Stocks and Homes Fairly Valued (excerpt)

In a speech last Thursday, Governor Jerome Powell expressed some concern that QE “might drive excessive risk-taking or create bubbles in financial assets or housing.” He indicated that the Fed’s staff is closely monitoring valuation metrics in various asset markets.

Regarding the stock market, he said: “By most measures, equity valuations seem to be within a normal range. Whether one looks at trailing or forward price-to-earnings ratios, equity risk premiums, or option prices, there is little basis for arguing that markets show excessive optimism about future returns. Of course, in the equity markets there is always downside risk.” I tend to focus on forward P/Es, which suggest that stocks are neither cheap nor expensive.

As for home prices, Powell said that the Fed's staff tracks a model that compares them to rents. I tried to duplicate it by dividing the median existing home price by the tenant rent component of the CPI. My results come close to Powell’s statement on this subject: “At the peak of the bubble, house prices were more than 40 percent above their usual relationship to rents, according to one model that the Fed staff follows. At their trough, house prices had fallen about 10 percent below fair valuation. Given the price increases over the past year, they are--by the lights of this one model--moving back into the approximate neighborhood of fair valuation.”

On the other hand, Powell was concerned about excesses in the credit markets. He mentioned Governor Jeremy Stein’s speech on this issue earlier this year. He added, “These concerns have diminished somewhat as rates have risen since mid-May.”

Today's Morning Briefing: The Usual Suspects. (1) Opera or detective drama? (2) Lots of witnesses with different stories. (3) Nineteen photos on the story board. (4) Forsyth’s theory: Deflating asset bubbles. (5) Inconclusive evidence. (6) Fisher and Dudley on same page for a change. (7) Powell says equities and homes are fairly valued. (8) Powell agrees with Stein on credit excesses. (9) Stein clams up and recants. (10) The cover story covers all the bases. (11) Fed model says QE is a dud! (12) Flows vs. stocks. (13) The year’s winners and losers so far. (More for subscribers.)

Earnings: Total vs. Per Share (excerpt)

Forward earnings for the S&P 500 rose to $117.09 per share during the week of June 20. It’s up from $112.99 at the end of last year. My target has been $118 for the end of this year. Industry analysts are currently estimating $123.65 for 2014. If that estimate doesn’t fall over the rest of the year, that will be the S&P 500’s forward earnings at the end of the year. I’ve been bullish on earnings, but not that bullish.

On the other hand, the four-quarter sum of the S&P 500’s net operating income has been flat over the past year through Q1-2013 around $900 billion. In the GDP accounts, cash-flow profits have also flattened over the past year around $1.5 trillion. Total corporate cash flow has done the same, around $2.0 trillion. However, both are at record highs.

When industry analysts listen to the earnings conference calls of the companies they follow, they’ve recently been hearing that revenues are slowing. They’ve also been hearing that managements plan to continue using excess cash flow to buy back shares and increase dividend payouts. When they put the specific numbers into their spread sheets, they get higher earnings per share as a result.

I track the divisors used by S&P to ensure that changes in shares outstanding, capital actions, and the addition or deletion of stocks to the index do not change the level of the index. They are rough proxies for the count of outstanding shares. Over the past 52 weeks through June 21, the divisors for the S&P 500, S&P 400, and S&P 600 are down 1.1%, 4.3%, and 2.3%, respectively. I suspect that corporations may not be buying back as many shares as they claim, and as analysts model in their spreadsheets.

In any event, although corporate cash flow has flattened along with corporate profits, it’s done so at a record high. There is plenty of it to drive stock prices higher. For the S&P 500, the sum of buybacks and dividends totaled $702 billion over the past four quarters through Q1-2013. Since the start of the bull market during Q1-2009, the sum total is a staggering $2.3 trillion.

Today's Morning Briefing: The Threepenny Opera. (1) A cast of 19 in the Fed’s opera. (2) They love to sing. (3) Writing the script during the live performance. (4) Dudley and Fisher agree on something. (5) Searching for a clear message. (6) Rising noise-to-signal ratio tends to depress P/Es. (7) Remarkably strong signal in forward earnings. (8) Shares are down for the count, so earnings are up per share. (9) Divisors as proxies. (10) Corporate cash flow still driving the bull. (More for subscribers.)

Emerging Markets & US Exports

There was no discussion of exports in Bernanke’s assessment of the economy during his press conference last Wednesday. They’ve stopped growing because global economic growth has been depressed by Europe’s recession.

Tightening global credit conditions and weakening commodity prices threaten also to depress emerging economies. How important are they to the US? More so than in the past, but not enough to hurt the US economy much at all. Total exports of goods and services account for 14% of nominal GDP. Merchandise exports to emerging economies account for 67% of total exports currently, up from about 50% in 1990. The good news is that US commodity imports have gotten cheaper.

Today's Morning Briefing: 'Undercurrent of Optimism' (1) Hilsenrath’s question. (2) Optimistic deputy is ready to terminate QE. (3) Fundamentals looking better. (4) Citigroup Economic Surprise Index turning up. (5) Will rising home prices trump rising mortgage rates? (6) Job gains boosting consumer confidence. (7) Capital spending trending higher along with profits. (8) Less fiscal drag from state and local governments. (9) Exports are a drag. (10) EMs matter, but not that much to US. (11) Three Fed tenors singing out of key. (12) Focus on overweight-rated S&P 500 Industrials. (More for subscribers.)

Gold & TIPS (excerpt)

The 10-year Treasury bond yield is up 91bps from this year’s low of 1.66% on May 2 to 2.57% yesterday, the highest since August 8, 2011. The selloff in the bond market was initially triggered by mounting concerns that the Fed would start to prepare an exit strategy from its ultra-easy monetary policy if the US economy continued to improve and the unemployment rate continued to fall. Those concerns were heightened during Fed Chairman Ben Bernanke’s congressional testimony on May 22. They were confirmed in his press conference on June 19.

The increase in the 10-year nominal Treasury yield has been surpassed by the 10-year TIPS yield, which is up 126bps from minus 0.62% on May 2 to 0.64% yesterday. This yield has been abnormally low (i.e., negative) since the fall of 2011. It seems to be in the process of normalizing back into a range of 1%-2%. 

Investors buy TIPS as a hedge against inflation. They buy gold for the same reason. So it isn’t surprising to see that the price of gold is highly correlated with the inverse of the TIPS yield. Nevertheless, this year’s free-fall in the price of gold is astonishing. It is also astonishing how well it predicted the jump in the TIPS yield.

Today's Morning Briefing: Great Liquidation? (1) Half right, half wrong. (2) Why are bonds so TIPSy? (3) An astonishing correlation between gold and TIPS yield. (4) Inflationary expectations still falling. (5) Normalization is painful for bond investors. (6) Global credit crunch again? (7) EMs getting crushed. (8) Another bearish article on China. (9) EMs matter more than ever. (10) Can America succeed as it did in the 1990s? (11) Forward earnings at yet another record high. (More for subscribers.)

P/E Correction (excerpt)

That’s quite a worry list that piled up last week. It’s remarkable that the S&P 500 didn’t fall more than 2.1% last week. And so far, it is down just 4.6% from its May 21 record high. This decline is attributable to the drop in the S&P 500’s forward P/E from 14.4 on May 21 to 13.6 on Friday. S&P 500 forward earnings is actually at a record high.

How much more downside might there be in the valuation multiple? It depends on how much higher the bond yield might go. My assessment is that it could rise up to 3%, which would probably attract lots of buyers. If so, then the P/E might retest and find support at the 13 level, which would knock another 4.4% off the stock index from Friday's close. That would make for a 9.0% correction in the market from May 21.

Today's Morning Briefing: From Pain to Gain? (1) Litany of woes. (2) Another “endgame” correction followed by another relief rally? (3) Fed follies. (4) A world of troubles in China, Greece, Brazil, Turkey, and Syria. (5) Another global credit crunch? (6) Bond yields are getting interesting. (7) Retesting P/E of 13? (8) NZIRP will outlast QE. (9) Are central banks trapped? (10) Of mice and men. (11) Fed intent on taking air out of bubbles? (12) The long good buy. (13) This time, defensive stocks underperforming. (14) No place like home. (15) “Man of Steel” (+). (More for subscribers.)