Pricing in Uncertainty

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How about that? The “explosive short-term rally” we wrote about yesterday exploded overnight in New York. It’s exploding here in Australia right now. The Dow was up 2.3% and Aussie stocks are already up nearly 2% before noon.

Does this mean stocks are good value for money at these prices? Not according to the charts published in the Reserve Bank of Australia’s most recent chart book. The first chart below shows that the price-to-earnings ratio on an index of Australian stocks actually exceeded all other peaks late last year and early this. Stocks were definitely not cheap.

Now it’s not clear if the P/E ratios above are based on trailing or forward earnings. It’s most likely forwards earnings estimates. And if that’s the case, it tells you how useless earnings estimates are. If analysts get it wrong using P/E ratios to tell you if stocks are cheap doesn’t help you much. What’s more, the way modern accounting works, earnings can be pretty much whatever you want them to be.

What about dividends? Stocks are usually a buy when yields peak. For one, at bear market bottoms when no one wants to own stocks, companies forced to pay out more in earnings to attract equity buyers. Secondly, economic troughs are accompanied by higher interest rates. The higher interest rates in the real economy are usually matched with higher yields on corporate bonds and larger dividends.

But as you can see from the second RBA chart below, yields above six percent on Aussie stocks are a kind of buy signal. Of course yields DID spike above six percent last year, but this was more a function of the crash in shares than a genuine cyclical bottom. You can also see that last year’s spike in yields was much more abrupt compared to the previous peak over six percent prior to the bull run of the early 1990s. Why?

In a normal economy – one without so much interest rate intervention – the economy would move from boom to bust more gradually. With GDP and earnings growth investors would pay a premium for stocks offering capital gains. During recessions or periods of slower growth, they’d shift to more defensive yield plays.

But we live in an abnormal financial world. Interest rates are whipsawed up and down as central banks try to prevent deflation in asset markets and inflation in consumer prices (which would alert the public to the nature of the fiat money scam). In other words, last year’s spike in yields did not indicate that stocks were cheap. What would?

Well you’d have to look at something more fundamental like intrinsic value. For example, we read this paper earlier today by Societe General analyst Dylan Grice. He makes the quite compelling argument that certain risk assets are most prone to the inflationary effects of quantitative easing programs by central banks (which he assumes we’ll see a lot more of).

But which risk assets? Equities? You bet. But only equities that are relatively undervalued on an intrinsic value to price ratio (IVP). Without going into the mechanics of the IVP (which presumably includes price divided by something like net equity or net tangible asset value), it’s worth noting that many of the stocks Grice flagged up as trading at or below intrinsic value were in oil and gas or metals and mining.

Why are those stocks trading below intrinsic value? Hmm. It could be the huge uncertainty hanging over both industries as a result of new regulatory threats (the threat to offshore drilling from the BP fiasco in the Gulf of Mexico and threat to miners from other governments replicating the Rudd assault and battery on mining profits).

So there is intrinsic value at a discount. And that, as our friend Greg Canavan pointed out in his latest alert, gives you some margin of safety. But it doesn’t guarantee prices will go up. Grice adds that, “Buying expensive risk assets on the view that they’re going to become more expensive is a dangerous game to play, but since government funding crises hammer risk assets while printing money inflates them, such funding crises should present decent value opportunities to buy into beaten up assets before the inflation ride.”

Grice is essentially saying stocks are a hedge against inflation. If true, certainly puts yesterday’s market rally into perspective. But it also shows you the inherently speculative nature of investing in stocks when asset markets are rigged by central bank money printing policies. It also points out that gold has intrinsic value in the sense that it is intrinsically scarcer than paper money.

For what it’s worth, Grice’s formulation does sound right. He writes that, “With government balance sheets in such a mess across the developed world (even with yields at historically unprecedentedly low levels), government funding crises are likely to be a recurring theme in the future. Since banks hold so much ‘risk free’ government debt, those funding crises point towards more banking crises which point towards more money printing.”

When and how it stops is a good question. But arguably, it’s just begun. The money printing, that is. And if that’s the case, equities are a theoretic but highly speculative hedge against inflation. When you think about it, though, that doesn’t much sound like stocks are a fundamentally good investment now, does it? Even if they are a good trade.

Meanwhile, the debate about RuddTax continues. Last night over pasta and prawns and a bottle of beer we read our friend Dr. Marc Faber’s latest report in which he writes:

If, indeed, the Australian government increases taxes on the mining industry it will bring down new investments in the Australian mining industry below where they would have been had higher taxes not been imposed. And unless lower future investments in the mining industry in Australia are offset by higher investments elsewhere in the world, the potential supply of industrial commodities will diminish and bring about higher commodity prices than if no tax increases had taken place. And if all the countries of the world follow the “wise” measures of Australia’s Rudd government and increase taxes and royalties on the mining industry everywhere around the world, fewer commodities will be produced at higher prices, which will hurt the consumer and result in lower tax revenues for governments and lower standards of living.

Mmm hmm. It makes sense intuitively that higher mining taxes will lower production, although the government has claimed the opposite. Dr. Faber’s contention that higher global taxes on mining will also lead to lower production of commodities is arguably bullish for resource prices, but only for the companies that can afford to stay in business to produce them.

His main point, though, is that high taxes might boost short-term government revenue. But that higher taxes – no matter how good they may feel to impose if you like sticking it to the miners in the name of the people – don’t and can’t increase long-term standards of living in Australia.

Only wealth creation and increases in productivity can elevate standards of living. No amount of government wealth redistribution will change that. The more of present production the government consumes, the poorer it makes everyone over time.

Dan Denning
for The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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21 Comments on "Pricing in Uncertainty"

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Ross
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I have been anticipating Grice’s line since mid 08. Other things to watch however are funding, counterparties, balance sheet bogeys like goodwill (especially in AASB land Australia) & US’s mark to fantasy, and currency. That’s alot to watch before you plunge in on NTA.

Stillgotshoeson
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Biker
Guest

Thanks for that interesting piece, Shoes. Found the ‘mega-rich’ definition quite dated, probably two decades out-of-whack, in fact.

Abbott’s financial practices, drawing on his home equity, will probably go unnoticed in the current Labor punch-up… but you have to question the wisdom of a bloke who would be PM using his housing loan as an ATM!
Sacre merde!`

Stillgotshoeson
Guest

reinforces my belief that one should not fear a downturn, but learn to best survive and profit from it.. no sense sitting on your behind saying “woe is me” and do something about protecting and improving your volatility and above all don’t look to governments for help.. take responsilbility for your future… not you personally BP you as in the general population

Stillgotshoeson
Guest

improving your *position in this volatility

Biker
Guest

Wondered about that!~

* Wondered if you were suggesting I substitute aviation fuel for ULP!~ ;)

Stillgotshoeson
Guest

Edit posts function would be nice :)

Lachlan
Guest

ha ha :)

Ned S
Guest

“mega-rich” apparently means “high-net-worth individuals, defined in the report as people having investable assets of more than $US1 million ($1.14 million)”:

http://www.smh.com.au/executive-style/luxury/numbers-up-for-our-megarich-20100623-yz9b.html

Wonder what pa mega-income such mega-rich are getting from their mega-wealth after paying their mega-tax in most of the world these days?

Biker
Guest
I was curious about Annie’s comments about paying too much tax a few daze back… . I decided to let it go, in case I was labelled ‘loaded’. (I think that was her term, anyway.) Considering a few here figure I’m a loose cannon, I didn’t want to light that match. For the first twenty years of our working lives we both probably paid too much tax. Now we honestly and legally pay what we are obliged to pay. That is simply a matter of structuring our finances _exactly_ and tweaking the amounts we allocate to assets, Super and cash,… Read more »
Ned S
Guest

Providing we structure personal income tax in the way we do, a VERY large proportion of the population will always have incentive to legally reduce the tax they pay. I figure Ken Henry was heading his bosses down a sensible track when he said in Recommendation 2 (in part) “A high tax-free threshold with a constant marginal rate for most people should be introduced”.

http://taxreview.treasury.gov.au/content/FinalReport.aspx?doc=html/publications/papers/Final_Report_Part_1/chapter_12.htm

Biker
Guest

What did you think of Recommendation 13, Ned? Having a go at the Widow’s Mite, doncha think?*

Interesting read, but there’s a whole lot of bollocks in with the bandages, methinks!~

* We make sizeable donations… but why shouldn’t someone with less earnings be able to claim a deduction for a lesser amount? That’s BS!~ :(

annie
Guest
Hi Biker I only wish I had ways to reduce my tax burden. I bought a house so no more provisional tax which is a start. I am a payee taxpayer, no investments properties and a very limited way of reducing my tax burden. If people can structure there lives to not pay more tax than they have to, well good on them I reckon. I don’t mind paying tax, but I want value for my buck. What I am annoyed about is we pay more for everything now, whereas in the past our taxes supported what I call essential… Read more »
Stillgotshoeson
Guest
I have no problem with user pays.. I would like to see the GST raised to 15% and all the inefficient state taxes removed. I have no problem with governments funding our highways as toll roads to fund those.. the government purse is only so big.. I would rather see government funding on health and education.. Lower income tax rates with a raised GST and I would also like to see the company tax rate reduced to try and keep more business here.. Quality of life in Australia stems from a higher wage base.. Lower company tax rates to help… Read more »
Biker
Guest
I can sympathise with your situation, Annie. Do you have access to salary packaging? That is one _initial_ step which cut our tax by almost half… and Super* also gave us a means to reduce our CGT… . Our utilities are becoming criminally expensive here, too. We see solar electricity systems as a means of reducing one charge… so much so that we’re now installing systems on rentals, for a 46% saving to tenants. For over two decades we’ve enjoyed sweet free water from the sky. In 1995, they ran a mains pipe past our driveway. We stayed independent. In… Read more »
Biker
Guest

No toll roads in WA, but our population is less, so it figures. West Aussies would probably change the government if they introduced them… .

“A healthy and educated population is a more productive than a poorly educated and unhealthy population…”

On this we agree.

As for 15% GST, it’s probably a fairer method of gaining tax across the board. Most retirees would disagree. It would have little effect on us personally, but pensioners, soon to become our major voting bloc, _would_ be affected. They’d turf the initiators even quicker than you can execute a PM!~ ;)

Stillgotshoeson
Guest

Most retirees would disagree

I don’t think you can ever have any government policy that everyone likes.. too many personal ideals..

Some think we live in a Society and wish for a more left leaning political landscape
Some think we live in an economy and wish for a more right leaning political landscape
and then we have the centrists..
Mortgage holders hate high interest rates, self funded retirees and non in debted persons like high rates… winners and losers in all things.. that I believe is/has been the labor parties biggest fallacy, trying to keep everyone happy… can’t be done.

Biker
Guest
Seeing the world through four frames: structural, human resource, political, and symbolic, can help prevent us from making too many quick judgements about events. Ignoring the political frame means a quick, painful demise. It really isn’t so much what is ‘right’ which will prevail, but whether it will fly. I’d bore you more with Bolman & Deal’s concept of aligned conceptual frameworks, as a way of a managing, but it’s enough to contend that if you leave out any of the four, you’ll probably wind up in merde. (Not you personally, but the more general ‘you’.) You’re right that there’s… Read more »
Stillgotshoeson
Guest
but there’s a better chance you’ll survive if you don’t offend the largest voting bloc! However offending the largest voting bloc may be in the best interests of the country.. not the government, not the offended largest bloc of voters…. LOwer personal tax rates, more incentive for people to work.. Lower Company Tax rates more companies stay here, and maybe more come, more employment = more people spending money on a higher GST rate giving governments money for the said largest voting bloc Raising compulsory super contribution will lessen the reliance on the public purse into the future. As much… Read more »
Biker
Guest

Shoes: “However offending the largest voting bloc may be in the best interests of the country…”

BP: “It really isn’t so much what is ‘right’ which will prevail, but whether it will fly.”

Biker
Guest

It. just. won’t. fly.

Perhaps with a benevolent dictatorship, or a totalitarian regime, a minority can ensure that their perception of what is right _will_ ‘fly’.
Unlikely in Australia in the next two decades.

And governments intervene. They govern. They intervene. We can expect more of that. No matter how independent we are, or would all like our personal situation to be, it might be wise to anticipate continual intervention. ;)

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