bizzXceleration: Performance, Value and Profit

Market Situation

Market rally hits 3 months, raising questions Three months can feel like a long time on Wall Street.In the stock market, where news about companies and the economy dictate buy and sell decisions in a matter seconds, the market's powerful rally is getting pretty old to some experienced players. Traders have been laying down bets on modest signs that the economy is halting its slide. That optimism has lifted the Standard & Poor's 500 index, a benchmark for many investments like mutual funds, an enormous 39 percent from a 12-year low on March 9. Those kinds of gains might normally take four years to materialize. Some analysts are asking whether ebullient investors have been too quick to shed their caution. Another round of economic data this week could help determine whether the gains will hold."Are we getting ahead of ourselves in terms of market levels? I believe that we are and I think investors would be wise to take some profits off the table," said Walter Gerasimowicz, chairman and chief executive of Meditron Asset Management.The rally has added 2,220 points the Dow Jones industrial average to put it within a dozen points of being flat for the year. But the Dow is still down 5,400 points from its high of 14,164.53 in October 2007. Green arrows began popping up on stock screens three months ago this week as traders determined that the economy was likely to sidestep a ruinous fall marked by the Great Depression and instead muddle through the worst recession in decades. But some analysts contend that investors are in danger of setting expectations too high for how quickly the economy can recover from the recession that started in December 2007. "When the predictions become less dour I think that introduces the possibly of disappointment," said Jeff Knight, head of asset allocation at Putnam Investments. "You don't have any evidence yet that things have actually gotten any better."

Where Buffett's money is going now Although Berkshire Hathaway (BRK.A, news, msgs) made only modest changes to its substantial ($35 billion-plus) equity portfolio during the first quarter, based on data pulled from the company's latest 13-F filing with the Securities and Exchange Commission, we were encouraged to find more than a few five-star stocks in the company's holdings.In fact, of the 41 securities in Berkshire's equity portfolio at the end of the first quarter, there were 13 stocks that are currently rated five stars by Morningstar's analysts. Berkshire had fairly large positions in five of these securities, each of which accounted for 4% or more of the company's total equity portfolio. In one case, Berkshire's Warren Buffett and Charlie Munger were actually adding to a position they had trimmed substantially during the fourth quarter of last year. We'll delve more deeply into each of them as we discuss the moves Buffett and Munger made during the most recent quarter.

This Rally May Need a New Source of Fuel Traditionally, the price-to-earnings ratio has been the most commonly used measure for valuing the market. Yet there are several ways to calculate P/E’s — and current economic circumstances make some methods particularly hard to apply. For example, a classic technique takes the current price level of the S.& P. 500 and divides that by the earnings of the companies in the index over the preceding 12 months, using generally accepted accounting principles, or GAAP. Based on these figures, the S.& P. has had an average price-to-earnings ratio of 12.6 at the end of bear markets since 1938. But this is no ordinary downturn. Because corporate losses in the fourth quarter of 2008 equaled profits registered in the previous two quarters, the market’s overall P/E, based on GAAP earnings, now stands at more than 100. That’s pricey by any definition. Because profit growth can be so unreliable in a severe recession, some strategists prefer to gauge stock prices by using so-called operating earnings, which exclude one-time write-offs like the expenses associated with closing down a factory or a company division. Based on operating earnings, the P/E of the S.& P. 500 is a much more palatable 22 today. But that’s still considerably higher than the average of 19 for the past two decades. What’s more, there are concerns about how quickly the market’s P/E has grown. It’s not uncommon for market valuations to rise in the latter stages of a recession, because stock prices tend to move in anticipation of a recovery. That means prices — or the “P” in the P/E ratio — often recover before earnings do. But they don’t usually expand this fast. But even if that technique is the best to use, it still means that the mind-set on Wall Street has shifted. Instead of betting on stocks because of unbelievably cheap prices, many investors are counting on the economy to rebound strongly. In other words, instead of betting on the “P” in the P/E ratio, stock investors are banking on the “E.” But at today’s prices, says Mr. Inker at GMO, “You’re not getting paid a ton for taking on risk.”

Is This Bull Cyclical or Secular? Many investors are now calling the rebound in stocks since early March the start of a new bull market. But it could be only a temporary respite from a longer-term bear market dating back to the beginning of this decade. If the market is poised for a multiyear run, investors can be more aggressive about diving into stocks. If the bear market will regain its grip on stocks and send prices lower again, investors need to be cautious. Historical data and the still struggling economy seem to point to the latter case, called a cyclical bull market in a secular bear market. For now, stocks are fully in bull-market territory, even if it doesn't feel that way given the losses that many investors are still nursing. "We have some very substantial headwinds on the economic front," says David Pedowitz, a senior portfolio manager at Neuberger Berman. Consumer spending is strained and there is significant excess capacity in the manufacturing economy, he says. Against that backdrop, expectations may be building for a bigger rebound in profits than will be possible, says Mr. Pedowitz. In late 2001, Ned Davis Research, a market analysis and money-management firm, raised the idea that stocks had entered a secular bear market, a long period of flat or declining stocks. That idea gained traction last autumn as stocks fell below levels of a decade ago. Ned Davis considers this the fourth secular bear market since 1900. The last one, from 1966 to 1982, ended when the Federal Reserve moved to aggressively crush inflation. These "secular" cycles run for long periods; secular bull markets have lasted from six to 24 years and bear markets 13 to 16 years. Within those cycles are many more cyclical bulls and bears -- nearly three dozen of each since 1900. (Ned Davis uses its own criteria for a cyclical bull or bear market, based largely on 30% moves.) During a secular bull market, the cyclical, or shorter, bull markets within them gained 110% on average and lasted nearly three years. Within secular bear markets, however, the gains in cyclical bull markets averaged 64% and generally were over within a year and a half. Long-term Bull vs Bear Graphic, Recent Cyclical Bear Graphic

Strategic Concerns

‘To Do’ List Is Getting Longer Today’s financial crisis is producing ever higher unemployment, investment losses, and home foreclosures. People now recognize that the unthinkable is thinkable, be it in the banking system or in the real economy. Yet some major structural changes, that are about to play out, have not as yet attracted sufficient attention – including the upcoming shrinkage and consolidation of the industry that provides investment management services to individuals, companies, pensions, and governments around the world. Two distinct yet inter-related drivers are at work. First, collateral damage from the largely self-inflicted war within the banking system which, as I noted in an earlier FT column, is gradually transforming banks into “utilities”. Second, the desire by governments to impose a peace by de-risking and re-regulating finance, lest today’s crisis morphs again – and this time into a global depression that would negate the progress that the world has made in the last ten years to improve living standards and alleviate poverty.These factors will inadvertently result in a major but uneven shrinkage of the investment management industry during 2009 and 2010. This unintended consequence will be felt most intensely in the levered (or “alternative”) space dominated by hedge funds and private equity firms. But it will spread well beyond that to traditional investment managers, particularly in the equity space and among those that are part of declining banking conglomerates. The alternative sector faces a perfect storm. These once prominent pools of capital are finding it harder to secure financing lines from banks. It is also proving harder for them to raise longer-term funds through bond issuance and initial public offerings.

The Future of Investing: Evolution or Revolution? The future of the global economy will likely be dominated by delevering, deglobalization, and reregulating, yet if so, it is important to state at the outset that we do not envision a mean reversion, cyclically oriented future, but instead a new world where players assume different roles, and models relying on bell-shaped/thin-tailed outcomes based on historical data are less relevant. Historical models look backward while modern-day finance is being fast forwarded and reconstituted almost as we speak. Whether evolution or revolution it is important to recognize that the aftermath of an economic and investment bubble transitioning from levering to delevering, globalization to deglobalization and lax regulation to reregulation leads to an across-the-board rise in risk premiums, higher volatility and therefore lower asset prices for a majority of asset classes. The journey to a new stasis is a destructive one insofar as it affects previously assumed wealth. Rough estimates suggest that as much as 40% of global wealth has been destroyed since the beginning of this delevering process. In essence, asset prices, which are really only the discounted future value of wealth creation, go down – not only because that wealth creation slows down but because it becomes more uncertain. In such an environment, equity interests in the form of stocks, real estate or even high yield bonds become re-rated. In turn, investor preferences towards risk taking, even when correctly calculated and modeled must be considered. In short, our stereotyped conceptions of what makes money are being challenged. As Bernstein says, there is no predestined rate of return. And a PIMCO corollary would counsel that future rates of return will be dependent on the beginning price and future growth rates and risk preferences that cannot necessarily be derived from historical models. Another way to summarize our caution would be to quote a recent comment by Barton Biggs. “I am a child of the bull market,” he said which upon further elaboration meant that he bought on cyclical dips with the expectation of riding mean reversion to an upward sloping trend line of prosperity and ultimately higher peaks. In a sense, we are all children of the bull market, although some of us are more mature than others – a bull market of free-enterprise productivity and innovation, yes, but one fostered by a bull market in leverage, deregulation and globalization that proved unsustainable in its excesses. We now must view ourselves as chastened adults, forced into acknowledging a new reality that is dependent upon bear-market delevering and debt liquidation to deliver us to our new and ultimate restructured destination – wherever it lies.

Poking Holes in a Theory on Markets For some months now, Jeremy Grantham, a respected market strategist with GMO, an institutional asset management company, has been railing about — of all things — the efficient market hypothesis. You know what the efficient market hypothesis is, don’t you? It’s a theory that grew out of the University of Chicago’s finance department, and long held sway in academic circles, that the stock market can’t be beaten on any consistent basis because all available information is already built into stock prices. The stock market, in other words, is rational. In the last decade, the efficient market hypothesis, which had been near dogma since the early 1970s, has taken some serious body blows. First came the rise of the behavioral economists, like Richard H. Thaler at the University of Chicago and Robert J. Shiller at Yale, who convincingly showed that mass psychology, herd behavior and the like can have an enormous effect on stock prices — meaning that perhaps the market isn’t quite so efficient after all. Then came a bit more tangible proof: the dot-com bubble, quickly followed by the housing bubble. Quod erat demonstrandum. These days, you would be hard-pressed to find anybody, even on the University of Chicago campus, who would claim that the market is perfectly efficient. Yet Mr. Grantham, who was a critic of the efficient market hypothesis long before such criticism was in vogue, has hardly been mollified by its decline. In his view, it did a lot of damage in its heyday — damage that we’re still dealing with. How much damage? In Mr. Grantham’s view, the efficient market hypothesis is more or less directly responsible for the financial crisis. “In their desire for mathematical order and elegant models,” he wrote in his firm’s quarterly letter to clients earlier this year, “the economic establishment played down the role of bad behavior” — not to mention “flat-out bursts of irrationality.” He continued: “The incredibly inaccurate efficient market theory was believed in totality by many of our financial leaders, and believed in part by almost all. It left our economic and government establishment sitting by confidently, even as a lethally dangerous combination of asset bubbles, lax controls, pernicious incentives and wickedly complicated instruments led to our current plight. ‘Surely, none of this could be happening in a rational, efficient world,’ they seemed to be thinking. And the absolutely worst part of this belief set was that it led to a chronic underestimation of the dangers of asset bubbles breaking.” But as much as I’ve admired Mr. Grantham’s writings over the years, I think the truth, in this case, is a little more subtle. Given the long history of bubbles, I suspect this crisis would have taken place with or without the aid of the efficient market hypothesis. People thought “it’s different this time” in the 1920s, long before anyone was writing about efficient markets. And over the course of history, professional money managers have been just as fearful of bucking the trend as they were during the Internet bubble. Mr. Fox sees it somewhat differently. On the one hand, he says, the efficient market theoreticians always assumed that smart market participants would force stock prices to become rational. How? By doing exactly what they don’t do in real life: take the other side of trades if prices get out of whack. Their ivory tower view reflected an idealized market that simply doesn’t exist. On the other hand, Mr. Fox says, what was truly pernicious about the efficient market hypothesis is the way it allowed us to put asset prices on a pedestal that they never deserved.

Investment Outlook: 2 + 2 = 4 Through my years here at PIMCO there have been numerous demarcation points where Baruch’s whispers almost turned into screams. Two plus two screamed four in September of 1981 with long-term Treasury yields approaching 15%, and two plus two boomed four in 2000 when the Dot Coms rose to prices that discounted the hereafter instead of the next 30 years. Similarly, 2007 was a screaming mimi with the subprimes – if only because the liar loans and no-money-down financing were reminiscent of a shell game, Ponzi scheme, or some other type of wizardry that was bound to lead to tears. 2009 is a similar demarcation point because it represents the beginning of government policy counterpunching, a period when the public with government as its proxy decided that private market, laissez-faire, free market capitalism was history and that a “private/public” partnership yet to gestate and evolve would be the model for years to come. How does one invest during such a transition? Investors should recognize that this grassroots trend signals – most importantly – an increasing uncertainty of cash flows from financial assets. Not only will redistribution and reregulation lead to slower economic growth, but the financial flows from it will be haircutted and “burden shared” by stakeholders. In turn, the present value of those flows should reflect an increasing risk premium and a diminishing multiple of annual receipts. This Outlook is not to bemoan this transition, but to recognize it. Slower growth can be a public good if it avoids the cataclysmic effects of double-digit unemployment, escalating foreclosures, and fear of financial insecurity. But the Obama cannon shot will have financial consequences. Do not be deceived by the euphoric sightings of “green shoots” and the claims for new bull markets in a multitude of asset classes. Stable and secure income is still the order of the day. Shaking hands with the new government is still the prescribed strategy, although it should be done at a senior level of the balance sheet. If the government indeed becomes your investment partner,  you should keep the big Uncle in clear sight and without back turned. Risk will not likely be rewarded until the global economy stabilizes and the Obama rules of order are more clearly defined.

Economic Recovery: Will Corporate Profits Recoup?  I keep thinking of something I heard Mohamed El-Erian, CEO of bond-investing giant Pimco, say at a conference in April: "We are so focused on whether recovery will be at the end of this year or the beginning of the next that we lose sight of the more important question. It's not whether the recession will be over; it's, What does the new normal look like?" It's a question with lots of facets. What will consumer spending look like? What will government deficits look like? What will my hair look like? But some of the most crucial unknowns have to do with corporate profits. Profits are, after all, what stock prices are supposed to be based on. Stocks have skyrocketed since early March, providing the earliest and strongest signal that the recession might ebb soon. One could even argue that rising stock prices brought optimism that has since begun to show up in real economic data, although if you think too hard about such feedback loops it will just make your head hurt. In any case, the future path of corporate profits should eventually determine whether the stock market will keep rising, whether companies will start hiring again, whether this recovery will feel like much of a recovery or not. And while Wall Street's analysts are all making (for the most part increasingly optimistic) estimates of what those profits will be, they really have no idea. That's because the mostly rising corporate profits of the past 35 years have been in large part the product of a long, long rise in indebtedness, especially consumer indebtedness. That rise in indebtedness is now giving way to what looks to be a long slide. At least, it had better be; if consumers start piling on debt again, we'll just have another, bigger credit crisis in a few years. But if they keep increasing their savings rate and reducing their debt loads, that's bad news for corporate profits, not just bank profits. Anybody who makes things that in recent years were bought on credit, from houses to washing machines to cars, is likely to be affected. So are stock prices.