The market outruns profits

I created a new model of the S&P500 that incorporates more variables and some nonlinear action. The chart at the left shows the results. The blue line represents the quarterly averages of the S&P 500 while the red shows quarterly averages produced by the model, the last three quarters of which are forecasts. The data analyzes quarterly averages because profit data is reported quarterly by the Bureau of Economic Analysis.

The model uses data back to 1948, and as the reader can see the value of the market has run ahead of where it should be in proportion to the growth in profits. Something similar happened in the dot.com bubble of 2000 but to a greater degree. Obviously, the market can deviate from valuations justified by profits for a very long time if people are confident, less risk averse, and willing to drive PE ratios higher.

The market could continue to rise through the holiday season if investors become convinced that the Fed will not raise interest rates due to poor economic data. And if the data become bad enough, investors might expect more rounds of quantitative easing in which the Fed pumps dollars into the economy by purchasing bonds from banks, or as I wrote last week, introduces the US to negative interest rates.

I don't expect profits to rise enough to justify the high valuations in the market since profits have been at record levels and are declining in the current reporting season. According the WSJ:

Profit and revenue are falling in tandem for the first time in six years, with a third of S&P 500 companies reporting so far. 

 Historically, profits continue to fall once they have climbed to record heights and start descending. The most likely scenario is that the market will fall to valuations more in line with falling profits.

Fed shuffles from ZIRP to NIRP

Inflation is fading; the economies of Asia, South America and Europe are collapsing; the people have tasked the central banks with fixing all things economic. Yet, reports by Fed economists show that the recent rounds of money printing through QE and low interest rates for six haven’t had the intended effect. They have certainly failed in Japan and the Big EZ (Euro Zone). What can they do to turn the world’s economies around? The answer from mainstream economists at the world’s central banks is more of the same. But if continuing to do the same thing while expecting different results is a sign of insanity?

Target date funds need good vibrations

Another fad in investing, like “smart” beta, is target date funds that allocate assets in an investor’s portfolio by the investor’s age. Target date funds follow an ancient concept: put most of your money, say 90%, in the stock market while you’re young because you’ll have the time to recover from market collapses. But as you get older you have less time to recover so you reallocate to bonds and cash while keeping just half your funds in the market. In the past, most advisers recommended getting completely out of stocks and into bonds, but the ridiculously low returns on bonds has forced older people to take greater risks and stay in the stock market longer.

Good management makes for great investing

Investors with the time will want to imitate Warren Buffet and invest in a few good companies rather than put up with a host of losers in an index fund, but analyzing individual companies in the way that Ben Graham taught is time consuming. Several experts have developed algorithms that examine financial data that helps weed out the worst.

But if an investor is going to marry a business he must become familiar with the quality of its management. Good management can turn a bad company around and value investors often want to buy shares in a company when it has hit rock bottom and has the potential to turn around.

Currency wars round three

I finally got around to reading James Rickards’ 2011 book Currency Wars: The Making of the Next Global Crisis and really enjoyed most of it.

The best parts are the history of the currency wars, Currency War I (1921-1936), Currency War II (1967-1987) and the launch of Currency War III in 2010 that still rages. War III will likely finish in the same way that the previous ones did but Rickards suggests far more disastrous results.

As Rickards explains, currency wars are a continuation of the ancient mercantilist economics that Adam Smith tried to drive a silver stake into the heart of but failed. Like vampires, mercantilism will live forever by hibernating in the dark places of economic thought and springing to life in tragedies, and that vampire has bitten most mainstream economists.