Fourth Quarter Earnings Will Be Horrible, But We Already Know That

Aluminum giant Alcoa (AA) kicks off fourth quarter earnings season after the closing bell today and there is little doubt that they will be the first in a series of profit reports over the next few weeks that will be absolutely brutal. Fortunately, most investors already know that, so the market's reaction is unlikely to mirror the dramatic sell-off we saw in October and November. The fourth quarter could prove to be the weakest quarter of the entire recession in terms of GDP growth (a 5 or 6 percent decline is both possible and probable), which would imply that corporate profits have no chance of exceeding expectations this quarter.

The key, however, is not what the numbers are but rather how the market reacts to them. With sentiment so negative on the earnings front, there will be instances where stocks actually do not drop, or even rise slightly after poor profit reports are announced. Since the stock market is forward looking, a company reporting a lousy number, if no worse than expected, will actually bring smiles to investors' eyes because it alleviates the concern that things could be even worse than many believe they are.

How the market reacts during this earnings season will be very telling for the near-term dynamics of Wall Street. If numbers come in weak as expected, but not a lot worse than the already low expectations, technical analysts will be quick to point that out as a positive sign. This would be a key signal that the market has reached a short term bottom. Such action would tell me that the market is truly looking ahead to possible economic stimulus and other actions that could help make the fourth quarter the worst quarterly GDP reading we ultimately see.

Conversely, a poor market reaction to these profit reports could mean a retest of the November lows. The market has done pretty well in recent weeks as it looks ahead to an Obama administration, but its patience will certainly be tested over the next couple of weeks. Personally, I think we will see a modestly negative reaction over the short-term, only because we have already seen a decent level of bargain hunting prior to earnings season.

Full Disclosure: No position in Alcoa at the time of writing, but positions may change at any time

No, It Is Not A Bull Market

I have heard it twice on CNBC already this morning, and the market has not even opened yet. For some reason people are claiming that since the market is up more than 20% from its lows that we have entered a new bull market. This idea that any rise of at least 20% constitutes a bull market is just plain silly. If a stock falls from $10 to $1 and rebounds to $1.20 it's a new bull market? Oh, please! Sorry folks, but there is no bull market in stocks, or oil, or anything else that has been crushed in recent months but has recouped a small portion of the losses.

Lesson from the Bernie Madoff Ponzi Scheme

As more and more news comes out about Bernie Madoff and how he managed to defraud many very smart people out of billions of dollars, it is useful to ask a simple question; what should we learn from what happened? From my perch the answer is very basic.

The few people who avoided Madoff's funds did so due to doubts over the highly suspicious consistent returns he claimed (many concluded he could not produce such steady profits from the strategies he claimed to be using). They avoided disaster because they lacked information and without knowledge of what their money was invested in, they were not comfortable investing with Madoff.

The others were not as fortunate, but it begs the question, does it make sense for anyone to invest money with a money manager if they are forbidden from knowing where the money is invested? I don't think so. I know I certainly could never look one of my clients in the eye and ask them to stop receiving account statements so their holdings could be secret. Trusting someone, as Madoff's investors have learned the hard way, is not a good enough reason to put a blindfold on and hand someone millions of dollars.

Now, many hedge funds will argue that disclosing their holdings strips them of their "edge" since many people will simply mimic top managers' trades and thereby reduce returns for the people coming up with the ideas. To curb this concern it is certainly reasonable to allow a slight delay in the reporting of actual holdings to ensure that a hedge fund manager can establish a full position before disclosing it to the public. You could also have investors sign a contract saying they will not act on or alert anyone to the nature of the fund's investments.

Regardless, if you are investing in any fund that does not adequately disclose where your money is allocated, I would strongly consider ceasing such an investment. It sounds obvious to many, but given what has transpired recently, it warrants mention.

Financial, Retail Weakness Mask Underlying Core Profitability

Simply judging from the stock market's performance over the last couple of months, you might think the entire U.S. economy is teetering on the brink of disaster. In reality though, the sheer ugliness of the financial services and retail sectors is masking the other eight sectors of the market that, while certainly weaker than they once were, are actually holding up okay given the economic backdrop. The easiest way to illustrate this is to show earnings by sector for the last three years; 2006, 2007, and 2008. Keep in mind the 2008 are estimates based on nine months of actual reported profits and estimates of fourth quarter numbers.

As you can see from this graph, earnings in areas like telecom, healthcare, staples, or utilities are doing just fine and can withstand further weakness in 2009 and still more than justify some of the share price declines we have seen in recent months.

The selling has been indiscriminate but the business fundamentals are quite differentiated, depending on sector, which is one of the reasons that the U.S. equity market has not been this cheap relative to earnings, interest rates, and inflation since the early 1980's. It is a gift for long term investors.

Remember, Markets Rebound Before Economic Data Improves

As we head into 2009, the economic backdrop looks gloomy. Two important measures in particular, employment and corporate earnings, are set to deteriorate further throughout next year. The unemployment rate has risen from 4.4% to 6.5%, but many are now predicting a peak of 8%-9% sometime in 2009. Corporate earnings will fall for the second straight year in 2008, but many top-down forecasters expect a third year of declines. Does that mean stock prices have a lot further to fall still? Not necessarily.

Remember, the stock market is a discounting mechanism. It reflects future events ahead of time, as the 50% decline over the last year or so reflects. At some point, stock prices reach levels where they already are reflecting the assumptions of continued weakness in unemployment and corporate earnings. Bill Hester, of Hussman Funds, helps to shed light on this concept. He writes:

"The four-week moving average of the jobless claims data breached 500,000, which has happened only 4 other times. It occurred in December of 1974, in April of 1980, in November of 1981, and in March of 1991. During the 12-month period following these periods, the S&P rose 32 percent, 30 percent, 20 percent, and 9 percent, respectively. These periods also shared attractive valuation. Over the four periods the price-to-peak earnings ratio averaged 8.75, which is about right where the market's current valuation is. Although it's a small sample, low valuation, coupled with economic data confirming a substantial contraction in the labor market, has offered longer-term investors very strong average returns.

Those returns aren't restricted to bull markets that follow the worst recessions. Returns following all of the recession-induced bear markets have been quite strong. First-year returns following a recession have averaged 37 percent with surprisingly little variation. Not including the out-sized gains following the 1982 bottom, all of these first-year bull markets gained between 29 and 44 percent."

Even if we assume, as the market has already begun to grasp, that both employment and earnings don't trough until mid or late 2009, we should not assume that the market will not hit bottom until those numbers stabilize or improve. Examining market history shows that the market rebounds before the economic data signal the recession has ended. As always, the market is a discounting mechanism.

Now, I don't know if the economy will bottom in early 2009, mid 2009, late 2009, or during 2009 at all. As a long term investor, I don't find it very helpful to try and guess between outcomes that are only a quarter or two away from each other. Even Nouriel Roubini, the biggest proponent around of a doomsday economic scenario, thinks the recession will end by the end of 2009. Even if you believe in his forecast, the market would start a new bull market in Q3 or Q4 of 2009 (3-6 months before the recession ends, as history suggests). If he is proved a bit pessimistic, it could be even sooner than that. As a result, long term investors should be buying, not selling at this point. Equity market valuations are too low to make the case that the market has not yet discounted most of the bad news we are likely to get in coming quarters.

When Markets Are Oversold, Not Much Needed For 500 Point Rallies

Today is a perfect example of why I do not recommend that long term investors, regardless of how afraid they are right now, sell their stocks into oversold equity markets to minimize short term pain. When sentiment is so negative, the mere nomination of a new Treasury Secretary can result in a 500 point Dow rally within hours.

All of this announcement did was lift some uncertainty from the market, but traders hate uncertainty. Does it matter that Geithner was one of the two or three people most talked about for this job? Not at all. All that matters is that now we know who it will be.

Now, does this mean we won't be down 500 points on Monday? Of course not. The point is, when markets are down so much and have priced in so much negative information, it does not take much to get a massive rally. Imagine what would happen if economic data begins to improve sometime next year?

Unless you are psychic it is very difficult to get out of the market and get back in time to catch most of the rebound. With electronic trading and instant dissemination of information these days, the market can move a couple thousand points in a matter of days (which nowadays is a 20-30% move). The odds are against you being able to get back in fast enough, which is why I don't even try.

So Far, Technical Support Levels Holding Up Well

During crazy market times like this I can talk my head off about fundamental issues that show the market is undervalued, but fundamentals don't matter right now. Stock prices are claims on future corporate profits forever? Who cares, earnings are going to be terrible in 2008, 2009, and maybe even 2010. Rather than trying to convince people (correctly) that earnings this year or next really don't have a material impact on a company's long term equity value, let's focus on what does seem to be working right now... technical analysis!

Long time readers of this blog know I don't use technical analysis because for a long term investor, charts don't tell us what stocks will do, earnings and valuations will. Still, technicals do work quite often in the short term because thousands of people are looking at the same thing and acting in the same way. Today was no exception, as the 10-yer S&P 500 chart below shows.

The 2002 closing low for the index was 776. Today we sank at the open, hit 776 and bounced significantly (818 as I write this). The long-term 2002 support level has held, which is crucial for the short term market environment. I might not care where the market trades today, next week, or next month, but a lot of people do.

Analyzing Stock Valuations During Recessions

Now that third quarter earnings reports have largely been released, I thought I would write a bit about valuing stocks during a recession. Having seen all of the numbers and listened to all of the conference calls, I am beginning the process of going through my client accounts and making adjustments, if necessary, based on what information has come out during earnings season.

Drastic business model shifts are rare, so this analysis largely involves looking at management's execution of a company's particular strategy (are they doing what an investor would expect) coupled with valuation analysis (what price is the market assigning to the business and what assumptions are embedded in those assumptions).

Valuation analysis is a bit trickier during a recession because earnings are at depressed levels. The key is to understand that a stock price is supposed to equate to the present value of expected future cash flows in perpetuity. As a result, corporate profits for any given single year are not always indicative of value, meaning that valuations using earnings during a recession will likely underestimate a company's fair market value and vice versa during boom times.

A lot of people these days remain negative on stocks, despite the recent crash in prices, because they are assigning a low multiple to depressed earnings and are concluding that stocks aren't very cheap, when in fact, they have not been this cheap since the early 1980's. For instance, many expect earnings for the S&P 500 to dip to $60 in 2009. Market bears will assign a "bear market" P/E of 10 to those earnings and insist the S&P 500 should be at 600 (versus 865 today). More aggressive projections might use a P/E of 15 (the historical average) and conclude that the market is about fairly valued right now (15 x 60 = 900).

The problem with this analysis, of course, is that it assumes the economy is normally in a recession and a $60 earnings target for the S&P 500 is a reasonable and sustainable estimate for the future. In fact, it represents a trough level of earnings, which is not very helpful in determining the present value of all future cash flows a firm will generate, unless of course the economy never expands again.

Consider an entrepreneur who sells winter coats, gloves, and hats in an area that has normal seasonal weather patterns. If this person wanted to sell their business and a potential buyer offered a price based on the company's profits during the month of June (rather than the entire year as a whole), the offer price would be absurdly low.

Because of that, you will often hear the term "normalized" earnings power. In other words, when valuing a stock investors should focus on what the company might earn in normal times, rather than at the extremes.

Take Goldman Sachs (GS) for example. Wall Street expects GS to earn $0.28 per share in the current quarter, whereas in the same quarter last year they earned $7.01 per share. Just as one should not use a $7 per quarter run rate to determine fair value for GS (the stars were aligned perfectly for them last year), one should also not use a $0.28 per share run rate either, because today represents close to the worst of times for the company's business.

Investors need to value stocks using a reasonable estimate of normalized earnings power and apply a reasonable multiple to those earnings. With cyclical stocks, oftentimes you will see share prices trading at elevated P/E multiples during the down leg of the cycle because earnings are temporarily depressed. Investors are willing to pay a higher price for each dollar of earnings (as shown by high P/E's) because they don't expect earnings to remain at trough levels longer term.

One of the reasons stocks are so cheap today in historical terms is because many firms are trading at single digit P/E multiples based on recessionary profit levels. Buying trough earnings streams for trough valuations has always been a winning investment strategy throughout history, which is why so many long time bears are finally stepping up and starting to buy stocks again.

Take a very recent purchase of mine, Abercrombie & Fitch (ANF), as an example. The stock is trading at $16, down from $84. ANF typically trades for between 10 and 15 times earnings. They earned $5.20 per share last year but profits are expected to drop to $3.30 this year and to below $3 in 2009. The 2007 level of profitability is not what I would consider a "normalized" number, but earnings could drop 50% from the peak by 2009 (to $2.60) and that would not be normalized either.

The great thing about today's market for long term value investors is that we can buy a company like ANF for only 6 times earnings, even after taking their 2007 profits and slicing that number by 50% to account for the recession! When the economy recovers, isn't ANF going to earn more than $2.60 per share and trade at more than 6 times earnings? If one believes that, then ANF is a steal (as is any other stock that is trading at a similar price) as long as one is willing to be a long term investor and wait out the full economic cycle.

Full Disclosure: Peridot was long shares of ANF at the time of writing, but positions may change any time

"Buy & Hold" Is Dead? I Think Not.

I find it rather amusing that six weeks of a horrendous market can lead so many people to declare that a "buy and hold" investment strategy is no longer viable. The evidence for such a claim is quite unimpressive, in my view. They assert that people who invested in the broad U.S. equity ten years have lost money so far, so "buy and hold" doesn't work.

Seriously? Yes, if you made a lump sum index fund investment in November 1998, waited a decade, never invested another penny, and sold today, you would have lost money over that time. "You would have made more by putting your money in the bank!" True again, but none of these arguments are very convincing. Let me explain why.

The stock market in the late 1990's traded at the highest valuation ever recorded. That was not a good time to invest in the market with only a lump sum. Conversely, today stocks are trading at the lowest relative valuation since the early 1980's. Those who use the last decade as evidence that "buy and hold" does not work anymore are simply telling us that buying high and selling low is a losing strategy. We already know that.

How many investors invested a lump sum in the late 1990's, never added to their investment, and sold recently? I don't doubt that some people did that (because they traded on emotion, not analysis) but to conclude that those few instances prove that a long term passive investment strategy is a bad idea is nonsense.

One way to avoid buying high and selling low is by dollar cost averaging into the market by adding to one's investments over time. 401(k) investors contribute a certain percentage of their income to their plans in equal (typically bi-weekly) amounts. Other investors try to max out an IRA every year to ensure they are always adding to their investments in order to build wealth faster over time. For people who follow those investment principles, even if they choose an index fund rather than active portfolio management, the fact that the market trades lower today than it did in November 1998 is irrelevant.

People are misguided if they believe they will always get rich by investing a lump sum of money in the market, regardless of price, by not following the investment or adding to it over time. Just because some investors have learned that lesson the hard way, it certainly does not mean we should proclaim that "buy and hold" is dead.

One final point. Unlike ten years ago, stocks today are quite cheap on a historical basis. As a result, I would be willing to bet that ten years from now the market will be meaningfully higher than it is today. Ironically, naysayers are out there advising people against doing just that.

With Share Prices Depressed, Dividend Yields Highest Since 1994

During the last couple of decades dividends have not really been a core focus for investors. That has been partly due to the fact that companies have been paying them out at historically low rates. Did you know that over the very long term dividends have represented about 40% of an investor's total return in the equity market? With the average large cap dividend rate below 2% for much of the last decade or two, many investors probably were not aware of that.

With stock prices down so much in the last year, dividend yields are creeping back up. The indicated rate on the S&P 500 today is about 2.8%, the highest since 1994 when the index was paying out 2.9%. We are still below the historical average for payouts (about 4%) but the trend is in the right direction.

I bring this up because as contrarian value investors add fresh funds to their portfolios and hunt for bargains in this market, dividends could very well play a bigger role than they have in recent years. Getting paid to wait for stock prices and the economy to recover (by collecting meaningful dividend payments along the way) is another way for investors to capitalize on the value in this market.

During the most recent bull markets, a yield of 3% was considered pretty darn good, but now investors can find much better payouts and do not always have to sacrifice the quality of company they invest in to secure above-average dividend yields. As you search for value during this bear market, keep in mind that dividends can significantly boost total equity market returns and such yields are getting easier to find nowadays.