TFTF

Re-Setting the Investment Scales

June 14, 2002

The news all seems so bleak sometimes. But is it? If my view that we are in a Muddle Through Economy is to prevail, then we surely must be seeing some good news somewhere. In this issue, I find some good news, some bad news and highlight a recent study which shows that the run in small cap stocks may be coming to an end. And much more, of course. Let's jump right in.

Is the Run in Small Cap Stocks Over?

There is reason to think it might be. Small cap stocks have outperformed large cap stocks by 100% over the last three years. "Cap" is short-hand for stock market capitalization. Small cap means the stock market value of the companies are small and vice versa.

Myles Zyblock of Brown Brothers Harriman did a study, looking back over the last 75 years, and finds that whenever small caps get into this 100% range, the small cap game is entering the late innings. In three of four times, the game was soon over. In WW2, the game went into extra innings, but not for long. It made a quick spike, and then large caps started to out perform.

If the pitching in the late innings is anything like the relief pitchers for my Texas Rangers, we should be very worried.

Now, this does not mean we have a bull market in large cap stocks in our future. It means that small caps are probably not going to do any better than their larger brethren. The higher small caps go relative to high cap stocks from here, the more it will begin to look like a bubble.

It is more likely, in my view, that small cap and large cap stocks will start moving roughly in tandem.

Your defense, if you want to be in the stock market, is to keep buying value stocks. If the stock market takes your value stocks up, sell them and buy more under-valued stocks. Value stocks nearly always out-perform growth stocks in a period when P/E ratios are falling. In periods like this summer, when stocks fall on even good economic news, there is a premium placed on value stocks.

Where's the Growth?

As I analyze the data for the past few weeks, several patterns emerge. One of my Three Amigos, capacity utilization, continues to improve, but not as much as expected. Industrial production improves, but not as much as expected. Initial jobless claims drop, but not very much. Unemployment finally starts to improve, but 60% of the improvement was in temporary jobs. The number of over-time hours grew slightly, which is usually a pre-cursor to a growth in employment. So we can expect small but steady improvements in employment in our future

In spite of the dollar dropping, import prices actually went down. Business inventories are down, but by only 0.2%. There is very little capital spending growth, and the growth that came from inventory re-building is largely over.

Inflation is still not in the near future. The Producer Price Index dropped another 0.4%, much more than expected. The PPI is in outright deflation over the past year. Commodity prices, although a few points higher than their lows, are having a hard time finding a way to increase. Mortgage applications and home building are holding up on a relatively high plateau. Mortgage payment delinquencies are improving, but only slightly.

But the consumer seems to be slowing down. Retail sales for May were down 0.9%, when the expectation was for them to be flat. Not surprising, then, that the Michigan Consumer Sentiment index dropped a rather large 6%. But what growth there is seems to be at discount retailers like Walmart and Costco. We all look for bargains.

Paul Kasriel writes that consumers now have only $.60 for every dollar of debt, down from $1.60 in 1950 and down over the last decade from $1.00. It is going to be hard to sustain strong growth in consumer spending as we run out of money to spend.

(That is another reason why the Fed is reluctant to start raising rates. It would seriously hurt the ability of the consumer to spend, as his cost of financing the debt will rise.)

The growth in consumer spending for this quarter will probably be about half what it was in the first quarter, and less than a third of the fourth quarter of last year. That is not a good trend. Growth will probably be less than 2%, which is rather tepid. Stephen Roach says, "For me, the 2% growth threshold has always been a key signpost for the American consumer. It doesn't always signal recession, but it certainly does flash a 'growth warning' that financial markets take quite seriously. That may well be the case today."

In short, if you want to be pessimistic about the economy, you have plenty of ammunition. If you want to find bright spots, you can easily do so. I choose to continue to say both sides are wrong. The data seems to suggest to me we are still headed for a period of slow but steady growth. Though some of my readers called me Muddle-Headed, I still think we are in a Muddle Through Economy.

Thoughts on a Bear Market

In the last long bear market cycle of 1966-1982, the economy actually grew faster than it did in the subsequent bull market era of 1982-2000. You can find other examples when the relationship between stocks and the economy were seemingly disconnected.

Ben Graham tells us that the "stock market acts as a voting machine in the short run, it acts as a weighing machine in the long run." What is voted upon is profit potential. What it actually weighs are real profits.

In bull markets, stock market investors believe that profits will rise. They plow into growth stocks, expecting growth to compound seemingly forever.

But in bear markets, investors start to look more at the real profits than in forecasts. That is what makes value investing so important.

As every bear market cycle starts, and this one is still an infant, there are cries for reform. People who were once the darlings of Wall Street become the ogres deserving of jail time. In that regard, the calls for reform should be expected.

The difference this time is in the nature of what is to be reformed. The reforms and changes that will come from the current cycle of angst will change, perhaps dramatically, how we determine what exactly constitutes a profit. This will be as hard as determining the what Bill Clinton meant by the word "is."

Now those of us who run small businesses know what profits are. It is the money left in the bank account at the end of the year, plus what we spend on personal items. There are a few loopholes we can use to shelter some "profits" from taxes, but very few. What you see in the bank is pretty much what you get.

But in the world of public corporations, a new way to look at profits emerged in the last 20 years. New "special purpose vehicles" were created to push items which would cut profits out of sight. Operating earnings, pro forma earnings and other euphemisms became ways to make the profit picture look brighter.

But now there is a rush to change all that. Accountants and corporations are becoming more conservative.

Re-setting the Scales

I get on a weight scale nearly every morning. Sometimes it shows me losing 20 pounds overnight. At those times, I know something has changed the scales, and I need to re-set it. As much as I would like to believe the scale, reality in the form of a mirror says I still need to lose a few pounds.

I think we are in the process of re-calibrating the weight machine of the stock market.

The Singapore Business Times tells us that "in the bear markets of 1949 and the early 70s and 80s, the average PE ratio of the 500 companies in the S&P 500 index was a mere 5 times to 7 times earnings."

"According to Thomson First Call, the consensus analyst S&P 500 earnings assessments and forecasts are $48.80 in 2001, rising to $52.20 in 2002 and to $62.60 in 2003. That places the index on a forward 2002 PE of 20 and 2003 PE of 16.

"S&P plans to deduct from reported earnings the imputed cost of options granted to executives, as well as expenses related to under-funded pension plans and restructuring charges for actions such as layoffs and relocating plants.

S&P's core earnings will also exclude charges for discontinuing a business line or product, charges related to mergers, acquisitions and litigation, and investment gains on pension-plan assets.

On current estimates, S&P calculates that core earnings of the index are $28.50. This estimate raises the S&P 500 PE to 36."

That is a little more than half of the First Call estimates. It is also much more realistic.

I and many other analysts have high-lighted for the past few years the ridiculous earnings estimates and the use of pro forma earnings. Now the S&P 500 is going to get conservative as well.

This is a major change, and you are going to see brokerage firms start to conform as well. The law suits that are mounting are going to force them to take more conservative stances. This will take some time, but eventually it is going to trickle down to the investor. This new profit weighing scale is going to put a ceiling on stock prices for a long time. As time goes on, investors are going to want more and more real earnings per share for the risk of investing in a company.

It has been like that in every bear market cycle since the Medes were trading with the Persians. It seldom happens over-night. It takes time, as each generation which has been trained to buy the dips slowly comes to realize a share of stock is a piece of a business, and not a lottery ticket.

We are witnessing this very thing today. Stock valuations, as noted above, are close to all time highs. Yet, after a 200 point drop in the Dow, the market came back strong. The NASDAQ closed up. The S&P, after dipping below 1,000, rallied to close over 1,000.

Many of you ask why I do not think a crash is in the near term. Today is a perfect illustration. We have seen two episodes this week of buying the dips. Of course, we close the week down, but the bulls have something to convince them we are at a bottom.

Andrew Kashdan of Apogee Research writes: "According to ContraryInvestor.com, individual mutual fund holdings appear to have held remarkably steady the past three years, despite the market's $4 trillion to $5 trillion paper loss. In other words, investors continue to "buy the dip," even as the dip keeps dipping ever lower. In not one of the last three years did equity mutual funds show a net outflow. It seems the lesson of "buy-and-hold" has been taken to heart at precisely the wrong time. Like ContraryInvestor, we can't help but wonder if the public might finally capitulate and dump a significant portion of its holdings. So far, this crop of individual investors seems determined to hang tough come hell or high water."

Could we see a real crash and a dizzying drop in the future? Absolutely. I will discuss such a risk in a few paragraphs. But for now, I think the tenor of the market is a sideways to down pattern. Could we go back up 10% before we drop another 14%? Absolutely.

Or we could just drop another 15% from here and set up another buying opportunity. No one knows how this will play out. But the eventual outcome will be that at the end of this bear market cycle, stock valuations will come back to norms, probably in the P/E range of 15-17. But this time, the valuations will be on the new, more conservative scales.

History teaches us that the pendulum usually swings back to 5 to 7 as investors get entirely too pessimistic. I would point out at that those levels, the S&P 500 would be below 250 today. I do not think the S&P will see 250.

What will happen is that earnings will grow, as the economy Muddles Through. Could real earnings in the S&P 500 grow from $28 to $60-$70 or more by the end of the decade? Of course. That is roughly 10% growth per year, and is quite possible. Do I think we will see a P/E ratio of 5 or 7? Not unless we have some horrific event none can now foresee.

That being said, a drop of 40% or more from here over this next cycle is certainly within historical norms. But one can argue, and very smart analysts I admire do so, that the stock market will drift sideways to down for a long time as earnings rise slowly, meeting somewhere in the middle.

The major downside risk I see is foreign investors taking their money and going back to more fertile territory. The Japanese, I am told, withdrew $24 billion in January alone. The recent rapid fall of the dollar will make investors nervous.

But when the head of the European Central Bank starts to talk down his currency, someone besides mama-san is worried. Dennis Gartman of the well-written Gartman Letter writes: "Turning then to Mr. Duisenberg's comments, we were taken-aback by them, concerning the euro and the "cultural diversity" of Europe. Duisenberg of course noted the language barriers that Europe has when compared to the language homogeneity of the United States and suggested that this alone shall make economic activity in Europe more difficult than in N. America. But he went on to say that European cultural diversity does in fact carry a price. He said,

"...if we want to preserve our cultural diversity, we will never be able to reach the higher rate of potential growth [of the United States.] We want to preserve that diversity, but we have to pay a price."

"We might have expected the arch Euro-skeptics to raise such a complaint, but we hardly expected the very centre of European monetary policy to raise it. Indeed, as more traders/money managers and corporate hedges read of Mr. Duisenberg's comments, we cannot help but believe that they will at least put in an interim top of some consequence for the euro... and it may be even more serious than that."

I, for one, hope that we see an orderly retreat of the dollar. Brown Brothers estimates that for every 1% drop in the dollar, we actually see a 0.3% rise in earnings growth because so many of our large companies are multi-national. An orderly drop in the dollar, say 7% this year and 7% next year, would be quite good overall for the US dnd world economy. This is why Duisenberg was "talking the euro down." He wants things to move on an even keel.

Sadly, the history of currency valuations is replete with examples of things not being so smooth. A rapid drop could seriously affect the stock and bond markets. We will need to keep a close eye on the dollar and foreign cash flows.

Modern Portfolio Families

Modern Portfolio Theory teaches us we should diversify our investments over many assets classes and invest for the long-term, as different classes will do well at different times. If you hold long enough, your portfolio will do well.

I took that advice to heart in my family planning, and diversified my portfolio of children. In addition to two biological daughters, we adopted five more. We further diversified among races and country of origins. I have about as diversified a family portfolio as one can have. Right now, I am still in the investing phase. I am still waiting for a return on my investment, other than love and affection, of which I have in abundance. Modern Portfolio Theory says if I hold on long enough, I should see a profit. I think I will hold on to this group for as long as God will grant me grace. I am beginning to wonder, though, if the dollars will ever stop flowing out.

Happy Father's Day to all.

John Mauldin

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