Thursday, May 31, 2012

A Positive Surprise Ahead for the Euro?

Longtime followers of my investment views are well aware of my skepticism of the conventional wisdom.  Given that, I can't help being intrigued by the possibility that the Euro and European stocks could actually rise in price.

Media coverage of the European government-debt crisis has been extensive and ongoing for many months.  I can't imagine that even the most casual observer or market participant is not aware of the risks to the currency, European nations, and the global financial system.  That doesn't mean that the risks are not grave.  They are.  But markets move when developments differ from expectations, and expectations are now extremely gloomy for Europe.

Bloomberg News reported the other day that China's sovereign wealth fund stopped buying government bonds in Europe recently, and that other governments have moved away from European government bonds.  Bloomberg even suggested that there is now a shortage of U.S. Dollars as a result of the shift in demand toward U.S. assets.  

It wasn't so long ago that the money-printing policies of Alan Greenspan and his successor, Ben Bernanke, were thought to cause a glut of dollars and result in an inexorable decline in the value of the dollar.  Instead, the U.S. Dollar Index has risen 12% over the past year compared to a basket of foreign currencies.  Go figure.

Along with such bleak news reports about Europe, there is now a record short position in the Euro among speculators in the currency markets.  It seems that everyone is now lined up against the Euro.

Along with my recent suggestion to begin moving out of U.S. Treasury securities and into some leading European stocks, one might even consider the risk/reward of going long the Euro.

Steve Lehman

Euro/dollar:  $1.23

Wednesday, May 30, 2012

Time to Buy Some Gold?

With the price of gold more than 15% below its all-time high set last autumn, one might wonder whether the bull market is over.  I don't think it is.  

Central banks continue to inject unprecedented funds into the financial system, resulting in negative real short-term interest rates.  Gold has done well during such periods.  In addition, gold is entering a seasonally strong period, which was in evidence each of the last two years with troughs in May/June and a surge into September (or beyond).

Furthermore, gold is having its worst month in thirteen years and sentiment measures reflect widespread pessimism (a good sign).  Commercial buyers, considered the "smart money," are optimistic about gold's prospects.  

Given these considerations, I'd make sure that my portfolio contained some gold.

Steve Lehman

Gold:  $1,565

Monday, May 28, 2012

The Safety Conundrum: Cash, Gold, or T Notes?

MONDAY, MAY 28, 2012

Investors--professional and individual alike--need a safe place for at least a portion of their assets.  Cash or money-market funds historically served this purpose.  

The most esteemed professional investors, who effectively have carte blanche when managing client assets, can set aside large portions of clients' assets when the investment outlook is cloudy or exceptionally risky.  Unfortunately most managers aren't permitted the latitude to do so and must remain close to 100% invested, regardless of the overall investment outlook.  

The expression "put money to work" is one of the most hackneyed in the professional investment business.  Watch CNBC for only a short time, and you are likely to hear it as a defense of putting cash reserves in the stock market.  A variation is, "Clients don't pay us a management fee to sit on cash."  The simple point is that there is considerable pressure on most professional investors to look like they are earning their fees by being active, regardless of whether valuations are sufficiently attractive to provide a favorable return/risk tradeoff.

This is especially true currently, as cash yields almost nothing.  It is even more difficult to be patient in waiting for better investment opportunities under this condition.  

Similarly for individual investors, savings and money market account yields of nearly zero percent exert pressure to earn potentially higher returns from bonds that expose the investor to the possibility of large swings in portfolio values from either bonds or stocks.  The notion of "saving for a rainy day" seems quaint these days, as "cash is trash" more aptly describes today's mindset.

There has been an effective alternative to cash since 2000.  Gold not only provided a superb alternative store of value by exceeding the rate of inflation.  It was a superior investment as well, with an annualized return of approximately 17% since 2000 (versus low to mid single-digit returns for stocks and bonds).  

Lately, however, the price of gold has fallen 18% since its peak last autumn.  Short-term supply/demand problems from India and Europe are probably factors for the decline.  Yet, the underlying global monetary policy environment is supportive of gold prices.  Short-term interest rates are still negative after subtracting the rate of inflation, and gold prices have tended to rise historically under this condition.  What is an investor to do?

Some of the largest investors who can't or won't hold cash or gold have used U.S. Treasury Notes as a safe place to park funds.  U.S. Treasuries are easy to buy and sell, and when anxiety forces selloffs in stock markets, Treasuries have risen in price.  But U.S. Treasuries are not risk-free.  With the U.S. Federal Reserve aggressively intervening to support markets and economic activity to an unprecedented extent, it seems only a matter of time before inflation rises or investors lose confidence in holding U.S. Government securities in anticipation of higher interest rates (and consequent capital losses on Treasury securities).

Another potential problem for U.S. Treasuries could be unexpectedly positive developments in Europe.  If the European financial crisis impels the Euro nations to agree to issue bonds for the entire Euro nations--including those financially strong and those financially weak--that could produce a flow of investment funds away from U.S. Treasuries and toward Euro bonds.  Price of U.S. Treasury securities would fall and those of Europe would rise.

Since the 2008 financial crisis, there seems to have been an inexorable decline in yields on U.S. Treasury notes and bonds.  But this actually has gone on for much longer than that, as long-term U.S. Government bond yields have been declining since the peak in 1982.

This 30-year period of declining interest rates (and rising bond prices) must be coming to a close.  While the yield on the 10-year U.S. Treasury Note could fall further from the current 1.75% level, particularly if Europe has further setbacks, I would look to exit U.S. Treasury holdings.  

So is there a reliable store of value for the short to intermediate term?  I think there are three:  cash, gold, and short- to intermediate-term investment-grade corporate bonds.

Steve Lehman

Thursday, May 24, 2012

European Stocks: Follow Carlos Slim

Mexico's Carlos Slim, one of the richest people in the world, is known for investing during crises, when asset prices are depressed.  He now considers the financial crisis in Europe to be another opportunity.  I agree.

Valuations are quite depressed, particularly on book value.  Investing in stocks with low price to book value ratios has provided among the highest returns over the decades compared to any other investment approach.  It is not, however, a timing tool.

I suggest buying some European stocks with cash reserves, or even with proceeds from reducing stakes in emerging market stocks, which seem vulnerable at current levels.

I long have advocated maintaining significant cash reserves for attractive investment opportunities that come along.  For those with cash, a strong stomach, and a long-term approach, European stocks now offer such an opportunity.

Steve Lehman

Sunday, May 20, 2012

Buy Some Stocks This Week

While valuation is the most important determinant of long-term returns from the stock market, sentiment and technical measures drive shorter-term returns.  These two shorter-term indicators of the stock market give reasons for optimism. 

The abrupt decline in stock prices over the last two weeks has caused sentiment measures to turn sharply from widespread optimism to pessimism.  The AAIA survey of individual investors, for example, now shows twice as many pessimists as optimists, which usually indicates a good time to buy stocks.  Other, proprietary measures, show similar pessimism that is historically associated with subsequent gains in stock prices.

Similarly, on a technical basis, stock indexes have fallen rather sharply, and particular individual stocks have had dramatic declines (one of my favorites has fallen 22% in about two weeks).  The 14-day relative strength index for the S & P 500 is below 25, which has tended to indicate an oversold market that would be due for at least a bounce.

For some time I have advocated maintaining above-average levels of cash reserves.  I'd use some of that cash this week to buy stocks in the U.S.  European stocks have been hit especially hard and offer long-term value, but I would wait for even better valuations there before making large purchases.

Steve Lehman

S & P 500:  1295

Thursday, May 17, 2012

Market Rebound Likely

Along with my recent suggestion to hold more cash than normal, I cited (on 4/18) the strong historical evidence to support a strategy of "Sell in May and Go Away."  The tendency of poor returns from the stock market from late spring to mid autumn might be skewed this year by another historical pattern, the presidential election cycle.  In years of presidential elections in the U.S. since 1900, there has tended to be a market correction in April and May, followed by a rally up to the election.

The 7% drop in the S & P 500 Index this month is consistent with the presidential cycle.  The stock market now seems oversold on a technical basis, and market sentiment measures have fallen sharply.  These two factors make it likely in my opinion that a rebound in stock prices is imminent, at least an oversold bounce.

This may not be a normal election cycle, however, as another political standoff over the U.S. budget and taxes looms by year end.  There could well be a significant increase in taxes and sharp spending cuts that would be a substantial drag on economic activity next year.

But for now, I suggest using some cash reserves--or even selling government or investment-grade corporate bonds--to add to stocks.

Steve Lehman

S & P 500:  1305

Friday, May 11, 2012

Trouble for Emerging--and Developed Markets?

The long-term case for emerging economies, their currencies, and their bond and stock markets has been compelling.  This has been reflected in excellent returns for their currencies, bonds, and stocks in recent years.  Faster economic growth, lower debt levels, and abundant natural resources are several reasons for long-term optimism compared to the developed economies.

But the Chinese economy--which has been a crucial source of demand for Europe and Brazil in particular--is slowing markedly.  Chinese economic reports have long been suspect, but even with an optimistic bias, challenges are appearing.  Chinese imports in April were basically flat, and exports grew only half as much as had been forecast.  A primary concern over the last few years was whether the rest of the world could satisfy China's voracious demand for raw materials and other commodities.  Warnings signs had been building, though, as China's fixed investment as a percent of its economy had significantly exceeded historical limits seen in other rapidly developing countries.  Now, with excess capacity in various sectors, demand for resources is slowing, along with economic output.

Though China and other emerging economies have worked to become less dependent on exports to Europe and the U.S., these regions still matter greatly.  And the economic struggles in Europe are now clearly affecting China (and the U.S., according to Cisco's quarterly results).

Unprecedented monetary policy expansion can still find its way to inflate market prices (note recent record prices for art and other assets).  But the economic underpinnings for stock markets are still not solid.

Steve Lehman

Thursday, May 10, 2012

Disturbing Cash Flow Trends

Cash generation by a business is of crucial importance.  Regardless of what profit and loss statements present, a business will not flourish--or even ultimately survive--if it doesn't generate sufficient cash for its operations, debt obligations, and to reward its owners.  The statement of cash flows also can be a useful check on the integrity of an enterprise's management.  As we have seen many times over the years, reported earnings can be manipulated by accounting techniques.  It is much more difficult to misrepresent the cash generation of a business.

So I found it disturbing to notice among the various first-quarter reports from companies that for a number of companies, there was a deterioration in the level of cash that was generated.  Or there was a disturbing disparity between reported profits and the amount of cash generated in the quarter.  I have concerns about the reported results of companies such as Coca Cola, CSX, Emerson Electric, DuPort, Caterpillar, Baxter, Nike, Pepsi, and Starbucks.

These concerns add to my caution about the current state of the stock market, though the recent selloff probably will be followed by a rebound.

Steve Lehman

S & P 500:  1355

Tuesday, May 8, 2012

Sotheby's: A Sign of the Times

Sotheby's, the venerable art auction house, is a reliable barometer in two ways:  for monetary conditions and the stock market.  When monetary policy is loose, cash finds its way to the art market, and prices get bid to astounding levels.

Sotheby's recently set a record for the most expensive artwork ever sold at auction, as Edvard Munch's "The Scream" sold for $119.9 million at a Sotheby's auction.  With monetary policies in many countries extraordinarily loose, such news is consistent with historical precedent.

Sotheby's stock also is a good barometer of broader conditions, as it tends to peak with the market and trough with the market as well, though to greater extremes.  It peaked near $60 a share in 2007 and above $50 in early 2011.  It troughed below $10 in 2009 and in the $20's in 2010 and 2011.  At today's price of $36, it is somewhat elevated--just like the broad stock market.

With Sotheby's stock--and the S & P 50--below record highs but well above trough levels of recent years, it is consistent with my view that now is not the time to take large positions in markets but to hold some cash in reserve for better buying opportunities.

Steve Lehman

S & P 500:  1363

Wednesday, May 2, 2012

The Maestro Returns

Former Fed Chairman Alan Greenspan, who was dubbed "The Maestro" at the peak of his influence before the housing bust and financial crisis ruined his reputation, opined on the stock market the other day.

He said stocks are "very cheap" and likely to rise.  However, he cited his widely used--but completely refuted by market history--"Fed Model."  The so-called Fed Model, which he invoked in the late 1990's, compares the "earnings yield" of stocks to the yield on U.S. Treasury Notes so as to assess the relative attractiveness of the two asset classes.  The earnings yield is the inverse of the p/e ratio.  So, with the S & P 500 now selling at about 13 times forecast operating earnings, 1/13 is 7.7%.  With the 10-year U.S. Treasury note yielding about 2%, that makes stocks look very attractive.

This is a faulty comparison for two basic reasons.  One is practical.  The Fed Model has not worked consistently over significant market history.  For example, interest rates in Japan early in the 1990's were basically zero, which of course made stocks look extremely attractive.  But stock prices declined over the next twenty years for a loss of about 70%.

Two, the return on stocks is not the earnings yield.  It is the dividend yield plus dividend growth, plus changes in valuation (p/e increases or decreases).  In addition, there are problems in using "forecast operating earnings," which are not audited and not in accordance with Generally Accepted Accounting Principles.  Real earnings are net income (after supposedly extraordinary charges for restructuring, e.g.).  Also, forecast operating earnings are almost always higher than earnings actually turn out to be, since Wall Street analysts tend to be too optimistic in their forecasts.  In addition, using next twelve months earnings when profit margins are perhaps at their peak produces high--maybe even peak earnings for this cycle--and reduces the p/e (and increases the earnings yield).  The Schiller p/e uses average earnings over the last ten years to smooth out the effects of the business cycle.  It currently is 25, which would give an earnings yield of 4%, not 7.7%.

Also, does it makes sense to use the U.S. Treasury note when rates are being artificially suppressed by government policy.  The AAA corporate bond yield would seem to be a better comparison, since stocks are risky assets--as are corporate bonds.   (Though many now think that U.S. Treasury notes are very risky because of the likelihood of large price declines from rising yields in the years ahead.)  

Using lower earnings would raise the market's p/e and lower the earnings yield (to 4%).  Using corporate bond yields of 4% would make bonds look much more attractive relative to stocks than in using the "Fed Model."

I do like to compare the dividend yield on stocks to the yield on bonds and on this basis, stocks are the cheapest in about 50 years.  But that assumes that bonds are the only alternative to stocks.  Now there are various asset classes available to even individual investors.  And don't forget about cash, which is the most attractive asset class near the end of a bear market.

My advice is not to follow the Maestro's lead.  There are stocks that are still attractively priced, but after a 30% gain in the S & P over the last six months, I'd wait for a correction before making large additions to stocks.

Steve Lehman

 S & P 500:  1405