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Equity Valuation – Part 1 Without COVID-19

Equity Valuation – Part 1 Without COVID-19

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To understand the current equity market valuation, a good place to start is to do a quick analysis of what market value looked like at the start of the year. We can then look to separate the impact of COVID on the economy and markets. At the time of writing, the S&P is heading towards 3,000.

PE ratio

A simple and decent method of equity valuation is to look at the PE ratio overtime – price of equities divided by their annual Earnings. For the S&P, it is currently just over 20, which is roughly the middle of the range of the past 5 years. Furthermore, it looks even more reasonable when compared with fixed income where bond yields are close to nothing.

Over the same period the stock market has risen strongly. In the chart below, I show that the value of the S&P has doubled in the last decade, as have quarterly earnings (S&P EPS)

Where does earnings growth come from?

The answer is of course that companies are part of the economy and as the economy grows then corporate earnings also grow. In the chart below, we see uninterrupted US GDP growth for the past 10 years and also a rising S&P based upon growing earnings.

This must all be consistent then?

This simple look at equities implies that the rapid rise in equities over the past decade has been fully justified by the fundamentals in the economy.

But I played a little trick in the charts above.
While the stock market, GDP and corporate earnings have all gone up over the past 10 years they have not gone up by the same amount.

  • Nominal GDP has risen by 50%
  • Corporate earnings have doubled
  • The US stock market has tripled

The part I want to look at more closely is the difference between GDP growth and the far more rapid growth in corporate earnings.


Any Reasons to be cautious?

It is remarkable to have such a large rise in earnings when compared to the overall economy and one would expect to see profits as a share of GDP to have risen significantly over the same period. With decent overall growth, then you might expect growth in profits to be better, and to offset this the share of the economy going to workers would be reduced. This would fit the idea that while growth has been good, more of the benefits go to the capital and capital owners and less to workers; in this recovery a lack of real wage growth is often cited as a concern in the face of rising equity prices.

When I look at the data however, it does not fit this intuition. This is a chart of corporate profits as a share of GDP over the past 60 years.

We can see it strongly mean-reverting and so the recent pattern is exactly what we would expect to see. In a recession wages are sticky and do not readily fall; it is companies that have profitability issues. We all know that companies go bust in recessions and in 2001 profits fell to 7% of GDP. In the early stages of a recovery, it is profits which rebound the fastest, wages remain subdued as there is still high unemployment so the gains from GDP growth go to businesses, and by 2014 profits as a share of GDP had nearly doubled to 12%. But later in the cycle this reverses, and profit margins are squeezed, which they have been for the past 5 years.

This does not make sense!

I have just told you two contradictory stories. One is that corporate earnings have been rising rapidly over the past few years, far faster than GDP growth. The other is that profits as a share of GDP have been falling as we would expect late in the economic cycle.

The reason I can tell you two completely different stories is that I have two different data sources. The first is the earnings (S&P EPS) as they are reported by companies. The second is profits as they are recorded in the income method GDP data – known as the NIPA data (National Income and Product Accounts).

These two ways of measuring earnings are not exactly the same. For example, the S+P is only 500 companies whereas NIPA represents the entire US corporate sector. There are also differences in accounting and tax. But logically they are highly similar, and it is no surprise that historically they track very well. Here is a chart from the late 80s until 2014 showing the rise in earnings (EPS) as measured by companies and as measured by the National Accounts. We can see that in the long run, they track pretty well but there are some periods of divergence for instance around the time of the dot com boom in the late 90s.

If I draw the more recent history, we can again see this divergence. The reported earnings have been rising rapidly (white line) while the NIPA measure of profits has been stagnating (orange line).

The relationship is easier to see if we take them as a ratio. In the chart below we see a large spike around the Dot Com bubble (EPS growing more than NIPA), a large spike down during the Great Recession (the opposite) and another large spike higher recently.

These differences are so large that they require an explanation.

  1. Dot Com spike

A bubble emerged in the late 90s with very high PE ratios i.e. companies were expensive compared to earnings. In addition, these reported earnings were inflated; a famous example you may recall was Enron who were highly “creative” with how they recorded and reported their earnings. When the bubble bursts and we move into recession then these accounting methods are not sustainable, and we see the rapid fall in reported earnings and the ratio of reported earnings to NIPA data renormalizes.

There is a danger in that earnings are presented to us by corporates in the most flattering version they can create. In a bull market, there are opportunities to keep presenting this managed version, perhaps similar to how people curate their Instagram feed. Through heavy use of filters and selective framing, someone might look as though they are very attractive with an opulent lifestyle. The recession is the equivalent of when you meet them in person and realise that the reality is not exactly what was promised.

  1. Great Recession

This rapid fall in reported earnings is easily explained as a result of huge write-downs taken by financial firms. This is a good example of an item that is recorded by companies as a change in earning, but not included in GDP data. Once the write-downs have finished, the ratio between reported earnings and NIPA profits renormalizes.

  1. Now

I have been searching for a good explanation of this divergence and am yet to find one. One plausible idea is stock buybacks, but this is not true as they are adjusted for in the earnings data. Other sources of divergence such as tax are real but do not come close to explaining the large difference.

Could the NIPA data be wrong?
This is data that will get revised, but it would take something extraordinary for GDP revisions to change corporate profits by the 40% divergence we have seen to EPS

Could it be financial accounting manipulation?
Some argue the rules are so much stricter now, so it is not possible. Surely what we learned from the last crisis is that Rating Agencies having strict rules on how to make a security AAA that enabled smart bankers to arbitrage those rules. I do not believe we could ever have rules so strict that smart bankers cannot find ways to optimise them. This does not mean that people must be lying or breaking the law. Bear in mind virtually everything that Enron did to inflate their earnings was legal.

Could it be offshoring profits?
There could be something here and it is a very murky and complex area. We know that the large tech companies have found ways to limit their onshore earnings, keeping profits in countries where they have to pay no tax but this is hardly a new phenomenon. It is something I will be looking into as an explanation.

Could it just not be a problem?
Maybe this is the first time we have ever seen a large, rapid, permanent shift in the relationship between reported earnings and NIPA data. Maybe. Most people in effect seem to be assuming this and financial markets are not at all concerned.

What if the NIPA data is right?

If the NIPA data is correct, then the PE ratio is currently far higher than 20. In the previous two cycles it was reported earnings that correct, not the NIPA data, and the timing of the correction is during a recession. As Warren Buffet said “You only find out who is swimming naked when the tide goes out”.

Summary

My view of value before COVID was that it was reasonable to belong to equity markets early in 2020. I was aware of the NIPA data divergence as an issue, but it has been an issue for a long time and it has not been a market driver. The trend towards higher earnings and higher equity prices had been very strong and I believed that it would take an event or catalyst to reverse it. If we are heading into a significant recession, then this may be the time we understand if the relationship between reported earnings and GDP profits will reconnect.

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International

Beloved mall retailer files Chapter 7 bankruptcy, will liquidate

The struggling chain has given up the fight and will close hundreds of stores around the world.

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It has been a brutal period for several popular retailers. The fallout from the covid pandemic and a challenging economic environment have pushed numerous chains into bankruptcy with Tuesday Morning, Christmas Tree Shops, and Bed Bath & Beyond all moving from Chapter 11 to Chapter 7 bankruptcy liquidation.

In all three of those cases, the companies faced clear financial pressures that led to inventory problems and vendors demanding faster, or even upfront payment. That creates a sort of inevitability.

Related: Beloved retailer finds life after bankruptcy, new famous owner

When a retailer faces financial pressure it sets off a cycle where vendors become wary of selling them items. That leads to barren shelves and no ability for the chain to sell its way out of its financial problems. 

Once that happens bankruptcy generally becomes the only option. Sometimes that means a Chapter 11 filing which gives the company a chance to negotiate with its creditors. In some cases, deals can be worked out where vendors extend longer terms or even forgive some debts, and banks offer an extension of loan terms.

In other cases, new funding can be secured which assuages vendor concerns or the company might be taken over by its vendors. Sometimes, as was the case with David's Bridal, a new owner steps in, adds new money, and makes deals with creditors in order to give the company a new lease on life.

It's rare that a retailer moves directly into Chapter 7 bankruptcy and decides to liquidate without trying to find a new source of funding.

Mall traffic has varied depending upon the type of mall.

Image source: Getty Images

The Body Shop has bad news for customers  

The Body Shop has been in a very public fight for survival. Fears began when the company closed half of its locations in the United Kingdom. That was followed by a bankruptcy-style filing in Canada and an abrupt closure of its U.S. stores on March 4.

"The Canadian subsidiary of the global beauty and cosmetics brand announced it has started restructuring proceedings by filing a Notice of Intention (NOI) to Make a Proposal pursuant to the Bankruptcy and Insolvency Act (Canada). In the same release, the company said that, as of March 1, 2024, The Body Shop US Limited has ceased operations," Chain Store Age reported.

A message on the company's U.S. website shared a simple message that does not appear to be the entire story.

"We're currently undergoing planned maintenance, but don't worry we're due to be back online soon."

That same message is still on the company's website, but a new filing makes it clear that the site is not down for maintenance, it's down for good.

The Body Shop files for Chapter 7 bankruptcy

While the future appeared bleak for The Body Shop, fans of the brand held out hope that a savior would step in. That's not going to be the case. 

The Body Shop filed for Chapter 7 bankruptcy in the United States.

"The US arm of the ethical cosmetics group has ceased trading at its 50 outlets. On Saturday (March 9), it filed for Chapter 7 insolvency, under which assets are sold off to clear debts, putting about 400 jobs at risk including those in a distribution center that still holds millions of dollars worth of stock," The Guardian reported.

After its closure in the United States, the survival of the brand remains very much in doubt. About half of the chain's stores in the United Kingdom remain open along with its Australian stores. 

The future of those stores remains very much in doubt and the chain has shared that it needs new funding in order for them to continue operating.

The Body Shop did not respond to a request for comment from TheStreet.   

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Government

Are Voters Recoiling Against Disorder?

Are Voters Recoiling Against Disorder?

Authored by Michael Barone via The Epoch Times (emphasis ours),

The headlines coming out of the Super…

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Are Voters Recoiling Against Disorder?

Authored by Michael Barone via The Epoch Times (emphasis ours),

The headlines coming out of the Super Tuesday primaries have got it right. Barring cataclysmic changes, Donald Trump and Joe Biden will be the Republican and Democratic nominees for president in 2024.

(Left) President Joe Biden delivers remarks on canceling student debt at Culver City Julian Dixon Library in Culver City, Calif., on Feb. 21, 2024. (Right) Republican presidential candidate and former U.S. President Donald Trump stands on stage during a campaign event at Big League Dreams Las Vegas in Las Vegas, Nev., on Jan. 27, 2024. (Mario Tama/Getty Images; David Becker/Getty Images)

With Nikki Haley’s withdrawal, there will be no more significantly contested primaries or caucuses—the earliest both parties’ races have been over since something like the current primary-dominated system was put in place in 1972.

The primary results have spotlighted some of both nominees’ weaknesses.

Donald Trump lost high-income, high-educated constituencies, including the entire metro area—aka the Swamp. Many but by no means all Haley votes there were cast by Biden Democrats. Mr. Trump can’t afford to lose too many of the others in target states like Pennsylvania and Michigan.

Majorities and large minorities of voters in overwhelmingly Latino counties in Texas’s Rio Grande Valley and some in Houston voted against Joe Biden, and even more against Senate nominee Rep. Colin Allred (D-Texas).

Returns from Hispanic precincts in New Hampshire and Massachusetts show the same thing. Mr. Biden can’t afford to lose too many Latino votes in target states like Arizona and Georgia.

When Mr. Trump rode down that escalator in 2015, commentators assumed he’d repel Latinos. Instead, Latino voters nationally, and especially the closest eyewitnesses of Biden’s open-border policy, have been trending heavily Republican.

High-income liberal Democrats may sport lawn signs proclaiming, “In this house, we believe ... no human is illegal.” The logical consequence of that belief is an open border. But modest-income folks in border counties know that flows of illegal immigrants result in disorder, disease, and crime.

There is plenty of impatience with increased disorder in election returns below the presidential level. Consider Los Angeles County, America’s largest county, with nearly 10 million people, more people than 40 of the 50 states. It voted 71 percent for Mr. Biden in 2020.

Current returns show county District Attorney George Gascon winning only 21 percent of the vote in the nonpartisan primary. He’ll apparently face Republican Nathan Hochman, a critic of his liberal policies, in November.

Gascon, elected after the May 2020 death of counterfeit-passing suspect George Floyd in Minneapolis, is one of many county prosecutors supported by billionaire George Soros. His policies include not charging juveniles as adults, not seeking higher penalties for gang membership or use of firearms, and bringing fewer misdemeanor cases.

The predictable result has been increased car thefts, burglaries, and personal robberies. Some 120 assistant district attorneys have left the office, and there’s a backlog of 10,000 unprosecuted cases.

More than a dozen other Soros-backed and similarly liberal prosecutors have faced strong opposition or have left office.

St. Louis prosecutor Kim Gardner resigned last May amid lawsuits seeking her removal, Milwaukee’s John Chisholm retired in January, and Baltimore’s Marilyn Mosby was defeated in July 2022 and convicted of perjury in September 2023. Last November, Loudoun County, Virginia, voters (62 percent Biden) ousted liberal Buta Biberaj, who declined to prosecute a transgender student for assault, and in June 2022 voters in San Francisco (85 percent Biden) recalled famed radical Chesa Boudin.

Similarly, this Tuesday, voters in San Francisco passed ballot measures strengthening police powers and requiring treatment of drug-addicted welfare recipients.

In retrospect, it appears the Floyd video, appearing after three months of COVID-19 confinement, sparked a frenzied, even crazed reaction, especially among the highly educated and articulate. One fatal incident was seen as proof that America’s “systemic racism” was worse than ever and that police forces should be defunded and perhaps abolished.

2020 was “the year America went crazy,” I wrote in January 2021, a year in which police funding was actually cut by Democrats in New York, Los Angeles, San Francisco, Seattle, and Denver. A year in which young New York Times (NYT) staffers claimed they were endangered by the publication of Sen. Tom Cotton’s (R-Ark.) opinion article advocating calling in military forces if necessary to stop rioting, as had been done in Detroit in 1967 and Los Angeles in 1992. A craven NYT publisher even fired the editorial page editor for running the article.

Evidence of visible and tangible discontent with increasing violence and its consequences—barren and locked shelves in Manhattan chain drugstores, skyrocketing carjackings in Washington, D.C.—is as unmistakable in polls and election results as it is in daily life in large metropolitan areas. Maybe 2024 will turn out to be the year even liberal America stopped acting crazy.

Chaos and disorder work against incumbents, as they did in 1968 when Democrats saw their party’s popular vote fall from 61 percent to 43 percent.

Views expressed in this article are opinions of the author and do not necessarily reflect the views of The Epoch Times or ZeroHedge.

Tyler Durden Sat, 03/09/2024 - 23:20

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Government

Veterans Affairs Kept COVID-19 Vaccine Mandate In Place Without Evidence

Veterans Affairs Kept COVID-19 Vaccine Mandate In Place Without Evidence

Authored by Zachary Stieber via The Epoch Times (emphasis ours),

The…

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Veterans Affairs Kept COVID-19 Vaccine Mandate In Place Without Evidence

Authored by Zachary Stieber via The Epoch Times (emphasis ours),

The U.S. Department of Veterans Affairs (VA) reviewed no data when deciding in 2023 to keep its COVID-19 vaccine mandate in place.

Doses of a COVID-19 vaccine in Washington in a file image. (Jacquelyn Martin/Pool/AFP via Getty Images)

VA Secretary Denis McDonough said on May 1, 2023, that the end of many other federal mandates “will not impact current policies at the Department of Veterans Affairs.”

He said the mandate was remaining for VA health care personnel “to ensure the safety of veterans and our colleagues.”

Mr. McDonough did not cite any studies or other data. A VA spokesperson declined to provide any data that was reviewed when deciding not to rescind the mandate. The Epoch Times submitted a Freedom of Information Act for “all documents outlining which data was relied upon when establishing the mandate when deciding to keep the mandate in place.”

The agency searched for such data and did not find any.

The VA does not even attempt to justify its policies with science, because it can’t,” Leslie Manookian, president and founder of the Health Freedom Defense Fund, told The Epoch Times.

“The VA just trusts that the process and cost of challenging its unfounded policies is so onerous, most people are dissuaded from even trying,” she added.

The VA’s mandate remains in place to this day.

The VA’s website claims that vaccines “help protect you from getting severe illness” and “offer good protection against most COVID-19 variants,” pointing in part to observational data from the U.S. Centers for Disease Control and Prevention (CDC) that estimate the vaccines provide poor protection against symptomatic infection and transient shielding against hospitalization.

There have also been increasing concerns among outside scientists about confirmed side effects like heart inflammation—the VA hid a safety signal it detected for the inflammation—and possible side effects such as tinnitus, which shift the benefit-risk calculus.

President Joe Biden imposed a slate of COVID-19 vaccine mandates in 2021. The VA was the first federal agency to implement a mandate.

President Biden rescinded the mandates in May 2023, citing a drop in COVID-19 cases and hospitalizations. His administration maintains the choice to require vaccines was the right one and saved lives.

“Our administration’s vaccination requirements helped ensure the safety of workers in critical workforces including those in the healthcare and education sectors, protecting themselves and the populations they serve, and strengthening their ability to provide services without disruptions to operations,” the White House said.

Some experts said requiring vaccination meant many younger people were forced to get a vaccine despite the risks potentially outweighing the benefits, leaving fewer doses for older adults.

By mandating the vaccines to younger people and those with natural immunity from having had COVID, older people in the U.S. and other countries did not have access to them, and many people might have died because of that,” Martin Kulldorff, a professor of medicine on leave from Harvard Medical School, told The Epoch Times previously.

The VA was one of just a handful of agencies to keep its mandate in place following the removal of many federal mandates.

“At this time, the vaccine requirement will remain in effect for VA health care personnel, including VA psychologists, pharmacists, social workers, nursing assistants, physical therapists, respiratory therapists, peer specialists, medical support assistants, engineers, housekeepers, and other clinical, administrative, and infrastructure support employees,” Mr. McDonough wrote to VA employees at the time.

This also includes VA volunteers and contractors. Effectively, this means that any Veterans Health Administration (VHA) employee, volunteer, or contractor who works in VHA facilities, visits VHA facilities, or provides direct care to those we serve will still be subject to the vaccine requirement at this time,” he said. “We continue to monitor and discuss this requirement, and we will provide more information about the vaccination requirements for VA health care employees soon. As always, we will process requests for vaccination exceptions in accordance with applicable laws, regulations, and policies.”

The version of the shots cleared in the fall of 2022, and available through the fall of 2023, did not have any clinical trial data supporting them.

A new version was approved in the fall of 2023 because there were indications that the shots not only offered temporary protection but also that the level of protection was lower than what was observed during earlier stages of the pandemic.

Ms. Manookian, whose group has challenged several of the federal mandates, said that the mandate “illustrates the dangers of the administrative state and how these federal agencies have become a law unto themselves.”

Tyler Durden Sat, 03/09/2024 - 22:10

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