Archive for March, 2013

• Morning News: March 8, 2013
  Eddy Elfenbein, March 8th, 2013 at 6:07 am

  China February Exports Surge, Supports Recovery Hopes

  Japan’s Nakao Defends Easing as China’s Chen Expresses Concern

  Abe Adviser Says Japan Can Forgo 2% Inflation If Economy Heals

  ECB Chief Plays Down Italy Fears

  Norway Oil Fund Posts Second-Best Year on Stock Market Rally

  Jobless Claims Fall Unexpectedly

  Warren Starts Taking On Banks And Regulators

  Banks Pass Fed’s Tests; Critics Say It Was Easy

  Pandora CEO’s Surprise Exit Overshadows Upbeat Results

  Offshore Cash Hoard Expands by $183 Billion at Companies

  For Icahn, a Game of Chicken With Dell’s Board

  BofA Looks To Play Catch-Up in Asia Corporate Banking

  In a Spinoff of Time Inc., Evolution Is Complete

  Value Of U.S. Dollar Plummets After Joe Flacco Signs NFL’s Richest Contract

  Joshua Brown: Scott Minerd: Here’s What Happens When Rates Rise

  Edward Harrison: Achuthan: The US Has Been In A Recession For Three Quarters Of A Year Already

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• Dow 36,000 Returns
  Eddy Elfenbein, March 7th, 2013 at 3:12 pm

  James Glassman, the co-author of Dow 36,000, returns today to explain what he got wrong and why the Dow can still make it to 36,000:

  First, investors have become more frightened of stocks, not less — as reflected in a higher equity risk premium, the excess return that investors demand from stocks over bonds.

  (…)

  The heightened fears of investors are reflected in lower valuations. Currently, for example, the forward P/E ratio (based on estimated earnings for the next 12 months) of the Standard & Poor’s 500 Index is about 14. In other words, the earnings yield for a stock investment averages 7 percent (1/14), but the yield on a 10-year Treasury bond is only 1.9 percent — a huge gap. Judging from history, you would have to conclude that bonds are vastly overpriced, that stocks are exceptionally cheap or that investors are scared to death for a good reason. Maybe all three.

  One way stocks could jump to 36,000 quickly would be for fears to subside and P/E ratios to rise. Assume that earnings yields fall to 5 percent. That would mean P/E ratios would go to 20, a boost of 50 percent in stock prices, assuming constant earnings.

  The second thing that’s been unexpected since our book came out is that U.S. growth has drastically slowed. Instead of the historic rate of 3 percent, or our projected rate of 2.5 percent, actual annual real GDP increases from the end of 1999 to the end of 2012 averaged just 1.8 percent. Inflation was lower than normal, too, so the nominal rate of growth was only about 4 percent, instead of about 6 percent.

  I still think Glassman is wrong about why he was wrong. Nine years ago, I explained why the logic behind Dow 36,000 was off base, and it’s been largely ignored by everyone.

  With some false modesty, I think I’m the only one who’s been able to explain why 36,000 doesn’t work. Here’s my original article:

  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 authors’ 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.

• The Breakdown in the XAU
  Eddy Elfenbein, March 7th, 2013 at 11:31 am

  I’m not exactly sure what this means, but I’m struck by the dramatic plunge in the Philadelphia Gold and Silver Index ($XUA). This is an index of 16 precious metal mining stocks.

  

  Since October the XAU hasn’t merely fallen but it’s practically plunged off a cliff. This is especially surprising since the XAU tends to be somewhat sympathetic with cyclical stocks. Not this time. The cyclicals have been doing well.

  Obviously gold hasn’t been performing well but the drop in the XAU has been very dramatic. I think in some respects the last few months have been a microcosm of the stock market of the 1980s as gold has fallen and paper assets have thrived. There seems to be a divergence within cyclicals as the commodity-based ones have lagged the heavy industry sectors.

• Morning News: March 7, 2013
  Eddy Elfenbein, March 7th, 2013 at 6:05 am

  Draghi Confronts Italy Impact as ECB Seen Holding Rates

  Bank Of England Reaches Fourth Anniversary Of Record Low Base Rates

  Investors Thrilled as Shoppers Fill Europe’s Outlet Malls

  BOJ Rejects Earlier Asset Purchases in Shirakawa Finale

  Fed Says Economy Posted Modest Growth In January-February

  Jobs, Factory Data Offer Hope For Economy

  Nasdaq’s Early Push

  Time Warner Opts to Spin Off All Magazines

  Adidas Committed to Reebok Brand in India

  J.C. Penney Takes Another Hit

  Dubai’s DP World Sells Hong Kong Logistics Assets

  Dell Investors Making a Big, Risky Bet

  Face-Lift at Facebook, to Keep Its Users Engaged

  Cullen Roche: Richard Bernstein: 3 Signs to Watch for the Next Bear Market

  Phil Pearlman: Why Are Most People Terrible Investors?

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• The Derisking Program at AFLAC
  Eddy Elfenbein, March 6th, 2013 at 1:44 pm

  One of key aspects in understanding AFLAC ($AFL) is that the company has greatly reduced its exposure to problem areas around the world. I don’t believe the market fully sees this. Kriss Cloninger, AFLAC’s CFO, recently discussed their investment portfolio at Citi’s 2013 U.S. Financial Services Conference.

  Now, let me discuss how we’ve substantially enhanced our investment portfolio over the last few years. From January 2008 to the end of 2012, we dramatically cut our holdings of sovereign and financial instruments in the PIGS countries. We’ve also lowered our investments in perpetual securities. And the successful derisking program that we completed in mid-2012 has enabled us to focus on enhancing portfolio quality.

  The U.S. corporate bond program we initiated in the third quarter of 2012 continues to be an effective means for enhancing our new money yields in the Japan portfolio. You’ll recall in the last half of 2012, our objective was to invest roughly two-thirds of our investment cash flow and U.S. dollar denominated publicly traded corporate bonds and then hedged the currency risk on principal back to yen.

  This successful investment program enabled us to surpass our budgeted new money yield for 2012. And it has also provided greater liquidity and enhanced the flexibility of our portfolio while increasing the opportunities to diversify our portfolio beyond JGBs.

  At December 31, this U.S. corporate bond program represented about 6.2% of our total portfolio. In light of the success of the corporate bond program last year and strong credit fundamentals of the investment grade corporate credits, we intend to continue this program in the first quarter of this year. Consistent with our asset allocation program, we’ll balance these investments with some JGBs for diversification and liquidity as well as other investment opportunities as they arise.

  Our ability to continue to implement new strategies is based on the evolving capabilities of the AFLAC global investment division. We’re going to continue to build this framework to support investments and newer asset classes and then move forward accordingly and we’ll update you on our progress with our analyst meeting in May.

  We’ve defined our investment objectives as maximizing risk adjusted performance subject to our liability profile and capital requirements. It’s important to note that all of our strategies have been back tested against our capital ratios and the ratios we’re trying to achieve.

• The Dow Breaks Nine Times Gold
  Eddy Elfenbein, March 6th, 2013 at 10:51 am

  In addition to making an all-time high yesterday, the Dow just reached another milestone — it’s now more than nine times gold.

  

  Peter Schiff, a well-known market bear and gold bug, said that gold and the Dow would eventually reach parity. The ratio reached a low of 5.7 eighteen months ago. In August 1999, the ratio peaked at 44.59.

• The Market Extends Its Gains
  Eddy Elfenbein, March 6th, 2013 at 9:58 am

  Wall Street already has its eyes fixed on Friday’s jobs report. The expectation is for an increase of 170,000 nonfarm jobs and for 180,000 jobs in the private sector. We got a sneak preview this morning when ADP, the private payroll firm, said that 198,000 jobs were added last month. The Street had been expecting ADP to report 175,000 jobs. As we know, the Fed has based its exit from 0% on the employment reports. We still have a long way to go.

  The good news this morning is helping the stock market extend its gain from yesterday’s record-beating day. The Dow is far from my favorite index; it’s price-weighted and only contains 30 stocks. That’s why I almost always refer to the S&P 500. Still, I understand the psychological impact of the oldest and best-known index finally breaking a new high.

  For its part, the S&P 500 has been as high as 1,544.71 this morning so it’s not that far from the all-time high close from October 9, 2007 of 1,565.15. Several of our stocks like Fiserv, JPMorgan, Stryker and Cognizant Technologies are at or near 52-week highs this morning. JPM finally broke though $50 per share. I think the bank will increase its dividend by five cents per share very soon.

  

• Morning News: March 6, 2013
  Eddy Elfenbein, March 6th, 2013 at 6:10 am

  Merkel Looks East for Austerity Allies in Hollande Talks

  ECB Battles Demons As Growth Slows

  China Central Bank Eyes Reform, More Flexible Yuan In 2013

  Australia Expands at Fastest Pace Since 2007 on Exports

  Chavez’s 692% Bond Gain Seen Living On to Fidelity

  Why Has Congress Left Housing to Fannie Mae and Freddie Mac?

  As Fears Recede, Dow Industrials Hit a Milestone

  Investors’ Quandary: Get In Now?

  Samsung Gets A Foot In At Key Apple Supplier Sharp With $110 Million Investment

  H-P, Dell Feel The Heat From Shareholders

  Yahoo Says New Policy Is Meant to Raise Morale

  Toyota Blinks on Camry Discounts After Sales Drop

  Jeff Carter: Great Entrepreneurs Aren’t Born, They Are Made

  Howard Lindzon: The Reasons I Journal…Pivotal Moments in The Market… and The Boom from the 2009 Bottom

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• Stats on the Rally
  Eddy Elfenbein, March 5th, 2013 at 1:19 pm

  I noticed that the S&P 500’s recent drop lasted from February 19th to February 26th. From top to bottom, the total loss came to 3.0001%.

  I hate to go to the edge of any fair use laws, but this Bloomberg article has so many good bits, it’s hard not to quote it at length.

  Almost $10 trillion has been restored to U.S. equities as retailers, banks and manufacturers led the recovery from the worst bear market since the 1930s. It took the Dow less than 65 months to rise above its previous high set on Oct. 9, 2007, more than a year faster than the recovery from the Internet bubble.

  While the Dow has more than doubled in the four years since its bear-market low, its valuation remains 20 percent less than the price-earnings ratio at the previous peak and 15 percent below its 20-year average.

  (…)

  The gauge plunged 34 percent in 2008 for the worst performance in 77 years as the housing bubble burst and the U.S. financial system required a government bailout.

  (…)

  American Express Co., Caterpillar Inc. and Home Depot Inc. have led the Dow’s rally since its 2009 low, climbing more than 275 percent as the economy recovered from the worst recession in seven decades. Hewlett-Packard Co., the largest personal computer maker, is the only stock still in the 30-company gauge to fall since March 9, 2009. The shares tumbled 22 percent as mobile devices such as Apple Inc.’s iPad and iPhone began to compete with PCs. Exxon Mobil Corp., which has rallied 38 percent, is the second-worst performer since the gauge bottomed.

  Bankruptcies and government bailouts helped make the Dow a different gauge than it was in 2007. Citigroup Inc., American International Group Inc. and General Motors Corp. were removed from the price-weighted average, while Cisco Systems Inc. and Travelers Cos. joined. Kraft Foods Inc., which took over AIG’s spot, was replaced by UnitedHealth Group Inc. last year after the food-maker split in two.

  (…)

  A rebound in corporate profits coupled with more than $2.3 trillion in Fed stimulus have pushed investors back into equities, sending the Dow up more than 116 percent from its March 2009 low of 6,547.05. The Standard & Poor’s 500 (SPX) Index is less than 3 percent below its record, reached the same day as the Dow.

  The Dow surpassed its dot-com-era record on Oct. 3, 2006, 81 months after it peaked in January 2000. The measure had tumbled 38 percent from the 2000 high of 11,722.98 to its bottom on Oct. 9, 2002, as the Internet boom collapsed.

  The gauge on average has taken about 6 1/2 years to return to previous record levels, according to data compiled by Bloomberg. Should the measure have followed that path, the Dow wouldn’t have posted a new record until the middle of 2014.

  (…)

  Dow profits are projected by analysts to increase 9.2 percent this year and 9 percent next year. Profit from companies in the S&P 500 will exceed $120 a share by next year, double the level in 2008, according to Wall Street estimates. That’s the biggest increase since the 142 percent gain amid the rally in technology stocks from 1993 to 1999.

  The expansion in the Dow’s valuation since March 2009 has been slower than the S&P 500’s, while both are cheaper than 2007. The Dow’s trading at 13.8 times earnings in the last year, compared with a multiple of 17.1 at its 2007 peak and 25.9 when it reached a record in January 2000. The S&P 500’s multiple is about 15 times profit, compared with 17.5 on Oct. 9, 2007.

  The operating margin, a measure of profitability, for S&P 500 companies is 19.9 percent after reaching 20.7 percent in August, the highest level in Bloomberg data going back to 1998.

• Dilbert on Market Manipulation
  Eddy Elfenbein, March 5th, 2013 at 12:00 pm

  Scott Adams of Dilbert fame recently said he thought the stock market was due for a 20% slide. Our friends at Business Insider followed up to see why. Here’s Scott’s response:

  Rob Wile at Businessinsider.com asked me to clarify my prediction of a 20% stock market correction in 2013. (See my post below.) So I tapped out the following message on my smartphone:

  —- Start —-

  “I’m glad you had the wisdom to get a cartoonist’s opinion on global financial markets.

  The 20% estimate is based on the fact that 20 is a big round number and more likely to happen than 30%. I don’t like to over-think these things.

  My reasoning is that the people at the highest levels of finance are brilliant people who chose a profession with the credibility of astrology. And they know it. Then they sell their advice to people who don’t know it. So that’s your cast of characters.

  Now consider that the characters – who are literally geniuses in many cases – have an immense financial motive, opportunity, and a near-zero risk of getting caught. How do you think that plays out?

  We can only give a guess of the odds that the market is being manipulated. So I ask myself: How often does the fox leave the hen house because he feels that taking an egg would be wrong?

  If you have a different answer from mine, I applaud your faith in human nature.”

  —– End —–

  Personally, I think it’s funny if a bit overly cynical. Remember, of course, that the super geniuses are also battling each other which brings a certain level of accountability to any attempts at manipulation.