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%."

http://www.fa-mag.com/fa-news/12604-bernstein-sees-new-us-bull-surpassing-1982-1999-market.html

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.

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.

http://www.telegraph.co.uk/finance/financialcrisis/9610717/French-business-erupts-in-fury-against-disastrous-Francois-Hollande.html

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.

Read more: http://www.businessinsider.com/bernard-arnault-trying-to-become-belgian-2012-9#ixzz29UfDjIE7

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. 

http://www.nytimes.com/2012/10/13/business/colleges-and-universities-invest-in-unconventional-ways.html?pagewanted=all&_r=1&hp=&nl=business&emc=edit_dlbkam_20121015

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.

Read more: http://www.sfgate.com/news/article/Wesleyan-ends-need-blind-admission-policy-3926596.php#ixzz29NsROodh

 
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.


http://randomglenings.blogspot.com/search?updated-max=2012-08-31T10:30:00-04:00&max-results=7&start=7&by-date=false

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.

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

5 Oct 12

Mr. Welch's 1.3 million followers on Twitter immediately began to comment, mostly negatively. The blogsphere quickly followed, with numerous commentators weighing in.


Most seemed to feel that it seemed highly unlikely that the BLS - mostly composed of career employees whose jobs will not be threatened regardless of who is the next President - would deliberately report false numbers to help President Obama.

Here, for example, is Reuters columnist Felix Salmon:

Does he have any evidence that the Chicago guys might be manipulating data? No. Does he think it’s even possible for the Chicago guys to be manipulating the data? Evidently, he does. What makes him say that? He won’t say. But is it a legitimate question to raise? In Welch’s eyes, absolutely, yes. If you’re Jack Welch, it seems, any time there’s US data which makes the government look good, the question can and probably should be raised: might the data be wrong? Or, might the government be manipulating it?

http://blogs.reuters.com/felix-salmon/2012/10/09/conspiracy-jack/

Eventually the tumult became so great that Welch announced on Monday that he would no longer write articles for either Fortune magazine or Reuters, largely due to their critical comments about his tweet.

In comments after his tweet last Friday, Mr. Welch indicated that his disbelief in the BLS report was largely based on his own personal recent experiences.  He remains involved with a number of different companies, and all of them continue to struggle; ergo, the overall U.S. economy must be struggling.

Jack Welch made a career relying in many cases on his instincts; even his autobiography is titled "Jack: Straight from the Gut".  It is not surprising, then, that he continues to believe that his instincts are often the best guide to what is really going on in the world around him.

I think that Mr. Welch is wrong, but like him I am relying on my "gut instincts".  My belief that last week's improvement in unemployment is real, and not an election year gimmick, is largely based on the significant improvement in housing that seems to be occurring in many parts of the nation.

Housing is a crucial part of our economy.  When new homes are built, or when existing homes are sold, our economy benefits.  Homes have to be furnished, repaired, and maintained, all of which involve businesses that employ thousands of people.

When the housing boom turned into a bust in 2008, housing activity came to a screeching halt.  Even now, when low mortgage rates have made home ownership more affordable than it has been for years, there still is a marked preference for renting versus buying.

But this is slowly changing, and as housing improves so too does the overall employment picture.

Last weekend I happened to watch an interview with Warren Buffett that appeared on the PBS program "Charlie Rose" in August 2011.

In the interview, Buffett noted that Berkshire Hathaway owns 70 different companies.  At the time - again, this is 14 months ago - the companies that were either directly or indirectly associated with housing were the ones doing the poorest in Berkshire's portfolio.

When housing recovered, Mr. Buffett noted, he expected unemployment to plummet, since so many different parts of the economy are related to the housing industry.

He says in the interview that he expected that unemployment in the United States would be 7.3% by the time of the Presidential election (it was around 9% at the time).  In the summer of 2011 this seemed wildly optimistic, but now seems at least plausible.

Housing is recovering, and this could be the reason that employment numbers are surprising on the upside.  Even the mortgage lenders at my employer Boston Private Bank and Trust Company said in a meeting this morning that the housing market in the Greater Boston area is stronger than it has been for years.

Here's the full interview with Warren Buffett if you have a spare hour:

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.” 

http://www.cnbc.com/id/49274230 

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.