Different Year, Same Old Story

It was postulated here earlier in the year that 2005 could very well turn out a lot like 1994, the last time the Fed went on autopilot and raised interest rates consistently for an extended period of time. The result was a flat-to-down market that ended up a mere 1% for the year (only after a substantial rally late in the year). As some of us expected, 2005 has indeed played out the markets tend to do when the Fed is increasing the cost of money.

To see exactly how similar it has been I decided to construct a year-to-date chart of the S&P 500 and compare it to the same nine-month period in 1994. Below you will find both charts, 1994 first, followed by 2005.

2005.jpg

More Northwest Craziness

This is a first for me; an analyst upgrades a stock to sell.

Standard & Poor's Equity Research upgraded Northwest Airlines to "sell" from "strong sell" but cut the price target. "With the shares off sharply today amid market talk about possible bankruptcy, we think the current share price more adequately discounts the risks of bankruptcy we foresee," S&P Equity Research said. Investors should sell shares of Northwest, "which we do believe is likely to file for bankruptcy, but our upgrade reflects possibilities for the share price," the research firm said. S&P Equity Research said shares could see upside if Northwest denied bankruptcy talk, reached agreement with striking mechanics, or if there are further oil price declines or "meaningful progress" with other unions. The firm cut Northwest's 12-month target price to $1.50, from $3.

So, let me get this straight. They think NWAC will go bankrupt, and their 12-month price target is $1.50 per share? Has a bankrupt airline ever given equity holders anything when they come out? And what is the difference between a sell and a strong sell? Do you use a market order if you want to sell strongly, versus a limit order if you just want to sell?

What Kinds of Market Returns Should We Expect?

You hear a lot about the "Fed Model" when discussions break out about valuing equities versus bonds. Larry Kudlow loves talking about this strategy on CNBC to back up his never-ending bullish stance on stocks. The model, simply speaking, compares the earnings yield on the stock market to the 10-year treasury bond yield.

If the S&P 500 trades at a 20 P/E, it's earnings yield is 5% (100/20). Since this compares favorably with the 4% treasury yield, Kudlow will argue that stocks are more attractive than bonds, and therefore should be bought. The thinking goes that if both investments were fairly valued, relative to each other, then their yields would be equal.

However, there is a problem with this so-called model. The equity market and the bond market hardly ever "yield" the same amount. As a result, any model that aims to make them equal is inherently flawed. If stocks and bonds were supposed to be relatively equal in value, it would make sense to base investment decisions on any discrepency, such as 4% versus 5% yields. If such discrepencies are extremely common, there is little reason to conclude they signal relative attractiveness or unattractiveness.

Let's show some evidence to further conclude that the Fed Model shouldn't be used as a powerful investment tool. When bond yields are historically low, as they are today, the Fed Model would predict a high level of attractivenness for equities as an investment class. After all, the lower the yield on bonds, the more likely stock earnings yields would surpass them.

Below you will see various ranges for the 10-year Treasury bond yield since 1965, along with the actual total return that the S&P 500 achieved over the following 10-year period. As you can see, low bond yields have not resulted in attractive stock price returns. In fact, one can argue the exact opposite.

10-Year Bond Yield -----Subsequent S&P 500 returns
--------- 0-5% --------------------- 4.3%
--------- 5-6%---------------------- 5.5%
--------- 6-7% -------------------- 10.5%
--------- 7-8% -------------------- 13.2%
--------- 8-9% -------------------- 16.7%
--------- 9-10% ------------------- 17.5%

Wall Street Research Still Screams "Buy"

Ever since New York AG Eliot Spitzer began his crusade to separate Wall Street's research and investment banking divisions, investors have been told equity recommendations would become more valuable. No longer would most stocks be slapped with "buy" ratings (or the ridiculous 1999 favorite "strong buy" rating). Whereas a "sell" rating in the 1990's could get an analyst fired, now such calls would become more common.

Well, you can throw all of that out the window. A.G. Edwards (AGE), a mid-sized investment bank, isn't even known for its relatively small investment banking division, so one would think their research would be more "valuable" than some competitors. However, a glance at their current ratings distribution is quite disturbing.

AG's research analyst team covers 689 companies. Of these, 70, or about 10% percent, have hired the company as an investment banker in the last 12 months. Astonishingly, only 17 of the 689 stocks covered had "sell" ratings as of August 8th. That's only 2 percent! The natural follow-up question would be, "How many of those 17 negative recommendations are also one of the 70 investment banking clients?" The answer is "not a single one."

The Buyouts Mount

After Washington Mutual's (WM) purchase of Providian and Bank of America's (BAC) recent buy of MBNA, it was widely expected that smaller credit card issuer Metris (MXT) would eventually get a similar takeover bid. In fact, readers of this blog were alerted to the potential of Metris even before those deals were announced.

Below is an excerpt from our post "Metris Continues its Turnaround" posted in December 2004:

"With some analysts still bearish on the company's future, combined with a staggering 24% of the float sold short, there are many reasons to think that Metris shares will continue their march higher in 2005. Contrary to popular belief, it's not too late to get in, even at the current $11 price tag."

Today's $15 per share cash bid by HSBC closes the book on the Metris story. Fortunately though, there are still excellent values in the financial services area, making reallocation of that capital a very opportunistic redeployment. Investors who want to stay in the credit card space should turn their attention to long-time Peridot favorite Capital One Financial (COF).

An Interesting Take on Conference Calls

I've written here before that if I were running a public company I wouldn't give quarterly financial guidance, but MicroStrategy (MSTR) is taking the focus on long-term business management even further (see below). Could this be a red flag signaling poor financial results in the future that the company would like to avoid having to talk about? There is no way to know, but I would not jump to such a conclusion without other information to back up that assumption. There is no doubt some investors will see this as a negative and bet against the stock because of it, but with 30% short interest already, that seems like a risky bet to make.

From a MicroStrategy press release issued July 21st:

"MicroStrategy Incorporated (MSTR), a leading worldwide provider of business intelligence software, expects to issue a press release on July 28, 2005, to announce its financial results for the second quarter of 2005.

MicroStrategy has recently reviewed its practice of holding a conference call to discuss its quarterly financial results. The Company believes that it is in the best interests of its shareholders to focus on long-term financial performance, which allows the management team to more effectively run operations and build long-term shareholder value. Accordingly, consistent with our decision at the beginning of this year to discontinue providing revenue or earnings guidance, the Company has also decided that it will no longer hold conference calls following the release of its quarterly financial results."

Side note: MicroStrategy's Q1 conference call from April 28th is quite entertaining, and might shed some light as to why that call was the last quarterly call the company hosted. Feel free to draw your own opinions and share them with me, as I think it's an interesting topic of discussion.

Goodbye Takeovers, Hello Takeunders

Rewind the clock back to March 2000. Do you remember BroadVision (BVSN), that high-flying e-commerce software company that traded at a split-adjusted $840 a share? Maybe you even owned the stock back then. Well, let's hope you don't own it anymore.

In one of the worst examples ever seen of acting in the interest of shareholders, BroadVision agreed Tuesday to be acquired by a private equity firm for 84 cents per share. Nevermind that is 99.9 percent below the stock's all-time high. It's 36 percent below the $1.32 the stock was trading at on Monday!