Wednesday, August 01, 2007

Equities are from Venus, Bonds are from Mars

The world is often a unusual and oft-varied place. Take women and men, the latter of whom I am told are from Mar, and the former from Venus, which if my spouse and I are any indication, is accurate indeed. Or more to the point of this blog, take the fixed-income and equity markets. Bizarrely, in the USA over the past three months, "price" and "Value" have, it must be said, mattered ever more and more to lenders, evidenced by widening credit and swap spreads. This is perhaps it always has been or should always have been excepting the past four-year interlude of essentially negative real interest rates, coincidental to massively loose fiscal policies (globally) coupled with floods of both petrodollars and overseas surpluses
"willing" (at least via official sponsors) financing any and all US CA requirements at knock-down prices. This has, in Q2 and last month , been more or less halted with the mauling of the sub-prime market, and the emerging credit and de-leveraging cascade that seems to have been irreversibly set in motion.

But over in USA equityland, which I will term the "Venus" of markets for her (and it IS a "Her") frequent irrationality, unpredictability, and sheer volatile irascibleness, things have moved in the opposite direction. For over the past four months, price-related (i.e. value anchored) factors have not only had no relevance at all, but have attributed negative alpha in large quantities, not seen since 1990, Q3 2002, and the tail-end of the internet bubble in 1999. Undoubtedly, PWMT (poor white mortgage trash) things like NEW, AHM and the like have contributed on the tails. But I am measuring the returns in a variety of ways, both tails, AND cross-sectionally, and while the extremes DO impact the tails, the cross-sectional pictures are fascinating.

The flip-side of price/value factors are typically non-price factors such as variously-framed naive price momentum, earnings revision & earnings momentum, and earnings growth viewed WITHOUT respect to price/value-based factors. And these factor returns I will point out to you, resemble accelerating runaway trains. This is true in EVERY momentum frame, and most earnings-revision, earnings-momentum, and earnings-growth frames. On top of this, the fat-tail over the past four months (following Cassandra's whimsical ill-timed Crash Prediction) has NOT been on the torpedo side, but rather on the positive side of the daily distribution of returns, with some contributions from PE takeovers and mergers, but most often from a positive earnings surprise.

In a layman's nutshell, "the market" has been buying overt earnings growth, positive changes in earnings forecasts, and what went up historically WITHOUT RESPECT TO ABSOLUTE OR RELATIVE PRICE OR VALUATION ANCHORS. This is nothing new, for the market, in its periodic syphilitic or hormonal fits does de-couple from what prudence and the amthematics of discounting would otherwise suggest.
But I will point out that the gods (and probability theory) does not favor those betting with the apparent crowd at these junctures.

But as one who heeds and respects the wisdom of the crowd (though rarely follows it in positions) one must always ask whether probability (the rear-view mirror) is potentially yielding erroneous results, and the future will [continue] to depart from the past in meaningful fashion. SO what's going on? In equityland, "Value" is viewed as the anti-christ. "Growth" is the saviour himself. Like the Saviour, who is viewed differently by different cultures, so to is "growth. Some see HIM in earnings revision. Some see him in quality (EVA, CFROI, Asset turns etc.) Others in high earnings growth, and still others (the Evangelical sect IMHO) in price momentum. "Value" is unreliable as a saviour for such company earnings are too highly correlated to the market's earnings, hence have little appeal to alpha-seeking investors desiring to stand-out. This, in turn, creates a feedback loop reinforcing behavours and data-miners alike . So during times of heightened risk, the "flight to quality" disregards price, opening large anomalies for those better skilled in the art of discounting, willing to warehouse quality risk and stomach the P&L variability. Needless to say, during times of a macroeconomic dislocation that sees deleveraging as the norm, taking on additional quantities of such "risk", ends up pretty low on the totem pole, when firms are coming to terms with redemptions, margin calls, untold quantities of dubious mortgage & junky PE debt on their books, in addition the opportunities that such fixed-income spread widening yields to all.

There IS opportunity in this equity spread for cowards. But given that the positive momentum tail is so absolutely expensive, and the "cheap tail" not all that absolutely cheap, either to the market or itself, for the brave, the trade is probably to drill the most expensive stocks, particularly ones with some US PCE component or sensitivity, for many of these players are also leveraged, and systematic, and amidst a crappy market, a fishing expedition for stops and pain thresholds in ostensibly very overvalued situations might shake more fruit from the tree than otherwise might be the case.


The Olive Oil Gazette said...

Nice take. Thanks.

"Cassandra" said...

just have a look at ISRG, AMZN, BWLD, CROX, TASR, RIMM AAPL, NILE TPX NVT CNQR all admirable companies but all which have entered the netherworld of valuation.

THen there are what one might thought would be cyclical plays that are to themselves more expensive than ever e.g PCP SGR POT AYE RRI ....

And of coures there are more.

Macro Man said...

From a naive top-down perspective, equity valuations don't look particularly rich at all on an index level. So what drives the wedge between apparent index-level value and single-security richness? Is it XON and the like that are 'artificially' reducing the PE etc of the indices?

And if you think value has been lousy in equities, it's been even worse in FX (I know you have some experience with this.) My estimate of the 3 year sharpe for a semi-sophisticated value strategy is -1.4, which I'm sure you'll agree is quite an impressive absolute value for a single strategy within a single asset class.

Charles Butler said...


The PE measure, certainly on the index level, has to be taken with a grain of salt - or better still, a revised model. The combination of low capital investment, high profits, easy credit and stock buybacks probably changes the actual thing we're calculating. To this I suspect we can tack on the undiscriminating weight of ETF's in the market... but I'm still waiting for the first study to appear.

"Cassandra" said...

MM - There are many permutations of conditions that impact "the index". At one extreme, you have Mar2000 "top", that saw the overall index hit highs even though most stocks were hitting lows and "cheap" as they've been, a phenom driven by a minority uber-large cap tech. Indexation in this instance reinforced the manic the feedback loop of buying high and selling.

Triangulating the reasonability of "the market" is a bit like judging a beauty contest. There is no real formula. There are lots of ways of objectively looking "it", that assists in making hypothesis and conjectures, eventually hopefully permitting one make a reasonable forecast based on vectors approximating an objective reality.

Indeed average index PE looks .. well.. average. Not too cheap, not too dear. But even here,, looked at more closely, markets (before the days of divergent momentum strategies) historically more often than not looked as expensive as today AFTER a recession when earnings were diminshed, and "cheap" AFTER a long bull run in earningsm thereby discounting the expected future diminishment in earnings. This was esdpecially true of "cyclicals".

Today things have (or or believed to have) changed. To some (The Gave's of the world). The business cycle is dead. Productivity gains seem nearly unending. Globalisation has spawned a period of unending growth. Credit and Wall St is irrelevant to Main Street, the premise which means no need discount anything, and that the euqity premium was in the past, irrationally high) and now has forever fallen to levels sympathetic with this brave new world of risk.

I say this with some derision, but it remains possible, despite my skepticism. And I DO respect such possibilities by asking myself the question each and every day, in Popper-esque fashion.

My observations however, are more precise, and my notion of "equity risk spreads" reflect a value-oriented notion of risk, rather than a return-oriented notion of risk. This means that while in the short-term - perhaps relating to the aversion the average arbitrageur to warehousing a position with a small negative skew in daily returns in exchange for a much larger fat tail - the "risky" position" in equity land (according to the market) is the one that nibbles against you, where as for me, the "risky" position is the one that is on the wrong side of larger longer-term convergence, that one can demonstrate is likely with some robust statistically-based significance. While LONG TERM such valuation differentials may be requited by future growth, price convergence has been the rule over shorter horizons, penalizing those who transgress the mathematics of discounting, and its implications upon future realized returns.

The momentum guys are fond of saying "but there is no free lunch and one must assume much "risk" to capture such return (where risk is defined as variability of earnings or cash flows or heightened down-market sensitivity). The contrarians, on the other hand might reply: "But how could be it "risker" if it rather reliably yields HIGHER returns in the future, for IF it were in FACT riskier, it would yield lower returns in the future.

In a nutshell, the market appears "averagely" valued partly because of the low valuations of Resource, Financial, and mega-cap pharma stocks, no material overvaluation of the largest cap tech stocks (avg 20x FY1 EPS), but a whole range of stocks in the cross-section ARE expensive their own normalized valuations and the contextual valuations (historically speaking) at this point in the economic cycle, represented by equal-weighted opportunity sets.

So while it is possible that globalisation and dollar collapse has materially changed the growth and cyclical prospects of these enterprises (which is the case baked into current share prices), they make little allowances that historically have been evident for, "shit that just randomly happens. Shit like a huge credit-led global deleveraging, increasing risk spreads across the world, increasing protectionism, rising interst rates, "nucular I-A-tollahs" and attacks by Israel to neitralize the threat, drought, inflation , or deeper than expected recession. Shit just happens sometimes, and that is perhaps why equity risk premiums have been what they have, and "old" and "momentum investment strategy" rarely sit side by side on someone's CV.

Robert said...


Great post and comments. I laughed out loud when you got to the "shit that just happens"

Great blog by the way. I try to check your blog and MM every day.

"Cassandra" said...

thanks. It really is the primary problem with perfection pricing AFTER growth has been recognized and rewarded in price appreciation or AFTER things haven't gone wrong for a long time and potential problems (like fiscal probs, overconsumption, overinvestment in housing, and misaligned currencies) have repeatedly been ignored . Though critics of this line of thought may be point out that each spin of the roulette wheel is independent, I think this is the wrong analogy. The correct one is blackjack, where the dealer is showing a 6, in the face of an overly positive count. Sure, the next card could be a five, but the odds are not the same as at other times.

Macro said...

Coincidentally (or not, as the case may be), the value versus growth debate has been played out in Cramerland this afternoon as well (i.e., TSCM.)

Thanks to liquidity/SWF/savings glut/et al, I cannot but imagine that this market cycle ends with indices looking not reasonable but expensive, even if there remain pockets of single security or single industry value within them.

Perhaps when the energy sector gets expensive and/or priced by Dr. Pangloss, it will be time to sell up and head for the hills with the proverbial stores of candles and tinned food...

Anonymous said...

Ahhh yes the cup of liquidity runneth over into every nook and cranny, blessed are those closest to its fount, for they transform it to strong wine, as it rusheth down the mountain it maketh its own rationale and its own risks, on the plain it deludeth the most righteous as to value. As it doth slow its followers seeketh the comfort of most liquid instruments, for verily those who are borne on to the great sea diluteth themselves.

Cassandra said...

Macro -

Remember: in addition to valuations stretching as a result of price appreciation in excess of earnings growth, so to can they expand as a result of earnings compressing faster than prices decline (and all permutations thereof). I AM, it must be said, partial to the view that almost everyone except unlevered under-speculatively-invested financial calvinists such as myself, believes they will prefer moderate inflation to deflation, and that powers that be will attempt to engineer it so. But because they attempt to make it so doesn;t mean they succeed (or as Annaly suggests, underestimate it until a time when i hindsight they will be seen as taking action its too late)

Charles Butler said...

One more for your list...

While my home team is out ranting about on the Moral High Ground and yours is still debating whether to join the international body which discusses these things (although I have to admit unilateralism worked quite well in Grenada), a very pissed off Putin is planting flags on the sea floor below the north pole as he continues to trump the various paradises of the postwar.

Anonymous said...

I think that Putin is playing his cards, getting advantage of internaational sees (sorry, oceans) laws signed by everybody else but US.

"Cassandra" said...


Don't fret, you can always send in the mounties! ;)