Sunday, January 25, 2009

Are Stock Market Prices Driven By Earnings or Inflation?

``All political thinking for years past has been vitiated in the same way. People can foresee the future only when it coincides with their own wishes, and the most grossly obvious facts can be ignored when they are unwelcome. Political language... is designed to make lies sound truthful and murder respectable, and to give an appearance of solidity to pure wind.” -George Orwell, 1984

Theory, Experience and the Consensus Thinking

My first venture into this field gave me the impression that stock market prices had been fundamentally driven by company earnings. Thus I worked my way into the learning the ways to “project” earnings. Now years after, I’ve come to the conclusion that the importance of earnings is secondary.

Yet, such mindset continues to reflect on the consensus thinking. As most of the books, the preaching of the academe and especially the orientations of my peers that are regularly communicated either verbally or through transcriptions via newsletters persist to influence the investing public.

Nonetheless, during the early days, from a strict “fundamental” standpoint, experience altered my perception of the markets. Going along with my contemporaries, I was made to believe that profits involved NOT only earnings, but from special activities as “deals or mergers”. So the goal now shifted from studying corporate fundamentals to one of ascertaining advance information from insiders, and correspondingly took bets on them.

And obtaining insider information meant networking with many people, which prompted me to join forums and groups. Unfortunately, the hunt for financial glory, which turned out to be a profit tryst was nothing but systematic punt and which ultimately taught me an expensive and emotionally agonizing lesson when the market reversed.

Nevertheless during the heydays of the 90s and the subsequent depression, I came to realize too that there had been some blatant inconsistencies with what is understood by consensus based on the dogma of “earnings-as-drivers” and from those acquired through experience.

I realized that on good times everyone seemed energized as the stock market levitated, and on the contrary, during bad times, everyone was either somber or looking for a new endeavor outside the stock market.

Market Tides And Stock Prices

It was then from the classic book “Reminiscences of A Stock Operator” of Edwin Lefèvre or a.k.a the legendary Jessie Livermore that my empirical observations was reinforced.

Remember this Edwin Lefèvre quote which we used to warn of the transitioning bear market in 2007,

``I NEVER hesitate to tell a man that I am bullish or bearish. But I do not tell people to buy or sell any particular stock. In a bear market all stocks go down and in a bull market they all go up...I speak in a general sense. But the average man doesn’t wish to be told that it is a bull market or a bear market. What he desires is to be told specifically which particular stock to buy or sell. He wants to get something for nothing. He does not wish to work. He doesn’t even wish to think. It is too much bother to have to count the money that he picks up from the ground.”

In contrast to mainstream brokers who ceaselessly bombard you with the hackneyed “earnings-as-drivers” of the market, market reality shows otherwise (see figure 1)

Figure 1: Market Tides Applies to the Phisix Sectors and the World

The upper window is the performance of the sectoral or industrial indices of the Philippine Stock Exchange which spans from 1996 to the present. Do you notice of any material divergence? The answer is none. (chart index: green-Mining, blue-Properties, black-Bank, pink-Commercial Industrial, red-Holding, red orange-service)

The point is stock prices in general, as rightly observed by Mr. Lefèvre, sink or swim depending on market tides.

Do you not wonder why speculative issues or even shell companies greatly outrun cash flow backed fundamental issues during bullmarkets? Or has there been any domestic stock issue (speculative or blue chips) that has been spared from today’s grizzly bear market?

Case Study: Robinsons Land Corporation

Let us make an actual comparison. I will use Robinsons Land Corporation (RLC) as an example. My choice of RLC came about out of availability, it is the company that last reported a disclosure on January 23 (I don’t own RLC) and is likewise Phisix component.

According to the company’s disclosure, “audited consolidated net income by the end of the fiscal year 2008 (October 2007 to Sept 2008) amounted to Php 3.15 billion, up 29% from the same period last year.” Even in 2007, the same figures showed a 42% growth.

On the other hand, its stock prices have COLLAPSED EVEN AS REVENUES CONTINUE TO CLIMB, albeit at a slower DOUBLE DIGIT pace. RLC prices peaked on February 2007 at Php 23 and closed at Php 4.8 Friday or a loss of an astounding 79%!

Yet if stock prices function as forward discounting mechanism based on future earnings streams then the recent stock price trend of RLC conveys a message of a very steep collapse of revenues and earnings, possibly similar to those in the US. Remember, RLC’s stock price slump has been two years old (in 2007 +1.5%, in 2008 -70%)! Usually markets are ahead of fundamentals by 6 months.

And at the close of November of 2008, which is not far from where RLC last traded Friday, according to the PSE, RLC has a dividend yield of 9.14%, 154 basis points higher than the Philippine government 10 year bond (!!!), a price-to-earnings of 5.82, a price to book of .73 and a debt equity of .78.

So the point is, if the market is CORRECTLY pricing future earnings then the company’s balance sheet and income will deteriorate tremendously over 2009 almost 24 months into the RLC price summit. On the other hand, the market may NOT have been reflective of the fair market value of the company and has been INFLUENCED BY OTHER FACTORS HARDLY CORRELATED with the company’s fundamentals.

And if we apply the same logic, the Philippine benchmark the Phisix or the PSEi which has lost nearly 55% from peak-to-trough, has a dividend yield is 5.63%, a PE ratio of 9.76, Price to Book at 1.28 and debt equity of 2.78. Yet the collapsing stock market doesn’t square with the economic figures which registered moderate but POSITIVE growth and NOT a recession.

In short, evidence defies consensus thinking. (I have seen the same story in 2002)

Bubble Cycles Defines Today’s Risks Environment

And curiously we see the same developments overseas. Going back to the chart, from 1999, seen from the lower window, exhibits some of major global benchmarks-S&P 500 (black), Brazil’s Bovespa (blue), Japan’s Nikkei (violet), Hong Kong’s Hang Seng (red) and the Phisix (green)-have ALL moved synchronically.

You might object, but what about my old mining and oil issues that became wall papers? Doesn’t this signify the need for fundamentals?

Well the answer to that question is shown in figure 2.

Figure 2: Cyclical nature of Commodity prices over 200 years

Let us put this into perspective.

This isn’t simply a matter of “speculative” issues that had gone kaput. The fact that Enron, once the 7th largest company in the US, went bankrupt in 2001, today’s quasi nationalization of the world’s former 18th largest public company in American International Group (AIG), the bankruptcy of Lehman Brothers, founded in 1850 (!) and was the fourth largest US investment bank, the forced merger of Bear Stearns-also founded in 1923 and was one of the largest US investment banks- with JP Morgan and importantly, the DEMISE of the US investment banking industry (Economist) or the transformation of its relics to bank holdings, only goes to show that whether it is a defunct speculative mining issue in the 1980s or erstwhile blue chip behemoths as today, they are subject to the risk influences of bubble cycles.

And an unwinding bubble cycle,

1. strips the CHIMERICAL INVINCIBILITY of industry leaders (e.g. US investment banks, real estate industry, mortgage lenders and etc…),

2. unmasks FRAUDS and corporate SKULLDUGGERY (e.g. Madoff and Enron) and

3. bankrupt UNVIABLE companies (old speculative mining issue)…

…all of which had been founded or built upon unsound business models.

The Philosopher’s Stone

Bubble cycles are shaped by monetary policies which are aimed at inciting PERMANENT boom conditions by omniscient ‘Powers That Be’, particularly interest rate manipulation.

Yet defying basic economic laws, when interest rates are forced below market levels or at the rate at which the demand for and supply of capital are equalized, excess credit, which the central bank creates, unduly expands demand for assets. Worst of all, by discouraging or even punishing savings, it encourages expanded risk appetite or speculation.

In other words, business projects that shouldn’t have existed at all are given false signals from which they rush in to take advantage of.

Yet, the ensuing illusionary boom distorts the capital structure and overvalues the currency through the intertemporal misallocation of resources or malinvestments, thereby increasing unpredictability into entrepreneurs’ plans. Moreover, an overvalued currency induces a shift of manufacturers overseas.

Hence, the onrush of demand for assets lowers the demand for money which leads to increases in interest rates and which ultimately impacts the feasibility of these unsound business model based companies.

Hence, the boom eventually turns into a bust, where according to Ludwig von Mises, ``The boom is called good business, prosperity, and upswing. Its unavoidable aftermath, the readjustment of conditions to the real data of the market, is called crisis, slump, bad business, depression. People rebel against the insight that the disturbing element is to be seen in the malinvestment and the overconsumption of the boom period and that such an artificially induced boom is doomed. They are looking for the philosophers' stone to make it last.”

Nonetheless some invaluable insights from the late University of Vienna Professor Fritz Machlup (1902-1983) in The Stock Market, Credit and Capital Formation, on the tight relationship between inflation, bubble cycles and the stock market (bold emphasis mine):

-A continual rise of stock prices cannot be explained by improved conditions of production or by increased voluntary savings, but only by an inflationary credit supply.

-Extensive and lasting stock speculation by the general public thrives only on abundant credit.

-Abundant funds, especially those of inflationary origin, may not find ready outlets in real investment.

-Any decrease in the effective supply of money capital is likely to cause disturbances in the production process.

-An inflated rate of investment can probably be maintained only with a steady or increasing rate of credit expansion. A set-back is likely to occur when credit expansion stops.

-The use of credit for financing working capital does not assure "self-liquidation" or liquidation free of disturbance. For the economy as a whole circulating capital mostly constitutes long-term investment and, if the volume of production is to be maintained, even permanent investment.

-The start of a general business upswing can be financed out of surplus cash balances without an expansion of bank credit. The temporary surplus cash balances, dishoarded at the beginning of the upswing, are set free again when the crisis is liquidated; they are then disposable for another upturn.

-If bank reserves are controlled by the monetary authorities, credit inflation should not be attributed to the stock-exchange boom. However, margin regulations may be an effective means of checking the expansion.

Conclusion and Recommendations

Overall, here are our observations and recommendations:

1. Seen from the overseas perspective, the transmission mechanism of inflationary policies from the US abetted by global policies geared towards financial globalization or the facilitation of cross border capital flows have narrowed national idiosyncrasies (decoupling) and reinforced synchronization of movements among major global stock market benchmarks (integration) during the recent boom cycle.

The same reverse effects from the credit bubble deflation can be seen today unfolding around the world today. And this convergent stock market deflation theme even applies to most of the US markets (see figure 3) or even to Warren Buffett’s flagship Berkshire Hathaway’s portfolio.

Harry Markowitz, the economist who popularized the Modern Portfolio Theory appears to have been invalidated with the recurring inflation deflation cycle. Today’s market conditions reveal that “diversification” under inflationary policies hasn’t been applicable…yet.

Figure 3: Gavekal: Deflating Margin Debt=Deflating Stock Market

2. Edwin Lefèvre’s empirical observation that individual stock prices move in the general direction of the markets is greatly supported by the role of central bank policies.

3. Monetary authorities have been aware of the significance of this stock market-inflationary policy relationship; hence have partly crafted policies in support of such outlook. As evidence, US Federal Reserve Chairman Ben Bernanke wrote in his A Crash Course for Central Bankers, ``History proves, however, that a smart central bank can protect the economy and the financial sector from the nastier side effects of a stock market collapse.”

4. Inflationary/deflationary environments shape risk taking appetites. Under loose monetary conditions or boom cycles, augmented risk appetites translate to a stretching for yields. This also means that the selection breadth by market participants of the asset horizon widens.

In general, like tea poured into a teacup that is filled to the brim, the tea spills over to the saucer and eventually out to the table and to the floor. An easy money landscape extrapolates to a “rising tide lifts all boat” as excess money diffuses to the general market.

And conversely, when the liquidity tide goes out or in bust cycles, you will learn that many have been caught swimming naked (estimated $30 trillion in 2008), to paraphrase the world’s best stock market investor Warren Buffett.

5. Because the Philippine stock market is largely underdeveloped, have low penetration level of exposure, have low degree of sophistication and whose domestic participants have inadequate understanding of the markets and thinks that they are some form of “gambling casinos”, an inflationary environment extrapolates to surging speculative activities which often directs punts to high volatile “issues”.

6. In advanced and sophisticated markets as the US, the weightings of “earnings as driver” may have bigger contribution to pricing relative to underdeveloped markets but as the Berkshire Hathaway portfolio shows has been impacted by the inflation deflation cycle.

7. Unlike typical brokers who will frame and impress on the public with the “earnings as drivers” theme, our advice is to understand not so much of “micro” fundamentals and “market timing”, but more from the unorthodox standpoint of comprehending the market, economic, political-inflationary and business cycles. Markets ultimately as seen today are driven by inflationary actions in the era of fractional standard based modern central banking.

8. Most brokers spread the wisdom of “earnings-as-drivers” theme but tacitly intend to induce trades, where earnings do not seem to matter. They will ask you to open a position based on fundamentals (e.g. PE ratio) and close the same position based on price actions (e.g. sell on resistance). Remember, “fundamentals” and “technical price actions” are distinct tools in approaching the market. Avoid the confusion by identifying, planning and implementing these tools (one or the other or a mix of) before going into any trade/investment.

9. Lastly Professor Fritz Machlup drives a very important point about the prospects of recovery, he says ``The start of a general business upswing can be financed out of surplus cash balances without an expansion of bank credit. The temporary surplus cash balances, dishoarded at the beginning of the upswing, are set free again when the crisis is liquidated; they are then disposable for another upturn”.

Again against consensus thinking, SAVINGS AND NOT CREDIT is likely answer for the recovery.

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