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Dollars and Sense Volume 4, Number 7 │March 2013 Market Update February 2013 Month in review Month YTD 3.5% S&P TSX Index 1.3% 7.8% Dow Jones Ind. 1.8% 1.4% 6.6% S&P 500 4.9% NASDAQ Comp 0.8% 0.2% 5.4% MSCI World S&PTSX Materials 2.9% 0.8% -1.5% 3.8% -5.4% 6.3% 3.3% 2.6% 13.8% -8.8% US Dollar Euro British Pound 3.3% -0.6% -1.2% 3.9% 2.8% -3.1% Crude Oil (WTI) Natural Gas Gold Copper Aluminum Zinc -5.6% 4.4% -5.1% -4.2% -4.5% -3.7% 0.3% 4.0% -5.7% -1.6% -3.9% -0.7% S&PTSX Financials S&PTSX Energy S&PTSX Utilities S&PTSX Info Tech Income Senior Gold Producers Income Corp (GPC) Can-Energy Covered Call ETF (OXF) Money Market Rates Current Highest GIC rates on the market (Mar. 5th) 1 yr 1.71% 2 yr 1.95% 3 yr 2.05% 4 yr 2.25% 5 yr 2.45% Bond Outlook: Lower for Longer, But Not Forever (Kathy Jones, et al) Posted By Kathy Jones, et al, Charles Schwab and Company On March 11, 2013 Lower for Longer, But Not Forever We’ve been in the “lower for longer” camp for quite a while, based on our view that sluggish economic growth, tightening fiscal policy, and the Fed’s easy monetary policies would keep interest rates low for an extended period of time. However, we’ve become more cautious about holding longterm bonds over the past year, due to our concern that the risk of being caught in an unexpected sharp rise in interest rates was worse than giving up some of the potential capital gains to be had as bond yields fell to new lows. We are not market timers and we still believe that laddered portfolios with average durations1 in the intermediate term range make sense for many bond investors. But we are often asked: what will change our view on interest rates? The following is a short description of what we’re watching. Follow the money, jobs and the Fed. We look for bond yields to move up when the economy is strong enough to generate more jobs and income growth. We think it’s surprising how many forecasters have been looking for interest rates to “normalize” before those things happened. We don’t believe that there is a set of “normal” interest rates. There are long-term averages and historical relationships between interest rates and economic fundamental factors. These are useful, but we also have to factor in all of the “abnormal” factors—such as the Fed’s zero interest rate policy and quantitative easing program, the unfinished de-leveraging cycle in the developed world and demographic trends. We think the three key factors to watch are the growth rate in money and lending, employment and Fed policy. Money and Lending. Since the onset of the financial crisis, the Fed has created an unprecedented level of reserves in the banking system. However, the demand for money was relatively soft until last year. Stronger demand for money tends to lead to higher interest rates and stronger spending may lead to inflation. The pace of lending has picked up and as a result, nominal GDP growth, which tends to track credit growth, has picked up as well. But both lending and nominal GDP are still growing at rates near the low end of the long-term trend. That suggests a relatively slow pace of real GDP growth, in the 2% to 2.5% region, which is what it has averaged since 2010. - sasdfsasdf seeasdfasdf Dollars and Sense March 2013 majority of the committee has voted in favor of their policies since the financial crisis began. The Fed’s official stance is that they will continue quantitative easing until unemployment falls to 6.5% with inflation in the 2.0% to 2.5% range. We are listening for any shift in policy stance by Chairman Bernanke to signal a change in the interest rate outlook. Credit Growth and Nominal Gross Domestic Product (GDP) Bottom line. We are still in the “lower for longer” camp but don’t expect to be there forever. We continue to favor a relatively cautious stance of reducing average duration to an intermediate-term range (5-10 year maturities, on average) based on our view that risk/reward for long-duration bond portfolios is unattractive. What Drives the Corporate Credit Market? Note: Nominal GDP is gross domestic product (GDP) figure that has not been adjusted for inflation. Source: St. Louis Federal Reserve Bank Credit of All Commercial Banks (TOTBKCR), and Gross Domestic Product (GDP), percent change from year ago, seasonally adjusted. Data as of December 31, 2012. Jobs and Income. In the U.S., where 70% of GDP is attributable to consumer spending, we see jobs and income growth as important factors to watch. Since 2007, when job growth declined and median household incomes flattened, consumer spending has slowed to an average annual growth rate of 1.9% compared to a 3.5% annual pace for the 25 years prior to the financial crisis. We are watching for unemployment to fall to a level where average hourly earnings and household incomes begin to rise again. Since the end of the recession in June 2009, job growth has been among the weakest of all post WWII recoveries. It could take more time. Investment grade corporate bonds have benefited over the past four years from declining bond yields and tightening of spreads to Treasuries. High prices and falling average coupons may make it difficult to repeat the strong returns that corporate bonds have generated over the past few years. But it seems that the risk of rising interest rates—not just on corporate bonds, but most fixed income investments—has been on everyone’s minds lately. We’ll discuss how corporate bonds have tended to react in rising rate environments, and some points to consider when holding, or adding to, corporate bond positions. What drives corporate bond performance? Investors often discuss “the bond market” and the risk that rising interest rates have on bond prices. But there is no one “bond market”—not all bonds are the same and there can be various reactions to rising rates. Corporate bond yields include a credit spread, which is additional yield above a Treasury with a comparable maturity, to compensate for the risks holding a corporate bond, such as the risk of default. So evaluating corporate bonds means looking at both Treasury yields as well as the potential for changes in the additional yield received from a corporate versus Treasury bond. Credit spreads tend to fluctuate based on market conditions. Credit spreads can be thought of as compensation for taking on the credit risk of owning a corporate bond. Spreads tend to fluctuate based on a number of factors, including the outlook for economic growth. If economic growth is expected to be strong, investors may be willing to accept a lower credit spread since the risk of default may be lower. If growth is expected to slow, the opposite may occur. Rising interest rates have tended to lead to tighter credit spreads in the past. We think that any significant rise in rates will be the result of a stronger economy, which may lead to tighter credit spreads. This can help offset the risks that rising rates have on the price of fixed coupon bonds. If Treasury yields rise by 20 basis points, for example, but credit spreads decline by 20 basis points, the result would be no change in yield for corporate bonds, all else equal. While Treasury bond prices would fall, corporate bond prices may not since their yields remained constant. Looking at the table below, we see that recent periods of rising rates have led to lower spreads. We would point out that rising Treasury yields can, and often do, lead to negative total returns for investment grade corporate bonds, but it can lead to outperformance relative to securities that don’t have credit spreads. Median Household Income in the U.S. 1984 to 2011 Source: U.S. Census Bureau, Current Population Survey, Annual Social and Economic Supplements. Last revised on June 8, 2012. The Fed. Not surprisingly, the Federal Reserve’s policy of anchoring short-term interest rates at zero and buying long-term bonds is an important component of our interest rate outlook. Recent comments from some Fed officials indicating concerns about the long-term adverse affects of quantitative easing may be the first hint that policy will be changing. However, Fed Chairman Bernanke and Vice Chair Yellen, along with NY Fed President Dudley, all permanent voting members of the Federal Open Market Committee (FOMC), are still in favor of quantitative easing, and the • Page 2 • Dollars and Sense March 2013 The impact by region and state will vary. The importance of federal grants by state varies, however, as does the potential impact of reduced federal spending in individual states and municipalities. The Pew Center on the States has published a useful interactive map estimating grants subject to sequester, by state, as a percent of revenue. The sequester may also be temporary, replaced by a long-term package of more targeted budget cuts. Reduced federal spending will be a drag on economic growth in the short-term, in our view. Federal employment drives 5% of economic activity nationally, according to the Pew Center Data. But in D.C. and surrounding areas, it drives 20% or more of local employment. Lower federal spending will also likely reduce national GDP growth in the short-term, in the consensus view of economists, leading to lower rates for longer from the Federal Reserve, transferring through to rates on other investments including muni bonds. Credit spreads are at their long-term average. But corporate fundamentals overall remain strong and default rates remain low, so we think there could be room for spreads to decline. In fact, the speculative grade default rate, according to Moody’s, has come down since the highs reached during the financial crisis and has been under the 20-year average for the past two and a half years. The spread of the Barclay’s U.S. Corporate Bond Index is roughly 1.4%, or 140 basis points. Although we don’t think they will approach their all-time low of 51 basis points anytime soon, there is room for compression. Moody’s outlook is negative on 4 Aaa-rated states and 40 local governments based on links to the federal government. Moody’s rationale for these negative outlooks relates more to their assessment of the connection between these governments and the credit quality of the U.S. government, not directly to sequestration, according to Moody’s commentary. If the U.S. Aaa rating is lowered, the ratings on these states and municipalities could be lowered also. States with Aaa ratings but negative outlooks include Maryland, Missouri, New Mexico and Virginia. The Bottom line. We think that tighter credit spreads could help offset some of the interest rate risk in corporate bonds if Treasury rates rise. But investment grade corporate bonds can still generate negative total returns in a rising interest rate environment. This don’t necessarily mean corporate bond investors need to rush for the exits, but we think it’s important to know how various asset classes may react, and try to be positioned accordingly. Standard & Poor’s has said that they expect the impact to be “uneven” across sector. Each government will manage this “new era” of reduced federal funding differently, in their view, just as they adjusted to 2008/09 recession and other threats to credit quality. They anticipate that the effects of sequestration will be “mildly negative in broad terms,” with potential for more impact in specific credits or jurisdictions. But “with only a few high profile exceptions,” state and local governments have made cuts to preserve credit quality. Sector views. Local municipalities and school districts may face decreased federal grant funding for education programs and public safety. Airports and ports may face operational cuts and layoffs. Essential-service infrastructure providers, such as water and sewer systems, generally rely on user charges than federal funds for operations, so they may be less impacted. Medicare reimbursements to doctors and hospital will be reduced 2%, potentially impacting not-for-profit hospitals. Issuers in the higher-education sector may face reduced grant funding, though most are not reliant on these funds for debt service payments or operations. Bottom line. Despite of threat of less support from the federal government, most states, municipalities, and other issuers in the muni market will adjust to the “new era” of reduced federal spending, in our view. The impact is another bump in the road for municipal issuers. But we don’t suggest a change in strategy for investors holding well-diversified muni portfolios at this time. Over the Past 10 Years, Rising Bond Yields Have Typically Been Accompanied by Tighter Credit Spreads Note: Excess Return is the curve-adjusted excess return of a given index relative to a term structure -matched position in Treasuries. The calculation method depends on the index type. A portfolio, for example, may have an excess return above the index on which it is based. It is important to note that receiving an excess return almost always requires one to take on more risk. Source: Barclays, Bloomberg and the Schwab Center for Financial Research. 10-year Treasury yield represented by the U.S. Generic Govt 10 Year Yield Index (USGG10YR). The corporate sector is represented by the Barclays U.S. Corporate Bond Index. Past performance does not guarantee future results. Sequestration’s Impact on Muni Markets A “new era” of federal austerity has arrived, as Congress debates spending cuts and allows sequestration—a series of across-theboard automatic spending cuts—to go into effect. Federal budget reductions will be a part of both the short- and longer-term revenue climate for municipal governments, in our view, whether sequestration takes effect in its current form or renegotiated into a series of more targeted reductions. For investors in muni bonds, here are some points to consider. Federal money makes up 34% of total state spending, according to the National Conference of State Legislatures. This seems like a large proportion of state budgets, but the money is spread out widely across a mix of mandatory and discretionary programs. Medicaid is one large federal program where there is a significant cross-over with state spending. Medicaid has been explicitly exempted from sequestration, however, lessening the potential impact on state budgets. • Page 3 • Dollars and Sense March 2013 Keep an eye on duration—or average maturity. Duration is a way to measure, and monitor, interest rate risk, and is generally related to the bond’s time to maturity. A rule of thumb is that an existing bond or fund would be expected to fall in value by the duration multiplied by the change in interest rates. A bond (or fund) with a duration of 5 might fall 5% in value if interest rates rose 1%. Schwab clients can look at the distribution of maturities, which is generally slightly longer than duration, of their fixed income portfolios by logging in to Schwab.com, then navigate to Guidance > Tools > Portfolio Checkup. Then click on the Fixed Income tab. For the duration of an individual bond or bond fund, talk with as Schwab Fixed Income Specialist at 877-563-7818. We suggest a mix of short-term and intermediateterm bonds or funds. A bond ladder mixes bonds maturing soon with some maturing later. We prefer ladders with maturities maxing out at about 10 years, for most investors. For investors who prefer bond funds, consider a mix of funds that fall into Morningstar’s “short-term bond” category for shorter term needs (money needed within 1-5 years) combined with “intermediate-term bond” funds for higher potential income earned on principal that isn’t needed soon. Bottom line. Risk in the bond market depends on where you invest. For investors worried about rising interest rates and/or inflation, short-term bonds or bond funds may fall in value if rates rise. But they are generally less sensitive to interest rate risk, for a shorter period of time, than longer-term bonds, all else being equal. For this reason, they should play a part in your bond strategy, in our view, in a low rate environment. Short-Term Bonds If You Think Rates Will Rise The most common question we hear from investors is the risk to bond investments if interest rates rise. The second most common question is will bond returns keep up if we see inflation down the road. Repeating a theme, it depends on bonds you hold, in our view. An allocation to short-term bonds—meaning bonds or bond funds with shorter maturities—make sense to us if you worry about if and when rates rise—or if we see higher inflation longerterm. Here are our thoughts to explain our view. The value of short-term bonds or bond funds is less sensitive to the risk that rates rise. Two factors tend to matter most when looking at risk in bonds: the level of credit risk (the risk of not getting repaid) and the level of interest rate risk (how long it takes to be repaid). The shorter the maturity of a bond or the average maturity of bonds in a bond fund, generally the lower the interest rate risk, all else being equal. Shortterm bonds or funds—which we define as having a single (or average) maturities between 1-5 years—are generally less sensitive than intermediate or long-term bonds, for shorter periods of time, if rates rise. Short-term bonds can be reinvested more quickly than long-term bonds. As a result, investors should be able to take advantage of the higher rates more quickly. For income-oriented investors, it may be helpful to have some money available and ready to reinvest when rates are more attractive. A short-term bond ladder with maturities from 1-5 years or a shortterm bond fund can meet this objective. The Fed will likely increase short-term interest rates if inflation rises above 2.5%. The common wisdom says that short-term bonds will never keep up with inflation. That’s likely true over long time periods. But it may not be the case during periods when inflation rises quickly. If inflation rises at a rate above 2.0% to 2.5% annually, the Fed has said that it would raise short-term rates. In the late 1970s and early 1980s, when inflation (as measured by the year-over-year change in CPI) was rising rapidly, rates on cash investments and short-term bonds rose quickly, as shown in the chart below. Short-term rates fell in close relationship with inflation thereafter. Rates on Cash Investments and Short-term Bonds: 19782013 Note: Yield to Worst is defined as the lowest potential yield that can be received on a bond without the issuer actually defaulting. Source: Bureau of Labor Statistics, Bloomberg, and Federal Reserve. Data as of March 1, 2013. Two Myths and A Legend (Hussman) By John Hussman, Hussman Funds On March 12, 2013 In late-2008, with the S&P 500 down 40%, I noted that stocks had become reasonably valued (see Why Warren Buffett is Right, and Why Nobody Cares). The coupling of improved valuations with an early improvement in market action – at least on postwar measures – was a fairly standard combination of events warranting a constructive position, though I noted that our approach still indicated the need to maintain a “stop loss” a few percent below those market levels in the form of index put options. Valuations are a far cry from reasonable today. On the policy front, I believed in 2008 that it was appropriate for the Treasury to provide capital to banks through the use of preferred stock (though I would have advised the use of Bagehot’s Rule – which would have provided that capital at much higher yields than the Treasury accepted). However, I did not believe that outright purchases of distressed assets were appropriate or ethical, and I railed against the notion of a Troubled Assets Relief Program (TARP), as well as Fed purchases of Fannie Mae and Freddie Mac’s liabilities, FASB accounting changes to reduce the transparency of financial reporting, and other interventions to defend bondholders and put bad private assets on the public balance sheet. As the government pursued those more outrageous policies, it became clear what I had expected to be a fairly orderly “writeoff recession” (involving the appropriate restructuring of bad debts) was not going to happen, and without that restructuring, that the • Page 4 • Dollars and Sense U.S. economy would be chained to the burden of those debts for a very long time. The inability of the economy to materially accelerate in recent years, and its constant hovering at the edge between expansion and recession, is a symptom of that failure to restructure debt in 2008 and early 2009. One cannot account for the full cost of defending bondholders during the crisis without adding in the trillions of dollars in additional government debt that has been expended in the effort to counteract that economic drag. I am glad that the economy has created jobs recently. But payroll employment is not a forward-looking indicator, and is unlikely to prevent the U.S. from joining a global downturn that is already in progress among developed countries (chart below from Dwaine Van Vurren). Note that U.S. recessions occurred in 1960, 1970, 1973-74, 1980, 1981-82, 1990-91, 2000-2001 and 2007-2009. The refusal to restructure debt in 2008 and 2009 (and the associated fear-mongering by financial institutions seeking government bailouts) did something else. It produced economic contraction and job losses unlike anything observed in the postwar period. The appropriate response, at least for any responsible fiduciary, was to stress-test every investment approach against data that included similarly deep economic and market contraction. In the Depression, the market decline from 1929 to 1931 erased the previous overvaluation, and took valuations to levels normally associated with prospective 10-year total returns of about 10% annually. But from there, stocks dropped by another two-thirds. A run-of-the-mill bear market represents a 33% decline, a typical cyclical bear within a secular bear market period averages a 39% loss (which would not be surprising over the completion of the present market cycle), and the past two bear markets each comprised 50% losses in the S&P 500 Index. It’s very important for investors to recognize the difference between a 20-25% drawdown, which is reasonably easy to recover over the course of a market cycle, and a 40% or 50% drawdown. Compounding is brutal where deep losses are concerned: a 50% loss requires a 50% gain just to get back to a 25% loss. In the Depression, the market’s loss grew to 85%, requiring a seven-fold gain to break even. Once the potential for Depression-era outcomes was on the table, ensuring the ability to successfully navigate that data was job one. The problem wasn’t to develop a model to “fit” Depression-era data (which is easy, but doesn’t necessarily generalize to new data). The problem was to develop an approach robust enough to navigate any random subset of historical data, including holdout data from the Depression, without the approach ever having seen it (a task that was satisfied using what are called ensemble methods). Concerned by the “two data sets” distinction between post-war and Depression-era data, we researched and implemented two adaptations to our approach, in order to be comfortable with our ability to properly navigate even the most extreme historical March 2013 market cycles. We don’t get a “do-over” on the cycle from 2007 to the present, which was interrupted by that need for stresstesting, but we are certainly moving ahead with confidence in the robustness of our approach. That approach is not bullish here, because a century of consistent evidence indicates that we ought not be bullish here. There are certainly aspects of the most recent market cycle that our present methods would have handled differently. One variation (resulting from the ensemble methods we introduced) is to demand a broader set of positive divergences in what we define as “early improvement in market action” – which would move the associated constructive shift to early 2009 when the S&P 500 was down 50%, rather than October 2008 when it was down 40%. In real time, the need to stress-test against Depression-era outcomes, and my insistence on making our methods robust enough to navigate extreme economic and market outcomes, resulted in what seems – in hindsight – to be a ridiculous miss. Fine, but understand the narrative of that miss, because it provides no basis to dismiss our present concerns. If you understand this narrative, it should be clear why the period since 2009 has contributed to my reputation as a “permabear” despite having no reluctance to advise a constructive position near market lows when the evidence supports it (nor did I have any reluctance to do so in early 2003, coming out of the preceding bear market, nor in the early 1990’s). Looking ahead, the most likely constructive evidence would be an improvement to reasonable or even moderately elevated valuations, coupled with a well-defined, early improvement in market action. I have little doubt that we will observe this sequence over the completion of the present market cycle, as that sequence has emerged in every market cycle throughout history. Now is not that time. As a side note, I should emphasize that we do seriously consider and incorporate trend-following methods in our analysis. However, it’s important to understand that simple widelyfollowed moving-average crossover methods are far less effective than investors seem to assume, and we instead focus on the uniformity and divergence across a wide range of market internals. Also, we find that the effectiveness of trend-following methods has generally vanished – on average – once the market establishes an overvalued, overbought, overbullish, rising-yield syndrome of conditions. Our present defensiveness is something that we would have had during late-stage, overvalued, overbought, overbullish bull market advances throughout history. Emphatically, I am not encouraging investors to deviate at all from their own investment discipline, provided that it is welldefined, well-tested, and matches their risk tolerance over the complete market cycle. But investors who have no such discipline – who believe that it is possible to simply “hold stocks until they turn down” or “party until the Fed takes away the punch bowl” – these investors are likely to be confounded by the failure of these simplistic notions to provide the comfortable exit they unanimously envision. Today is not 2003, and it is not 2009. The closer analogs (partially, but not solely on the basis of the recent overvalued, overbought, overbullish, rising-yield syndrome) are 2007, 2000, 1987, and 1972, not to mention 2011 – before a near-20% swoon – and 1929, at least on a valuation and technical basis. Two Myths and a Legend The present market euphoria appears to be driven by two myths and a legend. Make no mistake. When investors cannot possibly think of any reason why stocks could decline, and are convinced that universally recognized factors are sufficient to drive prices perpetually higher, euphoria is the proper term. Myth 1: As long as quantitative easing is underway, stocks will advance indefinitely. • Page 5 • Dollars and Sense This first myth is embodied in statements like “since 2009, there has been an 85% correlation between the monetary base and the S&P 500” – not recognizing that the correlation of any two data series will be nearly perfect if they are both rising diagonally. As I noted last week, since 2009 there has also been 94% correlation between the price of beer in Iceland and the S&P 500. Alas, the correlation between the monetary base and the S&P 500 has been only 9% since 2000, and ditto for the price of beer in Iceland (though beer prices and the monetary base have been correlated 99% since then). Correlation is only an interesting statistic if two series show an overlap in their cyclical ups and downs. If you want to talk about causation, the case for X causing Y is more compelling if the fluctuations in X precede fluctuations in Y. Even in that case, we say that X “causes” Y only if observing X gives us additional information beyond previous movements in Y itself. In the case of quantitative easing, much of what we observe as “causality” actually runs the wrong way. Market declines cause QE in the first place, and the result is a partial recovery of those declines. As I noted a few weeks ago (see Capitulation Everywhere), the effect of monetary easing has undeniably been very powerful in recent years. However, if you examine the data closely, this powerful effect is almost entirely isolated to a three-step pattern: 1) stocks decline significantly over a 6-month period; 2) monetary easing is initiated, and; 3) stocks recover the loss that they experienced over the preceding 6-month period. Regardless of whether one looks historically or even since 2009, a careful examination of the data is very clear: the essential feature of QE has been the recovery of preceding market losses that the market experienced in the months preceding the initiation of QE, with the impact of QE on investor risk preferences invariably wearing off after about 40 weeks. We would not rely on that precise horizon, but it’s worth noting that the relevant market low in the most recent instance was on June 1, 2012. March 2013 The problem with investors’ excessive faith in QE is likely to emerge at the point when sporadically emerging economic or financial strains (Europe, global recession, U.S. fiscal policy) weaken the inclination of investors to speculate – pitted against a monetary policy that has no material transmission mechanism other than to encourage speculation. As we observed in 2008, when the Fed was aggressively slashing interest rates well before Bear Stearns got in trouble (much less Lehman), Fed easing is not terribly helpful in a market where risk premiums are depressed and have not spiked materially. The same was true in early 2002, when I noted Wall Street’s “cheerleading position” at the time – that the economy was still too weak for the Fed to raise rates. Again, the Fed’s easing did not prevent the market from plunging about 30% between March and October of that year, despite positive GDP growth and an ISM above 50. Presently, investors are entirely ruling out the possibility that the stock market could decline significantly in the face of continued monetary easing by the Fed. This belief has far less basis in evidence than investors widely believe. Still, there’s no denying the recent market advance. So at least for a while, myth has been more convenient and profitable than fact. I doubt that this will remain the case much longer. Myth 2: Stocks are reasonably valued The second myth supporting investor euphoria here is the notion that “stocks are cheap on the basis of forward operating earnings.” It’s actually very fascinating how hard this myth dies, given how preposterously wrong the identical assertions turned out to be in 2000 and 2007 – both points where our standard valuation methodology indicated dismal prospective returns for the market (see The Siren’s Song of the Unfinished Half-Cycle for a historical review of these estimates). Part of the problem here is that year-ahead estimates for operating earnings (earnings without the bad stuff) are typically dramatically higher than trailing 12-month net earnings. As a result, forward price/earnings ratios are almost always much lower than “trailing” P/E ratios. But Wall Street conveniently disregards this fact – the “historical norms” that analysts assert for forward P/E ratios are really only applicable to the much higher trailing P/E ratios. The result is that stocks almost always look cheap relative to those inappropriately inflated “norms.” Another technique, of course, is to use norms that are heavily influenced by the late-1990’s bubble period – a period where valuations were high enough to produce near-zero total returns for investors for more than a decade. If you use a period of overvaluation to derive your norm, then your norm is overvaluation. How is that not obvious? One way to reduce this problem somewhat is to compare the forward P/E ratio of each stock to its own average forward P/E over the previous 5-year period. This doesn’t solve the entire problem, as we’ll see, but it’s notable that on a relative basis, forward operating P/E ratios are at about the same point they were at the 2000 and 2007 market peaks. The following chart is from Morgan Stanley (via ZeroHedge): Keep in mind that QE has no transmission mechanism other than inducing discomfort among investors. The entire stock of additional reserves created by QE is still sitting idle in the banking system earning next to nothing. It’s just that someone has to hold that zero-interest cash until it is removed from the system, and the entire objective of QE is to make each successive “someone” as uncomfortable as humanly possible, so they will go out and speculate enough to drive the prices of risky assets higher, and their prospective returns toward zero. • Page 6 • Dollars and Sense The larger problem with forward operating P/E ratios is that they purport to value a very long-term asset based on a single year’s financial results, which is only appropriate if that single year is adequately representative of long-term cash flows. This is where myth and reality are strikingly out of line. At present, corporate profits as a share of GDP are roughly 70% above their historical norm. Despite seemingly endless rationalizations and arguments for the permanence of this situation, the reason profit margins are elevated is actually very straightforward: March 2013 Notice that elevated profit margins are also strongly meanreverting over the economic cycle. In general, elevated profit margins are associated with weak profit growth over the following 4-year period. The historical norm for corporate profits is about 6% of GDP. The present level is about 70% above that, and can be expected to be followed by a contraction in corporate profits over the coming 4-year period, at a roughly 12% annual rate. This will be a surprise. It should not be a surprise. The deficit of one sector must be the surplus of another. This is not a theory. It’s actually an accounting identity. But the effect of that identity is beyond question. Elevated corporate profits can be directly traced to the massive government deficit and depressed household savings that we presently observe. I should note that this result is the outcome of hundreds of millions of individual transactions, so it’s tempting to focus on those transactions as if they are alternate explanations. For example, one might argue that corporate profits are high because people are unemployed, many workers have been outsourced, and government transfer payments are allowing corporations to maintain revenues from consumers despite low wage payments. That’s a perfectly reasonable of saying the same thing – but the transaction detail does not change the basic equilibrium that profits are elevated because government and household savings are dismal. One will not be permanent without the other being permanent. To see this, notice that corporate profit margins have always moved inversely to the sum of government and household savings. To understand how profoundly imbalanced the present surpluses and deficits in the economy are, the following chart shows the sum of government and household saving, as a percent of GDP. The historical norm for the combination of these is positive, at about 4%. At present, household and government saving sum to a combined deficit of 5% of GDP. • Page 7 • Dollars and Sense March 2013 “In my opinion, you have to be wildly optimistic to believe that corporate profits as a percent of GDP can, for any sustained period, hold much above 6%… Maybe you’d like to argue a different case. Fair enough. But give me your assumptions. The Tinker Bell approach – clap if you believe – just won’t cut it.” - Warren Buffett, “Mr. Buffett on the Stock Market,” Fortune Magazine 11/22/99 I started this piece referencing my 2008 comment Why Warren Buffett is Right, and Why Nobody Cares. I’ll finish it with the observation that today is not 2008, nor are market valuations anywhere close to being attractive. It should be clear from my numerous comments over the years that I have great respect for Warren Buffett, but this respect has always been grounded in a fairly good understanding of how he invests, particularly on considerations of valuation, revenue predictability, the importance of return on invested capital, and the necessity of a sustainable competitive advantage to drive the long-term stream of cash flows that a company can be expected to actually deliver to its shareholders over time. Here is the punch line. Any normalization in the sum of government and household savings is likely to be associated with a remarkably deep decline in corporate earnings. Notice that over the past three years, we’ve seen a very slight improvement in the sum of government and personal savings as a fraction of GDP. That change shows in the following chart as a decline in the blue line (the right scale is inverted). Accordingly, though corporate profits are still extraordinarily elevated, we have also observed a significant decline of earnings momentum in recent quarters. This is not some temporary anomaly. It should be clear from the previous chart that the normalization of government and household savings is just getting started. Last week, the euphoric mood of investors got an additional push from Buffett, who commented on CNBC that “We’re buying stocks now. But not because we expect them to go up. We’re buying them because we think we’re getting good value for them.” Frankly, I’m not entirely convinced that one obtains good value by paying a 25% premium over a company’s historical valuation norms for earnings, revenues, dividends and cash flows, unless considerable efficiencies can be unlocked that promise to make the course of future cash flows markedly different from that history. What I do believe is that Buffett’s recent investments are more indicative of competitive considerations and faith in management than they are indicative of valuation, particularly in the broad market. As Buffett observed more than a decade ago: “The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage.” So with great respect, I think it’s fair to say that on Buffett’s broader considerations, there may very well be reasonable investments available in stocks, provided that one doesn’t expect them to go up in the foreseeable future. That said, I am also entirely convinced that from a valuation standpoint – certainly the standpoint that a typical investor would have in deciding whether to allocate capital in pursuit of an adequate expected future return – present market valuations create dismal prospects for investors over horizons of less than 7 years. We presently estimate likely 10-year nominal total returns on the S&P 500 only slightly above 3.5% annually – with the likelihood of strikingly large market fluctuations over the course of the coming decade. As I noted a few weeks ago, it would be one thing if the reason for presently elevated profit margins was even a mystery. But there is no mystery here. Wall Street is grossly overestimating the value of stocks based on profit margins that are 70% above the historical norm. The expansion of profit margins is the mirror image of the plunge in government and household savings in recent years. Stocks are not cheap. Forward operating P/E ratios – indeed, any metric that does not adjust for the elevated position of profit margins – are presenting a wildly misleading picture of market valuation. Recognize the reasons for this now, or discover the consequences of this later. And a Legend In 1999, Buffett correctly recognized the overvaluation of the market – and the weak basis for investors’ assumptions to the contrary – when he noted that “you have to be wildly optimistic to believe that corporate profits as a percent of GDP can, for any sustained period, hold much above 6%.” As should be fully evident from both accounting identities and historical data, the fact that corporate profits are now 70% above their historical norms can be directly attributed to the extraordinary deviation of government and household savings from their own historical norms. Indeed, the relationship between nominal GDP and corporate profits, over the long term, is large enough to make nominal GDP itself a useful valuation metric. In practice, of course, we consider revenues, earnings, book values, dividends, cash flow, and even forward operating earnings (properly normalized) in our valuation approach. But it should be of more than passing • Page 8 • Dollars and Sense March 2013 interest that Warren Buffett himself has noted that the ratio of market capitalization to GDP is “probably the best single measure of where valuations stand at any given moment.” The chart below presents the ratio of market capitalization to GDP, using Z1 flow of funds data from the Federal Reserve with the blue line (left scale, log). The red line shows the actual subsequent 10-year annual (nominal) total return of the S&P 500. The right scale is inverted, so higher levels are more negative. Notice that the elevated ratio of market cap to GDP in 2000 correctly projected the negative total returns that investors would achieve over the following decade, with a great deal of volatility in the interim. By contrast, the lower but still-rich level of market cap to GDP in 2003 nicely projected the most recent 10-year total return of about 8% annually. The 2009 low was certainly nowhere close to the level of undervaluation associated with the 1949-1952 or 1982 secular lows, but was enough to indicate a likely return of about 10% annually over the following decade, which has essentially been compressed into the past 4 years. Presently, the ratio of market capitalization to GDP suggests a likely 10-year total return for the S&P 500 of about 3%, which is about the same estimate that we obtain from a much broader set of fundamentals. We estimate that the first 5-7 years of this horizon are likely to be associated with zero or negative overall returns for a passive investment in the S&P 500. — Just a reminder – Last May, my friend Mike Shedlock’s wife Joanne passed away from an aggressive form of ALS (amyotrophic lateral sclerosis). Mike (“Mish”) is an investment analyst whose work can be found on the Global Economic Trend Analysis site. In Joanne’s memory, and to benefit the Les Turner ALS Foundation, Mish has organized a conference in Sonoma California, on April 5, 2013. I don’t often speak at conferences or schedule media interviews, but that day, Mish, Chris Martenson, Michael Pettis, James Chanos, John Mauldin, and I will be speaking – for a very good cause. The Hussman Foundation has also committed a $100,000 matching grant to the Les Turner ALS Foundation, to match conference fees and encourage donations to support patient services and research for individuals with ALS. I hope you’ll join us in California. Thanks – John • Page 9 • Dollars and Sense March 2013 Chart of the Month A Stock Market Trend Has Developed That Coincided With The Last 3 Recessions In a new report, ECRI's Lakshman Achuthan reiterates his thesis that the U.S. economy is in a recession. Among his many points was this one about how consecutive quarters of negative earnings growth coincide with recessions. From his report: This is a bar chart of S&P 500 operating earnings growth going back a quarter of a century on a consistent basis, as we understand from S&P. Others can choose their own definitions of operating earnings, but this is the data from S&P. In this chart, the height of the red bar indicates the number of consecutive quarters of negative earnings growth. It is interesting that, historically, there have never been two or more quarters of negative earnings growth outside of a recessionary context. On this chart, showing the complete history of the data, the only times we see two or more quarters of negative growth are in 1990-91, 2000-01, 2007-09 and, incidentally, in 2012. This data is not susceptible to the kind of revisions one sees with government data. The point is that this type of earnings recession is not surprising when nominal GDP growth falls below 3.7%. So, even though the level of corporate profits is high, this evidence is also consistent with recession. In short, earnings recessions seem to coincide with economic recessions. • Page 10 • Dollars and Sense Company Snapshot – March 2013 Fundamental Analysis Mar. 2013 Market Cap Distribution Yield P/E ratio Price/BV Intel (INTC) INTC - (March 8th) $21.30/share Summary – Intel Corporation designs and manufactures integrated digital technology platforms. A platform consists of a microprocessor and chipset. The Company sells these platforms primarily to original equipment manufacturers (OEMs), original design manufacturers (ODMs), and industrial and communications equipment manufacturers in the computing and communications industries. The Company’s platforms are used in a range of applications, such as personal computers (PCs) (including Ultrabook systems), data centers, tablets, smartphones, automobiles, automated factory systems and medical devices. On February 2012, QLogic Corp. sold the product lines and certain assets associated with its InfiniBand business to the Company. In May 2012, Cray Inc. completed the sale of its interconnect hardware development program and related intellectual property to the Company. In September 2012, InterDigital, Inc.’s subsidiaries sold around 1,700 patents and patent applications to the Company. $107.2 billion $0.22 4.16% 10.2x 2.1x Technical Analysis Longer term – quadrant 4 – Bottoming Intermediate term – quadrant 2 - Accumulate • Page 11 • Dollars and Sense March 2013 FLLC Portfolio Tracker Current Company Symbol 52 Week Initially Added Recent Price P/E 22.05 Sold 19x Yield Sell Brookfield Intrastructure Partners LP BIP.un Hi 19.50 Low 15.50 Date Feb 26, 2010 Price 17.30 SELL Gold Participation and Income Fund GPF.un 12.25 10.12 10.75 12.65 Sold 6.4% Sell PMT 5.90 3.31 5.03 2.84 Sold 8.7% SELL Perpetual Energy (formerly Paramount Energy Resources) New Flyer NFI.un 11.76 7.32 9.65 11.48 Sold 11.8% SELL Labrador Iron Ore LIF.un 55.80 30.03 41.60 64.25 Sold 8.7x 10.8 SELL Maple Leaf Foods MFI 12.06 8.47 9.21 12.21 Sold 12x 1.4% SELL UIL Holdings Corp UIL 30.33 23.79 Mar 26, 2010 Sell date Nov 3, 2010 April 27, 2010 Sell date Aug 24, 2011 May 31, 2010 Sell date Nov 3, 2010 June 29, 2010 Sell date Nov 3, 2010 July 30, 2010 Sell date Mar 5, 2011 Aug. 30, 2010 25.90 30.53 Sold 19x 5.6% Sell PXX 3.98 1.94 Oct 7, 2010 Sell date Aug 24, 2011 3.90 5.02 Sold Buy Black Pearl (speculative stock with high growth potential, NOT Blue chip) AGF Management Ltd AGF.b 19.25 13.36 Oct 28, 2010 16.45 12x 5.68% SELL Canadian Oil Sands COS.un 33.05 24.24 26.69 17x 8.07% Buy Pfizer PFE 20.36 14 Oct 28, 2010 Sell date Mar 5, 2011 Dec 3, 2010 11.63 Sold 31.78 Sold 22X 4.25% Buy Home Equity Bank HEQ 8.33 6.12 Jan 3, 2011 6.55 Buy China Security and Surveillance CSR 8.89 4.09 Feb 3, 2011 4.90 SELL Proshares Ultrashort Euro EUO 26.40 17.64 17.45 SELL Nuvista Energy NVA 12.51 8.55 Apr 6, 2011 Sell date Sept 12, 2011 May 6, 2011 26.89 Sold 9.50 Taken over 6.50 Taken over 18.87 Sold 9.30 6.01 Sold SELL Crescent Point Energy CPG 48.61 35.30 June 8, 2011 45.03 43.30 Sold 28x 6.28 SELL Westshore Terminals WTE.un 25.85 17.57 July 28, 2011 22 24.75 SOLD 16x 5.9% Buy Capital Power CPX 28 22.26 July 28, 2011 23.85 21.82 22x 5.1% 16.70 *current buyout offer of $6.50 • Page 12 • 5.3% 4.27% 6.5x Dollars and Sense Current Company March 2013 Symbol 52 Week Initially Added Recent Price P/E Yield 10.43 7.6 9.0% 12x 5.2% Buy France Telecom FTE Hi 24.60 Low 17.21 Date Aug 26, 2011 Price 18.50 SELL Proshares Ultrashort 20+ year treasuries TBT 41.54 21.86 Sept 12, 2011 22.10 19.50 SOLD Buy Duke Energy DUK 71.13 50.61 57.75 64.85 SOLD SELL WisdomTree Europe SmallCap dividend DFE 48.15 31.04 33.90 37.55 SOLD Buy Canadian Oil Sands COS 33.94 18.17 Oct 6, 2011 Sell date Nov 5, 2012 Nov 10, 2011 Sell date Nov 5, 2012 Dec 14, 2011 20.75 21.35 7x 5.62% Buy Telefonica SA TEF 27.31 16.53 Feb 7, 2012 17.40 14.43 8.5x 7.5% Buy Canadian Natural Resources CNQ 50.50 27.25 Mar 7, 2012 34.70 32.10 15x 1.0% SELL Repsol REPYY 34.84 14.41 15.50 19.90 SOLD 9.5x 6.8% SELL Eni E 49.65 32.44 39.50 45.30 SOLD 8.0x 4.6% Buy Phoenix PHX 11.70 7.75 June 5, 2012 Sell date Nov 5, 2012 June 29, 2012 Sell date Nov 5, 2012 Aug 7, 2012 7.85 9.10 9.9 9.14% Buy CME Group Inc CME 60.92 44.94 Sept 5, 2012 55.10 62.59 12.1 3.10% Buy TOT S.A. TOT 57.06 41.75 Oct 10, 2012 48 51.44 8.01 5.91 Buy Cliffs Natural Resources CLF 78.85 28.05 Dec 4, 2012 29.40 23.83 5.8 7.1 Buy Fiat SPA FIATY 6.47 4.19 Jan 4, 2013 5.19 5.90 24 1.6 Buy Goldcorp G 50.17 32.34 Feb 8, 2013 36.07 33.23 17x 1.65 Buy Intel INTC 29.27 19.23 Mar 8, 2013 21.30 21.30 10x 4.25 5.58% These stocks are chosen using the same techniques as taught in the CIC course. FLLC is not an investment advisor and is not setting any target prices or financial projections. Never invest based on anything FLLC says. Always do your own research and make your own investment decisions. FLLC never recommends to buy or sell any stock. This email is not a solicitation or recommendation to buy, sell, or hold securities. This email is meant for informational and educational purposes only and does not provide investment advice. • Page 13 • Dollars and Sense March 2013 Technical Analytic View Date: Mar. 5, 2013 TSX 60: Long Term: (6-18 mths) MidTerm: (5-10 wks) Dow Jones Industrials: • rally may begin to correct here 90 Day Interest Rates: • governments determined to keep short term rates low for now • some symbolic increases (0.5% to 1.0%) 5 Yr Interest Rates: 30 Yr Interest Rates Gold: • rates have flattened • rates should trade sideways for a long time • longer term trend may have formed • sell into next rally • Cdn $ seems to be range bound between $0.95 to 1.05 US Canadian Dollar: LEGEND bottom forming Comments: • long term BUY signal has occurred, use the next intermediate correction to buy buy top forming Sell Current Course offerings Oakville - Tuesdays – Mar. 19th – Apr 30th Oakville Central Library Burlington - Wednesdays – Mar 20th – Apr 24th Tansley Woods Community Ctr Mississauga - Wednesdays – Mar 20th – Apr 24th Mississauga Central Library Hamilton - Fridays – Apr. 5th – May 10th 1685 Main St.W. Please visit our website www.fllc.ca www.canadianinvestorscourse.ca or Contact us at: 905-828-1392 The information contained herein has been obtained from sources believed to be reliable at the time obtained but neither the Financial Literacy Learning Centre Inc. (FLLC) nor its employees, agents, or information suppliers can guarantee its accuracy or completeness. This report is not and under no circumstances is to be construed as an offer to sell or the solicitation of an offer to buy any securities. This report is furnished on the basis and understanding that neither FLLC nor its employees, agents, or information suppliers is to be under any responsibility or liability whatsoever in respect thereof. • Page 14 •