“Davidson” submits:

The inflation indicator from Dallas Fed (Trimmed mean PCE) reported at 1.8% for past 12mos. Inflation coupled with the historical Real GDP trend create the “Prevailing Rate” which is used to capitalize the market’s return and provide a price estimate for the SP500. The current Prevailing Rate calculates to 4.89%

How this works across the business cycle is to take the long term earnings trend for the SP500 and capitalize the current monthly earnings trend value by dividing it by the Prevailing Rate:

The capitalization calculation gives a Dec 2011 estimate for the SP500 of 1507.1 while the closing price for Dec 2011 was 1257.6-see the chart SP500 vs. SP500 Earnings Trend Index below. To place this analysis in the proper perspective, an SP500 level of 1507.1 today represents the historical level of support investors have given the SP500 since 1978 (inception date of Trimmed mean PCE). I interpret this level as the buy point for long term value investors. The historical literature indicates that value investors buy stocks based on long term earnings trends and expectations that the trend is likely to recover.

Today using this analysis the SP500 is ~20% undervalued. But, an SP500 at 1507.1 is not what I am expecting for this market!!

If the business cycle lasts another 5yrs and inflation remains at the current level, then the SP500 would have a valuation of ~2025 in 2017. But, the potential exists for momentum hedge funds to price SP500 rising on the good news from a fully involved economic expansion as much as 50%-100% overvalued. I fully expect that we will witness an overvalued market at the point of economic maturity and have a strategy to deal with this when the time arrives which I have described in previous posts.

I have been recommending that investors be positive on equities since early 2009-see the “Bullish Recommendation Period” in the chart above. The current SP500 remains ~20% below the historical support level. The pull back on the European debt concern this summer will be seen in my estimation as a short term event and similar to the Iraq War of 2003, the Internet Bubble of 2000 or the Real Estate Collapse of 1990 – it will pass and the SP500 should track the economic trend as it has historically.

Already the market is becoming increasingly more comfortable with the financials and real estate while auto sales, global trade, industrial production and retail sales continue strong trends. The employment trend appears to be accelerating. Growth is all about employing individuals in productive activity who in turn add demand to the system which employs yet more individuals. There is a limit to this, but at the moment we are still in the early stages and have several years ahead of an increasingly more vibrant economy based on historical trends.

Inflation is relatively contained, the SP500 appears quite undervalued and the future looks bright. Optimism is warranted!!
 

“Davidson” Submits:

Good example of how 2 indices using different criteria provide different results. The Chicago Fed is a soft data sentiment index while the Ind Prod Mfg is hard data driven, i.e. actual $value of goods produced.

You can see that CFMMI was soft late 2003 into late 2005 and then mid-2006 till early 2007 while the Ind Prod kept rising without a similar pattern.

CFMMI turned with the Ind Prod at tops and bottoms, but was only helpful at calling a SP500 turn in early 2009.

My two cents:

Sentiment indicators can be very dangerous. Had you seen the Fed Sentiment weakening in 2003 and then flatline in 2005-07 and simply “sat out” the market, you would have made a VERY unwise investing decision. Why? The market almost doubled in that time frame:

Even at “top and bottoms” of the market, the sentiment indicator is meaningless unless a correspnding turn in the actual data is present.

People’s “sentiment” will rule markets on a day to day basis but it is the actual data that overtime rules the direction.

He is right. When we revise the prior month up, we then have to include that upward revision in the current month as all the “estimates” did not. The numbers are still going in the right direction…..and as was also pointed out to me by @Dukestjournal, Oct. also feature the latest iPhone launch so this makes the Dec increase even better

“Davidson” submits:

The Retail Sales figures were released today showing a 0.1% rise from Nov 2011 which itself was revised higher so that sales are 0.5% higher than Oct 2011. Yet, the media has found a means of being pessimistic on this report. Look at the trend in the chart below of Retail Sales vs. Household Survey Emp.

Do you see a reason to be pessimistic in these trends? I see no reason to be anything but optimistic!

The excessive market pessimism is beginning to turn in my opinion and is resulting in positive gains in financial issues. I think this is the result of the trends in Retail Sales and employment since Jan 2009 beginning to convert naysayers to a more positive view coupled with the very low returns currently available in Treasuries.

Optimism continues to be warranted for equities in my opinion.

Some relationships are so simple as to almost omit all others. For instance is rail traffic is increasing, so will GDP. If temporary employment is rising, so will overall employment. Yes there will be month to month anomalies but the trends and their relationship always hold. The same can be said of durable goods/employment. While durable goods will be more volatile month to month its trend, and that of employment levels match. So, ignoring whether the reading (which will be revised) today was .1% or .3% above or below the consensus is wise because as we step back, seeing the trend relationship tells us far more. Here it is simple, both are increasing and that bodes well…..

“Davidson” submits:

US Durable Goods Orders have been in an uptrend since April 2009. By most measures the pace has been ahead of the 2002-2003 economic recovery as can be visualized in the chart below. Employment tracks this economic indicator relatively closely with regards to the timing of changes in trend with Durable Goods being leading indicator for employment by 12mos-18mos. Employment tracks Durable Orders in general magnitude and direction.

The media was predictably negative on this report finding small details to claim as a poor reading for the economy while ignoring the whole. This is the reason for market underperformance with regards to economic progress since May 2011 in my estimation. This sets value oriented investors in the particular position of having value situations presented to them the past 7mos.

It is impossible to predict how long this period of unwarranted pessimism will last, but I urge all to take advantage of this situation. Once the pessimism turns towards optimism, investments today should provide better than average gains to those who able to believe in the trends in the chart below and ignore the media’s fearful forecasts.

One must be a contrarian to invest successfully.

Optimism is warranted!

Enjoy the Holidays.

Note: This is part of a much larger study being done on the subject

“Davidson” submits:

The context for the correlation of stock prices and book value per share comes from an examination of shareholder returns. The most prevalent view of modern finance is that investor returns come from increases in net cash which are generated over the course of business activity. This is expressed in general terms as a Return on Equity (ROE) defined as Net Income/Shareholder Equity or as a Return on Invested Capital (ROIC) defined as Net Income/Invested Capital. Various short-hand screens have evolved with the advent of computers that focus on single parameters the most common of which are Earnings per Share (EPS), Cash Flow (CF) or Free Cash Flow (FCF).

This study follows a different approach. Shareholder returns as used in this paper are viewed as adds to the value of the business (Retained Earnings), paid out as cash (Dividend) or some of each. No other uses of Net Income benefits shareholders. Shareholders do not receive Net Income or Cash Flow directly, only through the corporate managements’ decisions that relates to dividends and retained earnings. Viewed in this context, the growth in the price of common stock should be correlated to the rate of growth of its Dividends and Shareholder Equity/Share or Book Value/Share. Observation of numerous individual companies prior to this study indicated that in many instances there existed a strong correlation. The examination of the stocks comprising the SP500 were undertaken to identify the extent of the correlation.

The study was performed over two periods 2001-2010 and 2002-2008. The 2001-2010 period reflected the fact that the study had available 10yr data from Morningstar. The 2002-2008 period was selected based on the fact that the period end points reflected market lows during which it was believed that market prices were predominately dominated by long term value investors who in the investment literature had indicated they used book value as a significant factor in their investment decisions. The study had three goals 1) to illustrate whether or not there was a relationship between book value per share and price, 2) to establish the strength of the relationship and 3) to determine to what extent the correlation was reflected in individual members of the SP500. The study discovered that the SP500 demonstrated a strong correlation between Price and Book Value, but the relationship was seen to have additional determining factors when individual companies were examined.

Some companies were excluded because their SP500 membership did not span the period while others had negative end of period book values which could not used in calculation. As a result, the study involved 388 companies of the SP500. If a company had changed its fiscal year end during the period, i.e. fiscal year end changing from March 2002 to December 2008, the appropriate book values per share and month end prices were.

Table 1: Regression Summary Output for 2002-2008

The 2001-2010 study is shown in Chart 2: SP500 Growth Rate Price vs. Growth Rate Book Value per Share 2001-2010. The regression analysis can be seen in Table 2: Summary Output for 2001-2010. In comparison with the 2002-2008 findings, the 2001-2010 period produced a significantly lower P-Value, which indicated a weaker correlation. The lower P-Value in the 2001-2010 period hints that additional factors are likely coming into play to influence market prices once stock prices have risen somewhat above the market lows. As noted earlier, market lows attract the long value oriented investors who by their own words focus on book value and the returns that they expect to receive from that book value during better economic periods. Basically the influx of value buyers cause prices to rise ahead of BV growth.

Look at what $NFLX did the past few years:

It is not Netflix’s fault that investors priced its shares for perfection. But the Internet video company is to blame for managing its own balance sheet for the same flawless performance.

The former high-flier announced Monday night it had sold $200 million in new shares at $70 each and another $200 million in bonds convertible to stock at $85.80. Just months ago, the stock traded above $300. It is now at $72.

Netflix could easily have avoided this. The company has spent over $1 billion on share repurchases since 2007, leaving it with just $366 million in cash and $200 million in debt at the end of the third quarter. During that time, executives including chief executive Reed Hastings have been selling shares.

In buying back shares, Netflix failed to build a cash cushion against any slowdown in its heady growth rate. With expectations for healthy subscriber additions stretching into the future, the company locked into big contracts for streaming content. Since the start of 2011, the company has more than tripled such commitments to a whopping $3.5 billion, of which $2.9 billion is due in the next three years.

$NFLX was paying $222/share in the past year as it bough back almost $200M in stock. In doing so it depleted cash balances and took 900k shares from the open market. Now, to replace that cash, they will issue 2.8M shares (this does not include the convertible dilution assuming the stock ever sees a level it can be converted at) at $70….stunning. Mangle the balance sheet, mangle the stock price.

“Davidson” submits:

This commentary introduces the concept of the SP500 Total Shareholder Return Index to contrast the SP500 Earnings Trend Index (formally SP500 Investor Value Index). The reason for adding another index is simple. Market thinking the past 200yrs or so has focused on Net Income as the return to shareholders, but this is not the full picture of corporate performance as far as shareholder returns.

Shareholders receive only 2-streams of returns, i.e. Dividends and Growth in Corporate Assets or BV/Shr. As a shareholder one does not actually receive a payment that represents the growth of the corporation because it is reinvested for future growth. In some instances, management makes poor decisions and the amount reinvested is offset with inventory write-downs or charge-offs thus causing BV/Shr to fall. Another management action which results in less growth in BV/Shr than that which could otherwise be is share buybacks.

Share buybacks have, for as long as I have been in this industry, been touted as beneficial to shareholders. They are thought as a return of cash to shareholders and a substitution for dividends. Nothing could be further from the actual effect. Share buybacks use corporate cash very often to buyback stock at elevated Price/Book Value ratios which cause an immediate loss of return to shareholders than what would have been had the cash not been spent. Buy backs have received wide spread support since a securities’ law change in 1983. Buy backs have accelerated from ~4% of Net Income to over 40% of net Income since. This causes companies to grow at a slower rate than the Net Income that they are earning during economic uptrends when buy backs are most active.

Not seeing this effect, the market’s sole focus is Net Income. Buy backs are detrimental to shareholder returns!!

Thus the SP500 has 2 valuation indices below:

SP500 Earnings Trend Index-Tracks the historical support the market has given to SP500 Earnings over time
SP500 Total Shareholder Return Index-Tracks the actual returns that shareholders receive over time-Dividends and BV/Shr Growth

It is my opinion that the market’s love affair with Net Income leads to many misperceptions. The acceptance of share buybacks is one of these. There are many others too numerous to mention here, but they do not have factual support when one examines the how markets are priced over the long term and can identify the fundamental inputs.

One can see that the (dashed line) representing the SP500 Total Shareholder Return Index has lagged behind the SP500 Earnings Trend Index (solid line) from 2000 on due to heavy share buyback activity. The period of 2006 thru 2008 was a period of greater asset growth as a commodity bubble developed and this trend reversed till 2009 when buybacks accelerated.

Using the SP500 Total Shareholder Return Index provides a lower fair value for the SP500 based on the current core inflation readings and Real GDP growth rate assumptions. Even so, the SP500 remains undervalued by more than 18% which places fair value at ~$1420.

Yesterday I tweeted on the correlation between auto sales and recessions. The truth is we have never had a recession when auto sales are increasing. In fact, auto sales tend to begin falling 4-6months before a recession. See chart, shaded areas are recessions:

Further, when we see auto sales improving at double digit rates, it is easy to say the chance of recession is becoming more remote by the day.

Today Davidson runs the correlation between auto sales and employment. I think the questions he proposes on the chart is very valid, we may in fact be due for an acceleration in the household survey given the surge in auto sales and the fact it seems there is no pullback in sight for them for at least the next quarter. When $F and $GM are seeing the large YOY sales increases they are AND increasing production for Q1, that not only means more hiring and hours from them but throughout the whole auto supply chain.

“Davidson” submits:

The yesterday’s report of Auto&Lt Truck Sales rising to 13.6mil Seasonally Adjusted Annual Rate (SAAR) and this morning’s Household Survey Employment report rising by 278,000 to 140,580,000 employed is nothing but good news. Importantly, employment growth appears to be accelerating, but because no single or even a couple of months of data make a trend, we need to wait another 4mos or so to confirm this. The trends in the chart below are unmistakable. Yes they are up and they have not really wavered since 2yrs+ ago. The fears of recession should melt away as time passes and greater enthusiasm for the equity markets should develop.

I remain optimistic. You should remain optimistic. Equities remain an undervalued asset class in my opinion.

“Davidson” submits:

Today’s market is very much like that of that of the Iraq War in 2003. During that period the world was awash with fears that the world as we knew it was about to collapse as the US went to war in the center of the oil producing nations. Oil, I need not remind all, is the “life blood” of the global economy and the irrational belief that Mid-East nations would stop producing as a result of the US intrusion was so palpable that the markets swooned nearly 30%-see the LIGHT BLUE circled area in the chart. The economy as shown by the trend in the Household Survey was in an uptrend which did not waver. Today’s market is quite similar with a respected former US Secretary Treasury joining the chorus that the world has entered a recession and is on the verge of financial collapse based on the current fears of Europeans being unable to solve their debt problems and the US rolling into recession. The problem with this thinking is that it just does not square with the facts!!

The actual facts indicate that the US economy is in a typical recovery and that global trade which has expanded the past 2 ½ yrs continues to expand at a robust pace. Markets have a history of ignoring facts during periods of panic and this certainly is one of those periods. Yes, fear does drive the market over shorter periods, but in the end it is the economy which drives market prices and market psychology.

I remain quite optimistic that the current period of paranoia will pass and the markets will eventually reflect that the current pace of economic activity is in an uptrend. The economy trumps all!! The end of the world as we know it is not near!

Be optimistic and enjoy the holiday. We deserve it!

“Davidson” submts:

It has been an extraordinary 5mos in which multiple times the global financial system was reported on the verge of collapse only to days later be proven not so. This occurred so often that I lost count. Was it 8-9 times or was it as many as 20? It depends on who you are listening to and how important you think the individual’s insight carries with the investment/political classes. Well, we are still here doing the everyday things that are required to support families and simply get whatever jobs done that need doing like cleaning streets, growing food, taking kids to the doctor and repairing homes after storms. This basic type of activity shows up in various measures of the economy like Retail Sales.

The St Louis Fed just released Retail Sales update-this does much to dispel angst and provide a wider investment perspective. Retail Sales are in a solid uptrend and have been thus all summer and even since December 2008. This is one of those economic measures which reflect the pace of economic health.

We are OK and have been OK even though there have been hundreds of experts telling us that we were not OK.

This remains an excellent time to invest capital into the growing economy. Any economy which can take the onslaught of negative news that we have been exposed to the past several years is in a word, “OK”.

Today’s report on Industrial Production for October rising 0.7% strongly supports higher employment in future months. Industrial Production has a long history of being 6mos-24mos ahead of employment trends and thereby a good predictor of future SP500 prices albeit geopolitical events. Yes, the geopolitical news has been anything but positive, but over the long term economic activity trumps market psychology and this report confirms a long term uptrend that I would expect to see reflected in equity prices at some point just as has been reflected in past recoveries.

The chart below shows that the turning points in Industrial Production lead those of the Household Survey by some months. Although, there are not a precise set of months prediction prior to turns in the employment trends, the correlation is still significant enough to be good for investors who are patient and not bent on trading over the short term. The RED DOWN ARROWS identify periods of developing economic weakness in Industrial Production prior to the same being reflected in the Household Survey. The INDIGO DOUBLE ARROWS identify periods of developing economic strength in Industrial Production prior to the same being reflected in the Household Survey.

In spite of the negative geopolitical news and the many dire economic forecasts, the economy continues in a nice uptrend and the SP500 has been temporarily derailed by market psychology and remains attractive historically.

“BUY STOCKS!” is my advice! Poor market sentiment has no historical precedent of causing an economy to stall. Poor sentiment can cause a market to stall over the short term but there is no historical precedent for it keeping a market undervalued for long while the economy continued in an uptrend.