Don Miller (Money Morning):
The U.S. Federal Reserve may take an unorthodox approach to raising interest rates by paying interest on bank reserves rather than relying on traditional open market remedies, as it exits from its long-term fiscal stimulus programs, Reuters reported today (Tuesday).

Paying interest on reserves is mostly untested and would represent an unexpected twist in the Fed’s response to the financial meltdown.

“In the old days … the Fed controlled the federal funds rate with open market operations,” Antulio Bomfim, a former Fed economist now with Macroeconomic Advisors LLC in Washington told Reuters. “Now, at least in this period when reserves are over-abundant, the way the Fed hopes to raise the federal funds rate will be primarily by raising the interest rate it pays on reserves.”

Usually, when the central bank wants to set a target for the federal funds rate it buys or sells Treasury securities on the open market, influencing interest rates by deploying or withdrawing capital.

By paying interest on reserves, the Fed makes it attractive for banks to keep their money at the central bank as long as interest rates in private markets are lower.

By doing that, the Fed can put a floor under the lending rate that banks charge each other for overnight loans, which is the central bank’s traditional choice for influencing the economy. Open market operations to raise interest rates would be relegated to a supporting role in the initial stages of tightening.

In order to spark an economy mired in deep recession . . . Click here to read the rest of Mr. Miller’s article.

In its Feb. 17 presentation to the Treasury, GM proposed shrinking its debt 40% from $62 billion to $33.5 billion by modifying obligations to a union-retiree health fund, shedding 47,000 jobs, and persuading bondholders to accept less in an equity swap.

Now that the Treasury has rejected those proposals as too little too late, GM must find a way to come up with new cost-cutting efforts by slashing the debt even further and cutting more jobs in 2009.

The company will collect input from board meetings and the Treasury’s auto task force to create a framework for new discussions this week, sources familiar with the plans told Bloomberg News.

One measure of the company’s future performance which might be acceptable to the government would be to trim expenses so it can break even when U.S. vehicle sales are as low as 10 million to 10.5 million units, John F. Smith, GM’s group vice president for product planning told reporters last week.

The automaker had previously stated an industry-wide rate of 11.5 million to 12 million cars and light trucks as its break-even target.  By comparison, March deliveries declined for the 17th consecutive month to an annual rate of 9.86 million vehicles.

GM announced recently it would save about $1.1 billion when 7,000 union workers retire early or take buyouts this year and a new UAW agreement kicks in that cuts benefits and streamlines factory work rules.

The U.S. auto industry has cut 400,000 jobs over the past year and lost billions of dollars. After receiving $13.4 billion last year, GM has requested an additional $16 billion from the government to keep operating.  Chrysler LLC has also asked for a new round of funding.

Appearing on NBC News‘ “Meet the Press,’ Chief Executive Officer Fritz Henderson denied that bankruptcy was inevitable, but said the company was speeding up preparations for a possible court filing in case it is unable to meet the government’s requirements.

“Our preference is to do it outside of a bankruptcy process, but it would only be prudent to make sure that we’re planning for if we need to resort to that, that we can move and we can move fast,’ said Henderson

Under the terms of a court-supervised bankruptcy, GM would form a new company focused on its best assets, Bloomberg reported, citing people who asked not to be named because the details of GM’s preparations aren’t public.

That process might include a so-called 363 sale, a reference to a section of the Chapter 11 bankruptcy code that could create a new company from the assets and brands of GM, increasing the company’s survival chances.

But that’s not likely to help assuage bankruptcy fears in Michigan, where GM and the other big automakers have their headquarters and most significant operations.

There is “tremendous pain in our state” because of layoffs and financial losses in the auto industry, Senator Debbie Stabenow (D-MI) told Reuters.

“I do not support bankruptcy as the first, second or third option,” Stabenow said, adding that bankruptcy could shift pensions for GM retirees to the federal government.

GM Fights for Survival, Prepares for Bankruptcy

The single unit was higher within the 1.29 handle overnight than it is right now, as it has given back a bit of ground on the news that a European Union Commissioner, Buti, said that, “economic indicators point south very badly.” This is strictly, jawboning to keep the euro’s move VS the dollar in check, folks…

The Bank of Canada (BOC) did cut rates yesterday 75 BPS… You may recall me telling you yesterday that the “experts” thought the cut would be 50 BPS, but I thought it would be 75 BPS… Maybe, one day, these surveys of “experts” will include the Pfennig writer, as he seems to be more “on target” than the current “experts”! Now, Chuck, who would you be referring to here? HA!

I also said yesterday that I didn’t think the markets would care, and they didn’t, as the larger rate cut did little to hurt the loonie. In fact, the loonie rallied a bit on the news!

Again, I don’t understand the mentality here with these Central Bank rate cuts… It’s not the cost of the credit that’s keeping the credit crisis all locked up, it’s the availability of such credit / money! So… Here’s a memo to Central Banks around the world… “STOP ALREADY!” All you’re are doing is inviting inflation into your economy, and debasing your currency!

That glimmering light that I talked about the other day for the Credit Crisis is getting smaller all the time, as the Big 3 still don’t have their bailout from the Gov’t (read taxpayers)… It now looks as though it could get done today, but at a much smaller figure than previously discussed. It now looks as though the Big 3 will get $15 Billion and they had better smile and say “thank you very much” as they leave the room!

It also looks like the Big 3 will get the “Car Czar” that they so desperately fought to keep from looking over them. The “Car Czar” will have the power to call Chapter 11 on GM or Chrysler should they not deliver a sound plan by the end of March. Geez Louise, why do they get 4 months to some up with a sound plan? They should have had one to get the funds to begin with! OK, I had better stop there, I’m really pounding the keys right now… I think I’ll step away for a minute and cool off…

OK, I’m back now, hope you didn’t miss me, or that I was away too long! No wait, this is text, you have no idea how long I was gone! Silly me!

You know… I was thinking aloud in my car yesterday, and saying to myself that it sure looks like all those pundits that called for a breakup of the European Union by the end of the year, will have to put their tails between their collective legs, and fade away… You know, the European Union (EU) had more pressure on them in 2005, when the French voted no on the Constitution, and other things, and they held steadfast then, and if they could it then, then this little tiff with Spain and Italy will pass… These pundits like to point to the problems that Italy is experiencing… And I say…”What’s so new about that? Italy has had problems since I’ve been following currencies (1985 for those of you keeping score at home)! I truly believe that Italy and Spain like to complain about the European Union and the euro, but when they get behind closed doors, when they let their hair hang down, they thank their lucky stars that they were included in the Euro Club!

The boys and girls over at Bank of America (BOA) believe they are seeing the dollar repatriation flows waning… Now, I wonder how many research people they employ over at BOA, when all it would take is for one of them to read the Pfennig, to see that I said all that yesterday! Any way… Let’s listen to what BOA had to say about this… “The repatriation demand for the dollar may have run its course, we retain our core long euro-dollar exposure and add long euro-dollar exposure today”… Now… You would think that given the size of BOA that saying something like that could really “move the market”…

But, given the markets “don’t care” attitude until the credit crisis unlocks, I understand why it didn’t! The BIG POINT here is that we could very well be seeing all this dollar repatriation end. And… Like I said Monday, the risk takers were slowly dipping their toes back into the waters which is what it will take to get the currencies and precious metals on the rally tracks again. But, put these two things working together, and voila’ you’ve got the makings of what could very well be a Santa Rally…

The boys over at the Bank of Japan (BOJ) are at “it” again… Mom… He’s doing it again! He’s looking at me! Mom! He’s got his hand on my side of the car seat! OK, I’ll stop there… But the BOJ was “jawboning” again in an attempt to keep the yen from strengthening further VS the dollar. BOJ Gov Shirakawa reminded the markets last night that the Ministry of Finance has the option of intervening if necessary… The Ministry of Finance (MOF) are the signal callers for the BOJ, and they are the ones that determine if intervention is to come into play. For new readers… BOJ intervention means the Bank sells yen in the markets to keep it from getting too strong.

In the currency world, this is called a “dirty float”… And the MOF and BOJ like to keep it “dirty”…

OK, I was laughing when I wrote that last bit, but notice I didn’t carry on… Maybe I’m growing up! HA!

Down Under in the South Pacific, Australia saw a very nice rise in Consumer Confidence of 7.6%, adding on to November’s 4.3% gain. The index collapsed this summer, but with the rate cuts the Reserve Bank of Australia (RBA) have instituted, it seems to be rounding back into shape.

In New Zealand, Reserve Bank of New Zealand (RBNZ) Gov. Bollard, gave a speech titled “Everyone needs to play their part.” In the speech, Bollard, reminded everyone that New Zealand’s inflation rate is still very high (5.1%). Hmmm… Was that the “wink and nod” that interest rates are not going to go much lower? I think it was folks.. But I guess it all depends on if the rest of the world continues to think that by cutting rates they will unlock the credit crisis!

Both of these things for Aussie and kiwi could underpin the currencies at current levels…

And another “Commodity Currency” the Brazilian real really put on the Ritz yesterday with a very strong rally… Just another sign that the risk takers are dipping their toes again…

OK… I’ll slide away from the currencies for a minute to talk about a news article that one of my fave writers, William Pesek, provided to Bloomberg, titled: China Will Be Happy Geithner Isn’t a Goldman Guy… Here are some snippets of the article that can be read in its entirety HERE.

“Why does Goldman Sachs run your government?”

After seven-plus years in Asia, I’m no longer startled by this question. It was posed to me yet again recently — this time by Kuala Lumpur taxi driver Sumit Kotari.

“What’s wrong with America is that it’s run by investment bankers, mostly from the same bank,” the 49-year-old Malaysian said. “How can Americans stand for it? Is Barack Obama from Goldman Sachs, too?”

It has been reported in Asia that Neel Kashkari, assistant Treasury secretary in charge of the Troubled Asset Relief Program, worked for the same New York-based investment bank. President-elect Obama’s decision to seek advice from other former Goldman Sachs bigwigs, such as Robert Rubin, also grabbed attention.

Even the guy helping choose a replacement for Timothy Geithner at the Fed Bank of New York came from Goldman Sachs. It makes one breathe a sigh of relief that Geithner, who will be the next Treasury secretary, doesn’t have Goldman Sachs on his resume.

The point here isn’t to pick on Goldman Sachs. Yet it is seen by many in Asia as the gold standard of investment banks. Its name also is a byword for the perception of incestuous ties between Wall Street and Washington.”

OK, I’m back now… The point of the discussion is to acknowledge that to Asian, it appears that Goldman Sachs runs our country… Now, that may be perception, but as they teach you perception is reality. And you have to wonder if the Asian Central Banks are shaking their heads at what we’re doing, and how we’re doing it… Now, some might say, “Who cares what the Asian Central Banks think of what and how we’re doing it.?” Ahhh grasshopper… We all have to be very cognizant of what the Asian Central Banks think about us, because, you see… They hold most of our I.O.U.’s and they could make things very messy for us any time they wish!

So… How about the Illinois Gov. getting arrested yesterday? Could it be two Illinois Governors incarcerated? That whole story is pretty amazing that someone would do what he is alleged to have done, knowing that his phone was tapped!

Ok enough of that! We’ll see the Monthly Budget Statement / Deficit for November, today… Look for it to explode!

Currencies today 12/10/08: A$ .6590, kiwi .5465, C$ .7950, euro 1.2950, sterling 1.4830, Swiss .83, ISK 261, rand 10.21, krone 7.0475, SEK 8.1650, forint 203.50, zloty 3.05, koruna 19.99, yen 92.60, baht 35.50, sing 1.5010, HKD 7.75, INR 49.01, China 6.8835, pesos 13.50, BRL 2.4725, dollar index 85.71, Oil $43.80, Silver $10.02, and Gold… $792

Source: A Bailout For The Big 3

While from one perspective things look rather difficult, from another there is a ray of hope. What can you expect to earn from stocks over the next five years? It should make for an interesting letter. Note: this will be a little longer than usual, but part of it is there are a LOT of charts.

I likened this to the economic situation we are in now. With consumer spending “resetting” to a new lower level, we are going to have to hit the reset button on many business plans, and thus investments, as consumers are going to spend less and save more. Is that level 3% less? 5%? More? No one knows, but since we have not had a consumer-led recession since 1982, too many businesses assumed that the US consumer, like Superman, was bulletproof.

What will be the eventual savings rate? Will we get back to 7-9% from less than 1%? Maybe, because people are going to realize that savings today are the key to a happy retirement. That would put the new level of consumer spending a good deal lower than it has been. Thankfully, that climb in savings will not happen all at once but will play out over more than a few years. I think we will look back in the middle of the next decade and be quite amazed at how much US personal savings have increased. However, this is the Paradox of Thrift: what is good for the individual is hard on the economy, as by definition increased savings reduces consumer spending.

A quick point. This decrease in consumer spending that we are seeing now will not be a permanent condition. After we find that new lower level, consumer spending will start to grow again, albeit more slowly due to increased savings. That is because the US economy and population are growing, and increases in consumer spending are the norm in such conditions.

Now, and I have 100 Swedish witnesses for this, after I finished my speech Thursday morning in Stockholm for the institutional investors of Kaupthing Bank, I sat down and turned on my laptop, which is an Apple MacBook Air. There was a strange noise and then, I swear, I was staring at a blue screen. My Apple notebook, supposedly immune from the Blue Screen of Death, had frozen in a pale shade of blue. Later that night, over drinks, we speculated as to how Bill Gates could manage to do such things, remotely, in revenge. However, since the next day Apple in Malta could not fix it, I missed my deadline. I apologize. Now, let’s jump right into the letter.

Those Wild And Crazy Analysts

Quick review: Last week we showed how consumer spending is falling, as we are in a recession. We then highlighted how analysts are dropping earnings estimates as time goes on. From projecting 15% earnings increases for 2008, they have dropped projections over 40% from March 2007 until today. Actual numbers will be much lower, as analyst projections for the fourth quarter are too high.

The same holds true for 2009. Since March of this year, just six months ago, earnings projections for 2009 have dropped 40% and are almost 10% lower than they were projected for 2008. However, estimates for operating earnings are still roughly double those for as-reported (or what’s on the tax return) earnings. Analysts are still wildly overoptimistic. You can read last week’s (October 17) letter here.

Now, let’s look at the rest of the presentation. I argue in Bull’s Eye Investing and this letter that we should look at long-term secular bull and bear markets not in terms of price but in terms of valuation. On September 26, 2003 I wrote about why we see long-term secular bear markets. I summarized the letter in the speech, but I think it will be useful to review a portion of it today. Remember, this was written in 2003, as a “new bull market” was already nearly a year old. The S&P 500 was at 1,000. So, for the last five years, you are down over 10%.

Investing is more than about price. It is about timing and valuations. Let’s review. I put in bold some important points.

The Evidence for Investor Overreaction

Long-time readers know that it is my contention that we are in a decade-long secular bear market. It typically takes years for valuations to fall to levels from where a new bull market can begin. Why does it take so long? Why don’t we see an almost immediate return to low valuations once the process has begun?

Because investors overreact to good news and underreact to bad news on stocks they like, and do just the opposite to stocks that are out of favor. Past perception seems to dictate future performance. And it takes time to change those perceptions.

This is forcefully borne out by a study produced in 2000 by David Dreman (one of the brightest lights in investment analysis) and Eric Lufkin. The work, entitled “Investor Overreaction: Evidence That Its Basis Is Psychological” is a well-written analysis of investor behavior which illustrates that perceptions are more important than the fundamentals. Let’s look at that study in detail. Stay with me. This is important.

In any given year, there are stocks which are in favor, as evidenced by high valuations and rising prices. There are also stocks which are just the opposite. Dreman (NYSE:DCS) and Lufkin (NASDAQ:LUFK) (or DL for the rest of this letter) look at a database for 4,721 companies from 1973 through 1998. Each year, they divide the database up into five parts, or quintiles, based on perceived market valuations. They separately study Price to Book Value (P/BV), Price to Cash Flow (P/CF), and the traditional Price to Earnings (P/E). This creates three separate ways to analyze stocks by value for any given year, so as to remove the bias that might occur from just using one measure of valuation.

The top and bottom quintiles become stock investment “portfolios” for all three valuation measures. You might think of them as a mutual fund created to buy just these stocks. They then look ten years back and five years forward for these portfolios. There is enough data to create 85 such portfolios or funds. They first analyze these portfolios as to how they do relative to the market or the average of all stocks. They then analyze the portfolios in terms of five basic investment fundamentals: Cash Flow Growth, Sales Growth, Earnings Growth, Return on Equity, and Profit Margin. They do this latter test to see if you can discern a fundamental reason for the price action of the stock.

First, both the “out-performance” and “under-performance” of these stocks happens in the ten years leading up to the formation of the portfolio. Almost immediately upon creating the portfolio, the price performance comparisons change, and change dramatically. The “in-favor” stocks underperform the market for the next five years, and the out-of-favor (value) stocks outperform the market.

I should point out that other studies, which Dreman does not cite, seem to indicate that the actual experience of many investors is more like these static portfolios than one might first think. That is because investors tend to chase price performance. In fact, the higher the price and more rapid the movement, the more new investors jump in. The Dalbar study, among many others, shows us that investors do not actually make what the mutual funds make because they chase the hottest funds, buying high and selling low when the funds do not live up to their expectations. The key word, as we will see later, is expectations. Other studies document that investors tend to chase the latest hot stock and shun those which are lagging in price performance. Thus, forming a portfolio of the highest-performing quintiles is an uncanny mirror to what happens in the real world.

Why does this “chasing the hot stock” happen? DL tells us it is because investors become overconfident that the trends of the fundamentals in the first ten years will repeat forever, “… thereby carrying the prices of stocks that appear to have the ‘best’ and ‘worst’ prospects. Investors are likely to forecast a future not very different from the recent past, i.e., continuing improving fundamentals for favorites and deteriorating fundamentals for out-of-favor issues. Such forecasts result in favorites being overpriced, while out-of-favor issues are priced at a substantial discount to the real worth. The extrapolation of past results well into the future and the high confidence in the precise forecast is one of the most common errors made in finance.”

The more we learn about a stock, the more we think we are competent to analyze it and the more convinced we are of the correctness of our judgment.

Since you are not looking at the graphs, let me describe them for you. Predictably, the fundamentals improve quite steadily for the first ten years for the favorite stocks in comparison to the entire universe of stocks. But the price performance rises at very high rates, far faster than the fundamentals, particularly in the latter years. It clearly accelerates. It seems the longer a stock does well the more confident investors are that it will continue to do well and thereby award it with higher and higher multiples. The exact opposite is true of the out-of-favor stocks. Even though many of the fundamentals were actually slowly improving in relationship to the market as a whole, the stocks were lagging and the market punished them with ever-lower relative prices.

At five years prior to the formation of a portfolio, the trends of each group were set in place. The next five years just reinforced these trends. This re-strengthened the perceptions about these stocks and increased the level of confidence about the future. Again, past (and accumulated and reinforced over time) perception creates future price action.

Never mind that it is impossible for Dell (NASDAQ:DELL) to grow 50% a year or GE (NYSE:GE) to compound earnings at 15% forever. As many times as we say it, investors continue to ignore the old saw “Past performance is not indicative of future results.”

How much better did the good-performing stocks do than the bad-performing stocks in the ten years prior to creating the portfolios? The highest P/BV (Price to Book Value) stocks outperformed the market by 187%. The lowest stocks underperformed the market by -79%, for a differential of 266%! If you look at the P/CF (Price to Cash Flow) the differential between the two is 172%.

Yet in the next five years, the hot stocks underperformed the market by a negative -26% on a P/BV basis, and -30% on a P/CF basis. The out-of-favor stocks did 33% and 22% better than the market, respectively. This is a HUGE reversal of trend.

So, what happened? Did the trends stop? Did the former outcasts finally get their act together and start to show better fundamentals than the all-stars? The answer is a very curious “no.”

“… there is no reversal in fundamentals to match the reversal in returns. That is, as favored stocks go from outperforming the market, their fundamentals do not deteriorate significantly, in some cases they actually improve…. The fundamentals of the ‘worst’ stocks are weaker than both those of the market and of the ‘best’ stocks in both periods.”

In some cases, the trends of the worst stocks actually got worse. Even as the out-of-favor stocks improved in relative performance in the last five years, their cash-flow growth actually fell from 14.6% to 6.6%. While cash-flow growth for the best-performing stocks did drop by 6%, it was still almost 2.5 times that of the lower group. Read the following carefully:

“Thus, while there is a marked transition in the return profiles [share price], with value stocks underperforming growth in the prior period and outperforming growth stocks in the measurement period, this is not true for fundamentals. In nearly every panel [areas in which they made measurements], fundamentals for growth stocks are better than those for value stocks both before and after portfolio formation.”

“Although there is a major reversal in the returns [prices] to the best and worst stocks, there is no corresponding reversal in the fundamentals.” In fact, in many cases the fundamentals continue to improve for the growth stocks and deteriorate for the value stocks. The data and the graphs clearly show that the fundamentals for the growth stocks clearly beat those of the value stocks, even for the five years after portfolio formation.

And yet, there was a very stark reversal in price. Why, if not based upon the fundamentals?

DL goes to another research paper, which shows “… that even a small earnings surprise can initiate a reversal in returns that lasts many years.” They demonstrate that negative surprises on favorite stocks result in significant underperformance of this group not only in the year of the surprise but for at least four years following the initial event. They also show that positive surprises on out-of-favor stocks result in significant outperformance in the year of the surprise, and again for at least the four years following the initial event. DL attributes these results to major changes in investor expectations following the surprise.

So where was the overreaction? Was it in the years leading up to the surprise, which resulted in a very high- or low-priced stock (relative to the fundamentals), or was it in the immediate reaction to the surprise?

Other studies show analysts (as opposed to investors) are too slow to react to earnings surprises by being too slow to adjust earnings. Even nine months later, analysts’ expectations are too high. (We will see this as we look at analyst performances today!)

Stock Prices Are In Our Heads
Or, Maybe Investors Are Just Head Cases

Dreman and Lufkin then come to the meat of their analysis. For them, underreaction and overreaction are part and parcel of the same process. The overreaction begins in the years prior to the stock reaching lofty heights. As Nobel laureate Hyman Minsky points out, stability leads to instability. The more comfortable we get with a given condition or trend, the longer it will persist and then when the trend fails, the more dramatic the correction.

The cause of the price reversal is not fundamentals. It is not risk, as numerous studies show value stocks to be less risky.

“We conclude,” they write “that the cause of the major price reversals is psychological, or more specifically, investor overreaction.”

But DL go on to point out that when the correction comes, we tend to (initially) underreact. While we do not like the surprise, we tend to think of it as maybe a one-time thing. Things, we believe, will soon get back to normal. We do not scale back our expectations sufficiently for our growth stocks (or vice-versa), so the stage is set for another surprise and more reaction. It apparently takes years for this to work itself out.

As they note in their conclusion, “The [initial] corrections are sharp and, we suspect, violent. But they do not fully adjust prices to more realistic levels. After this period, we return to a gradual but persistent move to more realistic levels as the underreaction process continues through [the next five years].”

The studies clearly show it takes time for these overvalued portfolios to “come back to earth” or back to trend. Would this not, I muse, apply to overvalued markets as a whole? Might this not explain why bear market cycles take so long? Is it not just an earnings surprise for one stock which moves the whole market, but a series of events and recessions which slowly change the perceptions of the majority of investors?

Thus my contention that we are in just the beginning stages of the current secular bear market. These cycles take lots of time, anywhere from 8 to 17 years. We are just in year three, and at nosebleed valuation levels. The next “surprise” or disappointment will surely come from out of nowhere. That is why it is called a surprise. When it is followed by the next recession, stocks will drop one more leg on their path to the low valuations that are the hallmark of the bottom of secular bear markets. [Note: I wrote that in 2003.]

Given the level of investor overconfidence in the market place, and given the length of the last secular bull, it might take more than one recession and a few more years to find a true bottom to this cycle. It will come, of course.

But in the meantime, investors would do well do examine their own perceptions about the future, both positive and negative, and see if they might possibly be clouding their investment strategies. Remember, just because stocks are in a secular bear cycle does not mean there are not plenty of investment opportunities in other markets and strategies.

Just as there is more to life than work and money, there is more to investments than the stock market.

Can We Actually Predict Earnings?

Ed Easterling of Crestmont Reseach offers us the following very important chart. It is reported earnings compared to the historical trend line. As I have repeatedly written, earnings, especially when seen from a valuation standpoint, are mean reverting. They will fluctuate around the long-term trend line. And interestingly, that long-term trend line is nominal GDP. (Nominal GDP includes the effects of inflation.)

Total corporate earnings for any particular large country and stock market by definition cannot grow faster than nominal GDP (though individual stocks can do so). And since the S&P 500 is largely reflective of the US corporate world, earnings for the S&P 500 index will fluctuate around nominal GDP.

Notice how smooth that growth line for nominal GDP is? That will be important in a few paragraphs. But first, let’s look at how well Easterling’s historical trend line (which is nominal GDP) compares with Robert Shiller’s ten-year smoothed earnings. Rather than use the earnings from any one year, which as we know can fluctuate wildly, he smoothes them by using a ten-year average.

Important: Notice how closely correlated the earnings for Crestmont’s nominal GDP and Shiller’s smoothed earnings are.

Now, this is where it gets interesting. Shiller’s data is not predictive. But remember how smooth the earnings trend line from Crestmont was? Ed contends, and I agree, that there is a predictive element when we use nominal GDP. In other words, at some point in the future, earnings will grow back to and then exceed the long-term trend in nominal GDP.

So, while we are in the process of dropping below the mean or below the long-term trend line of earnings in terms of nominal GDP, we can be confident that at some point in the future those earnings will again revert above the mean. It seems to have been part of the economic laws since the time of the Medes and Persians.

This has important implications for future values. Let’s look at the next graph, from Vitaliy Katsenelson. Vitaliy uses a 6% growth of earnings as his baseline (which is, not coincidentally, very close to the long-term rise in nominal GDP). Again, notice how earnings fluctuate around the mean.

Notice also the small box on the right, which show where earnings could actually fall to if earnings drop by the same percentage as they did in the 2000-02 recession. That would suggest that earnings will drop below $40, from the currently projected $48. Remember, last year projections for 2008 were $82.

We will come back to this; but if we can project that at some point in the future earnings will once again revert to nominal GDP trendline, then we can make some projections about what earnings will be in the future, or at least what “trend” earnings should be!

Buffett versus Grantham

On October 16 Warren Buffett wrote an op-ed in the New York Times called “Buy American. I am.” Quoting from the beginning of the piece:

“THE financial world is a mess, both in the United States and abroad. Its problems, moreover, have been leaking into the general economy, and the leaks are now turning into a gusher. In the near term, unemployment will rise, business activity will falter and headlines will continue to be scary.

“So … I’ve been buying American stocks. This is my personal account I’m talking about, in which I previously owned nothing but United States government bonds. (This description leaves aside my Berkshire Hathaway holdings, which are all committed to philanthropy.) If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities.

“Why? A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now.”

Jeremy Grantham, head of GMO, which manages $150 billion, has another opinion. Note that Grantham lost a great portion of his management business in the late ’90s when he decided that the tech market was a bubble and did not participate. His huge pension fund clients decided he did not “get it” and left him in large numbers. He was right, they were wrong, and now his business is vastly larger. And again, he is putting his opinion and client money on the line. This from a recent Money Magazine article (courtesy of my friend Richard Russell):

“Historically, when a market bubble has popped, it has almost always overcorrected. But after the tech bubble burst in 2000, the stock market didn’t hit the lows it should have. Before it could, the housing bubble and tax cut that followed 9/11 kicked off the biggest sucker rally in history from 2002 to 2006. So I think the market isn’t cheap yet. There is more pain coming. I don’t think we’ll hit the low until 2010.

“Previously in the interview, Grantham had this to say. ‘All you have to do is open a history book and see what happens when you have a bubble. In this case, there was a bubble in housing and there was a magnificent bubble in risk-taking People were just shoveling their money into risk on the pathetic idea that risk is always rewarded. You don’t get rewarded for taking a risk. You get rewarded for buying cheap. Leverage is the ultimate demonstration of risk, and we never had system-wide leverage like this before. Ever. We had several firms that were leveraged 30 to 1(for every $30 of assets they put up $1 of equity and borrowed the other $29). At leverage of 30 to 1 you have to lose only about 3% of your $30 worth of assets and your dollar of equity gets wiped out. You’re bankrupt.”

So, who is right? And the answer depends on your view of what I call the third derivative of value investing. The first two are price and earnings. The third derivative is time.

Long-time readers know I contend that markets go from high valuations to low valuations and back to high over very long secular bull and bear markets which last anywhere from 13-20 years, or about 17 years on average. These cycles do not stop in the middle and reverse. They tend to go the full course. That is why I could contend back in 2003 that were we not in some new long-term bull market. Valuations had not reached the levels from which bull markets are made. Stock market cheerleaders tried to spin it, but valuations are the fundamental ground of investing. You ignore them at your own peril.

Now, let’s look at two more charts from Vitaliy. These show the long-term secular cycles in terms of valuation, both from one-year and ten-year smoothed P/E ratios. Note that we are not back to even below the mean, much less to some place we could call “low.”

So, let’s be a bit of an optimist. Let’s look at yet another chart from Crestmont Research. What happens if stock market earnings revert to the mean in either 3 or 5 years? Ed also assumes that P/E ratios once again rise back to 22.5. From last Friday’s close, such a reversion would yield very handsome returns: 23.5% compounded for 3 years and 15.9 % for five years. If you believe like Buffett that US earnings will revert back to (and above) the mean, then that suggests this is a time to buy, if you are buying for the long term. The full report is at http://www.crestmontresearch.com/pdfs/Stock%20PE%20Report.pdf

Back to 1974?

Go back and look at the valuation charts above. Note that in late 1974 valuations were still at about their long-term average. Buying then was not compelling from a valuation standpoint. But Richard Russell called the bottom in one of his more famous calls late in the year. And it was a “price” bottom.

There was a great deal of volatility in the next eight years, and another recession at the end of the period, before valuations finally got down to extremely undervalued single-digit levels. Thus, those years saw a rising stock market and ever-lower P/E ratios. That happened as earnings grew faster than the prices of the stocks! Why did prices not rise along with the earnings growth?

Now, gentle reader, we come full circle, back to the Dreman and Lufkin study. Investors, twice burned in the late ’60s and early ’70s, were reluctant to get back into the market in a large, overtly bullish way. They were cautious.

I think we may be in a reflection of that same period. While it is possible we have put in the lows for this cycle, I think that as the recession will be deeper and longer than most of us have experienced (think 1982), we will see more rounds of earnings disappointments. I think the market has more downside in its future. But sometime, whether it was last week, or a few quarters in the future, we are going to see a cycle low in terms of price.

But it will most likely be a repeat of 1974-1982. Lots of volatility. Very large run-ups followed by quick and vicious sell-offs on the way back up to new highs. This is NOT going to be a recovery back to new highs in two years. This is going to take a long time. Further, I don’t think nominal GDP will be 6% for the next three years, for reasons stated last week.

Investors are going to get their hearts broken by their favorite companies time and time again. The economic news will not be good for another year at a minimum. This is not the stuff that wild bull markets are made of. That time will come, but it is not yet.

That being said, I am a believer in American business. They will figure out how to maneuver and prosper in this new environment. In 12 years, earnings will have doubled from the trend of last year, which suggests earnings could be $140 in 2020. Put a multiple of 20 on that and we have an S&P 500 at 2,800, up over 3 times from today. That is the long view.

How Should We Then Invest?

Am I personally a buyer today, like Buffett? No, as I think that in a secular bear market you should see absolute returns rather than the relative returns of passive index investing. And, I think there is more pain to come in the market. But there are opportunities other than index funds or long-only mutual funds. So, where should we put money to work today?

1. While I don’t want to be long an index fund, if you are a stock picker (as Buffett is), then there is value out there. And if I am right and there is some more downdraft in the markets, then there will be more value in the near future. This is not a time for hope, it is a time for conviction. I wrote several long chapters in Bull’s Eye Investing on value investing. Vitaliy Katsenelson recently wrote a book called Active Value Investing. It is a good guide. Take your time. There is no hurry. But start your analysis and research now.
2. I like active absolute return managers and investing. In particular, I like actively managed commodity funds which have a bias for volatility. Note: this is NOT an endorsement of long-only commodity index funds. Also, there are a small number of active managers who have demonstrated an ability to navigate this market. As Buffett says, it is not until the tide goes out that we know who is swimming naked. We now have a MUCH better idea of what volatility can do to an investment manager and his systems, and who understands the meaning of the word hedge.
3. It is somewhat heretical to say it in this market, but there are specific styles of hedge funds I like. We are seeing the gut-wrenching demise of many black-box quantitative hedge funds. Hopefully, investors have learned their lesson. There is no free lunch. However, I think that long-short hedge funds (and the few mutual funds that use that style, like John Hussman’s) will once again find an environment in which they can prosper. If you want to be in the market, this makes a lot more sense to me.
4. I think that sometime next year it will be time to really think seriously about emerging market investments. Those markets have in general been beaten down far more than the developed-world markets. And the developed world is going to be growth-challenged in respect to emerging markets. You can find some real value. As an example, the largest liquor distributor in Thailand now pays an 8% dividend. Why? Because it was a large part of Thai index funds, and foreigners unloaded those funds in the current sell-off. And while Sweden can hardly be called emerging, last Thursday institutional investors were talking about the value there as foreigners have fled their markets, pushing values down.Now, here’s a rule. Write this down. If you are going to invest in an emerging market, make sure it is with someone who knows that local market. I do not want to have a manager with the name of Smith sitting in New York looking at a computer screen investing in Thailand for me, and neither should you! You need someone who understands the local scene.
5. Income is going to be critical. If you are going to put some money into bonds and other fixed-income instruments (not funds!), you should be doing it now. As I have been writing, there are simply steals out there in the fixed-income markets, as the margin clerks are forcing funds and individuals to sell any- and everything. The prices we see today will not be there in six months, and I doubt they will be there in three. If you are a fixed-income investor, you should be buying with both fists. But only if you know what you are doing. This is not the time for on-the-job training. Sometimes those bonds are selling at low numbers for a reason other than liquidity and margin calls. If you are not a seasoned fixed-income investor, then get professionals to help you. For portfolios of over $250,000 I can help you find a manager.
6. As I wrote months ago, we are seeing the rise of a new asset class I call Private Credit. These income and asset-backed lending funds are going to take market share from banks and become a market force of their own.
7. While today may not be the time in all markets, it will not be too long until you will be able to find either residential or commercial real estate at distressed prices almost anywhere, which you can buy and then rent out. Buying real estate at the right price and letting someone else pay down the loan is a proven formula for wealth in many a millionaire household.

In general, your target is not to beat the market. It is to beat zero. As I have written for years, the investors who win in this market are the ones who take the least damage.

Source: How Shall We Then Invest?

In fact, the home-furnishings sector, as a whole, has lost 27.3% of its value in the last 11 months. It is also down 31.7% from its highest close, which occurred almost three years ago.

For some individual companies, it’s even worse…

On May 2, New Jersey-based Linens ‘n Things filed for bankruptcy, defaulting on $1.35 billion worth of debt. This may finally be a sign that the market is nearing its bottom.

Bankruptcies will lead to decreased supply (Linens ‘n Things has already announced it will close 120 stores) and less competition… two factors that should help the profit margins on the remaining retailers.

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As you can see, after getting killed in 2007, home-furnishing companies are finally stabilizing. The sector has risen 13% since March. And it’s cheap. The sector is trading at a 34.1% discount to its historical, median P/E.

But, while the sector is no doubt very cheap, a 13% rally is not enough to get me excited…

The sector may just be in a temporary upswing in an otherwise bear market. I wouldn’t feel comfortable getting into this sector until it tests its previous low. If it makes another downward move that fails to take it to new lows, then the worst is likely behind us.

At that point you could buy any of the companies I mentioned above – Target, Bed Bath & Beyond, or Tuesday Morning. Costco and Wal-Mart would also benefit from an upswing in the sector, as would upscale retailer Williams-Sonoma

Good investing,

Ian Davis

Source: These Beaten-Up Retailers Are Showing Signs of an Uptrend

“The role of finance in the economy is going to come down significantly in the coming years,” Carlos Asilis, chief investment officer at New Jersey money manager Glovista Investments, tells the Wall Street Journal. “From a societal standpoint, we got carried away with finance.”

Wags might wonder if the Journal is deliberately playing down finance in keeping with its new emphasis on general news and especially politics now that it’s an arm of the Murdochtopus.   But as the paper rightly notes, “The trend already has hurt companies beyond banks and Wall Street firms. General Electric Co.’s first-quarter profits at its financial-services businesses were 21% lower than a year earlier.

Retailer Target Corp., which got 13% of its before-tax profit last year from credit cards, last month wrote off $55.5 million in credit-card loans, 8.1% of its total portfolio at an annualized rate.”

“I think you’re seeing a clear inflection point,” says Tom Gallagher, an ISI Group analyst. “Whether it’s financials as a share of the stock market or financials as a share of GDP, we’ve peaked.”

Indeed, the financials now account for over 21% of the S&P 500’s market cap.  That’s less than the 34% that technology represented at the height of the tech bubble in 2000, but the Journal is already calling the top.

For finance workers, this shift could resemble the 1980s, when manufacturing lost its pole position in the U.S. labor market and thousands found that skills they had honed over the years were less marketable. The Bureau of Labor Statistics already counts 60,000 fewer people working in finance than a year ago. Merrill Lynch & Co. is cutting 4,000 jobs, and Lehman Brothers Holdings Inc. is cutting 1,425. Many of Bear Stearns Cos.’ 14,000 employees are expected to lose their jobs when J.P. Morgan Chase & Co. swallows the firm.

Left unaddressed in the article is this most uncomfortable of questions: If our manufacturing sector has been hollowed out and shipped off to Asia on the assumption that “we think, they sweat”… and if even our think-work in the tech sector has been abandoned because moving money around was much more interesting and lucrative… what happens now that moving money around has lost its luster?

I’m not sure of the answer, but the fate of empires past has hung on similar questions.