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.

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).

AutoZone: Ripe for Investment at the Right Price

In today’s economic and financial market climate investors have to balance a stock market that is no longer cheap and an economy that has obvious structural damage. The consensus has concluded that below-average economic growth and employment could be with us for at least several more years. Given such circumstances we must be even more careful than usual in selecting companies to invest in.

In my mind, there are four things investors should look for when choosing new investments today. The first, valuation, is the obvious one for me as a value investor. No matter how much you like the story behind a stock, if you do not pay a fair price, the odds are stacked against you if you are trying to beat the market.

With so many economic headwinds, however, investors are likely to find their fair share of inexpensive stocks. Three other factors that I think are important, in no particular order, are:

1. A predictable and stable business outlook

There is no doubt that we are currently experiencing a fragile economic recovery. Any numbers of things could reverse the trend of the last several quarters and undo much of the progress that has been made. As a result, investors should focus on businesses where the outlook is predictable and relatively stable. This will make it fairly unimportant if GDP grows by a lot, a little, or not at all.

2. A strong market position that faces very few, if any, competitive threats in the near to intermediate term

A predictable and stable overall business outlook is great, but if a particular company is unable to successfully navigate and compete in that business, it could still falter. Not only must end demand be predictable, but the company’s own market position within that market is crucial as well.

3. Company management needs to put shareholders’ interests first

Unfortunately, this does not happen as often as it should (which is all of the time). Corporate executives routinely flush capital down the toilet at the expense of shareholders. They seem to all too often forget that they are working for the shareholders, not themselves or their cozy boards of directors. Management teams should have a clear focus on creating shareholder value and have a strong track record of putting shareholders first, ahead of themselves.

A company that I believe fits all of these criteria, and therefore would make an excellent investment in the current economic climate (at the right price, of course), is AutoZone (AZO), the large automobile parts retailer.

In this case, both the industry (automotive repair and maintenance), and the company (one of the largest and most profitable auto parts retailers in the country) epitomize stable and predictable businesses. The auto parts industry is largely non-cyclical, as cars need to be maintained no matter what the economy is doing.

Some may even argue that a weak economy bodes well for auto parts retailers because as new car sales decline, demand should rise for parts needed to keep older cars on the road longer. This is certainly a strong argument, and an incremental positive for the story, but even so AutoZone and their competitors have not seen any meaningful cyclical upswing in sales as the economy has struggled, and I would not expect one to occur going forward.

In addition, AutoZone has a very strong market position (more than 4,000 stores in the U.S. alone) and there is little in the way of new competition in the pipeline. One of the effects of the recession was a dramatic reduction in retail-related new construction and expansion, which had become a staple during the credit bubble.

The most enticing part of the AutoZone story for investors, however, is the shareholder-friendly nature of the company’s management team. Not only does management run a very tight and efficient operation (operating margins for the last fiscal year were 17% — very high for a retailer), but they allocate capital very intelligently.

Unlike some managers who crave growth, AutoZone has grown its store base meagerly in recent years, as it realizes that its industry is mature and population growth and some pricing power are the only real drivers of sales. The company is quite pleased growing sales in the low to mid single digits each year, rather than expanding too much, cannibalizing existing stores, and earning sub-par returns on its capital.

Where does this excess cash flow go? Mostly to share repurchases, which directly translates into value creation for shareholders. In fact, during the last decade AutoZone used free cash flow to buy back huge amounts of stock. Entering fiscal 2000, the company had 150 million shares outstanding. By the end of fiscal 2009 that number had been cut by two-thirds to an astonishing 51 million. Not surprisingly, AutoZone’s share price rose from $24 to $147 during that decade, for a gain of more than 500%.

Too many times managers and investors equate growth with stock price returns, but AutoZone is a perfect example of how you can create massive amounts of  shareholder value without rapid expansion. The company can generate strong double digit earnings growth, while only growing sales in the low to mid single digits, if it allocates capital in shareholder friendly ways. During fiscal 2009 AutoZone’s revenue grew by less than 7% but earnings per share rose by nearly 20%, largely due to an aggressive stock buyback program.

There is no doubt that the company is a strong investment candidate, especially in the current macroeconomic environment. As is always the case, however, investors need to make sure they pay the right price.

Full Disclosure: Peridot Capital was long AutoZone at the time of writing, but positions may change at any time

Chad Brand Interviewed on “Behind The Spread”

I recently did an interview with the investment site “Behind The Spread” which focused on learning about the backgrounds of various investment professionals.  They are interviewing the genius investors on KaChing and it was my turn in line. If you would like to learn a bit more about me and my investment philosophy, you can check out the Q&A here:

Chad Brand interview on “Behind The Spread”

Do Not Be Fooled, Earnings (Not Sales) Are What Truly Matter

The U.S. stock market has rallied six percent so far this week after second quarter earnings have thus far boosted investor confidence. The four large companies getting the most attention this week have all surpassed estimates (Goldman Sachs, Intel, Johnson and Johnson, and Yum Brands).

It is hard to paint these results with anything but a positive brush, but that has not stopped many commentators from trying to throw cold water on the initial set of earnings reports. Their core argument (which we hear all the time from the bears and really frustrates me) is that while earnings have been solid, sales have been uninspiring. “You can’t cut your way to prosperity” they say, alluding to the fact that cost cuts are helping U.S. companies exceed consensus profit expectations.

I roll my eyes when I hear this logic because sales are pretty much irrelevent when valuing equities. Shareholders own a proportional claim on a company’s future profits, not sales. Heck, if sales were all that mattered, the dot com bubble never would have burst and shareholders of would still be rich. The Internet bubble popped because selling dollar bills for ninety cents is not a sustainable business model. You might be able to rack up some serious sales growth that way, but the business will not survive.

Now, I do not disagree with the notion that sales have been lackluster. After all, we are in a recession so anything but weak sales would be a real surprise. Just remember that stock prices are based on earnings, not sales. As a result, if the companies I own can boost profits by cost cutting while the economy is in decline, that is fine by me. Once the recession ends, we will have plenty of time for sales growth to impress everyone.

“Buy and Hold” Doesn’t Work If You Completely Ignore Valuation

The current bear market resulted in the first negative ten-year period for the U.S. stock market in a long time. This has prompted many people to declare that the investment strategy of buying and holding stocks for the long term (“buy and “hold” for short) is all of the sudden “dead” or no longer viable.

Personally, I find this death pronouncement a bit odd. Just because stocks went nowhere from 1999-2008 means that investing in stocks for ten years is flawed generally? Since when does one instance of something not working render the entire concept flawed? I don’t think a 100 percent success rate is required for one to declare it a viable strategy.

The reason “buy and hold” became popular is because, over long periods of time, stock prices mimic corporate earnings, which have risen over business cycles since the beginning of our economy. Legendary fund manager Peter Lynch continually reminds people that it is no coincidence that over decades the gains in the U.S. stock market are practically identical to the gains in corporate earnings (stock ownership represents a proportional share in profits generated by the firm).

The key point here is that the relationship only holds over long periods of time. In any given year, there is virtually no correlation between earnings growth rates and equity market gains. That is why “buy and hold” is a widely accepted investment strategy. If you invest over the long term, the odds are extremely high that earnings and stock prices will rise, and do so at higher rates than other investment alternatives.

I bring this up today because a former CEO of Coca Cola was a guest host on CNBC this morning. He and the CNBC gang discussed the fact that shares of Coke are actually down over the last ten years (since this person left the CEO post), as the chart below shows.

The CNBC commentators were quick to point out that Coke’s earnings have more than doubled over the past decade, but the stock has actually lost value. Does this example support the idea that “buy and hold” is a flawed strategy, or is there something else at work here?

The latter. Coke stock carried a P/E ratio above 50 back in the late 1990’s, during the blue chip bull market. Even when earnings grow dramatically, if P/E ratios are in nose bleed territory, “buy and hold” may not work, as was the case with Coke.

As a result, “buy and hold” does not work blindly. If you dramatically overpay for a stock, there is a good chance that you won’t make any money, even over an entire decade. From my perspective, this does not mean that “buy and hold” is dead (the long term relationship between earnings and stock prices is unchanged), it simply means that valuation is important in determining future stock price returns (statistics show it is the most important, in fact).

The take away from this discussion is that “buy and hold” investors are likely to do very well over the long term, as long as they don’t grossly overpay for an asset. The U.S. stock market in the late 1990’s was more expensive, on a valuation basis, than at any other time in its history. Buyers during that time can’t be saved from their own poor decision of paying too much for a stock, even by a proven long term investment strategy. Unfortunately, most non-professional individual investors don’t focus on valuation when picking stocks for their portfolios, and often pay the price as a result.

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

Meredith Whitney Quitting Oppenheimer Helps Show Contrarian Indicators Still Work

As my clients know well, I am a contrarian when it comes to investing in the market. To me, buying a stock is no different than shopping for a new house, car, or wardrobe at the mall. You get your best deals when you are either buying things other people don’t want (store sale racks, foreclosed properties), or buying things when other people aren’t shopping for them (winter coats well into the season).

As a result of natural human behavior, many market participants use contrarian sentiment indicators to guide their investment strategy. Measures of investor bullishness and consumer confidence, for example, are proven contrarian indicators. Sometimes certain events can even mark emotional extremes.

Consider banking analyst Meredith Whitney’s decision on February 18th to leave her sell side job at Oppenheimer to start her own firm. Prior to October 2007, few people even knew who Whitney was, but after she became one of the first analysts to point out a possible capital shortfall at Citigroup (C) she immediately became the face of the banking crisis (thanks to the financial media) and has been extremely bearish on the group ever since.

So, we have a relatively unknown banking analyst make a good call on a large bank stock, the media picks up on it and runs with the story for months, and less than 18 months later she has enough of a following to start her own firm. These kinds of events often mark extremes, in this case, the depths of the banking crisis. For an analyst who made her career by being unrelentingly bearish on banks, it stands to reason the banking sector would be struggling mightily around the time she quit her job to go out on her own. It makes sense to question whether negative sentiment would be peaking around that time.

Of course, I wouldn’t have used this example if it didn’t serve as a positive data point for the contrarian indicator thesis. We won’t know for another year or two if Whitney quitting actually was a great contrarian indicator or not (it’s too soon to call the bottom in the banks), but it took only 12 trading days for the bank stocks (and the market itself) to put in a fierce and dramatic bottom on March 6th. Since then the market has risen 36%. Financial stocks have fared even better, soaring 105%.

Another contrarian indicator I follow is the number of worried emails and phone calls I get from my clients about their investment portfolios. If I get a few clients expressing concern over a period of days, that signals to me that sentiment is extremely negative and a bottom may not be far off. This personal indicator of mine peaked on March 2nd, merely four days prior to the market’s bottom.

All in all, contrarian indicators measuring sentiment among investors and other market participants can still be a very valuable tool when managing one’s investments. I recommend keeping them in mind as you continue to follow the market and your portfolios.

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

You Can’t Go Broke Taking Profits

A common saying on Wall Street, and for good reason. Although the stock market has been acting very well in recent weeks and today’s 200-point gain is a good start to this week, I am not going to be bashful about taking some chips off of the table for my clients and you shouldn’t be either.

It is a contrarian move (not surprisingly, coming from me), as the market is breaking through upside support levels on a technical basis, but I want to have some cash on hand to make purchases during the next correction. When will that drop take place? I have no idea but it certainly will come. I would not be surprised if it was soon. After all, the S&P 500 has rallied from 666 in early March to 907 in early May, a gain of 36%. Still, we are up less than 1% for 2009.

Trading in Dendreon Stock Shows Why Short Term Trading Is Such A Gamble

You may have heard about Dendreon (DNDN), a small money losing biotechnology company that is in the process of getting its cancer vaccine, Provenge, approved by the FDA. Full results from a crucial phase three study were released yesterday afternoon in Chicago, but about half an hour prior to their release, shares of Dendreon fell off a cliff for a couple of minutes and trading was halted for “news pending.” Between 1:25pm and 1:27pm ET Dendreon stock fell from above $24 to as low as $7.50, and were halted at $11.81 per share.

Immediately investors were baffled. The most plausible explanation was that the full study results somehow were leaked early, someone learned they were bad and sold their stock, which in turn caused others to panic and sell too. That would have been an odd turn of events, however, because the company had indicated recently that the study results were clearly favorable.

When the news was finally released to the public there were no surprises, which makes those trades just before 1:30pm very strange. The NASDAQ exchange quickly investigated the trades to see if any were made erroneously, but they found nothing wrong and the trades will stand. Today the stock reopened and is currently fetching about $24 per share.

This story only serves to further my personal belief that short term trading in the stock market is so speculative that it is really nothing more than gambling. Evidently somebody somewhere thought they saw or heard something that was negative for Dendreon, others followed suit and sold their shares like lemmings jumping off a cliff, but in reality there was no news at all.

Undoubtedly some investors quickly hit the sell button during those few short minutes yesterday afternoon, fearing that if they didn’t their stock would fall even further (Dendreon stock sold for $2 in March, so many people had huge gains). They lost between 50% and 75% of their money for no reason. Other investors surely had large paper gains in Dendreon and had stop loss orders in place to limit any future losses. Many of those stops were triggered as the stock collapsed from $24 to $7 and rebounded to $12 and those investors also lost big time.

As you can see the market is very complex and sometimes things happen that are not rational and should never have happened. Speculating on near term movements of stocks (especially small biotech companies) is a very risky endeavor. All the market needs is a willing buyer and a willing seller to agree on a price in one split second. Reality need not apply in such a case, but millions of dollars can be lost in a matter of minutes, as was the case with Dendreon yesterday.

Traders beware. In some cases Wall Street can look very much like a casino.

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