BNP Paribas on Equities Bubble

In a note issued late on Thursday, the credit analysts at BNP Paribas argued that “despite a close to 5o per cent drop in equity valuations, equities look not only rich but are significantly mispriced and are a bubble waiting to be pricked.”

Moreover, they contend that equity analysts are “ignoring the tremendous value embedded in investment grade credit.”

Here are some highlights, which include quite a lot of snickering at the “unfathomable” bullishness of equity types:

Over the past equity bubble decade, it has become fashionable for equity analysts to concentrate on Operating earnings as opposed to As Reported earnings, which factor in write-offs and restructuring charges (Charts 1 and 2). While the difference between the two measures was insignificant until the internet bubble, that difference has grown significantly to the extent that operating earnings look like numbers plucked out of thin air with little resemblance to economic reality. As credit analysts, we are taught that, for a given revenue base, rising costs lower profits, raise leverage and lower creditworthiness. How equity analysts can ignore this fundamental credit analysis is unfathomable to us.






Using current valuations, if one were to calculate the P/E multiple on 2009 earnings, one lands up with 14x using operating earnings and 30x using as reported earnings. We will leave investors to make their own judgment but P/E multiples of 30x certainly scream bubble to us.

As for the use of earnings yield, which they deplore as “another false measure”, equity analysts, using the operating earnings measure have also made the argument that earnings yield are significantly higher than 10-year US Treasury yields and hence equities offer value. This relative value comparison is fundamentally flawed on two counts. Firstly, as we have pointed out, operating earnings are not true earnings and secondly the relative value comparison, should be made to corporate bond yields not treasuries, which would be an appropriate apples to apples comparison. Using this measure, clearly it again illustrates the tremendous value in investment grade credit as opposed to equities.

BNP Paribas chart of expected earnings yield with S&P 500 at 850



Every bull and bear cycle is usually characterized by a significant event that anecdotally indicates over or under valuation in equities. The 2007 top was characterized by the generosity of Blackstone, which thought it fit to share its profits via an IPO, the equity piece of a highly leveraged entity and a known liquidity extractor.

The recent secondary offering by Goldman Sachs, could well mark the top of this bear market rally because GS, we believe would only issue equity at these valuations for two reasons, namely because it needed to as losses on its highly illiquid Level 3 assets continue to mount, or because it saw its equity valuation as being grossly overpriced.

The lack of institutional participation and endorsement of this deal, radio silence from Mr. Buffett, who, as a consequence of this deal got diluted and with both Moody’s and S&P maintaining their Negative Outlook despite the equity injection, it points to GS being very opportunistic in exploiting its equity overvaluation and having the need to build a buffer for future losses.

Time will tell, how significant this GS top will be but for now it makes us very wary of equities, especially US financials, as they have become the playground of day-traders.

They also the purported green shoots in mortgage applications - “not a sign of new home purchases but simply refinancing”.

As for commodities and trade, we will simply let the hard data and the charts do the talking here as commodities and the Baltic Dry index continue to show a “U” or “L” shaped recovery with no sign of “V”.

For the record, they’re expecting a “U” shaped recovery.

(from ft.com/alphaville, April 24, 2009)

Why Joseph Stiglitz doesn't like the TARP

What strikes me about the TARP is that the banks choose which assets to dump. Therefore, the taxpayers will hold the worthless assets.

The Obama administration’s bank-rescue efforts will probably fail because the programs have been designed to help Wall Street rather than create a viable financial system, Nobel Prize-winning economist Joseph Stiglitz said.

“All the ingredients they have so far are weak, and there are several missing ingredients,” Stiglitz said in an interview yesterday. The people who designed the plans are “either in the pocket of the banks or they’re incompetent.”

The Troubled Asset Relief Program, or TARP, isn’t large enough to recapitalize the banking system, and the administration hasn’t been direct in addressing that shortfall, he said. Stiglitz said there are conflicts of interest at the White House because some of Obama’s advisers have close ties to Wall Street.

“We don’t have enough money, they don’t want to go back to Congress, and they don’t want to do it in an open way and they don’t want to get control” of the banks, a set of constraints that will guarantee failure, Stiglitz said.

The return to taxpayers from the TARP is as low as 25 cents on the dollar, he said. “The bank restructuring has been an absolute mess.”

Rather than continually buying small stakes in banks, the government should put weaker banks through a receivership where the shareholders of the banks are wiped out and the bondholders become the shareholders, using taxpayer money to keep the institutions functioning, he said.

Stiglitz, 66, won the Nobel in 2001 for showing that markets are inefficient when all parties in a transaction don’t have equal access to critical information, which is most of the time. His work is cited in more economic papers than that of any of his peers, according to a February ranking by Research Papers in Economics, an international database.

Financial shares have rallied in the past month as Goldman Sachs Group Inc., JPMorgan Chase & Co., Citigroup Inc. all reported better-than-expected earnings in the first quarter. The Standard & Poor’s 500 Financials Index has soared 91 percent from its low of 78.45 on March 6.

The Public-Private Investment Program, PPIP, designed to buy bad assets from banks, “is a really bad program,” Stiglitz said. It won’t accomplish the administration’s goal of establishing a price for illiquid assets clogging banks’ balance sheets, and instead will enrich investors while sticking taxpayers with huge losses, he said.

“You’re really bailing out the shareholders and the bondholders,” he said. “Some of the people likely to be involved in this, like Pimco, are big bondholders,” he said, referring to Pacific Investment Management Co., a bond investment firm in Newport Beach, California.

Stiglitz said taxpayer losses are likely to be much larger than bank profits from the PPIP program even though Federal Deposit Insurance Corp. Chairman Sheila Bair has said the agency expects no losses.

“The statement from Sheila Bair that there’s no risk is absurd,” he said, because losses from the PPIP will be borne by the FDIC, which is funded by member banks.

Andrew Gray, an FDIC spokesman, said Bair never said there would be no risk, only that the agency had “zero expected cost” from the program.

“We’re going to be asking all the banks, including presumably some healthy banks, to pay for the losses of the bad banks,” Stiglitz said. “It’s a real redistribution and a tax on all American savers.”

Stiglitz was also concerned about the links between White House advisers and Wall Street. Hedge fund D.E. Shaw & Co. paid National Economic Council Director Lawrence Summers, a managing director of the firm, more than $5 million in salary and other compensation in the 16 months before he joined the administration. Treasury Secretary Timothy Geithner was president of the New York Federal Reserve Bank.

“America has had a revolving door. People go from Wall Street to Treasury and back to Wall Street,” he said. “Even if there is no quid pro quo, that is not the issue. The issue is the mindset.”

Stiglitz was head of the White House’s Council of Economic Advisers under President Bill Clinton before serving from 1997 to 2000 as chief economist at the World Bank. He resigned from that post in 2000 after repeatedly clashing with the White House over economic policies it supported at the International Monetary Fund. He is now a professor at Columbia University.

Stiglitz was also critical of Obama’s other economic rescue programs.

He called the $787 billion stimulus program necessary but “flawed” because too much spending comes after 2009, and because it devotes too much of the money to tax cuts “which aren’t likely to work very effectively.”

“It’s really a peculiar policy, I think,” he said.

The $75 billion mortgage relief program, meanwhile, doesn’t do enough to help Americans who can’t afford to make their monthly payments, he said. It doesn’t reduce principal, doesn’t make changes in bankruptcy law that would help people work out debts, and doesn’t change the incentive to simply stop making payments once a mortgage is greater than the value of a house.

Stiglitz said the Fed, while it’s done almost all it can to bring the country back from the worst recession since 1982, can’t revive the economy on its own.

Relying on low interest rates to help put a floor under housing prices is a variation on the policies that created the housing bubble in the first place, Stiglitz said.

“This is a strategy trying to recreate that bubble,” he said. “That’s not likely to provide a long-run solution. It’s a solution that says let’s kick the can down the road a little bit.”

While the strategy might put a floor under housing prices, it won’t do anything to speed the recovery, he said. “It’s a recipe for Japanese-style malaise.”

Even with rates low, banks may not lend because they remain wary of market or borrower risk, and in the current environment “there’s still a lot of risk.” That’s why even with all of the programs the Fed and the administration have opened, lending is still very limited, Stiglitz said.

“They haven’t thought enough about the determinants of the flow of credit and lending.”

(from Bloomberg, April 17, 2009)