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At 923 the S&P 500 is about 12 times the 2010 $74.10 forecast for the S&P 500 operating earnings by Standard and Poor’s, or the $74.48 forecast by “the Street” according to Thompson Reuters.  Barron’s reports a Capital IQ survey of six strategists’ forecast of $68.45 for 2010, making today’s 923 index price about 13.5 times 2010 operating earnings.

Actual S&P 500 operating earnings in 2007 and 2008 were $82.54 and $49.51.  That puts $74 at almost 90% of the 2007 earnings level — quite an amazing and surprising expected accomplishment given all we’ve been through.

S&P forecasts $55.61 operating earnings in 2009 for the S&P 500, while “the Street” forecasts $58.52.

There are more negative thoughts out there, however, such as Barclay’s Capital which sees $46 in 2010, which would put the S&P 500 at about 20 times operating earnings in 2010.

A multiple of 12 is attractive, while a multiple of 20 is not generally attractive, unless you can construct an argument for higher valuation based on low interest rates, but then you have to predict lower rates and interpret multiple years of lower rates as not an indication of terrible economic conditions.

You have to decide whether these numbers are realistic.  We’ve heard one strategist call them “wishful non-thinking”.  Robert Shiller refers to “spontaneous optimism” and “animal spirits”, neither of which sound similar to “rational analysis”.

Therein lies basic choices you must make.  Do you invest based on proven history (wait for the results) or on predictions made by others with methods, conflicts and biases not disclosed?  Do you invest on rationalized value or actual market price behavior?  Do you assume things have always worked out in the past and will again, or do you assume there are long-term structural changes in the economy that will create an adverse shift in the profits and growth curve thereby suppressing values and prices?

In terms of predictions made by others, here are the 2009 and 2010 percent changes in operating profits by sector for the S&P 500 from Standard and Poor’s analysts and from Thompson Reuters for “the Street”.

click images to enlarge

One of the difficulties using brief reports of earnings as are typically available in the financial press is that the numbers are disembodied.  They lack adequate historical context to be fully helpful.

Standard and Poor’s does a good job of providing context.  We have extracted data from a three of their reports and combine them in the following image.  While the format is different, all of the data is their data (except for some ratios based on their data that we calculated and show in blue).

The data is for the index and each of its ten sectors.

The table in the image shows past, present and projected operating earnings and “as reported” earnings, and P/E ratios based on the June 23 index price.  The data includes annual data and comparative data for Q1 for each year.  The percentage change between periods is also shown.

Large Image 1305 X 925 pix

One thing about the forecasts in particular bothers us.  The ratio of “as reported” to operating earnings is not good even in 2010 — much worse than in 2007.  If the index is still losing big, big bucks, the value of rising operating earnings is a little squishy.  Yes, it suggests good things someday, but when — and when are we supposed to take risks with our own capital betting that “one time losses” or “extraordinary losses” will stop offsetting operating profits?

Ratio of “as reported” to operating earnings:

• 2007: 75.6%
• 2008: 30.1%
• 2009: 51.5%
• 2010: 51.0%

Looking briefly beyond the large-cap universe of the S&P 500, let’s see what Standard and Poor’s has to say about the mid-cap S&P 400 and small-cap S&P 600.

S&P 400 Operating Earnings:

• 2007 $42.65
• 2008 $30.04
• 2009 $27.65
• 2010 $40.53 (13.68 forward P/E)

S&P 600 Operating Earnings:

• 2007 $18.99
• 2008 $10.22
• 2009 $10.18
• 2010 $17.46 (14.72 forward P/E)

Related ETFs: SPY, IVV, MDY, IJR

Disclosure: We may own any of these securities from time-to-time in managed accounts.

Richard Shaw
QVM Group LLC

The answer may depend on when you start the observation.

Two key asset classes are stocks and bonds. Let’s look at total stocks and sovereign bonds for each of the United States, the non-US developed markets, and the emerging markets to see how they are doing.

The sovereign bonds in the non-US developed markets are denominated in local currencies, while the emerging market sovereign bonds are denominated in US Dollars.

This daily chart beginning March 6, 2009 shows emerging market stocks and sovereign bonds handily outperforming their counterparts in the United States and the non-US developed markets.

click images to enlarge

On the other hand, this 1-year weekly chart shows emerging markets stocks and bonds still underperforming US market and just catching up to the non-US developed markets.

Prevailing thought is that emerging markets have a brighter growth and profits future than the US and other developed markets. Certainly if the recent the rates of change continue, emerging markets will be the stars, although they could be ahead of themselves. It may depend on how economically coupled or decoupled they are with respect to the developed markets. The data on that is mixed.

China, for example (according to the World Bank’s June report) had YTD year-over-year industrial production growth of positive 7.4%, but YTD year-over-year export volume growth of negative 22.7%. Either domestic Chinese consumption (about 1/3 of their economy versus about 2/3 of the US economy) rose tremendously, or China has experienced inventory build-up. If inventory and not sales has explained their production, that is unsustainable; and the related run up in copper and oil may be equally unsustainable.

Those short-term considerations aside, we are on the side that favors emerging markets for long-term gains – for those who can handle roller coaster rides.

Securities mentioned in this article: VTI, VEA, VWO, BND, BWX, EMB

Disclosure: We have owned all of these securities from time-to-time in managed accounts.

Richard Shaw
QVM Group LLC

We have said and wish to reiterate that you should buy makes good sense to own for fundamental reasons when it is going up and not when its goes down.

We think computers with their cold objectivity can help draw the line between up and down or flat.  As humans, we may tweak our own criteria to make sure that the securities we like are interpreted as we wish them to be, more than as they are in marginal situations.

What makes logical sense to us is to define your criteria of up and down, and then hand-off the task of deciding what is up and down to a machine that has no emotional attachment to the determinations.

Time frame is the biggest issue (1 year, 1 month, 1 week, 1 day, 1 minute, or 1 tick).  The indicator is the next issue (eyeball inspection, moving averages, moving average cross-overs, linear regression, or something else).

Here is a set of examples based on weeks and months, avoiding eyeballs, and using both moving averages and linear regression slopes (price only, not total return — dividends excluded).  It’s not meant to be definitive, just indicative of a computer-based approach you might consider for yourself.  All determinations were done by formula in the MetaStock software tool.  We made up the rules and MetaStock did the work.

We performed the test on 27 categories of assets that represent most of those found in individual investment portfolios.  Not all categories are in all portfolios, but the bulk of portfolios can be described by securities of the general type in this list.

click images to enlarge

In this exercise, we measured the direction (up or down) of the 200-day simple moving average and the 100-day moving average over the past 4 weeks and 2 weeks, and also the linear regression best fit trend line slope over the last 200 days and the last 100 days.

The data which is color coded as green for up, pink for down and yellow for flat, still begs the question as to up or down, but narrows the scope of the information that must be considered.

If this time frame and these measures make sense for your purposes, that’s all well and good — you can decide for yourself the net direction.  If not, it may point the way to an approach for your time frame and indicator choices using a rules-based and computer generated analysis.

Here are the charts for several of the securities studied so show how the indicators reduce the nearly infinitely varied price patterns into some semblance of order for interpretation — and we hope also showing how a machine and indicators can overcome the data overload and excessive subjectivity that the eyeball approach entails.

The gold line is the 200-day average.  The green line is the 100-day average.  The red line is the 200-day linear regression slope.  The blue line is the 100-day linear regression slope.

BND

TLT

TIP

BWX

GLD

UUP

VTI

VWO

FXI

Securities identified in this article: BND, MUB, IEF, TLT, LQD, VWEHX, BWX, EMB, VCVSX,PFF, VTI, VEA, VWO, VGK, EPP, EWL, FXI, IFN, EWZ, TIP, VNQ, DBC, GLD, USO, DBV, UUP.

Disclosure: we own most of these securities from time-to-time in managed accounts.

Richard Shaw
QVM Group LLC

June 25 (Bloomberg) – “Barack Obama may be the worst thing that ever happened to tax-exempt bonds …. “

We certainly agree and see more trouble for tax-exemption down the road.

Obama Chief of Staff, Emanuel said, “A crisis is a terrible thing to waste.”, and the administration is taking that advice by sponsoring and subsidizing the issuance of fully taxable municipal bonds — “Build America Bonds” (the camel’s nose under the tent).

Presidents since Franklin D. Roosevelt have tried to tax the interest payments from municipal bonds without success, but the debt crisis has provided Obama with a way.

Build America Bonds (we prefer “Obama Bonds”) pay 35% of the interest cost for fully taxable muni bonds.

Presumably the subsidy also improves the credit quality of the bonds by having a portion of the interest come from the US Treasury.

Example Bonds YTM Rate Comparison:

We based our credit quality argument on logic suggesting the federal payment stream to more secure than the state portion; and upon an unscientific study of two issues (a CA tax-exempt ‘34 GO yielding roughly 6%, and a CA taxable Build America ‘34 yielding roughly 7.5%).

Since the after-tax return on the Build America bond is lower than the after-tax return on the traditional tax-exempt bond, and the maturity dates are the same and both are state GO’s, we presume investors perceive lower credit risk on the Build America Bond (although the posted credit rating is the same for both at A2/A).

On the other hand, the lawyers for CA weren’t totally sanguine about the risks, because the terms of the bonds provide the state the right to call the bonds (presumably to replace with traditional bonds) if the federal funding is not provided in full.

Control Hook:

Because this government program is “temporary” (yeah right, a temporary government program that raises taxes), and because the current funding is limited, the government must selectively subsidize.

If the program is extended (read that made permanent), then rationing of a small program will grow into mandated use of a large program, with the federal government effectively deciding which state and local projects get funded at all.  It will go from selecting which projects to subsidize, to mandating federal funding and selecting which projects to permit to be bonded.

If you don’t believe that, then name a major federal funding program that doesn’t come with mandates.  Name a major federal funding program which doesn’t trap or addict states.

Tax Hook:

Bloomberg pointed out,

“Interest on state and local government bonds sold for public purposes has been exempt from federal levies since the Constitution was ratified and remained so after the 16th Amendment was approved in 1913 creating the federal income tax.  Presidents and lawmakers have tried to roll back the exemption for decades. Since the 1960s, Congress has passed legislation prohibiting use of public debt for racetracks, massage parlors, golf courses and other private purposes. The House Ways and Means Committee initially proposed subsidizing taxable municipal bonds in 1969. President Jimmy Carter and Bill Clinton also embraced the idea. … There were no hearings on Build America bonds before they debuted, so there was no opportunity to mount opposition…”

We suppose the lack of hearing on Build American Bonds is part of the transparency Obama promised and continues to promise.

Given the search for tax revenues, and the “share the pain” and tax the rich orientation of the current US legislative and executive branches, it has surely not gone unnoticed that 44% of the $72 billion of tax-exempt income in 2006 was claimed by households earning over $500,000 (the people in the general tax increase cross-hairs).

Eliminating the tax-exemption for those high income taxpayers would generate $30 billion of revenue.  That $30 billion would effectively have to be recycled as subsidy of taxable municipal bond issuance, but it would further governmental control of state and local governments, and further the redistribution of wealth.

There are opponents in Congress.  One notable voice is Barney Frank, chairman of the House Financial Services Committee.  He says there’s “zero chance” Congress would permit the municipal bond tax exemption to be eliminated.   Bloomberg noted that Barney has his most of his life savings in Massachusetts tax-exempt bonds.  We’d call that enlightened self-interest, as opposed to what Larry Summers called “unenlightened capitalists” when the first lien bond holders of Chrysler wanted their liquidation priority honored. We supposed Barney didn’t own any Chrysler bonds.

Adverse Investor Scenarios:

Here are some conceivable investor perspective scenarios adverse to municipal bond investment programs (not conceivable pre-AIG, pre-Chrysler, pre-GM, but conceivable now):

• Mandated Use of Taxable Munis: Federal government mandates state use of taxable municipals, resulting in lower supply of new tax-exempts to replace maturing tax-exempts, thereby phasing out tax-exempt investment opportunities (perhaps increasing the value of issued tax-exempts).

• AMT on Traditional Munis: The Alternate Minimum Tax is modified to phase out exemption for upper income tax payers.

• Prohibition of Bailout Money Use for Traditional Munis: As in the case of Chrysler and General Motors bailouts, where bondholders were royally shafted, muni bondholders may receive similar treatment in a California or other state bailout.  We can imagine the strings attached to a state budget bailout requiring 100% funding of any and all state obligations (and perhaps wish list projects) other than muni bond interest (or even principal) before any payments on tax-exempt muni bonds are made.

• Universal Muni-Tarp Jam-Down: To avoid adverse effects on states taking subsidy (let’s call it “muni-TARP”), as with the banks, there may be a jam-down so that states that don’t need the money have to take it any way.

The first action would limit reinvestment opportunities and probably generate a premium on issued bonds.

The second action would eliminate the scarcity premium on issued bonds.

The third action would  generate a discount on issued bonds, damage (perhaps collapse) the secondary market for traditional issues from states with “muni-TARP” funding, while putting a premium on issues from states that are not receiving “exceptional assistance” (as the term is used with bank TARP).

The fourth action would eliminate the premium for self-sufficient states, generated by the third action.

We own muni bonds for about ½ of our overall bond allocation, but are anxiously watching developments.  As Bill Gross, co-CEO of PIMCO, said in his recent missive, don’t turn your back on the government when it comes to your investments.

There’s not just future inflation to worry about with municipal bonds, but also possible vanishing tax-exempt reinvestment opportunity, and possible mandated contract rights violation.

Time Frame:

A year ago, we would not have considered these adverse scenarios to be a realistic risk, or have had the audacity to talk about them.  Now we do.  A few months ago, we would have said we do not believe any such changes, if ever, could be made in months.  Now we do.

Event Risk Fat Tail:

This nightmare story may never come true, but it might, and in terms of event risk, this would be a big fat tail for muni bonds — not a Black Swan, because it is on the radar screen — but off the charts in terms of historical events for municipal bonds.

Be Watchful!

Richard Shaw
QVM Group LLC

IRS Website Reference:

R-2009-33, April 3, 2009

“The American Recovery and Reinvestment Act of 2009 creates the new Build America Bond program, which authorizes state and local governments to issue Build America Bonds as taxable bonds in 2009 and 2010 to finance any capital expenditures for which they otherwise could issue tax-exempt governmental bonds. State and local governments receive a direct federal subsidy payment for a portion of their borrowing costs on Build America Bonds equal to 35 percent of the total coupon interest paid to investors.

This new program is intended to assist state and local governments in financing capital projects at lower borrowing costs and to stimulate the economy and create jobs. … Build America Bonds can be issued in 2009 and 2010. There is no volume limitation on the amount of eligible Build America Bonds that can be issued during this period”

IRS Notice 2009-26 “… provides guidance on Build America Bonds to enable state and local governments to begin using this program. This notice includes guidance on eligible types of projects and financings, initial implementation of the direct federal subsidy payment procedures, elections to use this program, and information reporting for this program.“

Actually, we don’t expect that to happen as a product phenomenon (although it may become a theme), but we do take note of the GDP growth ranking of Indonesia higher than Brazil and just behind China and India.  Indonesia is a very small market and its country funds have quite limited trading liquidity.  They have a long way to go to be in the same class as the BRICs for “investability”.

Country GDP Growth Outlooks:

The following table presents historical, estimated and forecasted GDP growth rates for selected countries reported by the World Bank and by the OECD in their June outlook reports.

click image to enlarge

Note that the developed economies are shrinking and not projected to approximate 2007 levels of growth until 2011.

The combined developing economies, excluding China and India, are shrinking and not expected to achieve 2007 levels of growth by 2011.

Among the BRICs, China and India are still growing, although at half the rate of 2007, and not expected to achieve 2007 GDP growth rates by 2011. Yet at half speed they will be growing more than 3 times as fast as the US in 2011.

Russia is shrinking more than Japan, the second worst in the batch reported by the World Bank in its “Global Development Finance” report in June 2009.  Growing its GDP at -7.5% now and expected only to achieve 3.0% growth by 2011, it is pulling up the rear — not much better than the developed economies in 2011.  Oil prices are a wild-card there, we would think.

The OECD in its June “OECD Economic Outlook” report has a less optimistic view of the 2010 US, European, Japanese and Indian economies, and a more optimistic view of GDP growth for China, Brazil, Turkey, Mexico and Russia.

Some relevant country and region funds are: SPY, VTI, IWV, BIK, EEM, VWO, IEV, VGK, EWJ, FXI, IFN, IF, EWZ, EZA, THD, TUR, EWW, RSX.

Richard Shaw
QVM Group LLC

[post-script: just noticed Trader Mark at Seeking Alpha reported last week that Morgan Stanley suggests adding Indonesia to BRIC to get BRICI.  Oh well, we tried to be original with our BICI comment, but are apparently late to the party]

Greater simplicity is most often the obvious need.  At the extreme of simplicity is the use of a handful of broad, passive index funds.

We frankly prefer an intermediate portfolio composition — less than complex, but more than simple — let’s call it “simplexity”.  However, for those seeking great simplicity in their portfolios, here are some very basic ideas.

A small group of funds could be used as a the core of a portfolio or as the entire portfolio (examples shown in the image above).

Once allocation weights are established for each broad asset category, if you have a large cash position,  you would step into the market for each category in stages based on the fundamental logic and/or market conditions applicable to each category.

To the extent that you wish now or later to have exposures that differ from the core funds, you could “tilt” the exposures by:

• Supplementation (such as by adding a China fund to increase that country’s overall weight in the emerging markets category, or by adding an investment grade corporate bond fund to increase the weight of that form of debt in the US taxable bonds category), or by

• Complementation (such as by adding an foreign currency denominated international Treasury fund to expand the fixed income exposure beyond US only bonds; or  by adding a commodity or real estate fund to expand into those categories).

There are all sorts of ways to supplement or complement core exposures with regional or country funds, sector or industry funds, market-cap and/or style funds, thematic funds, bond funds with different credit quality or duration, and other subclasses and categories; but selectivity is important to avoid recreating a complex mass of holdings, or inadvertently recreating a virtual broad index with many funds.

Tilting the few simple core positions remains an option when and if appropriate or desired to expose you to various risks/opportunities in a tactically targeted way.

Here are charts for seven of the funds identified in the image above as candidates for a simple portfolio:

Even if you don’t chose simplicity, or even “simplexity” for your portfolio, a simple portfolio concept may be useful as a benchmark against which to compare your actual results in yoru real portfolio.

Securities named or implied in this article: VT, ACWI, BND, AGG, VTI, IWV, VEU, MUB, VWITX, VEA, EFA, VWO, EEM, FXI, LQD, BWX, DBC, VNQ.

Richard Shaw
QVM Group LLC

Support, Resistance and Retracement:

The S&P 500 is approaching a potential support level at about 875 based on 20-day price channels.  If it pierces that level and stays there for a few days, a much larger downward move is probable.

click images to enlarge

An extended decline below 875 might likely go to the 805-810 area as a 1/2 retracement, or the 750-760 area as a 2/3 retracement, from the recent peak.

S&P 500 Internals:

Several internal dimensions of the S&P 500 also point downward at this time.

The percentage of the 500 constituent members with bullish Point & Figure charts has crossed the 75% level (at 59%) level in a downward move.  The ratio of new highs to new lows has crossed 25% (at 20%) in a downward move.  The percentage of constituents above their 50-day moving average crossed 50% (at 41%) in a downward move. The percentage of constituents above their 200-day average is approaching 50% (at 52%) in a downward move.

The trading volume in the index has declined ever since the price level exceeded about 800 in late March.

Primary Trend:

The 200-day simple moving average is still downward sloping.  The 200-day exponential moving average, while nearly flat, is still slightly downward sloping.

Linear Regression View:

Approaching the question of possible price ranges from a different perspective, linear regression best fit form various beginning points shows mostly possible price levels based on trend continuation.

The values for today that are implied by the linear regression best fit trend lines are:

• from Jan 1, 2008: 735
• from Sep 1, 2008: 787
• from Jan 1, 2009: 904
• from March 6, 2009: 960

Odds Cone Projection:

Taking a perhaps more balanced, not just downward view, a statistical probability approach based on prior volatility suggests theses price ranges to a 90% confidence level:

• 60 days forward based on 60 day history: 1020 to 784
• 60 days forward based on 40 day history: 1010 to 793
• 60 days forward based on 20 day history: 1003 to 700

Even though the odds approach is symmetrical up and down, we tend to put more faith in the lower ranges based on the the other decidedly negative factors discussed above.  If the market does go up, 1000 to 1020 may be the limit for the next 60 days.

We believe we are in a correction phase at this time.

Richard Shaw
QVM Group LLC

The charts below show the OHLC prices and two simple moving averages (middle panel), a percentage return comparison between the fund and the the US aggregate bond index (upper panel), and the share volume traded (lower panel).

click images to enlarge

1-Year Daily with 200-day and 100-day averages

3-Years Weekly with 40-week and 20-week averages

5-Years Monthly with 5-month and 10-month averages

China is more interesting as an equity investment for now.

There are concerns in the US that the rally may have gone too far too fast without adequate fundamental support (and may have already exhausted itself).

There are concerns in some quarters that China’s stock market may be even more ahead of itself, because of government stimulated production that is not matched by export growth, and perhaps not by internal consumption.

Both country funds are showing discomforting divergences with prices rising and volumes falling over recent weeks.  However, China has exhibited important trend oriented moving average cross-overs which may indicate a continuing ownership opportunity, tempered by the short-term risk that a retracement in the US stock market would drag most other country stock indexes down with it.

Richard Shaw
QVM Group LLC

click image to enlarge

This chart of S&P 500 rather readily suggests a range of around 750 to 1,000 for the S&P, and also a possible retracement level of about 800.  Those numbers are not too different from the range of forecasts put out by the big boys.

On the chart, the 750 and 1,000 levels could be seen as significant resistance and support levels, and 800 could be seen as a likely 50% retracement from the recent high to the March low.

Those same price levels correspond generally to the forecasts presented in terms of various multiples times “operating” and “as reported” earnings forecasts put out by the brand name investment managers.

Here are the institutional forecasts that we published in a recent article:

Institutional Estimates:

Goldman this week stated an expectation of 950 to 1050 for 2009

Marc Faber predicts a possible run up to 1000 to 1050 by July with a near-term retracement that will not go below 800.

Meryl Witmer thinks the market is just about right now. Archie McAllaster thinks the market is cheap at its current level.

Alan Abelson, editor of Barron’s, thinks the valuation is too high, and like Fred Hickey believes a selloff is in the offing, because the fundamentals don’t support the price level.

Deutche Bank predicts 1060 by year-end, while JP Morgan Chase is close to that predicting 1100 for 2009.

Morgan Stanley sees not much value above 825 to 850.

Barclay’s (older estimate from April 17) predicted 757 for 2009 year-end.

HSBC forecasts 900 for year-end 2009

Sidebar:

Talking fundamentals and technicals is like talking religion or politics.  It tends to enrage some people on both sides, and this article will undoubtedly generate a small number of strongly worded objections and condemnation.  However, we gotta say what we gotta say. We think fundamentals and technicals complement one another.  Each has strengths and each has weaknesses, and each has roles in a process. We use both.

You need to know what you want to buy, why you want to buy it, how much of it you should own (all fundamental matters), but then own it when its going up, and not own it when its going down (technical matters).

The fundamental and technical criteria and limits for each investor vary considerably, but our experience is that regardless of declared “religion” fundamental investors consult charts to some degree, and technical investors consult fundamental factors to some degree.  Few investors, if any, purely use only fundamental information without some amount of looking at charts, or purely use charts without some study of  market level or issue level fundamentals.

Our Prediction:

We are in the camp that says there we are more likely to see a retracement than a significant continuation of the rally (for both fundamental and technical reasons), and that if the rally continues it has less upside before a retracement than a retracement has downside.  Time will tell.

Richard Shaw
QVM Group LLC

The table below presents the ratio of the value of the the 200-day simple moving average now to its value 20 days (1 month) ago.  Values greater than 1.02 are shaded green for UP.  Values between 1.02 and 0.98 are shaded yellow for UPDN.  Values less than 0.98 are shaded pink for DN.

The table then presents the ratio of four moving averages (1-day [price], 25-days, 50-days, and 100-days) to the current 200-day average.  Values greater than 1.02 are shaded green for ABOVE.  Values between 1.02 and 0.98 are shaded yellow for NEARLY SAME.  Values less than 0.98 are shaded pink for BELOW.

click image to enlarge

Note: table data above are from MetaStock which tracks prices only, whereas charts below are from StockCharts which plots price adjusted for dividends.

Here are charts for the funds in the table:

Comments Based on Price Data (table data):

The primary trends for all of the categories are still in a downward movement.

Because of headlines, it is probably not surprising that China is closest by the measure used here to an upward trend, but it may be surprising that Japan is next closest to an upward trend.

Only China and Brazil of the categories studied have each of the four shorter moving averages above the 200-day average, with emerging markets overall nearly there, and with developed Asia excluding Japan next in position and not too far away.

Securities in table and charts: VTI, VEA, VWO, VGK, EPP, EWJ, FXI, IFN, EWZ.

Disclosure: we own some of the named funds in some managed accounts and may own any or all at various times.

Richard Shaw
QVM Group LLC

Before offering a prospect list in which you might find attractive ideas, we want to make it clear that diversification of sectors and individual securities is important; and that individual stocks involve more work to create and maintain in a portfolio than holding funds.  Generally, individual stock portfolios have higher risk due to concentration among a limited number of issues.  That higher risk could enable out-performance, but could also result lower performance than a diversified fund or index.

There are diversified equity income ETFs and mutual funds which should also be considered as alternatives to a portfolio of individual stocks.

We developed a filtered list of equity income prospects in two stages: (1) selection by Standard & Poor’s or Value Line for financial strength by their proprietary process (producing 595 stocks), then (2) subjection to the following criteria focusing on minimum yield and a history of dividend increases, sales growth and other criteria (resulting in a reduced list of 26 stocks):

The first stage filter by independent research firms reduces risk of insolvency, but says nothing about price volatility risk. The second filter by QVM assures that the selections have a higher yield than the S&P 500 index, and focuses on past behavior suggesting a good chance that the dividend yield will grow over time.

This table shows the 26 filter survivors along with certain information about them: sector, industry, yield, payout ratio, position within its 52-week price range, P/E ratio, 3-year sales and dividend growth, EV/EBITDA, and website address.

click image to enlarge (large: 1228 pix X 542 pix)

Average attributes of the list are:

• Yield 3.85%
• Payout Ratio: 48%
• 3-Yr Sales Growth 10.70%
• 3-Yr Dividend Growth 14.82%
• P/E Ratio 13.98
• EV/EBITDA 9.39
• Price in 52-Week Range 0.39

These are not recommendations for purchase, but are recommendations for further research if equity income through individual stocks is what you seek.

We own some of the stocks in this list in some managed portfolios.  Individual symbols are: IFF, WTR, GIS, K, AVP, FPL, NSC, AFL, PEP, VLO, ABT, ADP, CLS, JNJ, NJR, CVX, EMR, ENB, SYY, VFC, PAYX, HCBK, PPG, VVC, SO, SCG.

Richard Shaw
QVM Group LLC

This chart presents key data from Morningstar for 45 country and region funds, and color codes the data in comparison to the total US stock market as represented by VTI.

Attributes of funds that are more favorable than the same attribute for the total US market are shaded green.  Those less favorable are shaded pink, and those with an equal attribute value are shaded blue.

With respect to number of holdings and concentration of holdings, we acknowledge that there is opportunity to outperform a benchmark through a less diversified portfolio, however, for the purposes of this article greater diversification is deemed more favorable.  Readers seeking concentration would just need to reverse the color meaning for those two dimensions to get the information they want.

The full size file is large (1221 pix by 796 pix).

click image to enlarge

Some observations:

The funds in the list all have a higher expense ratios and fewer holdings than VTI (total US).  Some have much higher expenses and many fewer holdings.  It is important to understand that when you buy an index of a few dozen companies, you have more risk of a particular company driving results than if the portfolio has a few hundred (or even a few thousand) company holdings. Examples: FXI (China) and TRF (Russia and Eastern Europe) have only 27 holdings.

Similarly, funds with many holdings but large concentrations in a few holdings are driven more by single issue performance than funds without large concentrations. Examples: TKF (Turkey) has 83.89% of assets in the top ten holdings, and EWL (Switzerland) has 75.19% in the top ten holdings.

Most of the funds have higher 3-year total returns than the US, but also have higher 3-year standard deviation of return (volatility and range of returns).  Examples: US had a -7.4% return with 19.5% standard deviation, whereas FXI (China) and EWZ (Brazil) have approximately 19% returns and approximately 40% standard deviations.

Emerging markets of all sorts have dramatically outperformed the total US stock market year-to-date, as have some developed markets, such as EWA (Australia), EWO (Austria), EWK (Belgium), EWH (Hong Kong), EWS (Singapore), and EWD (Sweden).

On a trailing yield basis, there are greater opportunities than the total US market, but when year-to-date return is considered the list is shortened to these that have a higher trailing yield and a higher YTD return: VWO (emerging markets), EWZ (Brazil) EWM (Malaysia), EWW (Mexico), TRAMX (Middle-East & Africa — mostly GCC), EZA (South Africa), EWT (Taiwan), THD and TTF (Thailand), EWA (Australia), EWO (Austria), EWK (Belgium), EWH (Hong Kong), EWS (Singapore), EWD (Sweden) and EWU (United Kingdom).

If you want better 3-year returns as well, these countries drop off the list: EWO (Austria), EWK (Belgium) and EWU (United Kingdom).

If you seek lower volatility as well as higher yield and YTD return, the list goes to none — with opportunity comes risk.

Funds with substantially more favorable price-to-sales and price-to-cash flow ratios with at least moderately more favorable forward P/E estimates are: ISL (Israel), TRF (Russia & Eastern Europe) and TUR (Turkey). Toss in geopolitical risk issues and the list goes to none.

Staying on top of portfolio attributes such as these may be helpful to you as part (but not all) of the information you consider about choices for your portfolio.

Note also that data sources often provide different information about the same thing — sometimes errors, sometimes differences in data definition.  Checking more than one source and getting as close to primary sources as possible is important as you narrow your choices approaching a risk commitment decision.

Richard Shaw
QVM Group LLC

This article will attempt to back into some of the leading institutional projections using normalized earnings and historically experienced multiples.

Key Historical Index Price Levels:

The S&P stands now at 924. It had a low of 741 last November and 666 in March. The high in 2007 was approximately 1575. The low in 2002-2003 was approximately 770.

Institutional Estimates:

We cataloged a number of institutional forecasts in a recent article. The forecasts here come from that article plus a few newer ones. Estimate publication dates range from early May through now (issued within approximately a month).

Goldman this week stated an expectation of 950 to 1050 for 2009

Marc Faber predicts a possible run up to 1000 to 1050 by July with a near-term retracement that will not go below 800.

Meryl Witmer thinks the market is just about right now. Archie McAllaster thinks the market is cheap at its current level.

Alan Abelson, editor of Barron’s, thinks the valuation is too high, and like Fred Hickey believes a selloff is in the offing, because the fundamentals don’t support the price level.

Deutche Bank predicts 1060 by year-end, while JP Morgan Chase is close to that predicting 1100 for 2009.

Morgan Stanley sees not much value above 825 to 850.

Barclay’s (older estimate from April 17) predicted 757 for 2009 year-end.

HSBC forecasts 900 for year-end 2009

We recollect reading some noted analyst predicting 1200 to 1250, but can’t remember who. Let’s toss it is just to keep the range fairly wide.

Normalized Earnings.

Here is a table that presents S&P 500 “as reported” earnings (including 2009 projected “as reported” earnings from Standard and Poor’s) for 50 years (from 1960 through 2009), along with the year-end S&P 500 index price (current price shown for 2009).

Note: The earnings for 1988 - 2009 are definitely “as reported” and are obtained directly form S&P. The earnings from 1960 - 1987 are a best effort collection by Robert Schiller that may or may not be “as reported”, but probably are “as reported”. The older the data, the more likely to be “as reported”. Operating earnings are a more recent type of report used often to help managers ignore real losses that they don’t want to count. In theory, “non-operating” losses for individual companies are highly irregular and create noise in the data, and in theory operating earnings give a truer picture of going forward profitability of a company. However, in reality for an index there is a regular, low noise flow of “non-operating” losses that should be considered by index investors.

The earnings are normalized (averaged without inflation factor) for 4 years, 7 years and 10 years. The rationale for the periods is: 4 years as a presidential cycle, 10 years as a very long time, and 7 years as in between.

We end up with normalized earnings of $47 to $53 (2009 alone at about $29).

click images to enlarge

Historical P/E Ranges:

Based on the numbers in the table, we see an average P/E over the 50 years from 18.9 to 22.2 times “as reported” earnings for 4 to 10 year normalization, with a minimum ranging from 8.5 to 11.1, and a maximum ranging from 35.8 to 47.8.

We take the position that we are past the worst of the crisis for a while at least, and that we are far from being in a normal (average) situation. Therefore, it might be reasonable and justifiable to assign a multiple to the normalized earnings somewhere between the minimum and average values.

Without trying to split hairs over whether we are closer to bad or closer to average, if we simply use the mid-point between average and minimum multiples, we get 13.7 for the four-year normalization, 15.2 for the seven-year normalization and 16.6 for the ten-year normalization.

S&P Price Forecast With Normalization and Historical P/E:

The mechanical process we have just gone through yields predicted values of approximately 660 to 800 for the S&P as a “fair value” now.

A straight average valuation, which we feel is unjustified, would render fair value of 900 to 1075.

Normalization would tend to suggest that there is more downward logic than upward logic. Government spin on the economy, until today positive sentiment, plus nervous cash on the sidelines, may suggest more upside than downside.

In any event, we see roughly 590 to 880 as the most likely range into which the S&P 500 will move in the near future based on this method. That range is the 660 to 800 plus 10% overshoot on the high side and minus 10% overshoot on the low side.

Proxy SPY, with a 1/10th of index corresponding price range, would come out at about 59 to 88. The current price (June 15, 2009) is about 93.

Charting the Results:

This chart of the S&P 500 shows a plot of the index with two blue horizontal lines bounding the 660 to 800 “forecast”, and two red horizontal lines bounding a 10% error factor in each direction.

The result of this mechanical approach is similar to but more bearish than the forecast by Morgan Stanley and by Barclay’s, and much lower than the other institutional analysts cited above.

Do-Over With Operating Earnings:

If you do the same analysis, but using operating earnings, you get a more cherry result. That makes sense, because operating earnings don’t consider mistakes, errors in judgment, and unavoidable losses — all losses none-the-less. When you have 500 companies in an index, you can bet there will be some number, not always the same ones, who have non-operating losses each year.

Operating earnings have a 4-year to 10-year range from $60 to $66, while “as reported” earnings have a range of $47 to $53.

Note: Be careful when listening to and using earnings figures. You can get confused. We get confused when labeling and specification is absent or limited. Distinctions are important. Are they trailing or projected earnings? Are they “as reported” (all-in), or “operating” (selective loss exclusion)? Example of possible confusion in Barron’s this past weekend: In a panel discussion, Scott Black said, “Analysts expect it [S&P 500] to earn $54 this year. Strategists are using $43″ (he appeared to be talking about “as reported” earnings, but did not specify). Then Abbey Cohen said, “Goldman is forecasting S&P 500 earnings before provisions of $63 in 2009 and $71 in 2010″ (she did specify “before provisions”, meaning “operating” earnings).

The average multiples with “operating” earnings are lower, because the earnings are higher, but the index price is the same whether you use “as reported” or “operating” earnings.

Using the same logic (but ignoring “non-operating” losses), we see a range of fair value between about 860 and 960 (with 770 and 1060 as approximate boundaries with 10% overshoots on either side).

If investors follow “operating” earnings the market will go substantially higher than if they follow “as reported” earnings.

Cautionary Statement:

First, this is no more than one of many methods you might apply to attempt to gauge fair value. The real utility of valuation methods is to use several with different inputs to triangulate a figure. This is one of the methods. Consider several.

Because the markets are irrational short-term and rational long-term, wide variance from these estimates is entirely possible. Because so much is up in the air about US government intervention in the market process, the rules could be rewritten overnight which puts all forecasts into a cocked hat.

As an investor, you’ve got to try to read and lead the market, and chose when to play and when to stay; but you also have to protect and conserve assets when your play is wrong. We think protective stops on risk positions make sense in this uncertain financial environment.

Richard Shaw
QVM Group LLC

Disclosure: We own SPY in some managed accounts.

]]> http://www.qvmgroup.com/invest/archives/4770/feed http://www.qvmgroup.com/invest/archives/4747 http://www.qvmgroup.com/invest/archives/4747#comments Tue, 16 Jun 2009 01:51:37 +0000 RichardShaw http://www.qvmgroup.com/invest/?p=4747 Here is one super simplistic, maybe too simplistic, but certainly quick and dirty way to guess what might be a fair value of the S&P 500 index in the near future.

The following chart of 12-month trailing S&P 500 “as reported” earnings and year-end index prices provided by Standard and Poor’s shows that S&P projects $37.81 for 2010 “as reported” earnings for the index.

Looking back in history, we find that the last index price trough in the 2002-2003 period had “as reported” earnings that bracket the 2010 estimate.

The 2010 estimate is about mid-way between the 2002 and 2003 earnings, so it might be reasonable  to assume that the index level in 2010 might be mid-way between the 2002 and 2003 prices.  That would put the index in the high 900’s, near 1000, by year-end 2010.

The index is at about 924 on June 15, 2009.

There are earlier periods during the 1990’s that had earnings near $37 too, but they were in the midst of the dot.com boom which is an unrelated period of very high growth rate assumptions.

If you add one level of complexity based on the assumption of slower growth after 2010 versus after 2003, you might knock the valuation down a bit.

A 10% valuation haircut due to slower growth would put the index in the high 800’s, near 900, in 2010.

This angle on valuation is far from scientific, but is has some gut level kind of appeal.

If that’s reasonable, it doesn’t leave much room for gains from here.  The chart shows the 2003 and 2002 year-end prices from the table above (circled in red) and the possible price level derived with this super crude method (circled in blue).

click image to enlarge.

It’s tempting to discount this approach, because it offers no optimism and is seat of the pants only, but if earnings 18 months from now are 2/3 of what they were 18 months ago, and growth prospects are reduced, why wouldn’t a disappointingly low valuation be within the realm of reasonable probability?

The number one reason it might not be reasonable, is that the 2010 earnings estimate by S&P could be too low, but if it is not, then the index price prospects are not good.

The number two reason it might not be reasonable, is that earnings multiples may expand — low interest rates and all that.  Well, maybe, but the low rates are out of desperation, not normal cyclical pro-growth stimulation — and in our view the current federal administration’s policies are not pro-growth; and higher savings rates, higher tax rates, lower institutional leverage limits and tighter credit policies are not pro-growth.

We are very uncomfortable suggesting the possibility of such a dismal price future for the index, but we are not willing to totally disregard valuation perspectives, just because we don’t desire the outcome.

Richard Shaw
QVM Group LLC

Review Method:

We calculated the percentage of companies in several categories with rising primary trends using these criteria: the 200-day simple moving average must be greater than its value 20 days ago, 40 days ago and 60 days ago (roughly from the beginning of the rally).  Companies where the primary trend was rising before the rally began or for which the rally caused the primary trend to begin to rise would be counted by these criteria.

Here are the results:

• S&P 100: 1.0%
• S&P 500: 2.4%
• S&P 400: 9.5%
• S&P 600: 11.0%
• Nasdaq 100: 4.0%
• All US stocks: approximately 10%
• Highly rated companies for financial strength: 7.7%
• All dividend paying stocks with market-cap > $2.5 billion: 2.7%
• All non-dividend paying stocks with market-cap > $2.5 billion: 6.6%

Within the large cap category, consumer related and technology stocks accounted for virtually all of those with rising primary trends.  Within those rated highly for financial strength that were also in upward primary trends, just over 1/2 are financial companies, almost all of which are regional banks.

Conclusion:

Using the terms “high quality” and “low quality” seems too gross to us to describe leadership in terms of primary trend direction.  These more granular observations may be more illuminating:

1. Most US stocks are still in a primary downtrend
2. Non-dividend paying stocks have a larger fraction in upward trends that dividend paying stocks
3. Small-cap and medium-cap stocks are leading among those with rising primary trends
4. Among large-cap stocks, those highly rated for financial strength have a larger percentage in rising primary trends than large-cap stocks that are not highly rated for financial strength
5. The consumer related and technology stocks are in a more positive mode than other sectors.
6. Among those companies highly rated for financial strength that are also in upward primary trends, regional banks lead.

Financially Strong Companies:

We identified 522 companies rated as financially strong (in the “A” range) by either S&P or Value Line.  Of those, 40 (7.7%) have upward primary trends as we have defined that for this study (200-day average greater than one month ago, two months ago, and three months ago).

Here is a table of those 40 stocks, along with their yield, EV/EBITDA, 3-year sales growth, sector and industry (not recommendations, just data that may be useful for further research by those seeking financially conservative companies):

click image to enlarge

Richard Shaw
QVM Group LLC

Disclosure:  We do not own any companies mentioned in this article.

Much is being made of the fact that the key US equity indexes are near or slightly above their year-end 2008 level.  That is clearly better than not, but year-end 2008 was at a sorry level compared to year-end 2007.

These charts may help keep wider perspective.  They are three-year daily percentage performance charts that also show the 200-day simple moving average (a commonly used measure of the primary trend) and the year-end 2008 level.

The first thing you may notice is that exceeding year-end 2008 is far from where we once were both on the high and low side.   In most instances the primary trend is still down (only India shows a little curl up recently by its 200-day average).

The second thing you may notice is the superior performance of emerging markets versus the US, European and Japanese stock markets.  We included Singapore and Australia as key developed Asia markets, ex Japan.  They are also attractive, emerging market related countries that have outperformed the US, Europe and Japan YTD.

While the fact that emerging markets are ahead of developed markets this year is not sufficient to justify long-term over-weighting, it is certainly suggestive of the thesis.  More importantly, we subscribe to the Mohamed El-Erian / Mark Mobius / Jim Rogers concept that emerging markets are “where it’s at”, where it’s going and where it will be for a long time going forward.

Goldman Sachs makes similar projections about long-term GDP, where they expect emerging market economies to displace key developed markets in terms of their size rankings.  Specifically, they expect China to have a larger GDP than the US by 2027.

In our view, the massive changes in the structure of the US economy arising out of the recent credit crisis, the political opportunism that has followed, and the unprecedented US debt that has resulted will only accelerate and assure the relative out-performance of non-US markets over the long-term.

The US is in for a long workout period trying to overcome its new debt load, and find a new equilibrium for the dynamics of all the changes to rights and processes that have occurred and are expected to occur within the economy. Emerging markets will get less boost from US consumers, but they have created some internal consumer momentum of their own that can carry them forward while financially exhausted US consumers struggle and readjust.

We have been recommending for several years, that within whatever equity allocation you may have, if you are a long-term investor not currently or soon living through withdrawals from your portfolio, you should consider substantially over-weighting emerging markets and under-weighting developed markets.

We have no idea whether stock markets are likely to retrench from here, and if they do, emerging markets would probably fall harder as they have risen more.  However, over the long-term, we believe they will substantially outperform the US, Europe and Japan.

click images to enlarge

Richard Shaw
QVM Group LLC

From the thousands of companies available in the US, this list of 38 companies represents some of those with the greatest fundamental financial strength.

click image to enlarge

To develop the list we identified those companies rated in all of these three ways:

(1) better than B+ for Earnings and Dividends Strength by S&P,

(2) better than B++ for Financial Strength by Value Line

(3) pay some level of current dividend, have a tangible equity, and long-term debt less than 1/2 of book equity.

There are many other strong companies, but having two noted analytical firms (one qualitative in approach and the other quantitative in approach) rate them highly for financial strength, plus imposing several specific fundamental criteria, should create a fairly high comfort factor with the list as a research starting point.

There were 91 companies that both S&P and Value Line rated highly.  That list was reduced to 38 by adding the current dividend, tangible equity and limited long-term debt criteria.

For those investors who are quite concerned about the ability of a company to survive the current economic situation and unprecedented political intervention in the free market, only the financially strong companies can offer some amount sleep insurance.

These companies may or may not offer great gains opportunities, but today return OF capital is a greater focus by some investors than return ON capital.

This list is not a set of investment recommendations, nor a comprehensive list of potentially interesting companies, but it is a set of companies recommended for closer examination by those with low tolerance of insolvency risk, and a concern about their holdings being comparatively bankruptcy remote.

We have not done a review of the “story” behind each company and some may turn out to be clunkers, but we think it is a good research starting list for conservative do-it-yourself investors interested in individual companies instead of funds.

Richard Shaw
QVM Group LLC

They predict near term-growth for China at 8.3% in 2009 and 10.5% in 2010, compared to the world economy at -1.1% for 2009 and 3.3% for 2010.

Ranking countries by projected GDP for 2027, Goldman sees:

1. China
2. United States
3. EU-5
4. India
5. Japan
6. Germany
7. Russia
8. UK
9. Brazil
10. France

By 2050, Goldman sees this ranking:

1. China
2. United States
3. India
4. EU-5
5. Brazil
6. Russia
7. UK
8. Japan
9. France
10. Germany

The World Bank president says that China is the force that is stabilizing the world economy and may be the force to pull the world out of its slump, while acknowledging the fragile nature of the world situation and its vulnerability to new shocks.

We have consistently suggested that investors consider higher emerging markets equity exposures than are typically recommended.

Generally, we suggest that wherever you are in the allocation spectrum between equities, bonds and other; that your equities portion thinking begin with a world market-cap mixture from which you deviate based on perceived opportunity and risk.  We think the opportunities in emerging markets are greater than the opportunities in the US and EAFE countries, but with more volatility.

Consistent with the shift in the balance of economic power from developed toward emerging countries is the recent transfer of ownership of auto brands: Jaguar to an Indian company, Hummer to a Chinese company, Opel to a Canadian company with the help of equity from a Russian state controlled bank, and now Volvo being considered for purchase by a Chinese company.

Those auto changes are tangible examples and illustrations of continuing growth and financial power shift toward emerging countries — and of course, let’s not forget the central role China is playing in buying US massive Treasury issuance.

Once the lender to emerging markets, the US is now the borrower from them.  Once the financial disciplinarian to emerging markets, the US is now the one being cautioned to show discipline itself by China, its banker.

We own an emerging market basket (VWO), as well as China (FXI) and Brazil (EWZ) directly; and are overweight emerging markets within our equity allocation.

The emerging markets are closer to a bull condition than the US or other developed markets.  Accordingly, they should be somewhat more fully invested in an intended ultimate allocation than the US or EAFE countries by those who are reinvesting in stages based on evolving trends.

The primary trend is still down for most major indexes, as well as for China, but we may be in the process of approaching a new up trend (which would be indicated by an upward slope to the 200-day moving average by the cautious and conservative) — then again the situation is far from certain.

We are not out of the woods yet, so there is still plenty that can go wrong.  Keeping a sharp eye on developments, or better yet persistent trailing stop loss orders, is the prudent thing to do.

Richard Shaw
QVM Group LLC

The data provides a compact way to help develop an overall perspective on market performance and trends.

Data in the table first shows the ratio of the current 200-day simple moving average to its level 20 days ago and 200 days ago, as an indication of the short-term and long-term direction of the primary trend.

The data then shows the ratio of the current 100-day, 50-day, 25-day simple moving averages to their value 20 days ago, as an indication of the short-term direction of secondary trend indicators.

Next, the data shows the ratio of the price and the secondary trend indicators to the current primary trend.

Lastly, it shows the relative position of the price and the secondary trend levels to each other by showing the ratio of the price to the 25-day average, the ratio of the 25-day average to the 50-day average, and the ratio of the 50-day average to the 100-day average.

Those ratios that fall within +/- 3% (1.03 to 0.97) are shaded yellow to indicate relative stability or flatness.  Those with variation greater than 3% are shaded pink or green.

Pink shading is for ratios less than 0.97, indicating a downward movement (or for relative positions indicating an adverse relationship).

Green shading is for ratios greater than 1.03, indicating an upward movement (or for relative positions indicating a favorable relationship).

click image to enlarge

Richard Shaw
QVM Group LLC