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.

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.

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.

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.

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.