# Sound Markets

## Thursday, October 20, 2011

### Target Zero Inflation

Part of the rationale for a positive inflation target is that people will stop spending if prices go down a little bit. Some economists believe we will put off purchases for as long as we can to get a better deal in the future. Really? You won't buy something today because it will cost one or two percent less next year? I don't buy it, no pun intended.

If you have worked hard and saved money inflation causes problems. Interest rates reflect a number of forces. First, there is the return needed to compensate for risk and to compete with other investment opportunities. This is called the "real" rate of interest. The interest rate also reflects expectations about future inflation. Add the two together and you get the "nominal" rate of interest - the number quoted in the news and at your bank.

The problem with inflation is that if you choose not to invest - maybe you just didn't see anything you liked - you will lose money as inflation will make your dollars worth less in the future. This forces people to invest money when they wouldn't otherwise. Isn't it possible that savers would get a better deal, a higher real interest rate, if there was no inflation? This could occur because borrowers would have to compete against the saver's option to do nothing. Inflation takes this option away and offers nothing in return.

## Wednesday, October 13, 2010

### The Flash Crash and High Frequency Trading

## Monday, April 5, 2010

### China

## Wednesday, December 3, 2008

### Stock Market Expectations

“A stock is just a bundle of information masquerading as a security.”

If this is true then the information being conveyed these days seems quite bad. It is widely assumed that stock prices reflect investor’s expectations about what is going to happen in the future. Our job as investors is to try to determine if these expectations are rational or if there are opportunities for the taking.

To try and put current stock valuations into perspective I built a model to analyze what the market is saying about different industry sectors. The general idea is that at the most basic level all stocks are created equal and it is only differences in future earnings prospects or differences in risk that explain rationally divergent valuations.

The analysis seeks to help answer the following questions:

1. What long run equilibrium earnings yields are necessary to justify today’s sector valuations?

2. What kind of growth rate in earnings is required to explain risk-adjusted valuations?

3. Which sectors seem overvalued and which seem undervalued?

The model is similar to a dividend discount model except that earnings are discounted to obtain a present value for each sector. I forecast net income out four years with a terminal value calculated using the last period’s earnings. The discount rate for each sector is related to its risk and is calculated by multiplying a baseline discount rate of eight percent times that sector’s beta. The beta is the median company beta in each sector, calculated using the prior three years monthly returns. Thus, an important assumption of the model is that long term risk can be adequately represented by historical risk. Informed readers will note that this approach is a watered down version of CAPM combined with discounted cash flows.

In order to equate the present value with the current sector market capitalization, I used a linear program to solve for the required earnings yield in year four. In this calculation, current market capitalization was used as the denominator. Annual net income figures were found by interpolating between the trailing twelve month net income and that in year four. The slope of this net income trend was divided by average net income to obtain the implied growth rate. The results are presented below. Market value and net income (NI) numbers are in millions. The data was based on closing prices on December 1, 2008. The universe is the S&P 1500.

Let’s start by looking at the implied growth rate. The model output suggests that the financial sector recovers in year four to a level of profitability last seen in Q3 2003. To put this in context, this level of profitability is roughly half that seen at the end of Q3 2007. Given the need to permanently reduce leverage, this seems reasonable. For perspective, note that financial sector debt was roughly 20% of GDP in the early 1980’s and got as high as 115% in 2007.

The consumer staples and utilities sectors seems to be showing their stripes as a defensive plays (note the low betas) and appear undervalued. In order to justify its current market valuation, consumer staples profits need to decline by 5%. Profits in utilities need to decline by 12%. Contrast this with information technology, which needs to expand by 9% annually to reach fair value.

As a sanity check it is also useful to see what the model is saying about the broader market. For the market to be fairly valued, at least when using a discount rate of 8%, earnings need to expand by 7% annually to slightly over $700 billion in 2012. This compares with the average profitability over 2005 and 2006. Note that the roughly 2% increase needed in the market earnings yield can be explained by the recovery in profits forecasted for the financial sector.

Like all forecasts, the model used here is highly sensitive to the inputs provided. A decrease in the discount rate, which will be required when risk premiums decline as the financial crisis abates, will signal a major buying opportunity. For example, lowering the baseline discount rate from 8% to 6% indicates that the market is undervalued by 36%. On the other hand, using a rate of 8% could be considered generous in an environment where investment grade corporate bonds yield 7.5% and high yield bonds are off the charts. If we increase the baseline discount rate to 10%, the market is 21% overvalued. It appears that a meaningful and sustained decrease in corporate bond yields is required before stocks can embark on a meaningful recovery.