The S&P 500 According to the U.S. Treasury

Let's do a little common sense extrapolation. From the minutes of the August 4th Treasury Borrowing Advisory Committee meeting, we have this little factoid about American corporate income taxes.

Director Ramanathan discussed the components of federal revenues in the current fiscal year versus last year, noting that corporate income taxes (which generally account for about 10% of total receipts) were lower by over 50% year to date...
(source: Treasury Borrowing Advisory Committee)

Ok, so if tax revenues are down by 50% and there are no significant changes in tax rates, one can extrapolate that corporate profits are down 50% from a year ago.

A stock price is claim on long-term future cash flows from the company. Therefore, equity prices should be about half of what they were last year all things being equal.

But all things are not equal. Credit is different, money is different, business prospects are different, and perceptions of risks are different. Credit will not be as readily extended, the currencies across the globe are being diluted as fast as possible, businesses don't know when or where growth will come from, and everyone is on edge about credit defaults.

The SPY 52-week high is roughly 130 and today's trading is around 102. Valuations on stocks a year ago were at historic norms according to much of the research at Hussman Funds.

It sure seems to us that S&P 500 prices today are not at sustainable levels unless one presumes valuations last year were reasonable (i.e. the current year profits are a glitch on a much longer time frame) or currency debasement has been so deep current equity prices are normal when adjusted for real purchasing power. Neither of those seem to make sense, though, unless somehow the world is at a stage to repeat the growth of the 90s. How that might happen given the financial system's recent changes is a mystery.

The Bond Market Speaks

John Jansen's blog at Across the Curve gives us intraday bond market readings. One of today's posts on intraday spreads seems to us to indicate big money is preparing for economic weakness.

Today he points out, which has been repeated now for some time, that "TIPS spreads continue to narrow." Early this morning we found out overseas markets had no direction across the curve except in the 30-year bond. This might be anticipation of Federal Reserve interventions, except the long end of the curve has been particularly strong lately, which indicates subdued inflation expectations.

We think all this combined is telling us inflation is not presently feared, and that can only be based on a presumption that the economic environment is going to be soft.

If you you have a lot of long equity at this point, be careful. This same perspective came to us last weekend as we summarized last week's Barrons.

Meanwhile, over at Barrons, Michael Kahn provides technical analysis in "Fear Creeps Back into Bonds" suggesting bond market readings point to risk-aversion in the market place. The stock market is rallying on the new home sales report this morning as we write. Time will tell if equity markets are aware of this risk aversion or not.

What Does Soros Think?

Market Folly published a nice summary today of George Soros' hedge fund holdings.

This review by C. Kurdas on Soros' book The Alchemy of Finance will save you the trouble of reading the book. The book simply describes basic well known market psychology theory including a round-about way of describing the prevalence of existential belief in the minds of market participants. We like to summarize that with the catch-phrase, "You don't know Jack!"

If you want to be a successful, adaptable, 'reflexive' trader or investor, we recommend instead two books more directly addressing the issue of psychology listed below. As Mark Douglas pointed out in his book (the first one below) to a bond day trader whom he was advising, don't presume the other poor schmuck making a trade has better insights into the future than you. Stick to your strategy!

For adaptation to information as the market delivers it, we recommend reading John Hussman every week. Hussman is not a teacher, but his weekly commentaries to clients help you learn how professionals absorb data and apply it to reality, rather than trying to impose one's feeble world view onto the market.

Top Recommendations:
The Disciplined Trader: Developing Winning Attitudes
Trading for a Living: Psychology, Trading Tactics, Money Management

Take aways from Barrons, August 22nd, 2009

Stocks: Where's the demand-driven commerce? So far everything has been driven by government spending.

Look before you Leap

Gummy Bears

Banking and Finance: Commercial and Residential mortgages are worsening in some respects, in spite of all the green shoots. Some numbers and quotes from the Federal Reserve, and announcement that TALF will be extened.
Weekly Review

Technology: So where is the so-called PC Refresh cycle going to come from? Intel painted a rosy picture of the future, but three other tech companies have now joined the crowd of those who simply don't see any particular good news in the making.
View From the Top: No Rebound in Sight

Dividend Investing: Another piece on why reinvestment of dividends makes a good long term strategy. Read it if you haven't heard about that angle before. Skim for tickers if you have and like the idea. We think it makes sense to have some long term holdings in this phase of the business cycle in large cap companies with strong dividend histories. We'll leave it to the reader to judge whether Greek history provides any value to the theory.
Marathon Investing

Bonds: The best may be over for the bond market unless we get a sell off in corporates and munies and a rally in Treasuries for another buying opportunity. You can look for bond yields at your favorite quote provider, but there's also a good story on the municiple market. Suffice to say spreads between Treasury and corporates have narrowed in the last few months making it harder to find corporate bonds with a good chance of covering potential drop in purchasing power from quantitative easing. We might as well stick with the safety of Treasurys.
Seeking Yields on Munis That Aren't Puny

Speculative Plays:
Long MELA: "Taking Aim at Skin Cancer"
Short SHLD: "Washed Out"

Strategic Thinking:
Stocks are overpriced unless utopia breaks out real soon now. Commodity prices are priced right as long as China keeps buying what it doesn't presently need and India keeps it's capitalism in tact. Western economies are most likely going to see muted growth while Asia continues it's expansion of the middle-class demand for goods and services. The mindset "follow the money" suggests being invested directly in Asia and Brazil if not indirectly through domestic companies that get a high volume of revenues from them.

The off-the-cuff allocation at this point is long blue-chip dividend paying companies, short US indexes, and long commodity based companies or funds that pay dividends (or short their puts for dividends and purchases on pull-backs).

Caveat: While we are bullish on commodities in the one year time frame, we don't want to hide the fact that this week Barron's has a story that this might be a dangerous outlook. See "Base Metals on Borrowed Time"

Best of the Week
BRIC - forget Russia -- go where the commerce is. The interview with Christopher Wood contains some good insight into the macro-economics of the global economy, and why Brazil, India, and China have some specific characteristics about each of them that makes a focused investment in the right places a good idea. We highly recommend paying particular attention to his analysis of decoupling (in economics as well as the stock market) and what signs to look for that indicate decoupling of Asia equities.

What's our take on his expose?
Look for falling interest rates in Brazil. If FOREX fundamentals are right, Brazil bonds might be choice instruments there for income and long-term capital gains. One might also use the yields to buy something that is a domestic currency hedge in case your FOREX eats away at the gains.

India has the best of the equity markets of the three. See the interview for why that is. Our take then would be to look for small cap companies that supply goods and services to businesses.

In China, the strength is in state-owned companies, as they get the best of command economic privelidges. Thier financial services are especially inviting as corruption and greed that ruined Western finance is dealt with in China via execution. You may not share our opinion on the death penatly, but we think it provides a strong incentive for bank managers in China to be careful of thier actions.

When Premiums Make Sense

In the car industry there are rare events where certain cars sell at a premiums to MSRP when the product is rare and not likely to ever be available again.

While it's useful to know fact from fiction, especially in something that's easy to mathematically quantify, it's also good to know free market prices that are out of line with traditional pricing models don't necessarily indicate irrational behavior. Context is always the most important thing. While "bubble" is one of the most popular words in the investment community today, not everything you see that you don't value highly is a bubble. Context is everything.

When context lines up with analysis, you have strong forces at play. Such was the case in the dot.com bubble and the more recent real-estate bubble. On the other side of such crisis, when context no longer lines up with analysis, you have to put aside computer models and add human insight. In the case of PHK, the context is a rare bond market dynamic unavailable to retail investors. So it's not irrational for buyers to pay a premium to get a piece of something that won't be available shortly, specifically because it has very, very strong fundamental market forces behind the assets, and many of those assets are still priced to account for the end of the American economy within thier lifetime.

If $1.3 trillion of newly created money weren't chasing the bond market; if the Federal Reserve wasn't the primary market maker in commercial paper; if MBS and CDO bonds were trading in a free market; then PHK would probably be the worst product on earth. But this is not a free market. The dynamics of a deep pocket buyer chasing what no one else wants is unlikely to ever occur in my lifetime. Owning anything that has that kind of demand behind it can't be evaluated by traditional methods.

When the Delorean sold over MSRP, it wasn't foolish for those who paid the premium to get it while they could, because those who knew the auto market knew the prices would never be that cheap again, and the opportunity was limited. Now in hindsight we can see Delorean motors collapsed. So if you think the bond market and Federal Reserve buying program is going to collapse, you should not be participating in these bonds. But if you think the market is normalizing like it did in the other crisis, then a little investigation of fundamental forces is in order.

For months I would read John Mualdin describe the valuation of collateralized debt and the out of proportion pricing relative to real risk during the worst of the credit crisis. Every time I would salivate over the chance to buy those out-of-favor bonds as the irrational fear that the world as we know it was going to end tomorrow drove prices of even well-structured bonds into the ground. Not having a Bloomberg terminal or a bond trader's account, there was a fundamental opportunity of a lifetime that I had no way on earth to participate in. Then I discovered PIMCO was chasing that market for the same reason and in the same way I wanted, and had a vehicle available for me to jump on.

I paid a premium to get a piece of it because a) there was no other way for a common citizen to sell junk to the Federal Government at top dollar, and b) there were no option contracts I could buy to lock in the inevitable rise in price for this class of bonds, and c) Ben Bernanke's actions made it undeniably clear there was nothing on earth in the financial market that he wasn't willing to buy - nothing, not even the worst junk imaginable.

Like an option, there's no guarantee the market moves in your favor. One has to know the deeper fundamentals behind the cash flows and demands for the assets of the entity in question. You can't just look at the balance sheet values of the Real Estate assets of Sears Holdings Corporation (SHLD) and know what it's really worth. You have to know the actual location of that real estate and whether the real estate market itself will sustain, threaten, or increase that value. If the market for those R/E assets is drying up, SHLD may be overpriced. If they have a large government revitalization program behind them, SHLD may be under-priced. The issue boils down to whether the retail market has realized those values yet, or not. Price to book value may grow far more quickly than book value, primarily because book value is constrained while human intellect is not, even if abstractions and market forces not quantifiable by GAAP make it clear where future book values are most likely to move.

If we revisit this CEF when the credit crisis of 2008 is a distant memory, after bond spreads have normalized, and it still trades at a high premium, then I will join the short-seller's camp. Until then, Uncle Ben and Tim are ensuring the bonds I own through PHK have a strong, liquid, demand-driven market. I don't know any other product on earth that has an avid open buyer standing in the wings with an unlimited supply of blank checks to buy product.

When that buyer departs, things will change. But at this point their interest is strong and reliable.