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Mr. Market likes to switch labels.

June 05, 2010 | About:
crafool

crafool

6 followers
James Grant in his "Buy beer, sell bonds" article in the May 28, 2010 edition of his excellent Grant's Interest Rate Observer said the following:

"Mr. Market delights in switching labels. When he thinks nobody's looking he sticks the "risky" label on the safe asset, and the "safe" label on the risky asset. Yet, not infrequently, it's the supposedly risky asset that winds up preserving capital or even delivering capital gains. It all depends on price."

Isn't that the truth? The super safe U.S. Treasury is priced for perfection with a cellar dwelling yield of around 3.20%!!! Just think of the price investors are paying for an asset that no one concedes will be in short supply going forward and is denominated in a currency that can be created with the stroke of a key and in incredible amounts. Mr. Market has put the label of safe on it.

If you listen to the geniuses at CNBC like Maria Bartoroma (I don't know the exact spelling of her last name.), who told everyone watching NBC nightly news on Friday that "Her advice" is for people to step aside. Maria, NBC and CNBC are now advising investors. One would suppose that they and Mr. Market have put the label of "Risky" on stocks.

How risky are stocks? Well back of the napkin simplistic analysis using Bloomberg.com for data puts the following points out there:

The Dow Jones Industrial Average has a trailing P/E of 14.54 and a forward estimated P/E of 12.94. This puts an earnings yield (I did not calculate Enterprise Value, and just doing the rough calculation of dividing earnings and earnings estimates by price.) of 6.877% on the trailing P/E and a 7.72% on the forward estimated P/E. The Dow has an average dividend yield of around 2.75%.

We can now compare some apples so to speak. The Dow Jones offers an earnings yield of around 7% and the 10-year Treasury bond has a yield of around 3.20%. Of course the bond is before tax and the estimated earnings yield is after tax, we can get a better comparison by adding about a third to the earnings yield to compensate for the corporate taxes. We then get an estimated earnings yield for the Dow Jones Industrial average of around 9% versus the 10-Year Treasury Bond Yield of around 3.20%!!!!

Wow, 9% vs 3.20%!!!

Of course, one has no potential for future growth for possible inflation protection and the other has none. One has a historical yield of around 5.5 to 6% (How much is that going to hurt when yields move back towards normallcy? Can you say Ouch!!!) and that was before debt to GDP was at these levels and multiples when one adds in Obamacare, social security and of course the two wars.

Has Mr. Grant who some may remember accurately pointed out the mess in housing and when no one was calling for a strong reversal in the economy in the depths of the gloom and doom and put it in his letter and on the front page of the Wall Street Journal's Saturday Money and Investing Section directly confronting consensus and people like Nouriel Roubini (Again, I don't have the exact spelling.) and the so-called CNBC All-stars made another valuable point?

I think he is right about Mr. Market!!! Just take a look at some of the Dow Components like CVX, KO, JNJ and KFT to get an even more pronounced view. Definitely, think about going and subscribing to Grants Interest Rate Observer. In my opinion, its advice is far superior to the "Financial Pornography" of CNBC. www.grantspub.com

Happy investing to all.


(Editor Note: Maria's last name is "Bartiromo")


Rating: 4.1/5 (15 votes)

Comments

Sivaram
Sivaram - 4 years ago


I think in the very long term (say 10 to 30 years) I would agree with what you are saying. But for the next 10 years, I am not so sure. I lean more towards deflation--admittedly have been wrong for more than year now--and if you believe in that, the bond yields aren't very low. In the two serious periods of deflation in the modern era, Japan and Great Depression, bond yields kept declining much further.

In addition, I think there are two points I would question with your bond vs stock comparison. I'm not saying I am necessarily right with these poitns but it's something I don't agree with.

The first thing to note is that the earnings numbers are off multi-decdade high in corporate profit margins. There are lots of conflicting numbers floating around but the high appears to have been set in 2006 - here is an older chart; here is another (note that these charts refer to slightly different things.) One recent source I read suggests that, even after the bust, corporate profit margins are high. It's tough to say if the current reported earnings are anything meaningful, given how factors such as the huge financial profit being reported may not be sustainable.

If you think about the real world, you can see how these profit margins may decline in the future. Wage growth in countries like USA, Canada, and others, have been very low in the last decade. Yet corporate profit margins have been high. The reason, of course, is because the consumers who buy products from these companies have been living outside their means by running up their debt. The question is, what happens when that debt is not sustainable? Will someone who is financially struggling pay a higher price and buy a product from, say, Kraft versus no-name? I just wonder.

The other point I wanted to make was that, I'm not sure it's correct to look at pre-tax earnings and compare it to interest payments from bonds. I have to think about this more but I haven't seen it being done. Everyone I have encountered compare the reported earnings to bond yield. I think that's probably more meaningful than comparing pre-tax earnings to bond yields. After all, if you were an investor, there is no way you could avoid paying the corporate tax (unless the company re-locates to a low-tax jurisdiction.) The corporation pay that tax.

Historically, bond vs stock yields are something like 5% vs 10%, respectively. Based on your numbers (ignoring your tax credit for stocks), it looks like its something like 3.5% vs 7% right now (I'm just using rough, round, numbers.)
crafool
Crafool - 4 years ago
I understand your comments regarding profit margins for Jeremy Grantham at GMO writes about them regularly. I mean if there is anything more mean reverting it is definitely profit margins. I think that is a very valid argument for coporate profits as a percentage of GDP is high and makes many average companies questionable like small and mid-cap companies, however I used the Dow Jones Industrial Average. These big blue chip companies have "normalized" profit margins that stand to improve as some have the ability to utilize the vastly over-priced bond market to issue bonds at these generationally low levels (Note, Berkshire Hathaway is not a Dow stock but its bonds are yielding lower than the U.S. Governments. WOW!!! JNJ, KO and Kraft have all been refinancing their debt.), and buy up other companies. Note each has some sort of acquistion going on right now with cash components.)

In an inflationary environment one would love to borrow as much as one can as long as the debt is non-callable and fixed rate. I understand people view for deflation however that would be coupled with a Hawkish Federal Reserve not the Dovish Bernanke, politicians working to cut spending rather than increased spending like Obamacare, raising taxes (We may be getting that one.) and a rising dollar (Yes, we have had a counter trend bounce but a strong dollar boosts consumption of imports not the boost in exports that we need. I think in a world were the average Joe does not know the difference between "real" versus "nominal" GDP growth the government will air towards inflationary growth.

As far as comparing the earnings yields, I beleive all value investors following Graham and Dodd look at the pre-tax, but some easy ones would be Guru Joel Greenblatt, Gotham Capital and author of The Little Book that Beats the Market, and Mary Buffett, daughter-in-law of Warren Buffett and author of Buffettology. What I am doing is looking at Pre-tax earnings for a company can use those pre-tax dollars to issue debt/bonds and buy another company or its own stock which gives it the potential to increase its earnings, growth and share price.

So I stick by my 9% versus 3.20% comparison. Yes, it is extreme but one of the many reasons Bearish people like Jeremy Grantham say these U.S. Blue Chips look great and why John Bogle, Vanguard and Bill Gross of PIMCO put stocks a head of bonds the next several years.

One last thing regarding the Kraft versus generic competition. Yes, this company is recession resistant but not reseccion proof, however what people experience is the trade down. Yes, generics might take some share, but Kraft takes some share as people decide not to go out for dinner but eat at home. I think was JNJ that said it best when they saw some declines in their products but increases in Neutragena (I don't have the exact spelling.) as people trade from departments store brands to those avaiable at the grocery store.

Happy Investing to All.

Sivaram
Sivaram - 4 years ago


CRAFOOL: "I think that is a very valid argument for coporate profits as a percentage of GDP is high and makes many average companies questionable like small and mid-cap companies, however I used the Dow Jones Industrial Average. These big blue chip companies have "normalized" profit margins that stand to improve as some have the ability to utilize the vastly over-priced bond market to issue bonds at these generationally low levels"

I don't think it's just small caps that are going to see contracting margins. I actually think the large caps will likely suffer as much. This is one reason I don't get why Jeremy Grantham is so bullish on them.

In any case, you may be right in suggesting that the blue chips can leverage up and buy undervalued companies or reinvest in high-return projects. But if we get a deflationary environment, leveraging up would be lethal. I have no idea what is going to happen but it remains to be seen.

CRAFOOL: "I think in a world were the average Joe does not know the difference between "real" versus "nominal" GDP growth the government will air towards inflationary growth."

The consensus is heavily in your favour, including superinvestors like Seth Klarman who appear to have bet millions on inflation. The main reason I lean towards deflation is because, I believe the free market forces are far more powerful than any government. Bad debt seems to be very large and that will be deflationary (as well as overcapacity in China, etc.) Japan tried printing its way out of deflation in the late 90's and 2000's with no success. Similarly, I think you are seeing the market forces at work in Europe, in seeing how heavy government spending appears to only have a marginal impact. Other governments, such as the American and Chinese governments, also appear to have used up most of their ammunition and all it takes is another whiff of deflation to topple asset prices and/or cause losses from bad debt to be realized.

In any case, I think you are a value investor and probably don't give macro views much thought so it's not worth going into speculations on what may or may not happen.

CRAFOOL: "What I am doing is looking at Pre-tax earnings for a company can use those pre-tax dollars to issue debt/bonds and buy another company or its own stock which gives it the potential to increase its earnings, growth and share price."

The sources I tend to look at, who are more in the macro camp and not value investors per se, appear to use earnings yield off reported earnings (i.e. generally just the inverse of the P/E with no adjustments to E.) If you are comparing bond yield to earnings yield, I think it is still best to look at reported earnings (i.e. after-tax) because that is what the investor sees.

However, it seems that you are looking not from the investor's point of view, but, rather, from the point of view of the firm. Even in that case, I think you have to look at after-tax because the firm doesn't have access to pre-tax cash (unless I'm mistaken.) The firm has to pay income tax first, right? Even if the firm were to go and buy another company or buy back shares or something, it can only do that after paying the income tax.

(On a side note, when it comes to profit margins--the first topic we discussed above--I definitely see people using pre-tax profit margins. It's just that I haven't seen it being used for earnings yield, when comparing against other assets like bonds.)

CRAFOOL: "So I stick by my 9% versus 3.20% comparison. Yes, it is extreme but one of the many reasons Bearish people like Jeremy Grantham say these U.S. Blue Chips look great and why John Bogle, Vanguard and Bill Gross of PIMCO put stocks a head of bonds the next several years."

First of all, when has Bill Gross or John Bogle been bearish on stocks in the last 30 years? Probably never right? I think Gross was bearish here and there but generally wrong (since stocks beat stocks almost all the time.) As for Bogle, since he is a passive investor, I think he will be bullish on stocks since stocks will beat bonds in the long run. This doesn't mean we should ignore their views but just saying.

As for Grantham, I think he is right in suggesting that high-quality blue chips will outperform other classes; but I'm not as bullish on those high-quality stocks. The biggest risk for investors is P/E contraction (this is why I brought up the question mark about peak profit margins--the earnings matter so much to our near-term future.) Blue chips may be more attractive than the lower quality stocks--I definitely think small-caps are overvalued--but I have a feeling they will see P/E contractions.

CRAFOOL: "One last thing regarding the Kraft versus generic competition. Yes, this company is recession resistant but not reseccion proof, however what people experience is the trade down. Yes, generics might take some share, but Kraft takes some share as people decide not to go out for dinner but eat at home."

What you describe is a positive effect but I have a feeling the negative effect will outweigh it. My concern, which could turn out to be completely wrong, is based on the following. It's pure speculation so don't let it influence you too much but think about it.

My theory is that many high-quality consumer goods companies, including consumer staples, have done so well over the last 50 years because of increasing prosperity of consumers in America*. As disposable income grows, people spend more; as income goes up, people are willing to buy more expensive brands. The prosperity was real except for the last 10 years, and I would argue, for the next 10. Consumer prosperity was largely due to running up debt in the last 10 years, and I think their spending will weaken over the next 10 years.

When your income is growing, it doesn't matter if you buy Tide detergent that costs 50% more than other brands; or if you buy a nearly-identical stuffed toy from Disney versus something else. Well, when income isn't growing or is growing slowly, I think consumer behaviour will change. This is why I think investors should be careful with these companies. They are not going to go to zero but I can see them being stuck in their current price for a while.

Anyway, I admit that most of what I have said is speculation and I can't prove it. But we'll see how things unfold.

(* Some will argue that these companies will rely more on higher growth, emerging markets, in the future. That's true but their foreign EM sales are very small compared to their sales from America and Europe. )
crafool
Crafool - 4 years ago
Sivaram writes: The sources I tend to look at, who are more in the macro camp and not value investors per se, appear to use earnings yield off reported earnings (i.e. generally just the inverse of the P/E with no adjustments to E.) If you are comparing bond yield to earnings yield, I think it is still best to look at reported earnings (i.e. after-tax) because that is what the investor sees.

However, it seems that you are looking not from the investor's point of view, but, rather, from the point of view of the firm. Even in that case, I think you have to look at after-tax because the firm doesn't have access to pre-tax cash (unless I'm mistaken.) The firm has to pay income tax first, right? Even if the firm were to go and buy another company or buy back shares or something, it can only do that after paying the income tax.

(On a side note, when it comes to profit margins--the first topic we discussed above--I definitely see people using pre-tax profit margins. It's just that I haven't seen it being used for earnings yield, when comparing against other assets like bonds.)
You are correct. I am a value investor, and as such I follow a cardinal rule of value investors like Buffett, Klarman,Berkowitz, etc. in that when I decide to invest in a stock, I treat it as though I am buying the whole company. I can understand your preference for using after-tax earnings or reported earnings for comparing the earnings yield for stocks versus bonds, however you should adjust your bond yields for after tax in order to get a better comparison for yourself. As your logic goes, the bond yield on Treasury bonds or corporate bonds is not tax free to the investor, however taxable and part of it goes to old Uncle Sam (Yes, I am aware of IRAs. So no need to pull that up.)

Now, I would like to go back to the pre-tax earnings. If a company would like to lower its taxable income and possibly increases its earnings, it could simple issue bonds. The bond principle received from the bond offering would be tax-free just like a regular loan and the interest on the bond debt is an expense on the income company's income statement. The company then takes the cash and goes into the open market and buys its stock back, which supports its share price and possibly increases

earnings (This in my opinion becomes more probable the lower the interest rate environment, and people are lending money at very VERY low levels right now. I believe corporate America is probably saying Thank you, Thank you.).

I believe it is actually EBIT, Earnings Before Taxes and INTEREST that Leverage Buyout firms use to determine if buying a public firm and taking private look at and what many money managers that use "private market value" to determine intrinsic value use. Just look at the M&A that is taking place, and the lack of new equity issues. New issuance is occurring for the most part in the bond/debt markets and why not when the terms are so favorable. So I believe using my Earnings Before Taxes which counts interest paid on debt is actually more conservative.

I realize the extreme 9% versus 3.18% (As of 6/8/10). I have not seen this kind of spread since around 1999-2000, however at that time stocks were yielding around 3% and bonds in the 7 to 8% range. We all know how that turned out for equity investors (This was around the time John Bogle was talking about stocks under performance) and for bonds investors. As they say, isn't it funny how things can come full circle, and how Mr. market likes to play games and mis-label.

Happy Investing to All!!!

[b][/b]
Sivaram
Sivaram - 4 years ago
CRAFOOL: "I can understand your preference for using after-tax earnings or reported earnings for comparing the earnings yield for stocks versus bonds, however you should adjust your bond yields for after tax in order to get a better comparison for yourself."

Actually, the best analysis is to look at afer-tax, after-inflation, returns. But most people, including me, don't; we just look at earnings yield (off the inverse P/E ratio) and the bond yield. In any case, I think if you are going to apply a tax to the bond then you need to tax the stock as well. After all, shares get taxed twice (either capital gains tax or dividend tax, on top of the corporate tax.) The tax would favour shares over bonds but both need to be discounted by the tax.

CRAFOOL: " If a company would like to lower its taxable income and possibly increases its earnings, it could simple issue bonds...The company then takes the cash and goes into the open market and buys its stock back, which supports its share price and possibly increases earnings (This in my opinion becomes more probable the lower the interest rate environment, and people are lending money at very VERY low levels right now. I believe corporate America is probably saying Thank you, Thank you.)."

You are right and it may be one way some companies create shareholder value in the next decade. If you can pick the right companies, it may work.

However, in the grand scheme of things, it is not as obvious as it seems. Just because interest rates are low doesn't necessarily mean debt is cheap (from an issuer point of view.) Real rates are not that much off the historical average, if you believe there will be mild-deflation/low-inflation. Ignoring the view by some that central banks manipulate long-term bond yields--I don't believe they can do it totally and at all times--the yields are low because the market is pricing in a risk of deflation. If we do get mild deflation or low inflation, leveraging up (i.e. taking on more debt) can be dangerous.

The other thing to consider is whether boosting profits through leverage will create much shareholder value. For instance, I am pretty sure the market will attach a lower multiple (i.e. lower valuation than otherwise) if a company leverages up and buys back shares.

Having said all that, you lean more towards inflation and it would make sense to leverage up in such a scenario. If interest rates are going to rise (due to inflationary pressures) then it makes sense to take on debt at the seemingly-low rates right now. In fact, this is what corporate America has been doing in the last year. They have placed a huge bet on inflation. Junk bond issuance has been spectacular in the last year and investment-grade corporate bond issuance is pretty strong too. It remains to be seen whether this strategy will work out in the end.

CRAFOOL: "I realize the extreme 9% versus 3.18% (As of 6/8/10). I have not seen this kind of spread since around 1999-2000, however at that time stocks were yielding around 3% and bonds in the 7 to 8% range. We all know how that turned out for equity investors (This was around the time John Bogle was talking about stocks under performance) and for bonds investors. As they say, isn't it funny how things can come full circle, and how Mr. market likes to play games and mis-label."

I know we are having this debate on the details of your scenario but I actually agree with your overall view. Ignoring everything else, strictly from a contrarian point of view, bonds are likely to severely underperform stocks over the next 30 or 40 years. This shouldn't be surprising given how bonds have been in a huge bull market in the last 30 years (in fact, at the bottom of hte stock market in early 2009, bonds had beaten stocks for the past 40 years.) So I agree with you call "mis-label"; where I disagree is the next 10 years. I'm not so confident with a bearish bet on bonds in the next decade.
crafool
Crafool - 4 years ago


Published: Wednesday, 16 Jun 2010 | 12:05 AM ET PIMCO Bond Guru Bill Gross Moves into Equities

By: Geraldine Tan

News Assistant, CNBC Asia Pacific


http://www.cnbc.com/id/37721979

“Corporate equities, in terms of valuation, are selling at very low P/E ratios and in some cases might be perceived to be almost as safe, or almost as secure as the sovereigns themselves,” said Gross.

Follow the link for the complete story on CNBC's website.

I guess the "Bond King" seems to know that Mr. Market likes to switch lables.

Happy investing to all!!!

crafool
Crafool - 3 years ago


Just thought this was a timely comment regarding the spread and potential opportunity between two major asset classes.

Please follow the link: http://www.cnbc.com/id/39522030 . It takes you to a CNBC article and video featuring Warren Buffett and his opinion that stocks represent an opportunity versus bonds.

Check it out, and again remember Mr. Market likes to play games!!! It is good when we understand this fact.

Happy investing to all.

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