Wednesday, October 31, 2012

Should You Be Buying Stocks Pre-Election?

Embedded image permalink
courtesy:  @tradefast
(I apologize for the fuzziness of the above chart, but I think you can still make out the numbers).

One of the more common topics in recent client meetings is whether the equity markets are due for a major correction after the elections.

Or, put another way, should equity weightings be reduced, or at the very least new purchases deferred, until the "dust clears" after the elections next week.

Work done by Ned Davis Research indicates that historically, going back to 1900, markets typically rally after Presidential elections.

The type of rally differs based on which candidate wins.

If the incumbent wins, stocks historically have moved sharply higher, presumably since there is less uncertainty with regards to government policies in the coming years.

If the challenger wins, markets historically have sold off right after the elections, but then rally into the year-end once the new administration starts to take shape.

In either case, however, stocks tend to rally into the end of year.

I found the data in the chart above to be useful in framing the investment decision.  No one wants to buy "at the top", and since stocks have rallied nicely over the past 12 months clients are understandably concerned whether they wouldn't be better served by moving to the sidelines for the time being.

However, as you hopefully can see above, surveying the investment landscape with the S&P now nearing levels last reached in 2000 and 2007 reveals a number of important differences from prior years.

Most importantly, in my opinion, is valuation.  Even with a shaky economic environment, and corporate chieftains sounding a cautious note on the outlook ahead, stocks today are trading at less than 13x (forward) earnings.  P/E ratios were double today's level 12 years ago, when everyone it seemed wanted to be a buyer of stocks. 

Earnings have continued to grow for Corporate America, but the nervous tone of the market is rewarding results less enthusiastically.

Then there is the comparison of stocks with the alternatives - a familiar topic to regular readers of Random Glenings.

Dividend yields today are also double the level of 12 years ago.  With corporate America sitting on $1.6 trillion of cash reserves, there is significant potential for dividend increases in the years ahead.  Indeed, several corporations are openly discussing the possibility of a special year-end dividend in anticipation of higher dividend tax rates in 2013.

Dividend yields are also higher than bond yields.  The last time this occurred was in the 1950's.  While it is true that stocks can be more volatile than bonds, for income-oriented investors with a longer term time horizon will find plenty of opportunity in today's stock markets.

Finally, there is this:  S&P earnings for 2012 are now forecast to be around $105. If earnings grow at a modest +5% per year for the next couple of years, the stocks in the S&P will earn around $116. Applying a 14x multiple to this earnings gives an ending S&P value of around 1620 by the end of 2014.   This would mean that, including the 2% per annum dividend yield, stock investors could earn nearly +20% for the next couple of years.

Compared to a 5-year Treasury bond yield of 0.7%, or cash returns of nearly 0%, it is hard to make a case against stocks for all but the most bearish investors.

In short, I am advising clients to maintain equity positions, and possibly increase weightings if a significant market sell-off occurs.

Tuesday, October 30, 2012

Is the Bond Market "Irrationally Exuberant"?

From global equity strategist Michael Hartnett of Merrill Lynch:

The bond bonanza continues. This week's flows show the biggest bond inflows ever ($9.4bn). 

In December 1996, Fed Chairman Alan Greenspan made worldwide headlines by posing the question:  Are stock investors being irrationally exuberant?

The phrase "irrational exuberance" was first coined by Yale professor Robert Shiller, who mentioned it to Greenspan in an early fall meeting in 1996.

Dr. Shiller - who went on to write a book titled by the same name - was was questioning whether investors had bid the prices of stocks far beyond what fundamentals would warrant.

Shiller and Greenspan were eventually proved correct, of course, although the market did not actually begin to start declining until the early part of 2000.

The larger point, however, was that markets are often manic depressive in their actions. One day investors can be wildly over enthusiastic, and push prices to unsustainable levels.  On other days, gloom and doom settles over investors, and prices plummet to levels far lower than economic reality.

It would be hard to suggest that stock investors today are even remotely "exuberant".  Outflows from domestic equity funds have been almost constant for the past five years, and it is hard to pick up any investment or business publication without reading about some calamity that is about to occur.

In the bond market, however, it is a much different story.

Bond investors continue to gobble up fixed income investments of all different types.  For five straight years, individual investors have been fleeing the domestic stock market, mostly in favor of bonds.

However, with interest rates at historic lows, many are questioning what will happen when interest rates eventually begin to rise.

My feeling is that the most vulnerable group will be those that are moving in the bond mutual funds.

If you buy an individual bond with a stated final maturity, you at least have the comfort of knowing that you will eventually get your principal back, regardless of the future direction of interest rates.

Investors in bond mutual funds, however, have no such certainty.  Managers of bond mutual funds typically keep their interest rate exposure within a certain range, which in effect means that investors in bond funds lose the attractive feature of getting their money back at some point.

Put another way:  it is very possible to suffer a permanent loss of  principal by investing in a bond fund, even though bonds are typically considered "safe".

Writing on his blog The Reformed Broker, investment advisor Joshua Brown wrote a searing column on the fate that will eventually befall those that are plowing hard-earned investment assets into bond mutual funds at today's low yields:

There's going to be such a brutal bond investor slaughter at some point over the next decade that the streets of Boston's mutual fund district will run red with blood, the skies will be shot through with the lightning and thunder of unexpected capital losses and those who manage to survive will envy the dead....

And it will come.

You know how I know this? Because you lunatics are plowing money into fixed income at all-time low interest rates during the parabolic final phase of a 30-year bond market rally. You are going limit-up long into one of the most obvious blow-off tops in the history of investing. And you're doing this with almost guaranteed inflation ahead of us and only the prospects of negative real rates of return on your T-bills.

Thursday, October 25, 2012

Friday Reading: Ted Weschler of Berkshire Hathaway

My wife and I are heading to Charlottesville, Virginia this weekend to visit our daughter Caroline.

Caroline is a first year at the University of Virginia, and is enjoying college life tremendously. We are looking forward to seeing her!

We have some friends who live in the Charlottesville area.

One of their neighbors is a fellow named Ted Weschler.  Ted used to have his own investment shop in Charlottesville, but more recently is working with an insurance outfit in Omaha, Nebraska named Berkshire Hathaway, run by Warren Buffett.

Our friends report that Ted is a very unassuming, friendly neighbor, but seems to be constantly reading - a trait he shares with Buffett. Both men will spend days, if not years, understanding a company before committing capital (Buffett said that he read IBM's annual reports for 50 years before buying 5% of the company earlier this year).

Bloomberg ran a great piece earlier this week about Ted Weschler earlier this week which I thought was very interesting.  Here's an excerpt:

Like Buffett, Weschler sought an edge by studying company filings and dozens of other publications. The former hedge-fund manager once told David that he didn’t make an investment unless he had spent 500 hours studying the idea. 

“He’d go on vacation and take 10-Ks and 10-Qs with him,” said David, referring to the annual and quarterly reports publicly traded companies file to the U.S. Securities and Exchange Commission. “He still does.”

Benchmark Obsession

Writing in the Financial Times in September 2011, GMO investment strategist James Montier wrote a piece titled "Benchmark Obsession Undermines Investor Returns".

Montier discussed the fact that the investment community, and the investors they serve, are obsessed with "beating the benchmark".

Using the S&P 500, or some other widely followed index, managers are judged on their relative performance as to whether they have carried out the duties to which they were assigned, regardless of whether their investment approach matched the risk appetite of their clients.

Yet lost in the relative performance game is the basic overriding objective for any investor:  having more money in the future than they have today.  This is usually combined with a secondary, but very important objective: not losing money.

Here's how Montier put it:

Sir John Templeton, the pioneering global investor, argued that the aim of investing was quite simply "maximum real returns". Over time this simple but powerful objective has been lost.  This is all the more surprising because, clearly, real returns matter to the end investor, particularly in current markets. Pensions are paid from real returns not relative ones.

(I've always liked that thought: "Maximize Real Returns".)

Most of us have no idea, for example, what the relative return of the funds in our 401(k) has been - we are only interested in the bottom line.

The same is true when we think about the value of our houses - no one has the slightest idea of how the change in your home's value compares to any index, only whether the potential selling price is higher than what we paid for it.

Yet when we sit down to evaluate investment alternatives, or select an investment manager, inevitably the conversation turns to "How did they do relative to the benchmark?".

I was reminded again of the absurdity of this approach when I saw this article on the CBS Marketwatch website yesterday.

According to the article, 98% of municipal bond funds can claim they beat their benchmark (woe if you are in the unlucky 2% that did not!).

Here's what the article said:

In the muni-bond fund universe, those odds are much better. In fact more than 98% of funds beat their benchmark, according to a new study from professors at three U.S. Universities that measured risk-adjusted returns for 124 open-end funds going back to 1992. That staggering success, however, may have less to do with a manager’s investing prowess than the yardstick he’s using, according to co-author Haiwei Chen of the University of Texas, Pan American. “You need to look beyond when they tell you, ‘We beat the benchmark,’” he says.

It seems to me that most investment decisions would be best focused on which asset class offers the best risk/reward trade-offs, and allocate capital accordingly.

I'll end with a thought from the great value investor Bob Kirby, quoted in Montier's column:

"Performance measurement is one of those basically good ideas that somehow got totally out of control.  In many cases, the intense application of performance measurement techniques has actually served to impede the purpose it is supposed to serve."

Wednesday, October 24, 2012

An Early Winter for Corporate America

Stocks have started out the month of October in a sluggish fashion, with the S&P 500 off about -2% so far this month.

The market has been weighed down largely by weak corporate earnings reports.  Through the end of last week, 61% of the 127 companies in the S&P have missed revenue expectations, although more than half have beaten earnings estimates.

The gloomy mood of the market has not been helped by the downbeat commentary from corporate chiefs, who have generally reported that the economy has clearly slowed from earlier in the year.

It seems to me that some of the slowdown is not totally unexpected.  If I were head of a major corporation, I would be slow to initiate any new projects without a clearer picture of what government policies will be in 2013, especially with regards to taxes.

Then there is the whole issue of the fiscal cliff.  If Congress does not act before the end of the year, a whole host of draconian federal budget cuts kick in, and our fragile economy could be delivered a major blow.

So most of corporate America is hunkered down, building cash and delaying projects.  General Electric, for example, did a $5 billion bond issue earlier this week for the express purpose of building cash reserves in case Congress does not act before year end.  Corporations are borrowing, but then tucking the proceeds into cash reserves.

The cash build is startling.  Here's what CNBC said this morning:

Corporations are stowing away cash at record rates, reluctant to invest in their businesses or hire new workers as uncertainty clouds the future.

Amid a lackluster earning season that has featured many companies missing sales expectations, cash balances have swelled 14 percent and are on track toward $1.5 trillion for the Standard & Poor's 500, according to JPMorgan. Both levels would be historic highs.

Meanwhile, the public remains skittish about stocks.  Ned Davis Research (NDR) noted this morning that the public pulled $10.6 billion out of domestic equity mutual funds last weeks, the largest outflow since August 2011.

NDR goes on to say that a last week's poll from the American Association of Individual Investors showed just 28.7% bulls, while 44.6% are bearish.

Historically lots of cash on the sidelines, and bearish sentiment building,  would set up the market for a pretty powerful rally.

Will this time be different?

Tuesday, October 23, 2012

Is the High Dividend Stock Trade Over?

Investing in stocks that pay attractive dividend yields has been a very popular strategy over the past few years.

Worried about the economy, but needing income, investors have flocked to stable,  high dividend paying sectors like telecom and utilities, and prices have risen accordingly. 

For example, for the 6 months ending September 30, the prices of telecom stocks have soared by more than +20%, while the S&P 500 has risen just slightly more than +2%.

But is the rally in high dividend paying stocks overdone?

Joseph Paul, chief investment officer at AllianceBernstein, thinks that there is a bubble in high yield stocks, and has written an excellent blog post presenting his data.

Here's an excerpt from what he wrote last week (I added the emphasis):

...High-yield stocks are as pricey as they’ve been since the early 1950s, trading at a modest premium to the market versus a long-term average discount of 20%. We don’t view this premium as exorbitant given the current market anxieties, but it does limit upside potential and makes these stocks more vulnerable than others if sentiment turns. Most of the high-priced dividend-paying stocks are in mature, slow-growth sectors such as consumer staples, telecom and utilities, which are likely to look less appealing than more economically sensitive stocks in a sustained economic recovery.

Mr. Paul goes on to present a couple of charts that indicate just how much high yield stocks have outperformed the market, noting that as a percentage of the total market value high yield stocks have not been this high since the early 1980's:

 High-Yield  Stocks Consumer Record-High Share of Market

 And while he is not necessarily suggesting exiting high dividend payers, he does note that historically the group has been very vulnerable to higher interest rates:

Is There Two Much Bond Best in Your Equity Alpha?
The managers of high yield stocks at investment giant Pimco were making the rounds recently, and showed a chart indicating just how highly valued the telecom and utility sectors are relative to historic averages:
Throw on top of all of this valuation work is the very real possibility that tax rates on dividend stocks could rise significantly.

If Congress does not act before year-end, the tax rate for those in the highest income bracket will reach 43.4%, compared to just 15% currently.  While it is true that more than half of dividend-payers are in tax deferred accounts, it still leaves a very large segment of the market vulnerable to higher tax rates, if that comes to pass.


Monday, October 22, 2012

More on Year End Tax Planning

Photo courtesy of Ron Buist (
The next couple of months promise to be very interesting ones in the market.

The election outcome is of course very much in doubt at this writing.  Meanwhile, there are growing fears among corporate America that Congress will not act with sufficient resolve and alacrity to deal with the impending "fiscal cliff". Investors are left struggling how to best manage their accounts in light of the uncertain tax environment in 2013.

Although advisers typically tell clients not to make investment decisions based on taxes, this year might be different.

With capital gains rates at historic lows, and facing a pretty good likelihood that rates will move higher next year, many firms are advising clients to take capital gains this year, especially if they anticipate needing funds in the next year or so.

Bloomberg carried a good article this morning discussing different approaches being advocated by some large banks and brokerage firms. Here's an excerpt:


That’s the message from some financial advisers, who are telling wealthy clients that the remainder of 2012 amounts to a last-chance sale on federal tax rates. Taxes are set to rise in January in the U.S., pushing the top rate on dividends to 43.4 percent from 15 percent and the top rate on capital gains to 23.8 percent from 15 percent...

An investor who sells $100 of stock with a cost basis of $20 in 2012 would see proceeds -- after capital gains taxes -- of $88, said Robert Barbetti, managing director and executive compensation specialist at J.P. Morgan Private Bank. Next year, if Congress doesn’t act, earnings from the sale would drop to $80.96 if rates rise to 23.8 percent. That means the stock price would need to rise at least 9 percent for an investor to be better off selling in 2013, said Barbetti, who is based in New York

Meanwhile, Ned Davis Research (NDR) thinks that investors should focus on those sectors that have done particularly well over the last year as ones where selling in anticipation of higher taxes makes the most sense.

In a report issued on Friday,  NDR analyst Gary Sarkissian writes that investors should consider swaps from the best returning sectors into lagging groups in anticipation of potential tax-related year-end selling pressure.

NDR figures investors might be tempted to take profits in sectors like media, banks and health care stocks.  At the same time, automobile and semiconductor stocks may be interesting buy candidates, based solely on their year-to-date underperformance.

I'm not sure I totally buy into the idea that you should sell your winners and buy the laggards based on upcoming changes in tax policy.  However, NDR cites some pretty good historic evidence that this strategy has played out well in the past when tax rates were set to rise, so perhaps it is worth considering.

The Bloomberg article, by the way, pointed out that the last time there was a significant change in tax policy (1986), "positive realizations spiked 91 percent to $328 billion from $172 billion a year earlier, according to the Tax Policy Center.  Most investors waited until December to sell, according to a 1994 report in the National Tax Journal."

Thursday, October 18, 2012

Are Stocks Poised for Their Next Leg Higher?

I went to go hear Michael Hartnett yesterday.

Michael is the Chief Global Investment Strategist for Merrill Lynch, and I have quoted his work on many occasions on Random Glenings.

One of the reasons I respect Michael's work so much is that he focuses on what actually moves market prices:  fund flows.

As my business school professors used to remind me, the stock market is almost manic depressive.  Some days it is feeling wildly euphoric, while other days it depressed beyond reason.

Stocks in the long run will reflect fundamentals, but managing a stock portfolio has to recognize that fund flows will be a major contributor to investment returns.

Or, to quote investment legend Benjamin Graham, the stock market in the short run is a voting machine, but in the long run it is a weighing machine.

Over the past year Michael has continually noted the apparent distaste that the investment community has had for stocks.  Despite today's low level of interest rates, investors around the world have continued to flee listed equities in favor of bonds.

For example, this was on the CNN website this morning:

U.S. stock mutual funds lost $2.3 billion during the week ended Oct. 10, according to data from the Investment Company Institute. That was far less than the prior week, when investors yanked $10.6 billion. Nonetheless, it still marked the 12th straight week of outflows....

So far this year, U.S. stock mutual funds have bled nearly $105 billion. By comparison, those funds lost around $57 billion during the first nine months of 2010, and $80 billion during the first nine months of 2011.

However, despite investor worries, stocks have risen sharply in most parts of the world.

For the 12 months ending September 30, 2012, for example, the S&P 500 has produced a total return of more than +30%. Over the past 3 years, stocks have doubled, and the S&P now stands at roughly the same level in mid-summer 2007.

So what's going on?  How can stocks be moving higher with investor sentiment so sour?

Here's a chart that Hartnett showed yesterday which I though explained alot:



Central Bank Liquidity

Global GDP


G4 Bond Yields

Global bond market cap

Global equity market cap $33tn
(free float)

Source:  BofA  Merrill Lynch Global Equity Strategy, Bloomberg, Haver, DataStream

Look at the liquidity that the world's central banks have created. To be sure, this was not done to help stocks, but at least a portion of this has to have flowed in the market. The combination of adding more than $11trillion in funds to global economies, and pushing interest rates down by nearly 300 basis points in the same period, has helped asset prices significantly.

The world's economies, meanwhile, have continued to grow, and global GDP is now 25% higher than it was five years.  Yet the global market equity cap - the total value of all stock markets - is -13% less than it was in 2007.

In other words, while the world frets about fiscal cliffs and euro zone imbalances, the real economy has continued to perk along.

Hartnett believes that stocks have further to run.  While he believes the liquidity-based stock rally is on its last legs, he also thinks that the next stage of the stock rally will occur when bond investors start seeing losses in their portfolios as interest rates rise.

He doesn't ignore that there are risks in the markets - there always are, after all - but believes that once the rotation from bonds to stocks begins, it will provide sufficient fuel to power most global market averages significantly above current levels.

Wednesday, October 17, 2012

Richard Bernstein: We Are In The "Third Inning" of a Bull Market

The S&P 500 is just 0.7% short of the best close since 2007.  Housing and auto sales continue to surprise analysts on the upside. Even unemployment rates are moving lower.

Yet the bearish sentiment continues unabated. Investor attitudes seem largely focused on the risks in the stock market rather than the fact that the valuation of stocks relative to just about every other asset class screen are at historic wides.

Former Merrill Lynch strategist Rich Bernstein looks at the current market environment and thinks we're in a confirmed bull market, as Financial Advisor magazine reports in its most recent issue (I added the emphasis):

With the S&P 500 up more than 100% from its March 2009 low of 666, many people are asking if the bull market is over. Bernstein cited the absence of three classic bear market signals—yield curve inversion, extreme overenthusiastic sentiment, and lofty valuation—as evidence the bull market is young. He guesses that "we are in the third inning." 

Wall Street remains as bearish as it ever was. Today, retail investors believe they have to buy everything that performed well in the last decade—gold, emerging markets, emerging markets debt, REITs and hedge funds. All these asset classes boomed in the so-called lost decade between 2000 and 2008 at the same time as the credit bubble was inflating. 

Institutions continue to allocate major parts of their portfolios to hedge funds and private equity. Even though they can't keep up with stocks, institutions are "paying 2 and 20" to chase the last decade's returns. 

In 2002, everyone was asking "when to get back into tech stocks," Bernstein said. "It's hard to argue stocks are overvalued when the 10-year Treasury yields 1.7%."

Bernstein, by the way, is not your typical wild-eyed optimist.  Indeed, he lost his position with Merrill in 2007, when he refused to back down from his conviction that stocks were poised to move lower (never a good idea to tell investors to sell stocks when you work at a brokerage company!).

Part of the problem in today's market, I think, is that while growth trends may be moving higher, they are not accelerating at a pace that would create the feeling that the economy is doing anything but sputtering.

For example, Washington Post columnist Annie Lowrey noted on Twitter this morning that while housing permits are trending higher, they remain mired at a level no higher than they were in the winter of 1991.

In other words, while the housing numbers are positive, the absolute numbers remain historically low.
However, while I am not as optimistic, I think that Bernstein is probably right.  The conditions that would lead to a major market correction - tightening credit, overdone bullish sentiment, and high stock valuations - are not evident at this point.

Meanwhile, interest rates continue to creep higher.  If investors in bond mutual funds find that their investments in bond funds are losing value as rates rise, we might see a reversal of the stock to bond fund swap that we have seen over the past 5 years.

Tuesday, October 16, 2012

Mon Dieu! French Tax Rates Set to Soar

Storming the Bastille
Last Friday I wrote a short note discussing whether U.S. investors should be selling now in anticipation of higher tax rates in 2013.

As I noted, the "worst case" scenario seems at this writing to include capital gains tax rates going from 15% currently to as high as 30% under the most recent Obama proposal.  Taxes on dividends, meanwhile could potentially reach as high as 43.4% for taxpayers in the highest income tax bracket, compared to 15% currently.

Most analysts do not expect these types of increases to become effective, by the way.  The consensus view is that no matter who is our next President a bipartisan agreement with Congress will probably result in some kind of increase in rates from current levels, but still well below historic averages.

Meanwhile, across the Atlantic, French President Francois Hollande is proposing tax increases on investment income that make the American debate seem almost frivolous.

If President Hollande has his way, the top rate on capital gains in France will nearly double, from 34.5% to 62.2%. 

Understandably, as Ambrose Evans-Pritchard of the London Telegraph reports, business leaders are furious, and are warning of severe economic consequences if the proposed tax rates become law:

The immediate bone of contention is Article 6 of the new {French} tax law, which raises the top rate of capital gains tax from 34.5pc to 62.2pc. This compares with 21pc in Spain, 26.4pc in Germany and 28pc in Britain...

Mr Hollande is tightening fiscal policy by 2pc of GDP next year to meet EU deficit targets, with two-thirds coming from higher taxes. The budget does little to shrink the French state. Spending has risen to 55pc of GDP, similar to Sweden but without Nordic labour flexibility.

This will be an interesting debate to watch.  Several French business leaders are opening discussing changing their citizenship to other, more tax friendly countries. Meanwhile, public sentiment remains largely resentful against the rich and the powerful, who may perceive are not paying their fair share of the country's fiscal burden.

French billionaire Bernard Arnault, for example, is apparently now applying for Belgium citizenship to avoid his country's huge tax increases, which include a 75% tax rate on income above $1 million:

French first fortune, Bernard Arnault would become the man richest man in Belgium . According to Freedom of Belgium , the multibillionaire asked late August to be naturalized. His case is now on the table of the Committee on Naturalization s must ' ensure that the candidate has many "real ties" in Belgium.

The motivations of the owner of LVMH are not known, but it is more than probable that Mr. Arnault wants to enjoy the lower tax provided by Belgium.

Monday, October 15, 2012

When 60/40 Is Good Enough

Last Saturday, New York Times columnist James Stewart took a hard look at the investment returns of some of the most prominent university endowments, and found the results wanting.

Harvard, for example, reported a loss of -0.05% for the year ending June 30, 2012, while the S&P 500 gained +5.5% during the same period. Other university endowments are expected to have similar results.

The culprit appears to lie with the strategy of investing heavily in so-called alternative asset classes, and avoiding the "boring" strategies of the past which focused largely on the more traditional stock and bond investing.

Here's what Mr. Stewart wrote (I added the emphasis):

Even more startling, data compiled by the National Association of College and University Business Officers for the 2011 fiscal year (the most recent available) show that large, medium and small endowments all underperformed a simple mix of 60 percent stocks and 40 percent bonds over one-, three- and five-year periods. The 91 percent of endowments with less than $1 billion in assets underperformed in every time period since records have been maintained. Given the weak results being reported this year, that underperformance is likely to be even more pronounced when the fiscal year 2012 results are included.

These results, by the way, are not just of academic interest (pardon the pun).

Most universities rely on the investment returns from their endowments to support ongoing campus activities.  When shortfalls occur, or when results are less than budgets, cuts have to be made.

For example, my son Michael is attending Wesleyan University. 

Wesleyan has always had the reputation of being one of the more progressive liberal arts colleges, and Michael reports that Wesleyan continues this tradition today.

However, President Michael Roth of Wesleyan announced two weeks ago that Wesleyan was ending its "needs blind" admission policy.  The reason?  The size of Wesleyan's endowment is no longer sufficient, i.e. returns have not kept up with budgetary requirements:

 MIDDLETOWN, Conn. (AP) — Wesleyan University is ending its policy of remaining "blind" to all applicants' financial needs while considering them for admission, saying it doesn't have enough money....

The university's endowment was hit hard by the 2008 financial crash and more students needed financial aid. Wesleyan's endowment has rebounded to about $615 million, but the school has had to raise tuition to nearly $60,000, making it one of the most expensive schools in the country.

Last August I wrote about the experience of Norway's  Government Pension Fund Global (GPFG).

The returns of this massive government sponsored fund have beaten nearly every other large global pension fund for a very simple reason:  since inception, it has maintained an allocation of - you guessed it - 60% stocks and 40% bonds:

GPFG has proven to be one of the most recognized and successful funds in th world.  Although the government can withdraw up to 4% of the fund's assets each year to supplement fiscal budgets, the fund is now expected well beyond the expected life of some of its natural resources.

Interestingly, however, its current asset allocation is a very traditional mix of 60% stocks and 40% bonds - the same "boring" allocation that many money managers advocate for their clients. In recent years the fund has considered adding 5% in real estate, but it has moved in this direction slowly.

Friday, October 12, 2012

Should You Be Selling Now In Anticipation of Higher Tax Rates in 2013?

source:  Doug Short

One of the most common questions that has arisen in recent client meetings has been tax planning for 2013.

This is a very complex subject, so let me say at the onset that you should not make any final decisions based on my thoughts here today; please consult your tax advisor.

However, I wanted to pass along a couple of ideas

At this writing, with not only the Presidential race but numerous Senate campaigns very much up for grabs, it is difficult to know what tax rates will be in 2013.

The conventional wisdom is that if Governor Romney wins, tax rates on capital gains and dividends will remain relatively low:  15% on long-term capital capitals, and 15% on qualified dividends.

However, if President Obama is re-elected, it is possible that tax rates in 2013 could rise significantly, particularly if you include the 3.8% investment tax included as part of the Affordable Care Act (so-called Obamacare).

At the highest tax brackets, if tax rates revert to the pre-Bush era levels, long-term capital gains will be taxed at 23.8%, and taxes on dividends could rise as high as 43.8%.

Typically, if you ask most investment advisors, they will say something along the lines like "you should never let taxes dictate your investment decisions".  And while I agree in principal that this makes sense, I am not as certain that investors should at least be thinking about taxes as they consider not only low basis stock positions in their taxable portfolios, but their overall investment strategy as well.

Ned Davis Research (NDR) is out this morning with a piece that looks back at the last time there was a significant increase in capital gains taxes, in 1986. Analyst Lance Stonecypher of NDR writes the following:

The selling pressure on {stock} winners could be significant. {Looking at 1986} shows what happened to winners during the last half of 1986, the last time a capital gains tax of more than a full percentage point was being enacted....Stocks with high 52-week returns (i.e. momentum) significantly underperformed those with weak returns.  In fact, the top-decile momentum stocks produced a -0.6% return, while the bottom-decile stocks returned +20.7% between August 1986 and yearend (The tax hike was passed in October 1986, effective for the 1987 tax year.

In other words, taxes could play a major roles in stock market performance, especially as we approach year-end and we start to get some clarity in terms of which party will hold sway in Washington next year.

It is not clear what a rise in tax rates will do to dividend-paying stocks.  For example, telecommunication stocks have been big winners this year, largely due to their high dividend yields, and so could be vulnerable to profit-taking as we approach year-end, particularly if the elections skew more favorably to the Democrats.

However, NDR also points out that more than half of stock positions held by individuals are in tax-deferred accounts (e.g. IRA's and 401(k)'s), so any change in tax rates will not be a factor.  In addition, with bond yields so low, after-tax dividend yields for many stocks could remain above comparable corporate bond yields even if tax rates move to the highest rates.

Lots to think about.

Thursday, October 11, 2012

Housing and Unemployment Rates

Last Friday, after the Bureau of Labor Statistics (BLS) reported a surprising drop in the unemployment rate, former General Electric CEO Jack Welch tweeted his disbelief:

@jack_welch Unbelievable jobs numbers..these Chicago guys will do anything..can't debate so change numbers

Wednesday, October 10, 2012

Winston Churchill and Today's Markets

Winston Churchill once famously said that "democracy is the worst form of government except all of the others that have been tried."

Paraphrasing Churchill's comments, in a different context, stocks today are modestly overvalued except when compared to all of the other alternatives.

Ned Davis of Ned Davis Research (NDR) this morning points out that the median S&P 500 P/E ratio was 17.5 at the end of September. 

As Mr. Davis writes:

That is 6.0% above 'fair value' based on the median of 16.5 P/E going all the way back to 1964.  I like median P/Es because they leave out a lot of questionable earnings reports.  Based upon median P/Es, we are very mildly overvalued.

Davis goes to examine some other traditional valuation metrics, and many seem to tell roughly the same story:  The stock market appears mildly overvalued, especially with the prospect of upcoming gloomy corporate earnings season.

However, compared to other classes of investments - bonds and cash - stocks scream out as wildly attractive.

According to NDR, the earnings yield of the S&P is 6.05%.  NDR's interest rate composite (average of Treasury Bill yields, 10-year Treasury yield, and Moody's Baa Corporate Yield) was 2.15% as of last Friday.

The ratio of the earnings yield of the stock market relative to bonds is 280, which is the widest it has been going back to 1967.

Deutsche Bank agrees with NDR, noting in their work that the gap between the earnings yield on stocks relative to the Treasurys has not been this wide since the early 1980's.

In other words, while there is plenty to be worried about in the global economy, stocks relative to just about every other asset class screen at relatively attractive levels.

Vanguard founder Jack Bogle was interviewed on CNBC on Monday, and also agrees that stocks are the place to be for investors with a longer term time horizon:

There’s up to a 90 percent chance that stocks will post greater returns than bonds over the next 10 years, Vanguard Group co-founder John “Jack” Bogle told CNBC on Monday. 

 “I think the odds that stocks will give a higher return than bonds over the next decade are probably 85 to 90 percent,” he said on “Fast Money.”

“The fundamentals are that bonds are yielding maybe 2 ½, 3 percent if you throw in some corporates, and stocks are yielding 2.2 percent in the S&P [.SPX  1441.48  ---  UNCH    ],” he added. “Yet the S&P stocks are going to have earnings growth. There’s nothing extra the government can do or the bond issuer can do other than pay the agreed-upon coupon.” 

Tuesday, October 9, 2012

Third Quarter Report: Should You Be Selling?

Yesterday the IMF downgraded their assessment of the global economic outlook.

This represents their second downgrade in recent months, and understandably has caused many of my clients to question whether now is the time to be reducing or exiting equity positions.

My response so far is no.

I believe that the most likely policy response from the world's central banks will be more fiscal and monetary stimulus, some of which will doubtlessly flow into the equity markets.

I discuss this more fully in my third quarter letter to institutional clients:

The global tsunami of liquidity unleashed by the world’s central banks spurred market gains in the third quarter of 2012.

The S&P 500 produced a total return of +6.4% for the three months ending September 30, 2012.  Despite the backdrop of sluggish economic growth, the market has given investors a total return of over +30% for the last 12 months.

Besides easy monetary policy, stocks have been helped by record low interest rates.  The Federal Reserve announced in the third quarter that it intends to keep interest rates near 0% until at least the middle of 2015.  The Fed’s intention is to try to pry the trillions of savings now parked in cash reserves into riskier assets such as stocks, and so far at least it has been successful.

As is often the case, however, the gains in the market have been uneven across sectors. 

Telecommunication stocks have been the best performing sector year-to-date due primarily to their high dividend yields.  Technology stocks – lead by Apple, which is up an eye-popping +65% in 2012 – have been the second best performing sector so far this year. Lagging sectors, meanwhile, have been utilities (+1% YTD) and energy (+6% YTD).

The market valuation at current levels is roughly in-line with historic price/earnings levels.  However, compared to other investable assets such as bonds, the relative attraction of stocks stands at historically high levels, which offers the prospect of further gains ahead.  

Our focus for the remaining months of 2012 will be primarily on two areas.  First, stocks that have lagged the broader market averages this year (e.g. energy; industrials; utilities) could present an opportunity.  Second, while the broader economy has struggled, housing and auto sales have been brisk. Home sales are picking up from the 2009 lows, and many companies will benefit.  In addition, auto sales are now running at 4-year highs, and auto companies and related stocks should also do well.

At the same time, there remain several areas of concern.  Europe continues to struggle to find a workable solution to its euro troubles.  In Washington, the prospect of a fiscal cliff resulting from political gridlock could reduce growth forecasts for 2013, and hurt equity market performance as we approach the end of year.  Finally, corporate leaders have been quite vocal that many parts of their global businesses continue to be soft, particularly in the emerging markets.

We remain cautiously optimistic for stocks for the rest of the year.