Thursday, December 29, 2011

Gold Is at a Critical Level

For those who have had a significant holding of gold bullion over the past decade, congratulations!  Since the central bank of England sold the bulk of its gold from 1999-2002 at roughly $250 an ounce (oops!), the price of gold has risen eightfold.  Despite recent weakness, the price of gold has risen for 11 straight years.  Over just the past five years, the price of gold has risen 134%.  How long can this go on?

While I take technical analysis with a grain of salt, the price of gold is now at a critical level.  Since the major low in the fall of 2008, the price of gold has held above the line drawn through the lows during this period, as well as holding at or near its 200-day moving average.  

The recent weakness in the price of gold, which has fallen from more than $1,900 an ounce to $1,560 now, has shaken the faith of many in the gold bull market.  Prominent technician Dennis Gartman, for example, declared the bull market in gold over and said the price could fall to as low as about $1,150-$1,200.  

Broad sentiment measures now reflect pessimism toward gold, which historically has led to large price gains for gold.  In addition, commercial participants in the gold market (the “smart money”) have recently been buyers, which historically has led to annualized returns of 26% over more than forty years.

Furthermore, gold historically has risen in price when real T-Bill yields are negative—that is, when T Bill yields minus inflation are less than zero.  Such an environment reflects monetary laxity as well as no opportunity cost (from interest-bearing instruments) from holding gold.  And real T-Bill yields are now well into negative territory.

Despite these bullish reasons and the conceptual merit in owning gold amid rampant "money printing" as governments seek to stimulate economic growth, I am wondering when the bull market in gold will end.  

The weight of the evidence supports holding or buying gold for the time being.  But after 11 straight years of higher gold prices that have culminated in an eightfold rise, be thinking about when to leave.  After all, gold prices fell for 20 years, from 1980-2000.

Steve Lehman

Gold:  $1,560

Friday, December 23, 2011

Thanks and Happy Holidays!

I appreciate the level of interest that readers of the blog have shown since I launched it last February.  While it has helped me to keep up with financial markets and express my opinions primarily about broad market issues, I am contemplating a more specific offering of investment ideas in the year ahead.  

But more on that later.  For now, I wish all the readers of this blog peaceful, safe, and happy  holidays and good wishes for the year ahead.

Steve Lehman

Thursday, December 22, 2011

Investment Discipline Needed Now More Than Ever (Cont.)

I remain wary of the possibility of a "melt up" or a "melt down" in major stock markets.  Given the simple arithmetic of the difficulty of recovering from large losses, I am biased toward capital protection.

I have favored the shares of some of the world's leading companies, which have attractive dividend yields and moderate growth prospects for earnings and dividends.  There also are a number of depressed stocks that are quite cheap based on earnings and cash flows.  I am concerned, however, about the solidity of those earnings and earnings estimates for 2012.  Expectations are crucial to investment success.  High expectations for profit growth--for a single company or the market as a whole--are likely to produce disappointment and losses.  The converse is true for low expectations.

When aggregate expectations for earnings growth are low, the return on stocks has generally been in the high teens on an annual basis.  Conversely, when forecasts are for high growth, the return on stocks is about zero.  I am pleased that the 2012 consensus earnings growth for the S & P 500 has been easing, but it is fairly high, at 12%.  With Europe, Japan, and the U.K. likely to be in recession and the possibility of China suffering a hard landing in 2012, 12% growth seems too high.

When profits don't meet expectations for individual companies, investors in those stocks pay a high price.  Oracle, for example, yesterday had a significant profit shortfall and its stock fell 12%.  Concerns about the company's exposure to a sluggish Europe might signal broader concerns for the earnings prospects for other multinational companies, as well as for European companies.  

Deciphering whether a company will miss its earnings target is not easy.  In general, I try to avoid stocks that have a preponderance of "buy" ratings by Wall Street analysts, as there is much greater room for disappointment than when there are comparatively few buy ratings versus "hold" or even "sell."

There are few individual stocks that I would aggressively buy at current levels.  While there are a significant number that are quite depressed and seemingly undervalued, I am eagerly waiting for fourth-quarter results to be reported so I can do further analysis before committing substantial cash reserves.

Steve Lehman

S & P 500:  1252

Wednesday, December 21, 2011

A Bullish Composite Indicator

There are numerous indicators of the stock market, many of which have tended to work well over time.  Unfortunately, they don't work all of the time, and they often conflict with one another.  That is why investing is so challenging.

One of the most reliable indicators over the years was the dividend yield on the U.S. stock market.  When the dividend yield on U.S. stocks was 6% or higher, it was a buy signal.  When it fell to 3% or less, it was a sell signal.  Successful market technician Edson Gould called this his market "sentimeter."  But in the 1990's, the dividend yield on stocks fell to 3%--and kept on falling, as the technology stock mania rolled on.   I admit to having relied  too heavily on this indicator at the time and becoming too cautious.  Since then, I've tried to take each indicator on its own with a grain of salt and instead emphasize the weight of the evidence.

Today I came across a composite indicator by a prominent investment research firm.  This indicator includes monetary, economic, sentiment, and valuation components.  Its record using more than 40 years of data would have outperformed the S & P 500 by nearly 600 basis points annually.  Aside from a major faulty signal late in 2000 when it turned bullish before a big drop in stock prices, its record since then is particularly good.

This indicator now is in bullish territory, which has returned 15% annually on the S & P 500 since 1965 when at its current level.  That is interesting, but I remain neutral on equities for various reasons, including the investor complacency that is indicated by a VIX Index (of option volatility) reading of only 21.

Steve Lehman

S & P 500:  1244

Tuesday, December 20, 2011

Investment Discipline Needed Now More Than Ever

Today's explosive rise in stock prices was welcome in a year with little net gain to show for nearly twelve months of often sharp moves.  Yet, while on a short-term basis stock prices seemed oversold and likely to have a rebound, today's move was lacking in confirmation by trading volume and fundamental news.  

While better demand for Spanish bonds was good news for now, unexpectedly higher housing starts in the U.S. is not necessarily positive.  With an enormous overhang of housing supply still on the market--or being withheld until conditions improve--additional housing supply is not what will give the U.S. economy a sustainable lift.  

Many people seem to think that sustainable U.S. economic growth cannot occur until the housing and banking sectors turn the corner.  That is probably true, but banks continue to conceal the extent of their impaired mortgage-related (and European?) assets.  And as I noted, the housing market needs to work through the excess supply before it can return to even moderate growth, as prior levels of high volumes of unprecedentedly large houses will probably never occur again, largely for demographic reasons.

The investment implications of this are that one should set limits for purchases and sales, while using conservative assumptions about earnings growth over the next year.  If the ECRI leading economic indicator's forecast of a recession is incorrect and growth in the U.S. leads the developed world, then the conservative assumptions used in setting reasonable valuation buying levels will simply have provided a "margin of safety," which is always a prudent approach to investing.

Steve Lehman

Monday, December 19, 2011

Recent Market Weakness Increases Opportunities

The recent softness in the stock market has produced even greater declines in a number of stocks.  I am emphasizing high-quality multinationals with high dividend yields and dividend growth prospects, but I also am looking more closely at cheap stocks with low expectations.

If sentiment indicators become more pessimistic than they are now, I will be buying stocks selectively.  I continue to avoid European stocks because of headline risk for the Eurozone and the possibility of large declines in the Euro and losses for U.S.-based investors.  There are, however, a number of high-quality European companies with increasingly attractive valuations and dividend yields that are approaching very attractive levels.

A portfolio of core stocks of market leaders with high dividend yields and/or dividend growth and a small allocation to non or low-dividend yielding stocks, with high-yield bonds will produce an attractive level of current income, income growth, and total return prospects.

Steve Lehman

Thursday, December 15, 2011

Neutral on Equities Cont.

I remain neutral on equities, but I would tilt portfolios.  Within equities, I would favor U.S. equities, followed by modest tilts toward U.K. and Canadian equities.  I would tilt away from European and Japanese equities.  Growth in Europe will likely be sluggish for some time, and the booming export market to China will slow along with Chinese growth.  Japanese equities are quite inexpensive on a price to book value basis, but I now think they could well remain cheap--as they have for years.  Secular Japanese problems will likely weigh on stocks, and managements (though better than they used to be) are not generally shareholder-oriented.  Many Japanese firms do, however, score well in sustainability measures of management quality.

Within fixed income, I would move out of U.S. government issues into corporate issues, both investment grade and high yield.  Yield spreads are historically attractive, and corporate finances are generally sound.

Elsewhere, sentiment toward the U.S. dollar is quite elevated.  The converse is gold, which has taken quite a hit lately.  It is plausible that gold's success this year has led to profit taking.  I have been uneasy that gold has risen in 11 consecutive years.  I've thought that it could have one final burst, in a speculative blow off that would mark the end of its bull market.  I also have been uneasy about anecdotal reports of vending machines in the middle east that sell gold bullion, and central bank buying of gold (CB's tend to be good contrary indicators).  Yet, gold is still a small fraction of the typical institutional portfolio.  I think the recent decline is not enough to warrant buying gold, and it is worth waiting for a higher price for selling gold. Within a range of 0-20% of a portfolio allocation to gold, I'd be at about 10% here.

Steve Lehman

Monday, December 12, 2011

Still Neutral on Stocks

I continue to think that in general, stock prices are too high for significant new purchases, and they are too low for significant new sales.  

I recommend holding significant cash reserves and to set limit orders for both purchases and sales.  It is too easy to be swept up in the emotions of the day and to lose the discipline that I think is imperative in markets these days.  It no longer seems like a fair market for individual investors and their advisors, so disciplined buying and selling is critical in order to have a reasonable chance for success.  

Though high-quality stocks with attractive dividend yields have outperformed this year and are comparatively fully valued, given the volatility of markets and the still significant macro risks ahead, I'd build my portfolio core around such stocks.  With interest rates on savings and U.S. government debt in the 0-2% range, owning a portfolio of stocks of global industry leaders that offer dividend yields of 3.5%-5.5% is the way to go.  Such a portfolio will offer income growth that will likely keep up with inflation over time.

Steve Lehman

Thursday, December 8, 2011

Avoid U.S. Financial Stocks--With Few Exceptions

I long have had a bias against investing in bank stocks.  The main reason is that I don't have confidence in the reliability of their financial statements.  It was difficult enough when banks primarily took in deposits and made loans.  Even then, it was difficult to ascertain the soundness of the loan books.  One could get a sense of the conservatism of management's accounting practices by comparing loss reserves to non-performing loans, and noting the rate of loan charge offs.  

But as major banks became effective hedge funds with leverage of about 20:1 (common equity ratios of about 5%), it has become nearly impossible.  Banks not only hold loans and investments in various securities (some quite arcane with no reliable market values), but they have extensive derivatives holdings as well.

As U.S. banks struggle to emerge from the U.S. financial collapse in 2008, they still have substantial risk exposure to the European financial crisis.  According to the Institute of International Finance, American financial institutions have $767 billion of exposure through bonds, credit derivatives, and other guarantees to private and public-sector borrowers in the Eurozone's weakest economies.

Owning shares in the major U.S. banks at this point is highly speculative, as a positive outcome in Europe will likely send share prices sharply higher, while an unfavorable outcome will cause the opposite.  I don't have a strong view on either outcome and am generally avoiding Euro-related investments now.  

Instead, I'd favor major Canadian banks, which are rated as the most financially sound in the world.  They have dividend yields of 4-5% and reasonable long-term growth prospects.  I would favor buying these on a pullback, as they have rebounded with markets recently.

Steve Lehman

Monday, December 5, 2011

Portfolio Allocations Should Favor Equities Over U.S. Treasuries

When comparing the appeal of equities to U.S. Government bonds, the conventional approach is to compare the "earnings yield" on equities (the inverse of the price/earnings ratio) to the yield on Government bonds.  But as I have argued repeatedly over the years, the return on equities is not the "earnings yield" but is instead the dividend yield, plus the growth in dividends, plus (or minus) the change in valuations.  

So I prefer to compare the dividend yield on equities to the yield on Government bonds, after subtracting inflation.  On this basis, equities today are the most attractive relative to the "real" (after inflation) yield on government bonds in the 30 years of my records.  The only exception was early in 2009, when equities were even more attractive than they are today.  Note, though, that this attraction is RELATIVE to U.S. Government bonds, not the overall bond market that includes the mortgage, corporate, high yield, and international sectors.  I'll address those sectors another time.

I would hold little to no U.S. Government bonds at current levels, as I think that current yields are wholly inadequate to compensate investors for the potential risks down the road.

Steve Lehman

Saturday, December 3, 2011

Expectations Are Coming Down--Good!

Expectations in investing--as in life--are crucial to satisfactory outcomes.  Low expectations in investing tend to result in high returns, as people are pessimistic or cautious about prospective returns (or the economy, or corporate earnings) and are more likely to be pleasantly surprised.  Earnings expectations are particularly important, because it is surprises--positive or negative--that tend to really drive stock prices.

One reason for my neutral position toward stocks--aside from my optimism after the sharp selloff in August and September--has been high expectations for earnings on S & P 500 companies over the coming twelve months.

At the market bottom in spring 2009, the consensus estimate for S & P 500 earnings for the coming twelve months was for earnings to decline 20%.  Now those are low expectations!  Going back to 1979, when consensus estimates for S & P 500 earnings have been for less than 4.2% earnings growth, the annualized return on the S & P 500 has been 17%.  Conversely, when consensus estimates for earnings growth have been above 14.2% growth, the S & P has had a slightly negative return.

Consensus estimates have recently come down as economic growth forecasts for 2012 have moderated, particularly because of stagnant economic activity in Europe.  The latest estimate for S & P 500 earnings for the coming twelve months is 13%, which is in the middle range that has produced average annual stock returns of 7% back to 1979.

So for economically sensitive stocks such as ABB or G.E., I've been waiting for earnings estimates to come down to more reasonable levels before buying them.  The changes in consensus expectations are in the right direction.  But given this week's surge in stock prices, I am neutral on stocks now.

Steve Lehman

S & P 500:  1244

Thursday, December 1, 2011

Companies Move Toward a Greener Future, Despite Entrenched Interests

The entrenched interest and political clout of the industries that promote 19th-century, dirty fuels--the coal and oil industries--remains dismayingly powerful in the U.S.   Yet individual companies that have innovative managements in anticipating the future continue to move toward a cleaner energy future.

Germany's BASF is making a concerted push toward developing lighter, less expensive lithium-ion batteries to help reduce the cost of electric cars.  BASF's management anticipates stricter greenhouse gas laws, depleting fossil fuels, and rising oil costs.  Part of the initiative is the construction of a battery manufacturing plant in Ohio.  So while the coal industry in particular spends millions of dollars on advertising to distort the reality of climate change and the need to move beyond 19th century fuels, companies like BASF are forging ahead.  Such companies will likely continue to be leaders with competitive advantages because of the foresight of their top executives and boards.  They are the types of companies that a long-term investor should want to invest in.

Steve Lehman

Wednesday, November 30, 2011

Encouraging Bounce, But Will It Last?

The surge in stock prices over the last two days is impressive on the surface.  Will it be a sustainable rally of more than 5-10%, or is it just a technical bounce in an oversold market?

A longstanding adage of investing in the U.S. was "Don't fight the Fed," as monetary conditions in the financial system were considered a key determinant of the direction of stock prices.  But as Alan Greenspan's tenure went up in smoke, the adage became less foolproof.

The news that the developed world's major central banks made concerted efforts in increasing liquidity to preempt further strains in the European banking system--along with better economic news in the U.S.--was the catalyst for the surge in stocks.  But in the U.S. at least, trading volume today was relatively light given the big jump in the indexes, so volume at least today did not corroborate the strength of the move higher in stocks.  That is not a sign of a robust, sustainable move higher.

I've thought recently that stocks were technically oversold and due for a bounce, but was not as confident as I was at the end of September of a major move higher in stock prices.  I erroneously have avoided European stocks because of concerns about potential currency losses if the Euro would fall sharply.  So far I have missed opportunities there.  Yet, the constraints on the European banking system from the need to rebuild capital is curbing credit and constricting economic growth--for an extended time, I'd guess.  There are several European stocks that I find attractively valued, but after gains of nearly 10% in a few days, I'd wait for a correction before making additional purchases.

Steve Lehman

Monday, November 28, 2011

Oil Sands Operations Are Not Worth the Risk

The New York Times reported on research efforts by several start-up companies to reduce the environmental damage caused by oil (or tar) sands extraction.  There is a good reason for this.  Either of the two primary means to extract petroleum from the bitumen--the sticky, heavy oil that is mixed in with sand and clay--results in heavy environmental damage.  

There is enormous consumption of water using one extraction method--three to four times the oil that is extracted.  The other method burns enormous natural gas that causes greenhouse gas emissions to be several times higher than that of producing conventional oil.  Yet, as with the coal industry, the major oil companies with oil sands operations are claiming that these processes do not harm the environment.  

This dirty fuel, like coal, causes health and environmental damage far worse than the energy benefit.  There may be short-term profit opportunities from the tar sands, but it is not asustainable source of energy.  I'd avoid companies that operate in this sector because there are less risky ways to produce energy.

Steve Lehman

Friday, November 25, 2011

Stock Market Return Prospect Improve

The U.S. stock market has completed its worst Thanksgiving week decline since 1932, as the S & P 500 dropped 4.7%.  As a result, market sentiment measures have reversed sharply and have fallen to exceptionally depressed levels.  Consequently, return prospects for stocks have improved enough to warrant cautious buying.

For those investors with no allocation to emerging market equities, now is a reasonable time to initiate a position, with this area falling to a seven-week low.  Valuations on emerging market equities are favorable in absolute terms.  The earnings yield is 1.5 standard deviations above the 16-year average, for example.  Relative to developed markets, however, valuations are not particularly attractive.  Valuations in developed markets are attractive, especially relative to bonds.

A modest addition to emerging markets seems appropriate, with greater purchases of multinationals in the developed markets, notably the U.S.  If cash reserves are insufficient for this, I'd suggest reducing government bond holdings, as U.S. government bond valuations have become quite unattractive, both relative to inflation and relative to equities.

Steve Lehman

S & P 500:  1159
EEM:  36

Tuesday, November 22, 2011

Share Buybacks Are Good, But For Whom?

Free cash flow--when a company generates more cash than is needed in normal business operations--is typically highly valued by professional investors.  Surplus cash, when in the hands of capable management teams, can be used for debt reduction, new business ventures or acquisitions, dividend increases, or share repurchases.  All of those actions are expected to increase returns to investors.

Investors typically have cheered share buyback announcements because when a company enters the stock market to buy its stock, the additional buying demand presumably drives up the share price.  Using surplus cash for share buybacks also prevents managements from making poor capital allocation decisions--such as making expensive acquisitions of other companies--when the basic business lacks expansion opportunities.  But research by Fortuna Advisors found that over the last decade, companies that spent the most on share repurchases had significantly lower returns to shareholders than companies that spent the least.  (I would like to see more information on that, as well as corroboration by another study.)

There is a broader point as well.  What might be good for a single company--or at least its top executive--might not be good for the company's workers, investors, or the country as a whole.  The New York Times reported that as companies often continue to cut jobs and amass cash hordes, they're repurchasing stock in massive amounts--$445 billion authorized just this year.  This shrinkage of shares outstanding can increase reported earnings per share--and enable CEOs to hit bonus goals of eps--even though the underlying business is not growing satisfactorily (Zimmer is a notable example).

Such emphasis on achieving short-term eps targets is antithetical to sustainable investing.  Sustainable investing considers various stakeholders in a business enterprise, including workers and communities, and places a premium on managements who anticipate the long-term environmental and social challenges facing its industry.  Such companies tend to be better managed--period. Companies with superior managements that focus on the long term sustainability of businesses have a competitive advantage.  The evidence supports this, as companies ranked high in sustainability have produced superior returns to investors. So short-term earnings per share goals can produce a conflict between the interests of a handful of top executives and the interests of other stakeholders in the business--and when it's done throughout the economy--against the interests of the country as a whole.

Steve Lehman

Monday, November 21, 2011

Coal and Solar Energy Developments

While politicians in this country grandstand over the bankruptcy of Solyndra, a solar-energy company that received a loan guarantee from the Department of Energy, South Africa is the latest country to see the energy future and act, albeit belatedly, to move toward cleaner sources of energy.  

Eskom, the state-owned South African electric utility, plans to build solar plants at its coal stations.  In the U.S., solar energy is under attack because of the loss from the failure of Solyndra, which while significant at about $500 million, was only about 2.5% of the total loan guarantee program at the Department of Energy.  

Despite the political clout of the fossil fuel industry, renewable energy in the U.S. continues to grow and now exceeds nuclear power as a source of energy.  Coal, whose pollution externalities are not reflected in its price to consumers, must be phased out.  (Remember that there is no such thing as "clean coal," despite the massive advertising campaign of the coal producers.)  

Imagine what progress could be made if the government provided significant, ongoing support for renewable energy sources (as it has done for many years for the oil and coal sectors)?  Though the industrialized world will be reliant on oil for many years, the sooner we can move away from coal the better.  Recent scientific studies add to the incontrovertible evidence of the damage to human health from mercury pollution from burning coal.  

For investors, coal exports may sustain the industry for a while, but in this sector I certainly would not want to invest in the laggards in innovation and would (as I do in other sectors), favor the innovators rather than those who undermine scientific evidence in order to protect the status quo.

Steve Lehman

Thursday, November 17, 2011

Neutral on Stocks, But Further Declines Will Increase Their Appeal

I recently turned neutral on stocks after their extraordinary strength in October.  While there are numerous factors that affect stocks and numerous--and often conflicting--indicators, a good (contrary) indicator of investor sentiment is the VIX Index of option volatility.

In trying to identify market tops, there is little information in a low VIX level (which indicates widespread investor optimism), as low readings can persist and stocks continue rising for an extended time.  

A high VIX reading, however, has been associated with market bottoms over the past fifteen years.  When the VIX has been above 28.5 (less than 20% of the time), the S & P 500 Index has returned 40% annualized.  It closed today at 34.5.  Persistence at this level on the VIX Index, or even higher levels, will increase my confidence that stocks have greater near-term appreciation potential.

Steve Lehman

S & P 500:  1216

Monday, November 14, 2011

Two Quality Investments

Though the sharp rebound in stock prices over the past month has caused me to be cautious about the stock market overall, I still find individual stocks that remain attractive.  Merck and Vodafone are two examples that meet my criteria for competitive and financial strength, attractive valuation, and sustainability.

Last week Merck announced a dividend increase and an positive update of its prospects for important new drugs.  The dividend yield is 5%, which compares quite favorably with the overall stock market and for savings and fixed-income alternatives.  Merck generates significant excess cash after capital spending and dividend outlays, and it sells for less than 10 times estimated 2011 earnings per share. 

Vodafone was featured favorably in this week's Barron's magazine.  Its 45% ownership of Verizon Wireless will soon show tangible results, as Vodafone will receive a $4.5 billion dividend from the joint venture.  Since Vodafone will pass the Verizon Wireless dividend on to shareholders, the total dividend yield by Vodafone will be 7.5%.  That even exceeds the yield on many junk bonds.  Vodafone also has leading market positions in key markets and a management that is committed to returning cash to shareholders through dividends and share buybacks.  The stock sells for only 10 times earnings, despite the substantial stake in Verizon Wireless that is not consolidated on Vodafone's financial statements.

In addition, both Merck and Vodafone are widely recognized as sustainability leaders.  The companies' performance on environmental, social, and governance (ESG) criteria is exceptionally admired.  As positive sustainability assessments are increasingly recognized as an indicator of management quality that leads to superior returns for investors, the prospects for these two investments are indeed bright.

Steve Lehman  

Sunday, November 13, 2011

Cautious About Stocks (Continued)...

Though I can still find individual stocks that sell for attractive valuations based on p/e or  price to free cash flow, the widespread pessimism and oversold nature of the stock market a couple of months ago have been reversed after one of the strongest months for the stock market on record.

Two recent indicators now signal caution at least.  The put/call ratio for the S & P 500 has fallen sharply, indicating growing optimism.  Also, a key survey of individual investors--the American Association of Individual Investors--shows nearly twice as many bullish respondents as bearish ones.  This is almost a complete reversal from a couple of months ago.

So while I continue to encourage the purchase of selected individual stocks that meet strict quality and valuation criteria, I have a neutral position on the stock market overall.

Steve Lehman

S & P 500:  1264

Friday, November 11, 2011

ECRI Leading Economic Indicator Flashes Warning

I generally think that too much emphasis is placed on economic forecasts when making investment decisions.  However, recessions are not good for stock prices.  The Economic Cycle Research Institute's weekly leading index has an excellent record in forecasting recessions--and the latest readings are ominous.

Since 1967, when the ECRI weekly leading index has declined below its longer trend level (the 98-week trendline), a recession has followed.  The only major exception was early last year, when a decline was not followed by recession (though it was hard to tell).

The weekly index has been falling steadily in recent weeks.  So perhaps investors in the stock market should not get too comfortable in the weeks ahead, despite the encouraging news from Europe.

Steve Lehman

S & P 500:  1265

Wednesday, November 9, 2011

Earnings Expectations Remain High

Expectations in investing--as in life--are crucial to satisfactory outcomes.  In investing, high expectations for company performance--earnings growth particularly--tend to lead to disappointment.  Conversely, low expectations tend to lead to positive surprises--and profits.  This is why value investing has superior results over time, as cheap stocks tend not to be as bad as the consensus thinks and expensive stocks reflect the outstanding growth prospects that are obvious to even casual market observers.

Forward earnings growth expectations for the stock market overall are an important indicator of market expectations.  Over the past 32 years, when consensus earnings expectations for the next twelve months for S & P 500 are at least +14.2%, the S & P has had negative returns (excluding dividends).  When earnings growth expectations are moderate (earnings growth of 4%-14.2%), returns have been 7% annualized.  When expectations are low, however (less than 4% growth), the annualized return on the S & P 500 has been 17%.

At the end of October, the consensus earnings growth forecast for the next twelve months was 14.1%.  This is down from a high of more than 21% earnings growth that was forecast early in 2010 (before the big decline in stock prices).  Even further declines in growth forecasts to more realistic levels would help support stock prices.
Steve Lehman

S & P 500:  1276

Tuesday, November 8, 2011

Neutral on Stocks

Amid the frenzy over the U.S. debt ceiling extension and the financial crisis in Europe some weeks ago, I thought the odds favored a significant rebound in stock prices largely because of widespread pessimism among market participants.  With October's returns being among the highest on record, what is the mood among market participants now, and are stocks still attractive?

Not surprisingly, the sharp rebound in stock prices has lifted the mood of investors, as reflected by various sentiment surveys.  One particular indicator of market sentiment is the VIX Index of option volatility.  Low levels of the VIX indicate complacency among market participants, or even high levels of optimism.  This condition does not, however, mean that a sharp market decline in imminent.  Stock prices often have remained at high levels or risen even further when this condition has existed.

The converse has a much better predictive record.  When the VIX Index is at high levels, it indicates high levels of fear, and such periods tend to be followed by a sharp rebound in stock prices.  Specifically, when the VIX is above 28.5, the annualized return on stocks has been 39% on the S & P 500 going back to 1996.  August was a good example, as the VIX was above 40.  A sharp rebound in stock prices followed.   When the VIX is below 28.5, the return on the S & P has been negative (excluding dividends).  Today the VIX is at 29, right on the cusp.

For this and other reasons, I am neutral on stocks at current levels and recommend holding significant cash (outright or in high-yield bonds) in order to have ample resources for the next significant decline in stock prices.

Steve Lehman

S & P 500:  1276

Tuesday, November 1, 2011

Stock Market Thoughts

Stock market results the last two days show that the support for the market is a mile wide but only an inch deep.  Correlations among stocks are at historic highs, so it seems that on any given day, the Big Money either embraces risk or shuns it, driving stocks sharply up or sharply down.  It is so hard to invest in such a market environment that individual investors can be forgiven for shunning the stock market and just buying bonds, or even insurance annuities.

I haven't given up on stocks, at least where there is a real business underneath the stock.  I particularly seek businesses that produce useful products, are managed by individuals with high integrity and foresight, and which seek to ameliorate the adverse effects of their operations on the environment.  Such managers increasingly integrate environmental, social, and governance (ESG) principles in their business operations.  

I also favor companies that generate substantially more cash from their operations than is needed to continue the business.  Good things tend to happen when astute, shareholder-oriented managers have additional capital to allocate by raising dividends, repurchasing shares (at undervalued levels), reducing debt, or making acquisitions that enhance the business prospects.  Of course, as a contrarian, value- and income-oriented investor, I favor such stocks, especially when they have dividend yields of 4% or more and still generate surplus cash.  And such stocks are available.

So with bond yields unusually low and dividend yields on select stocks quite high (though not for the overall stock market), if this correction in stock prices continues, I'll be back in the market buying stocks.

Steve Lehman

S & P 500:  1218

Monday, October 31, 2011

Need for Sustainable Practices Becomes More Urgent

Today the United Nations estimated that the world's human population has reached seven billion people.  It has become a number so large that it is difficult to grasp--like the size of the national debt.  More alarming is the trend in population growth and the resulting demands on the earth's life-supporting capacity.  The world's population has doubled in just the last fifty years.  Think about that for a moment.  The increase has been one billion in just the last twelve years.

These developments have enormous implications for the ability to meet human needs in the decades ahead.  It's not just for aesthetic or compassionate reasons that the quality of the air, water, and natural environment in general needs to be protected.  With already nearly one third of the world's people lacking clean water, future demands on water and food supplies will cause even greater strains.

We, as global citizens, have the responsibility to foster sustainability in our personal behaviors and in electing government officials.  Likewise, corporations have a responsibility to do their part as well.  Top business leaders should recognize--and many already have--that by anticipating and acting on the challenges from population and resource strains (and climate change) that their comparative business prospects will improve and be sustained for years to come.  

We as investors can foster this as we allocate our capital toward the most sustainable businesses.  Research shows that incorporating environmental, social, and governing (ESG) factors into traditional financial statement analysis yields superior investment returns (as well as spillover benefits to the world overall).

Steve Lehman

Sunday, October 30, 2011

Time for Increased Caution About Stocks

Stock prices have had an amazing recovery since the worries and depressed prices only several weeks ago.  The S & P 500, e.g., is headed for its biggest monthly gain since 1974.  In just the last 18 trading days, the index has rebounded 18% since its recent low on October 4.  It's time to take some profits.

As I scan the prices of individual stocks that I've been tracking, some have surged 25-40% in just a few weeks.  I suggest continuing to research stocks and to set target purchase prices and wait to see what the market brings.  If prices continue to rise, enjoy the gains in existing holdings and continue to take some money out to keep cash available for future buying opportunities.

Steve Lehman

S & P 500:  1285 

Friday, October 28, 2011

Transparency and Integrity In the Financial System Are Still Lacking

A couple of high-profile insider-trading cases have been in the news lately.  But one mustn't conclude that this means that the system has been cleaned up so that a repeat of the 2008 financial crisis cannot occur.

There have been only modest reforms of the financial system since the crisis of 2008.  The system is still skewed to opacity and a lack of integrity.  Efforts by former Fed Chairman Paul Volcker and others to reform the system have been diluted by the political power of the big banks and major Wall Street firms.  For example, efforts to break up the largest financial enterprises into two areas to reduce systemic risk have failed.  It is imperative that activities that are government-backed are restricted to prudent business activities, while aggressive risk taking is conducted in entities that will be allowed to fail.  Yet, the political clout of the largest financial firms has blocked this reform.  The system remains one where profits are private, but losses are socialized and borne by the nation's citizens.

Furthermore, massive speculative activity in exotic derivative instruments continues to distort commodity and other markets, including the European government bond markets. 

In addition, attempts to bring hedge funds under similar regulatory oversight that other financial firms are under have been weakened to the point of insignificance.  (This is on top of the only 15% tax rate on income of the wealthiest hedge fund managers.)  The Securities and Exchange Commission sought to require hedge funds to disclose their holdings on a timely basis (as mutual funds must do), but intense lobbying by the super rich financiers resulted in a final rule that preserves the existing opacity and requires only general, belated disclosures.

There remain alarming risks to the financial system in an era of stunning income and wealth inequality that I believe will undermine the long-term prospects of this country.

Steve Lehman

Thursday, October 27, 2011

European Debt Agreement Is the Right Medicine

The agreement reached by European governments to address the sovereign debt crisis is the sort of responsible collective action that is lacking in the U.S.  Getting the heads of 17 governments to agree on a plan for painful spending and benefit cuts while the relatively strong (Germany) agree to contribute more is more than the U.S. can do within its own country.

A crucial component that was lacking in the U.S. financial crisis in 2008 is forcing bondholders to take large writedowns to reflect the impaired market value of their holdings of Greek government debt (for the U.S., it was holdings of subprime mortgage securities).  There will be a 50% writedown of Greek bonds, which will ease the debt burden of Greece and make the reported financial statements of European banks more realistic.

The failure of U.S. regulators to force writedowns of subprime mortgages (and other arcane securities) led me to have no confidence in the veracity of the financial statements of banks and other securities firms.  (Even before the crisis, I had a bias against investing in banks and other financial firms because of a lack of confidence in their financial statements.)

Granted, European banks have been in much weaker financial condition than those in the U.S. over the last several years--as I have noted a number of times--and the requirement that they raise their core capital to 9% of assets will be onerous.  It will cause massive dilution of existing shareholders through the issuance of more stock.  But this tough plan will cause a huge boost in confidence in "Old Europe."  Now if the elected officials and Wall Street in the "Old USA" could muster up the courage to do something like this.

Steve Lehman

Tuesday, October 18, 2011

Two Bullish Stock Market Indicators

In recent weeks, I've thought that the weight of the evidence supported a rebound in stock prices.  Despite a significant rebound in the stock market already, two indicator updates this week support further gains for stocks.

An important reason for my optimism has been widespread pessimism among market participants.  Market lows occur at points of high levels of pessimism.  Though sentiment measures have risen somewhat, some key indicators still reflect pessimism (which would be bullish for stock prices).  One fairly new indicator is the National Association of Active Investment Managers survey of equity allocations.  The update this week showed the lowest allocation to equities since late 2008/early 2009, when the market bottomed.  When such low allocations have occurred over the last five years, the annualized return on the S & P 500 has been 38%.

Another indicator update that is bullish for stocks is a measure of market breadth.  The current internal characteristics of the stock market are currently bullish.  Going back to 1965, when market breadth has been this bullish, the annualized return on the S & P 500 has been 16%.

These updated indicators are consistent with my opinion that further moderate gains in stock prices are ahead.

Steve Lehman

S & P 500:  1225  

Sunday, October 16, 2011

Upcoming Earnings Reports and the Stock Market Rebound

This week there will be numerous quarterly earnings reports by leading companies.  As usual, expectations will be crucial in determining how the stock market performs in response.  While I expect the market rebound to continue for a bit longer at least, expectations for corporate earnings are disturbingly high.

Consensus forecasts for S & P 500 earnings over the next twelve months reflect a 16% gain.  Back to 1979, when forecasted earnings growth was at least 14%, the S & P 500 had negative returns.  In contrast--and not surprising---when forecasted growth was only 4% or less, the annualized return on the S & P 500 was 17%.  When earnings forecasts for the coming twelve months were negative, significant market bottoms typically occurred (in March, 2009 notably).

So while I'd continue to ride the rebound in  a stock market that is probably fairly to slightly undervalued, I'd be sure to have significant cash on hand for the weeks ahead for when the majority of stocks again become significantly undervalued.

Steve Lehman

S & P 500:  1225

Stocks Versus Bonds

Investors don't consider the attractiveness of the stock market in isolation.  The question at any time is, "What are the investment alternatives, and how much should be allocated to each?"  With the proliferation of new investment instruments, individual investors now have access to investment categories--such as gold, commodities, and real estate--that previously were the realm of only large institutional investors.  So the question has become more complicated by the additional alternatives and the greater difficulty in valuing them.

Today let's consider the two most commonly held asset classes, stocks and bonds.  How attractive are stocks compared to bonds today?  First, consider stocks.  There are various methods for valuing stocks.  I think the best measures are stock prices relative to their long-term norms versus:  long-term (normalized) earnings, cash flow, revenues, and even to national economic output (GDP).  

In valuing stocks relative to bonds, it is common to compare the yield on bonds to the yield on stocks.  But which yield on stocks?  It is straightforward to compare the income yield on bonds to the income (dividend) yield on stocks.  

Mainstream market strategists typically don't compare the income returns on stocks and bonds.  Instead of the dividend yield, they use the stock market's "earnings yield," which is the inverse of the stock market's p/e ratio.  If the p/e of the stock market is 10, for example, then the earnings yield is 1/10 or 10%.  

But strategists usually calculate the p/e by using forecast operating earnings, which historically average about 20% above actual earnings as calculated by Generally Accepted Accounting Principles.  So when earnings are overstated in this way, p/e ratios are understated (and the earnings yield is overstated), making stocks look misleadingly cheap.  (The use of forecast, operating earnings reflects the bias in the financial sector toward stock-market optimism.)  Instead, I prefer using long-term average earnings over the last ten years.  This overcomes the favorable bias toward stocks when earnings and profit margins are at historic high (and perhaps unsustainable) levels.

There is another problem in using the earnings yield as it is commonly promoted.  There is not empirical evidence that supports comparing the earnings yield to the bond yield.  Bull markets in stocks have historically begun when interest rates are high and they move lower, not the reverse.  Yet, when bond yields are low, the earnings yield/bond yield comparison supports buying stocks.  This is a variant of the argument we have often heard over the last decade that "there is no alternative to stocks" because Alan Greenspan and Ben Bernanke drove short-term interest rates (on savings and money market funds) to near zero.  Yet, stocks have returned about zero over the past decade, despite there being "no alternative."  And in Japan, which has had interest rates near zero for the last two decades, stock prices are down about 70% during that time.

Furthermore, the earnings yield is not the actual return on stocks.  The return on a stock consists of its dividend yield plus the growth rate of earnings (and dividends), plus the change in valuation.  The return on a bond is its interest payments plus the change in the market value.  The change in market value is caused by a change in the prevailing market interest rate (and for corporate bonds, a change in the credit rating of the bond).

So how do stocks look now given their historic valuations?  Fairly to attractively valued.  Going back to 1881,  using 10-year average earnings, the current p/e of 19 times would produce an annualized real return (after inflation) of 5.6% over the next ten years.  That compares to 13 times at the market low in March, 2009, but 46 times at the market top in 2000.That is only good enough for the fourth-best quintile of historical experience, however.  Using the S & P 500 Industrial Index price to sales, the S & P is the most attractively valued since the mid 1990's (with the exception of the panic valuation lows of late 2008/early 2009).  The price to cash flow of the S & P Industrials also is the most attractive since the mid 1990's.  Using the dividend yield on the S & P 500, the dividend yield is the highest since the mid 1990's (again, except for the panic market lows of late 2008/early 2009.

When considering bonds in isolation, one should consider the real yield after inflation.  On that basis, current U.S. Treasury bond yields are unattractive, as they are negative after subtracting the latest 3.8% increase in the CPI over the past twelve months.

When comparing stocks to bonds, given the problem of using the earnings yield as the comparison with bond yields, I prefer as a starting point comparing the dividend yield on stocks to the bond yield.  Using this approach, it is not surprising that U.S. Treasury securities are currently unattractive relative to stocks.  Since 1981, the yield on Treasury notes has averaged 2.7 times the dividend yield on stocks.  Yet today, the S & P 500 Index has a dividend yield of 2.15%, which is greater than the 2.10% yield on Treasury notes.  If the ratio would return to the long-term mean, the Treasury yield would rise to 5.8% (or stock prices would rise so that the dividend yield would fall to 0.8%).  Considering long-term Treasury bonds, back to 1926 the mean is 1.7 times the dividend yield.  Today, it is 1.3 times, which is close to the historic norm.

Corporate bonds, whose yields have not fallen as much as those on Treasuries, are now fairly valued relative to stocks.  Since 1926, the Moody's Baa yield has averaged 2.5 times the yield on stocks.  Today, the average bond yield of 5.3% is 2.5 times the dividend yield.

In sum, Treasury securities are unattractive relative to their history and relative to stocks.  Corporate bonds are providing a reasonable yield after inflation.  Stocks are attractively valued relative to the last twenty years and fairly valued over longer period comparisons.

Steve Lehman

S & P 500:  1225

Wednesday, October 12, 2011

Do Not Chase the Stock Market Rally

As I noted several weeks ago, stock prices had fallen so sharply that a rebound seemed likely.  Furthermore, sentiment measures indicated widespread pessimism among investors, so the probability favored higher stock prices, at least in the interim.  This was particularly true for a number of high-quality stocks that had attractive valuations and dividend yields.

There indeed has been a sharp rebound.  The S & P 500 has risen 6% in the last five days, and the MSCI Emerging Market Index ETF (EEM) has risen 11%.  Good news from Europe is boosting stock prices today.  

This rally in stock prices provides relief, but I do not recommend chasing stocks now.  As I have emphasized repeatedly, one's starting portfolio allocation is crucial.  After recommending substantial cash reserves earlier this year, I favored moving cash into the stock market several weeks ago.  I would retain cash at this point, as volatility in share prices seems likely to continue.  It is always advisable to have cash on hand to take advantage of unexpected buying opportunities.

Steve Lehman

S & P 500:  1209

Tuesday, October 11, 2011

Positive Steps Toward a Sustainable Future

I believe that investments can be a force for good in the world and that for-profit companies that provide solutions to environmental and social problems can as a consequence find profitable growth opportunities.  While it can be frustrating that progress isn't faster as, for example, the world still relies primarily on 19th century fuels, there are signs of progress.

Two recent examples involve a public company and a private one, thousands of miles apart.  First, London provides a concrete example of the move toward "smart cities."  The combination of using the price system for proper incentives (charging stiff fees during high-traffic hours) with administration by a private company (IBM) has resulted in marked improvement in the quality of life for Londoners.  Traffic congestion has fallen 30%, traffic speed increased 37%, and air pollution (particulate matter and nitrogen oxides) fell 12%.  Money raised from the fees has been used to improve public transportation.

This has been an area of great promise for public policy, in my opinion.  Use the price system to provide incentives (or disincentives to pollute or add to traffic congestion) that further public policy goals.  If only we'd see that here in the U.S.

Transportation is clearly one area with negative externalities (fossil fuel use and pollution).  Real estate construction and operation is another.  Yet at the margin, some good things are happening with "green building" construction.  In Pittsburgh, PNC corp. will build what it claims is the world's tallest "green" skyscraper (with LEED platinum designation).  In Seattle, the Bullitt Center will be certified as a "living building."  The building is designed to produce as much electricity as it uses, making it both energy- and carbon-neutral.  The building will supply and treat all of its own water, capturing and storing rainwater.  And it will exclude numerous common hazardous materials in the building's construction.

The knowledge gained from projects like these will lower costs for future similar projects.  And if governments would do more to make the price (market) system incorporate negative externalities in items such as coal and oil, progress could be even more rapid.

Steve Lehman

Monday, October 10, 2011

Wall Street Strategists--Right This Time?

I empathize with Wall Street strategists who are forced to provide precise forecasts for the stock market (and profit growth, interest rates, etc.) as of specific dates, usually year end.  I've long thought that if one can get the direction of a market right with some sense of magnitude and perhaps a rough time frame, that is about all one can reasonably hope for.

The record of forecasters is generally abysmal, for obvious reasons.  The future is unknown, and any number of factors affect market prices.  But with so many media outlets these days, people demand forecasts and explanations after the fact to explain why things happen.  So that's what they get, misleading though that may be.

So the forecasters are at it again.  After the S & P 500 declined by 14% in the third quarter ended September 30, leading forecasters are on record with (at least public) optimism.  Twelve prominent strategists are looking for the biggest fourth-quarter gain in stock prices in thirteen years (with an average gain of 15%).  The last time they were this bullish was in 2008, when they predicted a fourth-quarter gain of 27%.  Instead, the S & P 500 fell 18%.  For those of us who are long, let's hope they're right this time.

Steve Lehman

S & P 500:  1195

Wednesday, October 5, 2011

Stock Market Pros and Cons

My sense has been that it is a good time to buy some stocks.  The crisis in Europe comes and goes by the day as an explanation for sharp swings in stock prices, and it should be fairly well discounted by now.  A more recent concern is that slow economic growth in Europe and the U.S. will lead to lower profits than had been expected.

This second concern is one that has troubled me since the reporting of second quarter earnings.  My analysis of cash generation by companies in various sectors revealed that there has been a marked deterioration in cash generation by companies, almost regardless of whether the sector was highly economically sensitive.  Of course, companies that are more economically sensitive have had a larger deterioration in cash generation.  And remember, it is cash generation--not reported accounting profits--that determines the value of a business, public or private.

Despite this concern, I've thought that current levels are good entry points for a number of stocks, for several reasons.  Market sentiment has been nearly as depressed as it was at the major market low in March, 2009 (before the market roughly doubled).  In addition, the VIX Index of option volatility recently exceeded 45 as well, a high level that has been associated with at least interim market lows.  Further evidence of depressed sentiment is the level of short positions on the NYSE, which were recently the highest since March, 2009.

Technically, the market is oversold after its sharp fall.   The percent of S & P 500 stocks that are above their 200-day moving average is exceptionally low, almost as low as in March, 2009. Finally, earnings-based valuations are attractive, as the S & P 500 was recently at 10.7 times forward earnings estimates, which was lower than in March, 2009 (though estimates are likely too high).

Earnings-based estimates are problematic in my view, at least when using single-year earnings.  When profit margins are near all-time highs, earnings are likely near peak levels.  In addition, analyst estimates tend to be too optimistic, and even with recent reductions, are likely still too optimistic for 2012.  A cautionary point is that at the market low in March 2009, the estimated change in S & P 500 earnings for the coming year was a 20% decline; now it is a 15% gain.

In addition to my concerns about excessive earnings estimates, there has been technical deterioration in the market's condition.  The rising trend going back to March, 2009 has been broken.

After weighing these pros and cons for the market, I still favor drawing down cash reserves for purchases at current levels.  Again, this presumes that one has significant cash reserves and that stocks are below one's long-term, strategic target portfolio allocation.  If one waits until the news is good, stock prices will likely already have moved significantly higher by then.

Steve Lehman

S & P 500:  1123