August 13, 2011

ChartMatters: Stocks Poised To Gain After The Downgrade Flash Crash (Guest Post)

By Andrew Butter

There are many theories about how to value the US Stock market (as a whole); some said that stocks were 40% over priced in May 2009, same story in August 2011. All it took was the hilarious spectacle of the workings of what passes for “modern” democracy to be aired on prime-time, for those same tired-old theories to get dusted off and paraded like some sort of universal truth.

40%...grow up! The acid-test of a “universal truth” is whether it can make accurate predictions in real-time.  Here’s a theory that has been right five times out of five, that says (a) the reversal just now was inevitable, (b) all that the downgrade did was provide the trigger and (c) it’s over.

In January 2009 that theory said the S&P 500 would bottom at 675, which it did in March (intra-day), then it said in May 2009 that the index (then 900) would go up in a pretty straight line to 1,200 (it did over the next twelve months); then it would reverse by 15% to 20% (it did by 16% in April 2010); then it would meander back up until it went over 1,300 which happened in April 2011, at which point it would reverse again by about 15% (actually it was 18%).

If you know of a theory about how the US stock markets works that can do five-out-of-five, in a row; without a caveat, well that could be right too.

The “without a caveat” part is important; like put a number for the inflection point in the future; rather than saying something “profound” like… “US Stocks could go down 40% and test March 2009 lows”, as in “could” means “could not” too.

Meanwhile I’m sticking to that theory, at least until it doesn’t work; perhaps sixth-time-lucky the sun won’t come up in the place the theory predicted?

How does that work…if it works?

Simple you do a valuation in line with International Valuation Standards (IVS), crank the handle, and out pops the answer. That gets you to the “fundamental” or intrinsic value, or what Farrell called “equilibrium” and what IVS calls other than market value.

The rest is just Farrell’s 2nd Law, which re-states Mises’ idea that making stupid investments, particularly geared-stupid-investments (he called them mal-investments) is inevitably followed by forced liquidation of those investments at an unattractive price.

Another way of looking at that is the “pebble in the pond” theory, where the dynamics of the “up” are inevitably reflected in the “down” that follows; and the net result is zero sum; that’s a law of nature and however hard those who call themselves God’s Workers try to defy nature, in the long-run, as Keynes pointed out, natural order always returns.

It doesn’t take long to build the valuation model and you don’t need to be an “expert”; the first time I did that for stock markets I knew was they existed and that you could download data from Yahoo Finance. To illustrate the depth of my ignorance at the time, then, I thought the DJIA was the same as SPX except that you multiplied by ten.

It took about half an hour to build the valuation model and about three hours to write the article and come up with the bad jokes. Only one thing about that which is hard to understand, which is how come Shiller, Smithers, Prechter, and all those other guys who say things like “could” and “might”; instead of “will”…just can’t “see” how easy it is.

What will the law of nature spew out next?

The “theory” says that the fundamental of the S&P 500 (expressed in dollars) depends on (a) the nominal GDP (in dollars) of the economy that companies listed on the index play in (which is wider than just the US economy), and (b) the yield on long-term US Treasuries (whatever their rating).

That gets you to the base line; then you have to look at the periodicity of the oscillation around the base line.

With regard to the downgrade....calm down, it’s not a big deal, sovereign debt only loses its 0% risk weighting when it drops below AA- and so nothing really changed, although one wonders what’s going to happen to non-sovereign debt?

The risk weighting of AAA synthetic collateralized debt obligations (CDO) lovingly crafted by Goldman Sachs is 20%, so presumably that stuff is now supposed to be less risky than the debt issued by a country which has the option of simply printing dollars to pay the debt back?

What’s really confusing is that 10-Year yields tanked after the downgrade, the way it’s supposed to work is that when you get a downgrade, the yield on your piece of the toxic asset pool, is supposed to go up.

What’s also interesting is that the S&P 500 started to tank the day after Lehman folded, but it took another two months for yields on the 10-Year to start to tank. This time around, they both tanked in tandem.

Perhaps the difference was that back then there was the legacy of George Bush who for all his failings; did mange to unite the nation behind him.  When George’s minions suggested TARP, he got a green-light to sign the check and when Ben started talking about TALF which started off as a $200 billion loan facility, and grew into a $1.6 trillion repository for second-hand shoes, no one batted an eyebrow.

But when Obama stood up and said, “come on guys, we got to roll over the debts that George and his policies (and God’s Workers) ran up, or we will get a downgrade”.

Congress and the nation said “we would prefer to have the downgrade”.

That’s democracy in action just like it works in other places where you don’t have the option of ticking “None of the above” on the voting slip, like in Syria.

What next?

Well, nothing much really, the exhibition of crass incompetence was the trigger for the inevitable to happen, it could have been something else.

But nothing has really changed, the unhappy ship of America will stagger onwards, and Americans with money will continue to spend it and continue to resist the efforts of the government to put its hand in their pocket so that the crumbling infrastructure and optimism of a once-great country can be re-built.

So more than likely nominal GDP growth will hover around 3% a year (how much of that is “real” is irrelevant insofar as the stocks are concerned), and so the 10-Year will hover around 3% too.

Plug those parameters ino the valuation algorithm and this is what you get:

The line to watch is the bottom of the triangles, whenever the price goes up faster than that line, there is a risk of a reversal.

So the model says that by August 2016 the S&P 500 will be flirting with 2,000, which works out at an average annual growth of about 10% a year, whether that will keep up with “real” inflation, is of course debatable.

About the Author - Andrew Butter is Managing Partner of ABMC, an investment advisory firm, based in Dubai that he set up in 1999, and has been involved advising on large scale real estate investments, primarily in Dubai.  (EconMatters author archive here)

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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