Things I Think I Know, And Some I Know I Don’t Know

A Backdrop For Our Current Investment Strategy

Last November, two months after the September 11^th  terrorist attacks tragically punctuated an eighteen-month bear market in stocks, I was invited on French television to comment on the investment outlook. (For our views back in mid-September, see: \"Pushing on A String… or A Spring?\")  The interviewer’s first question was: “The stock market keeps rising while there is no sign of pick up in the economy. Don’t you find this paradoxical?” The question was so disarmingly naive that all I found to answer was a single “No”.

Bull markets always get going in the midst of recession, when economic activity is still declining, profits are plunging, unemployment is rising and, often, some other crisis is aggravating this already sorry state of affairs.  This is why every country with a stock market has an adage like our “Buy when there’s blood in the streets”, or the French’s “Achetez au son du canon”.  [Note: the fact that the French buy as soon as they hear the sound of the canons while Americans wait until there is blood in the streets does not seem to give either a measurable investment edge].

In any case, the stock market recovery is now six months old and most observers agree that the economy, too, has turned the corner – after a roughly normal lag.  For us, however, this is reason for caution rather than enthusiasm.  Let’s try to sum up the current situation:

We have had a bear market. Major stock market indices peaked in the spring of 2000 and bottomed in September 2001.  The Dow Jones Industrials and S&P 500 indexes resisted the early months of the decline somewhat better than the broader market, but still managed to lose more than 30% over the whole period. “Bubblier” indexes, such as the NASDAQ and the Amex Morgan Stanley Hi Tech 35, peaked early on and wound up losing about 70% from peak to bottom.  All in all, the broader Wilshire 5000 Index would indicate that the stock market lost almost 40% of its total value over eighteen months: that clearly qualifies as a bear market, both in duration and amplitude.

We also have had a recession. The Bureau of Economic Analysis says so and future statistical revisions will probably confirm it.  Some slowdown had already been evident by early 2001, though largely concentrated in the overextended telecommunication and technology sectors.  Because of rapid obsolescence, excess inventories in these sectors can quickly lose value.  So, when the terrorist attacks all but guaranteed that there would be no early recovery in demand for phone and electronic equipment, inventory liquidation in these sectors accelerated sharply.  Business investment also dropped but, again, it had been buoyant mostly in the “new” economy, while remaining subdued in the “old”.  The sudden realization that growth expectations in the high-tech sectors had been unrealistic caused a sudden drought of financing followed by drastic cuts in capital spending on technology and telecommunications infrastructure.

Eventually, this was aggravated by similar, although generally less massive, reactions in other sectors of the economy.  Still, this recession is likely to rate as a mild one by historical standards.  In fact, it can be traced almost entirely to the aggressive liquidation of inventories, since final sales (G.D.P. excluding inventory changes) merely slowed to a still respectable 1.7% rate of growth for all of 2001.

Thus, while the fact that we have probably turned the page on a recession and a bear market should give us some comfort, the shallowness of the economic decline may take some power off the subsequent recovery.

The economy’s bounce may lack endurance. Surprisingly, consumers’ overall income and spending have held up much better than had been feared in the wake of the September tragedy, the announced layoffs, the reduced bonuses and the bursting of the financial and technology bubbles.  House prices also have held up in most areas, offsetting the negative “wealth effect” from the stock market decline.  And, with the help of unusually favorable weather, homebuilding, too, has remained a pillar of strength.

Still, there is a dark side to this.  The fact that large segments of the economy proved quite resilient in the recession also makes it likely that these areas won’t contribute much to a bounce beyond the expected rebuilding of inventories.  In particular, after very high rates of growth in consumption such as the ones we experienced in the second half of the 1990s, consumer spending historically has languished at sub-par rates for several years.  Indeed, few areas of consumer spending seem to have accumulated significant pent-up demand, while the high level of household indebtedness would seem to argue in favor of a period of repair for consumers’ balance sheets.

Meanwhile, many sectors of the “new” economy apparently still need to digest the over-investment of recent years, and the debt that was incurred in the process, so that only some older industries and some public facilities are candidates for an increase in capital spending.

History calls for subdued investment returns ahead. Various studies have documented that, over very long periods (up to 100 years), returns on U.S. stocks have averaged 9-11% a year, including dividends.  But this average covers very different cycles.  For example, in the seventeen years from 1982 to 1999, the annual return averaged an unprecedented 18.3%.  This even exceeded the 16.3% annualized returns achieved during the boom years that followed WWII (1948 to 1965) and, by comparison, the average annualized return in the seventeen years from 1965 to 1982 was a mere 6.7%.

Despite the stubborn expectations of the most naive of investors, the performance of stocks in the most recent bull market clearly are unsustainable.  Over the long term, if margins stay constant, profits will grow at the pace on a nation’s nominal G.D.P. (including inflation) and, unless price-earnings ratios rise, the stock market will rise at the same pace as profits.  As we will see below, there is not much room for expansion of either margins or price-earnings ratios, beyond an initial rebound from the recession just ended.

The negative stock market returns of 2000-2001 are a good start toward bringing stock prices toward their long-term trend, but it is still likely that returns in the decade that started in 2000 will average something below the long-term average of 9-11%.  Experience also tells us that these lower returns will likely be the result of more frequent declines than in the 1982-1999 period.

Valuations are still high. In 1998-1999, price-earnings ratios on the S&P 500 reached about 30x.  These were a record for the post-WWII era, and equaled three to four times the levels that prevailed at the onset of the great bull market, in the early 1980s.

Even at its September 2001 trough of about 950, the S&P 500 was still selling for 17 or 18 times the record profits earned in the year 2000, before the recession (either $52.90 or $56.13 depending on whether you count special charges or not).  This was a higher PE than at any market bottom since 1949, including several bottoms when bond rates were even lower than last September.  It was also more than 50% higher than the average PE of 11x for all market bottoms since WWII.  The same could be said of the ratios of price to revenue and price to book value.

As for now, the S&P 500 is up about 20% from its September low, to 1132.  Even if earnings recovered to $56 (excluding “special” charges) from the $39 earned in 2001, this level would represent more than 20 times earnings.  Prior to the late 1990s, this kind of level had not been seen since the stock market bubble of the early 1960s.

The ISI Group (www.isigrp.com) has a model that tracks trends in the S&P’s price-earnings ratio fairly well.  This model’s variables include changes in the trade-weighted dollar, inflation, bond yields and long-term productivity trends.  Depending on the optimism of one’s earnings assumptions, this model shows either a 20% over-valuation or a 15% under-valuation.  But it seems to us that all of the model’s components are likely to turn in a lukewarm or negative performance in coming years, so that there is little upside to be expected for the stock market from valuation factors.  For the market to post strong gains, corporate earnings must therefore be quite strong.  Unfortunately...

No one knows what earnings are… or will be.  Several major accounting scandals have recently highlighted the extent to which reported corporate profits can be and have been manipulated, as well as the laxism or complacency of auditors and financial analysts.

Not all of the accounting and reporting methods that have become commonplace in recent years are illegal – in fact, they generally aren’t.  But a growing number of companies have engaged in practices that, at best, confuse investor perceptions of companies’ true profitability, cyclicality and growth or, at worst, significantly inflate reported figures.  The culprits have included some highly respected corporate citizens that often are presumed to be above suspicion.  Just recently, for example, and only a few days before a respected bond analyst expressed strong criticism of General Electric’s accounting practices and reporting transparency, I became intrigued with an outpouring of large, new bond issues by that company, in a broad range of currencies and maturities. We requested a conference call with the fixed-income analysis department of a leading investment bank, only to be told that “we actually do very little work on GE, because there is no way they can be downgraded”.  Faith is the enemy of the critical mind…

Two areas where excesses have been rampant and will weigh on earnings comparisons for several years are write-offs and options.

·        Abracadabra: turning write-offs into earnings. A write-off is the recognition that one or several corporate assets are worth less than the values at which they were previously carried on a company’s balance sheet.  Usually, this derives from either the reduced earning power of a corporate asset (the sales or margins that it can generate have declined), or the fact that the company grossly overpaid to acquire the asset in the first place.  Since it is also an admission that earnings and growth rates reported in the past were inflated, it would be natural for write-offs to have a negative effect on a company’s stock price.

But in recent years, analysts have taken to disregard write-offs as  “exceptional” items somehow unrelated to a company’s operating performance: they even have begun to cheer them as a sign of management commitment to “restructuring”.  As a result, whereas write-off announcements used to penalize stock prices, they have increasingly given them a boost – at least temporarily.  Not surprisingly, these supposedly “non-recurring” charges have become quite popular and have thus been “recurring” with increased frequency.  More importantly, they have become a primary tool for managing what is reported as earnings. With nothing to lose by taking the largest possible write-offs, corporate managers have increasingly included in them everything that is remotely defensible -- provisions for future costs arising from mergers, for example.

Now, this practice of magically turning current “exceptional” (read “painless”) charges into future “operating” profits is coming under growing scrutiny.  It is finally being recognized that, by pre-charging future operating costs along with current “exceptional” write-offs, companies are artificially understating future costs and inflating future profits.  This new scrutiny of corporate reporting practices should reduce the use of over-generous write-offs and result in greater volatility and probably slower growth for reported earnings.

·        Options are no longer a “fringe” benefit.  Employee stock options used to be a relatively modest incentive reserved for top management.  With the intense competition for talent during the 1990s technology bubble, however, options were increasingly issued to a broad segment of the labor force in new and service industries and came to represent a significant portion of employees’ compensation packages.  The accounting treatment of options is complex but highly favorable to corporations.  Not only do they get more favorable tax treatment than their employees, but also they are allowed not to report as a cost of doing business what now often amounts to a significant portion of their payroll.  Obviously, with a lag, this has been raising highbrows and it is likely that labor costs actually included in the calculation of corporate profits will rise as a result – either because employee compensation will include fewer options and more salary, or because the accounting treatment of options is changed.

As to the fundamental outlook for profits, it is mixed.  The decline of the S&P 500 index’s operating profits in 2001 took them back roughly six years, to their 1995 level.  So, a significant bounce can reasonably be expected in 2002-2003 but we doubt that, beyond this, corporate profit margins will easily return to the late 1990s level (7.5% or so after tax), let alone surpass them.  As we mentioned, “reported” labor costs are likely to rise, even if actual wages don’t accelerate immediately.  In addition, reflecting a synchronized, global recovery in demand and capacity reductions in recent years, we are anticipating a bottoming out and re-acceleration of commodities and materials prices.  This should – at least initially – put additional pressure on margins.

Generally, inflation has been good for corporate profits, but mostly when it is reflected in the price of finished products – in fact, when finished product prices rise faster than materials prices.  This may take a few years to unfold, if history is any guide.  In the meantime, operating profits will face an uphill environment, offset at the reported profits level by yet another artificial boost by new accounting rules, which no longer require the amortization of goodwill.  Economist Ed Yardeni projects 2002 operating profits for the S&P 500 of $50.00 – including $2.00 from the FASB elimination of goodwill charges.  That estimate seems as good as any but, in view of the many crosscurrents, we would not bet the house on it.

The Dollar Joker.  In 1995, in the midst of almost universal gloom towards the U.S. dollar, we published a report entitled “The Decade of The Dollar”, based on the profound transformation for the better that we were detecting in the American economy.  Although it has not been a full decade since that report, the U.S. currency has since appreciated more than 40% against both the Japanese Yen and a reconstructed Euro.  It has appreciated even more against the currencies of many developing countries that are aggressive exporters.  Most importantly, the dollar has become the security blanket of investors worldwide, and massive flows of capital into the United States have led some economists to compare America with a powerful vacuum pump for global savings.

We believe that recoveries are taking hold in many economies outside the United States, from Europe and Japan to the developing countries of Southeast Asia.  Capital flows are partly a function of relative risk, but even more a function of investment opportunities.  Many of these economies have either greater recovery potential than the United States or greater long-term growth prospects.  In the wake of its 2001 recession and the bursting of its stock market technology bubble, the United States seem less risk-free now than it did only a couple of years ago, while \"straws in the wind\" may indicate a return to greater stability (both political and financial) for many other economies.  A 2000 report by Merrill Lynch predicted that 2001 would be, not a year for return on capital, but a year for the return of capital.  The report was premature, but it might be auspicious for 2002-2003.

A reflux of capital to the rest of the world, even partial, would weaken the dollar.  We need to watch the behavior of the U.S. currency closely, for a bout of weakness would probably be the signal of difficult times ahead for the American economy.

Theory upside down.  Economic theory used to hold that when a country lives beyond its means, a trade deficit results.  Capital then flows out to pay for the excess of imports over exports, which must be offset by inflows of foreign capital – either by borrowing abroad or by attracting foreign investors.  The exponential growth of financial market since the 1970s, resulting in a volume of financial flows that now totally dwarfs that of commercial transactions, has turned this theory on its head.  Today, financial flows occur independently of commerce, based on the perceived investment attractiveness of individual countries.  When money flows in, it tends to boost local consumption and investment beyond what could be afforded based on the nation’s income alone, and that throws the trade balance into deficit.

Of course, the United States did not need this to incur trade deficits, which have been a feature of the American economy for as long as I can remember.  But sustained, huge and growing inflows of capital have made excessive consumption and investment painless in recent years, resulting in a trade deficit approaching 4% of G.D.P. last year – compared to less that 0.5% as recently as 1991-1992.

Thus, a reversal of capital flows, which have overwhelmingly favored the dollar in recent years, could create a potentially severe withdrawal effect for the U.S. economy.

Summing up some parameters of our current strategy:

·        While the recession of the U.S. economy probably is over, its growth potential seems limited for at least a few years.  A “double dip” after an initial bounce may not be the most likely scenario, but it cannot be entirely ruled out. 

·        Even after the recent bear market, U.S. stocks as a whole have not presented the valuation characteristics of a major bottom, and overall stock market returns are likely to be sub-par for a number of years.

·        Many economies outside the U.S. seem to have restored some stability and offer better recovery or long-term growth potential.

·        Even if the growth of the U.S. economy is subdued, as long as it does not fall back into recession, the world’s economies are likely to experience a synchronized expansion for the first time in many years.

·        In a synchronized global recovery, many foreign markets offer a broader choice of undervalued shares.

·        Within the U.S. economy, companies and sectors exposed to old, cyclical industries (particularly materials), as well as to demand trends in foreign economies, should do best.  This is especially so since inflation is likely to reappear first in basic industries.

·        This global scenario is consistent with some reversal of capital flows, which in recent years have favored the U.S. dollar.

·        Such a reversal, evidenced by a weakness of the U.S. currency, would further detract from domestic demand growth in the United States, fueling a sort of vicious circle for U.S. investments.