Finance Matters

Archive for April 10th, 2010

So, how do stock values look now that the DOW is back to 11,000?

Not outrageous.  But certainly not cheap.

Measured using our favorite valuation technique, Professor Shiller’s cyclically adjusted PE analysis, the S&P 500 has a PE of 22X.  The long-term average (1880-2010) is about 16X.  The current level is actually close to the big bull market peaks of the past–with the exception of the gigantic one that peaked in 2000.

Check out the chart below, from Professor Shiller’s web site.  The blue line is the cyclically adjusted PE ratio for the last 130 years.  (The cyclically adjusted PE mutes the impact of the business cycle by averaging 10 years worth of earnings.  This reduces the misleadingly low PEs you get at peak profit margins, like the ones in 2007, and the misleadingly high ones at trough profit margins, such as the ones we had last year).

Note a few things:

• The long-term average for the cyclically adjusted PE is about 16X. 
• Stocks have spent vast periods above the average and vast periods below it, usually in multi-decade cycles
• We’ve just descended from the longest period of extreme overvaluation in history, suggesting (to us, anyway) that the next multi-decade cycle is likely to be below average
• At today’s level, 1200 on the S&P, stocks are trading at a 22X CAPE, about 30% above the long-term average

Now, you can also unfortunately see from the chart that valuation doesn’t tell you anything about what will happen next.  As the blue line shows, stocks can get a great deal MORE overvalued than they are today.  And they can stay even more overvalued for a decade or more.

But what the apparent overvaluation does tell you–or, at least, has told you in the past–is that your future long-term returns will likely be below average.  There’s a strong correlation between starting valuations and ending returns (high valuations lead to low returns and low valuations lead to high returns).  And today’s valuations can now be described as “high.”  (Not extreme, but high.)

Yes, you can argue that “it’s different this time.” You can argue that, since stocks have traded at an average CAPE of more than 20X for the past two decades, we’re in a new normal.  And you might be right.  But they don’t call “it’s different this time” the “four most expensive words in the English language” for nothing.

You can also argue that “interest rates are low, so P/Es should be high.”  That argument is in vogue right now, because there’s been an inverse correlation between P/Es and interest rates for the last couple of decades.

But take a look at the RED line in Professor Shiller’s chart.  The red line is interest rates.  As you can see, if you go back more than a couple of decades, there’s not much correlation.  (In fact, as the great UK economist Andrew Smithers has observed, there’s none.)

Again, Prof. Shiller’s chart doesn’t tell us what stocks are going to do in the near term.  As owners of index funds, what we’d like stocks to do is what they have been doing, which is keep going up.  We’re not expecting we’re going to get excellent long-term returns from this level, though.  And we’re really worried about that housing double-dip.

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If you’re living in San Francisco and working in a hot Valley startup or tech company, you probably have a bit of a commute. If you’re living in NYC and working in a hot startup in the area, not so much. Most tech companies in New York are in the city itself.

For the entertainment and edification of my northeastern readers, I’ve created a map that superimposes Valley companies on New York and Connecticut, assuming identical driving times and distance from commuter rail (Caltrain in the Valley and Metro North’s New Haven line in New York).

To make this more explicit, here are exactly where our Silicon Valley darlings would find themselves [assuming Manhattan were San Francisco]:

Adobe: Noroton Heights, Connecticut

Sun Microsystems: north side of Stamford, Connecticut

Apple: North Mianus, Connecticut

Google: North Greenwich, Connecticut

YCombinator: Greenwich, Connecticut

Facebook: Greenwich, Connecticut

Electronic Arts: between Mamaroneck and Eastchester, New York

Oracle: between Mamaroneck and Eastchester, New York

Wikia: Pelham Manor, New York

YouTube: Soundview, Bronx, New York

Zynga: Harlem, Manhattan, New York

Electronic Arts: between Mamaroneck and Eastchester, New York

Oracle: between Mamaroneck and Eastchester, New York

Wikia: Pelham Manor, New York

YouTube: Soundview, Bronx, New York

Zynga: Harlem, Manhattan, New York

This post is reprinted from Brad Hargreaves’ blog: Startup Adventures In NYC.

Read more posts on Startup Adventures In NYC »

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From Professor Hamilton at Econbrowser: Do rising oil prices threaten the economic recovery?

Ten of the 11 recessions in the United States since World War II have been preceded by a sharp increase in the price of crude petroleum. Oil had been holding around $80/barrel over the last month, but traded as high as $87 last week, leading the Financial Times to ask whether oil could give the “kiss of death to recovery.” Here is how I would answer that question.

See Hamilton’s post for his analysis with several graphs. He concludes:

$87 oil is certainly not helping the recovery. But I would be very surprised if it proves to be the kiss of death.

And with the opposite view from the Financial Times article:

Olivier Jakob, of Swiss consultant Petromatrix, said in a note that the “recovery of 2009 was fuelled with crude oil at $62 a barrel, not at $90 a barrel or $100 a barrel. We fear that the latest run on WTI will be the kiss of death for a global economy that was trying to avoid the possibility of a double-dip recession.”

I tend to agree with Dr. Hamilton. However I also watch vehicle miles driven from the Department of Transportation (DOT), and the DOT recently reported that vehicle miles driven in January were down from January 2009:

Travel on all roads and streets changed by -1.6% (-3.7 billion vehicle miles) for January 2010 as compared with January 2009. Travel for the month is estimated to be 222.8 billion vehicle miles.

Here is a repeat of the graph I posted last month:

Click on graph for larger image in new window.

This graph shows the percent change from the same month of the previous year as reported by the DOT.

As the DOT noted, miles driven in January 2010 were down -1.6% compared to January 2009, and miles driven have declined 2.9% compared to January 2008, and are down 4.7% compared to January 2007.

If miles driven continues to decline, I’ll be more concerned about oil prices.

 

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This post is reprinted from Calculated Risk.

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The tragic plane crash that killed Polish President Kaczyński along with nearly 100 of his fellow countrymen is so far being blamed on some combination of weather, pilot error, and technical failure of the plane.

That out the last explanation seems sadly believable.

Reuters has a factbox about the Russian-made Tupolev Tu-154, first developed in 1960.

* Russian airline safety hit rock bottom during the economic chaos of the early 1990s when there were at least 10 fatal crashes involving the Tu-154.

* Two of the worst crashes in the last 30 years involved the Tu-154 in the 1980s – one in 1984 when an Aeroflot Tu-154 collided with two airport service vehicles while landing at Omsk, Russia, killing around 174 people, and one in July 1985 when an Aeroflot Tu-154 crashed in Uzbekistan killing 200.

* There have been three deadly crashes of a Tu-154 in Iran since 2002, the last one in July last year killed 168 people. Iran said in February it was planning to stop using the planes.

So why was Poland still flying its President and so many other dignitaries in the plane?

Sadly, it appears the decision to keep flying the Tu-154 was in part a financial decision.

With all of Europe in austerity mode, to some extent or another, getting a new plane was seen as an unaffordable indulgence.

Instead, Poland recently had it refurbished.

The BBC reports:

[In] late 2008 Mr Kaczynski had suffered a couple of scares. Problems with the aircraft’s steering mechanism delayed his departure from Mongolia, forcing him to take a charter flight to Tokyo, and a week later the plane was caught up in turbulence flying to Seoul.

However, the aircraft had recently undergone a major overhaul and Aleksey Gusev, the head of the maintenance plant that carried out the work, told Polish TV that it should not have had technical problems.

“From the moment it entered service, the plane had had 5,004 flight hours and 1,823 landings, which for aircraft of this class is not a lot,” he said.

“The plane was flying quite well and there were no complaints.”

The overhaul was completed in December and included repairing the plane’s three engines. The next major service was due in six years.,

Obviously we’ll learn a lot more over the coming days and weeks, and again, the weather was apparently very bad, and based on some reports the pilots didn’t follow the exact instructions of air-traffic control. But there are other reports of gas leaks, and in fact a technical aspect is shown, drawing a line between the crash and the Polish budget should not be difficult.

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The global manufacturing index, put together by JPMorgan, hit a new cyclical high in March which we discussed here.

This is great news for the global economy as it represents rapidly expanding manufacturing activity.

Thing is, Goldman Sachs’ wonders whether the rebound could lose some steam going forward, given that much of the recent momentum was driven by companies rebuilding their inventories from what turned out to be overly cautious levels.

Goldman (Global Markets Daily, April 6th, 2010):

Meanwhile, the momentum in the advanced economies was very strong in March as PMIs generally surprised on the upside. However, production in the advanced economies has been playing catch-up with the inventory cycle, as we continue to point out. This driver is temporary, and as mentioned above, the underlying data show that this cycle is coming closer to an end. The jump up in PMIs this month coincided with a large jump up in inventory indices, particularly in the US. As the inventory pendulum begins to swing the other way, industrial momentum may begin to slow.

Our Global Leading Indicator (GLI), released last weak, also confirms this story. While the headline measure improved, pointing to a solid industrial picture, the components generally show that momentum has been slowing. The PMIs are telling us a similar story.

Note that America’s huge Q4 GDP growth was heavily influenced by an U.S.-wide inventory re-stock from overly defensive levels. Thus the global growth slow-down Goldman forecasts will parallel that expected of the U.S..

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