"The only function of economic forecasting is to make astrology look respectable." - John Kenneth Galbraith
I do not envy Janet Yellen, but I have to say that I am warming to her as the Federal Reserve Chair. Last week the FOMC had its meeting and the results are a slight testimony to the Federal Reserve in that she pretty much admitted that the data presented was too unclear to formulate a decisive direction for the main Federal Reserve's policies. Finally someone has come forward and admitted that they really have no clue where the economy is going and that they will have to wait to see what happens next before proposing a solution. This is refreshing in that she is owning up to what we already knew, the Federal Reserve is reactionary rather than being preemptive. For all of those who believed that the Federal Reserve had a "special" set of metrics that it could use to steer the economy on an even keel, this bubble has finally been burst. There never has been a magic number and there is no magic formula, they are just as constrained and confused as everyone else, the only difference is that they have massive sway over the markets and have used it to manipulate it for the supposed benefit of all.
Looking at their forecasts shows this first hand. While unemployment is expected to fall to 5.3% over the long run, inflation is expected to continue below the Federal Reserve target of 2% and GDP is expected to remain around 2.5%. I find these numbers very interesting as with anemic economic growth it will be increasingly hard to reduce unemployment much further than the current level so either the unemployment number is overly aggressive or GDP and inflation are too low. In response to this line of questioning Yellen responded that incoming data could prove stronger than expected and potentially invite rate
hikes that occur sooner and more rapidly than now envisioned but she also added that incoming data could go the other way too, and lead to rates
staying lower for longer than now envisioned. So in other words she is on the fence and other than continuing to reduce the monthly buy of Treasuries to zero by October the Federal Reserve is in a wait and see mode.
In order to track movements in the economy she has opened up that her dashboard of indicators is far larger than her predecessors. In other words the more data the better. The problem with all that data is that there is also a lot of noise infiltrating the decision making process but at least she is not confining herself to a short list of metrics that really have no baring on the economy. Using the underemployment rate, changes in consumer spending and the job quits rate are all better metrics than the unemployment rate. So while these are giving her a better indication of the labor market it could mean that the Federal Reserve remains in limbo for an extended period while they wait for an uptick across the dashboard during which time inflation could be rearing its head in metrics other than the Core PCE, her preferred metric.
The result could be that the Federal Reserve keeps interest rates low for an extended period (through 2016) only to be forced into trying to extinguish an accelerating inflationary fire after it has already burned half of the country. Once again acting in a reactionary way to data that the rest of us are witnessing first hand right now. At least she is more honest than her predecessors in saying that she has no ability to guess the future but outside of that know that you need to protect yourself rather than rely on the Federal Reserve.
Friday, July 25, 2014
Friday, July 18, 2014
Rule of 20
"A measure of stock valuations called the Rule of 20 states that the stock market is fairly valued when the sum of the average price earnings ratio and the rate of inflation is equal to 20."
The Rule of 20 is interesting in that should the total of these two numbers be less than 20 then the rule states that stocks are cheap and should be purchased and if they exceed this number then they are expensive and should be sold. Based on today's S&P500 index reading of 1965 and dividing this number by the expected total earnings per share of the S&P500 of $109, the price to earnings ratio of the S&P500 is just above 18. Add to this number the Federal Reserve's expectation of inflation of 1.5% and you can see that at this level in theory the S&P500 is slightly undervalued as the total is 19.5.
Looking at the ratio in a little more detail shows just how quickly this indicator can swing. If you take for example a more realistic inflation number of 4% (I am not sure that even this number is that realistic but it is closer to reality than the Federal Reserve's cooked number) suddenly the total is 22 and the indicator shows that stocks are overvalued. Furthermore if stocks cannot earn $109 this year and earn say $100 the index is suddenly flashing sell as it is now 23.65 a number not seen since before the 2008 crash.
The problem with looking at one indicator in isolation is thus highlighted. The numbers are based on expectations and once these change and the real numbers come in the indicator can swing pointing clearly to a buy or sell signal that was not present in the moment. This dilemma is normally present when an indicator of this nature reaches an inflection point. Were it to print a number of say 10 (which it did near the bottom in 2009) it is a clear buy indication, as was the sell signal it printed in 2007. At inflection points it is important that investors look at additional indicators to get a better understanding of the risks before deciding on a direction for the market.
Looking at a second indicator, the Price to Sales ratio, things look a lot different. The P/S ratio takes the value of the S&P500 and divides it by the total revenue of those companies. Sales is used for the simple reason that the sales number is the hardest number in the profit and loss statement to manipulate (readers of this blog can refer to the article on IBM and see just how badly earnings can be manipulated) so using this number gives a better idea of the market health. If sales are growing profits should follow but at present sales are actually contracting so this indicator is now at an all time high.
Another indicator is the price to GDP level. GDP is the total output of the nation and so a high price in relation to GDP shows over priced stocks. At present this indicator is back to its 2007 levels. I could go on but you get the picture that adding these indicators together shows a market that is in dire need of continued Federal Reserve stimulation and that is being tapered at a rate of $10 billion a month. Continuing on this path and it could spell trouble for the market right around October which has historically been one of the worst performing months in the history of the market - it gave us Black Monday and the Flash Crash among other fun meltdowns.
So while the indicators are signaling trouble there is still time to pull in your horns. Do not get caught holding the proverbial hot coal that the professional money managers are desperately trying to palm off onto any new comers to the market, or if you really need to be in the market make sure you have adequate protection or have the investment on a very short leash.
The Rule of 20 is interesting in that should the total of these two numbers be less than 20 then the rule states that stocks are cheap and should be purchased and if they exceed this number then they are expensive and should be sold. Based on today's S&P500 index reading of 1965 and dividing this number by the expected total earnings per share of the S&P500 of $109, the price to earnings ratio of the S&P500 is just above 18. Add to this number the Federal Reserve's expectation of inflation of 1.5% and you can see that at this level in theory the S&P500 is slightly undervalued as the total is 19.5.
Looking at the ratio in a little more detail shows just how quickly this indicator can swing. If you take for example a more realistic inflation number of 4% (I am not sure that even this number is that realistic but it is closer to reality than the Federal Reserve's cooked number) suddenly the total is 22 and the indicator shows that stocks are overvalued. Furthermore if stocks cannot earn $109 this year and earn say $100 the index is suddenly flashing sell as it is now 23.65 a number not seen since before the 2008 crash.
The problem with looking at one indicator in isolation is thus highlighted. The numbers are based on expectations and once these change and the real numbers come in the indicator can swing pointing clearly to a buy or sell signal that was not present in the moment. This dilemma is normally present when an indicator of this nature reaches an inflection point. Were it to print a number of say 10 (which it did near the bottom in 2009) it is a clear buy indication, as was the sell signal it printed in 2007. At inflection points it is important that investors look at additional indicators to get a better understanding of the risks before deciding on a direction for the market.
Looking at a second indicator, the Price to Sales ratio, things look a lot different. The P/S ratio takes the value of the S&P500 and divides it by the total revenue of those companies. Sales is used for the simple reason that the sales number is the hardest number in the profit and loss statement to manipulate (readers of this blog can refer to the article on IBM and see just how badly earnings can be manipulated) so using this number gives a better idea of the market health. If sales are growing profits should follow but at present sales are actually contracting so this indicator is now at an all time high.
Another indicator is the price to GDP level. GDP is the total output of the nation and so a high price in relation to GDP shows over priced stocks. At present this indicator is back to its 2007 levels. I could go on but you get the picture that adding these indicators together shows a market that is in dire need of continued Federal Reserve stimulation and that is being tapered at a rate of $10 billion a month. Continuing on this path and it could spell trouble for the market right around October which has historically been one of the worst performing months in the history of the market - it gave us Black Monday and the Flash Crash among other fun meltdowns.
So while the indicators are signaling trouble there is still time to pull in your horns. Do not get caught holding the proverbial hot coal that the professional money managers are desperately trying to palm off onto any new comers to the market, or if you really need to be in the market make sure you have adequate protection or have the investment on a very short leash.
Friday, July 11, 2014
The Unskilled Issue
I recently read an article that made a case for the next recession in the United States coming from the large drop in the wages of the lowest portion of the population. According to the study when there is a negative real rate of growth of the lower income this normally results in the onset of a recession for the simple reason that the in the economy most of the population falls below the median income due to the skewness of the income curve. Losing their spending power results in cutting back on goods and services and this leads to a recession as companies are unable to sell their wares into the market.
This article interested me as Africa is a continent with massive unskilled worker problems. More than 40% of unskilled workers in South Africa are unemployed which is why crime levels are so high. So if the United States is having a problem that may drag it into recession, what of Africa and how does one manage to get these masses employed and their real rates of income higher?
This is a global problem and one that is rapidly being exacerbated by the continued influence of technology on society. More and more there is a requirement for the unskilled to become skilled and so access to training and education is the obvious solution. Now while this may seem obvious the next issue facing the United States is one of massive student debt. I believe that it is imperative that the government provide assistance to students, the problem is that there are plenty of schools that are not providing the level of education required to ensure gainful employment once they depart the school. Furthermore while shortages are still prevalent in technology and other skilled sectors of all economies the problem is that the high school proficiency in science and mathematics are lacking so there is not a large enough pool of college entrants to fill these spots.
Taking this one step further spending money on higher education is wasted until you get your primary education house in order and in this respect the United States and South Africa are both lacking. In comparison the eastern economies place high regard on academic studies at the high school level there is a total disdain for this in these two countries. Now as always this is a very broad brush I am painting with as there are institutions in both countries that prize their level of education but overall the masses are pushed through the system with little regard for the follow on options required to stimulate the economies.
The obvious solution would be to target this as a place for large scale investment and new government policy to align the desired level of education with the expected challenges and opportunities of life beyond high school. No child left behind was flawed in that the result was that schools were rewarded for making sure that the bottom tier passed forgoing the rest of the kids in the grade. The thing to remember is that not everyone will be a science and mathematical whizz but with all the new technological developments being created unless this tertiary education can be improved these problems will remain.
This article interested me as Africa is a continent with massive unskilled worker problems. More than 40% of unskilled workers in South Africa are unemployed which is why crime levels are so high. So if the United States is having a problem that may drag it into recession, what of Africa and how does one manage to get these masses employed and their real rates of income higher?
This is a global problem and one that is rapidly being exacerbated by the continued influence of technology on society. More and more there is a requirement for the unskilled to become skilled and so access to training and education is the obvious solution. Now while this may seem obvious the next issue facing the United States is one of massive student debt. I believe that it is imperative that the government provide assistance to students, the problem is that there are plenty of schools that are not providing the level of education required to ensure gainful employment once they depart the school. Furthermore while shortages are still prevalent in technology and other skilled sectors of all economies the problem is that the high school proficiency in science and mathematics are lacking so there is not a large enough pool of college entrants to fill these spots.
Taking this one step further spending money on higher education is wasted until you get your primary education house in order and in this respect the United States and South Africa are both lacking. In comparison the eastern economies place high regard on academic studies at the high school level there is a total disdain for this in these two countries. Now as always this is a very broad brush I am painting with as there are institutions in both countries that prize their level of education but overall the masses are pushed through the system with little regard for the follow on options required to stimulate the economies.
The obvious solution would be to target this as a place for large scale investment and new government policy to align the desired level of education with the expected challenges and opportunities of life beyond high school. No child left behind was flawed in that the result was that schools were rewarded for making sure that the bottom tier passed forgoing the rest of the kids in the grade. The thing to remember is that not everyone will be a science and mathematical whizz but with all the new technological developments being created unless this tertiary education can be improved these problems will remain.
Friday, July 4, 2014
Risk or Opportunity?
"The man who knows it can't be done counts the risk and not the reward." - Elbert Hubbard
Currently I am in South Africa visiting friends and family and I have spent a lot of time trying to bring myself up to speed with the business and economic environment. After asking numerous questions and digesting the information it is clear that where some investors see only risk while others see opportunity. Like most investments the difference between determining whether the opportunity presents itself as an investment or something to be shunned comes down to your assessment of the risk of the investment and the expected reward, however there is more to the equation than first meets the eye.
When you look at investing in Africa as a foreigner the idea is daunting. The capital risk is enormous as not only can the investment be lost to government nationalization but strikes, bribes, extortion, corruption, blackouts and worker and social unrest are the norm, spending on protection is common place and governments can change overnight. In addition trying to find and retain skilled workers is becoming increasingly difficult and you start to wonder why anyone in their right mind would bother to invest at all. It is also no wonder that most African currencies are taking a beating against the dollar and the Euro.
As an example when the South African mobile phone operator MTN expanded into Nigeria they had factored in the cost to build the cell phone towers only to discover that the power grid was so poor that each tower required its own generator to provide power. Once these were installed they soon found that a new expense was required in that the generators were soon being stolen so now they had to hire security guards to protect the generators. Fortunately for them the opportunity was so vast that they were able to manage these expenses while continuing to profit which brings me to the first addition to the equation, recurring revenue. MTN can make a go of this because of the recurring revenue model that is the cell phone industry. Were this a one off project I doubt these expenses could possibly be borne.
The next thing to look at for MTN was that they had essentially maximized their opportunity in South Africa and so to expand they needed to look elsewhere. This is similar to a Apple or Microsoft in the United States who seek to grow their markets by expanding into new regions. For a South African country moving into Africa is the obvious choice as the expertise is there and they are already familiar with the lay of the land. This expertise is critical and has led to some other South African companies expanding based on first exploiting their local knowledge before taking on the rest of the world.
South African Breweries springs to mind. They started as a local brewer and soon managed to become the preeminent brewer in South Africa. They then tried to expand into Africa with minimal success until they realized that their lack of success was due to the lack of refrigeration. So they began delivering refrigerators to their distributors around the continent and sales started to boom - who doesn't want a cold beer on a steaming African safari? They are now one of the largest brewers in the world having acquired numerous other breweries including Miller.
The opportunity therefore presented itself to these businesses because of their proximity to the opportunity, their expertise and the recurring revenue that was present (once the refrigerator was installed the only cold beer in town was SAB's or the refrigerator was removed). So the next time that you determine an opportunity is worth an investment do not limit yourself to the risk and the reward equation but expand it to include expertise and recurring revenue!
Currently I am in South Africa visiting friends and family and I have spent a lot of time trying to bring myself up to speed with the business and economic environment. After asking numerous questions and digesting the information it is clear that where some investors see only risk while others see opportunity. Like most investments the difference between determining whether the opportunity presents itself as an investment or something to be shunned comes down to your assessment of the risk of the investment and the expected reward, however there is more to the equation than first meets the eye.
When you look at investing in Africa as a foreigner the idea is daunting. The capital risk is enormous as not only can the investment be lost to government nationalization but strikes, bribes, extortion, corruption, blackouts and worker and social unrest are the norm, spending on protection is common place and governments can change overnight. In addition trying to find and retain skilled workers is becoming increasingly difficult and you start to wonder why anyone in their right mind would bother to invest at all. It is also no wonder that most African currencies are taking a beating against the dollar and the Euro.
As an example when the South African mobile phone operator MTN expanded into Nigeria they had factored in the cost to build the cell phone towers only to discover that the power grid was so poor that each tower required its own generator to provide power. Once these were installed they soon found that a new expense was required in that the generators were soon being stolen so now they had to hire security guards to protect the generators. Fortunately for them the opportunity was so vast that they were able to manage these expenses while continuing to profit which brings me to the first addition to the equation, recurring revenue. MTN can make a go of this because of the recurring revenue model that is the cell phone industry. Were this a one off project I doubt these expenses could possibly be borne.
The next thing to look at for MTN was that they had essentially maximized their opportunity in South Africa and so to expand they needed to look elsewhere. This is similar to a Apple or Microsoft in the United States who seek to grow their markets by expanding into new regions. For a South African country moving into Africa is the obvious choice as the expertise is there and they are already familiar with the lay of the land. This expertise is critical and has led to some other South African companies expanding based on first exploiting their local knowledge before taking on the rest of the world.
South African Breweries springs to mind. They started as a local brewer and soon managed to become the preeminent brewer in South Africa. They then tried to expand into Africa with minimal success until they realized that their lack of success was due to the lack of refrigeration. So they began delivering refrigerators to their distributors around the continent and sales started to boom - who doesn't want a cold beer on a steaming African safari? They are now one of the largest brewers in the world having acquired numerous other breweries including Miller.
The opportunity therefore presented itself to these businesses because of their proximity to the opportunity, their expertise and the recurring revenue that was present (once the refrigerator was installed the only cold beer in town was SAB's or the refrigerator was removed). So the next time that you determine an opportunity is worth an investment do not limit yourself to the risk and the reward equation but expand it to include expertise and recurring revenue!
Subscribe to:
Posts (Atom)
