TheChek News Flow

Cargill acquires stake in Ukraine agribusiness

Cargill, the US-based agriculture trading group, has doled out $200m for a stake in UkrLandFarming, Ukraine’s largest agribusiness holding, in a potentially far-reaching deal that sources said would see both groups partner up in future grain exports to China and other growing markets.

The deal, for 5 per cent of the holding, boosts Cargill’s already strong trading presence in one of the world’s most promising agriculture commodity producers. It comes amid reports that China was increasingly rejecting imports of genetically modified US corn as it stepped up organic purchases from Ukraine.

The transaction puts a value of $4bn on UkrLandFarming, the world’s eighth-largest land cultivator and second biggest egg producer through its 77 per cent ownership in London-listed Avangardco.

The conglomerate was founded and built up in recent years through acquisitions by Mr Oleg Bakhmatyuk, a Ukrainian billionaire.

“The transaction will help Cargill secure long-term supplies from one of Ukraine’s largest farmers, and gives UkrLandFarming a very strong strategic partner that will help them achieve their goals of broadening exports, especially in Asia,” said Nick Piazza, chief executive of Kiev-based investment bank SP Advisors.

Ukraine, which harvested a record corn harvest last year of 29m tonnes, hopes to boost exports this season by some 35 per cent to 18m tonnes, catapulting the eastern European country to the ranks of the world’s top corn exporters. It now vies with Argentina for the rank of the world’s third largest corn exporting country.

Ukraine made its first corn shipment to China late last year, as part of a $3bn loan-for-corn deal brokered by state companies in both countries.

Last year, Mr Bakhmatyuk said UkrLandFarming hoped to sell up to 700,000 tonnes of corn to China this season, boosting total annual exports within five years to reach 6m tonnes with one-third destined for Asia.

The deal comes amid Ukraine’s deepest political crisis in a decade.

Home to some of the world’s richest farming land, Ukraine earned the title “Breadbasket of Europe” centuries ago for its ability to feed growing populations.

Cargill opened a Ukrainian operations base in 1991. In recent years it has acquired or built grain silos, sunflower seed processing capacity and an animal feed mill in the country.

Rival traders, including New York-listed Bunge and Archer Daniels Midland and Swiss-based Glencore, also have businesses in Ukraine including processing plants and export terminals on the Black Sea.

Cargill confirmed its 5 per cent stake in UkrLandFarming but said it did not have any intention to control, manage or operate the business.

Friday's disappointing jobs report is likely to curb the Federal Reserve's recent enthusiasm about the U.S. economic recovery, but it seems unlikely on its own to convince officials they should alter the policy course Chairman Ben Bernanke laid out for the central bank in December.

That course calls for gradual reductions in its monthly bond purchases as the recovery picks up momentum, with an eye to ending the program this year. The Fed has been buying mortgage and Treasury bonds to hold down long-term interest rates in hopes of boosting economic growth.

"It takes a lot more than one labor-market report to be convincing that the trend has shifted," Jeffrey Lacker, president of the Federal Reserve Bank of Richmond, told reporters after giving a speech in Raleigh, N.C., Friday. "In my experience one employment report rarely has an effect by itself on monetary policy."

The Fed's policy committee next meets Jan. 28-29. Officials will weigh then whether to reduce their monthly bond buys from $75 billion this month to $65 billion.

Mr. Bernanke suggested at his December news conference that the Fed's inclination is to reduce the purchases in $10 billion increments at every meeting in coming months.

Mr. Bernanke said in December, "If the incoming data broadly support the committee's outlook for employment and inflation, we will likely reduce the pace of securities purchases in further measured steps at future meetings." He added that the plan was not on a pre-set course and could be altered depending on new information.

Fed officials could decide to keep the program going longer than planned if evidence mounts that the economy isn't measuring up, as has happened several times before in an economic recovery that officially started in 2009. But other recent economic data have indicated a pickup in economic growth. The Fed tends to be an inertial institution, slow to change course until after evidence supporting a shift builds over time.

Still, the December employment report will likely put to rest for the time being any notion that the Fed might reduce the bond-buying program more quickly than planned because of robust growth.

"I've been pretty struck by the upbeat tone [in economic data] the past two months," San Francisco Fed President John Williams said in an interview with The Wall Street Journal earlier in the week. Fed Vice Chairwoman Janet Yellen, who becomes chairwoman Feb. 1, told Time Magazine she is expecting around 3% growth this year, which would be much better than in recent years.

The report was a reminder of the economy's past disappointments.

"Although consumption grew rapidly at the end of last year, we have seen similar surges since the last recession, only to see spending return to a more moderate trend," Mr. Lacker said.

The report exacerbated another conundrum for officials.

The jobless rate, at 6.7% at year-end, is falling largely because people are leaving the labor force, reducing the numbers of people counted as unemployed.

Because the decline is being driven by unusual labor-force flows—aging workers retiring, the lure of government disability payments, discouraged workers and other factors—the jobless rate is a perplexing indicator of job-market slack and vigor.

Yet Fed officials have tied their fortunes to this mast, linking interest-rate decisions to unemployment-rate movements. Since late 2012, the Fed has said it wouldn't raise short-term interest rates until after the jobless rate gets to 6.5% or lower. In December, officials softened the link, saying they would keep rates near zero "well past" the point when the jobless rate falls to 6.5%.

Most officials didn't expect that threshold to be crossed until the second half of this year. At the current rate, it could be reached by February.

The jobless-rate movement and the Fed's rhetoric create uncertainty about when rate increases will start. Short-term interest rates have been pinned near zero since December 2008, and officials have tried to assure the public they will stay low to encourage borrowing, investment, spending and growth.

Now, the public has more questions to consider: What does the Fed mean by "well past" the 6.5% threshold? Is that a year? A few months? How does it relate to the wind-down of the bond-buying program? What does it depend upon?

It will be Ms. Yellen's job to answer the questions. Mr. Bernanke's last day in office is Jan. 31.

Hollande ‘affair’ clouds key policy questions on French economy

The timing could hardly have been worse.

Headlines alleging that François Hollande was having a secret affair with a film actress erupted just days before the French president is to make one of the most anticipated public appearances of his struggling, 20-month old presidency.

In a turbulent political atmosphere already roiled by government efforts to silence the anti-Semitic outbursts of the comic Dieudonné, Mr Hollande was aiming to use a press conference on Tuesday to persuade a sceptical French public that he is capable of turning around the sluggish French economy.

Now awkward questions about his private life threaten to overshadow an occasion that will also be closely watched by France’s European partners, anxious that the eurozone’s second-biggest economy should not become a drag on the continent’s post-crisis recovery.

Mr Hollande has raised expectations that he will use the press conference to detail how he intends to accelerate the revival of an economy whose rate of recovery is lagging Germany, the UK and several other European countries.

Before the Dieudonné and love affair stories blew up, a big talking point in France had been the president’s New Year address to the nation that appeared to signal a shift towards the kind of market-oriented policies long demanded by the EU.

Mr Hollande stressed the need to cut France’s huge public spending bill, reduce its big tax burden and ease the heavy costs on business stemming from the country’s high social charges levied on employment.

In unusual language for a French socialist leader, Mr Hollande spoke of “excesses” and “abuses” in the social welfare system and said he was “certain that we can do more by spending less”.

The address prompted a wave of commentary suggesting Mr Hollande had come out as a “social liberal” – in French terms, a market reformist.

An angry Pierre Laurent, leader of the Communist party, said Mr Hollande had “turned his back on those that hoped they had elected the left to power”.

Bruno Cavalier, chief economist at Oddo Securities in Paris, wrote: “Under pressure from economic constraints and with his ratings at an all-time low, François Hollande has resolved to adopt a policy that prioritises supply. The intention is laudable.”

What Mr Cavalier and others will look for on Tuesday are details of what Mr Hollande proposes by his promise of a “responsibility pact” with business, particularly how far he is prepared to go in cutting labour costs for companies, currently returning record low profit margins as France continues to suffer weak international competitiveness.

Attention will also focus on whether Mr Hollande spells out plans for further spending and tax cuts. Since he took office, the tax burden has sharply increased as the government has relied mainly on higher taxes to bring down the budget deficit.

The government has already pledged to stabilise taxes from 2015 and shift the emphasis of debt reduction to spending cuts, with a target of €50bn, equivalent to about 2.5 per cent of gross domestic product, over the next three years. But with strong resistance on the left to welfare cuts, there is scepticism that Mr Hollande will go any further.

“I hope this U-turn is real, but I fear it is just smoke and mirrors,” says Philippe Villin, an independent adviser to many top French companies and a trenchant critic of the government.

He warns business against being lured into a “trap” of complicity with government policy. “The truth is, since the left came to power, there has been an accumulation of new charges and constraints and a terrible increase in the taxation of companies and individuals.”

The stakes are certainly high. The government has angrily dismissed recent claims that France has become “the sick man” of Europe. The economy was never as hard hit by the crisis as others, including the UK. It looks set to produce about 1 per cent growth in 2014, with unemployment likely to peak at just short of 11 per cent in the course of the year, below the eurozone average.

But business confidence and investment remain low, the trade deficit high and the Cour des Comptes, the national auditor, warned this month that France’s high level of public debt remains “in the danger zone” – susceptible to an increase in interest rates.

The onus is firmly on Mr Hollande to give a signal that his government can accelerate the recovery. But on Tuesday, he will first have to deal with the unwelcome issue of his love life.

Global steel industry set for recovery

The global steel industry is expected to make a recovery this year led by a rebound in Europe and the rest of the world, offsetting a slowdown in Chinese growth.

World production of steel will rise by 3.6 per cent in 2014, with growth finally returning to Europe after bottoming out last year, according to a Financial Times poll of 15 steel analysts.

A 2.4 per cent year-on-year increase in output in Europe, following six years of decline, will partly offset a slowdown in China as the world’s biggest steel producer moves from an investment to a services-driven economy.

Chinese steel production is expected to rise year-on-year by just 4 per cent, compared with about 6 per cent in 2013, according to top steel analysts.

Matthew De Morgan, chief executive officer of Duferco, the world’s biggest steel trader, said: “The steel sector will have a better 2014 in terms of volumes and we are past the bottom from this perspective, but the pricing outlook is not spectacular.”

The research supports forecasts by the World Steel Association that growth rates for Chinese steel output will drop below the rest of the world for the first time since 2006. The industry body expects world steel production excluding China to rise by 3.5 per cent year on year, surpassing growth of 3 per cent in China. Overall global growth last year was 3.1 per cent.

John Lichtenstein, global managing director of Accenture’s metals industry group, said: “This pattern will probably persist for the indefinite future as China shifts to a services and consumer-driven economic growth model, and growth in the other emerging economies takes stronger hold.”

The bulk of new steel production capacity growth is instead expected to come from regions such as India, the Gulf, Latin America and former Soviet states over the next few years, according to Brian Levich of Metal Bulletin Research.

The pick-up in European output will provide a boost to companies’ earnings, particularly Europe-based steelmakers such as ArcelorMittal and ThyssenKrupp, which have been hit by weak demand on the continent in the construction and car industries.

In recent months, steel companies have become more optimistic on the outlook. In November, Lakshmi Mittal, chief executive of ArcelorMittal, said it had passed the bottom of its two-year slump, while Tata Steel also noted modest improvements.

“All the indicators are moving in a positive direction; therefore, we are cautiously optimistic about the prospects for 2014,” said Mr Mittal, the Indian billionaire.

But top steel analysts warned there remained significant problems in the steel sector that would continue to weigh on profits and prevent a full recovery.

Seth Rosenfeld, analyst at Jefferies, said the industry remained “structurally impaired” by significant excess production capacity and low pricing power.

“Following years of demand destruction, a key risk for 2014 is that steelmakers may be too aggressive in restarting idled capacity in an effort to capitalise on current strength and take market share,” he said. “Should this happen, volumes may pick up but prices will remain depressed.”

While analysts foresee a strengthening of the recovery in steel output, they are far from predicting a return to the days of rapid global growth seen before the financial crisis.

World steel output between 2003 and 2007 rose more than 6 per cent a year for six years in a row, driven by a surge in production and consumption in China. Between 2000 and 2012 the country tripled its share of world steel output from 15 per cent to 46 per cent.

Khodorkovsky release sparks Yukos legal speculation

When Leonid Nevzlin, the former business partner of Mikhail Khodorkovsky, met the one-time Russian tycoon after his release from prison, he says the two men spoke “about the kids, the weather and other pleasant things”.

Since Russian president Vladimir Putin allowed Mr Khodorkovsky to be freed last month after ten years behind bars on charges of fraud and money laundering, speculation has mounted over whether Russia’s one-time richest man will be able to regain some of his wealth, and what his role may be in the proliferating legal battles over the remainders of the business empire that the Russian government removed from him.

Mr Nevzlin is one of those best-placed to know. In 2005, Mr Khodorkovsky transferred his majority stake in Menatep, the holding company which controlled his Yukos Oil group, to his fellow investor who had already fled to Israel.

After Mr Khodorkovsky’s arrest, Russian authorities started investigating Yukos for tax evasion and eventually placed the group into bankruptcy in 2007 and sold its Russian assets off to competitors, mainly state oil firm Rosneft.

But Yukos’ assets outside Russia remain beyond the control of the Russian state under two Dutch-registered protective foundations. Former Yukos managers who run those are also fighting a host of lawsuits in the European Court of Human Rights, the Netherlands and other jurisdictions over damages from the forced expropriation of the group and to defend the remaining assets against attempts from Rosneft to gain control.

The mushrooming litigation has been a constant thorn in the side of Rosneft. Only last Thursday, a New York court ordered Samaraneftegaz, a former Yukos subsidiary now owned by Rosneft, to turn over assets to the US to satisfy a judgment to pay Yukos Capital – a company under the Dutch foundations – US$186m and restrained it from transferring assets to either shareholders or affiliates. Samaraneftegaz has been refusing to pay the damages ever since 2007. The rare order amounts to an attempt to temporarily block dividends to Rosneft from this affiliate.

The US$186m is just one small part of a total of up to US$2.5bn in claims, according to Bruce Misamore, the former Yukos chief financial officer who helps run the foundations. So far, US$485m has been collected, and all other claims are either in some stage of litigation or may be submitted in the future.

The foundations also have in excess of US$1.2bn in cash from the sale of two former Yukos overseas assets. Eventually, this money should be distributed to former shareholders, who are believed to total as many as 55,000.

But this year, the Yukos managers who manage the assets have their eyes set on a much bigger prize: they are waiting for a ruling from the European Court of Human Rights on a claim related to the Yukos bankruptcy potentially worth in the tens of billions of dollars. Some suggest it is closer to the value that was placed on Yukos by analysts and economists at the time of liquidation, frequently stated as between US$40bn and US$60bn. Rosneft is defending the action.

Separately, Gibraltar-registered Menatep, now called GML, is awaiting a ruling in an arbitration under the Energy Charter Treaty in The Hague over a US$100bn claim against the Russian Federation.

Mr Nevzlin, who was unavailable to comment to the FT, told Russian media that Mr Khodorkovsky would have nothing to do with any of these claims – in line with the former Yukos chief’s assurances to Mr Putin that he would not fight for his former assets after regaining freedom.

In an interview with independent TV channel Dozhd aired late on Friday, Mr Nevzlin said Mr Khodorkovsky had “severely rebuffed” his attempt to inform him about the group’s finances. “He is not interested in this. Therefore we did not succeed to talk about business and finances with him,” Mr Nevzlin said. “It has become clear that as far as the management of the group by the trusts is concerned, I will continue to do that.”

The Russian newspaper Novaya Gazeta quoted Mr Nevzlin as saying that the transfer of Mr Khodorkovsky’s shares to him was irreversible.

But some of the conspiracy theories traded in Russia since Mr Khodorkovsky’s release see the tycoon as not only not fighting for his former wealth, but speculate he could try to make a deal with Mr Putin to settle the court case in The Hague in exchange for the release of Platon Lebedev, his other former partner, and Aleksey Pichugin, another former Yukos official, who are still in prison in Russia.

A ruling against the Russian state in the world’s largest-ever arbitration case in The Hague “would have a monstrous impact on the Kremlin regime and on Vladimir Putin personally – from a legal, reputational and also from a financial perspective,” said Andrey Illarionov, a former economic adviser to Mr Putin, in his blog. The date for a ruling has been postponed. “We had expected it early this year but were recently notified that it will now come before the end of the first half – so I expect it in June,” said Tim Osborne, the GML director who heads the case.

Mr Khodorkovsky’s partners fiercely reject the idea that the claim in The Hague could be withdrawn. “The group under the leadership of Tim Osborne intends to fight for victory in that process and fight for compensation from the Russian Federation no matter what,” said Mr Nevzlin in the Dozhd interview. “First and foremost, the group needs to win the case. If the case is won and damages are awarded, then one will be able to talk about things.”

Turkey clamps down on internet as Erdogan tightens grip on power

Turkey is seeking to increase control over internet access at a time when the government is also tightening its grip on the country’s legal institutions in response to a corruption scandal.

A legislative proposal put forward by the ruling AK party would give the transport and communication minister the power to block websites deemed to infringe privacy, as well as compelling internet service providers to retain information of their customers movements on the net.

The measure, attached to an omnibus bill, increasing its chances of passage, would also require ISPs to restrict access to proxy sites, which can allow users to circumvent censorship.

Turkey already has internet filters intended to protect children and made 1,673 requests for Google to remove material from the web in the first six months of last year – more than three times any other country – although most of its requests were turned down.

But some critics have alleged that the legislative initiative is part of a general trend in which the government of Recep Tayyip Erdogan, prime minister, is concentrating more power in the wake of a corruption investigation that has targeted a host of figures connected to the government, including four former ministers and Mr Erdogan’s own son, Bilal.

“These are politically motivated measures to curb the free flow of information on the internet even further in Turkey,” said Yaman Akdeniz, a law professor at Istanbul’s Bilgi University. “Looking at the current political climate, it is primarily for controlling the leaking of videos and WikiLeaks kind of documents.”

Last week, the government proposed legislation that would increase the justice ministry’s powers over the council that supervises Turkey’s judges and prosecutors - a move that the council’s acting chairman said, on behalf of a majority of its members, was unconstitutional and violates the separation of powers. Violence broke out at a discussion of these measures on Saturday, with a ruling party MP aiming a kick at a senior judge’s head. On Sunday, Mr Erdogan criticised the judge who was attacked in the brawl, calling him not a lawyer but a “militant”.

The government has also removed hundreds of police officers from their posts in the weeks since the corruption inquiry began on December 17. Mr Erdogan has attacked the probe as a “judicial coup” and a “modern coup, staged by friends” – a reference to the movement of Fethullah Gulen, a preacher and former ally who has broken with the AKP and has many followers in the police, prosecution service and judiciary.

While AKP officials says Gulenists in Turkey’s legal institutions are using the investigation as part of a feud against Mr Erdogan, the massive shifts of personnel in the police and among the prosecutors handling the case have made it harder for it to progress or for new lines of inquiry to be opened.

With hostilities intensifying between the AKP and the Gulenists, expectations had been growing that further revelations of alleged corrupt behaviour could be leaked on the internet. In recent years, a number of recordings involving high profile figures in Turkish public life have mysteriously appeared on the web.

However, the new legislative proposal on the internet could allow the government to shut down access to such videos.

Ankara’s push for greater powers has also raised concerns in Washington and Brussels. “The US supports the desire of the Turkish people for a legal system . . . where no one is above the law and where allegations against public figures are investigated impartially,” said Jen Psaki, state department spokeswoman, last week in the Obama administration’s latest expression of exasperation with Mr Erdogan. “We’ve expressed our concerns about some of the events that are happening directly, publicly and privately, and we’ll continue to do that.”

Beats seeks to unseat Spotify with music service

Beats Electronics, the audio equipment maker started by Jimmy Iovine and Dr Dre, the hip-hop star, has launched a new service with the aim of unseating Spotify as market leader of the nascent music subscription industry.

Beats Music will be available first in the US with other countries, such as the UK, to follow. Backed by music industry heavyweights and a group of billionaires that includes Len Blavatnik and James Packer, it has also struck a partnership with AT&T, to offer “family plan” subscriptions to the telecom operator’s customers.

The launch comes as competition heats up in music subscription, with Google-owned YouTube working on a paid and advertising-supported service, which is likely to launch this year.

Beats Music said its service would be more personalised than rival offerings, with data analysis and playlists from top artists helping subscribers discover new music. “The future of media is all about curation by trusted sources,” said Ian Rogers, Beats Music chief executive.

Unlike Spotify and YouTube, Beats will have no ad-supported free service. “We think you should pay for music,” said Mr Rogers. The design of the service reflected the shift to mobile music consumption, he added. “It was designed first for the mobile, not a [web] browser.”

The service will be available on iOS, Android and Windows phones and will cost $10 a month. AT&T customers will be able up to sign up to five family members to a single $15 a month subscription, similar to its family text message plans. “We know our customers have a big passion for music but there’s an affordability barrier . . . this solves that,” said David Christopher, chief marketing officer of AT&T Mobility.

By launching the new service, Beats hopes to capitalise on the popularity of its headphones and audio devices, which have been a hit with sports stars and musicians. Sales of so-called “premium” headphones have soared since the company launched its first range five years ago and a rash of imitators has joined the market.

The launch of Beats Music comes at a pivotal time for the music industry, which continues to grapple with the transition to digital distribution. US digital music sales declined in 2013 for the first time since the launch of Apple’s iTunes store a decade ago, according to recent data from Nielsen SoundScan.

Some artists, such as Beyoncé, bucked the trend: the singer gave the ailing album format a shot in the arm when she released her latest album as a fixed bundle on iTunes and became the fastest-selling release in the history of Apple’s online store.

But the broader trend is towards subscription services such as Spotify, Deezer and Rdio. A report last year from Nielsen SoundScan found that audio and video streams increased 24 per cent to 50m streams during the first half of 2013 compared with the previous year.

Beats last year sold a $500m equity stake to Carlyle, the private equity group, in a deal that valued the company at more than $1bn.

It also spun out Beats Music, raising $60m from a group of investors, including Mr Blavatnik, who paid $3.3bn for Warner Music in 2011, and Mr Packer, son of the late Australian investor Kerry Packer.

Marc Rowan, a co-founder of Apollo Global Management, the private equity firm; and Lee Bass, a Texan billionaire, have also invested in Beats Music.

Spotify last year raised about $250m in new financing from an early backer of Netflix, valuing the Swedish digital music service at more than $4bn. Technology Crossover Ventures led Spotify’s most recent financing, which came a year after a $100m investment led by Goldman Sachs had valued the company at $3bn.

"As long as the music is playing, you've got to get up and dance.... We’re still dancing."

- Chuck Prince, July 2007

Late last night the music may have just skipped a major beat after Goldman released a Friday evening note that is perhaps the most bearish thing to come out of Goldman's chief strategist David Kostin in over a year, (and who incidentally just repeated what we said most recently a week ago in "Stocks Are More Expensive Now Than At Their 2007 Peak"). To wit:

S&P 500 valuation is lofty by almost any measure, both for the aggregate market (15.9x) as well as the median stock (16.8x). We believe S&P 500 trades close to fair value and the forward path will depend on profit growth rather than P/E expansion. However, many clients argue that the P/E multiple will continue to rise in 2014 with 17x or 18x often cited, with some investors arguing for 20x. We explore valuation using various approaches. We conclude that further P/E expansion will be difficult to achieve. Of course, it is possible. It is just not probable based on history.

The current valuation of the S&P 500 is lofty by almost any measure, both for the aggregate market as well as the median stock: (1) The P/E ratio; (2) the current P/E expansion cycle; (3) EV/Sales; (4) EV/EBITDA; (5) Free Cash Flow yield; (6) Price/Book as well as the ROE and P/B relationship; and compared with the levels of (6) inflation; (7)

nominal 10-year Treasury yields; and (8) real interest rates. Furthermore, the cyclically-adjusted P/E ratio suggests the S&P 500 is currently 30% overvalued in terms of (9) Operating EPS and (10) about 45% overvalued using As Reported earnings.

Cue David Tepper to bring out even bigger greater fools who do believe in his 20x PE multiple "thesis." Cause if 20x works, why not 40x, or 60x, or moar?

* * *

Kostin's full "market is now overvalued" note:

We believe S&P 500 currently trades close to fair value and the forward path of the market will depend on the trajectory of profits rather than further expansion of the forward P/E multiple from the current 15.9x. We forecast a modest price gain of roughly 3% to our year-end 2014 target of 1900. We expect S&P 500 will climb to 2100 by the end of 2015 and reach 2200 by the end of 2016 representing a gain of 20% over the next three years.

However, many clients argue that the multiple will continue to expand in 2014 leading to another year of strong US equity returns. A forward multiple of 17x or 18x is often cited, with others suggesting 20x is reasonable given the strengthening US economy and low interest rates. Many on the buy-side have year-end 2014 targets between 2000 and 2200 reflecting a price gain of 9% to 20%, well above our more modest projection.

The current valuation of the S&P 500 is lofty by almost any measure, both for the aggregate market as well as the median stock: (1) The P/E ratio; (2) the current P/E expansion cycle; (3) EV/Sales; (4) EV/EBITDA; (5) Free Cash Flow yield; (6) Price/Book as well as the ROE and P/B relationship; and compared with the levels of (6) inflation; (7) nominal 10-year Treasury yields; and (8) real interest rates. Furthermore, the cyclically-adjusted P/E ratio suggests the S&P 500 is currently 30% overvalued in terms of (9) Operating EPS and (10) about 45% overvalued using As Reported earnings.

Reflecting on our recent client visits and conversations, the biggest surprise is how many investors expect the forward P/E multiple to expand to 17x or 18x. For some reason, many market participants believe the P/E multiple has a long-term average of 15x and therefore expansion to 17-18x seems reasonable. But the common perception is wrong. The forward P/E ratio for the S&P 500 during the past 5-year, 10-year, and 35- year periods has averaged 13.2x, 14.1x, and 13.0x, respectively. At 15.9x, the current aggregate forward P/E multiple is high by historical standards.

Most investors are surprised to learn that since 1976 the S&P 500 P/E multiple has only exceeded 17x during the 1997-2000 Tech Bubble and a brief four-month period in 2003-04 (see Exhibit 1). Other than those two episodes, the US stock market has never traded at a P/E of 17x or above.

A graph of the historical distribution of P/E ratios clearly highlights that outside of the Tech Bubble, the market has only rarely (5% of the time) traded at the current forward multiple of 16x (see Exhibit 2).

The elevated market multiple is even more apparent when viewed on a median basis. At 16.8x, the current multiple is at the high end of its historical distribution (see Exhibit 3).

The multiple expansion cycle provides another lens through which we view equity valuation. There have been nine multiple expansion cycles during the past 30 years. The P/E troughed at a median value of 10.5x and peaked at a median value of 15.0x, an increase of roughly 50%. The current expansion cycle began in September 2011 when the market traded at 10.6x forward EPS and it currently trades at 15.9x, an expansion of 50%. However, during most (7 of the 9) of the cycles the backdrop included falling bond yields and declining inflation. In contrast, bond yields are now increasing and inflation is low but expected to rise.

We addressed equity valuation using the Fed model and interest rate sensitivity in our December 6th US Weekly Kickstart. Simply put, the earnings yield gap between the S&P 500 and ten-year Treasury yields currently equals about 325 bp. Goldman Sachs Economics forecasts bond yields will creep higher to 3.25% by year-end 2014, a rise of just 25 bp. If the earnings yield gap remains unchanged, then the ‘fair value’ multiple according to the Fed model would be 15.2x at year-end 2014. The implied index level would be 1900 assuming our 2015 EPS forecast of $125. However, bond yields could rise by more than we expect and hit 3.75% while the yield gap could narrow to perhaps 275 bp. The resulting EPS yield of 6.5% represents a forward P/E of 15.4x implying a S&P 500 level of 1923. Exhibit 4 of the Dec 6th Kickstart shows valuation using various yields and yield gaps.

Incorporating inflation into our valuation analysis suggests S&P 500 is slightly overvalued. When real interest rates have been in the 1%-2% band, the P/E has averaged 15.0x. Nominal rates of 3%-4% have been associated with P/E multiples averaging 14.2x, nearly two points below today. As noted earlier, S&P 500 is overvalued on both an aggregate and median basis on many classic metrics, including EV/EBITDA, FCF, and P/B (see Exhibits 5-8).

* * *

Then again, this is Goldman, where dodecatuple reverse psychology in recos is the norm. If Goldman has just gone bearish, it would logically suggest it is very short and is hoping for a crash. But it could also mean it is hoping its clients panic and dump so collapsing trade volumes finally soar and Goldman makes at least some money on commissions, or is waiting for a plunge in stocks so it can put its massive cash hoard to use, or simply planting the seeds of the next Lehman-like event (now over 5 years later), which would serve as the periodic reset of what once used to be a business cycle? We are sure to find out soon because whatever happens, there will be volatility.