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.

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

A robber in a ski mask blamed the bank for what he was about to do, The Associated Press reported Feb. 22.

“You took my house, now I’m going to take your money!” the assailant hollered. Talk about a reverse mortgage!

The FBI plans to review the bank’s foreclosure records for clues.

The suspect is presumed to be ARM’ed and dangerous.

The New York Times reports that bailing out homeowners is becoming increasingly talked about. This graphic explains why:

Alan Blinder wants the Feds to enter the mortgage business as they did in the great depression. Hat tip: Greg Mankiw

Edmund Andrews worries that Mortgage bailouts could create moral hazard issues. Uh, you think?

Tanta is pretty unimpressed, though she does give us some thoughts on the issues around making mortgage securitization less of a disaster than it has been this time around.

Dean Baker points out that plans to buy up the mortgages does carry some risk. Throw in his lack of conviction that raising the ceilings for the mortgages that Fannie Mae and Freddie Mac can purchase in areas with high-priced homes will help.

This post on worries about the credit worthiness of Fannie and Freddie shows the markets are pretty unsure about them as well.

Mark Thoma gives his thoughts here and here.

Yves Smith has the most realistic reaction to all these proposals for solving these issues. They probably will not work, expose us to moral hazard, and would be far more expensive than Alan Blinder believes. Many of the solutions look at this as a temporary problem of credit markets and people who couldn’t afford their homes. That is true, but more fundamentally homes need to come down in price. Plans that assume the need to stabilize home prices, or help out borrowers who are over extended, are building in failure. Prices will likely not stabilize, and probably shouldn’t. James Hamilton seems to agree as well:

To the extent that analysis is correct, a “pause” in the foreclosure process will be helpful only if house prices are finished falling. But house prices decline sluggishly in response to market pressure, given the unwillingness of many sellers to acknowledge the magnitude of their capital loss. Even if the number of homes sold were to rebound tomorrow, there would remain a large inventory of unsold homes that will continue to push prices down.

Calculated Risk looks at the merits of the various home price indexes. James Hamilton weighs in on the topic as well.

The National Association of Home Builders remains cautious about the market going forward despite a slight up tick in activity. The fact that permits fell, starts were flat, and for single families at the lowest level since 1991 might have something to do with it (pdf.).

As abandoned homes pile up neighbors in Minneapolis are being urged to “adopt” their neighbors homes .

Barry Ritholtz lets us know about Rotten Neighbor.com .

Some believe this whole mess is part of a fundamental shift in the American landscape, with cites doing better, suburbia declining and taking on some of the characteristics of decaying inner cities. Extreme, but some of it has a ring of truth as urban living becomes more desirable and desired.

But we could be Britain!

Britain’s housing market is a “house of cards” that is set to implode after years of reckless mortgage lending, chronic oversupply of new flats and widespread fraud, a leading analyst said yesterday. (The Times) (via Barry Ritholtz )

Now for a Little discussion of the past

One of the ongoing debates over the last few years has been the economic impact of home equity withdrawal through home equity lines of credit and loans, cash out refinances, etc. How important was it? Was it sustainable?

I think those of us who worried about it can claim that it is now fairly clear it wasn’t sustainable. So let us go down memory lane and look at what was of such concern by the end of 2005:

Notice the two previous big drops came with pretty large economic downturns. The drops worsened the downturns and the downturns worsened the drops. That seemed pretty obviously something to be concerned about, but we negative Nellie’s were told to pipe down time and again. By this Summer that trend was reversing :

The problem for the market:

One would expect to see profit margins coming under pressure, even without the mortgage meltdown. Historically a housing downturn has been bad for the economy, despite claims by some that it would be “contained” and is a small part of the overall economy. Once again, that is without the mortgage and credit market meltdown we are now experiencing:

Nevertheless people still argued that Mortgage Equity withdrawal was somehow different than other debt because it was being used on improvements. Well that economic engine has gone into reverse:

ORLANDO, Fla. – Those fancy home fix-ups touted in cable TV shows and home magazines are losing their luster with consumers.

With the shakeout in the housing market, homeowners are worried they won’t get their money back from high-dollar redos.

And lenders are less willing to finance pricey home improvements.

That has caused a decline in nationwide remodeling.

“We saw a downturn in 2007, and 2008 looks every bit as tough for the industry,” said Kermit Baker, a researcher with Harvard University’s Joint Center for Housing Studies. “After some almost record-breaking growth, the market has stalled.”

Per capita home remodeling expenses in the region that includes Texas jumped almost 50 percent between 1996 and 2006. But since then, spending for home upgrades has fallen.

In a quarterly comparison, nationwide home remodeling expenditures have fallen about 10 percent since their high in 2006.

Researchers blame the downturn in the overall housing market for dampening the desire for home redos.

“Homeowners have been scaling back on their remodeling plans as the overall market has weakened,” Mr. Baker said.

“Homeowners are concerned that they may be overimproving their homes relative to their neighborhood and prices in the market.”

Studies back up those concerns. Average returns on a home remodeling project have fallen from 82.5 percent in 2003 to 70 percent last year.

With home prices depressed in many neighborhoods, homeowners are especially worried that they won’t get the bucks back they spend on luxury features such as saunas, European cabinetry and imported tile floors.

“There are some signs that the emerging weakness may be greater at the upper end of the market,” Mr. Baker said. “We are seeing more of a return to basics.”

That means less costly improvements and standard maintenance, he said, rather than “some of the sexier kitchen and bath projects.”

Tanta goes back over the argument at length at Calculated Risk, but obviously it has not been sustained. Nor was any where near all the equity withdrawn going to improvements on homes, so we can expect declines across a range of goods and services.

Tellingly, banks and lenders now agree on that fact:

Last year, 34 percent of borrowers said they used their home equity lines to pay off other debt and 29 percent used them for home renovation, according to a survey of lenders by BenchMark Consulting International. Another 31 percent used them to pay for other things, such as medical bills, weddings or vacations.

Paying off other debt in many cases only meant freeing up the ability to run those credit accounts up again. The assumption being that home appreciation would continue so they could do it again, or just plain didn’t have any plan at all. So the banks are now freezing people’s Home Equity Lines of Credit :

Larry F. Pratt, chief executive of First Savings Mortgage in McLean, said most mortgage documents he has seen give lenders wide latitude to suspend or freeze credit lines.

“A layperson would not recognize the language because it’s not that blatant,” Pratt said. “It talks about deterioration of the value of the asset or the value of the collateral. . . . It’s not boilerplate language by any means.”

Across the nation many borrowers are upset. This will put a crimp in consumer spending moving forward.

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

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

Technorati Tags bailout, credit crisis, Economics, economy, home equity, home equity loans, housing, subprime

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.

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

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

All About Alpha reviewed some of his points a little over a year ago, and I suggest reading the whole thing, but I particularly like these two takeaways:

In his opinion, alpha/beta bifurcation is somewhat of a red herring and we should just accept returns for what they are. (North American readers may be reminded of that old Reese’s Peanut Butter Cups commercial where a person eating chocolate bumps into a person eating peanut butter and they both declare that the (fortuitous) combination “tastes great!”. But in this case, Arnott might re-write it: “First guy: Hey, you got alpha in my beta! Second guy: No, you got beta in my alpha! Together: Mmmm, performs great!”)

and

In conclusion, Arnott accuses the finance industry of being too quick to hold onto theory in the face of conflicting empirical data. In the field of physics, he explains, scientists rejoice when conflicting empirical data is uncovered since it gives them an opportunity to advance their theories and create new ones. But in finance, Arnott says we tend to question conflicting data sets and conclude that they are either flawed or simply too small.

Because experience so conflicts with academic theory, advice, especially in the media, tends to often fall in the category of “pretty good advice that isn’t really true.” Advice that keeps investors (professional and amateur) from doing things which are likely to blow up in their face and/or give in to fear and greed.

However, instead of just saying “you can’t be trusted with the truth,” an unwelcome piece of advice, they instead lean on academic theories which justify that we have no insight on the future, act as if returns and risk are always correlated positively, that past returns are pretty good guides to future returns (even as they say past performance isn’t a guide) etc.

More on examples of this type of thing in coming days.

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Technorati Tags alpha, beta, finance, investing, investment advice, Rob Arnott

All About Alpha examines the results of a paper in the January 2008 edition of the Journal, European Financial Management which shows Steve had it right:

In other words, these “selection and exclusion rules” constitute active management (much to the delight, we’re guessing of Fundamental Indexation proponents). In fact, the authors say these rules have an effect remarkable similar to recognized trading strategies “such as momentum, autocorrelation and the limitation of tail risks.”

Result? Better performance during bull markets, worse in bear markets. Color us unsurprised. Indexes have both alpha and beta characteristics.

A core takeaway, risk and return characteristics of indexes have to be assessed. There is no true passive, and in building your asset allocation the construction of the index, whether invested in through mutual funds and ETF’s, or used as a benchmark, carries tremendous weight.

Read the whole thing.

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Technorati Tags alpha, benchmarks, beta, fundamental indexation, indexes, S&P500, Steve Galbraith