Remember W.B.: "The first rule of investing: Don't lose money. The second rule: Don't forget Rule #1." Remember the downside, grasshopper.
private market froth-iness
While it's not clear there is a bubble yet, some of the private market valuations I've seen are bubble-icious. My evidence is more anecdotal since I'm not an "on the ground" venture capitalist. But here is something from Fred Wilson, offering a good overview from a very credible source that there is a froth in the private markets. Money is sloshing around the bathtub, and I'd argue it's spilling over into all asset classes.
commodities running a marathon or sprint?
Commodities have been on a spectacular run since August. The Wall Street Journal’s front page story this morning specifically addresses agricultural commodities, including wheat, soybeans and corn. Along with precious metals, agriculture has led commodities’ price rise and helped incite continued inflows into these markets over the past several years. Traders cite on the ground reasons that prices have gone up so far so fast – including increasing consumption from China, multi-decade low reserves and higher corn ethanol production. Also, backwardation (future prices less than spot prices) in one-third of the GSCI commodities boosts the case for tight supply/demand conditions. But these supply/demand theses are valid regardless of price. (As with all non-income generating “assets,” pricing is an elusive exercise.)
Regardless of the specifically-cited reasons today, what I question is whether this is a modern incarnation of Gresham’s law, bad money driving out good. A hundred years ago, on a bi-metallic standard in countries that accepted other countries’ currencies as legal tender, the most “fine” or pure currency would be hoarded and the less pure (“bad” money) would be spent. Thus, as the debased money was used to buy the stronger currency, its relative price decreased and became even less valuable. The market saw to it that the worse currency was worth the least and the “good” money fell from circulation. Of course, this generally occurred in a system of fixed exchange rates and (mostly) convertible currencies. Today’s free-floating currencies are a relatively new development in monetary history.
Today, it looks like (“good”) physical assets are driving out (“bad”) fiat currency. Stated in terms of the dollar (because that’s how we measure them), commodities are clearly on the rise. Gold, silver, and copper, which as recently as a hundred years ago were used as a medium of exchange, were up 29%, 82% and 30%, respectively. Cotton and coffee gained 92% and 77%. As Standard & Poor’s observes, “2010 year can be broken down into two distinct periods – one extending from January through August and another covering the remainder of the year. The announcement of quantitative easing from the U.S. Federal Reserve has helped provide a bid for most commodities.” On one hand, it looks to me like the market is saying that fiat currencies are less valuable and/or are being debased. Or, we could have a speculative almost-bubble on our hands.
Bolstering the case for the latter is that ten years ago about $6 billion was invested in commodities. Today, it’s nearly $300 billion. Money flows tend to drive prices higher, all things equal, and it appears to be the same today. And where the money is flowing isn’t necessarily in the right direction. This Businessweek article elucidates some good points about commodity exposure. As someone smarter than me said, there is no asset class that enough money can’t spoil.
Whether these price increases are well-founded or not is open to debate, but there is a clear correlation between the announcement of “QE2” and the snapback in financial markets, including equities (correlation of commodities with stocks is near all-time highs). But not all commodities are moving higher – one that has bucked the trend is natural gas, which is abundant and experiencing low demand. Its price fell 40% last year. If the behavior Gresham discussed was occurring, we shouldn't expect its price to languish for long.
Still, we can't ignore the "hot money" going into commodities. For these, Wal-Mart may have said it best: "Watch for falling prices." What the wise man does in the beginning, the fool does in the end.
predicting economic data points
As usual, they got it wrong. According to the Wall Street Journal, economists in Dow Jones Newswires’ survey had forecast payrolls would rise by 150,000 and the jobless rate would fall to 9.5%. The actual numbers came in at 103,000 and 9.4%, respectively, meaning they were off the actual number by nearly one-third. In typical fashion, CNBC spent most of the morning speculating about the release. The repartee between two folks is classic “time filling” television when the number is only an hour or so from release.
This offers a case in point on why it’s best to ignore prognosticators, especially on metrics like jobs. These numbers may move one way or another, but there is no point in trying to trade on such information because we can’t know beforehand. Forecasters tend to be within a tight range of each other, so when there are big numbers they are just as surprised as the markets might be.
Of the 103,000 jobs created (statistically, at a 90% level of confidence) this month, 113,000 of them were private. About half the decline in the rate was due to folks leaving the labor force, the other half was actually increases in payrolls. Service-providing industries were by far the largest area that saw job creation, up 115,000. We can quibble over 10 or 20 basis point down tick in the headline number, but 16.7% is the number on which to focus. This is the so-called U-6, and it represents unemployed but also those who are working part time but want full-time work. Thus, it’s more comprehensive.
To get back to the point: it’s mostly pointless to focus on predictions, which tend to introduce noise into an investment process. Remember this the next time economic data is close to release and the media fills time with speculation.
This offers a case in point on why it’s best to ignore prognosticators, especially on metrics like jobs. These numbers may move one way or another, but there is no point in trying to trade on such information because we can’t know beforehand. Forecasters tend to be within a tight range of each other, so when there are big numbers they are just as surprised as the markets might be.
Of the 103,000 jobs created (statistically, at a 90% level of confidence) this month, 113,000 of them were private. About half the decline in the rate was due to folks leaving the labor force, the other half was actually increases in payrolls. Service-providing industries were by far the largest area that saw job creation, up 115,000. We can quibble over 10 or 20 basis point down tick in the headline number, but 16.7% is the number on which to focus. This is the so-called U-6, and it represents unemployed but also those who are working part time but want full-time work. Thus, it’s more comprehensive.
To get back to the point: it’s mostly pointless to focus on predictions, which tend to introduce noise into an investment process. Remember this the next time economic data is close to release and the media fills time with speculation.
how much is a trillion dollars?
I found this page through Greg Mankiw. It's a great way to visualize a number that is being tossed around a bit too casually these days.
quick market snapshot, new highs/lows
Yesterday's trading:
NYSE:
New Highs: 375
New Lows: 2
Nasdaq:
New Highs: 296
New Lows: 5
Juxtaposed against prevailing market valuations, it's telling to see new highs outnumbering new lows by such a wide margin.
title for a 2011 year-end entry
Another year has passed, while a new one begins. Each annual turn is often a time of reflection as well as prediction. In keeping with that tradition, today’s entry will comprise some of the former, but mostly the latter, and some of neither.
The S&P 500 ends the year up about 15%, the Nasdaq about 17% and the Dow 11%. From where I stand, that’s a banner year, especially considering that average annual returns are more like 8-9% and long-term expected returns from today’s levels look to be under 6%. (Thus we can say this one year’s returns represent two years' expected.) Commodities and other risky assets also had a great year. Bonds and stocks, both foreign and domestic, performed well. Commodities, in some cases, knocked it out of the park (think cotton, up 90%). Gold rose about 30%, oil 13%. Housing prices did not do so well, however, and the economy limped along.
So 2010 looked good for the markets. Does that have any relation to a 2011? As we have to disclose often, past performance is not necessarily an indicator of future results. Still, the two are often related. Specifically, past performance can be a contrary indicator of future results. As the saying goes, if something can’t continue, it won’t. I am optimistic about the future overall, but I see several areas that appear stretched and where future results may not be as robust as the recent past.
Today we learned that that Groupon accepted about $500 million of a $1 billion funding round. This is a two-year old company is an industry that doesn’t have a lot of barriers to entry. Sure, they were the first, but their margins are artificially high and their labor-intensive strategy depends a lot on street-level salespeople. There is a lot of panache here; Groupon is cool and retailers want to be associated with them - now. But “cool” is ephemeral and in business competition does not lay down just because you're bigger. Especially when the business model is so easily copied and the space nascent. Competitor LivingSocial has received investment from Amazon and it’s not a stretch to believe my favorite online retailer could move into that market. Yet Groupon is raising a billion dollars. To me, it’s unbelievable and is probably a sign of too-heady times in the private markets.
Meanwhile, the commodities rose still has its bloom on the ever-present investment thesis of increasing consumerism in emerging markets. I think there could be several surprises on the “emerging” front in the new year that will surprise a lot of the gung-ho investors in this space. I speak specifically about gold and rare-earth metals here, but I get the feeling that a lot of the agricultural commodities have run up too high (and so have some of the ag-related stocks). A thesis that makes sense at a price does not make sense at any price.
Oil seems fairly priced to me at present.
As for stocks, a previous post pretty well elucidates my thoughts here. Bonds are something I’ve also recently written at length about and my feelings here haven’t changed a whole lot. I think surprises to the downside on bonds and stocks await. Put premiums are low as markets near their recent highs amid high levels of investor bullishness. This tends to be the case near market peaks.
Are there any bubbles (other than in the use of the word “bubble”)? I think there is one in concerns over our fiscal and monetary situation. That is a funny thing to say because I, too, am concerned. It just seems to me that “everyone” is concerned about these two things and so they are probably somewhat overblown. Such things have a way of working themselves out. While it’s often felt that the good folks in Washington live in a different world, I’m not convinced they won’t take care of these problems. A year ago, I wouldn’t have dreamed Obama would break his campaign promises by passing a law that was largely deferential to Republicans. But it doesn’t take much to change Washington’s mind and/or direction these days and our problems will not just get worse in a linear fashion. However, fiscal and monetary issues should lead investors to plan for contingencies, protecting from downside deviation.
The solutions aren’t linear, either. Think protection from phase transitions, or more popularly, tipping points. Securities trading below intrinsic value. Healthy balance sheets. Excess cash. Opportunistic management teams with flexible operating philosophies. Don’t try and time the market, but be ready to pounce when Mr. Market turns manic.
Most of the economic data coming out is noisy. The bottom line is the economy isn't going gangbusters and I'd expect that activity would remain at a similar pace. Of course, that's the easiest expectation. Unemployment just can't come down as fast as we'd all like without some significant retraining and job creation in other sectors. It’s a structural issue which will take years to resolve. At the same time, corporate profit margins are well above their historic highs.
2010 was a fantastic year, personally as well as professionally. Each day is a chance to learn something new and I'd like to think I was able to do so. I hope 2011, despite its being an odd year, holds similar promise. Happy New Year.
the stock market ahead
In 2011, I don't think the stock market deserves to rally. Now, that doesn’t mean it won’t. (To be any good at making predictions, I must hedge.)
I see a few things. Abundant in the media are calls for stocks to rise and bonds to fall, with stocks being cheap. But why can’t stocks and bonds be expensive concurrently? Money will move out of bonds, so the story goes, and into stocks, making one less expensive and the other moreso. (One of my) problem(s) with this is that money flows don’t really tell the story. The stock market is simply trading of already-offered shares held by others. The company is not involved (excluding share buybacks and recaps). When A sells his shares he must sell to B, who pays money to A. B then owns shares and A holds cash. As John Hussman has pointed out, the fact that A brings his cash into the market doesn't make prices go up, since no cash has actually been added to the market. Instead of A holding shares, B holds them. The same amount of cash is “on the sidelines.” It is the eagerness of the buyer (or seller) that makes prices fluctuate, as stock prices are priced on the marginal trade. Okay, that was a little long to make the point but I think it was necessary.
When I look at stocks broadly speaking (S&P 500 Index) today, I see a market that discounts decade-ahead total returns of just under 6% over the next decade. Since returns tend to be more stable when predicting for longer periods of time, I am most comfortable with this 6%-for-the-decade number. But I’ll list a few others. Five year: 4.5%. Three year: 1.6%. One year: -8.9%.
(A couple things to note here: these numbers are based on my calculation of the intrinsic value of the market and include the current S&P 500 dividend yield of 1.89%. Intrinsic value is based on normal earnings, which use numbers representing long-term averages for earnings growth rates, returns on equity and cost of capital.)
What these numbers tells me is that over a decade returns might end up decent, but not spectacular given the potential drawdowns inherent to stock markets. And it also says if your time horizon is shorter than five years, return prospects don’t look to spectacular (negative on a price-change basis for one- and three-year periods). To use a holiday metaphor, these returns look like a fruit cake. I'd rather have sugar cookies.
It’s always best to judge each asset class relative to the cafeteria menu of available investment options. On that front, bonds don’t look much better. A ten-year Treasury yields 3.3% today, not spectacular and especially with a duration close to 7 certainly not worth a large risk, again, on a risk-adjusted basis. Shorter-term bonds seem the best place to reduce risks in this space - the most salient of which appears to be reinvestment risk. Too, interesting opportunities are emerging in municipal bonds. I may expound on this later.
start-up-tomism
It strikes me today that optimism in the professional investment community remains at a relatively low level. Why? Out-of-control government spending. The $1.4 trillion federal deficit. $13 trillion in national debt. Eurozone economic concerns and the implications for the future of the euro currency. Not to mention the Federal Reserve’s actions which could spur inflation. The potential for an abrupt rise in interest rates. Rising commodity prices. The rise of China and India as competitors to the U.S. An equity market still meaningfully below its 2007 highs.
Many of the above are valid concerns and indeed are areas that need work. The equity markets today are implying decade ahead returns around 5%, certainly not a place to take unmitigated risk. Interest rates are low (but rising), benefiting borrowers/spenders at the expense of savers. The volume of the above factors is loud and the focus on them disproportionately high among investors and the public at large. They can lead us to forget a couple of things.
First, most of them we can’t control. We simply can’t, other than through elected officials, reduce government spending. We can, however, get ourselves into better financial shape through our own actions and position ourselves for worse economic times through higher savings, for instance.
Furthermore, these things tend to work on one way or another. Let’s take it to the extreme and say that government debt continues to rise and short-term interest rates go to 10.0%. With the government rolling over roughly a third of its total debt each year we’re looking at another $300 billion in interest expenses each year just on short-term debt. Say we print money and devalue the dollar in world markets to pay for this extra debt. Interest rates rise across the country, prices rise for consumers and unemployment rises dramatically. We couldn’t have stopped it, but we could have assets invested and liquid assets available to ameliorate the personal impact. Okay, enough of that since it detracts from what I’m really trying to say.
That is, in the fog of our short-term focus on the above issues and the maddening tendencies of the media to bloviate about them 24/7, we forget the ingenuity of the U.S. spirit and what’s going on in the entrepreneurial community today.
At this point, startups are being created like wildfire and funding is rabid. Several prominent venture capitalists have declared that there could be a bubble forming in early-stage technology companies, especially so-called Web 2.0 companies. I’ve heard many write and speak about the prices at which early funding rounds are taking place. Apparently, they’re not grounded in reality at this point and to some it “feels” like 1998-1999 again. (However, there are certain fundamental differences that differentiates this period from then. I may touch on this at a later date, but it mostly relates to valid business models and actual earnings.)
Anecdotally, it’s becoming more prevalent to see local articles about new companies being started dealing with the tech space. I’m encouraged by these signs. Let me point out that first and foremost I am a value investor. I try and figure out the stream of cash flows (both positive and negative) that can be expected over the life of an investment and discount it at an appropriate interest rate. Startups don’t have the luxury of much visibility on this front and so I haven’t (not yet, at least) invested in them. Also, I understand macro and micro-economics that makes me reticent about trying to pick winners.
Surely, there is no way that all startups receiving attention and/or funding today can reach the level of the most popular examples – such as Groupon, Twitter and Facebook. It doesn’t work like that. Many, if not most, won’t survive another year. As Warren Buffett has said, first come the innovators, then the imitators, then the idiots. Probably a lot of the incremental funding is coming from those in the third category and when the level of sophistication falls, so does the quality of the overall pool.
My broader point can get lost in the micro discussion, so I’ll finish here. Just because the effects of competition will ensure that most of these businesses fail (90% as goes the statistic?), the activity speaks to an entrepreneurial spirit that is alive and well in this country. And it’s a spirit that will endure in spite of the broad economic, fiscal, and monetary concerns that receive disproportionate attention in media coverage.
no sabbatical excuse
I wish I could say I was on sabbatical this past year but that hasn't been the case. I simply haven't put enough effort into getting a few thoughts down "on screen" on a regular basis. I intend to remedy that.
I intend to write a bit more frequently after a hiatus that comes down mostly to reticence in sharing new investment ideas, as was the prior focus. With growing compliance concerns in the investment industry and given the inherent competitiveness of the market I cannot often write about original ideas I’m pursuing. Though I will certainly comment on specific companies I will not necessarily do so often, especially those I own for myself or clients. Nor will I present performance information of any type, as has always been my penchant. In fact, I intend to sometimes put down ideas that are only tangentially - or not at all - related to investing, but interesting nonetheless.
Concurrent with more frequent writing comes a couple thoughts:
(1) It can be a waste of time to do extensive editing to text, so expect some grammatical and spelling flaws to emerge from time to time (or just all the time). People generally understand the point without it being encased in perfect prose and spelling, each of which aren’t immutable anyway.
(2) Writing a blog on a frequent basis comes within the context of a busy schedule. Against this backdrop, just getting something type and posted is as remarkable as what is actually written. Still I hope, but can’t promise, that each post is worthwhile and presents at least a new kernel of insight that makes my comments worth reading. I fully realize this a difficult standard, but I will do my best to meet it.
How Long Will Gold Glitter?
I want to spend a little more time on gold here.
Fundamental demand, including Jewelry, Industrial and Dental, is down significantly year over year (8% and 19%, respectively, on a volume basis) while mining supply is up 18% and recycled gold supply is up 31%. Supply is not constrained and the demand from traditional users is very low.
Amidst this fundamental backdrop, investment demand is up 133% and ETF/investment product demand is up 159% year-over-year. At the same time, central bank sales are down 39% year-over-year and the lowest since 1997, meaning a normal source of sales has slowed dramatically. By not selling a normal amount of gold, central banks have become another source of investment demand because of the supply constraints it puts on the gold market.
The data shows that investment (speculation?) seems to be the only source of demand at this point and that its significant growth (and lack of central bank sales) seems to have moved the price higher. One may make money in gold, but only if there is someone later willing to pay a higher price. (This is also known as the greater fool theory.) Gold has a negative yield (it costs money to store), no intrinsic value (it generates no cash flows), and at the current time appears quite speculative despite the claims that it is a good inflation hedge.
Fundamental demand, including Jewelry, Industrial and Dental, is down significantly year over year (8% and 19%, respectively, on a volume basis) while mining supply is up 18% and recycled gold supply is up 31%. Supply is not constrained and the demand from traditional users is very low.
Amidst this fundamental backdrop, investment demand is up 133% and ETF/investment product demand is up 159% year-over-year. At the same time, central bank sales are down 39% year-over-year and the lowest since 1997, meaning a normal source of sales has slowed dramatically. By not selling a normal amount of gold, central banks have become another source of investment demand because of the supply constraints it puts on the gold market.
The data shows that investment (speculation?) seems to be the only source of demand at this point and that its significant growth (and lack of central bank sales) seems to have moved the price higher. One may make money in gold, but only if there is someone later willing to pay a higher price. (This is also known as the greater fool theory.) Gold has a negative yield (it costs money to store), no intrinsic value (it generates no cash flows), and at the current time appears quite speculative despite the claims that it is a good inflation hedge.
Average Returns are Expected with Stocks at Fair Value
The capital markets and the economy are related, but exhibit disparate behavior. The U.S. economy has not been performing well since March, but that hasn’t stopped the stock market from rallying nearly 60% from the lows. The market rally has not been limited to stocks. Indeed, risk aversion has meaningfully subsided across the capital markets; the least creditworthy stocks and bonds have led the charge higher. High yield bonds are up nearly 50% this year, more than double the S&P 500. These risky bonds now yield less than 8%, close to where very low risk (AA) bond yields peaked early this year. Triple-C bonds, which are “currently vulnerable and dependent on economic conditions to meet [their] commitments,” are up 92% for the year. It appears to us that from current capital market valuations, further (durable) price appreciation will require fundamental economic improvement.
We never know where the markets will move next, but we can make reasonable estimates of their intrinsic value. According to our estimates, the S&P 500 trades at 16 times normal earnings and near the high end of its value range. Using cyclically adjusted earnings for the S&P 500, stocks trade at closer to 20 times. (The price-earnings ratio for the market has averaged roughly 15 over very long periods.) Another measure of market valuation which focuses on the replacement value of assets, is over 0.80, just slightly above the long-term average of roughly 0.75. One measure taken alone may not indicate much, but several arrows pointing in the same direction demand more attention. And on many different measures, the domestic stock market in aggregate is no longer cheap but fairly valued.
Ultimately, investors should be rewarded for providing capital to those who use it. But contrary to popular belief, risk and return do not always follow a linear relationship; that is, high risk does not necessarily equate to a high return. Today, the capital markets appear much riskier than just a few months ago (at lower prices) and implied long-term future capital market returns appear to be merely average from today’s levels. What that means for the near-term direction of markets is anyone’s guess.
We never know where the markets will move next, but we can make reasonable estimates of their intrinsic value. According to our estimates, the S&P 500 trades at 16 times normal earnings and near the high end of its value range. Using cyclically adjusted earnings for the S&P 500, stocks trade at closer to 20 times. (The price-earnings ratio for the market has averaged roughly 15 over very long periods.) Another measure of market valuation which focuses on the replacement value of assets, is over 0.80, just slightly above the long-term average of roughly 0.75. One measure taken alone may not indicate much, but several arrows pointing in the same direction demand more attention. And on many different measures, the domestic stock market in aggregate is no longer cheap but fairly valued.
Ultimately, investors should be rewarded for providing capital to those who use it. But contrary to popular belief, risk and return do not always follow a linear relationship; that is, high risk does not necessarily equate to a high return. Today, the capital markets appear much riskier than just a few months ago (at lower prices) and implied long-term future capital market returns appear to be merely average from today’s levels. What that means for the near-term direction of markets is anyone’s guess.
Gold and Forex, Sitting in a Tree...
There seems to be something dangerous brewing in gold and in foreign exchange markets, at least as it pertains to individuals trading this stuff themselves and betting big. It is now far too easy to “play” in both areas and many of those venturing in now may be setting themselves up to be burned. The foreign exchange market is the world’s biggest casino, where leverage magnifies gains and losses to the point where fortunes can be (and are) won and lost in a matter of seconds. The dollar has been moving lower with remarkable consistency, lulling some to believe in a "can't lose" trend. Danger, Will Robinson.
Gold, on the other hand, strikes me as incredibly bid up, and there are no shortage of brokers there to help (exploit) the individuals scrambling to buy gold. Something tells me when the people facilitating the transactions make more than the investors, there is some froth in this market. While leverage is not inherent to this market as it is with forex, today's "investors" strike me more as the final group in a giant Ponzi scheme. It all comes down to price. Note that investors at the gold's height in the early 80s need a $2,000+ gold price to merely break even on their purchases almost 30 years ago.
Television and radio are now replete with advertisements for gold buying services and forex trading. Some caution is warranted in these areas; I would expect surprises to be the rule rather than the exception as we move forward. Reversion to the mean can be powerful.
The Federal Reserve and the Crisis
“[There is] no longer any fear on the part of banks or the business community that some sudden and temporary business crisis may develop and precipitate a financial panic such as visited the country in former years…We are no longer the victims of the vagaries of the business cycle. The Federal Reserve System is the antidote for money contraction and credit shortage.”
-- Andrew Mellon, Secretary of the Treasury, April 14, 1928
***** ***** ***** *****
What would the world be like without the Federal Reserve System? Why is it commonly believed that they have superior knowledge and always have everything under control? Do they really know exactly what is going on? At least one member of the Federal Reserve Board, Janet Yellen, President of the San Francisco Fed, has admitted they do not. She has essentially confirmed that their “solutions” have been a series of experiments. They threw some things at the wall to see what would stick, and some did. Now comes the far greater challenge – determining when to remove the unprecedented interventions. Will they remove this excess money in time to avoid adverse effects? Unfortunately, the last quarter century does not give us much hope on that front.
By keeping interest rates artificially low during the so-called Great Moderation, or the period from the early 1990s through mid-2000s that saw strong economic growth with little volatility, the Fed signaled investors that there were more savings in the system than actually existed. Without the Fed intervening in markets, interest rates would have fallen when there was a high amount of savings in the system and risen when savings available to fund investments was low. (Like corn, supply and demand for capital would dictate its price, or rate.) Savings rates since the early 1990s were low and falling, so interest rates would likely have been much higher than they were over the past several years. In effect, the price mechanism for capital was (and is) manipulated by the Fed, which creates false signals for investors and savers. This helped asset markets (stocks, real estate) to bubble and led investments to be funneled into unproductive areas for too long. (Higher interest rates – owing to low savings available to fund investments – would have restrained housing market activity, for example.) In effect, the stimulus provided by cheap money was not withdrawn when it should have been and the mess we’re in is at least partially a result. These false signals continue and it is difficult to imagine the Fed withdrawing excess liquidity anytime other than too late. Unfortunately, the Fed has shown they are more likely to be wrong late than right early.
Is the Future Any Less 'Uncertain' Now?
It may not be the time to exuberant just yet.
The winds of popular sentiment appear to be blowing in one direction with respect to the economy – that is, that the economy is stabilizing and things are looking up. We should see stabilization in the latter half of this year and positive economic growth in the first quarter of next year, we hear. True? Perhaps. I will not make those sorts of predictions because I just do not know (and I know it).
The S&P 500 has rallied about 40% off its early March lows. Emerging market stocks are up close to 70% from their March lows and up 42% for the year, versus an S&P 500 that was up about 5% through yesterday. The CBOE volatility index – VIX – which some call the “fear index” is lower than we saw back in September of last year, prior to the collapse of Lehman and the “economic Pearl Harbor,” as Warren Buffett so eloquently says. Granted, the markets are still about 40% below their highs, indicating another 66% gain needed to get back to even. But they have come up pretty far and fast, and the headwinds to corporate earnings mean stocks’ values have fallen since the highs (and record profit margins) of 2007.
As I laid out at the beginning of the year, our economy is not likely to be the same coming out of this crisis. Consumers are not likely to resume their spendthrift ways going forward. Rather, we’ll probably continue to see higher savings rates and years of deleveraging as consumers align their household cost structures to their income levels. This will probably mean smaller homes and less conspicuous consumption. Accordingly, the source of 70%+ of our economic activity (consumer spending) is likely to be much less robust and become a smaller part of the economy. Capacity utilization will probably be sub-optimal for some time, which means higher structural unemployment and lower wage growth (if not wage rate stagnation). If the government continues its profligate spending without commensurate cuts in entitlements (which it’s actually adding), we will not be able to avoid higher taxes down the road. My personal bias tells me higher taxes are likely because tough decisions on public pensions, Social Security, and Medicare/Medicaid, while probably salable to the public by the popular administration, are not as much fun as tackling health care reform and “green” energy. When the public is willing to suspend disbelief, we get trouble.
The various feedback loops created by all of these elements should result in lower levels of economic growth. Also, corporate returns on equity are likely to be lower and cost of capital higher, meaning price-earnings multiples on stocks might end up structurally lower. Remember, stocks trended strongly upward from 1982 to (roughly) 2007 because of a secular decline in interest rates. We saw interest rates come down from nearly 20% to nearly 0% today. Earnings multiples went from 8 to 20, a roughly 4% annual return solely from multiple expansion. Unfortunately, interest rates are at zero today and a rising interest rate environment is bad for stocks. Look at the market from the early 1940s through the late 1960s – a steady trending market marked by rising P/E multiples and robust corporate earnings growth. From there, the market went nowhere until the early 1980s, paving the way for another strongly upward-trending market. One can argue all they want, but the starting level of valuations plays a major role in long-term stock returns. Judging from this perspective, we clearly lack such tailwinds from where we stand today.
Governments, businesses and consumers do not become aware of all these realities overnight. They take time. It took years for people to go from saving 8-10% of their income (1950s through early 1990s) to 0% (2006), and to double their household debt as a percentage of income. The same goes for businesses and governments (which are run by consumers), who largely didn’t have a “rainy day” contingency plan going into this crisis. I think this is bound to change as we go forward. The result will be a more resilient economy but one that is less optimized should boundless growth and low volatility return.
The market appears fairly valued from both a bottom up and top down standpoint, assuming long-term normal profit margins. That’s not to say it won’t go higher or lower. But from what I’m seeing from a bottom up standpoint, the tremendous bargains we saw in the first quarter of the year are few and far between. Prices at current levels appear to offer only average long-term future return prospects. Yet those willing to dig can find select opportunities available in multiple asset classes.
The winds of popular sentiment appear to be blowing in one direction with respect to the economy – that is, that the economy is stabilizing and things are looking up. We should see stabilization in the latter half of this year and positive economic growth in the first quarter of next year, we hear. True? Perhaps. I will not make those sorts of predictions because I just do not know (and I know it).
The S&P 500 has rallied about 40% off its early March lows. Emerging market stocks are up close to 70% from their March lows and up 42% for the year, versus an S&P 500 that was up about 5% through yesterday. The CBOE volatility index – VIX – which some call the “fear index” is lower than we saw back in September of last year, prior to the collapse of Lehman and the “economic Pearl Harbor,” as Warren Buffett so eloquently says. Granted, the markets are still about 40% below their highs, indicating another 66% gain needed to get back to even. But they have come up pretty far and fast, and the headwinds to corporate earnings mean stocks’ values have fallen since the highs (and record profit margins) of 2007.
As I laid out at the beginning of the year, our economy is not likely to be the same coming out of this crisis. Consumers are not likely to resume their spendthrift ways going forward. Rather, we’ll probably continue to see higher savings rates and years of deleveraging as consumers align their household cost structures to their income levels. This will probably mean smaller homes and less conspicuous consumption. Accordingly, the source of 70%+ of our economic activity (consumer spending) is likely to be much less robust and become a smaller part of the economy. Capacity utilization will probably be sub-optimal for some time, which means higher structural unemployment and lower wage growth (if not wage rate stagnation). If the government continues its profligate spending without commensurate cuts in entitlements (which it’s actually adding), we will not be able to avoid higher taxes down the road. My personal bias tells me higher taxes are likely because tough decisions on public pensions, Social Security, and Medicare/Medicaid, while probably salable to the public by the popular administration, are not as much fun as tackling health care reform and “green” energy. When the public is willing to suspend disbelief, we get trouble.
The various feedback loops created by all of these elements should result in lower levels of economic growth. Also, corporate returns on equity are likely to be lower and cost of capital higher, meaning price-earnings multiples on stocks might end up structurally lower. Remember, stocks trended strongly upward from 1982 to (roughly) 2007 because of a secular decline in interest rates. We saw interest rates come down from nearly 20% to nearly 0% today. Earnings multiples went from 8 to 20, a roughly 4% annual return solely from multiple expansion. Unfortunately, interest rates are at zero today and a rising interest rate environment is bad for stocks. Look at the market from the early 1940s through the late 1960s – a steady trending market marked by rising P/E multiples and robust corporate earnings growth. From there, the market went nowhere until the early 1980s, paving the way for another strongly upward-trending market. One can argue all they want, but the starting level of valuations plays a major role in long-term stock returns. Judging from this perspective, we clearly lack such tailwinds from where we stand today.
Governments, businesses and consumers do not become aware of all these realities overnight. They take time. It took years for people to go from saving 8-10% of their income (1950s through early 1990s) to 0% (2006), and to double their household debt as a percentage of income. The same goes for businesses and governments (which are run by consumers), who largely didn’t have a “rainy day” contingency plan going into this crisis. I think this is bound to change as we go forward. The result will be a more resilient economy but one that is less optimized should boundless growth and low volatility return.
The market appears fairly valued from both a bottom up and top down standpoint, assuming long-term normal profit margins. That’s not to say it won’t go higher or lower. But from what I’m seeing from a bottom up standpoint, the tremendous bargains we saw in the first quarter of the year are few and far between. Prices at current levels appear to offer only average long-term future return prospects. Yet those willing to dig can find select opportunities available in multiple asset classes.
The Road to 2010 goes through 2009
Another year has come to a close, and another is beginning. And what a year 2008 was. 2009 will prove to be just as interesting, punctuated by more business failures amid bad economic data (and maybe even some good news). Just how bad it can get is anyone’s guess; how good it can get isn’t really on anyone’s mind at this point.
As an investor today it is more important than ever to have a macro viewpoint. For many years, it simply wasn’t necessary because the range of economic fluctuations was pretty narrow. Stability brought investors comfort and, according to popular thought, it was more or less safe to “buy on dips,” because the market would almost inevitably ratchet higher in ensuing years. Downturns were short-lived as the Fed took an aggressive stance, pumping in liquidity, but increasing the moral hazard a bit more each time. Slowly, risk aversion subsided. Investors began paying more for earnings and demanded less interest spread over Treasuries to compensate for the additional risk. Much of the returns of the past 25 years have been driven by investors’ willingness to pay higher multiples on earnings. Going back farther, though – over 100 years –stocks are up less than 5% annually, which happens to be the rate of earnings growth over that time. The rest of the roughly 9% compounded return has come from dividends, which will be back in vogue. (Some companies whose dividends may otherwise be sustainable may still have to temporarily curtail them in the current downturn, even stalwart companies.)
Fast forward to this year. We seen a broad based decline in the stock market, the first such major decline since the early 1980s. (The decline in 2001-2002 was really concentrated in a few sectors – media, telecom, and technology – and thus did not affect all sectors equally.) The market went into the year disjointed – with financials down considerably but energy, materials and industrials still holding up relatively well. Now, the market is no longer quite as disjointed, though the degree of undervaluation in the market is far from homogenous.
The most concerning issues are twofold: confidence and cost of capital. Yes, there are others, but I want to concentrate on these broad themes. Confidence underpins our whole economic system, especially with respect to its lubricant, credit. And confidence has been lost. To use a crude example, when your best friend sleeps with your significant other, it’s going to take a long time to trust either of them again. And I think that’s the case here. Trust is built up over a long period of time as confidence builds that the future will largely resemble the past. Trust in, for instance, underwriting standards, was built up over a long period of time as default rates remained low and leverage ratios were allowed to ratchet higher. The loans made late in the cycle kept it going for longer than would have normally been sustained because of the “Ponzi finance” nature of the activity. That is, new loans were used to pay interest and principal on the old loans. As long as credit was available and lenders were willing to suspend disbelief, this worked fine. Until it didn’t.
We’re going to get back to system that relies on the character of the borrower rather than purely (unreliable) quantitative measures. I’m not sure how exactly this will work, because financial innovations will remain a fact of life. But I know it will mean banks and other finance companies will retain a larger portion of their securitizations and/or provide stronger guarantees to security holders. Business models will evolve (with the help of what is likely to be heavy-handed regulation). Formerly profitable businesses will cease to be so, and the seeds of future banking problems will be planted.
The economy is a non-equilibrium, evolutionary system where feedback loops play a meaningful role. George Soros calls this “reflexivity.” The cost of capital across the system has risen quite suddenly, not just debt financing, where rates are obviously much higher and capital less available, but equity. What isn’t often considered is that higher stock prices (along with lower interest rates) bring down the cost of capital. And cost of capital has been falling since the early 1980s, which has been a tremendous tailwind for the values of financial assets. Consider the feedback loop here. At a lower cost of capital, there are more potential projects for companies to undertake. For instance, if cost of capital is 6%, projects with a return potential greater than 6% will add economic value. Adding economic value feeds back into higher stock prices, which decreases the cost of capital, and the cycle continues. And undertaking more projects means more capital spending, which feeds back into economic growth in a meaningful way and further lowers the cost of capital. But when cost of capital goes to 10% or 12% for an extended period, old projects will run off and newer ones will be made under more restrictive conditions. That is, projects with return potential higher than 10% or 12% are now needed to add economic value. (Most) companies would not undertake an 8% return project while paying a 10% capital cost since to do so would be value destroying. With the long-run average return on equity at 12-13%, there are far fewer projects when the hurdle rate is 10% than when it is 6%. Less economic value added means lower stock prices, which leads to a higher cost of capital, and the cycle continues. The longer stock prices stay low, the more likely it is we’ll be in a feedback loop that will look very different from the past 25 years.
Furthermore, when cost of capital is higher, the justified P/E ratio on stocks is lower. We’ve lived in a 15-20 P/E market for the past 20 years largely on the basis of lower cost of capital as interest rates have generally been declining and remained low over this period. The cash tax rate and growth rate do not vary much over time. Returns on capital have moved higher, too, but at least partially have been driven by the levering up, through debt, of the country. So as capital costs rise and the feedback mechanism kicks in, justified P/Es, in my view, will be much lower than we’ve been used to.
What does this mean for investors? Active management is going to be very important. Index fund investors are going to be more challenged. This last year should have proven, once again, that the efficient market hypothesis, beta, alpha, the capital asset pricing model, etc., are all garbage. Markets follow power laws, not normal distributions. Markets are open, complex adaptive systems, not closed equilibrium systems. Returns to the stock market are path dependent. They exhibit oscillations and experience periods of punctuated equilibrium that come about largely through endogenous factors that may or may not have exogenous shocks as the initial cause. Small changes can have big impacts (and do). It is not completely different this time, but it will be different for a while and investors must recalibrate their expectations for how stocks behave. We are likely to see a market, akin to the 1970s, that moves in a trading range over time. (Actually, we’ve already seen it – from 2000 forward.) Income from dividends will be more important in this kind of environment. Being willing to buy at high free cash flow yields and sell at lower free cash flow yields and being willing to hold cash at times will be key. If we get back to a market that forgets what has happened over the past year and resumes trading at its 15-18 multiple consistently, I would be very surprised. But I have been wrong in the past and will be wrong again.
Either way, it will be an interesting year, and I will make no explicit predictions regarding the markets. The economy is bound to get worse in the year ahead and geopolitical concerns will become more serious (for instance, a few countries may defect from the Euro currency), but asset prices will turn up well ahead of a recovery in the real economy.
As an investor today it is more important than ever to have a macro viewpoint. For many years, it simply wasn’t necessary because the range of economic fluctuations was pretty narrow. Stability brought investors comfort and, according to popular thought, it was more or less safe to “buy on dips,” because the market would almost inevitably ratchet higher in ensuing years. Downturns were short-lived as the Fed took an aggressive stance, pumping in liquidity, but increasing the moral hazard a bit more each time. Slowly, risk aversion subsided. Investors began paying more for earnings and demanded less interest spread over Treasuries to compensate for the additional risk. Much of the returns of the past 25 years have been driven by investors’ willingness to pay higher multiples on earnings. Going back farther, though – over 100 years –stocks are up less than 5% annually, which happens to be the rate of earnings growth over that time. The rest of the roughly 9% compounded return has come from dividends, which will be back in vogue. (Some companies whose dividends may otherwise be sustainable may still have to temporarily curtail them in the current downturn, even stalwart companies.)
Fast forward to this year. We seen a broad based decline in the stock market, the first such major decline since the early 1980s. (The decline in 2001-2002 was really concentrated in a few sectors – media, telecom, and technology – and thus did not affect all sectors equally.) The market went into the year disjointed – with financials down considerably but energy, materials and industrials still holding up relatively well. Now, the market is no longer quite as disjointed, though the degree of undervaluation in the market is far from homogenous.
The most concerning issues are twofold: confidence and cost of capital. Yes, there are others, but I want to concentrate on these broad themes. Confidence underpins our whole economic system, especially with respect to its lubricant, credit. And confidence has been lost. To use a crude example, when your best friend sleeps with your significant other, it’s going to take a long time to trust either of them again. And I think that’s the case here. Trust is built up over a long period of time as confidence builds that the future will largely resemble the past. Trust in, for instance, underwriting standards, was built up over a long period of time as default rates remained low and leverage ratios were allowed to ratchet higher. The loans made late in the cycle kept it going for longer than would have normally been sustained because of the “Ponzi finance” nature of the activity. That is, new loans were used to pay interest and principal on the old loans. As long as credit was available and lenders were willing to suspend disbelief, this worked fine. Until it didn’t.
We’re going to get back to system that relies on the character of the borrower rather than purely (unreliable) quantitative measures. I’m not sure how exactly this will work, because financial innovations will remain a fact of life. But I know it will mean banks and other finance companies will retain a larger portion of their securitizations and/or provide stronger guarantees to security holders. Business models will evolve (with the help of what is likely to be heavy-handed regulation). Formerly profitable businesses will cease to be so, and the seeds of future banking problems will be planted.
The economy is a non-equilibrium, evolutionary system where feedback loops play a meaningful role. George Soros calls this “reflexivity.” The cost of capital across the system has risen quite suddenly, not just debt financing, where rates are obviously much higher and capital less available, but equity. What isn’t often considered is that higher stock prices (along with lower interest rates) bring down the cost of capital. And cost of capital has been falling since the early 1980s, which has been a tremendous tailwind for the values of financial assets. Consider the feedback loop here. At a lower cost of capital, there are more potential projects for companies to undertake. For instance, if cost of capital is 6%, projects with a return potential greater than 6% will add economic value. Adding economic value feeds back into higher stock prices, which decreases the cost of capital, and the cycle continues. And undertaking more projects means more capital spending, which feeds back into economic growth in a meaningful way and further lowers the cost of capital. But when cost of capital goes to 10% or 12% for an extended period, old projects will run off and newer ones will be made under more restrictive conditions. That is, projects with return potential higher than 10% or 12% are now needed to add economic value. (Most) companies would not undertake an 8% return project while paying a 10% capital cost since to do so would be value destroying. With the long-run average return on equity at 12-13%, there are far fewer projects when the hurdle rate is 10% than when it is 6%. Less economic value added means lower stock prices, which leads to a higher cost of capital, and the cycle continues. The longer stock prices stay low, the more likely it is we’ll be in a feedback loop that will look very different from the past 25 years.
Furthermore, when cost of capital is higher, the justified P/E ratio on stocks is lower. We’ve lived in a 15-20 P/E market for the past 20 years largely on the basis of lower cost of capital as interest rates have generally been declining and remained low over this period. The cash tax rate and growth rate do not vary much over time. Returns on capital have moved higher, too, but at least partially have been driven by the levering up, through debt, of the country. So as capital costs rise and the feedback mechanism kicks in, justified P/Es, in my view, will be much lower than we’ve been used to.
What does this mean for investors? Active management is going to be very important. Index fund investors are going to be more challenged. This last year should have proven, once again, that the efficient market hypothesis, beta, alpha, the capital asset pricing model, etc., are all garbage. Markets follow power laws, not normal distributions. Markets are open, complex adaptive systems, not closed equilibrium systems. Returns to the stock market are path dependent. They exhibit oscillations and experience periods of punctuated equilibrium that come about largely through endogenous factors that may or may not have exogenous shocks as the initial cause. Small changes can have big impacts (and do). It is not completely different this time, but it will be different for a while and investors must recalibrate their expectations for how stocks behave. We are likely to see a market, akin to the 1970s, that moves in a trading range over time. (Actually, we’ve already seen it – from 2000 forward.) Income from dividends will be more important in this kind of environment. Being willing to buy at high free cash flow yields and sell at lower free cash flow yields and being willing to hold cash at times will be key. If we get back to a market that forgets what has happened over the past year and resumes trading at its 15-18 multiple consistently, I would be very surprised. But I have been wrong in the past and will be wrong again.
Either way, it will be an interesting year, and I will make no explicit predictions regarding the markets. The economy is bound to get worse in the year ahead and geopolitical concerns will become more serious (for instance, a few countries may defect from the Euro currency), but asset prices will turn up well ahead of a recovery in the real economy.
Time to be Aggressive?
The U.S. stock market capitalization is now just 65% of GDP, and stocks are trading around 10 times normal earnings. That is, stocks’ earnings yield is 10%. The current dividend yield is 3.6%, higher than the 3.2% on the ten-year Treasury note. On an absolute basis, the last time we saw these prices on the S&P 500 Index was in April 1997. But to find these valuation levels, one would have to go back to the mid-1980s. Yes, the economy is weakening significantly and will be very difficult for quite some time. And stock prices will probably still go lower, perhaps meaningfully so. But stocks are discounting a very difficult economic scenario already, and investors at current levels should do very, very well from here. As Warren Buffett recently wrote, "If you wait for the robins, spring will be over."
The State of the Stock Market
On the New York Stock Exchange:
New 52-week highs: 13
New 52-week lows: 1,813
Of the 52-week highs, 12 of them are Inverse funds. Take from this what you will.
New 52-week highs: 13
New 52-week lows: 1,813
Of the 52-week highs, 12 of them are Inverse funds. Take from this what you will.
Indiscriminate Selling Continues to Bring Expected Returns Higher
The world sure seems bleak right now. At least that's what the media is intent on conveying, as it produces an almost endless stream of bad news – home prices falling, food and gas prices rising out of control, stocks (and 401k balances) down significantly amid an uncertain and fragile economic situation. What is lost in the noise, however, is that our economy is in good fundamental shape. Because most people still have jobs, they largely continue to pay their mortgages despite fears of widespread defaults. True, some areas have been hit especially hard by problems in the housing market. But this is not the entire country! The average consumer is pretty well leveraged, and may realize that ratcheting back spending is a good idea, even though it may be painful to do so. Consumers ratcheting back their spending will affect the unemployment rate as the most discretionary items are cut from household budgets (especially as more people start to budget). Yet the situation we're seeing now is not really anything new.
While the widespread problems in the housing market are a relatively new phenomenon, it is just a different version of problems we have experienced in the past. This time it is the real estate market, last time it was Internet stocks, in the early 1980s with was runaway inflation. All brought stock prices down to levels that would, years later, look like a bargain. It is my contention that this time is no different. Like a B movie, the specifics may have changed, but the basic story is about the same.
What we won’t hear much about is the incredible opportunities available to investors right now. Home prices are lower, yes. But for those with available purchasing power, very good income-producing real estate is available at lower and lower prices. Cap rates (the assumed rate of return on property based on net operating income) are rising across the country as many of the former sources of financing with loose lending terms have shut down. Stock prices are now more than 20% below their highs of last year. Many of the world’s finest companies are selling at low multiples to long-term free cash flows. The time to invest new money is now. Asset prices may continue to get cheaper in the short-to-intermediate term, but those who have the courage of their convictions and invest now might just look like geniuses five years hence.
The difference is striking. Falling stocks prices have added about a cumulative 34% (3% annually) to the possible ten year returns from stocks. That is, a person investing now stands to earn an incremental 3% annually versus another person investing at the October highs - regardless of what the market does over the next ten years!
Over the long-term, stocks track earnings. The above chart show the last twenty years (1998-2008) of actual earnings, normal, or trend, earnings, and stock prices. The normal earnings line is the trend line, because it assumes earnings grow 6% annually without any volatility. The actual S&P earnings per share has tracked this line over time, and although it has diverged meaningfully at points, it has always seemed to tend back to it after diverging. Stock prices also track this trend, excluding the irrationally exuberant period of the late 1990s. Betting on stocks is a bet on future earnings. So if you believe that over the longer-term our economy will perform about as it has in the past, stock appear to offer reasonable returns from these levels. But these levels also appear to offer excellent opportunities to buy individual stocks that will perform significantly better than the overall market in the years to come.
While the widespread problems in the housing market are a relatively new phenomenon, it is just a different version of problems we have experienced in the past. This time it is the real estate market, last time it was Internet stocks, in the early 1980s with was runaway inflation. All brought stock prices down to levels that would, years later, look like a bargain. It is my contention that this time is no different. Like a B movie, the specifics may have changed, but the basic story is about the same.
What we won’t hear much about is the incredible opportunities available to investors right now. Home prices are lower, yes. But for those with available purchasing power, very good income-producing real estate is available at lower and lower prices. Cap rates (the assumed rate of return on property based on net operating income) are rising across the country as many of the former sources of financing with loose lending terms have shut down. Stock prices are now more than 20% below their highs of last year. Many of the world’s finest companies are selling at low multiples to long-term free cash flows. The time to invest new money is now. Asset prices may continue to get cheaper in the short-to-intermediate term, but those who have the courage of their convictions and invest now might just look like geniuses five years hence.
Amid all the uncertainty, what can we expect the stock market to look like in 10 years? I ran a few numbers, assuming different scenarios (none of which might illustrate what will actually happen, mind you) but using the same basic underlying idea. I’m assuming that earnings in the future continue to grow at about 6%, or the long-term trend rate. I then made separate lines of assumptions – that ending price-to-earnings ratios are 15, 20, and 25 ten years from now. Given these assumptions, what can we expect for returns from current market levels? The table below illustrates.
If P/Es stay about where they are, or 20 times earnings, we might expect annual returns of around 10% annually including dividends. If P/Es decline to 15, this number drops to 7.5%. At 25, we can expect annual returns of 13%, but when stocks have hit a P/E of 25 they have usually not stayed there for long. In addition to the above, I made another assumption not listed on the chart; that is an ending P/E of 10. In this scenario, stocks should return only a cumulative 10.9% over ten years, or 1% compounded annually, for a total return of 3.3% annually from current market levels. The only way I see us getting to a P/E of 10 is in a highly inflationary environment like the early 80s and/or one where the economy is stagnant. Which scenario ends up being close to the actual result is anyone's guess.
Lower valuations generate higher future returns despite the short term pain. The table below illustrates what these same numbers would have looked like from the highs of October 2007, when the S&P closed at 1,565.
The difference is striking. Falling stocks prices have added about a cumulative 34% (3% annually) to the possible ten year returns from stocks. That is, a person investing now stands to earn an incremental 3% annually versus another person investing at the October highs - regardless of what the market does over the next ten years!
Over the long-term, stocks track earnings. The above chart show the last twenty years (1998-2008) of actual earnings, normal, or trend, earnings, and stock prices. The normal earnings line is the trend line, because it assumes earnings grow 6% annually without any volatility. The actual S&P earnings per share has tracked this line over time, and although it has diverged meaningfully at points, it has always seemed to tend back to it after diverging. Stock prices also track this trend, excluding the irrationally exuberant period of the late 1990s. Betting on stocks is a bet on future earnings. So if you believe that over the longer-term our economy will perform about as it has in the past, stock appear to offer reasonable returns from these levels. But these levels also appear to offer excellent opportunities to buy individual stocks that will perform significantly better than the overall market in the years to come.
Ethanol Blend or Regular?
Is it better to fill up with regular gas or with discounted (and subsidized) ethanol blended fuel? In Iowa, for instance, it is ten cents cheaper to fill up with ethanol blend than to buy regular. It looks pretty tempting when filling up to spend less per gallon, but does the discount make it worthwhile?
The National Highway Traffic Safety Administration data show that ethanol has 75,670 british thermal units (BTUs) per gallon instead of 115,400 for gasoline. What this means is that with ethanol, one has to burn more fuel to generate the same amount of energy – 1.53 gallons to be exact. So ethanol has 35% (34.43% to be more exact) less energy per gallon than does regular gasoline. One would expect, then, that filling up with E85, which has a combined 81,629.5 BTUs, would achieve 29% fewer miles per gallon than straight gas. This works about about right. In a recent test by Consumer Reports on a Tahoe, the fuel economy dropped 27% when running on E85 compared with gasoline (from 14 mpg overall to 10 mpg (rounded to the nearest mpg). So using BTUs for the calculations seems reasonable.
So now let’s look at it from the perspective of a person filling up in a state with subsidized ethanol blend available widely. The ten cent discount comes with 90% gasoline/10% ethanol blend. Given this blend, we can expect 3.5% fewer miles per gallon. So in order to justify the price, one would expect the discount on blended fuel from regular gasoline to be more than 3.5% (otherwise we’d pay more on an energy-equivalent basis to use ethanol). That doesn't happen to be the case today.
With gas at about $3.60 and blend at $3.50, that’s only a 2.8% discount in price. (The higher gas prices go the smaller that ten cent price discount will be on a percentage basis.) If we assume the 3.5% less mileage is a good number, the breakeven price (where we should be indifferent between the two) is $2.86 for regular, $2.76 for blend. We’re definitely above that. For E85, prices should be 29% cheaper, or $2.56, for a fuel purchaser to be indifferent between the two alternatives. The last I saw, it was about $2.90.
Just some fuel for thought.
Full disclosure: I’m filling up with regular. I’ll take a look again when (if) prices fall to $2.86 or the price discount widens.
The National Highway Traffic Safety Administration data show that ethanol has 75,670 british thermal units (BTUs) per gallon instead of 115,400 for gasoline. What this means is that with ethanol, one has to burn more fuel to generate the same amount of energy – 1.53 gallons to be exact. So ethanol has 35% (34.43% to be more exact) less energy per gallon than does regular gasoline. One would expect, then, that filling up with E85, which has a combined 81,629.5 BTUs, would achieve 29% fewer miles per gallon than straight gas. This works about about right. In a recent test by Consumer Reports on a Tahoe, the fuel economy dropped 27% when running on E85 compared with gasoline (from 14 mpg overall to 10 mpg (rounded to the nearest mpg). So using BTUs for the calculations seems reasonable.
So now let’s look at it from the perspective of a person filling up in a state with subsidized ethanol blend available widely. The ten cent discount comes with 90% gasoline/10% ethanol blend. Given this blend, we can expect 3.5% fewer miles per gallon. So in order to justify the price, one would expect the discount on blended fuel from regular gasoline to be more than 3.5% (otherwise we’d pay more on an energy-equivalent basis to use ethanol). That doesn't happen to be the case today.
With gas at about $3.60 and blend at $3.50, that’s only a 2.8% discount in price. (The higher gas prices go the smaller that ten cent price discount will be on a percentage basis.) If we assume the 3.5% less mileage is a good number, the breakeven price (where we should be indifferent between the two) is $2.86 for regular, $2.76 for blend. We’re definitely above that. For E85, prices should be 29% cheaper, or $2.56, for a fuel purchaser to be indifferent between the two alternatives. The last I saw, it was about $2.90.
Just some fuel for thought.
Full disclosure: I’m filling up with regular. I’ll take a look again when (if) prices fall to $2.86 or the price discount widens.
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