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In some cases, institutional investors, including mutual funds and activist hedge funds, are the driving force behind the bigger dividends and buybacks. This year, financier Carl Icahn lobbied for a higher dividend at Blockbuster and a more aggressive stock buyback program at Time Warner, companies in which his hedge fund owns big stakes. The sharp rise in dividends and buybacks could have major ramifications for investors, corporations and the economy as a whole, depending on where the torrent of cash ends up. The payouts could provide a new boost for consumer spending or could push up stock prices if shareholders reinvest dividends in stock. But there could be an economic downside to the cash glut. The fact that companies have been sitting on so much cash is, in some respects, a vote of no-confidence in U.S. economic prospects: At least some companies may be signaling they can't find enough profitable ways to reinvest their earnings, so they are simply returning it to shareholders. Capital spending by the companies in the S&P 500 has grown only modestly over the past two years, after two years of declines, according to S&P. The recent and sharp rise in these payouts marks a significant transformation in the way companies allocate their profits. Dividends have been on the rise since the Bush administration succeeded in cutting the tax rate on them to 15% in 2003, as opposed to taxing dividends as regular income. But that tax cut is set to expire after 2008 and extensions have stalled thus far in Congress amid steep budget and trade deficits. Even after the recent rebound in dividend payments, however, the average S&P 500 stock has a dividend yield of just 1.8% -- about half the historical average. Currently, U.S. companies are sitting on near-record levels of cash. Among industrial companies in the S&P500, the amount totals nearly $631 billion on the books -- more than 7% of these companies' market value and the highest percentage since 1988. Some economists call the payouts this year an ominous development that may be stealing from future economic growth, since they suggest companies are having trouble spotting new products, projects or services they think will boost their growth. "These payments keep the economy growing more slowly because that money isn't flowing into capital spending," says Milton Ezrati, chief economist at Lord Abbett Funds. "If businesses are giving up on innovation, we have problems." Others could argue that U.S. companies are merely bringing their payouts to shareholders back near historical levels. A big driver of the record profits making these payouts possible isn't a runaway economic boom, but rather deep corporate cost-cutting in recent years. After the end of the tech bubble, executives pulled in their horns. Instead of shopping for acquisitions, many companies have refinanced debt to take advantage of lower interest rates and hacked away at costs that built up during frothier times. While acquisition activity has ticked up in recent quarters, private-equity firms have made many of these purchases. As a result, mammoth mergers haven't been as common as in the heady 1990s. When the economy finally got some traction in recent years, companies were leaner and more profitable. For a record 14 consecutive quarters, companies in the S&P 500 have reported double-digit profit growth. S&P projections have the record streak lasting at least two more quarters. If profits do remain strong, however, employees and unions may put pressure on companies to direct more of that money to higher wages and benefits, after several quarters of modest wage growth and benefit cuts at many firms amid rising health-care costs. So far, companies have felt free to spend their profits on their own stock. This year, nearly 60 companies in the S&P 500 have cut their number of shares outstanding by at least 4% through repurchases, according to S&P. Overall, in the first nine months of this year, S&P 500 companies paid out $147 billion in dividends and spent $231 billion on share repurchases -- a figure that includes only actual purchases, excluding buybacks not yet completed. Mr. Silverblatt of S&P expects dividend payouts and share repurchases for S&P 500 companies to top $500 billion for the full year. To put that figure in perspective, it could pay off the federal budget deficit for the just-ended fiscal year with about $180 billion to spare. And many companies have plenty of money left over after increasing their dividends and buyback programs. Dividends and buybacks have considerably different implications. A quarterly dividend check can serve not only as a carrot for investors, but also a check on overspending for corporate managers. Research has shown that companies that pay dividends tend to have healthier long-term profits than those that don't. If a company buys its own shares when they are cheap, it can support the stock price and thus boost investors' returns. Of course, the opposite holds true if the company buys at a price well above the shares' value. Dividend checks are favored by many investors because a dividend is cash in hand, whereas the value of a share repurchase depends on whether the company is buying shares at an attractive price. The good news for dividend fans is that it looks like there's ample room for these checks to grow from here. Today, 385 companies in the S&P 500 pay dividends, down from a peak of 469 in 1980. And even though billions are going out the door, dividends only comprise about 32% of payers' profits. Historically, companies have paid out about 54% of their profits as dividends.
The average Vanguard-administered defined-contribution plan offered 18 funds at the end of 2004, compared with more than 70 Vanguard funds offered to IRA investors, according to the study. The plethora of choices offered to IRA investors may result in "choice overload," Vanguard said. The median household income of those studied was $54,000 for investors in defined-contribution plans and $71,000 for IRA investors, compared with a U.S. median income of slightly more than $43,000. Defined-contributions investors were younger than their IRA counterparts, and more likely to be male. The Investment Company Institute reported that 40% of U.S. households owned an IRA in 2004. The Employee Benefits Research Institute said that more than 45% of working-age families had a family member with a defined-contribution plan in 2001, the most recent year for which data were available. Stocks accounted for about 70% of combined assets in IRAs and defined-contribution plans held by the average investor in his late 40s, Vanguard said. But half of the IRA holders put their entire accounts into stocks, compared with 20% of the defined-contribution holders. At the other end of the spectrum, 14% of the defined-contribution investors put all of their money into fixed-income investments, compared with 8% of Vanguard IRA investors. "It is interesting to us that so many people do appear to take extreme positions, so 100% equity or no equity," said Ms. Young. The IRA investors studied tended to be older as a group than their defined-contribution counterparts -- 17% were older than 65, compared with 3% of the defined-contribution group. But they aren't more conservative. About six in 10 Vanguard IRA investors put more than 80% of their assets in stocks, compared with about four in 10 of the defined-contribution holders.
Growth stocks are still trailing value by a slim margin so far this year. But take away the first quarter, and growth stocks have been on a tear. Large-capitalization blue-chip growth stocks have advanced 10.9%, on average, since the end of March, easily surpassing the gain of 8.2% for large value shares. Growth is also beating value among small-capitalization stocks since the end of the first quarter, 13.0% versus 10.8%. Does this make a trend? "I don't think I'd bet the farm on it," said Ernest M. Ankrim, chief investment strategist at the Russell Investment Group. "But I am willing to bet on it." Mr. Ankrim is not alone. A recent survey of money managers by the Russell group found that they were most enthusiastic about large-cap growth stocks. Nearly two-thirds said they were bullish about these stocks, while just 32% were bullish about large-cap value stocks. When it came to midcap shares, 51% were bullish for growth, versus 29% for value. In small-caps, 38% were enthusiastic about growth shares, versus just 20% for value. There are other signs that the rally may have legs. For starters, two of the most popular industries among money managers are health care and technology, both of which are classic growth sectors. By contrast, said Robert Turner, chairman and chief investment officer at Turner Investment Partners, a large percentage of the value stock universe is made up of financial sector holdings. And many of the names in it have underperformed over the last year as the Federal Reserve has raised short-term interest rates to stave off inflation. While many growth sectors could also be hurt by rising rates, "who's going to sell growth now, after all these years?" Mr. Turner said. After five years of severe underperformance for growth stocks, he said, most people who wanted to dump their shares have probably already done so. Investor attitudes, meanwhile, are changing in other ways. For the first time in a year and a half, more investors now want companies to use their excess cash to invest in capital spending rather than return the money to shareholders in the form of dividends or share buybacks, according to a recent survey of money managers by Merrill Lynch. Companies are being pressured "to stop running themselves for cash and to start running themselves for growth again," said David Bowers, chief global investment strategist at Merrill Lynch. If this trend continues, faster-growing companies would certainly receive more emphasis. A slowing economy caused by rising interest rates could also have that effect. After expanding by more than 20% in the first half of 2004, profit growth among companies in the S&P 500 has been slowing. In fact, Q3 earnings this year are expected to have risen by just under 16% and Q4 earnings are forecast to grow at 14.5%, according to Thomson Financial. Why would growth stocks be expected to excel when economic growth is decelerating? Though it seems counterintuitive, "when the economy slows and earnings slow, those companies that possess more robust earnings growth tend to trade at a premium," said Jeffrey Kleintop, chief investment strategist at PNC Advisors. This is one reason for Mr. Kleintop's recommendation that investors tilt their portfolios slightly toward growth, with a 55%t weighting for growth stocks versus 45% for value. Even the most ardent supporters of growth say that this time, things are likely to be different. Many money managers say they now expect greater parity between growth and value. And don't make the mistake of confusing growth for technology stocks. While it is true that tech was the engine that drove the growth rally in the late 1990's, investors now say they are finding good growth opportunities in a variety of sectors, including health care, consumer discretionary goods and some industrials. Zachary Karabell, senior economic analyst at Fred Alger Management, notes another distinction between the current growth rally and the one in the late 1990's. This time, even the tech names that are leading the charge - including the Internet search engine provider Google - are actually making money. "These are companies generating bona fide, high-double-digit earnings and revenue growth," he added. "These aren't ideals, hopes and dreams, but rather real profits." Related Article: Growth Stocks: So Cold They're Hot? Jeff Opdyke, WSJ
So what's going on? Currencies are supposed to tumble in price when trade deficits climb this high. There is a logic to the dollar's rally, though. I'll spell it out for you and then tell why you should look out for a turn in the dollar's fortunes in 2006. Three reasons explain the dollar's surprising rally this year: The dollar's up because the euro is down The U.S. dollar doesn't have to be a perfect currency; it just has to be better than the competition, the euro. (The yen, given Japan's negative real interest rates, isn't a starter in this race.) And it would be hard over the last six months to find a currency that's suffered more body blows than the euro. There's the France problem: The country's immigrant population has risen up in protest against problems that include 40% youth unemployment, and the French government has shown itself startlingly clueless about how to stop the rioting and fix the underlying problems. There's the German problem: Everyone (well, investors and economists, anyway) got excited that the fall's election might sweep a new government to power with a mandate to transform the country's rigid economy. Instead, the vote went just about straight down the middle, leaving the country to be governed by a grand coalition that doesn't agree on much of anything. There's the Italy problem: The country's budget deficit is way, way above the rules set by the European Union, and, with the Italian economy struggling to grow at all, nobody in Rome really wants to propose budget cuts. And finally, there's the United Kingdom problem: The Tony Blair government saw its anti-terrorist legislation go down to brutal defeat in the House of Commons on Nov. 9, just in time to undermine Blair's ability, as president of the European Union for six months, to broker a deal on the EU budget. Talks on the budget collapsed in June with Britain and France at loggerheads. That's enough to make anyone think twice about buying euros, no? The Fed has made it pay to buy dollars Alan Greenspan may find it painfully puzzling that the Federal Reserve's interest-rate increases, which have taken short-term rates from 1% in June 2004 to 4% currently, haven't pushed up long-term interest rates significantly. But, at the Nov. 10 close of 4.56%, the yield on the U.S. 10-year Treasury note is significantly higher than investors collect on either European or Japanese bonds. That day, the 10-year German bond was yielding 3.51%, and the Japanese government's 10-year bond was paying 1.57%. High oil prices High oil prices added about $1.5 billion to the trade deficit in September, even as the volume of imported oil dropped by about 2%. The U.S. imported about $23.8 billion in petroleum and petroleum products in September. That put a lot of money in the hands of Middle Eastern central banks and investors, who immediately put those dollars (remember, oil trades in dollars) to work earning interest by buying dollar denominated assets such as Treasury bonds. The trend reverses in 2006 The future is likely to bring major changes in direction to all three of the trends now driving the U.S. dollar higher against the euro and the yen. The shift is likely to be gradual. But by mid-2006 we're likely to see the dollar in at least modest decline against both the euro and the yen. It's hard to imagine that, in a year, the political and economic chaos in Europe will be worse than it is now. Six months from now, the French government is likely to have muddled its way to some kind of reduction in violence, the failures of the German grand coalition will have gone from alarming headlines to the butt of Berlin cabaret comics. Without the British prime minister in the hot seat, the French will be less interested in publicly humiliating the opposition. And the interest-rate gap between the U.S. and the rest of the world is likely to narrow, or at least stop expanding. The Bank of Japan has started to pave the way for reversing course with predictions of rising economic growth and joyous proclamations of a return of barely measurable inflation. Sometime in 2006, the Federal Reserve will stop raising short-term interest rates -- the betting on Wall Street is on an end to interest rate hikes at 4.75% to 5.5%. The lower end of that range is just a December, January and March rate hike away. If the Fed stops raising rates, that will give euro and yen rates a chance to catch up -- or at least stop them from looking less competitive with each passing Fed meeting. Try as we might, we at High Frequency Economics are hard pressed to invent plausible scenarios in which those interest rate spreads even start to narrow anytime soon. Hence, we are anticipating dollar appreciation will extend through the end of next year or early 2007, which is when the Fed may next plausibly be expected to start cutting interest rates. The dollar is in a perma-rise that will not abate any time soon. Other central banks are half the equation. We are not expecting much action from foreign central banks, either now or next year. Our core hypothesis until recently was that the European Central Bank will not hike rates this year or next. Friday's statement by ECB President Jean-Claude Trichet warned that at least one increase could come sooner than that. However, the case for aggressive monetary tightening is tenuous at best. Recent reports show falling headline inflation and minimal core inflation. Third-quarter economic growth was minimal, arguing against hiking ECB rates at all, never mind soon. We do not think inflation can raise its ugly head, either -- not with the jobless rate so high. In all, neither we nor anyone we know has a scenario in which the ECB will hike rates as fast or as far as the Fed has already done -- or is yet to do. So interest-rate spreads will continue to work against the euro for a long time to come. Similarly, Bank of Japan interest-rate hikes are unlikely for the foreseeable future. Prices continue to fall at an accelerating pace, and GDP growth is anemic. Again, even if we are very wrong in our assessment, we cannot imagine an outlook for BoJ monetary tightening that would raise yen rates faster than dollar rates are likely to rise. What has fallen from prominence is the markets' anxiety about the U.S. "twin deficits" and how they may undermine the value of the dollar. We never did understand why the U.S. fiscal deficit might undermine the dollar while similar-sized spending gaps in Euroland did not undermine the euro. Much bigger -- as a share of GDP -- fiscal deficits never once threatened the value of the yen. As for the current-account deficit, well, the U.S. dollar is the reserve currency of the world. This means many uses of dollars exist outside the United States that require an ever-growing dollar overhang. As a practical matter, using the current-account balance to predict the direction of the dollar has worked no better than flipping a coin over the last 30 years, when the United States started running a steady current-account deficit. So, we say, ignore the twin deficits and follow the interest-rate spreads, as you should have been doing all along.
Since they took the lead back in April 1999, small caps, as measured by the S&P Smallcap 600, have soared a cool 102%. During the same span, the S&P 500 declined 8%. But since the beginning of August, small-caps are down 2%, compared with a flat S&P 500. The "average" small-cap cycle lasts 5.7 years. That's based on data collected by Steven DeSanctis, chief small-cap strategist at Prudential Equity Group. The data goes back to 1926, which obviously confirms that this cycle, at 6.6 years, is no spring chicken. Still, while some small-cap runs lasted a mere 3.3 years (1991-94), others endured as long as 8.5 years (1975-83). Another big potential negative is if the public sours on small-cap mutual funds, which boast $419 billion in assets, according to Financial Research Corp. That's more than double the $182 billion they held at the beginning of 2003 and 3.5 times the money invested in them back in 1999, when the cycle began. The highest-quality stocks will do the best" in the months ahead, since they are the least expensive and should grow earnings at a better clip as the economy slows and the dollar weakens, says Jack Ablin, chief investment officer at Harris Private Bank in Chicago. Algin cites valuations and the fact that many giant companies have spruced up their balance sheets in recent years. Almost a third of nonfinancial firms in the S&P 500 have more cash than debt. Most important, Pradhuman feels the fuel for small-cap earnings growth, plentiful capital, is still readily available. In addition to tapping the high-yield market, he observes, small companies can turn to commercial banks, whose willingness to make loans, as measured by their tightening or loosening of credit standards, is the easiest it has been in more than 15 years. Over the next 12 months, even in a lackluster stock market, Pradhuman expects small-caps to outdistance big-caps by 4%-5%.
If you can identify these biases and relate them to specific investment opportunities, you'll have an advantage over the crowd. In other words, it's not enough to analyze a stock and come to the conclusion that it's undervalued. You need to ask yourself why it's undervalued -- what has caused other market participants to price the stock at what you think is an irrationally low level? If you can't come up with a reason, the stock might not be as cheap as you'd thought. It's Right Under Your Nose This one doesn't happen often, but occasionally stocks can quietly become cheap. If a company's share price goes sideways for some years while the business continues to chug along, the valuation steadily becomes more attractive. How can this happen? Stocks that don't move a lot (up or down) don't generate much news, and with thousands of stocks to watch, many money managers rely on the headlines to bring stocks to their attention. So even large businesses can just chug along under the radar. A contributing factor is that Wall Street generally goes with "what's working now," which means that some stocks might be cheap just because they're not in vogue. This happened with small caps and REITs -- among other areas -- when nothing but mega-caps and tech were going up in the late 1990s, and I think the same thing has been happening with large caps over the past few years. After a lengthy stretch of strong small-cap performance, many investors were projecting the recent past into the future and buying "what works" -- small caps -- rather than looking for bargains among large caps. Consider Coke, Johnson & Johnson, and Wal-Mart. Over the past five years, Coke and Wal-Mart shares are down by one third and by about 10%, respectively, while J&J's stock has risen about 20%. But J&J is generating 70% more cash from operations than it was five years ago, Coke's cash flow has risen 80%, and Wal-Mart's cash flow has doubled. They're bargains in plain sight that are mispriced simply because Wall Street has been too busy chasing China plays and energy stocks. The Smell Is Bad Stocks that have a "taint" are often priced irrationally. This was the case with Philip Morris (now Altria) for years, and you also often see it with companies that are emerging from bankruptcy. How could K-Mart have been so cheap when it re-emerged from bankruptcy? Because most investors didn't want to bother with a stock that had only recently risen from the dead. I think this is one of the reasons why J.P. Morgan Chase is so attractively priced right now. Investors hear the word "derivatives" and run screaming for the hills despite the fact that the more-exotic derivatives account for a single-digit portion of the firm's equity. Moreover, the vast majority of the firm's counterparties have credit ratings of BBB or above, which makes default pretty unlikely. So is Morgan's derivatives business a risk worth keeping an eye on? You bet. Is it enough of a worry for the shares to merit a price/book ratio of just 1.3? Nope. Guilt by Association Finally, you often see good companies in tough industries mispriced because investors tar them with the same brush as their less-attractive peers. The steel industry has gotten a bad rap from many investors who associate it with giant pension costs, crushing debt loads, bankrupt firms, and industry overcapacity. In most cases -- particularly for U.S.-based integrated steel companies -- this is an accurate assessment. However, when you look at a company like Gerdau GGB in Brazil -- with access to incredibly cheap hydroelectric power -- or Posco PKX in Korea -- with a virtual monopoly in the Korean market -- you see firms that can be pretty attractive investments despite their tough industry environment. Although both of these stocks only have a 3-star rating from us right now, we currently have a 5-star rating on Mittal Steel, currently the world's largest steel firm. Steel is a tough industry, but not tough enough that a company with a fully funded pension plan, an investment-grade credit rating, and dominant market positions throughout the world can't offer an attractive return when it's priced at just 5 times earnings.
But total return figures only show how a fund has performed over a specified time frame. They don't accurately reflect shareholders' experience, because they don't consider the timing of purchases and sales. Investors are notorious for their poor timing: They often purchase investments after periods of strong performance and sell them after weak performance. Timing decisions have a major negative impact on the returns shareholders actually pocket. As such, it's instructive to examine dollar-weighted returns to see how investors have really fared, because dollar-weighted returns account for cash flows in and out of a fund. I examined dollar-weighted returns on index funds that have been around at least 10 years. As most investors are painfully aware, the past decade included dramatic upswings and downswings that tested investors' discipline. The results indicated that, as with most active funds, investors' timing decisions were costly. The dollar-weighted returns for virtually all large-cap index funds were worse than their official returns for the trailing 10-year period through the end of Q3-05. As the table below shows, poor timing cost Vanguard 500 shareholders 2.7 percentage points of returns per year over the past decade. Fidelity Spartan 500 Index Investor FSMKX shareholders sacrificed 4 percentage points per year.
So is performance chasing to blame for these poor results? I certainly think that had a lot to do with it. Index funds offered an easy way to gain exposure to a hot stock market in the late 1990s. Large-cap stocks in particular were on fire during that time, luring many investors to large-cap heavy S&P 500 Index funds. Granted, indexing as an investment strategy was catching on with investors at about the same time, but I suspect that their popularity had more to do with the S&P's scorching bull-market campaign. As indexing became more popular, fund companies rushed to meet the demand by introducing index funds that bore their brand names. More large-cap index funds were rolled out in 1999 than in any other year. Although fund companies can't control investor behavior, marketing moves frequently encourage investors' worst tendencies. Even today, many investors still have a propensity to pile into the hottest funds at just the wrong time. Witness the recent strong inflows many energy funds have experienced this year. I still think index funds provide investors a great way to get low-cost, no-fuss exposure to the stock market, but they are good investments only if shareholders use them wisely and maintain the long-term orientation that's necessary to benefit from all they have to offer.
But there are four reasons why a fourth-quarter rally may not happen this year: high oil prices, rising interest rates, a low level of cash on the sidelines and high stock valuations. Chris Orndorff, head of stock investment at Payden & Rygel, thinks oil prices will head back up and interest rates will keep rising, hurting economic growth and knocking blue-chip's down 15% from here. By the end of the third quarter, stock mutual funds as a group were holding just 3.8% of assets in cash, the lowest cash level in more than five years, according to the Investment Company Institute, a trade group. Since 2000, cash levels have averaged about 5%. Because cash levels are so low, mutual-fund managers now have very little money left on the sidelines to invest in stocks. Inflows to stock funds that invest in the U.S. have been limited. One subject of widespread debate is whether stocks truly are cheap. The Standard & Poor's 500-stock index traded last week at about 18 times its component companies' profits from the previous 12 months. That was below the average of 19 that has prevailed since 1979, according to Ned Davis Research, making stocks by that measure look fairly priced, although not really cheap. But it is above the average of 16 that has prevailed since World War II, making stocks by that measure look still expensive.
Scott Ebner, head of new-product development at the American Stock Exchange's ETF marketplace, said one reason is that ETF sponsors "are always more cautious about their approach to products, especially in areas that are different, when they're not first to market." Barclays Global Investors' iShares ETF family was first to the fixed-income market in July 2002, when it launched iShares Lehman 1-3 Year Treasury, iShares Lehman 7-10 Year Treasury, iShares Lehman 20+ Year Treasury and iShares GS$InvesTop Corporate. In 2003, BGI launched iShares Lehman Aggregate and iShares Lehman TIPS. BGI, a unit of Barclays PLC, has about $14 billion in assets under management in the six fixed-income ETFs. A few months after BGI's 2002 launch, New York investment firm ETF Advisors launched Treasury Fixed Income Trust Receipts, or FITRS, that were based on Ryan Labs Treasury indexes. Gary Gastineau, the mastermind behind FITRS, said there was a good response to the products, which tracked U.S. Treasury securities with one-, two-, five- and 10-year maturities. After about six months though, the funds were forced to shut down largely because "we were going head to head with BGI," Mr. Gastineau said. BGI set its ETF expense ratios very low and "we had to match that when we came out," he added. Most people in the industry nevertheless believe more fixed-income ETFs are on the way. James Parsons, a managing director of iShares at BGI, said the most frequent request from institutional investors is for an ETF that represents the subcomponents of the Lehman Aggregate Index. Larger advisers, Mr. Parsons added, have expressed interest in a corporate-bond product, while the broader adviser community tends to want high-yield and emerging-market debt. (BGI filed with the Securities and Exchange Commission for a high-yield ETF about two years ago, but it has yet to come to market.) Still, there are challenges in creating bond ETFs and getting them approved by the SEC. When creating fixed-income ETFs, Mr. Parsons said one issue BGI had to overcome was pricing, or more specifically, how to get electronic pricing fed to the exchanges from more than one source. He added that corporate-bond trades are now required to be reported within 15 minutes of execution, a change that has improved price transparency in the market. For more liquid securities like U.S. Treasurys, electronic pricing occurs regularly. Bond ETFs are still new products to the SEC, so sponsors have to get so-called exemptive relief each time they file for a bond ETF, said Jim Ross, co-head of adviser strategies at State Street Global Advisors, which currently has 23 ETFs. This can take awhile because the SEC wants to ensure it is giving exemptive relief to products that have appropriate shareholder protection, Mr. Ross said.
A study conducted by David S. Scharfstein, a finance professor at the Harvard Business School, offers evidence of inefficient capital allocation among widely diversified companies. Professor Scharfstein found that managers of conglomerates generally felt compelled to invest something in all of their divisions, regardless of the divisions' growth potential - a phenomenon that he calls intrafirm "socialism." Because of it, conglomerates tend to invest too much in divisions with low growth potential and too little in those with high potential. Professor Scharfstein's findings help to explain why conglomerates can unlock value by breaking into component parts. Once those parts are separate, publicly traded companies, the businesses with the highest growth potential should attract capital more easily than the slowest-growth units. Why do conglomerates decide to become so diversified in the first place? A possible answer is suggested in research by the finance professors Owen Lamont of Yale and Christopher Polk of Northwestern. Writing in the January 2002 issue of the Journal of Financial Economics, they said companies with the lowest growth prospects tended to be the most likely to diversify. That is probably because such companies see greater growth opportunities in businesses unrelated to their own. Of course, once a slow-growth company becomes part of a group of unrelated businesses, Professor Scharfstein's intrafirm socialism kicks in, moving capital out of the fast-growing divisions. If the conglomerate remains intact for a long time, the results may leave investors lamenting its very creation.
The Seasonality Trading System was created by Norman Fosback in the early 1970s. Fosback is well known as the editor of several newsletters that were published from the 1970s through the 1990s. That system recommends being in the market for the last two trading days of each month and the first five of the subsequent month, as well as for the two trading days before exchange holidays. At all other times investors remain in cash. Over the 20 years through October 31, this hypothetical portfolio produced a 13.4% annualized total return in contrast to the Dow Jones Wilshire 5000 Index's 12.0%. The system lets investors keep pace with the market even though they're in cash more than half the time. This is why, on a risk-adjusted basis, this system is far and away the best-performing market timing system of any that I track at the Hulbert Financial Digest.
The result is that global investors are diving into a wide range of riskier assets: emerging countries' stocks and bonds; real estate and real-estate-backed debt; commodity funds; fine art; private-equity funds, which buy stakes in nonpublic companies; and the investment contracts called derivatives, including a kind structured to permit the sophisticated to take huge bond risks. For good measure, many investors use today's low interest rates to borrow money to amplify their bets. This "leverage," in effect, thus enlarges the already overflowing pool of investment capital. As these markets draw more investors, whose buying pushes up their price, prospects rise that a reversal could cause widespread pain. Where does this global flood of cash come from? Ben Bernanke, nominated to head the Fed, last March identified what he called a "global savings glut," which he said helps explain the relatively low level of long-term inflation-adjusted interest rates in the world. That there should be such a glut when U.S. consumers save none of their current income and their federal government borrows heavily might seem paradoxical. But plenty of others do save and accumulate cash to invest, including U.S. corporations. Companies' profits are near record levels, yet their expansion plans are muted, partly a hangover from the expansion excesses of the late-1990s stock-market bubble. So they have lots of money seeking a home. Abroad, many families' saving habits are the mirror image of Americans' free-spending ways. European and Japanese workers save far bigger shares of their incomes, and Chinese households a stunning 25%. In all, China is expected to have about $116 billion to invest abroad this year, much of which goes into U.S. bonds. The steep price rises on oil and many raw materials in the past three years have fattened the purses of commodity-producing countries. Exports by Russia, a big oil producer, are likely to exceed imports by $102 billion this year, the IMF estimates. About 60% of the Russian central bank's $163 billion in foreign reserves are invested in assets denominated in U.S. dollars. "People talk about a wall of money everywhere," says Peter Fisher, a former Federal Reserve and Treasury official who's now a managing director at BlackRock. "Bankers talk about too much money chasing deals. Private-equity funds talk of money chasing them. And buyers of corporate and asset-backed debt seem to come at the bond market from all directions." Why the 'Risk Premium' is Low Policy makers increasingly see worrisome consequences of this global cash surplus. As the price of an asset rises, the income it throws off declines as a percentage of the asset's value. This means investors are demanding less compensation than usual for taking on the risk inherent in owning the assets. The "risk premium" is low today and there are some sound reasons why it should be low. World economic growth has been unusually stable and predictable for several years. The U.S. economy grew at a 3.8% annual rate in Q3, the eighth straight quarter at about that pace -- the least volatile two-year stretch of growth on record. U.S. inflation did hit a 14-year high in September, but it remains low when energy prices are excluded. And the financial system hasn't seen the threat of a serious blowup since the 1998 Russian default and collapse of the Long Term Capital Management. But the concern is that, historically, very low risk premiums often presage a broad market decline that pushes down stock prices and pushes up what everyone must pay to borrow, hurting economic growth. As investors pile into riskier assets and their prices rise, they generate impressive returns for those who own them and attract still more investors. Cautious money managers who play it safe and stay on the sidelines run the risk of showing embarrassing low returns, and losing clients. Most choose to stay in the game. Investors' quest for higher returns can present a dangerous quandary, says Jim Sarni, who invests for pension funds and insurance companies at Payden & Rygel. "It makes you continue to invest in higher-yield instruments despite the fact that spreads are narrow" -- that is, their return above safe instruments is small. "So it becomes this vicious cycle," Mr. Sarni says. "It is a global game of chicken." There are signs in the past month or two that investors are becoming a bit more risk-averse. Yields on long-term Treasury bonds have begun to rise in response to the Fed's continuing campaign to raise the rates it controls, short-term ones. Yields on riskier bonds have risen even further. Valuations Rise for Stocks, Spreads Fall for Junk Bonds, Real Estate, CDOs In addition, risk premiums as reflected in the U.S. stock market, while low, are not as ridiculously low as they became in 2000 at the peak of the technology-driven stock bubble -- perhaps because of memories of fortunes lost when that bubble burst. One measure of stock investors' appetite for risk is how much they'll pay for a dollar of earnings -- the price-earnings multiple. The higher the multiple, the more willing they are to accept risk. That multiple for the S&P500 index averaged 14 from 1945 to 1996, then soared to over 30 during the tech and telecom bubble. Today, after a 2003 rally from post-bubble lows, it's 19, still pricey by historic standards. In July, when some private-equity firms decided to buy a financial-services firm called Sungard Data Systems, they decided to help finance the deal by issuing $2 billion of "junk" -- below investment grade -- bonds yielding more than 9%. Yield-hungry investors clamored to get some, and placed bids for four times as many of the bonds as the private-equity firms wanted to sell. Says Gerd Häusler, the IMF's director of international capital markets: "The search for yield has been the defining factor in financial markets for roughly the last two years." Pension funds have a tradition of conservative investing in blue-chip stocks and top-rated bonds. But the $18 billion Iowa Public Employees' Retirement System holds over $800 million of junk bonds, more than double what it held in 1999. "There's absolutely no reward for investing in government bonds," says Michael Fitzgerald, the state treasurer. "When interest rates are this low, we're looking for more risk." Money has poured into junk bonds in recent years, bringing yields on them to a very narrow 3.5 percentage points above those on super-safe Treasury bonds; three years ago, this spread was 10 points. Meanwhile, the 3.2 million employees of academic and research institutions who invest their pension money through money manager TIAA-CREF have sunk $8.9 billion of its $350 billion cache into a corporate real-estate fund. That real-estate allocation is up from zero a decade ago. It's been "one of our runaway hits," says John Cerra, a TIAA-CREF portfolio manager, who calls the real-estate investing a matter of prudent diversification. Wall Street has responded to the thirst for better returns with creative new instruments. Among the most popular are structures known as "synthetic collateralized debt obligations," or synthetic CDOs. Thanks to the magic of financial engineering, they can provide income from a pool of corporate bonds without anyone's needing to actually purchase bonds. The sponsor divvies up the synthetic CDO in slices that represent varying exposures to the risk of losses if any of the companies default. Then the sponsor sells investors the various pieces, according to their tolerance for risk and appetite for higher returns. But as with other investments, when many are clamoring to buy, returns get squeezed. In a measure of today's high demand, a conservative slice of a typical synthetic CDO now pays only about 0.25 percentage point more than the benchmark rate at which banks lend to one another. Two years ago, comparable synthetic CDOs paid about 1.45 percentage points more than the benchmark rate. One investor is a U.S. unit of Germany's Commerzbank. Its CDO holdings have risen to $500 million from nothing in three years. And though demand has driven the yield way down, "it's still better than in Germany," says Joachim Doepp, general manager of the U.S. unit. Short-term rates are only 2% in the countries whose currency is the euro. They're just over 1% in China -- and near zero in Japan. The plethora of investment capital has helped alter the climate, too, for a time-honored investment strategy known as "the carry trade." In this, an investor borrows money at low short-term rates and puts it into longer-term bonds that pay higher interest, pocketing the difference. This strategy, a mainstay business of big banks, pays off best when there's a wide gap between the short- and long-term rates. It gets dicier when the gap dwindles. These days, the gap is shrinking. The Fed is moving short-term rates up, of course. But, apparently owing to demand from investors with a lot of money to deploy, long-term rates have stayed stubbornly low. "It's about the worst combination of things," says Jon Schotz, chief investment officer of Saybrook Capital LLC, a hedge fund. He says his short-term borrowing rate has doubled over the past year, to 2.5%, while the yield on the higher-risk long-term municipal bonds he buys has fallen to about 5.7% from about 6.5%. Mr. Schotz says he has begun to borrow more while shifting his investments into less-risky bonds. But the additional use of borrowed money [leverage] would mean bigger losses if asset prices fell. How Things Could Go Wrong Some economists say that risk premiums are bound to rise, which means many asset prices would likely fall. No one is sure what the trigger would be. Rising oil prices could hold back global growth and impair corporate creditworthiness. Witness the recent bankruptcy filings of auto-parts maker Delphi, Northwest Airlines and Delta Air Lines, all of which burned holders of their securities. If the world's central banks boost short-term interest rates, investors might start selling some of their riskier assets in favor of newly attractive short-term instruments. The Fed has recently stepped up its anti-inflation rhetoric, and the European and Japanese central banks have indicated they may raise interest rates in the coming year. At the same time, corporations might revive expansion plans and become big borrowers again, pushing up long-term interest rates. Rising risk premiums, and thus falling asset prices, could then become self-reinforcing as leveraged investors unwind their positions to limit losses, driving asset prices down further and triggering still more selling. Under this scenario, the pain could spread to Main Street if newly risk-averse lenders demanded higher rates for mortgages. Rapidly rising mortgage rates could weaken housing prices. "Significantly lower asset prices would erode the large net worth of highly indebted households," says the IMF's Mr. Häusler. "They would cut back on their consumption, especially if their savings rate is zero or close to zero, reinforcing downward economic and financial trends." Yet the evidence to date is that a rise in premiums is more likely to be gradual and easily absorbed by the financial markets. When the debt of GM and Ford was downgraded to "junk" last spring, the moves caused pain among many hedge funds, but no broader contagion. Mr. Häusler suggests that pension funds' growing ownership of risky assets might even make such assets less vulnerable to sudden changes of sentiment. The reason is that the funds have long investment horizons, and might not dump assets as readily as other investors would. Similarly, the explosive growth in hedge funds in the past several years -- they number more than 8,000 now -- may mean there are more sophisticated investors willing to jump in and buy if asset prices fall sharply.
Hedge funds -- investment pools for the rich and institutions -- have a growing impact on asset prices. Their assets have more than doubled since 2000 to $934 billion as of last year, according to IFSL. That understates their influence because they often use leverage -- that is, borrow to buy additional assets. But not all indicators suggest a cash surplus. World money supply -- broadly defined cash in the banking system loosely influenced by central banks -- is growing only about 6% a year, in line with the past 10 years. In any case, it's not just that the supply of cash is high but that demand for it from certain areas is low, freeing it up for financial investment. Jan Loeys, global head of market strategy at J.P. Morgan Chase, says that in 2000, corporations in the major economies, on net, needed $524 billion of capital from outside sources for their business-investment needs. They raised it mainly through loans or by selling stock, bonds or short-term paper. But after the tech and telecom investment bubble burst, they found they had too much capacity and slashed expansion plans. Profits have since rebounded, but capital spending hasn't. Last year, companies generated $566 billion of cash over and above their capital spending needs. They have used it to boost dividends, pay down debt, buy back stock and buy other companies. Some is parked on their balance sheets. U.S. companies alone have about $1.3 trillion in liquid assets now. Unlike in the U.S., many people abroad consume far less than they produce. And high oil prices generate windfalls for some countries. Both factors produce large trade surpluses, and much of the foreign currency those surpluses earn ends up in central-bank reserves. Such reserves, excluding gold, doubled between 2000 and the end of June to $4 trillion, according to the International Monetary Fund. They're mostly invested in financial assets such as U.S. Treasury bonds.
To be sure, a big question was answered last week when Ben Bernanke was chosen to replace Alan Greenspan as the Fed chairman early next year. But as far as Mr. Rodriguez is concerned, the only uncertainty that's been lifted "is that we now know the name of the person," he said. "We don't know what his policies will be," he added. Because Mr. Rodriguez thinks that bonds aren't compensating investors for all the current risks, he is content to have as much as 45% of his fixed-income portfolio in cash or cash-equivalent investments. Should individual investors follow his lead? It's certainly tempting. While the yield on 10-year Treasury notes has risen recently, it's still less than 4.6%. Yet inflation, as measured by the CPI, shot up 4.7% over the 12 months through September. In other words, you're not earning anything on long-term government debt, adjusted for inflation. "This is the first time since 1980 that we've had a negative yield on U.S. Treasuries," says Steven J. Bohlin, managing director of Thornburg Investment Management. Short-term bank certificates of deposit, meanwhile, are starting to look attractive. Several one-year C.D.'s are offering interest of more than 4.25%, according to Bankrate.com. That's only a smidgen less than what a 10-year Treasury is paying. Yet for most individual investors, moving primarily or entirely to cash presents its own set of risks. For example, there is something called reinvestment risk. That's the danger that the economic picture will change several months down the road, causing interest rates to fall. In that case, a professional like Mr. Rodriguez may know exactly when he wants to step back into bonds - but individual investors who don't have time to pay much attention to their portfolios may not. The bottom line is clear. You don't want to make big bets with fixed income. There's just not enough reward for risk-taking in bonds. Investors can take several precautionary steps to tweak their portfolios in the face of what appears to be a rising-rate, rising-inflation environment. If you're deciding what to do with new money, there's nothing wrong with a short-term investment for now, instead of a long-term bond fund. With some of those short-term C.D.'s offering more than 4%, and taxable money market funds yielding more than 3%, these may be nice alternatives to long-term debt yielding only a sliver more. Now let's turn to your existing bond portfolio. Until recently investors were rewarded for staying at the long end of the curve. Long-term bond funds - which, according to Morningstar, own debt that matures in around 12 years, on average - have returned nearly 8%, annualized, over the last three years. But as long rates finally started to rise recently, long-term bond funds piled up losses of 1.2% in Q3. That was more than the 0.5% loss suffered by the average intermediate-term bond fund, which invests in debt that matures in seven years, on average, according to Morningstar. The gap in returns isn't surprising, because longer-dated bonds are more vulnerable to principal losses when rates rise. "The market environment we have now says one should stay short," Mr. Bohlin said. For a long-term investor, that may mean selling long-term bond funds and moving the money, at least temporarily, into a short-term or intermediate-term bond fund. If you're willing to time the market a bit, you may consider putting some of that money into a loan-participation fund, sometimes called a floating-rate fund, said Andrew Clark, senior research analyst at Lipper. These portfolios invest in short-term bank loans with adjustable interest rates. As a result, if market rates rise, these portfolios stand to gain, not lose. Over the last three years, floating-rate funds have returned 7.2% a year, on average. If you go this route, though, be prepared to monitor your account and market interest rates regularly. This is probably also a good time to stick with high-quality debt, Mr. Rodriguez says. Over the last year, his FPA New Income fund has sold most of its holdings in lower-quality, higher-yielding junk bonds, which have stumbled recently as investors have sought stability in this increasingly volatile bond market. There are other moves to consider. Harold Evensky, chairman of Evensky & Katz, a wealth management firm, says he recommends putting roughly 20% of his clients' fixed-income money into foreign bond funds, because those funds are not likely to move in lock step with domestic bond funds if interest rates rise in the United States. Mr. Evensky also recommends some exposure to Treasury inflation-protected securities. While TIPS funds offer a good hedge against inflation, some money managers worry that they could be vulnerable in a rising-rate environment, because many such funds invest in long-term debt. Fortunately, you don't have to hedge inflation within your fixed-income portfolio - there are many ways to accomplish this goal. Invest in gold, gold stocks and commodity-related equities to combat inflation. Or overweighting natural resources stocks and international stocks on the equity side. Monthly Employment Stats
Kathleen Utgoff, commissioner of the Bureau of Labor Statistics, said the tepid payroll gain wasn't attributable to hurricane-affected areas. "Job growth in the remainder of the country appeared to be below trend," Ms. Utgoff said in a statement. "It is possible, of course, that employment growth for the nation could have been held down by indirect effects of Hurricanes Katrina and Rita, for example, because of their impact on gas prices," she said. The figures released Friday don't capture the impact of Wilma because the data was collected before that storm made landfall in South Florida. "This soft October employment report, because of the BLS assertion that Katrina did not play a role, highlights economic risks," economists at Bear Stearns wrote in a research note. The economy sped up in Q3 despite Katrina. GPD rose at a 3.8% annual rate in Q3, outrunning Q2's 3.3% pace. An inflation gauge in the jobs report suggested that price pressures may be gathering steam. Average hourly earnings rose eight cents, or 0.5%, to $16.27, the biggest increase since February 2001. The gain amounted to a 2.9% increase in annual terms. Economists had predicted a more modest 0.2% increase. However, economists at Nomura Securities International played down the increase in hourly wages, noting that most of the gain came from an 0.7% increase in the manufacturing sector. "That increase however compares to a 0.4% drop in September and the need to average the two is mandatory," they wrote in a note to clients. Steven Wood of Insight Economics wrote in a note that "earnings are struggling to gain traction even though the labor market is tightening, especially after accounting for inflation. The flat workweek indicates that businesses remain very cautious. This reluctance may be dampening the wage gains that are needed to sustain strong consumer spending." October goods-producing employment rose by 49,000 jobs. The manufacturing sector elevated payrolls by 12,000 jobs, after falling by 28,000 jobs in September. The construction sector added 33,000 jobs last month. Service-providing employment climbed by 7,000. Retail jobs sank by 5,000 jobs. Employment dropped by 18,000 jobs in the leisure and hospitality category. The average work week held steady at 33.8 hours. There were 150.1 million people in the labor force last month, with 7.4 million of those out of work.
Just the Facts Senior Income Stats Scott Burns, The Dallas Morning News 11-20 Only one senior in 10 lives in poverty. The poverty threshold for a single person 65 or older is $9,060 a year. For a couple, the figure is $11,418. A person 65 or older is in the top 25% of all seniors with an income of only $26,777. They're in the top 50% with an income of only $15,199. Most income comes from Social Security. Seven in 10 seniors received at least half their income from Social Security. Nearly four in 10 received at least 90% of their income from Social Security. In 2005, according to a report from the Congressional Research Service, "Income and Poverty Among Older Americans in 2004, the monthly average Social Security check is $963 for a single person and $1,583 for a couple. A Gap Worth Exploiting in Bond Yields Conrad de Aenlle, NY Times 11-13 For taxpayers in the 33% bracket, the effective yield on 10-year munis is more than 6%, David Wyss, chief economist at Standard & Poor's, pointed out. That is far superior to the 4.56% yield on 10-year Treasury bonds, whose credit quality is only marginally higher. Why the wide discrepancy? Mr. Wyss noted that muni tax advantages accrue to individual American investors, not to the foreigners who are large owners of Treasury issues or to traders whose holdings amount to inventory in a business. That leaves salt-of-the-earth small investors as munis' only big constituency, and they have more tax-favored savings choices available than ever: 401(k) plans, IRA's, SEP's. The top tax rate on dividends has been cut to 15%, too. Current Market Volatility is 22% Lower than the Average Since 1960 Mark Hulbert, MarketWatch 11-02 The volatility we're experiencing right now is no greater than average, and may be is a lot less. When volatility is measured by the standard deviation of daily returns over the trailing month, for example, current volatility is right in line with the average seen since 1960. And when it is measured by the standard deviation of returns over the trailing quarter, current volatility is 22% lower than the average since 1960. So, in other words, even though recent market volatility appears to be extraordinary, it in fact is not all that unusual when viewed from a long-term perspective. Quick Facts, Stats & Opinions By S&P's reckoning, operating earnings for the S&P 500 companies rose 11.5% in the quarter. It was the 14th straight quarter of double-digit growth. Because profit growth rate calculations can vary depending on the definition of operating results (i.e., earnings before one-time gains or losses), the results look even better by some yardsticks. Thomson Financial estimates that S&P 500 profit rose 16% in the latest quarter. For 2005 overall, S&P expects blue-chip earnings to be up 13.4%. And it predicts an 11.5% rise next year. As for the workers whose toil is producing these results, wages and salaries for all private-industry employees rose 2.2% in the 12 months ended Sept. 30, according to the government's employment cost index. That was down from a 2.6% increase in the year ended September 2004. Add in benefits such as healthcare coverage, and total employment costs were up 3% in the most recent 12 months, compared with 3.7% in the previous period, government data show. (Tom Petruno, LA Times 11-27) With more than $2 billion of inflows this year to date, the Dow Jones Select Dividend iShares (ticker: DVY) is the single most popular domestic exchange-traded fund in 2005, easily surpassing such popular indexes as the S&P's 500 and Russell 1000. Because it is designed to own 100 high-yielding companies that have not cut their dividends in the past five years, the Dividend iShares fund has 60% of its assets invested in financials, telecom and utilities. After outperforming the S&P 500 in the latter half of 2004 (and more in the first half of 2005), it has recently been underperforming, having trailed the S&P 500 by over 400 basis points since July. We believe dividend growth is more attractively valued in today's market than dividend yield. (Thomas McManus, Banc of America Securities, Barrons 11-22) American households continue to confound the post-hurricane wisdom of economists and consumer-confidence surveys. Retail sales (not counting those of autos and food) rose a stellar 10.5% year-over-year in September-October, according to government figures. In September, Customer Growth Partners, the consulting firm of which I am president, conducted a detailed study of the impacts of more than 10 major natural or terror catastrophes and energy-price dislocations, back to the OPEC oil embargo in 1973-'74. Using government data and our proprietary retail database, we analyzed consumer spending in the month of the event, the next three months and the first Christmas afterward. In each year, consumer spending rebounded immediately after the event, sometimes quite smartly. The only time we saw an absolute y-o-y decline in monthly retail spending was the devastating exception of September 2001. (Craig Johnson, Barrons 11-21) Expectations for inflation one year out hit a 15-year high of 4.6% in October, according to the University of Michigan's Survey of Consumers. Over the 5- to 10-year time horizon, the median inflation expectation rose to a 10-year high of 3.2%, according to Michigan survey director Richard Curtin. ``Consumers are feeling more defenseless against inflation because they can't raise their wages,'' Curtin said in an interview. ``The cumulative strain of higher prices'' on household finances pushed the consumer-sentiment index to a 13-year low last month, following the second-largest three-month dive (22.3 points) on record, according to the report. Asked to explain their newly depressed state, ``more consumers cited higher prices than any time since 1982, and just as importantly, the fewest consumers cited income gains in more than a decade,'' according to the report. (Caroline Baum, Bloomberg 11-10) While media stories about China and India make us sound like the proverbial 98-pound weakling, our $12 trillion gross domestic product – what we produce in materials, goods and services – far surpasses that of any other nation. Richard W. Fisher, the new president of the Dallas Federal Reserve Bank, observes that the state of California alone produces more than China, and Texas produces 21% more than India. (Scott Burns, Dallas Morning News 11-13) According to the Federal Trade Commission, 10 million Americans are victims of identity theft each year, and federal data estimate that each victim spends about 90 hours and $1,700 fixing matters. The survey also indicated that 94 percent of consumers would accept added online security, though 81 percent said they would not want to pay for such extra measures. (CNET 11-09) The E.P.A. fuel economy estimates posted on the window sticker and listed on the agency's Web site warrant skepticism. Consumer Reports tested 69 vehicles this year and found that the E.P.A. figures significantly overstated mileage 90% of the time. "The E.P.A. test was developed in the 1970's and is not reflective of the way cars are driven today," said David Champion, director of vehicle testing at Consumer Reports. For the highway portion of the E.P.A. test, for example, the vehicle's average speed is 48 miles an hour, with the air-conditioner off and no braking for traffic. (Kate Murphy, NY Times 10-30) Let me see if I've got this right. Big oil companies are greedy, soulless corporate parasites, bleeding America with prices that are much too high. Wal-Mart, on the other hand, is a greedy, soulless corporate parasite that is bleeding America with prices that are... uh, too low. (Andrew Cassel, Philadelphia 10-30) Home Page Previous Factoid Top Sites
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