What's With Equity Valuation?
Gluskin Sheff
David Rosenberg
August 25, 2010
AND THE QUOTE OF THE DAY GOES TO …
John Roque at New York-based WJB Capital. This is a real beauty:
“We don’t believe there is any “bond bubble”. However, there is a bubble in people believing there is a “bond bubble”. Here’s how you will know if there is a bond bubble — ask your colleagues how many of them own bonds in their personal accounts. When nobody/almost nobody raises their hand you should be comforted in knowing that the prospects of the existence of a “bond bubble” have been reduced. By the way, this tactic has worked wonderfully for gold over the last decade.”
Folks, you know what it’s like when you wish it was you that was the one to come up with something brilliant like that? We couldn’t have put it any better. Nice turn of phrase, John!
HOUSING IN THE DUMPSTER
So let’s get this straight. Mortgage rates have tumbled nearly 100 basis points in the past year to a record low of 4.42% for the 30-year rate, yet existing home sales collapse a record 27% MoM to an all time low (data only back to 1999 for total sales) of 3.83 million units at an annual rate? Are you kidding me?
Not only that, but the government has implemented no fewer than eight programs to put a floor under the housing market. We suppose that someone in Washington could always argue that things would be much worse without all these incursions, but when is enough going to be enough? Let the housing market find its own equilibrium. Stop wasting taxpayers’ money on trying to influence what structure people would like to live in — there’s nothing wrong with renting and saving up for the down-payment (a word that has found its way back into the housing lexicon in the U.S.). Focus on the real crisis: job creation, or the lack thereof. It is absolutely a secular bear market when the government can expend so many resources to one sector and generate so little in the way of results.
Home listings actually rose 2.5% MoM in July so with sales sagging at a record rate, the inventory backlog surged to 12.5 months’ supply from 8.9 months in June and 8.3 months in May (and 7.8 months at the turn of the year). That is a record but there is only a limited history since the data include condos where the inventory backlog has soared to an all-time high of 16.5 months’ supply from 10.7 in June. For single-family housing, housing inventory skyrocketed to a 27-year high of 11.9 months’ supply, breaking above the prior 2008 peak of 11 months. Unless the laws of supply and demand have been repealed as they pertain to the residential real estate market, one would have to be of the view that more house price deflation is coming our way.
As an aside, and this pertains to the consumer, August chain store sales are thus far coming in below plan, at +2.6% YoY versus expectations of +2.8%. The Redbook survey said in its press report that “retailers are driving sales through price reductions, putting pressure on profit margins.” Again, this has a very Japanese feel to it — inevitably deflationary growth leads to erosion in nominal GDP which is what earnings are derived from. Bonds still look good here, even if a continued contrary view.
WHAT’S WITH EQUITY VALUATION?
The consensus has certainly taken down its numbers on profits and on the economy, but by not nearly enough. The consensus of equity analysts still sees 13% growth in operating S&P 500 EPS for the coming four quarters, even though the math does not work at all. For one, margins have already very rapidly expanded to cycle highs. This means that there is very low potential for profits to grow much in excess of nominal GDP growth, which, at best, will be low single digits. That would put EPS for the next year closer to $80 than the $88 consensus forecast and place the forward P/E closer to 13x than 12x (it is 12x on consensus view). Of course, if the economy does double-dip, then we are talking about EPS going down closer to $60 if the historical pattern during downturns reasserts itself, which then means the forward P/E multiple is really north of 17x.
This is why valuation is so tough — beauty is in the eyes of the beholder. Historically, the forward P/E with consensus estimates is 15.6x, and yet if you look at what we actually end up with, it is 19.2x. So the consensus is always publishing an earnings forecast that makes the market look cheap! And, this “bias” is close to 20%, on average. We still prefer the Shiller P/E, which uses the ‘bird-in-the-hand’ earnings, takes them in real terms, and cyclically-adjusts the earnings data, and the multiple here is 20.6x, which is 26% above the historical norm. So sorry, the only way you can get this market to show that it is “attractively” priced is to rely on consensus earnings projections, which by the way, are coming down but still too high.
Ditto for consensus real GDP growth, which sees 2½% growth for Q3 and Q4. It is not going to be too difficult to see flat to negative prints for both quarters barring some massive positive exogenous shock.
As for 2011, the consensus is at 2.8% for real GDP growth. Are you kidding me? This is a reason to start going the other way on a contrarian bet? You must be joking. When the sign on that 2.8% changes from a plus to a minus, dial us up.
So, with earnings estimates still +13% for the coming year and consensus GDP forecasts lowered, but still well above 2%, then it is hard to build the case that we have seen anything near full capitulation. Not only that, but equity fund managers are only sitting at 3.8% cash ratios — in the 2001 and 2008 downturns, these ratios got as high as 6%. Now that is capitulation and we are not there yet.
Plus, keep in mind that we are in a secular bear market, which is constantly peppered with flashy rallies and significant setbacks. Japan, for example, has just posted its fourteenth(!) 20%-plus decline in the Nikkei index since the peak was turned in 21 years (and 77%) ago!
(c) Gluskin Sheff
