Archive for May, 2009

• Why the Dow 36,000 Argument Doesn’t Work
  Eddy Elfenbein, May 27th, 2009 at 2:26 pm

  From nine years ago, here’s my review of Dow 36,000:

  Now that the Dow Jones Industrial Average has soared over 4,500 points since Alan Greenspan warned us of the market’s “irrational exuberance,” a mini-industry has evolved of publishing books that attempt to explain the “new market.” The latest addition to the genre is Dow 36,000 by James K. Glassman and Kevin A. Hassett, both of the American Enterprise Institute. To give you an idea of how crowded the field is becoming, two other books are titled Dow 40,000 and Dow 100,000.

  Unfazed by the Dow’s stunning climb, mega-bulls Glassman and Hassett have developed their own theory as to why the market has risen so much and why it will continue to rise. Their theory isn’t the usual litany one hears from Wall Street bulls (demographics, triumph of capitalism). Instead, their “36,000” theory goes right to the heart of investment analysis by questioning one of its elemental suppositions: namely, the idea that investments in stocks should demand a premium over investments in bonds due to the riskier nature of stocks. This isn’t split hairs they’re taking on.

  Reciting historical data, Glassman and Hassett show that over the long haul, there is no difference between the risks of stocks and Treasury bonds. Therefore, they reason, there should be no risk premium at all. The authors claim that with the risk premium excised from the market, the perfectly reasonable price, or PRP as they call it, for the Dow is 36,000 (more on that later). Mind you, they’re not merely saying the Dow will eventually hit this magic number sometime in the future. Instead, Glassman and Hassett claim that 36,000 is where the Dow ought to be right now. Or more precisely, that’s where the Dow should have been early this year when they started writing the book. Could they be onto something? At the time, the Dow was at 9000.

  The Dow very well may head to 36K, but it will have little to do with Glassman and Hassett’s theory. Their theory is seriously flawed due to major methodological errors.

  First, Glassman and Hassett err in their selection of an appropriate measure of risk for their purpose. The free market prices risk, just like it prices everything else. That price is included in the price of stocks. In order to measure risk, Glassman and Hassett should use a measurement that isolates risk from the price of stocks. They don’t do this. Instead, they compare the standard deviation of stock returns to the standard deviation of risk-free-bond returns. That’s a different animal. Sure enough, with progressively longer holding periods, stock returns’ standard deviations gradually get smaller. Upon realizing that at long term, the standard deviation of stock returns is the same as bond returns’, actually slightly less, Glassman and Hassett conclude that stocks are “no more risky” than Treasury bonds.

  That’s a faulty conclusion. Even if the standard deviations are the same size, it doesn’t say anything about the risk that they’re looking for. The point is, that risk has still never been isolated: It’s inside those returns no matter how long term you go. The variability of risk’s part of all these returns may be diminishing as well. That can happen even if risk stays exactly the same size. With Glassman and Hassett’s method, we have no idea how big the risk inherent in stock ownership is.

  Without all the mumbo-jumbo, think of two houses, identical in every way except one has a great view of the river, the other does not. How much does the river view cost? Easy. Compare the prices of the two homes, and the difference must be the price of the view. The fact that the prices paid may deviate from their own respective averages the same way, speaks nothing as to the price of the view. Glassman and Hassett are saying that since those deviations are the same, the river view is free.

  Running with this assumption, Glassman and Hassett reason that since risk and reward are related, assets with the same risk will have the same return. Therefore, stocks and bonds will have the same returns. For this to happen, they claim, “the Dow should rise by a factor of four.” How do they get four?

  Glassman and Hassett start with the “Old Paradigm” premise that bond returns plus a risk premium equals stock returns. With the risk premium “properly” removed, the yield on Treasuries—meaning their expected return—should be the same as the expected return for stocks. And that’s their dividend yield plus the dividend’s growth rate. So far, so good. Since the sum of these two is now about 1.5% above today’s Treasury yield, the yield on stocks needs to be adjusted downward in order to bring everything into balance. Specifically, it needs to drop from about 2% to 0.5%. With the yield dropping to one-fourth its previous level, stock prices will jump fourfold. Presto. That’s how we get from 9000 to 36000.

  Not exactly. The authors have made another mistake. It’s impossible to have a one-time-only ratcheting down of the market’s dividend yield. The reason is that if long-term stock returns don’t change, as the authors do assume, a lower dividend yield will always create a commensurate increase in the dividend growth rate. As a result, there will always be a new higher dividend whose yield will always be in need of being notched back down. And as a result, the dividend growth rate will increase, and the cycle will continue ad infinitum. The correct conclusion from their model is not a one-time-only fourfold increase in stocks, but one-time-only infinite increase in stocks. This means the authors are actually insufficiently bullish and, moreover, they’ve mistitled their book.

  Fortunately, the second half of the book is the more valuable by far. Once the authors stop making theories, they start making some sense. In this section, the authors discuss how investors can capitalize on the continuing market boom. The authors estimate the market has another three to five years perhaps before 36K is reached. In any case, their strategies are rather conservative: Buy and hold, diversify, don’t trade too much, don’t let market fluctuations rattle you, don’t time the market. All perfectly sound ideas and not specifically dependent on “Dow 36,000.”

  Glassman and Hassett also give the names of stocks and mutual funds they like. There’s nothing wrong with their stocks in the realm of theory, but readers definitely ought to avoid the author’s so-called Perfectly Reasonable Prices, which invite comparison to the famous description of the Holy Roman Empire—not holy, not Roman, not an empire.

  I’m not familiar with Kevin Hassett’s former work, but I’ve always liked James Glassman’s investing articles for The Washington Post. His articles are consistently incisive and informative. This book, however, is nothing of the sort. Dow 36,000 contains egregious errors and fallacious reasoning.

  Still, I do admire their ambition. With this book, Glassman and Hassett challenged a well-entrenched perception of reality. Being that this perception underwrites trillions of dollars, it’s a very, very, very, well-entrenched perception. Glassman and Hassett lost, and they lost badly. Old paradigms die hard, but they do die.

• Donaldson’s Earnings Plunge
  Eddy Elfenbein, May 27th, 2009 at 1:16 pm

  Donaldson (DCI) is one of my favorite stocks. This company really should be better known. The problem holding them back is that their business is about as dull as you can get—filtration systems.
  Still, the company has performed a remarkable feat. They’ve reported higher earnings for 19 straight years. Unfortunately, that’s all coming to an end this year.
  For the first two quarter of this fiscal year (ending in July), Donaldson earned $1.03 a share which was a bit higher than the 95 cents a share from the same period last year.
  The Q3 report came out yesterday and Donaldson earned just 35 cents a share which is a massive drop from the 57 cents a share last year. So for the first three quarters of this fiscal year, the company has made $1.37 a share compared with $1.52 from last year.
  In November, Donaldson said they expect full-year EPS of $2.16 to $2.36. In February, they said you better make that $1.70 to $1.90. This confirms Elfenbein’s Investing Rule #174503B: One Earnings Warnings Leads to Another. Then yesterday, they said $1.55 to $1.70. They made $2.12 a share for all of 2008.
  This is still a company I like a lot. Unfortunately, we’re in the worst part of its cycle right now. Even the best stocks will get slammed in order to please the market gods. I’m sticking with Donaldson but if you want to get in, you’ll probably see a better entry price in a few months.

  Year………….Sales……………..EPS
  1990…………$422.9……………$0.19
  1991…………$457.7……………$0.21
  1992…………$482.1……………$0.23
  1993…………$533.3……………$0.26
  1994…………$593.5……………$0.30
  1995…………$704.0……………$0.37
  1996…………$758.6……………$0.42
  1997…………$833.3……………$0.50
  1998…………$940.4……………$0.57
  1999…………$944.1……………$0.66
  2000…………$1,092.3…………$0.76
  2001…………$1,137.0…………$0.83
  2002…………$1,126.0…………$0.95
  2003…………$1,218.3…………$1.05
  2004…………$1,415.0…………$1.18
  2005…………$1,595.7…………$1.27
  2006…………$1,694.3…………$1.55
  2007…………$1,918.8…………$1.83
  2008…………$2,232.5…………$2.12

• Don’t They Know It’s Just a Bear Market Rally
  Eddy Elfenbein, May 27th, 2009 at 11:05 am

  Wisconsin fifth-graders kick the stock market’s ass:

  If your stock portfolio isn’t performing as well as you’d like, maybe you could hand it over to these fifth-graders. Four students at Tullar Elementary School in Neenah won the recent Wisconsin Stock Market Game, turning $100,000 of hypothetical money into more than $203,000 in 10 weeks.
  The winning team of Annie Czech, Bailey Morton, Jen Sagehorn and Sam Weiler invested exclusively in 15 financial stocks, of which 13 proved profitable.
  “It felt amazing,” Bailey said. “It felt like I was getting a quick sugar rush.”
  “I was really excited,” Annie said. “I wanted to scream.”
  Tim Hopfensperger, a teacher at the school and adviser to the young investors, also had teams finish second and fourth in the competition, which is sponsored by the nonprofit EconomicsWisconsin.
  “I am really pleased,” Hopfensperger said. “I am waiting to see what they will do in the future. A number of them will get involved in the financial industry.”

  I’m glad the gains were hypothetical. A real sugar rush is probably banned from school.

• Behind the Scenes at CNBC
  Eddy Elfenbein, May 27th, 2009 at 10:20 am

  Hear Dennis Kneale say that stories need “conflict, drama and struggle” to fool people into learning good information.
  

• How Many Gallons of Gas Does the S&P 500 Buy
  Eddy Elfenbein, May 27th, 2009 at 9:36 am

  Cool “Chart of the Day” from Clusterstock:
  

• AutoZone Beat Expectations But Not By Enough So Shares to Fall
  Eddy Elfenbein, May 27th, 2009 at 9:21 am

  This is getting a little post-modern for me. Shares of AutoZone (AZO) just reported blow-out earnings. The company earned $3.13 a share, 24 cents more than expectations. Obviously, consumers would rather fix up a car now rather than get a new one. Plus, the dealerships aren’t in the best of shape right now.
  But here’s the weird part: The shares are trading lower in the pre-market. Why? Reuters writes:

  Shares of the largest U.S. auto parts retailer fell 2.2 percent in premarket trading on Wednesday, with analysts noting that investors expected more from the company after a string of solid profit reports.

  So they beat expectations but not by enough. Um…then what was the expectation?

• AP: Roubini recommends Chinese model for North Korea
  Eddy Elfenbein, May 27th, 2009 at 9:09 am

  The AP reports:

  Impoverished North Korea can liberalize its economy while maintaining its political system if it follows the path taken by China and Vietnam, prominent economist Nouriel Roubini said Wednesday.
  “I think the lesson is that progressive economic opening and liberalization even in a formerly centrally-controlled economy can lead to beneficial changes,” Roubini told reporters on the sidelines of a technology forum.

  The headline reads “Roubini recommends Chinese model for North Korea” when I think he means that it’s one possibility. The AP makes it sound like Roubini supports the Chinese model.
  To Kim Jong Il, I think the words “Chinese model” mean something very different.

• The 20 Best-Performing Stocks of the Last Decade
  Eddy Elfenbein, May 27th, 2009 at 8:22 am

  From Business Week:
  Southwestern Energy (SWN)……………….3,662%
  Celgene (CELG)…………………………………..2,607%
  XTO Energy (XTO)……………………………….2,088%
  Stericycle (SRCL)………………………………..1,503%
  Gilead Sciences (GILD)………………………..1,491%
  Denbury Resources (DNR)……………………1,271%
  FLIR Systems (FLIR)……………………………1,190%
  Ventas (VTR)……………………………………….1,127%
  Range Resources (RRC)……………………….1,124%
  Lab Corp of America (LH)…………………….1,107%
  Quest Diagnostics (DGX)………………………..835%
  Chesapeake Energy (CHK)……………………..813%
  C.H. Robinson (CHRW)……………………………692%
  Varian Medical Systems (VAR)………………..677%
  Occidental Petroleum (OXY)…………………..634%
  EOG Resources (EOG)……………………………599%
  Express Scripts (ESRX)…………………………..595%
  EQT Corp (EQT)…………………………………….540%
  Apache Corp (APA)………………………………..486%
  CONSOL Energy (CNX)………………………….486%
  (Note: BW restricted the list to S&P 500 members with betas less than 1.)

• Rand Disappearing from Circulation in Harare
  Eddy Elfenbein, May 26th, 2009 at 10:48 pm

  Megabe may be a dictator but there’s one law he can’t change–Gresham’s:

  The South African rand is disappearing from circulation especially in Harare, as it continues to gain value over the American dollar.
  The rand however, remains the reference currency and is widely used in Midlands and Matabeleland.
  Traders in the market now prefer to sell their good in rand as compared to the US dollar.
  The parallel market is trading at a cross rate of US$1 at an equivalent of R9 with some trading as low as R8, 50 for a dollar.

• If you’ve ever wondered if shooting off fireworks under a frozen lake is cool, it turns out that it totally is.
  Eddy Elfenbein, May 26th, 2009 at 6:00 pm