Fourth Quarter 2012 Commentary

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In 2012, governments and central bankers worldwide succeeded mightily in pushing stock markets higher despite slowing and, in some major areas, declining economic growth. So concerned with deteriorating fundamentals were governments in all but a few emerging countries that they overtly promoted rising stock prices.  By directly purchasing bonds, many governments also pushed interest rates to all-time lows, providing bondholders with positive returns as well.

Nothing comes free, however.  To prevent potentially severe recessions, central banks resorted to unprecedented policies which raised debt levels to heights that have typically led to history’s greatest economic collapses.  Even fellow central bankers have warned that these actions risk painful economic consequences that could last for a decade or more.

Especially following successful Federal Reserve stimulus efforts, the phrase “Don’t fight the Fed” often becomes the rationale for abandoning all caution and going with the flow.  And conceivably, that abandon could be the roadmap for success in 2013.  But investors would be wise to evaluate the risks as well.

While the Fed succeeds more often than it fails, it has some glaring episodes of ineffectiveness on its resume.  In the United States’ most serious stock market collapses (1929-32, 2000-03, and 2007-09), the Fed aggressively attempted to bolster asset prices.  Having finally run out of interest rate tools, the Fed and the European Central Bank have of necessity resorted to unparalleled levels of money printing.  In 2013, stocks could continue to rise if investors retain their confidence in the central bank’s ability to support markets.  But today’s debt levels also present unprecedented risks.  Confidence could dissipate quickly, and markets could fall rapidly.  That puts great question marks and uncertainty around investments in the year ahead.

Mission’s longstanding equity selection process is built on valuation fundamentals.  Since 1986, it has selected equities that have on an annualized basis outperformed the S&P 500 by about 700 basis points.  In recent years, however, in which the Fed has dramatically altered free markets, our process has found very few equities meeting our traditional selection criteria.  Consequently, we intensified our search for an additional approach that would retain Mission’s carefully designed risk controls but would also be responsive to an environment dominated by central bank stimulus.  In our third quarter commentary I referred to two new equity allocation processes that we were prepared to initiate.  Back tested for more than three decades, each has outperformed the S&P 500, while suffering fewer and smaller losses than that index.  We invited clients with interest in exploring these alternatives to contact us.  Many did, and we have held several small group sessions to outline the processes and to respond to questions.  Most have chosen to add one of the new alternatives to their investment program.

While these new approaches are not designed to replace our time-tested traditional process, they have the potential to supplement that process in a period of artificial central bank stimulus.  We encourage all clients who want equities as part of their investment program to evaluate these processes.  We will continue to schedule small group meetings to review details.  Let us know if you would like to attend.

We continue to believe that while the Fed could still drive interest rates lower, thereby producing small profits in bond portfolios, there remains greater risk in the bond market than probable reward.  Central bank money printing will eventually produce inflation, although its timing is subject to a number of uncertain variables.  We have begun to build a position in gold as a hedge against eventual inflation.  Because short-term gold prices are based more on investor emotions than fundamentals, we are not inclined to chase prices.  We will continue, however, to build that position should prices decline.

We anticipate that great uncertainty and volatility will mark the year ahead.  If central bankers win their historic bet on more stimulus, markets could continue to rise.  If deteriorating fundamentals overwhelm central bank largesse, security prices could fall precipitously, as they have twice so far in this new century.  Investors should remain flexible and avoid fixed allocations to either stocks or bonds.

 

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We See What We Want To See – Part 2

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In last week’s blog post, I pointed out the strong tendency investment analysts have to bullishly spin virtually any economic or market development.  Economic growth is roundly and regularly applauded.  As I highlighted last week, many firms similarly applauded economic weakness over the past year, because it was likely to lead to more Fed intervention.

Reading most economic analysis provokes more yawns than smiles.  I found myself laughing out loud this week, however, as I studied a piece by a highly reputed research firm.  A report that over the past three months analysts had dropped their estimates for 2013 earnings of S&P 500 companies from $108 to $101 would logically be viewed as bad news.  What struck me as funny were the mental contortions that analysts will go through to impart a bullish spin: in this case, “$7 cut in earnings estimates reduces the risk of disappointments.”

In a separate report this week, an analyst turned other downbeat headlines into a positive.  From The Wall Street Journal – “Tepid Job Growth Fuels Worry”; Investor’s Business Daily – “Weak Hiring Offers Little Buffer For 2013 Tax Hikes”; and New York Post – “Shame Old Jobs Story”.  He summarized them under his own headline – “Still Climbing a Wall of Worry”. Rarely do you read analysts cautioning against overconfidence, a Slope of Hope, when headlines are upbeat.

It is certainly appropriate to examine the news through a skeptical lens, but be cautious of the analyst whose work almost always results in a positive conclusion.  Ultimately the successful investor has to process data through more discerning filters.

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We See What We Want To See

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We see what we want to see.

Over my 44 years in the investment business, I’ve seen that statement proven over and over throughout the decades.  It was brought to mind again this morning when I read a report from a reliable, nationally reputed research house.  Commenting on yesterday’s release of the Federal Open Market Committee’s minutes intimating that the Fed might end Quantitative Easing in 2013–far earlier than most have anticipated–the analyst drew a bullish conclusion.  He argued that for the Fed to reach that decision, the economy would almost certainly have to be on an expansionary trajectory.  Such, in fact, would be the conclusion drawn by most analysts, should economic growth improve.  That conclusion is illogical only if one examines the bullish rationale offered by the same firm and many others over the past year or so.  In that time period, as economic conditions weakened in the United States and throughout most of the world, the majority of analysts justified bullish outlooks on the basis of weakening fundamentals prompting the Fed’s expansion of Quantitative Easing and other forms of stimulus. Readers are left to conclude that declining economic conditions are bullish and improving economic conditions are likewise bullish.  Curious!  It tends to expose Wall Street’s perennial bullish bias.

Another frequently stated reason for analysts’ bullish outlooks is current equity valuations.  Most commonly cited is the market’s price-to-earnings (PE) ratio.  Having just reviewed the most commonly employed valuation measures for the S&P 500, I find this a good time to evaluate the investment industry’s bullish outlook.  According to Standard & Poor’s, the PE ratio–using Generally Accepted Accounting Principles (GAAP)–at year-end was 16.4, fractionally below the 17 average since 1926.  Before the mid-1990s, that long-term average was about 14 times earnings.  The sequential bubbles blown by the Fed’s largesse and the disappearance of earnings at the depth of the 2008-09 financial crisis have skewed the number higher.

Most analysts call today’s PE multiple “cheap” or, at most, “fair”.  That designation is only true relative to multiples since the mid-90s.  Investors have made minimal returns over that period.  Comparing today’s multiples to those of a period in which investors made virtually no positive return is a specious comparison.

Analysts also attempt to justify their valuation arguments by looking at today’s index price against forecasted earnings over the next 12 months rather than versus trailing earnings.  As history demonstrates very clearly, “hoped for” earnings are typically overstated and are progressively ratcheted down as forecasts get closer to reporting dates.  Another approach is to remove write-downs mandated under GAAP and compare price against operating earnings, which some wags categorize as “everything but the bad stuff”.  At 16.4, the GAAP multiple is far closer to the high end of the historic PE range than the low end.

Other valuation measures paint a far less favorable picture.  Price-to-dividends, price-to-book value, price to sales and price-to-cash flow look downright scary, except when compared to bubble readings from the period since the mid-90s.  These ratios are all currently above or virtually at history’s great valuation peaks that preceded the mid-1990s, including 1929, 1972 and 1987. Any honest study of today’s valuations demands an acknowledgement that the S&P 500 is historically very high relative to its underlying fundamentals.

Valuations have been excellent long-term forecasters of future stock market prospects.  Over the shorter term, however, they offer little guidance.  In all likelihood, the prospects for 2013 will be determined by investors’ retention or abandonment of confidence in the ability of central bankers to overcome massive debt problems with an unprecedented outpouring of newly printed money.

 

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