Bridgewater Associates: S&P Below 20 For First Time Since 1997 - July 2004

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Bridgewater Associates: Collection of Writings (1999-2012)

Bridgewater Associates: Collection of Writings (1999-2012)

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  • 1. Bridgewater® Daily Observations July 15, 2004 © 2004 Bridgewater Associates, Inc. (203) 226-3030 Jason Rotenberg Amit Srivastava United States S&P P/E Below 20 For First Time Since 1997 For the first time in 7 years, the US equity P/E ratio is below 20. At the peak of the equity bubble, P/E ratios had reached the mid 30s, and as earnings collapsed even faster than prices, P/Es reached 45 in 2002. Below we try to give some perspective on current equity valuations. Earnings growth over the last couple of years has been tremendous and has pushed the P/E ratio significantly lower. With bond yields as low as they are, valuations are attractive by historical standards (relative to the last 25 years), although we expect that the earnings explosion of the last few years is basically over and that earnings growth will more or less match GDP growth over the next few years as hiring picks up and wage pressures start to rise. Whether we look at reported earnings, operating earnings, or economic earnings the picture is basically the same – earnings are back to their long- term trends. The first chart below shows the P/E ratio back to 1919. Until recently, the P/E ratio rarely exceeded 20. S&P PE Ratio 0 5 10 15 20 25 30 35 40 45 50 19 23 27 31 35 39 43 47 51 55 59 63 67 71 75 79 83 87 91 95 99 03 PE down to 20 for the first time since 1997 A more useful perspective is comparing the yield on stocks (E/P) to the yield on bonds. Until 1980 or so, investors used to demand a higher yield on their stocks than on their bonds to compensate them for risk. This implied that for stock and bonds to have the same return over time, earnings would have to fall. A large chunk of the strong equity performance since WWII came about as this extreme risk premium shrank. Since 1980 the opposite has been true with the earnings yield being lower, and there were expectations for positive earnings growth. Right now, with bond yields at 4.5%, a P/E of 20 implies that the earnings yield is once again (slightly) above the bond yield. Implicitly, earnings growth expectations are poor. Bridgewater ® Daily Observations is protected by copyright. No part of the Bridgewater ® Daily Observations can be duplicated or redistributed without prior consent from Bridgewater Associates. Copying or redistribution of The Bridgewater ® Daily Observations is in violation of the U.S. Federal copyright law (T 17,U.S. code). 1 Bridgewater ® Daily Observations 7/15/2004
  • 2. 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% 19 23 27 31 35 39 43 47 51 55 59 63 67 71 75 79 83 87 91 95 99 03 Bond Yield Earnings Yield Bi hift i i i i 1980 ith b d i ld t i ll hi h th i Until 1980, earnings yields w ere typically much higher than bond yields The next two charts focus on the period since 1970. We show the same chart as above, as well as the gap between the earnings yield and this bond yield. From this perspective, the equity market is as attractive as it has been since 1980 (assuming that one’s earnings growth expectations have not changed). 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 Earnings Yield Bond Yield Earnings yield is low compared to history (at 5% or a PEof 20). But it is higher than bond yields and the yield has more than doubled in 2 years. Earnings Yield Minus Bond Yield -6% -4% -2% 0% 2% 4% 6% 8% 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 Highest earnings yield relative to bond yield since 1980 2 Bridgewater ® Daily Observations 7/15/2004
  • 3. The picture is basically the same if we use forward-looking earnings instead of backward-looking earnings. For the forward-looking earnings, we use a conservative expectation of 7% earnings growth (consensus estimates are for 13%, but they have historically overstated earnings growth, and the number is much higher than our own estimate as well). 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 Earnings Yield (12mo future earnings) Bond Yield Forward Looking Earnings Yield Minus Bond Yield -6% -4% -2% 0% 2% 4% 6% 8% 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 One reason to expect poor earnings growth is if earnings are inflated either because where we are in the business cycle or for some other reason. Today there is a good argument that this is not the case, or at least no more the case than typical. The first chart below shows trailing earnings relative to trend. Earnings are now just a bit above trend and are not really being helped by cyclical factors such as the front loading of profits related to the investment cycle (when one company books a sale as current profit, but the purchaser gets to back load the investment and amortize it over years). 3 Bridgewater ® Daily Observations 7/15/2004
  • 4. 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 S&P Trailing Earnings Trend Earnings back above trend If we look at operating earnings we don’t get a picture of reported earnings overstating earnings. For the chart below we adjusted operating earnings lower by 15% to reflect the long-term average level of write-offs (write-offs tend to by “lumpy” and looking at past write-offs may give a distorted picture of future profits – all we did below is smooth the write-offs by subtracting a constant 15% of earnings). 2.6 2.8 3.0 3.2 3.4 3.6 3.8 4.0 4.2 88 90 92 94 96 98 00 02 S&P 12mo Trailing Earnings (ln) S&P 12mo Training Operating Earnings (adjusted) ln Reported earnings once again a bit higher than adjusted operating earnings The picture for economic profits is also basically the same. Earnings are back to trend. Economic profits as reported by the Commerce Department make a number of adjustments to earnings such as adjusting for options expenses and estimating economic depreciation (instead of the tax treatment) to get to a truer picture of profits. Unlike reported profits, it peaked in 1997. 4 Bridgewater ® Daily Observations 7/15/2004
  • 5. 4.0 4.5 5.0 5.5 6.0 6.5 7.0 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 Economic Profits NIPA(ln) Trend Slightly above trend As mentioned above, current valuations are attractive even if we expect normal earnings growth going forward. Labor margins should deteriorate over the next few years, but we expect other factors to work in the opposite direction and offset the impact of labor margins. P/Es of 20 make US equities “cheap” relative to the last 25 years, but overall, we are only slightly bullish on equities as other factors such as flows and short-term pressures are offsetting valuations to some degree. Weak Retail Sales Report Retail sales were expected to be weak in June as we already knew that auto sales had been weak. The numbers came in even weaker than expected with overall sales contracting 1.1% and excluding autos 0.2%. If we exclude gas station sales, retail sales were flat in June. This is the second weak month in the last three, and may be indicative of growth peaking, but it is earning to tell. Compared to a year ago retail sales growth remains very strong, whether gas and autos are included or not. US Nominal Retail Sales M/M -2% -1% 0% 1% 2% 3% Jan-02 Mar-02 May-02 Jul-02 Sep-02 Nov-02 Jan-03 Mar-03 May-03 Jul-03 Sep-03 Nov-03 Jan-04 Mar-04 May-04 Retail Sales Excluding Autos Excluding Auto and Gas Excluding Auto and Gas no change in June 5 Bridgewater ® Daily Observations 7/15/2004
  • 6. US Nominal Retail Sales Y/Y 0% 2% 4% 6% 8% 10% 12% 96 97 98 99 00 01 02 03 04 Total Excluding Autos Excluding Gas and Autos As mentioned in recent observations there are some early signs that growth has stopped accelerating and may even be turning a bit lower, but it is still too early to tell. Weekly Sentiment: Below is our updated weekly sentiment. Composite Sentiment Index 26% -8% 29% 32% 53% 34% 56% 44% 19% 67% 8% 51% -100% -50% 0% 50% 100% T-bonds Euro$ Stocks Euro B-Pound S-Franc J-Yen C -dollar G old Silver C opper O il This Week Last Week 3-Month High/Low High OB Mod OB Neutral Mod OS High OS Composite Sentiment Index (avg of raw numbers) Market This Week Last Week 3 mth high 3 mth low T-Bonds 58 61 61 32 Euro$ 46 47 48 30 Stocks 55 56 67 48 Euro 62 63 63 45 B-Pound 70 60 70 40 S-Franc 70 65 72 42 J-Yen 58 59 68 40 C-Dollar 70 71 71 38 Gold 67 64 67 40 Silver 55 44 69 28 Copper 57 53 61 42 Oil 71 70 79 44 6 Bridgewater ® Daily Observations 7/15/2004
  • 7. Other Industrialized Countries Thursday Morning Market Update: Most equity markets were lower last night, bonds were flat, and the dollar was slightly higher. May German retail sales were revised lower and the DAX was down 0.9% while the CAC was down 0.7%. The FTSE was down 0.4% and the Mib 30 was down 0.6%. The Nikkei and All Ords were both up, however, 0.5% and 0.1%, respectively. Aussie bond yields were up 1 bp, and bund and gilt yields were unchanged. JGB yields were up 3 bp. In currencies, the A$ and euro were both 0.1% lower against the greenback, the yen was unchanged, and the pound was 0.2% lower. UK Inflation: Upward pressures are building… The UK harmonized CPI inflation for the month of June was mostly in line with expectations, and a tad below the BoE target inflation rate. However, upward pressures are gathering pace. The excess capacity has disappeared and the economy is running well above potential rate of growth indicating that capacity constraints are only going to get worse. Wages are also rising faster, and house price inflation is not showing any signs of slowing down. We think that the credit markets are not reflecting the full impact of strong growth and increasing pressure on inflation; therefore, we are short gilts. The UK harmonized inflation rate rose to 1.6% yoy in the month of June. The rate has stayed below the BoE target level of 2% for a while, but the pressures are building up for it to rise in near future. The following chart shows the historical annual growth rate in harmonized CPI. Harmonized CPI (YoY) 0% 1% 2% 3% 4% 5% 6% 7% 8% 9% Jan-88 Jan-90 Jan-92 Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 BoE target Harmonized Inflation below target, but pressures are building. In the UK, higher-than-potential economic growth has completely exhausted excess capacity. The following chart shows inflation rate against the GDP gap. The GDP gap has crossed into positive territory recently. 7 Bridgewater ® Daily Observations 7/15/2004
  • 8. -6% -4% -2% 0% 2% 4% 6% Jan-85 Jan-87 Jan-89 Jan-91 Jan-93 Jan-95 Jan-97 Jan-99 Jan-01 Jan-03 0% 1% 2% 3% 4% 5% 6% 7% 8% 9% GDP Gap Harmonized CPI (YoY) GDP gap positive now , and grow th is still running above potential rate. The capacity constraints are going to get worse as the UK economic growth has accelerated recently. As the following chart shows, our up to date broader economic growth gauge suggests that GDP growth is running well above the potential growth rate. UK : Monthly growth gauge -3% -2% -1% 0% 1% 2% 3% 4% 5% 6% Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Current grow th (3mma) Potential Grow th is significantly above potential. Housing price inflation has also turned up after a brief period of slowing down. Home price inflation is back above a 20%yoy growth rate. UK house price annual inflation rate -15% -10% -5% 0% 5% 10% 15% 20% 25% 30% 35% 40% Jan-83 Jan-85 Jan-87 Jan-89 Jan-91 Jan-93 Jan-95 Jan-97 Jan-99 Jan-01 Jan-03 Sharp turn-around 8 Bridgewater ® Daily Observations 7/15/2004
  • 9. Labor compensation has been rising as well. The labor markets are getting tighter as unemployment claims continue to fall, and this will put more pressure on wages to rise. The following chart shows annual growth rate in wages. Labor Compensation: Average earnings Index (YoY) 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% Jan-85 Jan-88 Jan-91 Jan-94 Jan-97 Jan-00 Jan-03 Wage inflation is rising. In summary, UK inflation has been creeping higher but more importantly, the upward pressures on inflation are building up. The credit markets have not fully discounted this and impact of strong growth. We continue to short UK bonds. Conclusions Credit Markets N. America US Canadian US Bonds Bonds Euro$ Moderately Neutral Bearish Neutral Europe UK Euroland UK Euroland Gilts Bonds Euro£ Short rates Moderately Bearish Neutral Neutral Neutral Asia Japanese Australian Japanese Australian Bonds Bonds Euro¥ Bank Bills Moderately Neutral Neutral Bearish Neutral Currency Markets Canadian Japanese Australian Dollar Euro Yen Dollar Moderately Moderately Moderately Moderately Bullish Bullish Bullish Bullish Equity Markets US Japanese German UK French Canadian Australian Equities Equities Equities Equities Equities Equities Equities Neutral Neutral Neutral Neutral Neutral Neutral Neutral 9 Bridgewater ® Daily Observations 7/15/2004