America Bankrupt/Dangerous Market

We have maintained since late 2007 that both the U.S. and European banking systems are insolvent. Were they required to mark assets to market they would have insufficient assets to cover their liabilities - a basic definition of insolvency. Fortunately for the banks on both continents, central banks have waived the requirement to mark assets to market while the banks attempt to earn enough profits to (eventually) write down bad assets sufficiently to return to solvency. Meanwhile the Federal Reserve has been stuffing its own balance sheet with toxic assets purchased from U.S. banks in an effort to expedite the process. Unfortunately for U.S. taxpayers, the Fed is paying top dollar for toxic assets, ensuring that taxpayers will suffer billions in losses. One example should suffice to make the point. The Fed's Maiden Lane LLC purchased $30 billion from Bear Stearns in order to facilitate Bear's sale to JP Morgan Chase - Jamie Dimon refused to go through with the purchase unless the toxic assets were first removed from Bear Stearn's balance sheet. Outrageously, the Fed allowed Bear to value the assets sold it without so much as a cursory inspection.

The U.S. government is insolvent as well. The number's don't lie! Well, okay they do, but only because government bureaucrats keep changing the accounting treatment to hide the true extent of the situation from the public. The government uses a quasi-cash basis to produce its yearly deficit totals - 2010 is expected to run around $1.3 trillion (almost 10% of GDP!!!) when the numbers are finalized. However on a GAAP basis (using generally accepted accounting principles), the 2010 number is $2.1 trillion - more than 50% higher than the official number. Broader GAAP-based federal deficits that include the unfunded liabilities represented by Social Security and Medicare have been running between $4 and $5 trillion over the last three fiscal years (2010's deficit is approaching $5 trillion).

Now here's the really important part...

The U.S. government can't make up the annual shortfalls through higher taxes as, "there are not enough untaxed wages and salaries or corporate profits to do so," according to Dr. John Williams, a noted private economist. Nor can the government cut spending sufficiently without touching Social Security and Medicare. To wit; the government could cut all other spending and still not eliminate the deficit! The United States will default on some of its liabilities. It is simply a question of when and how. The most likely scenario for default is through a combination of inflation (paying debt off with less valuable dollars) and a reduction in social security and medicare benefits (reneging on promises already made). The public should plan for retirement accordingly...

Meanwhile, the U.S. market is very overbought on a short-term basis and expensive longer term. It is highly likely that we will experience a painful pullback at some point in the next two to four quarters. It is also increasingly likely that the 2011-2013 investing period will result in a loss for the U.S. market and that the next ten years will see returns of only 5% to 6% versus a long run average of between 10% and 11%. Consider the following:

1) S&P 500 more than 8% above its 52 week (exponential) average 2) S&P 500 more than 50% above its 4-year low 3) *Shiller P/E greater than 18 4) 10-year Treasury yield higher than 6 months earlier 5) Advisory bullishness greater than 47% with bearishness less than 27%. (Investor's Intelligence)

“The historical instances corresponding to these conditions are as follows:

1) December 1972 - January 1973 (followed by a 48% collapse over the next 21 months)
2) August - September 1987 (followed by a 34% plunge over the following 3 months) 3) July 1998 (followed abruptly by an 18% loss over the following 3 months) 4) July 1999 (followed by a 12% market loss over the next 3 months) 5) January 2000 (followed by a spike 10% loss over the next 6 weeks) 6) March 2000 (followed by a spike loss of 12% over 3 weeks, and a 49% loss into 2002) 7) July 2007 (followed by a 57% market plunge over the following 21 months)
8) January 2010 (followed by a 7% "air pocket" loss over the next 4 weeks) 9) April 2010 (followed by a 17% market loss over the following 3 months)

10) December 2010 ….?????”

*The U.S. stock market has experienced losses over the following three-year period one-third of the time when Shiller's PE is above 19.5 - the ratio is currently 22.7!

Biechele Royce Advisors is currently overweight cash in its models and is maintaining a strict sell discipline in order to limit price risk in its clients' portfolios. We continue to favor blue-chip, dividend paying stocks in the U.S.

Currency War!

On 11 October we wrote, "The Federal Reserve is going to print more paper dollars, likely beginning shortly after the November elections. The estimates from the folks in the know is a minimum of $500 billion to $1 trillion. The U.S. economy is currently around $14 trillion and public debt is around $12 trillion - so a trillion in freshly printed greenbacks is not small potatoes. Recent comments from the likes of Federal Reserve Vice Chairman Dudley and the recently released FOMC meeting minutes all but assure that the Federal Reserve will act soon and in size. The September/October stock market rally is telling us as much."

NAILED IT!

The Federal Reserve announced on 4 November that they would be buying $600 billion in government bonds beginning immediately and running through the middle of next year. The stated intention is to drive interest rates even lower in an effort to stimulate spending and job creation in order to fight the deflationary threat which the Federal Reserve governers insist is looming. Well, most of the Federal Reserve governers anyway.

In a rare public disagreement with the consensus, FED Governer Warsh announced that he isn't concerned about deflation, citing Dr. Allan Meltzer's position that there is no deflationary threat. Dr. Meltzer, the author of dozens of academic papers and books on monetary policy and the Federal Reserve Bank, issued a scathing critique of the Fed just last week saying, "All this is not relevant now, since there is no sign of deflation in the United States. The Fed's claim that there is a risk of deflation should embarrass it." Meltzer's views carry weight since he is considered one of the world's foremost experts on the development and applications of monetary policy. It's time to take notice when Meltzer derides Federal Reserve policy in such strong terms.

So what is the Federal Reserve up to if it isn't slaying the deflationary dragon?

Well, it is almost a certainty that its real goal is to debase the U.S. dollar, making it easier for the United States to pay back the trillions it owes to its citizens, to the Chinese and other sovereign nations, and also making our exports more competitive in world markets. Of course the U.S. can't publicly admit it is following a classic "beggar thy neighbor" policy. Fed Chairman Bernanke isn't about to own up, nor is Treasury Secretary Geithner. On the contrary, Geithner just appeared on CNBC and said (with a straight face) that, "“THE U.S. WILL NEVER DO THAT. WE WILL NEVER SEEK TO WEAKEN OUR CURRENCY AS A TOOL TO GAIN COMPETITIVE ADVANTAGE OR TO GROW THE ECONOMY.” …

So is the rest of the world buying the baloney? Not hardly...

China's Dagong Global Credit Rating Co. just cut its credit rating on the U.S. to A+ from AA because of the Fed's plan to purchase bonds to spur growth and inflation. Dagong Global wrote, "The credit outlook for the U.S. is negative amid deteriorating debt repayment capability and a "drastic" drop in the government's intention to repay debt. The Fed's quantitative easing policy will erode the value of the dollar and is against the interests of creditors." Ouch!

And here is what German Finance Minister Schaeuble had to say about QE2 in an interview with Spiegel magazine last week, "I seriously doubt that it makes sense to pump unlimited amounts of money into the markets. There is no lack of liquidity in the US economy, which is why I don't recognize the economic argument behind this measure." He went on to say that, "It's inconsistent for the Americans to accuse the Chinese of manipulating exchange rates and then to artificially depress the dollar exchange rate by printing money."

It would appear that the rest of the world understands very well what is going on. But why should the U.S. consumer care if the rest of the world is getting hosed (with dollars)?

INFLATION!!!!!!

Gold is saying the inflationary threat is real, reaching more than $1400 per ounce before pulling back (temporarily most likely). Although it is always difficult to forecast price levels, it is quite possible that gold will reach $2500 per ounce within a few years if the Federal Reserve continues in its madness. The bottom line though is that inflation is bad for savers and good for debtors and U.S. savers will suffer right along with the Chinese, Germans, and Japanese. Inflation erodes wealth. Inflation destroys middle classes. U.S. citizens will suffer greatly in coming years as their purchasing power is dramatically eroded by the inflationary genie that the Federal Reserve appears determined to let out of its bottle.

Biechele Royce Advisors builds properly diversified portfolios using individual stocks and bonds whenever possible to reduce costs. We are currently overweight tangible assets such as real estate, precious metals, and commodities as well as non dollar assets, including international stocks and bonds. It is our belief that Inflation is coming and it could get pretty ugly if Bernanke and his lunatics continue to run the asylum.

Quantitative Easing a.k.a Money Printing

The Federal Reserve is going to print more paper dollars, likely beginning shortly after the November elections. The estimates from the folks in the know is a minimum of $500 billion to $1 trillion. The U.S. economy is currently around $14 trillion and public debt is around $12 trillion - so a trillion in freshly printed greenbacks is not small potatoes. Recent comments from the likes of Federal Reserve Vice Chairman Dudley and the recently released FOMC meeting minutes all but assure that the Federal Reserve will act soon and in size. The September/October stock market rally is telling us as much.

Will quantitative easing(QE2) more effectively stimulate consumption the second time around? After all, the Federal Reserve is estimated to have bought $1.5 trillion in bonds and mortgages between 2008-2010 during the first money printing exercise. Nevertheless, and despite $860 billion in fiscal stimulus thrown in by Congress, final demand grew at only a 1.3% rate in the first four quarters of recovery.

Although the public might not fully appreciate it, the Federal Reserve is boldly going where no central bank has gone before - and the unintended consequences could be disastrous. But what exactly is the Fed trying to accomplish with its radical departure from orthodox central banking? According to a Goldman Sachs report covering a Q&A session with Vice Chairman Dudley, successfully pushing interest rates down will allow those who are able to borrow to do so at lower rates, freeing up some of the income now being spent on debt service. Perhaps more importantly, QE2 will work on other elements of financial conditions, including equity prices and the exchange rate.

And there you have it. QE2 is intended to push the U.S. stock market higher and the dollar lower. The Federal Reserve is targeting the stock market and the dollar... and the smart money knows it, which goes a long way in explaining the recent stock, gold, and commodities rallies. Furthermore, Wall Street investors are also front running the Federal Reserve in the bond market, pushing rates lower without help from the Fed, but with the understanding that the Fed has their backs. (Not coincidently, the Federal Reserve began to signal its intention of carrying out another dollar debasement campaign in early September, just as the S&P 500 looked ready to test the early July low at 1003.)

But what could go wrong? Well first, it is possible that the Federal Reserve QE2 program will be smaller than expected, which would likely result in a bond market sell off. Rising rates could quickly end the stock and commodities market rallies as an already sluggish (contractionary?) economy reacts poorly to a higher interest rate environment. Conversely, the Fed may move HUGE and actually succeed in pushing interest rates down to the point where a falling dollar begins to generate significant inflation. In the latter case, you can expect interest rates to once again start to rise as inflation takes hold. Private bond investors will run for the exits, once again front running the Federal Reserve (with its now even bigger inventory of government bonds).

Who will the Federal Reserve sell to in order to reverse its successful inflation generating policy? What private investor is foolish enough to step in front of that kind of supply? Not the Chinese, who've let Washington know in no uncertain terms that they are opposed to another round of dollar debasement. Yet, unless the Federal Reserve can find a willing buyer for its trillions in bonds, it can not start to drain money from the economy and prevent inflation from ripping out of control. Unfortunately for stock investors, the second scenario will also likely lead to a stock market sell off due to the negative impact rising inflation and interest rates will have on the economy.

All in all it seems to us that investors would do well to sell into the current stock, bond, and commodities market rallies, locking in profits and preparing for a better buying opportunity down the road. Biechele Royce Advisors continues to hold higher levels of cash than normal in its client accounts because we continue to struggle to find good businesses available at great prices.

(Fun Fact: The U.S. stock market has now lost about 80% of its value in gold since the secular bear market began in March of 2000. We see the trend continuing.)

Debt, Inflation, and Governments

The S&P 500 may motor higher if the Federal Reserve implements an aggressive Quantitative Easing program as is increasingly likely. The July bottom may hold and the S&P 500 may take another run at the April 1219 high. Or perhaps the Federal Reserve will wait too long and the combination of a weakening economy and (still) overpriced market will lead to further selling, taking the S&P 500 back to a three digit number in coming months. Predicting short term market movements is a difficult task at best, in part because policy decisions yet to be made can greatly influence the market's path. For the record: we are of the opinion that the probabilities favor a sell off back below 1000 as the market digests the implications of a weakening economy and weaker than expected corporate profits. However, we are far more confident about our prediction of rising inflation in the years to come...

Next year the Federal Government is expected to spend approximately $3.8 trillion, exactly twice as much as the 2001 budget of $1.9 trillion. Amazingly, the federal government has managed to double its size in just one decade. Further, the U.S. has almost doubled its national debt in just the past 7 years. It now totals almost $120,000 per taxpayer. Unfunded liabilities, such as social security and medicare, equate to approximately $355,400 per U.S. citizen. Clearly the United States will default on some of its obligations because there isn't any way that every man, women and child in the United States of America can generate that amount of cash in time to meet all of those obligations as they come due!

But the form of default is critical because it determines who bears the burden, since not all defaults are created equally. For instance, the U.S. government could choose to default on its public debt, leaving foreign governments and U.S. bond investors holding the bag while John Q. Public escapes unscathed. Another option is for the government to renege on some of its social security and medicare promises by curtailing benefits, which means the elderly and poor would bear the brunt of the default. Or the government could decide to let inflation run wild, thus devaluing ALL of the debt it owes to everyone. Savers bear the brunt of this defacto default while debtors cheer (paying debt back with cheaper dollars is much easier to do).

It should be obvious which option is easiest politically. And in fact, inflation has always been the choice of every government everywhere throughout recorded history when too much debt was accumulated. The Federal Reserve has ballooned its balance sheet from $850 billion to $2.3 trillion in the last year or so and will likely explode it again to around $4 trillion over the next year if QE2 is implemented, as is increasingly likely. What is highly unlikely is that the same Fed who failed to see the tech and housing bubbles form, will successfully pull off what amounts to a high wire artist performing without a safety net... blindfolded... as it attempts to siphon all of that extra cash back out of circulation once it deems the economy rescued....

Biechele Royce Advisors continues to overweight non dollar and real assets and under weight fixed income and financial assets. We also continue to strongly prefer dividend paying stocks, which make up the bulk of a stock investor's return in secular bear markets....

Increasing Weakness

The S&P 500 is down almost 4% since we last blogged about the increasing likelihood of renewed recession and market weakness. Unable to retake the flattening 200-day moving average a second time, the market sold off and is now 2.5% below the 50-day moving average. Further, the 20-day moving average is set to fall below the 50-day, which would put the four main moving averages (200, 100, 50, and 20) in bear market order. The Japanese Nikkei is already in a bear market. The S&P 500 was down almost 18% at its low in early July and looks increasingly likely to retest it - and fall below 1000 on a failed retest. Our forecast is based on our outlook for the economy, which continues to show every sign of falling back into recession.

Our December 2009 forecast of at least a 20% pullback in the S&P 500 sometime in 2010 looks increasingly like another solid win for the home team. We had written that the spring of 2010 was the most likely time (missed it slightly as the pullback stopped at 18%) and that the fall was next most likely. Our belief in a 2010 bear market stemmed from a few basic observations. First, the 2009 market recovery went further and faster than any bear market recovery since 1933, leaving the S&P 500 about 35% overvalued based on a number of long term valuation metrics (metrics Wall Street doesn't like to acknowledge because it gets in the way of them selling product to the unsuspecting public). Second, the economic recovery touted by the Fed and the Obama administration just wasn't supported by the numbers. Inventory swings were the main factor in the positive GDP numbers in Q4 of 2009 and Q1 of 2010. Final demand remained punk, as you would expect given the huge debt load born by the consumer, the lack of credit formation, and unbalanced make up of GDP (the consumers' share had grown to a record 72% during the spending orgy and is likely to fall back to a more sustainable 66% or so in the coming years).

Pair an overvalued, overbought market with an under performing economy and you are likely looking at poor market action going forward - which was our call in December 2009 and remains our call today. Market performance in 2010 has more than justified our cautious stance coming into the year. And unless the Federal Reserve gets busy printing more paper, the S&P 500 looks increasingly like it will sink to new lows for the year. The market is unlikely to test new lows for the secular bear market that began in March of 2000 however, because the Fed is clearly targeting the stock market now as a source of wealth and will eventually get around to supporting it. The Fed is likely to act sooner rather than later with renewed quantitative easing - given Bernanke's latest statements - and that just might give the market a lift into year end, but perhaps starting from the 850-900 level....

Biechele Royce Advisors continues to advocate proper diversification among all major asset classes with emphasis on blue-chip dividend paying stocks in the U.S., tangible assets, and nondollar assets. We continue to believe that inflation will pose a major threat to wealth preservation over the next ten years. Finally, we offer another reminder that secular bear markets require a focus on capital preservation first and capital appreciation second…

Posted by Chris Norwood, CFA(R) at 8:42 AM

Recession Looming

We did get the short term pullback predicted in our 14 July blog. We referenced the 20-day moving average sitting at about 1075 as a likely destination. The actual decline bottomed on 20 July at about 1060 before the S&P 500 motored higher once again, retaking the 200-day moving average in the process. Unfortunately, the S&P 500 was unable to maintain above that long term trend line, peaking at 1130ish in early August, before sliding back below the 200-day (We had written about strong resistance in the 1100-1130 area likely putting a lid on the stock market for the foreseeable future).

The stock market has essentially gone nowhere since last October, validating our concerns about an overpriced market that had climbed too far and too fast after the March 2009 bear market bottom. We have stated repeatedly since last October that it is a high risk market and investors should proceed cautiously. We are even more concerned today because the market has now put in a ten month top and a broad decline is increasingly likely in the fall, or next spring at the latest. It increasingly appears as if distribution is occurring whereby professional investors distribute shares to the public, leaving the public holding the bag when the market decline starts in earnest. One indication of distribution is On-Balance-Volume (OBV), which is showing a negative divergence over the last few months, portending coming weakness.

But what is the fundamental case for a broad stock market decline? Well, how about a return to recession? The probability of another recession (or continuation of the one which started in early 2007) is quite high. Real M-3 (the broadest measure of money supply) is still contracting strongly year-over-year. Recession has followed 100% of the time when real money supply contracts on an annualized basis, typically with a six to nine month lag. As well, the ECRI is now contracting sharply and, again, recession has followed 100% of the time when the contraction is as sharp as now. Likewise, real retail sales are weakening with July real retail sales growth essentially zero - opening up the possibility that Q3 real retail sales will turn negative. Furthermore, a surprisingly bad June trade deficit number will result in a reduction in reported Q2 GDP. The deteriorating trade balance also increases the likelihood of a negative Q3 GDP number. Finally, a developing contraction in housing starts, along with deterioration in a slew of other housing numbers, adds further pressure to an economy already under siege.

Expect a retest of the recent 1010 low on the S&P 500 with a likely decline into the 800 to 900 area within the next six months. Investors should continue to proceed with extreme caution in a very high risk market.

(A major caveat: the Fed appears likely to initiate a new quantitative easing program sooner rather than later, which would provide major support to the stock market, at least in nominal terms.)

Short Term Top

The S&P 500 continued to fall until finding support just above 1000 (big round number), which we suggested might happen in our 30 June blog. The S&P 500 then rallied furiously over the next nine days, gaining 9% before running smack into the leading edge of resistance yesterday. (Also noted in our last blog - 1100 to 1130). The S&P tested 1100 yesterday and again today but has been unable to punch through. A couple of positive earnings reports from Alcoa and Intel have probably helped hold the index aloft, but it certainly looks as if the market is getting ready to move lower very short term - likely back to the 20-day moving average sitting around 1075.

More broadly speaking, the S&P 500 is now firmly entrenched in a downtrend and would need to break above about 1130 to renew any semblance of short term upside momentum. To the downside, the recent low of 1010 is likely to be tested in the coming months as increasing weakness in the economy translates into disappointing earnings. We are maintaining our price discipline, selling stocks as they approach fair value and buying stocks only when we believe we have a sufficient margin of safety to warrant taking the risk of adding new positions in what remains a high risk market.

Market Top

We warned in our 1 June blog that the market was likely to test 1000 (big round number) and then 950 (top of the bear market base) by the fall. We think the evidence, both fundamentally and technically, has grown stronger for more downside testing since our warning. Real money supply, as measured by M-3, is still contracting sharply (May annual real contraction 7.9%). Real retail sales are softening, falling in May by 1.0%. There are indications that the housing market is softening once again and that home prices are likely to turn lower. For instance, May's existing home sales according to the National Association of Realtors (NAR) showed a monthly contraction of 2.2% when a strong upside gain had been expected. The Federal Reserve has taken note of the softening economy by inserting language in its most recent communique that, "Financial conditions have become less supportive of economic growth on balance, largely reflecting developments abroad."

Rumors are already surfacing that the Fed is preparing to reinstate quantitative easing (QE), which would continue to sow the seeds of future strong inflation, but also put a floor under the stock market once again...

Quantitative easing is the process of buying our own debt in order to force more paper money into the economy. The Treasury issues bonds and the Fed buys them with money it prints expressly for that purpose. It is a sure fire way to create inflation.

Technically the market continues to weaken, with a breach of the 1042 level occurring Monday, 29 June. Tops take more time to form than bottoms typically, and the topping action is now about six months old, sufficient time to build up overhead supply to the point where the market is no longer capable of pushing higher without first selling off more substantively. Specifically, there is now stiff resistance in place in the 1100 to 1125 area that isn't likely to give way anytime soon. Meanwhile, downside risk is 800-900 at some point either later this year or by early next year, assuming our forecast of another recession is accurate AND the Fed doesn't go back into full blown QE mode. (Normally, I would acknowledge the likelihood of the S&P 500 moving below fair value - 850ish - as the secular bear market finally plays itself out completely and the market hits its ultimate low, but our activist Fed makes that scenario a remote one)

Investors should continue to proceed with caution in what continues to be a high risk market....

Picking Stocks Revisited

A friend suggested that I write about how to pick stocks in which to invest. Regular readers are aware that I frequently write about the economy and the markets (and have correctly forecast the current market turmoil in 2010). The reason that I shy away from writing about individual stocks is because I don't want my readers going out and purchasing them on their own. Knowing when to buy a stock is only half the investing equation. It is also important to know when to sell, and I can't be there to make that call for you - unless you are already a client of course. Nevertheless, I will update you on a stock I wrote about back in October of 2008 in order to better illustrate the art of stock picking, but first an update on the market.

Our most likely scenario for the remainder of the year is the continuation of an oversold bounce that takes the S&P 500 back to the 1150-1175 area before renewed selling takes us lower into the fall. Of course, it is also possible that the bounce is over already and we are headed lower now. Regardless of the eventual path, it is quite likely that the S&P 500 will test 1000 (big round number) and then 950 (top of the bear market base) before the year is over. Why? Well because it is quite likely that we are headed back into recession as the effect of the fiscal stimulus runs its course and the tremendous burden of U.S. debt reasserts itself. The stock market is merely a reflection of the underlying economy. A weak economy will eventually lead to a weak stock market - absent additional stimulus from the government (which can't be ruled out). Okay, now on to individual stock picking...

Below is an analysis I wrote of Intel in October of 2008. It well illustrates the thought process involved in seeking out good businesses at great prices. (Please skip down to the last couple of paragraphs of the blog for a summary if you aren't into the nitty gritty of analysis).

INTC $14.28 Intel closed today at $14.28 per share, but not before touching $13.37 intraday – a new 52-week low. The company is paying a dividend of $0.55 per share for a current yield of 3.85% and is expected to raise its dividend to $0.61 per share in 2009, according to Value Line – should reality meet expectations INTC will yield 4.27% for anyone buying at the current price, or some 40 basis points or so more than the 10-year Treasury. Now, of course, Intel common stock is riskier than holding a 10-year Treasury to maturity (although that premise seems increasingly uncertain given our government’s loose spending habits). On the other hand, we get much more than a debt instrument that pays par upon maturity when we buy part ownership of a company. We also get a growing stream of shareholder cash flow that can be returned to us by management either with increasing dividends, share buy backs or both.In fact, INTC will pay out around $1.19 per share in 10 years if management raises the dividend 8% per annum during that period – only one quarter the growth rate of the last 5 years. Anyone buying and hold Intel’s stock for the decade will then be earning 8.3% per annum on their original investment. Now compare that juicy 8.3% to the measly 3.85% you can currently earn holding the U.S. 10-year note… and you quickly get it – Intel is a raging buy at the current price as long as the company is around in 10 years and as long as management is able to continue to grow the dividend. And our analysis doesn’t yet include the possibility of additional cash that might be available to oh, say, buy in stock, resulting in the dividend yield rising even faster.In Intel’s case, a quick check of current year estimates reveals that the company will have approximately $0.55 per share in excess cash after paying its dividend and meeting its capital expenditure requirements. A three year average is often useful in ascertaining a company’s ability to throw off excess cash consistently. According to Value Line, Intel has generated approximately $5.66 in cash flow from 2006 to 2008, while making $2.76 per share in capital expenditures and paying out $1.41 per share in dividends, leaving approximately $1.49 per share in excess cash available to buy back shares, or $0.50 per share per annum. Adding the $0.50 in excess cash to the current $0.55 dividend gives you a current dividend yield of 7.35% (what the dividend yield would be if INTC management devoted all of its excess cash to the dividend). Unfortunately, Intel, like many management teams, often choose to buy back shares with excess cash. We think it unfortunate, because managements tend to pay top dollar for their own shares rather than waiting to buy in shares after their stock takes a dive. Nevertheless, buying in $0.50 per share per annum retires 3.5% of the outstanding shares at the current stock price (call it 2.0% net of stock option issuance), raising current and future dividends accordingly.Yet another way to do the math without the distortion of a changing share count: Intel generated $34.2 billion in Cash Flow After Taxes (CFAT) during the three years ending in 2007, against $17 billion in Capital Expenditures (CAPEX), leaving $17.2 billion available to shareholders. The entire company was available for purchase for a mere $154 billion at the beginning of 2008 (you could buy it lock stock and barrel right now for $82.8 billion). Taking the three year average shareholder cash number of $5.7 billion and dividing it into the current fully diluted shares outstanding gets you $0.99 per share in stockholder available cash – a nice current yield of 6.9%, some 3.1% better than the 10-year’s current yield.A couple ways then of looking at the yield to shareholders currently and a decade into the future in comparison to the 10-year Treasury – all favorable. We just need to make a judgment on whether INTC is likely to be around and prospering a decade from now.The company is currently the world’s largest semiconductor chip maker based on revenue, according to its 2007 10K SEC filing. INTC develops advanced integrated digital technology products, primarily integrated circuits, for industries such as computing and communications. Intel also develops platforms, which they define as integrated suites of digital computing technologies that are designed and configured to work together to provide an optimized user computing solution compared to separately. Intel currently controls about 80% of the PC processor market.For starters, Intel has grown revenues from $30.1 billion in 2003 to an estimated $40.4 billion in 2008, or a little over 34% during the five year period. Net profit is forecast to hit $7.3 billion in 2008, up from $7.0 billion in 2007 but well off the company’s peak profit logged in 2000 ($10.7 billion). Nevertheless, profit has grown steadily, albeit erratically, since the bottom fell out during the last recession in 2001 (profits bottomed in 2002 at $3.5 billion).Clearly the company is likely to still be in business and growing earnings given its dominating position in the microprocessor industry and strong balance sheet (almost 13 billion in cash on the balance sheet at the end of 2007). On the other hand, just looking at the increasing variability in earnings leads one to the conclusion that the company is no longer a true growth company and should be bought after business conditions (and the stock price) have weakened and sold when investor enthusiasm carries the share price outside of the realm of reasonable valuation. We believe the current valuation is in the buying zone, given our discussion of dividend and shareholder yields.

Whew! So what did Intel do in the 20 months since I wrote that analysis? Well, it bottomed at around $12 per share
in November of 2008 and retested that low in March of 2009, before marching to a 52-week high of $24.36 in April of 2010. Investors who bought INTC on my recommendation in October of 2008 would have made a pretty penny, earning over 50% on their investment (including the dividend) during the 20-month holding period (assuming they still owned the stock, which currently trades at $20.81). Had they sold the stock last fall when the return hit 50%, they would have earned approximately 55% annualized on their Intel investment. (My personal investment hurdle is the likelihood of earning 50% within two years. I regularly take my profits when I hit my target because business valuations simply don't change that quickly, making it highly likely that my initially undervalued business is no longer cheap enough to hold for the long-term without taking on too much price risk).

One other thing about investing in individual stocks....

You don't find good businesses at great prices among stocks hitting 52-week highs. You do find them among stocks hitting 52-week lows. I'm currently building a rather large position in a big blue chip S&P 500 company that recently lost over half its value due to a short term (in my opinion) problem with its business. My math tells me that I have a high likelihood of earning my 50% hurdle over the next few years.....

Bear Market?

We warned in December of 2009 of a likely correction in 2010 that could reach 20%, writing that it was most likely to occur in the first couple of quarters of 2010. "To summarize, we see a correction in the stock market sometime next year that could hit 20% and is likely to occur sometime in the next few quarters." (December 19th 2009). The S&P 500 has fallen just shy of 15% so far at its May 25th low.

We wrote about the high risk nature of the current U.S. stock market, first in February of 2010 and then again in March. On February 18th we wrote, "Further deterioration in the chart - in particular a breach of the recent 1042 low - will likely cause additional profit taking that could lead to our predicted 20%-30% 2010 decline." Finally, we wrote on May 19th that, "Prudent investors would do well to heed the warning shot that was fired on 6 May 2010, it quite likely presages more trouble to come...." (Six days later the S&P 500 hit a new low for the correction of 1040 inter-day, after falling almost 7% in just four trading days).

The wise guy traders (which includes just about everyone these days it seems like) bounced the market hard off the 1040 level on 25 May, making the 1040 area a line in the sand, a breach of which is likely to trigger a further round of selling. The bad news is that the S&P 500 recently failed to take back the 200-day moving average during last week's three day bounce and is setting up for another test of the now critical 1040 area. A close below 1040 opens the way for further declines, first to the big round number (1,000) and then to support at 950. It is possible that the market will rally out of its current very oversold condition first, which would delay any sell off to the 950-1000 level likely until the fall. (Even if an oversold rally does materialize, taking the S&P 500 back to the 1200 level, it is likely that the market will eventually test 1000 and perhaps 950 in the fall as the stalling economy pressures stocks.)

Now, the technical mumbo jumbo is a useful guide primarily because so many professional money managers utilize it. Mutual funds are speculative vehicles these days, turning their portfolios over 80% per year on average. The short term focus puts pressure on managers to track the technicals, making them a self fulfilling prophecy to some extent. It was no coincidence that the market bounced hard from the 1040 level. Everyone can read a chart and everyone could see that the February 1042 low was sitting out there as support. Likewise, it is no coincidence that the S&P 500 recently traded back to the 200-day and failed. Mutual fund managers see the 200-day there and place sell orders accordingly, creating resistance.

Fair value for the S&P 500 is still in the 850-900 area. A return to that level by the fall is still a real possibility and a decline to 950-1000 a fairly high probability event. Hopefully your advisors haven't ignored the high risk market and kept you fully invested over the last few months. Hopefully they too recognized, by late last year, that risk levels were building and prudent risk management was in order. Wouldn't it be nice if you had some cash built up already with which to buy good companies at great prices? Biechele Royce Advisors values price discipline above all else, knowing that the only sure way to outperform is by consistently buying assets for less than they are actually worth. Cash builds up on our clients balance sheets when we can't find undervalued assets to buy - that cash is available to put to work when assets sell off and good companies can be had again for great prices.... perhaps by this fall.

A Thousand Point Warning Shot

Many of you have probably heard that the Dow took a thousand point dive a few weeks ago. You might have also heard that a fat fingered trader might have been responsible for pushing the wrong button and setting the mini-crash in motion. Hopefully you aren't buying the urban legend...

First of all, real life trading doesn't work that way. It is not possible for a single, inadvertent keystroke to set off a market meltdown. Wall Street knows it and the political weenies likely know it as well. However, it does make for a good cover story to distract the masses from a far more worrisome reality - that the market is running on vapors and is increasingly exposed to the reality of an impending worldwide economic slowdown.

The government's search for a fat-fingered trader is a comical and ironic distraction. Of course, it is serving a purpose - keeping the masses entertained while also keeping the public from wondering if perhaps there is a fundamental reason for the market's brief crash. After all, it is far less worrisome to many to pin the meltdown on an "accident" than it is having to acknowledge that perhaps there is a pervasive, deep-seated rot setting in.

But where's the irony? Well, try this on for size. The government's witch hunt is focused on who might have pushed the wrong button to send the Dow careening 600 points lower in a matter of minutes (it was already down 400 points or so as a result of the steady, heavy selling that led up to the meltdown) rather than on who might have ridden to the rescue with heavy blasts of futures buying. Profit seeking traders are not known for a willingness to catch a falling knife, nor are they likely to willing place themselves in the way of a massive market meltdown. Who, then, stepped up and turned the tide with relentless, massive futures buying, even as the Dow's decline accelerated to four-digits? Perhaps the government should look into who jacked the market up 600 points in a matter of minutes? Perhaps the government already knows....


No, Fat-fingered Freddie didn't cause the market to plunge. What did do it was steady, heavy selling from nervous money managers who are beginning to see the writing on the wall. Tops take time to form and we may have started doing just that over the last few months. Sure the S&P 500 exceeded it's January high in April, but it has already retraced that gain and is currently trading below the January high and just above a flattening 200-day moving average. Furthermore, the 20-day has recently dropped below the 50-day moving average, portending continued market weakness, at least for a few more weeks. The 200-day lies in the vicinity of 1100, a big round number in its own right, making that level very important to traders (and that's most everyone these days). Finally, we've had ten days of well above average down volume since the middle of April, a sign that smart money is exiting. All in all the weight of the evidence suggests a very cautious stance is warranted from a technical point of view.

Fundamentally, the picture is even more worrisome. Europe is in trouble and contractionary forces there are likely to intensify in the coming quarters. The effects of the EU's self described Bazooka (the pledge of a 750 billion Euro backstop to Europe's banks) are already fading as the Euro is weakening again and approaching four-year lows, even as sovereign risk spreads have started to widen, despite intervention from the European Central Bank (ECB). The massive rescue package is as ill-conceived as the U.S. TARP effort (which led to a short term bounce in the stock market but saw an eventual 50% additional decline in the S&P 500 after the short-covering rally faded).

The ECB's proposed 750 billion Euro bomb is a declaration that they stand ready to buy almost $1 trillion dollars worth of distressed Euro-area debt in order to preserve the Euro. Of course, they are also on record as stating that they will sterilize the transactions to prevent the Euro from debasement (750 billion Euros let loose in the EU could create inflation on a massive scale if the transactions were left unsterilized). But that means the ECB is planning to, "debase the quality of its balance sheet by exchanging higher quality Euro-area debt with lower-quality debt of countries that are ultimately likely to default," according to Dr. John Hussman.

Now if that M.O. sounds familiar, well it should, since that is exactly what the Federal Reserve has done over the last couple years in the U.S. The Fed has exchanged U.S. Treasuries for the toxic assets residing on U.S. bank balance sheets, prostituting its own balance sheet in the process and setting the U.S. dollar up for a massive decline in value going forward.

But the worldwide debasement of paper currencies and the ultimate high inflation rates that will follow is for later. For now, it is likely that the EU economy will slow and eventually fall back into recession. Likewise, China is showing early warning signs of an impending slowdown. Finally, the U.S. economy is very likely to return to recession within the next quarter or two, based on the ongoing contraction in real money supply that began last December. Which gets us back to a much more reasonable explaination of what caused the Dow's thousand point drop. Rather than pointing to Fat-Fingered Freddie, we should instead be acknowledging that the professional money managers, who have composed the bulk of the historic rally off of the March 2009 lows, are beginning to edge toward the exit, and that their selling temporarily overwhelmed buying from the public. It's well known among traders that when an overcrowded trade reverses it often does so violently and to excess. Prudent investors would do well to heed the warning shot that was fired on 6 May 2010, it quite likely presages more trouble to come....

Beware Bonds!

Most individual investors are mostly wrong most of the time... It's a phrase I borrowed from well-known economist Dr. Marc Faber. The available evidence is pretty damning - for instance, individual investors captured only about one-third of the gains during the great secular bull market of the 80's and 90's, according to Dalbar, a Boston research firm, returning a mere 5.23% per annum from 1984 through 2000 even as the S&P 500 returned 16.3%. Behavioral finance explains much of what's wrong with the decision making among individual investors. The heuristics used by people to get through life - stereotypes, intuition, rules of thumb, just don't work well when investing. For instance, it turns out that good companies often make bad investments and that bad ones often make very good investments!

But we wrote about all of this in the 4th quarter of last year; why bring it up again so soon? Because individual investors piled into bond funds at a record clip last year and anecdotal evidence suggests that they are still at it even though the bond market is likely to get hammered hard here starting sometime this year if the economic recovery is for real. The 10-year Treasury has already risen steadily from its intra-day low of 2.06% set on 31 December 2008 to a current level of 3.74%. It will likely challenge it's 2008 high of 4.25% in short order. A move above 4.25% opens the way for a run into the high- 4s, a decidedly unappealing development for bond investors and home buyers alike.

What is the fundamental argument for higher interest rates though? Well, it centers around basic supply and demand dynamics. The U.S. government is likely to run a $1.4 trillion deficit this fiscal year (10% of GDP) and foreign investors can only be expected to absorb about $300 billion, leaving a monstrous $1.1 trillion of debt for domestic investors to finance. There aren't enough domestic savings to absorb that much new supply, which means interest rates will rise as demand fails to meet supply. Last year the Federal Reserve bought most of a similar amount of supply, but Bernanke is on record as saying the Fed is done with its quantitative easing and is out of the market.

A second fundamental argument for rising rates centers on the expected economic recovery. An expanding economy requires an increase in the velocity of money, assuming a constant money supply. Inflation will rise (and with it interest rates) as the velocity of money accelerates unless the Federal Reserve successfully reduces the money supply in a timely fashion, which will require them to raise short term rates aggressively. The combination of huge new supply and an expanding economy will likely prove a toxic mix for bond investors.

A second possibility, of course, is a failure of the economy to maintain a strong growth trajectory as the existing heavy debt load remains too onerous to allow any economic momentum to persist. A slide back into recession late this year or early next (our forecast) will result in continued huge deficit spending by the U.S. government and even more supply hitting the Treasury bond market as result. The Federal Reserve is highly likely to re-enter the bond market either directly or indirectly (with an assist from Treasury - courtesy of taxpayer money - through Fannie Mae and Freddie Mac for example ). The result of the latter scenario would be continued low rates (although not necessarily falling rates) for another year or two. The one major fly in the ointment in the second scenario hinges on whether foreigners will continue to support the dollar in the foreign exchange market. There is increasing evidence that foreign central banks are slowly edging away from the dollar as a reserve currency. A run on the dollar would likely cause interest rates to sky rocket as the U.S. is forced to beg for bond investors to take debt off its hands at any price.

Either way, interest rates are set to rise sharply over the next five to ten years; it's only a question of whether that climb begins now, on the back of a sustained economic recover, or in a few years, after another round of heavy fiscal and monetary stimulus. Bond investors will need to decide when to lighten up on bonds because those who stay in the Treasury bond market overly long will almost certainly get flattened by the approaching runaway train.

Individual investors, who increasingly seem to believe that Treasury bonds are a risk free investment, will wake up one day to the awful realization that they can lose large amounts of money in the bond market too....

The Importance of Estate Planning

Accumulating wealth for retirement is a basic goal of every investor. For many people, the vast majority of their retirement wealth is contained in a tax deferred or tax free investment vehicle. In fact, it is not at all uncommon to run across a couple with 80 to 90% of their entire networth in either 401(k)s, IRAs, Roth IRAs, or some combination of the three. Furthermore, many of these diligent savers go to great lengths to ensure that they maximize their tax-deferred contributions and invest those assets as prudently as possible to maximize wealth in retirement. Why then do so many investors fail to fill out even a few of the most basic estate planning documents to ensure that their nest eggs are used as intended in life, and make it intact to their loved ones upon the investor's death?

One quick example of the latter instance (passing assets along to the next generation) should suffice to show the importance of making sure you do the paperwork. The beneficiary form is easily the single most important estate planning document when dealing with IRAs and Roth IRAs. The beneficiary form controls who will get the investment portfolio and how long they will be able to keep it. What a shame if your loved ones don't get assets intended for them or can't take full advantage of the tax deferred feature of an IRA, or tax free feature of a Roth. Yet it happens all of the time because people fail to fill out a simple beneficiary form, instead relying on their will to take care of the distribution of assets after their death. Here's the problem though!

An individual who inherits an IRA without being named on the beneficiary form will not be considered a designated beneficiary, and that makes a HUGE difference. (An estate has no life expectancy and is never a designated beneficiary even when it is named as the default beneficiary, which is common in plan documents) Inherited IRAs and Roth IRAs must be emptied within 5 years of the death of the owner if the owner dies before the Required Beginning Distribution (RBD) date (always the case in a Roth since there is no RBD). Think about what that little oversight - not filling out a beneficiary form - just cost your heir! Rather than being able to allow assets to continue to grow tax-deferred for decades longer, your heir will be forced to empty the IRA - AND PAY INCOME TAX - no later than 31 December of the fifth year following your death. It's even worse when dealing with a Roth IRA since assets in a Roth can be held tax free and allowed to compound for decades as the beneficiary stretches out tax-free distributions over their lifetime, making for a considerably larger ultimate transfer of wealth between generations.

Failure to fill out a simple beneficiary form for your IRA or Roth IRA is just one example of an estate planning oversight that can cost your family dearly. Take a few minutes to review your beneficiary forms to make sure it doesn't happen to you. And then take some time to review your other estate planning documents as well....

High Risk Market STILL

The S&P 500 is overvalued by about 25%, but you wouldn't necessarily know it if you listened to the mass financial media. Fair value for the S&P 500 is around 900, based on how the market has been valued historically using 10-year trailing earnings as a measure. Again, you might be lulled into thinking the market is undervalued if you spend too much time listening to CNBC (Heehaw), or reading the likes of Barron's or the Wall Street Journal. Likewise, many of the brokerage firms are busy talking to clients and telling them now is the time to buy, buy, buy!

The only problem with that self-serving assessment is that it probably isn't true. Again, the S&P 500 is about 25% overvalued if history means anything at all. One of the best long-term measures of stock market valuation is the Price-to-Earnings (P/E) ratio, based on trailing 10-year average earnings (commonly known as Shiller's P/E). The current Shiller's P/E is about 20, well above the long run average of 15x - 16x, putting the current market in the top quartile in terms of EXPENSIVE. But why should you care if you are a long-term investor? Isn't it conventional wisdom to buy and hold your investments rather than "time" the market? And doesn't the Efficient Market Hypothesis tell us that no one can outperform the market by timing the market anyway? (since the market is always "correctly" priced given the known information), and therefore everyone should always be invested all of the time if they have a long-term time horizon?

In fact, you should care, because likely three year investing returns change drastically when buying into an expensive market - and your typical friendly neighborhood stockbroker (a.k.a. fee-based advisor) won't necessarily tell you that since they operate under the convenient assumption that stock market returns are unpredictable and, "oh what the heck, let's just always stay invested". Reality is somewhat different from that party line, however, and can lead to LOOONNGGG periods of time needed to recoup market losses for those investors who stay aggressively invested during high risk markets.

First the return assumptions typically used by advisors...

The standard return assumptions based on 125 years of data are: a normally distributed set of returns for a 3-year holding period averaging 9.5%, including dividends; a 15% probability of investors losing money over the 3-year period, a slight possibility of tripling their money and a slight possibility of losing around 80% over three years. The standard return assumptions in fact are merely past history projected into the future. But what if those return assumptions are wrong? What if the actual returns for a 3-year holding period where only 7% annually on average with a 28% probability of losing money during the 3-year holding period? Would you be quite so eager to own stocks then?

Probably not. And, as it turns out, the current Shiller P/E of 20 does create a return distribution in line with the second scenario. Shiller P/Es of 19.2 or higher produce return results averaging a mere 7% per annualized 3-year holding period with a likelihood of losses 28% of the time, according to Keith C. Goddard, CFA (Goddard used Professor Shiller's work on stock market price-to-earnings as his base data). Would individual investors make the same allocation decisions if they knew they had a 28% probability of losing money over a 3-year period rather than only a 15% probability of losing money? Again, probably not, if our experience with investors is representative.

Now, throw in the fact that the broad money supply is still in contraction (real M3 contracting is a 100% accurate indicator of recession 6 months down the road) and the already expensive market becomes an exceedingly dangerous one. Investors should plan accordingly....

(Biechele Royce Advisors will continue to buy good companies at great prices when we can find them, but continues to currently see very little of interest, which also indicates an expensive market.)

Roth IRA Conversions

"Roth conversions can trigger unintended tax traps and financial problems that are not being addressed in the mounds of 2010 Roth conversion information that currently dominates the media, " Ed Slott wrote recently in his newsletter, "Ed Slott's IRA Advisor."

Biechele Royce Advisors is fielding an increasing number of inquiries from clients and the public regarding Roth conversions. Roth conversions are a hot topic because the income cap for conversions was removed permanently starting in 2010 and the IRS is allowing investors to defer taxes on converted IRAs in 2010 only, until 2011 and 2012 (You can choose to pay 100% of the taxes owed in 2010 or pay tax on half the converted amount in 2011 and on the other half in 2012). A quick review of the main differences between a Roth and a regular IRA might help frame the conversion discussion.

IRAs are funded with pre-tax dollars, reducing an investor's tax bill in the year of the contribution. IRA investments grow tax deferred, but an investor is required to pay income tax on all distributions, which are allowed without penalty when the investor turns 59 1/2 years-old. Required minimum distributions (RMD) kick in once the investor turns 70 1/2. The Roth IRA is funded with after-tax dollars, which means no reduction in your current tax bill. However, you will never pay tax again on your Roth investments and there are no required distributions, making the Roth a very attractive option for anyone who meets the income requirements.

Investors have had an option to convert from an IRA to a Roth for years, but only if they made less than $100,000 annually. All investors are eligible to convert staring in 2010 however, and many investors are weighing the pros and cons as a result. Unfortunately, there is no simple answer to the conversion question and each situation must be reviewed individually. There are, however, a couple of basics to keep in mind when deciding whether a conversion makes sense. Roth conversions are most appealing to clients who have significant IRAs and wouldn't touch them if it weren't for the required minimum distributions (RMD). Roth IRAs are a much better estate planning vehicle since investors aren't required to take RMDs and can therefore leave more assets in a tax free investment vehicle for future generations. And unlike an IRA, which requires beneficiaries to pay income tax on inherited IRAs when taking distributions, Roth IRA distributions are tax free! As well, conversions are attractive to those investors who would owe very little additional income tax on conversion. Future expected income tax rates figure promonently into your calculations here. Income taxes are expected to rise sharply in coming years, which means many of us might be in a higher income tax bracket in retirement, making a conversion now more appealing. On the other hand, you may have less income in retirement, putting you into a lower tax bracket. One last piece of advice on conversion: it is almost never a good idea to pay the taxes generated from a conversion from the IRA since you want as much of your money to grow tax free as possible. Consequently, conversion becomes much less attractive if you don't have money set aside to pay the taxes. The bottom line on the conversion question? Consult with a trained investment professional (CFA) or a CPA for guidance.

Now that you've decided to convert, making sure to avoid the numerous tax traps and pitfalls takes some planning.

First, investors who choose to split the tax bill must understand that it is highly unlikely that the tax bill will be the same in 2011 and 2012. The total tax bill will depend on various factors including tax rates (which could well go higher) and overall income. Also, beware paying the conversion tax with IRA money if you are under 59 1/2 - you will unwittingly trigger the 10 percent penalty. You will also trigger the 10% penalty if you withdraw converted money within 5 years of conversion if you are under 59 1/2. Simple IRAs have a two-year holding period and can not be converted sooner; the IRS will treat it as a taxable distribution! Non-spouse beneficiaries can't convert an inherited IRA but can convert an inherited plan. Don't roll the inherited plan into an IRA and then try to convert or you will have a problem. As well, rolling a plan mid-year into an IRA after converting your IRA to a Roth will lead to a bigger tax bill than anticipated given how the pro rata rule is calculated (only applies if you have basis in your 401(k). Also, for those of you who are already taking required minimum distributions (RMD), you can't roll your entire IRA into a Roth without first taking the required distribution - you will owe taxes one last time! Oh, and for those of you hoping your child will qualify for tuition assistance... remember that tuition assistance is based on income not retirement assets. Converting your IRA to a Roth may disqualify your child from receiving assistance!

There are a number of other tax traps and gotchas that you must carefully consider before making your conversion. Please consult a knowledgeable investment professional before converting willynilly and inadvertently triggering unnecessary taxes and penalties. Qualified professionals include CPAs, CFAs, and CFPs.

A Market of Stocks - The Art of Stockpicking

(Excerpt from my October 2008 "From The Bleachers" Newsletter)

Perhaps this is a good time to shift to the topic indicated by the title up above, before readers decide we’re just a bit off the mark with it. Our fervent hope is to both entertain and educate our readers on the art of stock picking for – as the title declares – it is a market of stocks not a stock market in which we invest. To be fair, we are contrarian by nature, and a bit old fashion to boot. We recognize that index funds exist, that exchange traded funds are available with which to place your bets on red, black, or even green, but we prefer to build a portfolio the old fashion way, one well researched stock at a time. We hesitate to declare that we’re looking for an undervalued business in which to invest since we will almost assuredly be (mis)labeled as a value investor. So we will avoid the claim. Rather, we simply recognize that a share of stock means a share of ownership in a corporation which entitles the stock holder to a share of the profits, should there be any.

Now oddly enough, we have found over the years that companies that make increasing amounts of money are deemed more valuable (eventually) to investors than those who don’t, and the stock price of said company invariably rises over time as a result of the increasing stream of cash finding its way into the shareholders’ pocket, a truly wonderful outcome for those of us who enjoy turning a profit with our investing. It is our belief that we are buying ownership in a business that guides our search. Not for us the pursuit of a stock, simply because it is rising – that game belongs to the many speculators who invest with a six to twelve month time horizon. Speculators they are because they invariably buy a stock in the hope that it will trade higher in the coming quarters, allowing them to sell at a tidy profit and move on to the next piece of paper. The many mutual fund managers, institutional asset managers, and individuals who choose to rent a stock (and we are now fairly describing upward of 90% of the investors out there) are not interested in the value of the underlying business. They care only whether the stock price will rise in the short run, and turn to such devices as earnings revisions, upside surprises, relative strength indicators and insider buying to divine the short term future of a company’s stock price. We, on the other hand, care very much what price we pay for a company. Just as we choose not to overpay for a car, house, vacation, or that big flat panel TV that makes Peyton Manning’s flapping and stomping prior to the snap looking even more like a blue heron dancing in the shallows (Of course we are fans, season ticket holders as a matter of fact).

Don’t misunderstand however. We have owned all manner of stocks in our 20 years of investing. Technology stocks, drug companies (back when big pharma was considered a growth industry), the King of Beers, and the royalty of soda pop (Coke) have all found their way into our portfolios. We will buy anything in any industry if the price is right, and we are very patient in waiting for that happy event to occur. For instance, Coke was the poster child of expensive back in the late 1990’s, peaking in the vicinity of 55 times earnings if we remember correctly. We even used it as a marvelous example of a great company that was no longer a great investment. But we didn’t hesitate to pay some 20 times earnings in 2005, with the stock in the low 40s, nor did we hesitate to sell it some two years later in the high 50s when the price-to-earnings multiple no longer matched the company’s growth prospects. A market of stocks, not a stock market, and stocks as certificates of ownership in an ongoing business – two of the guiding principles of our investment philosophy.

INTC $14.28

Intel closed today at $14.28 per share, but not before touching $13.37 intraday – a new 52-week low. The company is paying a dividend of $0.55 per share for a current yield of 3.85% and is expected to raise its dividend to $0.61 per share in 2009, according to Value Line – should reality meet expectations INTC will yield 4.27% for anyone buying at the current price, or some 40 basis points or so more than the 10-year Treasury. Now, of course, Intel common stock is riskier than holding a 10-year Treasury to maturity (although that premise seems increasingly uncertain given our government’s loose spending habits). On the other hand, we get much more than a debt instrument that pays par upon maturity when we buy part ownership of a company. We also get a growing stream of shareholder cash flow that can be returned to us by management either with increasing dividends, share buy backs or both.

In fact, INTC will pay out around $1.19 per share in 10 years if management raises the dividend 8% per annum during that period – only one quarter the growth rate of the last 5 years. Anyone buying and hold Intel’s stock for the decade will then be earning 8.3% per annum on their original investment. Now compare that juicy 8.3% to the measly 3.85% you can currently earn holding the U.S. 10-year note… and you quickly get it – Intel is a raging buy at the current price as long as the company is around in 10 years and as long as management is able to continue to grow the dividend. And our analysis doesn’t yet include the possibility of additional cash that might be available to oh, say, buy in stock, resulting in the dividend yield rising even faster.

In Intel’s case, a quick check of current year estimates reveals that the company will have approximately $0.55 per share in excess cash after paying its dividend and meeting its capital expenditure requirements. A three year average is often useful in ascertaining a company’s ability to throw off excess cash consistently. According to Value Line, Intel has generated approximately $5.66 in cash flow from 2006 to 2008, while making $2.76 per share in capital expenditures and paying out $1.41 per share in dividends, leaving approximately $1.49 per share in excess cash available to buy back shares, or $0.50 per share per annum. Adding the $0.50 in excess cash to the current $0.55 dividend gives you a current dividend yield of 7.35% (what the dividend yield would be if INTC management devoted all of its excess cash to the dividend). Unfortunately, Intel, like many management teams often choose to buy back shares with excess cash. We think it unfortunate, because managers tend to pay top dollar for their own shares rather than waiting to buy in shares after their stock takes a dive. Nevertheless, buying in $0.50 per share per annum retires 3.5% of the outstanding shares at the current stock price (call it 2.0% net of stock option issuance), raising current and future dividends accordingly.

Yet another way to do the math without the distortion of a changing share count: Intel generated $34.2 billion in Cash Flow After Taxes (CFAT) during the three years ending in 2007, against $17 billion in Capital Expenditures (CAPEX), leaving $17.2 billion available to shareholders. The entire company was available for purchase for a mere $154 billion at the beginning of 2008 (you could buy it lock stock and barrel right now for $82.8 billion). Taking the three year average shareholder cash number of $5.7 billion and dividing it into the current fully diluted shares outstanding gets you $0.99 per share in stockholder available cash – a nice current yield of 6.9%, some 3.1% better than the 10-year’s current yield.

A couple ways then of looking at the yield to shareholders currently and a decade into the future in comparison to the 10-year Treasury – all favorable. We just need to make a judgment on whether INTC is likely to be around and prospering a decade from now.

The company is currently the world’s largest semiconductor chip maker based on revenue, according to its 2007 10K SEC filing. INTC develops advanced integrated digital technology products, primarily integrated circuits, for industries such as computing and communications. Intel also develops platforms, which they define as integrated suites of digital computing technologies that are designed and configured to work together to provide an optimized user computing solution compared to separately. Intel currently controls about 80% of the PC processor market.

For starters, Intel has grown revenues from $30.1 billion in 2003 to an estimated $40.4 billion in 2008, or a little over 34% during the five year period. Net profit is forecast to hit $7.3 billion in 2008, up from $7.0 billion in 2007 but well off the company’s peak profit logged in 2000 ($10.7 billion). Nevertheless, profit has grown steadily, albeit erratically, since the bottom fell out during the last recession in 2001 (profits bottomed in 2002 at $3.5 billion).

Clearly the company is likely to still be in business and growing earnings given its dominating position in the microprocessor industry and strong balance sheet (almost 13 billion in cash on the balance sheet at the end of 2007). On the other hand, just looking at the increasing variability in earnings leads one to the conclusion that the company is no longer a true growth company and should be bought after business conditions (and the stock price) have weakened and sold when investor enthusiasm carries the share price outside of the realm of reasonable valuation. We believe the current valuation is in the buying zone, given our discussion of dividend and shareholder yields.

Stock Picking

"So is there a reasonable expectation that a reasonably intelligent consumer can pick stocks?" was the question put to me by a friend. "That would be a challenge to blog on without it sounding like a sales pitch," he went on to write.

Indeed it will be, but I LIKE a challenge! Before I answer the question however, I need to tell you a little bit about myself so that you will better understand my world view...

The CFA Institute awards the Chartered Financial Analyst (CFA) designation to individuals who complete a three-year post MBA graduate program in finance, economics, accounting, statistics, and investing, and who have worked in the industry for at least three years. CFAs are trained as institutional investors and are hired by mutual fund companies, banks, insurance companies, and pension plans, among others, to invest assets on their behalf. My own background includes a 12-year run as a hedge fund manager ($55 million in assets and a tout in 2001 by Barrons as a top fund manager). As well, I've spent over 15 years dealing with individual investors and have learned quite a bit that the CFA textbooks don't teach an aspiring candidate. With all of that out on the table... here's my answer to stock picking for the masses.

Absolutely it is reasonable to expect that a reasonably intelligent consumer can (successfully) pick stocks! In fact, I could teach a person with average intelligence how to outperform the stock market by a wide margin over multi-year periods of time in just a few hours of instruction. Intellectually it just isn't that hard! Wanna beat the U.S. stock market over five-year periods? Piece of cake! Simply focus on companies with solid balance sheets, free cash flow, and which are trading in the bottom quintile of all stocks based on price to sales and/or price to book. You will outperform magnificently over 5 and 10 year periods. Now you won't necessarily outperform over one or two year periods. And you might not outperform after adjusting for volatility. But you will outperform in the metric that counts most - total return!

Okay, if it is so easy then why doesn't everyone simply eschew mutual funds and build their own portfolio of stocks? Because it takes patience and discipline, and a willingness to go against the crowd. John Maynard Keynes' edict that, "it is better for reputation to fail conventionally, than to succeed unconventionally." is spot on. It is well known in professional money management circles that losing money with the crowd is not a career risk, while losing money alone most certainly is! Individual investors share the same behavioral traits as the professionals. They would rather be wrong together than risk being embarassed alone.

Buying beaten down, out-of-favor stocks takes a level of courage and contrarianism that is uncommon to say the least. I have always found it amazing that more people don't focus on buying cheap assets, which can lead to highly profitable outcomes. Instead they are filled with the gambling lust, determined to find that needle in a haystack that might become Microsoft, or Google, or Cisco. The pot of gold at the end of the rainbow leads them to speculate, for instance, in small biotech companies, instead of buying historically profitable companies when they are demonstrably cheap. And speculating is exactly what most investors are doing these days. The average holding period for a stock on the New York stock exchange has fallen to 6 months, down from 6 years 40 years ago. Now, for those of you who would like to actually invest in good companies at great prices, here's all you need to do...

Buy companies with little or no debt. The current ratio should be 1.5x or better and long term debt should not exceed equity. Buy companies with low fixed costs and profitable histories, and which throw off plenty of free cash (what's left over after all the bills are paid, including salaries). Buy companies trading close to book value with a return on equity close to 15%, and buy them when they are trading cheaply based on their own history and relative to the stock market. Read the last few annual reports and the most recent 10K and 10Q to make sure that no long term negative changes to fundamentals have occurred. Finally, don't expect to make money in these stocks over night; it might be a few years before they kick up their heels and take you to the promised land of outperformance. Do all of those things and the academic data overwhelmingly points toward a serious case of studly performance in your future. About the only thing that could ruin it for you is faint heartedness, since you will be going against the crowd, forced to justify your choices to your friends who will sneeringly tell you what a fool you are to bet on boring stuff while they are getting ready to strike it rich in Nanobiotechno Industries Incorporated! Ignore them for they are the fools chasing a pipe dream and you are the true investor buying companies on the cheap!

High Risk Market

The S&P 500 fell almost 10% from its January 19th high to its February low. We wrote about the overbought market in our 2010 forecast and the likelihood of a 20% plus pullback sometime in 2010; the question is, has the expected decline already begun or is the market working off its overbought state by trading sideways for a few months (markets can correct in time instead of price, chopping sideways until earnings catch up with price). There is no question that the up trend from the March 2009 low is broken. Furthermore, with the 20-day moving average now below both the 50 and 100-day moving average, additional market weakness is a distinct possibility. Add in half a dozen distribution days (down days on heavy volume) since the January 19 high, and the case builds that the rally is on wobbly legs and will need to regain momentum in fairly short order if further profit taking is to be avoided (many institutional investors rely on charts to trigger buy and sell decisions, which is why charts are useful in the first place - circular reasoning I know, but very much a reality in the casino that passes for today's stock market). Further deterioration in the chart - in particular a breach of the recent 1042 low - will likely cause additional profit taking that could lead to our predicted 20%-30% 2010 decline.

As well, it is easy to build a fundamental case for further declines in the market. The S&P 500 is still about 20% over valued using $60 for earnings and 15x for a trailing multiple. (The S&P 500 has traded on average at 14 to 15x trailing reported earnings historically). Also, reported economic growth is mostly smoke and mirrors at the moment. The reported 5.7% Q4 GDP growth is likely to give way to Q2 and Q3 2010 growth in the 1% to 2% range, given the weak final demand components of the Q4 number. As you will recall, Q4 GDP got a huge assist from inventories declining at a slower rate, adding an estimated 4.4% to the final number. History indicates that subsequent quarters show punk growth when over half of GDP growth is coming from inventories.

In fact, there have been 9 quarters since 1970 in which GDP grew by at least 3 percent and at least half of the growth was due to inventories. While inventory spikes make for big growth numbers (average growth in the 9 quarters was 6.6%), average growth in the subsequent quarter averaged only 0.9% and only 1.6% in the second quarter following the blowout number. Weak growth numbers in the next few quarters will likely make current earnings forecasts overly optimistic, which will, in turn, pressure the stock market (It is possible that Q1 will come in fairly strong if the inventory swing hasn't quite played out).

One last indicator that the market is due for a further decline, or at least a relatively long period of sideways chop - the "we-can't-find-many-good-companies-at-great-prices" indicator is flashing at us. As many of you know by now, we do not do market timing. Rather, we look at risk levels in the market as context for our bottoms up, one-company-at-a-time, portfolio construction. It is currently taking us quite a bit longer to put new money to work in our client portfolios because we are just not finding that many good companies at great prices at the moment. Our price discipline held us in good stead in 2000-2001 and again in 2007-2008; we would expect it to prove beneficial once again in 2010. Meanwhile, we recommend continuing to treat the market as high risk, and plan accordingly...

Bogus GDP Report Revision

We wrote recently about the bogus Q4 GDP number which was reported initially at 5.7% last month. We believe the final number will come in somewhere between 2.0% and 3.0% when all is said and done - although we won't likely see that admission from our clever government bean counters for a year or so. Meanwhile, it looks as if there could actually be an upward revision in the GDP number as the December inventory number was likely flat, while the BEA assumed a sharp inventory liquidation in December. It is possible that the GDP number might temporarily be revised as high as 6.7% for Q4 2009, leading people to assume that a strong economic recovery is in place. Given that over 4% of the Q4 number would be due to a decline in the rate of decline of inventory liquidation and that personal income took a bigger hit than previously thought (based on Friday's downward revision in payrolls and hours worked) we are unable to get on board with the idea that the U.S. economy is powering strongly ahead. Rather, given continued weak end demand, we see an economy poised to decelerate back into recession sometime in 2010 - likely in the third quarter. Our confidence in that forecast is only increased by the continued and increasing contraction in real M3 (the broadest measure of money supply). As previously mentioned, contraction in real M3 is historically a 100% predictor of economic contraction in the following two to three quarters. We think it unlikely that it will be different this time.

And, of course, a renewal of the recession means a continuing rise in unemployment and decline in home prices among other (bad) things. A double dip recession is also unlikely to be a positive for the U.S. stock market....

Diversification Revisited

Proper diversification is one of the single most important tools for any investor. Properly diversified investment portfolios are the best means of protecting and growing wealth. There are two main levels of diversification, at the asset level, and at the individual security level. Most people ought to own both stocks and bonds, as well as real estate, commodities, and cash. As well, folks ought to own some international stocks and bonds since a good portion of the world economy is outside the U.S. and investors can miss out on quite a few attractive investment opportunities by limiting themselves primarily to home country investments. (Home bias is a well known investor mistake that leads investors to put too much of their money in domestic assets and not enough elsewhere). And well-diversified portfolios should also have diversification within asset classes. Too much exposure to any one company, through its stock or bonds, is an unnecessary risk that is unjustified in most cases. A couple of real life examples can help investors to understand how risky it can be to invest too much in one single asset class or one security.

The first example is a case in which an individual sold his business and retired. His fee-based advisor (stockbroker) built a portfolio consisting of $2 million in stock mutual funds and $400k in private real estate investment trusts. The $2 million in stock mutual funds consisted of a large cap growth fund, large cap value fund, small cap fund, and an international fund (a pretty common allocation for the many sales guys passing themselves off as qualified investment advisors). Of course, all of the funds were front loaded and paid the sales guy a hefty 5.75% commission along with a 0.30% yearly trailing commission, and of course our poor investor was also paying 0.60% annually to the mutual fund to actually do the investing. The $400k in private REITs was split into two investments with the same company, with basically the same commercial real estate exposure in both.

So what kind of diversification did our poor investor get for all those commissions paid? Very little is the answer. The three U.S. stock mutual funds all performed equally badly during the 2007-2009 bear market and the international fund did even worse. The illiquid private REITS can't really be valued since our investor can't get out of those particular roach motels at the moment - the REITs are husbanding their capital and have suspended redemptions for the time being. The bottom line is our retired investor is busily looking to unretire now that his portfolio has dropped from $2.4 million to $1.2 million. Oh, and in case you are wondering why the sales guy put our investor in illiquid private rather than liquid public REITS the answer is.... BIGGER COMMISSIONS!

Our second case study highlights both types of unwarranted concentration. The fee-based advisor had put an older couple 100% in bonds (at the older couple's request), using both mutual funds and individual bonds. Additionally, the advisor had placed the majority of the money allocated to individual bonds in GE Capital bonds and California muni bonds. In fact, the GE capital bonds alone made up approximately 50% of the entire portfolio. Yikes!

There are a few observations worth making here. First, commission based advisors must sell something in order to make money. Like any good salesman they will keep trying until they find something their customer likes. Don't want mutual fund A? How about mutual fund B? Don't really want to own stocks? No problem, I'll sell you bonds (and take a juicy slice of the mark up). The moral of this story is that commission based advisors often sell what's easiest to sell rather than providing actual investment advice to the client (and risk losing the sale). There is no way a couple in their mid-60s with a 25 to 30 year planning horizon should be allowed to put 100% of their money in bonds - unless they have so much wealth that purchasing power risk (inflation) isn't going to bite them in the budget in the out years. And after Enron, WorldCom, Bear Stearns, Lehman Brothers, AIG, GM, Fannie Mae, and Freddie Mac, do I even need to talk about the incredible risk assumed by having some 50% of your bond portfolio in just one company? The fact is that our couple did dodge a bullet as the Federal Government did have to (quietly) bail out GE last year when the commercial paper market seized up.

Building properly diversified, low-cost, portfolios that will both preserve and grow an investor's wealth is a critical step in planning for retirement. Appropriate portfolios are not static in nature as they must change as an investor's needs change. Unfortunately, most financial advisors are paid to sell products and do not actually make their money from giving advice or investing on a client's behalf. Consequently, their motivation to sell frequently gets in the way of sound investment advice. It is no coincidence that both of our poorly constructed portfolios were put together by fee-based advisors. The fact is that it is a huge conflict of interest, which investors would be well advised to take into consideration when dealing with "the sales guy".