ColinTwiggs, Author at the patient investor

March 27, 2014

Is the S&P 500 overvalued?

The daily press appears convinced the S&P 500 is overvalued and due for a crash. Yet the macro-economic and volatility filters that we use at Porter Capital and Research & Investment — to identify market risk so that we can move to cash when risks are elevated — show no signs of stress. So I have been delving into some of the aggregate index data, kindly provided by Standard and Poors, to see whether some of their arguments hold water.

The Price-Earnings ratio for the S&P 500 itself is not excessive when compared to the last decade.

The bears argue, however, that earnings are unsustainable. One reason advanced for this is that earnings growth has outstripped sales, with corporations focusing on the bottom line rather than business growth.

Faced with weak domestic demand, large US corporates have actively sought to manage their expenses so as to meet and exceed the market’s expectations. Combined with the unwinding of provisions taken in the GFC, cost management has allowed US corporates to achieve a 124% increase in 12-month trailing earnings off the back of a 25% increase in 12-month trailing sales since October 2009.
~ Elliott Clarke, Westpac

That may be so, but any profit increase would look massive if compared to earnings in 2009. When we plot earnings against sales (per share), it tells a different story. Earnings as a percentage of sales is in the same band (7% – 9%) as 2003 to 2006. A rise above 9% would suggest that earnings may not be sustainable, but not if they continue in their current range.

The second reason advanced is that business investment is falling. Westpac put up a chart that shows US equipment investment growth is close to zero. But we also need to consider that accelerated tax write-offs led to a surge in investment in 2009/2010. The accelerated write-offs expired, but the level of investment merely stopped growing and has not fallen as I had expected.

Private (non-residential) fixed investment as a whole is rising as a percentage of GDP, not falling.

Lastly, when we compare the S&P 500 to underlying net asset value per share, it shows how frothy the market was before the Dotcom crash, with the index trading at 5 times book value. That kind of premium is clearly unsustainable without double-digit GDP growth, which was never going to happen. But the current ratio of below 2.50 is modest compared to the past decade and quite sustainable.

I am not saying that everything is rosy — it never is — but if sales and earnings continue to grow apace, and with private fixed investment rising, the current price-earnings ratio does not look excessive.

March 26, 2014

Depleting Putin’s war chest

From Quartz:

The “First Law of Petropolitics,” coined by New York Times columnist Tom Friedman… states that when oil prices are high, the leaders of petro-states can become demanding and belligerent; when they are low, they are more prone to be pussycats.

Oil prices at elevated levels explain Russian belligerence. The graph below shows Brent Crude prices adjusted by the (US) consumer price index to reflect growth in real crude prices over the last decade. To bring crude prices down to pre-2005 levels will be no small feat.

Real Crude Oil Prices

March 25, 2014

China rebound boosts ASX

China’s Shanghai Composite Index found strong support at 1990/2000. Breakout above 2080 would suggest a rally to 2150. Rising 21-day Twiggs Money Flow indicates medium-term buying pressure. Breach of 1990 is now unlikely, but would warn of a decline to 1850.

Shanghai Composite Index

* Target calculation: 2000 – ( 2150 – 2000 ) = 1850

The ASX 200 responded with buying support, signaled by two long tails, at 5290. Recovery above 5380 would suggest another advance (confirmed by breakout above 5460), while failure of 5290 would signal continuation of the correction towards primary support at 5050.

ASX 200

* Target calculation: 5400 + ( 5400 – 5000 ) = 5800

ASX 200 VIX below 13 indicates low market risk.

March 25, 2014

Europe under pressure

Bearish (Twiggs Momentum) divergence on Dow Jones Euro Stoxx 50 suggests that a top is forming. Breach of support at 2950 or reversal of 13-week Twiggs Momentum below zero would signal a primary down-trend. Recovery above 3100, however, would suggest another advance and follow-through above 3180 would confirm.

Dow Jones Euro Stoxx 50

* Target calculation: 3150 + ( 3150 – 2950 ) = 3350

Germany’s DAX respected primary support at 9000, but may be headed for a second test. Bearish divergence on 13-week Twiggs Money Flow continues to warn of medium-term selling pressure. Breach of support would signal a primary down-trend.

DAX

A DAX Volatility rise above 20 would signal moderate risk.

DAX

The Footsie is at short-term support at 6500. Failure is likely, and would test the primary level at 6400. Declining 21-day Twiggs Money Flow below zero indicates medium-term selling pressure.

FTSE 100

* Target calculation: 6800 + ( 6800 – 6400 ) = 7200

March 25, 2014

TSX 60 at 2011 high

Canada’s TSX 60 is testing resistance at 820 on the monthly chart. Sharp divergence on 13-week Twiggs Money Flow warns of medium-term selling pressure. Reversal below 814 would indicate a correction, while follow-through above 826 would signal an advance to 850*.

TSX 60

* Target calculation: 810 + ( 810 – 770 ) = 850

March 25, 2014

Fedex bellwether

Bellwether Transport stock Fedex is headed for another test of primary support at $129/$130 on the monthly chart. Recovery above $145 would offer a target of $170*, but breach of support would warn of a primary down-trend — suggesting a broad economic slow-down. Breach of the (secondary) rising trendline, and support at $120, would strengthen the signal.

Fedex

* Target calculation: 145 + ( 145 – 120 ) = 170

March 25, 2014

S&P 500 correction threat

The S&P 500 continues to threaten a correction. Bearish divergence on 21-day Twiggs Money Flow indicates medium-term selling pressure. Breach of support at 1840 would confirm a correction, while recovery above 1880 would signal an advance to 1950*.

S&P 500

* Target calculation: 1850 + ( 1850 – 1750 ) = 1950

CBOE Volatility Index (VIX) at 15, however, suggests low market risk.

VIX Index

March 24, 2014

Stability is destabilising – Hyman Minsky

A pretty clear explanation of Hyman Minsky’s key ideas:

Most macroeconomists work with equilibrium models which assume the economy is fundamentally stable and that booms or crises are precipitated by external shocks “whether that be a rise in oil prices, a war or the invention of the internet”.

Minsky disagreed. He thought that the system itself could generate shocks through its own internal dynamics. He believed that during periods of economic stability, banks, firms and other economic agents become complacent.

They assume that the good times will keep on going and begin to take ever greater risks in pursuit of profit. So the seeds of the next crisis are sown in the good time.

March 23, 2014

Australia’s housing affordability crisis

This private submission by Michael Dromgool to Australia’s Housing Affordability Inquiry identifies supply restrictions as the key cause of the current housing affordability crisis:

Traditionally the flexible forces of demand and supply in the property market self-managed the development of land for housing. Development occurred in locations where and when demand was sufficient to warrant it, with a process that was responsive to demand.

…Now fast-forward to the present day. The government has shut off the supply of land on the city fringe to limit the city to its present size, abolishing a free market system in favour of a centrally-directed scheme that severely distorts the property market…..Smart growth is a deliberate policy to make land more expensive, to increase the city’s population density and force more people into apartments, not the detached houses that most people actually prefer to live in….

Economists and politicians in Australia confidently attribute the decline in housing affordability to strong demand driven by economic and population growth, conveniently neglecting the supply side of the equation…..

Many cities in the United States, such as Atlanta, still use responsive planning. In 1981 more people lived in Melbourne than Atlanta and in both cities the median house cost less than three years of median income in that city to purchase. Over 30 years demand from economic and population growth in Atlanta was stronger than Melbourne, it grew much faster and Atlanta’s population was nearly 50% greater than Melbourne’s by 2011 and the median house price there was $129,400, 2.3 times the median income of $55,800. Yet in Melbourne the median house price reached $565,000, nine times the median income of $63,100. The government tries to convince us that houses are expensive due to high demand, yet they are actually cheaper in a city where demand is substantially stronger. The state government of Georgia drew no arbitrary boundary around the city of Atlanta and consequently it expanded outwards onto greenfield land. In Australian cities, homes are expensive because the land is expensive.

March 23, 2014

George F. Kennan’s Prediction On NATO Expansion Was Right

Interesting argument against further expansion of NATO on Moon of Alabama:

George Kennan was the U.S. diplomat and Russia specialist who developed the cold war strategy of containment of the Soviet Union, though he later criticized its militaristic implementation. In 1998, when the Senate voted to extend NATO to include Poland, Hungary and the Czech Republic, Kennan was asked to comment. He responded:

“I think it is the beginning of a new cold war,” said Mr. Kennan from his Princeton home. “I think the Russians will gradually react quite adversely and it will affect their policies. I think it is a tragic mistake. There was no reason for this whatsoever.”

…..”It shows so little understanding of Russian history and Soviet history. Of course there is going to be a bad reaction from Russia, and then [the NATO expanders] will say that we always told you that is how the Russians are — but this is just wrong.”

Read a full report of the 1998 interview with George Kennan at NY Times: Foreign Affairs | Thomas L Friedman.