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Tuesday, June 17, 2008

The valuation trap

First of all, Goldman came in better than expected, but one should be aware of two crucial facts: investment banks can cook books better than anyone, since they have a lot of tier 2, tier 3 capital (valued with obscure prices) and off the balance sheet assets; and they can swap things away for a time (make them invisible). So Goldman had a positive momentum caused by rivaling Bear Stearns. Lehman problems, gaining plenty of their business and clients since other rivals like Merrill are also struggling, had a lot of Hedge Fund business coming their way in Prime brokerage and M&A and still yesterday (or in the last few days), they seem to have fired hundreds of VPs from investment banking. If the leader eliminates, then trouble is ahead. The other positive factor is that they are a leader in the commodity game and also picked up good business through the high interest and volatility. The same applies with a softer tone for Morgan Stanley, which is why the earnings expectations are a bit too low for both this quarter.

The valuation, which we hear so much of, is a bullshiting game, since a lot of parameters in statistical models have changed. Nevertheless, they keep referring to them and the worst part still is that the interpretation is dead wrong anyway. Beneath a valuation model based on inflation, thereby the inflation used over 60 years, is not the same inflation. As even Bill Gross from Pimco admitted, the Government does understate inflation, the model was changed two times. The last time under Clinton/Greenspan, understating inflation by 3% approx. to the official issued ones and, I believe, under Reagan it was downsized another 1-2 % - so real inflation is closer to 7-8%, which would suggest that PE average for the S&P 500 should be single digit. That would mean we had to shave off 1/3 of current value and bring us to an SPX around 900. That is for current earnings. However, we can expect dropping earnings going forward, so potential is towards 700 and that is pretty much where we are heading within 2 years, if the banking world survives as it is, which I doubt.

Excerpt from Barrons

But one of the many obstacles facing the stock market is that, by some key measures, it is close to what is known as "fair value."


In other words, stocks aren't supercheap, but they are not expensive either -- they are right about where they ought to be for some time to come. If those readings are accurate, investors should keep their hopes for a modest rebound.

"The market is pretty fairly priced," says Gail Dudack, a longtime market watcher and founder of Dudack Research Group.

The Standard & Poor's 500-stock index closed Friday at 1360.03, and most analysts see it ending the year between 1400 and 1500. While that would represent a gain of roughly 3% to 10% from here, an S&P at 1400 would be down between 4% and 5% for the year, and an index at 1500 would be up only a bit more than 2%.

The so called Fed Model also developed by Greenspan (very creative man) is also based 10 year US Treasury note - remember that is based on a totally undervalued inflation - and one year forward earnings of the S&P500. Based on authentic inflation it would make sense to a degree but the model would change dramatically with a 10 year trading at 8% interest, where it should be. Since everybody needs to do something for his retirement the investment funds are happy to invest according to that systematic approach since it also worked out for a while. The most pathetic thing also promoted by media was this core-inflation game - in the real world and thats the only thing that counts core inflation does not help you to pay off your higher bills. This brainwashing campaign was quite a nasty game since the purpose was to reduce labour cost by understating inflation thats a basic effect of globalisation. The buying bower was falling constantly but people, at least in America had the impression of rising wealth with stockmarkets and real estate markets gaining value. Now they have a double shock experience inflation explodes into heir face and the wealth they believed they would posses does not exist. Right now we are still in a phase of ignorance although the pain is spreading out.

The final effect of inflation is that stock markets tend to rise in the beginning, since inflation means ample liquidity, but on the other hand the current inflation is accompanied by a huge value destruction: house value; stock value; and buying value is destroyed (especially now with interest far below inflation - negative interest) and the never-seen mass destruction of money by banks in the mortgage meltdown. Currently, we are at $450 bil., but we are heading for at least $1 tril if not $2 tril. in bank capital. This by itself does not worry me but the value of savings from US households are at around $54 tril., down by $3-4 tril. from the top. I am afraid that we are heading for a more substantial losses in the years ahead. The FED allowed the banks to speculate excessively with leverages over 30 for investment banks and banks having funded the housing bubble, which Mr. Greenspan denies ever existed. It would take years and a great amount of pain to sort it out under normal conditions but in a cycle term we are heading for a depression.

After the major bear market plunges of 2000, 2001 and 2002, the model finally began to show the S&P 500 as undervalued. This occurred during the big swoon lower that started the summer of 2002 and continued into the month of October, as can be seen in Figure 2. But the rally of 2003 has made the S&P 500 considerably less undervalued than was the case in March this year (when the Fed Model showed the S&P 500 over 700 points undervalued). The S&P 500 remains, therefore, from a relative value perspective still a buy, according to the Fed Model. However, there are some underlying dynamics at work in the model's variables that lead to some interesting paradoxes.

Figure 1 - S&P 500 Fair value according to the Fed model's valuation
Source: MetaStock Professional

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