No Jobs Means No Sales Means No Recovery
Posted by Eddy Elfenbein on August 26th, 2010 at 11:42 am

Here’s a chart I made that I think may be helpful in explaining the current market to new investors.

This chart shows the trailing four-quarter sales and earnings for the S&P 500. This needs a little explanation. The black line is the sales for the S&P 500 and it follows the right axis. The blue line represents the operating earnings and the red is the as-reported earnings. Both of those lines follow the left axis. Notice that sales are much less volatile than profits.
I’ve scaled the two axes at a ratio of 12-to-1, which means whenever the red or blue line crosses the black line, the profit margin is exactly 8.33%. Unfortunately, the data only goes up to the first quarter of this year, but nonetheless, I still think it gets the point across.
Let me explain the difference between the red and blue lines. The as-reported figure refers to simply the bottom line that companies report each quarter. The blue line is the earnings number that’s adjusted for special items. Personally, I prefer to look at operating earnings because the market has historically been more closely correlated to it. Some analysts only look at as-reported earnings and I respect that choice. You can use either but just be aware of the pitfalls of either choice.
The problem with as-reported earnings is that they can fall off a cliff as they did during the fourth quarter of 2008. AIG, for example, reported an earnings loss of over $280 a share. When all those financial stocks reported monster losses it gave the impression that the entire market was worthless. The red line plunged to nearly nothing. The market, obviously, didn’t put a standard multiple on $7 of trailing earnings. Instead, the market’s behavior followed the blue line. I’ll skip the accounting debates. My view is that if market thinks the blue line is important, then I think it’s important.
The problem with the operating earnings, however, is that it can reflect poor “earnings quality,” meaning companies get creative with their accounting. A good warning sign of poor earnings quality is when there’s a big gap between the red and blue lines. This was a bigger issue a few years ago, but I’m not so concerned about it today.
Either way, let’s not get bogged down on the issue of operating versus as-reported. The important point I want to get across to new investors is that the market has responded to a dramatic upsurge in operating earnings since March 2009. That’s great news. The problem is that companies haven’t grown their profits by generating new business. Instead, they’ve grown their profits by increasing profits margins. And they’ve done that by cutting costs, principally labor costs. They’ve fired and laid off their way to prosperity!
Basic economics tells us that profits can only go so far without sales growth and that’s been dismal, and it’s partly due to all those lay offs. That black line needs to get moving. The Q2 data point isn’t up yet but it will show pretty much the same thing, sluggish sales growth.
I scaled the two lines at 12-to-1 because once the blue line passes the black line (meaning, the overall profit margin exceeds 8.33%), that’s usually when the economy starts hitting the breaking point. When you can’t increase sales quickly, you need to grow earnings by raising prices. But when you increase margins, you slow sales growth. Hence, the economy moves in a cycle. Notice how the blue line tends to lead the black line by a year or two.
In other words, profits generate sales. But this time around, it just doesn’t seem to be working.

The Larger the Fund, the Fewer the Stocks
Posted by Eddy Elfenbein on August 25th, 2010 at 3:20 pm

One of the important lessons of investing is that individual investors often have an advantage over professionals. They don’t have to meet quarterly goals. They don’t have to justify their actions to committees.
Another is that as mutual funds get larger, it’s harder for them to make nimble investments. Consider these words from Jack Bogle:

Jack Bogle shows how the investable universe of stocks declines sharply as a function of fund size. Assuming that a fund can hold no more than 5 percent of the outstanding shares of any company, Bogle estimates that a fund with $1 billion of assets can choose from over 1,900 stocks while a fund with $20 billion has a universe of about 250 stocks. So it happens that success can sow the seeds of its own failure.

True dat. This comes from an interesting report from Michael Mauboussin at Legg Mason (via Abnormal Returns). Of course, large mutual funds can invest in smaller stocks but those stocks play a much smaller role in the fund’s overall performance. It doesn’t take much to build a portfolio that’s nearly blind to moves of the overall market.
What really hurts individual investors is time horizon. While stocks have done better in the long run, that long run can indeed be a very, very long time.

The Dow Breaks 10,000
Posted by Eddy Elfenbein on August 25th, 2010 at 2:54 pm

The Dow dipped below 10,000 this morning but thanks to an afternoon rally, we’re above 10,000. It seems like it was only 11-1/2 years ago that I saw that happen before.

Is 2010 Like 1982?
Posted by Eddy Elfenbein on August 25th, 2010 at 12:51 pm

On Friday, the government will revise the Q2 GDP numbers and I don’t think it will be very good. With a little over two months until election day, some folks are comparing this year’s contest to Ronald Reagan’s first mid-term election in 1982.
Here’s how the economy looked back then compared to today.

The red line shows the GDP’s performance from March 1980 to December 1982. The blue is from March 2008 to June 2010.
The comparison isn’t very apt. You can see the economy actually recovered in 1981 before falling again in 1982. That probably hurt Reagan in 1982 but the later recovery certainly helped him in 1984.
This time, the economy slumped into 2009 and has so far had a very unimpressive recovery in 2010.

P/E Ratios of Financial Stocks
Posted by Eddy Elfenbein on August 25th, 2010 at 12:01 pm

Here’s another look at the P/E Ratios are selected large-cap financial stocks. The P/E Ratios are based on earnings estimates for next year:

David Merkel adds: “The key metric, which is hard to measure for financials, is earnings quality. That’s one reason why P/Es are so low.”

More on Stocks Vs. Bonds
Posted by Eddy Elfenbein on August 24th, 2010 at 3:49 pm

Here’s another quick-and-dirty view of how badly bonds have been beaten stocks recently. This shows the Vanguard 500 Index Investor Fund (VFINX) divided by the Vanguard Long-Term Investment-Grade Fund (VWESX):

I’m using Vanguard’s main S&P 500 index fund as a proxy for stocks and it’s main corporate bond fund as a proxy for bonds. It’s not perfect but it suits our purposes.
As you can see, bonds have beaten stocks consistently since mid-April (meaning, the ratio is falling). The ratio is about where it was 13 months ago, and it’s not terribly far from it’s very low reading from March 2009.
According to this reading, bonds have outperformed stocks since April 1988. It could be older, but the data only goes back to November 1987.

Time for US Treasury Consols?
Posted by Eddy Elfenbein on August 24th, 2010 at 1:00 pm

With Treasury yields being so low, here’s an idea to consider—let’s have the U.S. Treasury consider floating some long-term debt, some very long-term debt, like a 100-year bond. Hey, Norfolk Southern (NSC) just floated some 100-year paper and the yield was under 6% so why not Uncle Sam? Perhaps not a big auction at first, but it’s certainly worth dipping our toes in the water to see what demand is like (in other words, will China approve?). This could save taxpayers huge amounts of money.
In fact, why stop at 100 years? In the 18th century, the British government issued consol bonds which are perpetuities—bonds that never mature. The word consol refers to the fact that the issue consolidated all of the governement’s debt into one issue. The bonds are callable and the British government has lowered the coupon a few times over the past 250 years. The yield is so low now (2.5%) that they’re not worth redeeming which means the Brits did well off them.
I say let’s float some Treasury perpetuities. Start with a small auction at first to see how it goes. We used to have redeemable Treasury bonds although none is currently outstanding. But for political cover, we can say that these perpetuities aren’t callable for the next, say, 50 years. We could even call them “Obama Bonds.” I wouldn’t be surprised if we could lock-in 4%.
Students of finance will also be happy because once the maturity of a bond becomes infinite, the yield-to-maturity equation gets a whole lot easier. Just divide the coupon by the price and you’re done.

Bond 36,000
Posted by Eddy Elfenbein on August 24th, 2010 at 11:21 am

The bond boom continues. The yield on the 10-year T-bond briefly dropped below 2.5% this morning:

Nortfolk Southern just sold $250 million in 100-year bonds.

The interest rate on Norfolk Southern’s new debt is 6% for a yield of 5.95%, about 0.90 percentage points more than where the company’s outstanding 30 year debt was trading Monday. It was the lowest yield for 100-year debt bankers could recall, breaking through the 6% yield on the company’s 100-year issue in 2005.

What’s the point of even having a stock market if investors only want debt? Just float debt and buy back all your stock.

Medtronic Falls on Lower Guidance
Posted by Eddy Elfenbein on August 24th, 2010 at 10:32 am

Shares of the Medtronic (MDT) are getting bashed this morning after the company lowered its earnings guidance for fiscal 2011. In my opinion, the market is overeacting but of course, that’s what markets do.
Here are the facts. Medtronic earlier said to expect EPS for FY 2011 (which ends in April 2011) to range between $3.45 and $3.55 with revenue growth ranging between 5% and 8%. Now they’ve lowered that to a range of $3.40 and $3.48, with revenue growing between 2% and 5%.
If we take the midpoints of the EPS forecasts, then the downward revision is just 1.7%. The shares, however, have been down by as much as 11.5% today. I am concerned that one lowered forecast often leads to another (and another and another….).
Still, let’s not get ahead of ourselves. Medtronic just reported pretty good earnings for their fiscal Q1 of 80 cents per share. That hit the Street’s forecast on the nose. In June, the company said to expect EPS between 79 and 81 cents which at the time was lower than the Street’s view of 84 cents per share.
With today’s earnings, MDT technically earned 76 cents per share plus there were four cents per share in charges. Revenue fell by 4% to $3.77 billion but some of that was due to currency conversion. I don’t worry so much about variables that are out of the company’s hands.
What’s causing Medtronic’s problem? CEO Bill Hawkins said, “Although we have experienced a slowdown in the markets of our largest businesses, the investments we are making in emerging markets and emerging therapies will allow us to achieve market-leading performance over the long-term.”
The AP notes:

The world’s largest medical-device company said global sales for its Cardiac and Vascular Group fell 5 percent to $2.03 billion in the quarter. Those sales actually increased 1 percent when adjusted for foreign currency and the extra week last year.
Spinal revenue dropped 9 percent to $829 million due to growing pricing pressures and weaker procedure growth, the company said.
Spinal devices make up Medtronic’s second-largest franchise. Medtronic spent nearly $4 billion to acquire spinal implant maker Kyphon in 2007, though many analysts say the unit is not living up to expectations.

If you own MDT, I know today’s news seems very bad, but the stock is still a very attractive buy. With today’s downturn, MDT is going for about nine times the lower bound of the revised forecast. Plus, the dividend yield is up to 2.9%.
Here are the sales and earnings numbers going back a few quarters:

Pujols and the Triple Crown
Posted by Eddy Elfenbein on August 24th, 2010 at 9:56 am

Last night, Albert Pujols went three-for-four; he hit a single, a double and a three-run home run which was the 399th of his career.
Pujols now leads the National League with 33 home runs, 92 runs batted in, and he’s third in batting average at .319. Pujols trails only Joey Votto (.323) and Martin Prado (.320). In 18 games this August, Pujols is hitting .425 with nine home runs and 20 RBI.
All this means that Pujols has a good chance of becoming the first major leaguer to win the Triple Crown since Carl Yastrzemski in 1967. In fact, no one has really come close since then. In all that time, perhaps the next closest is Joey Votto this year who, as mentioned, is leading the league in batting, and he’s second in RBI and third in home runs.
Even if Pujols win the Triple Crown, there’s a good chance that Votto might edge him out for MVP. Votto’s Reds are currently 2.5 games head of Pujols’ Cardinals in the NL Central.
In my book, Hank Aaron is still the home run king. When he does hit his next home run, Pujols will be the third youngest to 400. I’ll be strongly rooting for him to get to 756.