Friday, July 5, 2013

“Boohoo-yahoo!” says the market.

2008 – 2010 and even the summers of 2011 and 2012 were traumatic times for many investors. As such, the skittishness and risk aversion in the market is easy to understand. But is this market response due to realistic expectations or due to the much acclaimed ‘recency effect’? An effect resulting from the still fresh memories of those traumatic events and forgetting about the long-term behaviour of stocks and investments in general. And yes, 2008 was one of the more severe bear markets in the last hundred years, but the stock market did not drop that much more from its peak than say in 1980-1982; the first major bear market in my adult life. That one is still a deep scar in my personal memory and 2008-2010 for me does not feel as bad.

Now that interest rates finally start to return to a more normal level compared to inflation, the markets panic instead of rejoice. Yes, corporate profits, at first sight may be somewhat suffering because of the slightly higher costs of money.
But let us put this in perspective. With interest rates rising from say 1% to 2.5% (something that would be a lot worse than we’re really experiencing), $100 borrowed would have interest payments going from $ 1 to $2.5. Now if the enterprise value of a company is around $1000 and it has an operating (EBITDA)/enterprise value  ratio of 10x or it earns 10% on its assets, then how would those earnings be affected?  Say the company has an loan to value ratio of 40% then it would have debt equal to 0.4 x $1000 = $400 and that would mean its interest payments have risen from $4 (4 x $1 interest per $100 borrowed) to $10. If operating earnings at $4 interest payments were $100 then Net Earnings (not counting taxes and depreciation) would be $100 - 4 = $96 and at the new higher interest rate those Net Earnings would be $100 – $10) = $90. That represents a drop of 6.3% in Net Earnings and thus its stock value should fall a maximum of 6.3%.
BUT interest rates are increasing because the economy is improving and thus so should the company’s revenues!   Even if those revenues only increased by 4%, because of economies of scale operating profits would likely increase to 5 or 6%.  For example, if the company’s manufacturing plant usage in the 1%-interest-rate economy was 80% then that extra 4% in sales in the 2.5%-interest-rate economy results in increased plant usage. (A plant which runs at certain fixed costs produces now more products at the same fixed costs; that should result in cheaper production costs and thus a higher profit margin.)
Thus operating earnings of $100 should increase to $106 and when you deduct from that the interest payment increase of $10 - $4 =$6, earnings basically stay the same at $100.  In real life, in the U.S., junk bond yields have increased dramatically (J) from 5.8 to 6.3% if I recall correctly, that is not even close to the more than doubled rates in our example.
Now ask yourself whether the recent interest increases in the real market justify say BCE losing 15% of its share price? Of course not, what we have seen lately is nothing more than the hysterical, schizophrenic market in 'over-reaction' mode. With a better economy not only do interest rates rise, but sales are also rising thus improving the profit margins for many companies.
Why do the interest rates rise? Well when sales increase, everybody wants to borrow money to expand and thus the demand for more loans and thus… higher interest rates. That brings us to the second part of this posting.
What’s this kafuffle about inflation?  Well, as one may inspect in real life, everything is relative. You see there are  at least two different ways of measuring inflation. There is inflation due to increased cost of living. This is expressed in the Consumer Price Index or CPI. The CPI has shown very little movement in terms of cost-of-living. Then there are many others, often the gold-bugs, who state that inflation is the ‘speed of money’ or the 'velocity' at which money is circulating through our economy. I am quoting here:

Economists have a term for how quickly money cycles through the economy. They call it “velocity,” and it’s defined as the average frequency with which a unit of money is spent in a specific period of time. As spending increases, or the money supply tightens, velocity increases, and vice versa. In practice, velocity is often calculated as the Gross Domestic Product (GDP) divided by the money supply.

In simple terms, higher values [inflation] reflect a relatively more free-spending society, with each dollar cycling through the economy more quickly. Lower values, on the other hand, indicate a relatively stingier society, in which each dollar circulates through the economy more slowly.

Thus when the central banks buy back bonds and paying for it by printing money, it created ample money supply in the economy; much more than consumers and companies required for loans. The result was artificially low interest rates.

The central banks printed so much money that despite the fact that banks were scared and they started to lend money. The abundance of cheap money available to banks lending it out at higher rates to their most credit worthy clients was too good an opportunity to make big profits and finally the banks caved in and started to lend out money again  at super profits after being paralyzed during the financial crises.

The result was an increase in the speed of money circulating in the economy. The banks started to use these enormous profits to rebuild their balance sheets. Eventuality the affordability of housing ( low prices combined with low mortgage interest rates) resulted in investors and other real estate owners tempted by high profits to return to the U.S. housing market.

In the meantime the speed of money has kept increasing and with that the risk that asset prices and the cost of living will go up. So, the speed-of-money can be considered to represent ‘inflation’. Hence the two schools:  one (especially gold-bugs) stating that inflation is reflected by the speed of money; the other school (including the central banks and government) that inflation is reflected by the CPI.

Gold Bugs love high inflation because they feel that gold is an inflation hedge and thus a high speed of money means higher gold prices. But in this contest of different inflation schools, the central banks appear to win; the idea that inflation, as represented by the CPI, is still far off. The market in general seems to agree with the central banks (for now) – the result is a crash in gold and silver prices.

But as usual, that same market is schizoid. Thus, it also feels that the speed of money has increased by so much that the demand for debt has increased; so much so that it justifies skyrocketing interest rates. Even worse, as shown above, now that same market has concluded that as a result of the rise of interest rates, corporate profits are about to crash and along with it stock prices. “Boohoo-yahoo!” says the market.

So for us ‘cool guys’ we try to get a ‘realistic picture’ as to the current state of affairs. Yes, we’re experiencing an overdone market correction in a mid- stage bull market. A time, during which we can still ‘buy-on-dips’ - provided we see very good value. Also, if you have already made some excellent profits (for example on AutoCanada Inc. - ACQ-T in our Lower PE-Moderate Dividend Portfolio) it may be time to cash some of those profits. A very attractive way to do that is by selling call options as I will describe in a later post. We also should consider moving gradually into fixed income. More about that in yet another later post.

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