You get conditioned to growth after 67 years of exponential credit expansion. We are wired to believe ‘normal transmission’ will return anytime soon.
Central bankers have developed an aura of omnipotence. We are constantly told, ‘Don’t fight the Fed,’ — as if they are immune to the laws of economics.
But what if the market develops immunity to the Fed’s cures and fights back? While the Federal Reserve still retains the confidence of the public, Bernanke can continue experimenting. Confidence is fragile and once shattered, the Fed is ill equipped to fight the market.
The share market is behaving like a foolhardy trapeze artist — performing recklessly, knowing the Federal Reserve will provide a safety net (again).
What happens if confidence is lost and the net removed? How hard could this market fall? Expect the unexpected.
Former United States Secretary of Defense, Donald Rumsfeld famously said:
‘There are known knowns; there are things we know that we know. There are known unknowns; that is to say, there are things that we now know we don’t know. But there are also unknown unknowns — there are things we do not know we don’t know.’
In the world of investing there is a fourth known. I call them the ‘we forgot we knew knowns.’These forgotten knowns are most evident when you hear phrases like, ‘This time is different.’
We all know markets rise and fall. We all know, at the market’s extremities, greed or fear replace reason. We all know busts follow booms. We all know you should buy low and sell high. How do we know this? Did we learn it at school? No, history taught us.
History also taught us fire burns you. Each generation does not have to learn this painful lesson over and over again. Yet when it comes to markets, the lessons are never learnt. Each generation appears destined to repeat the errors of their forefathers.
The benefit in this perpetual exercise of trial and error is the body of evidence it creates. This data serves to remind us of…the things we know we know but choose to ignore in our altered emotional state.
Buy in haste and repent in leisure — knowing the numbers helps avoid the numbahs (dazed realisation of your emotional impulse).
The share market has its own language — ratios, averages, percentages, volumes, multiples, margins — this is the language of math.
Mathematics is not emotional or illogical — it’s simply math. An oft-cited reason for a deal not proceeding is ‘the numbers didn’t stack up’. This is code for ‘the math did not make the proposition worthwhile’.
When a take-over is considered, the suitor doesn’t ask a social worker how the company
‘feels’, they bring in the ‘numbers men’.
Markets and math go hand in glove.
Thanks to our forefathers’ errors of judgment, there is an abundance of statistics on market values.
While math is straightforward, the interpretation of the math gives us statistics — and as they say, ‘There are lies, damn lies and statistics.’
For the average investor looking to identify value in the market, a key determinant is the Price to Earnings ratio (P/E). If a company earning $1M is valued at $15M, its P/E is 15. Sounds simple, but nothing in the complexity of markets is ever that simple.
There are a myriad of ways to measure P/E — using an average of last 10 years earnings; last year’s (trailing) earnings; current earnings; forward earnings. Each method has its devotees and they all paint a slightly different picture. However over the long term, distinct patterns emerge.
The first chart is the Shiller PE 10 Ratio (using the average of the past 10 years’ earnings to smooth out any earnings anomalies). The second chart is the PE based on current earnings. The third chart is PE determined by trailing 12 month earnings.
The boxed areas in the next chart are the Secular Bear Markets since 1900. Overlay the first three boxed areas with the PE charts and you see this is when PE’s fell into the single figure range (around 5 to 6). Secular Bear Markets crush your animal spirits. Pessimism reigns supreme.
This information is critical in trying to determine what devastation may lie in wait for us.
Analysts often reference the average PE (15 to 16) as a guide to fair value. This is misleading. If you look at the top two PE charts, the PE threads its way over and under the average — it rarely sits on the average.
The PE extremities are a result of excessive optimism or pessimism. Averages count for precious little when the mob is running (in either direction).
One of the reasons given for the US market’s record high is the ‘chase for yield’. Ultra low interest rates are forcing investors to buy income-paying shares.
A PE of 25 equates to a 4% return (a company earning $4M is valued at $100M). Compared to US bond rates, 4% looks attractive and validates a high PE.
However low bond rates do not always equate to high PEs. The following chart from www.ritholtz.com shows US 30 year bond rates back to 1790.
In 1950, the S&P PE bottomed out around 5 times and 30-year bond rates were only slightly above 2%. When confidence is shattered, the adage of ‘It is not the return on your money that counts; it’s the return of your money,’ prevails.
The numbers don’t lie. When moods change the PE multiple changes. The relationship is elastic. Tomorrow, I’ll show you that earnings are not only elastic, they’re pliable too. Stay tuned.
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From the Archives…
Multinationals vs. the Nation State
17-05-13 – Sam Volkering
The Federal Reserve Will Panic and Climb Even Higher
16-05-13 – Bill Bonner
Survival of the Most Capital Efficient
15-05-13 – Dan Denning
New Australian Home Buyers Aren’t Convinced
14-05-13 – Dan Denning
What Happens When Everyone in the World has Zero Interest Rates?
13-05-13 – Dan Denning