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The comparison with Treasury yields is even more dramatic. Recently, for instance, two-year Treasuries were yielding 1.9% while a two-year maturity fixed-rate annuity was yielding 3.09%. The yield advantage over Treasuries continues throughout the maturity range Ä a 10-year Treasury yields 3.77% while a 10-year annuity yields 4.73%. One word of caution here: These yields are highly fluid and will be different by the time you read this. In addition, I'm citing averages. Some are higher, some lower. What you can count on is that annuity yields don't fall as fast as Treasury yields. The CD-like fixed annuity is a simple product designed to function like a bank CD. The guarantee period matches the surrender penalty period. What you see is what you get. They run from a day [in maturity] up to 10 years - but 90% of what is sold is five-year contracts. The interest is compounded daily as with bank CDs, is tax-deferred until withdrawn (unlike a bank CD or Treasury obligation), and the contracts now offer the option of regular monthly checks. Basically, the insurance industry has cut commissions and offered a more attractive deal.
With more regular disclosure a given, the real question is just how big an improvement the SEC intends to make from its current twice-a-year standard. Expect a compromise that leads to a quarterly disclosure with a 60-day lag, so that the Sept. 30 holdings are released Dec. 1, for example. Increased portfolio disclosure could be in the offing by year's end, with investors likely to see the additional information well before the end of 2003.In the end, increased portfolio-holdings information will help investors, allowing firms like Lipper and Morningstar to come up with more meaningful and accurate portfolio measures, overlap indicators, and more. Further, it will allow the SEC to give investors what they want: more control over their funds.
Investors' reaction to Westmont's slashed profit estimate showed the power that analysts still have over share prices: Broadcom stock plunged $2.04, or 15%, to $11.86 on Thursday, the lowest price since the shares began trading in 1998. Yet Westmont didn't lower his official recommendation on Broadcom. He kept his rating at "2S," which under Salomon's grading system means he expects the stock to perform "in line" with others in its industry over the next 12 to 18 months - the 'S' meaning the stock is 'speculative' - meaning it has "exceptionally low predictability of financial results and highest risk and volatility". Of 25 analysts who follow Broadcom, 14 now rate the stock "buy" or "strong buy," and 11 rate it "hold" or the equivalent, according to data-tracker Thomson First Call in Boston. Regulators in the spring ordered Wall Street to be clearer in its stock recommendations and to include with every research report much more disclosure about how ratings work and whether a firm faces any potential conflicts of interest in following a particular stock. At Salomon Smith Barney, that resulted in a change from a five-level rating system to a three-level system: a 1 rating for "outperform," indicating that the stock, over 12 to 18 months, is expected to perform better than others in its industry that are followed by the analyst; a 2 rating for "in line," meaning the stock should perform in line with its peers; and a 3 rating for "underperform," meaning the performance is expected to be worse than the average peer stock. Salomon also includes letter ratings indicating whether a stock is considered low risk, medium risk, high risk or speculative. Some brokerages, such as Prudential Securities, have opted for simpler ratings. Prudential labels stocks either buy, hold or sell. Related article: Few Analysts Say the 'S' Word - Jeff Opdyke, WSJ
The role of optimism in the market can be expressed in hard, cold numbers, according to Vanguard Group founder John Bogle. He analyzed the stupendous stock market gains of the '80s and '90s as follows: During those two decades, the S&P 500 returned an average of 17% a year. Of that, 3.5 percentage points was in direct payments to shareholders through dividends. An additional 5.5 percentage points came from stock-price gains propelled by the 5.5 percent annual increase in corporate earnings. In other words, 9 percent a year came from solid sources - sources directly linked to the performance of the underlying corporations. Where, then, did the other 8 percentage points of annual stock returns come from? From investor emotion: from optimism, enthusiasm, irrational exuberance - whatever you want to call it. That enthusiasm can be measured in the stock-price gains caused by the gradual rise of the price-to-earnings ratio, from 8 in 1981 to 30 in 2001. Today, the P/E for the S&P 500 is probably in the low 20s, though it's hard to tell for sure because there is now so much uncertainty about what should be included in earnings. This translates to an earnings yield of 5%. That's a nice margin - not too big, not too small - over the 3% or 4% you can get with a decent bond. Many experts, in fact, think that a P/E of 20 should be considered the new norm, given the low interest rates and some other, more arcane, factors. If so, it's good news, as stocks would have to fall by another 25% to get us back to the old P/E norm of 15. What about the future? If the P/E stays at 20, there won't be any emotional factor driving stocks as there was in the '80s and '90s. We will have to depend on dividends, which average about 1.8% for the S&P 500, and earnings gains, which tend to average around 5.5%. Together, those would produce annual gains of a little more than 7%. Related articles: Death of Optimism - Niederhoffer & Kenner, MSN Money / Dave Kansas, WSJ, Ambiguity Aversion, Sara Calian WSJ / 'Negative' Bubble, D.C. Denison, Boston Globe
The survey, taken in January, concluded that 35.9 million households had such investments, down from 36.3 million during the earlier study, for a decline of 1.1%. The number of households that said they owned individual stocks, as opposed to mutual funds, outside retirement plans was off even more, falling 4.1% from 21.9 million households in 1999 to 21 million this year. But when investors with money in 401(k) and other employer-sponsored plans were included, the number of American households with a stake in the stock market had risen from 49.2 million households to 52.7 million [or 84.3 million investors. That represents an increase to 49.5% of households this year, from just 19% in 1983. (WSJ 9-27)]. The percentage of owners who professed to be unconcerned about "short-term fluctuations" in the value of their holdings fell to 77% this year from 83% in 1999.
First, the Dow Jones Industrial Average since 1950 has averaged an annual gain of about 18% in the year prior to a presidential election. Even more startling, the Dow has gained an average of 50% from the midterm-election-year low to the pre-election-year high since 1914, according to the Hirsch Organization, publisher of "Stock Trader's Almanac." The pattern held even after the crash of 1929, although the rise of 23% from the low in the midterm-election year to the high in 1931 didn't meet the historical average. Second, since the 1950s, investors who got into the market in November and pulled their money out in April have seen returns on the Dow of 8.2%, on average. In contrast, the average return during the worst six months - May through October - is 0.4% on the Dow. There's no guarantee that 2003 will follow suit, of course. But so far, only 1939 - which saw the start of World War II - didn't fit the pattern.
A typical program trade involves a smaller institution - say a college endowment. The endowment will set parameters to manage the risk to its portfolio. If, for example, the Dow breaks through the 8,000 level, an internal alarm may sound, triggering an automatic pullback from the stock market, maybe by shifting into treasuries. Thanks to technology, the endowment can place a single phone call to adjust its exposure to the equity and bond markets without having to engage in multiple transactions. The catch is that these automatic triggers, or trading programs, have grown in popularity as institutions have become more sensitive to protecting their principal investments. Numerous triggers being pulled at once can cause the market to swing erratically - explaining why it seems to move 100 points in the blink of an eye.
But that's only half the story. David Hershey, a senior portfolio manager at Lotsoff Capital Management, wants to change how pension funds are managed. He believes pensions can achieve their financial goals by investing in bonds. "There's a widespread belief that stocks outperform bonds over the long term," he said in a recent telephone interview. "I differ. The real reason equities outperform over time is that equities have more risk. If you elevate your risk in bonds, you can achieve the same return. For instance, if you leverage up the bond portfolio, you'll get the same risk." Corporate bonds and mortgage-backed securities, for instance, could be leveraged with short-term debt to provide 12% net yields. "Stocks are fine for most investors," Mr. Hershey said. "But they aren't good for pension plans because pension plans have real liabilities." When interest rates went down, the cost of funding those lifetime pensions went up. When interest rates went up, the cost of funding those lifetime pensions went down. As a result, a pension fund portfolio dominated by bonds would move in the same direction as its liabilities, not the opposite. I asked for an example. "Look at 1989 and 1995. Those were two big years for stocks. They were up more than 30 percent. In spite of that, pension liabilities rose faster than pension assets." I asked how that could happen. "Interest rates went down, so the cost of funding a pension went up," he said. "Now look at 1994. That was the year the Fed raised rates from 3% to 6%. They had left rates low for a long time [due to the banking crisis] and then had to go from a low rate to a market neutral rate in a short time. Pension liabilities went down." He pointed out that stocks had positive, bull market returns for 10 of the last 13 years. In spite of that, pensions had lost ground against their liabilities over the period. From 1989 through the end of 2001, the change in pension assets trailed the growth of pension liabilities by 7%.
First, from current levels, interest rates have a lot more room to rise than to fall. After all, there is a floor on interest rates, because yields are unlikely to drop below zero. But there is no ceiling. Indeed, in 1981, 10-year Treasurys yielded almost 16%. Second, as yields come down, bonds become much more volatile. Why? Suppose interest rates climb from here. Because today's yields are so low, there is less of a cushion to soften the blow from rising rates. Third, the spread between the yield on Treasurys and those on corporate bonds is unusually wide. Even if overall interest rates don't climb, there is a chance that the spread will narrow, hurting Treasury investors. There are some good reasons for these paltry yields. Stocks are in the third year of a brutal bear market. Corporate bonds seem iffy, thanks to all the accounting scandals. Meanwhile, inflation is subdued and the economic recovery is still tentative. Bond investors typically look for a return above inflation of three or four percentage points a year. But to get that return from 10-year Treasurys [currently yielding in the 3.9 - 4.0% range], you would need inflation close to zero. Inflation ran at 1.5% over the year through July. That figure is likely to climb, as a reviving economy drives consumer prices higher. Indeed, low inflation isn't exactly the norm. Since the Second World War, there have been just six calendar years when inflation was below 1% - and the last time was 1961. More on Bonds Caroline Baum, Bloomberg 9-11 One year after the terrorist attacks on the WTC and the Pentagon, most financial commentary is focused on whether stocks have bottomed. What's missing right now is any meaningful discussion of whether interest rates have seen their lows for the cycle. The fact that there is such a one-sided bet on interest rates [that they will stay low] should be a call to arms for contrarians, says Jim Bianco, president of Bianco Research in Chicago. There's a universal view that there is no inflation, that yields are going down because stocks are going down. When the bull market in bonds started in October of 1981, with 30-year yields at 15.21 percent, `the 20-year average rate of return for bonds was 2.4%,' says Paul McCrae Montgomery, a money manager and market analyst at Legg Mason Wood Walker, citing data from Ned Davis Research. In November 2001, with bond yields at 4.79%, `the 20- year total return was 13.1 percent,' he says. `People are used to good returns from a safe place to hide from the stock market. But bonds are going to be a poor investment going forward.' More Bonds Stats James Glassman, Wash Post 9-22 New figures by ICI show that for the first time since 1995, Americans in July had less money invested in stock funds than in bond and money-market funds. At the height of the boom in 1999, stock (equity) funds had $4 trillion in assets while money-market and bond (debt) funds had $2.4 trillion. Now, debt funds lead equity funds, $3.3 trillion to $2.8 trillion. Mortgage-Backed Securities Karen Damato WSJ 9-27 The rush by homeowners to refinance their mortgages is a gray cloud hanging over one of the largest and most popular categories of bond mutual funds, those investing in mortgage-backed securities. GNMA funds have returned an average of 6.9% so far this year and an average of 8.0% annually over the past three years, according to Lipper. Those solid returns have made GNMA funds a magnet for investor cash. GNMA funds pulled in $9.8 billion in new cash in the first eight months of this year, boosting their assets to about $64 billion in assets, Lipper says. Now, all mortgage funds face a similar problem: Mortgage rates are at their lowest level in more than 30 years. The average rate on 30-year loans just dropped below 6%, Freddie Mac reported Thursday. The current yield on Lehman Brothers' mortgage-backed securities index is just under 5%. That suggests that if interest rates stay at current levels, investors might reasonably expect a one-year return of 4.5% in a fund that has a half-percentage-point expense ratio or a return of 4% in a fund with a one-percentage-point expense ratio. Note - you should not put much weight on a GNMA funds' stated yields to compare funds or guess at the returns they will earn. Those yields are backward-looking, typically reflecting fund dividends over a recent 30 days. The figures have been tumbling and are likely to fall further as prepayments continue. Related articles: Stocks vs Bonds - Jonathan Clements, WSJ / Abby Schultz, NY Times
Dean Maki, an economist at Putnam Investments in Boston, notes that current consumer spending, while healthy for a soft economy, still is growing at only about half the rate it did it during the late 1990s. Moreover, the Fed said that growth in household debt, driven by mortgages, "remained rapid" in the second quarter at 9%, on a seasonally adjusted annualized basis. Home mortgages increased by $157 billion to $5.663 trillion, while consumer-credit debt, such as credit cards, increased almost $30 billion to $1.706 trillion. Federal government borrowings surged 13% -- the largest such gain in more than a decade. One positive measure in the Fed report is that disposable personal income grew about $119 billion, or 1.55% on an annualized rate, following a sharp drop in the measure in the fourth quarter of 2001. The increase in disposable income "means the household sector can get out of debt, which it's got to," says Jane D'Arista, program director for the Financial Markets Center, which studies monetary and financial policy. Still, Ms. D'Arista says the "big picture isn't good" because households are more dependent on home value staying high to hold up net worth.
The number of cloned animals living on American farms today is small - most estimates put it at fewer than 100. All are elite animals that cost tens of thousands of dollars to produce and are valued as breeding stock, not as meat. For that reason, products made from clones are likely to be a mere trickle in the marketplace, at least at first, farmers said. But if the technique becomes established and the price of cloning falls, farmers envision a day when entire dairy herds may be stocked with nothing but clones of the most prolific cows. The technique may never be cheap enough to produce animals for use directly as meat, but breeders said it's likely the first- or second-generation offspring of clones will wind up in the meat supply in large numbers. Other countries are moving in the same direction as the United States. A study published recently in Japan said cloned meat and milk are identical to the ordinary kind. That nation is now preparing to lift a ban. One concern for the FDA is that breeders going to the expense of cloning may also attempt genetic modification of the animals, perhaps to make them leaner or improve milk production. Such genetic manipulation poses far more potential problems than mere cloning does, and the FDA would likely require extensive proof that the gene-altered animals are safe to eat. The biggest remaining concern is animal welfare. Though clones that survive to adulthood typically seem healthy, they die in inordinate numbers in the womb or just after birth, and the pregnancies appear to be stressful for the surrogate mothers.
The likelihood of default is low for the vast majority of municipal bonds. But the default rate jumps significantly for bonds tied to some public works projects, particularly some backed not by government entities but by for-profit companies like airlines and department stores. One agency, Fitch Ratings, conducted a study in 1999 of municipal bonds that came to market starting in 1979 and found that munis in traditional sectors - state, county and city bonds backed by the taxing power of the issuer and used to pay for projects like schools, sewers and roads - are among the the least risky debt classes. They generally have default rates of 0.01% to 0.40%, the study found, compared with 1.49% for all municipal bonds. By contrast, the riskiest sector - industrial development bonds, often backed by corporations rather than public institutions - had default rates of 15% percent, according to the study. These bonds are often unrated or are rated below investment grade. Because many investors invest primarily in bonds of their home states - for the added tax advantages - local fiscal problems can weigh heavily on their portfolios. For diversification, Jim Lynch [the president of Lynchmunicipalbond.com, a firm that advises investors interested in building muni bond portfolios] said that at least 25% of a muni portfolio should be in bonds issued outside the home state.
During most of the last five years, that research showed potential declines of 30 percent to 50 percent. According to its August report, that danger no longer exists. The S&P 500 index would now decline only 8% (from its July close of 912) to be at the median valuation level for all the low inflation years from 1926 to the present. An 8% decline would take it to 839, a level that is higher than the July 23 low of 797. In other words, valuations are back to normal, and the bubble is behind us. A similar exercise with a broader group of 3,000 stocks is even more encouraging. Small- and mid-capitalization stocks, when benchmarked to historical valuations, would have to appreciate 33% to reach median levels. They are currently valued at deep bear market levels Ä at the bottom 25% of all historic figures. Researcher Leuthold's conclusion? Although the largest capitalization stocks are still somewhat overvalued, the broader market may be a bargain. Trusting indicators over emotion, the Leutholds group is buying. Is it safe to invest in stocks? Sorry, but no. While the bubble is gone and valuation has returned to normal levels, we have some heavy-duty depressants that could drag the market still lower. Here are the big three: Mutual fund redemptions. Mutual fund redemptions will be a drag on stock prices. Legg Mason analyst Ray DeVoe spent the summer reminding his clients that "capitulation" - the period when investors walk away in disgust - is seldom something that lasts for only a month or two. He points out that in the 96 months following the 1973-74 bear market, 95 were months of net redemptions. The record redemptions of July may only be the beginning of a long string of redemptions. Looking at the immediate future, figures from ICI show that equity mutual funds entered August with very low cash positions - about 4.6%. This means that any continuation of redemptions will force portfolio managers to sell stocks. Corporate pension earnings drag. The next shoe to drop in corporate accounting is more subtle than outright fraud but broadly dangerous. It is the sudden underfunding of corporate pension plans. The combination of lower interest rates (which raise the cost of funding a pension) and dramatically lower portfolio returns means many corporations with defined benefit plans will have to add new cash to their pension plans, reducing per-share earnings. Basically, corporate earnings will be swimming against a strong current. The global mess. Uncertainty has a way of reducing valuation levels. It happened after the Cuban missile crisis in 1962. It happened after the first OPEC price increase in 1973. It happened after the second OPEC price increase in 1979. And it put the markets on hold when Saddam Hussein invaded Kuwait in 1990. Today we have the uncertainty (and costs) of the war on terrorism, the possible invasion of Iraq, continued (and nuclear) tension between India and Pakistan, escalating violence between Israelis and Palestinians, and the ongoing implosion of the Japanese banking system. When it comes to worry, our plate is loaded. All other things being equal, worry tends to reduce valuation levels for stocks. Worry also favors returns that are realized (and paid out) today over returns that are a few years away. The bottom line? Watch. Don't plunge.
But there is a strong incentive for companies to classify expenditures as one-time even when they are recurring. Doing so could make a company appear to be delivering outstanding profits to its shareholders and to be exceeding the expectations of Wall Street analysts. To study how companies have responded to that incentive, Russell Lundholm, an accounting professor at the University of Michigan, and two of his graduate students, Jeffrey Doyle and Mark Soliman, turned to Thomson Financial's Institutional Brokers Estimates System, which recently became part of Thomson Financial's First Call database. They focused particularly on the more than 150,000 earnings reports issued from the beginning of 1988 to the end of 1999 in which companies excluded expenditures from their pro forma earnings. (Their research is circulating in academic circles as a working paper at http://papers.ssrn.com /sol3/papers.cfm?abstract-id=303563.) The researchers first looked for correlations between these companies' exclusions and their cash flows over the subsequent three years. If the companies had been correct in classifying their excluded expenditures as nonrecurring, then there would have been no correlation. In fact, however, there was a very strong one: on average, $1 of exclusions in a given report of pro forma earnings was associated with a total of $1.34 less cash flow over the subsequent three years. The researchers next searched for correlations between these companies' exclusions and the performance of their stocks over the next three years. On average, they found, the stocks of companies that had the largest exclusions significantly lagged behind those companies with the smallest ones. These results suggest that we should be skeptical of all expenses that companies exclude from their pro forma earnings. But the researchers did identify one exception: expenses that fall into the category known as "special items." These include restructuring charges, asset write-downs or losses on the sale of assets. Professor Lundholm speculates that this category is relatively immune from abuse because such expenditures are readily identifiable and tend to receive much publicity. Most of the abuse, in other words, takes place in other parts of companies' financial statements. The researchers ranked the earnings reports that satisfied this definition according to the per-share amount of the exclusions. On average, over the three years after the date of the earnings report, the stocks of the 10% of companies with the smallest exclusions performed 16.8% better, annualized, than those of the 10% with the largest exclusions.
The study concludes that analysts often do include important bearish nuggets - tucked beneath a bullish stock recommendation. They wrote that 'frequently, the verbal descriptions accompanying the recommendations appear in stark contrast to the ratings themselves'. In the study, 25% of the companies analyzed were tagged with ratings like "attractive" or "strong buy" in the year before they filed for bankruptcy-court protection, and just 2% were rated "sell." The study cites research on LTV. Morgan Stanley kept an "outperform" rating on the stock, its second-highest of four ratings at the time, for most of 2000 even as it warned investors that high debt levels could force steelmakers into bankruptcy. Merrill Lynch rated LTV a "buy" for much of 2000 as it also acknowledged difficulties at the steelmaker. Salomon Smith Barney gave LTV its highest rating in July 2000, though the investment bank also flagged LTV as "high-risk." Sanford Bernstein unit of Alliance Capital Management Holdings, whose research has long been viewed as untainted because it doesn't do investment banking, rated LTV an "outperform" just 60 days before the bankruptcy filing. The rating accompanied research that described the steelmaker as having a 50% chance of surviving downside risk, noting, "business is lousy and the company is bleeding badly." The EDS Example Aaron Elstein, WSJ 9-24 In trading Thursday, shares of EDS were down $19.26, or 53%, to $17.20 on the NYSE. Of the 23 analysts who follow EDS's stock, only four rated it "sell" or its equivalent, according to Thomson Financial/First Call. Many analysts were raising concerns about EDS's prospects before the company's bad news hit. Yet few were courageous enough to advise investors to sell the stock, choosing to hedge their bets with ratings like "hold" or "market perform," which, to many in the investment community, amount to recommendations to sell without saying such.
Information technology is more like cotton textiles in the 19th century. "Production was concentrated in Britain," says International Monetary Fund economist Markus Haacker, "but about half the goods were exported." Prices fell, and about half the benefits of British breakthroughs in making cotton textiles went to those in other countries that bought cheap cloth. "We find the same result for the information-technology revolution," he says. "If you export information-technology goods, you lose most of the benefits." Falling technology prices may have another unappreciated benefit: permitting poor countries to enjoy the payoff now largely claimed by rich ones. Once, railroads were an enormous boost to Mexico; it didn't have U.S.-style waterways to move goods, so trains replaced inefficient carts. Today, cellular phones are a convenience to Americans, but they bring phone service to remote places in Africa for the first time with benefits far greater than opening a cellular-phone factory would.
Yet, when pundits talk about the stock market's collapse, they don't talk about bad news. Instead, they talk about a stock-market bubble that inevitably burst. The whole notion bugs me. No doubt about it, there was a certain amount of irrational exuberance. But let's be realistic. All this Wall Street hype and investor overconfidence would have gone nowhere without good economic news. In the 1990s, the world seemed like a remarkably stable place and the economic news was relentlessly good. In the current decade, the world seems like a far scarier place and the economic news has been unremittingly bad. Against that background, the stock market's astonishing rise and subsequent collapse doesn't seem so surprising. In all this, there are three important lessons for investors. First, don't beat yourself up for failing to sell stocks in early 2000. At the time, there was far more uncertainty about the market's direction than pundits acknowledge today. Second, don't be fooled by "hindsight bias." If you believe that it was easy to predict the market crash, you might be emboldened to make big investment bets today. But the truth is, the stock market tends to be pretty darn efficient and it is awfully tough to earn superior returns. Finally, accept that stocks are heavily influenced by events. If the economy hadn't slipped into recession and Sept. 11 hadn't happened, the Dow Jones Industrial Average might now be hitting new highs, rather than trading close to its bear-market low.
"The markets since Sept. 11 have broken down, and it has little to do with terrorism; it has to do with corporate governance," says John Meara, president of money-management group Argent Capital Management. "Banks will not lend, and corporate executives are afraid to take on inventory." The question now is whether the stock market has finally washed out those excesses, which would mean that a rebound is coming, or whether there is more bad news to come. "The economy is improving slowly but the market is just trailing down because nobody has any confidence in the future," Mr. Meara says. He and many other investors remain persuaded that stocks will have to turn up eventually, probably after companies start reporting better earnings and stronger outlooks. But in part, he adds, restoring confidence simply will take time. For now, investors have become disheartened both at the fraud and at the economy's inability to grow. Weighed down by those anxieties, investors have been more susceptible to nagging worries about terrorism and global conflict. Recent U.S. warnings about an attack on Iraq have added to the jitters. So as August ended and September began, many investors decided simply to pull back from the stock market. Mr. Meara compares the situation to 1962, when the SEC issued a blistering criticism of trading abuses at the American Stock Exchange. That year, the world also came to the brink of nuclear war during the Cuban Missile Crisis. "If history is any guide, it took several months in 1962 for people to say, the earnings are coming through," and to decide that it was safe to invest again, Mr. Meara says. "Over the longer term, what matters is earnings - earnings predictability and confidence in the whole system," says Kevin McClintock, chief investment officer for stocks at money-management firm David L. Babson. "What we have seen is a decline in earnings and a recognition of how low-quality some earnings have been."
Economists say, the aging of the work force and the globalization of industries have combined to make a long stretch of joblessness more likely for many people. In addition, many women who lost their jobs in past downturns then dropped out of the labor force until the economy improved. Today, however, most families depend on a woman's income to pay bills, and women are more likely to continue looking for work for months. Time Heals All Wounds Jonathan Clements, WSJ 9-09-2002
The good news is the U.S. economy added jobs for the fourth consecutive month in August. Even better was the net upward revision to payrolls in June and July. The bad news is that private payrolls - jobs outside of government - fell last month for the first time since April. And more than half the revision to July job growth - from 6,000 to 67,000 - was a result of revising government jobs higher. More disappointing was the reacceleration of the declines in manufacturing jobs, which fell 68,000 in August. The diffusion index dropped to 46.7 in August from 48.8 in July. For manufacturing industries, the diffusion index fell to 39.7 from 48.2. July's plunge in the workweek - down 0.3 hour to match the all-time low of 34 hours - looked suspicious to many economists. Usually the workweek only falls so abruptly when the forces of nature (blizzards, hurricanes) conspire to prevent employees in large areas of the country from actually reaching their place of work. Some economists held out hope for a complete rebound in August. It didn't happen. The workweek rebounded by 0.1 hour while the manufacturing workweek, down 0.4 hour in July, inched back only 0.1 hour as well. The most encouraging news was not even in today's employment report but was implied by it. The fact that businesses are producing more without hiring new workers suggests stronger productivity growth and higher profits. So far in Q3, the index of aggregate hours is 1.8% annualized below the Q2 average. If forecasts of 3-4% GDP growth for the current quarter are correct, it implies a huge increase in productivity and a better bottom line for corporations, says Jim Glassman, senior U.S. economist at J.P. Morgan Chase.
Earnings for the companies in the S&P 500 reached $55.12 a share, excluding "goodwill" charges, in 2000, according to Thomson First Call, and then posted their biggest drop ever in 2001, falling to $45.16. This year, analysts expect a slight rebound to $48.81. But it's the estimates for next year that cause the split. Wall Street strategists who calculate these numbers - and whose track records in recent years have been less than sterling - are now saying earnings in 2003 will jump 12% to $54.75. Merrill Lynch's most recent monthly survey of fund managers, respondents said they expect just 7% earnings growth in the next 12 months, down from 10% the month before. Many of their customers are dubious. "My sense is you have very bifurcated expectations," says Steve Galbraith, Morgan Stanley's chief investment strategist, whose estimate for S&P earnings is $58. "Many, if not most, of our largest clients - focusing on the potential hit from options, pensions, war, whatever - see $45 as much more reasonable." These earnings numbers are important because they flow into one of the most-tracked barometers of the market, the price-to-earnings ratio. If investors believe the S&P companies will earn just $45 next year, then the price-to-earnings ratio based on 2003 earnings is a pricey 19.5. But if earnings are $60, the P/E falls to a more historically reasonable 14.6. So how might S&P 500 earnings get to $60? Few analysts believe the economy is poised to take off like a shot, and few believe corporate revenues will zoom up either. But some do see evidence that profits may pick up. The most common explanation is that companies have reduced costs, mostly by cutting workers, which potentially boosts profit margins. "The cost of labor has fallen relative to top-line revenue," says Bob Prince, director of research and trading at Bridgewater Associates. "Normally, that has a big impact on total profits, but this year it has not." But it will at some point, he adds. One reason for the delay is that earnings this year have been filled with write-offs, restructuring charges and all manner of bad news as companies attempt to put costly mistakes behind them and clean up their accounting. "I think it's a great environment for getting all your dirty laundry out," Mr. Prince says. "Who could be blamed for bad earnings?" Another factor depressing earnings is a huge spike in depreciation expenses taken by companies. That has been caused in part by legislation passed by Congress last fall allowing companies to accelerate depreciation and write off certain investments, in an attempt to get them to start buying equipment again. In fact, Mr. Prince argues that corporate earnings are significantly understated right now. He points out that operating earnings, which are generally used by analysts and which exclude what companies deem as one-time charges, were 39% higher than net income in the second quarter. Operating earnings always overstate profits, but the difference between operating and net income was unusually high; in normal times, the difference is 13%, meaning that net income could be set to rise. The real wild card here is operating leverage. During the boom years, companies invested billions of dollars in capital equipment in the belief that the good times would never end. The good times did end, of course, and when they did, this equipment, which effectively raised the companies' cost of doing business, acted as a lead weight on earnings. But if revenues grow faster than expected, all that extra equipment would be put to work, making companies efficient again. That, combined with lower labor costs, could send profits soaring. More Estimates LA Times 9-3 Analysts now are predicting that third-quarter profits for companies in the Standard & Poor's 500 index will rise 11.2%, down from the 16.6% increase they were forecasting July 1, according to Thomson First Call. Fourth-quarter earnings are expected to increase 22.9%, down from the previous prediction of 27.7%.
In addition to keeping track of the forecasts of economists, the Philadelphia Fed asks them near the middle of each quarter to estimate the odds that the economy will shrink over the coming year. The economists give a percentage for the current quarter and each of the next four. The magic number for the Anxious Index seems to be 30. When forecasters think that there is a 30 percent chance that the economy will shrink in the coming quarter, a downturn usually follows. "When we're up in that range, it really means a recession could happen at any time," said Dean Croushore, an economist at the Philadelphia Fed. (To take a look at the index, type in www.phil.frb.org/files/spf/prob.txt and check under "Mean Probability of Decline in Real G.D.P." The fifth column from the left covers the quarter after the survey.) The index rose above 30 before every recession since 1968, the earliest date for which the Fed has data. In good times, the index hovers around 10. So what does it say these days? After jumping to almost 32 early last year, shortly before the recession, it remained high until this year's second quarter, then fell to about 14. It moved to 18 in the most recent survey.
Junk-bond prices have fallen 6% this year through Thursday, according to the Merrill Lynch Master High Yield Index. That is their worst record since 1990, when the index fell 4.4% for the year. Because prices and yields move in opposite directions, junk-bond yields have soared, to an average of 12.7%, according to Moody's Investors Service, 8.9 percentage points higher than the 10-year Treasury note. Default rates on junk bonds peaked at 10.7% in January and were at 10.1% in July, according to Moody's. The last time rates jumped to such levels was in June 1991, when they hit 12.8%. The rate of corporate defaults is closely linked to the economy. When the economy improves, the default rate would be expected to decline, with prices rising and yields falling. "Because of these attractive yields and the lack of other options out there to get a decent return, this asset class has taken in a huge chunk of money recently," said Sandy Rufenacht, manager of the Janus High-Yield fund. Investors are hoping for a rebound rivaling that of 1991, when junk-bond prices rocketed 34.6 percent, according to the Master High Yield Index.
Now, ask yourself a question. How much return would you give up to be certain you would receive a return? Which return is more certain - a dividend or a capital gain? My guess is that most people would be willing to give up at least a tenth of their return to "insure" that they received it. Since most tax returns have top tax rates of 30 percent or less, taking current dividends over future capital gains is a sound decision for most people.
Beginning last December, however, the ratio of sales to purchases rose significantly above this historical level, according to the Vickers Stock Research Corporation, which gathers and analyzes the insider transaction data from the SEC. At one point in the spring, the sell-buy ratio over the trailing eight weeks was nearly three to one. The eight-week ratio began declining in mid-July, however, and now stands at 1.25, suggesting that insiders are selling at well under than their historical average rate. The ratio is likely to continue falling, according to Vickers, because insiders have sold at an even slower pace in recent weeks. New research sheds light on how long it may take for insider trading patterns to cause a change in the overall direction of stocks. It was conducted by three accounting professors - Bin Ke and Steven Huddart of Pennsylvania State and Kathy Petroni of Michigan State - and is circulating in academic circles as a working paper (http://www.smeal.psu.edu/faculty /huddart/Abstracts/KeHuPe.shtml). To measure the lag time, the researchers focused on companies that report lower earnings after many consecutive quarters of profit increases. Not surprisingly, these companies' stocks plummeted when their bad earnings were eventually reported. Of course, insiders would have an incentive to sell when they first had an inkling that their companies' fortunes might take a turn for the worse. In fact, the researchers found higher-than-average selling by corporate insiders began as early as nine quarters before such earnings reports. The researchers also found that insiders generally wrapped up their abnormally high selling at least three quarters before the release of a negative earnings report. The study offers a road map for interpreting the abnormally high amount of insider selling from December to July. If that selling conforms to the historical pattern, the bad news anticipated by these insiders will not become public knowledge, and thus fully reflected in stock prices, until sometime in 2003 at the earliest. In other words, the bear market may have further to go. Just the Facts Barton Biggs' Forecast First, the third-quarter pause in the U.S. economy is about over; Q4-21 and Q1-03 will be surprisingly strong, thanks to mortgage refinancing. Second, the long-term bears may be right that we are in for a decade of meager returns, but in the short run, equity markets (including tech) could surge if the economy and profits turn out to be stronger than expected. Third, I am still mildly bullish on bonds, including Treasury bonds, because I believe that investors will migrate out along the yield curve and that Treasuries have not yet discounted the persistence of low inflation. (Barton Biggs, Morgan Stanley via Wash Post 9-29) Earnings Update So far this quarter, 457 companies have warned that earnings in the period will be lower than expected, according to data tracker Thomson First Call in Boston. That is up sharply from the 354 companies that had issued warnings at this point in the second quarter and the 359 that had warned at this point in the first quarter. S&P operating earnings (results excluding one-time gains or losses) are expected to be up 8.5% in the quarter, after a 1.4% gain in the second quarter, according to analysts' average estimates as tracked by Thomson First Call. (Tom Petruno, LA Times 9-22) Consumer Spending The Census Bureau reported Friday that retail sales in August jumped 0.8%, after rising 1.1% in July. While the surge in auto sales accounted for much of the gain, even excluding that, August retail sales rose by 0.4%. Based on these figures, and assuming no increase at all in September, Benderly Economics, projects 5%-5.5% annual growth in real consumer spending in the third quarter. Comments Benderly, "Just when external conditions like the bear market, the accounting scandals, and the fear of war might have depressed consumer spending, the current quarter could turn out to be one of strongest in years." (Gene Epstein, Barrons 9-16) Another "Sell" Criteria You should know what a mutual fund's role is in your portfolio. You won't find this in the prospectus, but every fund should have a job within your portfolio, generally to cover a certain asset class and provide diversification, safety, aggression, or some other key characteristic. If you don't know the fund's job, it's hard to say whether the fund is actually doing it well, no matter how good or bad the performance numbers look. Further, you may outgrow a fund, so that something appropriate for a 40-year-old no longer serves much purpose for a 70-year-old. If you discover that the fund has no specific job, you may want to make a change. (Charles Jaffe Boston Globe 9-15) Valuations Part 2 Many of Wall Street's gurus . . . are arguing that the market is 20% to 40% undervalued. Their conclusion is based upon future expected operating earnings by the S&P 500. These forward-looking estimates are compiled from data submitted by Wall Street analysts. There are some strategists who are extremely dubious of these projections and rely on actual reported trailing earnings. For them, the market is still overvalued. (Dan Sullivan, The Chartist Mutual Fund Letter via Wash Post 9-15) Statictical Distortions Check the statistics, and 1999 looks like a big year for actively-managed funds. The funds returned 28.7%, outperforming the S&P 500 [and the index funds that mimic it], which gained of 21%. But if many investors in actively managed funds didn't feel like celebrating, there was a good reason for that. Only 48% of U.S. stock funds outpaced the S&P 500 in 1999, according to the Bogle Financial Markets Research Center. What happened? A few funds posted huge gains [like the short-lived Internet Funds], that pushed up the average for all funds. (Jonathan Clements, WSJ 9-15) Valuations While market sentiment leans toward the belief that recent earnings are overstated by accounting shenanigans, there is a pretty good case to be made that recent reported earning actually understate true corporate profitability. . . . Based on adjusted operating earnings, the PE of the S&P is now at 26, while it is 35 based on reported earnings. After adjusting for the level of interest rates, this PE is as attractive as we've seen in the past 13 years." (Bob Prince and Jason Rotenberg, Bridgewater Daily Observations via Wash Post 9-8) Average American's Biggest Investment The biggest "investment" most Americans make isn't in their homes or 401(k) plans. It's in Social Security. You laugh? Well, get this: The value of lifetime Social Security benefits to an average-wage, two-earner couple who turned 65 in 2000 was $300,000. The figure comes from C. Eugene Steuerle, an economist for the Urban Institute. The figure is the present value, in 2002 dollars, of lifetime benefits. (Scott Burns, via Seattle Times 9-8) Bad Advice While investors should never sell fund shares hastily, they should realize that even those top fund performers are likely - and sometimes even more likely - to suffer a future slump. Funds' salespeople, sometimes outsmarting themselves, frequently counsel clients to avoid selling overvalued stock funds after big run-ups because it would trigger a tax bill. Now, of course, many of those investors have no gains to worry about, so this year's excuse not to sell is that the fund is way down from its peak. (Aaron Lucchetti, WSJ 9-6) Proposed IRA Reforms Congress is casting about for IRA "reforms" that will be good enough not necessarily to get workers through retirement but to get legislators and the president through the next election. One version of the plan would push the age to 75 from the current 70 1/2. Another would simply abandon the requirement and let retirees make whatever withdrawals they wish whenever they wish - or none at all. Retirees are complaining that current mandatory withdrawals force them to sell stocks at today's depressed prices, thus shrinking their retirement savings prematurely. (Albert Crenshaw. Washington Post 9-1) Playing Survivor Don Christensen, author of 'Surviving the Coming Mutual Fund Crisis', predicted as early as 1995 that the stock market bubble would burst. The defensive measures the book suggests are worth looking at now, when investors are wondering whether the problem in their portfolio is with the funds they own or with the broader market. Christensen's suggestions: Avoid non-diversified funds; Avoid high-risk investment strategies (ex. funds that trade in illiquid securities or use margin and short-selling; Avoid high-turnover, high-cost funds; Read proxy statements; Avoid funds obsessed with the next big thing; and Dump funds that could turn you into an insomniac. (Charles Jaffe, Boston Globe 9-1) Labor Update The combination of technological advances in U.S. business and full employment led to gains in family income that reversed 20 years of income stagnation. That's the finding of "The State of Working America," a study to be released this week by the Economic Policy Institute. Productivity increases led to rising living standards. The labor outlook for the next few years is promising. "There will be a shortage of young people entering the labor force," notes economist Daniel Mitchell of UCLA, and that could prompt a return of the labor shortages of the late '90s. Families added 20 hours to their workweek in recent years, meaning that more workers worked full time or had multiple jobs. The increased work also accounts in part for the growth in incomes and productivity. Health insurance coverage also increased for U.S. workers in the late '90s, after falling for more than a decade. (James Flanigan, LA Times 9-1) 'RONDE' Investors have learned from the bear market some things about the practical math of risk. Consider a phenomenon we might call RONDE, or the Rule of Never-Diminishing Exposure. It says that the maximum possible loss in a stock is never less than 100 percent of your money. As Enron's shares wended their way from above $80 to below 10 cents, many a buyer stepped up, evidently thinking that the risk in the stock was reduced along with the price. Not so. As it turned out, buyers at $5 could lose just about as much as buyers at $50 - which is to say, almost all their money. (Chet Currier, Bloomberg 8-30) Quick Facts, Stats & Opinions According to Standard & Poor's, the dividend-paying stocks in the Standard & Poor's 500-stock index are down just 12% this year, while the nondividend payers are off 35%. (Jonathan Clements, WSJ 9-25) "The capital spending outlook is not as bad as advertised," said Sung Won Sohn, economist at Wells Fargo. "Excluding structures, a lagging indicator, expenditures on equipment and software bottomed during the first quarter of this year," Sohn said. "Outside of the aircraft and telecom sectors, equipment spending looks much healthier." (Tom Petruno, LA Times 9-22) From the stock market's lows reached after the terrorist attacks, on Sept. 21, 2001, slightly more than half of the market is up, with a median gain of 5%, according to Sam Burns of Ned Davis Research. The Dow is up just 0.9% from the 2001 low it hit Sept. 21. The tech-heavy Nasdaq is now 9.3% lower than its post-attack level. (Gregory Zuckerman, WSJ 9-15) In the past two decades, department stores' share of the apparel market has dropped to 40% from 70%, according to Service Industry Research Systems Inc. In home electronics, their share plunged from 26% to 5% and in furnishings from 40% to 5%. (Dina ElBoghdady, Washington Post 9-14) The Fed said consumer credit rose by a seasonally adjusted $10.8 billion in the month, the largest monthly gain since November. Revolving credit, which includes credit and charge cards, rose by $6.5 billion, while nonrevolving credit, which includes auto and other closed-end loans, was up $4.4 billion in the month. Consumer debt in June also was revised upward to an $8.9 billion gain. (Reuters 9-10) From April through June, the percentage of loans on which foreclosures were started rose to 0.40%, up from 0.37% the previous quarter, according to Mortgage Bankers Assn. of America figures. That is the highest level since the organization started tracking mortgage defaults in 1972. Mortgages already in the foreclosure process stood at 1.23% in the second quarter, up from 0.91% a year earlier, also a record. (Diane Wedner, LA Times 9-9) Monetary policy is still powerful economic medicine. The 13% increase in auto sales in August, the furious pace of mortgage refinancing, the strong markets for new homes and the furniture and appliances that go with them - all these stem from the low-interest-rate environment the Fed has helped create. Yet there is evidence that monetary policy may be working too well, shifting so much consumption to houses and cars that other sectors have begun to suffer as a result. (Steven Pearlstein, Washington Post 9-8) Eleven years ago, the S&P 500 stocks accounted for about 85% of all domestic market value. Today, the S&P 500 index accounts for about 74% of all domestic market value. (Scott Burns, Dallas Morning News 9-8) More than 50 companies in the S&P 500 yield more than 4%. In February, the yields of only three companies in the index were that high. Through Thursday, dividend-paying stocks in the S&P 500 were down 10.57% this year, on average, while those that didn't pay dividends were off 34.61%. (J. Alex Tarquino, NY Times 9-8) Challenger, Gray & Christmas, the job outplacement company, reports that 504,000 telecom jobs were eliminated in the 19 months through July. This year, telecom companies account for 23% of all jobs eliminated in the United States. (Gretchen Moregenson, NY Times 9-1) It is a hard concept to grasp, but nevertheless a truism, that after a big decline, the news doesn't have to be good for the stock market to rise. It just has to be less bad than what has already been discounted." (Barton Biggs, Global Investment Research, Morgan Stanley via Wash Post 9-1) Many stocks are still overvalued. It's not at all clear that all the bears or the weak hands have sold. . . . Nevertheless, it seems to us that the bear market is entering its terminal phase, albeit one that might last for some months. That's why it's too late to sell." (Sheldon Jacobs, The No-Load Fund Investor via Wash Post 9-1) Quick Tips Snail Mail Wins One Because of cost advantages and, in some cases, even an edge in speed, the Postal Service, FedEx and other physical delivery services now seem to be the dominant mechanism for bringing data-rich digital content, on demand, into the nation's households. The cost to the service provider of transmitting a data file the size of a typical DVD movie over the Internet could be nearly $20. What's more, a home user with a 56k modem could wait two weeks for a movie to download - vs the three days it would take to mail a DVD coast to coast. Assuming that the average disc video-renter Netflix sends out contains 8 gigabytes, that one company alone may be mailing out about 1,500 terabytes, each day. Video Store magazine estimates that, beyond rentals, about 1.5 million DVD's, or 800 terabytes, are sold each day. Estimates on how much data the Internet carries in North America each day vary from 4,000 - 2,000 terabytes. (Peter Wayner, NY Times 9-23) DVD Formats Pt 1 Big studio movies are released on the DVD-9 format, which can hold 7.95 gigabytes, or billions of bytes, or the DVD-10 format, which can hold 8.75 gigabytes. Some of the older releases, without the extra material, use the less expensive DVD-5 format, which holds about 4.3 gigabytes. Still quite rare are more voluminous formats like the DVD-18, which can store up to 15.9 gigabytes. (Peter Wayner, NY Times 9-23) Spam-Fighting A few spam-fighting programs recently pulled ahead of the pack with a slick new feature. When a message arrives from an unknown sender, the program sends a short query to determine that it comes from an actual person instead of a mass-mail server. For instance Matador requires the sender to select how many animals are in a specific picture. Bluebottle forces the sender to type the name of the recipient; if the name matches, the e-mail is allowed. Note: A sender who receives an authentication form or a request to count the cats may be taken aback if it originates from a regular correspondent. (Charles Bermant, Seattle Times 9-21) DVD Formats Pt 2 Two industry groups supporting conflicting standards for rewritable DVDs have apparently given up on resolving their differences and settling on a single standard. The DVD+RW Alliance and the DVD Forum support different formats, and there are at least four types of discs, causing headaches for consumers and device manufacturers. The result is an alphabet soup of formats and media that consumers must keep straight: DVD-R, DVD-RW, DVD-RAM, DVD+RW, DVD+R. Observers note that the market for rewritable DVDs depends largely on resolving the conflicting standards, making the discs and the formats fully compatible on PCs as well as home and portable DVD devices. Sony reportedly will release new drives that work with different formats, but pressure from companies including Intel may eventually push the two DVD organizations to find a compromise. (CNET 9-18 ) Long, complicated URLs are both hard to type and can get mangled by email programs. These services take long URLs and create short versions pointing to the same page - for free. These are (1) SnipURL, (2) TinyURL, and (3) MakeAShorterLink. (SearchDay 8-19) Home Page Previous Factoid Top Sites
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