“Unintended Consequences”: Principles of Circular Valuation #4

The market is (or has been) up.  So are earnings.  For a few days, at least, the S&P blew past apparent resistance at 1220.  Forward looking earnings are now projected to rise by roughly 6% this year and another 10% next year.  Great news, right?  Proof that QE2, or the market’s perception of it, will help to boost asset values?


Think again.  But, first, let’s consider the two opposing points of view on the subject.

First, the relatively mainstream view, as cogently detailed by Steve Hasset at Seeking Alpha, suggests that rising corporate earnings should easily support much higher prices.  Hasset’s own “RPF” (or risk premium factor) model tells him that TTM S&P earnings of $78.80 should support valuations in the range of 1434, reflecting a P/E ratio of 18.2.  From Friday’s close, that would suggest a run-up of 20% in the offing.

(For the mathematically inclined, download Hasset’s detailed paper on the RPF Model here.)

One measure of the relative reasonableness of Hasset’s efforts may be derived from consideration of Robert Shillers well regarded P/E-10 or CAPE (Cyclically Adjusted Price Earnings Ratio) analysis.  (More from Shiller.)  As discussed in this series of articles at AdvisorAnalyst.com, the ten year rolling average P/E of 21.4 remains well above the longer-term (since 1880) average of 16.4.  This would indicate that, while the market has “returned to” valuations near the mean, it has not, in fact. “reverted to” the mean.   (By the way, see a pretty good critique of Shiller’s methodology here, and another here.)

As a professional market modeler, I have to admire the RPF Model; it’s elegant and appears to be practical.  As Hasset demonstrates, this one provides R Squared reliability of 90% for predicting P/E ratios back to 1960.  For the record, that’s far better than Shiller’s produces.  But, like all models, the RPF Model is greatly dependent on it’s input assumptions. 

This too:  I’ll bet that digging into the data a little deeper will demonstrate that that R Squared value declines significantly (and the predictive error climbs dramatically) over the past ten years or so of the market’s history.  While some of that may have something to do with inaccurate earnings expectations, I would assert that a larger problem results from the Fed’s manipulation of one of the model’s primary inputs:  interest rates.

The above noted article closes with this caveat:  “Note: While the market has returned to the levels suggest by the model in the past, it is not always by price adjustments. This could mean that earnings are set to fall or interest rates rise or that the model is wrong or the factors need to be recalibrated. 

Well, there you go.  As Shiller himself states in the video interview included in the above-cited article, “It’s certainly true that the market’s earnings have been exceptionally volatile recently…” and, then,  “The other thought is, okay, long term interest rates are very low now, so that would seem to say, the stock market is very high, and also commodities and everything else should be high. There’s some truth to that, but the other question is, how reliably are those long term rates going to stay low?

That’s exactly right.  And, perhaps, the central point here is that, even with growing evidence of rising earnings, nobody has the slightest clue where interest rates are going.  “Up”, that would best describe the concensus – an easy call from the rock-bottom of the spectrum.  But opinions on the magnitude of “up”, well, podna, that’s a whole other can-o-worms.

As addressed in the prior posts in this series, when virtually every income-producing asset class in the world is valued on a basis relative to 10-Year US Treasury yields and everybody acknowledges that these rates have been and continue to be overtly manipulated by the good, caring, omiscient brainiacs of the Federal Reserve, well, don’t you have to recognize a bit of a circular reference conundrum?  Don’t you? 

Well, yes you do.  Shiller’s data and analysis, for all it’s short-comings, is replete with examples of just this simple fact:  Just as “water seeks it’s own level”, so too does money, notably via “real returns”.  Today, after two decades of willing ignorance, the world is beginning to realize that US Treasuries pay real yields that are far lower than have been commonly believed. 

Today, those rates are, in actual fact, negative.  That was before QE2.  Since QE2, still more cracks are developing in the dike as noted in the Wall Street Journal, here and here.  As both articles attest, QE2, like those before it, is designed to suppress interest rates and, now, appear to be having the exact opposite effect. 

And, for the record, the Fed wants low interest rates….even negative rates, not simply to keep the housing market afloat per se, but so that all of the assets in the world will maintain their air pressure.  In the stock market, the P/E ratio (which is simply an inverse yield rate) has to come down as interest rates go up.

And, rates are going up.  They may go up quite a lot by the time this plays out.  Monetizing the debt, an option that the Greeks still don’t have, doesn’t effectively change the equation.  A “soft default” of the sort the printing press provides is, in the end, still a default by another name. 

Rates are going up, as they must, in order to provide the “incredible shrinking dollar” a real rate of return. 

Rates are going up, if only as a function of the market’s growing realization that the only viable buyer of bonds is the guy with the printing press.

Rates are going up, enough so to completely erase the effects of QEX.  How high is that?  Well, we’re not done with the QE process yet, now are we?

Harry Tuttle





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