Maybe it is the complexity of the financial scenario or the small scale of assets (only $1.2 Billion), but outrage does not seem to exist for MF Global and its lead dog, Jon Corzine. Whether the disappearance of $1.2 Billion in clients’ assets is fraud or incompetence, it could impact your portfolio if you don’t watch out.

So what really happened at MF Global? MF Global is a broker-dealer, which means investors place assets with MF Global to place trades in stocks, bonds, futures, options, etc. MF Global custodies or holds the assets as well as conducts the underlying transactions for their clients. Several broker-dealers exist. You might use a discount custodian like Charles Schwab, Scottrade, TD Ameritrade, or E-Trade, or you might use a company like Merrill Lynch, Wells Fargo, and Morgan Stanley. The problem with MF Global arose because it also manages its own portfolio along with its duties as a broker-dealer. While managing its own money, MF Global screwed up. It leveraged its portfolio 34-1 and bet big on European sovereign debt. This amount of leverage is ridiculous. As an example, imagine you had $1 Million (don’t we all wish). Through the use of debt or options, you control $10 Million of assets with your initial $1 Million. If your $10 Million lost 10%, you now control $9 Million in assets, but the $1 Million you lost wiped out your initial $1 Million portfolio. You are broke. At 34 times leverage, it only takes a 3% loss to wipe out your initial capital and create a margin call (where you have to put in more money to keep your positions open).

This is what happened to MF Global. European government bonds have taken a beating over the past few months, and MF Global got a margin call. Problem is they didn’t have any money to cover the margin call. Instead, they took money from clients who were utilizing their broker-dealer services. Just imagine that you have a portfolio of stocks and bonds at your brokerage house. You expect that your assets remain your assets. These firms are regulated to ensure this happens, but it didn’t.  Clearly, if MF Global merely took client funds, this is fraud. Corzine should see jail time even if he didn’t directly authorize this practice since Sarbanes-Oxley mandates the CEO have a system in place to prevent fraud.

A chance exists that this isn’t fraud. It could have been rehypothecated assets. What is this? Hypothecation happens all the time. You probably do it with a mortgage. All it means is you put an asset as collateral to borrow money. For a mortgage, you borrow the money and use the home as collateral. You still own the home, but the bank can repossess the home if you fail to repay the mortgage. Rehypothecation is where the collateral is re-used by the bank or financial institution. Using the mortgage as an example, rehypothecation would be the bank using your home as collateral for a debt it is undertaking. Could you imagine your home being foreclosed upon because an investment by the bank went sour. This is rehypothecation. It was a big problem in 2008 because many banks, including Lehman and Bear Stearns, were rehypothecating clients’ assets in the shadow banking system. This can be totally legal. Hidden away in small print in the enormous brokerage agreement you sign, a clause may exist authorizing your brokerage to rehypothecate your assets.

This could affect you, and you might have no recourse. So what should you do? First, ask your broker if the current agreement allows them to rehypothecate your assets. If so, get the agreement changed or leave the broker. Second, if your brokerage firm has an investment banking arm or invests on its own behalf, leave them immediately. If Corzine and the other cronies at MF Global are not prosecuted for this sin, then it sends a signal to the other bankers that stealing client funds is ok. This puts your hard earned capital at risk. Don’t take a risk with a firm that has its own portfolio. Take action before you find your account has been raided.

I wanted to throw some thoughts out on the dreaded downgrade from S&P. Bottom line: it isn’t a big deal.

1. Why isn’t it a big deal? Investors in US government bonds already knows our government debt equals our Gross Domestic Product (GDP), which is the size of our economy. This isn’t news. S&P isn’t providing any information that isn’t easily attainable to the average investor. It isn’t like they discovered trillions in debt that we didn’t know about. Japan’s debt was downgraded in 2002, and everyone expected the worst for Japanese bonds. Yet, they have rewarded investors nicely since that point as yields dropped further and haven’t climbed like the world anticipated.

2. The markets may be volatile today and tomorrow, but it is short term noise. Ultimately, the market reflects the growth of the economy and corporate earnings. If those factors do well, so will the stock market. Certainly, higher interest rates affects corporate profits so this downgrade could hurt the market if interest rates rise. This leads to the next point.

3. Why did we get downgraded? Because we EARNED it (insert John Houseman impersonation here). Don’t believe the politicians as they blame S&P for the market turmoil or even the Tea Party Republicans. S&P should be applauded for standing up to the US government. Our politicians, both Democrat and Republican, put us in this position with their inept management and stupidity. This brings me to the next point.

4. Politicians are nothing more than professional wrestlers in Armani suits. Like wrestlers, they say horrible things about their competitors and fire up their fans (the base), but the reality is the fight is fixed.  Both parties overspend and swap favors then grab a beer after the “fight”. The difference between the Republicans and Democrats is similar to the difference between Jif and Skippy peanut butter…not much (but they are all nuts).

So don’t worry about the market volatility that much. In fact, you should be thankful for the volatility as it is this volatility that enables stocks to provide a higher return. The lack of volatility is why CDs pay so little. You know you are getting a guaranteed return – albeit paltry. For clients of Picket Fence Financial, you don’t have to sweat the stock market as we moved out in July as the Fed ended its Quantitative Easing program.

Either way, stick to your long term plan. Do not panic. This market could turn around for the better at a moment’s notice. If you don’t have a clear investment strategy, then this volatility should prompt you to do so.

How many of you could totally screw up at your job and not feel any pain or punishment? If you aren’t a corporate CEO, you probably can’t. Here is an article profiling a few corporate execs who jumped the shark at their previous firms only to latch onto high paying exec jobs at other companies. You really have to wonder what the Board of Directors are thinking at these other companies. I think so many of these problems, including egregious corporate executive pay, would be reduced or eliminated if the shareholders started suing corporate board members. These board members are usually well connected individuals, often times without any real business skills (think politician), who get these positions for their connections. So they have no real incentive to run the company well. They want the very generous pay and the prestige of serving on the board…great resume fluffer.

With so many lawyers in this country, I can’t imagine why we don’t see more lawsuits on the behalf of shareholders. Could be the laws protect the politicians who eventually sit on these boards?

I have been following the buy/sell ratio of corporate insiders for some time, and I have found that the number of shares sold greatly outnumbers the buys – often over 500 to 1. Corporate insiders are not putting their own money into their company stock, but they sure are cashing in the stock they have. I was glad to see an analysis hit the main stream press by TrimTabs. The reports points out how corporations are borrowing cash to buyback stock. While this is usually seen as a bullish maneuver because fewer shares exist resulting in a higher Earnings Per Share (EPS) calculation, it might just be a move for corporate execs to ensure their stock options are worth more. They certainly are not putting their own money into their company stock.

TrimTabs says companies spent a thumping $124 billion in the first three months of the year trying to boost their share prices by buying up stock.That works out at about $2 billion for every day the market opened.

Meanwhile, according to Trim Tabs, guess who avoided buying stock during the first quarter? Company executives. The “insiders.”

These are the guys whose stock purchases tend to strongly signal bull markets and genuine booms. They were spending investors’ money buying their stock, but weren’t spending their own.

TrimTabs says insiders’ stock purchases came to less than $2 billion for the entire quarter, a comparatively low level.

“We’ve never seen such a sharp contrast between what insiders are doing with their own money and what they’re doing with the money of the companies they manage,” TrimTabs Chief Executive Charles Biderman wrote in a note. Stock buybacks outnumbered executive stock purchases by the highest ratio TrimTabs has seen since it started tracking the numbers back in 2004.

“While insiders are willing to use corporate cash to try to support the value of their stock-based compensation, they don’t seem to think their stocks are attractively priced,“ Biderman said.

As you read the article, it does look suspicious that corporate executives would create a liability (debt) for the company to buyback stock after the market has increased 90%. Why didn’t they do this at the bottom? The corporate insider buy/sell ratio was much closer than it is today back in March 2009. So corporate execs were buying their company stock back at the market bottom.

There are always going to be more corporate sales than buys as corporate execs will need to diversify out of their company stock options, but the ratio has hit extremes. Certainly, this factor alone does not warrant selling stock, but it certainly needs to be part of your overall equation. Be careful about buying stocks when the insiders are jumping like rats on a sinking ship. That is all I am saying.

Great video from the Financial Times where Russell Napier is interviewed. Napier is a thoughtful analyst, historian and money manager who understood the problems of 2008 and called the 2009/2010 rally – so one is wise to listen to him. In this video, he explains why he sees the S&P 500 falling to 400 from its current 1300 level. Napier uses two valuation methods: the Price to Earnings based on rolling 10 year earnings and the Q Ratio. As an aside, I am putting out my newsletter which will explain these metrics further.

Napier says that the 2008/2009 bear market only took us to reasonable valuations. Usually, true secular bottoms exhibit extremely cheap valuations. We never got close. Napier even discusses how secular bottoms are met with apathy from investors. He claims in 2009 we had fear – even extreme fear – but it was not apathy. He believes when no one believes in stocks anymore we will be through the secular bear, and stocks will be a fantastic investment.

Even scarier than a 900 point drop in equities, Napier still prefers stocks to bonds. That speaks volumes to me.

http://video.ft.com/v/946244201001/Long-View-Historian-sees-S-P-fall-to-400

I saw this article provided by the Wall Street Journal, and it bummed me out. I like to think I am a contrarian in life and investing.  One of my current ideas is long dated or maturing Treasuries will be the place to be for the next few months. To see this in a mainstream publication like the Wall Street Journal bummed me out. While there are a few keen minds that agree with my simpleton thought process such as Jeff Gundlach, a top bond manager at Doubline Capital, the vast majority of investors believe that Treasury yields will climb and Treasuries wil lose value when the Federal Reserve ends its Quantitative Easing (QE) in June.

Even famed bond fund manager Bill Gross holds the view that Treasuries are doomed when QE II ends. Gross, who manages almost a trillion dollars in bonds at PIMCO Funds, has sold his entire position in Treasuries, and he has been everywhere talking about why he sold out. He thinks there won’t be enough Treasury buyers to make up for the absence of the Federal Reserve. In case you aren’t sure what QE is, the Federal Reserve prints money to buy Treasury bonds. Since the second round of QE started in September, the Fed has purchased almost 70% of the government’s Treasury issuances.  That is an enormous percentage of the Treasury’s issues so it is understandable to see why the Treasury could have to offer higher yields to attract investors. The WSJ article discusses this exact reasoning:

Bond bears doubt that enough buyers will step in and replace the bond-buying power of the Fed, which isn’t sensitive to prices, forcing the U.S. government to pay more dearly for its heavy borrowing.

That has led many investors to bet that Treasury prices will fall. “Almost every client we have seen in the last month is short” U.S. Treasurys, Mike Schumacher, global rates strategist at UBS, wrote in an email. At a lunch last Wednesday with nine portfolio managers from central banks, “everyone who expressed a view” was short Treasurys, he added.

So why am I bullish on Treasuries? The last line in the above paragraph is a start. Most everyone is bearish on them. The market likes to inflict as much pain as possible on as many participants as possible so if everyone is bearish, the market will probably deliver the opposite.

My main reason for liking Treasuries is history. Last year when the Fed ended its first round of QE in the summer of 2010, the economy and equities markets swooned, and Treasuries did very well. Money moved from risky assets to bonds. This also happened numerous times in Japan. During its 20 year bear market, Japan’s central bank would inject money and watch the economy and stock market pick up. The stimulus would end and so would the stock market rally. Great investment minds have been calling for the Japanese bond market to tank for years now, but it hasn’t happened yet as the Japanese economy deleverages. Our economy needs to delever as well.

Let me be clear on one point though. I think the dollar and Treasuries are doomed long term so long as the Fed continues to run QE programs and the government spends 40% more than it brings in with tax receipts. However, for the short term, I think Treasuries will do well. Just watch for the Fed to start its third round of QE. That changes my view.

Of course, you should not take this article as advice. My lawyers wouldn’t like that. Do your own research, but I hope this article gives you some food for thought.

A good friend of mine, Steve Goldberg, writes for Kiplingers and is a money manager. His specialty is mutual funds. He came out with an article today describing the nine rules he uses when selecting mutual funds. Check out his article for the full explanation, but here are his keys (with a few of my comments).

1. Ignore Short Term Performance: Totally agree here. Too many investors look at the star rating at Morningstar when investing in funds. This is dangerous as the stars heavily weigh short term performance. I remember picking an international bond fund a few years back that only had 3 stars. Many clients questioned why I would chose a fund with such a low performance. The reason was the fund invested in developed economies with shorter term durations (or maturities). The top performing funds were mostly emerging market funds with longer durations and questionable quality. During 2008, the top five star funds got slaughtered. So dig deeper than short term performance and the mighty Morningstar rating system.

2. Focus on expenses: There are three factors that determine your return: market returns, taxes and expenses. You can’t control the first; you can control the others or at least time them better. This is why I favor index funds or ETFs, but this holds for actively managed funds as well.

3. Corporate culture matters: I will never invest in Putnam, Invesco, Strong, or Prudential funds due to their involvement in the mutual fund trading scandal of 2003. I strongly suggest you don’t either. Don’t trust companies that put cash ahead of ethics.

4. Study risk adjusted returns: This plays with the short term performance. How much return are you getting for the risk you are taking? Many funds get the five star rating during good market environments only to get crushed when things turn south. This is because of the underlying risk in the portfolio of the fund. ALWAYS start with risk when investing, and you will make fewer mistakes. You may miss some good times, but it is the long term we are focused.

5. Consider long term returns under current manager: Basically, make sure there is steady management. If the fund has lots of turnover with managers, you should steer clear of the fund.

6. Watch for asset bloat

7. There are exceptions to every rule

8. Sometimes an index fund is the best choice: Steve and I have friendly disagreements on this point. I am an index fund champion; he likes actively manged funds. I do use three active funds right now for bonds. These are for international, mortgage and bank rate loans. However, for stocks, I am all index based and for about 50% of my fixed income funds.

9. The numbers don’t tell you everything.

Here is a well informed video from Morningstar.com about bank rate loans or floating income funds. I won’t get into the details too much as the video does this, but I think this will be a very valid asset class to hold in the coming years as interest rates rise. These funds hold short term debt, usually between 30 and 60 days, so the holdings turn over quickly, which reduces interest rate risk. The rates are usually tied to Prime or LIBOR so the loans automatically adjust when rates rise (and, conversely, shrink when rates drop).

Again, the video details the operation of these funds well, but I have added this to client portfolios. I expect a steadier return over the coming years as rates eventually rise. However, these funds did experience a large loss during 2008-2009 so if you invest in these funds, you need to take a long term focus. In client accounts, I use the Fidelity Floating Rate High Income Fund (Ticker: FFRXH). This is a more conservative floating rate fund, but it will still provide the interest rate risk insulation that I hope to achieve with these funds.

Today, the Federal Reserve Chief, Ben Bernanke, will hold a press conference to detail what the Fed’s plan is once the second round of Quantitative Easing ends. Some think they will let the plan end with the stipulation that the Fed stands ready to jump back in if needed while others believe that Quantitative Easing III will be announced. I really think it is totally anti-capitalist to have a cartel of 13 bankers control so much of our economy and markets, but that is where we are. I decided to write a letter to Uncle Ben, and I put it here first. Also, after the letter, I have some thoughts on how this decision should drive your investments.

Dear Chairman Bernanke:

Today, you will alert the markets to the Federal Reserve’s decision about extending QEII, implementing QEIII, or letting the markets function on a more normal basis. I do hope you choose the latter. Unlike most Americans, I realize that you actually work for the banks (since the Fed is owned by its member banks) and not the government (or its citizens) so I understand the banksters would be upset with you if QEIII doesn’t happen. Providing the banks with all that fresh liquidity has helped them make a fortune in the stock and commodity markets. I do feel for the banksters if you don’t do QEIII, I really do. I know this will probably mean that the banksters won’t be able to afford the newest Lamborghini. They would be forced to settle for the Mercedes S class. While this is a step down, I hear the S Class is awfully nice. In fact, I was driving my 1995 Jeep (saving up for a used Hyundai) on the highway the other day, and I was cut off by an S Class. As I drove into the ditch, I remember thinking the S Class maneuvered superbly. So I hope that you agree an S Class is an acceptable mode of transportation for the banksters.

If that doesn’t convince you to halt any attempt at QEIII, I hope you will look at the price of most commodities. Since the announcement of QEII, prices for staples like oil, grains, livestock, and industrial metals have increased around 50%. I do realize that the world is demanding more commodities as China, India and other emerging markets develop their economies, but I suspect the underlying demand hasn’t increased 50% in six months. I know you deny publicly that QEII caused any commodity inflation, but I know that you know that I know that you know (to quote Eddie Murphy) QEII is causing commodity prices to rise. Being the ever optimist that I am, I guess I could deal with a continued spike in commodities. Maybe it will allow me to shed those last, stubborn 10 pounds I have been trying to burn off since I won’t be able to afford as much food.

If you still aren’t convinced, I will make a desperate plea by reminding you that our nation became great with a market based economy. While we never had true capitalism, it was as close to a capitalist society as was ever seen. Maybe if we start to move towards the principles, upon which we were founded, we could correct our inefficiencies and malinvestment and start to grow again. I know – silly, isn’t it. I am so naive to believe in things like principles. If you find my thoughts humorous, I ask you don’t share them with the banksters. They may attempt to read it while driving their new Lamborghinis and run me off the road (as they laugh their tails off). I can’t afford to repair another front end to my Jeep, and I haven’t saved enough for that Hyundai either.

Sincerely,

Kirk Kinder

I know, I know. I am being too much of a smart ass. I just find sarcasm soothing when I am in an uncontrollable situation. I do think that the Fed’s decision is a critical step though. It will have a dramatic effect on your wallet so we need to understand how.

The reason it will be such a big decision is the fate of the dollar rests in the Fed’s hands. If they undertake more Quantitative Easing, the dollar will drop even further than it already has. To put it in perspective, the dollar is around the low last seen in 2008 before the crash. If it breaks this trend, the drop could be severe. This means inflation will be even more painful than it has been for the past six months. If QEIII is announced, then it would be wise to think about investing in commodities, especially gold and silver, along with stocks. I would also look at parking cash in foreign currencies. Everbank has FDIC backed CDs denominated in foreign currencies.

If the Fed halts its Quantitative Easing program in June, I expect commodities and stocks to slowly lose value as money moves to Treasuries. Last summer, the stock/commodity markets were tanking and Treasuries/the US dollar was doing quite well. Then QEII was announced, and the opposite happened. The general consensus of most is Treasuries will get hammered if the Fed stops buying them through its QE program. Bill Gross, the manager of the largest bond fund in the world, has sold all his Treasuries expecting rates to rise and bond prices to fall once QE ends.

As mentioned previously, most market pundits agree. I am certainly a contrarian here, which I like. I always remember that the market attempts to provide the most pain to as many people as it can. I do feel a bit relieved in that Jeff Gundlach shares my view. He has outperformed Bill Gross’ bond fund for the past decade or so.

I still believe the natural tendency of the economy is to deflate. We have way too much debt as a nation that must be reduced through repayment or default. Without massive amounts of money printing, liquidation will begin, and investors will move to the dollar or Treasuries as it is seen as a more guaranteed return than commodities or stocks. Long term, Treasuries are doomed, but a guaranteed payment – even if it loses value due to interest rates rising – is better than an unguaranteed return from stocks/commodities.

Please take a moment to read my disclaimer and remember I am not advocating you invest in any particular way. I am just throwing out ideas for you to ponder. So ponder away and watch out for those Lamborghinis and Mercedes S Classes. They will drive you right off the road. :^)

Here is the latest missive from John Mauldin who takes it from Ed Easterling. It is a great piece about stock market expectations looking at price to earnings compression and future growth. I expect lower returns for the foreseeable future due to the reasons laid out in this article. Great reading for all who care about their returns.

This week we look at another except from Ed Easterling’s gonzo book on stock market return projections, called Probable Outcomes. This section is entitled “Game Changer,” and it is that and more. (Again, thanks to Ed for letting us read his work!)

“Game Changer” is a thought-provoking, somewhat detailed analysis, with two major surprises. The first is that GDP growth was well below average last decade (a trend that could continue this decade); and second, slowing growth has a substantial negative effect on valuations (P/E ratios). This ties well into my own Endgame and suggests implications about slower growth, etc. (similar to what I project from work of my own). Slower growth drives P/Es lower (even without higher inflation, or deflation) and could drop the market by a third or so relative to “normal” cycles.

Ed and I talk about this a lot, and agree that readers must understand Endgame to appreciate how significant “Game Changer” can be. Probable Outcomes complements Endgame with specific implications for investors and policy makers who look to the stock market for returns over this decade.

Just another quick plug for Endgame from a review on Amazon:

“Endgame: ‘The final stages of an extended process…’ The aptly chosen title for Mauldin’s new book reflects the vision that he started sharing over a decade ago when he foresaw the Muddle Through Economy (he repeatedly warned about Muddle Through in his free weekly newsletter at Thoughts from the Frontline and in his best-selling books).

“In Endgame, Mauldin and Tepper detail the history of events that layered increasing debts on an underperforming economy. Their analysis is not limited to the U.S., but rather walks around the world highlighting a global issue. Mauldin again demonstrates his laudable ability to synthesize vast amounts of information into relevant nuggets. The first half of Endgame lays the foundation brick-by-brick, including a look at the basics of economics and recent research to understand the situation. The second half of the book proceeds country by country laying out the common and unique problems that they confront. It exposes a world of vulnerability, but not one that is hopelessly destined. Mauldin and Tepper are optimists, and present a call to action that can result in a successful endgame.

“Once again, as another decade starts, Mauldin assembles a plethora of data and charts to deliver information that investors, policy makers, and involved citizens need to better understand and act upon. From the classic principles of Minsky to the modern groundbreaking research of Reinhart and Rogoff, Mauldin explains clearly the credible scenario that the burdens from mountains of debt create another decade or longer of Muddle Through as a process rather than an event. Passage through the vestibule of the endgame requires restitution in the forms of deflation, inflation, volatility, and slow economic growth. Despite the headwinds, endgame need not be game-over – which appears to be Mauldin’s personal game plan for his new book. He includes writings to his children that their future can be much brighter than the current period that we confront. Knowledge is power and you’ll find both in Endgame.”

You can get the book at Amazon or Barnes & Noble. And enjoy “Game Changer”!

Your writing away analyst,

John Mauldin, Editor
Outside the Box

Game Changer

An Excerpt from Probable Outcomes: Secular Stock Market Insights

By Ed Easterling

Copyright 2010, Crestmont Research

Well-recognized and published statistics tell us that the long-term return from the stock market has been 10%. The reality is that the 10% average reflects the combination of periods with above-average returns and those with below-average returns. These periods, however, are not random sets of over and under. Rather, the stock market experiences these periods based upon fundamental conditions in the economy and the financial markets.

Further, the conditions are recognizable, and therefore stock market returns are relatively predictable over extended periods of time. These periods are known as secular stock market cycles. The term “secular” is derived from a Latin word that means an era, age, or extended period. Actually, an original Latin variation of the word has been closer to hand than most people realize.

On the back of the American one-dollar bill is the Great Seal of the United States. One part of the seal is the circle on the left-hand side bearing a pyramid topped with an eye. Look closely under the pyramid: there is a banner with the phrase “novus ordo seclorum.”

In 1782, Charles Thomson, a Founding Father of the United States, and secretary of the Continental Congress, worked as the principal designer of the Great Seal. There is extensive symbolism included in the seal. When Thomson proposed the seal to Congress, he described the meaning of novus ordo seclorum as “the beginning of the new American Era.”

When the word “secular” is used to describe stock market cycles, it expresses that the cycle is an extended period with something in common throughout. Secular bull markets are extended periods that cumulatively deliver above-average returns. These periods are driven by generally rising multiples of valuation as measured by the price/earnings ratio (P/E). Secular bear markets are the opposite: extended periods with cumulative below-average returns driven by a generally declining P/E for the market. Thus the secular aspect of these periods relates to the generally rising or falling trend in P/E over an extended period of time.

P/E is the price of the market divided by the earnings of the market. Investors and analysts often apply to individual stocks the same formula used for the market. This valuation multiple essentially represents the number of years’ worth of earnings that investors will pay for the investment. During certain conditions, typically when the inflation rate is low and interest rates are low, investors are willing to pay higher prices measured as a multiple of earnings for the market and for stocks in general. When inflation and interest rates are high, or when deflation (negative inflation) occurs, investors are driven to pay lower prices and multiples for the market. Probable Outcomes goes deeper into the financial reason for those decisions. At this point, it is important to remember that the stock market moves through periods of above- and below-average returns—known as secular stock market cycles.

The secular cycles are graphically visualized in figure 2.1, reflecting the secular bull market periods (green bars) and secular bear market periods (red bars). The blue line below the bars reflects the cycle of the P/E ratio that drives the green-bar and red-bar periods.

Figure 2.1 Secular Stock Markets Explained

Link: Secular Stock Markets Explained

The most significant aspects to note in this chart include the variability in time over which secular cycles occur. Some cycles were relatively short, while others lasted close to two decades. This graph also begins to gives us a sense that returns come in spurts rather than a more consistent uphill grind around an average that some people incorrectly believe is normal.

In particular, note the blue line on the lower part of figure 2.1, reflecting P/E and its cycle over more than a century. The historical range within which P/E has cycled has been relatively consistent: generally with lows that were near 8 and highs in the low to mid-20s (except, of course, the late 1990s bubble). The historical average has been near 15, depending upon the method and time period used.

Foremost, keep in mind two key points. The range of the P/E cycle, as established by the highs and lows, is largely determined by the real growth rate of earnings. The relative position of P/E within the range is what has been determined by the level of inflation and its trend.

Pop Quiz

Before venturing further into the discussion about the P/E cycle, pause a moment for a pop quiz to highlight the previous point about the effect of economic growth on P/E. There is new information that could actually make it different this time!

Beyond the insights from the question and its answer, this will start the journey toward the potential scenarios for the economy over this decade and the implications for stock market returns.

Over the past century in the United States, real economic growth before inflation has averaged near 3% per year. Over the decades of the 1970s, 1980s, and 1990s, the compounded average annual growth rate was 3.2%, 3.0%, and 3.2% respectively. So during the decade of the 2000s (2000–2009), when consumers were loading up their credit cards, homeowners were said to be using home equity like an ATM, unemployment averaged 5.5% and fell below 4% at times, and leverage was being added to leverage, what was the compounded annual growth rate before inflation rounded to the nearest percent?

The first choice, 4%, is the most logical response. It reflects the perception that much of the consumption and leverage artificially accelerated economic growth. People that choose 4% expect that the factors in the question boosted economic growth above the historical and recent average growth rate.

Following such a strong period of economic growth, most people answering “A” expect a period of below-average growth over the 2010s to make up for the excesses of the prior decade. They expect that periods during which growth was fueled by debt will be followed by offsetting moderation as the vestiges of leverage and excess consumption are addressed.

The second choice, 3%, is the contrarian response. It reflects a belief that this time was not different. Though some of the factors included in the question may have impacted economic growth, people who choose 3% either don’t believe that those factors had much effect, or presume that there may have been similarly unique factors during prior decades. Nonetheless, economic growth of 3% has endured for more than one hundred years and has been very consistent in recent decades. Some people in this group believe that 3% is likely for this decade, while others have begun to adopt the notion of a New Normal with slowing growth due to recent trends in demographics, government policy, taxes, etc.

The third choice, 2%, is the correct response, despite being least selected. Many investors are surprised that the decade of the 2000s experienced compounded annual growth of only 1.9%. Some economists say that it was a decade sandwiched by two recessions, while others blame it on the severe recession of 2008 and the related financial crisis. Yet excluding the recession of 2008 from the decade, the growth rate for the first eight years of the 2000s was still only 2.6%. Further, cumulative economic growth throughout the decade of the 2000s did not exceed 2.7%. It would have required an unusual surge—near 4.5% annually—in the final two years for the full decade to reach the historical average annual growth rate of near 3%.

This sets the stage for a dilemma. Will the decade of the 2010s restore the long-term average by growing at 4%, thereby defying the predominant belief of a slow-growth decade? Was the prior decade of the 2000s an anomaly, with future economic growth simply returning again to its long-term trend of 3%? Did something change ten years ago, and has economic growth downshifted to a level near 2%, or as some might contend, could the rate be even lower due to the economic, financial, and/or policy headwinds in front of us? All three scenarios are plausible, which makes economic growth Major Uncertainty #1. The answer to the dilemma has very significant implications for stock market returns over this decade and longer.

Game Changer

Probable Outcomes explores the possibility that future real economic growth, excluding inflation, may have downshifted from its historical trend of 3%. This major issue has not often been considered. In the past century, real economic growth has increased at slightly more than 3% annually. As a result of the relationship between earnings and the economy, EPS has increased at near 3% in real terms.

Therefore the range of the past P/E cycles has been driven by real growth near 3%. That level of growth has been considered a standard assumption. The recent decade and other factors are now challenging that assumption for the future.

One effect of slower economic and earnings growth is a lower level of earnings in the future. For example, over ten years, $1.00 compounds to $1.34 at 3%, but only to $1.22 at 2%. The difference is about 9.3% less EPS for the stock market under the slower growth scenario. Many analysts would consider that level of variance a minor forecasting error for EPS over a decade. Whether the stock market is 9% higher or lower in a decade is generally small change in the context of overall returns. But the implication of slower growth is far more significant than simply the ending level of earnings. Slower growth is a game changer.

There are three ways to assess its effect, all of which provide similar results. First, an extremely long-term model of earnings growth, dividend payouts, and present value can be constructed to assess the impact of changes in growth on P/E. Second, the academic formulas can be used to derive the effects on P/E based upon perpetual dividend growth. Third, the impact on P/E can be evaluated through the components of stock market return. Since all three approaches reflect comparable results, the more pragmatic third approach will be used to explore the implications.

Before examining the details, consider the significance of the issue. If the future growth rate of earnings decreases by 1% (i.e., near the reduction that would be expected if economic growth decreases by 1%), the historical average for P/E would decline from 15.5 to 11.5—representing a 26% decline in the stock market beyond the 9% shortfall from lower earnings growth. More dramatic, the typical peak in P/E falls from the low to mid-20s to the mid-teens; the adverse impact of slower growth increases at higher levels of P/E.

As previously discussed, inflation causes P/E to decrease because investors demand more return to compensate for higher inflation. Unlike the inflation rate, the growth rate of earnings does not necessarily change the return level that investors expect. They will still expect returns that are commensurate with the stock market and the expected inflation rate, but they will look to replace the contribution of slower earnings growth with another source of return.

To illustrate, assuming that a change in the growth rate does not change the inflation rate, the yields on government bonds can be expected to remain the same. Absent a change in credit quality from slower growth, the risk premium within corporate bond yields would not change. Likewise, the expected return from stock market investments can be expected to remain unchanged due to the growth rate.

When slower growth reduces the contribution of earnings growth to total return, another source of return is therefore needed to fill the shortfall. Stock market investors will not be willing to take equity risk without appropriate equity returns. If bond yields do not change, they will not compromise stock market returns. In this situation, stock market investors will step away until the price of the market declines to again provide appropriate returns. This is the function of markets—finding the price that provides a fair return.

This discussion relates to the effect from changes in the growth rate of earnings. To isolate that factor, several assumptions are needed, basically providing that the relevant relationships remain the same. First, based upon the previous economics discussion, a downshift in economic growth drives slower earnings growth. Second, long-term profit margins remain similar under both growth scenarios, thus the slowing of earnings growth is consistent with the downshift in economic growth. Third, the inflation rate remains constant across both scenarios for growth. Fourth, the expected return for stocks and bonds as well as the related equity risk premium for stocks does not change across both scenarios for growth. In other words, the relevant relationships remain the same.

Of the three components of stock market returns, two are available as sources of return, and the third one represents the way in which returns occur. The first source of return, EPS growth, is defined in this example as either providing 3% or 2% toward to the total return. As a result, the second source of return, dividend yield, will need to increase to compensate for lower earnings growth in the second scenario. Herein is the role of the third source of stock market returns: changes in P/E.

The dividend yield rises as P/E declines and vice versa. For the stock market to be positioned to provide equity-level returns, investors will look for the lower price that enables the dividend yield to rise sufficiently to offset the loss of earnings growth. The required decline in P/E varies based upon the starting level of P/E.

If P/E starts relatively high, then a higher decline is required to provide the required dividend yield increase. For example, if EPS growth drops by 1%, then the change in P/E required to increase the dividend yield by 1% is 7 points from 22 to 15, 4 points from 15.5 to 11.5, and 2 points from 10 to 8.

This shift in P/E relates only to the change in earnings growth. P/E would then be further affected by changes in the inflation rate.

There will likely be, and needs to be, much debate about the accuracy of the estimates presented above, and about nuances that could add decimal points to the factors, or adjust the effects based upon further scenario assumptions. However, whether using long-term models, academic formulas, or the component-based method, all three approaches provide similar results. It is therefore important to recognize that slower growth will have a significant impact on P/E at all levels of the inflation rate. As the discussion evolves into implications and probable outcomes over this decade, slower economic and earnings growth will have a direct effect on the P/E range.

In closing, P/E is a measurement tool for market valuation. The level of P/E, driven by the principles of present value, reflects the price at which the stock market can deliver sufficient returns to compensate for inflation and risk. P/E is driven lower when conditions of inflation change the outlook for required returns. In addition, P/E declines when deflation changes the outlook for the level of future earnings. Of particular note, slower long-term economic and earnings growth reduces future cash flows and drive P/E lower. Conditions of solid long-term earnings growth and low inflation therefore provide the best conditions for a high P/E. In an environment where economic growth and the inflation rate are major uncertainties, an accurate and valid measure of P/E is more relevant and needed than ever before.

Rainbows

Investors are confronting the reality of the current secular bear market. It is both the consequence of the previous secular bull market and the precursor to the next secular bull. The duration of the current secular bear period is uncertain. Should inflation or deflation overcome the economic environment in the near term, this secular bear could end sooner. That reality, however, would cause significant losses to stock market portfolios. If inflation or deflation slowly creeps into the economy, over the next decade for example, then this secular bear will have been one of the longer ones. However, if this decade repeats the relatively low inflation of the past decade, then the secular bear should remain in hibernation.

Beyond the inflation rate, economic growth also will have an impact on the future of this secular bear. Following last decade’s below-average economic growth, this decade could generate above-average growth to offset the recent shortfall. The result would be a solid boost to earnings in this decade. Economic growth, however, also could have downshifted during the last decade to a lower level for the foreseeable future. The result would be a significantly lower range of P/Es, but not necessarily a progression through the secular bear market. The economic growth rate can shift P/E upward or downward, but only inflation or deflation can end a secular bear market.

Whether this secular bear cycle ends in five years, ten years, or beyond, the result will be the start of the next secular bull market, which will bring an extended period of above-average returns. Spring finally will have sprung. This longer-term view of secular stock market cycles is the reason to look out across this secular bear to the next secular bull. The operative word is “across” this secular bear and not “past” it.

“Across” recognizes the reality of the risks and opportunities presented by secular bear markets. “Past” is the ostrich-like approach of ignoring reality with blind hope for an unrealistic outcome. “Across” is enabling, while “past” is disabling.

For investors who are accumulating for the future, secular bear markets are times to build savings for later investment. This is done not only through contributions but also through prudent investing with an absolute return approach to investment returns. The absolute return approach uses the dual strategy of risk management and investment selection.

Investment portfolios should be diversified across a range of investments that are diligently selected and actively managed, especially ones that control risk and enhance return. In particular, investors should not avoid the stock market or bond market. Instead, their objective should be to seek in both markets investments that incorporate elements of skill to enhance returns. Secular bear markets are not periods during which to avoid investing; they are periods that demand an adjustment to investment strategy.

For investors who are more dependent on their current assets, including pension funds and retirees, investment strategy should be paired with early recognition. The principles of absolute return investing are important for preserving capital and generating much-needed returns. But potentially more important than managing the investment portfolio, pension funds and retirees would be well served in this environment to manage their assumptions and expectations. Earlier recognition of secular bear market conditions enables potentially painful adjustments to be smaller. Delaying action until crisis has onset generally brings greater adverse consequences. It is not prudent to hope for the next secular bull market to arrive sooner as a way to address shortfalls. The longer expectations take to adjust, the greater the gap to fill with an increasingly short time to fill it.