Alternatives to Buy and Hold for Income Investors

In previous articles, I have detailed some sample portfolios that can be used in conjunction with a tactical asset allocation moving average strategy. For many readers who are nearing or in the early stages of retirement, however, the sample portfolios may not reflect their risk tolerance or desired allocation. This article lays out one example of a dividend focused ETF portfolio with a 40% allocation to bonds. There are numerous other considerations and alternatives in constructing a retirement portfolio (taxes, cash allocation, CD laddering, tax-free investments, age, etc.), but for those looking for a sample of a income generating investment portfolio, the chart below can serve as a starting point. Combined with a moving average strategy presented by professionals such as Mebane Faber, Tom Lydon, and others, an investor with a lower risk tolerance can use a more conservation asset allocation model to further increase risk-adjusted returns.

As if market participants needed a further reminder about the limits of relying exclusively on diversification for risk management, summed up 2008 by reminding us that ‘diversification works…until it doesn’t’. Most retirees or near-retirees cannot afford to see a 40-50% reduction in the equity portion of their portfolio, which for many of these investors still accounts (or accounted) for 40-60% of their holdings. Due to the power of compounding, that 50% loss requires a 100% gain to make back lost money. Capital preservation is critical for investors who need to rely on their capital to generate a montly paycheck. Given the choice between losing 40% in one year on an investment yielding 5% or allocating that money for a year to risk free cash yielding 1-2%, every investor would choose the latter.

What is a conservative, or any, investor to do? One option is to follow a tactical asset allocation model. If one had followed a simple tactical asset allocation model in 2008, the portion of one’s portfolio slated for equities would have been transitioned to cash early in the year as the major indexes fell below most long term moving averages and thus precious capital would have been preserved. Yield is critical for retirees to generate income, but even more critical and that which one cannot lose sight in the search for income is the need to avoid substantial drawdowns in capital due to significant market fluctations. A tactical asset allocation model is designed to do just that – avoid the major declines of bear markets and catch the majority, albeit not the entirety, of a bull market.

A simple ETF portfolio with an income focus could look like following. If one was using the 200-day EMA to determine buy/sell signals and updating positions on a monthly basis, the positions highlighted in bold would be long positions. The allocations dedicated to the non-bold postions would be in cash. As you can see below, it would be a relatively boring portfolio today with only 4 long positions out of a possible 19. Then again, a portfolio constructed along a moving average strategy would have had a positive return for 2008.

US Equities – 20%
Symbol Allocation Current Yield Description
PBP 5.00% 2.66% Buy-Write
VIG 5.00% 3.09% Dividend Achievers
DES 5.00% 8.93% Small Cap
VYM 5.00% 5.73% High Yield
Foreign Equities – 20%
Symbol Allocation Current Yield Description
PID 5.00% 8.83% Dividend Achievers
DWM 5.00% 5.80% DEFA
DLS 5.00% 7.12% Small Cap
DEM 5.00% 6.74% Emerging Markets
Fixed Income – 40%
Symbol Allocation Current Yield Description
IEF 10.00% 3.89% 7-10 yr Treasury
TIP 10.00% 5.89% US TIPS
LQD 10.00% 5.82% Corporate
BWX 5.00% 3.26% Int’l Bond
WIP 5.00% 3.18% Int’l TIPS
REITS – 10%
Symbol Allocation Current Yield Description
VNQ 5.00% 12.55% US REITS
WPS 5.00% 6.03% World REIT
Commodities/Alt Investments – 10%
Symbol Allocation Current Yield Description
DBC 2.50% 0 Commodity
LSC* 2.50% 0 Commodity-Momentum
DBV 2.50% 0.29% Currency Harvest
DBP 2.50%
Precious Metals

For further research and links to other resources, please visit my previous articles here and here as well as those I have cited in my articles. Also, Mebane Faber has a new book available discussing this very strategy, I have not read it yet but I think it would be well worth your time to check it out.

*Claymore plans a momentum based commodities ETF according to As I’ve previously written, LSC (or RYMFX) was used as a suggestion for a portion of commodity allocation due to its low correlation to equity markets and commodity markets. The downfall with LSC, however, was that it was an ETN and thus there is an element of credit risk. For those worried about the credit risk of ETNs but were intrigued by LSC, the new Claymore ETF could serve as a viable alternative.

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Weekend Readings: Mauldin, Kotok

From John Mauldin’s Investor Insight newsletter, a guest contribution by James Montier, Roadmap to Inflation and Sources of Cheap Insurance. The sources of cheap insurance include TIPS, Gold, dividend and inflation swaps, and Eurozone CDS’s that would hedge against a Euro breakup.
For those of us confused, PPIP explained by David Kotok of Cumberland: Head or Tails?
Mauldin’s Frontline Thoughts letter previews an upcoming article by Rob Arnott titled ‘Bonds: Why Bother?’ In it, he challenges the 5% risk premium normally assigned to equities (as quoted by Mauldin):

“My point in exploring this extended stock market history is to demonstrate that the widely accepted notion of a reliable 5% equity risk premium is a myth. Over this full 207-year span, the average stock market yield and the average bond yield have been nearly identical. The 2.5 percentage point difference in returns had two sources: inflation averaging 1.5 percent trimmed the real returns available on bonds, while real earnings and dividend growth averaging 1.0 percent boosted the real returns on stocks. Today, the yields are again nearly identical. Does that mean that we should expect history’s 2.5 percentage point excess return or the five percent premium that most investors expect?

Mauldin then states:

Let me be clear here. I am not saying you should put your portfolio in 20-year bonds, or that I even expect 20-year bonds to outperform stocks over the next 20 years. Far from it! The lesson here is to be very careful of geeks bearing charts and graphs (it will be a challenge for my Chinese translator to translate that pun!). Very often, they are designed with biases within them that may not even be apparent to the person who created them.

Professor and Nobel Laureate Paul Samuelson in late 1998 was quoted as saying, a bit sadly, “I have students of mine – PhDs – going around the country telling people it’s a sure thing to be 100% invested in equities, if only you will sit out the temporary declines. It makes me cringe.”

When someone tells you that stocks always beat bonds, or that stocks go up in the long run, they have not done their homework. At best, they are parroting bad research that makes their case, or they are simply trying to sell you something.

As I point out over and over, the long-run, 20-year returns you will get on your stock portfolios are VERY highly correlated with the valuations of the stock market at the time you invest. That is one reason why I contend that you can roughly time the stock market.

Valuations matter, as I wrote for many chapters in Bull’s Eye Investing, where I suggested in 2003 that we were in a long-term secular bear market and that stocks would be a difficult place to be in the coming decade, based on valuations. I looked foolish in 2006 and most of 2007. Pundits on TV talked about a new bull market. But valuations were at nosebleed levels. And now?

John Hussman on the Fed, Treasury, and Inflation

Another provoking weekly Market Comment from John Hussman. He is tepid on the markets as whole, viewing it ‘less favorably’ then when we saw similar levels last year and cautions us on inflation once safe-haven purchases of US Treasuries eases. As in previous weeks, he continues to blast the notion that bondholders of distressed financial companies should be bailed out and instead should share or shoulder the cost of a failed company. He proposes the following:

Make no mistake – we are selling off our future and the future of our children to prevent the bondholders of U.S. financial corporations from taking losses. We are using public funds to protect the bondholders of some of the most mismanaged companies in the history of capitalism, instead of allowing them to take losses that should have been their own. All our policy makers have done to date has been to squander public funds to protect the full interests of corporate bondholders. Even Bear Stearns’ bondholders can expect to get 100% of their money back, thanks to the generosity of Bernanke, Geithner and other bureaucrats eager to hand out the money of ordinary Americans.

Though I believe that the consequences (via credit default swaps and the like) are overstated of letting bondholders take a haircut, and will ultimately be no worse than having the public take the losses, the fact is that we don’t even need the bonds of major financial institutions to go into default. What we do need to do is offer those bondholders a choice:

1) The U.S. government takes receivership of the financial institution, changes the management, wipes out the stockholders and a chunk of the bondholders claims entirely, continues the operation of the institution in receivership, eventually reissues the company to private ownership, and leaves the bondholders with the residual. This is not “nationalization,” but receivership – a form of “pre-packaged bankruptcy” that protects the customers and allows the institution to continue to operate, followed by re-privatization. As I’ve previously noted, this would fully protect all of the customers and depositors at no probable expense to the public. Alternatively;

2) The bondholders voluntarily agree to move a portion of their claims lower down in the capital structure, swapping debt for equity (preferred or common), allowing the bank to have a larger cushion of Tier-1 capital, avoiding insolvency, and hopefully allowing the bank to recover by its own bootstraps, preferably assisted by debt restructuring on the borrower side (via property appreciation rights and the like). Similar debt/equity swaps would be an appropriate strategy toward failing U.S. automakers as well…

….As I’ve said before, the U.S. currently has a private debt to GDP ratio of about 3.5, which is nearly double the historical norm, at a time when the underlying collateral is being marked down easily by 20-30%. That implies total collateral losses of 70-100% of GDP; a figure that includes not only mortgage debt in the banking system, but consumer credit, corporate debt and so on. The holders are not just banks, but insurance companies, pension funds, foreign lenders, and others. Even so, there is no way to prevent huge, ongoing losses, because the cash flows off of these assets are not sufficient to service the debt. The only question is whether the bondholders appropriately bear those losses, or whether the public bears them inappropriately. A continued policy of protecting all of these bondholders would eventually require U.S. citizens to be put on the hook for something on the order of $10-14 trillion. We are nowhere near the end of this process.

We simply cannot make these bad investments whole unless we are willing to hand the next 10-20 years of U.S. private savings over to the bondholders who financed reckless lending. Those bondholders should, and ultimately must, take a portion of these losses, and debt obligations will have to be restructured. Wall Street has become a bunch of Tooter Turtles crying “Help, Mr. Wizard!” because it got so used to Greenspan bailing everybody out. But that constant attempt to avoid inevitable private market losses is what allowed this problem to become so noxious. It will continue to do so until we collectively scream loud enough for Congress to say on our behalf, “Enough.”

More on this topic (What's this?)
Anticipating The Rate Hike
Rising Interst Rates Historically A Positive For Equity Returns
Dividend Growth Stocks Protect Investors from Inflation
Read more on Inflation, Federal Reserve at Wikinvest

Mauldin on How to Solve the Housing Crisis

John Mauldin wrote a very provocative piece piggybacking on WSJ op-ed by Gary Shilling and Richard LeFrak. In an attempt to stem the decline in housing prices and soak up excess housing inventory, he proposes we give immigrants who come to American and purchase a home green cards. He is not necessarily suggesting an increase in immigration but rather that as a requirement for getting a green card foreigners be required to purchase a home if they want resident status.:

First, I am suggesting we transform the already existing legal immigrant flow, which is going to happen anyway, into a form which helps us solve a major crisis. I am not talking about adding another 1 million immigrants on top of the current legal inflow. Just change the nature of that inflow until the excess housing inventory is settled, and then we can go back to the current program, if that is what is wanted (more on that below).

Second, I am not suggesting we bring in or condone illegal immigrants. That is another issue altogether, for another debate at another time.

If we do nothing, unemployment is going to rise to at least 10%. That is certainly not good for the American worker. Home values are going to continue to fall. That is certainly not good for the American worker. The economy is likely to be stagnant for an extended period of time, which means job growth in a Muddle Through recovery will be slow and stagnant. That is not good for the American worker.

Hundreds of billions more of taxpayer dollars will have to go to banks to keep them solvent as falling home prices and increasing unemployment increase foreclosures. That is not good for the American worker and taxpayer.

And further, I am not talking about bringing 1 million foreigners to this country. I am talking about bringing 1 million future Americans, who want to work hard and live the American dream.

Readings for 3/21: Markman, Hussman, Sitka

Jon Markman on the stages of grief in the current financial crisis (note: we haven’t quite reached acceptance yet).

John Hussman expects
lower profit margins for some time but also projects long term returns on the S&P 500 in the range of 10%. He also continues to harp on the notion that the taxpayer should not be bailing out corporate bond holders:

…the defensive and structural (probably long-term) shift of consumers and businesses toward less borrowing and more saving, combined with aggressive competition to preserve market share, creates a situation where we can expect lower profit margins per unit of production for the foreseeable future.

In plain English, that means that backward-looking profits of recent years are not a good benchmark by which to gauge the valuation of U.S. stocks. Last October, my view was that the 600 level on the S&P 500 would represent deep undervaluation. Since then, however, it has become clear that we are observing a larger structural shift in the U.S. economy than seemed likely or necessary at that time. Presently, assigning a somewhat increased likelihood of normal profit margins in the future (rather than the elevated ones of recent years) results in a 10-20% lowering of future valuation benchmarks. Investors will do particular harm to themselves if they gauge valuations on the basis of the elevated profit margins that we observed in 2007...

On the basis of a wide variety of evidence, my own impression is that the S&P 500 is moderately undervalued, at about the level that is likely to produce total returns on the order of 10-12% annually over the coming decade. That is a reasonable rate of return, and could reasonably be considered as attractive relative to the returns likely from bonds of similar maturity. The difficulty, from my perspective, is that investors remain measurably averse to risk, even after last week’s “clearing rally.” To the extent that the current economic downturn is outside the norm, we should also be prepared to observe risk premiums and valuation extremes that are outside the norm. We will be attentive to improvements in market action that suggest a fresh, robust willingness of investors to accept risk. Presently, we don’t have that evidence.

Meanwhile, GMO’s most recent 7-year asset class return forecast is projecting an annual real return of 12.7% on US High quality stocks, 8.9% on US Small caps and Large caps, and 10.8% on emerging markets.


Sitka Pacific Capital thinks we may be close to a market bottom (within 12 months or so) and waiting for a valuation bottom on the S&P 500 may be ill-advised due to the influence inflation can have. An excerpt from their March monthly newsletter:

During the 1930’s, the valuation low was achieved solely by the decline in the price of stocks, which explains why prices and valuation bottomed at the same time. During the 1970’s, however, the valuation low in 1982 was achieved by a combination of stock price declines and inflation—which increased earnings. Even though stock prices bottomed in 1974 and rose thereafter, inflation drove earnings up even faster into the early 1980’s.

Because of inflation’s affect on the way stock valuations declined during the 1970’s and early 1980’s, the point at which stocks reached their lowest valuation was not the same point
that stocks reached their lowest price.

In both the 1930’s and the 1970’s, stocks lost roughly 90% of their value on an inflation adjusted basis. Our market today is well on its way to a similar target. When measured by the 10-year P/E stocks are still trading above historical lows near 8. However, stocks have already lost ~86% of their value against gold over the past 9 years. That should send a strong signal that we are much closer to the end of this valuation cycle than the beginning.

If inflation plays even a small part in bringing about the valuation low this time around, we may find that the best time to get back into the stock market is well before the low valuations everyone seems to be expecting. This bottom could happen very soon, or it might happen sometime within the next 12 months. Either way, we may be approaching a very good time to get into stocks.

More on this topic (What's this?)
Nearly 70% Of S&P 500 Stocks In Correction Or Bear Market Territory
S&P500 Getting Ready to Break
S&P Approaches Critical Tipping Point
Read more on S&P 500 (SPX) at Wikinvest

St Patrick’s Day Readings – Markman, Fleckenstein, Jubak, Shilling

From Bill Fleckenstein a proclamation that ‘I seriously doubt stocks have seen their final low.’ And this coming from a guy who recently closed up his short only hedge fund…

Jon Markman discusses the American consumer’s move away from brand name products to generic/low cost products and concludes:

As an investor, I’ll take one black coffee with a generic napkin in a plain paper box to go. I’ll stick with my view that stocks should still be avoided, as the economy will fall over the next nine months at least and share values will follow. But if you must own equities, stick with the companies like McDonald’s, Family Dollar, Amazon, Apple and Hershey that have shown the greatest agility in managing the most unpredictable part of the cycle, which is behind us. While they won’t rise the most coming out of the bottom — that’ll be the province of the most damaged stocks — they will be the least aggravating at the many twists and turns that still lie ahead.

Jim Jubak is bullish on ag stocks:

What we’re seeing is a mere pause in a trend that’s likely to run for decades. And moreover, it’s a pause that is likely to end this year. Food commodity stocks are about the only equities that I’m looking to buy “now-ish.” I’m not saying “now” because I don’t think the rally that began March 10 will hold. It’s a rally in a continuing bear market, and I’d rather buy into the next downward move rather than into this temporary upswing. But I’m definitely looking to buy food stocks in the next six months or so.

What do you want to buy in this sector? Monsanto and Potash would be my two picks in the sector among stocks that I don’t already own in the portfolio. (Jubak’s Picks already has positions in Deere and in fertilizer maker Yara International (YARIY, news, msgs). Other candidates are fertilizer maker Mosaic (MOS, news, msgs) and seed producer Syngenta (SYT, news, msgs). You can also invest in this sector by buying an exchange-traded fund that holds a portfolio of these food commodity stocks such as Market Vectors Agribusiness (MOO, news, msgs).

Gary Shilling provides a summary of where we’re headed from this excerpt from his Insights newsletter (compliments of John Mauldin). The article is long but worth the read and predicts deflation, an increase in the national savings rate, a long process of deleveraging, global protectionism, and slow economic growth:

In Sum

The deepening recession and spreading financial crisis is the beginning of the unwinding of about three decades of financial leverage and spending excesses. The process will probably take many years to complete as U.S. consumers mount a decade-long saving spree, the world’s financial institutions delever, commodity prices remain weak, government regulation intensifies and protectionism threatens, if not dominates. Sluggish economic growth and deflation are the likely results.

Discussing ‘The Bottom’

Despite CNBC’s exhilaration over the rally last week and rush to call ‘the bottom’, I remain skeptical that we’ve seen a market bottom; however, ultimately it doesn’t matter what I or anyone else thinks. I want to remain flexible enough to adjust to changing circumstances and the market’s trends will tell us where we are at. The previous few days I’ve read some interesting analysis of the market’s direction:

From Prieur de Plessis of Investment Postcards (emphasis added):

family:arial;font-size:85%;" >I will soon have the privilege to meet face-to-face with Richard Russell (Dow Theory Letters) again at the time of his Tribute Dinner in San Diego on April 4, when he will undoubtedly share his market wisdom. Meanwhile, he commented as follows yesterday: “So where are we now? Over the last few weeks the market has become drastically oversold – at the same time investors’ sentiment has grown progressively more bearish. Furthermore, since September 2008 we have experienced an amazing twenty-one 90% down-days, which may have exhausted the urge by big investors to sell.

family:arial;font-size:85%;" >“By the way, yesterday [Thursday] was a 90% up-day, the second of this week. This action strengthens the thesis that this advance has further to go.

family:arial;font-size:85%;" >“… are we now in a new-born bull market, or is this an upward correction in an oversold bear market? … on the basis of duration and values, I believe we are experiencing a significant upward correction in an ongoing bear market.

family:arial;font-size:85%;" >“How far might this rally carry? Every movement in the stock market, minor, secondary or primary, is eventually corrected. Upward corrections in bear markets tend to recoup one-third to two-thirds of the ground lost in the preceding down-leg. The bear market will do whatever it has to relieve its oversold condition and at the same time lure the greatest number of investors back into its folds.”

family:arial;font-size:85%;" >On the topic of rally “targets”, Adam Hewitson of prepared a few slides dealing specifically with key levels. Click here to access the presentation.

family:arial;font-size:85%;" >Not putting his faith in further upside potential, Bennet Sedacca (Atlantic Advisors) said on Friday: “We are taking profits after the recent 13% move in equities. The macro-economic view is just too negative for me. It never, ever hurts to take a profit. We are back to 0% equities.” Sedacca’s price target for the S&P 500 is in the 350-400 range, which is a decline of 47-54% from current levels. He sees the ultimate low only by October 2010.

family:arial;font-size:85%;" >Using rolling ten-year reported earnings, my research (based on Robert Shiller’s CAPE methodology) shows that the “normalized” price-earnings ratio of the S&P 500 Index is currently 12.6. This compares with a long-term average of just more than 15. Based on the historical PE/return patterns, this would imply average ten-year real returns off these levels in the order of 8% (see graph below). Although, at index level, this may not grab one as bargain basement returns, it certainly is starting to point to a broad area within which opportunities should arise for the judicious stock picker.


family:arial;font-size:85%;" >The debate on whether stock markets are witnessing A bottom or THE bottom will take a while longer to resolve. Taking one step at a time, it is quite conceivable that the rally may last until the release of potentially ugly earnings and guidance announcements in April, by when a clearer picture should emerge on whether the bottom has been reached or yet lower levels are in store.

family:arial;font-size:85%;" >For more discussion about the direction of stock markets, also see my recent posts “Stock markets: Relief rally or new bull?“, “Technical talk: S&P 500 up against resistance levels“, “Video-o-rama: Stock markets – turnaround time” and “Jeremy Grantham: Reinvesting when terrified“. (And do make a point of listening to Donald Coxe’s webcast of Friday, which can be accessed from the sidebar of the Investment Postcards site.)


Bob Bronson of Bronson Capital Markets Research sees a Supercycle bear market low still ahead (compliments of The Big Picture)


From Richard Shaw of QVM Group (compliments of Seeking Alpha), a fairly even handed summary of where we stand:


We find no fundamental and no charting basis for the S&P 500 to be charging up very high from here at this time, under the current economic conditions. See our article earlier today, “Winter Warming, More Snow to Come

As for clarity and visibility, Larry Summers (Harvard economist, former Treasury Secretary under Clinton, and head of Obama’s National Economic Council) said today “no one can know when the crisis will end”.

With a government policy dependent economy and stock market, we think that level of cautionary statement should probably cause investors with mature portfolios to wait for more “proof” that the situation will come under control, or to wait for a deeper discount in market prices, before taking more equity risk.

On the other hand, if you share Grantham’s concerns about becoming locked into a bear mindset, and if you have confidence in year-end projections in the 900+ range, and if you are emotionally and financially capable of being wrong, and if you can wait several years for a stock commitment to work out, then buying stocks today is not crazy — however, it’s not something we are ready to do with our own money just yet.

In a seprate article he also provides 13 reasons why we are in a bear market rally (as opposed to a bull market rally):

Why we think this is a bear market rally:

Given that this is Friday the 13th, citing 13 reasons that the bear will continue in spite of this rally seems appropriate.

1. Current P/E: the current 20+ P/E on trailing “as reported earnings” is too high for this set of negative sales, earnings and dividends growth conditions.

2. Forward P/E: the projected 2010 S&P 500 earnings by Standard and Poor’s at about $40 would only support 800 at best (20 P/E), and more likely would support 600 (15 P/E), assuming there was a general recovery under way — before that time, the current market should sell for less than 800, and perhaps less than 600.

3. Earnings: profits are still declining in the aggregate

4. Dividend Yield: banks and other companies continue to cut dividends, reducing stock appeal and putting total return in question until dividends stabilize and begin to grow (historically dividends generated about 1/3 of total return for the S&P 500)

5. Revenue: overall sales are down — declining sales, earnings and dividends are not reasons for bullish markets.

6. World GDP Growth: credible parties (Goldman Sachs, IMF, and noteworthy individuals, such as Nouriel Roubini, predict worsening global economies) — until forecasts for improvements within 12 months or less for the US or world economies become prevalent, the market is unlikely to “anticipate” with a sustainable trend reversal to a bull

7. Government Intervention: the US and global economies are currently highly government policy dependent, and while policies are becoming more clear, they are not all revealed, and there are suggestions more may be needed — the resulting uncertainty warrants low valuation until government policies to “save” and “stimulate” economies are no longer the centerpiece of investor hopes and earnings prospects

8. Real Estate: the US and global real estate asset deflation continues with waves of negative impact on household and institutional wealth — until property prices stabilize, or are believed to be about to stabilize, a new bull market will have difficulty gaining traction.

9. Other Bank Shoes to Drop: the major banks have not yet experienced likely future write-downs associated with non-mortgage asset types, such as credit cards and auto loans.

10. Auto Industry: the fate of GM, Chrysler and the entire supply chain is uncertain with unknown government involvement.

11. LBOs: private equity firms built on leverage, may not be able to continue to service and rollover the debt they used to make recent optimistic acquisitions — those debts could be a further burden on the financial sector.

12. Retirees and Pre-Retirees: the 55 and over crowd who control the largest portion of US private assets are not as likely to risk their life accumulations in stocks relative to bonds as they were in the boom times of the last couple of decades — that will delay the onset of a bull and subdue the extent of a bull when it occurs

13. Credit Availability: the credit and leverage availability that helped the US stock market recover from the 2002-2003 bottom is not available at this time to increase household expenditures and corporate capital investment — even the US government may be put on credit rationing by China, which today said it is “worried” about the credit quality of their US Treasury holdings, which has implications about their willingness to support the borrowing our “stimulus” programs require and assume to be available.


Finally, from John Mauldin’s newsletter Thoughts from the Frontline, an excerpt which seems to match Richard Shaw’s opinion (emphasis added):

So, I know a lot of you have stayed in the market the whole time it has been falling and are now wondering what to do. If you have a ten-year time horizon you probably can buy here and do OK. But I wouldn’t. I think this market is going to have more problems as we confront the real possibility that we will get some really poor earnings for the first and second quarters. The economy is simply weak, and that weakness is hitting more and more companies. From exporting companies to the big international firms, a global slowdown is hitting almost everyone. Even hospitals are being challenged. We could see a real bear market rally lure investors back in, just to crush their hopes this summer.

Markets go from high valuations to low valuations and back again over long periods of time. I believe that we have a long time to go in the current secular bear cycle. As I have written for years, this one began in 2000 and could last until the middle of the next decade. While we will see a “bottom” in stock prices at some point, maybe even this year, we have a long way to go to get to a really low P/E ratio.

Big secular bull markets happen when P/E ratios drop below 10 (and even lower). That acts just like winding a spring. When it is let loose, it explodes for a very long time. There is another bull market in front of us. I would rather be patient and rely on an absolute-return style of investing for now. If I miss the first part of this run, so be it. I see more risk than reward in this latest run-up.

March 11th: Hussman, Sedacca, Mauldin/Lewitt, Investment Postcards…

Of note in the articles below, while John Hussman and Bennet Sedacca are different stylistically, they both advocate in recent articles using metrics besides traditional earnings ratios to value the market (Hussman gives price to book and price to revenue as examples, Sedacca price/tangible book, price/tobin’s q, price/free cash flow). Also, John Mauldin gives us a sample of the HCM Market Letter by Michael Lewitt. A long read, but worth it. Excerpts at the bottom.

From Investment Postcards from Capetown, a good summary of where we currently stand in the market:

family:arial;font-size:85%;" >In short, the stock market still needs to do a considerable amount of work before evidence of a primary bear market low will be demonstrated. As a first step, the indices must clear their respective 50-day moving averages and the November 20 lows. (As mentioned before, the large deviations of the moving averages pointed to a massively oversold situation – almost like a spring that is stretched too far – and a measure of mean reversion was to be expected.)


family:arial;font-size:85%;" >It is possible that a rally may ensue and last until the release of potentially ugly earnings and guidance announcements in April. However, always remember the old adage: “bulls make money, bears make money, but trading against the primary trend makes for sleepless nights.”


From Investment Postcards, a rather depressing assessment of where the markets are headed by Bennet Sedacca (bold added):

family:arial;font-size:85%;" >family:arial;font-size:85%;" >This post is a guest contribution by Bennet Sedacca*, President of Atlantic Advisors Asset Management.

family:arial;font-size:85%;" >One of the misunderstood facts about bear markets is that they must be resolved in two distinct ways – TIME AND PRICE. History is full of examples of where markets should bottom based on a plethora of metrics. But when earnings estimates are nearly impossible to guess as the global economy spins out of control, we must revert to other measures that are far more tangible; price/tangible book value (note that I use tangible book value, which excludes those nearly worthless assets like goodwill), price/Tobin’s Q Ratio (Tobin’s Q is the replacement value of a particular company), and price/free cash flow.

family:arial;font-size:85%;" >While predicting future PRICES is a dangerous affair, it is even more difficult to grasp the other element of resolution – TIME, and how long it may take to reach the final destination at the bottom of the market.

family:arial;font-size:85%;" >My price targets over the past few years were for an initial stop of the S&P 500 at 750, then 600-650, then 500, then the eventual 450 level. Despite my expectations of miserable earnings and of global de-leveraging, I am sad to say that my ultimate targets may have actually been a bit too optimistic. My price target now for the S&P 500 is in the 350-400 range which is still a decline of 40-50% from current levels. My target in terms of time for the ultimate low for the S&P has been early to mid October 2010, which coincided with the typical October low in the second year of a Presidential Term.

family:arial;font-size:85%;" >As long-time readers may recall, I find the Presidential Cycle to be the strongest and most predictable cycle within the past century. A report out of Pepperdine University several years ago suggested that since 1952, if you had been invested in the S&P 500 from Day 1 of a Presidential Cycle until mid-October of year 2 of the term, a $1,000 investment would have turned into roughly $650, without even adjusting for inflation. If on the other hand you had invested from mid-October of year 2 of the Term and sold on the last day of the Presidential Term, your $1,000 would now be worth $71,000. Without a doubt, this is due to the relationship between stock prices, economic circumstances and Presidential Gallup Approval ratings which are amazingly synched.

family:arial;font-size:85%;" >Even if we are lucky enough to “guesstimate” the ultimate bear market bottom, this is only part of the equation. Making it through the bear market with the bulk of one’s capital intact is obviously Job #1. Buying at depressed levels, even within the confines of a secular or super bear market can be highly profitable.

family:arial;font-size:85%;" >Assuming we get the guesstimate even close to correct, we must then again guess just how long it will take before we start the next secular bull market. My guess is that it will take (holding my breath here) a period of 10-15 years from the secular bear market low, which I guess will be in 2010.

family:arial;font-size:85%;" >This decline has not been your garden variety bear market. Instead it has been a nasty, sometimes frightening, relentless move lower in equities, one that will be remembered for generations to come. Investing habits for many people will change for the remainder of their lives. Many will be forced to work well beyond their planned retirement age, sometimes at jobs they would not generally desire. The rebuilding of the banking, insurance, auto and other industries may take well over a decade as well.

family:arial;font-size:85%;" >There may be many cyclical markets lasting anywhere between 6 to 24 months along the way, market moves I fully intend to participate in. But my expectation as it regards the time to repair the economic problem is “Welcome to the Long and Winding Road”, or for me “When I’m Sixty Four” (I am currently 49).


For a more tempered analysis, I would recommend John Hussman’s Weekly Commentary. An excerpt from 3/9 (emphasis added):

As for the stock market as a whole, I continue to view the market as undervalued, but not deeply undervalued. So over the course of a 7-10 year holding period, I do expect passive buy-and-hold investors in the S&P 500 to achieve total returns somewhat above 10% annually. Shorter-term, however, investors may demand much higher prospective long-term returns in order to accept risk, and that’s a problem, because the only way to price stocks to deliver higher long-term returns is to drive prices lower.

While the stock market is extremely compressed, which invites the typical “fast, furious, prone-to-failure” rallies to clear this condition, my larger concern is that market action and credit spreads are demonstrating very little investor confidence, risk-tolerance or commitment to stocks. Value investors know that stocks have been much cheaper at the end of lesser crises, and traders are still sellers on advances. My impression is that only prices that allow no room for error (what Ben Graham used to call a “margin of safety”) will be sufficient to prompt robust, committed buying from value investors. This will be a fine thing for investors who keep their heads, are already defensive, and have the capacity to add to their investment exposure on price weakness, but other investors are likely to be shaken out of long-term investments at awful prices. This need not happen in one fell swoop, and we need not observe the “final lows” anytime soon. The problem is that even to get a sustainable “bear market rally,” somebody has to be convinced that stocks are desirable holdings for more than a quick bounce.

Probably the most important long-term risk to perceived valuations here is that the deleveraging pressure we’re observing is increasingly likely to cap future return-to-equity at a much lower level than was possible with extremely high levels of debt. This will make historical norms of price-to-book value and price-to-revenues increasingly relevant, while the recent history of peak-earnings (and perhaps even dividends) may be misleading because the recent peak in profit margins will be far more difficult to recover compared with past cycles. Again, I believe that stocks are undervalued, but not extremely so. Passive, long-term investors in the S&P 500 can reasonably expect average total returns moderately higher than 10% annually over the next say, 7-10 years, but there is a good chance that even these prospective returns are not high enough for value investors to make a firm stand.

The misguided policy response from Washington has focused almost exclusively on squandering public money and burdening our children with indebtedness in order to defend the bondholders of mismanaged financial institutions (blame Paulson and Geithner – I’ve got a lot of respect for our President, but he’s been sold a load of garbage by banking insiders). Meanwhile, I suspect that the little tapes in Bernanke’s head playing “we let the banks fail in the Great Depression” and “we let Lehman fail and look what happened” are so loud that he is making no distinction about the form of those failures. Simply letting an institution unravel is quite different from taking receivership, protecting the customers, keeping the institution intact, replacing management, properly taking the losses out of stockholder and bondholder capital, and issuing it back into private ownership at a later date. This is what it would mean for these banks to “fail.” Nobody is advocating an uncontrolled unraveling of major financial institutions or permanent nationalization as if we’ve suddenly become Venezuela.

The HCM Market Letter, written by Michael Lewitt, is a subscription service but John Mauldin was allowed to distribute a recent letter to his readers. It is a good read with thoughtful analysis. Some excerpts:

The Obama Administration is facing a near-impossible task trying to bail the U.S. economy out of the muck of years of ill-begotten economic policies. The biggest challenge facing policymakers is not short-term recovery, however. Eventually, stimulus is likely to arrest the forces of economic collapse and stabilize matters – at least temporarily. But the real problem is sowing the seeds of long-term, sustainable, organic economic growth. This is really the crux of the policy challenge. The United States in the midst of the worst economic downturn in 80 years as the result of a panoply of extremely poor economic policy choices. Economist Roger W. Garrison draws an important distinction between “healthy economic growth, which is saving-induced (and hence sustainable), and artificial booms, which are policy-induced (and hence unsustainable).”2 In other words, monetary policy that kept interest rates low for an extended period of time, tax policy that favored debt over equity, regulatory policy that allowed financial institutions to operate opaquely, and social policy that pushed home ownership regardless of affordability, all combined to create artificial economic demand that could only be financed with debt because the savings (i.e. equity) to purchase them did not exist.

Moreover, as more and more debt was created through financial engineering and policy prescription, the prices of these were bid up higher and higher. This led these products to become grossly inflated in value compared to any inherent economic worth they might possess. Once the bubble burst, their value dropped precipitously. Unfortunately, the face amount of the debt used to purchase these assets did not adjust downward at the same time. Assets that were purchased at inflated prices are now worth a fraction of what they were purchased for, leaving behind a serious dilemma for the owners of these assets and their creditors.

Following conventional economic thinking, the government believes that the solution lies in policies designed to reflate the value of these assets. The problem with this approach is that it is based on the incurrence of trillions of dollars of additional debt to create the demand needed to purchase these assets. Debt begetting more debt is a poor prescription for sustainable long-term economic growth. At best the government may be able to provide a short-term boost to the economy, but what the economy really needs is a solid, organic foundation for growth. Debt-financed government demand can’t be sustained indefinitely, which is why this policy is doomed to fail in the long run. The U.S. balance sheet is not a bottomless pit, although it is increasingly coming to resemble a Black Hole. At some point, the economy will have to generate sufficient tax revenue to pay for this government spending or the country will lose its AAA rating and ultimately become a troubled credit. Economic demand will ultimately have to become savings-driven or it will again collapse….

…A bear market rally is possible at any time. Investors should be aware that as the market moves lower, rallies have the potential to be extremely sharp since they are starting from compressed levels. Such rallies should be used to reduce overall equity exposure. That does not mean that equities should be abandoned totally. There are a number of stocks that are trading at well below book value (even taking into account the declining transfer value of their assets) that may be worth buying in the months ahead. The debt of these companies, which HCM is particularly active in, is even more compelling as an investment. But investors need to identify longer term changes in market behavior and the economic environment before becoming bullish again on stocks. Right now, there are no such signs, such as better employment, housing or GDP numbers, or tightening credit spreads, or improving market technicals. HCM is starting to sense that the forces of denial, as potent as they are, are starting to weaken. Accordingly, investors should structure their portfolios for further equity declines…

…HCM believes that after the stock market bottoms, it will drift along at a depressed level for an extended period of time. The American economy will experience less-than-trend growth for a similarly prolonged period of time. The economy will have to absorb trillions of dollars of bad debts and transition its resources away from speculative activities and toward new productive endeavors. The economy has to be completely retooled, and this process will not happen overnight, particularly because such a program must be directed by a highly inefficient democratic political system that is inefficient in reaching consensus about its goals and how to achieve them. Unfortunately, the deeper involvement of the government in the financial and other sectors of the economy is likely to stifle growth, innovation and creativity and further contribute to lower growth for years to come….

…The biggest problem with the budget – and with any budget, not just Mr. Obama’s – is that the government just wastes so much stinking money. The reason people find higher taxes abhorrent is not because they don’t want to help those less fortunate than themselves, or fund necessary government programs, but because they don’t want their money to be treated like Congress’s personal piggy bank. We would love to see the list of the $2 trillion of wasteful programs that Mr. Obama claimed his team has already identified for elimination. The amount of government waste is truly mindboggling, and Mr. Obama must insist on spending discipline if he is to have any chance to keep the budget deficit from exploding over the next four years.

Roubini: Further Lows Ahead, and John Mauldin: The Law of Unintended Consequences

From Nouriel Roubini and his RGE Monitor website:

What are the downside risks and the upside risks to these bearish predictions for US and global equities. On the downside we have argued here that there is at least a third probability of a L-shaped global near depression rather than the mere current severe U-shaped recession. If a near depression were to take hold globally a 40% to 50% further fall in US and global equities from current levels could not be ruled out. But in this L-shaped near depression the last thing one would have to worry about would be stock markets as more severe issues would have to be addressed (unemployment rates in the mid-double digits – 15% or above – and multi-year stagnation and deflation).

On the upside one could argue that the aggressive policy stimulus in the US and other countries will lead to a faster sustained economic and financial markets recovery that expected here. We have discussed why this “sustained” as opposed to “temporary in Q2-Q3” recovery is highly unlikely to take place. But the bullish argument for a non-bear market and early persistent recovery of global equities is based on a better than expected recovery of the US and global economy…

…Also the “6-9 months ahead forward looking stock market view” is not always borne in the data. During the last recession the economic bottomed out in November 2001 and GDP growth was robust in 2002 but the US stock markets kept on falling all the way through the first quarter of 2003. So not only the stock market were not “forward looking”: they actually lagged the economic recovery by 18 months rather than lead it by 6-9 months. A similar scenario could occur this time around: the real economy sort of exits the recession some time in 2010 but growth is so weak and anemic while deflationary forces keep an additional lid on pricing power of corporations and their profit margins that US equities may – like in 2002 – move sideways for most of 2010 – with a number of false starts of a real bull market – as economic recovery signals remain mixed.

Thus, most likely we can brace ourselves for new lows on US and global equities in the next 12 to 18 months. Eventually a more sustained recovery will occur once we are closer to clear signals that this ugly global U-shaped recession is not turning into a L-shaped near depression and that the global economic recovery is clear and sustained. Until then expect very volatile and choppy US and global equity markets with new lows reached in the next months and the year ahead.


size:100%;">From John Mauldin’s Frontline Thoughts newsletter, we get a great analysis of the contribution of the interrelationship between rating agencies, residential mortage backed securities, and mark to market accounting in our current economic crisis. A great overview for those looking to gain a basic understanding of some contributing factors to our crisis/recession/depression and what policies we can implement to better the situation. An excerpt (emphasis added):

Here’s the truth. That bond [a RMBS] should never have been rated AAA to begin with, and
it shouldn’t be rated CCC today. The ratings agencies took a perfectly fine corporate bond rating system and tried to bootleg it onto a security that has an entirely different set of circumstances. A corporate bond is a bond from one company or one obligor. An RMBS might have several thousand obligors. (An obligor is a person or entity that is obligated to pay back debt.)

It was very convenient for investment banks to get the rating agencies to use the corporate bond analogies, because that meant they did not have to explain a new system. Everyone knew what AAA meant, or AA or BBB. A bond buyer in Europe or at a pension fund simply looked at the rating and hit the buy button. Easy. No need for a lot of research. Make your purchases and go to lunch.

While I can’t go into specifics, I have looked into these bonds with some real interest. Let’s assume that you can actually buy an AAA tranche of an RMBS at $.60 on the dollar. That means that 80% of the mortgages would have to go into foreclosure and lose 50% before you would ever lose a penny.

There are AAA bonds selling at steep discounts that are composed of mortgages with 80% loan-to-value in 2005, a 7% interest rate, and 90+ percent performing loans. These loans are being called in as mortgagees take advantage of lower rates and refinance. And with Obama’s new proposed lower rates, even more of these loans will be refinanced. If you buy the loan at $.60 on the dollar, and it gets refinanced, you get an immediate capital gain of almost 50%! If it keeps on being paid, you get an effective rate of about 10%.

So, why wouldn’t there be a lot of institutions standing in line to buy such a dream investment? Because banks fear the danger that the security will get downgraded, just like the thousands of such instruments that have already been downgraded, and then their regulatory capital will be impaired. The technical banking term is that you would be screwed. So you don’t buy what would be a very good performing asset, because of the rules.

So, who can (and does!) buy? Hedge funds and private investors with liquidity. But these “vulture capitalists” (among whom are many of my friends) know that the sellers are operating from a position of weakness. And because there are not enough of them to buy the bonds on offer, the prices of these bonds are very low. Smart money managers are raising money to exploit these distressed sellers.

So, in effect, we are giving banks taxpayer money while forcing them to sell assets that might be worth $.95 cents on the dollar in a less-stressed world. We are shoveling money in the front door while it is being pushed out the back door to my friends at the hedge funds.

How much are we talking about? US banks and thrifts have $315 billion in AAA non-agency (Fannie and Freddie) bonds, insurance companies have $190 billion, broker dealers have $75 billion. Overseas investors have $160 billion. Banks have written down about $700 billion in assets. The majority of those losses have been mark-to-market write-downs and not actual losses. Yet taxpayers are in essence paying them to sell, because the rules say they have to raise capital.

Some simple rules changes would solve a lot of this problem. First, let’s recognize that the root of this particular problem is the ratings system. If an RMBS is likely to get $.95 of its capital, then it should be valued at some number below that, but don’t make them assign it 100% to their risk capital. That is like making the bank with the 1,000 home loans in its portfolio write off all of them because 18% are bad. In principle, there should be no difference.

Then, the Federal Reserve should call in the rating agencies and have a “come to Jesus” meeting. They are at the heart of the problem, and they need to fix it. They need to change their ratings system for packaged securities like RMBS’s.

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