Asset Values: A Look At The Stock Markets

Over the past year, I have spent a lot of time discussing the problems created by falling house prices and the effect this has on debt levels and personal solvency. Falling house prices have placed many owners in the uncomfortable position of having no equity or negative equity in their homes.

Recently, I wrote a post considering the economic value of small businesses and the impact this is having on the sales of these organizations.  The falling valuations of small businesses have put many owners in a similar position where the equity they have in their businesses has become rather small or has even become negative. (http://seekingalpha.com/article/279506-debt-deflation-and-the-selling-of-small-businesses)

Today in the Financial Times, financial manager and author Andrew Smithers provides us with a look at the valuations attached to larger businesses as represented by their values on stock exchanges.  (See “The Conditions For The Next Crisis Are Firmly In Place”, http://www.ft.com/intl/cms/s/0/f1ff9be8-a3e5-11e0-9f5c-00144feabdc0.html#axzz1SZnxOYcr.)

His fundamental conclusion, the US stock market is “overvalued” and this connected with high levels of private sector debt point to a very precarious situation for the economy.  In the US, “private sector debt is 2.6 times gross domestic product, and nearly twice the level reached after the 1929 crash.”

His estimates of the US stock market: it is “about 60 percent overpriced.” 

Smithers comes to this conclusion using two well known measures of stock market valuation: the “q” ratio, “the ratio of market value of non-financial companies to their net worth, adjusted for inflation”; and CAPE, “which is the cyclically adjusted price to earnings ratio.”  (The “q” ratio was developed by Nobel-prize winning Yale economist James Tobin and CAPE was developed by current Yale economist Robert Shiller.)

He cautions about the use of the ratio in trying to determine market moves: “Value provides little guide to short-term market movements.” 

“If we are lucky, stock markets will not fall sharply for some time.”

The reason is that when corporations are strong buyers of their own stock, the stock markets stay buoyant.  In fact, “the US stock market has risen and fallen exactly in line with corporate buying.”

Thus, Smithers continues, it is important to “predict whether companies will continue to be strong net buyers of shares in the months ahead.”

A key predictive variable…whether or not companies have “relatively high levels of cash compared with their total debt levels”…which US companies currently possess. 

“Over the past decade, at least, cash ratios have been a leading indicator of equity purchases by firms.” 

But, Smithers warns about the near-record level of debt that corporations hold “whether measured gross or net of cash, and whether compared with net worth or output.”

He says that this fact is “startlingly at variance with the claims frequently made that US company balance sheets are in great shape.”  Smithers argues that the aggregate data are most important here and not the individual balance sheets.

It is here I differ with Smithers.  I have argued over the past year that the economy has split into two components...those companies that are in “good” to “great” shape and have a lot of cash on hand and have even borrowed at the excessively low interest rates to improve their cash positions…and those that are in “bad” to “terrible” shape.  The division is, in essence, between the “haves” and the “have not’s.”

Some big companies are in really good shape financially while many other large- to medium-sized companies are not in very good shape at all.  These well off big companies are “keeping their powder dry”, buying companies here and there, and also purchasing some of their stock.  The others…well…they are really struggling. 

This is one reason merger and acquisition activity has been so strong this year.

But, this situation is also one underwritten by the Fed with very, very low interest rates and quantitative easing.  The “haves” have it all!  The “have not’s” have next to nothing.

So far the Fed’s quantitative easing has kept the stock market going and part of this, as described by Smithers, has been the underwriting of the cash accounts of many of the biggest corporations which has led to a portion of the stock buybacks that have taken place.  (Further gains have been achieved by using the Fed’s money to go “off shore” and get into world commodity and equity markets. See http://seekingalpha.com/article/276909-federal-reserve-money-continues-to-go-offshore.)

Of course, the businesses that are not in “good” financial health cannot engage in these activities.

Thus, the big and better off are fed…and the others must scratch for their survival.

Other than this slight disagreement with Smithers, we can get back to the crux of the story.

The US stock market, according to the two measures discussed here, is overvalued by about 60 percent. 

We cannot predict the exact timing of market movements, but, historically, whenever these measures get so “out-of-line” there has eventually been a correction. 

Smithers places this correction out somewhere in 2013.  Why?  “It’s the first year of the new Chinese government, of the new European stability mechanism, and—most important of all—the first year of the new US government.” 

Wherever the “blow” comes from, corporate cash flows “will almost certainly fall sharply”

Consequently,Smithers asks, “If corporate cash flow drops, who will buy the stock market?”

My question is, “When will the large- and medium-sized firms that are not in good financial shape and that are overvalued have to sell?”  We have seen this phenomenon take place in real estate.  We have seen it take place with the smaller businesses. Given the analysis presented above, this phenomenon is going to spread over the next year or two to even the larger businesses.  And, with market values too high, acquisition prices will be below stock market values, hence the markets will fall.

This is something that fiscal stimulus and quantitative easing cannot offset.  It is a part of the debt deflation process that follows years of credit inflation. 

The Citigroup "Rally"

The performance of the stock market today, March 10, 2009, I believe, provides us with a clear indication of what is predominantly on the minds of investors. The major concern of investors is the value of the assets that are carried by companies on their books, and especially on the asset values on the balance sheets of financial institutions.

I say this because Citigroup has been the “poster child” of what most investors feel is wrong with the financial markets and the economy. The perception is that Citigroup is so weighed down by assets that are not performing and that must be written down that there is little or no hope for its survival outside of a full takeover by the United States government.

Focus has been so strongly focused on the “asset problem” that other institutions, like Bank of America and JP Morgan Chase & Co., have also been affected with concerns about the value of their assets. As a consequence, the stock price of these and other financial institutions have declined drastically due to the uncertainty as to whether or not they are solvent.

The stock market took off right from the opening bell this morning. The cause—a memo written by Vikram Pandit, the chief executive officer of Citigroup, to employees of his organization indicating that Citigroup had been profitable for the first two months of 2009 and was likely to turn a profit for the first quarter of the year. If this happens it will be a sharp turnaround in performance for the company, a move to the black after five consecutive quarterly losses.

There was no indication about any special write-offs or credit losses, but the memo gave hope to the idea that Citigroup, even after such write-downs, would post a profit for the first quarter.

The hope that was forthcoming, I believe, is the hope that Citigroup will now be operationally in the black going forward and that this kind of performance would give them the time and cushion to continue to work off bad assets and take more modest charge-offs against profits in the future.

The hope is certainly not that Citigroup is “out-of-the-woods.” That would be too much to hope for. To me, what is captured in the market response is that Citi may still have time and not be forced into some precipitous governmental takeover action.

Now, let me say that this was just one day and just one piece of action released by someone that needs, in the worst way, to give some sort of encouragement to his troops. Tomorrow is another day and there will be more information and more market maneuvering in the future. But, it was a day in which there was a possibility for hope—no matter have small that hope might be.

The problem had been that investors had perceived asset values declining with no bottom to be seen. And, there was no one or no event in sight that might put a stop to this decline.

This is why I believe that the financial markets have not been giving President Obama and his team “good grades” on their efforts to craft an economic policy and a bank rescue bill. The economic recovery plan was proposed and passed by Congress, yet there was no “bounce” in the market due to this program. So far, any bank rescue bill talked about or outlined has been deemed a dud.

It is this latter failure that the financial markets have been reacting to. To the financial markets the concern over asset values has dominated everything else. The recovery plan does not address this issue and so does not provide any confidence to investors over possible bankruptcies and takeovers related to institutions that are insolvent due to the bad assets on their books. Expenditures on infrastructure and education and health care and so on are one thing, but a stimulus package like the one that passed Congress cannot prevent a collapse of the financial system as the value of assets plummet and are recognized.

And, so the memo relating to the two-month performance of Citigroup hit the market and gave investors some encouragement that there might be some possibility that the problem related to asset values maybe…just maybe…could be worked out. And this attitude spread to other companies and other areas in the stock market.

We see that the stock of Bank of America Corp. rose 28 percent, the stock of JPMorgan Chase & Co. rose 23 percent, and the stocks of PNC Financial Services and Morgan Stanley increased by double digit numbers. Of especial interest is that the stock of GE rose by 20 percent reflecting the spillover of the positive attitude given to the banks was also given to GE and the concern over the fate of GE Capital.

Again, all of these companies have seen the price of their stocks decline in the past six months or so because of the concern over the value of their assets.

As mentioned, stocks rose from the opening bell, seemingly responding to the contents of the Pandit memo. But, the market responded to other news that they interpreted in a positive manner.

Fed Chairman Ben Bernanke gave a speech that reinforced the “good news” coming out of Citigroup. In this speech, Bernanke discussed the need for moving onto a new regulatory system. The part of his statement that market participants focused upon was Bernanke’s claim that the accounting rules that govern how companies value their assets needed to be changed. The Fed Chairman was careful to say that he did not believe that the mark-to-market accounting rules should be changed. Still he did talk about how asset values should be treated and investors reacted to this in a positive way. Again, the focus of the market was on asset values and little else.

There was one other bit of news that the financial markets reacted to in a positive way and that was the comment of Barney Frank about the “up-tick” rule. This statement, although important in itself, was only a side-show in the movement of the stock market today. Its just that when the good news is poring in, look out!

The important take away about the performance of the stock market today is that the major focus of the investment community is on the value of the assets on the balance sheets of banks and other organizations in this country. This message should be read loud and clear by the Obama administration. Spending plans are fine, but the recovery of the country depends very heavily on what is done about the value of the assets on the books of banks and other organizations and how losses in value are going to be worked off.

This is important too because of what is on coming in the future. It seems as if the credit problem is going to accelerate as the defaults rise on credit card debt, as interest rates need to be reset on Alt-A and option payment mortgages over the next 18 months or so, and the looming bust in the commercial real estate market. The asset value issue is not going to go away soon.

So, we got a rise in the stock market. We may get several more in the next week or so. I don’t believe anyone can predict the movement in the stock market over the coming six months. There are still too many uncertainties. And, even if the stock market were to rise over the next six months, my bet is that the asset valuation problem is still going to be with us. And, in all likelihood it will still be with us next year at this time.

A Case Study in Unknown Asset Values: A. I. G.

My blog of March 1, 2009, “Uncertain Asset Values and the Stock Market” (http://maseportfolio.blogspot.com/), was written before the most recent news surfaced about the continuing bailout of A. I. G. I believe that the example of A. I. G. represents a perfect ‘test case’ for what was presented in that post.

The March 1 blog contended that the major uncertainty facing the investment community…and the Federal Government…is the value of assets on the books of many of the nations businesses…especially many large and important firms that are “too big to fail.” The argument is that this uncertainty has to be cleared up as much as possible before the economy is really going to have a chance to regain its health.

The problem now is that not only are companies withholding information from the investing public…but the government is also withholding information from the investing public. Specifically, companies…and the government…are afraid to release information on who they are dealing with…the “web of counterparties”…because of their concern that the release of these names would cause a panic leading to deposit withdrawals or the cashing in of insurance policies and so forth.

This is the old “after-the-fact” problem. I used to be a part of “information sessions” for journalists to help them understand banking and the issues that surrounded the banking industry. One of the concerns that always came up at these sessions was about what responsibilities “the press” had in reporting on troubled banks. That is, if a journalist “knew” that a bank was in trouble…what responsibility did that person have to report that the bank was having problems…and thus, perhaps, cause a “run” on the bank.

This is an “after-the-fact” problem. The bank is already a troubled bank…now what do I do?

One of the arguments I made was that journalists should keep up closely enough with banks to report when banks were starting to experience difficulties. By making this information public, the press could help prevent the bank getting too far into a mess because it would want to avoid the bad publicity and work to rectify the difficulties before they got “out-of-hand.”

This, of course, was very difficult because of the insufficient reporting requirements applied to banks and the secrecy surrounding the regulatory examinations. And, if banks knew that they were being scrutinized that closely by “the press” they would certainty make it just that much more difficult for the “outsiders” to obtain information.

So, investors and communities had little information on financial institutions that were important to them and had to “trust” the regulatory agencies to apply the appropriate oversight to the banking system. Of course, the regulatory agencies did not always have “full information”, especially as the financial conglomerates began transacting in very sophisticated derivative securities and taking many assets “off balance sheet.”

I believe that the company A. I. G. is a striking picture of how this scenario played out. A. I. G. is a holding company that began as an insurance company and then diversified itself into a financial conglomerate that included a hedge fund and other “black box” investment vehicles. Their primary regulators were the state insurance regulators (and some international regulatory requirements) and the state laws caused the subsidiaries to be highly segregated so as to ensure the safety of those the insurance subsidiary had insured.

The rest of the company was not regulated to any degree. As a consequence, A. I. G. was able to build up a huge financial conglomerate that could engage in untold transactions that were both un-regulated…and un-disclosed! The accounting and reporting rules were such that investors…and the public…and the government…and even other areas within the company did not have any idea about the risk exposure of the holding company or the “spider-web” of relationships that made it a potential “carrier of contagion.”

And, we…and the government…still don’t know what the potential damage could be from this dismal situation!

As a consequence, the probability of a fifth (this last bailout was the fourth return to A. I. G.) is a lot higher than we would like it to be. And a sixth? And a seventh?

With the government owning almost 80% of the company it would seem like any additional funds would be relatively small.

But, that is the problem…we don’t know! No one seems to have a handle on the value of the A. I. G. assets!

And, as I argued in “Uncertain Asset Values and the Stock Market”, this problem exists throughout the economy. What about the assets of Citigroup? What about the assets of Bank of America? Again, to quote the earlier blog, “It is not altogether clear that even the people running a large part of this economy have any idea about the value of their own assets.” Again, I take A. I. G. as the example.

And, then we have General Electric…and the problems of GE Capital. Again…we have another conglomerate with few pieces that go together. For years, GE Capital carried the rest of General Electric. And, what happens if you have one subsidiary making up for the “not-so-good” performance of other subsidiaries? You put more and more pressure on the performing subsidiary to produce exceptional results. And, how do you do that? You take riskier assets into your portfolio and you increase leverage. Simple!

Now, GE Capital is suffering along with other financial companies that attempted to extend “exceptional” returns. And, with GE Capital failing to perform…the spotlight is being focused on all the other subsidiaries that were only mediocre performers. Consequently, General Electric must face the value of ALL of its companies and determine what are the asset values under its umbrella.

This, to me, is the picture that is unfolding…and the problems we face are not going to be resolved until we get a better grasp on asset values. But, we need to do this quickly because…and this is the problem of bad assets…the value keeps dropping if the difficulties are not resolved. This is true of bad assets in an individual institution…I saw this over and over again in the banks I helped turnaround…and it is true with the financial and economic system. In fact, that is the problem with a contagion…bad assets tend to play off of bad assets…and the difficulties cumulate. This is all the more reason for attempting to get a handle on asset values as soon as possible.

A $787 billion economic recovery plan is insufficient to overcome the possibilities of a multi-trillion dollar write-down of assets!

Uncertain Asset Values and the Stock Market

“Value investors prefer to estimate the intrinsic value of a company by looking first at the assets and then at the current earnings power of a company.” This comes from the book “Value Investing: From Graham to Buffett and Beyond” by Greenwald, Kahn, Sonkin, and van Biema.

In value investing, the value of the assets is the first thing you should look at. Value, however, is uncertain and decisions about value are risky…that is, placing a bet on the value of an asset is a risky decision…and this throws us into a probabilistic world.

But uncertainty comes in different flavors. For example, in some situations we have a relatively good idea about what the underlying outcome distribution looks like. Games of chance like roulette or blackjack have uncertain outcomes but the probability distribution of possible outcomes is well known. On the other hand, the possible outcomes of a war are uncertain and we generally have very little knowledge of the probability distribution of possible outcomes. So at one end of the spectrum of uncertain situations we can say that our estimated probability is objectively determined, while at the other end we have to admit that our estimated probability distribution is entirely subjective.

The United States is at war right now…at war against an economic and financial crises. And, investors, as well as everyone else, have no idea what the probability distribution of possible outcomes looks like. We can’t even approximate such a distribution from historical statistics because there is insufficient information to produce any kind of a result that would be relevant in the current situation. The information that we are getting seems to be getting worse and worse.

This, to me, is why financial markets are performing as they are at the present time. No one can state with any certainty the values relating to the vast majority of assets in the United States.

Until people can gain some confidence that they know…even approximately…what is the value of assets relevant to them…they will not be willing to place substantial “bets” with much confidence. And, this will mean that financial markets will continue to meander lower.

One effort to get a handle on asset values is the “stress test” exercise of the Federal Government on large commercial banks. The effort is, of course, to see whether or not the asset values of these banks will hold up in a relatively severe economic downturn. The outcome of these stress tests will determine, to a large degree, the amount of financial help these institutions will get from the Treasury Department.

The problem is that the whole economy needs to face a stress test. It is not altogether clear that even the people running a large part of this economy have any idea about the value of their own assets. This is scary!

We have heard over and over again in the past year that one factor that has “caused” or at least “exacerbated” the current crisis is accounting rules such as the “mark to market” requirement faced by many institutions. I think that this is nonsense!

The problem, to me, is that there has been too little information forthcoming from the businesses and financial institutions in this country. I contend that the only reason the “mark to market” requirement might have caused organizations any trouble is that the managements of these companies believed that they would never be held to live up to this standard.

The “mark to market” requirement is meant to warn managements that their decisions with respect to asset choices will have consequences on their balance sheets and this will be revealed to the investment community in real time. Therefore, Mr. Management, if you want to invest in riskier assets or mis-match the maturities of your assets and liabilities in order to increase your return on equity, you will have to account for them “up front” if your decisions sour.

Knowing this to be the case, why would these managements go ahead and assume riskier positions unless they believed that the accounting rules would not be enforced?

Another bad argument to me is the one used by Long Term Capital Management in terms of the portfolio positions they took…”We can’t release information on our positions because of the fact that if we did our competitors would know what we are doing and copy us.”

Well, guess what? Their competitors knew what positions they were taking and copied them. And, the spreads Long Term Capital Management worked with got narrower and narrower…and so LTCM needed to use more and more leverage to get the returns they were shooting for…and trouble developed…and who knew about it? Not their banks…not their investors…not the regulators…no one but them. And, we ended up with another crisis.

And, this goes back even further. I am reading a book about Goldman Sachs. One situation stands out…the financial crisis created by the Penn Central bankruptcy in the early 1970s. The Penn Central hid information about its financial problems from Goldman Sachs, as well as others in the financial community, which resulted in a collapse of the commercial paper market leading to a Federal Reserve rescue and millions and millions of dollars in losses as well as an enormous amount of time in law suits and other regulatory assessments.

In doing bank turnarounds I found out very quickly in each bank I was involved in that the first thing an organization does when their decisions start going south is that they attempt to “cover up” results. One of the first things needed in any turnaround situation is to open up the books and let the fresh air in. It always seemed to me that greater openness and transparency of reporting results would have reduced the number of bank problems and bank failures that took place in this country.

Many argue that if people knew the trouble that banks had gotten themselves into there would be more “runs” on banks and the system would be less stable. This is an argument “after the fact” much as is the argument about “marking to market.” If the information were available earlier to the public and the investment community, there would be pressure on managements to respond quicker to bad decisions and resolve them before they got out-of-hand. Allowing the managements to delay action on these issues only exacerbates the problem, for it does not force the managements to solve them.

If there are to be any regulatory changes…and I am afraid that there will be way too many of them in our future…I would argue that the most important one would be related to the reporting requirements of all businesses in the United States. The records of American businesses…non-financial as well as financial…need to be more timely and more open and transparent to the world.

The investment community and the regulatory community should never be in a position where there is such uncertainty about asset values as there is at this time! We have the computer systems to accommodate a requirement to be more open and transparent…there is no reason why more information should not be forthcoming on a real time basis.

The stock market…as well as other financial markets…will continue to move lower as long as the uncertainty exists about asset values. A government “recovery program,” a plan to ease the burden of foreclosures, and even a bank bailout plan, will not stimulate bank lending and move the economy out of recession until we get a handle on asset values…throughout the whole economy. Valuing assets will take time…and even more time will be required to work out the associated solvency issues. But, even now, greater openness and transparency would help speed this process along. And, maybe give investors enough confidence to start buying again