February 2009

It Isn’t All Factored in Yet February 27, 2009 09:00 a.m.

When the asset declines began in 2007 (and even before that) a number of investors and advisors began saying all the bad news already was factored into market prices. This mantra was repeated during and after each leg down in the markets, and especially during the bear market rallies. The belief probably was highest during the fourth quarter of 2008. Many analysts expected that would be the worst of the downturn and would be the market bottom.

So far, the losing bet has been that the bad news already is factored into prices.

The fourth quarter earnings reports are proof that the markets are not an efficient mechanism that price in all known and knowable information. For the quarter, only 55% of companies beat their earnings estimates. That is the lowest reading for the current bear market. The only good news is that it is not as bad as the lowest readings of the 2000-2002 bear.

Even more telling is the way earnings estimates decline as we get closer to the earnings release. S&P 500 earnings were down about 36% from a year earlier. Yet, before earnings season began analysts were expecting an increase of about 30% in earnings.

For the current quarter, analysts are forecasting an earnings decline of over 30%. Keep in mind analysts are notoriously optimistic.

Further evidence the worst is not yet priced into the markets is today’s GDP report. It came in worse than expected, so investors will start the day by driving the prices of stocks down.

Another way of addressing the issue is: Are stock valuations low? I think the correct answer still is negative. A good analysis of this question is made regularly by John Hussman in his weekly commentary at www.HussmanFunds.com. The main points are that based on most earnings measures, the current price-earnings ratio is around 15. That is right around the long-term average, so stocks are not cheap by that measure. Further, Hussman prefers to use peak cycle earnings. By that measure, the P-E ratio is a bit below 15, but it still is not in the historic range of low valuations. In addition, the peak earnings of the last few years are unrealistic and not likely to be repeated. High leverage, low interest rates, and other factors that are not likely to be repeated boosted margins well above historic levels. So the appropriate earnings level to use probably is below the recent peak.

Two other good measures to watch are yields on corporate investment grade and high yield bonds. These bonds had nice bounces off the lows of November 2008, meaning their yields declined. More recently they have reversed course. The initial optimism of last fall is fading in the face of economic and corporate news that is worse than expected.

This still is a time to focus more on preserving capital than on seeking gains or boosting yield. Some analysts like to state that you have to be in the markets now, because stocks have their best gains in a short time when bouncing off a bottom. That might be true, though the data do not fully support it. The more important issue is the bottom can be spotted only after the fact. Those who have tried to time the bottom so far have lost a lot of capital. Hunker down and stay safe in our recommended portfolios.

Homeowners and More Feb. 20, 2009 11:30 a.m.

The President put forward his mortgage assistance proposal, and it did not go over well with a range of people, especially with the markets. Investors are accepting the notion that there is no easy solution to today’s problems, and it will take a while to stabilize the housing market and the economy.

As I have said before the problem with housing and the economy is too much debt. Income and the value of assets do not support the debt levels. Debt has to be reduced through defaults, principal forgiveness, or some other means. The new plan does nothing about principal and gives few homeowners an incentive to seek refinancing under the plan.

There are a number of realistic plans floating around. One is by John Hussman; another is by Barry Ritholtz. There are others that differ in the details. There are two main problems getting us there. One is the plans involve dissolving or significantly restructuring banks that hold the bad loans. The bank managers are too close to the politicians. The people in Washington want to save the existing banks and the jobs of the managers. The other problem is the bond holders who financed the banks would be hurt. Stockholders already have lost all or most of their money. The Treasury and Federal Reserve officials apparently believe bondholders need to be protected. That is why all plans from the government essentially involve using tax dollars to save bondholders investments in the banks.

In the meantime, there have been a few positive signs in the credit markets. A number of corporations floated new debt offerings in the last two weeks at reasonable interest rates. Spreads on both investment grade and high yield corporate bonds have come down. The credit markets are not completely healed, and these trends could reverse if the economy worsens. Also, some companies and real estate owners with debts coming due still are not able to refinance.

But we are past the credit crisis. As I identified the four stages of the crisis in the December 2008 issue of Retirement Watch, we are in the phase when consumers and businesses are cutting back. That leads to lower economic growth, which leads to more cut backs by consumers and businesses. Almost all economic data is uniformly bad. This stage likely will continue until consumers and businesses are through deleveraging their balance sheets.

Our portfolios have done well in this turmoil. We are essentially flat for the last month in the Sector Managed Portfolio, for example, and down just over 1% so far this week. That compares with an almost 7% loss for the week and 4% loss for the month in the S&P 500.

This continues to be a time to emphasize preserving capital. We will try to seek higher returns when there is less risk across the investment markets.

A Roundup of the Week Feb. 12, 2009 12:30 p.m.

There seems to be momentum toward agreement about the solutions for the financial crisis. Unfortunately, the people in Washington are not part of the movement. The latest to express basically the same views Andy Kessler, a former hedge fund manager, in an op-ed piece in the Wall Street Journal, the Journal’s editorial board, and historian Niall Ferguson.

Briefly, the situation is this: There is too much debt owed by individuals and businesses. Asset appreciation and income will not be enough in any reasonable period to make the debt levels realistic. Someone has to take the losses. The government’s policy to date has been to stall the decline hoping asset prices and incomes will rise. The taxpayers could take the losses, which is part of the basis of the government programs and proposals to date, but even those are half-hearted, stalling tactics. Or the executives, shareholders, and debt holders could bear the losses. The latter would be clean, quick and restore the system quickly.

The most important point now is the economy and markets need certainty. A constant stream of bandages and outlines simply freeze the economy longer.

How bad has the stock market been? We wrapped up the worst 10-year period for the stock indexes ever. That is no secret to my readers. I started warning about the potential for a “lost decade” in 1998. Does that makes this a bottom and a time to buy? Well, the prior 20 years of returns are not as bad. They are in the lower-middle group, according to Barron’s. But here’s an interesting point: 10 years from now we would have the worst 20-year period ever if we earn only average returns for the next 10 years. Don’t expect a repeat of the returns of the 1990s, but after the financial system is fixed we could easily see stock market returns of between 5% and 10% for the next decade.

The bond rally. Since last summer I have forecast that bonds will be better purchases after the crisis is over than stocks. Recently, corporate and high yield bonds have had strong returns while stocks declined. Money flow data show investors began moving from cash to bond funds. Did we miss the time to grab these investments?

I don’t think so. The bond markets are less liquid than stocks. A big money flow can move prices quickly. Most of these investors probably are backward-looking. There are a lot of defaults to come in the next year or two. When the defaults begin and gain momentum, I expect bond prices to decline again.

Waiting for the Change Feb. 6, 2009 02:25 p.m.

The Obama administration did not take long to pick up some of the Bush administration’s bad approaches. I have identified the following moves in the wrong direction.

Both administrations seem to have confused saving the financial system with saving individual banks and companies. There is a big difference. The system could survive just fine without the particular big banks and other companies the government has been struggling to save. The disappearance of some of the companies would have to be planned and managed, unlike the failure of Lehman Brothers. But the desire to preserve the institutions is one factor that has kept the government from developing a plan that actually will put the financial crisis behind us at a reasonable cost.

I attribute this failing to the too close ties between government and the financial services industry. Financial companies and executives are major contributors to both political parties. Top people readily move back and forth between government and financial firms. Financial executives regularly are on advisory boards for candidates and the government. As a result there are close personal and extensive financial ties between government officials and financial firms.

Another failing is the use of panic and urgency to push bailout legislation and try to prevent study and consideration. Each administration has done this, and each time markets declined while the legislation was being sold. The panic talk does not include an explanation of how the legislation really will help.

Meanwhile, I see little in the proposed legislation that will help the current situation. It does not reduce debt or otherwise rebuild individual and business balance sheets. The measures aimed at increasing jobs are meager, especially compared to the surge of job reductions that is sweeping the economy. Perhaps there will be better news in the latest financial bailout proposals expected to be proposed next week.

Two other worries: the new administration has not taken measures to reverse the weak dollar policy of the previous administration, and Congress is moving toward protectionism.

While others are willing to bet the recent and forthcoming government actions will help the economy, I have doubts. For now I continue to recommend a focus on preserving capital and waiting for fundamental improvements before increasing the risk in your portfolios.