Monthly Archives: March 2013

Summly – What Every Student, Parent, and Grandparent should know!

You have to watch this video.  It’s Charlie Rose interviewing 17 year-old Nick D’Aloisio.  He is the young man who sold his application a.k.a. “app” – Summly to Yahoo for a rumored $30 million dollars.

http://www.charlierose.com/view/interview/12850

There is so much to learn from this back and forth it is amazing.  In 16 minutes this young man tells you the future.  Mobile smart phones, learning to write code in his spare time, and creating apps for solving problems for yourself and others is the wave of the future.

Young people never seem to ask for career advice.  I do get an occasional MBA student asking to have a coffee now and again – by the way I don’t drink coffee.  I have been asked twice in the last four years for career advice and when I answer develop an “app” complete silence and a blank stare usually follow.  Everything in society today is changing at such speed it’s hard to catch your breath.  I see young people today lined up for commerce degrees and MBAs thinking of riches like past alumni.  Let me tell you a little secret.  Finance is so over.  Yes, you could have made a fortune in finance over the last 15 to 20 years when finance was the Wild West.  But finance blew up the world in 2008 and whole societies are now paying the price.  Would I go into finance today if I were a young person?  No way.  (See my blog post “Blowing Up the Financial Business”.)  I would write code.  “Apps” are the Wild West of today and for the foreseeable future.

OK, I get it – you don’t want to learn how to code.  You think it’s boring.  No problem.  Listen to Nick and learn how persistent he was emailing and trying to communicate with Apple’s App Store and his non reply letters they returned.

Then Nick moves into high gear, the piece de resistance of the video. Nick summarizes Steve Jobs words – “People never ask” and offers the famous anecdote of Steve calling Bill Hewlett at the age of 12 asking for spare parts.

Here is Steve’s actual quote,

“Most people never pick up the phone, most people never ask.  And that’s what separates, sometimes, the people that do things from the people that just dream about them.  You gotta act.  And you gotta be willing to fail…if you’re afraid of failing, you won’t get very far.”

Better still here are some video clips of Steve actually saying this and other inspirational things.

http://www.brainpickings.org/index.php/2011/12/02/steve-jobs-1995-life-failure/

Rarely have I seen such wisdom.  Such simplicity.  The world is changing in terms of jobs, careers and technology this is true but good old-fashioned persistence and “asking” have never gone out of style either.

The future is so bright with people like Nick coming along.  Makes me wish I was 17 again, how about you?

Why Apple’s Stock Price is Floundering!

“Apple’s valuation is a riddle wrapped in a mystery inside an enigma.”  I have revised Winston Churchill’s famous quote on Russia to make a point on investors, both professional and do-it-yourself types, that seem perplexed on Apple’s current valuation.  We have all watched while Apple’s stock price has inexplicably eroded from just over $700 per share to its current value of $452.08.  Why? This to my mind is what is wrong with the current state of finance. There is no definitive source or service available to have any discussion about valuation.  There is currently no math that exists today, in published textbooks or accredited courses that answer the question of valuation properly to the common man or investor.

New math has to be created.  New tools should be invented. The current orthodoxly is broken.  Isn’t there a Harvard MBA anywhere that can tell anybody the valuation puzzle that investors crave?  What is the key to unlock this valuation question?

Model Price Math to the Rescue!

First we calculate the model price or fair market value of Apple Inc. everyday – along with 2000 other companies.  As of last night the model price of Apple is $591.64.  Simple.

Here is our model price chart not only showing last night’s output but also a history of our model price calculation for our users benefit. (Purple dashed line)

Apple Inc. with weekly price bars and model price calculation (dashed line)

Apple Inc. with weekly price bars and model price calculation (dashed line)

For those interested, a daily updated chart of AAPL subsequent to this post will be maintained on Facebook, here.

How do we do this?

We created an algorithm that is so robust it works across all companies and industries.  Think of the differences in all these companies.  Think of the peculiarities of each company’s business model and balance sheet.  How is this possible?  By finding and inventing new mathematical equations that are relevant to the process of business.  By thinking about the process of solvency within the process of doing business, which every businessperson constantly thinks about not in an academic way but in a real world way.  By looking and examining balance sheets of all enterprises both private and public containing information that most if not all the investment community discards.

That’s how.

So in this blog I want to highlight just two concepts that reside in our calculation of model price that can go a long way to help in this valuation question on Apple Inc.

Theoretical Earnings (TE)

When I was introduced to the beginning mathematical concepts of model price work, some 15 years ago, one of the first concepts that peaked my interest was theoretical earnings or TE.  One of the big problems with analyzing any business, especially public companies, is that they are constantly in flux.  There is no constant or benchmark for analysis therefore all analysis is based on regression or relative measures with other businesses in the same industry.  If company X has a price/earnings ratio of 10 then company Y in the same industry with a P/E ratio of 8 must have some relative value.

The genius of theoretical earnings is the constant we are looking for is contained in the balance sheet of the company itself.   Using a company’s balance sheet, we can calculate a specific earnings number this same company needs in order to maintain state or constant in the future.   This constant or specific earnings number we call theoretical earnings.  It didn’t take us long to realize that the higher or greater the differential between theoretical earnings and estimated earnings per share the higher valuation the equity in question will achieve.  This is what the market, it seems to us, wants to value through a company’s share price among other concepts we have developed.

Apple Theoretical Earning’s

Here a chart of Apple’s TE relative to its’ 12-month forecast of earnings per share (EPS)

image0014

What is obvious from this chart is the parabolic growth of Apple’s earnings since 2007.  Remember the iPhone was launched in 2007 and the first iPad was released in April 2010.  One could argue Apple, with its brilliant founder – Steve Jobs – hit the perfect “three-peat”.  iPod with iTunes, iPhone and iPad launched Apple’s earnings into the stratosphere as you can clearly see.  What’s next?  Can these current levels of earnings be sustainable? Will there be a “reversion to the mean” with earnings in the company’s future?

Let’s go a step further.

Taking the data from the above chart, we can form a ratio of EPS/Theoretical Earnings – see chart below.

image0032

By looking at the chart you can see Apple went through three distinct periods.  The first period was between 1995 and 2005.  The period shows earnings relative to its TE fell to zero or Apple’s earnings were equal to its’ Theoretical Earnings and then rebounded.  The second period goes from 2005 to the beginning of 2010.  This second period highlights Apple’s EPS/Theoretical Earnings ratio of about 4 times.  The third period, when the iPad was launched saw earnings grow almost 8 times Apple’s TE.  Understandably the higher the EPS/Theoretical Earnings ratio the higher Apple’s valuation.

This brings us to the end of our chart.  Where is this ratio going in the future?  Will the EPS/Theoretical Earnings go back to a ratio of 4 times?  Will it go back to zero?  Or will the innovation keep happening, without Steve Jobs, and have this ratio turn around to achieve new highs?  What is your guess?

To date the market sees atrophy in this ratio and has acted on Apple’s share price accordingly.

Convexity

Convexity is one of our must difficult mathematical concepts to explain in relation to finance and the public markets however in some ways it’s an important part of our calculation of model price.  This mathematical construct is the feedback mechanism where the balance sheet of the company feeds into the stock price’s ultimate valuation in the public equity markets.  The higher convexity number computed the higher the company’s valuation.  However too high a convexity number will give a given company a higher valuation but will substantially increase variability (or volatility) in the company’s stock price as this feedback mechanism can become unstable.

Here is our chart on the calculation of convexity for Apple going back to 1995.

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What is this chart saying?  Convexity will NOT be a driver for increased valuation until this chart or convexity starts turn up.  There is a consequence of Apple’s management decision to capture its’ excessive profits on its balance sheet in the form of cash reserves or other assets – a lower share price valuation because of very low convexity.  Assuming Apple’s EPS/Theoretical Earnings returns to a ratio of 4 times, Apple’s overall valuation will probably be lower if this convexity number is unchanged in future periods.

How would you increase this convexity input into our model price calculation?  Reduce the size of the balance sheet is one answer.  This can be easily achieved by reducing the cash on the balance sheet by either paying out dividends and/or buying back company shares.  Interestingly another way to increase convexity is by way of a stock split.  The math works!  Yes, this is counter-intuitive but anecdotally all market participants know that when a company announces a stock split this is viewed as a positive usually pushing the market value of the company up!  Increased convexity is the mathematical reason.

Apple’s convexity number is 0.12.  To give you some context, the S&P 500 has convexity of 1.40 which is market capitalized weighted like the S&P 500 itself.  As you can see Apple has a long way to go to catch up with other companies in the popular index.  (Apple obviously influences this convexity number with being a large weight in the index.)  Microsoft has convexity of 1.86 and Amazon 1.17 for comparison purposes.

Conclusion

Hopefully this blog gives you a whole different perspective on Apple and its fundamentals.  The good news is Apple is currently trading under its calculated model price calculation, which we calculate nightly.  Another piece of good news is the shareholder base is changing as we speak.  Growth, and the momentum crowd are clearly exiting being replaced by the value crowd, probably more patient and more happy clipping coupons than price appreciation and or volatility.

The bad news for Apple is where our EPS/Theoretical Earnings ratio will travel?  Innovation and new products was the key to Apple’s enormous success, which translated into record profits and valuation highs.  Is this Apple’s future?  Was this a product of Steve Jobs unique vision that obviously will not be around in the future?

The numbers suggest to me, especially convexity, that Apple’s current management is happy to consolidate their position – giving out fresh iterations of their current product line (iPhone 15 anyone) – sitting on this enormous cash pile, waiting.  Wait for what you ask? Waiting for the next big product to launch.  Yes, this could be years down the road but no matter.  What is probably more important to Apple right now is to preserve the Job’s legacy and not screwing up then going back to its roots as an iconoclast think differently company that everyone finally came to admire.

S&P 500 – Why the US Stock Market is going up! (Part 2)

Do you remember the “Fiscal Cliff”?  Or how about “Budget Sequestration”?  You probably remember the words but foggy on the details.  That’s OK.  Have you heard of the Dow making new highs?  Of course you have.  Is there a connection?  Yes there is, however no one in the financial press can and will put the pieces of the puzzle together.  Model Price theory can connect the dots; so let me do this for you.

This won’t be the first time I have laid out this thesis.  Back in a blog post in July, I outlined the framework according to model price theory for a new bull market not only for US equities but also for the US economy as well.  I will quote from this blog and update the current “goings-on” adding context to these new highs.

First off a little bit of Model Price Theory

“Solvency Curve” and “Solvency Ratio” – See Key Concepts

Since the financial crash of 2008, the developed world has been in a “Balance Sheet” recession instead of a garden-variety inventory recession.  So by analyzing balance sheets in terms of solvency is an important aspect on what we can do to fix the predicament the US and much of the developed world finds itself.  The US Federal Reserve produces a quarterly balance sheet called “Flow of Funds” data, which encompasses balance sheet data on both federal and state governments but also data on the private sector.  This data is invaluable and when used with model price theory can explain much what we have seen and experienced in the last five years.

Review of our “Solvency Curve”

Illustration of our Solvency Curve.

Model Price "Solvency Curve"

Model Price’s “Solvency Curve”

The numbers on the x-axis or the bottom of the chart represent the output of a formula we call our “Solvency Ratio”.  Here is the formula for our ratio.

This formula can be applied to any balance sheet, individual, government and private and public companies.

Once you calculate the output from our Solvency Ratio formula, the result can be fit on our “Solvency Curve” to see where the output resides.  We have labeled and color-coded the ratio output which best describes the solvency of the organization or enterprise in terms of being insolvent, solvent and super solvent.  Also performing this exercise over time you can get a feel for the dynamic of how the organization or enterprise manage the solvency of their respective organizations.

US Federal Government

We can compute the Solvency Ratio for the US Federal Government by looking at the “Flow of Funds” data from the Federal Reserve Board.  We calculate this ratio to be 0.135.  This puts the US Federal Government on the cusp of what we call the 3rd Order of Insolvency.  If any entity including the US Federal Government slips into this category this implies “Total Insolvency” if not “Total Breakup” of the entity.  We have been doing solvency analysis on the US Federal Government for at least 10 years and I can say for the last 5 years this ratio hasn’t budge at all.  How can this be possible you say, with all of the debt the US Federal Government has been piling on in the last 5 years?  Good management of the ratio whether intended or not.  As the US Federal debt level increased (P), the Treasury insures there is additional cash set aside balancing out the R in our “Solvency Ratio” equation.  R maybe going up in proportion to P however it’s all with borrowed money.

Solvency Analysis of the rest of the categories in the “Flow of Funds” data

When we perform calculations on the balance sheets of the other categories besides the US Federal Government, (i.e., State and Local Governments, Commercial Banking, Nonfarm Nonfinancial Corporate Businesses, etc.), each category is either solvent or super solvent.  What is interesting is over the last 10 years, especially over the last 5 years each of these categories have been shifting right – moving right along the our “Solvency Curve” to a more solvent state.

This is not surprising to us and we have seen this many times especially in our own country of Canada.  As the Federal Government of any country goes evermore into debt the other participants or actors in the economy shift evermore right or become more solvent.  Why does this happen?  All participants know eventually they will forced to pay increased taxes and/or reduced services of their Federal Government and the US is no exception.

Therefore when looking at our “Solvency Curve” over the last 5 years in the US, the US Federal Government continues to borrow ever-increasing amount of nominal debt – while holding on to the brink of insolvency at 0.135 – with all other categories moving right building up solvency eventually knowing increased taxes or reduced services will be in the offing.

We can illustrate this point by placing “down” arrows on our “Solvency Curve” so you can visualize what is going on with all participants in the US economy.

Think about this, a similar “downward” action along their own “Solvency Curve” has been occurring in Japan for the last 20 some years.  Hampering any recovery for the Japanese people for a generation.

So what is my point?

With the “Fiscal Cliff” and the “Budget Sequestration” the US Federal Government made a serious down payment on reversing this negative action along their “Solvency Curve”.  President Obama’s stated goal is to have $4 trillion in a combination of increased revenue (taxes) and reduced spending over the next 10 years.  These two actions – “Fiscal Cliff” and “Budget Sequestration” – the President and Congress has achieved $1.5 Trillion permanent savings of the $4 Trillion goal.  THIS IS BIG!  This is progress even though the media will tell you the Republicans and Democrats are not doing anything.  The political parties are at each other throats! Don’t believe it.

Change the direction in our “Solvency Curve” – Welcome to the new bull market!

If and when the US Federal Government stabilizes its solvency picture or better yet reverses course to a more solvent nature – increasing our “Solvency ratio from 0.135 – guess what happens?  You guessed it.  The other participants and actors in the economy start spending their money.  Growth starts to happen.  Consumers and businesses starts to borrow money again believing expansion and business creation have a high probability of success.  Have a look at our “Solvency Curve” and notice the different direction of the arrows – see chart below.  As the US Federal Government becomes more solvent the economic actors or participants will start to invest in assets (Houses and businesses), companies will reduce record cash balances – see blog October 11, 2012 – (build plant and purchase equipment, hire additional staff, and start returning cash to shareholders) as economic growth begins to pick up.

CHART – Up Arrows

Model Price "Solvency Curve"

Model Price’s “Solvency Curve”

The US equity markets are sniffing a secular change occurring in the solvency of the US economy.  The “Fiscal Cliff” and “Budget Sequestration” negotiations provided a meaningful and permanent shift showing the US Federal Government is getting its act together and starting to improve its solvency position and the equity markets are taking notice.

This is why the equity markets have been so good lately.  This is why new highs have been achieved on the Dow Jones with the S&P 500 not far behind.  The US equity markets are sensing a secular shift in solvency driving a better economy and higher stock prices.

I wrote this in my July 17 blog, “What is going on with the world of finance, and how do you fix it!”

It is the US Federal government that is driving the other categories down the other side of the curve.  In other words, the solvency of the government is the issue.  Therefore, in my mind the President, or whoever, must layout a fiscal plan to at least balance or close the gap in the fiscal deficit.  When and if, the federal government starts to climb the left side of our solvency curve, the other categories will start to move up the right side of the curve.  The debate of raising taxes or cutting expenses is not the choice Americans have at this present time.  It’s both!  Taxes will have to be raised and expenditures have to be cut substantially in order to rectify the situation.  Once everyone sees the plan and its implementation, the other categories on the right hand side of the curve, especially corporations will start spending their records amounts of cash on hand.  Why?  The right side of the curve “categories” can see sustainability in the future of the federal government.  They can see a limit in terms of taxes and/or reduced services.  This will give them confidence in the future and they will spend money on long-term projects, igniting employment and giving confidence to other groups.  And so on.

You mean substantially increase taxes and the economy will boom – absolutely!  You mean substantially cut federal spending and there won’t be a depression – absolutely!

The New Bull Market

Yes, there will be a new bull market – when?  Simple, when both sides of the solvency curve start to move closer together as opposed to further apart.  No, when as in timing?  I don’t know.  But I will know it when I see it!

Well folks with “Fiscal Cliff” and “Budget Sequestration” of the last few months, I’m beginning to see it!!!

I conclude

The other observation I can make, is when we do enter this new bull market, it will be bigger than any other bull market we have ever had.  Why?  The extreme nature of where we are now on the solvency curve.  Obviously, US Flow of Funds data is not available for the Great Depression of the 1930’s (at least not to us), however the extremes on both sides of the curve, as it is today, haven’t occurred certainly in my lifetime.  So when today’s extremes start to stop and reverse course there will be a lot of “Rocket Fuel” for the next bull market.

Are you hearing any of this in the financial press?  I THINK NOT!

P.S. Just to be complete and tie together Part 1 and Part 2 of this blog, if S&P 500 has a positive transit of EBV+3 this will be an important indication the market will be comfortable with the secular turnaround in the solvency of the US economy and start of a new secular bull market in US equities.

P.P.S. Also see my blog on Fall over the Fiscal Cliff, Please!

S&P 500 – Why the US Stock Market is going up! (Part 1)

It’s good to be back from vacation.  Granted, it has taken me a few days to adjust to a new (old) time zone and lack of sunshine.

It has been a tough five years or so in Southern California so when the ever-ubiquitous flat panel televisions in public areas scream the steady drumbeat of the “Dow” making new highs people seem to listen and make rhetorical comments.  Yes, you have heard them all; “This cannot last!”, “It’s a bubble!”, and my favorite “Why is the market going up?” to no one in particular.

Model Price math to the rescue!

So what is going on?

First, let’s have a look at our Model Price chart for the S&P 500.  Remember this chart is an amalgamation of all 500 companies in the S&P 500, on a bottom up basis, aggregated by market capitalization.

S&P 500 with weekly price bars, EBV Lines (colored lines).

S&P 500 with weekly price bars, EBV Lines (colored lines).

Since mid November the S&P 500 has rallied up 15.56%, to within 20 S&P points of our EBV+3 line.  If you have been following my monthly S&P 500 Strategy blogs over the past year,(here, for instance) I have outlined many times that a market rally up to EBV+3 was the most likely market probability.  So far as we are concerned this is what we expected from the market and it occurred – so no big surprise here!  What will be interesting is what the market will do from here.

Let me go through the scenarios

Scenario 1. The market will “squeeze” up underneath EBV+3 and accrue gains as the growth in the EBV +3 occurs as you can see in the naturally upward slopping EBV line illustrates growth in the underlying companies balance sheets.  This “squeeze” could last days if not months.  Volatility will be reduced as the market patiently awaits economic news to move the market in one of two directions or scenarios.

Scenario 2 (a). The market corrects anywhere underneath EBV+3 line.  Obviously the bad economic news can and will come from anywhere, but any correction would be a buying opportunity for a subsequent rally back up to EBV+3, wherever the EBV+3 value is at the time of the rally.  I call this a “saw tooth” action, which can and will be repeated many times until the market is confident to have a positive transit of EBV+3.

Scenario 2 (b). The market, or the S&P 500 Index breaks out or has a positive transit of EBV+3.  As I have said many times this transit would be very bullish indeed.  The last time the S&P 500 had a positive transit of EBV+3 was back in mid 1992.  This breakout foretold one of the largest and longest bull markets in recent recorded history from mid 1992 to April of 2000.

What is my guess in Scenarios?

I do not believe the timing is right for a positive transit of EBV+3.  Why?  With a couple of decades of market experience and a guess, I think it’s too soon for a major positive transit with this current market.  Usually markets like to fool around, with major levels (EBV+3 is a major level) before a transit occurs.  Also major transits, like the one we are anticipating, usually occur when investors/traders are not paying attention – say middle of summer or August.  Just saying, and I’m giving you my best guess.

So the high probability trade, if you will, will be the market doing “nothing much” to a market correction highlighting my “saw tooth” pattern I have outlined my times before.

In summary, we are not surprised in the daily “new highs” which are occurring just underneath EBV+3. I have predicted a “high probability” course of action for the S&P 500 based on our model price chart for the short and intermediate future.  In Part 2, I will directly answer the question, “Why the US stock market is going up!”.

ModelPrice Guy will be on Vacation for a week!

Yes, tomorrow ModelPriceGuy will be focusing on the dimples of a golf ball as opposed to pixels on the screen.

No blog posts are to be expected however I have amassed over 180 blogs for your reading pleasure.  Also I will be intermittently looking at the Model Price Facebook app and making comments if appropriate.

I will return rested and looking forward to be working twice as hard as I have been over the last year.  Yes, I have been fooling around with videos but not quite happy how they are turning out – definitely more work required!

Will be back on March 11, 2013.

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