Trader’s Narrative

It isn’t difficult to argue that demographics is one of the most powerful engines of destiny for society and in turn every important facet within it, including the economy and the stock market. Think about it. Demographics determines what the priorities of a society, their spending patterns, their saving patterns, and beyond.

We are all familiar with the power that the ‘baby boomers’ have held sway over the North American economy for these past 50 years. Everything from modern marketing to pharmaceutical research (Viagra) has been shaped by their needs and wants.

So not surprisingly, this topic has garnered a lot of attention from academics in the field of economy. There are many studies which look into the consequences of demographics and you can find one at the end of this article.

In fact, this area of study has come to be a well worn path for economist. So much so that there is a short hand to describe a most intriguing ratio: MY ratio which stands for the middle-aged to young ratio or simply Middle-Young.

This ratio is key because in these two different stages of life, people have very different priorities which, aggregated as a great galloping herd, has an inevitable effect on the pattern of savings, spending and investing that happens in a given society.

When you are young, typically, your income is very small to non-existent. You are interested in spending primarily. Both as a means of entertainment and as a way to gain education in order to achieve your full earning potential later in life. So at this stage, the average young person has much higher expenses than income - which results in debt.

On the other hand, in middle age, the average person has reached their peak income potential. They do have expenses obviously but they are also mindful of their impending retirement and as a result, saving a portion of their annual income and investing it. The majority of this investment flows to the equity markets because that is where the best risk adjusted returns are.

The idea is to watch for the relative size of the asset rich, middle-aged members of a society to their much younger and poorer counterparts. If we have a low ratio, this means that there are fewer middle-aged people and relatively more younger people. And when the ratio is higher, there is an abundance of the older generation and less youth.

So it would follow then that demographics and especially the MY ratio potentially not only describes the fluctuations in the stock market, it also may explain the expansion and contraction in the Price/Earnings ratio.

After all, when you have an abundance of middle-aged investors chasing after stocks, they will be ready to pay a higher and higher price for them. And inversely, when you have few middle-aged investors there will be few competitive bidders for equities, allowing stocks to become extremely ‘cheap’.

Here is a chart from The Cowles Foundation for Research in Economics (authored by John Geanakoplos, Michael Magill and Martine Quinzii) which shows a remarkable correlation between the P/E ratio and the MY Ratio:

Continue reading ‘Does Demographics Drive The Stock Market?’

Here’s the thing. Earnings have collapsed. Utterly and completely. Like a house of cards. Like never before.

And because equity prices only fell by ~50%, that means the price earnings ratio skyrocketed to the stratosphere and beyond. Just look at the chart of the S&P 500 index’s P/E ratio - it looks like it just fell through a wormhole:

Source: Chart of the Day

Honestly, my initial reaction was to ignore this latest chart. First, because we already went over this months ago when the P/E ratio was 122: How The Price Earnings Ratio Can Fool You. But also because this whole issue is truly meaningless.

But then I realized that this chart is making the rounds on the internet at a torrid pace. It is being forwarded and many other bloggers are featuring it with a bearish slant. So while it really is a distraction, perhaps there’s something of value here. Not the data set graphed but rather the reaction of people and their fixation on this useless little statistic.

If anything, the morbid fascination with the gloomy and shocking picture the above chart depicts tells us about the public mood out there. And from a contrarian point of view, this is the sort of ‘worry’ that bull markets proverbially like to climb.

A reader, Wayne Whaley, who is also a veteran trader and registered CTA sends in this concise report on the earnings season:

“About 1/2 of second quarter earnings are in and we have a pretty good estimate now of what final earnings should look like at the end of the quarter.

With interest rates at current levels, you can make a mathematical case for P/Es in the 25-30 range

Observations:

Including the 2009 Second Quarter Estimate of 7.27, and using 979.26 as current S&P price

1) The P/E using last 4 quarters for E is 771.07
2) The P/E using last 8 quarters annualized for E is 37.21
3) The P/E using Standard & Poors estimate for 2009 earnings as E is 32.67
4) The P/E using Standard & Poors estimate for 2010 earnings for E is 26.28
5) Earnings for the third quarter need to come in around $8.50 to avoid a negative trailing one year earnings, which from the information I have would be a first (at least in the last century).

At best, you could argue that stocks are fairly valued even using estimates for 2010 earnings. Valuation techniques are interesting to calculate and make for interesting conversation but can be misleading for market timing purposes as the market can be over (1995-2000) or underpriced (1950’s) for years, especially when earnings and money supply are moving targets.”

The chart below provides perspective on the earnings collapse by focusing on 12-month, as reported S&P 500 earnings. This quarters earnings are expected to have fallen over 98% since topping in the third quarter of 2007. That makes this, by far, the worst decline on record all the way back to 1936 - the earliest we have data. In fact, real earnings have dropped so far that in the coming quarter will see the first 12-month period where the S&P 500 earnings are actually negative!

Source: Chart of the Day

While this is certainly makes for a great story that we can tell and retell to the grandkids (boring them to tears), it doesn’t really mean much. We are at an extraordinary moment in economic history. One where we are clinging to the ledge by our fingernails and peering down at the precipice below. In such unorthodox times, orthodox measures such as the price earnings ratio can fool, rather than inform you.

Last Friday we looked at the unprecedented earnings collapse that has fueled this bear market. The chart below is the flip side, showing the impact on the S&P 500’s valuation through the Price/Earnings ratio:

Source: Chart of the Day

While the P/E ratio is a familiar rule of thumb that helps us to calculate the relative value of the stock market, like any metric it has a handicap. Looking at the chart, it is clear what that is for the PE ratio. Just imagine how ridiculously meaningless the ratio would be if we actually see negative earnings as many are predicting we will, for the first time ever!

But there’s no reason to panic, running out into the street screaming at the top of your lungs. The fact that the S&P 500’s price earnings ratio is 122.45 right now, once again proves that the price dividend ratio is a superior measure to price earnings. Dividends are a much better way of measuring value because unlike earnings, they are not prone to creative accounting and are considered sacrosanct.

While the P/E ratio is finding irrelevance in the stratosphere, the price dividend ratio is 38.6 - click previous link to see a historical chart of the price dividend ratio. And click this following link to see a chart of the price earnings ratio before the silliness began.

As S&P 500 earnings have collapsed from $62.28 - a year ago - to the present’s miserly $7.21, dividends have been much more robust. Dividends were $28.93 in May 2008 and currently they are $22.87 - a fall of just 21%. The Dow Jones Industrial dividend has fallen even less, 3.6%.

In the end, this is why we use many different methods to measure and analyse the market. Sooner or later, any one of them will go bonkers and provide useless output. At that point, it is important to realize that and not follow it over the ledge like lemmings.

First the bad news: earnings are horrible. Downright depressing actually. As the chart below illustrates, we’ve seen nothing short of an utter collapse during the most recent bear market:

Clearly what we’re going through is not your average, plain-vanilla recession. That would be the blue dashed line above. Even the last recession which came about as a result of the popping of a massive speculative bubble in technology shares and topped off by the economic body-blow from the September 11th attacks pale in comparison. What we’re seeing is the single most severe drop-off in earnings on the record.

Now for the good news. It may not matter at all - that is, when it comes to the stock market. Of course, to the economy, the employees and companies involved there is a significant consequence and I don’t mean to trivialize it. But the stock market is not the economy. For an example of what I mean, consider the company that started the most recent earnings season.

Alcoa (AA) released their earnings report after market close on Tuesday. They reported a loss of about half a billion for the first quarter. As you might expect, at first its stock price fell in after-hours trading but it closed higher the next day (Wednesday shown by green arrow) and today it gapped up and closed almost 10% higher:

Is this normal? Yes, of course. In contrast to what you may have heard, stock prices are not driven by earnings. This is one of the key characteristics of the stock market that throws a lot of novices because it just doesn’t make sense. But it does, once you realize that prices are set by a number of factors and while earnings are certainly part of the recipe, they are not the dominant ingredient.

If you look at enough charts you’ll see stock prices that are falling for companies that are reporting increased earnings and also stock prices that rise with decreased earnings. The key isn’t earnings, which after all, can be heavily manipulated unlike dividends. But rather the meaning that investors attribute to them. In other words, the price-earnings ratio. And that, is all about “animal spirits” or sentiment.