January 2019 Data Update 2: The Message from Bond Markets!

I must admit that I don't pay as much attention to fixed income markets, as I do to equity markets, other than to use numbers from the markets as inputs when I value companies or look at equity markets. This year, I decided to look at bond market movements, both in the sovereign bond and corporate bond markets for two reasons. First, bond markets offer predictive information about future economic growth and inflation, and since one of the big uncertainties for equities going into the new year is whether the economy could go into recession, it is worth paying attention to what bond investors are telling us. Second, one of the stories in the equity market during 2018 was that the price of risk, in the form of an equity risk premium, rose and became more volatile, and it makes sense to look at whether the price of risk in the bond market, taking the form of default spreads, also exhibited the same characteristics. Bear in mind, though, that the bond market is not my natural habitat and if you are a fixed income trader or an interest rate prognosticator or even a Fed Watcher, you may find my reasoning to be simplistic and perhaps even wrong.

The US Treasury Market

The place to start any assessment of interest rates is the US treasury market, with it range of offerings, both in terms of maturity (from 1 month to 30 year) and form (nominal and real). When valuing equities on an intrinsic value basis, it is the long term US treasury that is your opportunity cost (since your cash flows on equity are also long term in intrinsic value) and the ten-year US treasury bond rate is my input. (The 30-year US treasury may actually be better suited to equities, from a maturity perspective, but has less reliable history, more illiquid and subject to behaving in strange ways). The path of the US 10-year T. Bond on a daily basis is captured in the graph below:

At the start of the year, I had argued that there was a good chance that the 10-year T. Bond would hit 3.5% over the course of the year, but after reaching 3.24% on November 8, the rate dropped back in the last quarter, to end the year at 2.69%.  

Returns on T. Bonds and Historical Premiums

If you bought ten-year treasury bonds on January 1, 2018, the rise in the T.Bond rate translated into a price drop of 2.43%, effectively wiping out the coupon you would have earned and resulting in a return for the year of -0.02%. The consolation price is that you would have still done better than investing in US stocks over the year and generating a return of -4.23%. Updating the historical numbers for the United States, here is the updated score on what US stocks have earned, relative to T.Bonds and T.Bills over time:

Download historical annual returns

There is no denying that historically stocks have delivered higher returns that treasuries, but as we saw in the last quarter this year, it is compensation for the risk that you face. 

The Yield Curve Flattens

The big story over the course of the year was the flattening of the yield curve, with short term rates rising over the course of the year; the 3-month T.Bill rate rose from 1.44% on January 1, 2018 to 2.45%on December 31, 2018 and the 2-year US treasury bond rate rose from 1.92% on January 1, 2018 to 2.42% on December 31, 2018. The yield curve flattening is shown in the graph below:

By December, a portion of the yield curve inverted, with 5-year rates dropping below 2-year and 3-year rates, leading to a flood of stories about inverted yield curves predicting recessions. I did post on this question a few weeks ago, and while I will not rehash my arguments, I noted that the slope of the yield curve and economic growth are only loosely connected.

The TIPs Rate and Inflation

Finally, I  looked at the rate on the inflation protected 10-year US treasury bond over the course of the year, in relation to the US 10-year bond. 

Note that the difference between these 10-year T.Bond rate and the 10-year TIPs rate is a market measure of expected inflation over the next ten years. Over the course of 2018, the "expected inflation" rate has stayed within a fairly tight bound, ranging from a low of 1.70% to a high of 2.18%. In fact, if the return on inflation was on investor minds, the memo seems to have not reached this part of the bond market, with expected inflation decreasing over the course of the year.

What now?

At the start of last year, when investors were expecting much stronger growth in the economy and had just seen a drop in corporate tax rates, the debate was about how much the US treasury bond rate would climb over the course of 2018. As we saw in the section above, the 10-year US treasury bond rate did rise, but only moderately so, perhaps because there was a dampening of optimism about future growth in the last quarter. That said, the Federal Reserve and its chair, Jerome Powell, are still the focus of attention for some investors, obsessed with what the central bank will or will not do next year.  

Intrinsic Riskfree Rates

As some of you have read this blog know well, I am skeptical about how much power the Fed has to move interest rates, especially at the long end of the spectrum, and the economy. To get perspective on the level and direction of long term interest rates, I find it more useful to construct what I call an intrinsic risk free rate by adding together the inflation rate and real GDP growth rate each year. The figure below provides the long term comparison of the actual treasury bond rate and the intrinsic version of it:

Download raw data

There are two versions of the intrinsic risk free rate that I report, one using just the current year;'s inflation and real growth and one using a ten-year average of inflation and real GDP growth, which I will termed the smoothed intrinsic risk free rate. This graph explains the main reasons why interest rates dropped after 2008, very low inflation and anemic growth. As growth and inflation have picked up in the last two years, the treasury bond rate has stayed stubbornly low, and for those who blame the Fed for almost everything that happens, this was a period during which the Fed was raising the Fed Funds rate, the only interest rate it directly controls, and scaling back on quantitative easing. At the end of 2018, the treasury bond rate (2.68%) lagged the contemporaneous intrinsic risk free rate (5.54%) by 2.86% and the smoothed rate (3.58%) by 0.90%.

Reading the Tea Leaves

What does this all mean? I am no bond market soothsayer, but I see two possible explanations. One is that the bond market is right and that expected growth in the next few years will drop dramatically. The other is that bond market investors are being much too pessimistic about future growth, and that rates will rise as the realization hits them.  I believe that the truth falls in the middle. Nominal growth in the US economy will drop off from its 2018 levels, but not to the levels imputed by the bond market today, and treasury bond rates will rise to reflect that reality. In the absence of a crystal ball, I will hazard a guess that the US 10-year treasury bond rate will rise to 3.5%, the smoothed out intrinsic rate, by the end of the year, and that GDP growth will drop by a percent (in nominal and real terms) from 2018 levels. As with all my macroeconomics predictions, this comes with a  money back guarantee, which explains why I do this for free.

The US Corporate Bond Market

If the government bond rate offers signals about future inflation and expected growth in the economy, the corporate bond market sends its own messages about the economy, and specifically about risk and its price. In particular, the spread between a US $ corporate bond and the US Treasury bond of equivalent maturity is the price of risk in the bond market. To see how this measure moved over the course of the year, I looked at the yields on a Aaa. Baa and Can 10-year corporate bonds (Moody's) relative to the US 10-year treasury  bond over the course of the year:

As with the equity risk premium, default spreads widened over the course of the year for all bond ratings classes, but more so for the lower ratings. Also, similar to the pattern in equity markets, all of the widening in the equity risk premium happened in the last quarter of 2018. In fact, the intraday volatility of default spreads increased in October, mirroring what was happening in the equity market. In a later update, I will be looking at country risk, using sovereign default spreads as one measure of that risk. These default spreads also widened in 2018, setting the stage for higher country risk premiums. All in all, 2018 saw the price of risk go up in both the equity and debt markets, and not surprisingly, companies will see higher costs of capital as a consequence.

Bottom Line

For the most part, the bond and stock markets were singing from the same song book this year. Both markets started the year, expecting continued strength in the economy, but both became less upbeat about economic prospects towards the end of the year. For stock markets, this translated into expectations of lower earnings growth and stock prices, and for bond markets, its showed up as lower treasury bond rates and higher default spreads. Investors in both markets became more wary about risk and demanded higher prices for taking risk, with higher equity risk premiums in the stock market and higher default spreads in the bond market. 

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Datasets

1. Historical Returns on Stocks, T. Bonds and T.Bills - 1928 to 2018
2. T. Bond Rates, Inflation and Real Growth - 1953 to 2018
3. Corporate Bond Default Spreads - Start of 2019

January 2019 Data Updates

1. Data Update 1: A Reminder that equities are risky, in case you forgot!
2. Data Update 2: The Message from Bond Markets
3. Data Update 3: Playing the Numbers Game
4. Data Update 4: The Many Faces of Risk
5. Data Update 5: Of Hurdle Rates and Funding Costs!
6. Data Update 6: Profitability and Value Creation!
7. Data Update 7: Debt, neither poison nor nectar!
8. Data Update 8: Dividends and Buybacks - Fact and Fiction!
9. Data Update 9: Playing the Pricing Game!

January 2019 Data Update 1: A reminder that equities are risky, in case you forgot!

In bull markets, investors, both professional and amateur, often pay lip service to the notion of risk, but blithely ignore its relevance in both asset allocation and stock selection, convinced that every dip in stock prices is a buying opportunity, and soothed by bromides that stocks always win in the long term. It is therefore healthy, albeit painful, to be reminded that the risk in stocks is real, and that there is a reason why investors earn a premium for investing in equities, as opposed to safer investments, and that is the message that markets around the world delivered in the last quarter of 2018.

A Look Back at 2018

The stock market started 2018 on a roll, having posted nine consecutive up years, making the crisis of 2008 seem like a distant memory. True to form, stocks rose in January, led by the FAANG (Facebook, Amazon, Apple, Netflix and Google) stocks and momentum investors celebrated. The first wake up call of the year came in February, first as the market responded negatively to macroeconomic reports of higher inflation, and then as Facebook and Google stumbled from self-inflicted wounds. 

The market shook off its tech blues by the end of March and continued to rise through the summer, with the S&P 500 peaking for the year at 2931 on September 20, 2018.   For the many investors who were already counting their winnings for the year, the last quarter of 2018 was a shock, as volatility returned to the market with a vengeance. In October, the S&P 500 dropped by 6.94%, though it felt far worse because of the day-to-day and intraday price swings. In November, the S&P 500 was flat, but volatility continued unabated. In December, US equities finally succumbed to selling pressures, as a sharp selloff pushed stocks close to the "bear market" threshold, before recovering a little towards the end of the year.  

Over the course of the year, every major US equity index took a hit, but the variation across the indices was modest.

The ranking of returns, with the S&P 600 and the NASDAQ doing worse than the Dow or the SD&P 500 is what you would expect in any down market. With dividends incorporated, the return on the S&P 500 was -4.23%, the first down market in a decade, but only a modestly bad year by historical standards:

I know that this is small consolation, if you lost money last year, but looking at annual returns on stocks in the last 90 years, there have been twenty years with more negative returns. In short, it was a bad year for stocks, but it felt far worse for three reasons. First, after nine good years for the market, investors were lulled into a false sense of complacency about the capacity of stocks to keep delivering positive returns. Second,  the negative returns were all in the last quarter of the year, making the hit seem larger (from the highs of September 2018) and more immediate. Third,  the intraday and day-to-day volatility exacerbated the fear factor, and those investors who reacted by trading faced far larger losses.

The Equity Risk Premium

If you have been a reader of this blog, you know that my favorite device for disentangling the mysteries of the market is the implied equity risk premium, an estimate of the price that investors are demanding for the risk of investing in equities. I back this number out from the current market prices and expected future cash flows, an IRR for equities that is analogous to the yield to maturity on a bond:

As with any measure of the market, it requires estimates for the future (expected cash flows and growth rates), but it is not only forward looking and dynamic (changing as the market moves), but also surprisingly robust and comprehensive in its coverage of fundamentals. 

At the start of 2018, I estimated the equity risk premium, using the index at that point in time (2673.61), the 10-year treasury bond rate on that day (2.41%) and the growth rate that analysts were projecting for earnings for the index (7.05%). 

The equity risk premium on January 1, 2018 was 5.08%. As we moved through the year, I computed the equity risk premium at the start of each month, adjusting cash flows on a quarterly basis (which is about as frequently as S&P does it) and using the index level and ten-year T.Bond rate at the start of each month:

While the conventional wisdom about equity risk premiums is the they do not change much on a day to day basis in developed markets, that has not been true since 2008. In 2018, there were two periods, the first week of February and the month of October, where volatility peaked on an intraday basis, and I computed the ERP by day, during the first week of February, and all through October:

During October, for instance, the equity risk premium moved from 5.38% at the start of the month to 5.76% by the end of the month, with wide swings during the course of the month.

After a brutal December, where stocks dropped more than 9% partly on the recognition that global economic growth may slacken faster than expected, I recomputed the equity risk premium at the start of 2019:

The equity risk premium has increased to 5.96%, but a closer look at the differences between the inputs at the start and end of the year indicates how investor perspectives have shifted over the course of the year:

Going into 2019, investors are clearly less upbeat than they were in 2018 about future growth and more worried about future crises, but companies are continuing to return cash at a pace that exceeds expectations.

What now?

I know that you are looking for a bottom line here on whether the numbers are aligned for a good or a bad year for stocks, and I will disappoint you up front by admitting that I am a terrible market timer. As an intrinsic value investor, the only market-related question that I ask is whether I find the current price of risk (the implied ERP) to be an acceptable one; if it is too low for my tastes, I would shift away from stocks, and if it is too high, shift more into them. To gain perspective, I graphed the implied ERP from 1960 through 2018 below:

At its current level of 5.96%, the equity risk premium is in the top decile of historical numbers, exceeded only by the equity risk premiums in three other years, 1979, 2009 and 2011. Viewed purely on that basis, the equity market is more under valued than over valued right now.

I am fully aware of the dangers that lurk and how they could quickly change my assessment and they can show up in one or more of the inputs:

1. Recession and lower growth: While there was almost no talk about a possible recession either globally or in the US, at the start of 2018, some analysts, albeit a minority, are raising the possibility that the economy would slow down enough to push it into recession, at the start of 2019. While the lower earnings growth used in the 2019 computation already incorporates some of this worry, a recession would make even the lower number optimistic. In the table below, I have estimated the effect on the equity risk premium of lower growth, and  note that even with a compounded growth rate of -3% a year for the next five years, the ERP stays above the historical average of 4.19%.
   
2. Higher interest rates: The fear of the Fed has roiled markets for much of the last decade, and while it has played out as higher short term interest rates for the last two years, the ten-year bond rate, after a surge over 3% in 2018, is now back to 2.68%. There is the possibility that higher inflation and economic growth rate can push this number higher, but it is difficult to see how this would happen if recession fears pan out. In fact, as I noted in this post from earlier in the year, higher interest rates, if the trigger is higher real growth (and not higher inflation), could be a positive for stocks, not a negative.
3. Pullback on cash flows: US companies have been returning huge amounts of cash in the form of stock buybacks and dividends. In 2018, for instance, dividends and buybacks amounted to 92% of aggregate earnings, higher than the 84.60% paid out, on average, between 2009 and 2018, but still lower than the numbers in excess of 100% posted in 2015 and 2016. Assuming that the payout will adjust over time to 85.07%, reflecting expected long term growth, lowers the ERP to 5.55%, still well above historical levels.
4. Political and Economic Crises: The trade war and the Brexit mess will play out this year and each has the potential to scare markets enough to justify the higher ERP that we are observing. In addition, it goes without saying that there will be at least a crisis or two that are not on the radar right now that will hit markets, an unwanted side effect of globalization. 

Looking at how the equity risk premium will be affected by each of these variables, I think that the market has priced in already for shocks on at least two of these variables, in the form of lower growth and political/economic crises, and can withstand fairly significant bad news on the other two. 

Bottom Line

I have long argued that it is better to be transparently wrong than opaquely right, when making investment forecasts. In keeping with my own advice, I believe that stocks are more likely to go up in 2019, than down, given the information that I have now. That said, if I am wrong, it will be because I have under estimated how much economic growth will slow in the coming year and the magnitude of economic crises. Odds are that I will see the tell tale signs too late to protect myself fully against any resulting market corrections, but that is not my game anyway. 

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Datasets

1. Historical Returns on Stocks, Bonds and Bills - 1928 to 2018
2. Historical Implied Equity Risk Premiums for US - 1960 to 2018

Spreadsheets

1. Implied ERP for January 1, 2019

January 2019 Data Updates

1. Data Update 1: A Reminder that equities are risky, in case you forgot!
2. Data Update 2: The Message from Bond Markets
3. Data Update 3: Playing the Numbers Game
4. Data Update 4: The Many Faces of Risk
5. Data Update 5: Of Hurdle Rates and Funding Costs!
6. Data Update 6: Profitability and Value Creation!
7. Data Update 7: Debt, neither poison nor nectar!
8. Data Update 8: Dividends and Buybacks - Fact and Fiction!
9. Data Update 9: Playing the Pricing Game!

Is there a signal in the noise? Yield Curves, Economic Growth and Stock Prices!

The title of this post is not original and draws from Nate Silver's book on why so many predictions in politics, sports and economics fail. It reflects the skepticism with which I view many 'can't fail" predictors of economic growth or stock markets, since they tend to have horrendous track records. Over the last few weeks, as markets have gyrated, market commentators have been hard pressed to explain day-to-day swings, but that has not stopped them from trying. The explanations have shifted and morphed, often in contradictory ways, but few of them have had staying power. On Tuesday (December 4), as the Dow dropped 800 points, following a 300-point up day on Monday, the experts found a new reason for the market drop, in the yield curve, with an "inverted yield curve", or at least a portion of one, predicting an imminent recession. As with all market rules of thumb, there is some basis for the rule, but there are shades of gray that can be seen only by looking at all of the data.

Yield Curves over time

The yield curve is a simple device, plotting yields across bonds with different maturities for a given issuing entity. US treasuries, historically viewed as close to default free, provide the cleanest measure of the yield curve,  and the graph below compares the US treasury yield curve at the start of every year from 2009 to 2018, i.e., the post-crisis years:

Treasury.gov: Daily Treasury yield curve

The yield curve has been upward sloping, with yields on longer term maturities higher than yields on short term maturities, every year, but it has flattened out the last two years. On December 4, 2018, the yields on treasuries of different maturities were as follows:

Treasury.gov: Daily Treasury yield curve

The market freak out is in the highlighted portion, with 5-year rates being lower (by 0.01-0.02%) than 2-year or 3-year rates, creating an inverted portion of the yield curve. 

Yield Curves and Economic Growth: Intuition

To understand yield curves, let's start with a simple economic proposition. Embedded in every treasury rate are expectations of expected inflation and expected real real interest rates, and the latter

Interest Rate = Expected Inflation Rate + Expected Real Interest Rate

Over much of the last century, the US treasury yield curve has been upward sloping, and the standard economic rationalization for it is a simple one. In a market where expectations of inflation are similar for the short term and the long term, investors will demand a "maturity premium" (or a higher real interest rate) for buying longer term bonds, thus causing the upward tilt in the yield curve.  That said, there have been periods where the yield curve slopes downwards, and to understand why this may have a link with future economic growth, let's focus on the mechanics of yield curve inversions. Almost every single yield curve inversion historically, in the US,  has come from the short end of the curve rising significantly, not a big drop in long term rates. Digging deeper, in almost every single instance of this occurring, short term rates have risen because central banks have hit the brakes on money, either in response to higher inflation or an overheated economy. You can see this in the chart below, where the Fed Funds rate (the Fed's primary mechanism for signaling tight or loose money) is graphed with the 3 month, 2 year and 10 year rates:

Interest Rate Raw Data

As you can see in this graph, the rises in short term rates that give rise to each of the inverted yield curve episodes are accompanied by increases in the Fed Funds rate. To the extent that the Fed's monetary policy action (of raising the Fed funds rate) accomplishes its objective of slowing down growth, the yield slope metric becomes a stand-in for the Fed effect on the economy, with a more positive slope associated with easier monetary policy. You may or may not find any of these hypotheses to be convincing, but the proof is in the pudding, and the graph below, excerpted from a recent Fed study, seems to indicate that there has been a Fed effect in the US economy, and that the slope of the yield curve has operated as proxy for that effect:

Federal Reserve of San Francisco

The track record of the inverted yield curve as a predictor of recessions is impressive, since it has preceded the last eight recessions, with only only one false signal in the mid-sixties. If this graph holds, and December 4 was the opening salvo in a full fledged yield curve invasion, the US economy is headed into rough waters in the next year.

Yield Curves and Economic Growth: The Data

The fact that every inversion in the last few decades has been followed by a recession will strike fear into the hearts of investors, but is it that fool proof a predictor? Perhaps, but given that the yield curve slope metrics and economic growth are continuous, not discrete, variables, a more complete assessment of the yield curve's predictive power for the economy would require that we look at the strength of the link between the slope of the yield curve (and not just whether it is inverted or not) and the level of economic growth (and not just whether it is positive or negative).

To begin this assessment, I looked at the rates on  three-month and one-year T.Bills and the two, five and ten-year treasury bonds at the end of every quarter from 1962 through the third quarter of 2018:

Interest Rate Raw Data

Following up, I look at five yield curve metrics (1 year versus 3 month, 2 year versus 3 month, 5 year versus 2 year, 10 year versus 2 year and 10 year versus 3 month), on a quarterly basis from 1962 through 2018, with an updated number for December 4, 2018. 

Interest Rate Raw Data

For the most part, the yield curve metrics move together, albeit at different rates. I picked four measures of the spread, one short term (1 year versus 3 month), one medium term (5 year versus 2 year) and two long term (10 year versus 2 year, 10 year versus 3 month) and plotted them against GDP growth in the next quarter and the year after. 

Interest Rate Raw Data

The graph does back up what the earlier Fed study showed, i.e., that negatively sloped yield curves have preceded recessions, but even a cursory glance indicates that the relationship is weak. Not only does there seem to be no relationship between how downwardly sloped the yield curve is and the depth of the recessions that follow, but in periods where the yield curve is flat or mildly positive, subsequent economic growth is unpredictable. To get a little more precision into the analysis, I computed the correlations between the different yield curve slope metrics and GDP growth:

Taking a closer look at the data, here is what I see;

1. It is the short end that has predictive power for the economy: Over the entire time period (1962-2018), the slope of the short end of the yield curve is positively related with economic growth, with more upward sloping yield curves connected to higher economic growth in subsequent time periods. The slope at the long end of the yield curve, including the widely used differential between the 10-year and 2-year rate not only is close to uncorrelated with economic growth (the correlation is very mildly negative).
2. Even that predictive power is muted: Over the entire time period, even for the most strongly linked metric (which is the 2 year versus 1 year), the correlation is only 29%, for GDP growth over the next year, suggesting that there is significant noise in the prediction. 
3. And 2008 may have been a structural break: Looking only at the last ten years, the relationship seems to have reversed sign, with flatter yield curves, even at the short end, associated with higher real growth. This may be a hangover from the slow economic growth in the years after the crisis, but it does raise red flags about using this indicator today.

How do you reconcile these findings with both the conventional wisdom that inverted yield curves are negative indicators of future growth and the empirical evidence that almost every inversion is followed by a recession? It is possible that it is the moment of inversion that is significant, perhaps as a sign of the Fed's conviction, and that while the slope of the yield curve itself may not be predictive, that moment that the yield curve inverts remains a strong indicator. 

Yield Curves and Stock Returns

As investors, your focus is often less on the economy, and more on stock prices. After all, strong economies don't always deliver superior stock returns, and weak ones can often be accompanied by strong market performance. From that perspective, the question becomes what the slope of the yield curve and inverted yield curves tell you about future stock returns,  not economic growth. I begin the analysis by looking at yield curve metrics over time, graphed against return on US stocks in the next quarter and the next year:

Interest Rate Raw Data

If you see a pattern here, you are a much better chart reader than I am. I therefore followed up the analysis by replicating the correlation table that I reported in the economic growth section, but looking at stock returns in subsequent periods, rather than real GDP growth:

As with the economic growth numbers, if there is any predictive power in the yield curve slope, it is at the short end of the curve and not the long end. And as with the growth numbers, the post-2008 time period is a clear break from the overall numbers.

What does all of this mean for investors today? I think that we may be making two mistakes. One is to take a blip on a day (the inversion in the 2 and 5 year bonds on December 4) and read too much into it, as we are apt to do when we are confused or scared. It is true that a portion of the yield curve inverted, but if history is any guide, its predictive power for the economy is weak and for the market, even weaker. The other is that we are taking rules of thumb developed in the US in the last century and assuming that they still work in a  vastly different economic environment. 

Bottom Line

There is information in the slope of the US treasury yield curve, but I think that we need to use it with caution. In my view, the flattening of the yield curve in the last two years has been more good news than bad, an indication that we are coming out of the low growth mindset of the post-2008 crisis years. However, I also think that the stalling of the US 10-year treasury bond rate at 3% or less is sobering, a warning that investors are scaling back growth expectations for both the global and US economies, going into 2019. The key tests for stocks lie in whether they can not only sustain earnings growth, in the face of slower economic growth and without the tailwind of a tax cut (like they did last year), but also in whether they can continue to return cash at the rates that they have for the last few years.

YouTube Video


Data

1. Raw data on US treasury rates, GDP growth and Stock Returns

Investing Whiplash: Looking for Closure with Apple and Amazon!

In September, I took a look, in a series of posts, at two companies that had crested the trillion dollar market cap mark, Apple and Amazon, and concluded that series with a post where I argued that both companies were over valued. I also mentioned that I was selling short on both stocks, Amazon for the first time in 22 years of tracking the company, and Apple at a limit price of $230. Two months later, both stocks have taken serious hits in the market, down almost 25% apiece, and one of my short sales has been covered and the other is still looking profitable. It is always nice to have happy endings to my investment stories, but rather than use this as vindication of my valuation or timing skills, I will argue that I just got lucky in terms of timing. That said, given how much these stocks have dropped over the last two months, it is an opportunity to not just revisit my valuations and investment judgments, but also to draw some general lessons about intrinsic valuation and pricing.

My September Valuations: A Look Back

In September, I valued Apple and Amazon and arrived at a value per share of roughly $200 for Apple and $1255 for Amazon, well below their prevailing stock prices of $220 (Apple) and $1950 (Amazon). I was also open about the fact that my valuations reflected my stories for the companies, and that my assumptions were open for debate. In fact, I estimated value distributions for both companies and noted that not only did I face more uncertainty in my Amazon valuation, but also that there was a significant probability in both companies that my assessment (that the stocks were over valued) was wrong. I summarized my results in a table that I reproduce below:

Apple Valuation & Amazon Valuation in September 2018

I did follow through on my judgments, albeit with some trepidation, selling short on Amazon at the prevailing market price (about $1950) and putting in a limit short sell at $230, which was fulfilled on October 3, as the stock opened above $230. With both stocks, I also put in open orders to cover my short sales at the 60th percentile of my value distributions, i.e., $205 at Apple and $1412 at Amazon, not expecting either to happen in the near term. (Why 60%? Read on...) Over the years, I have learned that investment stories and theses, no matter how well thought out and reasoned, don't always have happy endings, but this one did, and at a speed which I did not expect:

My Apple short sale which was initiated on October 3 was closed out on November 5 at $205, while Amazon got tantalizingly close to my trigger price for covering of $1412 (with a low of $1420 on November 20), before rebounding. 

Intrinsic Value Lessons

Every investment, whether it is a winner or a loser, carries investment lessons, and here are mine from my AAPL/AMZN experiences, at least so far:

1. Auto pilot rules to fight behavioral minefields: If you are wondering why I put in limit orders on both my Apple short sale and my covering trades on both stocks, it is because I know my weaknesses and left to my own biases, the havoc that they can wreak on my investment actions. I have never hidden the fact that I love Apple as a company and I was worried that if I did not put in my limit short sell order at $230, and the stock rose to that level, I would find a way to justify not doing it. For the limit buys to cover my short sales, I used the 60th percentile of the value distribution, because my trigger for buying a stock is that it be at least at the 40th percentile of its value distribution and to be consistent, my trigger for selling is set at the 60th percentile. It is my version of margin of safety, with the caveat being that for stocks like Amazon, where uncertainty abounds, this rule can translate into a much bigger percentage price difference than for a stock like Apple, where there is less uncertainty. (The price difference between the 60th and 90th percentile for Apple was just over 10%, whereas the price difference between those same percentiles was 35% for Amazon, in September 2018.)
2. Intrinsic value changes over time: Among some value investors, there is a misplaced belief that intrinsic value is a timeless constant, and that it is the market that is subject to wild swings, driven by changes in mood and momentum. That is not true, since not only do the determinants of value (cash flows, growth and risk) change over time, but so does the price of risk (default spreads, equity risk premiums) in the market. The former occurs every time a company has a financial disclosure, which is one reason that I revalue companies just after earnings reports, or a major news story (acquisition, divestiture, new CEO),  and the latter is driven by macro forces. That sounds abstract, but I can use Apple and Amazon to illustrate my point. Since my September valuations for both companies occurred after their most recent earnings reports, there have been no new financial disclosures from either company. There have been a few news stories and we can argue about their consequentiality for future cash flows and growth, but the big change has been in the market. Since September 21, the date of my valuation, equity markets have been in turmoil, with the S&P 500 dropping about 5.5% (through November 30) and the US 10-year treasury bond rate have dropped slightly from 3.07%  to 3.01%, over the same period. If you are wondering why this should affect terminal value, it is worth remembering that the price of risk (risk premium) is set by the market, and the mechanism it has for adjusting this price is the level of stock prices, with a higher equity risk premium leading to lower stock prices. In my post at the end of a turbulent October, I traced the change in equity risk premiums, by day, through October and noted that equity risk premiums at the end of the month were up about 0.38% from the start of the month and almost 0.72% higher than they were at the start of September 2018. In contrast, November saw less change in the ERP, with the ERP adjusting to 5.68% at the end of the month.
   
   Plugging in the higher equity risk premium and the slightly lower risk free rate into my Apple valuation, leaving the rest of my inputs unchanged, yields a value of $197 for the company, about 1.5% less than my $200 estimate on September 21. With Amazon, the effect is slightly larger, with the value per share dropping from $1255 per share to $1212, about 3.5%. Those changes may seem trivial but if the market correction had been larger and the treasury rate had changed more, the value effect would have been larger.
3. But price changes even more: If the fact that value changes over time, even in the absence of company-specific information, makes you uncomfortable, keep in mind that the market price usually changes even more. In the case of Apple and Amazon, this is illustrated in the graph below, where I compare value to price on September 21 and November 30 for both companies:
   
   In just over two months, Apple's value has declined from $201 to $196, but the stock price has dropped from $220 to $179, shifting it from being overvalued by 9.54% to undervalued by 9.14%. Amazon has become less over valued over time, with the percentage over valuation dropping from  55.38% to 39.44%. I have watched Apple's value dance with its price for  much of this decade and the graph below provides the highlights:
   
   From my perspective, the story for Apple has remained largely the same for the last eight years, a slow-growth, cash machine that gets the bulk of its profits from one product: the iPhone. However, at regular intervals, usually around a new iPhone model, the market becomes either giddily optimistic about it becoming a growth company (and pushes up the price) or overly pessimistic about the end of the iPhone cash franchise (and pushes the price down too much). In the face of this market  bipolarity, this is my fourth round of holding Apple in the last seven years, and I have a feeling that it will not be the last one.
4. Act with no regrets:  I did cover my short sale, by buying back Apple at $205, but the stock continued to slide, dropping below $175 early last week. I almost covered my Amazon position at $1412, but since the price dropped only as low as $1420, my limit buy was not triggered, and the stock price is back up to almost $1700. Am I regretful that I closed too early with Apple and did not close out early enough with Amazon? I am not, because if there is one thing I have learned in my years as an investor, it is that you have stay true to your investment philosophy, even if it means that you leave profits on the table sometimes, and lose money at other times. I have faith in value, and that faith requires me to act consistently. I will continue to value Amazon at regular intervals, and it is entirely possible that I missed my moment to sell, but if so, it is a price that I am willing to pay.
5. And flexible time horizons: A contrast that is often drawn between investors and traders is that to be an investor, you need to have a long time horizon, whereas traders operate with windows measured in months, weeks, days or even hours. In fact, one widely quoted precept in value investing is that you should buy good companies and hold them forever. Buy and hold is not a bad strategy, since it minimizes transactions costs, taxes and impulsive actions, but I hope that my Apple analysis leads you to at least question its wisdom. My short sale on Apple was predicated on value, but it lasted only a month and four days, before being unwound. In fact, early last week, I bought Apple at $175, because I believe that it under valued today, giving me a serious case of investing whiplash. I am willing to wait a long time for Apple's price to adjust to value, but I am not required to do so. If the price adjusts quickly to value and then moves upwards, I have to be willing to sell, even if that is only a few weeks from today. In my version of value investing, investors have to be ready to hold for long periods, but also be willing to close out positions sooner, either because their theses have been vindicated (by the market price moving towards value) or because their theses have broken down (in which case they need to revisit their valuations).

Bottom Line

As investors, we are often quick to claim credit for our successes and equally quick to blame others for our failures, and I am no exception. While I am sorely tempted to view what has happened at Apple and Amazon as vindication of my value judgments, I know better. I got lucky in terms of timing, catching a market correction and one targeted at tech stocks, and I am inclined to believe that  is the main reason why my Apple and Amazon positions have made me money in the last two months. With Amazon, in particular, there is little that has happened in the last two months that would represent the catalysts that I saw in my initial analysis, since it was government actions and regulatory pushback that I saw as the likely triggers for a correction. With Apple, I do have a longer history and a better basis for believing that this is market bipolarity at play, with the stock price over shooting its value, after good news, and over correcting after bad news, but nothing that has happened  to the company in the last two month would explain the correction. Needless to say, I will bank my profits, even if they are entirely fortuitous, but I will not delude myself into chalking this up to my investing skills. It is better to be lucky than good!

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Blog Posts

1. Apple and Amazon at a Trillion $: A Follow-up on Uncertainty and Catalysts (September 2018)
2. An October Surprise: Making Sense of Market Mayhem (October 2018)

The GE End Game: Bataan Death March or Turnaround Play?

It seems like ancient history, but it was just 2001, when GE was the most valuable company in the world, commanding a market capitalization in excess of $500 billion. The quintessential conglomerate, with a presence in almost every part of the global economy, it seemed to have been built to withstand economic shocks and was the choice for conservative investors, scared of the short life cycles and the volatile fortunes of its tech challengers. Unlike other aging companies like Sears that have decayed gradually over decades, GE's fall from grace has been precipitous , with the rate of decline accelerating the in the last two years. As a new CEO is brought in, with hopes that he will be a savior, it is the right time to both look back and look forward at one of the globe's most iconic companies.

GE: A Compressed History

GE's roots can be traced back to Thomas Edison and his invention of the light bulb. The company that Edison founded in 1878, Edison General Electric, was combined with two other electric companies to create General Electric in 1892. The company established its first industrial lab in 1900 and it would not be an exaggeration to say that it revolutionized not just the American home, with its appliances, but changed the way Americans live. For much of of the twentieth century, though, GE remained an appliance company, though it made forays into other businesses. It was in 1980, when Jack Welch became the CEO of the company, that the company started its march towards what it has become today.

The Market History

The first place to start, when looking at GE, is to see how markets have viewed it, over its life. Skipping over the first half of GE's life, the graph below looks at the growth (and recent decline) of GE's market capitalization over time:

As you can see, GE was a solid but unspectacular investment from 1950 to 1980, and exploded in value in the 1980s and 1990s, with Jack Welch at its helm, and reached its most valuable company in the world status in 2001. Under Jeff Immelt, his successor, the stock continued to do well, but it dropped with the rest of the market as the dot com bubble burst, but then recovered leaving into the 2008 crisis. That crisis was devastating for the company and while it did recover somewhat in the years after, the bottom has clearly dropped out in the last two years, with Jeff Flannery at the top of the company.

The Operating History

To get operating perspective on how the company has evolved over time, we looked at how GE"s key operating metrics (revenues, EBITDA, net income) have evolved since 1950:

In keeping with our earlier market cap assessment, between 1950 and 1970, GE was a good but not exceptional company, delivering solid revenue growth and decent margins. Under two CEOS, Reginald Jones in the 1970s and Jack Welch in the two decades thereafter, the company transformed itself. Jones helped the company navigate through the turbulent period of high inflation and oil prices, holding margins steady and delivering double digit revenue growth. Welch made himself the stuff of legend, by doubling margins and pushing the company to the top of the market cap ranks by the time he left the firm. His successor Jeff Immelt faced the unenviable task of following Welch, but managed to keep revenues growing and delivered high margins until 2008, when the bottom fell out for the company. 

The Business Mix Shift

To understand GE's current plight, we have to go back to Welch's tenure as CEO, when he remade the firm, by moving it away from its domestic and manufacturing roots and giving it a global and multi-business focus. GE's biggest leap during that period was into the financial services business, and one reason Welch was attracted to the financial services business was its capacity to generate high profits with relatively little investment. By the late 1990s, GE Capital was the engine driving GE's growth, accounting for almost 48% of revenues in 1998 and as you can see in the graph below, it continued to do so for much of the first decade of Immelt's stewardship:

In 2008, when the crisis hit financial service firms had, GE was significantly exposed, and in the years since, GE has retreated not just from the financial services business but also from its entertainment bets (with the sale of NBC to Comcast) and from the appliance business (now owned by Haier). GE's current business mix, broken down into more detail, is shown in the pie chart below:

GE Annual Report for 2017 (Invested Capital, allocated based upon assets by business)

Today, GE is in three businesses (aviation, healthcare and transportation) that have low growth and high profitability (margins and returns on capital), in three energy-related businesses (power, renewable energy and oil) with higher growth but low profitability (margins & returns on capital), one business (lighting) that is fading quickly and one (capital) that is declining, but dragging value down with it. Note also that the collective profits reported across businesses is  before corporate expenses and eliminations of $3.83 billion (not counting a one-time restructuring charge of $4.1 billion) that effectively wipe out about half of the operating profits. When computing return on capital, I allocated these expenses to the businesses, based upon revenues, and used a 25% effective tax rate, and while GE as a whole did not deliver a return that meets its cost of capital requirements in 2017, aviation, healthcare and transportation clear their hurdle rates by plenty. Replacing 2017 income in each business with a normalized value (computed using the average margins in each business between 2013 and 2017) improves the return on capital at the power and renewable energy businesses, but the overall conclusion remains the same. GE, as a company, does not look good, but it does have significant value creating businesses.

Corporate Life Cycle
While there are different ways of framing GE's current standing, I will use the corporate life cycle, since it encapsulates the challenges facing the company.

GE's light bulb moment might have been in Thomas Edison's lab in 1878, but at an official corporate age of 126 years, GE is an ancient company and its problems reflect its age. Other than renewable energy, all of GE's businesses are mature or declining, and by the laws of mathematics, GE itself is a mature to declining company.  Any story that you tell about GE going forward has to reflect this reality, and there are three possible ones that can lead to different values.

1. Break it up: If GE at its peak represented the glory of conglomerates, its current plight is a sign of how far conglomerates have fallen in the world. Across the world, multi business companies are finding themselves under pressure to break up and in many cases, their stockholders will be better off if they do. To gain from a break up, though, here are some of the things that have to be true. 

• Separable businesses: The different businesses have to be separable, since leakages and synergies across businesses can make it more difficult to cleave off pieces to sell or spin off. On this count, GE is probably on safe ground, since its businesses (other than GE Capital) are self standing, for the most part, with little in terms of cross business effects. 
• Willing buyers: There have to be potential buyers who are willing to pay prices for the pieces that exceed what they will generate as value for the holding company, as going concerns, and those higher prices either have to come from potential synergies or changed management. None of GE's businesses seem alluring enough to attract multiple bidders, willing to pay premium prices, and given GE's shaky bargaining position, it is more likely than not that a rush to unload businesses will do more harm than good. 
• Corporate Waste (at HQ):  A large chunk of the corporate overhead has to viewed as wasteful, with a big drop in corporate expenses accompanying the breakup. How much of the corporate expense of $3.8 billion that GE reported in 2017 is wasteful and could be eliminated with targeted cost cuts? Looking at the breakdown of these expenses, just about $2.2 billion in for covering pension obligations and breaking up the company will not relieve the company of its contractual obligations. Some of the remaining $1.6 billion may be fat that can be cut, but even cutting the entire amount (which would be a tall order) will not turn the company around.

Since GE will be trying to sell these businesses to buyers today, this is a pricing and not a valuation exercise, and I have estimate a pricing for GE's businesses below, using an EBITDA recomputed using the average operating margin in each business over the last five years to compute operating income and allocating corporate expenses to the divisions, based upon revenues. To convert the EBITDA to an estimated value, I used the EV/EBITDA multiples of the peer group:

Download spreadsheet

If GE is able to get buyers to pay industry-level multiples of EBITDA for each of these businesses, it will be able to net about $103 billion for its equity investors, higher than the market capitalization on November 14 of $72 billion. The problem, though, is that fire sales of entire companies almost never deliver the expected proceeds, as buyers, recognizing desperation, hold back. In fact, GE's attempts to extricate itself from a portion of its Baker-Hughes investment in the last few days show that these sales will occur at a discount.

2. Retrench and Reshape: The second choice for GE is to retrench and perhaps renew itself, not as a growth company, but as a stable, high margin company in businesses where it has a competitive advantage. In broad terms, the roadmap for GE to succeed in this path is a simple one,  shrinking or selling off pieces of its low-margin businesses, exiting the capital business and consolidating its presence in the aviation, healthcare and transportation businesses. To get a better sense of what the businesses would be worth, as continuing operations, I valued each of GE's business, using simplistic assumptions: I used the sector cost of capital for each business, set growth in the next five years equal to revenue growth in each of GE's businesses in the last five years and normalized operating income based upon the average operating margin that each of GE's businesses have delivered over the last five years:

Download spreadsheet

The value that I derive for equity is lower than the $103 billion that I estimated in the last section, but it does not require any near term fire sales at discounts. There are two big challenges that GE will face along the way. The first is that GE is saddled with a significant debt obligation, a legacy of GE Capital, that will not fade away quickly, and the debt obligations represent a clear and present danger to the firm.  One reason for the rapid drop in GE's stock price in the last few weeks has been the deterioration in the company's credit standing, as can be seen in the rising default spreads for the company in the CDS market.

The reason that GE is trying to sell some of its stake in Baker and Hughes to pay down debt, but bond markets are skeptical, with good reason. The second is that GE Capital is now more burden than benefit to investors. In the valuation table, note that the value that I have estimated for GE Capital's operations ($27 billion) is much lower than GE Capital debt ($51 billion); in fact, I derive very similar results in the pricing. Put differently, in my valuation, I foresee the cost of exiting GE capital to be $24 billion in today's terms, but spread out over time.  If GE can navigate its way through its debt payments to becoming a more focused company, with constrained ambitions, it could survive and reclaim its place as a holding for a conservative value investor.

3. Reincarnate (or the Bataan Death March): There is a third option that GE shareholders have to hope and pray that GE does not take, where the company tries to recapture its old glory, throwing caution to the winds and reinvesting large amounts in new businesses, or worse still, large acquisitions. While there is no indication that Larry Culp, GE's new CEO, has grandiose plans for the company, that may be because the company is in crisis today. If as the crisis passes, Culp is tempted to make himself the second coming of Jack Welch, the company will follow the path of other aging companies that refuse to act their age, spending billions on cosmetic surgery (acquisitions) before finally capitulating. If there is a role model that Mr. Culp should follow, it is less that of Steve the Visionary, and more that of Larry the Liquidator. 

General Lessons

Given its age, it should come as no surprise that GE has been the subject of more case studies than perhaps any other company in the world. In its earlier days, it was used as an example of professional management, and during Jack Welch's years, it was held up as an illustration of how aging manufacturing companies can remake themselves, with enlightened management at the top. Now that it is in trouble, I think that we look back at the last four decades and draw a different set of lessons:

1. Conglomeration was, is and always will be a bad idea: I never understood the allure of conglomerates, even in their heyday. Only a corporate strategist could argue that combining companies in different businesses under one corporate umbrella, paying hefty premiums along the way to acquire these holdings, creates value, ignoring the logic that you and I as stockholders can create our own diversified and customized portfolios, without paying the same premium. If there is a lesson to learn from GE's fall from grace, it is that even the best conglomerates are built on foundations of sand. Note, though, that while this lesson may be learned for the moment, it will be forgotten soon, as are most other business lessons are, and we will surely repeat the cycle again in the future.
2. Complexity has a cost: As I was going through GE's annual report, I was reminded again of why I have always described my vision of hell as having to value GE over and over and over again, for eternity. This company, through its actions and by design, made itself into one of the most complex companies in history, operating in dozens of businesses and across the world, with GE Capital acting as the cherry on the complexity cake, a gigantic financial service firm embedded in a large conglomerate. While that complexity served GE well in its glory days, allowing it to hide mistakes from sloppy acquisition practices and bets gone bad, it has bedeviled the company since 2008. Investors trying to navigate their way through the company's financials often give up and move on to easier prey. It may be too late for GE to do much about this problem, but as Asian companies rise in market capitalization, you are seeing new complex behemoths coming into play across the world.
3. Easy money has a catch: I know that 20/20 hindsight is both easy and unfair, but GE's experiences with GE Capital bring home an age-old business truth that when a business looks like it can make you easy money, there is always a catch. Jack Welch initial foray into and subsequent expansion of GE Capital was built on the allure that it was a lot easier to make money in financial services than in manufacturing. From the perspective of having limited capital investment and growing quickly, that was true, but financial service firms through history have always had periods of plenty interspersed with bouts of gut-wrenching and intense pain, when borrowers start defaulting and capital markets freeze up. By making GE Capital such a big part of GE, Welch bet the farm on its continued success, and that bet went sour in 2008.
4. The Savior CEO is a myth: I come to neither bury nor praise Jack Welch, but notwithstanding the fact that he has been gone almost two decades from the firm, GE remains the house that Jack built. Since Welch got the glory that came from GE's rise in the last twenty years of the last century, he deserves a portion of the blame for what has happened since. Don't get me wrong! Jack Welch was an inspirational top manager, a man with vision and drive, but he was also an imperial CEO, who made his board of directors a rubber stamp for his actions. As we look at a new generation of successful companies, this time in the technology space (the FANG stocks and the Chinese giants), with visionary founders at the top, it is worth remembering that power left unchecked in any person (no matter how smart and visionary) is dangerous.

The Bottom Line

As many of you know, I believe that every valuation has to have a story. With some companies, like Amazon and Google, the story is uplifting and optimistic, and the valuations follow, but they still might not be good investments, since their prices may be even higher. My story for GE is not an upbeat one, but if it (and its management) acts its age, accepts that slower or no growth is what lies in the future and does not over reach, it is a good investment. I believe that the market has over corrected for GE's many faults, and at the current stock price, that it is significantly under valued. I will buy GE, but I will do so with open eyes, not expecting (or wanting) dividends to be paid until the debt gets paid down and the company exits the capital business with as much grace (and as few costs) as it can muster. 

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Attachments

1. GE Pricing and Valuation in November 2018