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.

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 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.

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....