SPX Dividends and the Lost Decade

OK... so maybe "decade" isn't strictly accurate but it makes for a catchier headline. Unless you were so drunk that you couldn't see straight in the last two days - a prospect I must concede is entirely possible and/or warranted, all things considered - you would have seen that SPX is now at levels not seen since 1997. If you looked a little harder, you could probably have found some cheerleading-type articles saying that yields have never been better, market will recover, stocks are the bomb, etc, etc. Typically, these articles come unadorned with charts and tables and this usually is a sign that there is a bit of elision going on. Or maybe I'm just too skeptical.

My targets here are those that claim that the dividends reaped in past decade would have more than made up for any capital losses and in fact the returns would still have been decent. The first question that requires answering is: Returns compared to what? The gold-standard zero-risk investment is (or at least was) US Treasuries. Since the year 1997 has been mentioned so often, I'm going to use that as my entry point here. For those that want to play along at home, you should download the SP500EPSEST.xls file from the link on the right. I'll also reference some interest rates you can find in the St. Louis Fed database also linked on the right.

Here are the starting conditions: On December 31, 1996 SPX stood at 740.74 and the interest rate on the 10-year treasury pegged in at 6.54%. Let's make some gross simplifications and a few assumptions.

1) Purchase of 1 share of SPX for 740.74

2) Purchase of 740.74 worth of 10-year treasury yielding 6.54%

3) Dividend re-investment in SPX each quarter.

This last point is done because I believe that most people - or at least most buy-and-holders - probably just do the DRIP approach with their mutual funds. So now we have two plans: SPX vs. Treasury.

So at the end of the Q1/1997, the dividends were $3.61 and SPX was 757.12. This means that 0.0048 shares were acquired for a new total of 1.0048. This was then used to acquire dividends in Q2/1997, which were paid at a rate of $3.87/share which translates to $3.89 in dividends to reinvest and acquire another 0.0044 shares with SPX at 885.14 to bring the total owned to 1.0092. And on and on and on up until today, when you would own 1.2233 shares at SPX closing value of 773.14 for a total value of $945.82.

For the years until the treasury matures, it will throw off $50.41 in interest each year until it matures. At that point, to make this comparison easier, the accrued value is re-invested in a 2-year treasury. The interest rate on the 2-year at that point (1/1/07) was 4.8%. The total of $1274.80 would be re-invested at 4.8% simple interest. This produces a total value of $1397.19.

Hmm... so I'm clearly not getting something here. All the risk of the stock market for a lower return? Now, I was not educated in finance and perhaps my math is wrong but I'm pretty sure that the risk-reward equation is supposed to reward risk with a higher return. Excel's INTRATE function produces a rate of 2.31% on the SPX investment when the same formula returns a rate of 7.38% for the Treasury plan. And to add insult to injury, the SPX investment plan doesn't even keep up with CPI inflation. Don't believe me? Click through to BLS CPI Inflation Calculator and find out for yourself. Entering in that $740.74 investment in 1997 dollars produces a value of... $974.47 in 2009 dollars for a real-dollar LOSS. Granted, the real-dollar gain in the Treasury plan isn't glamorous but at least it's a positive number.

Now, the current rates on the 1o-year are an atrocious 2.799%, so the Treasury plan isn't exactly a viable strategy going forward from here. At least barring a wave of deflation that I'm thinking most of us don't even want to ponder. However, I am extremely skeptical of people using the Q4 dividends and the tanked SPX value and producing yields in the 3's. How on earth can you make the assumption that dividends will not fall further? Have balance sheets suddenly gotten stronger in the last two months? Looking at the past work and charts on dividends that I put up, it's pretty clear that it takes quite a bit of EPS degradation to knock dividends down a significant amount. But, look close at some of the charts of reported and operating EPS on this blog and you'll see that the forecasted EPS levels for 2009 look more like 2002 levels for reported EPS and 2005 for operating EPS. A quick look at the dividends from that era show a large difference. I'm not sure this gets bridged but I'm not exactly optimistic that the current yield will be maintained.

One can argue that these are anomalous times and you'll see all sorts of people who want you to invest your money through their service telling you that this is a great time to buy stocks at their brokerage. Just remember, there are real pitfalls to the buy/hold/re-invest strategy and the simple little chart should be plenty to illustrate that.

Updated S&P EPS - Throwing in the Refrigerator...

... and the oven, and the dishwasher, etc.

Apparently, the media is finally catching up with the S&P EPS estimates that have been out for a few days now and which I wrote about in the Kitchen Sinks & Miracles post. It would seem that this quarter is going to see everything thrown in as - amazingly - S&P has actually revised EPS for Q4/08 downward again. This is at least the 2nd update of EPS this week and this latest one holds some significant changes. And perhaps not coincidentally, there have been new discussions of valuation of SPX so I'm going to do a little updating on that topic as well.

First, let's have a new look at the SPX EPS estimates for both operating (opEPS) and as reported EPS (arEPS). Just this week opEPS for Q4/08 was revised from $6.33 on 2/10 to $5.77 on 2/13. The arEPS values were arguably even worse as it went from -$8.79 to -$10.44. Evidently, the hits just kept on coming. Perhaps more ominously is that this last revision took down Q1/09 arEPS estimate -15% from $9.87 to $8.36. And looking at the chart, this is the first revision of arEPS in some time that shows a significantly lower outlook for all of 2009 and into 2010. On average, the reduction was roughly -22.5%. However, the opEPS reductions was not nearly as severe, which would imply that S&P is expecting more write-downs, charge-offs, reductions in goodwill or whatever continuing for the next several quarters.


As in the prior post, here's a look at the EPS estimates over time. As already noted, the arEPS negative value is unprecendented. What is very interesting to me, from a trading perspective is the comparison between the tech implosion and current forecasts. The projections for Q4/09 opEPS show a recovery only to the levels of Q3/05. The case of arEPS Q4/09 has a projected value that puts it somewhere in between Q2 and Q3/02. Interestingly, the current level of SPX roughly corresponds to the SPX level between Q2 & Q3/02. I'm not quite sure what to make of this. (I won't even touch the effects of inflation/deflation here - that's far too expansive a topic for my little blog.) At today's SPX close, the PE based on opEPS - assuming no further revisions to the current quarter's EPS report - is 14.93 Using arEPS - which again, is what S&P itself will actually use for the PE of the index - the PE is 29.86!

When I wrote the last post on SPX earnings, I only briefly touched on the historical PE and just made some references. Then I looked back at my post archive and realized that some of the data I was pointing to was actually in some work I had done prior to starting this blog. I'm going to correct that here and update it a little bit.

At the right is a chart showing the trailing-twelve-month PE value using both arEPS and opEPS for calculation since 1988. Also included are the reported EPS values. (I thought it better to clutter the chart than the entry itself.) First, the average PE(arEPS) = 19.25 and the PE(opEPS) = 22.81. S&P only has data for opEPS going back to 1988, hence the limitation. In an earlier post on SPX and P/E, I looked at Shiller's historic data of arEPS and noted the average P/E from 1950 to Dec. 2008 was 16.59 with a standard deviation of 6.76. Considering the above mentioned PE values, neither metric is in "value" territory. However, look closely at the chart - specifically in the 2002-2003 period - when the market finally bottomed the PE(arEPS) was a still-elevated 27.14 and the PE(opEPS) was 18.51. Both of these are above the average. So what changed to put in the bottom? My guess is a recovery in arEPS. Yes, there was still another quarter before the true bottom in arEPS but by then, opEPS had shown some steady (if small) improvement.

My point in discussing this is that when various bears talk about how the market is overvalued and then they project SPX will be at such-and-such a level based on some multiple, they are suffering from similar biases as bulls. There is no "correct" multiple. Sure, you can hazard a guess based on history but look again at the chart right in the middle of the tech bust - the PE(opEPS) reached the mid-40s! That to me, signals that market players refused to come to terms with the reality of a burst bubble and corporate earnings although eventually they threw in the towel - sort of - and the market reached a bottom. So what you find right now is a debate of sorts. On one side you have bulls performing a sleight of hand claiming the market is cheap because PE(opEPS) is below the average PE(arEPS). And on the other you have bears claiming that the market will have to go down because it should have a PE of 15 and earnings going forward are awful. Granted, I have more sympathy for the bears, but to slap a 15 PE on SPX because that's what you consider a "fair value" is absurd in the face of popular delusion. The evidence that the bottom can form even when stocks are overvalued relative to historical averages is right there. Could multiple contraction occur? Certainly, and if popular trust is crushed by more revelations of criminal and rigged behaviour on the part of market makers, it could happen. (This was a major factor in Japan in their post-bubble era.) This would require a change in American popular sentiment that I suspect is no longer possible.

My (currently under-developed) opinion: In the next few years, the market will return to a situation in which investing is done based much more on dividends than on capital gains.

Always remember: "The market can stay irrational longer than you can remain solvent."

S&P - Kitchen Sinks & Miracles

S&P finally got around to updating their spreadsheet that shows their forecasts for EPS. Disturbingly, (at least for me), the forecast column for operating EPS had for about two weeks been replaced with the statement, "This series is under review should be posted soon." Not exactly reassuring in the current environment, particularly when it appeared beneath these bullet points:

• Operating set for the 6th quarter of negative growth, a new record (5 in Q4,'00-Q4, and Q4, 90-Q4,'91)
• As Reported also set for 6th, but did so during Q1,'51-Q2,'52
• Q4 Financial decline is worse than it appears: Q4,'08 is estimated at $-4.89 and Q4,'07 was $-4.05
• Operating EPS coming in 8% lower than top-down estimate, Staples coming in slightly better than expected, continued large Financial loss

S&P also makes this statement: Expect charges to continue for Q4, as companies clean house for a better 2009. When this line is combined with the numbers in the chart, it can be inferred that S&P is expecting this to be the Kitchen Sink quarter. Just because I'm a somewhat petty person, the charts of operating and as reported EPS that follow include S&P's prior forecasts. Obviously, 6/30 (Q2) and 9/30 (Q3) are concrete at this point and Q4 is 65% reported.

Readers of this blog probably have looked through the historic data and would probably discover that as reported EPS has never been negative. The write-downs expected for this quarter are that severe. Looking at the recovery in Q1/2009, S&P clearly believes that the Q4/2008 is going to be the nadir of EPS.

Considering the track record and the less-than-transparent process of marking assets, it remains to be seen whether this will be true. The operating EPS estimates for Q4/08 went from $24.62 on 9/3/08 to $8.19 on 2/3/09. If the as reported and operating EPS forecasts are compared looking out past this quarter however, there is clearly expectation for some write-downs to continue since the difference between these two values averages well over $5 through 2009. It appears that S&P thinks that these charges will be mostly confined to the financial sector. (I'll probably tackle this a bit more in a follow-up post in the next couple of days.)

Also interesting is the miraculous recovery that S&P anticipates in their opEPS forecast. Considering that operating earnings are supposed to ignore charge-offs and other incidentals, the leap from $8.19 to $14.64 would be an unprecedented percentage gain in opEPS for a single quarter. (As reported EPS has managed larger percentage gains, presumably because of the calculation.) However, the S&P Q4/09 estimate has EPS running below my guesstimate of growth from an earlier post on the topic. In that post, I estimated an EPS growth rate of 4% and extrapolated from Q3 information. Clearly the estimate for Q4/08 was horrendously inaccurate but the difference between this guess based on history and current S&P estimates for Q4/09 is $1 or a bit over 5% off. See the chart on the left, which also helps provide some context.

So how does this affect the valuation assessment of SPX? What version of EPS do you want to utilize? Bulls will seize on the PE based on opEPS which at today's close on a ttm basis is 14.68, assuming that the EPS value from S&P turns out to be accurate. However, on an as reported EPS basis, the PE is 28.74. This latter value is actually what S&P will report for PE on its own website. For historical reference, I would refer back to my earlier post on PE values. For the lazy, historic average as reported PE has been a bit over 16.5. So it's still not "cheap", unless you're a blinkered bull that wants to muddle the discussion by ignoring the differing EPS values used to assess PE. If you are one of those... I doubt you would be reading this, honestly. On a forward PE basis, things are equally divergent with the opEPS estimates coming up with 12.17 and arEPS calculating to 20.02. I've stated in an earlier post that Cliff Asness has estimated forward PE values based on operating earnings to historically have averaged around 11. Again, not cheap. When the historical average for PE(ttm,arEPS) is matched with anticipated arEPS for 2009, a level of 691 is calculated for the end of 2009. If you are feeling more bullish (or less morbid), the average PE (ttm) based on opEPS from 1988 to the present has been about 19 (charitably including the dot-com bubble period) and thus produces a SPX level of 1330.76 for the year's end. I'll pause here for laughter.

Bottom line, any significant rally of SPX from here will further shift valuation out of line with forecast and historical norms. (Excepting the "norms" of the aforementioned insane bulls.) That being said, in my opinion, this market has become more or less untethered to objective reality and now is like a balloon subjected to the gusts of panic and euphoria brought on by reactions to the latest macro data point, Bad Bank, or pundit dribble.

Revisiting Old Charts

Over the past couple of weeks I've posted up a few charts with some vague intention/goal of updating them now and then.

One of these was the SPX bottom finding chart. When I first posted it up on the 6th, it was somewhat concerning because of the implied risk for a reversal even though the indicator itself wasn't as reliable at finding tops as confirming bottoms. Here's an update of that chart to the right. On the plus side, the market didn't exactly leap upwards since then. On the 6th, SPX opened at 931 and Friday it closed at 831. I guess that's actually not too bad all things considered. This chart still confuses me a little bit when it's viewed over the span from Q1/2007 until now. Strangely, the spikes in risk for a bear reversal on SPX keep getting higher and the bottom spikes continue to be more shallow, forming a channel of sorts. Why speculators should be getting progressively more risk-a-philic puzzles me. Perhaps everyone is just getting more comfortable with the new market realities. The next sign-post I'll look for on this one will be around -0.50 and at that time it will be interesting to see how other SPX analysis is doing. This is the height of earnings season and so anything can happen.

The next thing I've talked about a little more recently is oil and the contango spread. This definitely deserves an updated chart since the spread has collapsed and has been cut roughly in half. Again, chart to the right. The last time I talked about it, the 1-year spread in NYMEX pricing was pushing towards $25/bbl. This has subsequently collapsed to just under $12/bbl and the 6-month has fallen from around $18.50 to just over $7/bbl.

To add a bit more detail, it turns out the spike in the spread was due far more to the plunge in the front-month contract (February until Jan. 20 assignment, March since) than a price run-up in the farther months. You can see this in the next chart that shows the front month price and 1 year out. Again, it should be noted that there was a substantial surge in open-interest in the March NYMEX contracts. My guess du jour is that there were a lot of people scrambling to roll their contracts out of February because of the situation in Cushing. At some point, I expect those contracts will be liquidated but we'll have to wait and see when/if that happens.

Levered ETFs and Real-World Volatility

When I started this blog, I never really expected to get much traffic and that basically has been the case. Still, I'm no different than most and retain some vanity and so installed the obligatory traffic tracker to see where people are coming from. I was surprised to discover that the pieces on DXO, DTO, and oil generally have been far and away the most popular. I guess I expected that after the trouncing that oil took that it would have been a dead area of little interest. But within the oil searches there was a vein of interest in levered ETFs themselves. That part I'll expand on a bit further here.

There are lots of levered ETFs out there but they all function in more or less the same way - they try to provide +/-2x the percentage daily move of whatever its benchmark index is. Just to take one example, this is from the ProShares prospectus (page 9):

Ultra ProShares are designed to correspond to a multiple of the daily performance of an underlying index. Short ProShares are designed to correspond to the inverse of the daily performance or twice (200%) the inverse of the daily performance of an underlying index.
The Funds do not seek to achieve their stated investment objective over a period of time greater than one day.

(emphasis mine)

These are very important caveats to bear in mind and they are in the prospectus to protect ProShares from real-world behaviour vs. uninformed investor expectations. So how can these ETFs be used effectively, given their path dependence? The post on DXO/DTO already showed that there are occasions when the ultra or levered ETFs perform outstandingly well - basically when the underlying benchmark moves in a straight line with little deviation. So what of the flip-side? I skirted this issue with an earlier post called "The Chop!" where it was noted that SPX had been exceedingly volatile on an intraday basis for the previous couple of months. I'll try to give a look at both possibilities.

First, you have to have a basis for modeling or in this case, generating random but similar paths. I took 100 days of SPX data ending on 1/16/09 and noted the open-close price percentage change in the index. Here's that daily price change distribution in a nice histogram. This isn't exactly a normal distribution and for the stats nuts, here is the description: mean=-0.308, std error=0.359, std dev=3.59, kurtosis=0.839, skew=0.178. Unfortunately, I'm somewhat limited by knowledge of JMP and thus confined more or less to what Excel has on offer. So I took a short-cut and decided to pretend this was a normal distribution anyway. I'll accept any help to improve on this assumption so critique away.

To ensure that the normal distribution assumption wasn't wildly off, I decided to randomly generate 5 sets of n=100 based on the mean and std. dev. noted above using Excel. Then these sets were compared to the actual data set. These results are to the left in the JMP graphic. (I apologize for the squashed look but it's a tall graphic.) They aren't dead-on, but statistically speaking they are pretty similar to the original set. (Set #1 in this case is the original SPX data.) Not great, but not terrible.

Moving ahead from this point seemed acceptable and so I decided to model the returns (before expenses) according to the daily goals outlined in the prospectus of 1x, +2x and -2x funds in this environment. I ran this 200 times with some interesting results.

The 1x is the basis for daily calculation of the levered models. But the table on the right is the final return from day 1 to day 100. For the use of these Ultra-ETFs to be ideal, one would hope to see a high probability that the performance would be beyond the 2x daily expectation. Looking just at the mean, one might be tempted to think that these funds are excellent performers but when the median performance is looked at, a different story emerges. Better than 50% (about 55%) of the time, the -2x fund "underperforms" in a choppy market. In this instance, "underperform" simply means less than +/-2x the target benchmark - it says nothing of its performance to prospectus specifications. For reference the actual performances during the period under analysis were SPY= -32.8%, SSO= -60.73%, SDS = 19.14%.

So that's the examination of a relatively choppy market. What about the performance under circumstances like the summer to fall period in crude oil?

You'll have to just grant me the same assumptions as the charts illustrated above because I don't want to further clutter up the space. Briefly, the sets generated are even more similar statistically than in the first case. If you would like to see the numbers from above let me know but I'll summarize with this: the data in question is USO from June 16 until December 24 or 135 sessions. The average intraday change was -0.64% with a std. dev. of 2.65. This is a couple of weeks before the peak, and seems a little more realistic in terms of market timing in that allows some wiggle room for being off.

The results are to the right in the same table. In this environment, the -2x modelled fund performed well even on a comparison of medians and in the simulated runs actually beat a 2x performance of the underlying benchmark 81% of the time.

So what can be drawn from this overly-long post? First, it should be remembered that this simulating is totally ideal - no expense ratio (generally >0.8%) and no slippage/remainder that seems to occur in terms of performance vs. stated goal on a daily basis. My hunch is that on significant volume/volatile days the NAV of these ETFs gets away from share price due to in/out-flows and eventually must be reconciled. But in terms of applicable trading, I suppose if you believe the benchmark that you are targeting is going to enter a period of strong directional movement without much volatility, then a levered ETF might be a decent wager. But beware the chop and churn that, combined with expenses and remainders, can systematically erode returns.

SPX Dividends, EPS, & Yield

I've made reference to SPX yields more than once since I've started writing this blog. It's a little more difficult to tackle because I rarely see (or at least haven't found) any "dividend estimates" in the same way that there are earnings estimates. This post will hopefully go some ways to providing context about dividends and yields historically as well as possibly addressing the questions that immediately pop out at me when I look at the chart of quarterly earnings and dividends to the right.

First, why haven't dividends fallen further when both operating (oEPS) and as reported (arEPS) earnings have declined significantly? And second, how far could they fall in the quarters ahead?

The data for this analysis comes from both Shiller and S&P. Shiller's historic data uses "as reported" earnings and S&P provides the operating earnings going back to 1988. When the chart is examined the steady and basically regular growth of dividends from 1962 through about 2000 is fairly remarkable. Then, things start to get a little hairy before resuming a rapid rise to a peak in Q4/07.

So what about the periods of earnings declines and their impacts on dividends?
There are several periods of considerable as reported earnings drops: most are obvious from the chart but also 2H/74 to Q1/75, Q4/81 to Q1/83. Looking at peaks in arEPS during these times, the average fall was about -45%. Interestingly, during these periods dividends were on average flat though this owes to the 1989 period when dividends somehow grew by 14.4%.

That being said, SPX dividends actually peaked in Q4/07 at 7.62, one quarter after earnings had peaked before beginning their current slide. Adding to this odd behavior is that dividends went up from Q3 to Q4 by 10.4% even as oEPS fell by -27% and arEPS slid -48%. Huh. Color me confused. At any rate, dividends are now off a bit over -6% from that peak. So how does this rate from a historical perspective in terms of yield?

Average yield of SPX since 1962 has been 3.13% and the current level with the dividends from this quarter is roughly 3.19%. Just for reference, during that period the 10-year treasury has averaged 6.95% and the average difference between SPX yield and the 10-year has been -3.83%. Currently, that difference is 0.80% and this seems to be the only time between 1962 and today that SPX has yielded higher than the 10-year. So... is SPX cheap?



From one measure - difference between 10-year Treasury yields and SPX yield - I guess so. But like everything else, this depends on some significant assumptions. First, that the Treasury yield will not begin rising (see earlier post for Federal debt requirements in 2009) and that SPX dividends will at least move along with any run up in SPX. From the basic historical average of SPX yield however, this doesn't really mark anything but a return to the average. And it also hinges on the assumption that earnings do not deteriorate further, at least in the near term. The chart to the right shows the 10-year vs SPX yields since 1962. Unfortunately, it would appear that the dramatic decline in SPX is more responsible for the climb in yields than increasing dividends. Or rather more accurately, dividends have not fallen nearly as much as the index (or EPS!).

Thus far the context has been filled in, more or less. Considering how wildly off the estimates for S&P EPS have been in the past quarters, the notion that they now have a firm grip on EPS going forward is umm... naive. Maybe wishful thinking, whatever. Let's assume though that EPS stabilizes at this current level which is approximately in the area of mid-2004 and perhaps increases at a modest rate similar to what I posited back in an earlier post. The 4.1% growth in oEPS would bring this metric up to roughly December 2005 levels by Q4/2009. Dividends at that time were about -15% lower than the current quarter. So if EPS grows at that slower rate, how much cash is available from the balance sheets of the S&P 500 to fund dividends? My guess is not nearly as much as there was before this whole debacle really got started. (I really need to go through the Fed's Flow of Funds report more closely to see if I can find some more data.)

Take what you will from this pile of information. I would not bank on the current level of dividends being sustainable through 2009 without some serious uptick in EPS which I honestly don't expect. Unless I have severely underestimated the stomach of corporations to seriously weaken their balance sheets in a vain attempt to boost share prices, it just doesn't seem possible. What SPX does between 12/31/2009 and today is anyone's guess, but I am expecting to hear about further dividend slashes coming up that will push SPX yield down in the next quarters.

Here's one other of my 2 cent ideas: When you look back at Shiller's entire data set, it looks like there was actually a time when people invested in the S&P for the yield paid rather than sheer capital gains alone. Might the market emerge on the back of that same model? It could make some sense and provide some level of confidence back to the market players.

SPX Bottom Finder

Anyone who knows me, or has sifted through the posts thus far on this blog, will recognize I can be a bit compulsive and have an unnatural enjoyment of working with Excel to find patterns and correlations. Sometimes this is in pursuit of confirming for myself something that I've read asserted as "common wisdom" and other times in trying to test out something I stumbled across that piqued my interest. Here's a chart of my latest investigation and a bit of explanation:

The idea was to create a measure to identify when turning point potential was high. This measure is in the red line. When it is above 0, the risk for a bearish reversal is higher and when it is below the potential for a turnaround to the upside is good. Unfortunately, the meter doesn't seem to provide very good timing on the market tops. However, I did like the bottom indicators. The yellow line is the average reading and the blue arrows in the chart mark out SPX bottoms. (I'll admit there was no particular numerical threshold for selection and it was done on just visual assesment - which I normally dislike.) At any rate, the blue arrows and lines line up pretty well with the lower risk for going long in the red-line meter. I haven't done the returns yet (perhaps a follow-up post this week) but I would be fairly confident in adding this measure to help with confirmation of a bottom. The nice thing about it is that several of the downward moves are very dramatic, which would allow for a quick decision.

Something that troubles me a bit is the current reading. I stated earlier that this meter isn't all that great at timing tops and bear reversals on SPX so it does not make me all that nervous. There is also some residual of the dramatic fall in the last quarter that I believe the indicator is working off, which is resulting in the very high risk reading for a drop.

I'll try to update this from time-to-time as I go along posting and see how it (and myself) performed.

SPX and P/E

In an earlier post, I had looked at some of the earnings forecast revisions that S&P had made in the past months. This time, I'm going to confine my discussion to historic PE levels and implications for the market in the future, considering the current earnings expectations.

For this, I downloaded Robert Shiller's monthly S&P data set (see sources at bottom) that goes back to the dark ages of the market. But since I just couldn't see how the S&P's valuation in the 19th century was relevant, I decided to restrict the set to 1950 until the present time. There are some caveats with the set that he explains and you should read but that I will omit here. Shiller's data set uses the "as reported" earnings as opposed to "operating" earnings. The former includes all the write-downs, write-offs, one-time expenses, etc. whereas the latter omits all of these things and is typically the number that you will read has been forecasted by analysts. Here is the chart of P/E & SPX. SPX on this chart is on a log scale to allow the movements in the 50s to be seen.

The last 3 months in the data set are estimated using the actual SPX levels but with the most recent S&P Q4/2008 EPS estimates. The average P/E from 1950 to present is 16.59 with a standard deviation of 6.76. The majority of the points (~73%) fall withing +/- 1 standard deviation. The only points that are above +2 standard deviations (PE>= 30.06) are unsurprisingly on the high end of the distribution. Approximately 4.2% of the months fall into this range and perhaps also unsurprisingly, essentially all of these points originate in the 2001/2002 bust period.

The next step was attempting to derive something useful out of this historic information. If you have had the displeasure of viewing any financial TV since the market began crashing in earnest, you've likely heard that this is a "great time to buy stocks because they are undervalued historically," or something of that nature. What seemed like the best thing to do with this data set was to bin the monthly PE values against 1 year SPX % returns and compare the data sets to see if there are any statistical differences.

In the chart, you'll see some circles that overlap and some that don't. The degree of overlap indicates how distinct these sets are. Similarly, the positive values in the comparison's table (just below the mean chart) show which groups are (and are not) connected. The deviations within each group are rather large, however the bins (>+2 std. devs, +1 to +2 std. devs, -1 to +1 std. devs and <-1 std. devs) are - at least on the extremes - relatively distinct. The +1 to +2 std. dev and -1 to +1 std. dev groups are not distinct and the very small circle is the representation of the former category. The summary for average 1 year SPX percent returns: <-1 = 13.91% -1 to +1= 8.42% +1 to +2 = 6.41% >+2 = -2.14%
Entire data set: 8.66%

So... where is the PE of SPX currently? Well, if you believe the S&P EPS estimates for Q4, the trailing 12 month PE should be a bit over 18. Not exactly in the "cheap" range to say the least but not as wildly overvalued as it had been in the 2nd and parts of the 3rd quarter. Most optimistically, I'd say SPX is averagely valued and an average return could be expected rather than a sharp rebound.

One other topic that I've not heard addressed in a very satisfying way: multiple contraction and multiple expectations if appetite for securities disappears or diminishes in the retail arena. After all, a lot of people would have been served quite well by simply putting their 401k contributions into US treasuries for the last 10 years. (Yes, I'm aware this is simplistic and overlooks dividends. Maybe I'll look at that in the future.)

Sources:
http://www.irrationalexuberance.com/ (download ie_data.xls)
S&P 500 EPS estimates (see link on right)

The Chop!

These are truly interesting times. Since October 1st the average intraday range of SPX based on percentage of the opening price has been 5.99%. For the period from 1962 until September 30th, that same value has been 1.44%. Rounding off the October 1 – present period to make a 50 session average of this intraday range finds that there has been no period since 1962 that has seen continued intraday volatility on a level remotely like this.

The last peak was in October 2002 just a bit above 3% and the period around the 1987 crash was 3.50%, though that latter reading is skewed considerably by a 3 day run of 20.47%, 12.96% and 9.5%. Excluding these three sessions and the volatility in the days before and after is essentially unremarkable. Here’s a plot of the 50 day average of SPX intraday range as percent of day open:

Some keen observers will be saying to themselves, “Hey, that looks a whole lot like the plot of the VIX and SPX.” And of course, they would be right for reasons I will get to below. But just so those clever folks can pat themselves on the back for something, here’s the chart of the VIX and SPX. (People that can recognize a VIX chart on sight need all the support they can get, after all.)


The reason that these charts are essentially identical (except for the noise in the VIX plot) lies in how the VIX is calculated. On this particular topic, it really pays to read the CBOE VIX white paper that lays out the calculation method. While the calculation itself is straight-forward, it will likely cause some head-scratching the next time you hear someone telling you that the VIX is predicting this or that for the markets. Here’s the basic overview with a few details left off for brevity:

The VIX is essentially a summation of the call/put average option prices (weighted for strike and time) on the SPX that is limited by two consecutive strike prices with zero bids. (For example: with SPX at 900, there might be no bids at 840 or 850 for puts and so 860 would mark the lowest term limit included in the VIX calculation. The call side works conversely.) The practical consequences of a calculation like this should be immediately obvious. When the SPX covers an intraday range of 6% as in the past couple of months, the number of strikes that will attract bids grows considerably and thus the terms summed in the equation grows. There have been numerous articles written and observations made about mean-reversion in the VIX. While the observation is more or less correct, in theory at least, the VIX has no upper limit.

So that’s all the VIX is – a weighted summation of a varying number terms based on the prices derivatives traders are willing to pay for contracts. This is only predictive if you believe that derivatives participants tend to be overly complacent during good times and too willing to pay too much for a hedge during bad times. But that assertion deserves a closer look so the next chart will show the VIX and SPX closes since the creation of the VIX. (It is worth noting here that the calculation of the VIX has changed in that time – the CBOE white paper details the date and nature of the changes.)

The correlation in the long term is 0.1716 – not really a strong value and more interestingly implying a direct rather than inverse relation. But that’s not being very fair to those people that believe the VIX has more to tell over a shorter term. In that respect they are correct: over any given 5 trading periods, the average VIX/SPX correlation is -0.6560. This is a pretty good result and the negative value is expected considering the typically inverse nature of the relation. However, this does not necessarily mean there is any causative or predictive nature to this relation. For that, offset data of the VIX and SPX closes can be used.

For me, a simple way to check whether or not one series is more predictive or reflective is simply to offset the data sets by varying periods and check the correlations against the original set. The inclusion of a chart for visual reference also helps (though not included here). As noted before, the average 5 period VIX/SPX correlation is -0.6560 and the entire set correlation is 0.1716. The table below shows the correlation rapidly breaks down to essentially none in the average 5-period correlation. The entire set correlation actually rises incrementally. To me, this implies little of predictive value and again shows that the VIX is simply reflecting the range of SPX.

Bottom line, using the VIX as a predictive tool on its own is of dubious merits and could lead to far worse. There are perhaps some possibilities in using some TA on the VIX to produce more reliable signals but the VIX on its own... you'd do as well flipping a coin.

Sources:
http://www.cboe.com/micro/vix/vixwhite.pdf
Notes:
- Data used is current up to December 5th.

Sector Rotation?

“The market doesn’t build rallies on toilet paper.”

Sure, the more jaded and cynical will make funny comments about the Fed monetizing the ever-expanding deficit in the future. And the very darkest souls might even make references to burning money to stay warm a la Weimar days. But I still think that statement stands on merits – consumer staples is the sector that money gets parked in when it has no better places to go. And when consumer staples, healthcare and utilities are the best performing sectors, the broad market isn’t really going to go anywhere in an economy that is still 70% dependent on consumer spending.

Here’s a chart from Yahoo! showing the various sector SPDR ETF relative performances over the past year-to-date:

SPY has been abysmal and XLP (Cons. Staples) has been the best relative performer followed by XLV (healthcare) and XLU (utilities) – generally not the sectors one would expect to lead a SPY rally.

However, in the last week the better performing sectors have been the year’s most beaten down – XLF (financials) and XLY (cons. discretionary). The collapse of energy has been one of the big reasons that SPY has not advanced further. Energy (XLE) and commodities (XLB) played a massive role in the SPY advance after the tech-bubble collapse – perhaps even more so than the financial sector. This chart link shows that pretty clearly: SPDR 1998-Present.

To go one step further, since August when the week's leading sector was XLF, XLY or XLK (tech) the average return on SPY was 0.33%. While that's not great, SPY has shed -30.3% in the same period. Further, when a defensive sector like XLP, XLV, or XLU has been the week's best performing, SPY has returned an average of -6.87%.

This is all well and good, but it is backwards looking. XLF and XLY have both pulled off of their lows and the 30 DMAs that had marked strong resistance areas in the past couple months has been breached in the case of XLY and being challenged in the case of XLF - both encouraging signs. Particularly so since SPY itself seems to have formed something resembling a bottom and the 30 DMA in that case has almost no room left to fall from a math perspective barring a massive blowout of the 800 level pretty soon.

In the coming week, there are no earnings releases of great note (see previous post) and the macro releases are generally of the variety that are ignored until Friday morning when the retail numbers for Novemeber are released. I am of the opinion that home sales numbers are kind of like GM in the Dow - they've been so bad, so long that they can no longer do any significant damage. The initial claims number coming up has some noise in it and the last few week's have been bad enough that it would seem very possible that an incremental improvement appears. However, even if it doesn't the last unemployment figures were horrific and essentially ignored by the market anyway so there's no reason to think this one won't be as well. Friday makes me nervous though since it will contain the first couple of holiday shopping days.

S&P... emphasis on the Poor's

S&P has been busy this last quarter.

I don’t download the SP500EPSEST.xls file every day but probably every couple of weeks, I check it out to see what’s changed. Unfortunately, I haven’t been able to find any source of data that watches the forecast changes from S&P over time. (If anyone knows of one, please let me know.) Every time I’ve opened the file, the revision to Q4 earnings has been negative.

The chart here shows just how drastically the operating EPS estimates have been cut from early September until the present. The quarter ending on 6/30 reflects actual data reported and the 11/12 value for the quarter ending on 9/30 is also real reported earnings.

But it helps to contextualize these revisions. So, the next two charts that illustrate this well. The first shows operating EPS (operating omits write-offs/downs) on a linear scale from 1988 to Q4/2009. The second is the same chart but with a log scale for the EPS side only. The pink line uses the actual operating EPS data. (SPX data was only included up to the end of the actual EPS data series and so stops on 9/30/08.)

Clearly, the revisions downward are reflective of the reality of this most recent quarter’s results. What is most intriguing is the expectation for growth in 2009 that is still built into these forecasts. The linear scale in the first chart shows the steeper slope of these forecasted EPS numbers compared to the entire period of 1988-present. This seems absurd in the face of a mounting recession and the deleveraging occurring. But again, it helps to have context.

Going back to the linear scaled chart, the period marked out from points 1 to 2 (Q2/92-Q2/98) had an average quarter-to-quarter percentage growth of 3.54%. The period marked out between points 3 and 4 (Q3/01-Q3/06) notched average quarter percentage growth of 4.63%. The average forecasted percentage growth rate for Q4/08 to Q4/09 using the most recent S&P forecast is 7.60%!

Making a somewhat optimistic assumption of quarterly EPS growth being an average of the 1-2 and 3-4 periods (4.08%) reduces the forecast considerably.







The forward PE for S&P's forecast at 850 is 10.51. For the reduced forecast it is 11.73. AQR's Cliff Asness has estimated forward PEs have historically been around 11. Considering the optimism of S&P's estimates and how much they've been revised downward, assigning a fair value to SPX at this point would be tricky at best. I'll revisit this in the future with respect to historic yields and PEs a bit more.

Sources:
http://www2.standardandpoors.com/spf/xls/index/SP500EPSEST.XLS
http://www.hussmanfunds.com/wmc/wmc070402.htm