Monthly Archives: December 2008

O’Shaughnessy: History Tells Us Now Is The Time to Buy

Jim O’Shaughnessy, Chairman and CEO of O’Shaughnessy Asset Management, believes that equity valuations “present buying opportunities akin to 1974 and 1982.” He writes that investors need to ignore short-term volatility and market-bottom calling, and instead focus on where stocks will be three to five years from now.

O’Shaughnessy offers a number of historical stats that put the recent decline, volatility and opportunity in context. One is that “there have only been 66 days that the Dow closed +/- 6% (total return) from the previous close. Eight of those days (12%) have come since September 29th of this year.” Second, according to “JP Morgan, the value of short-term cash holdings in the U.S. now exceeds the market cap of the S&P 500”. Third, the yield on short-term Treasuries recently went negative as investors flocked to less-risky assets.

But the “the pervasive fear and uncertainty have left stocks extremely cheap for the long-term investor” says O’Shaughnessy. He says that 153 stocks in the S&P 500 are now trading below book value, that the normalized P/E ratio for the S&P hit 10.4 on Nov. 20th (this level was among the 10% of the lowest observations in 52 years), and that long-term mean reversion would indicate that now is an excellent time to be a long-term equity investor.

Leveraging his knowledge on systematic long-term investing and stock market history, O’Shaughnessy shows that by selecting stocks using specific fundamental variables (low P/S, high buyback yield, and strong momentum), specific investment strategies can outperform the overall market coming off bear market and recessionary environments. He writes, “in the five-year period following recessions, the cheapest decile of stocks in our All Stocks universe outperforms the most expensive decile by an average of 13.96% annually!”

Hulbert: Current Crisis is “Textbook Illustration” of Liquidity Shock

In his regular New York Times column, Mark Hulbert looks at the stock market’s behavior since the credit crisis began and references a 2001 academic study to glean some insight as to what we can learn from these types of periods. He writes, “you can view the markets’ behavior since mid-2007 as a textbook illustration of a statistical pattern uncovered years ago by two finance professors, Lubos Pastor of the University of Chicago and Robert F. Stambaugh of the Wharton School of the University of Pennsylvania. They found that the financial markets are always vulnerable to what they called a liquidity shock — a sudden tightening of credit.”

According to Lasse Pedersen, a finance professor at New York University, this research can help us understand what has happened in the last 18 months. It also provides some clues for what could happen in the future. For example, Hulbert writes that “the research has found that when liquidity shocks occur, they are so intense that the securities most vulnerable to them predictably provide higher longer-term returns. This happens, Professor Pastor said in an interview, because these securities must compensate investors for the risk of big losses during those shocks.”

“According to the research,” Hulbert adds, “once a liquidity crisis passes, other factors come to the fore, and securities that have risen in price, like Treasury bonds, are then likely to perform poorly. By contrast, the best performers will be those securities that have lost the most during past credit crises — not just during the current one. Convertible bonds and junk bonds are two obvious categories that should do particularly well, but others, including stocks, should also benefit.”

Cash-to-Stock Market Ratio has Leuthold Group Bullish on Stocks

The amount of cash, bank deposits, and money-market funds ($8.85 trillion) is equal to 74 percent of the market value of U.S. companies, according to this Bloomberg article. The cash-to-stock market value ratio is the highest it’s been since 1990, according to Federal Reserve data compiled by Leuthold Group and Bloomberg. This huge cash hoard has made some professionals, including Eric Bjorgen of the Leuthold Group, more positive about equities. “There is a store of cash out there that is able to take the market higher,” said Bjorgen. “The same dollar you had last year buys you twice as much S&P 500 as it did a year ago.” In its December 2008 investor bulletin, the Leuthold Group wrote how stocks are offering investors “one of the great buying opportunities of your lifetime.”

According to Bloomberg, “Cash holdings peaked one month before equities began to recover during the two longest recessions since World War II. In July 1982, money of zero maturity as a percentage of the U.S. stock market’s value rose to 95 percent before a 20-month bear market ended and the S&P 500 began a six-month, 36 percent advance, data compiled by Bloomberg show. In September 1974, cash on hand reached $604.5 billion, representing a record 1.21 times U.S. stock capitalization. That preceded a 31 percent gain in equities between October 1974 and March 1975, Bloomberg data show.”

Neil Hennessy, president of Hennessy Advisors, says that “once the money starts to come back into the market, buying is going to beget more buying. People don’t want to be left behind.”

Gross: More Gloom — and “Enormous” Opportunities

Pimco founder Bill Gross lays out some ugly economic predictions in the latest issue of Forbes, but also offers a tip for how investors can profit from the U.S. financial woes: by buying preferred shares and senior debt of financial companies benefiting from the government’s bailout spending spree. In the past year, writes Forbes’ Bernard Condon, Gross has bought $100 billion worth of such investments. Gross thinks the government will want to ensure that it gets paid back the money it has given to these financial firms, and thus will keep doing — and spending — whatever it takes to turn them around.

In the meantime, Gross says preferred securities are the bargain of a lifetime. “It’s the most incredible value I’ve ever seen,” the long-time manager says, adding. “This is the Super Bowl for money managers. The opportunities are just enormous.”

One firm in particular Gross has focused on is AIG. Writes Condon: “There is no chance, Gross says, that the U.S. will let AIG walk away without paying [the $200 billion it has received from the government] back. So he’s picked up 5.3% of AIG subsidiary International Lease Finance and 4% of its American General unit at yields of 17% and 39.9%, respectively. ‘We’re buying $10 million and $20 million a day,’ Gross says. ‘It’s being spit out by deleveraging hedge funds.'”

Bargains in preferreds are the good news. The bad news is that Gross sees a lot more economic pain coming. He thinks Americans will “shift from risk to thrift for at least a generation,” writes Condon, adding that Gross sees lower profit margins and stock gains that “slow to a crawl”. Gross also says investors may use stocks as yield vehicles rather than growth instruments, as was the case in the 1930s and 1940s. Stocks will return 6% or 7% a year, “‘if we’re lucky”, he predicts.

Values Abound in Small-Caps

In this week’s Validea Hot List newsletter, John Reese says that his Guru Strategy computer models are finding an array of values among small-cap stocks, particularly among those that would be considered small-cap growth firms. Reese’s Hot List portfolio added eight new stocks on his regularly scheduled rebalancing, all but one of which are in the small-cap growth category — one of the market’s most beaten-down areas of late.

For 2008, Reese notes, small-cap growth has been the second-worst performer among the nine size/style categories, according to Morningstar. Small-cap growth funds have lost almost 45 percent on average, with only mid-cap growth (-46.4 percent) faring worse. And during the past three wild months, small-cap growth has been the single worst of the style box categories, having lost an average of more than 33 percent.

But two factors have Reese excited about small-cap growth right now. First, that area of the market is getting a lot of interest from his guru-based computer models, with many of the Hot List stocks getting approval from three or even four strategies. Second, small-cap stocks have shown a tendency to produce impressive bounce-back gains coming off of bad periods. Says Reese, “Kiplinger’s Anne Kates-Smith noted last week that ‘stocks of small companies, particularly those growing at a good clip, historically have had the edge at the dawn of new bull markets, and many people think there’s a good case building for the little guys in 2009’. Since the Great Depression, Kates-Smith says, small-cap stocks have gained an average of more than 50 percent in the first year of bull markets.”

In addition, Reese says, small-cap stocks have also gained an average of 44 percent in years when the economy was flat or contracted up to two percentage points, according to Kates-Smith, who adds that P/E ratios on small- and mid-cap stocks are at their lowest levels in almost 20 years.

And in the end, that point about valuations is key, Reese says. “While we don’t know for sure whether small caps as a group will lead the next bull market, what we do know is that the stocks in the Hot List are all selling at tremendous valuations,” he writes, noting that the small-cap stocks in the Hot List are selling at very low price/earnings, price/earnings/growth, and price/sales ratios, even after a year of being in a recessionary climate. “Those are the kind of numbers that make these stocks incredibly attractive to disciplined investors over the long haul, and they make me quite optimistic about the Hot List moving forward,” Reese says.

They Saw The Trouble Coming — And Some See More Ahead

Kiplinger’s takes a look this week at nine people who “called it right” in predicting the credit crisis and market collapse, and asks what they see coming for the year ahead. Some — like Jeremy Grantham, Robert Rodriguez, and Nouriel Roubini — are people whose opinions we’ve detailed in past posts, but here’s a look at the predictions (most of which have to do with the economy, not the stock market) for some of the others:

  • Peter Schiff, president Euro Pacific Capital: Dollar will keep falling, leading to a resurgence in commodities. “That will pierce the bubble in the bond market, causing interest rates to go up. So we’re going to be in a depressionary environment, but with rising prices and rising interest rates. Our economy will be a mess for years and years to come.”
  • Meredith Whitney, Oppenheimer & Co. analyst: “We believe we are now entering a new era in the financial landscape that will be characterized by expanded forced consumer deleveraging, with a pronounced downshift in consumer spending ” Regarding credit card industry, she believes well over $2 trillion of lines of credit will be pulled over next 18 month.
  • David Tice, Federated Investors’ chief equity strategist for bear markets: Sees continued dollar decline, and “very possible” inflation increase. “The S&P 500 index could easily fall to 450 or so. This will be a longer-term decline — you’ll see fits and starts and significant rallies, which will be selling opportunities. But it’s likely going to take four to five to ten years. Investors should be selling equities and conserving cash.” Says gold represents “phenomenal” opportunity right now.
  • Robert Shiller, Yale University professor: Says current situation has many similarities to Great Depression. “The Great Depression was a self-fulfilling prophecy — there was no reason for it other than that people were getting worried, and right now everyone’s worried about what bad times we’re in. We do have better monetary policy and a government that’s clearer on its fiscal policy, so I’m hopeful. Ben Bernanke claims he can stop deflation. Bernanke will be tested.”
  • Mark Kiesel, PIMCO portfolio manager: “The consumer went through a 20-year leveraging-up period. Now we’re going through the Great Unwind, and that takes time.” Recession will probably last until the second half of 2009, “but even as we come out, it won’t feel good. This will be an extended period of subpar growth. Credit is the blood that flows through the patient, and the patient has had a heart attack.” Too soon to buy stocks and too soon to buy a house, he says. “It won’t be time to buy until the credit markets have healed.”

Arnott Sees Huge Opportunities in Bonds

Add Robert Arnott to the list of well-known previously bearish investment managers who are seeing value in the market. “I like investments, if I’m getting paid to bear risk,” Arnott tells Brian Milner of Canada’s Globe and Mail. “And right now, this is one permabear who is strongly bullish on a wide array of markets.” Among those areas are a number of bond markets, including investment-grade and high-yield corporates; emerging-market debt, and inflation-protected government bonds.

Arnott also says that, apart from the most beaten-up sectors, the equity market is “broadly priced to reflect an expectation of recession. The bond market is priced for a Great Depression.” He likes deep value stocks, but says bonds are more attractive, and that could hurt stocks. “The ability of equities to recover handily is compromised, because there are better opportunities out there,” he says.

For example, investment-grade corporate bonds are now yielding about six percentage points more than comparable U.S. Treasuries, and five points more than the stocks of those same companies, Milner writes. That, he says, means stocks can only beat bonds if they show earnings and dividend growth better than 5 percent.

High-yield bonds, meanwhile, trade 20 points above Treasuries and 18 points above the stocks of the same companies, while emerging-market debt is yielding 10 percentage points above U.S. Treasuries, Milner writes.

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