Valuation Madness

This week we will look at a fascinating debate between two well-known investment analysts, I show you how to spot a stock market cheerleader, and ponder the significance (if any) of what the surprising GOP win of the Senate portends for our investments.

I am on the road as I begin to write this week's letter, speaking at the National Endowments and Foundations Symposium on the prospects for the economy and the markets for the coming year. Interestingly, when I spoke at this conference last year I was soundly taken to task by some pension/investment consultants for suggesting that the stock market would drop for a third straight year, even as the economy would Muddle Through.

"You must," I remember one saying, "have a 22% exposure to large cap growth stocks." I was dismissed as some kind of troglodyte bear brought in to amuse the locals, as this person noted the long list of large clients and solid pedigree of their firm. How could such a company with so many analysts and Ph.Ds be wrong? I note that I was asked back and they are not here. I learned a few things at this conference, which I will report to you today, and you can save the $2995 registration fee.

Investing By Committee

If you think you have been having investment problems, pity the average endowment and pension fund. Their investments are run by committee, and they hire consultants to give them advice on how to allocate their investments. Typically, these consultants are rear view mirror advisors, with tons of charts and graphs showing how if you simply stick with your stocks for the long run, you will do just fine. They trot out the famous Ibbotson study to prove their point. They show what a "blend" of various stock indexes will do. You must stay in the markets at all times is their basic advice. They tinker with the blends from time to time, but rarely suggest anything but long only strategies. In many respects, they are like the typical broker you know, except they deal with larger numbers.

These endowments are pressed to give up more and more money for their causes, as the need is always great, yet the funds they manage have been shrinking. There are some shell-shocked trustees at this conference, and they are a little more wary of whose advice they take. Not surprisingly, consultants willing to think out of the box are being listened to more and more. There are advisors who can point to good results for their clients over the past years. If you are an endowment or pension fund, write me and I will suggest a few.

Take a Risk, You Get Fired

Mark Yusko from the University of North Carolina made some very interesting points about the consultant problem. First, he noted that most consultants and managers have a strong incentive to not take risks, where risk is defined as doing something different than the herd of other consultants. If you suggest something different and you are wrong, you lose your job. If you suggest sticking with the standard line, you can blame the market and point out that everybody else had problems as well. You keep you job.

This was perfectly illustrated by the story of Jeremy Grantham of GMO Advisors, whose presentation we will discuss at length in a moment. Grantham is a famous deep value investors. He was taking his clients out of stocks in 1998 and 1999 (and even earlier), as value, by his calculations of traditional stock portfolios, simply got out of line.

He told us he lost 40% of his accounts during this period, which is a staggering number, since he manages nearly $20 billion. His large pension fund investors demanded that he keep up with other managers, and he refused, based on his sense of value. Now, these funds wish they had stayed, as Grantham has beaten the socks off his competitors.

How painful it must have been to lose that much business. It is a testimony to his character that he stood by his belief in value even as his income went down. But the clients that stayed also need to be commended, as it is hard to sit out the dotcom bubble as your peers are participating. I remember the articles about how Warren Buffett just didn't get it.

There are some outstanding endowments and pension funds, as well as consultants, that have done well in this environment. They did not stick with the herd, took the risk of being more conservative, and today they have been rewarded. They are the exception, however.

The second point Yusko made that I found interesting was that 85% of portfolio performance came from asset allocation and only 15% from actual stock picking prowess. Intuitively this makes sense, but I had not seen any data prior to this.

What he means is that the more important decision for large (and small) investors to make about their portfolio is in which asset class to be positioned. How much in real estate? Gold? Bonds? Stocks? Hedge funds, etc.? Actual stock picking only improves portfolio performance marginally, as large funds must buy larger stocks more representative of the market in general.

While stock picking clearly could make a much bigger impact on smaller individual portfolios, the principal is the same. If you allocate a large portion of your portfolio to stocks, you are subject to the whims of the markets. If you have the bulk of your assets in stocks and they go up, you do well, but if you ride it down, you have the opposite result. Making the decision as to what percentage of your portfolio to devote to particular asset classes has a huge impact on your overall portfolio.

Bull vs. Bear, Siegel vs. Grantham

The highlight of the conference was a debate between the ever bullish Professor Jeremy Siegel of Wharton and the currently bearish on US stocks Jeremy Grantham of MRO Advisors. (Note to self: never follow a Grantham speech again.)

Siegel wrote Stocks for the Long Run . It is the bible for buy and hold investing. Siegel points out that since stocks return 6-7% after inflation over the long run, which is far better than bonds, you must be in stocks, and ignore the ups and downs. It is fair to say he is a proponent of index investing. He does assume you are paying attention to which stocks you own. To his credit, he did write a very prescient piece in March of 2000 in the Wall Street Journal called "A Sucker's Bet" about the overpriced NASDAQ stocks, pointing out that no investor had ever made money long term on a large cap stock with a P/E ratio of 100, and listed 9 stocks which currently fit that description (Cisco, Yahoo, AOL, etc.).

For Siegel, it is always time to buy stocks. Today you should buy because at current market values he believes stocks are likely to rise 6-7% per year over the decade, thus being back to new highs at the end of that time. He bases this on his study which shows that after the market has dropped 40%, the subsequent five year real returns have averaged 8.6%, and were never negative.

He further points out the market is under-priced based upon his definition of value. You must ignore the current year earnings. To get a true picture, he maintains, you must look at a five year average of reported earnings. This drops the current P/E ratio to only 17.4.

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Then he argues that the market will not go back down to the historic average P/E of 14.6.Why? Because markets are more liquid, we are not going to have any economic disasters and investors are smarter than they have been in the past.

The correct P/E ratio that smarter investors will adopt in the future is somewhere in the low 20s.

Then he talks about the new S&P core earnings standard, which will give investors confidence. I wrote about them two weeks ago. Standard and Poors tells us that true core trailing earnings for the S&P 500 through June 30, 2002 was only $18.46, after deducting for options expenses, pension costs and other real world costs, not the reported $45 that companies would have investors believe.

I sat puzzled for a moment, as I multiply 22 times $18 and get a market value of the S&P 500 less than half of what it is today. Why buy? Aaah, he says, the recent S&P numbers included large write-offs, which will not happen next year. Next year, S&P core earnings will be $40-45 dollars, and thus the market is fairly priced, and will rise over time as earnings rise. Call your broker today.

(Interestingly, I stopped at this point in the column to run to the airport to catch my plane back to Fort Worth. As I was waiting to take off, I opened this week's Fortune, and there on page 190 was a chart showing that if you average the last five year's operating earnings on the S&P 500, you find the P/E ratio at 18.3. Buying at this point should yield better than average performance, we are breathlessly told by a fund manager, who presumably would like you to buy his funds, preferably today at such low values. Siegel acolytes are everywhere.)

Cooking the Data Books

Let's analyze the flaws in Siegel's main propositions. First, why should we use five year operating earnings? Frankly, we now know much of the operating numbers were of the EBIH variety (Earnings Before Interest and Hype). Real earnings are what matter, and by Siegel's own admission the market is going to start using S&P core earnings as the gold standard for evaluating profits.

Siegel's data shows P/E ratios of real earnings (not reported earnings), even with a 5 year average, is 22.5. Today's P/E ratio using S&P core trailing earnings is around 46. Siegel says the current P/E ratio for real earnings is 29. The differential between the two numbers is about 35%.

No one has yet done the S&P core earnings for the last five years, but if you assume that the ratio would be roughly the same, (a relatively safe bet), you would get the five year average (smoothed) P/E ratio to be about 30.

If Siegel is right that investors are now smart enough to know that P/E ratios should be over 20, then that means the market is roughly 1/3 over trend, with some serious room on the downside. If markets go back to trend, then they are overvalued by 50%. If they drop below trend, as they normally do, then a serious correction is coming.

My second real problem with Siegel's presentation is the assertion that S&P core earnings will be $40-45 in 2003. They were $18.46 in the 12 months ended June. I readily admit that earnings are going to grow, probably above average, as companies are aggressively cutting costs (read jobs) and slashing expenditures and the economy is growing, albeit slowly.

But to assume a 100-150% growth in earnings in 18 months is just not in the cards. Siegel presents no evidence that earnings can grow in such dramatic fashion. I can think of no time in history where this has happened. The S&P 500 is populated with large companies for whom 15-20% growth on the entire index is possible only in go-go growth years. We are in the Muddle Through Economy, and that type of growth is going to be tough.

But let's assume Siegel is right. There won't be as many large write-offs next year. All the really bad news is behind us. Let's assume profits rise by 75%. That takes us to $32. At Siegel's smarter investor P/E, we are still under 700 on the S&P 500, and if it goes back to trend, we are below 500.

The only way you can make the assertion that the market is fairly priced on an historical basis today is to twist the data as Siegel or Fortune did.

How to Spot a Market Cheerleader

Why do I bother going through this exercise if I think his data is so worthless? Because it is a prime example of the contortions that market cheerleaders and advocates of a buy and hold philosophy do to justify their beliefs. If the data doesn't justify your belief, then find something that does. If current P/E ratios don't work, then create 5 year smoothed ratios, using earnings levels from previous years that won't be repeated for many years. Don't tell your readers that it usually takes 5-6 years for companies to get back to new earnings highs after a recession.

Now, could the market decide to rise from here and never return? Of course, anything is possible. But History, as Grantham will now tell us, says it is not likely.

Jeremy Grantham took the stage after Siegel spoke, and immediately set the tone with the remark, "Investors are not smart."

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Grantham is not a congenital bear. He simply looks for investment classes which are below trend and buys them and sells them when they get above trend. Sometimes he buys too early and sometimes he sells too early, but he believes in the dictum that markets always come back to trend. I have often stated that markets are a mean, lean, reversion machine. Grantham is right. Markets always come back to trend.

He presents us with the benefits of his research into bubbles. He has looked at every bubble for which he could find data. His research goes back years and years and includes stocks, bonds, commodities and currencies. He has found 28 bubbles. He defines a bubble as a 40-year event in which statistics went well beyond the norm, a two-standard- deviation event. Every one of the 28 went back to trend, no exceptions, no new eras, not a single one that we can find in history.

He then argues the broad U.S. market today is still in bubble territory, as it has not come back to trend.

[Let me repeat for emphasis: with no exceptions, bubbles and markets will come back to trend.]

He notes that many markets and bubbles not only come back to trend, but go down right on past the trend line.

What is trend for the US markets? He gives us four measures. Based upon dividend yield, the market is overvalued by 50%. Based upon Tobin's Q (the market value of a firm's assets divided by their replacement value) the market is too high by 31%. The price of stocks to the 10 year average of real earnings is too high by 31% and as a function of market cap to GDP the market would need to come down by 45% to get back to trend.

The trend line for P/E is slightly under 15. Grantham thinks you could se this trend rise to 17.5 over time, as he does agree the markets are now more liquid and we live in somewhat safer times. But this would mean the market would need to drop substantially to come back to trend. How much depends upon whether you use core earnings, pro forma earnings, and forward or trailing earnings. But they all suggest the need for a substantial correction.

Notice that Grantham uses a 10 year average of real earnings instead of Siegel's 5 years of reported earnings. The longer time frame takes out the effect of the very high four years immediately prior to 2001, and thus does not "curve fit" the data to fit a desired outcome.

It is important for Siegel and other cheerleaders, if they want to maintain any type of credibility, to look for some way to suggest that stocks are fairly valued, as Grantham's next data shows. If you can't find a reason that stocks are at fair value, then you would logically be forced to acknowledge the effects of trend reversion.

What Will the Stock Market Return Over Ten Years?

Grantham breaks down historic P/E ratios into five levels, or quintiles. Level (or quintile #1) represents the 20% of years with the cheapest values (lowest P/E ratios) in history, right on through the fifth quintile which represents the 20% of years with the most expensive values.

What kind of returns can you expect ten years later after these periods, on average? Interestingly, the first two quintiles, or cheapest periods, have identical returns: 11%. That means when stocks are cheap, you should get 10% over the next ten years. The last, or most expensive period, sees a return over ten years of only 0.0%. Nada. Zippo.

We are in a period which would easily rank among the most expensive periods.

This basically squares with Professor Robert Shiller's (of Yale) data, written about in this column before. It is very public, and all cheerleaders are aware of it. To ignore it, they must show why "this time it's different."

In order for Siegel to predict, as he did, that stocks will return 6-7% over the next ten years, he must show that values lie between the second and third quintiles -- OR that investors will somehow start putting more value on stocks, and thus a floor on the market. He attempts to show current fair value by creating a five year smoothed average, and then argues that this time, investors are smarter and will not do as they have done in the past secular bear markets, which is to take stock valuations well below the historic average.

The problem is that the average over-run of the trend in a secular bear market is 50%, which is why stocks get so undervalued. By that, I mean stock market valuations do not stop at the trend. They tend to drop much lower. For Siegel to be right, we would have to see something which has never happened in history before. Stocks would need to drop to values 25% higher than the long term historical average and no further.

Grantham spends considerable time showing different valuation models, and all suggest the same thing: there is still more downside.

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This is not to suggest he does not find value - he just does not find it in the US stocks markets. He likes TIPS or inflation protected bonds, REITS, emerging market debt, market neutral strategies, international small cap value and small cap growth stocks, which show historical signs of being undervalued. He is willing to invest in these markets and be patient, believing they will return to the average values and higher, and then he will sell and look elsewhere for value. He is also a big fan of timber, which he shows has done well in every market environment.

One further thing of interest, he shows how a portfolio with the ability to short overvaluations will make anywhere from 2% to 4% more, depending upon the risk taken, than long only portfolios. That squares with my studies and observations. It is why I believe that certain styles of hedge fund investing will become more available over this decade, as the public at large will demand it. When long only portfolios return basically nothing for ten years, and long-short stock portfolios show solid absolute returns which are decent, portfolio envy will overcome the lobbying interests of the mutual fund industry, and hedge funds will be available to the general public.

The Dividends of a GOP Senate

What difference, if any, will a GOP controlled White House, Senate and House make to the stock market? It all depends on what they can get passed, of course. Lowering the capital gains tax would help marginally, I think, as would other measures.

But the big difference would happen if the double taxation of dividends was eliminated. Corporations pay taxes on profits, and if they are distributed as dividends to shareholders, they are taxed again at the individual level.

Here I agree with Siegel, who made an exceptionally strong case for the elimination of the double tax. (Siegel is a very smart man, just too committed to buy and hold investment styles.) When you combine the double taxation of dividends with incentive options for corporate executives, you get executives managing for stock growth, to make their options more valuable, which is a reasonable thing for them to do. Why should they manage for dividends, if the market wants growth?

If investors wanted old fashioned dividends, and made stock prices go up or down based upon dividend growth and pay-out, then managers would start focusing on actual profits, instead of paper profits, in order to be able to pay dividends, and thus see the stock price (and their options) rise.

This would be the most revolutionary change in corporate governance you could make. It would have far more effect than all the new SEC regulations they will enact. You can't fake real profits if they are paid out as dividends. The money has to be there.

This would also have the result of putting a floor on the fall in the stock market, as those stocks which now pay dividends would become far more valuable, and that segment would rise. It is the single most bullish thing for the markets of which I can think. It would stabilize the fall in 401k plans, and give Boomers a much better chance for retirement.

Can this get passed? I don't know. Daschle and his crowd will fight it tooth and nail, for reasons I cannot fathom, as their supporters/voters have 401k and pension plans as well. A "balance" will have to be found in the budget, to keep the deficit from rising even more. Using static revenue projections makes it hard to show it is not a budget buster.

As a stimulus to the economy and a boost to the stock market, nothing now on the table would come close to being as effective. If I were Bush and Karl Rove, and wanted to do the one thing they can actually do to avoid his father's fate of being a one term president due to a late term recession, then I would make this my centerpiece.

Now, I do not believe congress or presidents can do much about the economy, and should not take credit when things are good or get blamed when things are bad. I shake my head in wonder when politicians take credit for job creation, or blame their opponents when unemployment goes up.

But an elimination of the double tax on dividends would come as close to something which Congress can actually do to seriously affect the economy. Will it be enough to avoid a recession in the next few years? Probably not, as there are many forces which are beyond the control of presidents and congress which must be dealt with by the economy at large. But it would help soften the problems, plus it is the right thing to do. It remains to be seen if it can be done.

New Orleans Value

I am in New Orleans this early morning, finishing the letter and getting ready for meetings and speeches over the next two days, and then will rush to San Francisco on Sunday to speak at the Public Pension Funds Forum. I am so looking forward to getting home to my wife and family, as I did not realize that all these conferences were back to back when I committed to speak. I must admit, though, I will enjoy the great food of New Orleans. Tonight is dinner at Commander's Palace with old and new friends, among them good friend Bill Bonner of Daily Reckoning fame. Family and good friends are where the real values of life are, although a great meal, a friendly Bordeaux and good stories come in a close second. These are values which we make for ourselves, and do not depend on the markets or the economy to make them grow over time. Plus there is no taxation on the dividends.

Have a great week.

Your finding value where he can analyst,

John Mauldin Thoughts from the Frontline
John Mauldin

P.S. If you like my letters, you'll love reading Over My Shoulder with serious economic analysis from my global network, at a surprisingly affordable price. Click here to learn more.


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