S&P 500 Index Reaches 1,500 Again: A Multi-Decade Triple Top

spx-16year

If you are thinking we have seen this level on the S&P 500 index before, you are absolutely correct. As you can see, the last 16 years or so has been a roller coaster ride, with three separate bull runs to around these levels, and the prior two have ended badly thanks to bubbles bursting (dot-coms in 2000-2001, housing in 2008-2009). So do you want the good news first or the bad news?

The bad news is pretty evident from the chart. We have reached a triple top and U.S. stocks have now risen 125% from their lows made in March 2009. That is a huge move in just the last four years. It warrants being cautious in the short term, as the market does feel overbought here.

The good news is actually pretty good though. At the March 2000 peak of the dot-com bubble, the S&P 500 reached 1,553 and the index components earned $56 in profits. P/E ratio: 28 (the highest ever recorded). Students of market history should have realized that stocks were dramatically overvalued. (Author’s note: As a college sophomore at the time, I was less than well-versed in market history, so it was the beginning of my history lesson, and a very good one at that).

At the 2007 peak of the housing bubble, the S&P 500 once again pierced the 1,500 level, topping out at 1,576. Earnings for the index hit $88, giving the market a P/E ratio of 18. That is still a high valuation, but rather than being unprecedented, the market was simply at the top end of its historical valuation range. Dangerous, yes, but not unheard of.

You can see where I am going with this. Today the S&P 500 sits at 1,502 and 2012 earnings are likely to come in around $100. That P/E ratio (15) is only slightly above the long-term median of 14. So the U.S. stock market is not materially overvalued as it was in both 2000 (by a large margin) and in 2007 (by a smaller margin). Now, that does not mean we cannot see stock prices fall meaningfully from these levels. After all, P/E ratios aren’t everything (despite the dot-com bubble being far more dramatic in terms of overvaluation, the market actually fell more after the 2007 peak because the economic shock was larger), but U.S. corporations are now earning enough in profits to justify the S&P 500 trading at 1,500, especially compared with the two prior peaks on this long-term chart.

My takeaway: it makes sense to be cautious, but not alarmed.

The Most Entertaining CNBC Segment Ever: Ackman vs Icahn

Yeah, I don’t think they like each other. It’s rare that two hedge fund titans are on the opposite side of such a controversial trade (Herbalife HLF) and in this case the result is an on-air feud. If you have any interest or follow Ackman, Icahn, Herbalife, and/or activist hedge funds, you might find this as entertaining as I, and many others in the industry, did on Friday when this altercation unfolded live on CNBC.

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CNBC: Ackman vs Icahn 01/25/13 (27 min 39 sec)

A Challenging Global Outlook for the Next 50 Years

The above is never something I would venture to take a stab at, but GMO’s Jeremy Grantham has made a name for himself by making bold predictions about the future. His latest quarterly letter, entitled “On the Road to Zero Growth” is one of his best, in my opinion. A highly recommended read if you are interested in a 16-page article characterized by a lot of economic jargon. Granted, it makes a lot of sense and was written by someone who has been right an awful lot over his multi-decade investment career. Just thought I would share the link. Enjoy!

Let’s Face It, Given All That Has Happened Lately, A Market Correction Makes Sense

In a few short days I leave town for a two-week vacation (interesting timing I know, but it has been planned for months and therefore not market-related) but before I leave these volatile markets behind for some refreshing time away I think a few comments are in order. As I write this the Dow is down 400 points to below 11,500 and the S&P 500 index has now dropped 11% from its 2011 high. In the days of computer-driven trading stock market moves are more pronounced and happen faster than ever before, so it is important to keep things in perspective.

First, given everything that has happened in Europe this year, coupled with our own ugly debt ceiling political debate in Washington DC, it is completely reasonable to have a stock market correction. I would even go a step further and say it was a bit odd that the market held up so well prior to last week’s debt ceiling dealings. Historically the U.S. stock market has corrected (by 10% or more) about once per year. The last one we had was a 17% drop in 2010 during the initial Greece debt woes. That we have another one now in 2011 is not only predictable based on history, but especially when we factor in everything going on lately financially, economically, and politically. Let’s keep the market swoon of the last week or two in context.

From an economic standpoint, investors need to realize we really are in a new paradigm. The U.S. economy was goosed up by debt, both at the consumer level (credit bubble) and at the government level (tax cuts along with increased spending). As a result, we have to see both groups de-lever their balance sheets. Consumers are reducing debt and saving more, and many don’t have jobs. The government is now beginning to cut back as well. Consumer spending represents 70% of U.S. GDP and government spending, at $3.6 trillion per year, makes up another 25%. Corporations are the only bright spot in today’s landscape, with record earnings and stellar balance sheets, but their spending is only the remaining 5% of GDP. With both consumers and government agencies cutting back, a slowing economy and lackluster job growth are all but assured.

So are we headed back into a late 2008, early 2009 situation for both the economy and financial markets? While anything is possible, we probably should not make such an assumption. A slowing economy (say, 1-2% GDP growth) is far better than what we had at the depths of the financial crisis with 700,000 jobs being lost per month, negative GDP of several percentage points, and runs on the country’s largest banks. The 2008-2009 time period did not reflect a normal recession (which would last 6-9 months and be relatively mild). It was far worse this time and those events typically only happen once per generation, not once every few years.

The best case scenario short term is that the markets calm down and we meander along with 1-2% growth. Not good, but not horrific either. Could we slip back into a garden-variety recession due to government cutbacks, 9% unemployment, and a deteriorating economy in Europe? Sure, but that would likely result in a more typical 20% stock market decline over several quarters, not a 50-60% drubbing. And keep in mind we are already down 11% in a few short trading sessions.

What does this mean for the stock market longer term? Well, believe it or not, there are reasons for optimism once investors calm down and we really get a sense of what we are dealing with. With slow economic growth interest rates are going to stay near all-time lows. Buyers of government bonds today are accepting 2.5% per year in interest for a 10-year bond. Savings accounts pay 1% if you are lucky. The S&P 500 stock index pays a 2% dividend and many stocks pay 3% or more. Given the financial backdrop for U.S. corporations relative to the U.S. government, which do you think is a better investment; lending the government money for 10 years at 2.5% or buying McDonalds stock and collecting a 2.9% annual dividend? Investment capital will find its way to the best opportunities and even with slow growth along with the possibility of a double-dip recession, U.S. stocks will look attractive relative to other asset classes.

As a result, I think there are reasons to believe the current market correction is going to wind up being much more normal than the 2008-2009 period. With interest rates and government finances where they are, equity prices can easily justify a 12-14 P/E ratio. Maybe stock market players before the last week or two were just hoping we could escape all of this unscathed, despite the fact that market history shows that is rarely the case. In any event, while I am looking forward to spending some time away from the markets, I am not overly concerned about this week’s market action, especially in the context of global events lately. My hope is that by the time I return markets have calmed down and we can revisit how to play the upcoming 2012 presidential election cycle, even though that thought alone makes me want to take far more than two weeks off. 🙂

 

Biglari Holdings: You Can’t Be Serious!

This week marked the first time in my investing career that I have felt the need to write to the management team of a publicly traded company. Not only that, but I even surprised myself a little bit by actually going ahead and doing it. After reading a corporate press release from Biglari Holdings on Tuesday morning, I was absolutely irate. What could make me so upset that I actually wrote a two page letter and mailed it off to the CEO, despite the fact that collectively my clients and I own about 0.005% of the company’s stock?

Biglari Holdings announced this week that it was planning to reverse split its stock (which was already trading above $450 per share) 1-for-15, which would send the price up to nearly $7,000 per share and reduce the total shares outstanding to less than 100,000. The end result (other than an insanely expensive stock) is that anyone with fewer than 15 shares of the company (again, nearly $7,000 worth) would be forced to accept cash in return for liquidating their investment. That’s right, the company was forcing its smaller shareholders to sell and they had no say in the matter. At least if you own stock in a company that has agreed to a merger you can vote “yes” or “no” to the deal.

To my knowledge, I don’t know of any other company that has ever had the audacity to force its shareholders to sell all of their stock. And since all but two of my clients who are invested in Biglari Holdings own fewer than 15 shares (myself included) I just had to speak up, even though it clearly won’t matter to the company what I think. Still, if there was ever a time that small shareholders should complain to management, I have to think this would be that time.

Rather than post the letter on this blog, I chose to submit it for publication on a larger site (Seeking Alpha) with the hope that other upset shareholders might join me in voicing their discontent. A copy of the letter can be read here: An Open Letter to Sardar Biglari, CEO of Biglari Holdings.



Record Corporate Earnings Continue to Fuel Stocks, Analysts Optimistic for 2011

According to financial data collected by Thomson Reuters, 70% of S&P 500 index companies have reported third quarter profits so far and earnings are up 30% year-over-year. This compares to estimates of just 24% growth and explains why the U.S. equity market is knocking on the door of the 2010 highs made back in April. For all of the pundits complaining that Washington DC politicians have been bashing Corporate America too much, aggregate corporate profits are actually making new record highs (second quarter earnings were an all-time record) so we have to wonder exactly how tough companies really have it these days.

As we head into 2011 analysts are expecting corporate profits to keep surging, by about 13% next year. With P/E multiples about average historically, the strength of earnings will likely dictate much of market’s movement in 2011. Analysts notoriously overestimate profit growth (by a factor of nearly 2x over the long term according to studies done by McKinsey), so once again they are very optimistic about the coming year (corporate profits grow about 6% per year over long periods of time). As is usually the case, the numbers are telling a better story of reality than political and private sector commentators, which is why the market is doing pretty well despite 9.6% unemployment.

To gauge market prospects for next year, investors should continue to look at the numbers and ignore the posturing in the media and on the campaign trail. As things stand now, I would expect another gain for the U.S. equity market in 2011, but the magnitude will depend on whether the analysts are right or once again overly optimistic. That could be the difference between single digit and double digit returns over the next 12-15 months for stocks.

And on a somewhat related note, don’t forget to get out and vote tomorrow.

S&P 500 Index: Soon To Be The Cheapest Since 1989

The recent swoon in the U.S. stock market has gotten to a point where there are plenty of values to be found for those investors willing to ignore the near-term headlines and negative sentiment. In fact, if things stay where they are for the next quarter or two, the S&P 500 index will be the cheapest it has been in more than 20 years (based on the current 2010 earnings estimate for the index of nearly $82). Below is a chart of the S&P 500’s trailing P/E ratio from December 31, 1988 through December 31, 2010 (the P/E for the next six months is an estimate based on current consensus profit expectation, assuming the market stays at today’s level).

Source: Standard and Poor’s Data

As of today we are at a P/E of about 14 (on this chart, the second to last notch on the x-axis). Assuming stock prices and earnings estimates remain where they are, the U.S. market would end 2010 at its cheapest level since 1989 (12.5 times trailing earnings). I know the headlines have been bleak over the last eight weeks or so, but stocks are quite cheap, especially given low interest rates and tame inflation.

If earnings season is pretty good this quarter (including in-line guidance for the second half of the year), as I expect it to be, I will very likely allocate some additional portfolio cash into the equity market. Although the market chatter is centered around the increased odds of a double-dip recession, it is important to note (as was pointed out on CNBC just this morning) that we have seen only 3 double-dip recessions over the last 150 years. Does that mean it is impossible we could get a fourth? Of course not, it just makes it probably a lot less likely than the U.S. equity market is currently indicating.

WSJ: U.S. Corporations Sitting on Stellar Balance Sheets

From the Wall Street Journal:

“The Federal Reserve reported Thursday that non-financial companies had socked away $1.84 trillion in cash and other liquid assets as of the end of March, up 26% from a year earlier and the largest increase on records going back to 1952. Cash made up about 7% of all company assets including factories and financial investments, the highest level since 1963.”

The strongest balance sheet backdrop for Corporate America in nearly 50 years can only be a positive for the U.S. stock market. Extra cash for strategic mergers, share repurchases, and dividend payouts can help boost stock prices until businesses become confident enough to invest money back into their own asset bases. The latter likely won’t occur until some of the bearish headlines of recent weeks subside. Among the important ones I would highlight, in order of potential resolution, would be the financial regulation bill going through Congress, the Goldman Sachs fraud case brought by the SEC, and the Gulf of Mexico oil spill. Second quarter earnings will likely be quite strong, but the headline risk is trumping fundamentals for the time being.

Rather than Panic About Greece and the Euro, Make a Shopping List

I have been holding double-digit cash positions in most equity client accounts for much of 2010 and this week I began allocating some of that cash back into the market. We finally got a 10% correction, after more than a year without one. The market seems to be obsessed with Europe and the Euro exchange rate right now, but honestly we have to keep things in perspective. Most U.S. companies (excluding the large multinationals of course) are not going to be directly impacted by troubles in Greece and neighboring areas. The entire country of Greece has the same population as the state of Ohio, so that really keeps things in perspective, for me anyway.

Accordingly, I do think U.S. stock prices have come down enough in recent weeks to warrant some bargain hunting. I invested about half of my clients’ cash balances this week. It is quite conceivable that the market tests the intra-day low reached on the crazy flash trading/1,000 down day earlier this month (1,065 on the S&P 500) and finds some support there. The sentiment is pretty ugly right now, so although I am still keeping some cash onhand in case of further weakness, I do think it is time to nibble at good values.

My suggestion for investors who share those feelings would be to make a shopping list. Come up with a handful of stocks you would like to own and pick a price that you really feel good about. As the market gyrates, you may be surprised which companies you can grab at very attractive price points. If you are a long term investor, try not to panic. There really are some great deals out there right now, as the S&P 500 has fallen below 1,100 and into correction territory.

What Can Happen When Markets Are Run By Computers? Stock Trading Might Go Nuts Like Today!

This afternoon the U.S. stock market went bananas and I decided to sit down in front of the television, watch, and enjoy myself. When the entire market is run mostly by computers, not only can traders control the minute by minute action but they can even set the computer up so that once certain price levels are reached, their trades get executed automatically, so actual human action is not even necessary. What happens when the computers are overloaded or someone makes a mistake? Well, watch this short segment from CNBC and see how the Dow Jones can drop 500 points and then make it all back in less than five minutes.

This is why many people think short-term trading in the market is nothing more than gambling. Literally anything can happen on any single day, in a single hour or minute, or in this case, a few seconds. Market watchers will tell you to use limit orders as a way to specify your exact desired buy and sell prices to avoid getting taken to the cleaners when markets react violently like this.

The problem with that, of course, is that your order may hit in a moment of panic, and had you known that was happening, you never would have made the trade. Imagine if you came home today to learn that you sold 100 shares of Proctor and Gamble at $50 (a limit order you had set) because it traded there for a brief second based on computer malfunction, but rebounded to $61 within seconds. You would be furious. Limit orders are not always the answer. Investors, especially those who are novices, need to be very careful. As we saw today, the market can be a landmine.