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Monday, July 18, 2005

DowRant: Syncretic Analysis, Part II - Fundamentals

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Last week, I laid out the technical case (as I see it) for an interim top in the US indices, starting some time between July 14th and July 20th, at a price at (or slightly below) 10730 on the Dow. I've concentrated on the Dow mostly because it is actually the least "overcooked" of the US indices at the moment - so the analysis presents the most favourable view of both the potential extent of the rally, and the time left in the rally.

Today I'm going to do the part II of the triumvirate - the Fundamental discussion. I will do the Sentiment Analysis tomorrow morning (Australian time) after the USRant.


First, a note of caution.

Microsoft is currently biasing all index dividend yield calculations, because of a one-time dividend that it paid this past year.

For whatever reason, this is not being excluded from other people's dividend yield calculations (i.e., people are investing as if MSFT will continue to have a dividend yield of 12% in future).

So while on the one hand, supposedly-independent 'analysts' are perfectly prepared to exclude one-time 'bad' items from EBITDA (and from NPAT in the case of large-scale writeoffs of goodwill), and are prepared to treat pension plan accounting as if it in some way connected to an actual flow of dollars.

Meanwhile they are willing to retain one-time items that increase stated profits. There are two such items that are currently biasing valuation metrics upwards:

  • abnormally low tax treatments of repatriated profits (which lowers the effective tax rate and increases NPAT) due to the repatriation moratorium which expired with the last tax year;
  • the recently-weak US dollar; and
  • MSFT's special dividend.

You might be surprised that MSFT's dividend could boas the entire Dow (or the entire S&P500) until you bear in mind that (a) the Dow is price-weighted, and (b) that MSFT is one of the largest stocks in the S&P500.

Are you starting to see the problem? By excluding 'bad' items as being 'one-off', and retaining 'good' items that are clearly one-offs but which improve the final picture, many analysts are overstating the attractiveness of the Dow (and by extension, the attractiveness of other indices).

I guess that's why they are called 'sell side' analysts... as I've said before, never accept analysis from any firm that has a brokerage function - even if they give it away.

So. In what everything below, I will be using a more 'standard' estimate of MSFT's annual dividends... MSFT's dividends averaged zero from 1986 to 2003, and 16¢ a share since then. I will use 24c a share, just to be fair. That gives MSFT a yield of 0.93%.

There's no strong need to go 'too deep' in the fundamentals - the bad news is right there at the top line (the Price-Earnings Ratio and the Dividend Yield).

I wrote something a while ago, that showed (conclusively, in my view) that the average real return from a 10-year holding of US securities was negative when the Price-Earnings ratio was > 20 at the time of purchase. Furthermore, the distribution of those returns centred on a negative nominal return. In that piece, it was also made clear that the bulk of the significant excess returns from holding equities disappears if entries are excluded when the price-earnings ratio is < 15. (Significant market bottoms have historically be associated with a PER <10).

Currently, the Dow has a price-earnings ratio in the high 19s (and that is only once you exclude 'one time' items - which seem to crop up every single year). If you add back these 'bads', the Dow's PER climbs to 22x.

If you further understand that repatriated offshore earnings were undertaken at a time where the USD was at a 5-year low, you can see that the USD-denominated earnings amount was overstated relative to the USD amount that prevailed at the time the earnings were actually produced. As such, all companies that repatriated offshore-domiciled profits during the tax 'forgiveness', experienced a one-off gain of between 25% and 40% due solely to currency fluctuations. Significant currency-related gains are also 'one-off'; think about the impact of the falling USD on companies' revenue streams: a company that sold 100 widgets to foreign demand in 2000/01 could have had offshore demand fall by 25% but still would have showed an increase in USD-denominated sales revenue from foreign sources - because the dollar (as measured by the USDX) fell from about 120 to about 80.

If you even further understand that the repatriation tax moratorium drove down the average tax rate for companies that did this, you discover that the PER compared to genuinely (and independently) 'normalised' earnings is about 25x. That's closer to 1929 than to 1982 (the recent secular swing low).

So. The PER is in 'negative real (and nominal) long-term return 'space'. There is almost no need to go further.

But let's press on.

Dividends - especially when reinvested - are the source of almost all of the 'excess long-run return' from holding equities as compared to other asset classes. In other words, the core driver of higher returns from equities than from other asset classes, depends even more on the starting dividend yield than it does on the starting PE Ratio. The long run average dividend yield is above 4.5% - more than double its current level. Reinvesting those dividends gives a 'double whammy' to equity returns, since those (relatively high) dividends are reinvested at relatively low levels of valuation.

Currently, dividend reinvestment would be taking place at valuation level associated with negative real long-run (10-year) returns. A double negative whammy, in other words. At present, 21 Dow stocks have dividend yields less than 2.5%; more than half the stocks in the Dow yield < 2%. The highest-yielding stock in the Dow - General Motors - is in more shit than the Early Settlers, and is having to borrow buckets of money just to meet its retirement fund obligations.

The index's dividend yield is about 2.3% (2.16% if you weight the dividends the same way as the Dow itself is weighted, i.e., by price). Everyone is betting on the Greater Fool (i.e., on multiple expansion). As a sage once said "If you look around the room and you can't tell who the patsy is, look in a mirror".

Broader economy-wide patterns are also worth examining, most notably the degree to which the 'carve up' of economic activity is being skewed away from labour and toward capital.

Historically, the income shares of labour and capital in output has been tilted towards labour; in a piece I write in 2000 (in which I declared a top for US corporate earnings), capital's share of output had risen too far. It has since risen further. If the overall balance has tilted toward capital, then the proportion(that accrues to capital) of each marginal dollar of activity may actually exceed 100%.

Think of it this way: start with an economy that produces $1 worth of output, and has no government (bliss!). At the end of the year, it turns out that the 'split' of income between Labour and Capital is 60:40 to labour (i.e., Labour takes home 60¢ and capital takes home 40¢).

Some time down the track, we look at output again, and this time it's $2, and the capital-labour split is now 50:50. Capital now takes home $1 and so does labour.

Now, it turns out (if you do the sums) that capital had to accrue 60% of the 'second' dollar produced; in other words, real wages fell as output expanded. Capital pocketed 60% of the second dollars'-worth of output.

The picture on the US has been even worse than that: capital's share of income has risen such that the marginal share of capital in output is greater then 100%. That cannot continue for long - workers eventually realise that they have been going backwards, and that any increase in their lifestyle has been the result of accumulating debt.

Speaking of debt, an interesting 'debt deepening' is occurring; in the past the marginal contribution of debt to output has been as high as 1:1 - that is, each new dollar's worth of debt produced a dollar's worth of output. Currently it is taking $7 worth of new debt to produce $1 worth of new output (and that is after you exclude 'bad' one-offs).

So in summary, the Fundamental case for the Dow as an index are at the worst of their historical ranges: debt accumulation too rapid (and having rapidly decreasing contribution to output), earnings and dividend yields at the lower extreme of historical experience, and the broader economy extremely reliant on fiscal and monetary stimuli (i.e., borrowing from future production).

Finally ,the US is almost certainly in recession at the moment; I have my time-honored 13 Signs Your Economy Is screwed, and the US is currently hitting 10 of 13; any time the US has worse than 6/13, recession is guaranteed.

I've said this many times before: the broad economy only serves as an 'attractor' for stock markets. Markets do not look forward (where were they looking when the Nasdaq was at 5000?) In the short to medium term, the market depends on technicals (covered last week) and Sentiment - of which, more tomorrow.