The Big Picture | Earnings

Oil Bubble?

Friday, May 09, 2008 | 10:51 AM

My friend Paul points to this report by Factset, titled: An oil bubble to rival the internet boom.

The difficulty with the bubble moniker is determining exactly how much of the price is being driven by purely speculative factors. With Crude, a variety of forces are driving prices: A combination of both fundamentals (increasing demand, constrained supply, pipeline problems), technicals (Trend, money flow, etc.), along with the geopolitics of two Middle East wars -- as well as some speculation.

Additionally, we have seen the general perception of commodities shift, where they are now seen as a more legitimate asset class for portfolio managers, along with Equities, Fixed Income, REITs, cash, etc. than it has been previously.

Even If I disagree with the bubble thesis, I love any report festooned with lovely charts, and this one is no different:

Source:
An oil bubble to rival the internet boom (PDF)
FactSet, 3 May 2008
http://www.factset.com/websitefiles/PDFs/outlook/english/03-05-2008english.pdf

Unrealized Level 3 Gains

Thursday, April 24, 2008 | 08:13 PM

in Corporate Management | Credit | Derivatives | Earnings

If it weren't for the large non- cash profits on "hard-to-value" holdings, Goldman Sachs (GS) wouldn't have had much profit last quarter. Lehman Brothers (LEH) would have had significantly less. And Morgan Stanley (MS) wouldn't have had any.

That's according to Bloomberg's Jonathan Weil:

"Here's Rule No. 1 from Wall Street's public-relations playbook: If the company you run has big losses on hard-to-value assets, scream your head off about the accounting rules.

And what if the squishy values result in huge gains instead, as they have in the not-so-distant past? Rule No. 2: Stay mum about it for as long as the rules allow.

For months, we've seen a growing parade of executives and politicians complain that fair-value accounting rules are to blame for financial institutions' imploding balance sheets. Even the International Monetary Fund got in on the act in an April 8 report, suggesting the need for "some latitude in the strict application of fair value accounting during stressful events.''

There has been no commensurate outrage about fuzzy mark-to-market accounting that lets companies post unrealized gains on illiquid balance-sheet items."

Go read the full article . . .

Source:
Goldman, Morgan Stanley Hit `Level 3' Jackpot
Jonathan Weil
Bloomberg, April 23 2008
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=a0ZGtAQHLpiA

Earnings Comparison

Thursday, April 24, 2008 | 04:30 PM

in Earnings

via WSJ:

Schwab: We Don't Need Your Stinkin' Analysts

Monday, April 21, 2008 | 07:30 PM

in Earnings | Markets | Psychology/Sentiment | Valuation

Charles Schwab is raises an interesting issue regarding analysts:

"When Wall Street's almost 1,800 equity analysts figured U.S. earnings growth for the third quarter of 2007, they were 8.2 percentage points too high. Forecasts for the fourth quarter were wrong, too, overestimating profits by 33.5 percentage points, the biggest miss ever.

It's no wonder investors don't trust analysts, says Liz Ann Sonders, chief investment strategist at Charles Schwab Corp., which oversees $1.4 trillion for clients. Merrill Lynch & Co., Bank of America Corp. and the rest of the securities industry aren't losing credibility because of anything sinister. The problem is they didn't get their math right after credit markets froze nine months ago.

As Alcoa Inc. kicks off first-quarter earnings season [Monday], analysts say 2008 will be the best year ever for U.S. profits, data compiled by Bloomberg show. Earnings for companies in the Standard & Poor's 500 Index will rise 10.7 percent, even after Federal Reserve Chairman Ben S. Bernanke acknowledged that the economy may fall into a recession and banks reported $232 billion of writedowns and losses, the forecasts show. . .

The S&P 500 dropped almost 10 percent in the first quarter, the worst start to a year since 2001, as increasing unemployment, record mortgage delinquencies and a retreat in consumer confidence signaled that the economy is falling into a recession. Even with the decline, analysts' recommendations to "buy'' or "hold'' U.S. shares climbed to 94.5 percent, the highest rate in more than five years."

There's an old Wall Street expression about analysts: You don't need them in a bull market, and you don't want them in a Bear market. The latter half of that expression is usually because of the earnings downgrades adding to stock price action weakness.

Question: What will happen to equity prices if and when analyst downgrades start coming ?

~~~

What say ye?

Source:
Schwab Asks Who Needs Analysts After Biggest Flub
Michael Tsang and Eric Martin
Bloomberg, April 7 2008
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aafbjqdWG7pQ

Earnings Report Card

Monday, April 21, 2008 | 03:30 AM

in Earnings | Valuation

Very mixed results -- is the is glass half full or half empty?

Google's Black Box

Friday, April 18, 2008 | 10:00 AM

in Earnings | Web/Tech

My friend Paul asks, "Why Was Everyone Wrong-sided on Google?"

I am not sure, but an anonymous emailer has a theory. He notes that like GE Google (GOOG) also has their own form of a Black Box. Its the magic in between Google AdWords and Google AdSense.

"Stupid bloggers have no idea what they are getting paid for their Google ads. What is the CPM? You don't know. That gives Google a tremendous financial flexibility to "adjust" the payout on the fly to make up any revenue shortfall."

That all might be true -- it could account for some of the 42% revenue growth -- but it doesn't explain how Google managed a 20% click through rate on ads.

Question: Can (and does) Google change the rates they pay to meet their quarterly numbers?

Previously:

Kryptonite Caused GE's Miss
http://bigpicture.typepad.com/comments/2008/04/ge-loses-the-ma.html

Kryptonite Caused GE's Miss

Thursday, April 17, 2008 | 07:26 AM

in Corporate Management | Credit | Derivatives | Earnings

The sub-prime problem is Kryptonite to GE.

I'll get to that in a minute, but before I do, a brief review. Last week, I questioned CNBC's embarrassingly softball interview of GE CEO Jeff Immelt. As noted, it would have behooved Immelt to demand his reporters ask him tough questions in order to protect the NBC/CNBC brand.

I suggested ordering the anchors not to go soft on him: "I expect you to maintain our reputation as the pre-eminent business news channel, and if you are too soft on me, it costs the company its reputation. Ask me tough questions. Raise difficult issues. Challenge me as if this were 60 Minutes. Anyone who pulls their punches or throws me a softball question is fired."

That did not happen.

Now, less than a week later, both the WSJ and the NYT are questioning GE's strategies. And even more intriguingly, analysts are rethinking their decade of unswerving support about this whole industrial conglomerate thingie.

As is so often the case, many of the fundie guys completely miss the point. They seem to barely get just why GE missed so badly this quarter. Even worse, they misunderstand how GE was such a wonderfully consistent and predictable beat-by-a-penny machine for so long.

The answer to both of these issues can be summed up in two words: GE Capital.

Over the years, GE Capital was this wonderful black box straight from planet Krypton. It had super powers under the Earth's yellow sun that other merely mortal companies did not. Jack Welch played the role of Superman, with an ability to make this enormous global conglomerate meet or beat every quarter, regardless of economic conditions. His unearthly powers were unmatched by other companies.

Transparency? Ha! No analyst ever really knew what was going on in there. It was a highly leveraged hedge fund, but that never really mattered, just so long as GE kept up the illusion that these profits were the result of ordinary industrial -- rather than leveraged financial -- operations.

Unfortunately for Immelt, he is facing not just a run of the mill domestic slowdown, but a much more important problem for GE: The credit crunch and subprime debacle. This has hamstrung GE Capital's ability to pull a penny or two out as necessary.

In other words, sub-prime is Kryptonite to GE. Not only has it lost its ability to fly and repel bullets -- i.e., beat every quarter, regardless -- but it actually weighed the company's earnings down with its losses.

Jack Welch went on CNBC yesterday, and again today, to defend the GE conglomerate model; it was a futile effort to those who know how GE managed their earnings for so many years during the Welch regime. His appearance only served to remind viewers of how wonderful life was when Jack's magic black box had all its superpowers. Even worse, Immelt is stuck with a superhero -- but no superpowers.

GE Capital has been exposed to Kryptonite, and as everyone knows, when exposed to particles of its home planet, Superman becomes powerless.

As has GE Capital. . .

Previously:
Surprise: Gee! No, G.E.
http://bigpicture.typepad.com/comments/2008/04/gee-no-ge.html

Sources:
G.E.’s Shortfall Calls Credibility Into Question
NELSON D. SCHWARTZ and CLAUDIA H. DEUTSCH
NYT, April 17, 2008
http://www.nytimes.com/2008/04/17/business/17electric.html

Embattled GE CEO Defends Strategy
Immelt Scolded By Welch on TV; Appliance Sale?
KATHRYN KRANHOLD and CAROL HYMOWITZ
WSJ, April 17, 2008; Page A1
http://online.wsj.com/article/SB120839179207621423.html

Surprise: Gee! No, G.E.

Friday, April 11, 2008 | 10:00 AM

in Earnings | Economy | Financial Press | Valuation

So much for the theory that because there weren't a lot of profit warnings, earnings will be hunky dory.

Just back from a morning meeting, having heard about GE earlier this morn.

Obviously, this does not change our main thesis at all: The slowdown in Consumer spending caused by a weak economic recovery, and then by the Housing collapse, combined with increasing cautiousness on the side of Business spending and hiring is taking its toll on revenues and earnings. Markets are not cheap, and are not priced for a full blown earnings recession.

The stock market may be entering a mine field as earnings start to flood the tape next week. We shall soon see if investors are getting real about earnings. GE proves that the economic slowdown is directly impacting corporate America.

Again, there's that word "Surprise!" We know that financial services contribute about 35% -- down from 40% Q1 07 -- of GE's operating profit. So who is it that is truly surprised that they missed? Quite bluntly, the bigger shock would have been if they hit their numbers.

~~~

How many CEO's get to miss their quarterly numbers, and then get such a kid glove treatment from a major business news channel? I can tell you, not many.

"Hi Jeff! Hi Joe!"
click thru for softball interview

A few highlights:

- GE CEO Jeff Immelt blames the financial shortfall to a large degree on Bear Stearns;
- Immelt takes responsibility for the earnings miss;
-Immelt also confirmed GE's triple AA rating (something that id din't know you could do yourself);
- If we are not in a recession now, we are very very close

One point that needs to be made: There is an obvious conflict of interest for any journalistic entity to interview their own CEO. Its an interview that most journalists would shy away from. Its impossibly conflicted.

My friend Herb notes that this is a thankless task, and "CNBC would get criticized for not covering their parent. If I were interviewing my boss on tv I'd probably be careful -- at least if I valued my job." Given all that, this interview was stunningly gentle -- the only thing missing was a group hug at the end. I don't know what sex acts Spitzer paid for, but I suspect the interview above was not dissimilar to them.

~~~

Here's an alternative to this sort of nuzzling interview: If I were GE's CEO, I would say to my reporting staff:

"I expect you to maintain our reputation as the pre-eminent business news channel, and if you are too soft on me, it costs the company its reputation.

Ask me tough questions. Raise difficult issues. Challenge me as if this were 60 Minutes.

Anyone who pulls their punches or throws me a softball question is fired."

But that's just me . . .

How Cheap Are Stocks ?

Wednesday, April 09, 2008 | 07:07 AM

in Earnings | Economy | Markets | Trading | Valuation

One of our intermediate concerns about equities involves valuations. While we recently made a short term buy call, that is merely a trade that could possibly run for a couple of weeks or months -- but not much longer. That call certainly wasn't made because stocks are such screaming bargains.

As to valuations: Its hard to really say that stocks are cheap here. At best, I believe we can argue that -- assuming that historically high earnings do not fade -- that stocks are not terribly expensive. But that is very different than saying they are cheap.

Have a look at this lovely table from Dow Jones Market Data Center:
>

Stocks Are Not Cheap

You can also see the Yields On Dow Stocks here (Thanks, Tim!)

These are not the sorts of valuations you find at the end of Bear markets. And, James Montier points out a factoid that makes the above even worse: Analysts lag reality. James adds the damning observation that "They only change their minds when there is irrefutable proof they were wrong, and then only change their minds very slowly."

Have a look at his chart below: It is a linear time trend out of operating earnings and the analyst forecasts of those earnings (so the chart simply plots deviations from trend in $ per share terms).

>

As the red line in the chart shows, the earnings recession is just now beginning. But as the black line reveals, analysts have yet to lower their earnings numbers. Montier notes that the downgrading of estimates has been highly constrained to the financials (and to a lesser extent the consumer sector in the US for 2007).

Roughly speaking US earnings ex financials have been revised down by 1.5% compared to nearer 4% for the market as a whole.

Thus, our contention that markets have only priced in a short, shallow recession . . .

Source:
Asleep at the wheel, or, How I learned to stop worrying and love the bomb
James Montier
Apr 07 2008, 02:52 PM
http://www.investorsinsight.com/blogs/john_mauldins_outside_the_box/archive/2008/04/07/asleep-at-the-wheel-or-how-i-learned-to-stop-worrying-and-love-the-bomb.aspx

Related:
Schwab Asks Who Needs Analysts After Biggest Flub
Michael Tsang and Eric Martin
Bloomberg, April 7 2008
http://www.bloomberg.com/apps/news?pid=20601109&sid=anstoKu002tE&

Profit Projections

Tuesday, April 08, 2008 | 05:30 PM

in Earnings

Source:
Pepper … and Salt
April 2, 2008; Page A14
http://online.wsj.com/article/SB120709975061882223.html

How Will Q1 Earnings Compare To Q4?

Tuesday, April 08, 2008 | 03:00 AM

in Earnings | Video

After Monday’s NYSE close, Alcoa (A) reported a 54% earnings miss, blaming soaring energy costs and the weak dollar, reporting .37 (ex-items .44); .50 to .53 was expected.

For those who believe technology is non-cyclical, i.e., immune from recession, AMD missed Q1 revenue forecasts. The company said sales declined 22%, falling to ~$1.5B (AMD dropped 7% in after-hour trading). In response, the firm is cutting 10% of its workforce (1,600). PALM also issued an earning miss, saying its Q3 loss would increase to .53 vs. a forecast .30.

Which leads directly to this:

5 Reasons Why Bank Stocks Have Not Bottomed

Monday, April 07, 2008 | 12:00 PM

in Credit | Earnings | Employment | Valuation

Merrill Lynch says that they (ML) are through the worst of the credit crisis.

RBC Capital Markets believes that whether that is the case or not, Bank stocks remain attractive. Here are RBC's 5 reasons why bank stocks have not reached the bottom:

5 Reasons Why Bank Stocks Have Not Bottomed

1) Bank Stock Valuations Are Still Excessive:
• Current stock valuations of the Top 50 banks relative to historical valuations, remain expensive -- even with the recent poor performance.

• The Top 50 banks' forward 12-month P/E ratio stands at 13.2x, which is roughly one standard deviation above the mean (25-year avg of 10.9x).

• During the trough of the last two bank stock bear markets, 1990-91 and 2000-01, P/E ratios for the top 50 banks declined to 5.7x and 10.1x, respectively.

2) Recessionary Forces Will Lead To Bigger Credit Quality Problems:
• In prior recessionary periods, credit problems typically followed as a result of the weakening economy. We believe the U.S. economy is currently facing recessionary pressures that will only worsen extending into 2009.

3) Exposure to Riskiest Loan Areas Remains Extreme:
• Construction, Commercial Real Estate (CRE) and leveraged loans have provided steady growth over the past few years. Commercial loans outstanding for the US banking industry grew 64% from 2004 to 2007 due to demand from the syndicated loan market, in our opinion. As the economy weakens further in 2008, the underlying fundamental strength in commercial real estate and industrial America will soften leading to higher defaults in poorly underwritten CRE and leveraged loans.

4) Loan Loss Reserves Are Too Low:
• Bank management teams will often claim loan loss reserve adequacy only to boost reserves in subsequent quarters. We have adopted the Eyles Test (ET) for loan loss reserve strength. Banks should build and maintain reserves that will ensure survival during the down leg of the credit cycle.

5) Credit Problems Are Not Likely To Peak Until 2009:
• Given our belief that CRE, construction and leveraged loan portfolios have significant room to weaken in 2008, we believe credit problems will not reach their peak until sometime 2009.

Nice work . . .

Source:
Commercial Banks - Has The Hurricane Passed Or Are We In The Eye Of The Storm?
Gerard Cassidy, Jake Civiello
RBC Capital Markets, APRIL 3, 2008

FT: John Authers on Q1 Earnings

Tuesday, April 01, 2008 | 03:00 AM

in Earnings | Markets | Video

Authers notes (like us) there is still way too much optimism on Earnings growth; Even ex-financials, expectations are for double digit gains:

click for video:

Source:
Short View
FT, March 27, 2008
http://www.ft.com/cms/bfba2c48-5588-11dc-b971-0000779fd2ac.html?_i_referralObject=699507360&

Crude Oil = $108

Tuesday, March 11, 2008 | 03:00 AM

in Commodities | Earnings | Technical Analysis

Crude futures moved further into uncharted territory, with oil gaining momentum in defiance of a decline in other commodities.

Light, sweet crude for April delivery rose $2.75, or 2.6%, to $107.90 a barrel on the New York Mercantile Exchange, a settlement record. The front-month contract hit an intraday high of $108.21, marking the ninth out of the last 10 sessions in which a record was set.
>

Crude Oil April 2008 Futures

Source:
Crude-Oil Futures Soar To Another High, $107.90
BRIAN BASKIN
WSJ, March 11, 2008
http://online.wsj.com/article/SB120515816176724241.html

The John McCain Market Selloff

Friday, March 07, 2008 | 02:00 PM

in Earnings | Markets | Politics | Trading

Ever since the Primary on Tuesday, the market's have aggressively sold off. This clearly indicates the equity market's fear of a McCain presidency.

As the charts below show, ever since Tuesday -- when McCain's Intrade price soared -- stocks have been under continual pressure.

Had Barrack Obama knocked out Hillary Clinton, a mano-a-mano contest would have taken place. A well rested, fully funded Democratic nominee would have been a very tough opponent for the aging Arizona Senator.

However, the Democratic nomination now looks certain to go on for much much longer. It is highly likely to:

-Physically and emotionally wear down the two Democratic candidates;
-Force them to consume much of their war chest;
-Lead the electorate to become tired of the rhetoric, and disenchanted with both candidates
-Prevent the candidates from spending time doing much opposition research no McCain.

All of this works to McCain's favor. He can therefore rest, save his campaign warchest, maintain Media presence (but not to the point of over-exposure). All these positives show up at InTrade (see charts below), where McCain's bettors have upped the ante, sending his futures skyward.

And, the stock market has sold off, therefore proving that McCain must be bad for stocks and for the economy.

John McCain Futures Rally

>
The John McCain Market Selloff

~~~

Of course, I don't believe a word of that. But you would be surprised as to how many otherwise intelligent people spew variations of this sort of nonsense everyday.

I will unequivocally state that anytime you hear this sort of nonsense, you can rest assured that the speaker is a) an unabashed partisan; 2) relatively clueless about how market's operate; iii) never worked on a trading desk.

Markets operate not as forecastors, but as discounting mechanisms. Consider what has to be discounted to credibly say this: First, we would need to know who is likely to win the next election, 8 months in the future.

Remember, eight months ago, it was a lock that Rudy Giuliani was the GOP nominee, and Hillary was going to easily capture the Dem nomination. In case you haven't been paying attention, eight months is a lifetime in politics.

The next president gets sworn in on January 20, 2009. They have to put together a series of legislative proposals, then get them passed by Congress, then fund them. Then, they have to begin implementing them. The impact of these would likely be felt sometime around 2010.

Hence, the utter absurdity of the short term market twitches somehow reflecting unknown possible events, and their likely macro impact, several years hence. Ridiculous.

Consider these questions as the more likely stimuli this bloody market is actually responding to -- the nearer term events that are still unfolding today:

-Are we in a recession or not?
-Is the credit problem fixed yet?
-How much worse will housing get?
-Will earnings rebound in the second half of 2008?
-Will the US dollar ever stop falling?
-Are US deficits going to continue to skyrocket?
-How much more will consumers pull back on their spending?
-(Did I mention the housing picture is a disaster?)
-The war in Iraq is God-awful expensive, is there any relief in sight?
-Is Oil going to go to $150?
-Can the wobbly banks regain their footing?
-And how much more will inflation heat up?

The markets have enough data to digest before they even remotely begin to consider who might be president in 2009, and what they might do . . .

S&P500 Earnings for 2007: Down -4.2%

Friday, February 29, 2008 | 05:30 AM

in Earnings | Valuation

At the beginning of 2007, the S&P500 was over 1,400, the Dow was just under 12,500, and the Nasdaq was about 2,500. Stocks, according to consensus estimates, were "cheap," and profit growth expected to be 10%+.

With 90% of earnings reported by the S&P500 firms, we now have enough data to see how the full calendar year was for profits.

Here's the overview from S&P's Sam Stovall:

At the end of 2006, S&P equity analysts expected operating earnings per share (EPS) for the S&P Composite 1500 (comprised of the S&P 500, MidCap 400 and SmallCap 600 indexes) to advance 10% in 2007, a healthy follow-up to the 15% gain seen in 2006.

Yet with 2007's results nearly final, we now find that EPS for the S&P 1500 actually sank by almost 4% on a worse-than-expected fallout from the housing, subprime, and credit crises.

Within the S&P 1500, the S&P 500 index, which represents 88.5% of the market value of the 1500, likely registered a 4.2% year-over-year decline, while the S&P MidCap 400 (7.8% of the 1500) eked out a 0.1% gain, and the S&P SmallCap 600 (3.7% of the 1500) fell 5.6%.

The 1500's negative earnings results for the year were the result of deteriorating profit growth for the Consumer Discretionary and Financials sectors in particular, as these sectors posted declines of 17.8% and 33.3%, respectively, as of Feb. 19, 2008. The second half of last year was the toughest for the overall market, as it suffered through EPS declines of 9% in the third quarter and 22% in the fourth, a quarter that many dubbed the "kitchen-sink quarter" as companies wrote down everything—including the proverbial fixture. (emphasis added)

The relative performance of the mid-caps was likely due to the presence of many energy, commodity and agricultural stocks. Indeed, a few sectors have done rather well: The exporting industrials, anything Ag or energy related, consumer staples, utilities have all thrived. Financials, anything house related, many retailers, consumer discretionary all performed poorly. I was a little surprised by the full year number, thinking the good sectors and the first half numbers might partially offset the second half.

What does this say about the market itself as a forecaster?

Short answer: The easy, glib readings -- so favored by all too many ignorant media pundits -- are all too often, wrong. Accurately interpreting the body language of Mr. Market is far more difficult and nuanced than the usual nonsense you hear peddled.

Here's the amusing part: The same group of S&P equity analysts who foolishly were looking for a 10% advance in 2007, are now expecting a profits recovery in the second half of 2008. Their favorite sectors are (drum roll) Consumer Discretionary and Financials.

The thinking must be that the credit crunch will just go away, energy and food prices will drop, and the consumer will begin another wanton spending spree.

Hmmmm. I suspect this S&P profit forecast to be every bit as prescient as the previous one . . .

Source:
Earnings: A Clearer Picture Emerges
Sam Stovall
February 26, 2008, 7:44PM EST
http://www.businessweek.com/investor/content/feb2008/pi20080226_304457.htm

WTF Headline of the Day: "Dow 18,500? Believe It"

Wednesday, February 13, 2008 | 06:58 AM

I got a huge kick out of this headline last night:

Dow 18,500? Believe It
http://biz.yahoo.com/ms/080212/228434.html?.v=1

Morningstar based this number on the "fair value estimates" of the index's components. I have no idea how fair value is derived -- earnings? ROI? cash flow?

Regardless, this is Morningstar's forecast over the next 3 years; that translates to 14.8% annualized price return, excluding dividends. With divvies, returns are 17% per year.

And why I was so amused? Well, first off its precariously close to exactly half of the infamous Dow 36,000 book by Glassman & Hassett we all know and love so much. Could the timing of that book have been any better, published as it was on October 1, 1999?

Second, I find that high degree of certainty in the headline, well, cute. It ignores the basic reality of forecasts, that no one knows what the future will bring. And that is always amusing to me . . .

Source:
Dow 18,500? Believe It
Jeffrey Ptak, CFA, CPA
Morningstar, Tuesday February 12, 7:00 am ET
http://biz.yahoo.com/ms/080212/228434.html?.v=1

Previously:
Apprenticed Investor: The Folly of Forecasting
Barry Ritholtz
TheStreet.com, 06/07/05 - 01:05 PM EDT
http://www.thestreet.com/_tscana/comment/barryritholtz/10226887.html

The Flawed Fed Valuation Model

Tuesday, February 05, 2008 | 07:18 AM

in Data Analysis | Earnings | Fixed Income/Interest Rates | Quantitative | Valuation

There are lots of things that investors believe which I find perplexing. The Superbowl indicator is one, but the oddest to me is the so-called Fed Model, also known as the IBES Valuation Model.

It is not that the Fed model is so terribly wrong -- it has been both right and wrong over the years. Rather, it is the way too many people conceptualize it.

First, the definition of the Fed Model: Yield on the 10-year U.S. Treasury Bonds should be similar to the S&P 500 earnings yield (forward earnings divided by the S&P price). This, in theory, should inform you of when equities are over-priced or under-priced.

Note that the formula contains two variables: While it is commonly described as a way to evaluate when stocks are over- or under- valued, the other variable in the formula above is the forward S&P500 earnings consensus. SPX prices and the 10 year yield are the knowns, but while valuation and forward earnings are the unknowns.

Thus, the Fed model today might be telling you to things: When equities are undervalued -- or when consensus earning estimates are too high.

Let's see how that looks on a chart:
>

graphic courtesy of Hays Advisory (June 2007)

>
Looking at the chart above, we can identify some rather odd periods. The model had stocks extremely undervalued in 1979 -- just before a major 30% selloff. In 1981, stocks were fairly valued on the eve of the greatest bull market in history. From 1982-85, stocks bounced between slightly overvalued to undervalued, according to the model. In 1987, a very timely crash warning. 1998, an extremely early crash warning, missing a huge 2 year run in the indices. In 2001, it had stocks as undervalued -- and they proceeded to get a whole lot cheaper over the next 2 years. Equities have been extremely undervalued ever since.

Now, given that rather inconsistent track record, I find it hard to get too excited about this. But the most damning evidence against the Fed model is the period prior to 1960s. Over that entire, the Fed model had no utility whatsoever. "Out of sample" testing -- looking at a different set of data than the one proffered -- is quite damning to the Fed model.

Which brings us back to today. We continue to see the Fed model used to rationalize a bullish stance in equities. However, given that it is based in large part on analysts consensus for future SPX earnings, investors need to be extremely cautious relying solely on the Fed model. Why? Analysts are unflaggingly inaccurate at turning points. Example: Q3 S&P500 earnings consensus were +8% -- S&P500 earnings came in at -8%. Q4 has been similarly lowered, undercutting the earlier forecasts of undervaluation.

Now let's look at 2008. S&P 500 forward earnings over the next 4 quarters are as follows: Q1 = 3%; Q2 = 4%; Q3 = 20%; Q4 = 50%, according to UBS.

So stocks, so we are confronted with two possibilities. Perhaps, equities are seriously undervalued (that assumes earnings explode in 2H). An alternative explanation, and one I suspect is more likely: Analysts consensus earnings are wildly exuberant for the second half.

One last issue: Let's ignore the analysts, and merely consider mean reversion: As the chart below shows, earnings have been unusually high relative to history. If they merely mean revert, they will come down another 25%. Even worse, most mean reversion blows right past historical averages to opposite extremes.

Graphic courtesy of Vitaliy’s Contrarian Edge, from the book Active Value Investing: Making Money in Range-Bound Markets

The bottom line -- either equities are extremely under-valued, or analyst consensus earnings are significantly too high.

But to treat the Fed model as if it merely looks at valuation is to ignore a key variable -- future earnings consensus -- that tends to be wrong at the worst possible moment . . .

Sources:

Active Value Investing: Making Money in Range-Bound Markets
by Vitaliy N. Katsenelson
Wiley, September 28, 2007

A Profit Fumble -- or Not?
TOM LAURICELLA
WSJ, February 4, 2008; Page C1
http://online.wsj.com/article/SB120208551253339345.html

Fight the Fed Model: The Relationship Between Stock Market Yields, Bond Market Yields, and Future Returns
CLIFFORD S. ASNESS
AQR Capital Management, December 2002 http://papers.ssrn.com/sol3/papers.cfm?abstract_id=381480

The Fed Model: The Bad, the Worse, and the Ugly
JAVIER ESTRADA
IESE Business School January 2006
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=877245

Solving the Price-Earnings Puzzle
CARL CHIARELLA
University of Technology, Sydney - School of Finance and Economics
SHENHUAI GAO University of Sydney - Economics and Business
April 2002UTS Working Paper No. 116
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=880002

Blog Synthesis: Gunning for the Fed Model? http://www.cxoadvisory.com/blog/internal/blog-fed-model/

Equities, Earnings and Recessions

Monday, January 14, 2008 | 07:13 AM

in Earnings | Economy | Investing | Markets

There they go again.

The disinformation crowd is busy trying to confuse you, sucker you, make you lose money. It's not a conspiracy to make you poor -- just bad advice from the stupid.

No, stocks do not do well in recessions, as the usual dopes have said on TV.

Yes, they peak before the recession begins, and bottom before it ends, but by and large, recessions are typically a negative event for equities. Earnings falter, and P/Es adjust, typically driving prices lower -- and at times, much lower.

According to Northern Trust's Asha Banglore, the movements of the S&P 500 just prior to and during a recession act as a leading indicator to future economic activity. Her analysis of leading/lagging properties of the index -- and how much it changes during a recession -- is presented below.

In the post war period, the median percent decline of the S&P 500 from its peak to trough around recessions is 16.9%. That's using a monthly S&P500 average; Using weekly and daily averages produces steeper measurements of decline than does a monthly.

Today's WSJ has a similar analysis:

"If the economy is heading into recession, as many on Wall Street fear, history may offer some clues about what that might mean for stocks.

No two downturns are alike, but a look at market performance during previous recessions gives some clues about whether the market will have a relatively smooth rebound, meaning investors should be setting themselves up for the recovery, or a long, tough slog."

You can vary the results depending upon which periods you review, what data periodicity you rely on, and how what you use for start and end dates of recessions.

But to say that stocks do not go down during recessions is frighteningly wrong . . .

Sources:
The S&P 500 and Economic Recessions (PDF)
Asha G. Bangalore
Northern Trust, January 07, 2008
http://tinyurl.com/yr2whk

History Lessons: Past Recessions Yield a Few Clues
Stocks Can Suffer Badly, As Happened During '01,
But Not So in 1990-91
MARK GONGLOFF AND SCOTT PATTERSON
WSJ, January 14, 2008; Page C1
http://online.wsj.com/article/SB120027444331987485.html

Recession Hits U.S. Profits; Economy Might Be Next
Rich Miller
Bloomberg, Dec. 3 2007
http://www.bloomberg.com/apps/news?pid=20601087&sid=a_TgRes4VjjU&

Profits vs Cash Flow

Monday, December 03, 2007 | 11:54 AM

in Earnings | Economy | Valuation

Mike Panzner passes along this intriguing chart:

Not only are corporate profits at unsustainable 40-year highs relative to GDP, cash flow has been falling while profits have been rising in recent years -- not a very sustainable situation.

Source: Michael Panzner

Goldman Sachs: Sell Tech Selectively

Sunday, December 02, 2007 | 07:31 AM

in Apprenticed Investor | Corporate Management | Earnings | Technology | Valuation

Yeoman's work by Barron's Eric Savitz, who pens the must read techblog Tech Trader Daily, in assembling a laundry list of stocks downgraded by GS (published Friday after the bell).

The money quote from Goldman analysts states they have become "incrementally more cautious on tech fundamentals given the current macroeconomic backdrop."

Additionally, "with software a typically back-end loaded sale, if there is any concern on budgets in the early part of 2008, we would expect CIOs to hold off their purchases until later in the year."

The main area of concern: "Companies with large enterprise exposure and significant dependence on the U.S. consumer."

Ouch.

I have long advocated deciding on an exit strategy prior to owning a stock. While these downgrades may not mean immediately selling them, at the very least you should be revisiting your pre-planned exits. If you are unsure about selling, your trailing stop losses should give you some protection in the event of a selloff. If you are not using trailing stops, then you may want to tighten up your existing stops -- especially on those names that have enjoyed a good run.

What follows is a list of stocks affected by estimate cuts and/or price target changes by sector.

Semis/Chip stocks:

Advanced Micro Devices (AMD)
ATMI
Broadcom (BRCM)
Entegris (ENTG)
FormFactor (FORM)
International Rectifier (IRF)
Intel (INTC)
Intersil (ISIL)
Microchip (MCHP)
Micrel (MCRL)
Marvell MRVL)
Micron (MU)
Maxim (MXIM)
National Semi (NSM)
Nvidia (NVDA)
Teradyne (TER)
Texas Instruments (TXN)
Volterra (VLTR)

Hardware:

Dell
Directed Electronics (DEIX)
EMC
Emulex (ELX)
IBM
Intevac (IVAC)
Isilon (ISLN)
Lexmark (LXK)
Network Appliance (NTAP)
Sun Microsystems (Java)
Brocade (BRCD)

Goldman previously made similar moves this week in Software:

Adobe (ADBE)
Autodesk (ADSK)
BEA (BEAS)
BMC
Computer Associates (CA)
Check Point (CHKP)
Citrix (CTRX)
Cognos (CGNS)
CommVault (CVLT)
Informatica (INFA)
Macrovision (MVSN)
McAfee (MFE)
Oracle (ORCL)
Quest Software (QSFT)
Red Hat (RHAT)
RightNow (RNOW)
SAP
Secure Computing (SCUR)
Symantec (SYMC)
Tibco (TIBX)

Communications:

Netgear (NTGR)
Corning (GLW)
Cisco (CSCO)
Nortel NT)
Aruba (ARUN)
Juniper (JNPR)

Payment processing companies:

ADP
Paychex (PAYX)
Global Cash Access (GCA)
Global Payments (GPN)
Master Card (MA)
MoneyGram (MGI)
Amdocs (DOX)
Convergys (CVG)
CSG Systems (CSGS)
Synchronoss (SNCR)

IT services:

Accenture (ACN)
Bearing Point (BE)
Sapient (SAPE)
Affiliated Computer Services (ACS)
Computer Sciences (CSC)
EDS
Unisys (UIS)
Cognizant (CTSH)
ExlService (EXLS)
Infosys (INFY)
Patni (PTI)
Satyam (SAY)
Witpro (WIT)

Let me reiterate this: A downgrade on this many stocks is worth noting, but does not mean the world is ending. Experienced traders know to have a plan in effect, to follow their discipline, and to not get panicked into doing something foolish -- on the long or short side.

Sources:
Goldman Turns Wary On Tech Sector; Cuts Estimates, Targets For Dozens Of Stocks
Eric Savitz
Tech Trader Daily, November 30, 2007, 4:25 pm
http://tinyurl.com/yuqg75

Goldman Turns Cautious On Software, Citing Macro Factors; Cuts Ests
Eric Savitz
Tech Trader Daily, November 27, 2007, 9:41 am
http://tinyurl.com/ypl6u2