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That’s not because Wall Street projections for 2005 are so rosy. Just the opposite, in fact. I’m relatively optimistic about 2005 just because Wall Street is so very pessimistic. In contrast to 2004, which began with Wall Street assuming, after a great 2003, that everything would turn out right, 2005 is likely to begin with a huge reservoir of fear. And I can see a couple of areas where the current pessimism is, if not wrong, at least over-done. But before jumping too far ahead, we need first to better understand the current market rally and what it might tell us about the future. So what’s driving stock prices up so strongly in the current rally? The current rally is all about momentum. It sure ain’t fundamentals. The Conference Board’s composite index of leading economic indicators, which economists use to forecast growth, was down in October for the fifth month in a row. The conventional explanation is that the index is signaling a slowing economy and a weak 2005. The core Producer Price Index, which excludes volatile food and energy prices, climbed an unexpectedly strong 0.3% in October, raising fears that inflation at the producer level could be ticking up to levels that would have to be passed onto consumers. And, finally, Wall Street is predicting that we’ve passed the peak in earnings growth. Earnings for the stocks in the Standard & Poor’s 500 Index are now projected to climb 17% in Q3 from Q3-03, according to First Call. Sounds great -- except that it would be the first time this year that earnings growth has dropped from one quarter to the next. Wall Street projects that trend continuing in Q4-04 and extending into 2005. Projections for Q4-04 call for earnings growth of 15.3% and then of just 8.1% in Q1-05. Stocks don’t command higher prices when earnings growth is slowing, especially when interest rates are climbing. Instead of fundamentals, this rally is based on momentum feeding on momentum. Once the market moved upward on a mixture of relief that the election was over and joy at lower oil prices, sitting on a pile of cash became much less attractive. The more the stock market goes up, the more pressure money managers feel to join in. And the more money they put into stocks, the higher stock prices go, increasing the pressure to put even more money into equities. Look at mutual funds to understand the nature of this pressure. Of the 3,447 mutual funds in the MSN Money database that invest in stocks of large- and medium-size companies, 43% are trailing the S&P 500. The pressure is on these fund managers to at least catch up with the S&P’s 6.44% return for 2004 (as of Nov. 18). A 7% or 8% return may not be that different from 5%, but the difference is enough to swing a manager from “beating the index” to “trailing the index.” Bonuses and contracts to manage millions of dollars may hinge on a manager’s relative performance versus the index. The number of underperforming funds isn’t scattered randomly across growth and value styles, or across large- and mid-cap funds. Only 11% of mid-cap value funds are trailing the S&P and only 15% of large-cap value funds are lagging the index. But even with the recent rally, 40% of mid-cap growth funds and a whopping 75% of large-cap growth funds are trailing the index. The pressure is really on the growth managers to close that gap. Is it any wonder the stocks that are climbing in this rally are the kind of growth rockets (or growth-rocket wannabes) that these growth stock managers are most familiar with? All this sets up the market for one of those classic Wall Street about-face moves. The momentum that is fueling the current rally will work only as long as investors willfully ignore the bad news that current consensus projections show coming down the road in 2005. I’d even say the lifespan of this rally is determined by the balance between Wall Street’s fear of trailing the indexes for 2004 and its fear of the expected bad news of 2005. This argues that the current momentum market dominated by growth stocks and growth-wannabe stocks won’t last very far into 2005. (How far into 2005 depends on what money managers do with the seasonally large cash flows that result from end-of-year contributions to IRAs and 401(k)s that are available for investing in stocks in January.) And it argues for the likelihood of a strong correction after the first of the year, as money managers lose their motivation for buying stocks. Once the Dec. 31 performance figures are in the can, the fear of trailing the index for 2004 vanishes. Cash stops being a drag on performance in 2004, and turns into an insurance policy (again) against the fears of 2005. The stronger the rally this year, the deeper the correction is likely to be as money managers decide to take profits on “overvalued” stocks, and particularly on the “overvalued” growth stocks that led the rally. Any correction will develop its own momentum, a negative image of the momentum now driving this rally. Many investors will see any fall in stock prices beyond 5% (that’s halfway to the 10% threshold that serves as one traditional benchmark of a market correction) as confirmation of their worst fears for 2005, and as a sign to sell. The lower stocks go, the stronger that fear will get. It’s not all bad news. It’s just at that point, however, that investors with a longer view of the fundamentals of the global economy will want to start buying stocks. Not the growth-stock winners of the last rally of 2004, but stocks that will benefit from the now-unexpected good news of 2005. What is that potential good news? * A falling dollar gives U.S. companies protection from some imports, drives up exports and provides cover for modest price increases. I think this will turn out to be especially important for cyclical basic-materials producers in industries such as steel, because it means their earnings won’t peak until 2006 instead of early 2005. * The Chinese finally yield -- a little -- to pressure from the United States, but more importantly from the European Union and squeezed domestic manufacturers. They let the yuan appreciate modestly against the dollar. A cheap yuan is great for exports, but it kills the profitability of any Chinese company that has to import raw materials or components priced in yen, euros, Australian or Canadian dollars. That will take some of the pressure off the euro, keeping European growth rates higher than now projected, and it will give companies that compete with Chinese imports a little more breathing room. * The weak dollar and temporarily lower oil prices will give U.S. companies a solid shot at beating the low 8% consensus projection for Q1-05 earnings growth. The figure won’t be high enough to start talk of a new cycle of fast-growing corporate profits, but it will be enough to show that earnings and economic growth in general aren’t about to fall off a cliff. * A slightly stronger yuan will help the Chinese government restrain capital imports and ratchet back growth without turning the Chinese economy into a train wreck. That, in turn, will lead to a gradual change in focus by investors from worry that Chinese growth will slow too much, too quickly to a renewed interest in companies that will profit from Chinese growth. The rally that will result from that unexpected good news won’t look or feel like the sharp growth rally that has characterized the end of 2004 so far. It’s likely to look like the stealth rally in the first half of 2004, when dull old basic-materials stocks, cyclicals and food stocks climbed ahead while the rest of the market treaded water. And if all of this is true, investors who want to make and keep a profit will have to zigzag as the stock market does. That means riding growth stocks in the current rally but selling them when they hit your target prices or when the rally as a whole starts to feel long in the tooth and tired. It means sitting on cash for a while in 2005 to see if the correction that I think is likely in the first quarter of the year indeed materializes. And then it will mean redeploying that cash into value stocks, into cheap growth stocks and into the specific sectors that are most likely to benefit from a cheapening dollar. If that strategy recommendation sounds familiar, it should. It’s a replay of what worked in 2004. And the wild cards that could upset this strategy are largely the same as those which have hovered over investors for all of 2004: how fast oil prices rise after the current dip; how well or badly the war in Iraq goes; and how well or badly the Republicans use their increased power in Washington.
Before there's a missing element in this vision. It's not at all clear who would have the incentive necessary to build and maintain this wonderfully level playing field. `If all the so-called abuses were suppressed and the public protected against crooks and against its own greed and ignorance, so that nobody could lose money, who in blazes could make money?' asks a character in Edwin Lefevre's `Reminiscences of a Stock Operator,' written in 1922. `If everybody bought at the bottom, from whom would he buy?' As events unfolded in the '20s, we soon had a chance to study in excruciating detail the Lefevre character's argument that `legislation can't help much, because it can't keep a man from wanting to get something for nothing.' The stock market hit a ruinous boom-bust cycle in the late 1920s and '30s that led to a historic new regime of regulation, including creation of the SEC. Passage of the Investment Company Act of 1940 laid the groundwork for the modern mutual fund industry, which is a giant step up from much of what the '20s had to offer the public. No doubt about it: U.S. markets work vastly better with regulation, based on well-written legislation, than they ever did before. Today, the possibilities for improvement are by no means exhausted. That isn't the same thing as saying that all regulation is good, or that someday we will have a really wonderful thing going if we can just get the money-grubbing capitalists out of the picture. Capitalist money-grubbing is what makes the system work. Consider these dreamy possibilities: Stock-exchange specialists and dealers are replaced by a fully automated black-box system that matches buy and sell orders together without asking any reward for itself. The pace of trading is much slower, because every participant in the market now has the same, complete information. There is little point in trying to trade against the emotional ups and downs of the market, since much of the emotion has been removed. In this totally efficient atmosphere, virtually all pension funds, mutual funds and other pools of money are set up to track the market indexes at the lowest possible cost. But there is no give and take to set security prices where, or approximately where, they ought to be. The indexes are useless since there is no longer anything of tested value to base them on. Try to visualize what happens when some shocking development occurs like the terrorist massacres of Sept. 11, 2001 or the stock-market crash of October 1987. When some external trauma hits, how is the perfected, emotionless mechanism of the markets supposed to handle the resulting onslaught of imperfect, human behavior? Who's in charge, who's accountable? Not to worry too much about this dilemma. Experience teaches that few things in life are ever perfected, and the day of perfect markets will most likely never come. The good news is that might be for the best.
The policies in question are known as finite insurance or financial reinsurance. They are sold as ordinary insurance policies, which allow companies that buy them to receive favorable accounting treatment - smoothing out losses on their books, for example. To critics, finite insurance policies are structured less like insurance and more like loans. At heart, finite insurance is simply a form of financial engineering that masks the strength or weakness at the companies that buy them. As such, its use has probably had a much greater impact on investors and customers than other industry practices that Mr. Spitzer has singled out. The deals offer an especially rich vein for investigators to mine, industry analysts say. And last week, Mr. Spitzer sent out a flurry of subpoenas to insurers about policies they may have sold to help customers eliminate or offset losses that would have hurt their financial results. The SEC and the Justice Department are also scrutinizing financial engineering products sold by insurers. By far the biggest customers for such policies are insurers themselves, so investigators will be looking at how these companies may have used these contracts to make their books look better. Given the complexity and secrecy of such deals - they are often not disclosed on insurers' financial statements and require a good bit of detective work to find - cases related to them may not come to light for some time. But industry analysts who have uncovered some of the arrangements on their own in recent years say that their use is widespread. No one knows for sure how large the market is for such policies. Robert Arvanitis, president of Risk Finance Advisors, a corporate finance advisory firm that specializes in insurance, estimates that in any given year, $50 billion of all insurance premiums involve policies with some kind of finite element. Some deals have masked declining financial positions at both life and property-casualty insurance companies that later failed or are now on the edge. Finite insurance allows a company to avoid having to record a loss as a lump-sum deduction from its books; instead, it can spread out the loss over a predetermined period. The insurance premium that companies pay for the policy is tax deductible. And if the loss a company anticipates never materializes, policy holders even get back some of the premium they paid. For the companies that buy the policies, not having to report a loss means that their surplus - the crucial measure of their soundness and the figure that decides how much new business can be written - does not take a hit. This is why finite insurance often shows up on the books of weaker insurers. The trouble is that buyers of such coverage are mortgaging their future earnings power. In effect, they are giving up the investment income they would have earned on the money they used to pay the policy's premium. That is something investors in insurance stocks would clearly want to know about. The biggest risk in such a policy emerges when a regulator or auditor decides that it is not really insurance, in which true risk is transferred from one party to another, but a financing arrangement in which the premium paid by the company buying the coverage is seen as a deposit or a loan. In such a case, the beneficial accounting treatment disappears. "As users of financial statements, we believe that the volatility of an insurer's accounting results should reflect the volatility of the underlying economic results," said Michael J. Barry, a managing director at Fitch Ratings that holds a negative view of these policies. "But most finite insurance results in a disconnect between those two." As a result, Fitch tries to discount the financial effect of such deals when it assesses insurers' financial positions. A Brief History of Finite Insurance Finite insurance has been around since the 1960's, but the first company set up specifically to sell such policies, Centre Reinsurance, was started more than 20 years later. In 1988, Guy Carpenter, a reinsurance subsidiary of Marsh & McLennan, was instrumental in creating Centre Re. To some degree, the finite insurance products that Centre Re and others began to sell in the 1990's simply represented a way for the industry to formalize what insurers had been doing informally for decades. But it wasn't until the late 1990's that finite insurance took off. At that time, too many insurers were chasing too few customers, and premiums and profits were in decline. Hoping to increase the amount of premiums they took in, insurance companies became highly creative about the financial reinsurance products they were selling. At the time, financial services firms were acquiring insurance companies and integrating them into their operations. Perhaps inevitably, finance and insurance began to converge. By 2001,finite programs were growing more than 25% annually at Guy Carpenter. Michele Fleckenstein, a managing director at Carpenter and head of its Finite Specialty Initiative, explained why: "Companies are facing escalating pressure to achieve forecasted results. The need for these covers stems from the extreme pressure that companies face to make planned results and not have any surprises." All insurance is designed to ameliorate the effects of negative "surprises" - say, fires or floods. But increasingly, the types of surprises that finite insurance was intended to mitigate were those that led to volatile company earnings or asset write-downs. In January 1999, Reliance Insurance introduced a product it called Enterprise Earnings Protection Insurance. Reliance executives said the policies were designed for midsize companies interested in protecting their earnings from situations like a disruption in the supply chain or a loss of important customers. It is not clear how much of this insurance was sold. Reliance failed spectacularly in 2001, under a mountain of debt. Deductible Insurance vs Non-Deductible Hedging The American International Group, one of the world's largest insurance companies, is often at the forefront of developing new insurance products. In 1997, it created a policy that combined traditional insurance with coverage of financial risks and sold it to Honeywell. A double-barreled policy, it covered both Honeywell's currency risk and its more traditional risks, like increased workers' compensation claims. The policy eliminated Honeywell's need to hedge its currency risks with derivative contracts that were costly and not tax deductible, the way insurance premiums are. Derivatives are financial instruments whose values are based on another asset. The policy, as described on an A.I.G. Web site, is called a Coin, for commodity embedded insurance. Among its benefits, according to the site, is the "attractive tax and accounting treatment" that may be available in "this blended insurance program." It also "protects earnings from unexpected or unintended losses," the site says. But the coverage of possible currency losses by the policy resembled a derivative contract, as the Financial Accounting Standards Board said in 2001. It ruled that if the program involved little risk, it was not insurance and would have to be treated as a derivative contract and applied to its books. That would have eliminated the appeal of the policy. Accounting rule makers leave it up to the company to determine whether and how much risk is involved. So companies using such blended products may have been encouraged to overstate the risk to achieve the desired accounting treatment. Joe Norton, an A.I.G. spokesman, said Honeywell was the only company to buy a Coin. The contract ran for two and a half years, he said, and had a significant risk transfer component. He said Coins had not been marketed since 1999, and that it was an oversight that its description had not been removed from the Web site. AIG & Brightpoint Settle with the SEC A.I.G. also sold Brightpoint a different kind of finite insurance that helped that company hide $11.9 billion in losses in 1998, running afoul of the SEC. The insurer paid $10 million to settle the matter with the SEC, neither admitting nor denying wrongdoing. But when regulators announced the settlement of the case in September 2003, they said A.I.G. helped mislead investors by selling Brightpoint a "new 'insurance' product that A.I.G. had developed and marketed for the specific purpose of helping issuers to report false financial information to the public." This is the defining characteristic of finite insurance, according to Mr. Arvanitis at Risk Finance Advisors. "Anything that ultimately reduces the loss borne but doesn't change the accounting, or when there is a disconnect between the accounting for risk and actual incidence of risk, that is finite," he said. "Essentially, you're saying you made money and you didn't." As such, the most severe threat inherent in financial reinsurance is to investors who buy insurance stocks and to consumers who buy coverage from insurance companies. In both cases, finite insurance can mask problems at insurers. As the analysts at Fitch have noted, insurers who are in distress are often heavy users of finite insurance. For example, in 2001, the Kemper Insurance Companies executed two large finite transactions, known as retroactive policies, that covered losses already incurred. In a 2002 report, Fitch analysts noted that the effect of these transactions reduced Kemper's surplus by 15 percent. "Without the aid of various financial engineering tools," the report noted, Kemper's surplus would have declined to $1.12 billion at year-end 2001 from the $1.5 billion the company reported in its financial statements. After a failed expansion plan and severe downgrades by financial ratings agencies, Kemper began exiting the business in 2003. Of course, it is unclear what regulators will find as they delve more deeply into financial reinsurance. If companies misled auditors by claiming true risk transfer simply to get favorable insurance bookkeeping treatment, they could be subject to civil suits accusing them of accounting irregularities. But even if their accounting proves to have been accurate, that may not be the end of it. With finite insurance high on regulators' radar screens, it is now much more likely that some companies holding the policies will undo them to avoid attracting the attention of prosecutors, creating more problems for an industry that is already up to its neck in trouble, thanks to Mr. Spitzer. It is also possible that new sales of these policies will simply sputter. Either way, the implications for buyers and sellers of the insurance would be huge. "There is a sniff test here," said Mr. Barry of Fitch Ratings. "Are the buyers and sellers of the insurance exposing themselves to operational risk? Is there a regulator who will come in and say, 'I don't like this transaction, and you have to unwind it?' There are consequences."
As analysts and investors try to sort through the shifting situation - Mr. Spitzer's investigators remain at work - the overarching questions are whether there are bargains to be found in the wreckage and, if so, which stocks have become the most undervalued. The answer to the first is quite likely yes. As for the second, it depends on whom you ask. And, perhaps, when. Some bargain-hunters went promptly to work, driving the shares of American International Group, the world's biggest insurer, back up above $60 from the low of $54.70, where it closed on Oct. 22. The stock was $66.99 just before Mr. Spitzer made his accusations and filed a lawsuit. The stock of Marsh & McLennan, the chief target of Mr. Spitzer, crashed to $24.10, from $46.13, a fall of 47.8%. It has climbed above $27. Many Wall Street analysts have been circumspect about drawing investment conclusions on insurance stocks. They have taken some early comfort, though, from indications that Mr. Spitzer won't jeopardize the industry's basic viability. "It appears that the attorney general is not going to seek criminal charges against the companies, which would have had a detrimental impact on the business," Brian Meredith, an analyst at Banc of America Securities. He added, however, in maintaining his neutral rating on the shares, "we continue to caution investors that we have yet to hear from the Department of Justice." But many investors pounced on the opportunity to take or add to positions in the insurance industry, which has been the cornerstone of numerous financial dynasties, including those of Warren E. Buffett, W. Clement Stone of Combined International and Maurice R. Greenberg of A.I.G. "It's been a very profitable business for investors who can look past the boredom" of the insurance business, said David Dietze, president of Point View Financial Services. "It's hit a terrible bump in the road but the need and demand for insurance has never been greater." Losses from this year's hurricanes are relatively modest for the companies. Mr. Dietze bought shares of ACE Ltd., a company based in Bermuda that was named by Mr. Spitzer, at around $32.50 because he thought that its drop from the low 40's was "excessive." (Ace's chief executive is Evan Greenberg, who is Maurice's son and the brother of Jeffrey W. Greenberg, the previous chief executive of Marsh.) Mr. Dietze also picked up some stock in MetLife, whose roots are in life and health insurance, for the accounts of his clients, his employees and for himself. He said he found "a little paranoia" in the sell-off, with worried investors "painting with too broad a brush." Much of the investment focus is on Marsh & McLennan, whose market value had, at its lowest point, withered by more than $12 billion. The opinion of professional portfolio managers is mixed, ranging from strong enthusiasm to skepticism. Among the company's imponderables are the prospect of fines, the likelihood of civil lawsuits and the extent to which an impaired business model will shrink profits. Other factors that are difficult to discern are potential changes in customer loyalty and employee morale, a possible dividend cut and, not least, the unproven managerial talent of Michael G. Cherkasky, the new 54-year old chief executive. Analysts agree, at least, that it is a big plus that Marsh, after initial resistance, installed new management, replacing Jeffrey Greenberg with Mr. Cherkasky, a former mentor of Mr. Spitzer in the Manhattan district attorney's office. One of the bulls is Jeff Arricale, a financial services analyst at T. Rowe Price, which holds Marsh shares in some of its mutual funds. Although he is not persuaded that Mr. Cherkasky is the best choice for long-term leadership - one question is how he will allocate capital - Mr. Arricale said he thinks Marsh stock will climb into the $33 to $40 a share range within the next 12 months. To value the company, he estimates that the Putnam unit, which paid heavy fines from Mr. Spitzer's earlier campaign against abuses in the mutual fund industry, is worth about $10 a share. He also puts the value of the Mercer consulting business at about $10. The Kroll security business, from which Marsh inherited Mr. Cherkasky, adds about $3. That leaves the flagship insurance brokerage unit, the world's largest, which Mr. Arricale figures is worth at least another $10, for a total value of $33 a share. Against this considerable potential, Mr. Arricale calculates minimal risk. "If things go really wrong from here," he said, and disaster looms, "there's easily $24 or $25 left over for equity holders." Considerably less bullish is Mark Giambrone, a principal at Barrow Hanley Mewhinney & Strauss, a large manager of institutional money in Dallas. "When it comes to Marsh - and even to A.I.G. - it's hard for us to ascertain how large and how temporary the problems are," he said. And while Mr. Giambrone said he thought Marsh would "eventually right its ship," the risks seem to limit its stock potential to $30 to $33, not enough to merit purchase at current prices. As for A.I.G., he said, the global giant has long been "an enigma for us, an octopus with four tentacles behind its back," which traditionally trades at twice book value, "which makes no sense to me." Instead, Mr. Giambrone favors, among others, Hartford Financial Services, whose casualty insurance is balanced with a fast-growing life business, and Willis Group Holdings, a broker he says is likely to pick up market share. He recently added shares of both to portfolios. He thinks that the Aon Corporation, based in Chicago and second to Marsh in domestic corporate insurance, may also gain market share, but added that it has been badly run by its founder and chief executive, Patrick G. Ryan. Aon is under investigation by Mr. Spitzer for coercive practices, including tying the placement of business to the reciprocal purchase by insurers of Aon's reinsurance. Another voice of caution is that of Bill Riegel, who presides over actively managed domestic equities at TIAA-CREF. As a value investor, he anchors his analysis in price-to-book ratios and has found that while Mr. Spitzer has "injected fear" into the market, stocks in the property-casualty sector - not including brokers - are still not as attractive as they typically get at the bottom of cycles. Moreover, the companies face the headwind of rising interest rates. TIAA-CREF has done little bargain hunting recently, he said, mainly raising its stake in the newly merged St. Paul Travelers Companies. He calls XL Capital Ltd., based in Bermuda, "intriguing." While not necessarily recommending them at rebounded prices, Mr. Riegel, citing WellChoice and Anthem, noted that the shares of health insurers provided one of the most dramatic examples of indiscriminate selling induced by the Spitzer investigation. As for the brokers, Mr. Riegel has decided to wait. "Investors love oligopolies," he said. "And Marsh, despite its issues, retains a pre-eminent role. At some point the risk-reward is clearly going to favor taking a much closer look at it - and to a lesser extent Aon - at these prices. But I can't say that we've been able to get comfortable with some of the liabilities."
These are time-proven signals that forecasts of future earnings are likely to be pressured downward. The pattern of earnings-forecast revisions has turned more negative, as the chart on this page shows. That trend would appear even more worrisome if it weren't for the steady hikes in projected energy and materials earnings, as analysts race to catch up to commodity prices that have run ahead of most assumptions. Smith Barney strategist Tobias Levkovich maintains a "leading profits indicator" that has a good record of predicting reported results. It is currently signaling that consensus fourth-quarter forecasts for 15% growth in S&P 500 company earnings are too optimistic. For all of next year, profits are pegged for a 6% to 10% further gain, depending on whether you believe the somewhat sober top-down strategists or bubbly industry analysts. These numbers haven't stopped rising lately, placing them at risk of disappointment. The aforementioned moderating economic trend is one thing, exacerbated by what economists agree will be a lagged impact of high oil prices. Then there's an incipient profit squeeze apparently developing as higher production costs -- including commodities -- are only partially being passed through to finished-goods prices. Look, too, at the heady assumptions now embedded in those 2005 estimates, including hope for still-higher profit margins. Henry McVey, strategist at Morgan Stanley, calculates that 79% of the S&P 500 companies are now forecast to show improved profit margins next year, up from 68% this year. That would be a tough trick to pull off, given current historic highs in corporate profitability. It would be even tougher if companies quicken their hiring or if interest costs begin rising strongly. The Dollar & The Market And consider the dollar. The buck hit new lows against the euro last week and sits at levels last seen in 1995 against a trade-weighted basket of currencies. A weak dollar has been all but dismissed as irrelevant, or even embraced as a net positive, by the equity crowd lately. Indeed, a lower dollar is being cited as a reason multinationals' earnings will get an extra boost next year. Another rationalization for buying stocks with those depreciating dollars is that the weakness isn't alarming unless it goes too far, too fast. What level and speed should cause worry isn't usually pinpointed. Investors, for certain, have been conditioned to think this way. In the 20 months since stocks ramped off the pre-Iraq War lows, the dollar and stock prices have moved in almost precisely opposite directions, notes First Global Research. This inverse correlation is contrary to the predominant relationship between the two throughout history. Edward Keon of Prudential Equity Group calculates that in the 30-odd years since currencies were floated, U.S. equity returns have been twice as strong in strong-dollar periods as in times of a weakening greenback. There are prominent instances of powerful stock rallies amid a softer dollar, but this pattern is not the norm. Yes, it's true that there has long been an apocalyptic, bearish thesis out there that a dollar crisis would spur capital to flee U.S. markets, sending interest rates and inflation soaring and stocks into a collapse. And it hasn't paid to heed this case, with the crucial exception of several months beginning in the fall of 1987. But that doesn't mean that a further buckling of the dollar wouldn't result in stocks falling back to incorporate at least some probability that this chain reaction could arise.
But a new study by Minneapolis certified financial planner Jonathan Guyton, which appeared in October's Journal of Financial Planning, suggests retirees may be able to withdraw as much as 6.2% initially, provided they follow three rules. The strategy of increasing withdrawals along with inflation works fine, provided the markets and inflation are moderately well behaved. But if you get hit with either rapid inflation or a devastating market crash, you can rapidly run out of money, as you make larger and larger withdrawals from an ever-shrinking portfolio. To figure out how to combat that risk while maximizing income, Mr. Guyton analyzed two well-diversified portfolios, one with 80% stocks and the other with 65%. He found that the 80% stock portfolio could support a 6.2% initial withdrawal rate, while the 65% stock portfolio could start at 5.8%. But if you adopt those lofty withdrawal rates and you want to be sure your money lasts 40 years, Mr. Guyton says you need to follow three rules. • If your portfolio loses money during the year, you can't give yourself a raise the following year. In other words, if you add up your portfolio's year-end value and the money withdrawn during the prior 12 months and this sum is less than your portfolio's beginning-of-year value, you can't increase your next year's withdrawal to compensate for inflation. • No matter how high inflation gets, your maximum annual increase is 6%. • You have to avoid selling hard-hit stock funds. Instead, each year, start by lightening up on winning stock funds. Suppose you had targeted 6% of your portfolio for real-estate investment trusts and REITs have a good year. You would pare back your REITs to 6%, funneling the excess into a money-market fund. This money fund, says Mr. Guyton, should initially account for 10% of your total portfolio. Next, "rebalance" your bond funds back to their target percentages, again sweeping the gains into your money fund. The proceeds from rebalancing, plus the cash already in your money fund, should cover your spending needs. What if it doesn't? Mr. Guyton says you should draw down your bonds even further. As a last resort, sell more of your stock funds, starting with the prior year's best performers. All this, of course, is based on an analysis of historical returns. If we get wacky markets, miserably low long-run returns or you incur hefty investment costs, you may have to withdraw less than Mr. Guyton suggests. Moreover, because the first and second rules will occasionally limit spending increases, there's a chance that retirees who use Mr. Guyton's strategy will receive less total income over 40 years than if they had started with a lower initial withdrawal rate but got inflation increases every year. Still, Mr. Guyton's rules make a ton of sense to me -- and I suspect many retirees will find his approach appealing. After all, they get a decent amount of income initially and they may never see the downside, either because they don't live long enough or because the markets prove relatively benign. As Mr. Guyton puts it, "I wouldn't want to be the financial planner who has to look an 85-year-old client in the eye and explain why he has so much money and why he's had so little fun."
* First, sell investments from your taxable account that would be taxed at the long-term capital gain rate; * Next, withdraw money from your traditional IRA that would be taxed at your ordinary income tax rate; * Finally, consider taking money out of a Roth IRA that would be tax-free. "It's usually better to sell long-term investments held in taxable accounts instead of taking money from your tax-deferred accounts before you have to," says Spiegelman. "The long-term capital-gains tax is 15 percent through 2008, at least, but withdrawals from traditional IRAs and 401(k)s are taxed as ordinary income -- typically a higher rate." What's more, tapping your IRA means losing opportunities for tax-deferred compound growth. Sue Stevens, financial planner and author of Morningstar's Smart Ways to Tap Your Retirement Accounts, suggests that investors go so far as to set up a cash pool to cover two to five years' worth of expenses. "This simple step will alleviate much of your anxiety about cash flow," she writes. Investors might want to also consider matching gains and losses in their taxable accounts, says Ray Bellucci, IRA product manager for TIAA-CREF. To be sure, they must weigh their own circumstances, including unique estate-planning needs and special income-tax issues. For instance, Spiegelman says the following are possible exceptions to the general rule about withdrawing first from a taxable versus a tax-deferred account. Large IRA: If your IRA balance is very large, you may want to draw from it before age 70 and a half when required minimum distributions kick in. Otherwise, the RMDs may bump you into a higher tax bracket. Stevens suggests withdrawing just enough from tax-deferred accounts before 70.5 to take you up to the top but not beyond the 15% tax bracket. Is it better to sell shares than take dividends and interest? For his part, Spiegelman says you'll likely need to do both. Consider that a person with a moderate asset allocation might generate 6.5% a year, about 2 to 3 percentage points of which might be dividends. Assuming a person needs to withdraw 4% per year, the 1 to 2 percentage point shortfall would have to come from selling shares. Investors trying to generate cash from taxable retirement portfolios should consider having distributions swept into a money-market fund rather than be re-invested, Spiegelman says. That way you won't have to sell as many shares when the time comes to withdraw money from that account. Plus, you won't have to keep track of the cost basis of reinvested dividends. Which investment should you sell? Consider selling your winners so you can rebalance your portfolio back to its target. For instance, if your assets were in 60% stocks and 40% bonds, and when you're ready to withdraw money, it's 65-35 stocks to bonds, Speigelman advises s selling stocks to rebalance back to a 60/40 mix.
But some experts reject that conventional wisdom saying it is too simplistic. For one thing, investors holding funds in their taxable accounts owe tax on dividends and capital-gains distributions even if those sums automatically are reinvested. Tax law requires funds to pay out to investors the net gains on securities sold as well as bond interest and stock dividends received (after subtracting fund expenses). Particularly in taxable accounts, the reinvestment naysayers say, there are reasons to take the distributions in cash and then decide what to do with the money. The issue is taking control of one's finances. Rather than simply having distributions go back into the same funds without any planning, make a conscious decision about what you are going to do with that money. About once a year -- and year end is an obvious time -- investors also should "rebalance" their portfolios by shifting more dollars toward asset classes that have been lagging performers, advisers say. Reinvesting now and selling/rebalancing later might cause a taxable gain. Saying no to reinvestment brings cash flow in [to the portfolio] that can be used to rebalance. This is also an oppertunity to diversify a portfolio. If an investor holds only U.S.-stock funds, it might be smarter to add an international-stock fund to the mix. Tax complexities are a top reason that financial advisor John Costello advises against reinvesting fund distributions in a taxable account. When clients sell part of a mutual-fund holding or use fund shares for charitable giving, Mr. Costello advises them to specify the particular blocks of shares they are disposing. Generally, it makes sense to sell the highest-cost shares, in order to minimize taxable gains, but donate the lowest-cost shares to charities to reduce future capital-gains taxes. Doing that "specific identification" is much more complicated for investors who reinvest distributions, Mr. Costello says, because each reinvestment constitutes a separate purchase. He notes that one of his favorite funds, Dodge & Cox Balanced Fund, pays dividends quarterly, which adds up to scores of distinct purchases over the course of many years. Skipping reinvestment helps "to simplify the whole process," he says. Even advisers who shun dividend reinvestment in some cases favor it in others. Many advisers routinely reinvest within tax-favored IRAs and 401(k) plans, for instance. Because withdrawals from those accounts generally are taxed as ordinary income, there is no hassle of tax-lot accounting on share dispositions. Investors always can sell shares to rebalance their portfolios without a tax bill or complicated tax accounting. Tom Tracy, a San Francisco adviser, says he reinvests distributions in small accounts that hold only a single fund. He notes that fund investors typically pay no transaction costs to reinvest distributions. That is a reason to reinvest in cases where taking the cash and then purchasing additional shares later on would entail transaction costs. Mr. Tracy generally suggests his clients, who mostly invest through Charles Schwab, reinvest their dividends in funds such as Longleaf Partners Fund, T. Rowe Price Emerging Markets Stock Fund and Vanguard Value Index Fund for which they otherwise would have to pay Schwab transaction fees. Brian Reid, deputy chief economist at the fund industry's Investment Company Institute, notes that investors who buy Class A and Class B funds with sales commissions would pay additional commissions if they took their distributions in cash and later made additional purchases. But beyond saving on such costs, Mr. Reid focuses on the foibles of human nature in favoring reinvestment. "I'm a big advocate of reinvesting. I do it with all my accounts," he says. "It's the easiest thing and makes sure I don't put money aside and forget to deal with it."
Q: What has changed in the market since you've stopped running Magellan? A: Funny, it doesn't seem like much has changed. I was at a luncheon three or four years ago, and Michael Dell was speaking. Someone asked, what do you think your stock is going to do? And he yelled out at me, "Mr. Lynch is very good at that." So I said, if your earnings are higher in five years, your stock will be higher; if your earnings are lower, your stock will be lower. That's the way it works. People concentrate too much on the P, but the E really makes the difference. If companies have bad earnings, stocks do poorly. If earnings go from crummy to mediocre, stock usually goes up. If it goes from mediocre to very good, it goes up. Information is a lot more available. When companies publish, you get the balance sheet instantly. You used to have to wait until they mailed these things to you. That's the only difference from five or 15 years ago — the information is better, and it's current. Q: A lot of people are sitting on losses of 20% or more from the bear market. What would you say to people who bought a good stock, the company's earnings are OK, and they're still down the past five years? A: The question is, did everybody put their money into the market in March of 2000, or did they buy in 1995 or 1992? If you measure from the peak, the market is lower. Did everyone go to their bank in March of 2000 and decide to buy a bunch of funds? It didn't seem that way. That was just a blowoff, some stocks were overpriced at $50 and went to $150. It's one of those crazy things you'll tell your grandchildren about. The worst 10 years in the last 100 years of the stock market were 1928 to 1938, and you only lost 1 percent a year. That was a pretty ugly period. I don't predict the future, but I am a historian, and the stock market has been a pretty good place to be if you have a 10-year, 20-year horizon. Time is on your side. Two years is a short period. Four years is a short period. People said I was timing the market when I left in May of 1990. In May of 1990, the Dow was at about 3,000. What was it at its peak? Nearly 12,000. That's how great I was at predicting the market. Basically, we've had profits double, and the market has shrunk. The market was once 35 times earnings. It's about 17 now. Usually, if you subtract the inflation rate from 20, you get the P/E of the market. On that basis, with inflation at 2.5%, things seem to be OK on the P side of the equation, so you have to make an E bet. And I think 10 years from now, 20 years from now, the companies that make up the Standard & Poor's 500-stock index will be earning a lot more money. Q: How do you know when to sell? A: I remember a company that this fireman owned, and he had a system. He made $400,000 on a $5,000 investment. He held it for 25 years. And he said, "As long as they keep hiring, I'm going to hold on to it. When they stop hiring, I leave." So when they stopped hiring, he sold. Whatever reason you buy a stock is the reason you sell it. I owned Subaru once. They had a perfect niche. There was no one else in their market, had a great share, a superior car. Then the yen went up, and they had to raise their price. Chrysler introduced a low-end car, and Ford introduced a low-end car, and they were good cars. All of a sudden, Subaru had competition and guess what? The stock wasn't a buy anymore. You should write down why you own this thing, and if that isn't true anymore, that's the reason you sell it. Q: You mentor Fidelity analysts now. What do you tell them? A: Most people who get to Fidelity have had a lot of A's in their life. They always have the perfect answer. But the stock market gives a lot of F's. Generally, if there's a lot to be made in the stock, somebody doesn't like it, and there are a few problems with it. It's not like the company will have discovered a new product, have a wonderful balance sheet, and they just discovered oil on their property. Only a couple times in your career, everything falls in line. It's a passive business. You're like a referee watching a soccer game, and you can't affect the game. You can't make Chrysler sell more cars. You have to look at what's there and report what's happening. Q: What areas of the market interest you most now? A: Generally, growth over value. Value has destroyed growth the past two or three years. I could be dead wrong, I could be a year early, but growth is more attractive to me than value. Over time, people have made money in value stocks, and in growth stocks. When one outperforms the other for a long time, you're better off to look at the one that has been underperforming. Q: Any argument for preferring international stocks over U.S. stocks? A: If you want to research some emerging markets, you can find big firms with low P/Es. I'm not recommending them. What you don't want to do is go into an emerging market and buy a secondary company, or a real flaky company. That's really dumb. But that's how John Templeton did really well, buying great companies in emerging markets. When he was buying in Japan, it was an emerging market. Q: There's been a strong surge in commodity prices. Do you think it's a long-term trend? A: I have never owned much in oils, but I must say I have some oil stocks today. You look at the 81 million barrels a day that we consume, and you know, if the world grows at 2% a year, we need 1.6 million more barrels every day. And we haven't really made many discoveries the past 10 years. The North Sea has peaked out, the North Slope in Alaska has peaked out. You have Saudi Arabia running full out, Mexico running full out, and Russia coming back, so there's not a big cushion. If the economy is good in 2005 and 2006, the world demand for oil is going to go up. But it's the only group where people are assuming prices will be sharply lower next year. Everyone is looking for oil prices to fall 25% to 30%. Even if they do, these companies are going to earn a lot of money. Q: What sectors do you like? A: I have some money in airlines. It's not a big weighting, it's speculative, and it's the ones I think won't go bankrupt. I also own retailers and restaurants. I don't buy this argument that the American consumer is spent out, and that when the economy gets better, they've shot their wad. Don't underestimate the American consumer. If we're adding 150,000 jobs a month in 2005, 2006, they're going to be buying a whole lot of everything. Americans love to buy stuff. I have a large bet on telecom and tech. A lot of companies are still down 70%, 80%. If the stock sells for $3 a share and they have lots of cash, they'll be around. Q: What about banks? A: I think they're doing brilliantly. But when everything is going great, I'd rather tune in later. It's just the greatest scenario, everything is great, spreads are great, nonperforming loans are low. This is nirvana. They're cheap stocks, good companies. They're stocks to sell. I just like to look at things that are out of favor, and they don't fall into that category.
People often have a target amount they want to amass by retirement. That drives them not only to save like crazy as they approach their 60s, but also to load up on bonds, money-market funds and CDs, so they have a heap of cash available on the day they call it quits. But, of course, these folks won't spend their entire nest egg on a single day. Instead, once retired, they draw down their portfolio over 20 or 30 years. So how much cash do you need on the day you retire? I often suggest that each year retirees look to withdraw 5% of their portfolio's beginning-of-year value. For instance, if your nest egg is worth $400,000 at the start of the year, you would withdraw 5% of that amount, or $20,000, over the next 12 months. You can garner your 5% through dividends, interest and occasionally selling investments. Part of this money will be owed in taxes, so don't bank on spending the entire 5%. Even though you are withdrawing just 5% each year, I would keep more than 5% of your portfolio in cash. My advice: Stash 25% of your portfolio in money-market funds and short-term bond funds, so you have enough set aside to cover the next five years of retirement withdrawals. Meanwhile, invest the other 75% for long-term growth, by sticking maybe 25% in a mix of high-quality intermediate-term bonds, inflation-indexed Treasury bonds and high-yield junk bonds and the remaining 50% in a collection of blue-chip, small-company and foreign stock mutual funds. The growth from these riskier investments will likely come in handy. After all, during the course of a 20- or 30-year retirement, consumer prices could easily double, so you will want your income to keep pace. Indeed, because of the threat from inflation, keeping everything in low-risk investments is probably the riskiest thing you can do. As with your retirement savings, you won't spend your daughter's entire college account on a single day. Rather, you will likely draw down her savings over four years. This brings me to a popular rule of thumb: Once you are within five years of a financial goal, any money you plan to spend should be completely out of stocks. Over some five-year stretches, stocks have lost money. In fact, we have just had a couple of these rough spells. According to Chicago's Ibbotson Associates, the Standard & Poor's 500-stock index lost a cumulative 3% over both the five years ended in December 2002 and the five years ended in December 2003. If you wait too long to unload your stocks, you could get caught up in one of these rotten patches and find yourself selling shares at fire-sale prices. How should you use the five-year rule when handling your daughter's college account? Suppose you plan to put a quarter of her money toward each of her four college years. With that goal in mind, you might move a quarter of her college account out of stocks when she's five years from her freshmen year, another quarter when she's five years from her sophomore year, and so on. Don't be too mechanical about this. If your daughter is five years from college and stocks are deeply underwater, I wouldn't sell a quarter of her stocks. Instead, postpone all selling until shares bounce back. With five years until you need the money, you should get ample opportunity to sell at better prices. When it comes to emergency money, the conventional wisdom is that you should keep six months of living expenses in conservative investments. But should you leave a huge wad of cash languishing in low-returning investments in preparation for events that probably won't occur? As an alternative, I often suggest that folks keep maybe two months of living expenses in a money-market fund or a short-term bond fund. That should be enough to cover small-scale disasters, like the boiler going into a meltdown or the roof suddenly needing to be replaced. I would take the rest of your emergency money and invest for long-term growth, by buying a diverse mix of stocks and riskier bonds. To be sure, your next major financial emergency might coincide with a nasty bear market and it will be a bad time to sell these investments. But you could always borrow temporarily by, say, tapping your home-equity line of credit. You can then repay this money once your stocks and bonds bounce back. While we don't have a strict deadline with retirement, college and financial emergencies, that isn't the case with home purchases. To make that house down payment, you really do need a sizable chunk of money on a single day. Because there's no wiggle room, I would be more cautious with your house money than with your retirement, college and emergency money. Hoping to buy a house in the next few years? As you save for your future down payment, I would funnel every dollar into a money-market fund or a short-term bond fund.
After years of such miracles, investors finally seem to be wising up to the fact that an extra penny of profit is not only meaningless but may also be evidence of earnings management and, therefore, bad news. After all, the practice can hide what's genuinely going on in a company's books. A study by Thomson Financial examined how many of the 30 companies in the Dow Jones industrial average missed, met or beat analysts' consensus earnings estimates during each quarter over the last five years. It also looked at how the companies' shares responded to the results. Over the period, on average, 46.1% - met consensus estimates or beat them by a penny. Pulling off such a feat in an uncertain world smacks of earnings management. "It is not possible for this percentage of reporting companies to hit the bull's-eye," said Bill Fleckenstein, principal at Fleckenstein Capital. "Business is too complicated; there are too many moving parts." The precision has a purpose, of course: to keep stock prices aloft. According to Thomson's five-year analysis, companies whose results came in below analysts' estimates lost 1.08% of their value, on average, the day of the announcement. The loss averaged 1.59% over five days. Executives have lots of levers to pull to make their numbers. Lowering the company's tax rate is a favorite, as is recognizing revenues before they actually come in or monkeying with reserves set aside to cover future liabilities. If all else fails and a company faces the nightmare of an earnings miss, its spinmeisters can always begin a whispering campaign to persuade Wall Street analysts to trim their estimates, making them more attainable. Their stock might drift downward as a result, but the damage is not usually as horrific as it is when earnings miss the target unexpectedly. So it is not surprising that the strategy has become so widespread and that fewer companies in the Thomson study are coming in below their target these days. For the first three quarters of 2004, 10.9% missed their expected results, down from 11.7% in 2003 and 25% in 2002. At the heart of earnings management is - what else? - executive compensation. The greater the percentage of pay an executive receives in stock, the bigger the incentive to produce results that propel share prices. A study published last year by Qiang Cheng, assistant professor of accounting at the University of British Columbia's Sauder School of Business, and Terry Warfield, assistant professor of accounting at the University of Wisconsin in Madison, found that managers with high equity incentives are more likely to report earnings that meet or just beat analysts' forecasts than are managers who have low equity incentives. The study also found that managers with high equity incentives are less likely to report large positive earnings surprises, perhaps choosing instead to set aside the extra money for a rainy day. This practice is known as earnings smoothing. Unfortunately for executives on the beat-the-number treadmill, an extra penny isn't what it used to be. In 1998, Dow components that beat their numbers by a cent saw their stocks rise 0.78% the day of the announcement, according to Thomson. This year, the increase has averaged 0.15%. Returns over five days were flat in 1998, while stocks of companies beating estimates by a cent have lost an average 1.42% this year. This may be why the percentage of companies meeting or beating the estimate by a penny has also declined recently. This year, 35% of companies in the Dow average are in this category, down from 60% in 1998. Genuine gains now go only to companies that exceed estimates by more than a cent. This year, shares of these companies have risen 0.64% on average on the day of the announcement. Over five days, there was an average 1.91% gain. Meanwhile, the number of Dow component companies reporting results that are more than a penny above expectations has climbed significantly in the last few years, rising to 54.3% today from 27.2% in 2002. This means one of two things: executives have figured out that a penny doesn't jump-start a stock anymore and are speeding up the treadmill, or they are playing the earnings smoothing game less and less. Let's hope it's the latter. Companies should refuse to participate in the earnings management charade and investors should stop demanding it. "The marketplace wants quarterly measurement, but it has to be put into perspective," said Michael Thompson, director of research at Thomson. "What's more important is long-term viability of a company, and investors should be more respectful of that." Yes, investors who reward companies for the myth of making their numbers are a big part of the problem. But so are those in the media who report breathlessly when companies beat estimates by a penny or two. One company that successfully shuns the earnings game is the Progressive Corporation. Rather than whisper to analysts what they can expect from upcoming results, Progressive publishes monthly, in-depth reports on its Web site. The reports, which it began in May 2001, include an income statement, a balance sheet and segment information. Also included are changes in loss reserve estimates, a number that is closely watched by investors and which contributes to wide swings in earnings. "We never make promises to hit an earnings number," said Tom King, Progressive's treasurer. "We don't have predictable earnings, but it doesn't matter. We have been very clear on our financial reporting policies, and as a consequence we have not attracted those investors for whom meeting earnings numbers is important." How have Progressive's shareholders fared? Interestingly, the stock has been less volatile than the Standard & Poor's 500-stock index since the monthly updates began. It's not clear who got the earnings game going: executives or investors. But it's past time for it to stop. As the Progressive example shows, those companies that continue the charade do it by choice.
Most indexes define the market as the combined value of all stocks, weighting each stock according to its market capitalization. Constructing an index this way is known as cap-weighting. This is how the Standard & Poor's 500-stock index is built. Market cap isn't the only weighting variable that a benchmark can use. Another is a firm's total revenue. The Fortune 500 ranks companies this way. An index weighted by total revenue will differ significantly from one based on market cap. General Motors, for example, is the third-largest company in the United States, by total revenue; by market cap, it is not even in the top 100. Why should market cap be the best way to assign G.M.'s weight in an index? The conventional academic response is that investors, in their collective wisdom, determine the company's value. But investors sometimes make spectacular mistakes. During the bubble of the late 1990's, cap-weighted benchmarks assigned far too much weight to Internet stocks. As a general rule, in fact, cap-weighted indexes overweight stocks that have become expensive because of fads, and underweight unfashionable ones. This leads such indexes to under-report the market's true return. Some popular benchmarks aren't cap-weighted, but they have serious problems of their own. The weighting scheme of the Dow Jones industrial average, for example is based exclusively on price, so it is also vulnerable to investors' valuation mistakes. Or take an index that gives equal weight to each stock in it, like the Value Line Arithmetic Composite index. Though this index is immune to investors' valuation errors, it is difficult to invest in it, because maintaining an equal-weighted index requires many transactions, which are costly. In addition, because the market for an index's smallest stock will be relatively illiquid, an equally weighted index fund can never become very large. Three analysts at Research Affiliates, a research and asset management firm based in Pasadena, Calif., believe they have a better way of constructing indexes. They are Robert D. Arnott, the chairman of the firm, and two executives, Jason C. Hsu and Philip Moore. Their core idea is to weight a stock according to variables other than market cap. In addition to using total revenue, they constructed indexes using corporate book value, income, dividends, sales, or the number of employees. The researchers call their benchmarks fundamental indexes. Unlike cap-weighted indexes, they are immune to investors' valuation mistakes, since a stock's weight is not dependent on its price. The indexes are also easily implemented. They avoid the liquidity constraints faced by equal-weighted indexes, and because they need to be rebalanced just once a year, they incur only marginally greater turnover rates than cap-weighted indexes. They also perform significantly better than current benchmarks. An index based on a composite of several fundamental variables outperformed the S&P500 by 1.9% a year on an annualized basis from the beginning of 1962 to the end of 2003. These results were remarkably consistent, so that each index that relied on one fundamental variable performed similarly to an index based on a composite of all of them. This composite outperformed the S&P500 in every decade except the 1990's, when it lagged slightly. Each of the fundamental indexes "avoids the overweighting of overvalued stocks that is an inherent defect of cap-weighted indexes," Mr. Arnott said. One drawback is that some of the indexes rely on categories that could make them vulnerable to accounting fraud. Partly for this reason, the indexes are based on a five-year average of the variables used to weight stocks. Mr. Arnott argues that this "greatly reduces the potential for accounting shenanigans to play havoc with these new indexes." He adds that fundamental indexes that aren't dependent on accounting categories - those based on number of employees or dividends, for example - perform just as well. The researchers also studied the effect of their weighting scheme on small-cap stocks and foreign markets. Preliminary results suggest that the advantage enjoyed by fundamental indexes is even greater in these areas than among large-cap domestic stocks. As the approach's creator, Mr. Arnott's firm would presumably receive licensing revenue from an index fund or exchange-traded fund based on one of these fundamental indexes, just as Standard & Poor's and Frank Russell & Company gets revenue from index funds based on their benchmarks. So Mr. Arnott says he wouldn't be surprised to encounter resistance from current index providers. But if fundamental indexes produce better returns over the long run, they are likely to find eventual acceptance.
That's down by a third from 20 years ago, when Procter & Gamble, 3M, Coca-Cola, and IBM enjoyed the top rating. And it's half the number from the 14 outfits, including Mobil, BellSouth and Bristol-Myers Squibb, with triple-A ratings at the end of 1994. The list continues to dwindle. On Nov. 2, Standard & Poor's Rating Services placed Merck's triple-A corporate credit rating on watch with negative implications after the pharmaceutical concern revealed more on its probe into what it knew and when about problems with arthritis drug Vioxx. What happened? Credit ratings are a gauge of a company's ability to repay debt on time. The higher the rating, the lower interest rate the company has to pay. Have all these businesses fallen from grace? Since cash flows determine the ability to repay debt, do these outfits have cash issues? Well, the answers aren't that simple. BusinessWeek Online's Pallavi Gogoi, spoke with Nicholas Riccio, S&P's managing director for corporate ratings, about the rationale behind the changes on the corporate-debt front. Here are edited excerpts of their conversation: Q: How important is the triple-A rating? A: In days past, the symbol of that rating was important for a good number of corporate issuers. Twenty five years ago, most companies aspired to that level of rating. And a single-A would have been unacceptable to them. Q: So, why is anything lower acceptable today? What happened? A: The business environment is a lot more complex today. The CEO or senior finance manager has a broader-based constituency to deal with. Creditors may have been given certain preferences and higher priority in the scheme of things. But the shareholder revolution of the 1980's changed the way executives at companies think about their finances. Today companies are much more shareholder-oriented. And the number of triple-A's is not even a percentage of our total rated universe. Q: What has changed in the outlook of companies? A: In 1980's there might have been about 30 triple-A-rated corporations in America. But many of them embarked on higher-risk business strategies, which weren't consistent with a triple-A rating. Others were caught in a rapidly changing business environment. And still others acquired companies to step up growth. Previously, their constituency was banks and bondholders. Look at who was triple-A back then -- P&G, Coca-Cola, AT&T, Campbell Soup. It was part of their cultural milieu that being at the top of their game, a triple-A rating was a reflection of that. It's not like they had much to benefit from that rating [because] they didn't need to borrow as much. But in their dealing with bankers it represented their station in life. Some companies managed to have ample financial resources even as they grew. Look at GE, which managed to grow year after year and satisfy everybody -- and also maintain a triple-A rating. Q: GE needs the triple-A rating because it borrows more? A: GE would agree with that. GE probably borrows more than some of the other former triple-As. P&G or Campbell, for instance, might not have had similar borrowing needs. But later they borrowed to acquire other companies. For instance, General Foods acquired Oscar Meyer and lost its triple-A. Other companies, like Kellogg borrowed more to achieve other goals. Around 1984, Kellogg borrowed to buy back a huge amount of stock and lost its triple-A rating. Q: Did globalization affect this process? A: If you look at history, General Motors, Ford, and Eastman Kodak all lost their ratings because the business environment changed, and their business models no longer worked. The competitive dynamics in the global market changed, and their previous rate of success didn't translate in the new world. Q: You mentioned that some companies didn't necessarily need the rating anymore? A: Yes, companies like Coca-Cola and P&G became very aggressive financially. And Federated Department Stores acquired other stores. These were strategic business decisions which matched their priorities, such as growth. Q: How much do borrowing costs go up typically when a company's credit rating is downgraded? A: On average, a one-notch downgrade would add about 10 to 15 basis points to a company's financing costs. Q: So, companies are willing to bear that slightly higher cost of capital for other gains. A: Yes, sometimes you have to take on new risk to achieve your full potential growth. Companies weigh their options and the cost for those options, and a lower rating when measured against other inputs makes sense for them. Q: What was the last big downgrade? A: Royal Dutch Shell lost its triple-A in January, 2004. Bristol-Meyers lost its rating in July, 2002, and now we have Merck on watch. Q: Do any companies regain the badge of honor? A: Kellogg is the only company in recent memory that made it back. After losing it in 1984, the company had three years of tremendous growth and gained back the triple-A, only to lose it later on. And AT&T was a former triple-A-rated company that's not even investment-grade at this point. Keep in mind that the overall attitude in Corporate America has changed. The symbolic value of triple-As has changed. There has been a fundamental shift in attitude toward credit quality in the last couple of decades. The most pervasive ratings are in the universe of single-As to triple-B's. Q: So, money managers have companies with worse credit profiles to choose from for their portfolios. A: Much of Corporate America is below investment-grade today. It's easy for middle-market companies to access capital markets. And how people view credit quality has also changed. There's a lot of money to invest in low-rated, high-yield debt. I would say that in the 1980s, when investment-grade companies were doing leveraged buyouts and were downgraded, there was a lot of resistance from unhappy investors. Now it's less of an issue because most of these companies doing leveraged buyouts are already below investment-grade.
'Asia has hollowed out our manufacturing base and is now making inroads into services,' says Gross, chief investment officer at Pacific Investment Management Co. in Newport Beach, California, where he oversees $415 billion including the biggest bond mutual fund. `We can't really educate or innovate our way out of this.' In the circumstances, Gross says, the Federal Reserve will have to hold interest rates very low. `While that keeps the patient/economy breathing, it leads to asset bubbles, potential inflation, and a declining currency over time,' he says. Grantham, chairman of Grantham, Mayo, Van Otterloo & Co., a Boston-based manager of $66 billion in mostly institutional money, says `the current U.S. equity bubble' is the 28th he found combing through the history of currency, commodity and stock markets. All the other 27 bubbles, he says, `broke and went back to the pre-existing trend.' For the S&P 500 to do the same now, he calculates, it would have to hit 720, compared with a recent level above 1100. `Everything important about markets is mean-reverting' he says. `Prices are pushed away from fair price by a series of `inefficiencies,' and eventually dragged back by the logic of value.' One of those inefficiencies, says Grantham, is a phenomenon called herding, which occurs among both individual and institutional investors. In a highly specialized institutional world where managers are measured almost microscopically against benchmarks, Grantham says, `refusing on value principles to buy in a bubble will look dangerously eccentric. This has guaranteed increasingly larger and longer market distortions.' Gross gives us an external reason -- Fed policy -- to figure on bubbles as a continuing part of the investment scene. Grantham gives us an internal reason, forces in modern financial life that reinforce the human tendency to `buy because others are buying.' For myself, I need little convincing that we already live in a bubble-prone age. Stocks, notorious for their attempt to defy gravity in the late 1990s, have since been mimicked by real estate markets in many places, and perhaps some commodity markets too. Look no further than the almost-doubling in the price of crude oil over the last year. If bubbles are so readily apparent, and so dangerous, why aren't more investors fleeing them? In the week or two since Gross's and Grantham's commentaries came out, stock prices have actually risen. `The problem with bubbles breaking and going back to trend is that some do it quickly and some slowly,' Grantham writes. He says the time spans of past bubbles he examined ranged from three minutes to 18 years. Thus, a simple strategy of staying away when bubbles threaten poses problems for many people who need to invest within a limited period of years -- before the children are ready for college or it's time to retire. Suppose you or I detected an incipient bubble in the stock market when price-earnings ratios climbed above 15 to one in the early 1990s, and jumped out of stocks. A dozen years later, we would still be waiting for a proper chance to buy back in, and we would have lost a big chunk of precious time. So what to do? Investors can heed Grantham's advice to `lower risk and survive to fight another day.' Those who don't agree with his assessment of the situation can still take his view into account by submitting their investments to a Grantham- style crash-test. How would the investment plan look, and how would the investor feel, if the stock holdings were marked down by 35% or 40%? Given one's age and circumstances, how much time would the plan have to try to recoup the losses? No bullish investor ought to shy away from such questions. At the very least, they help differentiate between reasoned optimism and reckless see-no-evil, hear-no-evil hope.
Also at the same time, he trend in the size of the US current account deficit moved up. The central banks of the United States’ trading partners printed as much money as was necessary to acquire all the dollars entering their economies to prevent their currencies from appreciating. With those dollar they bought US treasury bonds and agency debt. However, beginning in Q2-04, the increase in the amount of new debt being offered by the government and government sponsored enterprises was insufficient to meet the demand for it. That’s why interest rates fell. More paper money is currently being created as a result of the rapidly expanding US current account deficit than is needed to fund the budget deficit and the GSEs’ demand for credit. A Second Source & More Stats Agnes T. Crane, WSJ 11-12 Many analysts contend that official institutions, led by central banks in China and Japan, have essentially subsidized inexpensive financing in the U.S. by keeping Treasury yields lower than they would otherwise be. Some estimate that Treasury yields are 0.5 percentage point lower than the market's fundamentals would otherwise dictate. Japan's and China own about a quarter of Treasurys outstanding, with respective holdings of $723 billion and $172 billion. Until other export markets show signs of rivaling the spending power found in the U.S., some analysts believe it isn't likely that officials on either side of the Pacific will jeopardize the status quo. Bond Market Update & Forecast Jonathan Fuerbringer, NY Times 11-14 This year bonds over all are close to matching stocks, with a total return for Treasury, corporate, mortgage and agency securities of 3.7%, according to Lehman Brothers. High-yield bonds have returned 9%. That is better than the 2.7% total return of the Dow and not far from the 4.5% return in the Nasdaq index. Only the S&P500, with a return of 8.1%, is doing a lot better. There has been a small net inflow - $100 million through last Wednesday - into mutual funds that invest in the Treasury market. More than $6.8 billion has flowed into TIPS funds. [The Pimco Real Return fund, with 85% of its $12.4 billion in assets invested in TIPS, had a total return of 6.9% through Oct. 31.] Net inflows into investment grade corporate bonds have been $13.4 billion so far this year, while $5.1 billion has flowed into high-quality investment grade funds, which buy bonds rated double-A or higher. But there has been an outflow of $4.4 billion from high-yield funds, as some investors have apparently wanted to reduce risk or just took profits after the 28.1% return of 2003. As for 2005, the consensus forecast from the Blue Chip Economic Indicators for November is that the 10-year yield will rise to an average of 5 percent by the fourth quarter. Such an increase would mean that the Lehman Brothers index for the Treasury market would have a loss of roughly 0.1% for the year. Bond Market Update & Forecast II Aaron Lucchetti, WSJ 11-14 Stock investors have been enjoying a post-election party. Missing out on most of the fun: bond investors. Since Election Day, bond returns have been shrinking fast. Bond yields have jumped, with the 10-year Treasury note's yield climbing to 4.19% from 4.07%. With stocks riding on post-election euphoria, the year-to-date total return now is nearly 9% for the Wilshire 5000 Composite Index, which reflects almost all stocks of U.S.-based companies. This is a lead of more than four percentage points over the 10-year Treasury's 4.6% return so far this year. (Total returns include interest and dividends.) Bond investors also are edgy over President George W. Bush's proposed agenda, which includes revamping the Social Security system and the tax code. These two ambitious projects could deepen the federal deficit and in turn flood the bond market with new supplies, sending bond prices lower. All the while, Americans continue to consume much more than they save, leading to a yawning current-account deficit and recently a falling dollar. The weakening U.S. currency isn't good for bondholders, because a weakening dollar often works to undermine foreigners' desire to keep buying billions of dollars of Treasury debt and other U.S. bonds. But investors shouldn't count out bonds just yet. After all, reports of their demise have been exaggerated before. Twice in the past 18 months, bond prices fell on bursts of economic optimism, only to fight back and make up for lost ground. And many investors make a persuasive argument that bonds could prove the skeptics wrong once again. They point out that global competition could keep a lid on inflation, foreigners may continue to buy vast amounts of Treasurys and the Bush administration may defy the odds and get deficits under control over the next four years. They add that a weak dollar may not be that hazardous for bonds unless the drop is particularly severe. The market "remains very difficult, with investors torn between the fear of higher rates and unwillingness to lose income via selling" bonds, says Leo M. Tilman, chief institutional strategist at Bear Stearns. For some, there are too many crosscurrents to make a surefire prediction about interest rates. Mr. Tilman sees a 40% chance that 10-year notes will yield more than 4.4% in the next couple of months, while he sees only a 10% chance that the yield will drop below 4%. The greatest likelihood, he says, is that yields stay fairly close to current levels as investors dissect the meaning of the latest economic numbers for jobs and inflation. Yields don't necessarily need to fall for bond investors to be happy. A 4.2% return looks relatively attractive at a time when some investors are nervous about terrorism risks and still haven't gotten over the stock-market losses of 2000 to 2002. "We're not going to shake that for a while," says Peter Coffin, president of Breckinridge Capital Advisors. Because investors are still nervous about stocks, he says, they'll be reluctant to move too much money out of bonds, especially if yields creep up a little more. Money-market investors could also be attracted by higher bond yields. "A lot of investors have sat in cash and been frustrated waiting for rates to rise," Mr. Coffin says. "We're defensive, as are lots of institutions." But he he thinks rates will rise only by "a little bit," maybe 0.1 or 0.2 percentage points on the 10-year Treasury note. Robert MacIntosh, chief economist at mutual-fund firm Eaton Vance, thinks bonds will take a few lumps in coming months. But he doesn't believe they'll get crushed by deficit or inflation scares. "Rates often go down during deficit periods," he notes, adding that he predicts the 10-year Treasury note's yield won't rise to more than 4.8% in the near future. "It's a control on more government spending." He also says bond investors shouldn't worry about foreigners bailing out of Treasurys because of the current-account deficit or a weakening dollar. "Countries we trade with like our deficit," he explains. Some find it to hard to get pumped up about opportunities in corporate bonds, with yields there falling even faster than Treasury yields in the past two years. "It's a challenging time to find value in the bond market," says Ben Gord, a portfolio manager at OppenheimerFunds. He's been looking at securities with calmer price swings, such as bonds backed by consumers' home-equity loans. Some who are more comfortable taking an overall bet on interest rates see the Fed continuing to raise rates, which could affect shorter-term bonds more than longer-term bonds. These investors are putting more money in longer-term Treasurys with the belief that the Fed will move to keep inflation from getting too high. Monthly Employment Stats
"This is the kind of job report you want to see at this stage of an economic recovery," said Jared Bernstein, an economist at the liberal-leaning Economic Policy Institute in Washington. "But we've been here before. Whether this will be a persistent trend is hard to know." The employment report surprised Wall Street economists, who had been expecting an increase about half as large. It also portrayed a much more vigorous labor market than that previously indicated over the past three months, as the Labor Department increased its earlier estimates of job growth in August and September by 113,000. On average, it said, the economy has been adding 225,000 jobs every month since August, substantially above the 150,000 needed to absorb new entrants into the labor force because of simple population growth. The unemployment rate inched up to 5.5% from 5.4%. But that increase was in large part a result of better employment prospects, which drew many previously discouraged unemployed workers back into the job market, reversing the labor force contraction of the prior two months. Economists, who had been baffled that the nation's relatively strong economic growth was not followed by better job numbers, were quite pleased. "We have been waiting for this for the better part of the last two or three quarters," said Robert Gay, a former economist at the Federal reserve who is global strategist at Commerzbank Securities. Manufacturers shed 5,000 jobs in October. But employment growth was broadly based across the service sector, with strong gains in the health and education sectors. The number of hours worked at private businesses remained unchanged, at 33.8 hours a week, but hourly wages increased 0.3 percent, to $15.83. Some one-time factors and seasonal effects improved the employment situation. The cleanup and reconstruction of the hurricane-ravaged Southeast contributed to the 71,000 new jobs in construction. The back-to school season increased teacher employment. But even stripping out these one-time events, Mr. Gay estimated the underlying job growth was around 200,000. "That is not a number to be pooh-poohed," he said. Financial markets were jolted by the data, with stock prices moving higher. Bond prices declined as the emerging employment picture bolstered the view that the Federal Reserve would remain the path of gradual monetary tightening, instead of any quick, sharp increases. The Fed is expected to raise short-term interest rates by a quarter point next Wednesday and again in December. With the presidential election over, the new job numbers were of little political consequence. Still, both parties grabbed them anyway. Democrats pointed out that there are still 371,000 fewer payroll jobs outside of the farming sector than there were when President Bush took office nearly four years ago. But Treasury Secretary John W. Snow portrayed them as validation of the administration's tax-cutting strategy. "Roughly 2.4 million jobs have been created since August of 2003, with 2 million so far in 2004," he said in a statement. The question now is whether this pace of job growth is sustainable or whether businesses will revert to the reluctance to spend money that has characterized their behavior since the economy sank into recession in March 2001. The slowdown in productivity growth, to 1.9 percent in the third quarter, is consistent with the view that businesses are feeling ready to hire again. Following a long period of high profits, low investment and meager payroll growth, most businesses are flush with cash. Jack Ablin, chief investment officer at Harris Private Bank, noted that with the election out of the way, businesses might be more willing to spend it. "Some of that cash could migrate its way into the labor market and pick up some employment." Yet the economy had a similar burst of job creation in the spring, which economists greeted as evidence that following a sustained patch of economic growth businesses had finally decided it was time to start hiring. But then a surge in energy prices restrained consumer spending. By June, job growth had been reduced to a trickle. And there are some murky patches in the October job picture: both part time work and work for temporary employment services jumped -indicating that many businesses might not yet be truly committed to having a bigger work force. And more than a fifth of the unemployed have been out of work for more than half a year, the highest percentage since March. With high energy prices, declining consumer confidence and a slowdown in car sales last month weighing on the economy, some economists believe that businesses' appetite for new workers might decline somewhat again. "I don't expect this pace to continue," said Mickey Levy, chief economist at Banc of America Securities. "But it does cast a very positive tone."
On average forecasters expect the report - the government’s first official snapshot of how the economy performed last month - to show employers added 160,000 payroll jobs, which would be the strongest pace in five months. The unemployment rate, which is based on a separate survey, is expected to remain unchanged at 5.4 percent. “We’re back now with a situation of having a lot of catch-up to do,” said Michael Englund, chief economist for Action Economics, which expects a report of 200,000 new jobs. “A bigger gain of 250,000 or more is possible, given the potential hurricane effect and normal month-to-month volatility,” the forecasting firm said in a report. Englund figures hurricanes may have trimmed 50,000 jobs from payrolls in September, despite a note from the Bureau of Labor Statistics indicating that the severe weather did not “materially” change its assessment of labor conditions nationwide.
In fact, since business doesn't really start hiring until it sees the whites of the expansion's eyes, the huge rebound in last year's summer quarter may help explain the solid half-point decline in the unemployment rate -- to 5.5% from 6% in October 2003. I wouldn't expect another half-point decline if GDP growth continues to run at a 3.9% clip. But, unfortunately, I might expect the same rise in payroll employment. Gains of 170,000 per month are not bad, but a quarter-of-a million average would be preferable. But that depends on GDP growth.
Government job statistics, meanwhile, tell a different story: a burst of hiring in the past month after several months of sluggishness. That trend can be seen in two surveys conducted by the Bureau of Labor Statistics - one based on payroll statistics from 400,000 businesses and government agencies, the other on data from about 60,000 households. Both government surveys, however, agree with the Monster index that the job market has improved since January - with about 1.8 million more jobs, according to the payroll data, and 1.2 million more people with jobs, according to the household data. But the government surveys disagree about the job market since the end of the last recession, in March 2001: the payroll survey shows 490,000 fewer jobs but the household survey found 2.6 million more people employed. The results of another widely watched jobs survey, a tally of help-wanted newspaper ads compiled by the Conference Board, a nonprofit research group, fall between those of the Monster index and the government's payroll survey. The Conference Board's monthly employment index for September, released on Oct. 28, dipped slightly from the same month a year earlier, but has been relatively flat for several months. There is a fundamental difference between relatively new online job surveys like the Monster index and the more established measures. The Web tallies measure jobs that are available, while the government surveys measure actual employment, or jobs that have already been filled. If the online surveys prove accurate over time, they may establish themselves as forward-looking indicators of trends that will appear later in the government surveys. By focusing on Internet job listings, the online indexes - which include a survey of 75,000 businesses by Corzen Inc., an online market research firm, and tallies by other online jobs sites like HotJobs and CareerBuilder - also measure something overlooked by other indexes. Advocates say the online indexes better reflect how so many job hunters are migrating to the Web from newspapers and employment offices. Web sites accounted for 20% of all employment advertising in 2003, up from just 3% in 2000, according to Corzen. Bruce Murray, Corzen's founder and chief executive, said the classified-ad figures compiled by the Conference Board were "no longer relevant, in our view." When economic growth slowed after 2000, he added, companies began "quite significantly to use online job boards instead of newspapers." He said the economy "really crossed a threshold." Internet-based employment indexes are starting to build followings on Wall Street because of their timeliness and their focus on what may be ahead. Typically, government surveys are out two or three weeks after data is collected, but online surveys usually appear within a week of the periods measured. CNBC and Market News International have cited Monster's index as influencing bond and commodity trading.
The Nov. 5 jobs report revealed that the economy churned out 337,000 jobs in October, nearly double even the most optimistic predictions from Wall Street. Merrill's conclusion: When it comes to jobs, quantity doesn't equate to quality. Digging in reveals that about 150,000 jobs were added by the construction, fast-food and hotel industries and temporary workers. Mr. Rosenberg attributes a majority to a "hurricane effect," largely from construction in the Southeast. Hiring was also highly concentrated. The "diffusion index," which measures the percentage of industries hiring, fell to 56.8 from 59.2 in September. This stands in stark contrast to the 68 readings recorded in April and March, the last time we saw 300,000 months. "Over two-thirds of the job gain last month was centered in just one-quarter of the employment pie," Mr. Rosenberg said. Companies also loaded up on part-timers, "not a sign of momentum in terms of business confidence," he wrote. The number of people working part time for "economic reasons" jumped by 280,000 in October. That may be because 22.2 percent have been looking for a job for 27 weeks or more. Let me acknowledge that 337,000 is a great number. But did it justify analysts' dismissal of June through September? "Of course, the mantra in prior months was that the payroll report was a flawed survey," Mr. Rosenberg wrote. "Lo and behold, now it's the real deal." Even with the upward revisions, the average gain over the last five months is 171,000, which barely keeps up with natural growth in the labor force. That helps explain why the labor force participation rate remained at September's low of 65.9 percent, well off its 67.3 percent April 2000 peak. In all, Mr. Rosenberg figures the economy is still about 4 million jobs shy of being fully employed. His solution for a market that refuses to acknowledge anything but the best news? "Just keep hikin', Mr. Greenspan. Don't stop 'til we start seeing employment go down," he advised.
Just the Facts Inflation, Portfolio Returns & Buying Power Jeff Brown, Philadelphia Inquirer 11-22 Inflation affects investors. To see inflation's effect, consider a portfolio worth $100,000 today, invested in a mix of stock and bond funds that will produce an average annual return of 8%. After 20 years, the portfolio would grow to $466,000. But if inflation averages 3% a year, the "real" - after inflation - return would be 5%, and the real value would be just $258,000. In other words, the portfolio would buy what $258,000 buys today. Now suppose inflation rises to a 4 percent annual average. The portfolio would average a real return of just 4%. In 20 years, it would still grow to $466,000, but the higher inflation would leave that with the buying power that $213,000 has today. So the mere 1 percentage point rise in inflation would do serious damage to the portfolio. Why Coal is Hot Again Simon Romero, NY Times 11-20 More than 100 coal-fueled plants that are vying for approval around the country - the largest increase in such projects since the 1970's. The reason for coal's resurgence is an intensifying fear in the United States that supplies will become scarce in electricity's other main fuel source, natural gas. And coal is a lot cheaper. Altogether, energy companies in the United States have announced plans to build more coal-fired power plants in the last 12 months than they did in the last 12 years. If all those projects get off the ground, utilities would invest more than $100 billion. During the 1990's, nearly every new electricity plant was built to be run on natural gas, which is cleaner-burning. But in the last five years, natural gas prices have skyrocketed as imports from Canada slowed and domestic production failed to keep up with demand. Prices have shot up to more than $6 for each thousand cubic feet from just $2 in 1999. A typical coal-fired power plant spends 2 cents per kilowatt-hour to fuel its operations, compared with 5 cents per kilowatt-hour for a plant fueled by natural gas. What Wal-Mart Knows Constance Hays, NY Times 11-14 When Hurricane Frances was threatening a direct hit on Florida's Atlantic coast. Wal-Mart mined its data and found that the stores would need more of certain products - and not just the usual flashlights. Strawberry Pop-Tarts are purchased at seven times their normal sales rate, ahead of a hurricane. And the pre-hurricane top-selling item was beer. How did they know? With 3,600 stores in the United States and roughly 100 million customers walking through the doors each week, Wal-Mart has access to information about a broad slice of America. By its own count, Wal-Mart has 460 terabytes of data stored on mainframes at its Bentonville headquarters. To put that in perspective, the Internet has less than half as much data, according to experts. Dividend Payers Winning Again Norm Alster, NY Times 11-14 For more than two decades, dividend payers have generally done a better job than other companies when it comes to enriching their shareholders. This year is no different. Through Thursday, the dividend-paying stocks in the S&P500 posted a total return of 13.8%, according to S.& P., versus a gain of 3.8% for the nonpayers. Since 1980, a period that embraces the longest bull market in history, dividend payers have outperformed nonpayers by almost three percentage points a year, on average, according to Howard Silverblatt, a market equity analyst at S.& P. Eight Habits Paul Brown, NY Times 11-07 In "The Seven Habits of Highly Effective People," Stephen R. Covey wrote that the the seven habits were: "Be proactive. Begin with the end in mind. Put first things first. Think win-win. Seek first to understand, then to be understood. Synergize. Sharpen the saw, or engage in personal renewal. In his new book, "The Eighth Habit: From Effectiveness to Greatness", his eighth habit is what Mr. Covey calls "voice," which has four components. "Voice lies at the nexus of talent (your natural gifts and strengths), passion (those things that naturally energize, excite, motivate and inspire you), need (including what the world needs enough to pay you for), and conscience (that still small voice that assures you of what is right and that prompts you to actually do it)." Earnings Update Christopher Noble, CBS MarketWatch 11-06 As of the end of the week, 442 companies of the Standard & Poor's 500 have reported earnings and the data suggest corporate earnings have grown 16.9 percent in the third quarter, higher than the 16.4% of last week, according to data from Thomson First Call. That means that the quarter will mark an end to the string of four consecutive quarters of at least 20% earnings growth, Thomson said. Of the companies reporting so far, 64% have reported earnings above analyst expectations, 16% have been in line and 20% missed expectations, a typical quarter, Thomson data show. Earnings Update II Charles E. Kirk, The Kirk Report 11-08 Thomson's weekly commentary gives a good big-picture view of how earnings have been. This week Thomson makes these important points: The three sectors in the S&P 500 index that are reporting the highest year-over-year growth are materials, energy, and technology. On the flip side, utilities, telecommunications, and financials are reporting the lowest year-over-year growth of the 10 sectors. In the fourth quarter - the materials sector and energy sector are again expected to have the highest year-over-year growth, with projections at 74% and 61% respectively. Quick Facts, Stats & Opinions According to Chicago's Ibbotson Associates, the Standard & Poor's 500-stock index has scored 10.4% a year since 1925. But if you bank on earning that sort of annual return, you won't save nearly enough. Remember, this 10.4% is the return you would have garnered over the past 78 years if you had been 100% in stocks, incurred no investment costs and paid no taxes. But very few investors are 100% in stocks and all of us incur investment costs and taxes. (Jonathan Clements, WSJ 11-20) Currently, 376 companies in the S&P 500 index pay dividends. Standard & Poor's now estimates that about 300 of those companies will increase their dividends in 2005. Companies have ample resources to increase dividends, says David Wyss, chief economist at S&P. He notes that cash in the coffers of companies in the S&P 500 stands at about $599 billion. (Stacy Trombino, businessWeek 11-18) Google is launching a new search engine today that will focus on finding works of academic research. Located online at scholar.google.com, the free service will facilitate Internet searches for theses, books, abstracts and technical reports. (Washington Post 11-18) As contrarians constantly remind us, the market rarely accommodates the majority.(Mark Hulbert, CBSMarketWatch 11-10) The dollar has fallen 10% against the euro since late April, dragging it back into negative territory for the year. Most professional global investors believe the dollar has further to fall against the European currency due to the ballooning U.S. budget deficits and China's shifting some investments into euros. International stock funds have received inflows of nearly $43 billion through Nov. 3, according to AMG Data Services. Historically, currencies move in sweeping trends, typically lasting five to seven years. Currently, the dollar is in the second year of a downward move, and John R. Taylor Jr., chairman of FX Concepts, a New York-based currency hedge fund, says it could easily slip another 25% to 30% during the next year or two. (Opdyke & Karmin, WSJ 11-08) Americans can own foreign currency outright. EverBank.com offers savings accounts and certificates of deposit in a variety of major and secondary currencies. Savings accounts require a minimum deposit of $2,500; CDs, a $10,000 minimum. The accounts are FDIC-protected, meaning the deposit is guaranteed. (Opdyke & Karmin, WSJ 11-08) Corporations are flush with cash these days. According to Standard & Poor's, the aggregate cash on the balance sheets of S&P 500 members stood at $590 billion on Sept. 30, up 126% from $261 billion five years earlier. (Shirley Lazo, Barrons 11-08) Closed-end funds are coming public at a torrid pace this year. In the nine months ended September, 39 such offerings came to market, raising $18.6 billion, according to a new report by Michael T. Porter, a senior research analyst at Lipper. Porter says it's best to give these initial public offerings a wide berth, however, at least in early trading. Three months after an IPO, closed-ends on average trade for 10.4% less than their offering prices, while the average discount rises to 5%. (Lawrence Strauss, Barrons 11-08) Americans are taking precautions to prevent identity theft online, but most don't remember to protect their personal information in one particular place - their wallets. Nearly half of Americans carry their Social Security cards in a wallet or purse, according to the American Express ID Theft Quiz. Your Social Security number is your most important piece of personal data, and it's also the one thing identity thieves need to steal your money and make new charges in your name. (Marshall Loeb, CBS MarketWatch 11-07) In some parts of the country, including Massachusetts, Colorado, Georgia, Maryland, New Jersey and others, consumers have been able to get one free credit report each year from all three major credit bureaus. The trouble is that most people haven't taken advantage of the offer. In fact, studies have shown that consumers in so-called free states have not checked their credit reports more dramatically than residents of states where payment is required. (Chuck Jaffe, CBS MarketWatch 11-03) Home Page Previous Factoid Top Sites
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