Market Overview -- 3/23/98 Update
*Graham and Doddsville Revisited* -- "The Intelligent Investor in the
21st Century" (3/23/98)
"The underlying principles of sound investment should not alter from
decade to decade, but the application of these principles must be
adapted to significant changes in the financial mechanisms and
climate." (Benjamin Graham)
Market Overview
The Dow keeps rising while earnings estimates keep falling. Not good.
With the trailing p/e on the S&P 500 at 27.6, the Market is obviously
priced for perfection. But, falling earnings, while better than
outright losses, nevertheless are less than perfection.
A colleague of the ursine persuasion constantly reminds us that
perceived perfection has always been a temporary state of affairs, if
not, in retrospect, an outright illusion. But, history also shows
that prices can remain above the historical mean for a long time.
Typically, the relation between the earnings on equity and the
interest on bonds shifts markedly in favor of the latter before stock
prices cave in. In other words, usually either earnings must fall,
interest rates must rise, or both must happen, before a Bull Market
comes to an end.
Interest Rates Not Likely To Rise
The situation in Asia seems determinative at the moment. A general
rise in interest rates can come from only 3 sources: 1) a perceived
rise in inflation; 2) an increased demand for borrowed money to
finance investment or consumption; or 3) a perceived rise in default
risk.
Conditions in Asia make the first two highly unlikely. In fact,
falling prices and belt tightening in Asia, in combination with a
disappearing Federal budget deficit, are preventing the Federal
Reserve from raising interest rates at the short end. For similar
reasons, the Market won't soon be demanding higher rates at the
intermediate or long ends.
And, there would be no point in East Asian countries' cashing in U.S.
Treasury Bonds, which would cause a rise in U.S. interest rates. Such
a move would send the dollar plunging, and, a strong dollar is
essential for them to work off the overcapacity in their export
industries.
The third possible source of rising interest rates, default risk, also
favors lower U.S. interest rates. The is because the more risky that
investments appear elsewhere, the more attractive U.S. debt (and
equity) becomes by comparison, thereby bidding the market price of
U.S. bonds up -- and their effective interest rates down.
Earnings Not Great; But Not That Bad Either
On the earnings front, the slowdown in East Asia, until recently the
world's fastest growing consumer market, is not good news in itself.
But, it is not generally appreciated how much greater are Canada,
Latin America, and Europe as markets for the direct exports of , and
therefore profits of, U.S. companies. Much of the business activity
of U.S. companies in Asia is still a matter of buying cheap raw
materials and cheap labor -- which now are cheaper than before in
dollar terms.
Much of the selling done by U.S. companies in these countries is done
in local currencies. Therefore the increasing value of the dollar
will not hurt local-currency denominated sales, though obviously
decreased local demand will cause some bottom line pain.
Earnings = Revenues - (Capital + Raw Materials + Labor)
There are basically 3 charges against revenues that determine net
earnings: the costs of capital, raw materials, and (most importantly)
labor.
As to the first factor, declining interest rates reduce the cost of
borrowing to finance consumption and investment. Both increased
consumption and lower cost of capital are favorable for earnings.
As for raw materials, those who have spent the past decade or so
hoping that demand for raw materials would outstrip supply in a
growing world economy -- sending commodities and raw materials prices
soaring -- our view remains: No way.
There are staggering quantities of oil and gas in much of Western
Asia. Political instability has always been a problem in extracting
it, and will remain so for the foreseeable future. But, the historic
barriers of anti-growth economic policies are being rapidly
dismantled. One way or another, even Iraq will eventually "play ball"
in order to bring their oil to market.
And, Western Asia isn't the only region of the world that is rich in
petrochemicals. There are huge quantities of oil and gas throughout
much of offshore Southeast Asia and the Gulf of Mexico. As demand for
petrochemicals rises, political, environmental, and technological
obstacles to its extraction have a way of receding.
Saudi Arabia and Venezuela have just inked an agreement to limit
production by 2 to 3 million barrels per day, effecting a spike in
spot prices for oil today. This is the same-old same-old. Iraq is
likely to soon come to market with almost a million barrels a day.
Iran is making plans for life-after-embargo. And, the Caspian Sea oil
comes online before the year is out. At the bottom line, "cheaters"
will continue to be rewarded with higher revenues and market share.
Their only disincentive to cheating is Saudi Arabia's standing threat
to unilaterally flood the Market with their own output -- a threat as
hollow now as ever.
And, precious metals are becoming increasingly unprecious.
Just this past week, Belgium announced it had sold off half of its
gold reserves. Countries are increasingly realizing that economic
efficiency, not treasure troves of precious metals, are the truest
measure of "The Wealth of Nations", as Adam Smith first argued more
than 200 years ago.
Hence, the guarantors of a growing national economy with a stable
currency are high profit margins and return on equity, not profitless
exports and a vault filled with someone else's currency or bonds.
This is a lesson in Economics 101 that East Asian countries are
finally having to confront.
And, the cost of electrical power and telco service, both in a sense
raw materials, are falling as deregulation proceeds.
Labor Cost Is The Big Question Mark
Of course, the most important cost components that impact earnings are
wages and benefits. These account for perhaps as much as 2/3 of a
company's before-tax expenses.
With U.S. labor force participation already at record levels for
peacetime, it is hard to believe that employers won't eventually have
to raise wages and benefits faster than workers can raise output
(i.e., faster than rises in labor productivity), thus squeezing profit
margins and causing inflation to accelerate. The latter would cause
the Fed to tighten in a heartbeat, at the same time that profit
margins, and therefore earnings, would be shrinking. A similar
scenario preceded the two-month Bear Market of 1987.
But, it is also hard to believe productivity gains in the 1990's have
been as anemic as government statistics report. For example, after a
decade of massive layoffs at Fortune 500 companies, both unit volume
and dollar volume of output are up greatly.
Further, there is no consensus on how best to measure qualitative
improvements in manufactured goods, much less in the increasingly
important services sector. Suffice it to say, government statistics do
not adequately measure quality improvements in either automobiles or
medical care, to pick two examples, although no one has yet come up
with an alternative on which there is widespread agreement.
Nevertheless, many of the workers newly entering the labor market are
not the most efficient workers in the population. And as the pool of
unemployed adults shrinks, management must pay higher wages for
workers of declining efficiency, to induce them to give up whatever
they have been doing, and enter the work force instead. As the
process continues, labor will eventually command a higher proportion
of corporate revenues, leaving less left over for shareholders.
But, as with shrinking earnings yields on stocks, the fact that
unemployment cannot forever shrink without squeezing profits and
igniting inflation is not the same as knowing at what point this will
occur. And, as with shrinking earnings yields on stocks, the
pessimism in the short term over the effects of shrinking unemployment
has proven unwarranted for several years running.
And, here again, East Asia's misfortune may rescue the Bull Market
from wage pressures on earnings, at least for the time being. A flood
of cheaper imports from countries desperate to export their way out of
debt puts price pressure on domestic U.S. companies. But, it also
makes it harder for the Fed to argue that prices are about to resume
rising, and it takes some of the hiring pressure off of the domestic
labor market. Rising imports of goods, in effect, imports cheaper
foreign labor (a point not lost on opponents of free trade).
The Chairman Of The Board
Given the source of inspiration for our attempts at financial
analysis, we cannot leave this subject without quoting the "Sage of
Omaha" (which city he now calls the "cradle of capitalism").
In his Letter to Shareholders in Berkshire Hathaway's latest Annual
Report, CEO Warren Buffett writes:
"Though we don't attempt to predict the movements of the stock market,
we do try, in a very rough way, to value it. At the annual meeting
last year, with the Dow at 7,071 and long-term Treasury yields at
6.89%, Charlie and I stated that we did not consider the market
overvalued if 1) interest rates remained where they were or fell, and
2) American business continued to earn the remarkable returns on
equity that it had recently recorded. So far, interest rates have
fallen -- that's one requisite satisfied -- and returns on equity
still remain exceptionally high. If they stay there -- and if
interest rates hold near recent levels -- there is no reason to think
of stocks as generally overvalued. On the other hand, returns on
equity are not a sure thing to remain at, or even near, their present
levels.
"....Corporate America is now earning far more money than it was just
a few years ago, and in the presence of lower interest rates, every
dollar of earnings becomes more valuable. Today's price levels,
though, have materially eroded the 'margin of safety' that Ben Graham
identified as the cornerstone of intelligent investing."
[It goes without saying that Buffett's letters to Berkshire
shareholders are required reading for serious Value Investors. The
complete text of this year's letter may be found at:
berkshirehathaway.com]
We feel Buffett's appraisal is not inconsistent with our view, now
more than a year old, that "the Market is mildly, but not wildly,
overvalued." Our concern, however, is not with the present Market
viewed as a snapshot. Rather, we are concerned with the moving
picture. A year ago we were worried that momentum would carry prices
well past rational valuations, with an inevitable and sharp pullback
to follow. At that time we hoped that a pause in the action would
occur, though we did not foresee what the source might be. Then in
August, the financial meltdown in East Asia arrested the U.S. Market
at a sustainable level.
Now, the Bull has resumed its forward charge at a pace that earnings
growth cannot possibly match. The one hope is that interest rates
will fall enough to make up the difference between the advance in
stock prices and declining earnings growth. Labor market tightness
notwithstanding, this is not impossible, given collapsing commodities
prices, a balanced Federal budget, and pressures to ease Asia's burden
of repaying their dollar-denominated debt, as a reward for carrying
out promised structural reforms.
But, as the Chairman of the Board has put it, the margin of safety has
"materially eroded". For the past three years, throwing "darts at the
charts" (which is what Indexing amounts to) has been richly rewarding.
We predict, without hesitation, that this "Nifty 500" will not do as
well in the coming three years.
If we knew how to time the top of the Bull's advance, and could move
from equities into bonds, thence back into equities after the stock
pullback had reached its bottom, we would be typing this on a laptop
on the deck of a yacht in the Mediterranean.
But, we don't; so we aren't.
Summary
1. In the long run, the risk-adjusted earnings on stocks must exceed
the interest on bonds for stock prices to rise. Therefore, the
current Bull Market is sustainable only for as long as the rise in
earnings and/or the fall in interest rates equals or exceeds the rise
in stock prices.
2. At this time, the factors putting pressure on earnings -- wage
increases and falling demand in East Asia -- appear to be in
approximate equilibrium with the factors pushing down interest rates
-- lack of inflation and the "safe haven" status of U.S. bonds.
Therefore, current Market levels are more or less justified. But,
another doubling of prices in the coming 3 years is not in the cards.
3. A gradual change in the relation between earnings and interest
rates that is adverse to stock prices will be reflected in a gradual
downward readjustment of these prices.
4. A sudden shock relative to earnings and/or interest rates will
likewise be accompanied by a sudden shock to stock prices.
5. We do not know, and do not know how anyone could know, whether the
near term future will be more like 2, 3, or 4.
Thus, our advice remains what it has been for the past 3 years.
Either:
1. Index in an S&P 500 vehicle, and take satisfaction in the
knowledge that future returns, though less than those of the recent
past, will still be far greater than those of most professionals; or
2. Concentrate in a handful of stocks carefully selected according to
Value Investing criteria.
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Graham and Doddsville Revisited
Editor: Reynolds Russell, Registered Investment Advisor
Web Site Development/Design: ariana <brla@earthlink.net>
Consultants: Axel Gunderson, Wayne Crimi, Bernard F. O'Rourke,
Allen Wolovsky
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"There are no sure and easy paths to riches in Wall Street
or anywhere else." (Benjamin Graham)
(C) Reynolds Russell 1998. |
