Systematic Relative Strength

From time to time, The Economist runs a chart of the Big Mac Index.  It may be the only market index named after a hamburger!

They use it to illustrate purchasing power parity, the idea that the same item should cost about the same amount in every currency.  The graphic is below:

Source: The Economist

One of the stunning things, to me, was that despite an absolute pummeling of the Euro lately, the Big Mac is still more expensive in Euros!  Despite the weakness we’ve seen already, maybe there is more to go.  It’s cheapest to clog your arteries in China and Russia, which is a potential argument that the yuan is still too low.

Source: Fox News

I have to admit I’m actually a little hungry after writing this post!  Next time I suppose I should leave out the picture of the burger.

From Financial Advisor Kid:

If it’s not one thing, it’s another thing.  There will never be a shortage of trends!

Yes, it’s a college degree. According to an article in the Atlantic:

The typical college graduate earns $570,000 more than the average person with only a high school diploma over her lifetime. That makes college the best big investment on the market, Michael Greenstone and Adam Looney find in this remarkable report on the value of a higher education.

Let’s say you’re deciding where to invest $100,000 at age 18. Maybe you think to put it in gold, corporate bonds, U.S. government debt, or hot company stocks. It turns out the best investment — by far — is college. “The $102,000 investment in a four-year college yields a rate of return of 15.2 percent per year,” the authors report, “more than double the average return over the last 60 years experienced in the stock market” and more than five times the return in corporate bonds, gold, long-term government bonds, or housing.

Source: The Atlantic

Now imagine if you take those enhanced earnings and invest them in the stock market…

This from First Trust’s chief economist Brian Wesbury, by way of Real Clear Markets:

We use a capitalized profits model to value stocks, dividing corporate profits by the 10-year Treasury yield. We compare the current level of this index to that from each quarter for the past 60 years to estimate an average fair-value. Not only are 10-year yields low (2.2%), but corporate profits are growing strongly. As a result, and hold onto your hats, this top down model says that the fair-value for the Dow is currently 40,000.

However, we think the Treasury market is in a bubble. So, instead of a 2.2% yield, we use a more conservative discount rate of 5% for the 10-year Treasury. This generates a “fair value” of 18,500 on the Dow and 1,940 for the S&P 500. In other words, the US equity markets are currently undervalued by about 65%.

So what does our model say if profits revert to the historical mean of about 9.5% of GDP? Even in that scenario, and assuming a 5% yield on the 10-year Treasury, equities are about 21% undervalued, with fair value at 1430 for the S&P 500 and 13,700 for the Dow.

The problem with this scenario is that it takes the worst of both worlds: a major decline in profits and a surge in interest rates. In the real world, a large decline in profits would normally be accompanied by a drop in bond yields. In other words, our model says the risk of investing in equities today is very low.

I have no idea if he is right or not, but I feel better after reading it!  Market sentiment has been so negative lately that I think I just like reading something where we aren’t all on the way to hell in a handbasket.

Source: caglecartoons.com

From Carl Richards:

He explains in Your Neglected Stock Market Backup Plan:

The stock market is doing what stock markets do. Yet we run around like it’s such a shock. We don’t know when it will happen, and often it’s hard to tell why, but the fact that the market went down shouldn’t have surprised anyone.

To be clear: this is not a problem with the market. This is a problem with us. How in the world can you invest your hard-earned money without a plan for both the good and the bad days? Any plan needs to account for the reality that markets go down as well as up.

Carl’s blog at the New York Times is full of humor and insight, but he often hits the nail on the head when discussing behavioral issues!

From Louis Woodhill at Forbes.  Funny stuff.  An excerpt to give you the flavor of the “interview.”

Below is the transcript of an exclusive Unconventional Logic (UL) interview with the elusive Mr. World Financial Markets (WFM) himself.

UL: Thank you for taking the time to speak with us today. What do your friends call you? Can I just call you “World” for short?

WFM: I’m nobody’s friend, and you can call me “Mr. Markets”.

UL: Yes. Right. Well. Moving right along, Mr. Markets, there are a lot of pretty anxious people out there wondering just what on earth is going on. The Dow went down 635 points one day, and up 430 the next. We were hoping that you could shed some light on this.

WFM: Look, I tell you everything I know every second of every trading day. The answers to all of your questions are in the numbers I give you. What is going on should be obvious.

Mr. Markets seems to be a fan of our “in price there is knowledge” thesis!  And:

WFM: Hey, do you know what this job is like these days? Not only do I have to guess what stocks, bonds, and commodities are worth, but I also have to try to guess what your stupid paper dollar is worth. And, it all changes every millisecond! Forty-five years ago, when you had a gold standard, all I had to do was value stocks and commodities. And, those values didn’t change very much, or very fast. A few points on the Dow was a big deal. And, no foreign currency work at all. Fixed exchange rates! Ah, those were the days.

If I can find his phone number, perhaps Mr. Markets will also be interested in opening a Global Macro account.

The world is indeed more complicated than a generation ago.  Money goes where it is treated best and with increased globalization and computerization, the money can now go into just about any asset class anywhere, electronically.

It’s hard to repeal the economic law of supply and demand.  In many parts of the world, the family of the bride has to pay a dowry to obtain a suitable husband.  But in a role reversal, men returning from war in South Sudan have to pay to obtain a suitable wife!  From BusinessWeek:

Like many countries, South Sudan, which won its independence on July 9, is grappling with inflation. Only here the rise in costs is measured in the cattle needed to pay the bride price—what a young man gives a young woman’s family for her hand in marriage. It’s a reversal of the dowry payment by the bride’s family, a practice once widespread in the West.

With hostilities over, thousands of men have returned home, driving bride prices up 44 percent since 2005.

It’s not just financial markets that adjust for supply and demand—all kinds of changes are reflected in prices.  Price is worth paying attention to, especially when it is different from normal expectations.

(Click to Enlarge)

Perfect for a day like today.

HT: CW

—-This article was originally published August 17, 2009.  Financial reporters are still trying to scare the stuffing out of everyone.