The Long View

Deutsche Bank strategist Jim Reid notes in a report last week that the S&P 500 index is back to its long-term trend, although earnings are well below trend.

So that would at least partially explain the market's wacky P/E ratio this year - the Q1 P/E ratio (using the 3/31 close of 798) was 116. Using trailing 4-quarter earnings through Q1 with the 6/24 closing price of 901 gives a P/E of 131. See the excel file - http://www2.standardandpoors.com/spf/xls/index/SP500EPSEST.XLS

Earnings are terribly volatile, and momentary trailing four-quarter earnings, are insufficient for prudent decision-making.

The problem, however, is that it looks very like we are in a secular, or long-term, bear market that started in 2000. These periods have lasted 17-20 years and have ended with p/e ratios in the single digits. So we may have a long way to go.

Assume 4% earnings growth from here in a low-inflation world, and average p/es, and the S&P 500 will not regain its 2000 high until 2018. Assume a high inflation world and earnings growth will be higher, but the p/e will be lower (historically there has been an inverse relationship between inflation rates and p/es). That would leave the market still below its 2000 high in 2020.

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Source:
The Economist. The long view.
The Economist. June 24, 2009.
http://www.economist.com/blogs/buttonwood/2009/06/the_long_view.cfm

© 2009 Michael Cale

Treasury Yield Week

It will be interesting to see how the bond markets react to the Fed's FOMC meeting this week. The committee meets Tuesday and Wednesday.

The Fed is losing credibility. It is clear that the money-printing policy is not working as well as the Fed would like. So now the bankers will will try to talk their way out of the mess they've created.

Today from Bloomberg:

Chairman Ben S. Bernanke has to convince investors the Federal Reserve can take back more than $1 trillion it pumped into the U.S. banking system to pull the economy out of the longest decline in more than six decades.

Bernanke and his colleagues, who meet June 23 and 24 to map monetary strategy, have said they need to continue buying assets and keep interest rates low for a long time to help revive growth. Rising Treasury bond yields show Wall Street is concerned their policy may lead to an inflationary bubble: Ten- year notes reached an eight-month high of 3.95 percent June 10.

In the U.S., concern is growing that consumer-price inflation will accelerate, based on trading in Treasury Inflation Protected Securities. Expectations for 2015 to 2019 -- the so-called five-year, five-year-forward rate calculated by the Fed -- increased June 2 to 3.18 percent, the highest since November, before sliding to 2.68 percent on June 16. The average since 2005 is 2.66 percent.

Behind investor unease is a $1.2 trillion jump to $2.07 trillion during the past year in the portfolio of mortgage, Treasury and other securities the Fed owns, as it flooded the banking system with reserves. The balance sheet rose to a record $2.31 trillion in December and has fallen since as the financial crisis eased and banks’ demand for short-term credit ebbed.

Meanwhile, the Fed is adding to its holdings of long-term securities, pledging to buy this year as much as $1.25 trillion of mortgage securities, $200 billion of agency debt and $300 billion of long-term Treasuries.

Anxiety over the Fed’s pump-priming program is twofold, according to Robert Eisenbeis, chief monetary economist at Cumberland Advisors in Vineland, New Jersey. The first worry is the central bank lacks the tools to unwind its monetary stimulus quickly enough. The second is that even if it can act in time, it won’t because of political opposition to tightening credit when unemployment is 9.4 percent, a 25-year peak.

Bernanke is also scheduled to testify this week before the House Committee.on Oversight and Government Reform.

Previously - Treasury Yields Headed Higher
Flirting With Inflation.

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At the time of publication Mr. Cale held long positions in TBT.

Source:
Rich Miller and Michael McKee. Bernanke Must Reassure ‘Confused’ Market About Rate Strategy.
Bloomberg. June 22, 2009.
http://www.bloomberg.com/apps/news?pid=20601109&sid=a3icASndPQHE

Graphic courtesy of Bloomberg.

© 2009 Michael Cale

Laffer: Inflation Ahead

This week, Arthur Laffer, creator of the Laffer Curve, published a dire warning in the Wall Street Journal.

Here we stand more than a year into a grave economic crisis with a projected budget deficit of 13% of GDP. That's more than twice the size of the next largest deficit since World War II. And this projected deficit is the culmination of a year when the federal government, at taxpayers' expense, acquired enormous stakes in the banking, auto, mortgage, health-care and insurance industries.

With the crisis, the ill-conceived government reactions, and the ensuing economic downturn, the unfunded liabilities of federal programs -- such as Social Security, civil-service and military pensions, the Pension Benefit Guarantee Corporation, Medicare and Medicaid -- are over the $100 trillion mark. With U.S. GDP and federal tax receipts at about $14 trillion and $2.4 trillion respectively, such a debt all but guarantees higher interest rates, massive tax increases, and partial default on government promises.

But as bad as the fiscal picture is, panic-driven monetary policies portend to have even more dire consequences. We can expect rapidly rising prices and much, much higher interest rates over the next four or five years, and a concomitant deleterious impact on output and employment not unlike the late 1970s.¹

In order to prevent this inflationary scenario, the Fed must reduce the monetary base back to a normal level. To do so, the Fed will have to sell bonds. The Treasury is already selling bonds at a record pace to support massive government spending. For the Fed to join in the bond-selling party would put further upward pressure on interest rates.

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At the time of publication, Mr. Cale owned a long position in TBT.

Sources:
1. Arthur Laffer. Get Ready for Inflation and Higher Interest Rates.
Wall Street Journal. June 11, 2009.
http://online.wsj.com/article/SB124458888993599879.html

Charts courtesy of St. Louis Fed

© 2009 Michael Cale

Bank Profits - Lipstick on a Pig

In April, the Financial Standards Accounting Board (FASB) changed the rules so that banks and other financial companies could determine what their assets were worth without using market prices. This small accounting change is having an enormous impact. 

But everyone knows it hasn't changed the fundamentals. Too many banks made bad investments and are in poor financial shape.

Analysts who have examined the quarterly profits and government tests say that accounting rule changes and rosy assumptions are making the institutions look healthier than they are.

Citigroup’s $1.6 billion in first-quarter profit would vanish if accounting were more stringent, says Martin Weiss of Weiss Research Inc. in Jupiter, Florida. “The big banks’ profits were totally bogus,” says Weiss, whose 38-year-old firm rates financial companies. “The new accounting rules, the stress tests: They’re all part of a major effort to put lipstick on a pig.”

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Source:
Yalman Onaran. Bank Profits From Accounting Rules Masking Looming Loan Losses.
Bloomberg. June 5, 2009.
http://www.bloomberg.com/apps/news?pid=20601109&sid=alC3LxSjomZ8

© 2009 Michael Cale