Hot money abounds. So does the lack of risk management skills of many hedge fund and private equity players. The powerful combination of the two creates distortions that impact financial assets everywhere. And provides yet another example why the Fed's domestically-driven rate decision looks more irresponsible with each passing day.

Bernanke Blinks

As the cost of money went down yesterday, so did the credibility of Ben Bernanke.



Since when did John Kerry become Fed chairman? Talk about flip flops. How do you go from being an advocate of the market discipline and exude confidence in holding the line against bailouts and then do exactly the opposite in less than 2 weeks!?!?

Frankly, I am less stunned by the ½ point Fed Funds rate cut and more so with the unanimous vote that supported it. Accordingly, I am sensing that this is not Bernanke’s Fed. The dynamics of the Fed board bear studying and the minutes of yesterday's meeting will be most illuminating re Bernanke’s leadership skills (release next month). Until then, upcoming economic and earnings data points will shed light on just where the US (not the global) economy stands. For now, a useful exercise would be to consider what the rate cut means to valuation models, which is where all economic matters must lead investors to.

From a valuation perspective, what yesterday’s Fed action implies is that we have taken a step back toward the PE (private equity) valuation model*. And in doing so, has put back in play (to some degree) the takeover premium and hot money game that the global liquidity drainage action of the past year was slowly taking away. Therefore, valuation metrics and earnings expectations for 2008 must now come into view.

Once again, the simple, elegant yet very effective modified Fed model that I use (see update table above - click on image to enlarge) provides a guide to possible scenarios. It is the yellow zone of the table that I wish to draw your attention to. Specifically, the prospects that a $96 S&P operating earnings number is a reasonable earnings expectations for the next 12 months. If rates rise (thanks to concerns of rising global inflation), then the enlarged yellow box implies a high single digit return for US equities from current levels.

This, of course, assumes that the credibility damage created by yesterday’s Fed action does not produce unintended consequences. And in a highly uncertain world, unintended consequences should always be assumed.

Investment Strategy Implications

With the strong rally and the expected rise in longer term rates, the valuation gap to full value has and will continue to close. Accordingly, the recent 100% invested position expressed in my Model Growth Portfolio (see performance data in left column) will be reduced at the next re-balancing (Monday). Until then, the trade recommendation made nearly two weeks ago (buy Homebuilders – XHB) has achieved its target and is hereby removed. Other changes are forthcoming.

*see prior blog postings on Private Equity via the Topics Discussed listings in the left column of this blog.

Cold Turkey

Enough with all the moaning and groaning over a normal stock market correction. Volatility returns and the game changes but apparently, like an addict, certain market participants insist on their liquidity fix.



The Fed does not need to cut anything beyond what it has done thus far. Frankly, the one thing that should be cut is the crap from the East Hampton crowd. “Oh, look at the poor homeowner. He/she needs help”, wails the hedge fund/private equity manager, crocodile tears streaming down his face as he contemplates his next plea for a government bailout (that’s what a rate cut amounts to) from the veranda of his mansion overlooking the Atlantic. ("Jeeves, get me another martini.")

What is needed is more clarity as to who owes what to whom. Considering the $400 trillion in OTC credit derivatives (that’s 8 times the world GDP), getting to know what we don’t know would certainly help. Hopefully, the Fed can achieve some of this through its discount window initiative.

What is not needed is to listen to the cries for what is in effect a government bailout for those who created the mess in the first place. Looks like free market ideology applies only when times are good.

Keep serving the cold turkey, Ben.

Piercing the Veil

excerpts from this week's report:

"To help understand the consequences of the current credit squeeze, it is worthwhile to distinguish between what can be measured and what cannot.




What can be measured might be considered the low hanging fruit. It is the scenario that progresses from the mortgage mess to its impact on US consumer spending, which then takes the US economy to below growth expectations for the remainder of this year and next possibly resulting in a recession. The larger manifestation of this scenario is a real test of the decoupling thesis – should the US consumer contract, will there..."

"The good news is that the above is measurable and knowable. All items noted are visible. And the investment strategy consequences can be prepared and acted upon.

The bad news is what is not measurable in the current credit squeeze. And that is the big risk factor that should not be ignored..."

"...one would hope that by putting the banks on the hook for the discount window loans they present (which presumably will come from that very same hedge fund/credit derivative black hole world), some light will be shed into the nether world of hedge funds and private equity..."

also in this week's report

• Valuation Model
• 2Q07 Earnings Update
• ETF Model Growth Portfolio
• Key Economic Indicators

Note: To gain access to this week's report (and all previous reports), please click on the Blue Marble Research Services link to your left for info.

The New PE Ratio Revisited

Back on June 5th, I posted the following comment: "It can be heard with increasing frequency that your standard P/E (price to earnings) ratio should be replaced with a new PE (private equity) ratio. As the chart to your left shows (see June 5th posting), the combination of stock buybacks and PE deals is reducing the supply of equities and, thereby, adding fuel to the bull market fire. At around $2 trillion and counting, corporate cash and PE deal money (not to mention the $1.5 trillion in cash plus the 4 to 8 times leverage from the hedgies) are clearly having a profound impact on many areas of the investment landscape.


Equity valuation 101 teaches us that private market values are always higher than public market values. Accordingly, investor expectations can be reset to a higher level if enough investors believe more deals are on the way. A price to deal ratio, if you will. As with all new era talk, however, it is advisable to temper the enthusiasm as expectations based upon a continuation of the extraordinary stock buyback + PE driven deals at the current pace may not be sustainable resulting in PEs reverting back to P/Es."

Since that posting, a whole raft of issues have arisen in the private equity space the result of which is an increasing concern that the equity markets in the US may be losing a main engine of stock market appreciation - the private equity machine.

Investment Strategy Implications

Stocks are rising in emerging markets and for the companies that serve those markets due to the extraordinary growth rates there and the assumption that there is more to come. In the US, however, a great deal (some say too much) of the equity price appreciation is due to the power of financial innovation, with private equity and hedge funds at the forefront. Should the PEs and hedgies' difficulties not only persist but expand, stocks will likely slip back to their pre PE valuation days. Moreover, should the earnings outlook change, then a much more substantial decline in stocks would occur in which both the multiples would contract (from PE to P/E) and as the E itself drops. This scenario is most definitely not what the current market level is priced for.

What to Listen for When Bernanke Speaks Today

Today’s 1 PM speech by Fed Chairman Bernanke will be closely watched by most investors for what he says about the direction of interest rates. It may, however, be a more fruitful exercise to listen to what the Chairman says about key issues such as non-bank lenders than the likely non-statement re his views on rate changes. For example, in his last speech given on June 15th, he stated the following:

“Endogenous changes in creditworthiness may increase the persistence and amplitude of business cycles (the financial accelerator) and strengthen the influence of monetary policy (the credit channel). As I have noted today, what has been called the bank-lending channel--the idea that banks play a special role in the transmission of monetary policy--can be integrated into this same broad logical framework, if we focus on the link between the bank's financial condition and its cost of capital. Nonbank lenders may well be subject to the same forces.”

Where Alan Greenspan was noted for his opaqueness (to put it generously), Ben Bernanke, on the other hand, assumed his position as Fed chair promising a more candid and clear spoken view of his positions. Unfortunately, he learned early on that being too candid can produce more problems than benefits. Therefore, being a good student, the professor is a quick study and adjusted his pronouncements accordingly. But to what level of candor has he moved to in his commentaries?

Having read his (and other Fed head) speeches, the sense I get it that Mr. Bernanke likes to frame his views in larger thematic concepts rooted in his theoretical views on how monetary policy should function. For example, in the June 15th speech referenced above, a careful reading reveals that he is keenly aware of the psychological dynamic of investor, corporate, and consumer sentiment and the impact it has on the real and financial economy. In other words, he tempers his ivory tower views with a real world recognition of how markets and economies work.

As I said, when it comes to matters pertaining to interest rate changes, today’s speech will likely be a non-event. Therefore, what should be a more productive use of time is to listen for the larger thematic issues, such as his views on non-bank lenders and unregulated money.

And read between the lines. He may not be Greenspan but he is certainly not loose-lips Ben. There’s lots of info and insight there.

The New PE Ratio

It can be heard with increasing frequency that your standard P/E (price to earnings) ratio should be replaced with a new PE (private equity) ratio. As the chart to your left shows, the combination of stock buybacks and PE deals is reducing supply of equities and, thereby, adding fuel to the bull market fire.

At around $2 trillion and counting, corporate cash and PE deal money (not to mention the $1.5 trillion in cash plus the 4 to 8 times leverage from the hedgies) are clearly having a profound impact on many areas of the investment landscape.

Investment Strategy Implications

Equity valuation 101 teaches us that private market values are always higher than public market values. Accordingly, investor expectations can be reset to a higher level if enough investors believe more deals are on the way. A price to deal ratio, if you will.

As with all new era talk, however, it is advisable to temper the enthusiasm as expectations based upon a continuation of the extraordinary stock buyback + PE driven deals at the current pace may not be sustainable resulting in PEs reverting back to P/Es.

How the Virtuous Circle…

Support for higher equity values is anchored in the belief that we are in a virtuous circle: a Goldilocks version of money, economies, government policy, central bank accomodation, corporate management and profitability, and the markets.

Here’s how the virtuous circle works:

The US consumer buys what emerging economies and oil-exporting countries sell, and capital flows to the emerging economies and oil-exporting countries rise. The emerging economies and oil exporting countries recycle the capital back into financial assets, primarily debt. This lowers rates (producing the so-called “conundrum”), which help provide the wherewithal for US consumers to borrow at very attractive rates to support their lifestyles. Lower rates also help support higher asset values (equities and real estate), which further helps the US consumer to spend through the wealth effect (including MEW – mortgage equity withdrawals).

Products sold by emerging economies generate internal growth, which produces demand for raw materials and infrastructure builds that help fuel global consumption and generate incremental profits for global corporations. The resultant global growth and expanded markets coupled with globalization, technological innovation, and advanced management techniques help corporations generate above average top and bottom line growth.

Corporate leaders, by “creating value” through profitability and growth above the cost of capital, are kept in check via private equity and activist investors (including hedge funds) and the threat of M&A. Traditional long-only portfolio managers and their need for short-term performance support this environment when they willingly sell their shares to the highest corporate buyer. In the absence of a hot new issues market, the equity pop they receive from an M&A deal helps goose up their performance numbers.

Lastly, central bankers stand at the ready to provide liquidity as needed so that global growth remains sustainable and consistent.

Investment Strategy Implications

Of course, there is more complexity to the story, but I think you get the picture.

The virtuous circle is a stool that stands on many interconnected legs and requires many things to go right and few to go wrong to sustain itself. Yet, despite investors' persistent low regard for what could wrong, nothing is without risk.

Tomorrow, I will describe how the virtuous circle can become the vicious cycle.