Send an Email
Favourite Sites
  • Whitney Tilson
  • Recommended Booklist

  • Favourite Blogs
  • Calculated Risk
  • Reflections on Value Investing
  • "The market can remain irrational longer than you can remain solvent" - John Maynard Keynes

    Thursday, April 29, 2004

    Valuing Google
    I'm probably going to write more on this but valuing google on a relative basis against Yahoo provides an indication of where the shares are likely to trade. It's interesting that the financials of both companies are relatively similar.

    Shares Out665M246M
    Implied Market Cap from P/S32Bn
    Implied Market Cap from P/E34Bn
    Implied PPS from P/S$130
    Implied PPS from P/E$140

    Most interestingly based on a discounted cash flow analysis I calculate Price Per Share (PPS) of around $20-$40.

    Tuesday, April 27, 2004

    The Price of Oil Relative to the US Dollar

    I have seen many articles refer to the fact that oil prices have increased because of the fall in the US dollar. This implies that oil behaves somewhat like a currency or gold and that as the US dollar falls Oil becomes more expensive as does gold or Euros. This sounds reasonable on the surface and here are a couple of links in which this is mentioned:

  • - "Between the end of February 2002 and the end of February 2004, the price of oil in dollars rose by 51 percent (from $20 a barrel in 2002 to more than $35 a barrel today), but it rose by only 4 percent in euros. Over the same two-year period, the value of the dollar plunged from 1.16 euros per dollar to 0.80 euros per dollar. In this situation, it is perfectly rational for foreign suppliers of oil to charge more in dollars to make up for the falling value of our currency." " It may seem like a stretch to blame the price of oil on fiscal mismanagement, but the rising price of oil is closely tied to the falling dollar, " - this has been republished by many other newspapers
  • -- "Why do I blame the Fed for this? Because the Fed controls the supply of dollars in existence. And a depreciating dollar implies that there are too many dollars in existence. So, if the Fed had printed fewer dollars in the past, the dollar would not have depreciated and the price of oil would be coming down, not staying high." -- this is from Northern Trust Company.
  • "WTI crude oil forward prices are currently at or above US $28 barrel through 2008 on the NYMEX. Some of this indicated price appreciation in crude oil may reflect compensation for the falling value of the US dollar, but I believe as many others do that we have also entered a new era of crude oil supply and pricing." - MARCEL R. COUTU, President & Chief Executive Officer, Canadian Oil Sands Limited.

    Of course the corollary is also quite reasonable. That is, the US dollar rises when the US economy is strong. When the US economy is strong demand for oil increases and with the increased demand comes higher oil prices.

    As there seemed to be no research into the subject I took data from early 1983 for oil prices and a weighted index of the US dollar against a basket of currencies. You would expect to see a negative correlation of oil prices increase with a decrease in the dollar. In fact the correlation was positive and nearly .6. This would seem to indicate that a rising US dollar, which we may be about to see with interest rates rising, should cause oil prices to move even higher.

    This bodes very well for an investment in Canadian Oil Sands (COSWF, COS_u.TO).
    Will the market be overvalued in 12 months time

    At today's valuation - yes, very.

    I realize that the previous question, Is the market overvalued is not quite the correct question. The problem is that there is really more than one value of the market. There is today's value and there is the value looking forward. In the event that something is materially different in the future then the valuation has to move from the current to the future valuation.

    Where this is really going is that the 20-25% overvaluation of the market based on long term averages of interest rates indicates that the market has a long way to fall when interest rates do rise. The fed model is provides a snapshot suggesting a stock valuation given an interest rate. Now we are probably at a fair value for the S&P with a fed funds rate of 3.5% but any higher than that, such as the long term 5.8% average, leads to a 20% or more overvaluation.

    This can play out in three main ways:
  • The stock market does not increase in value until earnings catch up with the 20% overvaluation. Stagnant market for four years. -- 25% chance
  • Price to earnings multiples expand as interest rates decline and the market continues to move higher (somewhat unprecedented). Market keeps increasing. -- 10% chance
  • The stock market drops as would be indicated by the fed model and the market overshoots. Bear market upcoming a bad year in 05 - 65%

    Based on my likelihood weightings (which are based on more factors than just the fed model, such as the length of bull markets) there is a lot of downside risk in the broad market right now because valuations are so high. This is not a particularly good time to buy the market. Over the next few years any opportunity to buy the market below 855 on the S&P probably has 6-10% upside per year and increasingly larger upside as you get a price better than 855.

    Of course this has little to do with the economy. I expect that we will see a very prosperous economy due to the global boom. The US economy is likely to perform very well and to keep performing very well for a good few years to come. The reason stocks are risky is not because of the economy but because they are currently priced too high. This is the core argument of those in the Bull Market in a Secular Bear Market camp. Based strictly on valuations I believe they are probably correct. There will be buying opportunities in the next decade but they will be at substantially lower prices.

    I read an incredibly study which timed secular bull and bear markets. It showed that secular bear markets don't end until PE ratios get down to the single digits. Now I don't think there is any reason to think that is going to happen in the near future with the economy so strong but the risk from today's valuations is ALMOST ENTIRELY TO THE DOWNSIDE

  • Sunday, April 18, 2004

    Is the market overvalued?

    Probably yes, very slightly.

    To answer that question from a fundamental point of view we need to have a look at a stock market valuation model. One of the most popular valuation models is known as the Fed model. This model asserts that the earnings yield on stocks should equal the yield on a 10 year Treasury. There is both a descriptive and mathematical basis for the model. The reason it's called the Fed model is that it first turned up in the report that the Federal Reserve Open Market Committee receives from its staff.

    The underlying descriptive reason for it is based on opportunity cost. Basically investors will place their money wherever they can get a better yield on a risk adjusted basis. Given that the S&P 500 (S&P) is so diversified and has a 100 year track record (or at least the Dow Jones index does) it is not perceived to be riskier than treasuries over a long period of time. Therefore if 10 year Treasuries offer a higher yield than stocks then money will flow into them, deflating the value of the S&P and raising the S&P yield, creating equilibrium. Correspondingly if the S&P offers a better yield, then money will leave treasuries and enter the stock market, depressing the price of bonds and raising the yields.

    I was a little dubious about the assertion that investors consider them equal on a risk adjusted basis so I looked at the correlation between the 30 year treasury yield (which closely tracks the 10 year with a relatively constant spread) and the S&P 500 yield over 27 years. I also looked at the fed funds rate yield versus the S&P 500 yield over 50 years. The correlation was .71 and .74 respectively, where 1 would mean that they moved completely in harmony. My reason for testing the 30 year treasury is that stocks are valued based on their long term ability to generate cash and that 30 years seemed a better valuation period than 10 years. Even if that didn’t hold I thought that 30 year bonds may better reflect the difference between 10 year bond's risks and the S&P (the 10 year/30 year spread may account for the risk difference between bonds and stocks). It turns out that the relationship between 30 year bonds and the S&P yield that the S&P yield has been about .91 percentage points below the 30 year bonds and therefore the ten year bond is the better measure.

    This led me to develop a similar model to the fed, specifically to develop a linear equation for the relationship between the Fed Funds rate and stocks as well as the 30 year Treasury and stocks.

    So what does this model say about the value of securities today.

    With the fed funds rate so low, I'm inclined to disregard those results but they show a 38% under valuation of the S&P 500. The 30 year Treasury equation shows a 30% under valuation of the S&P. This looks very promising, right....

    Well the problem is that interest rates tend to revert to the mean and that the fed is guaranteed to raise rates at some point in the next 12 months. The Fed model is relatively useful at providing a snap shot of expected valuation at a point in time but is not necessarily effective at looking into the future.

    Therefore I also calculated the value of the S&P 500 based on the long term averages of the Fed Funds rate and the 30 year Treasury bond. These show the S&P 500 as overvalued by 20% and 25% respectively.

    I then propose that the average of these two probably makes for a reasonable approximation for the fair value of the S&P 500 today. According to the Fed Funds rate average we are 1.4% undervalued (remember this series had 50 years of data but is more volatile). The 30 year Treasury has the S&P 500 4.5% overvalued. By further taking the average of these two valuations I would suggest that the S&P 500 is slightly overvalued.

    Given this along with the fact that we are a few percentage points ahead of the expected Dow Jones at this point in a bull market I'm inclined to say that it is time to move into more defensive positions. I don't expect that we have seen the peak of the bull market, but whole of market returns from this point on are not going to be spectacular. If interest rates move back to their long term average then we are not going to see any growth in the S&P 500 for 3-5 years and may even see a 20-25% drop.


    April 2003   May 2003   June 2003   July 2003   August 2003   September 2003   November 2003   January 2004   February 2004   March 2004   April 2004   May 2004   June 2004   July 2004   September 2004   October 2004   February 2005   March 2005   April 2005   May 2005   June 2005   July 2005   August 2005   September 2005   December 2005   April 2006   May 2006   June 2006   January 2007   December 2007   February 2008   April 2008   May 2008   June 2008   July 2008   August 2008   September 2008   October 2008   November 2008   December 2008   January 2009   April 2009   May 2009   July 2009   August 2009   September 2009   October 2009   January 2010   February 2010   April 2010   July 2010   August 2010   October 2010   November 2010   January 2011   February 2011   April 2011   June 2011  

    Disclaimer and Disclosure Analyses are prepared from sources and data believed to be reliable, but no representation is made as to their accuracy or completeness. I am not paid by covered companies. Strategies or ideas are presented for informational purposes and should not be used as a basis for any financial decisions.
    To reduce Spam click here for my email address.

    This page is powered by Blogger. Isn't yours?