mauldin letter
Is the Run in Small Cap Stocks Over?
Where's the Growth?
Thoughts on a Bear Market
Re-setting the Scales
Modern Portfolio Families
And Much More!!
By John Mauldin
The news all seems so bleak sometimes. But is it? If my view that we
are in a Muddle Through Economy is to prevail, then we surely must
be seeing some good news somewhere. In this issue, I find some good
news, some bad news and highlight a recent study which shows that
the run in small cap stocks may be coming to an end. And much more,
of course. Let's jump right in.
Is the Run in Small Cap Stocks Over?
There is reason to think it might be. Small cap stocks have
outperformed large cap stocks by 100% over the last three years.
"Cap" is short-hand for stock market capitalization. Small cap means
the stock market value of the companies are small and vice versa.
Myles Zyblock of Brown Brothers Harriman did a study, looking back
over the last 75 years, and finds that whenever small caps get into
this 100% range, the small cap game is entering the late innings. In
three of four times, the game was soon over. In WW2, the game went
into extra innings, but not for long. It made a quick spike, and
then large caps started to out perform.
If the pitching in the late innings is anything like the relief
pitchers for my Texas Rangers, we should be very worried.
Now, this does not mean we have a bull market in large cap stocks in
our future. It means that small caps are probably not going to do
any better than their larger brethren. The higher small caps go
relative to high cap stocks from here, the more it will begin to
look like a bubble.
It is more likely, in my view, that small cap and large cap stocks
will start moving roughly in tandem.
Your defense, if you want to be in the stock market, is to keep
buying value stocks. If the stock market takes your value stocks
up, sell them and buy more under-valued stocks. Value stocks nearly
always out-perform growth stocks in a period when P/E ratios are
falling. In periods like this summer, when stocks fall on even good
economic news, there is a premium placed on value stocks.
Where's the Growth?
As I analyze the data for the past few weeks, several patterns
emerge. One of my Three Amigos, capacity utilization, continues to
improve, but not as much as expected. Industrial production
improves, but not as much as expected. Initial jobless claims drop,
but not very much. Unemployment finally starts to improve, but 60%
of the improvement was in temporary jobs. The number of over-time
hours grew slightly, which is usually a pre-cursor to a growth in
employment. So we can expect small but steady improvements in
employment in our future
In spite of the dollar dropping, import prices actually went down.
Business inventories are down, but by only 0.2%. There is very
little capital spending growth, and the growth that came from
inventory re-building is largely over.
Inflation is still not in the near future. The Producer Price Index
dropped another 0.4%, much more than expected. The PPI is in
outright deflation over the past year. Commodity prices, although a
few points higher than their lows, are having a hard time finding a
way to increase. Mortgage applications and home building are holding
up on a relatively high plateau. Mortgage payment delinquencies are
improving, but only slightly.
But the consumer seems to be slowing down. Retail sales for May were
down 0.9%, when the expectation was for them to be flat. Not
surprising, then, that the Michigan Consumer Sentiment index dropped
a rather large 6%. But what growth there is seems to be at discount
retailers like Walmart and Costco. We all look for bargains.
Paul Kasriel writes that consumers now have only $.60 for every
dollar of debt, down from $1.60 in 1950 and down over the last
decade from $1.00. It is going to be hard to sustain strong growth
in consumer spending as we run out of money to spend.
(That is another reason why the Fed is reluctant to start raising
rates. It would seriously hurt the ability of the consumer to
spend, as his cost of financing the debt will rise.)
The growth in consumer spending for this quarter will probably be
about half what it was in the first quarter, and less than a third
of the fourth quarter of last year. That is not a good trend. Growth
will probably be less than 2%, which is rather tepid. Stephen Roach
says, "For me, the 2% growth threshold has always been a key
signpost for the American consumer. It doesn't always signal
recession, but it certainly does flash a 'growth warning' that
financial markets take quite seriously. That may well be the case
today."
In short, if you want to be pessimistic about the economy, you have
plenty of ammunition. If you want to find bright spots, you can
easily do so. I choose to continue to say both sides are wrong. The
data seems to suggest to me we are still headed for a period of slow
but steady growth. Though some of my readers called me Muddle-
Headed, I still think we are in a Muddle Through Economy.
Thoughts on a Bear Market
In the last long bear market cycle of 1966-1982, the economy
actually grew faster than it did in the subsequent bull market era
of 1982-2000. You can find other examples when the relationship
between stocks and the economy were seemingly disconnected.
Ben Graham tells us that the "stock market acts as a voting machine
in the short run, it acts as a weighing machine in the long run."
What is voted upon is profit potential. What it actually weighs are
real profits.
In bull markets, stock market investors believe that profits will
rise. They plow into growth stocks, expecting growth to compound
seemingly forever.
But in bear markets, investors start to look more at the real
profits than in forecasts. That is what makes value investing so
important.
As every bear market cycle starts, and this one is still an infant,
there are cries for reform. People who were once the darlings of
Wall Street become the ogres deserving of jail time. In that regard,
the calls for reform should be expected.
The difference this time is in the nature of what is to be reformed.
The reforms and changes that will come from the current cycle of
angst will change, perhaps dramatically, how we determine what
exactly constitutes a profit. This will be as hard as determining
the what Bill Clinton meant by the word "is."
Now those of us who run small businesses know what profits are. It
is the money left in the bank account at the end of the year, plus
what we spend on personal items. There are a few loopholes we can
use to shelter some "profits" from taxes, but very few. What you see
in the bank is pretty much what you get.
But in the world of public corporations, a new way to look at
profits emerged in the last 20 years. New "special purpose vehicles"
were created to push items which would cut profits out of sight.
Operating earnings, pro forma earnings and other euphemisms became
ways to make the profit picture look brighter.
But now there is a rush to change all that. Accountants and
corporations are becoming more conservative.
Re-setting the Scales
I get on a weight scale nearly every morning. Sometimes it shows me
losing 20 pounds overnight. At those times, I know something has
changed the scales, and I need to re-set it. As much as I would like
to believe the scale, reality in the form of a mirror says I still
need to lose a few pounds.
I think we are in the process of re-calibrating the weight machine
of the stock market.
The Singapore Business Times tells us that "in the bear markets of
1949 and the early 70s and 80s, the average PE ratio of the 500
companies in the S&P 500 index was a mere 5 times to 7 times
earnings."
"According to Thomson First Call, the consensus analyst S&P 500
earnings assessments and forecasts are $48.80 in 2001, rising to
$52.20 in 2002 and to $62.60 in 2003. That places the index on a
forward 2002 PE of 20 and 2003 PE of 16.
"S&P plans to deduct from reported earnings the imputed cost of
options granted to executives, as well as expenses related to under-
funded pension plans and restructuring charges for actions such as
layoffs and relocating plants.
S&P's core earnings will also exclude charges for discontinuing a
business line or product, charges related to mergers, acquisitions
and litigation, and investment gains on pension-plan assets.
On current estimates, S&P calculates that core earnings of the index
are $28.50. This estimate raises the S&P 500 PE to 36."
That is a little more than half of the First Call estimates. It is
also much more realistic.
I and many other analysts have high-lighted for the past few years
the ridiculous earnings estimates and the use of pro forma earnings.
Now the S&P 500 is going to get conservative as well.
This is a major change, and you are going to see brokerage firms
start to conform as well. The law suits that are mounting are going
to force them to take more conservative stances. This will take some
time, but eventually it is going to trickle down to the investor.
This new profit weighing scale is going to put a ceiling on stock
prices for a long time. As time goes on, investors are going to want
more and more real earnings per share for the risk of investing in a
company.
It has been like that in every bear market cycle since the Medes
were trading with the Persians. It seldom happens over-night. It
takes time, as each generation which has been trained to buy the
dips slowly comes to realize a share of stock is a piece of a
business, and not a lottery ticket.
We are witnessing this very thing today. Stock valuations, as noted
above, are close to all time highs. Yet, after a 200 point drop in
the Dow, the market came back strong. The NASDAQ closed up. The S&P,
after dipping below 1,000, rallied to close over 1,000.
Many of you ask why I do not think a crash is in the near term.
Today is a perfect illustration. We have seen two episodes this week
of buying the dips. Of course, we close the week down, but the bulls
have something to convince them we are at a bottom.
Andrew Kashdan of Apogee Research writes: "According to
ContraryInvestor.com, individual mutual fund holdings appear to have
held remarkably steady the past three years, despite the market's $4
trillion to $5 trillion paper loss. In other words, investors
continue to "buy the dip," even as the dip keeps dipping ever lower.
In not one of the last three years did equity mutual funds show a
net outflow. It seems the lesson of "buy-and-hold" has been taken to
heart at precisely the wrong time. Like ContraryInvestor, we can't
help but wonder if the public might finally capitulate and dump a
significant portion of its holdings. So far, this crop of individual
investors seems determined to hang tough come hell or high water."
Could we see a real crash and a dizzying drop in the future?
Absolutely. I will discuss such a risk in a few paragraphs. But for
now, I think the tenor of the market is a sideways to down pattern.
Could we go back up 10% before we drop another 14%? Absolutely.
Or we could just drop another 15% from here and set up another
buying opportunity. No one knows how this will play out. But the
eventual outcome will be that at the end of this bear market cycle,
stock valuations will come back to norms, probably in the P/E range
of 15-17. But this time, the valuations will be on the new, more
conservative scales.
History teaches us that the pendulum usually swings back to 5 to 7
as investors get entirely too pessimistic. I would point out at that
those levels, the S&P 500 would be below 250 today. I do not think
the S&P will see 250.
What will happen is that earnings will grow, as the economy Muddles
Through. Could real earnings in the S&P 500 grow from $28 to $60-$70
or more by the end of the decade? Of course. That is roughly 10%
growth per year, and is quite possible. Do I think we will see a P/E
ratio of 5 or 7? Not unless we have some horrific event none can now
foresee.
That being said, a drop of 40% or more from here over this next
cycle is certainly within historical norms. But one can argue, and
very smart analysts I admire do so, that the stock market will drift
sideways to down for a long time as earnings rise slowly, meeting
somewhere in the middle.
The major downside risk I see is foreign investors taking their
money and going back to more fertile territory. The Japanese, I am
told, withdrew $24 billion in January alone. The recent rapid fall
of the dollar will make investors nervous.
But when the head of the European Central Bank starts to talk down
his currency, someone besides mama-san is worried. Dennis Gartman of
the well-written Gartman Letter writes: "Turning then to Mr.
Duisenberg's comments, we were taken-aback by them, concerning the
euro and the "cultural diversity" of Europe. Duisenberg of course
noted the language barriers that Europe has when compared to the
language homogeneity of the United States and suggested that this
alone shall make economic activity in Europe more difficult than in
N. America. But he went on to say that European cultural diversity
does in fact carry a price. He said,
"...if we want to preserve our cultural diversity, we will never be
able to reach the higher rate of potential growth [of the United
States.] We want to preserve that diversity, but we have to pay a
price."
"We might have expected the arch Euro-skeptics to raise such a
complaint, but we hardly expected the very centre of European
monetary policy to raise it. Indeed, as more traders/money managers
and corporate hedges read of Mr. Duisenberg's comments, we cannot
help but believe that they will at least put in an interim top of
some consequence for the euro... and it may be even more serious
than that."
I, for one, hope that we see an orderly retreat of the dollar. Brown
Brothers estimates that for every 1% drop in the dollar, we actually
see a 0.3% rise in earnings growth because so many of our large
companies are multi-national. An orderly drop in the dollar, say 7%
this year and 7% next year, would be quite good overall for the US
dnd world economy. This is why Duisenberg was "talking the euro
down." He wants things to move on an even keel.
Sadly, the history of currency valuations is replete with examples
of things not being so smooth. A rapid drop could seriously affect
the stock and bond markets. We will need to keep a close eye on the
dollar and foreign cash flows.
Modern Portfolio Families
Modern Portfolio Theory teaches us we should diversify our
investments over many assets classes and invest for the long-term,
as different classes will do well at different times. If you hold
long enough, your portfolio will do well.
I took that advice to heart in my family planning, and diversified
my portfolio of children. In addition to two biological daughters,
we adopted five more. We further diversified among races and country
of origins. I have about as diversified a family portfolio as one
can have. Right now, I am still in the investing phase. I am still
waiting for a return on my investment, other than love and
affection, of which I have in abundance. Modern Portfolio Theory
says if I hold on long enough, I should see a profit. I think I
will hold on to this group for as long as God will grant me grace. I
am beginning to wonder, though, if the dollars will ever stop
flowing out. |
