Unemployment rates and recessions in the US

Often one hears in interviews on media covering business issues and financial markets that a recession cannot happen if the unemployment rate is low.

As it turns out, the opposite is what usually happens, as you can see from the graph below, which shows unemployment rates over time.

The graph shows that periods of low unemployment usually precede recessions, even though recessions cause high unemployment!

Is there a relationship between interest rates and PE ratios?

Summary

- We look at the relationship between 10y Treasury yields () and Shiller PE10 ratios () from 1971 to 2021.

- When these two measures are compared and correlated, without time lags, there seems to be no relationship.

- When we consider time lags, a relationship becomes apparent: periods of tightening, when yields go up, seem to be followed by contractions in Shiller PE10 ratios.

10y Treasury yields vs. Shiller PE10 ratios from 1971 to 2021

The graph below shows the relationship between 10y Treasury yields and Shiller PE10 ratios during the period going from 1971 to 2021. The low Shiller PE10 ratios shown at the bottom generally occur during market crashes. The R-squared for the relationship is shown next to the best-fitting inverted J curve.

As we can see, the 10y Treasury yield explains only 5.1 percent of the variance in the Shiller PE10 ratio, even after nonlinear function transformation (aka “warping”). The relationship is weaker if it is modeled as a linear association. This goes against the idea that there is a relationship between 10y Treasury yields and Shiller PE10 ratios.

Arguably the time period considered is too large to be representative of what might happen today. Notably, the S&P 500 has been much more strongly influenced by high growth companies since 2003, after the crash of the “tech bubble” and the emergence of a few large and very successful technology companies.

10y Treasury yields vs. Shiller PE10 ratios from 2003 to 2021

The graph below shows the relationship between 10y Treasury yields and Shiller PE10 ratios during the more recent period going from 2003 to 2021. Again, the low Shiller PE10 ratios at the bottom occur during the market crash of 2008 (those ratios did not drop as much during the COVID crash), and the R-squared for the relationship is shown next to the best-fitting J curve.

As we can see, the 10y Treasury yield explains 12.3 percent of the variance in the Shiller PE10 ratio, with nonlinear function transformation (aka “warping”). Still, this is a small number, which goes somewhat against the idea that there is a relationship between 10y Treasury yields and Shiller PE10 ratios.

However, closer inspection of the data suggests that market corrections and crashes, where typically Shiller PE10 ratios contract quickly, follow periods of tightening (top-right part of the graph). Also, PE10 expansion appears to occur after easing (top-left part of the graph).

Time series of 10y Treasury yields vs. Shiller PE10 ratios from 2003 to 2021

The graph below shows a time series with 10y Treasury yields in blue and Shiller PE10 ratios in orange, during the period going from 2003 to 2021. Since this is a time series graph, with time varying along the x axis, we can more easily spot lagged relationships.

Here we can see that periods of tightening (blue arrows up) appear to be followed by periods where the Shiller PE10 ratios drop (orange arrows down). This suggests that there is a relationship between 10y Treasury yields and Shiller PE10 ratios.

Conclusion

There seems to be a relationship between 10y Treasury yields and Shiller PE10 ratios. Periods of tightening, when yields go up, seem to be followed by drops in the Shiller PE10 ratios drop. And, given that yields rising precede PE10 ratios dropping, there is a predictive “flavor” to the relationship.

The problem is that as yields go up, so do PE10 ratios, until a point is reached where PE10 ratios drop precipitously. While it is not clear when the tipping point is reached, it seems to occur after a 1 to 2 percent point rise in yields.

A simulation-based valuation of Heliogen (HLGN): February 2022

Summary

- HLGN is a renewable energy technology company founded in 2013; it is headquartered in Pasadena, California ().

- In this post we provide a simulation-based (sim-based) valuation () of HLGN.

- Our results suggest the following fair values – stock price: $12.21, and price-to-earnings ratio: 85.36.

- At the time of this writing, HLGN trades at $4.77, so it appears to be undervalued, with a potential upside of 155.97%.

Heliogen (HLGN)

Heliogen, Inc., is a renewable energy technology company founded in 2013. The company is headquartered in Pasadena, California (). It has invented an artificial intelligence technology to enable solar power energy generation and storage, for which it has already been granted multiple patents (), with yet other patents pending.

Among its patented solutions are the following: HelioHeat, for the production of heat for use in industrial processes; HelioPower, a solution for power generation; and HelioFuel, a solution for hydrogen fuel production. The company has recently signed an agreement with Bloom Energy (), a multi-billion dollar company that sells fuel cell systems for on-site power generation.

Estimating a fair value for the stock

In this post we provide a simulation-based (sim-based) valuation () of HLGN.

Since the company has only recently become public, we assumed an expected growth in earnings for the next 5 years of 50%, which is what we used for the sim-based earnings growth rate. While this may seem like a lot, it is conservatively based on Bloom Energy’s recent sequential quarterly sales growth rate of 65.22%. We used 30% for net profit margin in our sim-based analysis, which is typical of high-growth technology companies; and a price-to-sales ratio of 10, which is at the low end of valuations for those types of companies.

Note that we assumed a positive net profit margin for a company that actually has a negative margin; we explained the rationale for this, in the context of our sim-based analyses, earlier in this blog ().

The table below summarize our sim-based results.

Since our sim-based analysis uses a S&P 500 return as a basis, our results summarized on the table above suggest the following fair values – stock price: $12.21, and price-to-earnings ratio: 85.36. At the time of this writing, HLGN trades at $4.77, so it appears to be undervalued, with a potential upside of 155.97%. It should be stressed that this is a 10-year out valuation, which is a typical range for a variety of companies; it is not a 15-year or 20-year out valuation, which are sometimes used for high-growth firms.

Final thoughts

HLGN became public on the last day of December 2021 via a special purpose acquisition company (SPAC) offering, reached a local peak share price of $16.35 on that same day, and then tanked to a low of $3.12 in late January 2022. It has steadily been going up since then, with a very low correlation with the S&P 500. The latter (S&P 500) has been going down since late 2021.

In spite of this roller coaster ride, the company seems like an asymmetric bet at the moment, with a lot of upside potential. Arguably the valuation above is rather conservative given the many avenues for income. Some examples are: producing hydrogen at a low cost for distribution and use (to generate electricity, and power large machinery such as trucks and aircraft), building and operating onsite solar energy power plants, patent royalties, and sales of carbon credits. Just to name a few.

Disclosure

The author owns HLGN shares at the time of this writing.

The crash of 1987 happened as the yield curve was steepening

Summary

- It is generally considered a bad sign if the 10y-3mo or the 10y-2y differences in yields fall.

- This is particularly true if the differences in yields fall below zero (a yield curve inversion).

- However, the crash of 1987 happened as the yield curve was steepening, not flattening or inverting.

A crash without an inversion

When talk of a market crash intensifies, many people look for clues from the US Federal debt market to assess the probability of a crash happening soon. There is a widespread belief that the main clues come from Treasury yield differences, or the yields paid by US Federal debt instruments with different maturities.

It is a bad sign if the 10y-3mo or the 10y-2y differences in yields fall below zero (a yield curve inversion). However, as you can see on the figure below, the 1987 stock market crash happened around the time the 10y-3mo and 10y-2y yields peaked.

We show both the 10y-3mo and the 10y-2y differences in yields because some market experts have more confidence in the 10y-3mo signals, whereas others prefer those given by the 10y-2y differences. The reality seems to be that both the 10y-3mo and the 10y-2y differences in yields provide the same overall signals.

But the inversion preceded the recession

Having said that, the 1987 crash was followed by another smaller crash, related to the 1990 recession. This recession was indeed preceded by a yield curve inversion.

So, one could say that the yield curve inversion worked yet again, as it has done repeatedly, as a leading indicator of a recession.

Conclusion

The yield curve inversion phenomenon is a very good predictor of economic recessions, arguably one of the best leading indicators available to investors. And market crashes usually happen around recessions. But a market crash may happen without an economic recession.

In fact, the crash of 1987 happened as the yield curve was steepening, which is essentially the opposite of flattening – and arguably a bullish signal.

A simulation-based valuation of Alphabet (GOOG): December 2021

Summary

- GOOG was founded in 1998 and is headquartered in Mountain View, California (). It derives most of its sales from online advertising services.

- In this post we provide a simulation-based (sim-based) valuation () of GOOG.

- Our sim-based analysis suggests the following fair values – stock price: $3,385.97, and price-to-earnings (PE) ratio: 32.57. GOOG trades at $2,942.38, so it appears to be undervalued, with a potential upside of about 15%.

- GOOG’s leadership position in a few areas, and broad base of ventures with explosive growth potential, could lead to PE expansion, which would make our estimates above rather conservative.

Alphabet (GOOG)

GOOG was founded in 1998 and is headquartered in Mountain View, California (). It derives most of its sales from online advertising services, although other areas are growing at an accelerated pace. It breaks down its operations into three segments: Google Services, Google Cloud, and Other Bets.

Notable sources of revenue in the Google Services segment are hardware sales (e.g. the Pixel phone); and ads on Android, Chrome, Google Maps, Google Play, and YouTube. Google Cloud provides cloud infrastructure services, on which other (mostly third party) applications are run. The Other Bets segment could be seen as a very successful venture capital business.

Estimating a fair value for the stock

In this post we provide a simulation-based (sim-based) valuation () of GOOG.

At the time of this writing, the company had a profit margin of 30% and a price-to-earnings ratio of 28.3. The expected growth in earnings for the next 5 years is 30.09%, which is what we will use for the sim-based earnings growth rate. The table below summarizes our sim-based results.

Since our sim-based analysis uses a S&P 500 return as a basis, our results summarized on the table above suggest the following fair values – stock price: $3,385.97, and price-to-earnings (PE) ratio: 32.57. At the time of this writing, GOOG trades at $2,942.38, so it appears to be undervalued, with a potential upside of about 15%.

Final thoughts

Is inflation likely to become a problem for GOOG? We often hear from experts on business media outlets that inflation has a much more pernicious effect on growth stocks than value stocks. We looked into this issue in another post (). Our analyses suggested that growth stocks may do better under relatively high inflation (around 5%) than value stocks.

Moreover, GOOG’s leadership position in a few areas, and broad base of ventures with explosive growth potential, would allow it to: (a) raise its prices to make up for inflation; and (b) take advantage of the massive optionality generated by its Other Bets segment. Many other firms would not be in the same position, in part because the leaders in any industry are by definition only a few in number. All of this could lead to PE expansion, which would make our estimates conservative.

Finally, if the stock market experiences a correction, will GOOG shares go down? Mostly likely. In our view, that would be a buying opportunity.

Disclosure

The author owns GOOG shares at the time of this writing.

A simulation-based valuation of Uber Technologies (UBER): November 2021

Summary

- Uber Technologies (UBER) is an American company () that provides mobility as a service.

- In this post we provide a simulation-based (sim-based) valuation () of UBER.

- Our results suggest the following fair values – stock price: $106.99, and price-to-earnings ratio: 130.65.

- At the time of this writing, UBER trades at $45.12, so it appears to be undervalued, with a potential upside of 137.12%.

Uber Technologies (UBER)

Uber Technologies (UBER) is an American company () that provides logistics services of a genre that is sometimes called “mobility as a service”. It does not own any transportation assets (e.g., cars, or trucks), and is headquartered in San Francisco, California.

Its services are constantly expanding, and currently include: ride-hailing, food delivery, package delivery, freight transportation, electric bicycle and motorized scooter rental, and ferry transport. UBER receives a commission on fares, often of 25%. These fares are quoted to each customer in advance, using a dynamic pricing model.

Estimating a fair value for the stock

In this post we provide a simulation-based (sim-based) valuation () of UBER.

At the time of this writing, the company had a negative net profit margin of -17% and a price-to-sales ratio of 5.51. UBER’s estimated earnings growth rate for the next 5 years is 59.34%. We used 10% for net profit margin in our sim-based analysis; this is the margin of Avis, a car rental company.

Note that we assumed a positive net profit margin for a company that actually has a negative margin; we explained the rationale for this, in the context of our sim-based analyses, earlier in this blog ().

The table below summarize our sim-based results.

Since our sim-based analysis uses a S&P 500 return as a basis, our results summarized on the table above suggest the following fair values – stock price: $106.99, and price-to-earnings ratio: 130.65. At the time of this writing, UBER trades at $45.12, so it appears to be undervalued, with a potential upside of 137.12%.

Final thoughts

UBER has the potential to become a one-stop shop for all transportation needs, which makes its total addressable market quite large. Pressures to provide benefits to drivers will probably continue, but these may in fact create barriers for smaller competitors, further solidifying UBER’s leadership position.

One could argue that the development of autonomous vehicles could significantly increase UBER’s profit margins, but it is also possible that the developers of the technologies enabling autonomous vehicles will provide logistics services that could drive UBER out of business.

Disclosure

The author owns UBER shares at the time of this writing.

A simulation-based valuation of Facebook (FB): October 2021

Summary

- FB is the largest online social network in the world (). Given its enormous reach, with 2.5 billion monthly active users, it is a much sought-after conveyor of ads.

- In this post we provide a simulation-based (sim-based) valuation () of FB.

- Our sim-based analysis suggests the following fair values – stock price: $417.67, and price-to-earnings ratio: 32.61. At the time of this writing, FB trades at $324, so it appears to be undervalued, with a potential upside of about 29%.

Facebook (FB)

FB is the largest online social network in the world (). Given its enormous reach, with 2.5 billion monthly active users, it is a much sought-after conveyor of ads. As such, most of its sales are from ads placed within its “ecosystem”: the Facebook app, Instagram, Messenger, WhatsApp, and various app-specific features. Ad sales represents more than 90% of FB’s total sales; with 50% being in the U.S. and Canada, and 25% in Europe.

Estimating a fair value for the stock

In this post we provide a simulation-based (sim-based) valuation () of FB.

At the time of this writing the company had a profit margin of 37% and a price-to-earnings (PE) ratio of 25.3. The expected growth in earnings for the next 5 years is 28.6%, which is what we will use for the sim-based earnings growth rate. The table below summarizes our sim-based results.

Since our sim-based analysis uses a S&P 500 return as a basis, our results summarized on the table above suggest the following fair values – stock price: $417.67, and PE ratio: 32.61. At the time of this writing, FB trades at $324, so it appears to be undervalued, with a potential upside of about 29%.

Final thoughts

Is inflation likely to become a problem for FB? We often hear from experts on business media outlets that inflation has a much more pernicious effect on growth stocks than value stocks. We looked into this issue in another post (). Our analyses suggested that growth stocks may do better under relatively high inflation (around 5%) than value stocks.

Moreover, FB’s leadership position would allow it to raise its prices to make up for inflation. Many other firms would not be in the same position, as the leaders in any industry are by definition only a few in number. This could lead to PE expansion, which would make our estimate conservative.

Disclosure

The author owns FB shares at the time of this writing.