Our main export over the last 20-plus years has been the U.S. dollar. We've run up huge trade deficits, sending dollars over seas to China, Japan, Korea, the EU, the Middle East, and to anyone else who would take them in exchange for their goods. The virtuous cycle has worked until now because the giant vendor financing scheme suited every one's interest. U.S. consumers got cheap goods from overseas and were allowed to spend beyond their means by borrowing cheaply. Export led foreign economies were able to sell into one of the largest consumer economies in the world, keeping their labor forces employed and running up huge surpluses in the process (reserves are a wonderful thing when hard times hit, since you have to pay back international debt regardless of whether you're earning sufficient currency or not).
But what to do with the tsunami of dollars flooding their shores? How to avoid the Renminbi, Yen, Won, Baht, Peso, and Real, among others, from strengthening and thus decreasing the competitiveness of their goods in the world market? Why, recycle all of those excess dollars back into the U.S. by purchasing the (until now) safest investment in the world - U.S. Treasuries. Buying U.S. Treasuries with surplus dollars had the beneficial side effect of keeping U.S. interest rates far lower than they would otherwise have been, in turn stimulating the U.S. consumer to take on even more cheap debt with which to buy more foreign goods.
Clearly though the trend was unsustainable and had to come to an end eventually. At some point the foreign vendors financing our purchases would want to get something tangible in exchange for their store of paper money. Now it increasingly appears that the end is near as America's policy of dollar debasement is obviously vexing the foreign holders of U.S. debt.
China, in particular, appears to be signaling that it is serious about ending the trend. The Chinese have accumulated some $2.2 trillion in U.S. debt, primarily U.S. Treasuries. but lately they have been signaling an end to unlimited Treasury accumulation. Instead they have been diversifying away from US Treasuries by using the roughly $200 billion accumulated each quarter to buy other currencies and assets. More ominously for the U.S. Treasury market, the Chinese are now indicating a desire to actively sell Treasuries in order to buy U.S. strategic assets, according to Chinese official Li Daokui in a statement made at the World Economic Forum.
"We would like to buy stakes in Boeing, Intel, and Apple, and maybe we should invest in these types of companies in a proactive way," Li said at the Forum. "Once the US Treasury market stabilizes we can liquidate more of our holdings of Treasuries," he went on to say. HELLO?
The Chinese liquidating their Treasury holdings isn't a dollar negative if they use the proceeds to buy American assets, but it could send the bond market reeling, driving up interest rates and throwing the United States into recession in the process. The Federal Reserve is already financing the entire budget deficit (and has been for almost two years now). Is the Fed ready to prostitute its balance sheet further by stepping into the breach to buy China's Treasuries if they follow through with their plans to swap out T-bonds for hard assets? Perhaps. But will the rest of the world allow the Fed to get away with it for long? Not likely....
Dollar dumping by the major holders of our debt is a growing possibility, with serious consequences likely, not the least of which are rising interest rates and an economy in recession. Neither bonds nor stocks will weather that particular storm very well.....
Thursday, September 15, 2011
Monday, September 12, 2011
Recession All But Certain
The government likes to spin the numbers as does Wall Street. Politicians seek re-election and Wall Street seeks transactions. You will almost never hear a fee-based Advisor, insurance agent, or product selling financial planner (all distributors of Wall Street's products) tell you that now is NOT a good time to buy, because they make most of their money from the commissions they get when they sell you something. The positive spin coming from Wall Street economists is often nothing more than cover for their product selling compatriots.
But the data now strongly suggest that we are either already in or will soon be in another recession. The deterioration in financial and economic measures that provides a unique signature that always and only is observed during or immediately prior to U.S. recessions is in place. These include a widening of credit spreads on corporate debt versus six-months prior, the S&P 500 below its level of 6 months prior, the Treasury yield curve flatter than 2.5% (10-year minus 3-month), year-over-year GDP growth below 2%, ISM Purchasing Managers Index below 54, year-over-year growth in total non-farm payrolls below 1%, as well as important corroborating indicators such as plunging consumer confidence. The evidence has 100% sensitivity (these conditions have always been observed during or just prior to each U.S. recession) and 100% specificity (the only time we observe the full set of these conditions is during or just prior to U.S. recessions), according to Dr. John Hussman
We have been forecasting a bear market (20%-40% decline) since late last year with the most likely starting period the spring of 2012 and the second most likely starting period the fall of 2011. The S&P 500 is at 1137 as we write, having peaked in April at 1370.58. A 20% to 40% decline would put the S&P 500 in a range of 822 - 1096. We are mindful of the fact that average valuation for the S&P 500 over the very long term, based on average 10-year trailing earnings, replacement cost analysis, and the dividend growth model is in the 900 range. Our conclusion is that we will likely see 900 or thereabouts in the coming bear market if the European sovereign and banking situation is contained. We could quite possibly see 500 on the S&P 500 if it is not (although 500 might seem like a mind-boggling number to many investors, it should be remembered that we hit 666 intra-day in March of 2009). It's probably also worth pointing out the 500 on the S&P 500 would be about right as a starting point for the next great secular BULL market based on past valuations in 1919, 1946, and 1982. For the record, we are not anticipating a decline to 500, believing that 800-1000 is the more likely floor. But we do feel it's a number worth mentioning since the European banking and sovereign debt crisis could very easily spin out of control, sucking the U.S. (courtesy of our hyperactive Central Bank) into the maelstrom.
Biechele Royce Advisors is continuing to buy good companies when we can find them on sale. We are emphasizing dividend paying blue chip stocks with defensive characteristics. We are watching high-yield bonds with interest and believe a buying opportunity will present itself within the next year. We are still overweight non-dollar assets as we continue to believe that the wildly inappropriate monetary policy currently being conducted in the U.S. has a high probability of sparking strong inflationary pressures before all is said and done. Finally we are waiting to put excess cash to work should we be fortunate enough to experience a market cleansing decline into the 800-1000 area. We have a long and growing list of good companies that we'd love to own at the right price!
But the data now strongly suggest that we are either already in or will soon be in another recession. The deterioration in financial and economic measures that provides a unique signature that always and only is observed during or immediately prior to U.S. recessions is in place. These include a widening of credit spreads on corporate debt versus six-months prior, the S&P 500 below its level of 6 months prior, the Treasury yield curve flatter than 2.5% (10-year minus 3-month), year-over-year GDP growth below 2%, ISM Purchasing Managers Index below 54, year-over-year growth in total non-farm payrolls below 1%, as well as important corroborating indicators such as plunging consumer confidence. The evidence has 100% sensitivity (these conditions have always been observed during or just prior to each U.S. recession) and 100% specificity (the only time we observe the full set of these conditions is during or just prior to U.S. recessions), according to Dr. John Hussman
We have been forecasting a bear market (20%-40% decline) since late last year with the most likely starting period the spring of 2012 and the second most likely starting period the fall of 2011. The S&P 500 is at 1137 as we write, having peaked in April at 1370.58. A 20% to 40% decline would put the S&P 500 in a range of 822 - 1096. We are mindful of the fact that average valuation for the S&P 500 over the very long term, based on average 10-year trailing earnings, replacement cost analysis, and the dividend growth model is in the 900 range. Our conclusion is that we will likely see 900 or thereabouts in the coming bear market if the European sovereign and banking situation is contained. We could quite possibly see 500 on the S&P 500 if it is not (although 500 might seem like a mind-boggling number to many investors, it should be remembered that we hit 666 intra-day in March of 2009). It's probably also worth pointing out the 500 on the S&P 500 would be about right as a starting point for the next great secular BULL market based on past valuations in 1919, 1946, and 1982. For the record, we are not anticipating a decline to 500, believing that 800-1000 is the more likely floor. But we do feel it's a number worth mentioning since the European banking and sovereign debt crisis could very easily spin out of control, sucking the U.S. (courtesy of our hyperactive Central Bank) into the maelstrom.
Biechele Royce Advisors is continuing to buy good companies when we can find them on sale. We are emphasizing dividend paying blue chip stocks with defensive characteristics. We are watching high-yield bonds with interest and believe a buying opportunity will present itself within the next year. We are still overweight non-dollar assets as we continue to believe that the wildly inappropriate monetary policy currently being conducted in the U.S. has a high probability of sparking strong inflationary pressures before all is said and done. Finally we are waiting to put excess cash to work should we be fortunate enough to experience a market cleansing decline into the 800-1000 area. We have a long and growing list of good companies that we'd love to own at the right price!
Tuesday, August 23, 2011
Common Mistakes with Wills
Your Will can have a major impact on your family (including your spouse), friends, and favorite causes after you're gone. It is all too common for someone to die without a will, ensuring that their wishes aren't honored in death. Wills allow individuals to specify how they want their assets divided up after they are gone and can greatly impact the individual's legacy - assets distributed smoothly and in accordance with the individual's wishes, or squabbling and legal challenges that can cause hurt feelings and ill-will among your loved ones.
A second common mistake is making surprise decisions on who gets what, which can also lead to hurt feelings and family conflicts. Most people do not want spouses, children and other relatives fighting over their assets when they are gone, but that is exactly what can happen if they don't take the time to explain to their heirs what they plan.
Cutting out a spouse is surprisingly common, but unless you have a prenuptial agreement, your spouse is entitled to receive up to one-half of your estate, whether you write it into your will or not. Have your spouse sign a waiver before your death or expect your estate to face claims afterwards.
At the other end of the spectrum are those individuals who are in a second marriage and leave everything to their spouse. The children from the individual's first marriage can end up with nothing after the spouse dies if he/she has remarried in the interim. One solution is to set up a marital trust within your Will that holds assets for your spouse and then transfers them to your children after your spouse's death, ensuring that your assets stay in the family rather than going elsewhere.
Another common error is forgetting about Insurance/IRA designations. Separate beneficiary designation forms control the distribution of retirement accounts, annuities and life insurance after death. It is critical to complete beneficiary forms for these assets if you wish to avoid probate court, and the costs and publicity that goes with the probate process. Assets titled in your name, as opposed to jointly held with rights of survivorship, without designated beneficiaries will be distributed according to the general instructions in your Will, possibly triggering taxes much sooner than otherwise would be the case.
Please feel free to call or email with questions!
A second common mistake is making surprise decisions on who gets what, which can also lead to hurt feelings and family conflicts. Most people do not want spouses, children and other relatives fighting over their assets when they are gone, but that is exactly what can happen if they don't take the time to explain to their heirs what they plan.
Cutting out a spouse is surprisingly common, but unless you have a prenuptial agreement, your spouse is entitled to receive up to one-half of your estate, whether you write it into your will or not. Have your spouse sign a waiver before your death or expect your estate to face claims afterwards.
At the other end of the spectrum are those individuals who are in a second marriage and leave everything to their spouse. The children from the individual's first marriage can end up with nothing after the spouse dies if he/she has remarried in the interim. One solution is to set up a marital trust within your Will that holds assets for your spouse and then transfers them to your children after your spouse's death, ensuring that your assets stay in the family rather than going elsewhere.
Another common error is forgetting about Insurance/IRA designations. Separate beneficiary designation forms control the distribution of retirement accounts, annuities and life insurance after death. It is critical to complete beneficiary forms for these assets if you wish to avoid probate court, and the costs and publicity that goes with the probate process. Assets titled in your name, as opposed to jointly held with rights of survivorship, without designated beneficiaries will be distributed according to the general instructions in your Will, possibly triggering taxes much sooner than otherwise would be the case.
Please feel free to call or email with questions!
Friday, August 5, 2011
Market Update
The market topping process we wrote about Tuesday is now complete. The stock jockeys bounced the market hard on Wednesday in an effort to avoid a close below the March 16th low (1249), which would have put the top in place and brought in more short term selling. Unfortunately the Wednesday bounce was short lived and itchy trading fingers started pushing buttons on Thursday, pounding the market lower. The S&P 500 basically opened at its high and closed at its low on big volume - just about as negative as you can get from a technical stand point. We will likely get an oversold rally starting either late today or more likely early next week as the speculators (which is almost everyone these days) try to jam the market back into its six month trading range (1249-1370). The rally is likely to fail and further downside testing (perhaps all the way to the low 1100s) is likely by the fall. We continue to think the market will likely rally into year end, following this sell off, with the onset of the real bear market not occurring until sometime next spring. Our best-guess scenario is predicated on the Federal Reserve and/or the Administration coming up with yet another ill-conceived, short term program to support the market, delaying, but not preventing, the inevitable bear market that lurks out there in our future.
Our longer term forecast is unchanged - a bear market within the next 12-18 months that takes the S&P 500 down 20%-40% from its 1370 high. The bear market's underlying causes will include the simple fact that S&P 500 fair value is only about 900, making it an expensive investment currently. Additionally, record net profit margins will revert to their long run mean at some point as the economy continues its slide back into recession, resulting in disappointing earnings from the S&P 500's constituents.
Biechele Royce Advisors continues to buy good companies at great prices as we find them, but has been carrying extra cash in client portfolios and favoring more defensive investments in anticipation of the selling we are now experiencing.
Our longer term forecast is unchanged - a bear market within the next 12-18 months that takes the S&P 500 down 20%-40% from its 1370 high. The bear market's underlying causes will include the simple fact that S&P 500 fair value is only about 900, making it an expensive investment currently. Additionally, record net profit margins will revert to their long run mean at some point as the economy continues its slide back into recession, resulting in disappointing earnings from the S&P 500's constituents.
Biechele Royce Advisors continues to buy good companies at great prices as we find them, but has been carrying extra cash in client portfolios and favoring more defensive investments in anticipation of the selling we are now experiencing.
Tuesday, August 2, 2011
Recession and the Bear
Last week was a big down week for equities, with most major averages down around 4%. DJIA lost 4.24%, S&P500 down 3.92%, and NASDAQ fell 3.58%. The S&P 500 was down 2.2% for July. Treasuries rallied for the week, with the 10-yr. yield lower at 2.79%. Some of the economic highlights to go with the weak stock market action were:
Q2 GDP disappoints…Q1 revised lower.
U.S. economy grew by only 1.3% in Q2, and Q1 was revised down to a mere 0.4% growth rate.
(Weakness in consumer spending suggests that higher prices for certain food / energy items have played a role in restraining spending.)
0.1% increase in personal spending was the lowest since Q2 2009 in the midst of the recession.
Budget cuts in state/local government contributed to a 3.4% drop in government spending.
It appears that sub-par growth continues to be the path of the economy for the second half.
GDP growth has now decelerated to a level below the 2% threshold that has been a predictor of recession in the past. Jobs and housing are closely linked and both remain a drag on the economy. New home sales fell in June as potential buyers pulled back from the market amid job uncertainty and tough lending standards. Canceled home transactions in June jumped to 16%, way above the 4% level seen in May and the 9-10% range of the last year. Tight appraisals and tough loan underwriting scrutiny are to blame, according to the media. Most of the activity in the housing market are distressed sales.
Technically, the market has broken the uptrend begun on 7 July 2010 and continues the topping process begun 18 February 2011. A drop below the 16 March low of 1249 would put the top in place and sharply increase the likelihood that the secular bear market is resuming. We continue to think it more likely that a retest of the 1 July 2010 low at 1011 won't occur until sometime next spring but a fall retest is a possibility. Regardless, we continue to maintain a defensive posture in client portfolios given that S&P 500 fair value is around 900 and that the economy is clearly slowing.
Q2 GDP disappoints…Q1 revised lower.
U.S. economy grew by only 1.3% in Q2, and Q1 was revised down to a mere 0.4% growth rate.
(Weakness in consumer spending suggests that higher prices for certain food / energy items have played a role in restraining spending.)
0.1% increase in personal spending was the lowest since Q2 2009 in the midst of the recession.
Budget cuts in state/local government contributed to a 3.4% drop in government spending.
It appears that sub-par growth continues to be the path of the economy for the second half.
GDP growth has now decelerated to a level below the 2% threshold that has been a predictor of recession in the past. Jobs and housing are closely linked and both remain a drag on the economy. New home sales fell in June as potential buyers pulled back from the market amid job uncertainty and tough lending standards. Canceled home transactions in June jumped to 16%, way above the 4% level seen in May and the 9-10% range of the last year. Tight appraisals and tough loan underwriting scrutiny are to blame, according to the media. Most of the activity in the housing market are distressed sales.
Technically, the market has broken the uptrend begun on 7 July 2010 and continues the topping process begun 18 February 2011. A drop below the 16 March low of 1249 would put the top in place and sharply increase the likelihood that the secular bear market is resuming. We continue to think it more likely that a retest of the 1 July 2010 low at 1011 won't occur until sometime next spring but a fall retest is a possibility. Regardless, we continue to maintain a defensive posture in client portfolios given that S&P 500 fair value is around 900 and that the economy is clearly slowing.
Wednesday, June 22, 2011
Laddered Bond Portfolios
I received a call from a Dow Jones newspaper reporter yesterday asking me my thoughts on laddered bond portfolios as a strategy for income in retirement. She was under the impression that I was not in favor of them - possibly from something I'd written in the past (although she wasn't able to quite recall what she'd read and I wasn't able to quite recall what I might have written). Anyway, we had a very pleasant half hour conversation about laddered portfolios, fee-only versus fee-based (brokers) advisors, variable annuities, and properly diversified multi-asset portfolios...among other investment topics.
But I thought I ought to pass on my thoughts on laddered bond portfolios to my readers, since it was the primary reason she called.
I think a laddered bond strategy makes quite a bit of sense for retirees, but only as a part of a properly diversified multi-asset portfolio. I am not in favor of single asset portfolios for anyone, let alone a retiree. Putting your eggs all in one basket is never a good idea, even if it is in the supposedly safe basket of Treasury bonds, which I personally believe carry quite a bit of risk currently. (Bill Gross of Pimco is on the same page by the way as his firm - the largest bond investor in the world - is currently completely out of Treasury bonds according to statements the bond king has made in recent months).
Bonds were known as certificates of confiscation back in the early 1980s, before the great bond bull market kicked off in 1982. Bond investors had lost their shirts over the prior 15 years or so as interest rates had risen steadily along with inflation. Negative real rates eroded bond wealth steadily for better than a decade. However, Paul Volcker's Federal Reserve changed all of that by committing to sound monetary policy designed to bring down inflation and restore the stability of the dollar as a store of value. Bonds have proven a splendid investment ever since... until now.
It is highly likely that inflation will continue to rise and, with it, interest rates over the next decade. We may have another year or two to wait before the trend really gathers steam, but without drastic changes in U.S. monetary and fiscal policy, the odds of a long bond bear market are high. A laddered dollar bond portfolio is not where you want all of your assets in such an environment. Yes bonds will mature yearly and can be reinvested at higher rates, but the bonds in you portfolio will lose value. Any sales necessitated by unexpected cash needs will result in losses. And generating capital losses in bond investing is a cardinal sin. Even more dangerous is the strategy of attempting to "ladder" a bond mutual fund portfolio, given that bond mutual funds have a perpetual duration - duration is a measure of bond price sensitivity to changes in interest rates. The longer the duration the bigger the price moves in a bond, and perpetual is as long as you can get.
Far better to build a properly diversified multi-asset portfolio for our retiree that might include a laddered bond portfolio to go with the high-quality dividend paying blue chip stocks, the dollar diversifying international assets, and the inflation hedging tangible assets (real estate and commodities primarily).
The S&P 500 is rallying short term after moving into oversold territory, but is likely to at least retest the recent low at 1256. It is still too early to tell if the correction is merely the pause that refreshes on the start of a topping process that will ultimately lead to the next downleg in the ongoing secular bear market. We reiterate that fair value for the S&P 500 is in the 900 area and that the economy is now showing clear signs of slowing - a combination that would suggest prudence is the better part of valor at the moment.
But I thought I ought to pass on my thoughts on laddered bond portfolios to my readers, since it was the primary reason she called.
I think a laddered bond strategy makes quite a bit of sense for retirees, but only as a part of a properly diversified multi-asset portfolio. I am not in favor of single asset portfolios for anyone, let alone a retiree. Putting your eggs all in one basket is never a good idea, even if it is in the supposedly safe basket of Treasury bonds, which I personally believe carry quite a bit of risk currently. (Bill Gross of Pimco is on the same page by the way as his firm - the largest bond investor in the world - is currently completely out of Treasury bonds according to statements the bond king has made in recent months).
Bonds were known as certificates of confiscation back in the early 1980s, before the great bond bull market kicked off in 1982. Bond investors had lost their shirts over the prior 15 years or so as interest rates had risen steadily along with inflation. Negative real rates eroded bond wealth steadily for better than a decade. However, Paul Volcker's Federal Reserve changed all of that by committing to sound monetary policy designed to bring down inflation and restore the stability of the dollar as a store of value. Bonds have proven a splendid investment ever since... until now.
It is highly likely that inflation will continue to rise and, with it, interest rates over the next decade. We may have another year or two to wait before the trend really gathers steam, but without drastic changes in U.S. monetary and fiscal policy, the odds of a long bond bear market are high. A laddered dollar bond portfolio is not where you want all of your assets in such an environment. Yes bonds will mature yearly and can be reinvested at higher rates, but the bonds in you portfolio will lose value. Any sales necessitated by unexpected cash needs will result in losses. And generating capital losses in bond investing is a cardinal sin. Even more dangerous is the strategy of attempting to "ladder" a bond mutual fund portfolio, given that bond mutual funds have a perpetual duration - duration is a measure of bond price sensitivity to changes in interest rates. The longer the duration the bigger the price moves in a bond, and perpetual is as long as you can get.
Far better to build a properly diversified multi-asset portfolio for our retiree that might include a laddered bond portfolio to go with the high-quality dividend paying blue chip stocks, the dollar diversifying international assets, and the inflation hedging tangible assets (real estate and commodities primarily).
The S&P 500 is rallying short term after moving into oversold territory, but is likely to at least retest the recent low at 1256. It is still too early to tell if the correction is merely the pause that refreshes on the start of a topping process that will ultimately lead to the next downleg in the ongoing secular bear market. We reiterate that fair value for the S&P 500 is in the 900 area and that the economy is now showing clear signs of slowing - a combination that would suggest prudence is the better part of valor at the moment.
Monday, June 13, 2011
Correction
The market is finally starting a correction that could eventually turn into a full fledged bear market, depending on what policy decisions the administration, the Federal Reserve, the ECB, and the Chinese make in response to a slowing economy in the U.S. and rising inflation overseas. The S&P 500 has lost 7.7% since its 2 May peak of 1370.58 (5.3% of that loss coming in June). The next key support is 1249 - the 16 March low. Selling pressures sufficient to take out the 1249 support level would sharply increase the likely of further significant downside testing. There is strong support for the S&P 500 from 1150 down to 1000 however, making the onset of a full blown bear market unlikely in the next few quarters. Tops take time to form and it is more likely that a bounce off of 1249, or perhaps off of 1220 support (10.9% pullback) will see the S&P 500 rally into year end and finish somewhere near the May 2 high of 1370.
Nevertheless, a renewal of the secular bear market this year can't be ruled out. S&P 500 fair value is in the 900 area, net profit margins are at record levels (and will certainly fall going forward), and the U.S. economy is showing signs of slowing. As well, the Chinese are tightening monetary policy and the ECB is talking about tightening monetary policy - both entities would like to deflect inflation away from their shores.
On the other side of the ledger is the President's desire to win re-election. It is very likely that Obama will take steps to bolster the economy short term (and by extension the stock market) in order to win re-election. No post WWII incumbent has won re-election with unemployment above 7.2%, which means Obama must do something fairly quickly to light a fire under the jobs market if he hopes to serve a second term.
Likewise, Ben Bernanke continues to send signals that QE2 will not be the end of his monetary largess. He apparently remains determined to use every monetary policy tool in his tool box to keep the stock market afloat while the banks continue to repair their shattered balance sheets. Bernanke is likely to trot out another initiative immediately on the heels of QE2's end on 30 June. Our forecast is still for a resumption of the bear market sometime in the next 12 to 18 months, but we continue to believe that we are more likely to feel the Bear's bite in 2012 than 2011.
We continue to look for high-quality dividend paying blue chips to buy. We also continue to invest in shorter duration fixed income investments, given the likelihood of rising interest rates in coming years. Finally we continue to invest in nondollar assets that will provide a hedge against purchasing power loss as the shortsighted policies pursued by politicians (on both sides of the aisle) and the Federal Reserve all but ensure rising inflation over the next decade.
Nevertheless, a renewal of the secular bear market this year can't be ruled out. S&P 500 fair value is in the 900 area, net profit margins are at record levels (and will certainly fall going forward), and the U.S. economy is showing signs of slowing. As well, the Chinese are tightening monetary policy and the ECB is talking about tightening monetary policy - both entities would like to deflect inflation away from their shores.
On the other side of the ledger is the President's desire to win re-election. It is very likely that Obama will take steps to bolster the economy short term (and by extension the stock market) in order to win re-election. No post WWII incumbent has won re-election with unemployment above 7.2%, which means Obama must do something fairly quickly to light a fire under the jobs market if he hopes to serve a second term.
Likewise, Ben Bernanke continues to send signals that QE2 will not be the end of his monetary largess. He apparently remains determined to use every monetary policy tool in his tool box to keep the stock market afloat while the banks continue to repair their shattered balance sheets. Bernanke is likely to trot out another initiative immediately on the heels of QE2's end on 30 June. Our forecast is still for a resumption of the bear market sometime in the next 12 to 18 months, but we continue to believe that we are more likely to feel the Bear's bite in 2012 than 2011.
We continue to look for high-quality dividend paying blue chips to buy. We also continue to invest in shorter duration fixed income investments, given the likelihood of rising interest rates in coming years. Finally we continue to invest in nondollar assets that will provide a hedge against purchasing power loss as the shortsighted policies pursued by politicians (on both sides of the aisle) and the Federal Reserve all but ensure rising inflation over the next decade.
Friday, May 27, 2011
Stocks For The Long Run?
There are at least a few academics who argue that stocks are too risky for retirement portfolios and that an all bond portfolio is more appropriate for retirement portfolios, given the much more predictable return streams of bonds versus stocks. Bond portfolios can be constructed to ensure that cash flows match known cash needs throughout a retirement plan. Unfortunately, bonds are not particularly good at preserving purchasing power when inflation unexpectedly makes an appearance (Biechele Royce is forecasting rising inflation over the next 10 plus years). Stocks, then, are a necessary evil for investors who fail to save enough during their accumulation years - the vast majority - to make it possible to survive in retirement on an all bond portfolio.
Okay, okay time out.... You are puzzled because I'm dissing stocks for the long run aren't you? I mean, the baby boomers grew up in the stock friendly world of the 1980s and 1990s. We were told that stocks always deliver a superior return over the long run and that most of us should just forget about bonds and pile into stocks as long as we were looking at a 10-year plus time horizon. We were told that we'd end up with far more wealth in retirement by sticking with the superior long run returns of stocks. Well.... we weren't really getting the whole story when it comes to stock returns versus bond returns as it turns out.
The fact is that bonds have far outperformed stocks over the last 10 years, to the tune of 5.23% per annum, and have kept up with stocks over the last 20 and 30 year periods with far less volatility. The fact is that investors over the last 30 years would've been far better off sticking with bonds ONLY. But that must be a very unusual occurrence right? Not really. It turns out that there have been a number of very long periods during which bonds were superior to stocks. The period 1803-1857 comes to mind - bonds trounced stocks handily and it wasn't until 1871 that stock investors managed to break even. Stocks failed to match bonds once again from 1929 -1949 and stocks didn't manage to break even until the early 1960s. We've had a huge bull market in bonds since 1982 and it may not be quite over yet.
But it is probably coming to an end, given that nominal interest rates aren't likely to fall much further absence outright deflation - something that Federal Reserve Chairman Ben Bernanke says isn't possible if a central bank is willing to keep printing money, as ours clearly is. So back to stocks for the long run then? We don't think so given the tremendous over valuation that currently exists. It is hard to get excited about loading up on stocks when they are trading some 45% above fair value.
And that leaves us with a conundrum - neither stocks nor bonds are particularly attractive for the long run right now, making it a difficult time to be an investor. I am holding cash and gold stocks personally, along with a position in a single stock. I have a list of companies I intend to buy when the next big sell off hits, likely sometime in the next 12-18 months.
Biechele Royce Advisors builds properly diversified portfolios (mine is not) and is currently overweighting nondollar assets, tangible assets, and big blue chip dividending paying U.S. companies. We continue to buy good companies at great prices as we find them.
Okay, okay time out.... You are puzzled because I'm dissing stocks for the long run aren't you? I mean, the baby boomers grew up in the stock friendly world of the 1980s and 1990s. We were told that stocks always deliver a superior return over the long run and that most of us should just forget about bonds and pile into stocks as long as we were looking at a 10-year plus time horizon. We were told that we'd end up with far more wealth in retirement by sticking with the superior long run returns of stocks. Well.... we weren't really getting the whole story when it comes to stock returns versus bond returns as it turns out.
The fact is that bonds have far outperformed stocks over the last 10 years, to the tune of 5.23% per annum, and have kept up with stocks over the last 20 and 30 year periods with far less volatility. The fact is that investors over the last 30 years would've been far better off sticking with bonds ONLY. But that must be a very unusual occurrence right? Not really. It turns out that there have been a number of very long periods during which bonds were superior to stocks. The period 1803-1857 comes to mind - bonds trounced stocks handily and it wasn't until 1871 that stock investors managed to break even. Stocks failed to match bonds once again from 1929 -1949 and stocks didn't manage to break even until the early 1960s. We've had a huge bull market in bonds since 1982 and it may not be quite over yet.
But it is probably coming to an end, given that nominal interest rates aren't likely to fall much further absence outright deflation - something that Federal Reserve Chairman Ben Bernanke says isn't possible if a central bank is willing to keep printing money, as ours clearly is. So back to stocks for the long run then? We don't think so given the tremendous over valuation that currently exists. It is hard to get excited about loading up on stocks when they are trading some 45% above fair value.
And that leaves us with a conundrum - neither stocks nor bonds are particularly attractive for the long run right now, making it a difficult time to be an investor. I am holding cash and gold stocks personally, along with a position in a single stock. I have a list of companies I intend to buy when the next big sell off hits, likely sometime in the next 12-18 months.
Biechele Royce Advisors builds properly diversified portfolios (mine is not) and is currently overweighting nondollar assets, tangible assets, and big blue chip dividending paying U.S. companies. We continue to buy good companies at great prices as we find them.
Monday, May 16, 2011
Presidential Cycle
The S&P 500 sold off two weeks ago, losing 1.72%. Energy was the hardest hit, declining close to 7%, followed by materials, which was down 3.77%. Defensive sectors such as Staples and Telecom were flat or only down slightly. The overall market traded basically flat last week until a Friday sell off closed it out near its recent lows.
So much for the very short term action. Longer term the S&P 500 is trading 45% above fair value, according to Jeremy Grantham of GMO ($108 billion under management), who pegs fair value at 920 for the S&P 500. Grantham’s estimate of fair value gibes with both Tobin’s Q and Shiller’s P/E (very good long term measures of stock market fair value). All of which means equity investors are still playing with fire. Hide out in bonds? Not Treasury bonds, at least not according to Bill Gross of Pimco fame. Bill has informed the world that Pimco has sold all of its Treasury holdings ahead of the end of QE2 (set to finish up at the end of June).
Grantham had thought that the combination of QE2 and the third year of the presidential cycle could push the S&P 500 back to between 1400 and 1600 by October of this year – putting it back into bubble territory. (Grantham is a student of bubbles in various asset classes throughout history and measures them against average valuations. He uses a two standard deviation divergence from long-term fair value to mark a bubble – what is supposed to be a once in 44 year event). Grantham now thinks it much less likely that the S&P 500 will reach the 1400-1600 level by fall, given its failure to advance farther by now. Historically, the market has advance 20% in the first seven months of the third year of the Presidential cycle (started last October). The entire return, on average, for the 48 month cycle is only 21%, meaning investors can expect a whopping 1% return from the S&P 500 over the next 41 months based solely on the Presidential cycle. Of course, these are only averages for the Presidential cycle and don’t take into account things like the current overvalued state of the market or the current jobless recovery (negatives for likely future returns.)
Bottom line for investors (and yep I know I’m starting to sound like a broken record) is that the market remains very overpriced and a dangerous place to be right now. Healthy levels of cash will ensure that any 20% to 30% decline from current levels in the next few years will make it possible to buy cheap assets that will provide above market rates of return going forward.
Biechele Royce Advisors continues to buy good companies at great prices as we find them. We are holding extra cash in clients’ portfolios for the inevitable rainy day that is coming, likely in the next 12 to 24 months.
So much for the very short term action. Longer term the S&P 500 is trading 45% above fair value, according to Jeremy Grantham of GMO ($108 billion under management), who pegs fair value at 920 for the S&P 500. Grantham’s estimate of fair value gibes with both Tobin’s Q and Shiller’s P/E (very good long term measures of stock market fair value). All of which means equity investors are still playing with fire. Hide out in bonds? Not Treasury bonds, at least not according to Bill Gross of Pimco fame. Bill has informed the world that Pimco has sold all of its Treasury holdings ahead of the end of QE2 (set to finish up at the end of June).
Grantham had thought that the combination of QE2 and the third year of the presidential cycle could push the S&P 500 back to between 1400 and 1600 by October of this year – putting it back into bubble territory. (Grantham is a student of bubbles in various asset classes throughout history and measures them against average valuations. He uses a two standard deviation divergence from long-term fair value to mark a bubble – what is supposed to be a once in 44 year event). Grantham now thinks it much less likely that the S&P 500 will reach the 1400-1600 level by fall, given its failure to advance farther by now. Historically, the market has advance 20% in the first seven months of the third year of the Presidential cycle (started last October). The entire return, on average, for the 48 month cycle is only 21%, meaning investors can expect a whopping 1% return from the S&P 500 over the next 41 months based solely on the Presidential cycle. Of course, these are only averages for the Presidential cycle and don’t take into account things like the current overvalued state of the market or the current jobless recovery (negatives for likely future returns.)
Bottom line for investors (and yep I know I’m starting to sound like a broken record) is that the market remains very overpriced and a dangerous place to be right now. Healthy levels of cash will ensure that any 20% to 30% decline from current levels in the next few years will make it possible to buy cheap assets that will provide above market rates of return going forward.
Biechele Royce Advisors continues to buy good companies at great prices as we find them. We are holding extra cash in clients’ portfolios for the inevitable rainy day that is coming, likely in the next 12 to 24 months.
Tuesday, April 12, 2011
Real Asset Allocation
"The market tends to be priced in a way that if you want to try to outperform, you have to take the risk of looking like an idiot," according to Ben Inker, the head of asset allocation at Boston-based global money manager Grantham, Mayo, van Otterloo & Co. (GMO has approximately $107 billion under management). And looking like an idiot can get you fired in the money management business, which means the markets are not efficient, since money manager behavior is predictable. Career risk is real and money managers do make decisions to avoid taking on career risk. It is far better to lose money together than make money alone. Likewise, it is important to stay up with the Jones when the market is rising. Falling behind the pack in a bull market can get you fired as well. Mutual funds are currently fully invested, with cash levels back to the 2007 lows. Its a curious decision mutual fund managers have made to go "all in" right now given the demonstrably overvalued market and the obvious catalysts for a correction/bear market, unless you understand that it is career risk that is driving the train, not investment risk. Inker's quote bears repeating because it is the alpha and omega of money manager behavior. "The market tends to be priced in a way that if you want to try to outperform, you have to take a risk of looking like and idiot." Inker goes on to explain that to outperform you have to deviate from your benchmark, and that increases the risk of under performance and, in the extreme, looking like and idiot and getting fired. It is no coincidence that fully 75% of the so-called actively managed funds are actually closet indexers according to academics (closet indexers claim to actively manage their funds but actually mimic their benchmark, leaving investors to pay high fees for something they could get for a fraction of the cost by simply investing in index funds). And what is the impact on the market as a result of the career-risk factor? Markets exhibit herd-like behavior, which leads to momentum, and money flowing into whatever strategy is doing best, according to Inker. Valuations rise to extremes within the better performing asset classes and sectors until the gravitational pull of replacement cost exerts itself. Replacement cost (Tobin's Q is a very good long term measure of the relationship between the market and replacement cost) eventually always brings the market back to fair value, but typically with an overshoot to the downside first (as the herd exits in mass, ignoring valuations on the way down just as it did on the way up). Biechele Royce Advisor (like GMO) increases allocations to assets and sectors AFTER they have dropped and decreases allocations to assets and sectors AFTER they have risen, in order to take advantage of a HUGE inefficiency in the markets created by career risk. However, we primarily let individual securities lead us to our over and under weights, using big picture considerations to provide a context for our valuation decisions. In other words, rather than making a broad call on an asset class, we instead do basic business valuation in order to buy good companies at great prices. Likewise we let basic business valuation drive our sell decision, making sure we exit a position once the company has returned to fair value.
Friday, March 25, 2011
Variable Annuities - the New Snake Oil
The cliche of the snake oil salesman is deeply embedded in American cultural in the form of frequent depictions in the movies of those fast talking salesmen touting their wares to a crowd of curious onlookers. Most of you probably have seen a scene from a western in which the smooth talking dandy pitches his wonderful elixir as "good for whatever ails you!" Variable annuities with a guaranteed minimum wealth benefit (GMWB) are increasingly sold in much the same manner. Insurance agents and fee-based "advisors" increasingly push variable annuities on anyone and everyone, regardless of their age, income, and wealth. Frequently these salesmen don't even understand what they are selling, only that they get BIG commissions for selling them. Are you a 78 year-old single woman with Alzheimer, but with $1.3 million in the bank? No problem! You NEED a variable annuity with a GMWB rider. A couple in your mid-60s with two defined benefit plans between you? No problem! You need TWO variable annuities and you definitely need to replace the ones you were already sold in your Roth IRAs with two brand new ones that are waaaaay better! Why are they better? Because they are NEW and generate another commission for ME! The truth is that variable annuities are one of the most oversold products out there because of their big commissions, not because of their actual performance. Now here's a dose of reality courtesy of Dr. Michael Edesess (advanced mathematics and economics), Louis Mittel of Advisor Perspectives, and Robert Huebscher. Variable annuities under perform a passively managed fixed income portfolio by almost 1.60% annually on average based on modeling 100,000 trials using random date-of-death Monte Carlo simulations. In fact, a passive fixed income strategy has a higher internal rate of return (IRR) for all life spans through 113 years of age. The variable annuity returns just can't make up for their higher fees and the cost of the longevity insurance embedded in the product over shorter periods of time. Of course, insurance industry sponsored research "shows" that variable annuities are superior to passively managed fixed income portfolios. However insurance industry studies are flawed to say the least. For instance, industry studies assume that an investor will live to be 90 years of age 100 percent of the time even though the actual probability is only 19%. As well, insurance industry studies "show" that variable annuity income will keep pace with inflation even though inflation has averaged 3% over the last century and the actual nominal median average income increase for variable annuities is only 0.5% per year (far below insurance industry claims). So the next time the snake oil salesman comes a calling, "JUST SAY NO!" Biechele Royce Advisors could sell you variable annuities and make those big commissions, but instead chooses to do the right thing by building you properly diversified stock and bond (fixed income) portfolios to help you achieve a successful retirement. Best Regards, Chris Christopher Royce Norwood, CFA Biechele Royce Advisors, Inc.
Tuesday, March 15, 2011
Valuations Matter
The table below summarizes very nicely why we continue to view the U.S. stock market as high risk and low return. We have been projecting since the beginning of the year that a 10% to 20% pullback was likely sometime in the first two quarters of 2010 . We think the events in Japan are now serving as a catalyst and believe the correction has begun. The S&P 500 is down 6.2% peak to trough currently and we expect it to fall to at least 1200 before the current pullback is over. A correction to the 200-day moving average would result in a decline of about 12% and is the minimum we expect at the moment. A deeper correction back to 1100 is certainly possible. Biechele Royce will continue to buy good companies at great prices as they come available.
TABLE
10-year S&P 500 total returns by P/E level
***Shiller P/E is currently 24***
Shiller Avg Annual Return
Below 12 16.0%
12 to 16 14.3%
16 to 20 10.3%
20 to 24 6.6%
Above 24 3.5%
5-year S&P 500 total returns by P/E level
***Shiller P/E is currently 24***
Shiller Avg Annual Return
Below 12 16.5%
12 to 16 12.4%
16 to 20 9.3%
20 to 24 11.6%
Above 24 3.2%
(Note the jump in five-year returns for valuations in the 20 to 24 range: it is the result of short-term momentum in bubble markets. The S&P 500 hasn't seen Shiller P/Es at or above 24 except for a very brief period in 1929, and then during the current bubble years encompassing 1999 to the present.)
Please feel free to call or e-mail with questions about the current investing environment...
Regards,
Christopher Royce Norwood, CFA
Biechele Royce Advisors, Inc.
Wednesday, February 9, 2011
Dividend Paying Stocks Are Superior
Dividend paying stocks outperform with lower volatility. Put another way... non-dividend paying so-called growth stocks are inferior investments. Now that might come as a surprise to many of you who've been suckered into buying growth stocks by your fee-based (stockbroker) advisors (either directly or via growth mutual funds), but the empirical evidence is irrefutable. You are better off buying "stodgy" dividend paying stocks because you will make more MONEY with less RISK.
The latest in a string of studies done by the academic world has once again verified that dividend-paying stocks are better investments than the zero dividend crew. Specifically, a study done by Dr. C. Thomas Howard (Reiman School of Finance) for the period January 1973-September 2010, shows that companies which grew their dividend out performed dividend cutting stocks by more than 10% annually. Companies that merely maintained their dividend outperformed companies with no dividend by 5.29% annually. Let's do some Q&A...
Would you rather have $24,267 or $9,285? Would you rather have $21,288 or $11,977? The first number is what you'd accumulate from 1973 thru September of 2010 if you stuck to dividend growing stocks and made an initial $10,000 investment. The second number represents dividend cutting stocks while the third amount is a portfolio of no change dividend paying stocks and the final number are the GROWTH companies that pay no dividend. Kinda makes you wonder why the brokers are always pushing growth stock mutual funds on you doesn't it?
But it gets even better! You can have the $24,285 portfolio with less risk - as measured by volatility. Dividend growing stocks had a standard deviation of 17.6% versus a standard deviation of 26.6% for zero dividend paying stocks. Standard deviation is a measure of volatility which means lower is better.
Now some of you might point out that there is a tax penalty associated with dividends in non-qualified accounts (qualified accounts such as IRAs, 401(k)s and 403(b)s don't pay taxes and aren't impacted). And you'd be right. However, the out performance of dividend paying stocks more than compensates you for holding them - EVEN IN A TAXABLE
ACCOUNT.
The bottomline (once again) is that investors are far better off buying dividend paying stocks (directly if possible to cut out the mutual fund fees) rather than the high-flying, zero dividend paying growth stocks that are typically pushed by the commissioned based salesmen passing themselves off as investment advisors.
Biechele Royce Advisors buys good companies at great prices. We are currently focusing even more than normal on high-quality dividend paying stocks in our equity portfolios. Fair value for the S&P 500 is between 800-900 and we expect the market to exhibit increased volatility over the next few years as the current cyclical bull market ends and the secular bear market resumes.
The latest in a string of studies done by the academic world has once again verified that dividend-paying stocks are better investments than the zero dividend crew. Specifically, a study done by Dr. C. Thomas Howard (Reiman School of Finance) for the period January 1973-September 2010, shows that companies which grew their dividend out performed dividend cutting stocks by more than 10% annually. Companies that merely maintained their dividend outperformed companies with no dividend by 5.29% annually. Let's do some Q&A...
Would you rather have $24,267 or $9,285? Would you rather have $21,288 or $11,977? The first number is what you'd accumulate from 1973 thru September of 2010 if you stuck to dividend growing stocks and made an initial $10,000 investment. The second number represents dividend cutting stocks while the third amount is a portfolio of no change dividend paying stocks and the final number are the GROWTH companies that pay no dividend. Kinda makes you wonder why the brokers are always pushing growth stock mutual funds on you doesn't it?
But it gets even better! You can have the $24,285 portfolio with less risk - as measured by volatility. Dividend growing stocks had a standard deviation of 17.6% versus a standard deviation of 26.6% for zero dividend paying stocks. Standard deviation is a measure of volatility which means lower is better.
Now some of you might point out that there is a tax penalty associated with dividends in non-qualified accounts (qualified accounts such as IRAs, 401(k)s and 403(b)s don't pay taxes and aren't impacted). And you'd be right. However, the out performance of dividend paying stocks more than compensates you for holding them - EVEN IN A TAXABLE
ACCOUNT.
The bottomline (once again) is that investors are far better off buying dividend paying stocks (directly if possible to cut out the mutual fund fees) rather than the high-flying, zero dividend paying growth stocks that are typically pushed by the commissioned based salesmen passing themselves off as investment advisors.
Biechele Royce Advisors buys good companies at great prices. We are currently focusing even more than normal on high-quality dividend paying stocks in our equity portfolios. Fair value for the S&P 500 is between 800-900 and we expect the market to exhibit increased volatility over the next few years as the current cyclical bull market ends and the secular bear market resumes.
Wednesday, January 12, 2011
The Current Rally
So there I was rereading my last blog and I could sorta kinda understand why some of my readers e-mailed me to sarcastically thank me for my gloomy outlook. To those readers and everyone else let me proclaim...
The world is NOT coming to an end! (and no that's not a change of mind on my part.) My intention in my last blog was to make sure everyone is aware that the economy is sick and likely to stay that way for a long time given the crushing debt load - both public and private. As well, I wanted to make sure you folks understood that the market risk level is extremely high. However...
You can invest prudently, even in today's overvalued stock market, and earn a positive return over the next 10-year period. But chasing momentum, volatility, or credit risk will likely lead to losses over the long-term unless you happen to be a very good speculator. Fair value for the S&P 500 is somewhere around 800-850 based on a number of very good long-term valuation metrics (which are not widely followed by Wall Street because they have limited use for speculators focusing on short term returns). For instance, investors using Tobin's Q, price to trailing 10-year average earnings, and the long-term dividend growth rate as guidelines would have anticipated the 10-year period of negative stock market returns that began in 2000. Currently those valuation metrics are forecasting a return of 3.5% to 4% during the next 10-year period - a big step up but still well below the long-term historical return of 10%.
The current rally is not based on attractive valuations but rather speculative forces chasing higher risk, lower quality assets, egged on by the Federal Reserve's blatant promises of more money printing. Examining return factors makes it painfully obvious that speculators are chasing stocks with the greatest exposure to market fluctuations, commodities, credit risk, small-cap risk, and volatility while avoiding stocks with reasonable valuations, stability, high-quality earnings, and attractive dividend yields. In fact, looking at thirteen week factor returns tells a compelling story of speculation that, when coupled with an overpriced market, makes it almost inevitable that bad things will eventually happen to those investors choosing to play the risk game.
Return sources for the 13-weeks leading into year-end 2010 from high to low were: Market Beta (Risk) - 17.8%; Raw Materials Beta (Commodity sensitivity) - 17.5%; Credit Spread Beta (Macro Economic Sensitivity) - 14.7%; Small v Large Beta (Style sensitivity) - 12.5%; Silver Beta (Commodity Sensitivity) - 10.9%; Sigma Risk (Volatility) - 10.7%; Operating Cash Flow Yield (Valuation) - (- 4%); EPS Stability (Quality) - (-5.6%); Value v Growth Beta (Style Sensitivity) - (-5.9%); Return on Invested Capital (Profitability) - (-6.6%); Dividend Yield (Valuation) - (-9.3%); 10-Year T-Note Beta (Macro Economic Sensitivity) - (-9.6%); High v Low Quality Beta (Style Sensitivity) - (-15.7%)
Clearly the high risk, low-quality garbage stocks have dominated the rally into year end while lower risk, high-quality stocks have trailed sharply. Tellingly, Operating Cash Flow, Sales/Price, Market Cap, and EBIT/Enterprise value lead all other return factors over the last 10-years, meaning valuation does eventually win out! More specifically, those investors who focus their attention on the underlying value of the businesses in which they are investing will do just fine over the long run as price (eventually) always follows value. Buying good businesses at great prices only adds to both the margin of safety and the ultimate returns. Businesses that are steadily growing cash flows over time create a situation where it is nearly impossible for an investor to lose money - as long as the investor is willing to wait for market prices to reflect underlying values. Which brings us back to current valuation levels....
Given that fair-value for the S&P 500 stands around 800 to 850, it would seem prudent for investors to set aside at least some cash now in order to take advantage of better valuations sometime in the (near?) future. And for those of you reluctant to raise some cash because you're worried about missing the next great bull market? Relax! The gains we are currently experiencing in the market will almost certainly reverse sometime in the next few years and quite possibly in the next few quarters. The fact that net profit margins are currently 50% above their long-term mean (and it is a strongly mean reverting series) all but ensures that corporate profits will begin to disappoint sometime in the next few years (few quarters?) and cause a market sell off back toward fair value. Capital preservation is still the priority of the day and cash is not a dirty four letter word!
Biechele Royce Advisors is holding more cash than normal for its clients. We don't buy stocks unless we can invest in good companies at great prices. We are focused on high-quality, dividend paying stocks in our domestic portfolios and expect to have an opportunity sometime this year to add to our holdings at lower prices.
The world is NOT coming to an end! (and no that's not a change of mind on my part.) My intention in my last blog was to make sure everyone is aware that the economy is sick and likely to stay that way for a long time given the crushing debt load - both public and private. As well, I wanted to make sure you folks understood that the market risk level is extremely high. However...
You can invest prudently, even in today's overvalued stock market, and earn a positive return over the next 10-year period. But chasing momentum, volatility, or credit risk will likely lead to losses over the long-term unless you happen to be a very good speculator. Fair value for the S&P 500 is somewhere around 800-850 based on a number of very good long-term valuation metrics (which are not widely followed by Wall Street because they have limited use for speculators focusing on short term returns). For instance, investors using Tobin's Q, price to trailing 10-year average earnings, and the long-term dividend growth rate as guidelines would have anticipated the 10-year period of negative stock market returns that began in 2000. Currently those valuation metrics are forecasting a return of 3.5% to 4% during the next 10-year period - a big step up but still well below the long-term historical return of 10%.
The current rally is not based on attractive valuations but rather speculative forces chasing higher risk, lower quality assets, egged on by the Federal Reserve's blatant promises of more money printing. Examining return factors makes it painfully obvious that speculators are chasing stocks with the greatest exposure to market fluctuations, commodities, credit risk, small-cap risk, and volatility while avoiding stocks with reasonable valuations, stability, high-quality earnings, and attractive dividend yields. In fact, looking at thirteen week factor returns tells a compelling story of speculation that, when coupled with an overpriced market, makes it almost inevitable that bad things will eventually happen to those investors choosing to play the risk game.
Return sources for the 13-weeks leading into year-end 2010 from high to low were: Market Beta (Risk) - 17.8%; Raw Materials Beta (Commodity sensitivity) - 17.5%; Credit Spread Beta (Macro Economic Sensitivity) - 14.7%; Small v Large Beta (Style sensitivity) - 12.5%; Silver Beta (Commodity Sensitivity) - 10.9%; Sigma Risk (Volatility) - 10.7%; Operating Cash Flow Yield (Valuation) - (- 4%); EPS Stability (Quality) - (-5.6%); Value v Growth Beta (Style Sensitivity) - (-5.9%); Return on Invested Capital (Profitability) - (-6.6%); Dividend Yield (Valuation) - (-9.3%); 10-Year T-Note Beta (Macro Economic Sensitivity) - (-9.6%); High v Low Quality Beta (Style Sensitivity) - (-15.7%)
Clearly the high risk, low-quality garbage stocks have dominated the rally into year end while lower risk, high-quality stocks have trailed sharply. Tellingly, Operating Cash Flow, Sales/Price, Market Cap, and EBIT/Enterprise value lead all other return factors over the last 10-years, meaning valuation does eventually win out! More specifically, those investors who focus their attention on the underlying value of the businesses in which they are investing will do just fine over the long run as price (eventually) always follows value. Buying good businesses at great prices only adds to both the margin of safety and the ultimate returns. Businesses that are steadily growing cash flows over time create a situation where it is nearly impossible for an investor to lose money - as long as the investor is willing to wait for market prices to reflect underlying values. Which brings us back to current valuation levels....
Given that fair-value for the S&P 500 stands around 800 to 850, it would seem prudent for investors to set aside at least some cash now in order to take advantage of better valuations sometime in the (near?) future. And for those of you reluctant to raise some cash because you're worried about missing the next great bull market? Relax! The gains we are currently experiencing in the market will almost certainly reverse sometime in the next few years and quite possibly in the next few quarters. The fact that net profit margins are currently 50% above their long-term mean (and it is a strongly mean reverting series) all but ensures that corporate profits will begin to disappoint sometime in the next few years (few quarters?) and cause a market sell off back toward fair value. Capital preservation is still the priority of the day and cash is not a dirty four letter word!
Biechele Royce Advisors is holding more cash than normal for its clients. We don't buy stocks unless we can invest in good companies at great prices. We are focused on high-quality, dividend paying stocks in our domestic portfolios and expect to have an opportunity sometime this year to add to our holdings at lower prices.
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