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

Monday, October 3, 2011

A Good Time to Buy Gold

I have recently emphasized the distinction between long-term (strategic) investment decisions and shorter-term (tactical) decisions.  Strategic decisions should be based on one's financial circumstances, investment goals, and risk tolerance, combined with the long-term prospects for various asset classes.  A primary factor for the return prospects of an asset class is its starting valuation.  Entering a market at a low valuation level (relatively cheap to its history and to alternatives) sharply increases the probability of satisfactory returns.  Entering at a high valuation level (relatively expensive relative to the investment's history) lowers the odds of achieving satisfactory returns.  And entering a market with the asset's price well below its long-term trend or level improves one's odds, while entering at a price well above the long-term trend tends to reduce one's odds for success.

Strategic investment decisions can also be based on long-term themes, such as increasing scarcity of water resources or of commodities, such as oil.  In such cases, as long as the long-term theme seems sound, one might continue to hold such investments, while reducing holdings or rebalancing the overall asset mix if prices rise so sharply as to be well above the long-term trend.  Valuations might not be helpful in such cases.  Gold falls into this category.

I have been a proponent of gold over the stock market since 2000.  (My main reason has been that the price of gold reflects the (lack of) confidence in paper money and the monetary authorities of the world's major nations.  In particular, I sharply criticized the policies of Alan Greenspan, who I thought was one of the worst central bankers in history.)   Since that time, the gold price has risen more than sixfold, while overall stock prices have been about flat.  

With gold prices rising this year for the eleventh consecutive year, I have increasingly thought that investors should look for the exit so they will know where it is (like before taking off in a plane).  On 7/31, 8/10, and 9/15, I cautioned against making new or additional purchases of gold (it had risen to about 30% above its 200-day moving average).  

I now suggest (re)entering the gold market.  An appropriate price of gold is difficult, if not impossible, to value.  Instead, I rely on the thematic approach and on market sentiment and technical measures.  Sentiment measures now reflect widespread pessimism toward gold.  When this has occurred since 1974, the annual price of gold rose by 24% on average.  Similarly, "commercial" gold market participants are now buying heavily.  This supposedly "smart money" condition also has coincided with an average annual gain in the price of gold of 24% since 1983.  While I'd thought that the price of gold might decline to close to its 200-day moving average below $1600, I now recommend buying gold (with a targeted portfolio range of 5-20% of one's assets, depending on one's circumstances). 

Steve Lehman

Gold:  $1,656