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Economy volatility a hurdle for stocks

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  • Faras Tweaky
    Rather than inflation, it may turn out that economic volatility is the true test facing equities in the years to come. Coming in the wake of an almost
    Message 1 of 6 , Mar 24, 2010
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      Rather than inflation, it may turn out that economic volatility is the true test facing equities in the years to come.

      Coming in the wake of an almost unprecedented set of circumstances and policies, the outlook for growth and inflation is extremely murky. For equity investors that means there is far less certainty over both the outlook for profits and how to value them than they had grown used to in the 25 years to the onset of the current crisis.

      It is not simply that very low interest rates and bloated central bank balance sheets may cause inflation. That is true, but it is also possible that Japanese-style deflation takes hold. There is a higher chance now of wild swings in inflation, growth and monetary policy than any time in the post-World-War-Two period.

      This again is about the death of the so-called Great Moderation, a construct that held that economic growth and inflation had somehow become more biddable. That was largely an illusion, but as long as it lasted investors became more willing to pay more for company profits.

      The steadier economic growth is, the more predictable corporate profits become. Steady inflation too is a huge boon to investors; it allows for easier discounting of future cashflows and also leads to fewer gut-wrenching mistakes by policy-makers. It is, after all, a lot easier to travel 60 miles on hour on a straight, level road than on one with sharp curves, steep climbs and sudden downhill legs.

      Long periods of moderation tend to amplify this effect. Investors become more and more willing to up the multiples they will pay for given streams of future earnings.

      What is interesting about the current period is not that investors thought better of their former easy confidence but how quickly something like that confidence has come back. Price/earnings ratios in the United States — currently in the 14-15 neighborhood — have begun climbing once again and are at levels below recent peaks but still far above where they were for much of the 1970s and 1980s. PE ratios fell during most of the last decade, driven downward by the popping of the dotcom bubble more than the evaporation of the Moderation mirage.

      The volatility of inflation has already spiked higher, to levels not seen since the 1980s.

      “We’ve moved into a rare area … where valuations are far above their typical levels for the current level of economic volatility.” William Hester of the Hussman Funds wrote in a note to investors.

      That may well be because investors are betting not that policy-makers are going to be able to stoke growth and control inflation at the same time, but rather that they will stop at nothing to reflate the economy. Betting on Bernanke and against Depression was clearly a good strategy in 2009, but it seems the situation is far more complicated now.

      DEMOGRAPHIC SUPPORT FOR EQUITIES EBBS

      Tim Bond, strategist at Barclays Capital in London, thinks stock market valuations are fair value now, more or less, but sees them being pressured in coming years by a combination of factors, including economic volatility.

      Demographics, Bond argues, will offer dwindling support for equities as the baby boom generation ages and begins to retire. As the late middle-aged prepare to retire, they are likely to hold less in equities, while those actually in retirement will have to begin to eat their savings. That should pressure equity valuations for at least a decade unless, of course, Chinese and Indian savers suddenly and unexpectedly acquire a taste for developed market equities.

      I’d bet the traffic mostly runs the other way.

      It is also true, and puzzling, that lower levels of global economic growth now appear to be needed to stoke commodity inflation. This, if sustained, will be a headache for central bankers and investors from Beijing to Washington.
      In the end, as we have had an officially engineered reflation, the biggest risks to PE ratios come from official policy mistakes. These are of two types: the deliberate and the inadvertent.

      A central banker now has a much more difficult time knowing what the actual state of the economy is. No one really understands what will happen to U.S. interest rates as Fed support ends: not you, not me and certainly not the Fed itself. No one knows either when or how banks will begin to lend again in force, stoking the speed of money in the economy, and with it inflation. The Fed could, in good faith, get it horribly wrong.

      Further, unemployment is high and will take years to fall to acceptable levels. Continuing to run huge deficits may be the right thing to do in that circumstance, politically, economically or morally, but it is hard to argue that it won’t create temptations for central bankers and raise the risk of economic volatility.

      Pricing that risk may take a while, but the effects for equities will be profound.


      Courtesy: Reuters


    • Faras Tweaky
      Rather than inflation, it may turn out that economic volatility is the true test facing equities in the years to come. Coming in the wake of an almost
      Message 2 of 6 , Mar 24, 2010
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        Rather than inflation, it may turn out that economic volatility is the true test facing equities in the years to come.

        Coming in the wake of an almost unprecedented set of circumstances and policies, the outlook for growth and inflation is extremely murky. For equity investors that means there is far less certainty over both the outlook for profits and how to value them than they had grown used to in the 25 years to the onset of the current crisis.

        It is not simply that very low interest rates and bloated central bank balance sheets may cause inflation. That is true, but it is also possible that Japanese-style deflation takes hold. There is a higher chance now of wild swings in inflation, growth and monetary policy than any time in the post-World-War-Two period.

        This again is about the death of the so-called Great Moderation, a construct that held that economic growth and inflation had somehow become more biddable. That was largely an illusion, but as long as it lasted investors became more willing to pay more for company profits.

        The steadier economic growth is, the more predictable corporate profits become. Steady inflation too is a huge boon to investors; it allows for easier discounting of future cashflows and also leads to fewer gut-wrenching mistakes by policy-makers. It is, after all, a lot easier to travel 60 miles on hour on a straight, level road than on one with sharp curves, steep climbs and sudden downhill legs.

        Long periods of moderation tend to amplify this effect. Investors become more and more willing to up the multiples they will pay for given streams of future earnings.

        What is interesting about the current period is not that investors thought better of their former easy confidence but how quickly something like that confidence has come back. Price/earnings ratios in the United States — currently in the 14-15 neighborhood — have begun climbing once again and are at levels below recent peaks but still far above where they were for much of the 1970s and 1980s. PE ratios fell during most of the last decade, driven downward by the popping of the dotcom bubble more than the evaporation of the Moderation mirage.

        The volatility of inflation has already spiked higher, to levels not seen since the 1980s.

        “We’ve moved into a rare area … where valuations are far above their typical levels for the current level of economic volatility.” William Hester of the Hussman Funds wrote in a note to investors.

        That may well be because investors are betting not that policy-makers are going to be able to stoke growth and control inflation at the same time, but rather that they will stop at nothing to reflate the economy. Betting on Bernanke and against Depression was clearly a good strategy in 2009, but it seems the situation is far more complicated now.

        DEMOGRAPHIC SUPPORT FOR EQUITIES EBBS

        Tim Bond, strategist at Barclays Capital in London, thinks stock market valuations are fair value now, more or less, but sees them being pressured in coming years by a combination of factors, including economic volatility.

        Demographics, Bond argues, will offer dwindling support for equities as the baby boom generation ages and begins to retire. As the late middle-aged prepare to retire, they are likely to hold less in equities, while those actually in retirement will have to begin to eat their savings. That should pressure equity valuations for at least a decade unless, of course, Chinese and Indian savers suddenly and unexpectedly acquire a taste for developed market equities.

        I’d bet the traffic mostly runs the other way.

        It is also true, and puzzling, that lower levels of global economic growth now appear to be needed to stoke commodity inflation. This, if sustained, will be a headache for central bankers and investors from Beijing to Washington.
        In the end, as we have had an officially engineered reflation, the biggest risks to PE ratios come from official policy mistakes. These are of two types: the deliberate and the inadvertent.

        A central banker now has a much more difficult time knowing what the actual state of the economy is. No one really understands what will happen to U.S. interest rates as Fed support ends: not you, not me and certainly not the Fed itself. No one knows either when or how banks will begin to lend again in force, stoking the speed of money in the economy, and with it inflation. The Fed could, in good faith, get it horribly wrong.

        Further, unemployment is high and will take years to fall to acceptable levels. Continuing to run huge deficits may be the right thing to do in that circumstance, politically, economically or morally, but it is hard to argue that it won’t create temptations for central bankers and raise the risk of economic volatility.

        Pricing that risk may take a while, but the effects for equities will be profound.


        Courtesy: Reuters


      • Drew
        ... There is a higher chance now of wild swings in inflation, growth and monetary policy than any time in the post-World-War-Two period. ... Question: What is
        Message 3 of 6 , Mar 24, 2010
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          Faras wrote:
          -------------------------------------------------------------------
          There is a higher chance now of wild swings in inflation, growth and monetary policy than any time in the post-World-War- Two period.
          -------------------------------------------------------------------
          Question: What is the foundation for this "Peter Schiff" type of statement?
           
          Drew

           


          From: Faras Tweaky <faras_110@...>
          To: behavioral-finance@yahoogroups.com
          Sent: Wed, March 24, 2010 7:58:00 AM
          Subject: [Behavioral-Finance] Economy volatility a hurdle for stocks

           

          Rather than inflation, it may turn out that economic volatility is the true test facing equities in the years to come.

          Coming in the wake of an almost unprecedented set of circumstances and policies, the outlook for growth and inflation is extremely murky. For equity investors that means there is far less certainty over both the outlook for profits and how to value them than they had grown used to in the 25 years to the onset of the current crisis.

          It is not simply that very low interest rates and bloated central bank balance sheets may cause inflation. That is true, but it is also possible that Japanese-style deflation takes hold. There is a higher chance now of wild swings in inflation, growth and monetary policy than any time in the post-World-War- Two period.

          This again is about the death of the so-called Great Moderation, a construct that held that economic growth and inflation had somehow become more biddable. That was largely an illusion, but as long as it lasted investors became more willing to pay more for company profits.

          The steadier economic growth is, the more predictable corporate profits become. Steady inflation too is a huge boon to investors; it allows for easier discounting of future cashflows and also leads to fewer gut-wrenching mistakes by policy-makers. It is, after all, a lot easier to travel 60 miles on hour on a straight, level road than on one with sharp curves, steep climbs and sudden downhill legs.

          Long periods of moderation tend to amplify this effect. Investors become more and more willing to up the multiples they will pay for given streams of future earnings.

          What is interesting about the current period is not that investors thought better of their former easy confidence but how quickly something like that confidence has come back. Price/earnings ratios in the United States — currently in the 14-15 neighborhood — have begun climbing once again and are at levels below recent peaks but still far above where they were for much of the 1970s and 1980s. PE ratios fell during most of the last decade, driven downward by the popping of the dotcom bubble more than the evaporation of the Moderation mirage.

          The volatility of inflation has already spiked higher, to levels not seen since the 1980s.

          “We’ve moved into a rare area … where valuations are far above their typical levels for the current level of economic volatility.” William Hester of the Hussman Funds wrote in a note to investors.

          That may well be because investors are betting not that policy-makers are going to be able to stoke growth and control inflation at the same time, but rather that they will stop at nothing to reflate the economy. Betting on Bernanke and against Depression was clearly a good strategy in 2009, but it seems the situation is far more complicated now.

          DEMOGRAPHIC SUPPORT FOR EQUITIES EBBS

          Tim Bond, strategist at Barclays Capital in London, thinks stock market valuations are fair value now, more or less, but sees them being pressured in coming years by a combination of factors, including economic volatility.

          Demographics, Bond argues, will offer dwindling support for equities as the baby boom generation ages and begins to retire. As the late middle-aged prepare to retire, they are likely to hold less in equities, while those actually in retirement will have to begin to eat their savings. That should pressure equity valuations for at least a decade unless, of course, Chinese and Indian savers suddenly and unexpectedly acquire a taste for developed market equities.

          I’d bet the traffic mostly runs the other way.

          It is also true, and puzzling, that lower levels of global economic growth now appear to be needed to stoke commodity inflation. This, if sustained, will be a headache for central bankers and investors from Beijing to Washington.
          In the end, as we have had an officially engineered reflation, the biggest risks to PE ratios come from official policy mistakes. These are of two types: the deliberate and the inadvertent.

          A central banker now has a much more difficult time knowing what the actual state of the economy is. No one really understands what will happen to U.S. interest rates as Fed support ends: not you, not me and certainly not the Fed itself. No one knows either when or how banks will begin to lend again in force, stoking the speed of money in the economy, and with it inflation. The Fed could, in good faith, get it horribly wrong.

          Further, unemployment is high and will take years to fall to acceptable levels. Continuing to run huge deficits may be the right thing to do in that circumstance, politically, economically or morally, but it is hard to argue that it won’t create temptations for central bankers and raise the risk of economic volatility.

          Pricing that risk may take a while, but the effects for equities will be profound.


          Courtesy: Reuters


        • Peter Greenfinch
          Hi, guys! I m not sure this prediction game, however interesting it is, and although I have also an opinion, helps us advance in our BE / BF exploration. Well,
          Message 4 of 6 , Mar 24, 2010
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            Hi, guys!

            I'm not sure this prediction game, however interesting it is,
            and although I have also an opinion, helps us advance in
            our BE / BF exploration.

            Well, at least it confirms a general definition / law of investment as "making decision under risk and uncertainty".

            So, everybody its own bets :-)

            All the best.
            Peter

            --- In Behavioral-Finance@yahoogroups.com, Drew <thestockowl@...> wrote:
            >
            > Faras wrote:
            > -------------------------------------------------------------------
            > There is a higher chance now of wild swings in inflation, growth and monetary policy than any time in the post-World-War-Two period.
            > -------------------------------------------------------------------
            > Question: What is the foundation for this "Peter Schiff" type of statement?
            >
            > Drew
            >
            >  
            >
            >
            >
            > ________________________________
            > From: Faras Tweaky <faras_110@...>
            > To: behavioral-finance@yahoogroups.com
            > Sent: Wed, March 24, 2010 7:58:00 AM
            > Subject: [Behavioral-Finance] Economy volatility a hurdle for stocks
            >
            >  
            > Rather than inflation, it may turn out that economic volatility is the true test facing equities in the years to come.
            > Coming in the wake of an almost unprecedented set of circumstances and policies, the outlook for growth and inflation is extremely murky. For equity investors that means there is far less certainty over both the outlook for profits and how to value them than they had grown used to in the 25 years to the onset of the current crisis.
            > It is not simply that very low interest rates and bloated central bank balance sheets may cause inflation. That is true, but it is also possible that Japanese-style deflation takes hold. There is a higher chance now of wild swings in inflation, growth and monetary policy than any time in the post-World-War- Two period.
            > This again is about the death of the so-called Great Moderation, a construct that held that economic growth and inflation had somehow become more biddable. That was largely an illusion, but as long as it lasted investors became more willing to pay more for company profits.
            > The steadier economic growth is, the more predictable corporate profits become. Steady inflation too is a huge boon to investors; it allows for easier discounting of future cashflows and also leads to fewer gut-wrenching mistakes by policy-makers. It is, after all, a lot easier to travel 60 miles on hour on a straight, level road than on one with sharp curves, steep climbs and sudden downhill legs.
            > Long periods of moderation tend to amplify this effect. Investors become more and more willing to up the multiples they will pay for given streams of future earnings.
            > What is interesting about the current period is not that investors thought better of their former easy confidence but how quickly something like that confidence has come back. Price/earnings ratios in the United States â€" currently in the 14-15 neighborhood â€" have begun climbing once again and are at levels below recent peaks but still far above where they were for much of the 1970s and 1980s. PE ratios fell during most of the last decade, driven downward by the popping of the dotcom bubble more than the evaporation of the Moderation mirage.
            > The volatility of inflation has already spiked higher, to levels not seen since the 1980s.
            > “We’ve moved into a rare area … where valuations are far above their typical levels for the current level of economic volatility.” William Hester of the Hussman Funds wrote in a note to investors.
            > That may well be because investors are betting not that policy-makers are going to be able to stoke growth and control inflation at the same time, but rather that they will stop at nothing to reflate the economy. Betting on Bernanke and against Depression was clearly a good strategy in 2009, but it seems the situation is far more complicated now.
            >
            > DEMOGRAPHIC SUPPORT FOR EQUITIES EBBS
            > Tim Bond, strategist at Barclays Capital in London, thinks stock market valuations are fair value now, more or less, but sees them being pressured in coming years by a combination of factors, including economic volatility.
            > Demographics, Bond argues, will offer dwindling support for equities as the baby boom generation ages and begins to retire. As the late middle-aged prepare to retire, they are likely to hold less in equities, while those actually in retirement will have to begin to eat their savings. That should pressure equity valuations for at least a decade unless, of course, Chinese and Indian savers suddenly and unexpectedly acquire a taste for developed market equities.
            > I’d bet the traffic mostly runs the other way.
            > It is also true, and puzzling, that lower levels of global economic growth now appear to be needed to stoke commodity inflation. This, if sustained, will be a headache for central bankers and investors from Beijing to Washington.
            > In the end, as we have had an officially engineered reflation, the biggest risks to PE ratios come from official policy mistakes. These are of two types: the deliberate and the inadvertent.
            > A central banker now has a much more difficult time knowing what the actual state of the economy is. No one really understands what will happen to U.S. interest rates as Fed support ends: not you, not me and certainly not the Fed itself. No one knows either when or how banks will begin to lend again in force, stoking the speed of money in the economy, and with it inflation. The Fed could, in good faith, get it horribly wrong.
            > Further, unemployment is high and will take years to fall to acceptable levels. Continuing to run huge deficits may be the right thing to do in that circumstance, politically, economically or morally, but it is hard to argue that it won’t create temptations for central bankers and raise the risk of economic volatility.
            > Pricing that risk may take a while, but the effects for equities will be profound.
            >
            > Courtesy: Reuters
            >
          • Kwok Yeung
            Uncertain market and economic conditions can create great opportunities for some investors who can take advantage of the emotional behaviour of other
            Message 5 of 6 , Mar 24, 2010
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              Uncertain market and economic conditions can create great opportunities for some investors who can take advantage of the emotional behaviour of other investors.

              If assets, such as bonds, stocks and real estate, are viewed as purely money making machines, investors should focus on the expected yields, rather than the expected prices of the assets in the future.

              When U.S. 30-year treasury bond yield is trading at 4.7% and S&P 500 companies are earning 6.25% (i.e. 16 times PE), it is difficult to argue against buying stocks, if the average earnings growth rate for coming year is expected to be greater than zero (which I think is a reason assumption.)

              In order to diversify risk further, investors may buy stocks in different parts of the world.  Economic conditions can change from time to time and a nation such as Japan may suffer from deep trouble for decades. But the chance of seeing economic hardship for the world for decades would be very slim.

              So why should we worry about the average level of growth rate for earnings and economies in the coming 30 years ?  As long as they are expected to be great than zero, it is fine to buy stocks. Many investors worried about risk, because they are afraid of suffering from losses. They do not mind if they end up making more profits than expected.

              Any comment?

              K.C.


              --- On Wed, 3/24/10, Faras Tweaky <faras_110@...> wrote:

              From: Faras Tweaky <faras_110@...>
              Subject: [Behavioral-Finance] Economy volatility a hurdle for stocks
              To: behavioral-finance@yahoogroups.com
              Date: Wednesday, March 24, 2010, 11:57 AM

               

              Rather than inflation, it may turn out that economic volatility is the true test facing equities in the years to come.

              Coming in the wake of an almost unprecedented set of circumstances and policies, the outlook for growth and inflation is extremely murky. For equity investors that means there is far less certainty over both the outlook for profits and how to value them than they had grown used to in the 25 years to the onset of the current crisis.

              It is not simply that very low interest rates and bloated central bank balance sheets may cause inflation. That is true, but it is also possible that Japanese-style deflation takes hold. There is a higher chance now of wild swings in inflation, growth and monetary policy than any time in the post-World-War- Two period.

              This again is about the death of the so-called Great Moderation, a construct that held that economic growth and inflation had somehow become more biddable. That was largely an illusion, but as long as it lasted investors became more willing to pay more for company profits.

              The steadier economic growth is, the more predictable corporate profits become. Steady inflation too is a huge boon to investors; it allows for easier discounting of future cashflows and also leads to fewer gut-wrenching mistakes by policy-makers. It is, after all, a lot easier to travel 60 miles on hour on a straight, level road than on one with sharp curves, steep climbs and sudden downhill legs.

              Long periods of moderation tend to amplify this effect. Investors become more and more willing to up the multiples they will pay for given streams of future earnings.

              What is interesting about the current period is not that investors thought better of their former easy confidence but how quickly something like that confidence has come back. Price/earnings ratios in the United States — currently in the 14-15 neighborhood — have begun climbing once again and are at levels below recent peaks but still far above where they were for much of the 1970s and 1980s. PE ratios fell during most of the last decade, driven downward by the popping of the dotcom bubble more than the evaporation of the Moderation mirage.

              The volatility of inflation has already spiked higher, to levels not seen since the 1980s.

              “We’ve moved into a rare area … where valuations are far above their typical levels for the current level of economic volatility.” William Hester of the Hussman Funds wrote in a note to investors.

              That may well be because investors are betting not that policy-makers are going to be able to stoke growth and control inflation at the same time, but rather that they will stop at nothing to reflate the economy. Betting on Bernanke and against Depression was clearly a good strategy in 2009, but it seems the situation is far more complicated now.

              DEMOGRAPHIC SUPPORT FOR EQUITIES EBBS

              Tim Bond, strategist at Barclays Capital in London, thinks stock market valuations are fair value now, more or less, but sees them being pressured in coming years by a combination of factors, including economic volatility.

              Demographics, Bond argues, will offer dwindling support for equities as the baby boom generation ages and begins to retire. As the late middle-aged prepare to retire, they are likely to hold less in equities, while those actually in retirement will have to begin to eat their savings. That should pressure equity valuations for at least a decade unless, of course, Chinese and Indian savers suddenly and unexpectedly acquire a taste for developed market equities.

              I’d bet the traffic mostly runs the other way.

              It is also true, and puzzling, that lower levels of global economic growth now appear to be needed to stoke commodity inflation. This, if sustained, will be a headache for central bankers and investors from Beijing to Washington.
              In the end, as we have had an officially engineered reflation, the biggest risks to PE ratios come from official policy mistakes. These are of two types: the deliberate and the inadvertent.

              A central banker now has a much more difficult time knowing what the actual state of the economy is. No one really understands what will happen to U.S. interest rates as Fed support ends: not you, not me and certainly not the Fed itself. No one knows either when or how banks will begin to lend again in force, stoking the speed of money in the economy, and with it inflation. The Fed could, in good faith, get it horribly wrong.

              Further, unemployment is high and will take years to fall to acceptable levels. Continuing to run huge deficits may be the right thing to do in that circumstance, politically, economically or morally, but it is hard to argue that it won’t create temptations for central bankers and raise the risk of economic volatility.

              Pricing that risk may take a while, but the effects for equities will be profound.


              Courtesy: Reuters


            • Bob Bronsons
              As far as valuing the stock market using the so-called Fed Model by comparing the aggregate corporate earnings yield, or the inverse of the stock market’s
              Message 6 of 6 , Mar 24, 2010
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                As far as valuing the stock market using the so-called Fed Model by comparing

                the aggregate corporate earnings yield, or the inverse of the stock market’s P/E

                ratio, to bond yields, or interest rates – anywhere on the maturity spectrum –

                it’s a popular, but overly simple methodology being only a two factor-model. 

                 

                We believe that it not theoretically adequate and, unsurprisingly, has it hasn’t

                been historically effective since it has yielded poor performance results as we

                demonstrate here: Quantifying and Forecasting an Equity Risk Factor 

                 

                Also, expanding on Campbell-Shiller’s work as explained, we also demonstrate

                that market P/E ratios -- by themselves --whether using trailing or future earnings,

                as reported GAAP type or any of the variation of operational or cash flow earnings,

                do not even reasonably consistently predict the stock market’s performance over

                the next six or twelve months, or even over next two, three or even five years. 

                 

                The optimal utility using the P/E ratio, using very long term averaging of the EPS

                denominator, for predicting stock market performance has proven to be over

                a Supercycle Period, or the following ten to twenty years yielding a maximum

                r-squared of about 50%.

                 

                For example, the S&P 500 is currently selling at a P/E ratio of about 24.2 using

                S&P’s latest estimate for Q1 ’10 earnings per share on a four-quarter trailing

                basis using GAAP. 

                 

                During the past 139 years Revealing BAAC Supercycles there have been

                145 monthly periods within a four point range of that P/E ratio (i.e., 28.2 max

                and 20.2 min).  The subsequent median six- and twelve-month price-only

                returns, have been 67% and 73% less, respectively, than the median returns

                of all 1,666 monthly periods, which have been +3.1% and 6.2%, respectively. 

                 

                Using future four-quarter earnings, which proxies for perfect forecasts of EPS,

                did not improve the results.  There have been 280 monthly periods with median

                under performances of 52% and 104%, respectively, than the medians of that

                1,660 monthly subset.

                 

                We believe it cannot be reasonably argued that today’s stock market is fairly

                valued, much less undervalued, based on of past or future corporate earnings,

                or the related P/E ratio, or their relationship to bond yields (interest rates). 

                 

                To the contrary, discussed here: As Forecasted – A 12-Year Retrospective

                none of our Supercycle stock market valuation indicators have reached their

                mean reversion target areas, and even more importantly, they all show that

                the stock market has become significantly overvalued again.

                 

                As always, I more than welcome questions, comments and constructively

                critical feedback.

                 

                Bob Bronson

                Bronson Capital Markets Research

                http://www.financialsense.com/editorials/bronson/main.html

                 

                 

                 

                From: Behavioral-Finance@yahoogroups.com [mailto:Behavioral-Finance@yahoogroups.com] On Behalf Of Kwok Yeung
                Sent: Wednesday, March 24, 2010 12:42 PM
                To: behavioral-finance@yahoogroups.com; Behavioral-Finance@yahoogroups.com
                Subject: Re: [Behavioral-Finance] Economy volatility a hurdle for stocks

                 

                Uncertain market and economic conditions can create great opportunities for some investors who can take advantage of the emotional behaviour of other investors.

                If assets, such as bonds, stocks and real estate, are viewed as purely money making machines, investors should focus on the expected yields, rather than the expected prices of the assets in the future.

                When U.S. 30-year treasury bond yield is trading at 4.7% and S&P 500 companies are earning 6.25% (i.e. 16 times PE), it is difficult to argue against buying stocks, if the average earnings growth rate for coming year is expected to be greater than zero (which I think is a reason assumption.)

                In order to diversify risk further, investors may buy stocks in different parts of the world.  Economic conditions can change from time to time and a nation such as Japan may suffer from deep trouble for decades. But the chance of seeing economic hardship for the world for decades would be very slim.

                So why should we worry about the average level of growth rate for earnings and economies in the coming 30 years ?  As long as they are expected to be great than zero, it is fine to buy stocks. Many investors worried about risk, because they are afraid of suffering from losses. They do not mind if they end up making more profits than expected.

                Any comment?

                K.C.


                --- On Wed, 3/24/10, Faras Tweaky <faras_110@...> wrote:


                From: Faras Tweaky <faras_110@...>
                Subject: [Behavioral-Finance] Economy volatility a hurdle for stocks
                To: behavioral-finance@yahoogroups.com
                Date: Wednesday, March 24, 2010, 11:57 AM

                 

                Rather than inflation, it may turn out that economic volatility is the true test facing equities in the years to come.

                Coming in the wake of an almost unprecedented set of circumstances and policies, the outlook for growth and inflation is extremely murky. For equity investors that means there is far less certainty over both the outlook for profits and how to value them than they had grown used to in the 25 years to the onset of the current crisis.

                It is not simply that very low interest rates and bloated central bank balance sheets may cause inflation. That is true, but it is also possible that Japanese-style deflation takes hold. There is a higher chance now of wild swings in inflation, growth and monetary policy than any time in the post-World-War- Two period.

                This again is about the death of the so-called Great Moderation, a construct that held that economic growth and inflation had somehow become more biddable. That was largely an illusion, but as long as it lasted investors became more willing to pay more for company profits.

                The steadier economic growth is, the more predictable corporate profits become. Steady inflation too is a huge boon to investors; it allows for easier discounting of future cashflows and also leads to fewer gut-wrenching mistakes by policy-makers. It is, after all, a lot easier to travel 60 miles on hour on a straight, level road than on one with sharp curves, steep climbs and sudden downhill legs.

                Long periods of moderation tend to amplify this effect. Investors become more and more willing to up the multiples they will pay for given streams of future earnings.

                What is interesting about the current period is not that investors thought better of their former easy confidence but how quickly something like that confidence has come back. Price/earnings ratios in the United States — currently in the 14-15 neighborhood — have begun climbing once again and are at levels below recent peaks but still far above where they were for much of the 1970s and 1980s. PE ratios fell during most of the last decade, driven downward by the popping of the dotcom bubble more than the evaporation of the Moderation mirage.

                The volatility of inflation has already spiked higher, to levels not seen since the 1980s.

                “We’ve moved into a rare area … where valuations are far above their typical levels for the current level of economic volatility.” William Hester of the Hussman Funds wrote in a note to investors.

                That may well be because investors are betting not that policy-makers are going to be able to stoke growth and control inflation at the same time, but rather that they will stop at nothing to reflate the economy. Betting on Bernanke and against Depression was clearly a good strategy in 2009, but it seems the situation is far more complicated now.

                DEMOGRAPHIC SUPPORT FOR EQUITIES EBBS

                Tim Bond, strategist at Barclays Capital in London, thinks stock market valuations are fair value now, more or less, but sees them being pressured in coming years by a combination of factors, including economic volatility.

                Demographics, Bond argues, will offer dwindling support for equities as the baby boom generation ages and begins to retire. As the late middle-aged prepare to retire, they are likely to hold less in equities, while those actually in retirement will have to begin to eat their savings. That should pressure equity valuations for at least a decade unless, of course, Chinese and Indian savers suddenly and unexpectedly acquire a taste for developed market equities.

                I’d bet the traffic mostly runs the other way.

                It is also true, and puzzling, that lower levels of global economic growth now appear to be needed to stoke commodity inflation. This, if sustained, will be a headache for central bankers and investors from Beijing to Washington.
                In the end, as we have had an officially engineered reflation, the biggest risks to PE ratios come from official policy mistakes. These are of two types: the deliberate and the inadvertent.

                A central banker now has a much more difficult time knowing what the actual state of the economy is. No one really understands what will happen to U.S. interest rates as Fed support ends: not you, not me and certainly not the Fed itself. No one knows either when or how banks will begin to lend again in force, stoking the speed of money in the economy, and with it inflation. The Fed could, in good faith, get it horribly wrong.

                Further, unemployment is high and will take years to fall to acceptable levels. Continuing to run huge deficits may be the right thing to do in that circumstance, politically, economically or morally, but it is hard to argue that it won’t create temptations for central bankers and raise the risk of economic volatility.

                Pricing that risk may take a while, but the effects for equities will be profound.

                Courtesy: Reuters





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