Applied Finance Group
April 21, 2010
Since its March low in 2009, the S&P 500 is up more than 70%. Given that a year ago the economy was starring at an abyss and market valuations reflected such thoughts, a big chunk of the 70% return is not unreasonable. The important question to answer now, however, is what underpins the current upward move of the market, and the likelihood of its sustainability.
As we noted in our December discussion “Beta is Your Best Friend,” in order to outperform in 2009 a portfolio had to have significant Beta exposure. In most cases, high beta stocks meant financials, consumer discretionary, and other distressed stocks. So far in 2010, the tale has more or less continued in uninterrupted fashion with high Beta stocks leading the way among various factors. Before we go all in on Beta in search of Alpha, we need to understand how normal it is for high and low beta stocks to respectively over and under perform their given universes.
The table below begins to tell the story about Beta over the long-term, in 2009, and year to date. (Long term – annualized return from 2/20/98 to 3/26/10; 2009 - 12/31/08 to 12/31/09; 2010 YTD – 12/31/09 to 3/26/10. 0-100 represents the universe of the largest 1000 in market cap.; 81-100 represents the highest 20% of Beta stocks in the universe; 0-20 represents the lowest 20% of Beta stocks in the universe.)
The important observation is that over long periods of time, Beta portfolios show very little correlation with actual market returns, indicated by blue bars in the chart above. Whether you buy high or low Beta stocks, the returns are very unreliable and thus it is hard to accept Beta as any sort of systematic risk or fundamental indicator variable. Though recently, Beta has been a very powerful variable, it is unlikely to be a consistent predictor over the intermediate term (after all, why should market volatility from 5 years ago have anything to do with performance today). More likely, the extreme volatility of the past 2 years resulted in the most beat up stocks having the highest Beta. With the economic system recovering, it makes sense that these same stocks showed the best subsequent returns. However, as a long-term signal, Beta appears to have little value as a discriminating factor.
Conversely, let us examine the performance of a fundamental factor, AFG’s Percent to Target (PTT) Ranking.
The table below begins to tell the story about AFG’s PTT over the long-term, in 2009, and year to date. (Long term – annualized return from 2/20/98 to 3/26/10; 2009 - 12/31/08 to 12/31/09; 2010 YTD – 12/31/09 to 3/26/10. 0-100 represents the universe of the largest 1000 in market cap.; 81-100 represents the highest 20% of PTT stocks in the universe; 0-20 represents the lowest 20% of PTT stocks in the universe.)
The first observation is that PTT is a consistent factor identifying stocks likely to over or under perform a given universe in each of the three periods, although there were some abnormally high returns from the bottom quartile in 2009 and year to date (Red and green bars for 0-20 quartile). While the future is never certain, we believe ignoring such a strong long-term fundamental factor is silly. Ironically, our research led us to play the role of market cheerleader in the first half of 2009, given the extremely low expectations baked into prices then, but we now find ourselves in the role of market curmudgeon. Examining the growth expectation imbedded in the latest S&P500 prices, we feel valuation levels are rather troubling. Back at the March low in 2009, the S&P 500 was priced at an implied median annual sales growth of negative 5% for the next 5 years. Based on April 1 price this year, the S&P 500 was priced at an implied median annual sales growth of a positive 11% for the next 5 years. We do not think our economy will likely support a nearly 70% expansion of corporate America over the next 5 years, although it is from a rather low base.
While the market has consistently shown the ability to go higher in the face of increasingly unreasonable expectations (we all remember the Tech Boom among other periods), the story never seems to have a Hollywood ending. Currently, as the VIX continues to decline, it seems as though respect for risk has again started to take a back seat to lust for gains as economic news trickles in with indications of economic vigor. We think of this in terms of thousands of pieces of good news. Sadly however, the news jigsaw hasn’t changed much for the better, specifically:
According to Bloomberg, an April survey still shows Unemployment will have an average of 9.6 percent for all of 2010 and 8.9 percent in 2011. The country is still well on its way to have the nation's debt reach $15 trillion next year, or about 95% of GDP. In February, two-year notes sold by Berkshire Hathaway yielded 3.5 bps less than Treasuries of similar maturity, according to data compiled by Bloomberg. Procter & Gamble, Johnson & Johnson and Lowe’s Cos. debt also traded at lower yields in recent weeks, a situation suggesting the market believes it is safer to lend to those corporations than to the US. This is an indicator that the US credit market may face increased turbulence in the months ahead. Oil prices are climbing on the back of demand from China and Asia. This will create problems for consumers as this rise morphs into higher gas prices, which is likely to curtail discretionary spending. The housing market continues to be weak in spite of massive government intervention to support the market with tax credits, loan guarantees, and foreclosure programs. Lastly, let us not forget, the healthcare bill was passed. While the bill was sold as a program to bend the health care cost curve, the reality is that such a bill does very little to address cost as its focus is coverage. Further, costs for employers will rise via health premiums as aspects of the bill create a dramatic free-rider problem between those that pay for health insurance today and those that will wait to utilize the no “pre-existing” condition aspect of the new law to only purchase insurance when they need treatment. Lastly, taxes will increase next year as the sunset provisions on the Bush tax cut lead to higher rates on labor and capital. While C-Corp rates will not increase, successful S-Corp owners will see marginal tax rates increase, curtailing their ability to invest or spend to spur economic activity. All told, it is difficult for us to understand why the portions of the market trade near record highs facing such head winds and expensive fundamentals. However, it is buyers and sellers which make this business interesting, challenging, and fun every day.
This leads us to conclude with a thought first articulated by Dr. Victor Canto earlier this month, and reiterated recently by Larry Kudlow – namely that increased economic activity right now makes perfect sense. Their analysis stems from economic actors looking out to higher taxes next year and thus moving more of their economic activity to this year. You can read Victor’s article here, and Kudlow’s here. Dr. Canto will be speaking at our annual Research Summit in Las Vegas this June, find information here.
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(c) Applied Finance Group