Sunday, August 26, 2007

Knowing What Ain't True / Hussman

Once again it is good to have a sober guy like Hussman who is the perfect "anti spin" to the crowd that is using false analyse to spin the markets to "cheap" valuation. So everybody that will use the mantra" Fed Model" is obvioulsy clueless, lying, desperate, drunk ....... ;-) And we will hear this a lot down the road when the Fed is cutting during the next years.

Es ist immer wieder beruhigend die nüchterne Analyse von Leuten wie Hussman zu lesen. Er ist so ziemlich das genaue Gegenteil der sonst üblichen Zunft die in allen nur erdenklichen Wegen diesen Markt als "günstig" erscheinen zu lassen. Allen die also das Argument "Fed Model" benützden um den Markt günstig zu rechnen sind entweder ahnungslos, lügen, verzweifelt, betrunken .....;-) Und da die Fed in den nächsten Jahren etliche Zinssenkungen durchführen wird dürfte das ein Hauptargument der Bullen werden.

Have historically reliable valuation methods become meaningless? Has the underlying relationship between valuations and subsequent market returns broken down?
The potential for historical market relationships to change, and for new methods to outperform existing ones, is a question that constantly drives our research. It's why I've done such extensive studies on discounting models, the Fed Model, interest rate relationships, the effect of buybacks, and so forth. Still, my impression is that investors are easily worried by the possibility that “this time it's different,” and by the belief that normalized P/E ratios and the like haven't “worked” in the past few years. On that issue, it's essential to recognize that valuation is not a short-tem timing tool, but has its primary effect on market returns over periods of 7-10 years and beyond.

As Will Rogers once said, “it ain't what people don't know that hurts ‘em – it's what they do know that ain't true.” The fact is that many “new era” arguments have no provable basis even in the data of the past decade, much less in long-term historical data.

Long-Term Return Projections - The Tale of Two Models

This next brief section should be my last Fed Model piece for a while :)

Consider the two alternative models below. The first presents the 7-year annual return for the S&P 500 implied by the Fed Model. The green line is based on a “normal” 10% annual total return, plus the amount of over/undervaluation implied by the Fed Model, amortized over 7 years. The blue line is the actual 7-year total return of the S&P 500.

Note that the relatively low readings in 1987 and the 1998-2000 period were the only times that the Fed Model would ever have been materially negative, and so are the only times the projected 7-year market return dipped materially below 10%.

Fed Model: Projected 7-Year S&P 500 Total Returns vs. Actual

The above chart does not look materially different if one uses, say, the Treasury bond yield + 3% as the “normal” S&P 500 return, so I chose a constant 10% norm so that all the variation in that green line is driven by Fed Model itself.]

Now consider 7-year projections based on the simple S&P 500 price/peak earnings ratio. Note that the fit is remarkably close, even without adjusting for profit margins (which further improves the fit). Indeed, the only material outliers were the 7-year period (starting in late 1967) that ended with the brutal market lows of late 1974, and a set of 7-year periods from about 1990 to 1996 that ended in the heights of the market bubble. Note also that while the 7-year projection in 2000 was more negative than actual returns have been, those actual market returns have still been in the low single digits since 2000, and then only because valuations returned to present, still rich levels.

Price/Peak Earnings Ratio: Projected 7-Year S&P 500 Total Returns vs. Actual

Currently, the 7-year projection for S&P 500 total returns is about 5% annually.

Look at the enormous swing from extreme undervaluation and high projected returns in the early 1980's to extreme overvaluation and low projected returns by 1998. This is the period during which the Fed Model was constructed. The essential error of the Fed Model is that it is based only on this period, and assigns nearly all the corresponding movement in earnings yields to a “fair value” relationship with 10-year Treasury yields. According to the Fed Model, the market was only slightly undervalued in 1982. That's insane. Again, my passion about this particular fallacy is that it has crept into virtually all of Wall Street's current valuation analysis, though under countless guises, such as “capitalized earnings models ” or “bond-equivalent P/Es” or “forward operating multiples.” Investors will be badly hurt by these notions. ....

With that, I think I'm done with Fed Model studies for a while. I've done my best to warn loudly, I've put the data out there, and have analyzed this thing to pieces. The Fed Model has no theoretical validity as a discounting model, is a statistical artifact, would never have been materially negative except in 1987 and the late 1990's (even in 1929 or 1972), yet views the generational 1982 lows as about "fairly valued," is garbage in data prior to 1980, and vastly underperforms proper discounted cash flow models and normalized P/E ratios. If investors still wish to follow the Fed Model, my conscience is clear, and my hands are clean.

Fed to the Rescue?
As I've noted in recent weeks, the Federal Reserve has been doing exactly what it should be doing – acting to maintain the soundness of the banking system. The Fed's intent here is not to absorb private losses. It is to make sure that banks don't have to contract their loan portfolios because of short-term withdrawals of funds. Though the Fed did open itself to slightly more credit-sensitive collateral, these securities are still investment grade and generally short-term in nature. Again, since these securities are collateral only, the creditworthiness of the underlying mortgages only becomes an issue for the Fed if the banks default on repaying their borrowings to the Fed. At that point, we've got far bigger problems.

It's important to distinguish between Fed actions to maintain liquidity in periods of crisis and Fed actions intended to affect the volume of lending more generally. As I've frequently noted, since reserve requirements were eliminated in the early 1990's on all bank deposits other than checking accounts, there is no longer any material connection between the volume of bank reserves and the volume of lending in the banking system. In normal circumstances, the Fed is simply irrelevant. The issue at present is that there is an unusual spike in the demand for reserves in the banking system. This is exactly the situation in which the Fed does have an important role.

Though the Fed will most probably cut the Fed Funds rate by half a percent, possibly all in the September meeting, or perhaps split between September and October, I don't believe that such an easing has much capacity to eliminate the inevitable default problems ahead in the mortgage market. As Nouriel Roubini has pointed out, there is a major difference between illiquidity (which Fed operations have a good potential to offset) and insolvency (which can be offset only by explicit bailouts at taxpayer expense, as we saw during the S&L crisis). My impression is that most of the worst credit risk is held outside of the banking system, so there is little concern that losses will need to be covered by deposit insurance. A greater share is probably held by investment banks and hedge funds, and my impression is that taxpayers will be hard pressed to allow Congress to use their tax money to finance the bailout of Wall Street financiers, when they've got their own mortgage bills to pay.

As a side note, I'm intrigued that investors have been so willing to lower their guard about credit concerns and the potential for continued blowups, based on nothing but the short-term interventions of the Fed. Most likely, the worst credit risks are being held in the hedge fund world, where reporting is monthly and nobody has to say nothin' until the month is over.

And on the subject of what investors know that ain't true, it's not clear that investors should really be cheering for an environment in which the Fed would be prompted to cut rates because of recession risk. Recall that the '98 cuts were largely due to illiquidity problems from the LTCM crisis, not because of more general economic risks. In contrast (with a nod to Michael Belkin), below are a few instances when the FOMC successively cut the Fed Funds rate in attempts to avoid recession: 2000-2002 and 1981-1982. Those cuts certainly didn't prevent deep market losses. Speculators hoping for a "Bernanke put" to save their assets are likely to discover - too late - that the strike price is way out of the money
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