Sunday, August 29, 2010

Corporatocracy Has Replaced Capitalism

¹²Why We Are Totally Finished— Corporatocracy Has Replaced Capitalism

By D Sherman Okst | 29 August 2010

Capitalism Fixes Problems & Preserves Democracy

Capitalism is what we should be relying on to fix our problems. Capitalism has it's own ecosystem, just like biology's ecosystem. An economic ecosystem that weeds out the weak, has parasites that eat the failures and new bacteria that evolves and grows replacements for that which failed. A system that keeps everything in balance.

The problem is we are no longer a capitalistic society. What we were taught in school is now utter and absolute nonsense. Capitalism is a thing of the past.

As outlined in "It's Not A Financial Crisis— It's A Stupidity Crisis", we created two back to back bubbles. The air out of the Tech Bubble was sucked up for fuel by our next stupidity crisis: The Housing Bubble.

Now, after the second Stupidity Crisis there isn't a third bubble to inflate. If we still lived in a capitalistic environment the banks and financial institutions that created loans for folks who should have remained renters and then sold those loans as investments to pensions and countries would have been cleansed by capitalism's ecosystem.

But that isn't what happened.

In a very anti-capitalistic move the government decided that stupidity and criminal activity should be rewarded. I'd say they took our money, but it is worse, we didn't have that much money. So they 'borrowed' the money in our name. The loan has a variable rate. They borrowed so much money that our kids cosigned the loan. In fact, our kid's kid (yet to be) 'signed' on the dotted line.

That is unequivocally immoral[!?!]

They gave that borrowed money to a bunch of morons as a reward for stupidity. [[That's immoral!: normxxx]] Morons who created subprime loans, liar loans, no income no documentation loans and other fraudulent instruments. Morons bundled that trash, got it rated AAA and then sold these turds or 'weapons of mass destruction' that they had the audacity to name 'complex financial instruments' or derivatives to pension funds, countries and other "investors".

Then it all blew up. Big surprise.

For blowing up the world's economy this Stupidity Crisis was falsely named an 'Economic Crisis' by CNBS and 535 morons on a hill in DC (Ron Paul and a few other fiscally responsible adults excluded). The idiots who created the mess were rewarded with a 700 billion dollar "bailout". This "bailout" was anything but a bailout and had a price tag of anything but 700 billion. The actual price tag is closer to 11 trillion and puts us on the hook for another 13-17 trillion— not counting interest.

Think about that for a second. This stupidity crisis is the equivalent of our Federal Debt which took a generations of politicians over a hundred years to wrack-up.

For anyone who still believes we live in a free country where capitalism reigns please show me one economic textbook which states that failure and fraud are supposed to be rewarded with borrowed taxpayer money. For anyone who believes we live in a democracy please show me a textbook that says the government will en-debt you and your kids and their kids to pay for a failed business. How is that democratic?

"Law of Morons"

Years ago, while serving on a committee I came to a sad realization. Like gravity, there is the another invisible force which I dubbed "The Law of Morons". Put a group of very intelligent, well meaning people in a room together, put them on a committee or some governmental body that is devoid of guiding principles or merit based decision making and "The Law of Morons" will prevail. The collective IQ will drop to the smallest shoe size in the room. And hope for loafers, because collectively this body won't be able to tie anything together— not even a single shoelace.

Government Creates Problems

Basically our government is comprised of many well meaning intelligent people who for whatever reason— re-election, greed, the "Law of Morons", corporate puppet strings (read: lobbyist), self interest, corporatocracy, or whatever else— do nothing but create massive problems. Either lack of regulation (where it's needed) or too much regulation (where it's not needed). And without any uncertainty— too much DEBT along with a debt that will NEVER be repaid and a deficit that is only likely to grow larger [[as the Republicans cut taxes while the Democrats increase spending: normxxx]].

They have failed us. Terribly!

With debt and a failed capitalistic society our democracy is now at risk. Serious risk.
A democratic society requires a stable and effectively functioning economy. I trust that we and our successors at the Federal Reserve will be important contributors to that end.
Alan Greenspan

Serious irony there unless he was talking about the end of a democratic society. Greenspan was primarily responsible for muzzling Brooksley Born's attempt to regulate derivatives. And our deficit now requires that we counterfeit "money" to service our debt payments.

Forget about GDP, it is a bogus measure cooked up by the BEA (US Bureau of Economic Analysis). GDP is so thoroughly baked that it makes the folks who cooked Enron's books look like saints. Let's focus on what we take in and what we pay out. We take in about 2 trillion in taxes and other revenues. We borrow about 2 trillion of which about 1 trillion must be taken off for debt service, and we spend well over 4 trillion.

To deal with the $1.6 trillion++ shortfall we just print/counterfeit it. This debases the value of every dollar we hold, stealing wealth from every hard working American. It causes the need for more dollars to be injected into the system, which increases the amount of taxes that Americans pay.

There are only two crimes serious enough to be listed in our Constitution: treason and counterfeiting.
"Solutions Create More Problems" ~ Al Bartlett (Worked on the Manhattan Project).
Another asked, "Is there any intelligent life on earth to change our future to a sustainable one"?
Dr. Bartlett replied,
"Is there any intelligent life in Washington, DC is the bigger question?"

We Have a Corporatocracy: Not capitalism. Corporatocracy: A government that serves the interest of, and may de facto be run by, corporations.

Some states have government workers who have powerful 'union' corporations that influence the government's decisions. California has a massive pension mess, created in large part by government unions and elected officials who have catered to these unions.

"Too Big To Fail" is living proof that capitalism is dead. These TBTF institutions that blew up the economy in 2008 with their stupidity crisis, at the very least deserved to fail. They blew it. That is the definition of capitalism. You do well you are rewarded, you screw up you close shop. You commit fraud and you do time.

But with a Corporatocracy you get a Hank Paulson— a former Goldman Sachs CEO worth about 700 million dollars [[but only if GS stays solvent.: normxxx]] who winds up as our past Secretary of the Treasury. There is a serious distinction between a civil servant and someone who serves a corporation, especially the last corporation he worked for. His salary was only six figures, but his benefit was that he got to cash out of his stocks and pay no taxes. He gave the morons who blew up the economy 700 billion dollars. He had another former Goldman Sachs employee disperse the funds while the current CEO of Goldman Sachs professed to be "Doing God's work."

The movie "The Corporation" can be viewed at NetFlix or online with Hulu.

In Summary: Our debt and our inability to revive capitalism and cut the waste in government will be our demise. Sadly, the only glimmer of hope I see is that Corporatocracy will destroy itself. I say sadly, because it will destroy the average American citizen also, like some mindless parasite that kills it's host.

Capitalism is dead and that is why we are totally screwed.

In Summary: My faith in the 5Gs: (God, Gold, Guns, Grub & 'The Government Will Continue to Screw It Up') remains strong.



The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

Ten Stock-Market Myths That Just Won't Die

¹²Ten Stock-Market Myths That Just Won't Die

By Brett Arends | 29 August 2010

The Dow Jones Industrial Average last week ended up pretty much where it had been a little more than a week earlier. A rousing 200-point rally on Wednesday mostly made up for the distressing 200-point selloff of the previous Friday.

The Dow plummeted nearly 800 points a few weeks ago— and then just as dramatically rocketed back up again. The widely watched market indicator is down 7% from where it stood in April and up 59% from where it was at its 2009 nadir. These kinds of stomach-churning swings are testing investors' nerves once again. You may already feel shattered from the events of 2008-2009. Since the Greek debt crisis in the spring, turmoil has been back in the markets.

At times like this, your broker or financial adviser may offer words of wisdom or advice. There are standard calming phrases you will hear over and over again. But how true are they? Here are 10 that need extra scrutiny.

1. "This is a good time to invest in the stock market."

Really? Ask your broker when he warned clients that it was a bad time to invest. October 2007? February 2000? A broken watch tells the right time twice a day, but that's no reason to wear one. Or as someone once said, asking a broker if this is a good time to invest in the stock market is like asking a barber if you need a haircut. "Certainly, sir— step this way!"

2. "Stocks on average make you about 10% a year."

Stop right there. This is based on some past history— stretching back to the 1800s— and it's full of holes.

About three of those percentage points were only from inflation. The other 7% may not be reliable either. The data from the 19th century are suspect; the global picture from the 20th century is complex. Experts suggest 5% may be more typical. And stocks only produce average returns if you buy them at average valuations. If you buy them when they're expensive, you do a lot worse.

3. "Our economists are forecasting…"

Hold it. Ask your broker if the firm's economist predicted the most recent recession— and if so, when.

The record for economic forecasts is not impressive. Even into 2008 many economists were still denying that a recession was on the way. The usual shtick is to predict "a slowdown, but not a recession". That way they have an escape clause, no matter what happens. Warren Buffett once said forecasters made fortune tellers look good.

4. "Investing in the stock market lets you participate in the growth of the economy."

Tell that to the Japanese. Since 1989 their economy has grown by more than a quarter, but the stock market is down more than three quarters. Or tell that to anyone who invested in Wall Street a decade ago. And such instances aren't as rare as you've been told. In 1969, the U.S. gross domestic product was about $1 trillion, and the Dow Jones Industrial Average was at about 1000. Thirteen years later, the U.S. economy had grown to $3.3 trillion. The Dow? About 1000.

5. "If you want to earn higher returns, you have to take more risk."

This must come as a surprise to Mr. Buffett, who prefers investing in 'boring' companies and 'boring' industries. Over the last quarter century, the FactSet Research utilities index has even outperformed the exciting, "risky" Nasdaq Composite index. The only way to earn higher returns is to buy stocks cheap in relation to their future cash flows. As for "risk," your broker probably thinks that's "volatility," which typically just means price ups and downs. But you and your Aunt Sally know that risk is really the possibility of losing principal.

6. "The market's really cheap right now. The P/E is only about 13."

The widely quoted price/earnings (PE) ratio, which compares share prices to annual after-tax earnings, can be misleading. That's because earnings are so volatile— they're elevated in a boom, and depressed in a bust.

Ask your broker about other valuation metrics, like the dividend yield, which looks at the dividends you get for each dollar of investment; or the cyclically adjusted PE ratio, which compares share prices to earnings over the past 10 years; or "Tobin's q," which compares share prices to the actual replacement cost of company assets. No metric is perfect, but these three have good track records. Right now all three say the stock market's pretty expensive, not cheap.

7. "You can't time the market."

This hoary old chestnut keeps the clients fully invested. Certainly it's a fool's errand to try to catch the market's twists and turns [[ie, short-term is essentially 'noise' and, on average, you will lose. Even trading intermediate term— which has some trend— requires skill and effort to be successful. Long term is best, and timing simply means you wait to buy when stocks are historically cheap and sell when they are historically extremely overvalued. Avoid buying or selling in between; that takes what 90% of stock market investors lack— great patience! : normxxx]]. But that doesn't mean you have to suspend judgment about overall valuations.

If you invest in shares when they're cheap compared to cash flows and assets— typically this happens when everyone else is gloomy— you will usually do very well. If you invest when shares are very expensive— such as when everyone else is absurdly bullish— you will probably do badly.

8. "We recommend a diversified portfolio of mutual funds."

If your broker means you should diversify across things like cash, bonds, stocks, alternative strategies, commodities and precious metals, then that's good advice.

But too many brokers mean mutual funds with different names and "styles" like 'large-cap value', 'small-cap growth', 'midcap blend', 'international', 'small-cap value', and so on. These are marketing gimmicks. There is, for example, no such thing as "midcap blend". These funds are typically 100% invested all the time, and all in stocks. In this global economy even "international" offers less diversification than it once did, because everything's getting tied together.

9. "This is a stock picker's market."

What? Every market seems to be defined as a "stock picker's market," yet for most people the lion's share of investment returns— for good or ill— has typically come from the asset classes (see No. 8, above) they've chosen rather than the individual investments. And even if this does turn out to be a stock picker's market, what makes you think your broker is the 'stock picker' in question?

10. "Stocks outperform over the long term."

Define the long term? If you can be down for 10 or more years, exactly how much help is that? As John Maynard Keynes, the economist, once said: "In the long run we are all dead."



The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

Monday, August 9, 2010

When Bad Is Good

¹²When Bad Is Good
Sentiment Is Now Gloomy Enough To Support A Rally

By Mark Hulbert, Marketwatch | 28 August 2010

CHAPEL HILL, N.C. (MarketWatch)— From a sentiment perspective, the Dow's dropping below the 10,000 level appears to be the straw that broke the camel's back. And that's good news: It puts contrarian analysis back solidly on the side of the bulls. When I last devoted a column to stock market sentiment, at the beginning of August, I reported that the veritable "wall of worry" that a bull market likes to climb had weakened considerably. I concluded by saying that the fate of July's rally would depend on whether sentiment quickly dropped back into the pessimism category. (Read my Aug. 3 column.)

Not only did this drop in sentiment never materialize, but advisers continued to become even more bullish in the sessions following that column. From a contrarian point of view, therefore, recent market weakness has not come as a complete surprise. Fortunately, however, in recent sessions many advisers have thrown in the towel.

Consider the average recommended domestic equity exposure among a subset of short-term stock market timers tracked by the Hulbert Financial Digest (as measured by the Hulbert Stock Newsletter Sentiment Index, or HSNSI). This average currently stands at minus 6.6%, which means that the average short-term stock market timer is actually recommending that his clients allocate 7% of their equity portfolios to shorting stocks.

In early August, in contrast, when advisers were 'insufficiently' worried, the HSNSI stood at 35%. A week after my early-August column, furthermore, the HSNSI got as high as 47.5%. This means that the average recommended equity exposure has dropped more than 54 percentage points in a little more than two weeks' time. That should be enough pessimism to support a rally.

In addition, market timers who focus on the Nasdaq market in particular— and who tend to be an especially volatile bunch— are even more bearish right now. Their average exposure now stands at minus 50%, which means that they're now allocating half their equity portfolios to an aggressive bet that the market will continue declining. They may turn out to be right, of course.

But, historically, market timers on average have been wrong more often than they've been right. I acknowledge that it's not comfortable to step up to the plate when the stock market is acting as dismally as it is right now. But, to quote Nathan Rothschild's famous phrase, the time to buy is when the blood is running in the streets— and that's not easy to do, to say the least.

Also, don't forget that you will be perennially late if you wait to invest until it feels easy or comfortable to do so. Just think back to early August, when the Dow Jones Industrial Average (DJIA 10,151, +164.84, +1.65%) was trading at the 10,700 level and things felt a lot better.



The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

Saturday, August 7, 2010

'Forgotten' Indicators Are Flashing Danger

¹²'Forgotten' Indicators Are Flashing Danger: Economist

By Antonia Oprita | 7 August 2010

Despite statements from officials and analysts that a double-dip recession will not hit the US, there are some little-watched indicators that are pointing to a [significant] downturn in the economy, David Rosenberg, chief economist and strategist at Gluskin Sheff, said in a market commentary note. Analysts are almost in unison when they predict a jobless recovery, but not many think the economy will slide into recession again. Many are forecasting a revival of the Federal Reserve's quantitative easing efforts when it meets on Aug. 10 to breathe life into the anemic recovery.

"The level of complacency over the economic outlook is palpable and so reminiscent of the fall of 2007 when everyone believed the Fed could navigate us into a soft landing in the face of a credit collapse," Rosenberg wrote. "Now the pundits (including even its architects) have all but abandoned the ECRI weekly leading index (WLI) as a leading indicator of economic activity," he said. The Economic Cycle Research Institute (ECRI) index claims it is able to predict when a turn in the economic cycle follows [[but despite a rapid and largely unprecedented extended fall in the ECRI WLI since its March peak, its architects still have not called for a recession, saying the 4½ month dip in the index has not 'persisted' long enough…: normxxx]].

ECRI— an independent forecasting group— uses 19 leading indexes covering various aspects of the economy such as exports, imports, house prices, services and employment to gauge the health of the US economy.

While Rosenberg says a double dip "may well be averted" the recovery "is proving to be extremely fragile. Many market commentators and prognosticators still see this cycle as a classic post-war correction in GDP rather than what it really is— the aftershocks of a post-bubble credit collapse," he wrote. Some analysts point to the fact that the ISM index is well above 50 to show the recovery is on track.

But "out of the 18 industries polled in the ISM, only 10 reported growth, which was down from 13 in June and the lowest tally since December 2009, while 4 actually contracted," Rosenberg wrote. What's more, the new orders component in the ISM was down 12.2 percentage points in the last two months, he added. "The last time this happened was October 2008 and in fact is a 1-in-25 event," according to Rosenberg.



The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

When Upbeat Analysts' Consensus Spells Danger

¹²When Upbeat Analysts' Consensus Spells Danger

By Spencer Jakab | 1 August 2010

As Charles Dickens might put it were he to toil on today's Wall Street, great expectations can lead to the very best and worst of times. At the moment, a bumper crop of corporate profit reports has helped US stocks shrug off economic worries and has prompted Wall Street analysts mostly to raise their estimates. Collectively they expect earnings for 2010 to be nearly 7 per cent higher than they did in January. These bottom-up forecasts call for the companies in the S&P 500 to grow earnings by 33 per cent this year and another 16 per cent in 2011.

Although it seems counterintuitive, this optimism could be setting stocks up for a fall. Ned Davis Research has looked at forward analyst expectations for earnings growth and calculated that annualised market returns dropped to negative 12 per cent when forward earnings expectations were 15 per cent or higher. Conversely, returns averaged 18 per cent when forecast growth was 5 per cent or less.

Recent stock market history saw an extreme example of this. Near the end of 2007, just after stocks hit their all-time high, analyst consensus was calling for the S&P 500 to earn a record $102.78 a share in operating earnings for the following year. One could have reached the same figure by just extrapolating the trend of the preceding few years but, as we now know, there was very little about that period that one could extrapolate into 2008 or 2009. Actual earnings for the year were $57.20, a little over half of expectations.

Bill Hester, a fund manager, has quantified this tendency of Wall Street's finest to forecast via the rear-view mirror. He calculates the correlation between earnings growth for the coming year and analyst expectations to be a mere 0.28, while correlation with the past year is a far higher 0.75. Though strategists are also prone to excessive optimism or pessimism, their top-down expectations actually tend to be more sober than thousands of individual analysts who miss the forest for the trees. Current operating earnings forecasts for all 500 index constituents are about a quarter higher than Standard & Poor's own top-down expectations.

But analyst consensus of operating earnings remains Wall Street's preferred benchmark. It now stands at $95.79 a share, valuing the market at a price-to-earnings ratio of 11.5 times. This is wildly optimistic.

Revenue growth is expected to decelerate to 6.3 per cent in 2011 from 8.8 per cent this year, which would normally be a fairly pedestrian pace. But revenue is intrinsically tied to nominal gross domestic product growth of the economies into which the companies in the index sell, plus any market share gains. US nominal GDP growth averaged 3.25 per cent in the past decade, but companies in the S&P 500 grew their sales by an extra 2.75 percentage points on average. Since nearly half their sales go abroad, this was helped by booming emerging markets and the big decline in the dollar, which translates to higher reported revenue.

With inflation tepid, global growth merely so-so and the dollar strengthening recently, nominal GDP is seen growing by only 3 per cent next year and sales may not do much better. It is possible to give the S&P 500's constituents the benefit of the doubt on revenue. What strains credulity far more are expectations that operating profit margins will reach 9.11 per cent next year, a level commensurate with the peak of the boom years.

As we now know, much of that profitability stemmed from a financial sector reporting artificially high profits during the housing boom. The long-run average going back to 1997 is just 6.8 per cent. So some awfully optimistic assumptions get us to next year's 16 per cent earnings growth. What if we plugged in revenue growth of 5.75 per cent, forecast nominal GDP growth plus the extra revenue growth that S&P 500 companies have enjoyed over the past decade, and then applied the average corporate margin? Earnings would be just $71 a share.

Such a back-of-the-envelope forecast is no substitute for Wall Street's 'wisdom'— indeed it is not even a forecast. But, just as professionals now value the market on 'cyclically adjusted' p/e ratios, it might provide a sounder basis for valuation. After all, there are few economic series that revert to the mean as reliably as corporate margins.

Plugging in these numbers, US stocks would be trading at 15.5 times 2011 operating earnings rather than a far more attractive 11.5 times. And, since operating earnings are on average about 19 per cent higher than reported net earnings, that would put the market's actual 2011 p/e multiple at a somewhat pricey 18.5 times earnings using normalised forecasts. Given today's bullish corporate headlines, it is understandably difficult and possibly premature to become cautious. Then again, analyst consensus has a nasty tendency to lure investors into trouble.

Thursday, August 5, 2010

The Stupidest Advice I've Ever Heard

¹²The Stupidest Advice I've Ever Heard

By Jeff Clark | 5 August 2010

"You have to own stocks here," says one CNBC talking head after another. "There's too much money on the sidelines, and as stocks keep going up, investors will feel the pressure to put that money into the market. That will push stock prices even higher."

Give me a break.

Is that the best reason they can come up with for buying stocks? It's not because stocks are cheap (they're not), or that growth rates are high (they're not), or because the business climate is bustling (it isn't). No, they're telling you to buy stocks now based on the "greater fool" theory— the hope that a greater fool will come along and buy the shares from you at a higher price later.

It's the stupidest advice I've ever heard.

First off, we've been listening to that sort of talk for most of the past year and stocks are roughly at the same level as they were last summer. Oh sure, the S&P 500 did manage to pierce 1,200 in April. That was the month mutual funds experienced their largest cash inflows of the year. It was also the month that preceded the 1,000-point 'flash crash'.

So much for the strength of the greater fool theory.

The talking heads also argue that there isn't anything else for investors to do with their money. They'll just have to buy stocks. After all, who's going to sit in 0% money market funds, or buy 10-year U.S. Treasuries at 3%, or buy long-term corporate debt for 4.5%?

Wait a minute. Investors have been sitting in 0% money market funds for two years. They have been gobbling up 10-year Treasuries at 3% yields. And corporate America had no problem issuing billions of dollars in debt last month at the lowest interest rates in two decades. It seems to me, if the money hasn't come in from off of the sidelines by now, it probably isn't going to.

The problem is the average investor no longer trusts Wall Street. They know it's a rigged game and most folks don't want to play it anymore. Who wants to go up against high-frequency trading programs and the Goldman Sachs trading desk, which hasn't had a losing day since the Romans conquered Greece? Investors have been settling for measly returns in exchange for not getting scammed. That's probably not going to change anytime soon.

In order to coax the average investor back in from off of the sidelines one thing has to happen: Stocks need to get cheap enough to where the value and the potential for future profits— even with the threat of increased taxation on those gains— far outweighs the risk of loss in a rigged system. We're still pretty far away from that right now.

Best regards and good trading,



The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

Wednesday, August 4, 2010

Batten Down The Hatches

¹²Gold Meltdown Or Mania— Batten Down The Hatches

By Louis James | 5 August 2010

As Doug Casey said recently, we expect things to come unglued soon. With the ongoing madness in Europe, it seems to me that things are starting to look visibly less well glued already. In contemplating the possibility of another stock market meltdown, it seems important to me that in spite of the exuberance with which investors rushed back into the market over the last year, the memory of 2008 remains vivid, tempering enthusiasm with caution.

For example, the market still has relatively little appetite for early-stage, grassroots exploration projects. By our latest estimates, Mr. Market is willing to pay on the order of ten times more for Proven & Probable ounces in the ground than for less certain resource categories. With this evidence of caution in mind, and the great unwinding of the broader credit markets well underway, it seems likely that our sector is less leveraged than it was before the crash of 2008.

If a panic in the broader markets put liquidity-crunch-induced pressure on the gold price, the meltdown should be less severe than in 2008 and the eventual rebound could be dramatic, possibly triggering the mania we've been calling for. Remember: the market crash drove gold down almost to $700 in October '08, but the same fear drove it almost back to $1,000 by February '09. Silver topped that with a 60% rebound over the same period.

As the debt-glue holding everything together continues to lose its grip, the ride will only get rougher. As bad as 2008 was, if the Crisis Creature appears to be coming back when everyone on Main Street thought it was dead, the fear should be much worse— and that should drive gold way, way north. It's possible the fear, coupled with the lack of any safer alternatives, could prevent gold from 'melting down' at all, sending it instead straight up through the roof into the clear blue Mania Phase sky.

With its industrial metal aspect, however, another big economic meltdown could hit silver harder than gold, and it might take longer to recover, especially if base metals don't rebound the way they did in 2009. That said, silver has always tracked gold, so when gold heads for the moon, we expect silver will as well. It could reach even higher, if supply is cut by reduced base metal demand, as most silver production is as a by-product of base metal mines.

Either way, I don't care if gold drops in the weeks and months ahead; the overall trend is for widespread economic fear and uncertainty to continue, holding gold prices up and eventually driving them higher. That makes the current retreat look like a great buying opportunity. In fact, putting my money where my mouth is, I picked up some more gold buffaloes just yesterday, when gold dropped to $1158. As I type, it has rebounded to $1181. I plan to buy more every time I see a sharp drop like this over the summer.

So, in addition to our multiple recent calls to take profits and go to cash, I want to reiterate that gold is cash. And it's a whole lot more attractive than the dollar, the euro, or any paper money at present— not just as a speculation but for security as well. Unfortunately, the stampede to safety that drives investors to gold is not likely to drive them immediately to junior exploration stocks.

What About The Stocks?

The junior exploration stocks— "The most volatile stocks on earth"— is not what fearful people will be looking for— not until the panic sufficiently recedes and greed joins fear in equal measure in the marketplace or in greater measure, come the Mania Phase. If I'm right about fear being the driving force in the markets in 2010, whereas greed drove them in 2009, gold will have to deliver a serious wake-up call— perhaps holding over $1,500— to really get the show on the road again for the gold stocks. If that happens while fear of a global economic slowdown continues to push oil prices lower, gold producers should be able to report extraordinary profit increases, even as other industries are tanking, and finally penetrate deeply into the awareness of broader pools of investors.

Cashed-up majors won't have to wait for that to benefit; they may seize the opportunity created by market weakness to buy successful explorers, with significant discoveries in hand, while they are on sale. Well, some of the more nimble ones, like Kinross or Agnico-Eagle, might. The bigger companies, like Newmont and Barrick, didn't lift a finger to pick up any bargains after the crash of 2008 and may be too cautious to act the next time around as well.

Be that as it may, acquisitions will increase the demand for quality exploration projects— the pipeline from exploration to development must be kept full— and good prospectors should at last get their day in the sun. Punctuating this sequence will be the occasional big win on a new discovery. There haven't been that many this cycle— not enough to replace all the gold the majors are depleting every year— but there have been some, and the market always loves a discovery.

After the first quarter of '09, greed outpaced fear and great development stories did phenomenally well; we saw better gains on large and growing gold stories than we did on the big producers. If fear retakes predominance in 2010, it's profitable production that should do best, and I'd expect the biggest winners overall to be new, emerging, and highly profitable precious metals production stories. Spectacular discoveries should also do spectacularly well, but those are harder to predict. New and rapidly expanding production should be the sweet spots.

Generally, I think we'll see our markets trading largely sideways over the next few months, with great volatility, until the debt-fueled "growth" in the global economy is exposed for the sugar high that it is. We've been forecasting that scenario for long enough here at Casey Research. I expect this to play out by the end of this year, or 2011 at the latest, depending on how fast fear returns to the broader markets.

What To Do

If I'm right about this, the strategy called for is a more cash-focused version of our "Buy only the Best of the Best" program. Buy nothing new unless you're offered a great bargain in a solid company that can deliver significant new or expanding production. Nothing less than 50,000 ounces gold-equivalent per year in production will get much notice, and anything less than 100,000 ounces per year AuEq will have to struggle for respect. A solid company, of course, has great people, lots of cash, and the goods in hand.

If you want to speculate on a discovery, make sure you have very good reason to believe the project has much better than average odds of delivering a discovery— and it has to have world-class potential. That's not hundreds of thousands of ounces but millions of ounces of gold, or equivalent. If things do come truly unglued this year, we may well see 2008-style bargains on great companies with the staying power to recover and go on to new highs. Watch for it. Prepare for it.

Buy Low, Sell High— it's a formula that requires patience but is the only way to go.

Must-Reads That Will Radically Change Your View

¹²Must-Reads That Will Radically Change Your View Of The Stock Market

By Dan Ferris | 4 August 2010

Most people view the stock market like a lottery game. They make short-term bets on businesses they know little or nothing about and generally lose money. But there's another way to practically guarantee you'll make money in stocks. It requires you to stop obsessing about the market's day-to-day fluctuations and learn something about the businesses you're buying and selling.

You can learn about this method in a number of ways. But I think a great introduction is to read three short books, and one important chapter of another book. By the time you've read all four selections, a light bulb ought to switch on in your head. You should be convinced there's a better way to buy stocks than making random guesses about short-term share price movements.

Last fall at the annual Stansberry Alliance meeting, I was asked for a single book recommendation. I enthusiastically recommended Joe Ponzio's F Wall Street, which I had just finished a few hours earlier. F Wall Street teaches you to think about the value of a business first and forget about the price of its stock until you understand the value well enough. That's what all the best investors say. Look past the noise. Look past the short term. Forget about market risk. F– Wall Street! Focus on value. Be a business analyst, not a market follower.

I probably shouldn't tell you any of this. If you gained expertise in valuing businesses, you'd almost never buy stocks. Most public companies are simply too hard to value. Those that aren't too hard to value spend most of their lives overvalued by Mr. Market. When I tell my readers I'm having trouble finding "cheap stocks," it goes without saying I mean "cheap stocks I understand well enough to value". Ponzio also provides a reasonable valuation shortcut method "for 'armchair' investors who see the value in stocks, want to stick with large, stable companies, and don't want to invest hundreds of hours of research each year."

The book treats a hard subject in a straightforward, easy to understand manner.

Ponzio's final chapter is on patience, another hugely important concept. As I'll show my Extreme Value readers in the August issue (which comes out this week), mastering time is the most important factor in any investment plan. If you can't learn to be patient, you simply cannot make money in stocks. If you can be patient enough, success is virtually guaranteed. If you want to sign up for Extreme Value in time to get the August issue delivered to your inbox this week, click here. [[Note: I do not subscribe to Extreme Value and have no idea of its worth.: normxxx]]

Overall, F Wall Street is well-written and highly readable. It's also worth re-reading. I keep it at arm's length at all times when I'm at home. Most financial books stink. This one is great. Read it and learn from it.

Another valuable investing book is Joel Greenblatt's classic, The Little Book That Beats The Market. Using a simple story that's a joy to read, Greenblatt teaches the reader the ideas behind his Magic Formula investing concept. Magic Formula investing is a simple idea that says you should buy the best businesses when they're trading at suitably cheap prices. Greenblatt offers simple metrics and guidelines so you can learn to identify a good business and know when it's cheap enough. Greenblatt's book, too, is worth re-reading. It's next to Ponzio's book on my shelf.

Another book I often recommend is Frank Singer's little 27-page masterpiece, How To Value A Business. Singer's booklet provides a simple formula for valuing a business, which requires that you estimate the probability of a company's earnings occurring. Think about that. Most people take the earnings for granted. They don't bother wondering about the likelihood of earnings occurring. There are many highly cyclical businesses out there. Once you get real about the likelihood of a given level of earnings happening again, you start realizing a lot of stocks are just too risky to fool with.

Singer's book also prompts you to think about three different types of value, Liquidation Value, Stock Value (which is really IPO value), and Ongoing Business Value. Liquidation value is not the subject of the book. Nor is Stock Value. Singer admits there seems to be no sense or logic to IPO valuations.

Singer provides you with basic tools to understand the value of an ongoing business. He also shows you how ongoing business value can be much higher for a strategic acquirer than for an investor like you or me. A strategic acquirer is another company in the same business. Businesses are worth more to strategic buyers because the key inputs, the earnings, and the probability of the earnings occurring are higher for the strategic buyer. He buys the business because he thinks he can wring more profit out of it. And he thinks higher profits are highly certain. So he pays more. Like Ponzio and Greenblatt, Singer's book contains good examples and anecdotes.

The other must-read I recommend most consistently is Chapter 20 of Benjamin Graham's The Intelligent Investor. The chapter is called "Margin of Safety as the Central Concept of investment". I recommend you re-read it once a month. It's that important.

Once you learn about value, you have to keep in mind business values are inherently imprecise. You can't pinpoint them. You can only estimate them within a given range. Margin of safety is simply the margin for error investors need because it's impossible to pinpoint business value.

For example, if you think a company's stock is worth $100 a share and you buy it for $95 a share, you don't have a real margin of safety. If that $100 company is a World Dominator and you buy it for $75 a share, you're getting a margin of safety. Say the company is a riskier business, not a World Dominator. In that case, you'll want a bigger margin of safety. You might want to wait until it sells for $60 or even $50 a share.

Warren Buffett once said something like this: You want to build a bridge to withstand 30,000 pound trucks, then you want to drive 10,000 pound trucks on it. You don't want to drive too many 29,000 pounders across it. If most investors learned to value a business, they might exit the stock market altogether. My guess is most stock investors who learn to value a business become very picky about the stocks they'll own. They buy less often, sell less often, and hold longer.

And they make more money.

Dan Ferris And Sean Goldsmith

Tuesday, August 3, 2010

Best Trading Strategy For August

¹²The Best Trading Strategy For August

By Jeff Clark | 3 August 2010

The bulls got it. The monthly chart of the S&P 500 closed above its 20-month exponential moving average (EMA) on Friday. That's bullish action. And it negates the bear-market signal that occurred on June 30— when the S&P closed below its 20-month EMA.

Here's the chart… This marks the first time since late 1990, when the U.S. was preparing to kick Iraq out of Kuwait, that the bear was forced back into hibernation in just one month. The bear market signals in late 2000 and early 2008 led to dramatic declines in stock prices. I expected we were in for something similar this time around, too. Based on yesterday's action, it appears that won't be the case.

At least, not yet.

It's hard to give up on the bear case. After all, global economies are a mess. Unemployment is high [[…with no real end in sight— see Beware The Move In Durable Goods: normxxx]]. Government, corporate, and individual debt burdens are out of control. And everything just seems, well, bearish.

But when it comes to the stock market, price action trumps everything else. And right now, the price action is bullish. Yes, it's possible the chart will flop back into bear-market territory by the end of August. The S&P 500 only needs to lose about 2% from yesterday's closing price to do so.

Whippy moves like that are unusual, though not out of the question when most of the volume in the market comes from high-frequency trading and algorithm-based computer programs. Nonetheless, if you trade on the basis of technical analysis, you have to respect the current signal. Of course, that doesn't mean we abandon all common sense and jump into the market with both feet.

Stocks are extended here. They're overbought. The S&P 500 is up 10% in one month, and it can use a break.

It didn't make sense to sell or short stocks into oversold conditions early last month when the above chart first flashed a "sell" signal. It also doesn't seem too wise to be aggressively buying stocks right now. Perhaps the best strategy for August is to take a cue from the "big time" Wall Street traders, who took off for the Hamptons last weekend.

Relax. Take some time off to get away from the pressure. And come back in September.

How To Trade A Bear Market

You cannot ride a bear. Rodeo cowboys score points by staying on the bull as long as possible. Investors profit by doing the same.

But a bear is a completely different animal. No cowboy is crazy enough to saddle up and try to ride a grizzly. Yet investors try it all the time— and they get killed.

Bear markets are not for riding. They're for trading. That means you wait for severely oversold conditions before you buy anything. Then you sell when conditions become less oversold.

And you wait for severely overbought conditions before selling stocks short. Then you cover those trades when the market turns neutral. It's not a "buy-and-hold" environment. It's a "scalping" environment— you play only the best setups and take profits quickly.
[ Normxxx Here:  Stocks are still in a secular bear market (that started in cy2000) and are likely still in a cyclical bear market (that probably started in May).  ]

Short-term conditions were wickedly oversold by 1 July, and the intermediate-term indicators pointed to a strong bounce. But rather than sell into violent downside moves, it's smarter to wait for the inevitable bounce and use that strength to cash out of long trades and enter a few short trades. [[Maybe by the end of this month, but anyways probably during the September-October-November time frame. Still, I would hold off on any attempt to swing trade here: the market is too risky/volatile for that. It's OK for short term trades only.: normxxx]]. As you can see from the nearby chart, stocks usually do bounce hard at the beginning of a bear market

The bear markets that began in late 2000 and early 2008 both experienced bounces where the S&P 500 rallied back up to test the breakdown level of the 20-month EMA. I expected something similar to happen this time as well— before a much more serious decline took hold. But the upmove overshot and morphed into a buy signal. Stocks may still be headed much lower by the end of the year; but right now, it is too risky to short any. Don't be surprised if they work still higher over the next month or so. [[SPX 1200?: normxxx]]

The Right Time To Short Stocks

It's dangerous to be short stocks right now.

Yes, we may have entered a bear market in May. And yes, stock prices will likely end the year far below where they are today. But stocks were so oversold and investor sentiment was so pessimistic, a huge bounce was inevitable.

We got the first stage of that bounce in July. And it was so strong that it cleared the 20-month EMA hurdle and 'signaled' an 'end' to the (1-2 month?) cyclical bear! [[Or, did it!?! In any case, that severely oversold condition is long gone, but we are still far from severely overbought.: normxxx]]
[ Normxxx Here:  In fact, the parallels to 2008 are eerily similar. In 2008, stocks rose from a March low to a May peak then tumbled in June to a July low and an August peak. This year, stocks rose from a February low to an April peak then tumbled in May to a June low. However it recovered strongly in July and is still on an upswing. In other words, the 2010 move (so far) is advanced one month from the 2008 move. Nevertheless, historically, August has been the month in which the markets have "rolled-over" into a Fall selloff.

The markets can deal a crushing blow to prematurely and overly aggressive bears who hope to make some 'easy' money betting on the downside. That's what bear markets do. That's why you should wait for a strong bounce and a strongly overbought market (which this isn't yet) to try any shorts.
Of course, bear markets are usually even more brutal to long-term investors who insist on holding stocks in a declining environment. But bear markets also crush traders who try to sell short into oversold [[or even 'neutral': normxxx]] conditions. The biggest "one-day wonder" rallies always seem to occur in the midst of a bear market. They serve to shake out the traders who got a little too aggressive betting on the downside.

There will be plenty of opportunities to make money shorting stocks in the midst of this bear market, if that's what it still is. There's not much to be gained, though, by shorting stocks when the market is this strong, short term. Be patient. Give this rally another few weeks, or maybe even more, to run its course. You might even put out a few longs here. Start nibbling on short positions when the S&P stalls (or obviously turns over), investor sentiment soars again, but most stocks are already short term positive or definitely overbought. Pay close attention to the talking heads over at CNBC. If they once more eagerly declare the 'return' of the bull market— for as far as the eye can see— then get out your songbook and sing-a-long with the fat lady.

[[I am holding my breath and keeping my powder dry; in a market like this, it is better to be too late than too early. But in any case; it is not a time to take big risks— either way.: normxxx]]

Best regards and good trading,

Monday, August 2, 2010

Valuing The S&P 500 Using Forward Operating Earnings

¹²Valuing The S&P 500 Using Forward Operating Earnings
Click here for a link to ORIGINAL article:

By John P. Hussman, Ph.D. | 2 August 2010
All rights reserved and actively enforced.

It is impossible to properly estimate long-term cash flows based on a single year of earnings, regardless of whether one uses actual net earnings or projected operating earnings.

It is impossible to properly value the stock market based on a single year of earnings, regardless of whether one uses actual net earnings or projected operating earnings.

Writing each of these sentences only once is woefully inadequate. If I had my way, investors would have to write them over and over five days a week. Wall Street analysts would have to write them a hundred times a day, immediately upon arriving to work.

In recent weeks, I've seen "valuation" arguments that literally treat future estimated operating earnings as if they are a pure, immediately distributable dividend that will grow indefinitely without the need for capital investment, while sustaining current record profit margins forever. I've heard analysts say, with a straight face, that stocks are 'cheaper here' than they were at the 2009 lows, because the ratio of the S&P 500 to the current forward operating earnings estimate is lower today than it was 16 months ago. I've seen analysts presume to "capitalize" earnings into some sort of market valuation by doing nothing more than dividing estimated operating earnings by corporate bond yields that are presently nearly indistinguishable from Treasury yields.

The primary question investors need to ask is whether these analysts have actually examined the historical record of these approaches— not just whether they have an anecdote about some extreme such as 2000 or 1987— but whether they have done a robust, long-term evaluation. Unless a "valuation" methodology is accompanied by long-term, decade-by-decade evidence showing that the valuation method is actually correlated with realized, subsequent market returns (particularly over a horizon of say, 7-10 years), then you are not looking at the sound valuation work of an investment professional. You are either looking at a random guess or a sales pitch.

Don't get me wrong. There are many thoughtful, well-disciplined financial planners and asset managers— usually far away from Wall Street— who are excellent stewards of their customers' investments. My difficulty is not with those professionals, but with the careless and inept reasoning that passes for analysis hour after hour on the financial news. If you take away one thing from this week's comment, it is that stocks are a claim to a long-term stream of cash flows that will actually be distributed to investors over time, and that this stream of cash flows cannot be estimated from a single year's earnings number.

The main reason for this is that profit margins vary from year-to-year over the business cycle, and tend to mean-revert over the long-term. Earnings (net and operating) tend to be depressed during periods of economic strain, but when they reflect compressed profit margins, they are strongly associated with above-average rates of subsequent growth over the following 7-10 years. In contrast, earnings that reflect elevated profit margins are strongly associated with poor rates of subsequent growth.

When analysts take earnings figures at face value, and presume to "capitalize" them simply by dividing by interest rates, they demonstrate a Kindergartener's grasp of securities valuation. Case in point is the treatment of forward operating earnings. The first problem is that analysts tend to treat these as if they are distributable cash flows. Unfortunately, operating earnings exclude a whole range of charges that may not occur on an annual basis, but are legitimate costs and losses incurred as part of the ordinary course of business.

Meanwhile, operating earnings often include a benefit from those very same "extraordinary" sources— provided they make positive contributions (witness the large boost to the operating earnings of major banks this quarter, resulting from the reduction in reserves for future loan losses [[potentially simply postponing those losses to a future reckoning: normxxx]]). Forward operating earnings take these hypothetical earnings to the next level, and are based on the year-ahead forecasts of Wall Street analysts. As long-term readers of these comments know, I am terribly concerned about the increasingly careless use of operating earnings as a measure of stock valuation, because I have yet to see an operating earnings model that is not ignorant, devious, misleading, lacking in historical evidence, repeatedly catastrophic, or all of the above. Not least of these concerns is that the commonly quoted "norm" of 15 for the P/E ratio properly applies to the ratio of the S&P 500 to trailing 12-month net earnings, which are invariably much lower than forward operating earnings.

Operating earnings are not even defined under Generally Accepted Accounting Principles (GAAP). They were spawned by Wall Street in the early 1980's, so there is (conveniently) no long-term history for this measure, meaning that the valuation bubble between the late 1990's and 2007 represents a significant chunk of the observable record. Still, the increasingly common use of this earnings measure requires us to somehow deal with it constructively. As it turns out, the lack of history prior to 1980 is not particularly difficult to overcome.

We can very accurately explain the relationship between forward operating earnings and standard earnings measures using variables that have been observable throughout history. We can form good estimates prior to 1980 on that basis (see August 20, 2007 Long Term Evidence on the Fed Model and Forward Operating P/E Ratios). It is then straightforward to calculate objects such as the Fed Model (the ratio of the forward operating earnings yield to 10-year Treasury yields), and to demonstrate that it has zero correlation with subsequent market returns.

The question then becomes— is there any way that forward operating earnings (FOE) can be employed as a useful measure of market valuation? The answer is actually yes.

Valuing The S&P 500 Using Forward Operating Earnings

I should emphasize from the outset that the proper valuation of a stream of future cash flows requires one actually to model the stream of cash flows earned, delivered as dividends, reinvested, and obtained as terminal, liquidation or buyout payments. Methods that rely on multiples such as P/E, price/revenue, price/dividend and so forth are approximations at best. They perform better if the fundamental metric being used is relatively smooth, and varying rates of growth are explicitly taken into account.

That said, discounted cash flow models can always be mapped to "multiple-based" models. The issue there is that you'd better know what assumptions are baked in, and whether they're reasonable. For example, in an ideal world, a stock that earns E, pays a proportion d of that out in dividends, reinvests the rest to grow at a perfectly constant rate g, and is expected to stay in business into the indefinite future, should have a P/E ratio of d/(k-g) where k is the desired long term rate of return (say 0.10 or 10%) that the stock should be priced to deliver. For more on discounted dividends, see the September 12, 2005 comment, The S&P 500 as a Stream of Payments.

Unfortunately, all of this stuff gets abused. I remember in the market bubble of the late 1990's and into 2000, a bunch of Wall Street analysts were saying that stocks were still cheap based on the 'dividend discount model'. The problem was that they were assuming growth rates (g) of 10% or higher, when the peak-to-peak growth of S&P earnings and dividends had never exceeded 6-7% over periods of a decade or more. The Dow 36,000 guys basically tried to justify a P/E of 100 for the Dow by assuming that earnings were dividends, and then picking a "g" that was so close to "k" that the denominator of the above model was 0.01, or 1%. I wondered why they didn't go all the way and set k=g so they could publish "Dow Infinity."

But I digress.

The two main failures of standard FOE analysis are that 1) analysts assume a long-term norm for the P/E ratio that properly applies to trailing net, not forward operating earnings, and; 2) analysts fail to model the variation in prospective earnings growth induced by changes in the level of profit margins, and therefore wildly over- or underestimate long-term cash flows that are relevant to proper valuation. By dealing directly with those two issues, we can obtain useful implications about market valuation. As I have frequently noted, it is not theory, but simple algebra, that the long-term annual total return for the S&P 500 over any horizon T can be written as:

Long term total return = ((1+g)(future PE / current PE)^(1/T)- 1) + (dividend yield(current PE / future PE + 1) / 2)

The first term is just the annualized capital gain, while the second term reasonably approximates the average dividend yield over the holding period. For the future P/E, one can apply a variety of historically observed P/E ratios in order to obtain a range of reasonable projections, but the most likely outcome turns out to be somewhere between the historical mean and median. You have to get two things right: the "normal" future P/E and the prospective long-term earnings growth rate g. 'Standard' FOE analysis misses on both counts.

Very simply, looking out over a 7-10 year horizon, the proper historical norm for price-to-forward operating earnings is approximately 12.7. Moreover, one cannot simply apply the long-term operating earnings growth rate of 6.3% (0.063) as an unchanging measure of g. Rather, an accurate growth rate for the model has to reflect the level of profit margins at any point in time, since the current P/E multiple may reflect either depressed or elevated earnings. For a 10-year investment horizon, the proper value of g should take into account the gradual normalization of margins. Historically, the best estimate is approximately:

g = 1.063 x (0.072 / (FOE/S&P 500 Revenues))^(1/10) - 1

The chart below presents the historical projections obtained using this analysis, along with the actual 10-year total returns achieved by the S&P 500.

Currently, the forward operating earnings model above suggests an average annual 10-year total return for the S&P 500 of 5.5%, while indicating that the S&P 500 was briefly and moderately undervalued at the 2009 market low. Not surprisingly, the 1988-1991 model projections underestimated the market's subsequent 10-year total return, as the period a decade later— between 1998 and 2001— represented the extremes of the subsequent valuation bubble. Overall, the correspondence between projected and actual 10-year market returns is very close. Taken together, my impression is that this is a record that a reasonable and informative valuation model ought to produce.

Last week, I noted that our standard model (which is based on peak-to-peak earnings) suggested a somewhat higher 10-year total return near 6.7% annually. The difference between that model and the forward operating earnings model above is that the peak-to-peak model calculates a growth rate based on the position of earnings within a long-term growth channel, and does not formally take profit margins into account. The chart below provides a good range of what our most reliable valuation models project for S&P 500 total returns over the coming decade, and presents the complete post-war history.

Though each of our metrics is slightly different, all concur that the market was moderately, but not historically undervalued, at the 2009 low, which briefly approached the level of valuation that was observed at the 1970 low, but was nowhere close to the valuations seen at points such as 1950, 1974 and 1982. I clearly underestimated the willingness of investors to drive stocks back to strenuous overvaluation so quickly. Earlier this year, the market was more overvalued than at any point prior to the late-1990's bubble, and is currently near the same level of overvaluation as the 1972 and 1987 market peaks. At present, all concur that the S&P 500 is most likely priced to deliver a 10-year total return of roughly 6%, albeit with the likelihood of significant interim volatility.

Stocks are emphatically not cheap on a historical basis. Analysts who encourage investors to take a different view on valuations should at least be expected to present similarly extensive historical evidence supporting those perspectives.

[Important Notes— A spreadsheet including forward operating earnings estimates (bottom-up are most common) and the most recent four quarters of index revenues can be downloaded at no charge by registering with To compute the current 12-month FOE from 2010 and 2011 estimates, take the weighted average. For July (month 7), the 2010 estimate was 82.15, and the 2011 estimate was 94.60, producing a weighted average of (12-7)/12 * 82.15 + 7/12 * 94.6 = 89.41, with 12-month trailing revenues of 918.98 for the index.

The calculation of
g in the model above uses trailing 12-month revenues and is calibrated on that basis. The implied 10-year rate of total return can be compared with potential risks and alternative rates of return as one chooses. Of course, it's up to individual investors to decide what level of potential return is acceptable, but keep in mind that historically, investors have not generally tolerated low or mid single-digit implied equity returns for long, so lower projected returns are also associated with dramatically higher risk of intermediate-term loss.

Investors who believe that a 10-year expected return in stocks of about
6% is an outstanding prospect relative to historical and probable market volatility, and believe that other investors, in aggregate, will embrace that same belief indefinitely, are welcome to classify stocks as "fairly valued" here. We are not in that category.]

One final note to our colleagues in finance— we read a lot of research here— articles, blogs, news clips, subscription services, academic papers, and so forth. You'll see comments and links all over our research referencing various sources. We're happy to see our own work picked up, and are particularly pleased when professors use it in their classes. But come on, guys— when you use someone's content, or agree with someone's point, acknowledge the person and then add your own work. Don't just lift models or material.

Bill and I do our best to always include attribution when we use other people's work (send us a note if we miss one!)— except that when we criticize someone's approach, we may omit names unless the person appears to be damaging or misleading investors. I know this is the age of the internet, but common courtesy still applies. None of us is 13 anymore.

Economic Risks Continue

Last week, new claims for unemployment remained within their recent range at 457,000, GDP growth came in at a disappointing 2.4% for the second quarter, nearly half of which represented inventory accumulation, the ECRI Weekly Leading Index deteriorated [still further] to a -10.9% growth rate, and the markets were cheered somewhat by a Chicago Purchasing Managers Index above 60. Clearly, there are cross-currents to the data here. For our part, we are closely focused on the leading components of the data, rather than measures that provide less timely information.

Our own Recession Warning Composite is a primary basis for concern. Notably, once a recession signal emerges, the composite often tips back and forth due to variations among individual components. Those signals tend to become solid as an economic downturn takes hold, but in any case, just one signal is sufficient. With other leading measures also clearly deteriorating, the primary fact that would change our views would be uniform improvement in those leading measures, not simply a rally in the S&P 500 sufficient to take it a bit over its level 6 months ago.

The ECRI Weekly Leading Index continues to receive attention, and in our view, for good reason. As I've noted before, the WLI growth rate is tightly correlated with the Purchasing Managers Index, with the strongest correlation being at a lead-time of 13 weeks. Notably, the WLI growth rate 13 weeks ago was still a positive 12.7, so on that basis, we're still not quite at the point where we would expect to see a wholesale deterioration in the PMI. A 12.7% read on the WLI growth rate is consistent with a PMI just over 60, so the Chicago PMI number was actually right in the pocket, and does not contradict expectations of softer economic activity, at least not yet.

The national PMI indices come out this week, but again, the July figures may be a mixed bag. In contrast, one would expect the August and September figures to show material weakness. To the extent that we do not observe that, and particularly if other leading measures improve, our concern about probable economic weakness will abate. We're not at that point at present.

New claims for unemployment will also be important early evidence of economic conditions over the next few months. Below, I've inverted the ECRI Weekly Leading Index, plotting it against the amount by which weekly new claims for unemployment (4-week average) exceed their 5-year norm. While WLI downturns (blue spikes on the chart) are not always associated with a spike in new claims (see 1987, when the weak WLI was driven almost exclusively due to stock price weakness), the leading tendency of the WLI is strong enough that we should not ignore the potential for increased layoffs.

Given that the 5-year norm for new unemployment claims is about 400,000 weekly, it's possible we could be looking at new claims well above 500,000 weekly by September. Again, the relationship is not tight enough to form the basis for strong predictions, but it is clear that investors should not easily discard caution on the basis of one positive economic figure or another. Importantly, the WLI growth rate was 14.9% 23 weeks ago, so we are still in the period where the recent deterioration in leading indicators may not be confirmed by coincident data.

With regard to mortgage losses, the housing market remains in a fascinating period of "extend and pretend," where it is clear that mortgage conditions are worsening, but we have not yet seen an explosion in foreclosures, or a movement of the growing inventory of foreclosed homes onto the open market. The main exception is Fannie Mae and Freddie Mac, which have been accelerating foreclosures in recent months, accompanied by a regular influx of funds from the U.S. Treasury (which already exceeds $145 billion) to bail out losses on what would otherwise be insolvent GSE debt. The Lender Processing Services (LPS) June Mortgage Monitor provided the most recent report last week, noting that
"…foreclosure starts for loans owned by the Government Sponsored Entities (GSEs) are at an all-time high. The largest percentage of GSE foreclosure starts are coming from loans that are six or more months behind on payment. This finding is consistent with the reports of increased Home Affordable Modification Program (HAMP) trial period cancellations. Total delinquent and foreclosure inventories remain at historically elevated levels, with Jumbo and Agency prime product experiencing the greatest percentage increase since January 2008. The report also shows that two loans are deteriorating in status for every one loan that improved."

As James Saccacio, the CEO of RealtyTrac observed a week ago,
"The roller coaster pattern of foreclosure activity over the past 12 months demonstrates that while the foreclosure problem is being 'managed' on the surface, a massive number of distressed properties and underwater loans continues to sit just below the surface, threatening the fragile stability of the housing market."

On Sunday's edition of Meet the Press, Alan Greenspan remarked that there is a huge number of homes that would go "underwater" if home prices were to slip by another 5-7%, and that such an event could potentially trigger a large wave of additional foreclosures. I am not familiar enough with the price distribution of existing mortgages to contribute much insight here, but the remark does help to explain why banks appear so reluctant to bring the massive inventory of delinquent and foreclosed properties onto the market. It is not clear precisely at what point the burgeoning inventory of foreclosures and delinquent mortgages will impact the markets, but it is clear that conditions are not improving, and that fresh economic weakness would tend to destabilize an already fragile situation.

At the same time, it is not out of the question that we may be quietly allowing U.S. banks to go insolvent without disclosure, [[we've done it in the past: normxxx]] covering the losses over time out of wide interest spreads on existing loans, and that we may be able to avoid outward evidence of mortgage deterioration simply by allowing the Treasury to go further and further into deficit on behalf of the GSEs. Undoubtedly, all of this will produce future strains in the form of inflation risk, longer-term commodity price pressures, fiscal instability, stagnant lending activity, continued failure of smaller institutions, further loan writedowns, and other events. The losses are inevitable, and to some extent even quantifiable.

The real question is who will actually bear those losses and when. The official policy is clearly for the public to do so, massively, preferably quietly, and over a very long period of time. Still, my impression is that fresh economic weakness could prove to be a tipping point, and that both investors and the public should understand that they are likely to pay terribly for the current abundance of apparently 'free' lunches.

Market Climate

As of last week, the Market Climate for stocks was mixed— valuations remain unfavorable, technical action was mixed but tenuous, with various indices flirting with widely observed levels of support and resistance (e.g. the 1100 level on the S&P 500), while leading measures of economic activity remain decidedly unfavorable. As I noted last week, the average historical outcome of similar combinations has been negative, largely because the deterioration in economic measures [eventually] tends to trump technical action even when it has been more favorable than it is at present. Still, there is a clear speculative element in day-to-day market action here, as trend-following investors remain heavily focused on very specific price levels, which can trigger short-term bursts of buying and selling pressure.

Overall, my impression is that the near-term dynamics of the market are likely to be dominated by this sort of speculative trend following activity— primarily because it will probably still take another 4-8 weeks until sensitive coincident economic measures (such as ISM figures and new claims for unemployment) begin to predictably reflect the deterioration we've seen in various composites of leading indicators. Again, if we do not [actually] observe that deterioration, and particularly if the leading measures broadly improve, our concerns about the economy would tend to abate. For now, we remain defensive.

In bonds, the Market Climate remained characterized last week by moderately unfavorable yield levels and favorable yield pressures. The Strategic Total Return Fund continues to carry a duration of just under 4 years, largely in intermediate-term Treasury securities. I am not at all convinced that Treasuries with a maturity much past 5 years will provide adequate yields to maturity, or even positive real returns, as we move through this decade.

But inflation concerns are clearly a longer-term issue. We are likely to observe strikingly larger budget deficits ahead for a while, but at the same time, the eagerness of investors to hold default-free paper is likely to be quite strong. In that environment, you can print a lot of government liabilities with seemingly no consequence.

It's in the back half of this decade where the eagerness to hold those liabilities will probably abate, with unfortunately no ability to reduce the supply since the dough will already have been spent. That will likely push us into an inflationary experience much like the 1970's, which followed the rapid increase in government spending and the move to persistent deficits after the introduction of the Great Society programs of the late-1960's.

M O R E. . .