Putting the Correction in Perspective

November has been the worst month for stocks in several years. The S&P 500 is now negative for the year, and sits 10% below its high and 8.5% lower this month alone. Not only do long term investors like myself take a multi-year outlook of the future when investing money, but it also helps to put things in perspective by looking back at where the markets have come from in a multi-year scenario. Much like a student who gets a C on a tough exam might be in fine shape if previous grades in a semester have been all A’s, investors need to realize that markets don’t go up all the time, just as good students can’t possibly ace every test.

Stock prices rise, on average, 75 to 80 percent of the time in any given year. After four magnificent years of gains in the market, we are overdue for some poor performance. We might finish down this year, or next year, or both, but regardless, take a look at how far we have come over the last five years:

We can’t possibly expect gains like this to continue indefinitely. Even a pullback to something like 1,300 on the S&P 500 index would simply be a normal, healthy retracement after extremely large gains. Perspective like this is important when markets are rattled, as they clearly are right now. I don’t know how long the correction will last, or how low we will ultimately go, but I will remind people that these types of moves are normal, and are required to maintain a healthy marketplace.

As for how to approach new investments in this type of environment, I don’t think meaningful changes need to be made. When fear of the unknown grips markets in the short term, as is happening right now, long term investors simply need to ignore the short term noise and focus on long term fundamental stories. Investment themes need to be able to weather your view of how the world will look five years from now, not five hours from now. If you invest in a company that has a bright long term future, and pay a very reasonable price for it, the odds are in your favor that you will make good money over time. And that fact won’t change based on anything that happens today, next week, or even in 2008.

The Implications of Negative Earnings Growth

Undoubtedly, the underlying driver of the U.S. stock market in recent years could be summed up in two words; earnings growth. Equities now face a hurdle, however, as third quarter profits for the S&P 500 could very well decline year over year for the first time in five years. The implications for the market are pretty important.

At the outset of the year, market forecasters were calling for low to mid double digit returns for the market, supported by rising earnings and slight multiple expansion. It was my view that multiple expansion was unlikely (due to a lack of low P/E ratios to begin with, coupled with decelerating economic and earnings growth rates), so market returns would more likely track earnings advances, which would put us up in the mid to high single digits for the year. The S&P 500 is slightly above that pace right now, but it will likely be an uphill battle from here.

The reason is that without multiple expansion or earnings growth, there is no way for the market to advance meaningfully, by definition. The end result is likely to be a range-bound market as judged by the major indices. In fact, as the chart below shows, we have already begun to see this scenario take shape.

S&P 500 Index – Last 6 Months

From an investor perspective, this infers that stock picking will be all that more crucial to achieve investment gains. Not surprisingly, I would suggest focusing on individual situations where either multiple expansion or earnings growth are largely assured. The ideal investment candidate would be set up nicely for both, which would allow for solid gains regardless of whether or not the overall market advances meaningfully in coming months.

Examining Dualing Market Outlooks

Does anyone else find it pretty strange that two people can look at the exact same set of data and reach two dramatically different conclusions? I’m speaking of market strategists who try and determine if the overall equity market is overvalued or undervalued. The bulls think we are 20 or 30 percent undervalued and the bears see the exact opposite scenario. How can people differ that much on the outlook for the domestic stock market? It’s not like we’re are trying to value a single company, where I could understand widely varying outlooks. The stock market as a whole can’t be overvalued and undervalued at the same time.

The key to analyze this dichotomy is to look at the S&P 500 P/E ratio, which is the most widely used metric to value the overall market. This isn’t as simple as it sounds though. You arrive at different numbers depending on if you use the trailing twelve month (TTM) P/E or the forward P/E. Personally, I use forward P/E ratios when valuing stocks, because equities are claims on future earnings, not profits already earned. However, the most bearish market strategists use trailing numbers because doing so results in higher P/E ratios, which imply higher valuations. For the purpose of this piece, I’ll use TTM P/E ratios, mainly because historical data is easier to find.

Another point of contention is which earnings calculation to use. The two most commonly cited are operating earnings and GAAP earnings. Operating earnings are meant to gauge how much cash a firm’s operating businesses are generating, whereas GAAP numbers are really more of an accounting standard and don’t always reflect true profitability. For instance, one of the biggest contributors in GAAP earnings is stock options expense. Accountants insist that companies issue GAAP income statements that place a value on expenses incurred by issuing stock options, even though no economic cash cost is incurred.

Currently, the P/E on the S&P 500 index is anywhere between 15.4 (forward operating earnings) and 18.0 (trailing GAAP earnings) depending on which of the four measures (forward vs trailing/operating vs GAAP) you use. I don’t think we need to agree on which P/E to use to analyze whether or not the market is wildly overpriced or underpriced. For the most part, the bears think P/E ratios should be lower, or will be lower shortly. The bulls think if P/E multiples do anything, they should go up, not down.

Keep in mind, I am referring only to those people who think the market is meaningfully mispriced right now, say by 20 percent or more in either direction. I fully understand that this is only a subset of all market pundits. I’m simply interested in looking at the dichotomy that exists between them.

Let’s take a look at an interesting chart that should shed some light on this debate. The graphic below shows the historical trailing P/E of the S&P 500 index (blue) along with a five-year moving average (black).

As you can see from the chart, the stock market typically trades at a P/E of between 10 and 20. Depending on which number you use, we are currently either right smack in the middle of that range, or on the upper end of it. If you are using P/E ratios as your yardstick, you really can’t make a compelling argument that stock prices are dramatically too high or too low.

The real question in this analysis, if we assume the historical range is a pretty good guide to stock market valuation, is whether we should be closer to 10 or 20. How much investors are willing to pay for equities can depend on many variables, but the most important ones are interest rates and inflation. Don’t take my word for it though, both logic and historical statistics back up this assertion.

Since stock prices reflect future earnings discounted back to present day values, there is a negative correlation between interest rates and stock prices. When rates are low, investors are willing to pay higher multiples of earnings, and vice versa. Inflation measures have the same effect on demand for equities. When inflation is high, the “real” (net of inflation) return on stocks goes down or becomes negative, which crimps investor demand for equities, lowering multiples.

Since the economic backdrop is crucial in determining the appropriate valuation level for stocks, the fact that the United States currently is operating a growing economy in a low interest rate, low inflation environment sheds a great deal of light into where stock prices might trade. The middle or upper end of the historical range is not only not unrealistic, but it makes a lot of sense.

Making the argument that P/E ratios should be dramatically higher is simply not prudent given the historical data. Defending a P/E toward the low end of the range also isn’t very compelling given the current economic backdrop. As a result, I think a simple look at history, coupled with a basic overview of current economics, shows that the market is neither wildly overvalued, nor wildly undervalued.

Post-Vacation Thoughts

Wow. What a week and a half to take a vacation. Either it was a great time to miss, or it was the opposite. Obviously I’m biased, but I’d have to go with the former. Sometimes the daily volatility of the market sends investors on more of an emotional roller coaster than anything else, and that isn’t usually helpful. After all, roller coasters end up right where they started for the most part.

It looks like the S&P 500 traded in a 8.9% intraday range during the 8 trading days I missed, from 1370 all the way up to 1503. Despite that, when all the dust settled, stock prices dropped only 2 percent during my time away, so really my trip (I was in Boston and Cape Cod) saved me some emotional highs and lows.

I haven’t had a lot of time to catch up yet, but one thing did get my attention, so I thought I would share. I don’t know if it got a lot of airtime or not (likely not given it was pretty eventful with the Fed moves, etc), but the market finally got the long awaited 10 percent correction (at least on an intraday basis — 11.9% — it was only 9.6% on a closing basis).

Now, normally this would be unimportant enough that I might not even mention it, but there are a couple reasons why I think it is notable this time around. First, there were tons of people who were refusing to jump in with excess cash until we got that “official” drop. It sounds silly, but when investment strategists think the market is overbought, as many had for several months as the S&P crossed 1400 and then 1500, they need a significant sell-off to be convinced some excesses are removed. I have no doubt that market players who were waiting for a 10% down move are beginning to put some cash to work slowly.

Normally, a 10 percent correction is no big deal. We expect them to happen. I don’t have any statistics handy, but I’d guess we see one every year or so on average. They are normal and very healthy. Amazingly though, we had gone four and a half years without a full 10 percent drop in the S&P 500 index. This worried a lot of people because it was the longest streak ever without a sizable market drop. I don’t think it signaled the end of the world or anything to anybody, but when you go that long, you are due for a fall, and while nobody knows exactly when it will happen, it still prevents investors from getting overly bullish and firmly committing investment funds. The streak, in the eyes of many, was simply a symbol of the times, an overbought market that was being powered by many things, including the private equity M&A boom, which appears to be normalizing.

As I comb through the individual company news times of interest from the last week and a half, I’ll be sure to share anything that catches my eye that would have otherwise been posted had I been in the office. Feel free to let me know if there is anything you would like me to write about in coming days. It’s good to be back, and thanks for your patience during my vacation time.

Hedge Funds Can Just Freeze Redemptions… Must Be Nice

Maybe it’s just me, but is anyone else amazed that when hedge funds run into trouble (as many have recently by investing in mortgage-backed securities) and investors ask for their money back, the fund can simply say no? This is astonishing to me.

Now, don’t get me wrong. Managers can run their funds any way they want. Typically, fund rules stipulate that investors can withdraw money only during certain windows (quarterly and annually are most common). That makes sense, as it can be tough to put on positions if people can just come and go as they please. But how about when you ask for your money back during a pre-approved window and the hedge fund comes back and says “Sorry, but we have frozen redemptions.”

Bear Stearns (BSC) did this with their recent funds that ultimately went bust and are being sued right now because of what they allegedly told investors regarding the riskiness of the portfolios when they tried to get their money out.

Why on earth would anyone invest in a hedge fund that gave you no guarantee that you could take your money out if you wanted to? How can hedge funds get away with simply denying one’s request? Do any readers out there invest in hedge funds? Are you worried about wanting to get your money out at some point and being told you can’t? Seems risky to me…

Full Disclosure: No position in BSC at the time of writing

Why Would a CEO Stick with Quarterly Guidance?

I read an interesting take on this question today and I think it has a lot of merit. While many of us would prefer public companies abandon quarterly guidance, there are reasons why a CEO would keep giving it out. One reason might be to make them look good, and therefore enhance their job security.

If you are an active investment manager (whether for personal assets or professionally) you have likely observed in recent years that a pattern has developed during earnings season on Wall Street. Companies tend to beat estimates for the most recent quarter and guide estimates lower for the current and/or future periods. The end result is that most quarters finish with earnings coming in ahead of estimates on the whole.

While stock prices might dip in the short term because investors care more about future guidance than earnings already booked, this practice sets the bar very low. By keeping expectations meager, it maximizes the odds that the company will beat numbers next quarter, and that makes management look good. Under-promise and over-deliver (“UPOD” as Jim Cramer calls it). It works, and it’s what public companies should do in general (although maybe less often than every three months).

I think this is a great explanation for why many companies will keep playing the guidance game. It sets the bar low, makes them look like they’re doing a good job running their companies, and boosts their job security. If you don’t give guidance at all, the analysts could set the bar too high, forcing you to miss numbers and get an earful from investors.

How can investors play this growing trend? Buy stocks after a post-earnings sell off due to a guide down. After the company sets the bar low, investors adjust their valuations accordingly. Over the next couple months, Wall Street will realize the numbers are too low and the stocks will get a boost as strong performance is priced in again. Use that strength to pare off positions before the next earnings report if you think they might be lackluster or conservative.

That seems like the best way to trade the ever-growing trend of beating earnings and guiding lower for future quarters.

Seagate Adopts Baffling Policy on Financial Guidance

I am sitting here listening to the second quarter conference call hosted by Seagate Technology (STX), the world’s leading provider of hard disk drives for the consumer electronics industry, and I just had to write a post with the audio going in the background. Seagate CEO Bill Watkins has just announced that his company is changing their policy on company guidance.

I have written on this blog before that financial guidance is very overrated. Many companies have abandoned giving guidance completely (kudos to them) and others have at least stopped giving quarterly projections. So, I was expecting STX to either cease quarterly guidance and give only annual projections, or to halt guidance completely. Wrong on both counts!

Seagate will now give only quarterly guidance. Are they kidding? The whole point of stopping quarterly guidance is to focus management on the long term and not put them in a situation where they might take actions just to hit a number in the short term. Now they are embracing three-month projections?

I understand them not wanting to give out annual projections. The disk drive business is very hard to predict, as it is largely a commoditized market. Supply and demand, and therefore pricing, is tough to gauge over long periods of time. Essentially, STX management is saying they have no idea what they will earn in fiscal 2008 (which began on July 1st).

If you are going to ditch giving guidance, then stop giving guidance! It seems very strange that they say they are focused on the long term, but yet are still going to predict sales and profits every three months. They should have just stopped guidance altogether.

Full Disclosure: Some Peridot clients have positions in STX, but those positions are under review

How Relevant is Dow 14,000?

The move from Dow 12,000 to Dow 14,000 has been pretty stunning. How relevant is that index though? We can argue that it is heavily weighted towards mega cap stocks, and that is true, but so is the S&P 500 since it is market cap weighted. Some of you may not be aware of this, but the Dow Jones Industrial Average is not market cap weighted. Instead, it is share price weighted.

This serves to make its moves pretty much irrelevant in terms of gauging the market’s overall health. A one dollar move in Boeing (BA) has the same effect as a one dollar move in Microsoft (MSFT), even though Boeing trades over $100 per share and MSFT shares sell for $30 each.

What is the end result of this pricing method for the Dow? Boeing has more than 3 times as much influence as Microsoft does, and the same pattern holds for any other Dow component. In fact, materials and industrials account for a whopping 35% of the Dow Jones Industrial Average due to their high share prices (which may not be shocking given the name of the index).

Those two groups have been leading the market higher, so it is not surprising that the Dow has been soaring. On the other hand, financial services firms have been lagging this year, but they only account for 14% of the Dow, more than 30% less than their weight in the S&P 500. Dow 14,000 is a nice round number, but it really doesn’t tell us a lot about the market as a whole, only certain sectors that dominate its composition.

For a 40% Premium, How Could Hilton Say “No” To Blackstone?

Rumors of a large private equity deal in the lodging industry had been running rampant recently and late Tuesday we learned that Blackstone Group (BX) plans to acquire Hilton Hotels (HLT) for $18.5 billion plus the assumption of debt. Hilton shareholders should be elated, as they are getting a 40% premium for their shares.

The M&A boom we are seeing right now is clearly propelling the market higher. Firms like Blackstone have billions of dollars to put to work and they can’t raise more money until what they have now gets spent. As a result, you see prices like this being paid for Hilton. For a 40% premium, they had to say “yes” to Blackstone. If the offer was 20%, maybe they pass, but not 40%.

And this is a big reason why the market has been so good lately. Private equity firms need to spend their cash hoards and aren’t afraid to overbid if it means getting a deal done. The companies getting bought out jump, helping the market. The stocks considered next in line for a bid get a pop on the rumors and speculation, and short sellers have to scramble to cover any positions that could possibly get a bid. You can’t afford to risk being short a name like Hilton before a Blackstone bid comes along.

Liquidity will dry up at some point, deal flow will lighten up, and market returns might be subdued, but there is really no way to know when exactly that will happen. It is clear the private equity firms themselves think we are in the late innings, or else we would not have seen Blackstone go public and KKR file for an IPO just a few hours ago. Until the game is over though, there is plenty of liquidity to keep stock prices fairly high.

Investors should simply focus on values in the marketplace. Maybe one of your companies gets a bid, maybe not, but it would be wise to make sure you are comfortable with your investments even if they remain independent. Unless you think you are the ultimate market timer, I would avoid the private equity IPO market, including Blackstone, KKR, as well as the others that will surely follow suit as long as the new issue market can support them.

Full Disclosure: No positions in the companies mentioned at the time of writing

How Should Hedge Funds and Private Equity Be Taxed?

It seems like Congress goes into attack mode anytime somebody is making a lot of money. In some cases I agree with our elected officials and in other cases their arguments make little sense if you look at the big picture. Take the oil companies for instance. We all know the industry is swimming in money. If Congress aims to repeal subsidies these firms get from the federal government, I have a hard time opposing the idea. Our country does not need to subsidize our oil companies. However, if you propose some kind of excess profits tax simply because oil prices are high, that is ridiculous. We live in a market economy and markets are cyclical. You can’t tax companies during boom times just because you feel like it.

Anyway, the topic du jour is the taxation of hedge funds and private equity funds. Again, we have a group of wealthy people who are making billions and paying the same (if not less) taxes as the average worker. To figure out where I fall on issues like these, I try not to bring politics into it at all. To me, it’s logic-driven reasoning that should rule the day and help form an opinion.

I haven’t been following the issue that closely, but the sticking point is the fact that hedge fund and private equity fund general partners split investment profits with their limited partners. The investment managers serve as general partners and collect 20% of the profits from the investments they make, which is often taxed as long-term capital gains, at a rate of 15%. The fact that someone can make $100 million and only pay 15% in taxes is evidently upsetting a lot of people in Washington.

At first blush it might seem like the 15% tax rate makes sense. If a hedge fund has $100 million in assets and earns 10%, there is $10 million in profit to be divided up. Assuming an 80/20 split, the manager makes $2 million and the limited partners share $8 million based on their ownership percentages. Since the $10 million in profit was the result of capital gains, then it is easy to see why some feel the 15% tax is fair.

There is one difference though, that seems very important. The whole point of having a low capital gains tax rate (relative to income tax rates) is to incentivize people to invest in businesses and put their capital at risk. Such actions are the life blood of our capitalist system. In return for risking your own money by investing in other ventures that need funding, you are rewarded with a lower tax rate on any profits you earn.

The problem is, hedge fund managers aren’t risking their own capital a lot of the time. They are pooling money from their investors and managing it for them. Sure, they don’t earn anything unless they produce positive returns, but if they lose money, they don’t lose as much, if at all, because they typically have less capital at risk, if they invest in the fund at all. This seems like the most logical reason why one would be against the 15% tax rate for hedge fund managers.

Now, it’s true that most fund managers have invested some of their own money in the funds they manage. Perhaps what the tax law needs to say is, when you have your own money at risk, you can claim profits as a capital gain, but when your investors are simply sharing a portion of the profit earned on their capital, in return for your management ability, then that income should be treated as a management fee, and therefore taxed at ordinary income tax rates.

It’s a tough issue for sure. I just hope the law going forward reflects reality, meaning that if you get a tax break for capital gains, it better actually be your capital that was put at risk in order to produce the gains in the first place. A fair compromise in my eyes would be to allow managers to pay 15% on the portion that is their own capital at risk, and ordinary income tax rates on fees earned on limited partner’s assets that are paid out to the general partner. That way, the whole point of the 15% capital gains tax rate (reward risk taking with lower taxes) is preserved.

What do you think?