Author Archives: Art

Equities Index Models are Price to Earnings Models

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In these last few months of shifting focus to Latam Credit, I devoted a material amount of time to the transition from the mindset of a single name equity investor to the midset of a macro asset allocator having views on asset classes such as credit spreads, interest rates, and equity indexes (mainly S&P 500 and Bovespa) as well as equity sub-index views (like having a view on cyclicals versus non-cyclicals) to understand where investment is flowing.

Credit investing and rates investing are sensitive to investor relative return perceptions between asset classes. At the end of the day most bonds get paid back, yet there is still volatility in the asst class as funds flow into and out of credit and rates. Why is this?

The results of search for the answer to this why are surprising in that the skill-set and way of thinking at the index level of investing is in many ways different than what is requires for investing at the single-name level.

A quick example is earnings misses/beats. Single name investing many time is about knowing which company is better at its business than its competitors. So at the single name level it could be that a business’s competition is better and customers shifted to a competing product, and so the company lost sales and therefore missed earnings. In this case, though, at the index level sales likely stayed the same, and the earnings merely moved to someone else’s bottom line in the index. Who earned them only changed the the total earned in aggregate didn’t. So the index earnings don’t move in this case, and if index P/E doesn’t move, index price stays the same as well.

Inside the index one will see one company rally and one company sell-off but an index investor won’t feel anything. This concept is captured in the average correlation statistics of the S&P 500 (here shown as of July 28, 2011 from a Goldman Sachs report by David Kostin):

Pairwise and Sector correlation of the S&P 500When pairwise correlation is very low, as it was in the mid 90s and mid 2000′s, the prevailing stories are idiosyncratic – stories about winners and losers within a sector and between sectors (cyclicals versus non cyclicals, etc).

In todays environment, pairwise correlation is actually quite high by historical standards. This can be thought as prices of all companies (to exaggerate a little bit) are rising and falling together.

This is interesting, because in general, as shown below (also from GS/Kostin), index earnings are slow to change (and they are only reported in 4 two month periods per year effectively).

S&P 500 Earnings Graph at 2011-08-03 from Goldman Sachs

Given that index earnings don’t change quickly, one might expect index price volatility to be low and therefore in high pair-wise correlation times, one might expect single name volatility to be low. This is not the case. Index volatility is not explained by earnings beats/misses at the index level.

So what’s going on then? The short answer is Index investing is 10% forecasting index earnings which is more or less easy given that they don’t change much/quickly day-to-day as shown above and 90% forecasting Index Price-to-Earnings ratio, which itself can be broken down into price-to-book and ROE forecasts.

Price to Earnings = Price to Book x Book / Earnings

Return on Equity = Earnings / Book, therefore:

Price to Earnings = Price to Book / ROE

This can be counterintuitive, but the implication is that improvements in ROE should lower Price to Earnings if Price to Book doesn’t change.

So bottom line is that Earnings don’t change much, so forecasting index levels becomes of game of forecasting price to earnings and/or price to book and ROE of the index.

The punchline is that what drives Price-to-Earnings many times are factors outside of the equities markets and many analyst equity models. One extremely important factor to watch and understand is 10 year US Treasury rates. They are extremely correlated with price to earnings of the S&P 500 as noted below (here shown as of August 3, 2011 from a UBS report by Jonathan Golub):

Price to Earnings of the S&P 500 versus 10 Year Treasuries from UBS So today the stories are not about individual winners and losers but about the merits of owning equities as opposed to rates.

There are very deep implications. From 2009, at least, to be a US Treasuries trader is to be an Equities Index Trader. Broadly people taking views on the S&P 500 index level are taking views on US Treasury 10 Year rates because the link between the two is that the same factor that drives 10 Year rates drives price-to-earnings ratios.

So to tie everything together, Index Earnings don’t change quickly. Most of the volatility in the index is explained by changes in Index Price-to-Earnings. So Index models (to forecast the Index Price) are really Index Price-to-Earnings models.

Furthermore, given the very high correlation, any equity index model has to consider the interest rate effect on price to earnings or at least have a reality check on whether the forecasted price-to-earnings level of the model checks witch what is likely in the Interest Rate market (particularly 10 Year Treasuries).

So the bottom line is that as growth expectations have been revised down, 10 year Treasuries have rallied, and this has pressured Price-to-Earnings of the S&P 500.

When will this stop? Probably when growth expectations are all repriced, which should finish in the next week or two. Keep an eye on GDP revisions and 10 Year Treasury interest rate action and you’ll get a sense of when it’s safe to be long equities again or when the 10 Year Treasury is at risk of selling off.

Abraço, Arthur

São Paulo Value

What is Sao Paulo?

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A noisy grey city….

This is a view from my apartment looking at the University of Sao Paulo in the direction northwest. The buildings are in an area called Jagare across the river Pinheiros.

Sao Paulo is the city of apartment buildings. They are everywhere.

Here’s another view of the university this time looking west.

Arthur

 

Return to blogging and renewed focus

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Have been in Brazil a little over two years now. The time is flying by even if the country only is marginally improving (though the growth path is clear).

With two years of on the ground experience am a little older and wiser ;)

My business here has gradually focused to Latin American (LATAM) credit, so that is was I am most likely to write about going forward in this blog.

Have watched a number of blogs (actually I read a substantial number through RSS feeds) and my general thoughts are that to be relevant on a small budget, a blog should be focused. That means that its audience will likely be small, but that is the tradeoff to get read and to be rewarding to the author as well.

To try to appeal to a large audience is tiring, expensive, and uninspiring. The writing will have to be bland, and its impact short lived. Specific punchy articles are more likely to get picked up in search and quoted by someone.

In general I think the trend with instant publishing through Scribd and blogs will be short current articles that will displace much of traditional print media. Books will be focused more on history and fiction. Any reference book is already out of date the minute it is published. Plus the amount of things that one can do with a book is so limited. Hyper-linking and multimedia are one. Also hyperlinking refers outward, books are difficult to refer/cite (how many people read footnotes).

So back to business – mine is focused on Latam Credit, mostly in USD actually (for a number of reasons that may come out in future posts), and my blog will most likely evolve to be an english language blog by some fund manager based in Sao Paulo Brazil who discusses the credit markets generally with a relative value framework that will pull in discussions of currencies, rates, and equities.

It will be one of the first english language LATAM focused blogs in Brazil (where we speak Portuguese), so it will likely attract some following.

Will it be The Big Picture? No. Will it help you make money? Probably. Will it appeal to someone? Definitely.

Abraço,

Arthur O’Keefe, São Paulo Value

p.s. I just moved my hosting to HostGator from FutureQuest, and it’s great. For more advanced features, HostGator is really incredible. Gary North deserves the credit as he writes about them every once in a while. He’s approaching 70 if not already past, and I figure he’s very sensitive about saving time….

Many changes

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Have spent the last few months working on my business as well as refining my investment analysis.

Recently have opened a hostgator account and will now transition this blog there and restart it.

More to follow in the coming weeks.

Art

 

Risk on but be hedged

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Have an article forthcoming for the last few weeks, but I have been struggling to find time to publish it. Will try to do so in the coming days.

In the meantime, just want to put out that since the beginning of the month, the risk return balance has shifted tremendously to a short vol, long equity with a macro hedge strategy. Sounds complicated but basically it’s that mega-cap equities should outperform in the next couple of years if debt stays at this level more or less. Only in the most dire situation will debt outperform megacap equities and I don’t think we are there yet.

An example is Walmart which has growing foreign business and is the low cost retailer for the us. The stock hasn’t moved in ten years while over the same period earnings per share have quadrupled.

Given that it was a ten year trend to cheapness, I expect the reversion to take at least a year, but there should be money to be made.

Similarly tech is very cheap – MSFT, INTC, HPQ.

Buy long dated calls where you can get the cheaply, sell medium dated puts where you can get paid dearly, and manage risk by hedging in the macro indices.

Try not to lose money,
Arthur O’Keefe
São Paulo Value

Bloomberg Story from another planet: Bond Yields Showing No Economic Spoils for Republicans in 2010

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Trying out the WordPress app for my iPad. Came across the below story on Bloomberg. Not sure what to say. I try to keep objective but this story seems to be written to appear objective but is anything but the case.

I will go into this later, but the yield curve is steep because the low end is pinned down by the fed, and it has an extremely high chance of flattening. And if you follow the line of reasoning of the story, I think you have a decent chance of decreasing your net worth.

I continue to see evidence of an extremely unstable market with little volume. Stocks on a valuation basis don’t look so bad if we didn’t have serious deflationary factors. However we *do* in fact have serious deflationary factors as evidenced by the recent enormous flattening of the yield curve. Indeed one wonders if the writer of the story has looked at the recent price action on the five and ten year treasuries. Very unhealthy indeed!

Will try to update when I get time. In the meantime….

Try not to lose money.

Arthur O’Keefe, São Paulo Value

http://www.bloomberg.com/news/2010-08-22/bonds-showing-no-economy-spoils-for-republicans-as-rates-point-to-recovery.html

Bloomberg News, sent from my iPad.

Bond Yields Showing No Economic Spoils for Republicans in 2010

Aug. 23 (Bloomberg) — Former Republican House Speaker Newt Gingrich says Barack Obama’s policies are “artificially extending the recession.” Congressman John Boehner, the party’s leader in the House, says “stimulus policies aren’t working.” Republican Senator Jim Bunning calls Federal Reserve Chairman Ben S. Bernanke’s tenure “a failure.”

The U.S. bond market disagrees. The economy has never contracted with the difference between short- and long-term Treasury yields as wide as it is now. That gap, at 2.11 percentage points for 2- and 10-year notes, signals a 15.5 percent chance of a recession in the next year, according to the Federal Reserve Bank of Cleveland.

“Reports of the death of the recovery are greatly exaggerated,” said Andrew Busch, a public policy strategist at Bank of Montreal’s BMO Capital Markets in Chicago and former adviser to Republican presidential candidate John McCain and Treasury Secretary Timothy F. Geithner.

As politicians step up their rhetoric ahead of the November midterm elections, bond traders are watching the so-called yield curve for clues to the direction of the economy because before each of the last seven economic contractions, long-term yields fell below short-term debt. While that gap has narrowed since reaching a record 2.91 percentage points in February, it’s still almost double the average since 1990.

Though economists are paring their forecasts, they still predict growth in gross domestic product of 3 percent this year and 2.8 percent in 2011, according to the median of 66 estimates in a Bloomberg News survey. Goldman Sachs Group Inc. economists say most of the sectors that drag down an economy, including housing, employment and capital spending, have “already suffered big hits.”

No Double Dip

“As signs of slower U.S. growth have multiplied, market participants have become worried about the possibility of a double-dip recession,” the firm’s economists wrote in an Aug. 12 report. “The probability is unusually high – between 25 percent and 30 percent – but we do not see double dip as the base case.”

The yield on the two-year notes due in July 2012 fell to a record low of 0.4547 percent last week, as investors pushed the price of the security up 2/32, or 63 cents per $1,000 face amount, to 100 8/32. The yield on the benchmark 10-year note, a 2.625 percent security due in August 2020, declined to as low as 2.53 percent, the lowest since March 2009.

The $8.18 trillion market for Treasuries, which help determine the cost of funds for everything from mortgages to corporate bonds, has returned 8.05 percent this year, including reinvested interest, Bank of America Merrill Lynch index data show. They lost 3.7 percent in 2009.

‘Policies Aren’t Working’

Republicans, who lost control of the House of Representatives and Senate in 2006, are pointing to rising demand for bonds, falling yields and faltering stocks as a sure sign the economy is poised to contract. The Standard & Poor’s 500 index is down 3.9 percent this year.

It is time for Obama to “face up to the fact that his stimulus policies aren’t working,” Boehner of Ohio said Aug. 7, a day after the government reported the unemployment rate held at 9.5 percent in July.

The White House hasn’t made much progress in selling the stimulus spending to voters. Asked how their opinion of the programs had changed in recent months, respondents to a Bloomberg National Poll were divided almost evenly among those who say they had become more supportive, those who are less supportive and those who haven’t changed their view.

‘We’ve Gotten Through’

A steep yield curve traditionally indicates economic growth as investors demand more compensation for the risk of faster inflation. A flatter yield curve signals contraction and little threat of inflation.

Though yields are hovering near record lows, the curve as measured by projections of the three-month Treasury bill rate to 10-year note yield suggest the economy will strengthen by about 1.14 percent over the next year, according to a July report from the Federal Reserve Bank of Cleveland.

“The growth trajectory in the economy is sluggish, but positive, with no contraction on the horizon” said Wan-Chong Kung, a money manager who helps invest $89 billion at FAF Advisors in Minneapolis. “We’ve gotten through a really tough downturn in the economy. It could have been much worse if we didn’t have the type of policy that was put in place on the fiscal and monetary front that.”

Inverted Yield Curve

There have been 33 official recessions since 1850, and only three times has the economy fallen back into negative growth within a year, according to data at the National Bureau of Economic Research.

The difference between 2- and 10-year yields is up from negative 0.19 percentage point in December 2006, just before the economy began to shrink.

An inverted yield curve has twice failed to predict a recession — in late 1966 and late 1998. The bears say bonds may be sending another “false positive.” With the Fed’s target rate for overnight loans between banks at a record low of zero to 0.25 percent, it may be impossible for long-term yields to fall below short-term debt.

“As long as the Fed continues with ultra easy policy the yield curve’s relative importance as an economic signal is diminished,” said Christopher Sullivan, who oversees $1.6 billion as chief investment officer at United Nations Federal Credit Union in New York.

A gradual recovery may not be enough to bolster Democrats in the November elections, BMO’s Busch said. “The number one thing on voters’ minds are still jobs, and we haven’t seen any significant progress on the employment front.”

Signs of Improvement

Since the stimulus legislation was approved in February 2009, the U.S. unemployment rate has climbed to 9.5 percent in July from 8.2 percent. The administration projects the jobless rate will average 9.7 percent for the year. Spending by consumers has slowed, with the savings rate rising to 6.4 percent in June, from 1.7 percent in August 2007.

There are signs of improvement, as production in the U.S. rose more than forecast in July. Production at factories, mines and utilities climbed 1 percent, twice the median forecast in a Bloomberg News survey, figures from the Fed showed last week.

Companies in the U.S. added workers in July for a seventh straight month as private payrolls that exclude government agencies rose by 71,000 after a June gain of 31,000, Labor Department figures showed. Corporate spending on equipment and software jumped at a 22 percent annual rate last quarter, the biggest increase since 1997, signaling confidence among company executives.

‘The Facts’

“There seems to be a doom and gloom out there,” Doug Oberhelman, chief executive officer of Peoria, Illinois-based Caterpillar Inc., the world’s largest maker of construction equipment, told analysts in a meeting at the New York Stock Exchange on Aug. 19. “We just don’t see it that way for lots of reasons. The facts aren’t bad in our business.”

The more than 75 percent of the companies in the S&P 500 that reported second-quarter profits exceeded the average analyst estimate since July 12, data compiled by Bloomberg show. Earnings will rise 36 percent this year, the most since 1988, forecasts show. Following the 2001 recession, income growth never exceeded 20 percent.

“The main difference between 2008 and now is that corporations are making money,” said Andrew Brenner, managing director at Guggenheim Capital Markets LLC, a New-York based brokerage for institutional investors.

Not Japan

As earnings rise, companies are cutting their interest expense. The 10 lowest-yielding U.S. corporate bond deals ever were sold in the past 14 months, according to Deutsche Bank AG. Armonk, New York-based International Business Machines Corp. issued $1.5 billion of 1 percent three-year notes on Aug. 2, the lowest coupon on record for that maturity.

The bond market is saying that it may be years before the Fed raises rates to foster the recovery, said Carl Lantz, head of interest-rate strategy in New York at Credit Suisse Group AG, one of 18 primary dealers of U.S. government securities that trade with the central bank.

Slow, persistent growth will help stave off the fear that the U.S. is starting to look like Japan in the 1990s, when the Bank of Japan struggled to revive its economy amid a combination of deflation and recessions, he said.

“The economy is improving and the yield curve will stay steep as the market is pricing in a return to more normal rates further out the curve,” said Lantz. “It will feel like Japan for awhile, but ultimately we are not Japan. We are seeing subpar growth, and a muddling along that is not particularly satisfying, but we are on the path to an eventual return to normal growth.”

To contact the reporter on this story: Cordell Eddings in New York at ceddings@bloomberg.net

Find out more about Bloomberg for iPad: http://m.bloomberg.com/iphone

Sent from my iPad

How do you invest in this environment? Invest in doing something real.

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Quick tactical note of how I see things panning out in the US.

Having been an options trader and having invested for a while, I have a healthy appreciation and fear of the path of an investment’s returns. AIPC which was a great investment for me by any measure promptly lost half its value before eventually assuming a path that would result in it’s being purchased for over 6 times my first buy print on the stock. Great return, tricky path. At one point the “investment” showed a -50% return. Sticking with it yielded an awesome IRR.

Which brings me to the first half subject of this note…. Do we invest thinking that this is a deflationary envrionement (forget equities and stick to fixed income) or an inflationary environment (the opposite)? Indeed, I find valid arguments from both the deflationists and the inflationists and believe both are right. How is this possible? I suspect that we will have relatively bad deflation in the US before the currency finally weakens and then leads to inflation.

Why won’t we have inflation in the short term? The quick answer is that it would solve too many problems and make life too easy. Following the principal of maximum pain, then this scenario is unlikely. What problems would inflation solve? While I am worried about the budget deficit of the US, I think there are bigger problems in the short term with the various public pensions and entitlements – social security, medicare, state and local workers – as well as a debt overhang from the housing bubble with its associated overhang on banks balance sheets. In short everyone would benefit in a situation where pensions, benefits, and debt obligations are held constant in nominal terms while we experienced a large dose of inflation. The debt load would be alleviated, and everything would strengthen.

But isn’t the US operating like Zimbabwe, you might ask? Isn’t hyperinfation just around the corner due to a currency collapse? In short no. Zimbabwe had a number of things against it. First is that the state actively destroyed production capacity by breaking up and redistributing productive farmland. Second is that it was a small component of the global export market so its sudden competitiveness due to a currency devaluation would not be noticed. Third is that there was little history of rule of law. Forth is that it has no military. Fifth is that it has a limited population base and what it does have is limited in terms of global competitiveness. There are more, but you get the idea. The US, with a currency collapse, would suddenly become a force to be reckoned with. It was once a manufacturing powerhouse, and that can indeed return with the right forces. Furthermore, all its debts are local currency denominated. Yes the US is extremely dependent on oil and would suffer greatly in the short term with a currency crash, but it’s also resilient and would eventually adapt and compete. So bottom line is that while that may eventually happen, it’s just too convenient to happen in the very short term.

So what is likely in the short term? Deflation. The exact opposite of all of the above. Possibly with global competitive currency debasement leading to very little relative devaluation perhaps. States and local municipalities finding ways to cut pensions or perhaps even worse raising taxes on others to continue paying pensions. Either way someone is going to lose purchasing power. Same deal with entitlement programs. It doesn’t look good.

This brings me to the second half of the subject. In an environment like this, where you expect things to continue to deteriorate, there are no great passive investment returns to be made. Shorting (an inherently levered strategy) will get you killed in the long term as the market experiences increased volatility and periodic rallies for whatever sane or insane reason. In the meantime the general trend will be down. To get a feel for what this looks like, look at the graph of SDS: UltraShort S&P500 ProShares (SDS) via wikiinvest:

You got the direction right but still lost money. So what’s the answer? It’s actually not so surprising or depressing. The best thing to invest in when faced with these issues is in whatever is real that you can do to keep employed, keep relavent, and keep producing something of value (which should be rewarded with money if the product is in demand).

With declining per-capita productivity (which is what you get with increasing unemployment), it’s not going to be easy. And I expect the returns for purely passive investments to decline – after all capacity utilization should decline in an environment like this, so what will “investing” pay? What investments are needed when there is steadily increasing capacity due to decline in demand? Bottom line is that it’s going to be tricky.

There’s always money to be made in dealing with short term capital crunches and by making markets where you are matching buyers and sellers, but it’s hard to make a living at that unless you are devoted to it full time. If that’s not your calling or edge, then find something that is your calling or edge that you can become an expert on and trade/get paid for other goods. Invest in yourself – your skills – and try to keep acquiring productive assets and growing your productive skill set.

This is the time for active investing – doing things like building businesses, streamlining production, and anticipating demand and meeting it.

Try not to lose money.

Arthur O’Keefe, São Paulo Value