The Third Pig

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About two years ago, actually the date was November 10, 2008, I got the following email from a client and friend. It read:

Hey Ben,

Hope all is going well. Everything is going well here. I need your input on house that my wife and I are looking at. My wife and I are looking at a buying a foreclosure. We have submit an offer as soon as possible. My proposal is to use a substantial amount of my account as a down payment and then replace the money in my account when our current house is sold. I'm thinking that my current house may take a month to sale. Do you see any issues with this plan?... I look forward to hearing from you.

Thanks,

Client X

My response was:

Hey Client X,

Sorry you couldn't reach me. Feel free to call me on my cell at anytime. The voicemail was full because as you might guess, I've been getting a lot of calls lately...

I would really like to answer your question thoroughly. So that I cover most of the pro and cons of this financial decision, I will take a little more time to write something up. But, for your immediate gratification, let me say that I think the plan you have laid out has significant financial downside. That is not to say executing your plan the way you've spelled it out won't be the right thing for you and your spouse to do. It may suit your immediate lifestyle and emotional needs. However, financially, there are much better ways to approach the purchase of a new home given your circumstances and the current environment. In a nutshell, I think the plan as laid out would set you back financially but that your finances are not the only factors that should be considered. There are the lifestyle/emotional factors as well.

I will write something up for you that will explain more thoroughly the financial downsides tonight and email you promptly. I will be available to speak by phone anytime after 3pm tomorrow.

Til then,

Ben

The letter in its entirety can be found here. My advice then:

Continue reading "Not Fortune Telling, Just Good Sense" »

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Posted by Ben Taylor at 02:49 PM |
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Flickr by Mr. Keef

Last week I did a video saying that I thought we were still in a new bull market. This was a follow up to a video I did in January listing some of the indicators I follow as reasons I thought we were in the early stages of a bull market. I pointed out that even with all the bad news about the economy, and jobs, and bailouts, the S&P 500 remained above 800. I saw this as a positive sign.

Since last week, the economic news has gotten worse. There have been renewed talks about nationalization of our banking system. [Psst. We’ve basically already nationalized the banks.] In response, the Dow reached a new 6-year low, penetrating the bottom it reached this past November. The S&P 500 broke through the 800 price barrier and threatens to challenge the low of 752 it reached last year. As of this moment (9:55 a.m.) the S&P 500 is trading at 769.

So was I wrong about this being a new bull market? Technically, no if the market holds where it is. Unless the S&P 500 falls below 752 (the November 20, 2008 price), this will still (technically) be considered a bull market. Recall I pointed out in the in first video that only once has the market declined 20% or more, rebounded 20% then, broke through the previous low. Could that happen now? Well we’re very close. It’s definitely possible.

Does any of this matter? Not really. The overall point I was trying to make in the videos and the past few posts on the topic is that stocks are cheap. They remain cheap. As I pointed out in the last video, we don’t know what the market or the economy will do in the next or any six month period. But it is highly probably the stock market will generate very good returns over the next five to ten years. And an investment in stocks now makes a lot of sense at these valuations. I’m still optimistic.

Next week I will be doing another video highlighting why I’m still optimistic about the market using some specific company examples. Stay tuned.

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Posted by Ben Taylor at 01:28 PM |
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Last month I posted and videoed about whether or not we were in a bull market based on five market indicators. I said that one way to tell if we’re in the beginning of a bull market is to try to ascertain whether or not we had seen a bottom. I concluded that we had seen a bottom in the market (November 20th, 752 level in the S&P 500) and that we’re in a new bull market trend. Today I’d like to look at another three:

1. Worst GDP decline in 25 years

On January 30, 2009, the BEA reported that GDP shrank 3.8% in the 4th quarter of 2008 (chart below). This was the worst showing in 25 years. The last time the economy shrank this severely was the 1st quarter of 1982. What did the market do the day these figures came out? It declined 2.2%, falling from 845.1 to 825.9. Not much of a move considering the news.

2. Job losses skyrocketing and unemployment trending toward double digits

February 5, 2009, the Labor Department reported 598,000 were lost bringing the total since the beginning of 2008 to 3.6 million. The unemployment rate went up to 7.6% making it the highest it’s been in decades. What did the market do that day? It went up 2.7% from 845.9 to 868.8.

3. Market price to GDP ratio

Back in 2001, in a Fortune magazine article Warren Buffett presented a chart comparing the total market value of U.S. based business as a percentage of GNP. An update of that chart is presented below. In the article Buffett said, “If the percentage relationship falls to the 70% to 80% area, buying stocks is likely to work very well for you." Currently this ratio sits below 75%.

I compared the market value of U.S. equities using the Wilshire 5000 index which comprises all stocks traded on the major exchanges in the U.S. I then compared it to GDP, a decent proxy for GNP. At the November 20th low, the percentage relationship between the two figures was 64% (Wilshire 5000 = 7.4 trillion and GDP = 11.7 trillion) and by the end of December remained below 80%.

Even if the market breaks through the 800 level, which who knows, it might, I am still on the side of this being a new bull market.

Disclosure: I and the clients of Brick Financial Management, LLC are own shares of iShares S&P 500 Index ETF but positions can change at anytime.

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Posted by Ben Taylor at 12:41 PM |
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Two weeks ago I posted a video on YouTube declaring that I thought we were in the midst of a new bull market. I went on to say, in order to tell if we have entered a new bull market it is best to try and determine if we have seen a market bottom. November 20, 2008 was the day the S&P 500 reached 752. As of January 6, 2009 when the S&P 500 reached 934.7, it represented a 24% advance from the November 20th low. Technically, once an advance of 20% or more is underway that is a new bull market. But in an effort to be thorough, I went through five criteria I look at to determine if we were in fact in a new bull market.

Truthfully, I stole the criteria from Benjamin Graham’s The Intelligent Investor. In the book, Chapter 8, “The Investor and Market Fluctuations”, Graham explains how to recognize market tops. He gives five criteria. I simply turned those criteria on their head and replaced one with another I think is more relevant (at least to me). The criteria were:

1. A significantly low price in the market index.

From Oct. 9, 2007 through Nov. 20, 2008, the S&P 500 declined 52%, making it the third-worst bear market since the 1929-32 crash which saw a decline of 54%. The only other decline more significant than the ones just mentioned was 89% during the Great Depression. Additionally, the calendar year decline of 39% was only surpassed two other times in (1931 and 1937) in over 180 years. In other words the severity of the decline indicates that we are at a significantly low price.

2. A significantly low P/E on the market

At the 752 level, the S&P 500 was trading at a P/E ratio on trailing operating earnings per share of 11.5x. This is equal to the lowest operating P/E ratio in the 20 years that S&P has been tracking operating results and significantly lower than the average operating P/E ratio of 19.3x since 1988.

Another P/E measure is the Graham P/E (named for Benjamin Graham) which uses an inflation adjusted 10-year average for earnings. For the nine previous bear market bottoms the Graham P/E averaged 14.4x. At the 752 level in the S&P 500 the Graham P/E clocked in at 12.3x. This was lower than even markedly low P/Es.

3. High Stock market dividend yields versus relative to long-term bond yields

Dividends paid by Standard & Poor’s 500 Index companies in the 12 months prior to December of 2008 amounted to 3.5% of the benchmark’s closing value yesterday. In early December, the 10-year yield fell as low as 3.4%. Intuitively, stocks should yield more than bonds as they represent the more volatile investment. However since 1958, 10-year notes have yielded on average 3.7% more than stock dividends. The present condition, dividend yields higher than bond yields, serves as an indicator stocks are priced the lowest they have been relative to bonds in 50 years.

4. Low Level of margin accounts

Margin is commonly used in a speculative manner. When the market is rising, buying stocks with borrowed money can and does juice returns. But in a declining market, they can be a death certificate. Margin accounts declined 47% from July of 2007 to November of 2008.

5. High volatility in the market

The best measure of volatility we have today is the CBOE VIX. The VIX, is also called the fear index. When it is high it indicates there is a plethora of panic selling in the market driving prices down. Market prices and the level of the VIX move in opposite directions. Historically, a VIX above 20-25 meant there was a lot of selling. Since the high of October 2007 to date, the VIX has averaged almost 32 and even reached an intraday high approaching 90. Warren Buffett himself even indicated he had never sell panic like this in all his years of investing. Panic selling usually means market bottoms.

Although we have seen the market pull back from the 934 price it reached on January 6^th, it has not dipped below 800 since then. If history is any indicator, we are in the first few days of a new bull market.

Disclosure: I and the clients of Brick Financial Management, LLC are own shares of iShares S&P 500 Index ETF but positions can change at anytime.

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Posted by Ben Taylor at 07:35 PM |
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Articles that appear on The Third Pig occasionally appear on the Seeking Alpha website and are regularly picked up by the general financial media outlets including Yahoo Finance, Reuters and other financial blogs. I have listed some of the latest entries and other locations they can be found:

Asset Allocation in 2009: Best to Go with the Devil You Know at:
Yahoo Finance: http://finance.yahoo.com/q/h?s=SBUX and http://finance.yahoo.com/q/b?s=BRK-A
Fav.or.it: http://fav.or.it/post/953406/asset-allocation-in-2009-best-to-go-with-the-devil-you-know

Coach: Luxury on the Cheap at:
Guru Focus: http://www.gurufocus.com/forum/read.php?2,42620
Fav.or.it: http://fav.or.it/post/929527/coach-luxury-on-the-cheap

Five Things to Be Thankful for in This Market at:
Reuters: http://www.reuters.com/finance/stocks/marketViews?symbol=COH.N
Yahoo Finance: http://finance.yahoo.com/q/b?s=COH&t=2008-12-15T03:55:28-05:00

GM Bailout Would Be Agony For Taxpayers at:
Yahoo Finance: http://biz.yahoo.com/ic/news/330.html?time=1226885400 

Obamanomics and the Stock Market at:
Stock Shoot: http://stockshoot.com/content/view/6602 

Buffett and Cramer Agree: It’s Time to Buy Stocks at:
AOL Finance in the Headlines area: http://finance.aol.com/related/berkshire-hathaway-inc-cl-b/brk.b/NYS?topic=144012971&tab=3 

Greed, When Others Are Fearful, Is Good at:
Wall Street Oasis: http://www.wallstreetoasis.com/newswire/greed-when-others-are-fearful-is-good

If you would like to share some of the above articles with your friends, family or associates just click any one of the icons below for the various websites including ShareThis, Digg.com and Facebook. Here is to a wonderful 2009 in the market.

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Posted by Ben Taylor at 05:28 PM |
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The stock market ended the year of 2008 posting one of its worst annual price performances ever. The Standard & Poor's 500 index dropped 38.5% for the year marking its worst performance since 1937’s 39% drop in the index. In fact it was the first time the index saw a 30% or more drop in price in those 71 years. So if you survived this year, give yourself a pat on the back.

Investors over the past year made many wrong moves, paralyzed by fear, they drove down stock market prices to unreasonable levels. One bright spot is patient investors could invest in stocks very cheaply. Valuation levels had not been at those levels since the early 1980’s. Although the S&P 500 has advanced more than 20% from its low of November 20^th, there remain bargains to be had.  

With so many bargains to choose from, some investors may experience paralysis because of greed. Which stock does one pick? In such an instance, it is best to invoke the spirit of Charles Munger, co-chairman of Berkshire Hathaway. In an Outstanding Investor Digest article some years back Munger was quoted as saying:

“For an ordinary individual, the best thing you already have should be your measuring stick. If the new thing isn’t better than what you already know is available then it hasn’t met your threshold. This screens out 99 percent of what you see.”

Although I picked up a few new positions for myself and my clients’ portfolios, in following Munger’s advice I found that the positions already in the portfolios were of solid companies that were similarly beat down as the market. Every nook and crannie of the market was hurt this year. It couldn't be avoided. And the potential of being hurt further is still present. However, when choosing where to allocate funds, sometimes it is best to go with "the devil you know".

Instead of scouring the investment universe for the new thing, I simply averaged down. The following chart marks the return of a few positions from the beginning of the year to the S&P 500’s low on November 20^th and then the return to the end of the year from that November date compared to the market’s return.

Although as a group the stock of these companies declined to a similar degree as the market, their rebound so far as been nearly 50% greater. Although it is too soon to say, I believe superior companies will bounce back to a greater degree than the average stock. I think this is what we are seeing in the chart above.

Disclosure: I and the clients of Brick Financial Management, LLC owned shares in all the companies mentioned in this post at the time of this writing. But positions may change at any time.

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Posted by Ben Taylor at 06:10 PM |
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The last couple of posts (here and here), I have been listing some things to be thankful for in this market. Here's # 3.

3.     The Inevitable Market Rebound

This bear market has been the most severe we have seen since the decline of 1929. The good news is that we are not likely to see precipitous declines from here. So, although it is impossible to pick the exact bottom, it would be my guess that we are in the “bottom range”. I feel strongly that over the next 3 to 5 years, the market will be much much higher. And according to the data below, most of that recovery will come in the first few days and months.

On average, using the last nine bear/bull markets as a proxy, 87% of the S&P 500’s high has been recovered in the first year of the market bottom. On average, all of the prior high, and then some [122%], has been recovered by the second year. This is represented in the following chart [click image for larger view]:

For example, on August 25, 1987 (light blue highlight) the S&P 500 reached a high of 336.77. Then it began a drop over the next three months, which included the infamous Black Monday when the market dropped more than 20% in one day, and by December 4, 1987 the market had fallen to 223.92, representing a 34% drop over that period and a loss of 112.85 points off the index. However, within one year of the bottom, the market had returned to 277.59, rebounding 53.67 points, a 24% return, from the bottom and recovering 48% of the loss of the previous high. By the second year, the market had stood at 348.55, recovering a full 110% of the previous high of 336.77.

In fact, in most instances, you will recover a full third of what you’ve lost in the first 40 days into a new bull market. Buy and hold is not dead. No one can time the market so it pays to stay fully invested even in times of uncertainty.

Disclosure: I and the clients of Brick Financial Managment, LLC hold positions in iShares S&P 500 Index ETF (IVV) and ProShares Short S&P 500 Index ETF (SH) but positions may change at any time.

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Posted by Ben Taylor at 05:10 PM |
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Many of us may find it hard to be thankful for much in this economy, especially when it comes to our portfolios. From its October 9, 2007 peak of 1565.1, the S&P 500 has been down as much as 52% hitting 752.44 on November 20, 2008. But every cloud has a silver lining. The other day I decided to list a few things to list a few things to be thankful for in this, and most bear markets. Here's #2.

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Posted by Ben Taylor at 12:56 PM |
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Buffett’s Detractors
Warren Buffett has had his share of detractors since his New York Times Op-Ed piece in which he announced he would be buying American stocks in his personal account. According to Buffett, “…fears regarding the long-term prosperity of the nation’s many sound companies make no sense… But most major companies will be setting new profit records 5, 10 and 20 years from now.”  

The crux of the detracting argument is Buffett’s call is untimely, he is too rich to worry about asset allocation or time horizons and you, we are not him. Dianne Francis of Canada’s National Post sums up this viewpoint:

"…guys like Warren Buffett also operate in a parallel universe of Cash-Rich, Long-Term, Value Investing. He’s making big bets on American stocks. We should not for lots of reasons. He's just plain wrong and I wrote about that yesterday. The stock markets are not capable of being a valid pricing mechanism for anyone for some time. Besides that every day brings more bad news, and new developments.”

Seems to me the detractors have cherry-picked certain lines from Buffett’s piece. Buffett in no way suggested the near term picture would be pretty. In the near term, markets are likely to continue their record breaking volatility and investors may suffer yet more loses. Buffett wrote,

• “In the near term, unemployment will rise, business activity will falter and headlines will continue to be scary.”
• “To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions.”
  
• “…businesses will indeed suffer earnings hiccups, as they always have.”
  
• “Let me be clear on one point: I can’t predict the short-term movements of the stock market.”

But Buffett’s qualifying statements are beside the point. His overall point was clearly missed or ignored - due to the widespread fear in the marketplace, stocks of strong businesses are cheap. And, in the long term, these businesses are likely to grow through economic booms and busts. Since, in the long term, stock prices are highly correlative to the performance of businesses, it makes sense to buy when the prices of stocks are below the value of the underlying businesses. That time, according to Buffett, is now.

The Typical Investor Buys High and Sells Low
Buffett goes on to point out the resiliency of the market. He also emphasizes most investors’ uncanny ability to miss out on those gains because of their tendency to buy when they are comfortable (at market tops) and sell when they are fearful (at market bottoms). To underscore Buffett’s point, consider the following:

Research conducted by DALBAR, Inc shows for the 20-year period ending December 31, 2007, the typical mutual fund investor failed to capture the returns of the market. Although the average mutual fund trailed the market by about 2.5%, during this 20-year period, the typical mutual fund investor received a return of 4.48% while the market returned 11.82%. In fact, the investors’ returns were barely above the rate of inflation which clocked in at 3.04% during the period. 

The disappointing results received by equity investors is totally due to the manic depressive buying and selling described by Buffett. As the chart below demonstrates, investors sell their mutual fund shares [demonstrated by the downward blue bars] just when market performance deteriorates [demonstrated by the orange line in negative territory].
 

When Ms. Francis suggests the market is a “valid pricing mechanism” she demonstrates, as do her fellow Buffett detractors, she does not understand that price and value are not the same. In the short term, stocks markets are never valid pricing mechanisms. Investors who believe otherwise allow their emotions to dictate their investment timing, a sure way to diminish investment results as the chart/table above demonstrate.

“Adding many converts to the value approach will perforce narrow the spreads between price and value. I can only tell you that the secret has been out for 50 years [now over 75 years], ever since Ben Graham and David Dodd wrote Security Analysis, yet I have seen no trend toward value investing in the 35 years I have practiced it. There seems some perverse human characteristic that likes to make easy things difficult… There will continue to be discrepancies between price and value in the marketplace, and those who read their Graham and Dodd will continue to prosper.”

I’ll be re-reading my Graham and Dodd.
 

Disclosure: none

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Posted by Ben Taylor at 04:49 PM |
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Warren Buffett, Letter To Shareholders 2009 Berkshire Hathaway Annual Report

"...neither Charlie Munger, my partner in running Berkshire, nor I can predict the winning and losing years in advance. (In our usual opinionated view, we don’t think anyone else can either.) We’re certain, for example, that the economy will be in shambles throughout 2009 – and, for that matter, probably well beyond – but that conclusion does not tell us whether the stock market will rise or fall."

Benjamin Graham, The Intelligent Investor

"Nearly all bull markets had a number of well-defined characteristics in common, such as (1) a historically high price level, (2) high price/earnings ratios, (2) low dividend yields against bond yields, (4) much speculation on margin, and (5) many offerings of new common-stock issues of poor quality. Thus to the student of stock-market history it appeared that the intelligent investor should have been able to identify the recurrent bear and bull markets, to buy in the former and sell in the latter... "

Graham went on to say that there have been sufficient variations in market cycles to make rendering identifying the exact high and the exact low of the market. Thus, as Graham puts it,

But it seem unrealistic to us (he and David Dodd) for the investor to endeavor to... wait for demonstrable bear-market levels before buying any common stocks."

Jeremy Grantham,

On November 20, 2008 Grantham published a short quip on the market. His firm (GMO) gave it's forcasts for the next 7 year period beginning October 31, 2008 when the S&P stood at xxx.

As told to James Montier, of SG Securities. "If stocks look attractive and you don't buy them and they run away, you don't just look like an idiot, you are an idiot."

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Posted by Ben Taylor at 02:40 PM |
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