As Revenue Growth Slows, P/E Declines

Firms can’t use accounting gimmicks to hide revenue growth. They can keep earnings up with various balance sheet maneuvers and cost cutting, but markets can see through it.  Looking at the graph below of Johnson & Johnson (JNJ), Weldon the CEO from 2002 to 2012  was aloof and allowed JNJ to run without tight reigns. By 2010, there was serious problems at both the consumer division and the medical device division.  The stock more or less bottomed around the time Weldon left the CEO chair in 2012.

JNJ Growth


Financial Imbalances

Below is a collection of financial and economic imbalances that have been emerging.  These imbalances are very likely to revert and over correct using history as a guide.  It can’t be predicted as to when or what events will trigger these reversions.


Investors are paying more for less.

EBITDA is like rent on a rental property.  EBITDA is earnings before interest, taxes, depreciation and amortization.    If you rent a property for $800 per month your EBITDA is $800 per month. Companies have been helped by cheap money in driving their earnings, but the “rental” income from the S&P 500 has declined as the price of the S&P 500 has increased.




Margin Debt hits a new record.



Corporate profit margins are 70% above the norm at 11% of the economy. Labor Share at an all time low. 

Corporate profits are out of historical balance relative to wages compared to the size of the economy. They have always reverted in the past.

Chart of corporate EBITDA to the labors share.


Wages and Profits


Same idea, this chart shows corporate profits and wages & salary accruals relative to GDP.




Corporate profit margins have consistently reverted to the mean.

Economist John P. Hussman has shown that corporate profit margins are just the inverse of government and household savings, below is a clip from this link:

“The deficits of one sector emerge as the surplus of another. As a result, deep deficits in combined government and household saving have created a mirror-image surplus of corporate profits in recent years. The chart below shows the relationship between 3-year changes in government and household savings versus 3-year growth in corporate profits (partly overlapping, but partly subsequent as inventories and other factors can induce slight lags). The upshot of this chart is that recent improvements in government and household savings are already working their way through the economy, and are likely to be observed as a contraction of corporate profits in the next few years.”


While valuations (at least partially based on excessive corporate margins) are stretched. 


Here are a couple of stock market models that combine various factors.  One thing about models is that you must assume that each time is different because it is.  So the models don’t work the same way each time or sometimes they fail.

One model is from here:


The chart below uses these factors:

1. S&P 500 Index overvalued, with the Shiller P/E (S&P 500 divided by the 10-year average of inflation-adjusted earnings) greater than 18. The present multiple is actually 25.

2. S&P 500 Index overbought, with the index more than 7% above its 52-week smoothing, at least 50% above its 4-year low, and within 3% of its upper Bollinger bands (2 standard deviations above the 20-period moving average) at daily, weekly, and monthly resolutions. Presently, the S&P 500 is either at or slightly through each of those bands.

3. Investor sentiment overbullish (Investors Intelligence), with the 2-week average of advisory bulls greater than 52% and bearishness below 28%. The most recent weekly figures were 55.2% vs. 15.6%. The sentiment figures we use for 1929 are imputed using the extent and volatility of prior market movements, which explains a significant amount of variation in investor sentiment over time.

4. Yields rising, with the 10-year Treasury yield higher than 6 months earlier.

The blue bars in the chart below depict the complete set of instances since 1928 when these conditions have been observed.



Here is another model from: Note that the period around 2000 was back tested so it was not real time. The authors claim that the points to the right of 2000 is a real time model.

Greedometer (10 input) 1999 to October 2013 and S&P500


Markets are free to ignore models.   They are not a predictive machinery either. They measure the current state of affairs.   Much like a thermometer reads 100 F in July, it has no idea it is going to be -10 F in January.  If, in fact, it turns out that assets values have been pushed too high by excessive easing, markets don’t have a opinion on this or a forecast they simply react when the excessive easing has been reduced.   Markets could very well continue higher into 2014 or even 2015 before a mean reversion takes place.






How Bubbles Form

If we assume that this stable financial atmosphere (very slow growth, low inflation, zero interest rates, high profit margins)  continues indefinitely and the fear stimulus of the ’08 meltdown fades, then the human condition says we can pay very high prices for stocks.

Let’s look at one stock that represents the market as a whole for an example.  YUM! Brands has a stable and growing business.  The stock currently trades at $73.86.  I will use this stock to compare the two fundamental choices an investor has.  An investor’s basic choice is to invest in either a 1o year US Treasury bond (T-bond) paying 2.69% or buy into equity investments.  YUM! pays a dividend of 2% ($1.48 annually ) that has been growing about 10% a year. At first, it looks like the 10 year T-bond is a better deal, i.e. 2.69% vs. 2%. Yet, if YUM!’s dividend continues to grow at 10% then 10 years from now the dividend will be $3.84 and your yield will be 5.2%.  So the choices are not completely clear because YUM!’s dividend is growing and the T-bond’s return isn’t.

The dividend discount model provides an answer.  The value of YUM! according to the formula is:

Price = D/(k-g)  where D = the dividend, k is the discount rate in %, and g is the very long term growth rate in %.

k is an estimation of how risky YUM! is relative to the T-bond.  This is where the troubles start. Coming out of 2008, investors thought that stocks were way more risky than the T-bonds and the growth rate, g, was going to be low because the economy is going south.   So at that time an investor might have used a k of 10.76% (4x as risky as a T-Bond) and YUM! can grow at 2% for a very long time. So YUM! would have been valued at :

$1.48/(.10-.02) or $18.50 per share (actual low price in ’08 was $21.50)

As the financial world became more stable investors may have thought that YUM is only 3X as risky as the T-bond (k= 8.07%) and that YUM! can grow at 3% for a very long time. We would calculate:

$1.48/(.0807-.03) or $29.19 per share

Today,  the situation looks very stable and things will continue like this indefinitely.  So now investors may perceive YUM! as only 2x as risky as a T-Bond (k=5.38%) and YUM! can now grow at 4% for a very long time.  YUM! has been growing north of 10% for many years on average so 4% for a very long time now seems rational.

$1.48/(.0538-.04) =  $107 per share

We could keep going here and come up with some really high numbers for YUM!.

The chart below shows what is happening in the overall stock market. The numbered lines show the premium investors are willing to pay for the market.  The market price is the squiggly line.   The growth rate of the economy has not changed for several years, either has interest rates.  Thus the main reason the stock market has been going up and may well continue is that the perceived risk or k has been dropping.  Investor are willing to pay higher and higher prices just because they think the risk has declined not because the economy or the growth rate has improved.   Noticed how investors believed there was very low risk just before 2008.  Just because investors think the risk is low doesn’t mean it’s so, it just reminds us that investors measure the current state of affairs without regard to what could happen. History has shown financial shocks are not predictable and are more likely than can be calculated.

As long as there are no financial shocks, stock prices are going to continue higher and in my estimation have become at risk for financial shocks.  There is no margin of safety between peoples’ perception of low risk and the reality that risk exists in the same probability as it always does.  Just because something hasn’t happened recently doesn’t make risk go away.














Headlines and Hurricanes

The macro headlines are pretty gloomy:  Europe is in trouble, USA deficits, and China slowing down.  Should we sell everything and go into cash for safety?   Nope, ignore and move forward. First, there is no sure way to figure out how these macro markets are going to unfold.  Second, the bad news eventually follows good news and you don’t want to be in cash when events surprise to the upside. Third, even if you could figure out how these issues are going to unfold, there is a pretty good chance that our stocks will not follow the macro prediction.  When markets were down three years in a row, i.e. 2000-02, we had some of our best years.

When I say there is no sure way to figure out how macro markets will unfold, I do it with extensive consideration. I will be traveling to FL this summer.  I will be checking out our investment in Pantry (PTRY), looking over some real estate St. Joe (JOE) owns and an investment Leucadia (LUK) has made in the area.  LUK has purchased the old airport in downtown Panama City. These guys find some interesting things to invest in.  Hurricanes can disrupt this area during this part of the year and possibly my trip.  What is the ability to forecast a hurricane in the area?  The big hurricanes are called Cape Verde Hurricanes. They are born near islands that rest off of the west coast of Africa.   To see how they start we have to back up even further to the 500 mile diameter Sahara Desert where the sun beats down on the surface of the desert creating a huge dome of rising hot air. This rising air creates a vortex and high winds that suck in more air and dust as the super heated column of air rises. As these waves of rising hot air move west they come over the ocean at the Cape Verde Islands.  Once over the ocean, the clouds seeded with dust can form a hurricane.  NASA, NOAA ( National Oceanographic and Atmospheric Administration), European scientist and several universities have committed quite a bit of resources, i.e. satellite images, weather stations, planes to collect data and computer models to figure out this phenomenon and have been at it for years. The effort is called African Monsoon Multidisciplinary Analyses (AMMA).  Scientist have a pretty good handle on the ingredients and the physics of weather, but are still lacking some small initial conditions that bands several thunderstorms together over Cape Verde to form the hurricane.


These weather systems are very similar system to the stock market, i.e. systems where small initial conditions can have a big impact eventually.  With weather we have a shot at figuring some of this out, i.e. very similar initial conditions repeat over and over again.  In the economy/stock market completely new initial conditions are always coming into the equation.  New leaders, laws, and technologies are constantly adding brand new initial conditions.  Just like a thunderstorm that fizzles over Cape Verde, most initial conditions in the economy just die out, but some reach a tipping point and have a massive effect.  The housing bubble was just one of those events. If we look back far enough, it is likely that just a few initial conditions reached a tipping point which resulted in this bubble. You can’t predict which initial conditions will fizzle and which will reach a tipping point. The housing bubble and hurricanes blow out the same way; they just run out of energy.   I have extensively studied many economic indicators and stock market models over the last 25 years, some look promising and work for a while, but all eventually fail.  This is due to some new initial condition that hits a tipping point and voids the correlation in the model. Since you can’t really predict why they are working, you can’t predict when they will fail either.


Could the slowing in China, the US debt problems or the European Union reach a tipping point and cause large dislocation?  Quite possibly, of odds I can’t calculate. Each one of these events would have a different effect.  A further deterioration in Europe wouldn’t affect our YUM! investment near as much as a drastic slowing in China.  So even if I could accurately calculate the odds of each event, which I can’t, you would end up with too many possibilities to make an investment decision.  If, in fact, one of these situations would cause a dislocation, we will look for an opportunity once we get there. Otherwise I don’t pay much attention to the headlines.



Massive Copper Mine – Oyu Tolgoi, Gobi Desert

Here is a good You Tube clip on the massive Oyu Tolgoi, OT (Turquoise Hill) copper mine.  The mine is located in the Gobi Desert in Mongolia.  The costs to bring the mine online are estimated at $6.5 billion.  OT will start production in 2012.  The mine will have a huge impact on the economy of Mongolia.  Over several years this one mine will double the GDP of Mongolia.


The Second Renaissance

The Second Renaissance is a term I am using to describe the rapid movement of the world’s population from cooking with wood to electricity to using an iPhone.   It’s a one time event in the history of planet earth.  It can happen in a short bus ride from a village shanty to a new modern factory, much faster than the the First Renaissance happened.  It’s a leap, for many,  from pre-Industrial Revolution, bypassing over 100 years, landing squarely in the 21st century sometimes in a matter of hours.

Below is a link to a You Tube video by Hans Rosling showing the modern history of  life span and income from 1810 to 2009:

What are the ingredients have brought about this change?   There are several; for one the Internet has allowed masses to arise against tyrants and throw them from power.  It’s allowed technology to flow to the corners of the globe.  The rule of law, democracy, land ownership, absence of war, education, health, infrastructure,  crop and farming science, all contribute.  The Internet also shows the leaders of underdeveloped nations and their masses what is happening in the rest of the world.  You can bet Cubans watch  their brethren’s  lifestyles 90 miles away in FL., this plays over and over again around the globe.

For a single indicator of the progress I again turn to a video from Hans Rosling.  I can’t think of a better measure than a washing machine.  If somebody has a washing machine they have electricity and time to read themselves and educate others.  Time to pursue what they like to do and thus what they are best at.  Which leads right back to author Adam Smith and his book the “Wealth of Nations”, 1789. Wealth is created when a resource is liberated for a better use.  It’s a far better use of time to read to a child than to hand wash clothes.

Here is the washing machine video from Hans Rosling:

Watch the end of the video for current day examples.

Layered on top of the above is the rapid development of new technology, this will allow the developed nations to continue to move forward and for underdeveloped countries to make bigger and bigger leaps when the conditions become right.  For example, many countries bypass running phone lines and go straight to cell phones, no need for gas guzzling, fume spewing 1970s cars, clean 40 mpg are available, etc.

What does this mean as investors?  There will be rapid development in some countries on earth.  Many US companies will participant in this rapid change and growth.  Most in the world will want the very same things that we have in this country.  What was successful in the US will likely work elsewhere.  Modern food and health care will be adopted quickly because they are most basic needs and wants of humans.