Statistical Shocker: S&P 500 Performs Best When Economy is Shrinking

Impossible, right? As a money manager I spend a decent amount of time explaining to clients, readers, family, and friends that the stock market does not mirror the economy in real time. Just because the unemployment rate is 9.5% and GDP growth is decelerating does not mean that the stock market is a poor investment option. Stock market returns and GDP growth simply do not track each other, and as a result, reading economic reports will not help you figure out where stock prices are headed.

As always, I try to present numbers to people so they do not simply have to take my word for it. In today’s world of media sound bytes and political maneuvering Americans all too often repeat something they heard from one of their favorite media or political pundits as if it was fact, even when a tiny bit of research can disprove the claim.

In order to show that stock market movements do not mimic the economy, I decided to compile data from 1958 (the first full year the S&P 500 index was published) through 2009. While I had no idea what the actual numbers would be, I was confident they would show that stocks and the economy shared a very low correlation. Sure enough, the results were even surprising to me. It turns out that the S&P 500 has performed best when GDP growth is actually negative (i.e. when the economy is in a recession). Since 1958 there have been 7 years when U.S. GDP shrank and the S&P 500 gained an average of 24% per year during those periods. Pretty interesting, right?

Here is the full data set. I divided economic growth into 4 subsets (negative, zero to 3%, 3 to 5%, and above 5%).

As you can see, there is very little correlation between the economy and the stock market. Not only that, investors choosing to own stocks only in years with negative GDP growth would have earned nearly 4 times as much than investors choosing to invest only when GDP was growing at 5% or better. So the next time someone tells you the market is going to drop because the economy is bad or unemployment is high, send them a link to this blog post.

GM Buys Subprime Lender for $3.5B (Some Companies Just Never Learn)

Just when I thought General Motors was on solid footing and heading in the right direction after shedding a large portion of its liabilities in bankruptcy, they seem to have forgotten what has happened over the last several years in the world of credit. One of the big reasons GM’s losses were compounded during the recession was because they funded a lot of subprime loans for their vehicles through GMAC. When those loans went sour, the losses not only negated the razor thin margins they had on the vehicle sales themselves, but resulted in a company that lost money on most of their cars. Hence, SUVs (with their fat profit margins) became a focus for the company, even in the face of rising gas prices, which aided their competitors in stealing market share.

Since GM has exited bankruptcy and the economy has stabilized management has stated publicly a desire to once again expand into the subprime auto finance market, but this time GMAC was hesitant (and understandably so). Undoubtedly, the result has been that GM could be selling more vehicles if they were willing to finance customers with bad credit who could not get loans elsewhere. This morning we learn that for $3.5 billion in cash GM is buying AmeriCredit (ACF), one of the larger subprime lenders in the country. They will use this new financing arm to get more cars into the hands of more people, many of whom could not get loans from third party lenders due to bad credit, no job, etc.

While I am sure those in the industry will praise this deal as a way for GM to maximize unit sales, we need not completely forget how cyclical economies work. Subprime lending pays off when the economy is improving but when the business cycle inevitably turns (as every economy does), the loans turn sour, the losses are crushing, and the cycle starts all over again. To me this highlights one of the core problems our domestic economy has developed over the last 10 or 20 years. We continue to follow the path of loose credit when things are going great and at the first sign of a downturn, credit standards increase dramatically. Once things stabilize, we hear that banks are slowly reducing their standards and loan volumes increase again.

For the life of me I cannot figure out why banks and specialty lenders refuse to maintain the same lending standards throughout the entire business cycle. The idea that lending money to people who are likely to default is good business sometimes and bad business other times baffles me. Sure, the few banks that always make smart loans, despite the economic backdrop, make a little less profit during boom times, but they also weather the recessions quite well in return for such prudence.

This kind of cyclical lending activity from the likes of GM (and most others) only contributes to the boom and bust economy the United States has seen become even more pronounced over the last decade. Fortunately, GM is set to go public via an IPO sometime in the next 12 months, at which time the U.S. taxpayer can shed its majority ownership in GM and therefore no longer be in the subprime lending business.

Update (9:15am)

Here is a 15-year chart of AmeriCredit’s stock price which puts into graphical form the cyclicality I mentioned above.

Full Disclosure: No position in AmeriCredit at the time of writing, but positions may change at any time.

Motorola Continues Questionable Turnaround Strategy

Despite heavy competition that seems to get more fierce by the day, Motorola took another step Monday to increase their exposure to the mobile phone market. In order to raise the cash needed to reinvest in their mobile device division, which made up 32% of overall company revenue in 2009, Motorola is selling a large piece of its network equipment division to Nokia Siemens Networks for $1.2 billion in cash. The assets, which account for 17% of revenue, will add about $0.50 per share in cash to the company’s coffers and boost the mobile device business ($7 billion annually) to 39% of company sales, as total sales will drop from $22 billion to about $18 billion after the divestiture.

I continue to find this turnaround strategy less than exciting from an investor standpoint. Motorola is essentially divesting itself of a slower growth business despite a strong market position and stable cash flow in an effort to reduce the diversity of the company’s business lines. If the mobile device market was not so competitive, Motorola had a better leadership position already, and/or the profit margins on cell phones were higher than its other divisions, I might think such a move was smart. However, we have seen how difficult it is to make a lot of money selling mobile phones. In order for this transformation to work for investors, Motorola has to somehow figure out a way to steal consumer subscribers from Apple and corporate customers from RIM, which seems like a very difficult task (not to mention strong second tier players such as HTC, Samsung, LG, and perhaps HP/Palm).

From an investment perspective, buyers of Motorola today have to want to get exposure to their mobile business (think Droid, etc). While their new products in this space are undoubtedly pretty solid offerings, without significant market share gains in the market going forward, I do not see Motorola really boosting their underlying profitability with this turnaround plan. Not only that, but with plans to split the company up into two pieces early next year (mobile devices/home and enterprise), Motorola is going to live and die by the mobile business even more as time goes on.

Meanwhile, the company does not appear to be getting top dollar for their other businesses. This latest deal has them giving up 17% of their company’s sales in return for about 50 cents per share in cash (which is only about 6% of their market value). At that rate, the entire company would only be worth about $3 per share (the stock spiked up to around $8 yesterday on the news of the sale).

Now, the company would make the argument that the networks business they are selling was a drag on their valuation (as the least desirable part of their company), but the numbers seem to tell another story. Motorola had previously contemplated selling their entire home and networks business (~$10 billion in sales) for between $4 and $5 billion. They abandoned that plan and sold only the wireless network part ($3.7 billion in sales) for $1.2 billion, due in part to a lack of interest at the price they were asking.

All in all, with a market value of $18 billion Motorola better figure out a way to turn their mobile phone business into a consistent money maker, as the company is selling off a lot of their profitable divisions to focus on the one business line that is losing money. Based on how the mobile phone market has played out in the last few years, Motorola has a tall task ahead of them, and shareholders should be wary.

Full Disclosure: Long Apple and RIM, and no position in MOT, at the time of writing, but positions may change at any time.

BP, Goldman Sachs, Google, and FinReg… What a Day!

Today is the kind of day that investment managers such as myself love; lots of resolutions on multiple issues that have been holding back certain companies, stocks, and industries. Let me tackle each one briefly.

BP: While it is nice to see the ruptured well capped without any oil spewing out, we have to keep things in perspective. This is a test, this is only a test. The well has been capped for only a couple of hours and leaks could still surface, not to mention the fact that the pressure could further damage the well. Hopefully the relief wells can be paired with this latest cap to finally put a stop to the oil leak, but it is too early to say and the rally in BP shares today (up 3 points) will easily vanish if any issues arise.

Goldman Sachs: News of a $550 million settlement with the SEC is great news for investors. Most were assuming a $1 billion fine to ensure they avoided a fraud charge but it came in at half that amount. Goldman reports earnings Tuesday and the numbers have been ratcheted down a lot due to a weak trading environment early in the second quarter. With the bar set so low, they could surprise on the upside, but the stock is getting a nice bump from the SEC deal, so any further move higher may take some time to develop. I still see GS as the premier firm in the space and earnings should climb back later in the year, which is why I will still be holding the stock for clients.

Google: The stock is down after revenue for the second quarter came in a bit higher than estimates but profits fell short on higher expenses. The company is back in acquisitive mode so free cash flow is on the decline. Without a new, clear growth engine (I am not convinced yet that Android app sales will fit the bill, but they are promising) I would not be willing to pay a premium for the stock. With 2011 earnings estimates around $31-$32, putting a 15 P/E on that gets you to $475 per share, right where the stock is trading after-hours. Color me neutral at these levels.

FinReg: Now that this bill has passed the Senate, we can finally stop hearing about it so much. The banks will see their margins on certain financial products squeezed temporarily (overdraft protection, for instance, is now opt-in, not automatic), but banks will always find ways to recoup the lost income in other ways (free checking accounts, for instance, may become less common in the future). The negative talk today was that the banks and investors are worried because the bill gives regulators a lot of power in forming new rules and this adds to uncertainty. This argument baffles me. Regulators already have the power to make new rules to deal with issues they discover in the marketplace. The bill gives regulators oversight over a few more areas of the financial services industry, but the idea that giving them the power to make rules is a new and overly aggressive idea is simply wrong. That has always been the role of regulators! Now we just need them to do their job, and frankly, that is the part that always seems to let the American people down. I have no reason to think anything will be different this time around.

Full Disclosure: Long shares of BP and GS at the time of writing, but positions may change at any time.

Contrarian Statistic: Credit Card Delinquencies Drop to 8-Year Low!?


“The number of consumers behind on their credit card payments fell to an eight-year low in the first quarter of 2010, the American Bankers Association said Wednesday. Overall, delinquencies across a wide-range of consumer debt categories have also fallen. High unemployment and plummeting home values during the financial meltdown appear to have spurred consumers to shore up their finances and banks to limit their lending, resulting in fewer Americans being late with payments, the industry group said. About 3.88% of bank credit card accounts were past due by 30 days or more in the first quarter of the year — the first time since 2002 that the rate has fallen below 4%, the ABA said Wednesday.”

As a contrarian investor I always find these kinds of figures interesting because people often do the opposite of what they should be doing (as is often the case when they make stock decisions). Common sense would dictate to many people that when the economy gets rough outstanding consumer credit would increase, as would delinquency rates, and when the economy is doing well people would use their additional wealth to pay off debt.

In reality, however, historical data shows the opposite, as this story does. When times are tough and they have less money consumers choose to repay debt faster. Conversely, they pile up debt when times are good even though that is when they actually have the money to pay cash! Very odd, but not at odds with other data that has shown that consumers and investors often do the opposite of what might be considered obvious to many (such as buying more stock after a price decline and selling shares into a significant rally).

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.