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Tuesday, July 10, 2007 1:30 AM

Tightening Cycle

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A couple of interesting charts were presented in Minyanville on Monday by Jeff Saut in Subprime Sublime? and last week by Bennet Sedacca.

First let's look at a chart of global treasury rates posted by Sedacca.
If this is not a stunning example of global tightening what is?
Click on chart for a better view. In particular note the 3 month change.

On Monday Jeff Saut posted this chart about the S&P has fared in past tightening cycles.

History shows that equity prices do not usually fare well at the end of tightening cycles. The bulls counter with comments about how the S&P is undervalued by the Fed Model, PEs, bond yields etc.

From where I sit, few can compete with John Hussman when it comes to valuation. If you are a follower of fundamentals and are not reading his weekly commentary, you are missing out. Let's take a look at what Hussman has to say about the bullish arguments.

May 21, 2007 How Much Do Interest Rates Affect the Fair Value of Stocks?

If you watch CNBC for a few minutes, you'll immediately hear some analyst claim that stocks are cheap because the “forward earnings yield” on the S&P 500 is higher than the 10-year Treasury yield. The next analyst will just say that “stocks look cheap compared with bonds.” The next will offer some strange convolution of the so-called "Fed Model," like “Sure, P/E multiples are above average, but bonds are trading at a P/E of 21.” After a short break from the monotony by some kind of circus clown playing with horns and buzzers, another analyst then comes on saying how the firm's “valuation model” (which is driven by forward operating earnings and interest rates) implies that stocks are 20% undervalued.

Wall Street is presently managing trillions of dollars of other people's money on the basis of a single toy model, originally discovered in a packet at the bottom of a Cracker Jack box.

The Fed Model asserts that earnings yields and Treasury yields have a 1-to-1 relationship, that stocks are undervalued anytime the earnings yield on the S&P 500 is higher than the 10-year Treasury yield, and that the gap between earnings yields and interest rates is the prime determinant of subsequent market returns.

It speaks volumes about the shallow analysis on Wall Street these days that all of these beliefs can be dispelled in a single chart.

There is, in fact, no stable relationship between earnings yields and interest rates. The relationship is actually negative in data since 1929, is marginally positive (but statistically insignificant) in data since 1950, and is only strongly positive in data from 1980 through 2000 as a statistical artifact of the disinflationary period from 1980 to 2000.
June 4th commentary Speculating on Speculation
Stocks have historically lagged Treasury bills, on average, from the point that conditions have reflected rich valuations, high bullishness, and overbought short-term trends, until the point that those conditions have been cleared by at least a moderate market decline. This has not been true of every single instance, but is certainly true on average. Moreover, when such conditions have been compounded by rising interest rate trends, the typical returns have been clearly negative, and on several occasions, spectacularly so.

The real problem is that it's simply not true that the level of interest rates has a reliable relationship to the level of stock yields, and it's on that misconception that Fed Model adherents will ultimately have their heads handed to them. They're relying on that levels argument to conclude that stocks are reasonably valued here.

And despite the fact that the S&P 500 P/E was just 7 then [in 1982] and is 18.4 times record earnings on record profit margins now (and over 25 times earnings on normalized margins), the model suggests that stocks are “cheaper” today than they were in 1982. I'm sorry, but that's insane.

Moreover, if we examine data prior to 1980*, the picture turns ridiculous, suggesting that stocks were never overvalued prior to 1987, including in 1972, just before they lost half their value. If one wants to believe the Fed Model, it's worth noting that the market's current valuation is about the same as at the 1929 peak.
June Commentary by William Hester on Private Equity and Market Valuation
“Buyout Bingo.” “Merger Monday.” At the point a trend in the market is identified with constant alliterations, it's probably about to stop working. That term “Buyout Bingo” came across the newswires recently – an apt description of the popular strategy of building a portfolio of stocks with “takeover characteristics” and then sitting back in hopes of seeing them purchased at a premium by private equity investors.

The pick-up in the number of private equity deals beginning a few years ago was rooted in better conditions. The universe of attractive takeover stocks had average cash flow yields of 15 percent and borrowing rates were rock bottom. But the argument that the current pace of private equity deals provides evidence that stocks are fairly valued needs to be reconsidered. Current deal flow alone can't be an indicator of investment opportunity because it is too clouded by factors outside of valuation. And it's becoming increasingly difficult to argue that, on average, the universe of potential candidates to take private represents attractive value.
June 18th New Economy, or Unfinished Cycle?
It's also important to emphasize that standard bear market declines have historically produced losses averaging about 30% - generally not just 20% (15% declines don't even qualify). I don't expect the next one to be a significant exception.

Suffice it to say that the only reason to buy stocks here is a) the belief that one can sell them to a greater fool at higher prices despite already overvalued, overbought, overbullish and rising yield conditions, or b) the belief that the stock market will soar 30-50% from these levels, without experiencing even a minimal bear market in the next 4-5 years.

Presently, the market's valuation on the basis of price/revenue, price/book, and price/dividend is higher than at any prior historical market peak on record except the 2000 peak. On the basis of normalized profit margins, the current P/E for the S&P 500 would be about 25 times record earnings rather than the (still elevated) multiple of 18.4. Even if we give only 25% weight to that normalized value, and give 75% weight to the prevailing multiple, the resulting P/E for the S&P 500 is still over 20, and is about the same as what prevailed prior to the 1929, 1973-74, and 1987 market plunges. This market is only “cheap” if one couples non-GAAP “forward operating earnings” with the Fed Model. As I've detailed in recent weeks, that approach has ridiculous implications even in the data sample (1980-2000) that was used to construct it, and is quickly and easily verified as pure garbage in pre-1980 data, using any proxy remotely close to estimated “forward earnings.”

Still, it bears repeating that if one adheres to the Fed Model, stocks are currently far cheaper than they were at the historic 1982 lows, but as expensive as they were at the 1929 peak. If that seems sensible, then nothing I say can help.
History suggests that the current merger mania buyout bingo game is going to end very badly. History said the same thing about the housing bubble as well but everyone ignored that until it was too late.

Given that Central Banks can't hope to reinflate asset bubbles when bonds truly break down, the above charts show conditions are aligned for a massive selloff, globally. Remember that once the dotcom bust got some steam going, lower interest rates by the Fed did not help for quite some time.

Structural Conditions are actually much worse now than in 2000. Consumer debt has skyrocketed, bank exposure to real estate is at peak levels (see Kool Aid & Krispy Kremes), the carry trade will have to unwind some day, the job picture is poor (see Fed questions the BLS jobs model), mortgage rates are rising, and foreclosures are at all time high numbers. We have all these issues and we are still not in a recession yet (not officially anyway).

In 2000 we had the mother of all housing bubbles to get the economy out of a slump. In a world more leveraged to debt than addicts are to heroin, what's the Fed's next magic fix?

The problem comes when it is no longer possible for that debt to be serviced. That problem is both now and growing. It's now for consumers, and growing on account of corporate buyout bingo and debt financed share buybacks.

Lower interest rates will not help consumers one bit if they don't have a job to pay the bills. Nor will lower short term interest rates help homeowners if mortgage rates don't also drop. The stage is now set for a massively deflationary credit bust coupled with rising bankruptcies. Hardly anyone sees it coming even though there were no takers at 11 cents on the dollar in the recent Bear Stearns hedge fund collapse.

Deflation was not in the minds of the Fed in 2000 as the dotcom bust got underway. Nor is deflation on the Fed's mind now even as various hedge fund and subprime blowups are happening right before our eyes. History is about to repeat. The problem for the Fed is they shot their wad fighting an imaginary deflation threat in 2000. This time however, the deflationary threat is real but there will be no revival of the housing bubble as an escape hatch for debt ridden consumers. But that won't stop Bernanke from trying. Look for gold to soar as a result.

Sometimes I trade gold futures but I have no current position in futures at this time. I do have a basket of gold miners that I am holding. I have no other positions relevant to this post.

Mike Shedlock / Mish

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