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July 30, 2002

Rational Pessimism?

Practicing Random Acts Of Logic And Senseless Rationality...Although it should really be no surprise to anyone, it's pretty darn clear that emotion can play a big role in investment decision making on a day to day basis. At times more meaningfully than others. We continue to try reinforcing in ourselves the constant need to remain calm and collected regardless of market circumstances at any one point in time. Whether it feels on any one given day as if the world is coming to an end or conversely that trees really will grow to the sky, we hope to maintain as much control over our personal systolic and diastolic pressure readings as possible. Often easier said than done. More importantly, we hope to be able to distinguish the defining characteristics of emotional stock trading relative to rational or fact based securities pricing. Clearly an acquired skill that is much more of an intuitive art than any type of quantitative science.

To suggest that recent action in the financial markets appears a bit emotional is nothing short of an understatement, both on the equity and fixed income sides of the equation. As you may know, just last week the two year Treasury kissed a yield level that was an historic low. In like manner, recent action in the equity markets, as represented by the S&P 500 in the table below, can be described as a bit out of the ordinary. Here's a little look at the eight worst quarterly experiences for the S&P over the last 50 years (for now, 3Q 02 still remains a question mark as to ultimate outcome):

To flip Greenspan's prior mid decade "irrational exuberance" equity market characterization pondering on its head, are we now watching irrational pessimism? Or is this clever rationality in its current modern day digital format? For now, the answer probably lies somewhere in between. Yes, valuations have been compressed in this so far in process bear market for equities. But in like manner, we just may be nowhere near having experienced the entirety of systemic reconciliation needed to lay the infrastructure for the next secular bull run. As the markets have become obviously driven by greater amounts of emotion at the current time, we need to keep a sharp lookout for historical road markers sunk into concrete near the edge of the asphalt by the generations of travelers before us who have already been down this road and have left their stories for our contemplation.

Flashing Red Warnings, Unseen In The Rain. This Thing Has Turned Into A Runaway Train...Certainly two of the most important markers of the financial path ahead are interest rates and inflation. In terms of equities, nothing short of critical in trying to get a handle on valuation rationality at any point in time. Despite macro and company specific valuation parameters having compressed over the last 2 1/2 years, stocks as a group still sell at valuations that can be considered much nearer historical highs than not. But relative to markers such as very low interest and inflation rates, we need to remain at least open to the idea that stock valuations appear to be falling into the atmosphere of the semi-rational. Low interest and inflation rates have historically supported higher equity valuations that not. Even at cyclical market bottoms. As you know, one of the current arguments of Street strategists far and wide is that the Fed's valuation model suggests equities are undervalued at the moment. A model based on the historical relationship of interest rates and stock prices. Likewise, many a specific dividend discount valuation technique suggests the same. In our mind, the important question in assessing the relationship between equities and interest rates (and implicitly inflation) is whether financial history of the recent past is still a valid guidepost. Or whether what we are living through at the moment in terms of the economy and the financial markets is different than what has been experienced over say the last three to four decades of modern financial history.

Periods of low interest rates and low inflation have historically been supportive of corporate earnings growth and macro economic expansion in the past. There is no question that nominal interest rates as witnessed in the Treasury market today are quite low. The same goes for inflation as measured by the year over year change in both the CPI and the PPI. On face value, it would appear that these two nominal indicators would be supportive of above average equity valuations. But are they at the moment?

As we have mentioned before, the year over year change in the CPI and the PPI at the present have very little precedent anywhere over the recent past. If you believe that the CPI and PPI are suggestive of corporate pricing power in the aggregate at both the consumer and producer levels of the economy, then we live in a period where few corporations can use the lever of price to affect potential changes in macro corporate profitability. Certainly no secret in that cost cutting among corporations has been the modus operandi of P&L reconciliation over the past few years:

Before moving forward, we want to make one quick tangential observation. As you look at the charts above, periods of significant year over year weakness in the CPI and PPI over the last three decades were seen in 1986, 1998 and now. It just so happens that two of these three periods have something very similar in common. 1986 and 1998 were two periods also marked by severe, but temporary, weakness in the price of crude oil (as measured by the price of West Texas Intermediate), Crude ultimately being picked up as a significant input in the CPI and PPI, whether overtly or through the transmission mechanism of intermediate materials costs:

Given that crude today is nowhere near what were the low prices seen during the mid-1980's and latter 1990's, we have to infer that current weakness in both the CPI and the PPI is being driven by something much different than simple commodity price input weakness. Something at least unrelated to crude (which is actually up quite substantially from the most recent lows). Broader pricing power weakness in both the producer and consumer sectors of the economy seems the answer. Pricing power weakness driven by a downward rate of change in final demand and global excess capacity in part partially driven by the preceding credit cycle.

So is currently non-existent inflation and correspondingly low interest rates, to use the Street's current characterization, a true support to equity prices via the interpretation of price discounting models? To attempt to semi-intelligently approach the question, we went back and looked at the relationship between the 10 year Treasury yield and the year over year change in both CPI and PPI. This is what life has looked like over the past three decades:

In our own possibly convoluted manner, we are trying to get a little historical perspective on the cost of corporate capital (interest rates) versus corporate pricing power. By simplistically subtracting the year over year rate of change in CPI and PPI from the 10 year Treasury yield, we get a very rough sense of the real cost of capital to corporate America. (Although corporate debt carries yields higher than like maturity Treasuries, interest rate swaps and other assorted derivatives related vehicles have lowered the actual cost of debt to corporate America in the modern era for now. At least until the derivatives market is stress tested at some point, that is.) As you can see in the above charts, the "real" cost of debt capital is anything but low at the current time. Moreover, during periods of significant corporate profit stress in days gone by, this relationship between the 10 year Treasury yield and the CPI/PPI rate of change has been negative near significant financial market and economic lows. We are currently nowhere near what have been the prior character of these relationships during times of stress. Historically, these were periods where interest rates were very stimulative on a real basis. Periods where it made all the sense in the world for corporate America to borrow. Academically, to achieve a similar relationship in today's world relative to both current year over year change in CPI and PPI, the 10 year Treasury yield would have to fall well below zero. Although it's just a guess mind you, we'd suggest that's not in the cards. Especially if the dollar has anything to say about it.

Although interest rates as measured by the 10 year yield are at one of the lowest nominal readings in decades, this yield level compared to the current annual change in the CPI and the PPI appears onerous set against historical precedent of the past three decades, specifically in similar periods where economic stimulation was a pressing monetary and fiscal matter at hand. These charts and current relationships argue that the "appearance" of low nominal rates of interest and inflation are doing quite little for corporate profitability. In fact, less than quite little, they suggest an uphill battle for improvement in corporate profitability above and beyond current cost cutting measures. Meaningfully, does that also imply that comparing current stock valuations to interest rates and inflation rates is also quite misleading? It certainly suggests as much.

For Those Who Wave Lanterns At Runaway Trains...History has been kind enough to leave us a number of markers in terms of the relationship between interest rates, inflation, corporate profits and the macro economy. But validating the current relationships seen in the charts and discussion above are the reflections we see in the rippling waters of the equity markets of the moment. In questioning the role of the interest rate input in the Fed valuation model or other price discounting techniques, the following table has to at least raise an eyebrow or two at the current time:

We've been updating this table for some time now just to keep ourselves focused on the interplay between interest rates and equity prices. Rather than dragging you through a ton of additional numbers, suffice it to say that nowhere in the last 50 years has monetary accommodation even approaching what we now experience meant so little to equity prices. You remember the chants from Street strategists a little over a year ago. "Never has the Fed lowered interest rates "X" times whereby the market has not been higher "Y" months later". Funny how no one mentions this relationship anymore. Maybe not so funny given the fact that there really is no precedent for this lack of response to interest rate cuts anywhere in the last half century in terms of subsequent stock price recovery. If this doesn't at least suggest that the current valuation marker of interest rates is a bit suspect at the moment in terms of historical accuracy or context, we just don't know what does.

The last table we will leave you with that we hope helps to put into perspective the extremes of current monetary accommodation relative to contemplating appropriate equity valuations is the following:

Although it's much more than a darn good bet that the Fed is not about to raise interest rates any time soon, it is also very telling in terms of the meaning of interest rates to current stock prices that S&P performance since the last rate cut in December of 2001 has been so poor. As you can see in the table above, the only other period of similar monthly longevity between the last rate cut and first rate increase of a new cycle was the 1960-63 period. A period where both interest rates and inflation was quite low. Of all the periods shown above, it was probably the period most similar the the present in terms of the inputs to valuation and dividend discount models (interest and inflation rates). Of course, and at least for now, the striking differential being stock price response. For now, close to a 50% performance dichotomy.

Although both current interest rate and inflation rate levels appear supportive of above average common equity valuation multiples, it's not the face value nominal number relationships that count, but rather the economic and financial market context in which these numbers relate to each other that may be the most important analytical construct of the moment. This is not to suggest that stocks are destined to crash ahead (that's already happened.) For macro equity valuations to support stock price advancement going forward, corporate earnings must grow from here, and not just on the back of cost cutting. Furthermore, at near four decade lows in yields, Treasury prices must remain stable at worst for the valuation models to truly be predictive. Given the US trade imbalance, the over-ownership of US dollars globally, the mounting US Federal deficit, and the continuation of extremely accommodative monetary policy, we'd suggest that there is just as much principal risk in intermediate to longer dated bonds as there may be in stock prices looking down the road.

To suggest that the equity markets of the moment are being irrationally pessimistic just may be akin to Greenspan suggesting investors were becoming irrationally exuberant in 1996. At that time, irrational exuberance hadn't even made a guest appearance relative to what was to unfold post these comments. We'd suggest that the relationship between interest rates, the rate of inflation, and stock prices may be very different at the moment relative to anything seen in the past four to five decades. The exact period cited in most valuation models such as the Fed version. Beware of strategists bearing simplistic valuation comparatives. Nothing is ever too easy on Wall Street...at least not for very long.

The End Of Ewe-Phoria?...As you will remember us conceptually beating to death in the past, we are avowed adherents to the constant of non-linearity on Wall Street. Almost nothing ever happens in a straight line. The near 30% pounding the S&P has taken since April 1st is a pretty dramatic example of vertical acceleration to the downside. A somewhat slow motion crash, if you will. We would not be surprised at all to see some backing and filling in terms of upside potential. And maybe some rather violent backing and filling over short periods of time. Especially in a world where program and hedge based trading makes up a pretty significant slice of daily volume.

However, what we strongly suggest monitoring ahead are the actions of equity mutual fund holders. Although we never want to extrapolate short term trends too far out in time, what we have witnessed over the last 10 weeks is nothing short of precedent setting within the context of the "new era". During the last ten weeks (for the period ended 7/24), $75 billion in domestic equity fund exposure has been extracted by fund owners. Since the averages topped in early 2000, there has never been this type of a consistent ten week period of outflows, to say nothing of the dollar magnitude involved. On the back of an envelope, we calculate this withdrawal as being on a percentage basis just a hair shy of the amount that was withdrawn from the domestic equity mutual fund complex in the period directly subsequent to the 1987 debacle. Fear has certainly been called up from the bullpen and is now warming up on the pitchers mound.

Very often, the public has been notoriously wrong at market turning points. As a matter of relatively general characterization over the last 2 1/2 years, equity mutual fund holders have consistently sold after the market has already gone down and consistently purchased after a recovery. But, given that cash as a percentage of equity fund assets was running near 5% a month or so back, the forward actions of equity fund holders is becoming a bit critical in terms of the possibility for more forced selling. In addition to this short term cash withdrawal rate, this is the first year where total year to date flows into domestic equity mutual funds are actually negative this far into the year:

Do you think the public ewe-phoria regarding stocks is dying down? N-a-a-a-a, n-a-a-a-a, can't be. Can it?

Distinguishing the Forest From The Trees...Certainly one of the most cited graphic examples of this bear market in equities is the long term S&P chart. Surely at this point no one is unaware of the massive and technically classic head and shoulders pattern this index has traced out. Simple, elegant and straightforward in its message. For now, this equity bear market has taken back the three and one half years of gains prior to the top. When looking at mega bears such as the 1929 experience, that is pocket change. The 1929 bear wiped out 15 years of prior bull market experience. We're not about to suggest that the equity markets are headed to levels seen in 1985. In fact we'd be shocked if that happened. In like manner, a trip back to the neckline of the H&S formation could easily be a 12+% experience from here. There is a lot of pessimism out there at the moment. The media is virtually fully engaged. A move to the neckline or a bit above would be minor in the greater scheme of things. Technically, we expect something like this to happen and maybe in the not too distant future.

Nonetheless, we'd simply suggest that from a macro standpoint, this bear market is intact until the head and shoulders top is ultimately violated to the upside. Simple enough?

Market Observations
ContraryInvestor.com

Contrary Investor is written, edited and published by a very small group of "real world" institutional buy-side portfolio managers and analysts with, at minimum, 20 years of individual Street experience. Our credentials include CFA, CPA and CFP, as well as the obligatory MBAs in Finance. We are all either partners or employees of institutions with at least $1 billion under management.

Contrary Investor is our vehicle for providing what we believe is institutional quality financial market research, analysis and commentary that is characterized by honesty, integrity and credibility. We live the business and hope to bring what we learn from our daily experiences to our work at Contrary Investor. Having checked our egos at the door many moons ago, we hope to allow our work to stand on its own and speak for itself, without the personal promotion of any one individual getting in the way. No investment guru's here. Just lifelong students of and participants in an ever-changing financial marketplace.

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