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Relative valuation is widely used to analyze start-ups because there seems to be no other choice. After all, a brand-new company has little hard financial data to plug into the standard valuation models that analysts use for mature companies. But by using relative valuation — basing stock value on that of others in the industry — a young company’s share price can occasionally become wildly divorced from reality. In an interview, Professor Metrick acknowledged the dearth of hard data on start-ups. But he also said that this should not be used as an excuse for “anything goes.” By substituting some reasonable assumptions for the data otherwise needed to apply the conventional models, his model provides its reality check. One important assumption deals with how fast a start-up’s revenue will grow. Investors are especially prone to exaggerating this, because before a start-up goes public its typical growth rate is very high. To arrive at a realistic assumption for a specific start-up, Professor Metrick looks at the revenue growth rates of all other companies in its industry after they went public. He assumes that the start-up’s revenues will grow faster than those of 75% of the comparable IPOs — an assumption that gives the start-up a big benefit of the doubt. Another crucial assumption involves how long a start-up can grow faster than its industry average. In his research, Professor Metrick found that the median start-up does so for five years after going public. Again, to give start-ups the benefit of the doubt, he assumes they can outpace their industry for seven years. Armed with these and other assumptions, he can calculate the present value of a start-up’s future earnings. This approach, known as the discounted cash flow model, is perhaps the one most widely to value mature companies. He concedes that the number produced by his model is by no means perfect. But because it makes generous assumptions about start-ups’ growth in several crucial ways, he said, it sends a warning signal if the valuation it reaches is significantly less than the market’s. Consider Riverbed Technology, a data network company that went public in October. Professor Metrick’s model calculates a value for the company of $184 million, or less than 10% of its market capitalization of $2 billion. To bet on Riverbed Technology at its current price, you presumably would need to believe that its revenue growth rate will be even higher than his model already assumes, and that it will beat the industry average for far more than the next seven years. Those are high hurdles, Professor Metrick reminds us. As an example of a new issue that may be more fairly valued, he offers InnerWorkings, which provides printing solutions to corporate clients. His model calculates a value for this company that is nearly double its current market cap of $702 million. His model is also helpful as a reality check on companies that have been public for a couple of years and that investors may be valuing on the assumption that their high growth rates will continue forever. In such cases, analysts’ estimates of growth are now available, so the model can rely on them. Consider the conclusion reached by this model when retroactively applied to Cisco Systems in early 2000, just before the Internet bubble burst. At the time, the market valued Cisco as the most profitable public company. If applied to Cisco then, the model would have calculated it was worth only about one-tenth as much. That’s a remarkable conclusion, because the analysts themselves were then wildly optimistic about Cisco’s future growth. “The model at that time would have shown that the analysts’ growth assumptions, high as they were, were not nearly high enough to justify Cisco’s valuation,” Professor Metrick said. Cisco’s stock, of course, fell to less than $10 a share in 2002 from more than $80 in early 2000. And what about Google, which has risen to around $460 a share from an initial offering price of $85 in August 2004? As with Cisco, Professor Metrick fed into his model the consensus of analyst estimates for Google, rather than basing his growth-rate assumptions on an average of other young tech companies. His model values Google at more or less its current price. But that doesn’t necessarily mean Google is a good investment at the current price, he says. To believe that it is, you presumably have to believe in the consensus growth assumptions of analysts. Still, he added, his model shows that the market is not overvaluing Google anywhere nearly as much as it did Cisco in 2000.
The list of this year's financial market highlights is dominated by what didn't happen. The non-events helped give Wall Street the confidence it needed to power ahead in 2006. As the year ends, major U.S. stock indexes are on track for their best gains since 2003, with the S&P500 up 13% through Friday. And there also was plenty of good news to go along with the absence of bad news: The global economy continued to expand, corporate earnings kept growing and long-term interest rates fell in much of the developed world in the second half. Here are some of the 2006 market memories that will linger: A Scarcity of Failure GM stock began the year at $19 a share, near its lowest level since 1982, as many on Wall Street figured the ailing auto maker was bound for bankruptcy. But GM is still afloat. And guess which stock in the Dow Jones industrial average has posted the biggest percentage gain in 2006? With four trading days left, GM's shares are up 51% on the year. Although the Fed, the European Central Bank and the Bank of Japan were tightening credit in unison in the first half - a good recipe for market trouble — financial accidents just didn't happen the way some pessimists dreamed. Default rates on corporate junk bonds worldwide remain near all-time lows. The mushrooming derivative securities market (futures, options, interest-rate swaps, etc) again didn't live up to the "weapons of mass financial destruction" moniker detractors have given it. And there were few notable casualties among hedge funds, whose go-anywhere investment approach is an invitation to mischief. To be sure, the housing market has stumbled, as evidenced by rising mortgage defaults. But there has been enough strength in the rest of the U.S. (and global) economy that most individual, corporate and government borrowers are making good on their obligations, which in turn has helped keep stock and bond markets in clover. The Price of Risk is Falling One natural result of the lack of financial hiccups is that many investors have become more emboldened. The mind-set has become, "If I haven't lost money yet, maybe I never will." The problem is that, as stock and bond prices have been bid up, the "risk premium" has shrunk or disappeared in many corners of the world's securities markets — meaning, your potential return seems unlikely to compensate for the risk you're taking at these levels. But that's what investors were told a year ago about junk bonds. Those who listened forfeited a return of nearly 10% on the average junk bond mutual fund this year. The Russian stock market surged 686% from 2001 through 2005. Too much? Evidently not. It's up 65% this year, after recovering fully from the short-lived spring dive in stocks worldwide. The more investors win, the less cautious they become. On Wall Street, an index that measures expectations of future stock market volatility hit a 13-year low this month, which suggests that "investors believe the good times will last to perpetuity," says David Rosenberg, an economist at Merrill Lynch. But there's also an air of desperation in the hunt for decent returns. The relatively low level of interest rates means that playing it safe nets you little — about 4.6% a year in interest on a 10-year U.S. Treasury note. That may only feel like a fair return when every other investment is deep in the red. What Was Hot - Now is Not What's bad for hard assets is good for stocks and bonds. Some investors had little use for stocks or bonds in the first half of this decade. What was the point, when your home was the best investment going? For many hedge funds and other big players, commodities were the hot ticket from 2002 to 2005. After a two-decade bear market in things like oil and copper, their prices rocketed, fueled in large part by China's boom. But everyone now knows that the sky really wasn't the limit for home prices. And ditto, it seems, for prices of many commodities. Crude oil peaked at $77 a barrel in July, and now is at $62.40. That is only a sliver above where it ended last year. Copper, at $2.83 a pound, has tumbled from a record high of nearly $4 a pound set in May. Some commodity markets still are riding high. But it can't be a coincidence that as air has come out of the hard-asset bubble, stocks and bonds are having a much better time. A Rising Faith in the Central Bankers The U.S. stock market has been gleeful because it believes that the Fed has achieved its stated goal: a "soft landing" for the economy, meaning a slowdown that will rein in inflation without threatening recession. The Fed keeps warning that it may not be done raising short-term interest rates. In recent weeks, some data have raised the opposite concern — that the economy might fade too quickly. Wall Street hears what it wants to hear, which is, "We're having a soft landing, period." Since mid-year, stocks are way up, bond yields are way down. European markets also have shown enormous faith in their central bank this year. The European Central Bank has continued to tighten credit even as the Fed has gone on hold since June. Yet an index of German business confidence hit a record high this month. And a Bloomberg index of 500 European blue-chip stocks is near a six-year high. The Fed and ECB have made money more expensive, but not all that expensive. And there's still plenty sloshing around worldwide, looking for action. The old analogy is that central banks take away the punch bowl just as the economic party is getting good. Markets seem certain that the bowl is staying — and that it's half full rather than half empty. A Little Scandal Casused Little Alarm The year's big corporate scandal was the revelation that executives at hundreds of companies have for years engaged in "backdating" of their stock options: They cherry-picked the option exercise prices, in some cases hunting on the calendar for the day when the stock was at its lowest for a given period. That gave many executives built-in gains on the options, as opposed to pricing them on the day they actually were granted by company directors. The scandal demonstrated, once again, that no amount of money could ever be enough for America's top executives. Scores of officers have quit or been fired as a result of backdating allegations. Many companies have been forced to reduce prior earnings to account for the extra compensation of the rigged options. The SEC and the Justice Department have only begun to bring charges. Shareholders of the companies involved have lost $100 billion in market value as many of the stocks have fallen on the news, a recent academic study estimated. But unlike the Enron-era wave of scandals in 2002, this one hasn't been enough to bring down the market as a whole. Are investors more discerning about this kind of thing — or is it that they simply aren't all that surprised anymore by cheating executives?
If you’re an income investor, many Wall Street strategists offer this first piece of advice: hoard cash. They say it’s hard to beat the 5% that many money market accounts and certificates of deposit are now paying. Richard Bernstein, the chief investment strategist at Merrill Lynch, is recommending a portfolio allocation of 50% stocks, 30% bonds and 20% cash. And Stuart A. Schweitzer, the global markets strategist at JPMorgan Asset Management, said investors should put more of their portfolios into cash than they might normally feel comfortable with. “With yields upwards of 5%, even if the Fed eases a bit in 2007, as it might, cash will still earn a far sight better than it did two to three years ago,” Mr. Schweitzer said. Of course, that doesn’t mean investors should ignore a stock that pays a good yield. If investment income is important to you — and you plan to hold some equities in your portfolio — strategists recommend looking for large-cap stocks that still pay decent dividends and have a good track record of raising them over time. “We are pretty bullish on companies whose stocks can provide a nice income return, but also some earnings growth,” said Henry McVey, the chief investment strategist at Morgan Stanley. For now, Mr. McVey said, a good dividend yield is at least 3%, which is well above the average yield of 1.8% for the S&P500 index. Mr. McVey said that many American companies could afford to pay more dividends and might do so in the future. The companies in the S&P500 now pay 29% of their profits to shareholders in the form of dividends, on average — a figure that Mr. McVey said was historically low. Since 1984, the average dividend payout ratio for the index has been 39%. But he said that as more baby boomers retired, many would demand higher dividends. Among the stocks that are typically popular with dividend-hungry investors, many have yields that are low by past standards. In particular, the shares of many unregulated utility companies and REITs, have risen so sharply this year that their yields have plummeted to little more than 2%. Although their yields are typically not as high as those of the best-yielding utilities or telecommunications stocks, shares of J.P. Morgan Chase are yielding 2.8% now, while those of Citigroup are yielding 3.6%. Mr. Bernstein of Merrill has two more bits of advice for American investors who want to bolster the yield of their portfolios: shop for dividends abroad, and bulk up on high-grade bonds at home. Although the dollar has fallen 9.8% against the euro this year, Mr. Bernstein said the dollar could slide further in 2007. If it does, he said, Americans can benefit from owning foreign stocks that pay good dividends. “People always talk about diversification by geography, but they’re thinking of capital gains. They never think about diversification in terms of income,” he said. “But if you’re bearish on the dollar, why wouldn’t you want your dividends in Swiss francs?” Mr. Bernstein said Americans can hunt for good dividend-paying European stocks in the same corners of the market where they would look at home — utilities, telecommunications and consumer staples. He said investors who preferred mutual funds could look for a global equity and income fund that owns a hefty stake of European dividend-paying stocks, or a European-focused fund with a good yield. If you want to bolster interest income on the fixed-income side of your portfolio, Mr. Bernstein strongly advises against riskier issues. The value of high-yield bonds and emerging-market debt has risen so much in recent years, he said, that investors simply aren’t being compensated for the extra risk. Finally, Mr. Bernstein cautioned investors not to wait until they were facing retirement to focus on investment income — and to remember the lifelong benefits of compounding dividends and interest. He pointed to the technology-heavy Nasdaq composite, and its performance against utilities stocks, which traditionally pay big dividends. The Nasdaq returned 11.1% a year, on average, from its creation in February 1971 through November this year. The S&P utilities index, meanwhile, had average annual returns of 11.4%. “Classic mom-and-pop utilities beat tech stocks, because of the power of compounding dividends,” Mr. Bernstein said. “The tortoise beat the hare.”
If you toss out January, a spectacular month for small-capitalization stocks, blue-chip shares have actually led the market this year. Since Jan. 31, the Russell 1000 index of large-cap stocks returned 12 percent through Thursday, versus 8.3 percent for the Russell 2000 index of small caps. But there is a problem with this logic. If you’re a buy-and-hold investor, you cannot just toss out January’s results. That is like throwing out the Oct. 19 crash and proclaiming 1987 a banner year for stocks. If you consider the full year's performance through Thursday, blue chips are again the losing team, with the Russell 1000 up 15.4%, versus 17.6% for the Russell 2000. And despite large-cap outperformance in December, small-cap shares have generally been the fourth-quarter stars, posting gains of 8.2%, versus 6.9% for their large-cap cousins. “When suddenly, it appeared as if the Fed was going to stop hiking rates and the economy looked stronger than expected, globally, people said: ‘I want to be back in the risk bucket,’ ” said Alan Skrainka, chief market strategist at Edward Jones. While this turn of events has frustrated investors in blue-chip stocks, it’s not that surprising, said James A. Shambo, a financial planner in Colorado Springs. “The market has a tendency to do that which most of us think it won’t do,” he said. “It loves to humiliate us.” There are several bigger lessons in the recent developments: Keep an Open Mind & a Diverse Portfolio Even if you expect one asset class to outperform, don’t turn your back on competing investments. “There’s nothing wrong with thinking that small stocks will no longer provide the type of leadership that they’ve shown in recent years,” said Tobias Levkovich, chief United States equity strategist at Citigroup Investment Research. “But that’s way different from saying that they’ll no longer provide you any returns.” The fact is that while small and large stocks often take turns leading the market, success among these competing assets isn’t mutually exclusive. Consider the period from 1995 to 1999, when large-cap stocks returned double-digit gains in five consecutive calendar years. But while the small caps badly trailed the large caps, they still managed to produce double-digit gains in four of those five years. Heading into 2007, many investors again believe that large caps are likely to outperform smaller stocks, partly because of the age of this bull market and a slowing economy. But even if the big stocks outperform, “I would say overweight the large caps and underweight small caps - but don’t eliminate small caps from your portfolio,” said Sam Stovall, chief investment strategist at Standard & Poor’s. Citigroup's Levkovich believes that in 2007, small and large stocks could post highly competitive returns. Based on current prices, he predicts that the S&P500 could gain 13.4% next year, to 1,600. And he forecasts that the Russell 2000 could climb to 888, a 13.7% jump. Jone's Skrainka said the bottom line “ is that you need to own appropriate amounts in both large and small stocks at all times and stop playing this game.” Your Diversity Can Add to Your Patience - Which Should Be Rewarded It can take years for an asset class to regain market leadership. For instance, after a long period of small-cap outperformance from 1974 to 1983, large stocks seized control in 1984. But by the early 1990s, it appeared as if small stocks were ready to reassume the lead, as the Russell 2000 index posted solid gains in 1991, 1992 and 1993. Yet it wasn’t until 2000 - a good seven years later - that small-company stocks really took over, with the bursting of the Internet bubble. Only Make Small, Marginal Sector-Weighting Bets Even if you think a turn in market leadership is near, beware the risks of short-term tactical bets on a single asset class. If you make such a bet on a large-cap rally, keep checking to ensure that the underlying conditions that drove your decision are still true. At the beginning of this year, for example, there were plenty of reasons to be bullish on large-cap stocks. For starters, blue-chip stocks had underperformed small stocks for the previous six years, and no investment can lead the market in perpetuity. This is also the fifth year of the bull market, which means that this rally is older than average. Historically, small stocks start to lose some of their advantage in a bull market’s latter stages. Finally, investors tend to gravitate to shares of large, industry-leading companies as the economy begins to slow. That is particularly the case during recessions, when stock market gains may be hard to come by. Earlier this year, there was a strong fears that the economy might slip into a full-blown recession sometime in 2007. But in recent months, those fears have subsided as the economy has proved more resilient than was previously thought. Corporate earnings growth has also been surprisingly resilient. To be sure, profit growth is slowing. But earnings aren’t falling off a cliff - and small-cap earnings growth is still expected to outpace that of large caps. For instance, while earnings among the S&P500 companies are expected to grow 10% next year, on average, profits for the S&P600 small-cap index are forecast to climb 12%, Mr. Stovall said. As Thomas McDowell, chief executive of Rice Hall James, put it, “as long as earnings continue to surprise on the upside and the forecast remains positive, people will be reluctant to make that shift from small to large.”
Formulary: A formulary is a list of prescription drugs covered by a particular health plan, including the Medicare Part D drug plans first available in 2006. Drugs may be grouped in different "tiers" that require varying co-pays; some plans will also cover unlisted drugs in return for higher co-pays. From The Global Language Monitor on 8-27: ‘Truthiness', from the Emmy nominated 'Colbert Report', was named the Top TeleWORD of the year in The Global Language Monitor's annual survey of words from television that profoundly influenced the English Language. "Truthiness" according to Colbert means "truth that comes from the gut, not books," was also deemed the word that best sums up 2006 by participants in an online survey conducted by Merriam-Webster. Perhaps a second definition gives truthiness a more correct spin - “the quality of preferring concepts or facts one wishes to be true, rather than concepts or facts known to be true.” 'Wikiality', also from the Colbert Report was named No. 2. "Wiki" is an internet buzzword (from the Hawaiian wiki wiki for 'quick, quick') that describes collaboration software where anyone can contribute to the on-going effort. "Wikiality" or Wikipedia + reality = truth based on consensus rather than fact. The growing popularity of the online encyclopedia, for which the public writes and edits entries, gave rise to the term. From UPI on 12-14: The U.S. Web site BuzzWhack.com says "leveraging our assets" is one of the worst buzzwords of 2006. "Mission-critical," "conversate," "information touchpoint" and "synopsize" rounded out the top five worst buzzwords, selected by readers of the Web site. One of the most fun buzzwords of the year was "blamestorming -- a group process that involves looking for scapegoats for a failure," the newspaper said. From Buzzwhack.com of 12-04: The 'fun' buzzwords of 2006, which included: clockroaches: Employees who spend most of their day watching the clock - instead of doing their jobs plutoed: To be unceremoniously dumped or relegated to a lower position without an adequate reason or explanation. adminisphere: The upper levels of management where big, impractical, and counterproductive decisions are made. deja poo: The feeling that you've stepped in this bull before. bobbleheading: The mass nod of agreement by participants in a meeting to comments made by the boss even though most have no idea what he/she just said. From Frank Bruni, NY Times of 12-24: With “YouTubing” or being “YouTubed,” 2006 coined a verb that was tethered to the most prominent of those sites and, in addition to that, connected to our worries about the death of privacy, about millions of prying eyes and mouse-clicking fingers. The term “sanctimommy” went beyond deft wordplay, vaulting into the realm of social commentary. Self-beatified and eagerly censorious mothers were everywhere, shaming anybody who dared question their noble callings or unimpeachable judgments. This witty tag for them took because they were itching for a takedown. The same article mentioned Food miles - an expression for the concept that the mileage of food before it reaches the consumer (or the plate) is a good indicator for the environmental impact of the food and its components. The positive environmental effects of specialist organic farming may be offset by increased transportation, unless it is produced by local farms. Also mentioned was "hummer house" - an overly large single-family residence. From Carolyn Sayre, Time Magazine of 12-25: Brokeback Marriage Thanks to to movie, there's now a term to describe a union between a gay man and a straight woman or a gay married man having an affair.
Online portfolio-analysis tools, offered by independent investment-research firms as well as major brokerages, have been around for years. But more brokerage firms are adding these tools as a service to current or prospective customers, and existing tools are becoming more sophisticated. E*Trade Financial earlier this year began offering clients access to a portfolio-analysis tool created with RiskMetrics Group, while investment-research firm Morningstar has recently added several new features to its online toolbox. These resources can be useful for small investors, financial advisers say. But it's important to understand how they work and what data they're using -- or not using. Some tools rely on historical investment returns to predict how a portfolio will perform in the future. Yet when predicitng expected returns, you have to look forwards. And users should remember that there may be important aspects of their financial situation that an online tool doesn't know. "These tools can be helpful, but it's up to the investor to interpret them in a larger context," says Chris Musto, an analyst at Keynote Systems, an Internet test and measurement firm. Some investors may also find they want or need the assistance of a flesh-and-blood financial adviser. That said, if your portfolio is due for a checkup, here's a sample of Web sites offering useful and free portfolio-analysis tools. Morningstar.com At Morningstar, users can access one free tool that helps rebalance a portfolio and another that "x-rays" a portfolio to see how holdings may overlap. With the Portfolio Allocator, investors can enter their current mutual funds and other portfolio holdings -- as well as their desired mix of stocks, bonds and other asset classes, and their target exposure to stocks of various styles and sectors. The site then suggests how users might adjust their holdings to meet the targets. The Instant X-Ray examines current holdings and calculates exposure to various asset classes, stock-market sectors and world regions. It "x-rays," or looks inside, mutual funds to list the individual stocks that account for the greatest percentage of portfolio assets. Investors who have entered their portfolio on the site also can see their Personal Return. This feature, introduced in October, aims to give users a more accurate picture of their own investment returns by factoring in fees paid and the timing of purchases and sales. RiskGrades.com This site from RiskMetrics Group, a financial-risk-management firm, helps investors understand a portfolio's overall risk. The firm's RiskGrades are based on the historical variation in an asset's returns and how that variation compares with the ups and downs of a broad, global basket of stocks. More recent returns are weighted more heavily than those long past. As a result, "instead of just being a historic statement of what the volatility has been, it's a prediction of what the risk is going to be tomorrow," says Jason Mirsky, director of wealth management at RiskMetrics. Users can enter a portfolio of stocks, bonds, funds, cash and equity options. The site will calculate RiskGrades for the total portfolio as well as for individual holdings. A What If feature allows users to see how their portfolio's risk would change if they bought or sold a particular holding. And an Event Risk Analysis helps investors determine how their portfolio might react to unusual market conditions, such as a currency crisis or tech-stock meltdown. www.FinPortfolio.com This site from financial-software company FinPortfolio aims to cover the entire investment process, helping users set an asset allocation, select investments and monitor their portfolios. Users who don't pay for the site's advanced features can track one portfolio of stocks and funds. Investors can enter their existing portfolio and get a snapshot of their allocation to various asset classes, as well as to stock-market sectors. If users enter personal data -- such as investment time horizon, household income, risk tolerance, age, and tax rate -- the site will suggest an appropriate investment risk level and asset allocation. The site also will show the likelihood of achieving specific financial goals entered by the user and show how those odds might be affected by taking on a different level of risk. Another feature, called Portfolio Optimization, is designed to show investors how they can adjust their current holdings to create a portfolio that might be reasonably expected to increase returns without additional risk. One limitation: The free optimization tool covers a portfolio with no more than five holdings. Fidelity.com Since last year, mutual-funds and brokerage giant Fidelity Investments had made its Portfolio Review tool available to noncustomers as well as clients. Users enter information such as current holdings, financial goals, time horizon, level of investment knowledge and risk tolerance. The tool generates a suggested allocation to various asset classes including U.S. and foreign stocks and bonds, and compares that mix to the user's current allocation. Investors can view a model portfolio, composed of either only Fidelity funds or a mix of Fidelity and outside funds, that closely matches the suggested asset allocation. The tool also suggests hypothetical trades that could help the user move closer to the target portfolio mix, telling investors which holdings they may want to buy and sell and in what amount.
Whether your portfolio had a 'good' year also depends on your personal circumstances and your risk tolerance. What was a good investment return this year? Here are some things to consider in making that judgment: A good return isn't necessarily an above-average return. The first question to ask in evaluating your returns is, how much risk are you willing to take? If your risk tolerance is low — that probably means you should have a big chunk of your money in high-quality bonds, high-dividend stocks, cash accounts or other investments that aren't likely to decline dramatically in any given period. If you've got a conservative portfolio, your overall return may only be in single digits even in a year like this. But that may still be a good return given your risk tolerance. Geordie Crossan, president of advisory firm NBS Financial Services, says the downside of years like this is that some risk-averse investors get starry-eyed about stocks, forgetting how much they hate it when their portfolio loses money. In the bear market years of 2000, 2001 and 2002, the blue-chip S&P500 fell 10%, 13% and 23%, respectively. Some people who thought they could handle losses of that magnitude discovered the pain was too extreme. Now, in the fifth year of a bull market, "If you've been sitting in bank CDs, [this] is not the time to jump on the bandwagon" in stocks in search of higher returns, Crossan warns. How much do you need to earn to meet your goals? Look at your 2006 return in the context of the annual average return you'll need to get where you want to be over time. "What we often see is that people can actually assume less risk than they think they have to take" to meet their objectives, Crossan said. If earning an average of 7% a year on your nest egg for the next 10 years will give you the lifestyle you want, trying to earn 12% may be unnecessary — besides putting your portfolio at greater risk of loss in bad market years. The stock market is flying high now, but another steep decline is out there somewhere. One of the big reasons to keep portfolio volatility manageable via good diversification is that it will lessen the chance that an investor will want to dump stocks in down years — at exactly the wrong time. If you're young, a single-digit return may mean you aren't taking enough risk. For younger people, the best thing about a year like this in the stock market is that it may give them the confidence to be more aggressive for the long haul. It's a wake-up call for people who have forgotten what stocks can do for a portfolio in a bull market. Generally, the younger you are, the greater the percentage of your portfolio that should be in stocks — in good market years and bad. Over time, the equity market is going to provide your nest egg with growth. You aren't going to get that from conservative bonds or cash accounts, even if their interest yields seem reasonably attractive in the short term. Many young investors who remember how sharply the stock market fell in 2000-02 are overly conservative in their asset allocation because of it, even though they may have decades of saving ahead of them. Even older people, he says, should realize that they're going to need some portion of their assets in stocks to provide growth over time. A client who is 62 might still need to have about 60% of his assets in stocks, and 40% in bonds and other income-generating investments. A 62 year old still might live another 30 years, and that means the portfolio will have to grow, not just generate interest income. It's not what you earn — it's what you keep. If most or all of your investments are in tax-deferred accounts, taxes are an issue for later in life. But investors who have money in taxable accounts should think about their after-tax returns as well as their nominal returns. Cnsider the after-tax appeal of cash dividends on common stocks. Dividends are subject to a maximum federal tax rate of just 15%, at least through 2010 under current law. To put it another way, Uncle Sam lets you keep 85 cents of every $1 you earn in dividends. The state, of course, then takes its cut. Even so, the low federal tax rate on dividends makes them highly attractive for investors who are trying to increase after-tax returns.
In the last year, some of the nation's largest retailers began reporting how much they've profited as a result. Last winter Best Buy reported a $43 million gain in fiscal 2006 from cards that hadn't been used in two or more years — 3.8% of its earnings of $1.14 billion. Limited Brands recorded $30 million in 2005 revenue because of unredeemed cards, or 4.4% of its $683 million in net income. Nonetheless, the 2006 holiday season is likely to see record sales of gift cards. The National Retail Federation, a trade group, estimates that shoppers will buy $24.8 billion of cards, up 34% from last year. Shoppers are buying more of them from more places, including drugstores, jewelers, spas and even supermarkets. They are buying cards with higher dollar values — some over $100, and more cards are being packaged with accessories to make them look less like plastic money. Consumers spend their way through some cards faster than others. Supermarkets and gas stations have close to 100% redemption rates, said Bob Skiba, who runs the gift card division of Ceridian Corp.'s Comdata gift card division. Cards from clothing and department stores, however, can wind up in the forgotten pile, what retailers call "breakage." "You don't have to buy a sweater every day, but you do have to eat and fill up your car," Skiba said. "Where you can delay the purchase, or it's at your convenience that you make the purchase, we see the breakage." Retailers say they would prefer that customers use the cards, and for good reasons. "They have money in their pockets that's pointed to our store," said John Fleming, Wal-Mart's marketing chief and a former Target executive. Even better, he said, wooing customers with gift cards doesn't require the usual spate of discounts or promotions. In addition, a retailer can't report revenue from a gift card when it is sold. The revenue is recognized as the card is used or — thanks to new guidance from the Securities and Exchange Commission — after it has gone a long time without being used. The SEC's clarification prompted several companies in recent months to report — many for the first time — gains from unused cards. Gift cards also have changed the way merchants view January. "It used to be the week after Christmas was really about clearance," said Wal-Mart's Fleming. "Now, with the trend toward gift cards, it's a completely different selling opportunity. It's not just about clearing out inventory." One reason for the shift: Research shows that most consumers will spend more than the card is worth, using their own money to add as much as 5% to 75%. "More often than not, they have a $20 gift card and they see a $35 dollar sweater," said Richard Giss, a partner in Deloitte & Touche's consumer business division in Los Angeles. "And they say, it's really only a $15 sweater, because that's all I have to pay." Since the lowly paper gift certificate evolved into the modern, shiny, plastic gift card, it has won over tens of millions of consumers. Two-thirds of shoppers told American Express pollsters that they planned to buy gift cards this year for groceries, gasoline, restaurant meals, department store wares, concert tickets or home furniture. Sellers have tried to get around the criticism that the cards are impersonal by jazzing them up. Target offers a ruler-decorated card that reads, "Teachers Rule." Best Buy sells a card shaped like a snowboard. Givers can buy gift cards printed with their photos or a custom greeting. Stores also are offering boxes and other creative ways to wrap the cards. Percentage of people surveyed who said they bought cards of a given type: Department stores: 47%; Clothing stores: 34%; Bookstores: 31%; Restaurants: 28%; Discount stores: 25%; Electronic stores: 18%; Home improvement: 16%; Coffee shops: 15%; Speciality stores: 13%; Grocers, cinemas, toy stores: 12%. Sell or Swap Gift Cards Online WSJ 12-24 A well-intentioned relative gives you a gift card to a bookstore, but what you really crave is new clothes. Or vice versa. What do you do? Most people toss the card or give it to someone else. But there's a third option: You can go online and swap the present for something you really want. The National Retail Federation estimates gift-card sales will total $25 billion this holiday season, and some analysts estimate as much as $3.5 billion of that will never be spent on goods. You don't have to contribute to that eye-popping loss. Cardavenue.com lets people auction or trade gift cards. Registration is free, but you need an account with PayPal, eBay's online payment system. Sellers and traders pay a fee equal to 3.95% of the card's value, plus an additional 50-cent closing fee. For auctions, you can specify a minimum bid. Fees are flat at PlasticJungle.com, a sell-or-trade site that also uses PayPal. You can list a card for 90 days for $3.99, no matter the value. Rather than an auction process, you set sale prices upfront. You can also sell some cards to the site directly. GiftCardBuyBack.com is another service where you can sell cards to the company rather than other individual shoppers. The site will pay 60% to 80% of a card's value, but doesn't accept all retailers. Checks usually arrive within 10 days of sending the card, according to the site, but may take longer during the holidays. The flip side of this secondary market: If you're looking to buy gift cards, you may be able to get them online for, say, 10% to 25% off. Although buying from a third party increases the risk of fraud, most of the sites say they have safeguards to protect consumers.
Should we be concerned right now? Yes, because the correlation between stock market tops and soaring M&A levels is no coincidence, according to Matthew Rhodes-Kropf, an associate professor of business at Columbia, who has studied the subject closely. “Periods of high relative valuation are nearly always associated with high M&A activity,” he said in an interview, “and the stock market has fallen after each major merger wave.” Understanding the reasons for the correlation is the difficult part. Though it is easy to see why an overvalued company would want to acquire another — because it could pay for the deal with overvalued stock — it is hard to see why the company being acquired — the so-called target — would sell itself for stock that is priced too high. One answer is provided in a theory from Andrei Shleifer, an economics professor at Harvard, and Robert W. Vishny, a finance professor at the University of Chicago. They discussed their idea in an article titled “Stock Market Driven Acquisitions” in the December 2003 issue of the Journal of Financial Economics. A copy is at post.economics.harvard.edu/faculty/shleifer/papers/StockMarketDrivenAcquisitionsF.pdf. The professors argue that if the target company’s managers have a short time horizon, they will be willing to sell their company for stock even when they suspect it to be overvalued. These managers may be ready to retire, for example, or have options or stock they are anxious to sell. Because these managers can quickly unload the stock of the acquiring company that they receive in the deal, they may have little concern that it’s overvalued and unattractive from a longer-term point of view. Another theory was proposed by Professor Rhodes-Kropf and S. Viswanathan, a finance professor at Duke, in an article they wrote in the December 2004 issue of the Journal of Finance titled “Market Valuation and Merger Waves.” (A copy of the study is at www0.gsb.columbia.edu/faculty/mrhodeskropf/joffinal5.pdf). According to this theory, a target company’s managers can’t determine in advance whether a high-priced offer reflects real synergies of the potentially combined company or the overpricing of the acquirer’s shares. Professor Rhodes-Kropf says this means that we shouldn’t be surprised by the number of acquisitions that occur during periods when — from the benefit of hindsight — stocks appeared to be overvalued. Because both of these academic theories focus on deals financed with stock, they apply only partially to the current merger wave, much of which has been paid for with cash raised through debt financing. (This undoubtedly reflects the fact that debt is so cheap right now, Professor Shleifer said.) Professor Rhodes-Kropf cautions stock-market investors not to take solace in that difference. “To the extent the current merger wave reflects an overvalued debt market, it stands to reason that it will eventually correct — just as overvalued stock markets eventually correct,” he said. “And it can’t be good news for the stock market if money is destined to become much tighter in coming years.” The bottom line is this: The current merger wave means that stocks are probably closer to the overvalued end of the spectrum than to the opposite extreme, and that they also are vulnerable to tighter money in coming years. This doesn’t necessarily mean that stocks will fall in the near future. But it does imply that their prospects are well below average.
The time for highflying stocks that don’t throw off dividends should be over; these stocks tend to do best at the beginning of bull markets. If history is any guide, dependable dividend-paying stocks should be coming to the fore. But that hasn’t been the case in this end-of-the-year run-up. Since equities emerged from their doldrums in August, stocks in the S&P500 that don’t pay dividends soared 17.8%, on average, through Wednesday. By comparison, dividend payers gained 11.2%. Given the attention that dividends have received lately, the situation is especially perplexing. Earlier this year, Congress extended the favorable tax treatment that dividend investors enjoy. Under the Tax Increase Prevention and Reconciliation Act, the maximum rate on qualified dividend income will be capped at 15% through 2010. This performance gap may seem a discouraging development. Yet this is no time to turn your back on dividends. In fact, you could argue that dividend-paying stocks are just doing what they were designed to do. Because of their payouts, dividend-issuing stocks are far less volatile, on average, than stocks that rely solely on capital appreciation. “Dividends function sort of like anchors,” said Howard Silverblatt, senior index analyst at S&P. “This means that during good times, stocks that pay dividends don’t go up as much. But when times are bad, they don’t go down as much.” When the broad stock market was hammered in July, the shares of nonpayers tumbled 4.3%, on average. But dividend-issuing stocks lost only 0.6% in total return. This year through Wednesday, dividend payers in the S&P500 were up 17.2%, on average, versus 13.9% for the nonpayers in the index. Moreover, since 1980, dividend payers have beaten the nonpayers by an average of 2.2 percentage points a year, Mr. Silverblatt said. The recent performance lag may offer a buying opportunity for dividend seekers. “Historically, high-quality dividend-paying companies trade at premiums to lower-quality companies that don’t pay any dividends,” said Jack Ablin, chief investment officer at Harris Private Bank. That’s because, in the long run, investors are willing to pay more for the safety and stability of dividends. But the recent underperformance by dividend payers may have reduced this gap, Mr. Ablin said. “In essence,” he said, “the current environment allows for a free upgrade in your portfolio.” Investors also need to understand why nonpayers have been doing so well in recent months. Instead of climbing the proverbial wall of worry, stocks now appear to be scaling a mountain of hope. Judith Saryan, vice president and portfolio manager at Eaton Vance, said that investors “are anticipating that the Federal Reserve will start to lower interest rates next year.” As a result, they have been gravitating to sectors of the economy that tend to do best in the early stages of a new cycle. Not surprisingly, “the sectors that have done well lately are consumer discretionary stocks and information technology,” she said. And those two sectors happen to be the lowest-yielding sectors in the S&P500. Technology in particular has been on a tear. Since August 11th, tech stocks have returned 21.3%, on average, according to S&P. That’s nearly twice the gain of the S&P500. Yet only about a third of tech companies pay dividends, Mr. Silverblatt said. Investors are banking on future tech earnings. While profits for the S&P500 are expected to slow considerably next year, tech earnings are expected to accelerate rather rapidly. In fact, Wall Street’s consensus forecast for 2007 earnings growth for tech stocks is 21%, according to Thomson Financial. Tech stocks have proved to be quite volatile this year. Consider the period from May 5 to Aug. 11. During this troublesome stretch, the S&P500 lost 4.5% of its value. But tech stocks tumbled significantly more: 12.7%.
A government-appointed trustee is trying to recover the money, but workers have been told they can expect to get back perhaps half what they lost. "I'm going to be up measuring roofs when I'm 75 years old," said Elliott, a husky man with steel-gray hair. "I didn't do a lot of things over the years because I was trying to save for retirement. Now I see I was paying for somebody else's vacations." Traditional pensions are guaranteed under a federally backed insurance plan. But no comparable protection exists for 401(k)s, even though they are rapidly replacing pensions as the financial backbone of retirement for most Americans. By law, all assets in 401(k) plans must be covered by private insurance policies known as fidelity bonds. But the bonds are required to cover just 10% of the retirement plan's assets or $1 million, whichever is less. At companies with fewer than 100 employees - such as Elliott's company - the plans are not subject to annual independent audits that could deter embezzlement. An estimated 9 million Americans have their savings in 401(k) and profit-sharing plans small enough to be exempt from the annual audit requirement. That's about 20% of the people in defined-contribution retirement plans. Thefts from 401(k)s at large companies are practically unheard of. These plans generally are run by big investment firms whose reputations could be ruined by pilferage. Employees typically choose their investments from a menu of mutual funds and can monitor their account balances around the clock. It's a much different picture at many smaller companies. The plans may be overseen by the firm's owner or business manager. Employees often have no say in how their money is invested and no way to monitor their accounts. When theft occurs, it tends to happen at companies on the edge of bankruptcy. As the firms collapse, there may not be enough assets left to repay workers or enough insurance to cover their losses. "For many people, this is their only retirement asset," said Karen Ferguson, director of the Pension Rights Center in Washington, D.C. "The fact that it's almost completely unprotected reflects a major shortcoming in the law." Business groups have generally resisted calls for greater protection for workers at smaller companies, saying theft is rare. Tighter oversight or enhanced insurance would raise costs for small employers, they say, and could lead many of them to abandon their programs. "Fraud and theft are illegal in all 50 states," said Jim Klein, president of the American Benefits Council, a trade group representing employers. "You can pass all the laws you want, but it doesn't prevent somebody from getting mugged in the street. We need to enforce the laws that we have." The Department of Labor, which is responsible for safeguarding pension and retirement benefits, says it brings about 1,500 cases a year against employers accused of illegally diverting their workers' retirement money. But department officials concede that they do not have sufficient staffing to routinely monitor 401(k)s or investigate every complaint. Attorney Austin Barnes, 41, started working for a small, struggling law firm in Cleveland two years ago and immediately enrolled in his company's retirement savings plan, kicking in about $350 a month. He was the only contributor to the plan. He started to worry when he didn't get a quarterly statement, but he said his boss told him it was just a clerical delay. Months passed, and his inquiries went unanswered, he said. A year into the job, he cornered the firm's managing partner and accountant. "They said the account was never set up — the money was never there," he said. "But $4,327 was taken out of my paychecks." Barnes sought help from the Upper Midwest Pension Rights Project in St. Paul, Minn., which contacted the Labor Department. Investigators made several calls, he said, but the law firm refused to cooperate and regulators decided not to pursue the case. "It wasn't worth their resources," said Barnes, who left the firm in disgust. He said he hasn't gotten his money back, and that it wouldn't be worth the time and trouble to sue the firm. "This won't break me, but if somebody had told me that laws that protect your retirement accounts only apply when you're with a bigger plan, I would have been a lot more careful," he said. Alan Lebowitz, a deputy assistant secretary of labor, said the department has fewer than 500 investigators to respond to complaints about the nation's 700,000 defined-contribution retirement plans, mainly 401(k)s. The department is forced to practice triage, he said. Workers often have no idea their savings are being stolen until it is too late, said Mary Browning, director of the Upper Midwest Pension Rights Project. In many cases, she said, the employers raid workers' savings in an attempt to rescue their businesses. "Our experience is that when there is a problem like this, the company was going down the tubes and the employer was siphoning off cash, desperately trying to keep it going," Browning said. When traditional pension plans fail, the Pension Benefit Guaranty Corp. steps in to ensure that retirement checks keep flowing. The plan would pay 100% of the promised retirement benefits, up to a ceiling of $47,659 per year, for people whose pensions collapse this year. There is no comparable program for 401(k)s. Benefit experts say that's partly because government oversight has not caught up with the massive shift from traditional pensions, in which retirees are guaranteed a regular benefit, to defined-contribution plans such as 401(k)s, in which workers provide for their own retirement. "It's only recently that people are finally recognizing that the size and scope of the defined contribution system warrants the same kind of attention as the defined benefit system," said David Wray, president of the Profit Sharing/401(k) Council in Chicago. Brokerage firms that hold investments in stocks and mutual funds are insured against the theft of assets under an industry-funded program, the Securities Investor Protection Corp. If a similar plan was created for 401(k) accounts, employers could pass on the costs to employees.
But investors who randomly sweep up shares in companies that are buying back stock with the goal of beating the market are likely to be disappointed. According to a recent study of the S&P500 index by Birinyi Associates, companies that had buybacks outperformed those that didn’t by a mere percentage point over the period from 2000 to 2005. Zero in on the right stocks and the gains can be significant. This is seen in small undervalued companies — those with high book-to-market-value ratios — where management says it is buying back shares because they are bargains. Theo Vermaelen and Urs Peyer, professors at French business school Insead, tracked the 50 stocks that best met those conditions in every year from 1992 to 2002 and found that they produced gains 65% greater than those of the S&P500 index over the next four years. How much stock is being bought, and how often, can influence the share price. Bigger purchases are generally thought to be better, and the flexibility of long-term regular buying is often seen as a more confidence-building signal for the market than buying back shares all at once. Microsoft, with a one-time $20 billion buyback, with $20 billion more to come, has returned nearly 30% since the buyback announcement. Exxon has been buying back stock through 25 consecutive quarters, spending more than $60 billion, and its shares have gained better than 60% during the stretch. How a company finances a buyback matters. Free cash flow generally trumps debt, but again, it depends on business conditions. And after buyback announcements, potential investors should check that the companies are actually buying back stock. Buybacks may serve only as a cover for executives to exercise their options, buy their shares at a discount and sell them at market value. Such transactions can be a net loss for the company, with the number of shares remaining unchanged in the end. With so many ways to shuffle shares, it’s not surprising that Birinyi also found that, taken together, the S&P index companies issued 133% more stock than they bought for the 10 years ended in 1995. Two professors at Georgetown, Allan Eberhart and Akhtar Siddique, found in a study of more than 7,000 buyback announcements from 1981 to 1995 that the number of shares in the companies making the announcements actually increased by 24%, on average.
The professors focused on those companies that economic theory suggests would be most vulnerable to investor sentiment: small-cap growth companies, which have relatively few assets and little or no record of consistent earnings. Traditional balance-sheet analysis provides relatively little insight into these stocks, so their valuations can be subjective, supported largely by investor enthusiasm. The professors studied the period from the beginning of 1963 to the end of 2001. They found just what a contrarian would expect: after periods when sentiment was particularly high, like the months and years leading to the bursting of the Internet bubble in early 2000, small-cap growth stocks proceeded to perform very poorly. That makes sense, because investor enthusiasm would have bid the prices of these stocks to very high levels and made them vulnerable to even the slightest decline in that enthusiasm. The reverse was the case after periods of low sentiment, the professors found. Small-cap growth stocks are punished particularly harshly when investors become discouraged, and from such low levels they can provide handsome subsequent returns. What about companies for which traditional balance-sheet analysis is more useful — larger companies, generally, and those in the so-called value category? The professors found that investor sentiment has relatively little effect on these stocks. That also makes sense, according to the professors, because such stocks’ valuations are less vulnerable to the way the sentiment winds are blowing. More from "Investor Sentiment and the Cross-Section of Stock Returns" Baker & Wurgler How Sentiment Was Measured Baker & Wurgler formed a composite index of sentiment that is based on the common variation in six underlying proxies for sentiment: the closed-end fund discount, NYSE share turnover, the number and average first-day returns on IPOs, the equity share in new issues, and the dividend premium. The closed-end fund discount is the average difference between the NAV of closed-end stock fund shares and their market prices. Prior work suggests that CEFD is inversely related to sentiment. Zweig (1973) uses it to forecast reversion in Dow Jones stocks, and Lee, Shleifer, and Thaler (1991) argue that sentiment is behind various features of closed-end fund discounts. NYSE share turnover is based on the ratio of reported share volume to average shares listed from the NYSE Fact Book. Baker and Stein (2004) suggest that turnover, or more generally liquidity, can serve as a sentiment index: In a market with short-sales constraints, irrational investors participate, and thus add liquidity, only when they are optimistic; hence, high liquidity is a symptom of overvaluation. Supporting this, Jones (2001) finds that high turnover forecasts low market returns. The IPO market is often viewed as sensitive to sentiment, with high first-day returns on IPOs cited as a measure of investor enthusiasm. We take the number of IPOs and the average first-day returns. The share of equity issues in total equity and debt issues is another measure of financing activity that may capture sentiment. Baker and Wurgler (2000) find that the equity share is inversely related to subsequent market returns. The equity share is defined as gross equity issuance divided by gross equity plus gross long-term debt issuance using data from the Federal Reserve Bulletin. Our sixth and last sentiment proxy is the dividend premium, the log difference of the average market-to-book ratios of payers and nonpayers. Baker and Wurgler (2004) use this variable to proxy for relative investor demand for dividend-paying stocks. Prior Studies & Their Findings The results challenge the classical view of the cross-section of stock prices and, in doing so, build on several recent themes. First, our results complement earlier work that shows sentiment helps to explain the time series of returns (Kothari and Shanken (1997), Neal and Wheatley (1998), Shiller (1981, 2000), Baker and Wurgler (2000)). Barberis and Shleifer (2003), Barberis, Shleifer, and Wurgler (2005), and Peng and Xiong (2004) discuss category-level trading, and Fama and French (1993) document comovement of stocks of similar sizes and book-to-market ratios. Finally, we extend and unify known relationships among sentiment, IPOs, and small stock returns (Lee, Shleifer, and Thaler (1991), Swaminathan (1996), Neal and Wheatley (1998)). Baker & Wurgler's Findings We find that when sentiment is low (below sample average), small stocks earn particularly high subsequent returns, but when sentiment is high (above average), there is no size effect at all. Conditional patterns are even sharper when we sort on other firm characteristics. When sentiment is low, subsequent returns are higher on very young (newly listed) stocks than older stocks, high-return volatility than low-return volatility stocks, unprofitable stocks than profitable ones, and nonpayers than dividend payers. When sentiment is high, these patterns completely reverse. In other words, several characteristics that do not have any unconditional predictive power actually display sign-flipping predictive ability, in the hypothesized directions, once one conditions on sentiment. When stocks are sorted into deciles by sales growth, book-to-market, or external financing activity, growth and distress firms tend to lie at opposing extremes, with more “stable” firms in the middle deciles. We find that when sentiment is low, the subsequent returns on stocks at both extremes are especially high relative to their unconditional average, while stocks in the middle deciles are less affected by sentiment. (The result is not statistically significant for book-to-market, however.) This U-shaped pattern in the conditional difference is also broadly consistent with theoretical predictions: both extreme growth and distressed firms have relatively subjective valuations and are relatively hard to arbitrage, and so they should be expected to be most affected by sentiment. More Studies on the Closed-End Fund Discount Schmitz, Glaser & Weber The most prominent proxy for individual investor sentiment is the closed-end fund discount (CEFD) proposed by DeLong, Shleifer, Summers, and Waldmann (Noise Trader Risk in Financial Markets - 1990) and Lee, Shleifer, and Thaler (Investor Sentiment and the Closed-End Fund Puzzle - 1991). It is an empirical fact that closed-end funds are, on average, traded with a substantial discount on NAV of the stocks in their portfolios. Since closed-end funds are predominantly traded by individual investors, their sentiment should affect the CEFD. There are also some critical views on CEFD as a proxy for investor sentiment and the infuence on stock prices. For example Swaminathan (Time-Varing Expected Small Firm Returns and Closed-End Fund Discounts - 1996) finds that the CEFD can indeed forecast small stock returns. However, the discount contains fundamental economic information about small firm earnings growth rates and future inflation, and thus, it is not a measure of sentiment but a proxy of individual investors' rational expectations about future economic conditions and/or their risk aversion to macroeconomic risks". Elton, Gruber, and Busse (Do Investors Care About Sentiment? 1998) find that the CEFD is not an important factor in the stock return generating process at all. Similar results are provided by Doukas and Milonas (Investor Sentiment and the Closed-end Fund Puzzle: Out-of-sample Evidence - 2004) and Qui and Welch (Investor Sentiment Measures - 2004). More Studies On Using Ratios to Predict Stock Price Movement Jonathan Lewellen Andrew Ang and Geert Bekaert, 2002. Stock return predictability: Is it there? John Campbell and Robert Shiller, 1988. The dividend-price ratio and expectations of future dividends and discount factors. Eugene Fama and Kenneth French, 1988. Dividend yields and expected stock return. William Goetzmann and Philippe Jorion, 1993. Testing the predictive power of dividend yields. S.P. Kothari and Jay Shanken, 1997. Book-to-market, dividend yield, and expected market returns: A time-series analysis. Jeffrey Pontiff and Lawrence Schall, 1998. Book-to-market ratios as predictors of market returns.
Price/Earnings Ratio If a stock sells for $20 and the company earns $1 a share, the P/E ratio is 20. The higher the ratio, the more expensive a stock is in relation to its earnings. It is best to compare a stock's P/E with that of industry peers as well as the overall market. If a company is trading at a relatively high P/E, it means investors have high hopes, but any disappointments could send shares tumbling. Academic research demonstrates that buying low-P/E shares is a recipe for success. But sometimes P/E ratios are low for a good reason: Past earnings were strong but future earnings are expected to tumble. The market is somewhat attractive based on P/E. The S&P500 trades at a P/E ratio of 17.8 based on the past 12 months of earnings. That is lower than the average P/E range of 19.2 since 1980. Price/Free Cash Flow Free cash flow ia the cash income that a company is left with after paying expenses. If a stock has a low ratio of price to free cash flow, that suggests it is a healthy business that has a lot of money left over for dividends, stock buybacks or other steps to improve a stock's return. To figure a company's free cash flow, go to the "cash flow statement" in shareholder reports. Take operating cash flows and subtract all capital expenditures, or money reinvested in the business. For companies with a lot of debt or that hold a lot of cash, it is best to also take out interest expense and interest income. Stocks now trade at less attractive levels in relation to cash flows than they did earlier this year, but this year's figures are among the most attractive since 1996. Price/Book Value Book value is a measure of a company's assets minus its outstanding debt or other obligations. If a company's shares are worth $2 billion and its book value is $1 billion, then it is trading at two times book value. Price-to-book is a key metric for financial companies and homebuilders, but is less important for some other industries because book value doesn't include things such as patents, research and development and brands or the creativity of workers. The S&P 500 currently trades at 3.1 times book value, about the level of the past few years though below the expensive level of about 4.5 in the late 1990s. Price/Sales A company with shares worth $500 million and sales of $1 billion would have an attractive price-to-sales of 0.5. But sales don't guarantee profits. So companies with low price-to-sales ratios should have a good plan to turn those big sales into earnings, or the stocks won't benefit. Companies in the S&P 500 now trade at 1.5 times their sales, close to the level of recent years but above levels of the early 1990's. Return on Invested Capital To get the return on invested capital, or how much profit it generates from the amount it invests in its operations, divide a company's earnings (before interest and taxes) by total assets.
Staying the course with stocks may be the most important investing decision you'll ever make - even more crucial than which stocks you own. That's because longer investment horizons make market losses less likely. While there's a one-in-five chance that U.S. stocks will lose money in a given year, the S&P500 has never declined in any 10-year period since 1940. Markets over the long term go up. You can get that by just having a diverse portfolio and holding it. You don't have to have timing magic. U.S. stocks have finished in positive territory annually more than 70% of the time in the past eight decades. In about a third of those years, the market's annual return was greater than 20%. Stocks declined in 23 of those 80 years, but staying invested through the rough patches would have been rewarding, with the U.S. market returning 10.4% annualized on average over the full span. When everything's going up, everyone's time horizon is infinite. When everything's going down, it's infinitesimal. Monthly Employment Stats
Professional and business services employment increased by 43,000 in November and has risen by 426,000 over the year. Job growth has occurred in a number of industries, including architectural and engineering services, management consulting, and computer systems design. Employment in temporary help services was flat over the month and has changed little since January. Health care employment rose by 28,000 in November. Hospitals and doctors’ offices each added 6,000 jobs. Over the year, health care employment has increased by 309,000. In leisure and hospitality, employment growth continued in food services and drinking places. This industry added 34,000 jobs in November, raising total job gains over the last 12 months to 295,000. Employment in wholesale trade continued to trend up in November. Employment in this industry has risen by 288,000 since its most recent low in August 2003. Within retail trade, employment grew over the month in clothing and accessory stores; health and personal care stores; sporting goods, hobby, book, and music stores; and nonstore retailers (which include catalog and internet retailers). General merchandise stores continued to lose jobs (-12,000 after seasonal adjustment); since August 2005, employment in this industry has decreased by 107,000. In the goods-producing sector, mining employment grew by 4,000 in November with gains in support activities for oil and gas. Employment in mining has grown by 136,000 since its most recent low in April 2003. Construction employment declined by 29,000 in November, following a loss of similar size in October. The November decline was spread across all component industries. Since peaking in February of this year, employment in residential specialty trades was down by 109,000. Employment in nonresidential specialty trades edged down in November, after trending up during the first 10 months of the year. Manufacturing employment continued to trend down (-15,000) in November. Motor vehicles and parts lost 7,000 jobs. Employment continued to fall in two construction-related industries: wood products (-6,000) and furniture and related products (-5,000). Computer and electronic products manufacturing added 5,000 jobs over the month. The average workweek for production and nonsupervisory workers on private nonfarm payrolls was unchanged at 33.9 hours in November. The manufacturing workweek and factory overtime both fell by 0.1 hour to 41.1 and 4.2 hours, respectively. Average hourly earnings of production and nonsupervisory workers on private nonfarm payrolls rose by 3 cents, or 0.2%, in November to $16.94. Average weekly earnings also rose by 0.2% in November to $574.27. Over the year, average hourly earnings increased by 4.1%, and average weekly earnings increased by 4.4%.
Quick Facts, Stats & Opinions The Dow Theory Mark Hulbert, MarketWatch 12-22 William Peter Hamilton, the original author of the Dow Theory, never codified it into a series of unambiguous rules. He instead introduced it in dribs and drabs in editorials for the Wall Street Journal in the first three decades of the last century. The general outlines of the Dow Theory are clear enough: A bull market is confirmed when the Dow Jones Industrial Average and the Dow Jones Transportation Average jointly reach significant new highs, while a bear market is signaled when both averages reach significant new lows. Market turning points occur when the two averages trend in opposite directions --"non confirmations" in Dow Theory parlance. Research has shown that the Dow Theory has beaten the market over the long term. Consider a study conducted in the mid-1990s by three finance professors - Stephen J. Brown of New York University, William Goetzmann of Yale University, and Alok Kumar of the University of Texas at Austin. They fed Hamilton's market-timing editorials from the early decades of the last century into neural networks, a type of artificial intelligence software that can be "trained" to detect patterns. Upon testing this neural network version of the Dow Theory over the nearly 70-year period from 1930 to the end of 1997, they found that it beat a buy-and-hold by an annual average of 4.4 percentage points per year. Their study appeared in the August 1998 Journal of Finance. Goldman Sachs' Abby Joseph Cohen 2007 Projections David Gaffen, WSJ 12-07 Goldman Sachs strategists Abby Joseph Cohen and Michael Moran see the S&P 500 gaining about 10% in 2007, establishing a target of 1550 for the index for the end of that year. Goldman also predicts the Dow industrials will hit 13500 by the end of next year, and say current prices “properly reflect a reflect a favorable fundamental picture for 2007.” Broadly, the firm is looking for inflation to remain contained, while corporate earnings maintain strength. Goldman did well in 2006 in terms of year-end targets — the firm expected the S&P to hit 1400 and the Dow to reach 12000; it has since surpassed both. Ms. Cohen and Mr. Moran still see the market as undervalued. “We conclude that the major U.S. stock price indices currently trade below fair value. Our model suggests undervaluation of about 10% on a 12-months forward basis,” they write. “This time last year, the same model estimated undervaluation of roughly 12%.” Among the firm’s other predictions: Slower growth in earnings: They see S&P 500 earnings-per-share growth slowing to about 6% in 2007 after growth of about 18% in 2006, putting operating EPS estimates at $87 for 2006 and $92 for 2007. Another big year for private equity: “The current undervaluation of publicly traded equities suggests that the powerful interest in alternative investments, including private equity, and merger and acquisition activity will not soon end,” they write. “Ample liquidity has been sourced from monetary policy and low interest rates, corporate balance sheets, and substantial pools of investment funds.” Volatility to rise: Goldman says the low levels of volatility have bred a willingness for riskier assets with lower premiums than in the past, and they see this changing in the coming year. “It is not difficult to imagine a rise in asset price volatility, if only back towards more normal levels,” they say. Some 900-plus funds were liquidated or merged out of existence in 2006, down about 25 percent from 2005 and the lowest extinction level in several years. (Chuck Jaffe, MarketWatch 12-31) The average price gain predicted for the S&P 500 in 2007 is 9%, according to a Bloomberg News survey of investment strategists at 14 major brokerages. (Tom Petruno, LA Times 12-31) The typical, stubborn buy-and-hold investor often can ride through periods of "good company, bad stock," where a terrific business goes through a cycle where it's either overvalued or out of favor with the market. That said, studies show that average investors bail out when losses move beyond 20%. If a security nosedives and investors flee, any subsequent rebound does not deliver redemption, because the typical investor missed it and only experienced the losses. (Chuck Jaffe, MarketWatch 12-26) Standard & Poor’s says today that the ratio that measures the level of distressed bonds as a share of all high-yield, or speculative-grade, issues, hit a 26-year-low of 1.6% in December. A bond is referred to as “distressed” when its difference in yield above comparable Treasurys rises to more than 1000 basis points, or 10 percentage points. (Madeleine Lim, Dow Jones Newswires 12-26) Bianco Research points out that the S&P 500 has not declined by 2% since July 13 — the second longest-period without a 2% correction since 1964. “Only the 1995 period saw a longer string of days without a 2% correction,” they write, noting that a 2% decline really isn’t a correction in the first place, just noise. (David Gaffen, WSJ 12-26) Thomson Financial estimates earnings growth for the financial services sector will come in at 34% for the fourth quarter. Removing this sector from the market leaves a growth rate of 3% for the remaining nine sectors. The growth rate for materials is also expected to be 34% — but this is a much smaller sector. (David Gaffen, WSJ 12-26) According to data compiled by the NPD Group, L.C.D. TVs held 49% of the market in 2006, compared with 26% last year. Plasma’s market share increased to 10% from 5%. At the same time, sales of picture tube TVs dropped by more than half, to 21% this year from 46% in 2005. (Eric Taug, NY Times 12-25) According to the latest survey released by the National Assn. of Realtors, 80% of all buyers seeking to purchase a home did at least some searching online — up from just 2% in 1995. The study showed that 81% of buyers who used the Internet to search for a home eventually purchased through a real estate agent, in contrast with 63% of non-Internet users, who were more likely to purchase directly from a builder or from an owner they knew in advance of the transaction. The median age of a 'first-time buyer' was 32, a fairly consistent finding since 1981, with a median income of $58,300. The median buyer purchased a home costing $165,000 with plans to stay in that home for six years. The median down payment by first-time buyers was 2%, although 45% purchased a home with no money down. The 'average home buyer' was 41, earned $71,800 and purchased a home of about 1,815 square feet for $214,000. The buyer searched for eight weeks and viewed nine homes before making a decision. The average 'repeat buyer' was 47, earned $81,900, purchased a home costing $249,000 and planned to stay in that home for nine years. (Tom Kelly, LA Times 12-24) In an article by Parris Kellermann of Bloomberg News, the reporter writes "Shares of companies with rising dividends advanced at an average annual rate of 10.6% from Jan. 31, 1972, through 2005, and non-dividend-paying stocks rose 4.1%, according to Ned Davis Research." Looking for more info, I found the following from the Franklin Templeton U.S. Rising Dividends Fund: An investment of $10,000 in stocks with rising dividends in 1973 rose 366% by 2004, turning into $333,975 by December 31st of 2004. An investment of $10,000 in stocks with static dividends in 1973 rose to $141,312. An investment of $10,000 in non-dividend paying stocks rose to $71,662. “According to a study by Hewitt Associates, only 34% of employers will offer holiday bonuses this year, down from 41% last year. Most of the Scrooges have never had a bonus program, but some have dropped their plans,” writes Hannah Clark of Forbes. “According to Hewitt, two-thirds of the companies who have eliminated bonuses did so in the last five years.” (David Gaffen, WSJ 12-14) Britt Beamer, chairman of consumer-researcher America’s Research Group, said consumers are more deal-driven than ever. A survey by ARG showed 81% of respondents were planning to attend early bird holiday sales, up from 64% a year ago. “There are just a lot more people out there wanting bigger and bigger deals,” he said. “What we have going on in America is that when there’s not one thing that you have to have, you can be much more deal driven.” (David Gaffen, WSJ 12-14) One reason Wall Street is poised to turn in a solid performance in 2006 — the S&P500 is up nearly 13% this year as of yesterday — may surprise you. “Three years after a tax cut that was supposed to light a fire under the category, dividend-paying stocks are finally taking off,” Megan Barnett writes in SmartMoney. “Through September, the top 100 dividend payers in the S&P500 had returned 14% to investors, handily outperforming stocks with no yields, which had logged 5% returns.” (Paul Brown, NY Times 12-09) With telephone companies pushing into the TV business, rate increases planned by cable operators for 2007 are going to be the most moderate in years. Next year, for example, Comcast will raise the cost of its most popular 75-channel analog package an average 4.5% -- from about $41 a month to $43 -- its lowest increase in more than a decade. Time Warner Cable is planning increases of the standard cable package in some markets, in Dallas and Los Angeles the rate will stay the same. Cablevision Systems Corp., an operator serving the NYC, isn't planning to raise its standard rate at all. Last year, average satellite prices rose 8.1% compared to cable's 5.1%, according to Kagan Research. Dish Network's basic package that includes more than 80 channels costs $29.99 a month now and will remain at that price next year. Verizon's new TV service, which includes 200 channels of TV and music, will be priced at $42.99 monthly. AT&T is charging $44 a month for one of its packages, which includes 100 channels. (Sarmad Ali, WSJ 12-07) According to spam-filtering company IronPort Systems, spam doubled from last year to this year, now representing more than 90 percent of all e-mail traffic. Much of the increase is attributable to image spam, which quadrupled over the same period of time and now accounts for between 25 and 45 percent of all spam. With image spam, text is converted to graphics, which can be read by individuals who receive them but not by spam filters on the lookout for words and phrases that can identify a message as spam. (CNET 12-06) Morgan Stanley economist Richard Berner has revised his earlier call on the Federal Reserve, saying now that the firm no longer thinks the Fed will tighten policy next year. “The risks that growth will remain weak for longer have increased, and the odds that inflation will rise further have declined,” he writes. (David Gaffen, WSJ 12-05) Despite all this worry about an economic slowing, the following stock indexes are currently trading at the 99th percentile of their 52-week high: the S&P Mid-Cap 400, the Russell 2000, the Russell 2000 Value, the MSCI-Barra World Index, and indexes from Canada, China, Mexico, and Taiwan, according to Citigroup. (David Gaffen, WSJ 12-05) It was 10 years ago tonight that Mr. Greenspan let the slip the term “irrational exuberance.” Oddly enough, the federal-funds rate is at the same spot it was at the time of that speech — 5.25%. The Fed has altered the rate 40 times since, leading Jim Bianco of Bianco Research to muse, “One wonders if the economy would have been better off with this rate unchanged at 5.25% over the last 10 years rather than the 40 changes made by the Fed.” (David Gaffen, WSJ 12-05) Nearly 40% of U.S. households have at least one recurring monthly payment that is automatically linked to a credit card, according to MasterCard Inc. research. (Robin Sidel, WSJ 12-06) Hedge Fund / Private Equity News Briefs Hedge funds are poised to finish 2006 with double-digit returns for the first time in three years. Long/short equity, which claims one-third of all hedge fund assets, was up 10.6% through November, according to The Hennessee Group. According to Financial News, citing investors, the Penta Japan Fund skyrocketed 183.3% through Dec. 8, while The Gradient European Fund soared a healthy 36.1% through Nov. 30. On the other hand, the Blue Sky Japan Fund was down 29.1% so far this year, while Crispin Odey's Odey European Fund is off 1.9% and John Duffield's New Star U.K. Hedge Fund tumbled more than 20%. Other strategies had more of a consistent positive attitude. Emerging markets as a strategy climbed 15.1% through October, says Hedge Fund Research, but the hottest offerings in that category are GLG Partner's fund, surging 48.1% through Dec. 8 and William Browder's Moscow-based Hermitage Fund up a nifty 37.9%. A winner among merger arbitrage offerings so far is Atticus' fund in that strategy, up 33.8% through early December, while its European event-driven fund did even better, rising 40.5%. In convertible arbitrage, a prime contender for comeback strategy of the year, GLG's market neutral fund moved up 24.4%, while the Ferox Fund added 18.7%. Not everyone is walking away a winner, strategy wise. Global macros are up just 2.2% so far, according to Hennessee, and short-selling-focused hedge funds stood at -2.0% as of Oct. 31, says HFR. (DailyII 12-21) Commodities investors are abandoning index funds en masse and turning to hedge funds to elevate the level of returns, according to a survey of Barclays Capital clients. The number of commodities investors seeking HFs has more than doubled in the last year, from 21% in a similar survey in 2005 to more than 50% today. This increase comes as the percentage of Barclays customers -- including pension funds, hedge fund, retail distributors and the like -- allocating more than 10% of their portfolios to commodities has more than tripled in the past 12 months to 53%. The news bodes poorly for commodities index funds, which in the current survey was the choice of just 3% asked, compared with 47% a year ago. The results of the study also reflects a change in the way investors view commodities. In last year’s survey, 63% said they allocated to the sector to limit risk and diversify their portfolios. This year, only 43% felt that way, while the percentage of those selecting commodities to produce absolute returns surged from 15% in 2005 to 32% this year. Another driving force behind the change, says MarketWatch, is the drop in prices in the crude-oil market and the rising carrying costs, now at 20%. "The study highlights the concern about listed index investments," Kamal Naqvi, Barclays Capital’s director of commodities sales. (DailyII 12-14) New popular item, same old story. Infrastructure funds are the latest new vehicle to sweep the world, and that’s creating the well-known problem of too much money chasing after the few good investments, a problem, which Standard & Poor’s says can threaten private equity funds. Infrastructure deals, S&P analyst Michael Wilkins told AltAssets, are "becoming increasingly highly leveraged, reflecting what we believe to be a pricing bubble caused by the wave of new funds chasing limited assets." According to S&P, between $100 billion and $150 billion has been raised in the sector and is just itching to be invested; there’s been $145 billion of mergers and acquisition activity in the sector so far this year. Wilkins predicts 2007 will see more of the same: "Valuation and debt-to-EBIDTA multiples in infrastructure M&A deals have been soaring, while equity contributions have generally been decreasing. As a result credit quality is suffering across the sector as infrastructure assets adopt aggressive balance sheet in an attempt to fend off private equity players." As a result, he says, the infrastructure sector is "in danger of suffering from the dual curse of overvaluation and excessive leverage" -- shades of the dot-com bubble burst. (DailyII 12-13) Venture capital investment is expected to hit more than $32 billion this year, the highest since recording more than $51 billion in 2001, according to an Ernst & Young/Dow Jones VentureOne report. According to the report, growth has been fueled by interest in burgeoning markets such as China, clean technology and seed/early stage funding. "Venture capitalists are responding to the need of large multinationals to get closer to the innovation pipeline, whether through partnerships with promising start-ups or acquisitions of innovative companies," said Gil Forer, global director of E&Y’s Venture Capital Advisory Group. (DailyII 12-12) Low market volatility will continue to present “significant challenges” in 2007, according to Man Investments’ annual review and preview of the hedge fund industry. Market volatility is “still close to multi-year lows in almost all asset classes,” according to the report, which “could make it difficult for directional and trend following strategies to identify strong opportunities.” (DailyII 12-07) Hedge Fund Citadel reportedly spent $5.5 billion in associated investment costs last year; the net asset value of its two hedge funds was $13 billion. The high fees, which surprised Wall Street types, reportedly are the byproduct of frequent trades and heavy-duty leverage, which at the end of August, according to FT, was 12.5 times. By the way, Financial News reports that Citadel’s 1,069 staffers have invested almost $2 billion of their own money in funds they manage. (DailyII 12-05) Home Page Previous Factoid Top Sites
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