The peak in 2000 marked an unprecedented 160% overshooting of the trend, which is double the overshoot in 1929. The index has been above the trend for 17 years. We also see that the major troughs saw declines in excess of 50% below the trend. If the S&P 500 were sitting squarely on the regression, it would be hovering around 820. If the index should decline over the next 12 months to a level comparable to previous major bottoms, it would fall to the vicinity of 400-425.

That is a teeny bit lower than how I see it, but it is about right. However, he provides a chart which adjusts for inflation using John Williams’ shadow government stats. That shows the markets at all time lows. You can see and read the rest here.

I have one problem with that analysis. While I do think some adjustment might make it look a little better, if John Williams’ numbers are correct then stocks should be as low as they are because GDP and earnings have been horrible in inflation adjusted terms for a very long time. We have been in a recession for two decades similar to Japan. I don’t think that is true, but if so then stocks deserve every bit of the undervaluation they have experienced.

I’ll stick with the first graph being slightly overstated. It should be noted that statisticians would likely have problems with the while idea of the long term regression line having any meaning. I disagree, there are fundamental economic reasons the line makes sense as an approximation. I won’t go into the details now, I just want it noted I am aware of the issue.

Hat tip: Barry Ritholtz.

Technorati Tags chart, mean, regression, stock market, Valuation

You can take a look at what the bottoming process has looked like for all the bear markets since WWII here. Hat tip: Calculated Risk.

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Technorati Tags Bear markets, crash of 1929, great depression, market bottoms, Oil Crisis, tech bubble

We’re currently at a P/E around 14, a bit below the historical long-run average P/E of 16.3, meaning you could expect a slightly above-average return from buying stocks now. Specifically, if companies were to pay their shareholders all the income to which they’re entitled in the form of a dividend, that dividend would give you better than a 7% immediate return, and over the long run, the dividend would grow at least at the rate of inflation. That’s a return that proved more than sufficient compensation to investors for the extra risk they faced from stocks over the last century and a half, which included plenty of times tougher than those we’re going through at the moment. To me, a 7% real yield sounds like an attractive investment, despite the risk, and certainly dominates most other alternatives as a long-run vehicle for saving for retirement.

I agree with that, though I think most people would be surprised that attractive pricing means only a 7% yield plus inflation. In dividends are actually likely to grow 1-2% faster than inflation. Unfortunately we do not get all of that real yield because companies retain far more of their real dividend than necessary and do not distribute it to their shareholders. Much of that retained dividend is wasted. which brings me to a point of disagreement:

But isn’t it possible that the P/E will decline further, to much below the historical average, before the carnage is finished? Sure it is. But here’s another way to look at that. Companies in fact don’t turn over 100% of their profits to the shareholders as dividends, but re-invest some of those profits in the hope that future earnings will increase faster than inflation. The typical stock in the S&P 500 today is giving you a 3% dividend, which you could hope will grow 3% faster than inflation over the long run as a consequence of the reinvested profits. That again to me sounds like a very nice investment. You can buy and hold for the long term with the philosophy that it’s that stream of growing dividends that you really want and are going to get. Let the market price of the stock go up or down from here wherever the psychology of the market may take it– you’ve still received what you paid for, and it’s a reasonable deal.

Loner term those reinvested profits grow only a bit faster than inflation and trail GDP growth. Long term it is only about 1-2% above inflation. So, 3% plus 1-2% plus inflation gives us 4-5% above inflation. Still reasonable, but hardly spectacular. Of course payouts could rise and increase the dividend yield without reducing growth. So 4% dividend yield, plus 2% (let’s be optimistic) and 3% inflation. That is 9%. With some appreciation in the P/E ratio returns could be higher, perhaps substantially so.

The rest of the post is pretty good for someone who wants to invest themselves, needless to say we believe we can, and have, do much better. Not because of stock picking prowess, but asset allocation decisions, especially hedging against risk or avoiding it in many situations. The graph above over the past few years shows why that can be pretty effective. Nevertheless, sound advice.

John Hussman gives a very good way to look at the opportunities and risks in the current market as well, and some sound advice about approaching this with a long term focus but careful attention to the risks. Investing now does offer good long term returns, but you may be able to do better later. Some exposure is certainly warranted and John gives a good explanation as to why. Known by many inaccurately as a “Perma Bear” he is certainly no mindless cheerleader.

Thanks for visiting Risk and Return. Please feel free to contact us with any questions and/or comments. Please note our disclaimer.

Technorati Tags investing, Jim Hamilton, Robert Shiller, S&P 500, stocks, Valuation

Money tends to go where it is best treated, as measured by an asset class, hedge fund or by a traditional investment adviser. As a result, a lot of money will be shifting by year-end, and it is bound to have a disruptive market effect as well as likely to feed continued volatility.

If you delegate investing to an adviser, here are several questions that you may consider asking during a 2008 year-end review of your investment performance:

1. What were your adviser’s expectations for the stock market’s returns in 2008, and how did these expectations compare to the actual results?

2. How did your investment performance compare to that of the major indices? In what areas did you outperform, and in what areas did you underperform — and why?

3. What was your adviser’s economic and credit expectations, and how did these expectations compare to the actual events? Where and why were his assumptions wrong?

4. Did your adviser change his strategy as economic and financial events changed? If he didn’t, ask why?

5. Did you experience outsized individual stock or large specific industry or sector share price losses? Did your adviser institute a discipline to stop losses, or were your losses allowed to compound? Did your adviser “double down” on poor investments?

6. Ask your adviser whether he “eats his own cooking” — that is, did he invest along with you in the same investments, and are both of your interests aligned?

Briefly, I think I will answer for those of you who do invest with us, how I would answer the questions. Feel free to question us more closely in person. Note: While this discussion applies broadly to all of our clients, it is specifically addressed to the vast majority of our assets under management, accredited and qualified investors (those with a net worth of 1 million and up) in our model portfolio’s.

1. What were your adviser’s expectations for the stock market’s returns in 2008, and how did these expectations compare to the actual results?

In our case this discussion really should not be constrained to 2008. We believe we are in the midst of a long term bear market that began with the bursting of the tech bubble in 2000, especially for US financial assets. We participated in the cyclical bull that began in 2003, with significant allocations to international, emerging market, real estate and other high flying assets. Starting in 2006 we began to become more defensive as valuations became more and more unreasonable, allowing our portfolio to move forward based on those areas we felt were most attractive. That allocation allowed us to post strong results through the third quarter of 2007, but the portfolio was dominated more and more by assets not dependent on the general direction of the market. By 2007 we felt returns were likely to turn negative, the economy would struggle and a defensive portfolio was the most prudent path. We had by February of 2007 scrubbed nearly all exposure to financial stocks from our portfolio.

In general our expectations have been met. The markets, especially financial stocks have struggled. Following our strong showing through the first three quarters of 2007 we had a strong burst in the fourth quarter as the markets in the US fell. We weathered the storm in January with a small gain and when all was said and done had a solid first half of the year, with positive returns in each quarter, with solid gains in June to finish off the second quarter.

We began to have concerns short term with our exposure to commodity stocks, especially energy, and hedged that exposure somewhat. We assumed that some of the relationships in our hedged positions might have a short term reverse as well. Unfortunately all of our main performance drivers reversed from the middle of July to the middle of August. It was unusual that all would reverse at the same time, as opposed to being spread out. Unfortunately most, if not all, of our gains during 2008 were lost, though we were still positive since the downturn in the broader equity markets began in October. We feel that most of what we are doing now is still well positioned, with the most likely trouble spot being our unhedged positions, specifically commodity stocks and Asia. Depending on their relative performance we will have a flat to positive end to the year. Our expectation is we will finish the year with returns in the high single digits, which is what we expected at the beginning of the year.

What about surprises? The relative strength of small cap and real estate stocks stick out. We feel they will resume their under performance going forward. Commercial real estate is starting to roll over and we expect that to weigh on REITs. Small cap stocks are still very overvalued, and earnings likely to continue to disappoint. As credit markets and the economy become even more strained access to credit will hit them hard. If they struggle greatly relative to larger, higher quality stocks we could see our expected return numbers increase markedly.

2. How did your investment performance compare to that of the major indices? In what areas did you outperform, and in what areas did you underperform — and why?

We have outperformed broad market indices handily year to date, since the downturn began, and for trailing one, three and five year periods. Heck, we are positive for the year! Accomplishment enough, if unspectacular. Compared to the indices the various areas of our portfolio have performed from okay to fantastic. No major underperforming areas.

3. What was your adviser’s economic and credit expectations, and how did these expectations compare to the actual events? Where and why were his assumptions wrong?

We felt the US faced a high probability of a recession coupled with a worldwide slowdown. We felt the credit markets were the most vulnerable, due to a severe housing downturn, and inflation would be an concern. Interest rates were a bit uncertain since, with inflation an issue and growth vulnerable, the fed would be pushed in both directions. More importantly, due to the difficulties in the credit markets we felt interest rates would be relatively insensitive to the federal reserves efforts and interest rates would remain stubbornly high, with credit spreads likely to widen dramatically. Thus we felt diversifying credit exposure internationally would be prudent and bonds would not be as positive a counter to equity risk as they were in the last downturn.

That has all come true, but our moves to diversify in fixed income have not proven of much benefit. However, our emphasis on other strategies to reduce risk versus fixed income has added value, demonstrating that an over reliance on traditional fixed income to protect in a downturn would not be optimal. In fact, fixed income has been a drag on performance on both the upside and downside of the market over the last two years for us.

4. Did your adviser change his strategy as economic and financial events changed? If he didn’t, ask why?

Yes, though our change occurred before the downturn. We have made some small tactical changes as the year has progressed, though our fundamental approach we feel is still sound. We are preparing for some significant changes in the near future, especially if the equity markets weaken substantially from here and we position the portfolio for a more positive market environment.

5. Did you experience outsized individual stock or large specific industry or sector share price losses? Did your adviser institute a discipline to stop losses, or were your losses allowed to compound? Did your adviser “double down” on poor investments?

This question really doesn’t apply to us since we don’t trade individual securities, though we have hedged positions where one side or the other have struggled. That of course is the expectation for a hedged pair of positions targeting an absolute return. Nevertheless we wish some had been more successful, even if as a pair they outperformed the indices.

6. Ask your adviser whether he “eats his own cooking” — that is, did he invest along with you in the same investments, and are both of your interests aligned?

Not only do we, it is a core value at our firm, and that is exactly how we put it. “We eat our own cooking.”

Hat Tip: Barry Ritholtz

Thanks for visiting Risk and Return. Please feel free to contact us with any questions and/or comments. Please note our disclaimer. For information on our investment process see here.

Technorati Tags absolute returns, advisors, assessing performance, bonds, investment performance, markets, stocks

Of course, the follow on question I get repeatedly, especially those who have been investing with Bill Miller and Legg Mason Capital all the way down, is that surely it is time to get back in?

Obviously Bill, and Legg Mason in general, believe that the sell off in financials is overdone, and that long term investors will be rewarded at this point. Of course, they have said that all along to disastrous effect. The question moving forward is whether they are right now, or is it that they still don’t understand the situation?

I am not one to assume I know the future, but what I do believe is that it is important to assess the risk to any investment thesis. So let is start with the general issues:

• Maybe financials are undervalued, but how can anyone have confidence in what the value of many of these institutions is? What are their assets worth?
• The thesis seems to assume that once credit markets ease and the economy improves it will be back to business as usual. However, whole lines of business are not only going to be weak for some time, such as mortgage origination and lending, but in many cases may not exist going forward.
• The money they made in the past was based on ways of doing business, and with amounts of leverage, that they, regulators and investors will not want to see going forward.
• How diluted will any investment one makes today be once the turnaround starts? Repeated capital raising has already decreased existing investors share of the companies dramatically. So even if business gets back to its past levels each share will still be worth a lot less. How much more capital will they need to raise?
• What is the risk of failure of many of these institutions?
• Finally, how much worse will it get in terms of losses, and thus how much capital will need to be raised if they are to survive?

To get a handle on these risks let us take a quick look at a few things.

Remember when the losses would be less than 100 billion, then maybe 200 billion? The 500 billion mark has now been crossed. I still stand by my estimate of at least 1.2 trillion before it is all said and done. Given the strains the financial sector has shown so far, how is it going to weather more than double the hit it has already taken?

Before speculating about that, lets look at this chart:

>

As you can see, the massive attempts to raise capitalhas resulted in little more than a loud poof!

All charts via Jake at Econompic Data

Thanks to Barry Ritholtz for the charts.

Most institutions have seen more capital destroyed than they have raised, and essentially all have a much weaker capital base than when they started. So, if we assume that more losses are forthcoming, and the most optimistic estimates are in the 400 billion range, we will see even more raising of capital, further diluting the worth of every share outstanding.

Given the losses and further dilution alone I would suggest the risk factors are extremely high. Except it gets worse. Who is going to give them the capital to survive future losses? At this point the largest sources of capital, private equity firms and soveriegn wealth funds, have already committed vast sums to this sector. How much more are they willing to cough up given the risks? Thus many of these institutions may go under. Of course, normally they would be acquired by a stronger institution,  but that also requires stronger institutions. The breadth of this crisis means that hardly anyone is strong enough to acquire a failing institution, especially with their own losses mounting.

The gist? While the future is unknown, and there may be factors which make the worst case scenario’s less likely than it appears, and we should never underestimate Wall Streets ability to find ways to squeeze money out of us, at this point the risks move any capital devoted to the banks, brokerage houses, Fannie, Freddie and the others is not investment, but speculation. Extremely risky speculation at that. Sometimes speculation pays off, but the odds seem stacked against it at this point.

Technorati Tags banks, Bill Miller, broker dealers, credit crisis, financials, Legg Mason

Buried around a truism, the New York Times has produced a misleading and rather silly piece on the value of “predictions.”

The thrust of the piece is that predicting the markets and the economy, especially in the short term, is fraught with peril. True enough. That is why whenever giving our view of the future it is in terms of the risks one takes relative to the returns one might get. Hence the name of this site.

However, some things can be said, and often with a great deal of confidence. Timing is an issue, the magnitude can cover quite a bit of ground, but things can still be said. The problem for investors is that in a world filled with conflicts of interest and myopia how to tell which views on those tradeoffs to which one should pay attention? It is not that “predictions” (which is a term they use loosely) are to be ignored.

Anyway, that is the stated context for the article. The subtext however is the denigration of “outlandish” predictions, by which they mean those emanating from us negative nellies. Thus, the somewhat cautious claim of Bill Gross of a trillion dollars in losses related to the credit crisis is trivialized:

But despite this decidedly mixed track record, forecasters still enjoy a rapt audience, particularly at a moment when so much in the markets depends on the uncertain course of the housing market and the broader economy.

At investment and commercial banks, losses tied to bad mortgage investments, which now exceed $450 billion, are certain to rise further if home prices continue to decline and more
people default on their mortgages. Last week, Bill Gross, a prominent bond fund manager, offered another forecast for the final bill: $1trillion. Some market watchers say the figure could be even higher.

Obviously we will not know for sure until some time down the road, but it is interesting that Gross, as well as a number of others who have been hooted down for their alarmism, have consistently been proven to be too optimistic. The 450 billion dollar figure which everyone recognizes will go dramatically higher (that is math, not opinion) is already dramatically higher than we have been repeatedly told would be the most the losses would be.

Our firm, as well as a number of others, are not band wagoning here. We “predicted” that we would be fortunate if the losses didn’t reach a trillion or more. No precision, no claim to knowledge we didn’t have, just a little simple math which showed it would be “bigger than a breadbox.”

Despite that obvious track record which shows that some people saw at least the general outline, if not the exact shape of things, we get this kind of piffle:

Ideally, predictions on companies and stocks would be “thoughtful, nontheatrical forecasts that take a look at long-term fundamentals,” said Abby Joseph Cohen, a longtime strategist at Goldman Sachs.

But, Ms. Cohen added, less dramatic forecasts rarely make headlines. “If what is being provided to viewers and readers are these theatrical forecasts, that is what many people will pay attention to because that’s what they have available.”

Abby may be a wonderful person to have over to dinner, and a dear friend to have, but she is also someone who has led more investors over a cliff than any major strategist of the last ten years. Abby has been the outlandish one, as anyone who was unfortunate enough to listen to her in 1999 and 2000. I am sure she views the thoughts of those who have consistently stressed the risk levels and overvaluation of stocks over the last 10-12 years as being outlandish in their claims. However, look at the returns of the market over the last 10+ years (10 year return for the S&P500: 2.55%.) Pitiful.

“We have gone from an abnormally calm period, and we’ve blown right through normal volatility,” Ms. Cohen said. “We are in an exceptionally volatile period.”

Does anyone fact check at the Times? That is an outlandish claim. It is most decidedly not true. For those who wish to get a more accurate description of volatility today versus history, the essential Ed Easterling of Crestmont Research will bring you up to speed (pdf.) Listen to Abby at your peril.

This however tales the cake. First, the truth:

Another source of investment guidance used to come from research analysts, who try to predict quarterly earnings at companies. But there is a great deal of guesswork involved here, too. Analysts correctly predict earnings only a fifth of the time. Nearly two-thirds of quarterly earnings beat estimates, and the rest come in too low, according to data from Thomson Reuters. Many companies, of course, try to defuse overly optimistic forecasts to manage investors’ expectations and deliver “better-than-expected” results.

Then this nonsense:

This year, Wall Street’s crystal balls have performed even worse than in the past. As earnings season for the second quarter winds down, 67 percent of companies reported earnings higher than what analysts had predicted, and 22 percent reported earnings that were worse. Only 10 percent of companies matched analysts’ expectations.

We go from a decent point about how wrong analysts are to this misleading………

Okay, I will attempt not to get steamed. The problem with analysts is they are consistently too bullish, and by huge amounts. Exactly the opposite of what that statement implies. Yes, companies consistently beat the estimates when they are finally reported, but only after analysts slash those estimates almost down to the day the reports are made. This year companies have consistently failed to make estimates that were made just weeks earlier. Compared to what was “predicted” 3, 6 or twelve months ago the earnings have been dramatically lower. There is a problem with analyst predictions, and investors should be warned. However, this just muddies the issue of what those problems are. Conflicts of interest, behavioral biases, being too optimistic about the particular industries they cover (even when not conflicted) etc. It is not that they are too cautious about earnings prospects.

Then, to add insult to injury, we get this:

Poor predictions are nothing new in the financial world: in 1999, a pair of prognosticators — James K. Glassman and Kevin A. Hassett —published a book titled “Dow 36,000”; the blue-chip index closed last week at 11,370.

But investors seeking light in a dark period may just have to stick with no one’s predictions but their own.

That helps investors. We get evidence that some of the silliest predictions of the past were wrong; a false implication that analysts are often wrong, but too bearish; a plea from one of the most disastrously bullish strategists of our era not to listen to outlandish claims from people who have been proven correct; and people who make valid points (such as Taleb) are placed in a context with which I am sure they are uncomfortable; all in the service of a message that no one’s advice is worth taking. Never mind that most of the greatest investors of the past half century warned repeatedly that returns were likely to be unsatisfactory, regardless of this present crisis. Never mind that many, if not most, of those same voices warned repeatedly that the housing market was set for a fall, that a credit crisis was likely imminent, and on and on.

No, we shouldn’t listen to anybody.

Since the Times doesn’t want to tell you this, or examine it, I’ll jot down a few things to keep in mind.

• Analysts are almost always too bullish.
• As one of her sources, Taleb, would likely agree, economic models based on assumptions of equilibrium (essentially all of them) unsurprisingly almost always (until the horse is out of the barn) predict some sort of equilibrium, or at least a tendency to move back towards it. Thus economic activity is often well outside of their predictions. More importantly, “fat tail,” or extreme, events occur at rates far more frequent than their models assume. There are literally dozens of market and economic events which have occurred over the last century, when statistically (according to the assumptions of modern finance and economics) it was unlikely even one would happen.
• The real returns from stocks are much lower than most market commenters and professionals realize.
• You can with a fair degree of confidence predict most asset class returns over 5-10 years of time. I said with a fair degree, not certainty. Unfortunately most attempts to do so use unrealistic assumptions or historic returns. The first problem is obvious, but requires knowledge of what is reasonable. Most people use the latter, historic returns, as their guide. Big mistake.
• Also, somewhat off topic, though important nonetheless, stocks are not cheap yet, but they may still go up.
• I think it is unlikely they will not go lower from here.
• For Clients: If stocks do go up smartly and we don’t do as well as we could have, we have had a pretty darn good 12 months (or five years for that matter.) Trailing a bit now would hardly be a crisis, and as last year proved, we may not trail even then.

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Technorati Tags forecasts, media, New York Times, Risk

Using far more “off the cuff” methods than Nouriel Roubini, the IMF, Jeremy Grantham, John Hussman, UBS, John Paulson or Goldman Sachs, I have been expecting the starting point for discussion should be something around 1.2 trillion, with significant risk to the upside on that number. That was across the system.

Now, in addition to that rather prominent band of bears comes Bridgewater, one of my favorite reads, who estimate that financial institutions alone will see losses of 1.6 Trillion. This comes courtesy of Paul Kedrosky who translated the leaked report:

Explosive Study: The banking crisis will be much worse

Westport (USA) – The expected losses from the financial crisis will reach $1600 billion. To-date financial institutions have so far announced only $400 billion. The pessimistic forecast comes from a confidential study by Bridgewater Associates, the second largest hedge fund in the world.

“We are facing an avalanche of bad assets,” says the study. The biggest losses were the U.S. credit banks before. “We have big doubts that the financial institutions will be able to have enough new capital in order to cover the losses,” the authors write.

Bridgewater Associates in financial circles enjoy a first-class reputation, several central banks are among its customers. “Bridgewater are on the pessimistic side,” says George Magnus, Senior Economic Adviser at UBS in London, “but they have absolutely right.”

I don’t know if this hitting the blog world explains the sickening reversal in the market today, but if it doesn’t it probably should.

Off the cuff ? What do I mean?

Simple, sometimes when you start adding up something that is really huge it doesn’t really matter or help to know exactly how much risk there is, or where all the damage will come from, it is bigger than a breadbox, or in this instance, bigger than a piano falling from 10 stories up. At some point it pays to just get out of the way. I remember telling clients who kept asking me when would be a good time to invest in the Nasdaq (especially QQQ’s) during the last bear market that I had no idea, and frankly didn’t see the point in trying to figure it out. I wasn’t even going to look at it until it was below 1500. The usual response was a blank stare and incredulous statements about how it “couldn’t go that low!”

Same here. Once the losses start going past the trillion point get back to me, I may bother to put a more precise estimate on it, though by then you probably will not care.

Or, to put it the way I put it in response to a discussion of what we were going to do based on our outlook for the market and how bad that outlook should really be:

It seems to me that debating whether a building you are about to fall off of is 30 or 60 stories high is a bit irrelevant, the answer is still “step away from the ledge.” I don’t think it changes what we should be doing now to know exactly how bad it is going to get.

Is this priced into the market? No, a thousand times no. On a related note, Barry Ritholtz looks at what happens after big one month sell-offs. In the past a rebound, but he asks good questions for those tempted to trade this for a bounce.

Technorati Tags banks, credit markets, economy

That is a pretty stunning collapse. Few things correlate with economic activity more than freight, and for rather obvious reasons.

While I have been very negative on the economy shorter term for some time, I will say I doubt this will be a particularly deep recession. On the other hand, I also expect it to be rather drawn out. Obviously I could easily be wrong on both counts.

I will repeat what I have said over and over, in a probabilistic world we cannot know the future, but we can say that the risks are rather high and we should all consider lowering the amount of risk we face. That means more cash in our savings accounts, more defense in your portfolios (if you are going to take risk, make it risk that doesn’t correlate with US financial markets) and reducing debt.

With both financial markets and housing prices I would be wary. Your situation may differ, but I keep hearing people say things must be attractive at this point. Housing is a much better deal than it was, etc.

That is exactly right, but I suspect that this also likely holds true. It is approximately 4 1/2 hours from Baton Rouge to Shreveport. Alexandria lies halfway between. When my children ask me how far we still have to go, while I undoubtedly have far less distance to go than when I started, I still have just as far to drive as I have already driven.

In many areas of the financial markets and housing things may be less expensive than they were, but they are still way too expensive and there is a lot more bad news coming down the pike.

Technorati Tags economy, freight, investing, markets

The indicator in question focuses on corporate money-raising. Considerable research has shown that when companies turn aggressively to the equity market for their financing needs, through new issues or secondary offerings, it is a sign that the stock market is overvalued. Though there is no easy way to interpret the data, current trends in corporate finance appear no worse than neutral for the stock market’s intermediate-term prospects. And the data may actually be painting a bullish picture.

[...]

Professor Lamont, who is also a portfolio manager at DKR Capital, a hedge fund in Stamford, Conn., has calculated the new-list percentage back to 1929. Its all-time high was nearly 15 percent, at the beginning of the Depression. Its second-highest level, almost 11 percent, was in March 2000, just before the Internet bubble burst. (He published these results in 2002 in an academic working paper.)

This result doesn’t surprise me, and is intuitively reasonable. There is also this:

Two researchers who have studied these patterns are Malcolm P. Baker, a finance professor at Harvard Business School, and Jeffrey Wurgler, a finance professor at New York University. For each year from 1927 through 1996, the professors calculated the share of total capital raised by publicly traded corporations that came from issuing stock — what they call the equity share.

Over the 12 months after the quartile of years with the lowest equity shares (when this proportion was no higher than 14 percent) the stock market returned an average of 14 percent, according to the professors. In contrast, the market had an average net loss of 6 percent following the quartile of years with the highest equity shares (when this proportion was no lower than 27 percent). Their results were published in the October 2000 issue of the Journal of Finance.

This likewise makes sense that you would generally observe those conditions.

Where does the equity share stand now? In an e-mail message, Professor Wurgler said it was 6.1 percent for 2007 through September, the latest date for which data are available. Because this puts the current market solidly in the quartile of past years that were followed by above-average returns, he says the data are sending “a bullish stock market signal.”

So maybe I should be trading in my bearish hat over the next few years? I don’t think so:

In separate interviews, he and Professor Baker hastened to add that this bullish signal by no means justifies throwing caution to the wind. They pointed out that companies have had far easier access to cheap debt financing in recent years than they did in earlier decades. As a result, they argued, the current low equity share may not be strictly comparable with similarly low previous readings — and thus may not be as bullish as it otherwise would appear.

Throw in large cash reserves, record profit margins (which are reliably mean reverting) and companies hardly needed to issue equity. They already did that in extremes earlier. Much financial activity was diverted to private equity and M&A as well.

But judging from how companies have been raising new money, Professor Baker said, there was little evidence of extreme levels of speculation at the recent stock market high. At least to this extent, he said, this means that “there is less downside risk in the market today than there was in March 2000.”

Maybe so, though it seems a big risk one must account for in any decision on how to allocate assets. The problem, like with much finance theory, is that these are coincident indicators of the real problem, excessive speculation driving assets far above a reasonable estimate of their long term value. When stocks are overvalued companies do tend to issue equity, we see more companies going public, etc. However, they are not the actual driver of returns, and thus can give us a hint to check on whether the market is overvalued, but not whether it is.

Simply put, any reasonable assumption about growth in earnings, payout ratios and profit margins predicts low returns. Whether those low returns are fairly valued or not, there they are. If valuations decline to boot, we have a major decline in store.

I don’t believe investors realize how low the embedded returns in stocks are. Since I believe investors think that the US stock market can give them higher returns at these levels than is likely, when they are disappointed by declining profit margins and growth rates below their assumptions (combined with looking at their pathetic returns over the last 10 years) they will likely adjust the price. That adjustment could come fairly quickly (It would take a 30% or more drop from here just to get back to equities being priced to deliver real returns close to 5%) or by a combination of smaller declines and rallies going on for years, such as we have seen since 2002. That of course assumes inflation doesn’t become a larger issue (very much in doubt) and/or the pessimism doesn’t cause a large over shoot to the downside. When investors have been disappointed for a period of 10 years or more they have had a habit in the past of getting in very dark moods.

Hat tip: Abnormal Returns

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Technorati Tags equity, IPO's, returns, Risk, stock market indicators, Valuation

If a recession does occur, it could last longer and be more painful than the past several downturns because of differences in its origin and character. The recessions that began in 1991 and 2001 lasted only eight months from the start of the downturn until the beginning of the recovery. Even the deeper recession of 1981 lasted only 16 months.

But these past recessions were caused by deliberate Federal Reserve policy aimed at reversing a rise in inflation. In those cases, the Fed increased real interest rates until it saw the economic slowdown that it thought would move us back toward price stability. It then reversed course, reducing interest rates and bringing the recession to an end.

In contrast, the real interest rate in 2006 and 2007 stayed at a relatively low level of less than 3%. A key cause of the present slowdown and potential recession was not a tightening of monetary policy but the bursting of the house-price bubble after six years of exceptionally rapid house-price increases. The Fed therefore will not be able to end the recession as it did previous ones by turning off a tight monetary policy.

The unprecedented national fall in house prices is reducing household wealth and therefore consumer spending. House prices are down 10% from the 2006 high and are likely to fall at least another 10%. Each 10% decline cuts household wealth by about $2 trillion, and this eventually reduces annual consumer spending by about $100 billion. No one can predict the extent to which the coming fall in house prices will lead to defaults and foreclosures, driving house prices and wealth down even further. Falling house prices also discourage home building, with housing starts down 38% over the past 12 months.

But the principle cause for concern today is the paralysis of the credit markets. Credit is always key to the expansion of the economy. The collapse of confidence in credit markets is now preventing that necessary extension of credit. The decline of credit creation includes not only the banks but also the bond markets, hedge funds, insurance companies and mutual funds. Securitization, leveraged buyouts and credit insurance have also atrophied.

The dysfunctional character of the credit markets means that a Fed policy of reducing interest rates cannot be as effective in stimulating the economy as it has been in the past. Monetary policy may simply lack traction in the current credit environment.

Read the whole thing, but it mirrors much of what we have been saying. Here is Martin on the Charlie Rose show where he stresses that it is not just a subprime issue, that all kinds of assets were not priced appropriately, and frankly still are not:

Hat Tip: Barry Ritholtz

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Technorati Tags Charlie Rose, credit markets, Economics, fiscal policy, Martin Feldstein, monetary policy, NBER, Risk, the economy

On the investment merits however, stocks in general are at extreme levels only exceeded significantly by the recent tech bubble. Only by comparison to the elevated levels of the last 15 years can the S&P 500 be considered even reasonable, much less inexpensive. Unlike 2000 when many asset classes were reasonable, and only cap weighted indexes and a few components were expensive, almost all asset classes are overvalued. In many ways, from a valuation standpoint, this is a far more tenuous situation than 2000 when you could easily select assets that had not taken part in the bubble. Now there are few places to hide.

So no, the market hasn’t “discounted” a recession. Even the idea that the U.S. economy is in recession is contentious. The S&P 500 is off only about 10% from its record highs, recession concerns and a weakening of profit margins are not reflected in market prices. At best, they are discounting a slowdown based on the assumption that recent earnings growth and profit margins can be extrapolated longer term once we get past it.

John Hussman put it well (my emphasis)

Similarly, in stocks, analyst estimates reflect a quick return to record profit margins about 50% above their historical norms. If those assumptions disappoint and it becomes clear that profit margins will not be forever sustained at record highs, it doesn’t only imply near-term earnings disappointments – it implies that the whole stream of future earnings impounded into stock prices is wrong.

Since I believe this has been a long term issue, how bad has the valuation penalty been so far? Since April of 1998 the return of the S&P 500 has been below that of Treasury bills. That is almost 10 years! Since 2000 the S&P 500 has trailed inflation. In fact, the S&P500 has trailed treasury bills since Nov. of 2005 as well.

Is the market significantly cheaper than in 1998? No. Should we expect better going forward? No. The likely path is we will get similar or worse returns in an interesting way.

So, who will make money with real returns that an investor might consider satisfactory? The lucky, savvy speculators, the hedgers (I put my money on L/S guys in the vein of Julian Robertson) tactical asset allocators who hedge and protect capital (using some of the above) etc. Indexers, closet indexers and other low tracking error portfolios will disappoint.

Vitaliy Katsenelson, author of Active Value Investing: Making Money in Range-Bound Markets (Wiley Finance)points out some of the reason’s markets aren’t as cheap as they seem (and even then we are talking about p/e ratios well above “average.”)

Unfortunately, the cheapness argument falls on its face once we realize that pretax profit margins are hovering at an all-time high of 11.9%, almost 40% above their average of 8.5% since 1980. Once profit margins revert to their historical mean, the “E” in the P/E equation will decline. If the market made no price change in response, its P/E would rise from 17 to 23.8 times trailing earnings.

Maybe profit margins will stay high?

Profit margins revert to the mean not because they pay tribute to mean-reversion gods, but because the free market works. As the economy expands, companies start earning above-average profits. The competition reacts to fat margins like bees sensing sugar water. They want some, too, so they fly in and start cutting into these above-average margins. This always has happened in the past, and it will happen again and again in the future.

Let us see a chart, we all love charts:

Vitaliy deals with the most common reason’s people believe “it will be different this time.” So read the whole thing.

Let us move on to the misuse of forward operating earnings. Comparing the historical PE ratio to forward earnings estimates fails the smell test in a number of ways. The proper comparison would be to historical forward PE’s, not trailing PE’s. On that basis we end up with a lot lower forward PE to call “average.” Throw in the elevated profit margins and we get some really scary numbers for the market to get to “average.” John Hussman:

Now, to the issue of P/E ratios based on forward operating earnings. As noted above, it’s clear that forward operating earnings are generally much higher than the record level for trailing net earnings to-date, and of course, record earnings are always equal to or higher than raw trailing earnings.

Investors are used to the idea that “normal” P/E ratios are typically in the range of 14 to 16. But as Cliff Asness of AQR has repeatedly stressed, those norms are based on raw trailing earnings. If you calculate P/E ratios based on earnings figures that are higher, you clearly obtain lower P/E ratios.

As it happens, the long-term historical norm for the P/E ratio based on forward operating earnings would be about 12.

Of course, that means we get a chart:

Look closely. Exactly when has the market been more expensive on the basis of forward earnings? The mid 60’s, which led to one of the worst periods for stock returns in market history. 1987 which corrected in a day and of course the entire late 90’s to now. All periods of severe under performance.

Uh, John gives us a caveat:

Of course, that average of 12 includes the heights of the late 1990’s bubble. The historical average was just 10.6 prior to that point.

I am inclined myself to throw out the late 1990’s (we do all agree now that the valuations of that period were insane, whatever we said at the time, right? So should insanity be used to justify anything?) Your mileage may vary. Back to those profit margins (my emphasis)

It gets worse. Currently, profit margins are at the highest level in history, which further reduces the P/E multiple we observe. If investors wish to use that observed P/E ratio as their standard of value without normalizing for profit margins, they should be aware that they are implicitly assuming that profit margins will remain at current levels indefinitely.

Okay, another chart:

The following chart presents the ratio of forward operating earnings to S&P 500 revenues (net profit margins are even more volatile).

Chart: Historical Profit Margins (Forward Operating Earnings / Revenues)

You’ll notice that prior to 1995, there were only a few instances when operating profit margins exceeded 8%. At those points, prior to the late-1990’s bubble, the forward operating P/E for the S&P 500 averaged just 8. That’s not a typo.

No, I am not predicting an 8 PE down the road. I am saying that in any historical sense the markets are not, and have not, been cheap. That is why returns have been low, below that of treasury bills for a very long time, and likely to be so over any reasonably long term interval going forward.

Go ahead and read John demolish the “Fed Model” of valuing the stock market while you are at it. In fact, Go ahead and read this from John on that very subject as well.

For further thoughts, check out Barry Ritholtz’s similar demolition. He gives us another chart on the ridiculousness of forward operating earnings from the Wall Street journal:

Look at that. How do we get from 3% and 4% for the first two quarters (which I find unlikely in and of themselves, but maybe) to 16% for the year? From Barry (my emphasis)

Analysts are unflaggingly inaccurate at turning points. Example: Q3 S&P500 earnings consensus were +8% — S&P500 earnings came in at -8%. Q4 has been similarly lowered, undercutting the earlier forecasts of undervaluation.

Now let’s look at 2008. S&P 500 forward earnings over the next 4 quarters are as follows: Q1 = 3%; Q2 = 4%; Q3 = 20%; Q4 = 50%, according to UBS.

Earnings explosions like the ones above generally only occur after earnings collapses. Earnings grow reliably at about a peak of 6% over the long term, and the average is lower. In fact, the average is only around 1% over inflation depending on your point of measuring (it looks a bit higher now, it was a good bit lower at the trough of the last earnings collapse.)

Since clients may read this I want to reiterate that seeing the challenges ahead are exactly what this site, and our investment policy, is all about. The reason we have done so well, especially over the last year, is that we have expected and accounted for these, and other, factors we have been covering. The danger is for those investors, or their advisors, who haven’t faced up to the implications of high valuations.

We’ll deal with the Fed Model in more depth here at Risk and Return in the near future. John and Barry hit some of the highlights, but there are fundamental issues which I think deserve more exploration.

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Technorati Tags Asset Allocation, Fed model, indexes, John Hussman, Julian Robertson, operating earnings, return, Risk, S&P500, Valuation, Vitaliy Katsenelson

First, Jeff tackles the subject of stock buybacks and the piece echoes some of the issues I brought up in my post, The False Promise of Buybacks. Except, his version is more entertaining. So go read The Shareholder Letter You Should, But Won’t, Be Reading Next Spring which is part of his post “The Great Private Equity Cash Robbery of 2007.” I will note two interesting points he made prior to the shareholder letter:

So, was yesterday morning’s 400-point opening decline the selling climax?

[...]

Well, as far as NotMakingThisUp is concerned, the most obvious thing missing in all of yesterday’s headlines was this: no share buybacks were announced by any major company before, during or after the brief morning sell-off.

Not one.

During the panic of October 1987, grey-beards will recall, the tape was clogged not only with headlines of trading-halts amidst the worldwide rush to sell, but also with a steady stream of share buyback announcements by U.S. companies.

Coke, P&G and many others that week and in weeks subsequent to the Crash of ’87 used the substantial cash on their balance sheets to take advantage of the market dislocations that caused even the good stocks to be sold with the bad, and cannily bought their own stock back at deep discounts to its inherent worth.

Why then, were there no share buy-backs announced yesterday?

Could it be that the Great Private Equity Cash Robbery of 2007, in which previously healthy companies either “cleared” their balance sheets of cash—to use the euphemism employed by Steve Odlund, the Chief Cash Clearer at Office Depot—by buying back their own stock at bull-market peaks or faced the prospect of having it cleared for them by the Private Equity Cash Robbers?

I guess Jeff agrees with my friend Tim on this one.

My next recommendation is that you read the entire series he has put up on Warren Buffett’s purchase of Dairy Queen.

I am of course a great fan of Mr. Buffett, but like Jeff I am under no illusions about what the great hedge fund manager is doing. He is making money. He is interested in protecting his company’s shareholders interests, not those of the shareholders from whom he is acquiring his companies. Value investing means underpaying.

The series is a great introduction into looking at a transaction from multiple perspectives. It is a human story, and a financial story, with fascinating characters. Jeff’s biting wit makes it all the more enjoyable.

Part I, Part II, Part III.

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Technorati Tags Dairy Queen, private equity, stock buybacks, Warren Buffett

Finally it is the long-term investor, he who most promotes the public interest, who will in practice come in for most criticism, wherever investment funds are managed by committees or boards or banks. For it is in the essence of his behaviour that he should be eccentric, unconventional and rash in the eyes of average opinion. If he is successful, that will only confirm the general belief in his rashness; and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy . Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally
-John Maynard Keynes

Random Roger wants to know what his readers think of the strategy of trying to replicate the type of portfolio that David Swensen of Yale has created.

It is certainly a good question, as Yale’s returns are stunning. His interest is peaked by taking a look at this article in Registered Rep magazine.

So what do I think? I suspect regular readers, and our clients, know we are enthusiastic about the approach, though we do tackle it a bit differently. So Let’s take a look at what Yale does, and David Swensen recommends for retail investors:

YALE ENDOWMENT ASSET ALLOCATION TARGETS

Real Assets 27%
Absolute Return 25%
Private Equity 17%
Foreign Equity 15%
Domestic Equity 12%
Fixed Income 4%

Source: Yale Corporation

SWENSEN’S RETAIL ASSET ALLOCATION TARGETS

Domestic Equity 30%
Foreign Developed Market Equity 15%
Foreign Emerging Market Equity 5%
Real Estate 20%
Short-Term U.S. Treasuries 15%
Inflation-Protected U.S. Treasuries 15%

Source: David Swensen

Actually, not a bad strategic allocation on the retail side, and according to Registered Rep it did pretty well through last Summer. What it lacks is any direct hedging similar to the absolute return option, Real assets other than Real Estate, and Private Equity.

Real Assets can be replicated to some extent through ETF’s and some mutual funds. Absolute Return vehicles can include long/short funds, Managed Futures, and for some, actual hedge funds. In addition, direct hedges from mutual funds can be used where appropriate. You will not have access to the favorable cost structure that Yale gets.

A word about Private Equity.

David Swensen speaks to this in his book Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment but some of the lack of volatility is a statistical artifact present in some of his real assets and private equity. Since they are illiquid, the value of these investments often cannot be known, it is estimated or marked to model, rather than to the market. In reality Private Equity is both very volatile, and likely very correlated to the public equity market.

What Private Equity really provides to Yale, is higher returns. Swensen believes they can get top managers, but he admits that if you don’t have top managers that Private Equity does not even outperform once adjusted for risk. He feels though that the dispersion of skill is higher, and that with proper due diligence it can be identified. His results seem to confirm that.

Our twist upon this theme

So, whether we are talking about non accredited, or accredited, investors, how does our approach differ and can it be replicated? We add a tactical element. That goes for private equity as well. In our discussions we have been very wary of private equity, we didn’t think money being invested over the recent past was being invested in a way likely to generate much return, and possibly it would be disastrous. In essence we saw a Private Equity bubble about to pop.

The returns had been reasonably good mostly due to leverage built on easy access to credit. Leverage is fine if you know what you are buying, our suspicion is that most people didn’t realize the risk they were facing if the market turned south, credit dried up, recession, etc. To put it another way, the risk vs. return ratio was out of whack. I think our fear during that time of greed was as usual a good thing to have. We may get a bit greedier when there is a lot more fear in general.

Yale has a pure strategic asset allocation, in essence the managers in the Real Asset and Absolute Return spaces make the tactical decisions. We do the same, but we also tactically increase and decrease (within the constraints of the Investment Policy Statement of our clients) our net exposure to any given traditional benchmark, or beta. We are quite willing to hedge our exposure to US stocks for example, or to go short one part of the market, long another. That is, if we see the expected gap in performance over a two to three year time span as being quite large. We don’t want to be operating in the area where random noise can eliminate that potential return. “Fat pitches” only need apply when it comes to such strategies.

In addition, when upside returns look low, and the potential downside looks high, we increase our allocation to absolute return managers and strategies.

That goes to the problem I have with the strategic retail portfolios I see discussed by Roger and his links (including in the comments.) While over the long haul I believe a portfolio such as the ones examined might do better than more traditional allocations with consistent rebalancing (they have in the past) I don’t think it will get investors where they want to be over the nearer term, say the next five years, and it will take some awfully good years for them to ever catch up to the type of compounded rate of return investors expect.

Unlike 2000-2006, a period that started with a few over valued areas and many components of the market ranging from reasonably priced to under priced, nothing as an asset class is cheap right now. The reasons Real Estate (in the form of REIT’S) was such a fine diversifier are not as applicable now. Traditional asset class diversification may help (though adding huge slugs of Real Estate, something until recently we have always had, made little sense when the article Roger is discussing was written) but it will likely lead to very low returns relative to history. After eight years of low returns another five to seven more is likely to really alter people’s financial plans.

Rather, we suggest adding in diversification of strategies as well. That means portable alpha, or portable alpha inspired strategies, hedges and other strategies to emphasize absolute returns at the portfolio level until markets go through an extended cathartic sell off. Until that happens, whether over the next six months or three years, permanent returns are likely to be hard to get with a mix of diverse, but over valued securities. The eventual sell off will likely eliminate most of the returns gained during any upturns, leaving the investor with returns barely above, and quite possibly below, the rate of inflation. The most over valued areas should likely just be avoided or used as a hedge.

Of course, as Jeremy Grantham recently pointed out, cash isn’t such a bad thing either.

To put it another way, the publicly traded diversifiers of the past have been bid up in price and are now likely very correlated, at least on the downside.

What is the longer term problem with tactical approaches?

They are difficult to do. Both from a knowledge standpoint, and psychologically. Most investors, including professionals, have no idea what the historical valuation of the market is, or what return the market is priced to deliver in various asset classes. Essential information to adequately pursue this kind of strategy.

As the quote I began this post with states, the largest constraint is the psychological will to allow themselves returns that do not track the larger market. We say we want non correlation, but what we mean is we don’t want to go down with the market. The idea of not tracking the market on the upside is not what we want to hear. Even tremendously successful investors, like Jeremy Grantham, Rob Arnott and John Hussman suffer for the impatience of their clients, no matter their great track records and the logic of what they are doing.

Yet, unless one has the ability to time pretty closely the market, that is exactly what you have to do to carry off such a strategy. That will also be true of the type of replicated portfolios Swensen and others are proposing. The goal is performance over several years time. Hedges which over time turn out hugely profitable will not be received kindly during the upward marches which populate even extreme bear markets. Intelligent active asset allocation is therefore the province of the few and the thick skinned, thus the popularity of static strategic asset allocation.

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Technorati Tags Asset Allocation, bonds, Commodities, David Swensen, Hedge Funds, portfolio management, private equity, real assets, real estate, Risk, stocks, Yale

One earnings report to watch this week, though, is Harley-Davidson (HOG). It’s a solid company with a loyal customer base—I’m one of them actually—but, motorcycles are a luxury item. For every guy like me that rides practically every day, and uses a motorcycle as their primary transportation—there are about 10 guys that ride for maybe 2,000 miles a year. Or less. Those people are gonna stop riding—and buying—new motorcycles.

In fact, if the rumors are true, they already have, and Harley’s results for last quarter will be below analysts estimates. In the last year, Harley sold substantially fewer motorcycles than in 2006. Also, Harley’s stock has already lost about half of it’s value in the last year already, and disappointing earnings for last quarter won’t help.

The thing is, Harley is an interesting proxy for luxury buying. If Harley’s sales are looking bad on the 24th, when earnings are announced, that’s a pretty good indicator that consumers are shutting off buying non-essentials, a good indication of belt-tightening, and general economic cooling.

So what happened?

Revenue for the quarter was $1.39 billion compared to $1.50 billion in the year-ago quarter, a 7.7 percent decline. Net income for the quarter was $186.1 million compared to $252.4 million, down 26.3 percent versus the fourth quarter of 2006. Fourth quarter diluted earnings per share were $0.78, a 19.6 percent decrease compared to $0.97 in the fourth quarter of last year.

[...]

“Harley-Davidson managed through a weak U.S. economy during 2007,” said Jim Ziemer, Chief Executive Officer of Harley-Davidson, Inc. “As we announced in September, we reduced our wholesale motorcycle shipment plan for the fourth quarter, fulfilling our commitment to our dealers to ship fewer Harley-Davidson motorcycles than we expected our dealers worldwide to sell at retail during 2007,” said Ziemer.

[...]

Revenue from Harley-Davidson motorcycles was $1.12 billion, a decrease of $105.5 million or 8.6 percent versus the same period last year. Shipments of Harley-Davidson motorcycles totaled 81,206 units, a decrease of 11,642 units or 12.5 percent compared to last year’s fourth quarter.

[...]

U.S. retail sales of Harley-Davidson motorcycles decreased 14.2 percent for the quarter. The heavyweight motorcycle market in the U.S. decreased 9.0 percent for the same period.

[...]

For the full year of 2007, worldwide retail sales of Harley-Davidson motorcycles decreased 1.8 percent compared to the prior year. In the U.S., Harley-Davidson dealer retail sales decreased 6.2 percent for the full year; international retail sales increased by 13.7 percent. The U.S. heavyweight motorcycle market was down 5.0 percent for the full year of 2007.

To recap, miserable in the US, but offset to some degree by strong sales overseas. I think that meets Dale’s requirement for a bearish signal for the US economy. That was also at the low end of estimates. Yeah, it is getting whacked.

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Technorati Tags earnings, Economics, economy, Harley Davidson, HOG, investing, luxury goods, motorcycles, recession

China turned in yet another double digit year:

China’s economy grew by 11.4 per cent in 2007, the highest pace in 13 years, but the trend of decelerating exports to a slowing US recorded in the final two quarters is expected to be carried into moderating growth this year.

China’s economy has now grown at double-digit rates for five straight years, an achievement hailed by the government as a “hard won gain” of difficult policy decisions.

New York Insurance officials are pressuring banks to bail out the insurers:

Leading US banks are under pressure from New York state’s insurance regulator to provide as much as $15bn to support struggling bond insurers, people familiar with the matter said on Wednesday night.

I am not sure if that is the right move for the banks, but you have to think they are saying to themselves, “How lovely, we pay these guys to insure bonds, when they cannot pay us they want us to provide the money they need to pay us back. Just lovely.”

The Congress has passed a stimulus bill. Of course, when are the checks supposed to arrive? In June. Haven’t I spoken about the time issue before? I think I have. Yes.

Steven Dubner has a similar observation, and some support. Bruce Bartlett throws in this chart to illustrate history supports we skeptics (click image to enlarge)

Which goes to prove that recessions end and stimulus rarely appears until after they are over.

Are we in recession? Calculated Risk looks at a little covered set of data from the Philadelphia Federal Reserve Bank.

Bespoke compiles some data to help us understand how a Bear Market behaves. That is part of my next post, I have some thoughts on that as well.

I stand by the claim that as investors we should pretty much discount fiscal stimulus as a plus any time soon. Greg Mankiw doesn’t think things are bad enough for this to do much good in any case, and potentially is a long run negative.

Tyler Cowen discusses the law of unintended consequences:

Dubner and Levitt have an article in the NYTimes with three examples of the law of unintended consequences, the Americans with Disabilities Act made it more costly to hire people with disabilities and reduced their employment, ancient Jewish sabbatical law intended to help the poor has made them worse off, and the endangered species act has resulted in habitat destruction.

If it isn’t a law it is certainly a key risk factor.

Oh, and about that fraud, 7.1 Billion dollars worth by a single trader.

Which leads Barry Ritholtz to feel the Fed intervened for the wrong reasons. I lean his way on this. In fact, this kind of makes the point that he is right.

Hat tip: as always, some of this is from Abnormal Returns. Even if not, go there.

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Technorati Tags bond insurers, China, Federal Reserve, fiscal policy, fiscal stimulus, Links, recession

So what should investors, especially those of us allocating across asset classes rather than picking individual stocks, think about claims that share buybacks are a big positive:

• Announcements do seem to be a short term positive, because investors and many in the media believe they are important, but long term many never occur! Hence the article I linked to. Pumping up the attractiveness of the stock market based on announcements ignore this fundamental problem.
• Share repurchase programs are often a shell game. Generally new share issuance exceeds repurchases. The repurchase plans are announced to great fanfare, the issues of stock, and options on stock, are quietly distributed. While for any one company that may not be true, for the market as a whole it is. Let us quote Bill Bernstein and Rob Arnott :

[M]any investors believed that stock buybacks would permit earnings to grow faster than GDP. The important metric is not the volume of buybacks, however, but net buybacks-stock buybacks less new share issuance, whether in existing enterprises or through IPOs. We demonstrate, using two methodologies, that during the 20th century, new share issuance in many nations almost always exceeded stock buybacks by an average of 2 percent or more a year.

[...]

Investors were told the following:

[...]

When earnings are not distributed as dividends and not reinvested into stellar growth opportunities, they are distributed back to shareholders in the form of stock buybacks, which are a vastly preferable way of distributing company resources to the shareholders from a tax perspective. True, except that over the long term, net buybacks (that is, buybacks minus new issuance and options) have been reliably negative.

Why does this happen?

• Amongst other factors there is this. In research conducted by the Center for Financial Research & Analysis and the Corporate Library a disturbing, if predictable, pattern was noticed. They looked for companies with share repurchase programs while basing compensation of executives on earnings per share. Not earnings overall, but per share. They also wanted to see how many of these companies had negative cash flows over the two previous years. How many were in the S&P 500? 78. Worse, none of this was disclosed in their proxies. Warren Buffet described this practice in his usual witty style in 2005 (pdf .).
• Management also often conducts stock repurchase programs while busily selling their own stock.
• Repurchases only make sense if that is the best alternative for the cash used. When is that? – Only if the shares are undervalued. If not we should want the dividend. The unfortunate truth is that companies generally buy their shares back when they are going higher and on a run. Historically they have done a poor job of making that key investment decision. Recent history is instructive, buybacks kept picking up steam even as this current correction was approaching. Momentum investing is fine if that is what you want to do, but you hardly need management to do it for you.
• The announcements often are accompanied by a bump in the price, causing the company to pay a higher price than otherwise.
• The sheer size of the buyback programs can move the market, destroying some of the value.
• Of course management which profits from stock options often doesn’t care. They want per share appreciation, the options don’t qualify for dividends.
• Much of the recent binge of repurchase plans was carried out through debt. When this is done the entire effect is really one of leverage. The proper amount of leverage on the balance sheet is certainly open to discussion, but let us always be aware that leverage increases potential gains and losses. Higher risk should therefore mean a lower multiple on those earnings as well, diluting the expected boost to the stock. Given this leverage is often diluted by the factors above, but the cost of servicing that debt remains, we are left with reason to question repurchases as a productive strategy even more. If things get tight companies may need that cash. Dividends can be cut, cash can be drawn down, but the interest cost of that debt may remain.
• But Buffett likes them! If Warren is on my board and has real power I have some faith in the decision on whether dividends, stock buybacks, or reinvesting cash flows makes sense. Generally I have far less faith in management or boards. He seems to feel the same way. Dividends don’t provide shares to send out the back door as compensation. Repurchases do.

Stock repurchases can be a good thing for an individual company, so can leverage, but we are asset allocators, and the total level of stock repurchases tells us nothing about whether that is a wise use of our capital of a diversified selection of stocks. In aggregate it should makes no difference to the value of an index. John Hussman explains that well here .

While there are tax benefits, given the issues surrounding them in practice, an explosion of repurchases as we saw in 1999 and this year, is a bad sign, not a good one. It shows irrational exuberance and carelessness with capital.

Even if it did not, it is certainly no positive to be preferred above paying a dividend or reinvesting cash flows. In aggregate the value of the companies stays the same. It can only increase returns (leaving aside taxes) by increasing leverage with all the risk that entails.

Update: I received some feedback from a couple of people, good friends Tim Randolph and Dale Franks. Both feel the agency feels the agency problem I discuss above is a major contributor. Here is an excerpt from Dale’s e-mail:

Once tax law shifted compensation from direct salary to stock options and other incentive types of pay, it really served to do little more than magnify the agency problem., i.e., executives gaming the agency relationship between managers and owners for thier own profit. I think repurchase programs are often little more than back door for executive to increase their compensation based on EPS.

At every step of the way since moving away from direct compensation, we’ve seen increasing agency problems, and corporate boards have just been abysmal at reigning in executives. Allowing executives to actually sit on the board–or practically as bad, nominate board members of their choosing–has resulted in all sorts of corporate governance failures.

I’d actually be interested now in looking at some research on the timing of repurchase programs and following re-issuance, because I suspect that a signifigant fraction of repurchases are nothing more than a scheme to puff up EPS–and perhaps stock prices–in the short term, then pay off the repurchases through a re-issue. But, to my mind, that only seems to work reliably if the stock price rises or at least remains stable betwen repo and reissue. If it doesn’t, then you either lose cash, increase debt, or issue new shares at a rate that’s dilutive.

In short, it’s the kind of thing you can do in a bull market without anyone noticing, but which becomes very noticeable in a bear market.

The thing is, if you do it through leverage, while it does bad things to your debt ratio, most investors just aren’t geeks enough to run your debt ratio, quick ratio, inventory turnover ratio, etc., etc. So, the risk isn’t as obvious. But most investors are least attentive enough to notice if you cut the dividend yield from 3% to 1%. They notice that real quick.

Tim posited that it was also a way for some executives to load the company up with debt, increase compensation and make them less attractive for LBO’s. Dale is skeptical. I’ll put it in the hopper as one issue.

Dale throws in that he is planning on posting some of his work on corporate governance reform. Looking forward to it.

Thanks to Abnormal Returns and Barry Ritholtz for linking! While you are here check out the Harley Report, worries about the unseen frauds, our collection of recommended links and musings about them, or the various odds and ends about Baton Rouge, LSU, history and other topics scattered around.

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Technorati Tags Asset Allocation, Buybacks, dilution, dividends, investing, management, repurchases, research, Risk, stock options, stocks, Taxes

Click here for Global Correction

*Mouse over the cities on the maps to get the hard numbers.

Thanks for visiting Risk and Return. Please feel free to contact us with any questions and/or comments. Please note our disclaimer.

Technorati Tags bear market, correction, equities, global equities, stocks

Dale Franks gives his rundown on what to look for going forward from the economy, and the implications for investors:

We’ve dropped off about 20% from the stock price highs of October, so we’re about due for a rally. Especially with the Fed obliging everyone with rate cuts. At this point, though, I’d look askance at any rallies in stock prices over the near term. bear markets, after all, have rallies too, which turn out to be fuel for a little hope before reversing in crushing disappointment. Don’t get sucked in by a bear-market rally, especially if the rally is sharp and quick. Chances are that it’ll just be a spike in a general downward trend for stock prices.

In fact, there were three rallies of 20% or more in the last bear market. Each hailed as the beginning of a new bull by the professional cheering class.

The highlight for me however is his own personal bellwether:

One earnings report to watch this week, though, is Harley-Davidson (HOG). It’s a solid company with a loyal customer base—I’m one of them actually—but, motorcycles are a luxury item. For every guy like me that rides practically every day, and uses a motorcycle as their primary transportation—there are about 10 guys that ride for maybe 2,000 miles a year. Or less. Those people are gonna stop riding—and buying—new motorcycles.

In fact, if the rumors are true, they already have, and Harley’s results for last quarter will be below analysts estimates. In the last year, Harley sold substantially fewer motorcycles than in 2006. Also, Harley’s stock has already lost about half of it’s value in the last year already, and disappointing earnings for last quarter won’t help.

The thing is, Harley is an interesting proxy for luxury buying. If Harley’s sales are looking bad on the 24th, when earnings are announced, that’s a pretty good indicator that consumers are shutting off buying non-essentials, a good indication of belt-tightening, and general economic cooling.

Dale also provides a list of what he is watching as far as the data on housing, employment, credit, etc.

Thanks for visiting Risk and Return. Please feel free to contact us with any questions and/or comments. Please note our disclaimer.

Technorati Tags bear market, consumer spending, Dale Franks, Economics, Federal Reserve, Harley Davidson, markets, motorcycles, Slackernomics, stocks

What does this mean for investors. Quite a number of things – none of which are particularly good over the long term:

1) Why Cut today? What was the motivation for today’s cut? Would waiting 7 days have done anything. other than allowing some of the excesses to get wrung out of the system?

2) Equity Market Dysfunction? Is it that the equity markets are not working properly? Likely not. Are rates too high? I doubt that’s the reason for any of our economic woes. Then what is it – are lowered equity prices a problem?

Globally, equity markets have been in the process of “Repricing Risk” – why is the Fed disrupting that? Further, there is now a recognition that S&P500 earnings were priced way too high – especially in the event of a European and Asian slow down. That lowered “E” in the P/E adjustment is also under way.

3) TANSTAAFL: The free lunch crowd (a/k/a Long & Wrong) has been chanting for Fed cuts. However, these are not with0out consequences, as Inflation remains a pernicious threat.

Here’s a question: What goes to $5 a gallon first – Milk or Gasoline? How about $6?

4) How Independent is the Fed? The Fed is supposed to be an independent entity, whose mission is a) price stability (inflation) and b) maximizing employment (growth).

However, today’s action reveals an apparent third obligatory goal – protecting investors and market prices. I had no idea that back-stopping speculators and hedge funds was part of their mandate…

5) Capitulation? The Market gapped 400 points, and is now climbing higher (off 300 as I type this). My second biggest concern is that the Fed merely delayed the inevitable. This market saving cut prevented a thorough, 5% wash out. In other words, all the Fed did was prevent a healthy capitulation.

6) Pushing on a String? My biggest fear is that we close down 500 points anyway. That would be the worst of all worlds: A compromised, political Fed, working on behalf of speculators, to the detriment of ordinary taxpayers, is proven to be a paper tiger. That scenario would but the “F” in Fugly.

7) Decoupling US Equities from Global Slowdown? Other markets were down much more than the US. But that makes sense, seeing as they have been a whole lot more than the US over the past 5 years . . .

Bill Gross echoes Barry and I:

“It’s a sad testament to think the Fed has to cut interest rates eight days in front of a meeting to salvage the equity markets. The U.S. economy is in a rather sad state of affairs in that it depends on housing and stock prices to keep going.”

-Bill Gross, founder and chief investment officer, Pacific Investment Management Co. (PIMCO)

Paul Desmond in the Wall Street Journal builds on the theme:

In many ways, this is what a classic bear market looks like: After a long period of exuberance, a downturn hits one part of the economy — in this case, the housing market and mortgage-backed securities. Eventually, that leads to broader losses, even for strong companies, and markets begin a prolonged grind downward. . .

The current market looks a lot like the beginning of past bear markets, such as the ones that began in 2000 and in the 1970s and 1987, said Paul Desmond, president of market-research firm Lowry’s Reports in North Palm Beach, Fla. First, the most troubled stocks decline — home builders and financial stocks in the current case — and then others gradually get hit, including small stocks, retailers, technology stocks, and foreign stocks. Finally even stocks of strong companies are affected.

What happens, Mr. Desmond says, is that trading volume and price movement get heavier and heavier for stocks that are declining, and lighter and lighter on the buying side, as more investors look for a way out. When the selling reaches a climax, the bear market is nearing an end, but Mr. Desmond says he doesn’t see any sign of a climax yet.

“We feel we have been in a bear market since July. Everything that we have seen since then has just been a progression, almost like a disease that you are monitoring and the disease is spreading,” he says. “We are still a long way from a major bottom.”

He is watching for a sign of panic selling, but says it hasn’t gotten to that point yet. “Everything we are seeing looks like a typical bear market,” he says.”

Update: Barry has two interviews with Paul:
Q&A: Paul Desmond of Lowry’s Reports
Part II — Q&A: Paul Desmond of Lowry’s Reports

Technorati Tags Barry Ritholtz, bear market, decoupling, Employment, equity markets, Federal Reserve, Inflation, interest rates, monetary policy, Paul Desmond, stocks

In retrospect, what should the fed have done differently?

Risk and Return is really about implications for investment policy, and thus identifying which factors have implications is key. Pumping for particular policy choices really isn’t our role. Still, in identifying what probably should have been done we can better recognize the impact of future events. Here is the quick, and therefore somewhat inelegant, response I gave him:

First, I do think interest rates were kept too low, too long. The goal was to inflate asset prices, specifically housing, to stimulate the economy. Of course, high asset prices mean lower returns later, or in this case, declines. That worked, but what do you do next? The loans encouraged by high, and rising, prices don’t make sense when that condition clears.

The fear at the time was a deflationary spiral (see Japan since the end of the ’80’s.) The problem I had with that fear, and it was legitimate, was that for all the issues surrounding the tech and stock bubble (the latter not being over) Japan’s crisis was a financial, and specifically related to a real estate bubble, collapse. In order to avoid the Japan disease, we have put those very same conditions in place. The tech and stock market bubble collapse (once again, that collapse is still in process, and will be for some time) was unlikely to lead to a Japan scenario. I don’t think this will either, but it certainly has much more of a chance, which makes the policy much harder to defend. Recessions come and go, huge financial crises are not to be played with, even if the worst case scenarios are unlikely.

Second, if you are going to inflate housing, and in essence create a strategy for raising prices that may not be sustainable long term, it certainly makes sense to curb speculative excesses and fraud through regulation. I am no fan of regulation, but irrational prices encourage irrational greed. Doing what you can to ensure loan quality in this kind of environment was a no brainer. At minimum fraud needed to be curtailed. That wouldn’t have avoided the crisis, but it would have made it less severe. The Fed created conditions, it then needs to work to ameliorate the risks to the broader economy those artificial conditions create. Low regulation environments make sense when the ultimate investors and home buyers pay for their greed or mistakes. The discipline of the markets. However, if you create a situation where that solution causes broader systemic issues due to your own policy, the market will not work it out, because politicians and economic actors can’t afford for that many people to suffer.

To elaborate, moral hazard is in play. Politicians will try and fix it, leading to a spiral of further regulation and short term fixes, reinflating of assets and a rescue which encourages the same excesses. Worse, these solutions are unlikely to make much difference in the short term. Their impact will be after the current problems are likely to have worked themselves out systemically already. If they haven’t, the problem is therefore likely beyond the policies ability to accomplish much and will sow the ground for future crises from declining asset prices, that is if there are any assets left to inflate. Housing doesn’t seem likely to easily recover merely due to lowering rates again, and long run, do we want their prices to stay artificially high?

To put it another way, wasn’t using interest rates and a hands off regulatory policy in tandem to inflate housing values among the root causes of what got us here in the first place? If so, then stretching the pain out too much may help avoid a true Japan scenario, though I don’t think that is likely, but it is very likely to set us up for problems for years to come. I don’t envy Bernanke, his choices are pretty unappetizing all the way around at this point.

As an aside, I think this is a good time to read about Ben, here is a thorough biographical article by Roger Lowenstein that has taken the financial blog world by storm. (via Crossing Wall Street)

Technorati Tags Anna Schwartz, assets, bubbles, Federal Reserve, Housing Market, Inflation, interest rates, Japan, loans, monetary policy, moral hazard, mortgages, regualtion