Vitaliy Katsenelson: The pain of mean reversion

Friday, February 20th, 2009

This post is a guest contribution by Vitaliy N. Katsenelson*, author of Active Value Investing: Making Money in Range-Bound Markets and director of research at Investment Management Associates.

The stock market has dropped. Corporate profits have collapsed. And profit margins have reverted toward the mean. What is next?

Before I dive into the discussion, let me explain the chart below, which I named appropriately, “The pain of mean reversion.”

I looked at reported earnings for S&P 500 and compared them to the “average case” earnings scenario. In the “average case” scenario I took reported earnings of S&P 500 in the early 1990s and grew them at 6% - an average growth rate of GDP over the last century which happens to be the same as earnings growth for stocks during the same century.

If the economy had no cyclicality and profit margins remained constant, you would see nice, steady growth earnings for S&P 500 stocks like the one in the chart.

Of course, profit margins do not stay constant - they fluctuate, thus actual earnings swing above and below the steady 6% trend line.

Click here for larger chart.

How far will earnings drop?
You’ll never go wrong quoting Mark Twain when he said “History doesn’t repeat itself, but it does rhyme.” Our challenge as investors is to look at the past and figure out how history will rhyme with the future.

If you were to look at the recent history of the 2001 recession, earnings dropped 54% from their highs to their lows. If S&P 500 reported earnings were to drop by the same amount this time around they’d be at about $39. We are already below that level, 2008 estimates for S&P 500 were revised down again, now to $28. However, this is where Twain’s rhyming thinking becomes important - note that in 2001 earnings went only 18% above the “average case” line; in 2007 they were 31% above that line. If we were to follow the higher they climb the harder (deeper) they fall logic, this would lead us to believe that earnings will drop further this time, estimates for early 2009 earnings indicate that.

When will we see average earnings?
The good news is S&P “average case” earnings are about high $70s to low $80s a share (see big red squares in yellow shaded area) - which would make the market cheap (with a PE of about 10). But here is the bad news (don’t shoot the messenger please) - we just won’t see those “average case” numbers for a while.

The 2001 recession was driven by the overcapacity in the corporate sector. Corporations rationalized their inventories and factories, higher unemployment followed - we were in a recession. Excesses were worked out, corporations started to hire, and voila - we were out of the recession. Of course the recovery process was also aided by a “friendly” Fed, it took interest rates to (at the time) an unprecedented low levels and kept them there until corporations and consumers got seriously drunk on cheap money and spent themselves into serious debt for which we are paying now.

In the 2001 recession it took two and a half years for earnings to rise from their bottom to their average.

Unfortunately we’ll not be that lucky this time - we are in a consumer recession. Consumers are two thirds of the economy and they are deleveraging. As a side note: This deleveraging goes beyond big ticket discretionary items like large screen TVs and SUVs. Now it is showing up in lower consumption of staples like iced tea by Snapple which competes with cheapest commodity of all - tap water. Now, more expensive branded products like diapers and tissue made by Kimberly Clark are forced to compete with generic store brands. The meaning of the word staple is being redefined by this economy.

The Fed, being even “friendlier” than the last time, has lowered interest rates to almost zero, buying long-term bonds etc. But this time around the Fed’s booze will not do the trick - consumers are still suffering a hangover from the last Fed’s “help” - they don’t want to borrow and banks, after incurring huge losses, are behaving like real banks - only giving loans to people who’ll pay them back.

In addition to consumer deleveraging, government debt is skyrocketing with every bailout, thus taxes and interest rates are likely to be significantly higher once the economy normalizes.

The Earnings recovery will likely take longer than many expect, therefore, there is a very high possibility that the “average case” earnings growth going forward will be below the historical average of 6%

Are we about to embark on a secular bull market?
The market is a discounting mechanism - stocks will rise in the anticipation of a future earnings rebound, before the rebound. Similar to the stock market forecasting ten out of the last three recessions, it will discount a few recoveries before the real one takes hold.

What does this mean? We’ll likely have a few “fake” head starts and disappointments before the actual earnings recovery takes place.

As I argued in my book Active Value Investing: Making Money in Range-Bound Markets, we are very likely in the midst of a secular range-bound (trendless, volatile but going nowhere) market that started in early 2000. Historically, range-bound markets started at the end of the secular bull market when P/Es were above average. They ended when P/Es stopped declining (mean reverting), after a visit to below average territory (around 10-11 or less). The current range-bound market started at much above average valuation and will likely rhyme with the past finish at below average valuation as well.

Based on the Pain of mean reversion chart we are trading somewhere between 30 and 10 times earnings. However, neither number is very meaningful. Let me explain:

2008 estimates of $28, the “E” in P/E of 30, are distorted by massive charge offs.

The “average case,” the “E” ($80) that went into P/E of 10, lies in a far away land that … well, let me put it this way, you and I will get to grow sick of presidential campaign advertisements at least once or maybe even twice before that “E” is in sight.

Even based on 2010 “E” estimates ($40) stocks in the S&P 500 are trading at 21 times earnings.

Despite the decline, the market is still not cheap. Sorry, we are not likely to embark onto the new secular bull market anytime soon. History and data suggest that the choppy markets that we have seen since 2000 will likely continue. Owning a broad market index will not pave a road to prosperity. It comes down to not just owning stocks but owning the right stocks.

P.S. As a side note I believe significant earnings write-offs will continue well into next year as financial stocks will pass their write-off torch to companies in energy, materials and industrial sectors - stuff stocks - that will be writing off the investments they’ve made over the last five years.

By the time, I finished putting these thoughts together, which on and off took about two weeks, 2008, 2009 and 2010 estimates were taken down by about 20-25%.

If you missed it, Vitaliy did three 5 minute segment interviews on Yahoo TechTicker on Tuesday with Aaron Task and Henry Blodget.

1. Only Time Can Cure What Ails Us: Stocks Slump on Bailout, Stimulus News

2. Range-Bound at Best: The Long View on Stocks Isn’t Much Better, says Vitaliy Katsenelson

3. Active Value Investing: The Bull Case for EBAY, Philip Morris and Supervalu

* Vitaliy Katsenelson is author of Active Value Investing: Making Money in Range-Bound Markets and director of research at Investment Management Associates. He is also an adjunct faculty member at the University of Colorado at Denver, Graduate School of Business where he teaches Practical Equity Analysis and Portfolio Management. Vitaliy, a CFA charter holder, received both his degrees - bachelor of science and master of science in finance - from the University of Colorado at Denver, where he graduated cum laude.

Tags: Case Line, Case Scenario, Corporate Profits, Director Of Research, Early 1990s, Earnings Growth, Estimates, GDP, Growth Stocks, Investment Management, Lows, Management Associates, Mark Twain, Market Profits, Mean Reversion, Profit Margins, Recent History, Recession, Stock Market, Stocks, Trend Line
Posted in Bonds, Economy, Markets, Oil and Gas | No Comments »

The Man Who Made Too Much: The Other Paulson

Sunday, January 11th, 2009

Portfolio.com’s February 2009 issue profiles John Paulson, the now legendary hedge fund manager whose record payday in 2007-’08 came as a result of doing what can only be described in its entirety as “shorting Subprime.” What’s remarkable about his feat is that there was no simple way to do so at the time 2 years ago. No subprime instruments existed that one could short, and no representative futures or other derivatives were available to make this a strategy that others, no less, Paulson, could employ in order to facilitate his gigantic bet against subprime mortgages and housing.

This is this weeks must-read piece. Here are a few excerpts to whet your appetite:

Hedge fund manager John Paulson has profited more than anyone else from the financial crisis. His $3.7 billion payday in 2007 broke every record, and he made it all by betting against homeowners, shareholders, and the rest of us. Now he’s paying the price.

By scoring returns of this magnitude, Paulson has dwarfed the success of George Soros, whose currency trades in the 1990s made him so much money that he has spent much of the rest of his career atoning for them.

Paulson makes no apologies. During our conversation in his conference room, he describes in detail how he pulled off the greatest financial coup in recent history—a two-year bet that the calamity we are now experiencing would take place. It was a megatrade involving dozens of financial instruments, along with prescient wagers that banks like Lehman Brothers would eventually go under.

The article also features an eye-opening conversation between Jim Chanos and Bear Stearns’ Alan Schwartz:

Chanos, for one, is tired of the blame-the-shorts litany, and he recalls a conversation with Bear Stearns’ Schwartz to make his point.

The day before the Fed’s rescue of Bear Stearns, Chanos says he was walking to the Post House restaurant in New York City, when, at 6:15 p.m., his cell phone rang. He saw the Bear Stearns exchange come up on his caller I.D. and took the call.

“Jim, hi, it’s Alan Schwartz.”

“Hi, Alan.”

“Well, Jim, we really appreciate your business and your staying with us. I’d like you to think about going on CNBC tomorrow morning, on Squawk Box, and telling everybody you still are a client, you have money on deposit, and everything’s fine.”

“Alan, how do I know everything’s fine? Is everything fine?”

“Jim, we’re going to report record earnings on Monday morning.”

“Alan, you just made me an insider. I didn’t ask for that information, and I don’t think that’s going to be relevant anyway. Based on what I understand, people are reducing their margin balances with you, and that’s resulting in a funding squeeze.”

“Well, yes, to some extent, but we should be fine.”

“This is now 6:15 on Thursday night, the night before the collapse,” Chanos says. “It was after a meeting with Molinaro”—Bear Stearns C.F.O. Sam Molinaro—“who basically told him at that meeting, ‘We’re done. We’re gone. We need money overnight we don’t have.’ So here he is, calling one of his biggest clients to go on CNBC the next morning to say everything’s fine when clearly it’s not. And he knew it wasn’t.”

Chanos refused to go on CNBC. By 6:30 the next morning, word was out that the Fed was engineering the rescue of Bear Stearns. Chanos realized that he could have been on CNBC while that was ­announced. “I thought, That f*cker was going to throw me under the bus no matter what.”

Then, Paulson’s outlook:

Paulson is astounded that some optimists continue to expect that somehow the formerly unsinkable economy will remain afloat, at least long enough for the government’s rescue boats to arrive. “Now that we’re in a recession, they’re probably admitting, ‘Okay, we’re in a recession, but it will probably last just two to three quarters.’ So they’re always underestimating the severity of the magnitude,” he says.

Paulson’s own view of the current situation is much darker. He predicts that the recession will last well into 2010 and that unemployment will reach 9 percent, a sharp increase from its current perch just below 7 percent. “We have a long way to go before we reach the bottom,” he says.

About his recent presentation:

Slides in Paulson’s presentation declared that the U.S. had slipped into its deepest recession since World War II. His charts displayed the usual parade of bad tidings: a steep decline in home prices, soaring mortgage delinquencies, credit contracting, and hemorrhaging in the financial sector. The 14th chart showed his strategy. It read, “How do we benefit near-term?”

Paulson’s answer came in four bullet points: Cut leverage and build cash, eliminate exposure to the equity markets, maintain only short-term securities, and prepare for bargains in debt securities of distressed companies—a “$10 trillion opportunity,” another chart pointed out

/Read on

Tags: Alan Schwartz, Bear Stearns, Bet, Calamity, Coversation, Derivatives, Financial Crisis, Financial Instruments, George Soros, Hedge Fund Manager, Issue Profiles, Jim Chanos, Lehman Brothers, Litany, Megatrade, No Apologies, Paulson, Recent History, Subprime Mortgages, Time 2, Wagers
Posted in Credit Markets, Economy, Markets, Outlook | No Comments »