Le Battle Royale: France's War of Words with U.S. CEO

If you didn’t hear or read about this week’s testy exchange between Maurice Taylor, the CEO of Titan, a US-based tire company, and the French Industrial Minister, Arnaud Montebourg, you missed some serious sparks.  We don’t wish to wade completely into the middle of a massive firefight, but we think the exchange, specifically the concerns expressed by the Titan CEO, raises some interesting questions about French policy relative to their neighbors, the sustainability of the French model in an ever-changing global economic environment, and the broader role of unit labor costs influencing industrial decision making.  First, here are the two letters in their entirety, with Montebourg’s response following Taylor’s initial letter.

Taylor:

Dear Mr. Montebourg:

I have just returned to the United States from Australia where I have been for the past few weeks on business; therefore, my apologies for answering your letter dated 31 January 2013.

I appreciate your thinking that your Ministry is protecting industrial activities and jobs in France.  I and Titan have a 40-year history of buying closed factories and companies, losing millions of dollars and turning them around to create a good business, paying good wages. Goodyear tried for over four years to save part of the Amiens jobs that are some of the highest paid, but the French unions and French government did nothing but talk.

I have visited the factory a couple of times. The French workforce gets paid high wages but works only three hours. They get one hour for breaks and lunch, talk for three, and work for three. I told this to the French union workers to their faces. They told me that’s the French way!

The Chinese are shipping tires into France - really all over Europe - and yet you do nothing. In five years, Michelin won’t be able to produce tire in France. France will lose its industrial business because government is more government.

Sir, your letter states you want Titan to start a discussion. How stupid do you think we are? Titan is the one with money and talent to produce tires. What does the crazy union have? It has the French government. The French farmer wants cheap tire. He does not care if the tires are from China or India and governments are subsidizing them. Your government doesn’t care either. “We’re French!”

The US government is not much better than the French. Titan had to pay millions to Washington lawyers to sue the Chinese tire companies because of their subsidizing. Titan won. The government collects the duties. We don’t get the duties, the government does.

Titan is going to buy a Chinese tire company or an Indian one, pay less than one Euro per hour and ship all the tires France needs. You can keep the so-called workers. Titan has no interest in the Amien North factory.

Best regards,

Maurice M. Taylor, Jr.

Chairman and CEO

Now, Montebourg, translated from French:

Sir,

Your insulting and extremist words show a complete ignorance of France, its competitive advantages, as well as its worldwide acknowledged attractiveness and its links with the United States of America.

France is proud to welcome on its soil more than 20,000 foreign companies, representing  close to 2 million jobs, a third of its industrial exports, 20% of its private R&D, and 25% of its manufacturing jobs. Every year, we count 700 decisions of investments creating jobs and value in France. And this solid attractiveness does not weaken, on the opposite every year it becomes stronger.

Within those foreign investments, the United States rank at the top. 4200 subsidiaries of American companies employ about 500,000 people. The presence of American companies in France is very old : Haviland since 1842, IBM since 1914, Coca-Cola since 1933, General Electric since 1974. And how many others. Those links are every year renewed: In 2012, companies such as Massey-Ferguson, Mars Chocolate, and 3M have chosen to increase their presence in France.

What are the decisive factors in those investment choices? Foreign companies seek in France quality infrastructure, an enjoyable life-style, and an energy among the most competitive in Europe, as well as an environment very favourable to research and innovation. But above all,  far from your ridiculous and disparaging remarks, all of those companies know and appreciate the quality and productivity of the French workforce, the commitment, know-how, talent and skills of French workers.

To amplify this attractiveness, the French government has recently taken 35 steps within the framework of the National Pact for growth, competitiveness and employment. Among those, tax credit and employment lightens by 6% companies' employment costs between 1 and 2.5 SMIC [ie: SMIC French minimum wages]. Furthermore, the unions have just stroked an agreement on job security, which illustrate the quality of social dialog [French buzzword for negotiation between unions & corporations] in France, and how important it is for my government.

May I remind you that Titan, the company you manage, is 20 times smaller than Michelin, our French internationally famous technological leader, and is 35 times less profitable. This shows how much Titan could benefit and profit enormously from an investment in France.

France is especially proud and happy to welcome American investments as both our countries are bound by an ancient and passionate friendship. Do you even know what La Fayette did for the United States of America? For our part, we French, shall never forget the sacrifice of young American soldiers on the Normandy beaches to deliver us from Nazism in 1944. And, as you choose to criticize your own government in the letter you addressed to me. I have to tell you how much the French government admires the policies set up by president Obama. As the minister in charge of Industry, I am especially impressed by his actions in favour of the relocation of manufacturing jobs in the United States, and of radical innovation. Actually, our current policy exhibits a certain closeness with that inspired by your president.

You evoke your intention to exploit the workforce of certain countries to flood our market. I have to tell you that this unethical and short-term calculation will sooner or later hit the just reaction of the states. That is already the case for France and its increasingly numerous allies within the EU that plead for trade reciprocity and are organizing a response against dumping. Meanwhile, rest assured that you can rely on me to encourage the relevant services to check your import tires with increasing zeal. They shall be especially careful regarding the respect of social, environmental and technical norms.

Arnaud Montebourg

We believe Taylor won the exchange decisively.  In the spirit of the season, however, we’ll be as fair as we can be to Montebourg.  The French government, as Montebourg pointed out, is trying to increase labor market flexibility and reduce labor costs, though the reforms are agonizingly incremental.  And, the Hollande regime, as tone deaf as it’s been on so many other issues, has begun to realize on some level that they better establish a better working tone with domestic and international companies lest the country become a total pariah in international industrial circles.  Hollande has initiated a charm campaign recently in an attempt to cauterize some of the self-inflicted wounds.  

Nonetheless, moving back to the heart of the matter, Taylor’s frustration, whether some consider it excessively harsh, is confirmed by some of the data out there.  Numbers don’t lie.  France relative to its neighbors, and the broader developed and developing world for that matter, has increasingly become an expensive place to conduct business over the past decade.  Trends that were in place prior to Hollande’s assumption of power certainly aren’t being ameliorated by the current regime, at least not at a pace required to compete effectively with competitor nations.  

Let’s look at unit labor costs in the Euro Zone since 2000.  Per the OECD, unit labor costs “measure the average cost of labor per unit of output and are calculated as the ratio of total labor costs to real output…It is also the equivalent of the ratio between labor compensation per labor input worked and labor productivity.”  Generally, we’ll just say that rising unit labor costs indicate a situation where compensation to workers is rising faster than productivity.  If unit labor costs in a particular country get “out of whack” relative to other countries, there’s a good chance that the offending country will experience a loss of competitiveness and negative economic impact.  Here’s a chart based on Eurostat data illustrating European unit labor costs since 2000:

Source: Marc to Market Blog

As you can see above, the periphery countries Greece, Italy, Portugal, Spain, and Ireland experienced dramatic increases in their unit labor cost metrics pre-crisis.  France wasn’t far behind over this period.  German unit labor cost dynamics were relatively stable, owing to labor market reforms enacted about a decade ago.  Since the onset of the Great Recession and the subsequent sovereign debt crises, unit labor costs in the periphery have begun converging with Germany.  Ireland, Greece, and Spain especially have seen a dramatic drop off relative to peak.  Of course, this transition has been incredibly painful in these countries.  Progress is being made. In Greece, for instance, the current account deficit has been cut in half.  With the periphery countries experiencing a dramatic drop off, Italy is the only country in Europe that has experienced a greater rise in unit labor costs than France since 2000.  That’s not the kind of company one wants to keep.  Furthermore, the periphery countries will probably continue to see labor costs decline over the intermediate term which will leave France sticking out even more like a sore thumb.  

Is this affecting French growth?  It’s taken a bit of time, but the economic crises in the periphery are starting to infect French economic prospects.  This week, Markit released their composite output indicators for a range of countries.  The French Composite Index, which includes both private-sector services and manufacturing output, declined from 42.7 in January to 42.3 in February (sub-50 numbers indicate contraction in this diffusion index), far below the 47.3 number for the Eurozone as a whole.  Year over year GDP growth in Q4:2012 came in at -0.3%, the first negative year over year number since 2009.  Considering the decent correlation between the composite PMI numbers referenced above and GDP growth, it wouldn’t be surprising to see these numbers deteriorate further during the first half of this year.  Overall, it’s outside the scope of this post to tease out quantitatively how much competitiveness factors such as unit labor cost differentials are affecting relative economic growth.  We’ll just say, intuitively, it’s certainly not going to be a help going forward to have a labor cost/productivity structure moving further and further away from the peer group.  

The French government and labor groups have their work cut out for them.  The status quo is unsustainable, and the Titan CEO has brashly articulated why.  While it may be noble on the surface to stand up for domestic labor groups and promise the world in terms of wage sustainability and job security, the simple fact is that economies are open and transportation and communication networks are as efficient as ever.  “Money goes where money is treated best.”  The Titan CEO is correct.  The tires the French need can be produced anywhere, whether Eastern Europe, India, or China, and delivered quickly and efficiently to French shores.  Certainly, the French could try a more closed model and try protecting domestic industries, but this would be extremely counterproductive in the end economically.  Eventually, the periphery countries had to succumb to the forces of convergence, and France will too.  The transition has been painful for the periphery countries, especially because the transitions were de facto imposed against their will by markets. French labor groups are probably facing the same dynamics; it would be much better for them to work to become part of the solution and get ahead of the issue instead of waiting to get dragged kicking and screaming to the table. Much talk of late has surrounded the notion of “reshoring” in the United States as companies move production back from China and other areas around the globe.  This gradual resurgence in US manufacturing prospects was preceded by a long decline.  This frustrating period was a story of convergence as well.  Unit labor costs in manufacturing in the US reached unsustainable levels.  As such, all things being equal, it became more attractive to move production to offshore centers such as Mexico and China.  As one would expect, wages in the US stagnated while wages in China, for instance, moved dramatically higher.  The nascent reshoring fad is the fruition a long move towards convergence and equalization between Chinese and US unit labor costs.  Depending on the source, China’s unit labor costs have been compounding at near double digit rates over the past decade while US unit labor costs have remained flattish.  US labor is highly competitive with other countries now when adjusting for factors like transportation and intangibles such as managerial efficiency in terms of managing far flung assets.  It’s been a unpleasant ride, but the US is now increasingly prepared to move forward.  France, on the other hand, may just be getting started down a painful path.  They’d be much better served by seriously addressing their competitiveness issues than pointing fingers at decision makers.

Positive Quarterly Streaks: How Long Do The Streaks Last?

With plenty of debate out there about the sustainability of the current rally, we thought it might be interesting to approach performance data for the S&P 500 in a different way and see how the current rally stacks up against historical data on a rolling 1-quarter, 2-quarter, 3-quarter, and 4-quarter basis in terms of consecutive quarters of positive performance.  Ignoring the magnitude of performance gains, several interesting observations stick out.  As usual, let’s move to the data.

There are a few notes regarding methodology.  First, the period covered stretches back to 1950, a total of 255 quarterly observations.  Second, the rolling period returns represent simple, nominal returns and therefore don’t account for dividends or inflation.  Finally, when looking at the rolling 3 and 4 rolling quarter periods, a single negative quarterly result did not break a streak if the loss didn’t exceed 1%.  There were a few instances in the middle of longer periods, including the current period, where markets took a slight breather, but resumed climbs for several more quarters.  We felt this kept with the spirit of the discussion, i.e. trying to understand the persistence of rallies and positive market performance from a calendar perspective.

As of this morning in the S&P 500, the market is marking its 1^st consecutive quarter of 1-qtr positive returns (Q4:2012 was negative), 5^th consecutive quarter of positive rolling-2-quarter returns, the 5^th straight quarter of positive rolling-3-quarter returns, and 14th quarter of positive rolling-4-quarter returns (the exception mentioned above applies to the quarter ending 9/30/11, which shows a -0.86% year over year return.  Nonetheless, the market has been in a relatively consistent up-streak since the 2009 lows).  Since 1950, the average quarterly streak for single quarter positive performance is 3.11 quarters.  The average streak for rolling-2-month positive performance without an interruption is 5.18 quarters.  The average streak for 3-rolling-quarter positive performance is 9.58 quarters.  The average for a trailing 4-quarter period is 11.50 quarters.  As the number of rolling periods decreases, the numbers become volatile.  Hence the average length of a streak increases as we move from 1 performance period to a rolling-4 calculation.  

*Exception described above in methodology applies.

As with other data we’ve looked at over the past several weeks, the overall market environment makes a difference when looking at these numbers, though only at the one, two, and three quarter rolling points.  During secular bear markets, still technically our current situation, the average positive performance streaks are as follows: 2.43 quarters for single quarter performance in isolation; 4 quarters for 2-quarter rolling performance; 8.57 for 3-quarter rolling performance; and 12.2 for 4-quarter rolling performance.  For secular bull markets: 3.63 for single quarters; 6.05 for rolling 2-quarters; 10.17 for rolling 3-quarter; and 11.18 for rolling 4-quarter.  It’s interesting that the positive streaks for rolling 4-quarter performance are actually longer during secular bear markets than during secular bull markets.  We do know from our post several weeks ago, however, that overall rally performance during secular bulls is much stronger.  

The current value of 5.68% rolling two-quarter performance comes in above the average of 4.52%, but is exceeded by 116 of 255 observations.  Rolling 3-quarter performance of 11.77% comes in above the average of 6.77%, and is exceeded by 90 observations.  Rolling 4-qtr performance of 8.02% is below the long-term average of 8.99%, but exceeded by 136 observations.  Of the 90 observations ahead of the rolling-3-quarter number, there’ve only been four instances when the next calendar observation turned negative: 9/30/2011, 6/30/2010, 9/30/2000, and 12/31/1987.  Three of the four instances involved major short-term external events, or short-term instances, that shocked the markets.  In 2010 and 2011, flare ups in European credit markets caused performance to decline sharply before resuming.  In 1987, several factors combined to cause the harrowing October ’87 stock market crash.   Of the 136 rolling-4-quarter observations ahead of the current performance-wise, only seven times has the following quarterly observation turned negative: 9/30/2011, 12/31/2000, 9/28/1990, 9/30/1981, 3/31/1977, 6/30/1969, and 3/31/1960. Therefore, in most cases strong quarterly performance, at least when looking at several rolling periods, tends to morph into slower positive performance gains before turning negative rather than experiencing a sharp or immediate reversal.  

Ok, there are a lot of numbers here, so what can we take away.  Over the past 60+ years, there’s generally been strong persistence on a calendar basis when it comes to US markets generating positive performance numbers.  Although the numbers differ somewhat, the persistence in calendar terms holds up reasonably well during secular bear markets, though we know the magnitude of secular bear market rallies overall in terms of actual performance significantly lags the performance of rallies during secular bull market periods.  The numbers may give some additional comfort to traders out there using momentum as a factor in investment decision making.  As for the current situation, things are a bit muddier.  In calendar terms, the rally is long in the tooth when considering the fact that there have been 14 quarters of positive year over year performance (which of course, includes the one slight hiccup we discussed in the exceptions near the top).  The three month rolling number streak is relatively young by historical standards, though.  As we’ve observed in other blog posts, valuation for the US is stretched by historical standards, yet the magnitude of the current rally off the last major correction is below average compared to other cyclical bull runs.  Since longer-term valuations have never reached levels associated with secular bear market ending points and are actually much closer to points associated with secular bull ending points, we think the current rally, at least in the US, represents a rally within a secular bear, not the kickoff to a new multi-year positive streak as witnessed in the ‘80s and ‘90s.  Market sentiment has begun to creep higher, but at this point hasn’t reached extreme positive levels across the board, a good thing for the bulls.  Taking all into consideration, we believe the current rally could have legs for a few more quarters in the US, but that caution could be warranted, perhaps sometime in late 2013.  This cyclical bull market rally may be in the later innings, but as the numbers above suggest, not to mention past episodes with above average valuations, rallies can last much longer than many people imagine.

Valuation and Sentiment Roundup

Valuation

It’s been approximately 3 months since we last looked at valuation indicators in the US and abroad.  Now that equity markets have rallied extensively around the world over the past quarter, it’s a good time to revisit some of the valuation metrics.  For good measure, we’ve also included several sentiment indicators that might provide some extra color in terms of trying to figure out if the rally has more upside from here.  

First, let’s focus on US valuation metrics.  As in the past, we’ll focus on two primary valuation indicators in the US: the Shiller 10-year CAPE normalized P/E, which uses Professor Robert Shiller’s public earnings database and takes average trailing 10-year earnings as a way to eliminate some of the volatility in the S&P 500 earnings number; and, the Q-ratio, which uses US government data to approximate a real-time price to book ratio for US equity markets.  Both of these indicators have displayed reasonable statistical significance in terms of predicting future 10-year annualized returns.

The Shiller P/E for the US is 22.6x as of today, which is approximately 1 standard deviation above the long term average P/E of 17.4x.  At this level, predicted annual returns for the S&P 500 over the next ten years (including dividends) come in at 2.5% adjusting for inflation (real return) and 6% nominal, versus long-term averages of 5.73% and 8.88% respectively.  In other words, this long-term P/E metric predicts sub-average annual returns for the US over coming years.  

The Q-ratio for the US is currently 0.97 versus a long-term average of 0.74.  This is approximately 0.8 standard deviations above the average.  Currently the Q-ratio predicts long-term, annual, total real returns of 2.6%, almost exactly in line with the Shiller P/E number provided above.  The charts for both indicators follow.  As you can see, current US valuation levels are still far from levels typically associated with secular bear market bottoms.  Significant progress has been made; the starting levels for these valuation metrics at the beginning of the secular bear market in 2000, however, were astronomical relative to historical experience.

Source: IronHorse Capital, Federal Reserve Bank of St. Louis, Bloomberg

Source: Shiller Online Data, IronHorse Capital

Moving on to global markets, we’ll use Jim O’Neill’s normalized earnings data from Goldman Sachs below.

Source: Datastream and GSAM calculations as of February 2013, Goldman Sachs

 While his US calculation deviates slightly from ours (actually more elevated), the point to take away from the global perspective is that US markets are among the most over-valued when compared to the peer group.  Conversely, long-term valuations for nearly all global Developed and Emerging Market equity indices remain decently below their historical averages.  Among the major global indices, only Australia and Mexico join the US in trading above historical mean.  Even with recent rallies, many European markets remain significantly undervalued.  The highest valued major European market is Germany, and it’s still just middle of the pack.  Amazingly, both the IBEX index in Spain and the FTSE MIB Index in Italy are up over 30% since last summer, yet both indices still trade at single-digit valuation levels.  Emerging markets ex-Mexico show decent under-valuation.  Granted, growth metrics have been spotty of late in Brazil and Russia, but these two emerging market anchors are trading at valuations below most if not all of the developed world.

Market Sentiment

Traders and investors often eye various market sentiment indicators for clues as to whether equity markets are due for a trend reversal.  The metrics are best viewed from a contrarian angle.  Generally, highly optimistic sentiment indicators are associated with market tops, while deep pessimism is associated with market bottoms.  

Many prognosticators of late have expressed skepticism of late about the recent rallies in US and global markets.  Some skepticism is warranted, especially in the US, due to the high valuation levels relative to historical averages.  Interestingly, several indicators that cover equity market sentiment in the US and abroad show lower sentiment levels than many market-watchers would expect at this point in the cycle, perhaps giving some credence to one pundit’s description of this rally as, “The most-hated rally ever.”  On balance, these indicators could show that there’s still decent underlying buying support for this rally over the intermediate term despite the fact that valuations have become elevated.  

In the US, the AAII Bull/Bear/Neutral numbers are widely followed as an indicator of extreme optimism or pessimism.  Currently, the numbers are tilted to the bullish side, but below levels usually associated with major market tops.  To make more sense of the numbers, we use the Farrell Sentiment Indicator developed by Bob Farrell, the former technical strategist at Merrill Lynch.  He devised a formula incorporating the bull, bear, and neutral numbers and takes a 10-week moving average.  If the average pokes above 1.5, the market is far too optimistic.  If the number dips below 0.50, investors are too pessimistic.  Through this week, the 10-week average is sitting just north of 1.0.  As shown in the chart below, sentiment has certainly perked up from summer levels, but remains significantly below levels even a few years ago ahead of the European debt crisis.

Source: Bloomberg, AAII

Another indicator in the US, the put-call ratio, is also showing subdued positive sentiment.  We use the 10-day moving average of the put-call ratio to smooth out any volatility in the underlying numbers.  Currently, the 10-day moving average is 0.96, which is elevated relative to the average of 0.915 observed over the past 10 years.  This is currently approximately 0.4 standard deviations above the norm.  The elevated put activity relative to calls indicated elevated pessimism.  As a point of comparison, the put-call ratio was over 1 standard deviation below normal in early 2011, an indication of extreme optimism and a precursor to the market declines and volatility that occurred later in the year.  It doesn’t appear that investors have thrown caution to the wind yet.  

United States: PUT-Call Ratio: Recent Data

Source: Bloomberg, CBOE

Finally, to capture sentiment in European markets, we’ll refer to the BNP Paribas “Love-Panic” market sentiment indicator.  Again, to smooth out any underlying volatility in the numbers, we use the 4-week moving average.  As of this week, the indicator’s 4-week moving average stands at -0.41, approximately 0.2 standard deviations below the historical average of 4.32.  Like the US, strong rallies of late in European markets haven’t pushed market sentiment to extreme positive levels.

BNP Paribas "Love-Panic" Model, Europe:

Source: Bloomberg, BNP Paribas Equity & Derivative Strategy

Markets in the US and Europe are technically overbought, at least on a short-term basis in many instances.  As such, we wouldn’t be surprised to see some corrective action in coming weeks or months.  The fact that many investors still haven’t joined the market party yet, at least according to sentiment indicators, could help explain recent market action here and overseas where dips are short-lived and decent buying action appears on any pullback.  Accordingly, equity markets could continue to confound and surprise bearish investors in the short to intermediate term.  

Taking the high US valuation figures into account from the beginning of the post, we don’t necessarily believe yet that the US markets have completely exited the secular bear market that began in 2000.  In the US especially, we believe there is more volatility ahead at some point.  Ex-US markets, mainly those in Europe and in emerging markets, remain positioned to outperform US markets over the next decade in our opinion.  Of course, as much as we’d like markets to move in straight lines, there will be plenty of moves and pushes and pulls along the way to keep life in the markets interesting.

Emotional Rescue

In last week’s “Interesting Articles” email, we linked a post entitled “Mr. Market Doesn’t Care What You Think.”  That article focused on the link, or lack thereof in many cases, between market performance and consumer sentiment.  As markets move deeper into earnings season, we couldn’t help but think of that title again when it comes to the stories and sentiment surrounding three particular companies: Apple, Amazon, and Research in Motion, soon to change its name to Blackberry.  Each of them has either reported earnings or made a big product announcement over recent days and weeks.  All three have made stock moves in recent months that have confounded a wide range of pundits, bloggers, and analysts.  We can’t think of many other names in the marketplace of late that have inspired as much debate. All are prominent brands with relatively long histories and, in the case of Apple and Amazon at least, very large market caps.  In that respect, one would expect an intense spotlight.  However, the intensity of recent moves in the stocks has ignited debates about fundamental stock picking and the efficiency of markets.  When it comes to picking individual stocks (and thinking about broader market moves), there are lessons we can all learn from recent action.

First, let’s quickly recap the stories and recent moves.  

• Apple, of course, rallied relentlessly for the past three years, moving from a low of near $100 per share in early 2009 and hitting $700 per share in late 2012.  This past fall, Apple became the most valuable company in the world measured by market cap.  Astronomical increases in revenue, profit, and cash flow fueled those gains.  The company started paying a dividend under Tim Cook’s leadership.  Even with the massive appreciation in share price, the incredible growth in revenue and income has kept multiples at what many consider to be “value stock” levels.  Currently, the trailing 12-mo P/E is 10x, and trailing EV/EBITDA is approximately 5x.  Of late, the stock has been under pressure; it’s fallen 36% percent since late September.  This downward move has inspired an enormous volume of debate, with many incredulous that a company with such a strong fundamental backdrop can act so poorly, especially relative to the broader market advance we’ve witnessed over the past four months.  This “frustrated” side represents the majority with many of its representatives citing the continued top-line growth, additional opportunities to return cash to shareholders, strong brand awareness, and, of course, the compressed multiples (“It’s a growth stock with value stock characteristics.  How can this stock not go back up!”).  The skeptics point to declining margins, increased competition, and the fact that year over year earnings increases have shrunk considerable over recent quarters.
• Research in Motion, the maker of Blackberry smartphones occupies the other end of the spectrum.  The stock and the company’s prospects have been in relentless decline since the introduction and proliferation of the iPhone and Android mobile ecosystems in 2007 and 2008.  Blackberry at one time was the dominant force in the mobile smartphone space with market share levels solidly north of 50%.  Market share over recent years has fallen to approximately 2%.  The stock price followed the trajectory of the business, declining from a peak near $140 to a low of $6.22 in late September.  While revenue is still above levels seen in late 2008, owing to the strong growth in overall smartphone sales in recent years, EBITDA has been halved and net income has actually crept into negative territory.  Since September, however, the stock price has doubled, even taking into the account declines this week after the announcement of their new smartphone operating system.  Like Apple above, this move over recent months has generated massive debates over the nature of the move, especially from those looking at the fundamentals and pulling their hair out strand by strand.  The frustrated, representing a majority, tend to believe the company will remain in a death spiral.  This group has been absolutely incredulous when it comes to the recent stock move (“This company is old news!  They’ll never catch up to Apple and Android! Nothing else matters!”).  Of course, judging by the short interest in the stock, this group probably represents a good number caught up in a short squeeze.  To those on the other side, the company still appears cheap; these folks believe that if Blackberry can just hold the line with the new operating system and maintain a number three position in the cell phone pecking order, that the stock could continue to rebound dramatically due to the large cash position, debt-free balance sheet, and compressed multiples/expectations.
• Amazon straddles the line.  Without a doubt, Amazon has become a phenomenal brand and success story.  Over the past several years, the company has moved away from the core book and music categories to deliver a wide range of goods from food to household items.  They’ve established digital video and music stores to provide serious competition to Apple iTunes, Netflix, and other entertainment companies.  Amazon Prime, which allows users to pay a yearly fee for free shipping and access to digital video streaming, has been an enormous help in building brand loyalty.  Even though Amazon faces increasing pressure to pay sales taxes in various locales, they’re working to significantly enhance their distribution network. In some areas, rumors suggest Amazon wants to move decisively into same-day delivery.  Revenue has more than doubled since the end of 2009.  The stock price has moved in lockstep, from just below $50 in late 2008 to $265 currently.  There’s been one little problem, however.  EBITDA and Net Income growth have been lagging to put it mildly.  Amazon continues to trade at very high multiples.  Estimated P/E for the coming year is 85x.  P/B is nearly 15x.  EV/EBITDA is a very high 40x.  An earnings report over the past week has reignited the controversy over the future trajectory over the stock.  Similar to RIMM, a solid number of observers are extremely frustrated that the stock has continued to march higher even though the company consistently fails to deliver solid bottom line growth.  This group cites increased sales tax collection initiatives, potentially better online competition, and, of course, extremely high valuation ratios as reasons the stock should decline.  Proponents of the stock point to the massive top-line growth and Amazon’s increasingly dominant market share position in online shopping, not to mention its increasing mindshare in the overall marketplace.  Likewise they point out that Amazon is wisely investing in the future and that profits will come in spades once the management vision is completely executed.  The earnings report generated one of the better lines this week from one of those incredulous about its new 52-week highs.  Blogger Matt Yglesias stated, “…Amazon, as best I can tell, is a charitable organization being run by elements of the investment community for the benefit of consumers.  The shareholders put up the equity, and instead of owning a claim on a steady stream of fat profits, they get a claim on a mighty engine of consumer surplus.  Amazon sells things to people at prices that seem impossible because it actually is impossible to make money that way.”  

Again, all three above have tended over recent months or years to confound a significant number of critics and analysts, many of them well-respected practitioners of fundamental stock analysis.  We’re not here in this particular blog post to make a judgment about the future direction of the above companies or the direction of their market prices.  Instead, we’re here to again point out the fundamental truth at hand: no matter how logical the argument, no matter how obvious over or undervaluation, no matter how obvious it seems that a particular business model is the greatest or worst of all time, the market at large could care less.  In the cases above, and in many other cases in the current market, prices have made moves that upend the apple carts for a majority of investors.  Several famous market clichés tend to capture this truth:  “Don’t catch a falling knife;”  John Maynard Keynes famous line, “The market can stay irrational longer than you can stay solvent;”  and, “What Wall St. knows ain’t worth knowing.” 

As campy as some of the statements are, there’s a lot of truth here.  Watching the stocks above run against the consensus logic, which in many cases is sound, leads us to several conclusions that investors need to keep in the back pocket.  

1. Momentum is a powerful force in the marketplace.  
1. The above may sound obvious, but there are some interesting observations about market structure behind this statement.  The overall market is heavily influenced by the activity of large institutional investors, from mutual funds to hedge funds.  Most of the people managing funds are incredibly capable and logical analysts with many years of experience investing in public equities.  Nonetheless, the professionals driving much of the market movement (and even a good number of the “machines” increasingly engaging in investment activity) are just as subject to the same biases and psychological errors witnessed across a wide range of human activity.  There’s no need to talk about all the behavioral quirks here, but there are some that stand out.  Prominently, managers are subject to herding behavior.  As a stock moves higher, for instance, and generates positive performance, it’s easy for investors, individual and professional alike, to justify jumping on the bandwagon.  Upside performance, such as that seen over recent years in Apple and Amazon, generates numerous positive articles in the mainstream press pointing out the performance and in many cases providing reasons why performance can only continue to improve.  In the earlier phases, valuations are usually reasonable providing cover.  Managers are cognizant of the public press and of the fact that their individual investors are attuned to the performance of these particular companies.  It becomes important to have the high-flyers in the portfolio to show investors that one is clued into “what’s hot” in the marketplace and business community.  Or, simply, the “missing out” component in the brain ignites pushing investors into the stock.  Either way, massive flows of capital move in that direction.  Confirmation bias creeps in.  Managers and individuals begin to ignore any evidence that runs contrary to their position and focus entirely on evidence that confirms the thesis.  As price continues to climb, and this became an issue with Apple, the stock becomes a bigger and bigger piece of a benchmark index leading other investors to add to the allocation simply to keep up with benchmark performance.  Price/performance takes on a life of its own.  In general, this is referred to as a stock under “accumulation.”  
2. Of course the same thing happens in reverse, leading to institutional “distribution.”  The story changes, usually due to some sort of catalyst (unexpectedly bad earnings report, corporate action, etc.) leading institutions to begin selling the stock and taking profits.  In Apple’s case, the Q3 earnings report and the maps debacle changed sentiment.  As witnessed during the buy phase, the initial move is most likely justified by the fundamentals, but price movement takes on a life of its own.  It doesn’t help that the stock is often trading at lofty multiples and resting on a weak market foundation.  Managers only see the negative stories from this point forward.  Unlimited prosperity becomes “death spiral.”  News coverage becomes unrelentingly bad and managers don’t want investors to see any traces of the position in their portfolios.  Stock performance becomes dreadful, in many cases exceeding anything logical relative to the true business prospects.  Once again, it takes a catalyst to arrest the decline.  For RIMM, this was a better than expected earnings report for Q3 followed by news that the new operating system would be unveiled on time.  
3. To close with the RIMM/AAPL example and show how quickly momentum can change, within a few short months in late 2012, the AAPL story changed from a company that could do no wrong to a company that couldn’t get anything right, even though nothing had fundamentally changed at the product level.  Snafus like the maps issue became prominent whereas during the up phase snafus like “antenna-gate” were largely ignored by investors.  RIMM, on the other hand, went from a company with a relatively small user base, poor technology and execution, and no prospects whatsoever in the press and analyst community, to one with a contender on its hands, “innovative” operating system, and a “solid base” of users to upgrade.  Again, like Apple within weeks headlines that would have been framed in a negative context were written with positive overtones.  
2. Following from the above, markets are definitely not truly “efficient” in the short or even intermediate term.  Market efficiency debates have been a prominent part of the discourse in finance disciplines for quite some time and there’s no way to even begin to hash out the research on this.  Watching companies and markets trade on a daily basis, however, it’s quite apparent that asset prices can become quite unhinged from intrinsic value to the up and downside and (as the above bullet implies) emotional investing impulses can significantly override logic and good sense.  In the late 1990s, many technology stocks traded at multiples that could never have been justified by any rational model, yet they continued rising for months and months.  Moving away from stocks, we witnessed this disconnect in the housing market in the mid-2000s; there were many analysts screaming from the rooftops that the assumptions justifying high price ratios relative to historical mean were bunk and completely unrealistic.  That didn’t stop people from lining up as far as the eye could see to buy unfinished condos.  In any case, placing too much faith in market efficiency and logic can lead to very poor investment outcomes.  Perhaps you though Amazon was extremely overvalued in 2010 (it was by many traditional conventions) and shorted the stock or sold a position.  This would have cost the investor a pretty penny.  Similarly, buying RIMM in early 2011 when it was near $50 may have seemed like a decent prospect trading with the stock trading at 12x earnings and an EV/EBITDA of 7x; this would have cost you 80% of your capital over two years.  Over the intermediate to long-run, the fundamentals tend to work themselves out and markets seem to demonstrate efficiency.  Many of the individual stocks trading at astronomical multiples during the tech boom fell dramatically in price, many never having reclaimed prior peaks.  Looking at a broad market, the Nasdaq still trades approximately 40% below its early 2000 peak.  Housing prices eventually collapsed, but are now much closer to median multiples witnessed over the historical record.  The time it takes, however, for the market to come to its senses can be long indeed.
3. If markets and stock prices can be inefficient momentum machines, chewing up logical analysis like a dog bone, what’s an investor to do?  Knowing that momentum and price inefficiency can combine to create harrowing outcomes for investors, it’s important for investors to develop some semblance of a rules-based approach when investing.  Some fundamentally-oriented investors still incorporate technical trading rules into the investment process to impose discipline, for instance.  As we’ve seen a cheap stock can become demonstrably cheaper; perhaps a technical rules based approach can orient an investor to exit a position until more favorable momentum climes develop.  Some investors incorporate rules such as stop-loss tactics.  These types of rules aren’t guarantees that frustrating outcomes won’t occur, of course.  There’s nothing more frustrating than getting stopped out of a position, only to watch prices reverse course and shoot to the moon.  Rules can work in reverse as well.  Technical trading rules can help investors maintain discipline, keep winners in a portfolio, and capture upside.  For those investors not inclined to incorporate these tactics, simply observing certain portfolio management conventions can prevent poor outcomes.  For instance, one could adjust position sizing to fit relative risk tolerances.  For the more risk averse, smaller positions sizes and higher diversification levels lead to less anxiety if the forces above push heavily against the investor’s tip-top analysis in a particular stock.  On the flip side, setting explicit price or multiple targets can help maintain discipline and define exit points for winners.  Whatever the case, the ultimate idea is to suppress the behavioral biases and emotional responses that contribute to bad outcomes. 

Platforms like the blogosphere and Twitter provide an interesting real-time observation deck to view the frustrations and emotional responses of investors in companies like Apple, RIMM, and Amazon when stock price movements aren’t following the consensus logic.  As described throughout, price movements can cause a considerable amount of intense, emotional debate about “who’s right” and “who’s wrong” in particular situations.  This shows up sometimes in raw emotional outbursts on the various social platforms.  To borrow the phrase again, Mr. Market doesn’t care.  As an investor, throwing up one’s hands in frustrating and shouting at the market-at-large only exacerbates negative outcomes.  Investors need to enter every position with a clear plan as to the justifications for the position (valuation etc.), potential outcomes and targets, and plans for exit under various circumstances, positive or negative.  This type of action plan helps cut through the considerable noise out there, impose discipline, and keep reasonable losses from becoming much larger losses.

Rally-Ho!

Last week we discussed the magnitude and duration of corrections in secular bull and bear markets.  As we discussed, corrections in secular bear markets tend to be bigger than those observed during secular bulls, and tend to last longer.  This week, we’ll turn last week’s analysis on its head and discuss the nature of the rallies, often referred to as “cyclical bull markets”, that occur between the major corrections.  Currently, this side of the bull/bear ledger is more germane considering markets in the US and around the globe have been on a tear higher over the past several months.  Like last week, we’ll review the period from roughly 1950 to the present, picking up with the end of the secular bear market in 1949.  Again, as we discuss differences in performance during secular bull markets and secular bear markets, keep in mind that there have been five secular market cycles since the market peak in 1929: the bear period from 1929 to 1949, encompassing the Great Depression; the secular bull period from 1949 to 1968, which peaked in the wake of the Nifty 50 craze; the bear period from 1968 to 1982, which was marked by political upheaval and “stagflation”; the secular bull from 1982 to 2000, which culminated with the tech craze and the highest valuation levels recorded in modern times; and the current secular bear period, which began in 2000, marked by the tech bust, subdued economic growth, the “Great Recession” and sovereign debt crises.

Over the past 60 or so years, the major corrections (15%+) we discussed last week have been followed without exception by moderate to furious rallies that oftentimes push markets past prior peak levels.  Like market corrections, the nature of the rallies is related to the overall market environment, secular bull or secular bear.  In a mirror image of last week’s data, post-correction cyclical bull market rallies tend to last much longer and achieve much stronger performance outcomes during secular bull markets than the rallies that occur during secular bears.  Let’s look at the S&P 500 data pertaining to the rallies:

* Highlighted Areas represent Secular Bear market periods. 

We’ve witnessed 17 rallies post-correction since 1949, including the present rally.  As you can see above, the median post-15%+-correction rally across all markets has lasted a little more than two and a half years and generated nearly 75% in returns (simple return, not including dividends).  The longest and best performing rally without a 15% intervening decline was the rally from 1990 to 1998, which lasted nearly 8 years and produced a return trough to peak exceeding 300%.  Wow!  The shortest post-correction rally occurred in 1980 as the US grappled with a double dip recession.  Lasting about two-thirds of a year, the rally still managed to produce trough to peak returns of 43%.  This was closely followed in shortness of duration by the short rally between round one of the European sovereign debt crisis in 2010 and round two in 2011.  This relatively short-lived rally also produced the smallest overall return in the data series at 36%.  

Breaking the data down in to secular bull and secular bear periods provides some interesting contrasts.  Median performance for cyclical rallies during secular bulls exceeds performance during secular bears by approximately 30 percentage points, 86% to 58%.  Furthermore, median rally duration is two years longer.  There’s more variance/volatility in the secular bull numbers owing to the fact there are a few significant outliers to the upside, notably the 300%+ return during the ‘90s.  Secular bear market rallies tend to be more consistent statistically in terms of performance and duration.  

Similar to the data last week, there’s no major statistical relationship between starting normalized P/E ratios and subsequent rally performance.  The R-squared, a statistical measure of how well starting P/E levels in this case influence performance, is a mere 0.04.  Correlation is -0.2.  P/E ratios tend to have a much stronger statistical relationship to long-term annualized returns and tend to display little correlation to short-term moves.  Hence, more often than not, it’s not a very good idea to rely on P/E ratios for market timing purposes!  The lowest starting P/E for a post-correction rally was 6.64x in 1982.  This also happened to mark the switch from secular bear market to secular bull market.  The highest starting P/E for a rally was 33.77x in 1998.  Of course, the P/E at the end of the 1998-2000 rally was an astronomical 43x; this happened to mark the end of the 18 year secular bull market.

Where do we stand today?  Since the absolute trough associated with the late 2011 swoon, the S&P 500 has rallied approximately 40%.  The duration of this rally is 1.3 years.  Most market observers believe we’re still enmeshed in the secular bear market that began in 2000.  Using past rallies within secular bears as a guide, this rally is still under the median in terms of duration and overall performance.  There is one thing to consider.  To paraphrase Mark Twain, history doesn’t necessarily repeat, but it certainly rhymes.  During the last secular bear market from 1968 to 1982, the first major post-correction rally from 1970 to 1973 proved to be the longest duration-wise as well as the best performing.  The pattern could be repeating itself here, which bears watching.  While the sample set is small, each secular bear over the past century has ended with normalized valuations in the single digits.  Currently, normalized P/E sits at approximately 23x.  This doesn’t preclude the market from rallying furiously, as seen in some past episodes.  However, there are probably decent odds that investors will witness another round of major market turmoil in coming years.  The good news: time-wise, we are probably in the later innings of the secular bear.  At some point in the not too distant future, investors should see another 15 to 20 year period of outsized global equity returns.

Corrective Action

With markets having rallied significantly over the past several months, both in the US and around the globe, we thought it might be interesting to take a look at the frequency, duration, and depth of market corrections over the past 60 or so years.  We’re not undertaking the exercise in anticipation of major upcoming market turmoil.  Instead, it’s a reminder that investors’ expectations for equity market performance are often romanticized on some level.  Memories can be very short.  Investors often underestimate the frequency of corrective episodes.  In reality, it’s a normal part of the process of investing in equity markets.  Over time, equity market returns have been solid.  Investors just have to endure some bumps and volatility along the way.  Of course, some of the bumps are a lot worse than others.  As we’ve discussed in the past, the severity of corrective action is best viewed within the broader context of “secular bear market” or “secular bull market” action.  These cycles generally have lasted 15 to 20 years over the past century and are generally bookended by valuation extremes; “secular bull markets” end when valuations are severely stretched, while “secular bear markets” have usually ended with long-term valuation indicators at severely compressed levels, such as single-digit P/Es.

For this exercise, we defined a correction as any peak to trough decline exceeding 15%.  Because there is much more data available, we focused exclusively on the S&P 500.  We took the liberty of adding the correction of 1953 in light of the facts that the peak to trough decline was 14.8%, very close to the 15% threshold, and the correction lasted nearly a full year.  On to the data:

*Highlighted Cells represent periods during Secular Bear Markets

From 1950 through the end of 2012, there have been 16 major corrections.  Nine of those 16 corrections have occurred during secular bear markets.  

This brings some interesting observations to the surface, however.  While the frequency of corrections is nearly equal between secular bear and secular bull markets, the nature of those corrections is markedly different.  During secular bull markets, the last of which occurred between approximately 1982 and 2000, the average length between correction troughs and subsequent market peaks is nearly 4.5 years.  The longest stretch between corrections occurred during the mega-1990s bull; nearly eight years passed between the correction in late 1990 and the correction in 1998 associated with the LTCM and Russian debt default debacles.  During secular bear markets (we’ve been in a secular bear since 2000), the length between corrections falls to approximately 2 years on average.  Furthermore, the duration of the corrections during secular bear markets far exceeds the durations generally observed during solid market up periods.  Average correction duration during a secular bear is approximately 1.25 years, with the longest peak to trough decline occurring over approximately two and a half years from 2000 to late 2002.  Secular bull corrections have lasted on average a little less than half a year.  Interestingly, 6 out of the 16 corrections identified here have lasted a quarter of a year or less.  Finally, and probably most important to investors, the magnitude of correction declines (at least those corrections meeting our criteria) during secular bears exceeds that of secular bulls by a decent margin: 33% on average to 23%.  The most devastating peak to trough decline, of course, occurred between late 2007 and early 2009.  That decline of nearly 58% will remain seared in investors’ memories for quite a while.

If, back of the envelope, we total up all the calendar time from 1950 to 2012 during which investors were mired in correction, it comes out to about 14 years of market time.  This represents about 22.5% of the calendar space over that time frame.  Even with the volatility and deep declines investors have experienced over the past 12 years of this secular bear, it’s probably not a stretch to believe that the typical investor would probably underestimate how much time the market spends in corrective stretches (might make for an interesting survey).  

A few final notes pertaining to the data: 10 of the 16 major corrections have been associated with official US recessions as dated by the National Bureau of Economic Research.  As for the other six, those have generally been associated with a gut-wrenching series of negative headlines, such as the near collapse of LTCM in 1998 or the string of crises associated with the European sovereign debt crisis over the past few years.  There is a statistical relationship between the starting Shiller P/E value at the peak and the subsequent magnitude of the correction, but the connection isn’t rock-solid; the r-squared is approximately 0.23 and the correlation is approximately -0.47.  The average starting normalized P/E was approximately 21x, above the long-term average of 16x.  Notably, four major corrections, 1953, 1976-1978, 1980, and 1980-1982 began with below average normalized P/E ratios.  Matter of fact, the early 1980s corrections began with normalized P/E ratios in the high single digits.  

Again, we’re not trying to scare investors here, but just pointing out that to achieve the solid long-term returns of approximately 6% per annum without dividends/9% with dividends in equity markets, you sometimes have to take a few lumps.  It’s always tempting to try to time every single correction to enhance the return profile.  In practice, timing the shallower corrections has proven quite difficult and even counter productive for investors.  Conversely, the deep-dish declines as witnessed in 2008, 2000-2002, and 1973-1974, were generally preceded by a combination of significantly above average valuations, clear signals of impending economic recession via leading economic indicators and other metrics, and clear technical deterioration and signs of distribution in major market indices.  

As the Months Go By...

Listen to enough talking head chatter every week or month, and you’ll hear a number of calendar-based market clichés.  “Sell in May, go away.”  “Santa Claus Rally.”  “January Effect.”  As we enter a new year, we thought it may be interesting to highlight some statistical data on monthly performance over the past 80 or so years to give you an idea which months and portions of the year have been the most promising for investors, and which months have proven discouraging.

First, let’s present a table with the monthly data (1930 through 2012) for the S&P 500. 

A few things stand out.  First, right now we’re in the middle of the “sweet spot” of the bat when it comes to seasonal performance.  December and January have proven to be the best months performance-wise historically.  Even more interesting, this performance has been among the most consistent of the months in terms of performance.  Three quarters of the time, December has been positive, whereas January has witnessed positive performance approximately 64% of the time.  December and January have two of the lowest standard deviation figures among the months and the two of the lowest spreads between the historical maximum return and the historical minimum return.  Hence, there’s definitely something to the notion of a Santa Claus rally, and a general carryover of the good cheer into the New Year.  

The December-January party has typically led to a February hangover of sorts.  February is the third worst performer behind September and June.  Just as December and January are relatively consistent positive performers, February has been consistent in its dourness with the second lowest standard deviation among all the months.  It isn’t surprising to think that there would be some consolidation after two strong months.  Nonetheless, historically, February consolidation has allowed the market to regroup for solid spring performance.  

Is there something to the “Sell in May, go away” maxim?  Definitely.  September and June are the two worst performance months of the year, with May coming in fourth overall (September is the only month that has produced a negative median return historically).  May, June, July, and September are among the worst months in terms of percentage of positive months.  And, the volatility of the return streams from May through October is higher than witnessed during the period between November and April.  Overall, since 1930, the average May to October return is 1.84% vs. 4.76% for the November to April period.  The median return is 2.76% vs. 5.24%.

As with any bit of statistical analysis, nothing is ever set in stone.  There’s always variance making it very dangerous to make big market gambles in any given year based upon factors such as these.  For all we know, performance during the summer of 2013 could prove to be the best of all time. In any case, there’s clearly been a distinct performance advantage historically for the winter and early spring months in contrast to the summer and fall.  And, when it comes to individual months, December has been a consistent, reliable booster for portfolio managers’ performance.  For those with longer time horizons, understanding and incorporating data such as this could help shape certain decisions, such as tweaking asset allocation processes or deciding on the timing of hedges.