Saturday, September 5, 2015

Miscellaneous Thoughts about the Market

Here are some thoughts I had about the market in recent weeks. The first 2 sections explain why I think the S&P 500 is still overvalued eve after the recent drawdown.

Earning growth expectations for 2016E still unrealistic

Below are revenue and earnings performance of S&P500 for past 10 years, 2016E data are based on analyst estimates. (I got the data from here)

Notice that in 2016E S&P revenues are supposed to grow 6.3% and earnings 10.5%. Digging deeper into the Factset file referenced above, you can see this is because the analysts are assuming 1) energy sector rebounding sharply, 2) all time high margins.

These assumptions strike me as unrealistic. Regarding the former, the energy sector is expected to grow 19% in 2016 – and this is after being revised downward from 34% a few months ago. The risk is if oil stays lower for longer that 19% earnings growth may not pan out. Regarding the latter point, how we’re supposed to see all time high margins is beyond me, especially when margins have been trending down in recent quarters.

Even if energy sector rebounds sharply, forward P/E multiples should not be high because that’s a one-off rebound, not a recurring growth pattern.

The idea of “low rates justify higher forward P/E” is double counting

Two most often heard reasons for high valuation multiples the past year are 1) low rates, 2) growth. The theory is that the “justified” P/E ratio is calculated as dividend payout divide by (required return on equity – growth). Where required return on equity is defined as risk free rate + “equity risk premium”. Leave aside the equity risk premium which is not directly observable, low rates and strong growth should lead to higher valuation multiples.

This all seem very sensible but does not jive with the data – at least not the rates part. If you run a regression where y = earning yield, X1= 10yr US Treasury rates, X2 = earnings growth, the result (which surprised me) would show that interest rate is NOT a significant factor at all!

I find that counterintuitive – obviously low rates should force up equity prices, no? I think it’s because much of the impacts of low rates are already reflected in growth. If you think about it, low rates are supposed to drive more investment and consumption, which lead to higher earnings growth. So the idea that lower rates justify higher forward P/E ratios is double counting – because the impact of low rates is already reflected in higher forward earnings.

Random Thoughts

How can stock prices be random? When people say stock prices are random, what does that even mean? S&P500 is around 1920 today. So you mean to tell me SPX is as likely to be at 20,000 tomorrow as it’d be at 1940? That’s nonsense. Or are they saying returns are random? So SPX could return 5% next year, or it could return 1030%? That’s clearly absurd also.

I think what they meant is that returns follow a normal distribution or some other probability distribution. But you don’t know what that distribution is. Now that seems likely. But still, “random” would imply stock prices have 0 correlations with fundamentals such as earnings movements. That’s clearly false.

So what do people really mean by “random”? Most likely, it’s just code for saying “it’s so complicated that I can’t figure it out”. I’m not sure they tried.

You don’t believe government can pick winners and losers. So why do you think you can?  Lots of reasons here. Somebody has to win. Besides, investing is not just picking winners and losers, valuation counts too. You buy a “winner” company at 100x free cash flow and you’re going to be a loser.

Day trading is a sad way to live. With the market turbulence, I found myself looking at charts of S&P futures all day. I drew lines of support and resistance and gaps. I looked for breakouts, failure to breakout, and “fake outs”. At one point I found myself checking the charts every hour, staring at minute by minute candle charts of ES Sep’15 oscillating between 1930 and 1950. This is all quite miserable, so I stopped. No day trading for me.

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