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|Executive Summary||May 1, 2009|
In most situations, a 6.1% decrease in gross domestic product, the rise of a border-jumping, potential flu pandemic, and the bankruptcy of one of America's most well-known auto firms would likely mean some rough times for stock investors. But when you're coming off a period in which the specters of bank nationalization, a second Great Depression, and all-out financial Armageddon were raised, it's a different story.
Despite the worse than expected GDP numbers, the swine flu worries, and Chrysler's Chapter 11 filing, stocks have remained on their bullish run over the past two weeks, with investors letting those concerns roll of their backs and instead focusing on small steps forward for the economy.
And there were, in fact, several of those good economic signs. For one thing, consumers -- whose spending makes up about two-thirds of U.S. economic activity -- are turning more and more positive. For the first quarter, consumer spending was up 2.2%, the Commerce Department reported, and The Conference Board's consumer confidence index surged 46% in April. That data -- while still below levels associated with economic growth -- suggests that consumers believe the economy is nearing a bottom, according to The Conference Board.
They're not the only ones seeing positive signs. The Federal Reserve this week said that the economic contraction, while still ongoing, is slowing. And the Economic Cycle Research Institute -- whose leading indicators have a good track record of predicting economic shifts -- said enough of its signals have turned upward to indicate with certainty that a recovery is coming, according to Reuters. And the group thinks it should come before summer is done.
Another reason for optimism: First-quarter earnings, while not fantastic, are exceeding expectations. According to Bloomberg News, 70% of the 309 S&P 500 members reporting earnings as of April 30 have beaten analysts' estimates. And while some of the positive earnings surprises were the result of cost-cutting layoffs, investors took heart yesterday in the news that new claims for unemployment -- which many analysts expected to rise -- fell slightly last week.
That's not to say everything is rosy. Overall unemployment and underemployment rates are still high, and the financial sector still has a ways to go in working out all of the bad debt that has clogged the system. In addition, the government's first round of bank "stress tests" reportedly found that Bank of America and Citigroup will need to raise more capital.
The housing market also continues to struggle. Home prices fell almost 19% in February, according to new data, and foreclosure starts jumped 20% in March, according to CNN. But there are signs that things may be on the verge of getting better. Housing and Urban Development secretary Shaun Donovan said this week that, while more data is needed to confirm a long-term trend, the market is showing signs of turning around. "Since January, what we've seen is both prices and sales volumes moving up and down around a relatively stable number," he said, according to Reuters. Signs of recovery are greatest in the hardest-hit areas, like California, he added.
One final economic note (and it's a positive one): In his most recent newsletter, Jon Markman notes that the steepening yield curve -- which shows the difference between short- and long-term interest rates -- bodes very well for the economy. For one thing, banks benefit because they pay out little on deposits and take in higher long-term rates in their loan assets, he says.
In addition, Markman notes that fixed-income investors "will also be encouraged to bailout of the market, since bond prices fall as yields rise, and may just find the equity market tempting. Given the massive flight to quality seen over the last year, as risky capital was whisked away into money market accounts and U.S. Treasury funds, we could see a similarly impressive reversal of this flow."
This is more than a hunch. Markman says a steep yield curve has been a strong indicator of the end of recessions throughout history, turning upward a number of times as the economy improved. "According to a model maintained by the Federal Reserve," Markman writes, "the current yield curve suggests that GDP will expand at about a rate of 3% over the next year. Moreover, the probability that the economy will be in recession in 12 month's time is well under 2%, according to this model."
All of these "green shoots" of hope were enough to keep the market humming over the past two weeks. Since our last newsletter, the S&P 500 is up 0.9%, as it continues its climb back toward the black for 2009. The Hot List, meanwhile, continues to outperform the index by a substantial margin, gaining 4.5% over the past two weeks. It is now well in the black for 2009, having gained 9.6% vs. the S&P's 3.4% loss. Since its inception nearly six years ago, the portfolio has gained 79.8%, during which time the S&P has lost 12.8%.
Why Not to Listen to the "Why Not to Invest" Crowd
The market's continued strength over the past two weeks is very encouraging. For stocks to continue to climb after such a surprisingly weak GDP announcement and during the quasi-hysteria caused by the swine flu news indicates that expectations had gotten so low in the earlier part of this year that stocks did indeed become quite undervalued. Now, any flickers of hope seem to be slowly pulling money back into the market -- and there's a lot of it out there to pull back. According to Forbes, investors have $9.5 trillion in money with zero maturity -- cash sitting in Treasuries or money market accounts. Charles Schwab's Chief Investment Strategist Liz Ann Sonders says that is more than the value of all publicly traded U.S. firms, and represents the most money sitting on the sidelines in history.
Still, even with all that cash laying in wait, many are saying that now is no time to put money into stocks. I disagree, and I thought it would be a good time to counter several of the bearish arguments I've seen recently. Here they are -- with the other side of the story.
"We're Due for a Pullback": Yes, the dramatic turnaround we've seen since March 9 has been a bit dizzying, and makes one wonder whether it was too much too soon. But a closer look shows that it may, in fact, have been just the right amount. According to Kenneth Fisher, one of the gurus upon whose writings I base my strategies, the nature of bottoms has historically been "V-shaped", meaning that the steeper the decline at the end of a bear market, the steeper the incline at the start of a bull run.
When we look at the current turnaround, the "V-shapedness" is pretty striking. Back on Jan. 12, the S&P 500 sat at 870.26. Over the next eight weeks exactly, it tumbled to that 676.53 March 9 low. As of yesterday's close (which was two days shy of exactly eight weeks since the March 9 low) the index was back up to 872.81 -- less than one-third of one percentage point from that Jan. 12 starting point.
Could there be a "post-V" pullback, though? Maybe. But history shows it's no sure thing. Back in 1982, after bottoming following a nasty bear, the market surged 22% in about 40 days. It then had only a minor pullback of a couple percent before surging almost 20% in the next 40 or so days. The bottom line: Trying to avoid a 10% or 15% pullback that might never occur is, for me, too risky a proposition -- especially given that equity prices are still fairly low. Avoid stocks at these valuations, and the odds are you'll be sorry.
"The Great Depression Recovery Took 25 Years": This, frankly, sounds terrifying on the surface. And, in literal terms, it's true that the Dow Jones Industrial Average took about 25 years after its Great Depression bottom to reach its pre-Depression high. Does that mean that it could be 2027 before we get back what we've lost in the recent market crash?
According to Mark Hulbert, founder of Hulbert Financial Digest, that's pretty unlikely. Hulbert said in a recent New York Times column that the 25-year Depression recovery figure is misleading for three big reasons. First, major deflation --- by 1936, the Consumer Price Index was 18% lower than it was when the market crashed in 1929 -- made the dollar worth much more than it had been. So, the amount of purchasing power investors gained in the recovery when the market turned up by, say, a dollar, was greater than the amount of purchasing power they lost for each dollar of declines in the preceding bear market.
Second, the Dow took 25 years to recapture its pre-Depression price high, but that doesn't include dividends. And when the market bottomed in 1932, the dividend yield of the overall market was almost 14%, according to Yale Professor Robert Shiller's data. Those payouts were no doubt a big boost to investor's portfolios.
Third, Hulbert notes that the Dow can diverge significantly from "the market". And back in the late 1930s, IBM was removed from the index. It went on to be one of the best-performing stocks of the '40s, Hulbert says, and the popular stock was likely in many investors portfolios even though its gains didn't help the Dow.
So, when you take all of those factors into account, when did investors really regain the purchasing power they had, pre-Depression? About four-and-a-half years after the 1932 market bottom, Hulbert says. That's just four-and-a-half years to regain the losses suffered when the Dow declined 80%.
"Bonds: The Best Long-Term Investment": A couple of big names -- Rob Arnott of Research Affiliates and Forbes' Gary Shilling -- have made headlines with articles along these lines recently. Shilling and Arnott are both very smart men and are extremely knowledgeable about the financial world, but I -- and many others -- believe their data is somewhat misleading.
Shilling, for example, contends that stocks underperform bonds, even in very bullish periods. In fact, he says, 25-year Treasury bonds generated 11 times the return of the S&P 500 from the early 1980s through March of this year. That may be true, but the problem with Shilling's argument is that the early 1980s was perhaps the greatest period to buy Treasury bonds in history. With inflation rates around 13% or so, T-bonds were offering yields in the 15% range. Today, the rates are in the 3% to 4% range. In addition, to make the stocks/bonds comparison through March of this year means you're valuing stocks just a few weeks after a low that represented the second-largest bear market decline ever. Doesn't seem like a good time to get a "big picture" view of what to expect from stocks in the future.
Arnott's study also has similar biases. One of the major periods he looks at, for example, is 1979 through 2008. (For a more in-depth look at the stocks/bonds issue, see Brett Arends recent piece for The Wall Street Journal at http://online.wsj.com/article/SB124096744859166453.html.)
"Haven't You Heard? Stocks are More Risky in the Long Run" A recent study by two notable professors -- Lubos Pastor of the University of Chicago and the National Bureau of Economic Research and Robert Stambaugh of the University of Pennsylvania's Wharton School -- found that stocks actually become riskier over longer periods of time, contrary to what conventional market wisdom states. The reason lies in the fact that the future gets harder to predict the farther out you go. For example, we have a decent idea of what global warming's impact will be in the next year. But 20 years from now, the picture gets much murkier.
Given all that we've been through in the past year or two, the study injected another level of fear into the stock debate: If stocks just lost more than half their value in a matter of a year-and-a-half, why would anyone want to invest for longer -- and riskier -- periods?
Well, in an interview with one of Wharton's web sites this week, Stambaugh indicated that things weren't that bleak for stocks, and urged readers not to misinterpret what the study meant. The study's findings about volatility increasing over longer periods doesn't mean that volatility in the future will be greater than the high volatility levels we've been experiencing in the past several months, he said: "We expect that sort of short-run volatility to moderate. Our paper is more about what a more typical environment -- or more average environment -- for volatility would offer an investor in terms of short-run versus long-run. We'd all be very surprised if [this historically high short-term volatility] were to continue for long periods".
In addition, Stambaugh said the study only looked at stocks. Other asset classes could get riskier over time as well, he said. "It's quite possible that this same kind of [long-term] uncertainty in nominal bonds could well make them less attractive," he said, adding that he and the study's other authors hope to due follow up research on that issue.
Speculation Doesn't Just Hurt Bulls
Now, to be clear, all of this is not to say that the market's current run is going to continue, uninterrupted, for months and months. What it does mean, however, is that much of the anti-stock rhetoric that is lingering in the post-crash environment seems somewhat overblown, or based on mere speculation about potential disastrous consequences -- and allowing speculation to keep you out of the market can be as dangerous as allowing speculation to pull you into the market. I'd rather continue to look at the facts and the long-term data, and right now I think both are indicating that this is no time for long-term investors to bail on stocks.
Guru Spotlight: Joel Greenblatt
Anyone who has ever put cash in the market knows that making money in stocks is hard. But what a lot of investors don't realize is that while it is difficult, it doesn't have to be complicated. You don't need incomprehensible, esoteric formulas and you don't need to spend every waking hour analyzing stocks -- Joel Greenblatt has proved that.
Back in 2005, Greenblatt created a stir in the investment world with the publication of The Little Book that Beats The Market, a concise, easy-to-understand bestseller that showed how investors could produce outstanding long-term returns using his "Magic Formula" -- a purely quantitative approach had just two variables: return on capital and earnings yield.
Greenblatt's back-testing found that focusing on stocks that rated highly in those areas would have produced a remarkable 30.8 percent return from 1988 through 2004, more than doubling the S&P 500's 12.4 percent return during that period. Greenblatt also posted impressive numbers in his money management experience, with his hedge fund, Gotham Capital, producing returns of 40 percent per year over a span of more than two decades.
Written in an extremely layperson-friendly manner, Greenblatt's "Little Book" -- it's only 176 pages long and small enough to fit in your jacket pocket -- broke investing down into terms even an elementary schooler could understand. In fact, Greenblatt said he wrote the book as a way to teach his five children how to make money for themselves. Using several simple analogies, he explains a variety of stock market principles. One of these he often returns to involves Jason, a sixth-grade classmate of Greenblatt's youngest son who makes a bundle selling gum to fellow students. Greenblatt uses Jason's business as a jumping off point to explain issues like supply, demand, taxation, and rates of return.
In reality, the "Magic Formula" is less about magic than it is about simple, common sense investment theory. As Greenblatt explains, the two-step formula is designed to buy stock in good companies at bargain prices -- something that other great value investors, like Warren Buffett, Benjamin Graham, and John Neff also did. The return on capital variable accomplishes the first part of that goal (buying good companies), because it looks at how much profit a firm is generating using its capital. The earnings yield variable, meanwhile, accomplishes the second part of the task -- buying those good companies' stocks on the cheap. The earnings yield is similar to the inverse of the price/earnings ratio; stocks with high earnings yields are taking in a relatively high amount of earnings compared to the price of their stock.
To choose stocks, Greenblatt simply ranked all stocks by return on capital, with the best being number 1, the second number 2, and so forth. Then, he ranked them in the same way by earnings yield. He then added up the two rankings, and invested in the stocks with the lowest combined numerical ranking.
The slightly unconventional ways in which Greenblatt calculates earnings yield and return on capital also involve some good common sense -- and are particularly interesting given the recent credit crisis. For example, in figuring out the capital part of the return on capital variable and the earnings part of the earnings yield variable, he doesn't use simple earnings; instead, he uses earnings before interest and taxation. The reason: These parts of the equations should see how well a company's underlying business is doing, and taxes and debt payments can obscure that picture.
In addition, in figuring earnings yield, Greenblatt divides EBIT not by the total price of a company's stock, but instead by enterprise value -- which includes not only the total price of the firm's stock, but also its debt. This give the investor an idea of what kind of yield they could expect if buying the entire firm -- including both its assets and its debts. In the past few months, we've seen how misleading conventionally derived P/E ratios and earnings yields could be, since earnings had been propped up by the use of huge amounts of debt. Greenblatt's earnings yield calculation is a way to find stocks that are producing a good earnings yield that isn't contingent on a high debt load.
In my Greenblatt model, I calculate return on capital and earnings yield in the same ways that Greenblatt lays out in his book.
We added the Greenblatt portfolio to our site in January of this year, but we have been tracking its performance internally for several years, and its underlying model has factored into our Hot List selections for the past year or so. So far, the model has been a strong outperformer. Since we began tracking the 10-stock Greenblatt-based portfolio in late 2005, the S&P 500 has fallen 31.0 percent, but the portfolio has gained 2.8 percent. So far this year, it has been particularly strong, posting a 15.0 percent gain vs. the S&P's 3.4 percent loss.
Part of the reason the model significantly outperformed the S&P this year is that it doesn't invest in financial stocks. Because of the way they and utility companies are financed (i.e. with large amounts of debt), Greenblatt excludes them from his screening process, so I do the same. He also doesn't include foreign stocks, so I exclude those from my model as well.
While Greenblatt's methodology is completely quantitative, one of the most important aspects of his approach is psychological -- and it's something that I believe is critical to keep in mind in the current financial climate. To Greenblatt, the hardest part about using the Magic Formula isn't in the specifics of the variables; it's having the mental toughness to stick with the strategy, even during bad periods. If the formula worked all the time, everyone would use it, which would eventually cause the stocks it picks to become overpriced and the formula to fail. But because the strategy fails once in a while, many investors bail, allowing those who stick with it to get good stocks at bargain prices. In essence, the strategy works because it doesn't always work -- a notion that is true for any good strategy.
News about Validea Hot List Stocks
Lincoln Electric Holdings (LECO): On April 28, Lincoln reported a first-quarter net loss of $3.6 million, or 8 cents a share, down from net income of $53.5 million, or $1.24 a share, in the year-ago period. Excluding charges, earnings were 9 cents a share, falling short of analysts' forecasts of 23 cents a share, Reuters reported, adding that revenue fell 34 percent to $411.8 million. Analysts expected $422.7 million. The firm cited the rapid and steep deterioration in overall global demand, and the impact of liquidating higher cost inventory as reasons for the loss. The company is considering staffing, compensation level, and manufacturing facility changes that would save $20 million to $25 million per year, Reuters said. Investors didn't mind the loss, however; shares has risen 12% since the announcement as of Thursday afternoon.
BJ Services Co. (BJS): On April 21, BJ Services announced fiscal second-quarter earnings of $43 million, or 15 cents per share, down from $127.3 million, or 43 cents per share, in the year-ago period as drilling activity decreased amid the global recession, the Associated Press reported. Revenue dropped 18 percent to $1.05 billion. Analysts had expected profit of 22 cents per share on revenue of $1.13 billion, AP stated. Again, however, investors weren't too worried. The stock gained more than 20% from April 20 through April 29.
Ceradyne Inc. (CRDN): Ceradyne announced a first-quarter profit of $708,000, or 3 cents a share, down from earnings of $32.4 million, or $1.18 a share, in the year-ago period. Analysts expected earnings of 20 cents a share, according to bizjournals.com. Sales fell 47% to $99.8 million amid the global economic slowdown. The firm said it has a strong balance sheet and had positive cash flow of $10.5 million in the first quarter, however.
The Next Issue
In two weeks, we will publish another issue of the Hot List, at which time we will rebalance the portfolio. If you have any questions, please feel free to contact us at email@example.com.
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