Dr. Ed Yardeni who has been very bullish on earnings is now signaling that warning. Even if we don’t have a recession he believes earnings will slow dramatically next year and fourth quarter earnings are likely to have more negative guidance and downside surprises:

October should provide a very interesting Q3 earnings season. We have been very bullish on the past nine earnings seasons. We have our concerns about the tenth one. We won’t be surprised if there are more negative earnings surprises this time and lots of cautious guidance about Q4’s outlook. The biggest negative is likely to be that sales and earnings in Europe slowed significantly during the quarter, and are likely to worsen over the rest of the year.

US domestic sales and earnings could also be disappointing given the weakness in all the Fed and ISM surveys of business during July and August. There is a strong correlation between S&P 500 operating earnings on a year-over-year basis and the ISM purchasing managers index (PMI) for manufacturing. This index dropped from the most recent cyclical high of 61.4 during February to 50.6 during August. This suggests that the year-over-year growth rate in S&P 500 operating earnings is heading towards zero, unless there is a surprising rebound in the PMI over the rest of the year.

S&P 500 operating earnings was $24.85 per share during Q2, up 18.9% y/y. Industry analysts are currently forecasting $25.04 for Q3, which would be up 15.1% y/y. They expect earnings to be up 15.1% during Q4 and 13.7% during all of next year. Again, these forecasts are likely to be too optimistic if purchasing managers indexes remain subdued in the US and if European economies remain depressed. We are predicting that earnings will be up only 5.3% next year.

He provides this chart:

The correlation is obvious, but two things stick out . First, earnings lag, and often a good bit. Second, the huge divergence in the magnitude of the move after the downturn. This has two interesting aspects to it which makes me suspicious that we will actually see earnings slow even more than Dr. Ed suspects.

First, the positive. These are operating earnings, not reported earnings. This actually makes the chart less concerning. Notice in the downturn lots of losses were not counted in operating earnings or we would see earnings had actually gone negative. Companies and analysts treat many losses as extraordinary (and thus ignore them in operating earnings) while treating gains as almost always part of operating earnings. Thus the apparent downside versus upside discrepancy when it comes to earnings in this graph is less than meets the eye.

Second, the negative. Despite the first caveat, since earnings were driven so much by margin expansion and departed so greatly from the underlying fundamentals since 2009 (as is obvious in the graph) the decline should be proportionately greater to bring things back to normal. Declines in activity from peak profit margins tend to be much larger relative to underlying revenue  than typical. We saw that in 2007- 2009 (even though it might not show up on the graph as in 2008 when huge losses were stripped out of operating earnings) While margins in 2007 were strong, underlying earnings were nowhere near as out of whack relative to underlying fundamentals as the past two years.

Dr Ed’s mid single digit forecast makes perfect sense given the direction of the ISM. However, as the outsized upward move in the graph suggests, we should prepare ourselves for the strong possibility that a downside overshoot of operating earnings due to peak profit margins will lead to a more pronounced slowdown in operating earnings than typical at any given level of the ISM. Reported earnings could potentially go negative even if we avoid recession if the slowdown is persistent.

How big of a decline?  If profit margins were to decline to just slightly below their long term average it would imply a 40% decline in earnings without a recession! If revenue were to drop as well the declines could be even larger. Will that happen? We cannot know, but average profit margins are obviously a possibility.

(Hat tip: Abnormal Returns)

First, stock returns don’t typically consist of exciting price gains with dinky dividends tacked on. Over the eight decades ended September 2010, dividends contributed 44% of S&P 500 total returns, according to research by Fidelity Investments. And that includes a long, anomalous stretch during the 1980s and 1990s, when valuations bloated and yields shrank. During the 1970s, when returns averaged 5.9% a year, dividends contributed 71% of that figure.

That is all true, but it actually understates the importance of dividends. If you take out inflation dividends have over the long term contributed more than 80% of the real return (return above inflation) and over 100% of the real return during the seventies. James Montier provided these charts (pdf) to illustrate:

At the end of the day this is as it should be. Investors often talk as if dividends don’t matter as long as we get capital appreciation, but that is extremely short sighted.

Certainly we want fast growing companies who can reinvest their earnings at high rates of return to do so. However, the bar should be high since management and analysts are overoptimistic about their ability to do so. More fundamentally remember what the point of owning stocks is ultimately. It is to receive dividends. What is the point of owning a company if you never receive any of their earnings?

Casual readers might reply that people have made fortunes investing in companies that do not pay dividends, but they would be missing the point. Why do they make a fortune? Why do investors (at least over time) reward growing companies with a higher stock price?  If it is just because earnings are going up, we have to ask the question, “how does that help the investor?” They receive no cash from that growth. Is it just a game? We all just sit around bidding up companies that grow even though it does not benefit us directly for the price to go up? Are we all just making side bets because we know everyone else will want the stock because they know everyone else will want the stock ad infinitum? Often investors do act that way. They think that way and the market becomes divorced from dividends, free cash flow or any relationship with any tangible benefit for the investor. That leads to bubbles and busts and investor irrationality.

It should not be that way though, because there are only two reasons we should allow a company not to pay us its earnings.

1. Because some of those earnings are needed just to keep the company going. All companies need to maintain and replace existing equipment and other assets.
2. Because we want them to grow (accrete to book value) and be able to pay a larger dividend in the future. Warren Buffet’s Berkshire Hathaway is an example of a company that has focused entirely on that since Warren still believes Berkshire can earn a high enough return on retained earnings to justify doing so.

That is it. Number two being the key. If a company can retain a dollar and reinvest it to grow future income at a rate of 15% per annum for example it would make more sense for them to do so than give it to us. However, investors need some cash at times in the meantime, and we can sell shares (which appreciate due to growth.) Without that promise that at some point in the future a dividend will be paid owning stocks would be silly, akin to betting on horses. They would not go up!

Wonderfully, over time investors do earn a return that equates to the dividends distributed over time as the charts above illustrate. It does get out of whack from time to time. When it does the market eventually corrects that discrepancy, which is what the awful returns of the last 11 years has been all about at the end of the day. JJ Abodeeley calls it The Value Restoration Project.  We call it a secular bear.

Here is a wonderful chart from Doug Short which shows just how correlated dividends and growth are over time:

This chart tells us a very interesting story (though it is from July.) We use trend growth in both the Real (after inflation) price of stocks and the real growth of dividends. Trend Real Growth in Earnings has been somewhere around 1.5%.

Some things to notice.

Trend real growth in the index has been 1.7% a year, which is far lower than people realize. The rest of the return from stocks has been inflation and dividends as discussed earlier. Growth has been a minor component. We want to emphasize this quite carefully. The return of stocks is defined by the dividend yield, the growth in real earnings, inflation and a rise in P/E ratios. One could argue for real dividends as a better guide than reported earnings, but over time those should even out. There is nothing else. If someone argues for higher returns than implied by estimating each of those numbers they are wrong. It is not a difference of opinion, they are wrong. If they argue for faster growth than the 1-2% above inflation mentioned above, remember they are saying things will be much better than the past. Maybe so, but it is certainly unlikely.

Since 1870 a gap has grown between the two numbers in the graph above, which should track, to about 64%! Almost all of which is accounted for by the period since 1982. In all fairness some of this is because dividend payouts have shrunk, and possibly that will result in larger payouts in the future. Some of it is that the price since 1982 has gone way too high. This gap will likely shrink both by payouts from stocks increasing and prices coming down.

Of course Wall Street has been busy disguising the lack of cash actually returned to investors through accretion to book value and dividends by getting us to focus on forward operating earnings. How has that worked out? John Hussman shows us:

Historically, the actual reported net earnings of the S&P 500 have averaged only about 72% of one-year forward operating earnings estimates by Wall Street analysts. The sum of dividends and increments to book value have been even lower, averaging just 60% of forward earnings estimates (and representing only about 84% of the net earnings reported to investors). The remaining portion of “earnings” reported to investors goes the way of the Dodo.

Not too well.

Since dividends have been given short shrift in recent decades it would be wrong to say that stocks were as overvalued in July as the 64% gap in the graph on Real Price and Real Dividend’s would lead one to believe (since with the market price well above trend the overvaluation would have been a lot more that 64% without that caveat.)

However, we should acknowledge that stocks using normal assumptions of growth of 1-2% above inflation plus dividends (about 2.12% today) are priced to deliver over the long-term only about 3-4% above inflation. Not exactly inspiring. Throw in about .5% to account for a low payout today (assuming the retained earnings are not squandered, a big if) and we get 3.5% to 4.5% above inflation. If we set fair value at a projected return of 6% above inflation stocks would need to fall by about 58% at a 1% real growth rate and 25% assuming a 2% real growth rate.

Note that a 2% real  growth rate is not only above long-term averages, it is also unlikely since we are already at peak profit margins. From peak profit margins long-term real growth rates have generally averaged between 0% and 1%. Because companies are loath to cut dividends, barring a major financial crisis we should expect the floor to be closer to 1% on dividend growth (and that rate possibly higher as payouts increase) though earnings would likely be much more volatile.

This leads me to the second quote that stuck out:

Second, from here, broad-market returns might be smaller than investors are accustomed to. Bradford Cornell, a finance professor at the California Institute of Technology who specializes in valuation, argued in a paper published last year in the Financial Analysts Journal that stock returns are inextricably tied to economic growth, which is necessarily slowing around the developed world. Stock investors, he says, should expect to collect their dividend yields plus about 1% a year in price gains after inflation.

The connection between dividends, long term economic growth and the growth in earnings and dividends we have been discussing is exactly why Bradford Cornell’s paper is mentioned in the article. Growth is lower than we think and not nearly as important as dividends in explaining your long-term return. You can find his paper here.

What about stock buybacks? Yes, they do count, though their worth is highly exaggerated and are not equal on a dollar for dollar basis to dividends. However, it is a way for companies to return cash to shareholders. What it doesn’t do is increase the value of the S&P 500 as a whole.

First of all the index is already adjusted for share buybacks. So adding them into the index numbers to assume a higher return is double counting.

Second, the value of share buybacks is they reduce the share count, meaning each individual share can receive more of the dividend, even if delivered far in the future.

If dividends are not high then returns are low once speculative mania has reversed. The positive side of that is negative overreaction will eventually arrive and stocks will be yielding 4-6% at some point in time, usually because of financial disorder or inflation. When it does long-term returns can be far above 6% real (such as in 1982 or 1974.)

At that point the Value Restoration Project will be finished as well as the secular bear. Then we can actually be long-term investors again in the US stock market and not speculators hoping for historically unusual outcomes to bail us out.

It is now urgent for investors to recognize that the set of economic evidence we observe reflects a unique signature of recessions comprising deterioration in financial and economic measures that is always and only observed during or immediately prior to U.S. recessions. These
include a widening of credit spreads on corporate debt versus 6 months prior, the S&P 500 below its level of 6 months prior, the Treasury yield curve flatter than 2.5% (10-year minus 3-month), year-over-year GDP growth below 2%, ISM Purchasing Managers Index below 54, year-over-year growth in total nonfarm payrolls below 1%, as well as important corroborating indicators such as plunging consumer confidence. There are certainly a great number of opinions about the prospect of recession, but the evidence we observe at present has 100% sensitivity (these conditions have always been observed during or just prior to each U.S. recession) and 100% specificity (the 0nly time we observe the full set of these conditions is during or just prior to U.S. recessions). This doesn’t mean that the U.S. economy cannot possibly avoid a recession, but to expect that outcome relies on the hope that “this time is different.”

Always and only don’t occur that often in economics or finance. When they do you should take notice. In fact, I know of no time when the economy showed year-over-year GDP growth below 2% alone that did not result in a recession.

Can the Federal Reserve help? I am dubious, but John makes a further point that investors need to keep in mind:

While the reduced set of options for monetary policy action  may seem unfortunate, it is important to observe that each time the Fed has attempted to “backstop” the financial markets by distorting the set of investment opportunities that are available, the Fed has bought a temporary reprieve only at the cost of amplifying the later fallout.

The answer of course is not to keep “fixing” the banks but allowing stock and bondholders to take losses and leave behind healthy restructured financial institutions, but I doubt that will happen. I suggest you read the whole thing.

Moving on he addresses the effects of Quantitative Easing and some investors hope that The Bernanke does it again:

Imagine that Ben Bernanke announced that he is going to stop spitting watermelon seeds into a can. Should we all become concerned that he is suddenly not doing enough to stimulate the economy? Well, only if you think that spitting watermelon seeds into a can is stimulative to the economy. And this is precisely the point. The successes of QE2 included a brief boost to pent-up demand which has already reversed, a boost to speculation in the stock market that has already reversed, a plunge in the value of the U.S. dollar that has persisted because the increased stock of U.S. dollars has persisted, and a wave of commodity hoarding that injured the world’s poor by raising prices of food and energy…

Once again, we recommend his entire discussion of this issue.

Finally we get to the heart of the matter, which is even if the economy does fine, stocks are not cheap. We hear differently from others, but we suggest you keep his thoughts on this in mind (my emphasis)

Before accepting conclusions based on a given valuation model, investors should demand similar evidence of its historical reliability. That evidence should be easy to produce, of course, and yet analysts typically don’t produce it. Hint – for many of these approaches, this is because evidence linking those methods to subsequent market returns does not exist.  

Oh, and the rally he expected and occurred has now moved from being predictable to one where further upside is a matter of luck.

There are a few people who I consider must reading in investing. Jeremy Grantham and James Montier are two of them, and now that Jeremy has hired James they are both at the same firm:

He confesses that taking the job at GMO has been his best move to date, keen to make the point that he has no intention of ever leaving the role that has given him the freedom to invest in his own way.

“I’ve spent the best part of my years working out how I wanted to invest and I was incredibly fortunate that the guys here wanted me to be a part of the asset allocation team. In previous roles I had been surrounded by people who were either salesmen, product engineers or analysts, all of whom didn’t give a damn about investing,” he says.

“Compare that to GMO where you are surrounded by people that do nothing all day other than talk about investments – it’s great. What could be better than being paid to come in and think about the thing that I love?”

I feel very similarly and to a large extent that is the beauty of Thompson Creek for me as well.

“People occasionally ask me what GMO stands for and I say ‘generally miserable observers’,” he jokes. “If you look at asset markets generally, nothing is cheap. That’s not normal. Usually there is some market, somewhere, that looks out of whack and interesting.”

With almost 50 per cent cash weightings across the fund range at GMO, Mr Montier and his team are not about to break his investment code and go rushing into markets – regardless of what his clients say.

“People tend to think that investment always has to be exciting, and in many ways the sell side exists to propagate that idea. My views don’t change from month to month and potentially year to year unless markets move and things change,” he says.

“These clients are not paying me to always be fully invested, they are paying me not to do something stupid with their money. Investing more than we are right now would, potentially, be doing something stupid because it would mean buying expensive assets and that is not right to me.”

The curse of being a value manager, he says, is being too early; too early getting out of market positions and too early getting in.

“If you go back and read my research, you’ll generally find that I was two years too early for everything. Way back in 1995, I predicted Thailand would be the next market to crash and of course the Asia crisis hit in 1997,” he says.

“But at the end of the day, I don’t have to know when things change, all I have to believe is that it will change. I do believe that at some point value will be restored and we will get mean reversion and at that point I will look to put that capital to work.”

But, he warns: “It could be this year or three years hence.”

If that sounds like something that could have been written by me it is no accident. I wear my influences on my sleeve. Which of course means other characteristics as well, ones shared by Jeremy Grantham and Rob Arnott as well. When questioned about his many career moves caused by his  irritation of the salesmen, product engineers or analysts, his response was:

“I have spent my career telling people things they don’t want to hear. I can’t help but be honest and that can get me into trouble. There are times that I wish I’d learned to keep my mouth shut over the years, but I’ve never managed yet to successfully do so.”

He smiled: “I can see no reason why that would change, so I will continue to tell people when I think they are doing silly things.”

There seems to be no lack of investors doing silly things so we should expect him to be speaking often. The whole thing is worth a read.

“Given how oversold the markets are we expect a relief rally. That rally could be quite explosive if news seems for a while to be getting better.

We suggest using any rally to position yourself for more weakness. Or, to put it more plainly, patience with market risk until things are a lot cheaper.” – The View From the Bluff, August 10^th 2011

That is from our last View From the Bluff two weeks ago on Wed. August 10^th. On Thursday August 11^th the “relief rally” began with an explosive move upward of over 4.6%. A week later a third of the market decline was erased. That kind of precise timing is luck folks, but we think the thinking behind it was sound.

However, as John Hussman pointed out Sunday before last:

The prone to failure part of the rally arrived with a vengeance last Thursday and the rally seemingly resumed yesterday.

So, what to expect going forward?

On a fundamental basis the US stock market is still overvalued. As discussed in our last “View from the Bluff” profit margins are already likely to begin retrenching. If the economy gets worse that will likely accelerate along with a slowing of sales.

Narrower segments of the US market are now near fair value, especially the highest quality parts of the market.

Overseas markets are another story. International and developing markets are looking reasonable on the whole. Not cheap, but around fair value. Some individual markets (such as Japan and parts of Europe) are actually looking cheap.

Longer term technical indicators are now all pointing toward a longer term bear market. For the S&P500 to get back to its 200 day moving averages (simple and exponential) by the end of the month would require gains of over 10% and 8% respectively.

Europe is in a real pickle, though you are probably tired of us talking about it for going on 4 years now. Still, European banks have been, and continue to be, in worse shape than American banks, as stunning as that possibility may seem. China is looking shaky with a Real Estate and credit crisis of their very own a real possibility. They may not import many of our goods, but our sins, economic and otherwise, seem to be consumed with eagerness.

Finally the economy is slowing, both in the US and globally, and almost all the indicators we look at are flashing that a recession is becoming very likely. However, not yet (though we are keeping an open mind.)

Given the weight of evidence every opportunity to reduce risk or move into non correlating strategies in the US markets should be taken before the “not yet” becomes an “already happened.” My best guess is we don’t go substantially below where we have been before the end of the year, which gives you time to liquidate, hedge or redeploy at higher points should the market rally. Obviously I wish markets worked out neatly enough for you to have complete confidence in waiting for higher prices to do so but they do not.

We will likely have a number of strong rallies going forward. The market is still oversold, investor sentiment is overly bearish and insiders are increasing their buying, so we would expect some consolidation here or even further advances. Use them to reduce risk. If you want stock exposure, concentrating on the highest quality parts of the US and International will likely do best should the market decline further (and the evidence is that risk is extremely elevated) but do well enough should the market and economy bounce back. That however is looking less and less likely.

Big up days will provide good opportunities to reduce exposure by either selling or hedging (and big up days are a bad sign on average, a topic we will address this week on the blog.) The damage of a longer term bear usually happens over 12-18 months, not one. Andrew Smithers (Author of Valuing Wall Street and calculator of the Q Ratio) expects a further rally due to stock buybacks and other factors but strongly believes investors should use it to position for an eventual decline:

“Investors should not, in general, buy stocks at this level, as the stock market is likely to become cheap at some time during the next 10 years and there is therefore a high risk that anyone buying today will lose money before they start to get a positive return,” Smithers said. “In these circumstances, they are likely to be better off by holding cash until the market has fallen.”

Smithers uses Equity Q, a variant of a ratio made famous by Nobel Laureate James Tobin, as an indicator of whether the market is overvaluing or undervaluing company assets. He uses estimates of market value published by the Federal Reserve.

Investors are “foolish” to use price ratios based on current earnings as a yardstick of whether the market is attractive, Smithers argues.[…]

“There are widespread claims that the U.S. stock market is attractive,” Smithers wrote on Aug. 15. “While foolish, these views are common. The risk that I see for those who have to take a short-term view is that their relative performance will suffer in a rally and that this will drive them to buy if the market does rally which, given the bad medium-term outlook, would amplify their poor performance.”

“Corporate buying has moved with the stock market in recent years,” Smithers wrote. “Companies are likely to use their cash resources to buy shares.” [….]

“It is common to find that investors, often supported by ill-judged comments by investment bankers and financial journalists, try to value shares on the basis of current profits,” he wrote. “This is, of course, very foolish as it means that they undervalue companies when profits are low and overvalue them when profits are high — as they are today.”

We like the cut of Andrew’s jib. Wait to take lots of risk until markets have fallen sometime in the next 10 years! That is patience.

Smart, but likely not realistic for most people, and of course there are ways to exercise that patience besides holding cash. Luckily, I doubt investors will have to wait 10 years. It has never taken 10 years for a market this overvalued to reach a more attractive point in the past, so we should act on the basis that such a long wait is unlikely. Our own research says even three years from now would be almost without precedent and conditions in the economy and markets suggest we may see it within the next year. The principle however is sound.

Shorter term we have a fork in the road at hand. Will we get our respite to reposition or will the downdraft continue? John Hussman describes the environment we are in from a decision making process quite well:

“Ideally, present conditions will be associated with what we’ve observed historically – a few weeks of moderate advance to clear the deeply oversold condition of the market, most likely followed by a fresh shift to a defensive stance. Given that the expected return/risk profile has just peeked above zero, we would prefer not to immediately experience the market’s version of “Whack-A-Mole,” but are prepared for that possibility as well. A break below the area around 1050 on the S&P 500 would put us in a situation much like 2008, where nearly every expectation of short-term stabilization was promptly dashed. For now, we don’t see the sort of uniform breakdown that we observed then. A break to fresh lows by numerous indices, an explosion of new lows in individual issues, and steep weakness in utilities or corporate bonds would quickly change that assessment, and we will respond accordingly.”

Could this be a false alarm? Sure, but like last year when the market advanced strongly from September through January the risk reward is on your side. Even in the worst case, if you missed those gains in their entirety they were eventually completely wiped out. All you would have missed was the rollercoaster. Any large and long rally from here will eventually suffer the same fate if history is any guide (See last issue for why) and it is unlikely you will miss all of any such rally anyway.

However, if the preponderance of evidence proves correct you derive three salient benefits:

• The first is you avoid the stress of a declining market, which is far worse than the stress of missing a rising market or suffering small, but easily recoverable, losses.
• Secondly you avoid large losses. We’ll assume that benefit needs no justification.
• Third, by preserving capital, even if you suffer some losses, you have the chance to redeploy it later when the markets are significantly cheaper and rates of return are far higher. In other words, nothing can make your financial future more secure than being able to take advantage of a market after a substantial decline. If prepared for they can be welcomed, not feared.

There Always Seem to be Bulls in our China Shop

For the fourth time since 2000 a significant selloff has been greeted with the typical “this has been a healthy correction” and talk of “overblown fears” and “irrational overreactions.” Now, we have no doubt that the markets swift descent shows a great lack of rationality. Certainly the collected companies that comprise the S&P 500 are not worth 20% less than they were back in April. Yet, we must marvel at the double standard the investment industry applies to such things, since it is just as true that the S&P 500 wasn’t worth 25% more in April than it was at the beginning of September 2010 either.

However that move was claimed to have been based on “strong fundamentals” “ample liquidity” and other factors that changes the actual worth of a company by little in the first case and generally not a whit in most of the others. Pointing out that the value of stocks as a whole arises from earnings (and only earnings that eventually can be returned to shareholders, not squandered by companies such as Hewlett Packard) and dividends over many years and decades and not what happens in any one cycle, year, quarter or month makes most commentary on CNBC or the bleating of various investment houses a bit beside the point. Pointing out that the trend growth in earnings and dividends is somewhere between 1% and 2% above inflation a year makes justifying a move of 20% or more in any direction based on “fundamentals” seem a bit silly. In fact, trend growth in the price of the S&P 500 index has been only about 1.7% a year above inflation (the rest of the fabled 10% a year we always hear about has been dividends and inflation.) All of the fundamental numbers have been remarkably stable in the long run. In a rational world stocks wouldn’t move around much more than that per year.

The chart below illustrates both concepts well:

As an advisor this belief that we need to always “sell sunshine” permeates the advice we get about the advice we need to give to you. Our e-mail in boxes are filled with coaching suggestions on how to convince our clients to not only stay invested, but buy stocks. Investment houses tell us the same (see also here.) However, we rarely get advice from business coaches or large firms on how to explain to clients that markets are overvalued, that reducing risk even during a bull market can be a good idea in some circumstances or that there is ever really a time to sell. Of course, what are all the asset managers on Wall Street going to say when they get on CNBC? “Investors shouldn’t invest in my XXX cap fund because XXX cap stocks are overvalued and long term returns will be poor.” Maybe some have and I just missed them. That is why independent voices should be given more credence:

“4. Ignore the asset-gatherers and the brokerage firm strategists, their job is to calm markets and soothe investors. Let’s say Morgan Stanley runs $1 trillion in stock market wealth for investors. And then let’s say they felt there was serious trouble ahead. Do you really think they would ever make the sell call? Can Morgan Stanley really say “Sell 20% of your equities”? No. Because that would be $200 billion in supply hitting the stock market at once – they would crash it all by themselves! Too Big To Keep It Real has always been the problem with the wirehouse advice model.”

By the way, Josh Brown’s entire post on how to survive a crash is worth reading if you have the time.

The markets irrationality is not to be bemoaned really. For the patient investor the markets short term irrationality is what gives it the potential to deliver abnormal returns.

Of course, just because we agree that the market is not worth 20% less than it was in April in no way means we believe the US market is cheap (which is the illogical conclusion many analysts jump to, which show the biases of Wall Street and the industry overall quite clearly.) Every measure we look at shows it was at least 40% overvalued then. If we thought that the current dive was due to some well considered epiphany from investors we would call it logical but not yet logical enough. Alas, we think it is just panic and while value is the gravity that wears away the pernicious effects of irrational exuberance and the salutary benefits of  extreme pessimism we think it has little directly to do with shorter term movements. Or, we should say, not consciously.

To know the truth, all you need is simple addition and subtraction

Is the US market cheap now? We addressed that last letter but let us look at it another way by breaking down the markets returns into its components. The long term return of the stock market is around 6% above inflation (This is known as the Real Return, the rest of the 10% we always hear about has been inflation.) If long term growth in earnings has been about 1.5% above inflation (and it has been give or take about a half percent depending on the time period) then to reach a similar return of 6% over the long term we need to receive dividends of about 4.5% (which unsurprisingly is about what the average long term dividend yield has been. Funny how that works.) Right now the S&P 500 yields about 2.2%. What would we need to happen for the dividend yield to be 4.4% today? We would need for the market to fall about 50%!

Over the long term, the math above about what return you can expect from the market is relentless. The message is clear though, cheaper prices means higher returns.

In fairness, we think the need for a 50% decline to get to fair value is a bit much. We think fair value is above that since 6% above inflation is really more than we have a right to expect from stocks in the first place. We like 5.7% ourselves but if one assumes a lower required return than that the market is at the less expensive end of the range we describe below. In addition, dividend payouts are lower than in the past which arguably distorts things a bit (which is really debatable, but we are going to be optimistic.) Making those adjustments comes up with a range for the US from an extremely optimistic 22% further to fall to reach fair value to our more pessimistic 50%. Most likely the real number is around 35-45% lower from yesterday’s close, which just happens to be the range of fair value if we look at other fundamental measures of value, though the Q ratio shows something closer to 50%. When value calculated using a broad range of very different measures and methods of calculation roughly agree we feel comfortable in saying we are roughly correct, which is certainly better than a being precisely wrong.

Doug Short provides a great resource for tracking various measures of value we look at in addition to our own “components of returns” approach. The numbers are from the end of July, so take off about 10%. We also hasten to add that each of these valuation methods have been shown to actually correlate with subsequent long term returns, unlike most claims about value which claim that current markets are cheap (Click here for a larger version)

The most optimistic assessment is using the arithmetic trend for the S&P 500, which would be around 900 or about 22% further down from yesterday. The most pessimistic is the Q Ratio at a bit above 50% after the recent decline, which  interestingly enough reads as being as far away as the difference between real dividend growth and the trend in equity prices seen in the earlier chart. We doubt that is a coincidence.

If this were an exact science we would let you know, but certainly the market is not cheap.

Further Reading

We have been of the opinion since 2000 that we have been in a long term (or secular) bear-market. Obviously that has proven true. How far away are we from the end? JJ Abodeeley and I discuss just that in Are We There Yet?

JJ also does a great job of dealing with a pet peeve of ours, the use of forward operating earnings estimates to claim that markets are cheap in The Misuse of Forward P/E. Of course, we have spent more than 15 years listening to people claim stocks were cheap no matter the environment to predictably disastrous ends so why should we expect anything different? He also takes a swipe at the foolishness of claiming the market is cheap because of bond yields, which always warms our hearts.

As always, please contact us with any questions or comments.

With warm regards,

Lance Paddock

CEO and Director of Investment Strategy

Thompson Creek Wealth Advisors

Disturbingly the market was much more expensive in 2000.

That the biggest bubble in US stock market history would be finished bursting by now would be unusual.

 Most of us can relate to driving and having children ask “Are we there yet?” JJ Abodeeley tries to answer that question. Written at the end of last week, JJ sees what we have been going through since 2000 as a long process of the market working itself from an expensive peak to a cheap bottom as well. JJ calls it the value restoration project  and looks at how far we have to go realistically. JJ also writes at his blog Value Restoration Project which is a regular read of mine. JJ will be contributing here on an occasional basis going forward. JJ is a Director and Portfolio Manager for Sitka Pacific Capital Management, LLC, a SEC-Registered Investment Advisory firm offering Absolute Return and Global Multi-Asset Class strategies.

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The declines in the stock market over the last three weeks have done a lot of damage to most investors’ portfolios. This would merely be an inconvenience if it meant that future returns could be expected to be robust enough to compensate for the losses. In a July 22nd post which coincidentally, was the most recent top in the stock market, I suggested that “the conditions present in the market suggest that the value restoration project in stocks, underway in fits and starts since 2000, will eventually resume.” Investors in the stock market may rightly be viewing this recent decline of about 12% over the last 16 trading days as a painful, but necessary, correction in prices which will once again bring value back to the market. After all, as I wrote in two recent missives, Expensive Markets Mean Low or Negative Prospective Returns and Denominators Matter

The fact is that what you pay matters and expensive markets today mean low or even negative prospective returns going forward. The value restoration project, which began with the peak of the stock market in 2000, is ongoing despite a 2 year cyclical rebound on the heels of unprecedented stimulus.

History however, suggests that market prices broadly will eventually resume declining relative to several denominators, in particular, normalized earnings and gold. Since late 2009, the market’s gain has been of a very different nature– not only have stocks actually declined versus gold and other currencies, but they have been powered by normalized valuations going from expensive (19-20x) to more expensive (23x). This makes the gains over the last year or so particularly vulnerable.

So, in the spirit of Summer driving season and family road trips, the recent market decline begs the question, “Are we there yet”? Unfortunately, checking in with some important valuation indicators suggests the decline of the last several weeks has not accomplished enough to merit a more aggressive long-term portfolio stance.

Normalized P/E Ratio

The Value Restoration Project Resumes

For most of the Spring, the S&P 500 traded between 1300 and 1350 and sported a normalized P/E ratio of around 23x trailing 10 year earnings. At the time, I conducted a historical analysis that found that when the cyclically adjusted P/E ratio is between 22 and 24 the average annual real returns (after inflation) for the subsequent 10 years is -2.2%, the median is-3.1% and the distribution looked like this

With the S&P’s recent decline to 1178, the Cyclically-Adjusted or “Shiller” P/E has decline from a recent high of 23.6 to a somewhat more palatable 20.4. This begs the question of what sort of long-term returns have investors historically seen when the market P/E stood at similar levels as today? There have been 125 monthly occurrences since 1881 when the normalized P/E ratio was between 19 and 21.The average annual real return with dividends reinvested over the subsequent 10 year period is about 1.6%, with roughly 1/3 rd of the 10 year periods resulting in negative returns. While somewhat more encouraging, these are hardly the returns that dreams are made of– or financial planning assumptions, for that matter. For those who prefer to see their probable outcomes expressed in nominal returns, the average is about 4.5%.

A thorough understanding of history suggests that today’s P/E level is still not low enough to warrant a buy and hold or passive approach to U.S. stocks broadly. As Ed Easterling of Crestmont Research is fond of saying, “secular market cycles are not driven by time, but rather they are dependent upon distance—as measured by the decline in P/E to a low enough level to then enable a significant increase.”Considering that the most recent secular market is starting from a spectacularly overvalued normalized P/E of 43.8x in 2000, we have quite a bit farther to travel.

Stocks Priced in Gold

Like a normalized earnings measure, adjusting stock market prices for the effects of a nearly constantly depreciating currency, allows us to assign deeper meaning to price. Please consider my recent post Denominators Matter! What the Price of Gold Tells Us About the Value of Other Assets. The good news is the stocks prices have become even cheaper when adjusted for gold. Amazingly, the nominal price gains since the market low in March of 2009 have now been completely lost, when adjusted for gold. While this is mainly good news for those who own gold, it also gives us insight into the process by which the market is returning to a level where real, long-lasting value can be seen.

Fellow contrarians or disciples of mean reversion may think that this trend is poised to reverse, however a longer-term perspective is in order. We can easily see the secular bull and bear cycles from this chart which shows the Dow Jones Industrials Stock Index adjusted for gold since 1969. The 7x rise in gold since 1999, coupled with the nominal price decline in the Dow or S&P 500, has gone along way towards rectifying the imbalances in the valuation of the two asset classes. However, history suggests that durable, decade long, market bottoms are made at much lower levels.

No, we are not there yet

The recent sell off in the markets have been fast and furious and it would not be surprising to see stocks recover some of the recent losses in the weeks and months ahead. However, as John Hussman wrote in Two One-Way Lanes on the Road to Ruin

It is important to recognize that the S&P 500 is presently only about 13% below its April peak, and the word “only” deserves emphasis…The main problem here is that we essentially have nowhere constructive to goon the upside – advisory sentiment is already overbullish, and despite the recent decline, our 10-year total return projection for the S&P 500 has still only climbed to 5.1% annually. The ensemble of evidence remains steeply negative here.

This evidence most certainly includes the long-term valuation measure discussed here. Investors who take steps to protect their portfolios from the inexorable value restoration project will be in position to benefit from the next real bull market in stocks.

One of the most consistent messages I’ve heard throughout my career is that the market is inexpensive or at least “fairly valued” based on next years earnings. We hear it at heights of euphoria and the depths of despair. I don’t recall ever hearing the consensus or even a vocal minority calling the market overvalued based on forward earnings estimates. In fact, we rarely even hear perma-bears cite high P/Es based on forward estimates as the primary cause for concern. Over a decade with low and often significantly negative returns, how can that be? A Flawed Exercise What makes market calls based on forward P/Es so dangerous is that the concept makes such good intuitive sense. We know the market’s primary function is to look forward and discount the future back to the present. We know that valuation, as James Montier puts it, is “the closest thing we have to a law of gravity” in finance. We know that earnings, while flawed in many ways (another discussion for another day), are essentially what investors want to pay for. To confuse matters worse, when analyzing an individual company’s stock, skilled investors absolutely would want to forecast forward earnings, make pro-forma adjustments from GAAP and then estimate a fair value based on a P/E multiple of that estimate. Valuing the market on forward earnings estimates is a flawed exercise which often leads to incorrect assumptions about future market returns. It just doesn’t work very well. 1. The earnings estimates are usually inflated by improper adjustments and blind optimism In another post criticizing a typical Wall Street approach to valuing the market, I challenged the conventional wisdom that operating earnings represented a clearer picture:

I’m no accounting expert, but I know one thing: pro-forma operating EPS is what company management uses to make their results look as good as possible without being accused of wrongdoing. Stock option expense? It’s not real money. Business restructuring? One-time event. Overpaying for an acquisition? Just a non-cash write down.

It’s not that on a company-by-company basis there aren’t legitimate adjustments that should be made, however most sell-side analysts simply take management guidance and run it through management blessed models making their forward EPS estimates questionable. Aggregating those estimates gets you to an even worse place when analyzing the market as a whole. Ed Easterling of Crestmontquantifies these adjustments for us

“As Reported” earnings reflects the past and projected (by S&P analysts) net income from the five hundred large companies in the S&P 500 Index.  This measure is based upon Generally Accepted Accounting  Principles (GAAP) and is the  measure that historical averages are based upon.  “Operating” earnings reflects a subjective  measure of earnings (by other S&P analysts) that adds back certain costs and charges.  It attempts to reduce the impact of the business cycle and one-time charges, yet it is generally considered to be an optimistic view of earnings.  This measure of earnings per share (EPS) is NOT comparable to the long-term average P/E, since operating earnings excludes a variety of costs and charges that reduce the funds available for dividends.  On average, ‘Operating EPS’ is almost 20% more than ‘As Reported EPS’.

In a recent update from Crestmont, this number was established at roughly 16% over the past 20+ years. This is clearly NOT a function of extreme events or unusual occurrences that should be omitted from our analysis, but is instead a systematic overestimation of earnings. Of course, “as reported” earnings also have their limitations like undue influence from large losses in a small number of companies. As chronicled by Denis Ouellet at his excellent blog, AIG alone shaved over $7  from S&P 500 reported earnings in the 4th quarter of 2008, even though the stock at the time had little effect on the index’s price. And both operating and reported earnings on the index level are subject to issues of non comparability when the folks at S&P simply remove failing companies (stocks) and replace them with successful ones.  Yet another reason why a normalized earnings measure like Shiller’s, Ben Graham’s, or Ed Easterling’s is so useful.   2. The resulting P/E multiple is usually improperly compared to historical averages or notions of fair value The typical analysis goes something like this: at 13x next year’s earnings, the S&P 500 is attractively valued compared to it’s long-term historical average of 15x. That is comparing Apples to Oranges. 14x is the long-term average P/E based on reported earnings since 1900.  Many cite the arithmetic mean of 15x which gets a bit of an unfair lift from the bubble years without a comparable low-end offset according to Ed Easterling. 14x is consistent with both the median and trimmed-mean and serves as a better guide for “average” in this case. So what is the long-term average P/E based on forward operating earnings? What is the number that we can compare the oft-cited valuation measure to? While there is no good really long-term data on forward estimates, we can get a pretty good idea by going through this exercise:

Hypothetical $100 reported EPS Operating EPS is about 16% more than reported EPS= $116 operating EPS Forward EPS is about 6% more than current EPS historically=  $123 forward operating EPS An average P/E of 14x on $100 is only 11.4x the SAME level of earnings, using forward operating earnings

This is the approximate historical average that we should be comparing to the market P/E based on consensus estimates. While the above exercise may lack scientific rigor, the eminently quotable John Maynard Keynes would certainly approve as he too “would rather be vaguely right, than precisely wrong.“A glance at this chart from Goldman Sachs (I added the bars at 10x and 15x) shows the more recent past of the P/E based on “Next 12 months Operating Earnings Estimates.” The P/E spent much of the first 15 years below 10x and was only pushed above 15x in 1997 before falling once again below 15x for much of the last 4 years.

Average Valuation ? Fair Valuation However, our analysis on market valuation should not stop there. While the average P/E on forward earnings is approximately 11.4x, it would be unwise to assume that every instance of  above average P/Es means overvaluation and every instance of below average P/Es mean undervaluation. There are many drivers of intrinsic value or fair value that have significant impact on measure such as P/E multiples. The obvious wild card is inflation. During periods of higher inflation investors rightly demand higher nominal returns to compensate them for the loss of purchasing power. This pushes P/E multiples down as investors pay less for future earnings which also tend to be of lower quality. Note, this is NOT an endorsement of the so called Fed Model. Please see Cliff Asness’ classic work Fight the Fed Model: The Relationship Between Stock Market Yields, Bond Market Yields, and Future Returns. If you are too busy to read the paper that disproves one of the most widely used asset allocation forecast tools, I’ll sum it up for you– forget bond yields when forecasting future stock market returns– the only thing that matters is starting and ending valuation.

In fact the theoretical construct of the Fed Model which says that at low nominal interest rates, P/E multiples should be higher combined with the elevated nature of future earnings allowed for some erroneous justification of wildly expensive markets in 1998-2002 and again from 2004-2007. One can conduct a good smell test by looking at the Goldman chart above and see that on forward earnings the market appeared to be “equally cheap” in 2007 as it was in 2009 (about 15x) when intuitively we know (and the 10 year normalized measures confirm) that the market was much cheaper in 2009 than it was in 2007. A Better Way? Obviously I think there is a better way to try to ascertain the market’s value. Valuation ratios based on Normalized Earnings is one place to start the analysis. How we determine “fair value” based on these earnings is another matter. I covered a few versions used by GMO, Hussman, and others. I recently discovered Denis Oulette’s valuation approach– “The Rule of 20? in the Valuation section at the excellent www.news-to-use.com. I intend to spend more time applying some of his framework to a normalized earnings measure and will report back in a future post. In the meantime, the next time you hear a pundit tell you the market is “cheap” or below the historical average based on next year’s earnings, be sure to run, not walk away to find a more suitable comparison of value.

For the second straight year we have seen the old saw about selling in May work out. Selling July 22^nd would have been wonderful as the market has been down almost every day since.

Good things come from every crisis however and we welcome investors renewed interest in thinking about both risk and return. I suspect that will end shortly after the market renews its ascent, but it is welcome nevertheless.

Which means, all of a sudden, lots of people want to ask our opinion again. I fear our warnings had begun to get tiresome until the last few weeks. We agree and are looking forward to spreading a more cheerful message as soon as things get a good bit cheaper.

So, what do we think?

First, this slide should have been expected, even if it has been faster than normal. The typical pattern in overvalued, over bullish  markets with underlying economic fundamentals deteriorating is for a series of incremental advances to be followed by selloffs that eliminate weeks, months and years of returns in rapid fashion. This is an unusually rapid and steep descent, especially this early in a cyclical bear, but outside of that pretty much what one would have expected. The hard part was the timing, not the outcome.

Last Fall we explained that worrying about missing out on a move up was a misplaced concern for long term investors, since any gains in the market would eventually be lost (at least in inflation adjusted terms.) In all likelihood you would have the opportunity to invest at much more attractive prices later. All you would miss was the rollercoaster ride in between. As we have seen, the gains of the past year have been essentially wiped out in a matter of weeks.

Unsurprisingly for those who know us well, we tend to repeat ourselves since our base case is still as valid as it has been for much of the last decade. The details keep shifting, but the outlines of the market beast have remained remarkably consistent.

Markets are overvalued: Whether we use regression to the mean, Shiller P/E’s, the Q ratio, estimates based on components of returns, or any number of other models, we see levels at least 20-25% above historical averages or fair value (which we define for the S&P 500 as a level which should result in a return of about 5.5?6.0% above inflation over time if P/E’s were steady.) We also think that the downside is not necessarily far off, an opinion which we have held for the last year and a half. To see why, let’s look at one of our favorite measures of how expensive the market is at any point in time, the Shiller P/E (also known as a normalized P/E and the Graham and Dodd P/E.)

Source: Multpl.com

The blue line above is not the price of the market. It is a measure of how expensive the market is. It is arrived at by taking the average of the previous ten years of earnings and dividing them by the price of the S&P 500. The key point to observe is that when stock prices get too high in comparison to past earnings you will notice that the blue line declines pretty rapidly. Generally within three years of levels we see today, even after the recent selloff. Last fall we pointed that out as well, and in all likelihood that process has begun. A short term rally is likely as well, but over months rather than weeks the likelihood of further weakness is high. We would need to see a further 20% decline from here to get to an aggressive reckoning of fair value at around 900 on the S&P500.  To be considered cheap would require much more.

Thus whatever happens in the short run, returns are likely to be poor on a longer term basis.

Certainly things are better than they were at the end of June when markets were at near bubble levels, but we suggest you think about it this way. If we average the additional return added over the next 10 years by the slide since the spring it amounts to increasing returns by about 1.5% annually. That is not insignificant, but it hardly makes stocks a screaming buy. Our base line for returns of the S&P500 seven years from today is now a bit less than 2% more than inflation. So, if inflation is 2% we think the market is priced to deliver around 4%.

The risks to that are to the downside however, so while we think that the extra return we should get from the market having gotten cheaper is a good thing, we have a ways to go before the US Stock Market is actually attractive overall.

Which does not mean we will see a straight decline from here. In fact, we would hazard that we will see a fairly substantial rally that will leave the market above where it is right now by the end of the month, if likely still below its peak of the year. If the market were to rise from here we suggest people who are carrying too much risk use the opportunity to reduce it if the market is not above its 200 day moving average by the end of the month, or hedge.

Of course, as we hear every day no matter where the market is, some people claim it is cheap.

We strongly suggest that if a commenter or advisor claims a measure shows stocks are cheap; ask that they demonstrate that the measure has been useful in forecasting returns in the past. Ask that they show the assumptions about growth and the other factors such an outcome requires. Make them show their work. Send it to us and we will analyze it. We would love to find a more useful indicator than the several we use.

We spend a lot of time researching which models have predictive power and what factors do not (you can read some examples of our thoughts on various models and factors here, here and here) When we look closely the models which are being used to claim the market is cheap have either shown no predictive ability, have assumptions which are either false or completely out of line with past experience or (most commonly of all) are merely asserted as true.

The most common method is to compare “earnings yields” to Treasury bond yields. This is the so called “Fed Model.” Curious readers may read Cliff Asness’ classic paper on this topic, but the short version is that it does not work:

“The crucible for testing a valuation indicator is how well it forecasts long?term returns, and the Fed Model fails this test, while the Traditional Model has strong forecasting power. Long?term expected real stock returns are low when starting P/E’s are high and vice versa, regardless of starting nominal interest rates.”

Overvalued Markets are dangerous: When losses come they tend to be far higher than normal and downturns occur more frequently.

Our economy is awash in debt: American consumers will be reducing debt (deleveraging) for several years.

Thus the economy will grow in fits and starts until that process is over: We don’t know how long that will take, but it will likely be measured in years, not quarters. Unsurprisingly this “recovery” has been the weakest and most compromised in US history. We have warned of that likelihood for several years now. John Mauldin surveys just how weak this recovery has been:

“There is no way to spin the GDP report that came out recently as anything but very bad. It was just last May that consensus second-quarter GDP growth stood at 3.3%. Subsequently, this was revised downward to 2.7%, but the final number came in at just 1.3%. Normally, at this time in a recovery we are growing at close to three times that number, or 3.6% (you can see the data at http://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm).

Even worse, the first-quarter number was revised down from 1.90% to an anemic 0.36%. For new readers, note that the first estimate of a quarter’s growth is just that, an estimate. Three monthly revisions follow, and after a few years, it is revised yet again with the aid of hindsight. With this in mind, 4th quarter of 2010 GDP declined from 3.1% to 2.35%, with further revisions yet ahead!

And it gets worse. The Bureau of Economic Analysis went back and revised the numbers for the recession. It might surprise you to learn that the recently “ended” recession was worse than we thought at the time. The peak to-trough decline was 5.1% instead of 4.1%. That means that in real terms the economy has not yet recovered to pre-recession levels.”

David Rosenberg (via John Mauldin) adds:

“going back to 1947 and never before have we seen this dynamic of the level of overall economic activity lower on the second birthday of the recovery than it was at the prior cycle peak. Typically two years into a recovery, real GDP is already 9.5% above (emphasis mine) the pre-recession high.”

Jeremy Grantham elaborates(pdf) on his long held views about the likelihood of continued economic weakness:

“So here we are more than two years later, at the one-third mark in the seven lean years. Profit margins, as we will see later, are far above what I expected then. But everything else is perhaps at least a little worse. First, when I talked about 2% growth I was talking about a reduction in our trend line growth. I did not intend to count from the dead low of the economic recession. In fact, I argued that of course there would be an economic bounce with all of the spare capacity and unemployment. Had we averaged 2% growth from 2007 until now, GDP would be up 7% today. It is actually just under dead flat. To make up this 7% shortfall in the remaining 3.5 years (December 2007 to December 2014) would take an extra 2% a year, that is, 4% annual real GDP growth. Given our current headwinds, this would seem to need a miracle. Even to average 1.5% growth for the seven years from 2007 to 2014 would take 3% a year growth, which seems at the upper end of a reasonable range. So, unfortunately, at the end of the first period (in hockey terminology), my dismal seven-lean-year forecast looks all too accurate and, perhaps, even optimistic. To this point, there has never been such a weak and slow recovery from a steep decline. The revised numbers show that at the 2009 low we had had by far the biggest drawdown in GDP (-5.1%) since the Great Depression. The reasons that I thought it would take at least seven years to get back to normal are still mostly in place. Some have modestly improved, but many are worse.”

Shorter term we expect that near term weakness will be followed by a rally: We have felt the rally after 2009 would take the S&P 500 to around 1500 on the back of massive stimulus and investor myopia. This would set us up for another decline of approximately half again for the third time since 2000.

Even though that was our opinion, we suggested you not trust it. There were far too many things which could derail the hoped for near term profits and a whole lot of them are starting to look more and more likely. Now the market seems to be agreeing with us. We think those risks are what has precipitated the recent sell offs, not the debt downgrade which fundamentally is not all that important. So, I guess we should be thankful we didn’t trust that opinion either.

China looks shaky; the European debt crisis we have been speaking about since 2007 isn’t going away and the renewal of the housing downturn we have warned about has arrived with a vengeance.

Most frightening is the potential for current record profit margins to revert to the mean. Market pundits have spent the last two years assuming they were going to stay high, and in fact climb indefinitely!

When you hear someone discuss stocks as cheap based on their fundamentals, inevitably we find they mean assuming profit margins stay at near record highs for many years in the future. We give you two charts to look at from Crestmont Research. We are looking forward to our readers spotting any evidence in these graphs that profit margins or the profits that depend on them, can stay high especially if we go into a recession.

The red portions of the lines are what analysts are assuming. We can see that estimates of earnings not only assume record profit margins and earnings far above the long term trends, but they have to continue. Looking at that graph we are willing to say that maybe earnings will go that high and set new records for above trend growth. However, the assumption that they will remain there is quite unlikely.

Obviously, as we have repeatedly seen over the past decade, others disagree. For others sake we hope they are right, but we prefer not to rely on unlikely outcomes from people who have led investors repeatedly over cliffs. We want to prepare to profit from the dashed expectations of the market to our advantage when it comes.

Interestingly enough even with the aggressive, if possible, assumptions about near term earnings, and discounting the likelihood of an earnings retrenchment sometime in the next few years, those lofty assumptions show a large deceleration in earnings growth. Look at the estimate below for earnings in 2012 assuming record profit margins and earnings farther above trend than any time in our past:

Needless to say the big increases are over even with the aggressive assumptions of the analyst community. We can see that continued record profit margins and above trend earnings leaves us with that teeny increase in 2012.

We don’t know the timing, but we hope the evidence above tells you why we are pretty comfortable that within the next three years the stock market is exceptionally vulnerable even if the economy does fine. If it does not, and current events in Europe, China and the US give us little reason to accept that as a given, the declines could be quite large. For example, let us look at the chart on profit margins above. If that line were to go back to just slightly below its average it would imply a 40% decline in earnings without a recession! If that were to happen a 50% decline in the stock market from here would not be unusual. If economic news were to turn south as well and thus growth slow, the decline in earnings could obviously be much worse. Will that happen? We don’t know, but it shows why we feel the risk reward ratio is so poor.

Of course current events could make such an event happen sooner, or not. Our assumption was that just like with the debt situation in Europe the markets would initially react favorably to any deal on the debt ceiling. That turns out not to have been true, and thus our concerns about the market suffering from other issues is increasing. The economy is slowing precipitously and if that does not change margins could come under pressure very quickly. Whatever the merits of any deal to restrain spending in the long term, in the short term it could be a real blow to a very weak economy that is very dependent on government spending.

Given how oversold the markets are we expect a relief rally. That rally could be quite explosive if news seems for a while to be getting better.

We suggest using any rally to position yourself for more weakness. Or, to put it more plainly, patience with market risk until things are a lot cheaper. When that happens we will gladly suggest taking on substantially more market risk. We are about where we were a year ago. The strategy shouldn’t be that much different, any gains from here are unlikely to be retained once inflation is taken into account, the intermediate potential upside is not that high and the potential downside is far larger.

The goal should be to attempt to make money should the market rise from here, but not to subject yourself to potentially large losses. That can be accomplished with cash, fixed income, a mix of alternative strategies whose goal is to do better than cash and, most of all, patience.

Keep your equity exposure tilted toward high quality stocks with solid balance sheets and growing dividends if you choose to have any. Since mid February the performance advantage of High Quality has been extremely large.

Japan continues to look interesting. Jeremy Grantham does a good job of explaining why:

“We at GMO also believe that Japan is likely to “regress,” in the mathematical sense, toward levels of profitability that would be considered normal in other developed countries. We expect the progress to be very slow and uneven. If it does not happen at all, then Japanese stocks are priced like the average of all other developed equities, or a bit cheaper. If, however, by some chance margins improve quite fast, then Japanese stocks will likely be the best performing stocks around and could hit double-digit real returns for seven years. Japan’s remarkable resilience in the face of electricity shortages gives some inkling of what they are capable of. How quickly we have forgotten their obvious talents of 20 years ago. Can all of those talents really be lost forever?”

 Europe has started to look interesting, including countries such as Italy which has gotten a tremendous pounding.

Emerging Markets look okay.

Getting outside the box, timberland and well managed farm land should do better than most major asset classes on a 20 year time horizon or longer. They should also be great diversifier’s. We are looking at such opportunities for those whom it fits.

Other natural resources on a longer term horizon are attractive, but we suggest waiting until a recession has driven prices down significantly. Until then long short strategies such as Global Macro funds and Managed Futures are a better way to access them. We suggest looking at metals, fuels, fertilizer and other commodities when prices are low as well as the companies that mine and sell them.

Real Estate in general is not all that attractive, especially publicly traded, but they are getting more interesting quickly. On the private side well chosen projects at good prices can still be found.

When to take risk? Patience is the key, though given the speed of this decline we may not need as much as usual. Start building once we get below 900 on the S&P500. Individual names may fall to nice levels sooner, but at the asset class level that is where you are getting reasonable. How you execute that can vary, but this late in the “recovery” (such that it is) getting aggressive overall above that level doesn’t make sense. Have some available in conservative strategies or cash to deploy should we get to levels below 750 or so.  If we go into a recession levels that level or lower would be unsurprising.

As always, please contact us with any questions or comments.

With warm regards,

Lance Paddock

CEO and Director of Investment Strategy

Thompson Creek Wealth Advisors

Rather than spending our energy on analyzing a specific data set, as most analysts do, we should instead be focusing the bulk of our effort on deciding which data set we should be studying in the first place.

Mark illustrates this issue by generously comparing two different advisory firm’s claims about how undervalued/overvalued the markets are which seemingly use a similar rationale. I say generously, because in order to not have his main point get lost in the weeds he avoids digging into each firms methods, which would be necessary in order to have the discussion Mark suggests we have.

So let us have that discussion.

First though, let me make a quick disclaimer. My comments are not in any way meant to claim that either firm is a good or bad advisor in general. Firms can make good/bad arguments on this topic, and still be good choices to manage your assets, or a portion of them, depending on what your goals, needs or objectives are. I can disagree with someone’s claim that stocks are (or are not) cheap in general without that changing my opinion of their abilities as a stock picker at all (or I might  feel they have other merits of note.) If that is what you are looking for, you need to evaluate them on far more factors than this question. If you are relying on them to make asset allocation choices for you in general based on value then depending on how important other factors are in their process, this question may be extremely important.

Consider, for example, Don Hays, of the Hays Advisory Service. Earlier this week, in arguing to clients that the bull market is destined to continue strongly for many more years, he presented a chart of the Dow Jones Industrial Average back to the stock market’s late-1974 low.

Compared to a trendline that he drew connecting that low to the stock market’s October 2007 high, stocks currently are well below trend — nearly 40% below, in fact. Hays asks: “How could anyone be neutral on the U.S. stock market with a history like this?”

An answer is provided by, among others, Jeremy Grantham, the chief investment strategist at Boston-based GMO. Grantham also is a strong believer in regression to the mean, having placed the principal at the core of his investment approach. By looking at a lot more history than just the last four decades, Grantham has concluded that stocks are overvalued right now and dangerously close to forming another bubble. In fact, according to Grantham’s calculations of fair value for the S&P 500, the market is around 40% overvalued.

Here is the chart Don uses:

Here is where Mark chooses to be generous:

So take your pick. Even if you believe the markets follow a regression-to-the-mean process, you still can conclude that stocks are either as much as 40% overvalued or as much as 40% undervalued.

Mark wants us to concentrate on the point that we need to have the debate, not make the debate in his article, so I understand. However, really? Can you really make that conclusion either way? Are they even really using the same type of reasoning? I suspect Mark doesn’t believe so based on the next two statements:

Unhelpful as this discussion is to those who want to know whether to buy or dump stocks, it does help us focus on an under-appreciated aspect of historical analysis: Whatever time period you choose to focus on, you’re in effect assuming the stock market in the future will perform like it did over that period. Once you choose a time period, in other words, what you find becomes virtually a foregone conclusion.

He has quickly identified a common flaw with many arguments, choosing particular time periods, and one of these claims is based on a very particular time period to get their claim to work. Mark knows that as he gently tells us:

It’s hardly a surprise, for example, that you will reach a bullish conclusion upon comparing the market’s current level to a trendline connecting the December 1974 bottom and the October 2007 top — as Mr. Hays has drawn.

He then gives his preference:

For my money, I prefer to look at more history than just the last four decades. In fact, I think a compelling argument can be made that recent decades are, if anything, actually an unhelpful basis for comparison — since they represent the apex of the Pax Americana era in world history. After all, it’s quite unlikely that the U.S. will enjoy the same degree of geopolitical hegemony and financial power around the globe over the next several decades as it did over the last several.

Good points, but it really lets Mr. Hays off the hook. Now that we have set the stage for the discussion, let us see look at how we should look at the data, and why.

Mark makes some good points about picking the time periods. Mr. Hays picks a period that includes very low valuations and then ends at period with very high valuations without providing any data about that fact. Those issues however are not the main problems with his argument contra Mark’s plea. The same period, with just a different set of lines changes the conclusion dramatically. So choosing the data set to use is an important question, but how you use it is just as important. Here is the same chart with me adding a line from an early peak of the market to the latest low of that market using the same graph:

If the mere arbitrary drawing of a line changes your view of the markets trend from around 8000 on the Dow to around 16000 then that should tell you that the exercise is pointless and meaningless. Mr Hays’ argument is not valid. We can all play around with this type of analysis and put lines wherever we wish and it will not mean anything. The statistically minded of us will immediately recognize the problem, neither line is a regressed trend line at all, and thus tells us little about any underlying trend. Jeremy Grantham does use regression to trend, but he first develops a true trend line using regression analysis. So does Doug Short. Just as importantly Mr. Hays’ chart is not adjusted for inflation (also known as showing a “Real Return”) while Jeremy Grantham and Doug Short do:

Notice that this chart is much flatter once you take out the distortion of inflation and the message quite different when you use a true regressed trend line. Interestingly, while picking the time period does change the trend line, a true trend line such as this is far less sensitive to doing so than mere lines drawn from a low to a peak. In fact, even cherry picking the time period Mr. Hays did, but using a true trend using regression analysis would still yield an overvalued market, if less so. That robustness to starting and end points is an example of a way to test one’s conclusions and methodology. Even a time period specifically chosen to come up with a distorted outcome wasn’t enough to change the conclusion to an opposite one, it just softened it. You even come up with something around a fairly valued market, but certainly not dramatically undervalued,  if you choose the particular time period illustrated in Mr. Hay’s chart and do not adjust it for inflation.

So, using real regression to the mean analysis, adjusting for inflation and using more data (all the way back to 1870) shows us a market that is 40% or more overvalued, just as Mr. Grantham claims. Even if one were to argue that adjusting for inflation wasn’t appropriate and that pre 1970 data wasn’t relevant anymore and not adjusting it for the low and high starting points, merely using an actual regressed trend line shows the market as at best fairly valued. I’ll take a well thought out process that has shown itself to be predictive of future returns (see here) using valid statistical techniques and adjusting for as important a factor as inflation over arbitrary (okay, not arbitrary, carefully chosen to arrive at a conclusion) lines drawn on a graph to give the appearance of rigor.

I would argue that these two men (firms) are not even using the same type of reasoning. This is masked because both of them use the word trend, but they are talking about two very different animals.

I also think it is important to point out that Jeremy Grantham uses regression to the mean as a general approach (when things get too high they go down, when they get too low they go up) more than he relies on a specific trend line. GMO uses a regressed trend as a tool, but make their decisions with more weight given to their components of returns analysis and regression to fair value (which for the S&P 500 would be an expected return of 5.7% above inflation. We suggest using a number of different methods as well (normalized P/E over various time frames, Q Ratio, Market cap relative to GDP, etc.) and to use methods which when tested show a statistically significant relationship to subsequent returns and over long time periods and different market environments.

Mark didn’t want to say all that so he could convince others to begin the work of winnowing the wheat from the chaff in general as opposed to spending his time on this specific difference. Hopefully this is a first step in the right direction of doing so.

There is so much wrong with that statement, so many misleading claims. Feel free to point out the issues in the comments if you see any I don’t mention. Read the article here.

My short list:

1. Operating earnings are compared to reported earnings (apples to oranges)

2. Forward earnings are taken as gospel and compared to todays prices rather than current earnings compared to todays prices (apples to oranges.) Will they rise 18% this year? Maybe, but I doubt it.

3. Earnings are not normalized (possible peak earnings compared to mid-cycle earnings)

4. Profit margins are not normalized (near records on the most mean reverting aspect of finance)

5. Do we really believe the market is cheaper than it was in 2009, much less 1985?

6. Comparing todays valuations to the most overvalued period in market history as if being cheaper than sky high makes the market attractive. This becomes more important when you realize that the measures less manipulated (though still questionable) are all said to be the cheapest since various periods in the mid to late 1990′s. To keep that in context realize Greenspan famously uttered the words “Irrational Exuberance” in 1996. Even if the measures were not so problematic being “cheaper than in 81 percent of occasions since 1998″ is a little like claiming to be the most chaste woman in a brothel. It says something but hardly implies celibacy.

Take one method of measuring how cheap the market is, the Shiller P/E or P/E 10 compared to its long run average:

The top red line is todays level. which is lower than much of the time since the mid 1990′s. However, notice that that is more expensive than almost any period prior to that point and far above the long-term average. Being cheap compared to  1998 through today tells us little more than how insanely high the market got in the late 1990′s. Every legitimate method we look at show similar levels of overvaluation. Even a cursory look at this chart shows that the market is likely to get significantly cheaper which makes articles such as this extremely disappointing though it seems to be the conventional wisdom.

One aspect of the report we touched on earlier was that it combines a number of different methods  to test their effectiveness as well as show the returns each projects. In our own research we use components of returns analysis such GMO and Rob Arnott use and analysis of risk premia such as Index Investor uses in addition to the relative valuation methods that are used in this report. However, this is the most thorough analysis of relative valuation methods over 5, 10, 15, 20 and 30 years we have seen. Despite looking at various different aspects of a company they are remarkable in their agreement. Each can be distorted somewhat which is one reason various methods are useful to look at. While they do not use each in their model it is instructive to see what each factor predicts. (Click image for larger version.)

Testing shows that the least predictive of these methods is PE 1 with averaging earnings over longer time periods making them more accurate. The only method which predicts even okay returns is PE 1. All of the more accurate methods, including their own, predict returns barely over inflation.

Are there any methods which are more hopeful? Yes, but none of those show any evidence that they work in forecasting future returns. You should demand evidence that methods work, no matter how god they sound. You can read the full report here.

The second positive to come out of the last few years is that more and more of this work is being released over the internet. The variety of methods now publicly available makes it possible for us to feel a great deal more confident about our assumptions. Using various methods which have stood the test of time can improve results over any one method.

Unfortunately some methods continue to be discussed and promoted which testing shows do not work. The most common is some form of comparing earnings yields on stocks to a bond yield or interest rate.  We will not go into all the reasons such approaches should not work in this post, the most important thing to remember is that they do not work. The same goes for all the methods we hear about that claim that the market is cheap or reasonably valued. No matter their credentials, no matter their fame, no matter their past investment success, if they claim that a certain measure of how cheap or expensive the market is is valid, ask them to show their work. If they cannot show rigorously that the method has predicted longer term returns accurately across a number of market environments, then anything they say on that subject (though certainly not others) should be heavily discounted.

So what sources and methods have proved reliable?

GMO produces a seven year forecast that uses the components of returns to arrive at a forecast of “real returns” , which means after accounting for inflation.  As an investors it is better to earn 5% if inflation is 1% (4% real) than 8% but inflation is 6% (2% real.)

John  Hussman’s model has been reliable over time and Ed Easterling has done excellent work in this regard. The Shiller P/E, Q Ratio and Regression to trend have all done well and Doug Short has done great work in making all three measures available to investors.

We are going to update readers on each of these measures on a regular basis as well as our own thoughts on them. Today however I want to introduce another set of work I have been watching the last few months from the advisory firm Butler|Philbrick & Associates. Doug Short introduced them to me a little while ago and their latest estimates can be found here.  Feel free to visit the site and read the entire report and follow the links to their methodology, but I will cut to the chase. They combine a number of different valuation methods and combine them to produce a statistical model which has tracked future performance quite closely, and it works for reasons that make sense.Notice in the chart below how closely 15 year returns matched their model. Notice how poorly 15 year returns were predicted to do in 2000.

Click for larger image

So, exactly what does their model predict?

That is in line with other valid estimates that we see. In making plans we suggest investing in ways that can be profitable in that kind of environment and saving without the assumption of high returns. Notice, this assumes the economy does average, which in general it has. If it should do worse these numbers could be worse. However, patience in allocating capital, and using strategies appropriate to this environment, can do better. Most importantly they can do better by avoiding the worst downturns (and even profiting from them.)

Thoughtful minds are reading Scott Vincent’s recent paper, “Is Portfolio Theory Harming Your Portfolio” (HT: @jasonbremer)

In the paper Vincent argues that the flawed foundation of Modern Portfolio Theory (MPT) that risk=volatility has allowed MPT advocates to control the language of the debate and set the stage for the obvious conclusion that passive index-based investing is inherently superior. And don’t think for a second that this debate is simply theoretical, academic, or unimportant– the basic tenets of MPT shape the decisions of nearly every institutional money manager, wealth management firm, investment counselor/consultant, and financial planner in profound and often disturbing ways. YOUR money is almost certainly being managed with these ideas at the core. The traditional approach to asset allocation is built on false axioms.

While Vincent’s direct assault seems to be focused on highlighting the mistreatment of active, concentrated equity or fixed income asset managers vs. holding a passive equity or fixed income index, his arguments hold sway over the much larger and dangerous consequences of MPT on asset allocation. My assertion is that most damage to investors portfolios from the traditional approach to investing comes from the foundation of static, backward looking assumptions informing broad asset allocation decisions.

Vincent’s Case

In the piece, the author does a fantastic job of summarizing the history of Modern Portfolio Theory and it’s building block components:

• Harry Markowitz’s work on “Portfolio Selection” (which informs the chart above) proved mathematically that diversification could reduce volatility which he equated with risk
• William Sharpe’s Capital Asset Pricing Model (CAPM) which mathematically defines an asset’s return into two parts:
  • systemic risk or “beta” which describes how an asset has historically behaved relative to “the market” or a broad index
  • idiosyncratic (stock specific) risk  which can and should be diversified away
• Eugene Fama’s Efficient Market Hypothesis (EMH) which asserts that the market is ultimately efficient at pricing all available information

Vincent notes that most advocates for passive investing and MPT start with a compelling statement:

Active managers in general have been shown to underperform passive funds, especially when taking into account their higher management fees, taxes, sales charges, and trading costs. If you can make more money in index funds then why bother with the hassle of trying to find a good manager?

On the surface, that’s hard to argue with. I’ve seen studies that indicate after taxes, 80% of active long-only equity managers underperform their benchmarks over long time periods.  Here’s the problem: Most “active” managers aren’t active at all. They are closet indexers:

While diversification has always been a selling point for actively managed mutual funds, the average number of holdings in a fund have increased dramatically since MPT made the scene. The average number of stocks held in actively managed funds is up roughly one hundred percent since 1980… the average fund holdings had risen to approximately 140 positions by 2000. The actual number of holdings in a given year could easily surpass 200 because portfolio turnover exceeds 100 percent per year on average…Investors in actively managed funds suffer – they receive quasi-active management at full active management prices.

MPT and the quantification of investing has further (mis)informed the debate by seeking a easy way to label and quantify “risk.” In 1952, Harry Markowitz chose variance or volatility of prices or returns to define risk. He did so because it was mathematically elegant and computationally simple. However, this idea has serious limitations (most of which Markowitz has since acknowledged).

On the individual stock level, Vincent notes

Risk is often in the eye of the beholder. While “quants” (who rely heavily on MPT) might view a stock that has fallen in value by 50 percent over a short period of time as quite risky (i.e. it has a high beta), others might view the investment as extremely safe, offering an almost guaranteed return. Perhaps the stock trades well below the cash on its books and the company is likely to generate cash going forward. This latter group of investors might even view volatility as a positive; not something that they need to be paid more to accept. On the other hand, a stock that has climbed slowly and steadily for years and accordingly has a relatively low beta might sell at an astronomical multiple to revenue or earnings. A risk-averse, beta-focused investor is happy to add the stock to his diversified portfolio, while demanding relatively small expected upside, because of the stock’s consistent track record and low volatility. But a fundamentally-inclined investor might consider the stock a high risk investment, even in a diversified portfolio, due to its valuation. There’s a tradeoff between risk and return, but volatility and return shouldn’t necessarily have this same relationship.

I would add to this sentiment, particularly for equities as an asset class; there is actually more risk (chance of loss) when volatility is low, and less likelihood of loss when volatility is high.

Additionally, not all volatility or standard deviation is created equal. Most investors, for example, do not think that the prospect of achieving returns that are 2 standard deviations ABOVE average is risky, where the opposite is clearly so. So MPT’s cornerstone– its definition of risk– is incomplete at best and at worst, completely misleading.

Vincent continues

Regardless of MPT’s shortcomings on both a theoretical and empirical level, its dominating influence will not easily be dislodged. MPT is deeply woven into the fabric of our financial system, its mathematical grounding and precise answers inspire confidence. Further, its application is crucial in bringing increased scale and profitability to the financial services industry. Few want to see change. As such, common sense and judgment will continue to diminish in importance as top-down, quantitative strategies and blind diversification gain investment dollars.

And this is the part the ticks me off the most. The ideas behind MPT are so self-serving for our industry that despite their shortcomings, we can’t seem to move past them. Of course fear of embracing Maverick Risk (see my recent post) help keep the status quo alive and well

There’s a feeling of safety that accompanies index investing; neither the advisor nor the investor risks losing face or losing a job over putting money to work in a broad index. We enjoy the mathematical certainty of MPT, it’s reassuring that we can fix a value to assets, and that we can quantify risk in a non-subjective manner – free from human error…When defending an entrenched system that furthers the economic interests of powerful entities, the rationale doesn’t need to be sound, it just has to be somewhat convincing.

Vincent’s Prescription

The author contends that smart investors should welcome the dumb money move to highly diversified, passive strategies, while acknowledging if you ARE the dumb money or are forced on some level into limited choices (like 401(k) plan participants or beneficiaries of trusts with bank trustees– at least don’t pay active management fees for closet indexers.

An informed investor should welcome this shift. As highly-diversified strategies gain assets, inefficiencies become more prevalent because share prices are increasingly driven by factors other than fundamentals… there is compelling empirical research that shows active managers who are truly “active,” do persistently outperform indexes. The astute individual investor can seize the opportunity that blind, passive index investing provides in the form of increased market inefficiencies by hiring active managers who have shown the ability to exploit and profit from these inefficiencies.

Take advantage of the fact that your neighbors are leaving for passive funds, as their passive investments could provide the inefficiency your manager seeks to exploit.  But, by all means, avoid investing in highly diversified active funds whose returns closely match an index.  If index returns are what you seek, then pull your money and invest in efficient passive index funds or ETFs (emphasis mine).

This is where many investors stop thinking about their portfolio. They say, Yes! index returns is what I seek. After all, if you buy and hold the market you can earn the long-term returns right? Unfortunately, the answer to that is no. The long-term “average” returns are rarely available. In fact, depending on where you are standing, the returns are either much higher, or much lower. Consider this chart from Crestmont Research which shows that even for periods as long as 10 years, average rarely occurs:

MPT & Asset Allocation

Scott Vincent seems to be focused on encouraging investors to choose the correct managers (truly active, relatively concentrated, fundamentally-focused) WITHIN asset classes like stocks or bonds. And he is certainly compelling. However, as I alluded to earlier, his argument holds sway over the much larger and dangerous consequences of asset allocation.

Consider this chart which you’ve probably seen in one form or another. It shows expected risk and return of various mixes of asset classes and the typical approach to asset allocation which Modern Portfolio Theory has spawned:

So what’s wrong with this picture? Lots of things.

The first is the inputs– namely expected returns and volatilities of various asset classes– most investment programs are built on logic like this:

• Bonds will return 5% on average over the long-term but be between 0-10% in any given year
• Stocks will return 10% on average over the long-term but be between -10% and +20% in any given year
• Some might include other nuance regarding different types of bonds like High Yield or different types of stocks like Emerging Markets
• Some might include different types of assets like real estate, commodities, or “alternatives”

The problem of course is this is an incomplete description of investment returns:

• The math contends that returns are randomly and unpredictably distributed around the average
• This “normal distribution” of returns contends that larger market movements outside of the ranges above will be relatively rare
• “Average” returns ignore the role of valuation and the importance of when you start investing (buy) and when you finish (sell) even over multi-decade time horizons

The traditional approach to asset allocation is built on false axioms. The phenomenal secular bull market in stocks and bonds from 1982-1999 created the perfect conditions for the  nearly religious acceptance of MPT. In a recent post, Expensive Markets Mean Low (or Negative) Prospective Returns, I made the case that valuation matters greatly and currently portend disappointing returns for both stocks and bonds. Traditional asset allocation has no way of dealing with this in a way that successfully protects portfolios from experiencing meaningful and unnecessary drawdowns.

 

The Normal Distribution Does Not Apply to Long Term Stock Returns. Source: stockcharts.com

As colleague Brian McAuley penned in Sitka Pacific’s March 2010 client letter

Whether or not these themes are presented directly, they underpin the advice that most investment advisors give their clients. At its core, the message is usually something similar to this: “The markets are random and unpredictable, so the best way to invest is to properly diversify and wait for the averages to play out.”

However, what most investors seem to be unaware of is  that this whole theory of random movement of  market prices was proven false over 50 years ago by one of the most influential mathematicians of the 20th century, Benoit Mandelbrot. The random motion of market prices was a very nice theory, but it just doesn’t match what actually happens in the real world.

In a completely random world, a large movement in prices would be a relatively rare event. But we know from market history that large movements in prices happen far more frequently than they should if prices moved completely randomly. In fact, if we look at annual  market returns, there are 50% more extreme events than there should be… It’s clear that there are other forces influencing the markets that aren’t taken into account by the statistics of purely random movements—and they have to do with human behavior.

Since the movement of market prices is not random, most investment advice given today that is based on Modern Portfolio Theory is simply wrong. Particularly, the assumption that market risk can be reduced by diversification has led to frequent catastrophic results throughout market history—most recently in 2008.

Although the theory of random market movements was proven false more than 50 years ago for those fluent in mathematics, with multiple bubbles and busts in the last decade it has become painfully obvious to everyone that there is more to market movements besides a Brownian-like random motion. Markets are subject to the rational and irrational decisions made by millions of people, and as such they are prone to cycles of extremes in sentiment and valuation—booms and busts.

Even those who bill themselves as “active” asset allocators typically only move within a small range of acceptable allocations such as 40-60%. Consider even this progressive asset allocation policy:

My Prescriptions

Obviously, I think investors can do better. Just as Scott Vincent highlights the cadre of truly active, relatively concentrated investment managers who have “beaten the market” consistently– there are asset allocation strategies which aim to improve upon the traditional approach. At Sitka Pacific, we’ve taken an “Absolute Return” approach to the markets. From our 2006 Annual Review

We have the flexibility to take more meaningful actions to preserve capital, manage risk and volatility, and invest where the best opportunities are. Our goals are simple: to preserve capital first and generate an absolute positive returns second. In order to achieve those goals we look at the market as a means to generate a return, not something that should be blindly followed. We use the market when it can be useful to us, and can look elsewhere (even to cash) when there is more risk than potential reward in the market. The flexibility to manage risk may prove critical over the next several years.

Lots of managers aim to do the same thing. I’d recommend finding one who not only has demonstrated a successful approach in various market environments, but also whose process seems repeatable and makes sense to you. Take Mebane Faber at Cambria and his GTAA ETF. It’s a pretty straightforward process that using long-term momentum indicators to decide when and when not to be invested in various markets. It’s an improvement on a static approach, but might leave a little something to be desired for folks who wish to have a fundamental approach to their portfolio. John Hussman’s approach at the Hussman Funds is worth a look as well. For Do-it-Yourselfers, I’d recommend this post by David Merkel: The Impossible Dream Project for a good look at how to build your own process. For our approach to be successful, we need 3 Key Traits:

When one is trying to be dynamic and active in their approach, flexibility is hugely important. Whether it’s the inherent inflexibility of an investment committee, the curse of success (overconfidence), ingrained cultural constraints, or simply the challenge of moving around and effectively deploying a large chunk of assets, large, well established firms often lack flexibility.

Folks in this position, MPT devotees, and folks who don’t want to rock the boat too much would be wise to consider several emerging theoretical frameworks which aim to improve upon the status quo.

• Post-Modern Portfolio Theory (PMPT) is compellingly described in this FPA Journal article by Pete Swisher and Gregory Kasten.
• Allocating based on Downside Risk (versus Mean Variance) seems like a no-brainer and should be evaluated by anybody trying to “optimize” portfolio allocations. Here is a good primer.
• Fundamental Indexing: Research Affiliates is a good source.
• Risk Parity, which Bridgewater, PanAgora, and AQR  are all pursuing in various forms, takes a different view of targeting acceptable levels of risk as opposed to returns

source: Unified Trust 

 

These approaches all have their own limitations and should be evaluated critically (like anything involving your or your client’s money). Ironically, one can make the argument that “Absolute Return” or GTAA or Fundamental Indexing can be considered as distinct asset classes, with their own projected risk and return characteristics and lower correlations to traditional benchmarks. In this case, MPT would suggest that “efficient” portfolios should have an allocation to them, just as many traditional investors have embraced alternatives to varying degrees.

Regardless of how you are currently invested, the shortcomings of MPT and its pervasiveness in portfolios is becoming increasingly clear. The last two years have given MPT-based investors a reprieve from the secular bear market underway since 2000. The next two years may not be so friendly. Investors should take the leap into truly active investing and asset allocation, even if it just means “trying it” with one or more managers or funds.

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 whole 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.

As one of the few who saw this crisis coming and how it might play out across the board, not just in particular areas, he deserves a listen. As one of the most successful investors of the last 30 years he would warrant a listen anyway.

Watch the whole thing.

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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 fact, dividends are actually likely to grow only 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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Earlier this year, Mr. Bush derided a modest plan to provide $4 billion to states and localities to buy foreclosed properties, saying that buying up empty homes helps only “the lenders or the speculators.” Actually, it protects entire neighborhoods and local economies from the effects of foreclosures by preventing a greater buildup of unsold homes and a further drop in prices.

This site is not about politics, but before I discuss this some disclosure is necessary. I am a fan of free markets. I do not however belong to that group of fans who believes that the market left to its own devices comes up with an optimal outcome (however one might define optimal.) There are a number of reasons to favor free markets, that isn’t one of them.

Still, one reason to favor markets, and all the pain and inequity they come with, is that even if one believes that well thought out policies could cure whatever evils (however one wishes to define them) that the market (or our world in general) afflicts us with, it is highly unlikely that we will ever get such policies. This kind of solution is exhibit number 10,549 of that truth.

I only address the politics of this, because as investors we are forced to analyze things which will undoubtedly rub some peoples political beliefs the wrong way, and this is one place where I cannot avoid it, no matter how much I might wish to do so.

The absurdities

So what exactly have our leaders in Washington, and pundits on the board of the Times, come up with?

First let us deal with the absurd aspects of this plan. The government buys up a bunch of foreclosed properties that are theoretically driving down the prices of other homes. Uh, does anyone else see the big gaping hole in this logic? After the government buys them, they are still abandoned! Unless the government just takes them off the market indefinitely (thus restricting supply) rather than sell them, how does that solve the problem of excess inventory?

What it does do is allow the lenders to get a price higher than they would if the homes had to sell at a price that people could actually afford. So, bankers and other lenders get bailed out and taxpayers have a bunch of homes they have to sell at prices lower than they paid for them. Personally, I would rather have our taxes not be used to bail out lenders.

One problem homeowners are facing is abandoned homes becoming a drag due to lack of maintenance. Will the government keep all these homes up? As little faith as I have in the lenders, the profit motive will likely make them better stewards (if only marginally, given the enormity of the issue) than the state.

A Little Reality

Most important, is that we investors need to avoid falling for simple sounding solutions that will in the end not help that much. The ultimate problem with housing is not greedy lenders (greed is nothing new) or deadbeats, government policies (a personal favorite post of mine) or incompetent regulators (though all had their role in getting us to this point.) It is that housing prices are too high.

For reasons stated above this particular solution is not going to help keep prices high, but what if they could? Is that really good? Housing is extremely unaffordable in many markets. Prices will come down. Is dragging that out the best answer? I find that in isolation a dubious, and at best a marginal, good. Given the cost, in tax dollars, inflation, misallocation of resources and the moral hazard of lenders and borrowers believing that risk can be taken with some portion of it underwritten by the state, the benefits should have to be huge. As investors we should be skeptical that the end result will be good for the rest of the economy.

The same problem comes even with trying to keep interest rates low. Let us assume that these various measures, combined with low interest rates, slows, or even temporarily halts, the decline in housing prices.

Much as with claims about the “fed model” there is the belief that lower interest rates will allow people to afford a home that they could not a higher rate, ( also that lower prices will result in demand curves that shift) etc. All of these arguments miss a key point. Interest rates change. A stock price that is “justified” by todays interest rate, says nothing about whether it will be similarly “justified” in the future. Nor does a high price being “justified” by low current interest rates mean you will get a satisfactory return. It just means it will be better (actually that isn’t a given either) than a bond yielding 3% (or whatever the low rate happens to be.)

So it is with housing. Absent a speculative bubble such as we just went through in housing, low interest rates might encourage people back into the market. It might halt the slide in housing prices from going back to an economically reasonable level as fast, or temporarily. However, those buyers will not be selling to people with similarly low rates in the future. In an efficient market (stop giggling Barry and Jeremy) markets would see through temporary low rate periods and price housing at sustainable levels that vary little around interest rates. I suspect in this instance gun shy homeowners will (or even lower.) At the end of the day however it doesn’t matter even if they do not. All that means is that down the road prices will fall when interest rates go up and prospective buyers cannot afford them any longer. The same for being able to “afford” a house at a lower credit score. Prices still have to be affordable for succeeding groups of home buyers. In much of the country they just are not. This not just “gonzo” pundits beating some fantasy bear drum, but yes Jeff, “real” economists such as Martin Feldstein (who has some trenchant comments on the health of the economy and misreading of the GDP data as well)

I’ll tell you what worries me. We saw house prices overshoot by 60% relative to costs of building and relative to rents. And I worry about the possibility that they will keep falling; they will spiral downwards. In the same way that they went much too high, they could go much too low. And if that happens, then we are going to see individuals feeling a lot poorer, cutting back on their spending, defaulting on mortgages, and we’re going to see the holders of those mortgages see their assets, their capital being cut and therefore their ability to make loans being cut.

Incoherence

Bill Gross should know better, but unfortunately he doesn’t seem to realize that after decrying the destructive potential of housing prices rising faster than inflation and incomes, that keeping them from correcting that rise is destructive as well, and unlikely to work.

So let us end with one more political (if non partisan) note. If all these policies could help keep prices up, if other policies suggested are effective as well, what have we done?

Encouraging people to buy houses at prices that were economically too burdensome, and likely to eventually lose value, is what got us into this mess in the first place.

Why is it a virtue for the government to do exactly what we are criticizing mortgage companies, banks and even the fed for encouraging home buyers to do in the past? Isn’t the end result just the same thing if possibly a bit more drawn out? Investors beware.

Update: Dean Baker (another “real” economist) takes up some similar themes:

Have the NYT editorial writers not noticed this bubble or do they think the housing bubble was a good development that the government should try to foster?

The level of incoherence of the housing policy advocated by the NYT is astounding. Why on earth should Congress act to keep house prices above their market level?

House price supports will not work in the long-run. If we keep house prices high, builders will construct more houses and the over-supply will grow even larger. In this way, a house price support program is like a farm price support program, except we have a $20 trillion stock of housing. The market for most farm products is in the tens of billions of dollars annually.

A house price support program will end up costing the government billions and possibly tens of billions of dollars. Is it better for the government to spend this money (most of which will be paid to banks) supporting house prices than to pay for health care, child care or good rental housing?

Furthermore, since house prices will eventually fall to their market clearing levels, will the NYT policy even help moderate income homeowners? They will be paying far more in housing costs for the years they still in their home than they would to rent a comparable unit. This will be diverting money that they may have otherwise used for their kids health care and child care or other necessary expenses. And, since the house price will fall, they will never accumulate any equity.

Jon Henke also smells the whiff of the farm support program.

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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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