Wednesday, March 20, 2013

Wall Street Rant: Is This Bull Market Fundamentally Driven?

Those who read this blog know that I have a great appreciation for the Shiller PE10, also known as CAPE – Cyclically Adjusted Price Earnings. I came across a nice post from blogger Wall Street Rant asking the above question and providing some haunting data.
The post starts with the observation:

Fundamentally driven bull markets should rely more on cyclically adjusted earnings growth and less on investors willingness to pay ever increasing multiples on those earnings. To look into this I decided to focus only on bull markets of 100% or more. I looked at the Starting and Ending Shiller PE using Robert Shiller’s online data and updated it with daily pricing data for the important dates (as he only has monthly prices). Then I divided the Bull Market gains by the amount of PE expansion to see how much gains investors were receiving per unit of PE expansion. The results are below, sorted by most fundamentally driven to least fundamentally driven. The results are quite interesting.

The referenced chart is below:

The blogger ends with this observation (emphasis mine):

Take a look at the 1974-1980 Bull Market compared to today….The magnitude of the advance is similar between the two but the 1974-1980 advance only relied on a PE expansion of 2.2 vs 11.1 today. You will also notice that those that relied least on PE expansion tended to experience smaller subsequent bear markets. The top 5 averaged a bear market loss of 30.4% vs the bottom 4 which averaged a 48.5% loss. If history is any guide people should expect that the next bear market will be deeper then average because this bull market is lacking a fundamental underpinning.

UPDATED: 3/19/2013 – Corrected chart to reflect the proper starting PE of 8.8 for the bull market starting 6/13/1949. However, this did not change the overall ranking of any of the bull markets.

Doug Short or at Advisor Perspectives blog had the following exchange with Wall Street Rant author:

In an email exchange with the author I pointed out that the current bull market came within a hair’s breadth of a 20% decline at 19.39% in early October 2011, based on daily closes.

I received the following thoughtful response:

It’s true that 10/2/11 only missed the 20% threshold by a hair (someone also made a post about it crossing if you count intraday) but that is also the case in many other bull markets. For instance, for the 1987-2000 bull market in 1998 the market went from 1186.75 to 957.28 or a fall of 19.34% (and using intraday highs and lows you can get beyond the 20% threshold as well…intraday 7/20/1998 to 10/8/1998). Or in 1990 the market fell from 368.95 to 295.46 or 19.9%.Then also for the 1974-1980 Bull market the market went from 107.46 on 12/31/76 to 86.9 on 3/6/1978 or down 19.1%. Haven’t looked at all the others but I’m sure there are similar pullbacks….now that I look at these things maybe this is why the seemingly arbitrary 20% level is often used. Also, If 2011 was the start of a bull market then it’s the second highest starting PE ratio for a bull market by a long shot (only 2002 matches it…and it is a big outlier).
Count this as another in a long series of posts pointing out the overvaluation of the market and what drives it, the last one was last week.

Scott Dauenhauer CFP, MSFP, AIF
Meridian Wealth Management

Monday, March 18, 2013

Idiocracy: Why Cyprus Matters

Cross-Posted from the Official Meridian Blog at Meridian Wealth Management.

Late Friday night news began to break of a deal to provide support to failing banks in Cyprus.

Disregarding other details, the deal required all bank deposits under 100,000 Euro (in any Cyprus bank) to have a levy of 6.75% imposed.  For bank depositors with balances over $100,000 Euro, the levy would be 9.99%.  Those who lent money to the bank, known as senior bond holders would continue to be made whole.

In one announcement, a chaos was unleashed on the world that could have far reaching consequences. For a complete run down of what happened and updates see PragCap's post "Sowing the Wind."

Imagine waking up to find you had 6.75% less money in your bank account.  This has not yet happened in Cyprus, it must be voted on, but the banks are on Holiday until that vote happens and no one can move their money.  If the vote happens and passes (my guess is it won't), when the citizenry awakes they will find their bank accounts lighter.

This proposed solution to recapitalize the Cyprus banking system is important to the US and the world for several reasons.

It turns out that the President of Cyprus said that "haircuts" for deposit holders was not a negotiating point just a few weeks ago, but let's take a step back.

When a bank becomes insolvent and is in need of recapitalization there are several ways it can do so, a few of which are:  issue additional stock, convert debt to equity, receive a bail out, tap deposit holders.  In the United States we have something called the FDIC which in addition to providing some banking regulation and resolution also insures deposits against bank failure up to a certain dollar amount, currently $250,000 (its a bit more complicated than that, but you get the picture).  No matter how badly capitalized your bank is in the U.S., even if it fails you are guaranteed to get back every penny of your deposit as long as it isn't above the $250,000 mark.  Cyprus has a similar insurance program, but up to 100,000 Euros...which is why this "levy" is so important and such a stupid idea.

Confiscating 6.75% of a person's wealth who you have guaranteed will never lose a penny is an abdication of a promise.  When a banking system goes back on its word, it loses all credibility and panic ensues. Panic leads to bank runs.  Bank runs lead to collapse and contagion.  The biggest problem with this "levy" is that it comes from (or appears) to be come from the European Central Bank (ECB) (and more so, Germany) and thus sets a precedent of how other troubled nation banking systems could be approached.  If it could happen in Cyprus, why couldn't it happen in Spain, Italy, Portugal or any weak country with the ECB as its banker? A bank run in Cyprus could lead to capital flight in other countries as depositors fear confiscation. Such contagion could lead to meltdown.

Another issue is that the senior bondholders are not getting hurt.  Granted, if you converted all the senior debt to equity, you haven't come close to solving the problem - but requiring insured depositors to take a hit and making bondholders whole is sending a bad message.  Worse, by levying against smaller depositors who were supposed to be insured against loss, the levy against the very rich (in this case Russian Oligarchs) depositors only needed to be 9.99%.  Remember, those with balances above 100,000 Euro are taking a chance with their deposits, they have counterparty risk and knowingly accept this - in effect they are creditors of the bank (yes, technically all deposit holders are creditors, but not in reality if there is real deposit insurance).  By hitting the insured depositors with a 6.75% levy the rich deposit holders avoided what likely would have been a 30 - 40% hit to their account balance.

Again, this sends the wrong message - we will defend the rich at the expense of the less powerful poor.

Not allowing insolvent banks to fail and not wiping out bondholders and unsecured creditors may be the right thing to save the "system" (though I doubt it), but it sends the message that the elites will be protected at all costs.

Cyprus matters both because of the deal that was made (but not yet voted on) and for how the deal ends up being implemented, if at all.  If insured bondholders are forced to take losses, panic and contagion may be the outcome in other weak Euro nations.

I don't believe the vote will pass, after all, these politicians don't have very far to run - it is an island after all.  This begs the question of what happens next, either way it will be interesting to watch.

Regardless of what happens, you can chalk this up to complete idiocracy.

Scott Dauenhauer CFP, MSFP, AIF