What Is The Market Saying?: CAPE and q

With the S&P500 having recently reached withing fifty cents on a closing basis of a new high recently, I think it is prudent to have a look at what some market valuation indicators are saying. We have referred to this source before. This is an image from Smithers & Co.which I believe to be the ultimate authority on stock market valuation as calculated in q, that being the value of the replacement cost of corporate assets. The chart, which also includes Shiller's cyclically adjusted 10 year values of price earning ratios (CAPE10) shows the q ratio against its geometric mean, thereby yielding a percentage above or below fair value. Fair value is assumed to be equal to replacement cost. For a more in depth discussion of the rationale for this measure, please refer to Smithers' two books: Valuing Wall Street and Wall Street Revalued.

So what is this tool saying? Let's have the folks at Smithers & Co. spell it out for us:

With the publication of the Flow of Funds data up to 31st December, 2012 (on 7th March, 2013) we have updated our calculations for q and CAPE. Over the past year net worth has risen by 7.6%, with the most significant rise being in the value ascribed to real estate (+ 5.9%). Interest-bearing assets have risen by 5.8% while interest bearing liabilities have risen by 8.2%.

Both q and CAPE include data for the year ending 31st December, 2012. At that date the S&P 500 was at 1426 and US non-financials were overvalued by 44% according to q and quoted shares, including financials, were overvalued by 52% according to CAPE. (It should be noted that we use geometric rather than arithmetic means in our calculations.)

As at 12th March, 2013 with the S&P 500 at 1552 the overvaluation by the relevant measures was 57% for non-financials and 65% for quoted shares.

Although the overvaluation of the stock market is well short of the extremes reached at the year ends of 1929 and 1999, it has reached the other previous peaks of 1906, 1936 and 1968. (here)

Sixty five percent! I have opined elsewhere on the difficulty of using this information as a timing tool. Both it and CAPE10 are measures that require a long term (10 years?) view in order to even consider its use. In fact, Smithers & Co. publish this information only quarterly, when they have verifiable sources for its calculation (Federal Reserve Flow of Funds data, etc.). Nevertheless, this measure has to give anyone considering new investments in the market great pause-- and existing investors a test of their tolerance potential for losses. Of course the overvaluation was MUCH worse in 2000 and slightly worse is 2007. The former led to losses of nearly 50% and the latter to greater than 50% losses. Yet here we are again with the S&P500 at the 1550 level and the market seemingly rich by a significant margin. Caveat emptor.

Ten Stock Market Myths

I am going to revive a post that I intended to put up during the initial rebound from the 2008-09 selloff. This advice has been around for awhile and the original article is attributable to Brett Arends. He wrote it in 2010. The full story is here.

I think it is particularly timely, given what is going on in the stock market. I am not suggesting that everyone become a market-timer. It's too difficult psychologically. It's less so at tops: the market has moved up- often to extreme valuations- and everyone has the urge to lock profits in. It feels smart. What is doubly difficult is to place money at risk when the world seems it is about to come to an end. Think March 2009. It feels wrong. Your hand shakes when placing the buy order. Then the market continues to sell down. You see red. And you want to "cut losses". THAT now seems the smart thing to do. But very often it is the wrong thing. If only we were computers and could take the emotion out of such decisions! But we are not.

Have a read.

Ten Stock-Market Myths That Just Won't Die

At times like this, your broker or financial adviser may offer words of wisdom or advice. There are standard calming phrases you will hear over and over again. But how true are they? Here are 10 that need extra scrutiny.
1. "This is a good time to invest in the stock market."

Really? Ask your broker when he warned clients that it was a bad time to invest. October 2007? February 2000? A broken watch tells the right time twice a day, but that's no reason to wear one. Or as someone once said, asking a broker if this is a good time to invest in the stock market is like asking a barber if you need a haircut. "Certainly, sir -- step this way!"

2. "Stocks on average make you about 10% a year."

Stop right there. This is based on some past history -- stretching back to the 1800s -- and it's full of holes.

About three of those percentage points were only from inflation. The other 7% may not be reliable either. The data from the 19th century are suspect; the global picture from the 20th century is complex. Experts suggest 5% may be more typical. And stocks only produce average returns if you buy them at average valuations. If you buy them when they're expensive, you do a lot worse.

3. "Our economists are forecasting..."

Hold it. Ask your broker if the firm's economist predicted the most recent recession -- and if so, when.

The record for economic forecasts is not impressive. Even into 2008 many economists were still denying that a recession was on the way. The usual shtick is to predict "a slowdown, but not a recession." That way they have an escape clause, no matter what happens. Warren Buffett once said forecasters made fortune tellers look good.

4. "Investing in the stock market lets you participate in the growth of the economy."

Tell that to the Japanese. Since 1989 their economy has grown by more than a quarter, but the stock market is down more than three quarters. Or tell that to anyone who invested in Wall Street a decade ago. And such instances aren't as rare as you've been told. In 1969, the U.S. gross domestic product was about $1 trillion, and the Dow Jones Industrial Average was at about 1000. Thirteen years later, the U.S. economy had grown to $3.3 trillion. The Dow? About 1000.

5. "If you want to earn higher returns, you have to take more risk."

This must come as a surprise to Mr. Buffett, who prefers investing in boring companies and boring industries. Over the last quarter century, the FactSet Research utilities index has even outperformed the exciting, "risky" Nasdaq Composite index. The only way to earn higher returns is to buy stocks cheap in relation to their future cash flows. As for "risk," your broker probably thinks that's "volatility," which typically just means price ups and downs. But you and your Aunt Sally know that risk is really the possibility of losing principal.

6. "The market's really cheap right now. The P/E is only about 13."

The widely quoted price/earnings (PE) ratio, which compares share prices to annual after-tax earnings, can be misleading. That's because earnings are so volatile -- they're elevated in a boom, and depressed in a bust.

Ask your broker about other valuation metrics, like the dividend yield, which looks at the dividends you get for each dollar of investment; or the cyclically adjusted PE ratio, which compares share prices to earnings over the past 10 years; or "Tobin's q," which compares share prices to the actual replacement cost of company assets. No metric is perfect, but these three have good track records. Right now all three say the stock market's pretty expensive, not cheap

.
7. "You can't time the market."

This hoary old chestnut keeps the clients fully invested. Certainly it's a fool's errand to try to catch the market's twists and turns. But that doesn't mean you have to suspend judgment about overall valuations.

If you invest in shares when they're cheap compared to cash flows and assets -- typically this happens when everyone else is gloomy -- you will usually do very well.

If you invest when shares are very expensive -- such as when everyone else is absurdly bullish -- you will probably do badly

8. "We recommend a diversified portfolio of mutual funds."

If your broker means you should diversify across things like cash, bonds, stocks, alternative strategies, commodities and precious metals, then that's good advice.

But too many brokers mean mutual funds with different names and "styles" like large-cap value, small-cap growth, midcap blend, international small-cap value, and so on. These are marketing gimmicks. There is, for example, no such thing as "midcap blend." These funds are typically 100% invested all the time, and all in stocks. In this global economy even "international" offers less diversification than it did, because everything's getting tied together.

9. "This is a stock picker's market."

What? Every market seems to be defined as a "stock picker's market," yet for most people the lion's share of investment returns -- for good or ill -- has typically come from the asset classes (see No. 8, above) they've chosen rather than the individual investments. And even if this does turn out to be a stock picker's market, what makes you think your broker is the stock picker in question?

10. "Stocks outperform over the long term."

Define the long term? If you can be down for 10 or more years, exactly how much help is that? As John Maynard Keynes, the economist, once said: "In the long run we are all dead."

I'll put up a post shortly sharing some valuation metrics for the market. This blog is about planning and wealth preservation and accumulation. Not advice but use it to plan accordingly.

Secular Bear Market Update

From planner Doug Short and his popular blog Financial Life Cycle Planning, a very revealing chart about how the secular bear market has affected a portfolio invested strictly in the S&P 500 index of stocks:


(Right click for a larger image.)

In a word: DEVASTATING.

Nearly 45% down in real terms after 10 years. That is why I talk about risk and absolute returns. Most investors can't stand a) the volatility much less b) the losses inherent in investing this way.

Lessons Learned

Two recent MetLife studies have shown that on one point financial advisers and baby boomer clients are remarkably aligned: It is more important to protect assets from losses than to achieve market gains.

As we have shown before losses really hurt investor's portfolios. Three years of 20% gains followed by a loss of 20% turns the total gain into a pedestrian 8 plus percent. A fifty percent gain followed by a 40% loss does not leave an extra 10% to the good. It's a LOSS (100 x 50= 150; 150 x (1-.40)= 90.

So what do advisers do about risk of loss? 74% recommend diversification according to MetLife. But apparently only 28% of baby boomers are taking that advice. Know what I say? I'm with the baby boomers! Diversification as practiced and preached is wrong-headed. Why? Because the only TRUE diversification is not among asset classes which show HISTORICAL non-correlation. That is looking in the rear view mirror and attempting to drive the car! As we have seen, in declining markets asset classes all tend to go toward a correlation of one. The only diversification occurs among asset classes that have DIFFERENT VALUATIONS. Asset classes that are valued richly decline rapidly. Asset classes that are undervalued decline less rapidly or even go up. As an example take small cap value stocks and REITs in 2000-2002. The market had shunned them for years. If you liked REITs during the tech bubble you were eating thin gruel for returns. But the bubble bursts and viola! happy days were here again. Most stocks went down. REITs and small cap value more than held their own. Why didn't this work in 2008-09? All asset classes except bonds were richly valued. Every one. REITs, utilities, commodities, international stocks. The explosion in cheap credit and money chasing whatever return it could find assured that. When the market started declining they all went down. The only exception was bonds! End of story (and benefits of diversification).

So if you want diversification, check the historical valuation of the asset class being suggested. Can it be done? Sure it can. An asset allocation shop like GMO (which we've written about before) does it all the time. Then, take a tip from Mark: If it's high, it won't diversify. (Apologies to Johnny Cochrane)

James Montier Compilation

James Montier is a member of GMO’s asset allocation team. Prior to that, he was the co-Head of Global Strategy at Société Générale. Montier is the author of four outstanding books:

• The Little Book of Behavioral Investing: How Not to be Your Own Worst Enemy (Little Book, Big Profits)

• Behavioral Finance: Insights into Irrational Minds and Markets

• Behavioral Investing: A Practitioners Guide to Applying Behavioral Finance

• Value Investing: Tools and Techniques for Intelligent Investment

Montier has been the top-rated strategist in the annual Thomson Extel survey for most of the last decade. He is also a Visiting Fellow at the University of Durham and a Fellow of the Royal Society of Arts.

Tim du Toit is the editor and founder of Eurosharelab and recently assembled some of Montier's published writings for a blog article. The assemblage was picked up by Barry Ritholtz of The Big Picture blog and can be found here. Montier is one of my favorite authors. I find his work to be a must-read.

The Same Ol' Story: Active Versus Passive Management

This data gets repeated every year with little substantive change. Active managers that can consistently beat indexes are hard to come by.

From Standard & Poors, their index on the value of active management of asset classes for 2009:

* Over the last five years, the S&P 500 has outperformed 60.8% of actively managed
large-cap U.S. equity funds; the S&P MidCap 400 has outperformed 77.2% of mid-cap
funds; and the S&P SmallCap 600 has outperformed 66.6% of small-cap funds.

*The five-year data results are similar for actively managed fixed income funds. Acrossall categories, with the exception of emerging market debt, more than 70% of active managers have failed to beat benchmarks.

If you are interested in being "in the market", any decision to hire an active manager for the asset class has to be heavily scrutinized. What is his/her "edge". Over time, what makes you think the asset manager can maintain it? Does the risk of failure jeopardize you getting to your goal? If so, why take it?

Are You A Stock Or A Bond?

Moshe Milevsky wants you to be smarter about risk. Dr. Milevsky is the Executive Director of the Individual Finance and Insurance Decision (IFID) Centre and is an Associate Professor of Finance at York University in Toronto, Canada. He is the author of three books on investment management and retirement planning. Recently, he penned a short article for The Wall Street Journal on a topic where investing and retirement planning intersect, entitled "How to Think Smarter About Risk".That article is here.


Milevsky believes that too many investors may be taking big chances with their money because they aren't considering the most important asset of all: themselves. And he wonders if a large, sustained drop in the stock market would affect your personal finances. Most people would be devastated by a return to the stock market lows of 2009. But Milevsky thinks you should think more broadly. Most importantly, he believes you should think about how such a drop would affect your paycheck and your career. It depends upon the person:

Earnings in some professions are tightly linked to the stock market—an investment banker, say, or portfolio manager or financial adviser—while others, such as hospital nurses or tenured professors, are relatively immune to these zigs and zags. Most people will fall somewhere in between.

Consider this an exercise in personal risk management. It isn't intended to gauge whether you believe the stock market will test those levels again, and I'm not asking whether you are bullish or bearish. That is not what personal risk management is about, even if it is how most people practice it. The issue here is: If the bear returns for a prolonged visit, regardless of your subjective view of these odds, how would it affect your current and future earning power? And—more important—are you properly considering it when creating your investment portfolio?

Milevsky worries "that one of the problems plaguing both investors and their financial advisers is that asset-allocation decisions are based excessively on how people feel (risk-averse or risk-tolerant) and what they believe (bullish or bearish about the stock market) as opposed to how much risk their personal balance sheets can tolerate.To put it in even more-basic terms: As part of any asset-allocation strategy, you need to determine whether you are a stock, with earnings that can fluctuate wildly with the market, or a bond, with earnings that are less flashy but steady. You will likely find that the overall level of risk you are taking is much higher or lower than you think."

Milevsky goes on to discuss his concept of "a personal beta", your individual balance sheet and the role of insurance in changing some balance sheet items from "stocks into bonds". It's definitely worth a read.

New q Valuation for SP 500: Smithers & Co.

History, history! We fools, what do we know or care.-
William Carlos Williams

Doug Short of Financial Life Cycle Planning (www.dshort.com) and I have been exchanging correspondence about the q ratio and its uses. He is generating a methodology to update this measure more frequently. I wrote an article here sharing a few of Smithers thoughts on q as a timing tool. Quite curiously, Smithers & Co., addresses the topic of updates by its readers in its commentary which accompanies the release of its quarterly chart. Let's take a look. Here is the latest chart:



And here is the related commentary:

With the publication of the Flow of Funds data up to 31st March 2010 (on 10th June 2010), we have updated our calculations for q and CAPE, which show very little change from our previous calculations.

Non-financial companies, including both quoted and unquoted, were 62% overvalued according to q at 31st March 2010, when the S&P 500 index was 1169. Adjusting for the subsequent decline to 1087 (10th June, 2010), the overvaluation had fallen to 50%. Revisions to data had little impact on q, with downward revision to net worth for Q4 2009 of 2.9% being offset by a downward revision to the market value of non-financial equities of 2.1%. Net worth for Q1 2010 fell slightly as equity buy-backs exceeded profit retentions.

The listed companies in the S&P 500 index, which include financials, were 58% overvalued at 31st March 2010, according to our calculations for CAPE, based on the data from Professor Robert Shiller’s website. Adjusting for the subsequent decline to 1087 (10th June, 2010), the overvaluation had fallen 46%. (It should be noted that we use geometric rather than arithmetic means in our calculations.)

And what of more frequent revisions? This is what the commentary offered:

As net worth and cyclically adjusted earnings per share change little during a quarter, only changes in share prices are important for changes in the market value between our quarterly updates. The value of the market can thus be readily adjusted by viewers to this website. As the S&P 500 index changes, viewers can simply insert the new value and calculate the q and CAPE values, i.e:

With the S&P 500 at 1169 as at 31st March 2010, q was 1.6166 and CAPE was 1.5761.

To update as at 10th June 2010, when the S&P 500 was 1087, for q take 1.61 × 1087 ÷ 1169 = 1.50 and for CAPE take 1.58 × 1087 ÷ 1169 = 1.46.

Smithers and Wright have written two books on stock market valuation and the q ratio. The first was Valuing Wall Street. The second was Wall Street Revalued. Both are on my bookshelf and are HIGHLY recommended reads for an investor.

The stock market is overvalued. It's as overvalued as it was in 2007 despite never having reached the absolute price level of the SP 500 reached then (1565). That is because earnings are quite a bit lower and the price being paid for them are too high in relation. This overvaluation will resolve itself as it always does. We just don't know when. Long term investors have been warned.

Market Valuation Measures: Improvement and Possible Use

For the past couple of weeks blogger and financial planning consultant Doug Short has been providing his readers with a series of posts which discuss and refine three measures of market valuation: his own measure of trendline valuation, Shiller's PE10 and one of my favorites, the q ratio of James Tobin as used by Andrew Smithers and others. The articles purpose is to demonstrate the benefit of their use by investors and, presumably, to make the measures more timely and useful. I applaud his work in this direction. The latest article is here and his excellent chart, showing these measures in the past and to date follows.



I wanted to chime in about the use of such indicators as a possible timing tool by investors. Can the q ratio be used in this manner? Here is what Smithers himself has said ("Wall Street Revalued", p. 77):

Selling equities when they are overvalued can be sensible, but only if the prospective returns from the sanctuary asset, in which the funds previously invested in equities are temporarily lodged, will exceed those on equities over the uncertain time period in question. The uncertainty about the time when the investor will wish to return to equities makes cash (or its equivalent, such as money on short-term deposit), the most likely and generally sensible choice as a sanctuary asset. Although real cash returns vary, the asset can at least be realized in the short term at its original nominal value. Bonds have an even greater exposure to inflation and even if that is stable the nominal value at any time prior to maturity is uncertain.

How true. The return on a "safe" asset is very low. The return on equities, even when shown to be overvalued, can still be relatively high. To switch from equities to cash requires a fine and bold calculation that the sanctuary asset return, plus any avoided losses, will exceed the return given from equities in the interim. THat is a judgment of three uncertainties: the length of time it takes for "fair value" to reassert itself in the equity space; the return on equities until that time; and the return on the "safe" asset class chosen.

Smithers continues:

Historically, there have only been five peaks in the market's overvaluation since 1900... . The average time between peaks has been 24 years but the average is far from regular and each of the last two swings has taken over 30 years from peak to peak.

...

If, for example, the real return on equities is normally 6%, Treasury bills can be expected to give at least a 1% real return and the stock market has an equal chance of being over- or under-valued in 15 years' time, then the limits of overvaluation given a limited number of rational investors will be just over twice. (Ed note: log terms).

...

A glance at Chart 15 shows that, during the period for which we have adequate data, only twice has the market become so overvalued that it was worth while (sic) selling on either of these assumptions: the first time being prior to its 1929 peak and the next prior to its peak in 2000.

Is the q ratio then largely ineffective as a timing tool? Apparently Smithers believes- given his assumptions- its use as such to be quite rare: twice in nearly 100 years. That's hardly the holding time-frame for the average investor. (Endowment investing is different.)But the rub (there's always one isn't there?) is in Smithers' assumptions regarding time elapsed from observed over-valuation to realize fair value, the prospective return from equities as an asset class, and the return from the sanctuary asset. If any one of these assumptions is altered, the calculus changes. And as we have written on this blog, not every market expert agrees with these values. I would only point the reader to my posts about John Hussman's models or Jeremy Grantham's forecasts to see how tweaking the assumptions might work a bit differently for the creative investor. What if bubbles were observed to burst more frequently than granted by Smithers? What if the sanctuary asset class is not cash but has some, though limited, volatility and a much higher expected return? What if the observed over-valuation shows that the expected return for equities over a given timeframe is not 6% but two percent, one percent or even ZER0? The possibilities for thoughtful substitution by an investor become great.

Switching Out of Bonds Isn't the Answer. Or Is it?

Christine Benz, Morningstar's director of personal finance, has written an article on the dilemma that faces bond investors today. The dilemma is the combination of historically low rates (present)and the threat of inflation (future). That formula is deadly for protection of principal. Her article is instructive for the purpose of seeing what knots we can tie ourselves in if we are not clear about what we are saying to our audience in this area. But it still manages to contain some good advice. It reads (in part):

Whether your guru is Jack Bogle, Bill Gross, or Roger Ibbotson, the smart money is on bonds posting disappointing returns during the next decade.

The logic is certainly sound. Bond returns are composed of two elements: whatever income they pay out and any price changes in the bonds themselves. And on both counts, the situation for bonds looks bleak. Current yields, historically a good proxy for bond returns in the future, remain ultra-low--about 1%-2% for shorter-term bonds and 3%-4% for intermediate-term bonds. And should interest rates head higher--and they really have only one way to go, following generally declining rates for more than two decades--prospects for declining bond prices are very real.

Given that dour outlook, it's tempting to downplay bonds as a portion of your portfolio. Some investors have suggested that you might as well hunker down in cash until worries about rates blow over. You'll have to settle for lower yields, but at least you won't face the principal losses you might confront in bonds.

Alternatively, if market watchers are right that bonds are in for a depressing decade, all the money we might see come sloshing out of bonds would have to go somewhere. From that standpoint, it might seem compelling to swap at least some of your fixed-income stake for stocks.

Mark here. We have ALREADY seen a mass exodus by retail investors from equities into bonds, bond funds and structured products. We've chronicaled that here. That flight has bid up prices to levels last seen in 2007 before the Lehman Brothers implosion. And equities have run 80% off their bear market bottom. Should we now reverse field? Benz writes that:

the bond market is a pretty efficient machine, and current bond prices factor in multitudinous bits of information about the economy and the prospect for interest rates. For you to take an antibond bet and, say, shorten up your fixed-income portfolio or move entirely to cash, you're essentially saying that you have better foresight of what bonds will do in the future compared with other market participants. You might, but you might not.

Mark again. The author appears to be saying "The market is likely smarter than you. All you are doing is guessing." Well, MAYBE. In Spring of 2000 with the market at 1550 plus on the SP500, did the market "have it right"? How about in Fall of 2007 at about the same levels? Good lord I had hoped that this canard that the market is some efficient discounting machine had gone the way of the dodo bird. It's a nice theory that runs aground on empirical observation. So if we don't possess The Crystal Ball we should do nothing? What we absolutely KNOW is that returns from bonds will be LOW. That's a given. Sure they could move lower. But that would be a temporary capital gain and likely quickly given back. If it is not that signals BIG TROUBLE for the economy and bonds returns will be your least worry.

And while it's hard to get excited about investing in an asset class with the threat of losses looming over it, it's also worthwhile to consider the likelihood and magnitude of losses one might face in bonds, especially if you have a time horizon of a few years or more. (If your time horizon for your money is shorter than that, you belong in cash.)

The Barclays Capital U.S. Aggregate Bond Index, a broad index tracking much of the domestic fixed-income market, hasn't posted a loss in any rolling three-year period since 1983. Granted, that was a very favorable period for bonds, marked by generally declining interest rates. But even an examination of a less forgiving bond-market environment shows that the threat of rising interest rates shouldn't prompt a wholesale panic.

A recent Fidelity study, looking back to the period of 1941-81, when yields rose from 0.5% to 16%, showed that investors in intermediate-term Treasury bonds actually lost money in just 1% of the rolling three-year periods during those 40 years. Yes, rising rates depressed bond prices during that period, but the higher yields that investors were able to pick up offset the price declines in most cases. Due to the ability to earn higher yields, intermediate-term Treasury investors actually made money during that inhospitable 40-year stretch. They averaged a 3.3% annualized gain during that period, well below bonds' average gains of 5.3% since 1926, but a positive gain all the same.

Additionally, the magnitude of losses that one might expect from bonds, even in a tough interest-rate environment, is also apt to be a lot lower than what you'd see from stocks. To use a recent example, long-term government bond funds, which tend to be extremely sensitive to changes in interest rates, lost 9% in 2009 amid concerns that rates would trend higher. Such a loss is never welcome, to be sure, but it pales in comparison to the 37% loss that S&P 500 investors faced in 2008.

Hmm. Are we saying invest because your losses, if any, are likely to be small as well as any gains, that is, over 40 years you see, so the whole thing would be "No Harm No Foul" if you do? And by the way, were those paltry returns real or nominal? I guess she is saying what I said above: Bonds could be the least of your worries. Let's move on.

What to Do?
Even though the prospect of rising rates shouldn't dictate a wholesale revision of your asset allocation, there are still steps to take to protect yourself.

For starters, consider downplaying long-term bonds as part of your portfolio, as Jack Bogle suggests in this video (Ed: Morningstar video link ommitted). Yes, long-term bonds have gained about a percentage point per year, which is more than intermediate-term bonds, on average, during the past decade, but their volatility as measured by standard deviation has been almost twice as high.

Second, consider delegating a big chunk of your portfolio's fixed-income position to a core fund whose manager isn't shy about factoring in the interest-rate environment into his or her outlook. A few that Morningstar analysts like include Metropolitan West Total Return (MWTRX), Harbor Bond (HABDX), and Dodge & Cox Income (DODIX).

Finally, if you're holding money you truly can't afford to lose, stick with true cash rather than short-term bonds or much higher-yielding (and higher-risk) substitutes such as bank-loan funds. Yes, yields on certificates of deposit and money market funds are low right now, but you're looking to this sleeve of your portfolio for stability rather than big return potential.

Okay, finally we get to the meat of the article. After much chasing of our tails while setting up the problem, we see she recommends a few bond funds that will do the heavy thinking and lifting for you. I have NO quibbles with the three she recommends. They are well managed and have good histories. If you want a bond fund or two in your portfolio you could do A LOT worse.

But do investors have to own funds that invest only in bonds for their income portfolios? Let's say you take the route of adding some equity exposure to your income portfolio. Where are those that will buy income generating equities (REITs, utilities, MLPs) as an example? Where is Berwyn Income Fund, which buys dividend stocks in up to 30% of its portfolio, (BERIX) in her list? Have you seen those 10 year returns? Or those that hedge the interest rate risk by alternative means? Have you heard of Hussman Strategic Total Return (HSTRX)? What about THOSE returns life of fund? Must an income investor eschew ALL volatility in this part of the portfolio (if they even still divide it up into the old bond/equity buckets)in order to get to their goal (the promised land)?

Giving it the benefit of the doubt, the article tries to be a balanced look at this difficult topic. It ends up I think falling short of where it needs to go. (I wanted to write "a bit of a hash" here but thought that a wee bit harsh.) It's difficult to give advice about bonds these days. It truly is. Deflationary pressures abound in the short term. Those auger for low rates for some time. The money sloshing around out there to fix our problems says the future holds just the opposite. That at some time inflation must return. Just not now.

The author's advice is to pick a manager who has shown flexibility in the past. Can't quibble with that. Which managers have protected principal through difficult environments? That says a long history here may be needed. Or was succesful navigation of the latest low interest rate period enough? The manager likely had to skillfully manage some additional risk in order to get ANY kind of returns.

Don't limit yourself to traditional bond funds or managers. Perhaps it's not a bond fund you need at all. Look around. I bet you can come up with some better alternatives than even I have. Write me if you do. And thanks Christine for letting me ask some hard questions around your article.

Good luck. It's a tough bond environment out there.

High Quality Stocks vs. The SP500

GMO's theme that high quality companies are the only value in the US market gets a boost from none other than First Eagle Funds (11% returns life of fund) and their research director Bruce Greenwald. Video interview and transcript via Morningstar's Ryan Leggio. See here.

While high quality may outperform on a relative basis go-forward, you can see that on days like today, everything goes down. That being said, I also expect this subset of the market to outperform. Junky stocks (high debt, no franchise) have had their run off the lows, just like they did in the last Crash. Time for franchise companies to show what their franchise is worth.

The Apprenticed Investor

One of the best investing and trading series ever written, by popular financial/trading/media blog host Barry Ritholtz (The Big Picture). Collected together from various publications, all for the first time.

Find it here.

Thanks, Barry!

The Good, The Bad and The Ugly: GMO Weighs In

In a nice article at Morningstar, the venerable Jeremy Grantham weighs in on valuations of markets and sectors. Long time readers know I really like Grantham's Quarterly Letters (www.gmo.com) and Monthly Outlooks. The link is here.

A few of the key takeaways provided by Morningstar's Ryan Leggio from his notes at a talk given by Grantham and Ben Inker, head of risk at GMO, to investment professionals last Wednesday:

Pension plans assume they can achieve an 8% nominal return with a 60/40 portfolio. Since bonds yield about 4%, this means they assume equities can return about 11% annualized going forward from today's valuations. By contrast, GMO thinks equities will return about 6%. With these assumptions, a 60/40 portfolio is more likely to return about 5% annually.

GMO thinks most equity categories are overvalued. This is because it forecasts the S&P's profit margin will return to its 6% historical level rather than rise to the 7%-plus level analysts are forecasting.

High-quality stocks are a free lunch in GMO's opinion. Since 1965 they have beat the S&P 500, but they should have a lower equity risk premium because they are better companies with better balance sheets than the average S&P 500 company.

Quality stocks are the cheapest they have ever been on a relative basis since 1965 compared to the S&P 500. The last time they came close to this level was in 2000 (tech bubble) and 1969 (right before Nifty-Fifty era).

Thanks Ryan!

Blog Note: Grantham said in his latest Quarterly Letter that a "run to the old highs" was possible. The crisis in Europe and the return of risk and fear in the markets seems to have tempered such optimism.

The Good, The Bad and The Ugly: Returns Going Forward

Morningstar has a good video of Rob Arnott discussing the returns environment for many major asset classes. If you don't know Rob, he is the chairman of Research Affiliates, and he's also the former editor of the Financial Analysts Journal. The link is here.

A highlight (or lowlight) from his video interview:

And yields on stocks--they've doubled in the last 10 years, because it was such a horrific decade. They're still half what they've been historically.

So the yields on stocks are low. The yields on bonds, and an array of other asset classes, are low. People need to ratchet down their return expectations. If you're expecting double-digit returns on your investments, then I'm a bear. I think you're not going to get there.

If you're expecting 5% return on your investments and you're well diversified and you're taking advantage of an array of alternative markets--yeah, that's not just achievable, but reasonably easily achievable. 6% or 8% is possible.

In my opinion, if you are successful timing in to and out of asset classes (this is really what Arnott is suggesting), 6-8% is possible. If you have the usual two-class equities and bond orientation and less than a ten year horizon, getting to 3-4% real returns is going to be a challenge. Not investment advice.

Right On Cue!

It must be something in the water. Or a conspiracy! The same week Bloomberg posts a nice article about the dangers of high yield, Fidelity chimes in with a look at how investors can earn more interest "without excessive risk". Let's see what they have to say. The story is here.

With the average checking account and three-month brokered certificate of deposit (CD) yielding a humble 0.25%,1 you may be yearning for a little more yield on your everyday cash and short-term investments.

Well, don't expect much help from the Federal Reserve, which continues to indicate that it plans to hold its benchmark Federal Funds rate low for an extended period. Still, there are ways that could help you eke out more yield on your cash and short-term investments—without taking on excessive risk.

"It can be done without committing either to long-term bonds or to the volatility that can come from dipping too far down in credit quality," says Richard Carter, vice president of fixed-income securities at Fidelity. "The recent steepness of the Treasury yield curve (see chart below) means that you may be able to get a little more yield for extending maturities a little further than you would have in a period like year-end 2006, when the curve was essentially flat."

What You Can Do

First determine how much of your short-term investments are for immediate needs and has to be easily accessible and liquid. This money should stay in a checking account, money market account or fund, or short-term FDIC insured CD, regardless of the low yield. Beyond that, however, there are a variety of strategies that can help you earn more on your cash and short-term investments. Consider these four:

1. Consider slightly longer maturities

For money you don't need right away, consider investments with slightly longer maturities, including Treasuries, which can provide higher yields. For instance, a 12-month Treasury is currently yielding close to 0.40%, a two-year Treasury close to 1.00%, and a three-year 1.50%. Other options: longer-term FDIC-insured CDs and short-term bonds from agencies or government sponsored enterprises (GSEs). The table below illustrates how slightly higher maturities can bring higher yields. Of course, it's important that your CDs stay within the FDIC protection limits,2 and remember that, while GSEs are strongly supported by the government, in most cases, they aren't explicitly government-guaranteed options.

2. Build a short-term ladder

You can also ladder these securities and invest equal amounts across several maturity buckets. For example, with a three-year ladder, it's now possible to earn annualized returns of roughly 0.8%-1% depending on the bond type chosen (see table below). The three-year ladder strategy won't have as high a yield as buying a three-year bond outright, but it will provide periodic "liquidity events" when your principal matures. That way, if rates rise within the next 6-12 months, you'll be able to reinvest the maturing principal at higher rates.

3. Consider short-term bond funds

Investing in short-term Treasury, government, or other investment-grade bond mutual funds—which is similar to investing in ladders of securities typically maturing in five years or less—may provide higher yields while reducing interest rate and credit risk. They may also provide diversification among issuers and are generally easier to sell than an individual bond.

"As a short-term bond fund manager, I have more opportunities to look at the market and look for attractive investments," says Rob Galusza, portfolio manager of Fidelity Short-Term Bond Fund (FSHBX). "This allows me to allocate assets into higher-yielding bonds more quickly, should rates rise."

4. A more aggressive choice: floating rate or leveraged loans

If you are more aggressive and comfortable with increased credit risk and potential for principal loss, consider mutual funds that invest in floating rate bank loans, which are primarily secured loans made by banks to non-investment-grade companies. Floating rate bank loans have coupons that reset periodically, or "float," based on a fixed premium over a market rate such as the London Interbank Offered Rate (LIBOR), which is the rate that banks charge each other for loans less than one year. And in case of bankruptcy, floating rate loans are senior in standing to bonds on the balance sheets of these companies. The average yield is currently 5.26% according to the S&P/LSTA Leveraged Performing Loan Index.

"The floating rate feature of these loans helps to reduce interest rate volatility, while the combination of seniority, security, and floating rates helps to limit the price volatility of the investment," says Christine McConnell, manager of Fidelity Floating Rate High Income Fund (FFRHX).

Keep in mind the risks of floating rate loans, however. These loans are often lower-quality debt securities, and generally are subject to restrictions on resale. Also, they may not be fully collateralized, which may cause the floating rate loan to decline significantly in value.

Next steps

Despite the low interest rate environment, there are still opportunities to earn more yield by diversifying your cash and short-term investments. Remember, however that because liquidity and risk are key, money for emergencies stills belongs in a checking account, money market account or fund, or short-term CD.

Okay, not much new here. My comments: The floating rate option is not for the faint of heart. At least the article describes it as "aggressive". The longer maturities give you additional interest rate risk. If you keep it short, you can always roll it over at higher rates should they increase. (If rates go lower here, that likely signals big trouble somewhere, either in the economy, the markets or both.) It's a very tough environment for those looking for yield.

The Reach for Yield

Investors are absolutely desperate for returns. Two market crashes and the resultant efforts by the Fed to cushion things by driving interest rates to near zero have investors clamoring for anything with a yield. High yield bonds are not the exception. In fact they may be the poster child for this phenomenon.

In a Bloomberg story appearing today the syndicator reports "Junk Bonds Sell With Weakest Creditor Protection Since 2007". The story is here. It's potentially a sad one. I see nothing but grief coming from this if the economy doesn't stabilize.

Two years after suffering $213.2 billion of losses when debt markets froze, investors in junk bonds are accepting what Moody’s Investors Service calls the weakest creditor protections since 2007.

Even with housing starts hovering at their lowest levels on record, Beazer Homes USA Inc. managed to sell bonds this month on terms that allow it to add more debt. The Atlanta-based builder couldn’t even do that when it issued debentures at the height of the housing bubble in 2006 and its credit rating was seven levels higher. In a report last week Moody’s singled out CF Industries Inc., Standard Pacific Corp., AK Steel Corp. as borrowers offering debt on terms historically available only to higher-rated companies.

“We got ourselves in trouble with that in the past and here it is again,” James Kochan, the chief fixed-income strategist at Wells Fargo Fund Management in Menomonee Falls, Wisconsin, said of the trend toward looser debt covenants. “It’s not that surprising, but it is disturbing,” said Kochan, who helps oversee $179 billion.

Lenders are letting down their guard just as worsening government finances raise doubts about the sustainability of the global economic recovery. Money managers say they have little choice but to go along. They need to find a home for the record $29.4 billion that has flowed into high-yield bond mutual funds the past 16 months from retail investors seeking to join in a rally that has produced an average 69 percent return since the market bottom in March 2009.

Weaker Safeguards

About 60 percent of high-yield borrowers this year offered weaker investor safeguards than on debt they issued previously, according to Covenant Review LLC, a New York-based research firm that analyzes bond offerings. Those include no limits on the amount of debt companies can have and few restrictions on using assets as collateral for future borrowing, reducing what’s available to satisfy creditor claims in a bankruptcy.

“This trend represents more than an episode of ‘back to the future,’” Moody’s analysts including Alex Dill, the firm’s senior covenant officer, wrote in their report. “It reflects a weakening in covenant protections even below those existing at the peak of the market, in 2006 and 2007.”

Beazer sold $300 million of 9.125 percent bonds due in 2018 on May 4 that carry lighter restrictions than its 2006 issue on the amount of debt the builder can add and how it can use money raised from selling assets. The terms also allow Beazer to double its capacity to pay dividends to shareholders even after a 90 percent drop in its stock, according to Covenant Review.

‘Poor Standing’

The company’s senior unsecured bonds are rated Caa2, which Moody’s defines as “judged to be of poor standing and are subject to very high credit risk.” Beazer was rated Ba1, one step below investment grade, in June 2006, when it issued $275 million of 8.125 percent 10-year notes.

Jeffrey Hoza, a vice president and treasurer of Beazer, and Chief Financial Officer Allan Merrill didn’t return calls seeking comment. Junk bonds are rated below Baa3 by Moody’s and less than BBB- by Standard & Poor’s.

Overseas Shipholding Group Inc., the largest U.S.-based oil-tanker owner, sold $300 million of bonds in March, its first offering in six years. Debtholders gave the company the leeway to sell assets, new secured debt and pay dividends to equity holders, according to Covenant Review. The bonds, due in 2018, are rated Ba3 by Moody’s and an equivalent BB- by S&P.

‘No Resistance’

“We were not going to do a deal if we were not able to get that kind of flexibility,” said Morten Arntzen, the chief executive officer of the New York-based company. “We had no resistance to it” from potential investors, he said. Proceeds from the sale were used to repay debt under a revolving credit facility, the company said in a March 29 statement.

Overseas Shipholding’s covenants are “nearly useless,” according to Covenant Review. Investors bid up the debt anyway, pushing the 8.125 percent notes to as high as 102.25 cents on the dollar last month, according to Trace, the Financial Industry Regulatory Authority’s bond-price reporting system.

“They’re a high-yield issuer that’s getting away with investment-grade covenants,” said Adam Cohen, founder of Covenant Review. “You shouldn’t have a high-yield bond that gives you less protection than a lot of the high-grade bonds out there.”

Cash is flowing into mutual funds that specialize in high- yield debt at an accelerating pace. EPFR Global, a research firm in Cambridge, Massachusetts, estimates that before last week, investors put $8.57 billion into the funds, up from $7.33 billion in the same period of 2009.

Soaring Issuance

That money helped push down yields on speculative-grade bonds to 8.23 percent on April 27, the lowest since July 2007, from 21 percent in March 2009, Bank of America Merrill Lynch indexes show. Yields averaged 8.77 percent as of yesterday.

Borrowers are taking advantage of the demand, issuing $109.1 billion of debt this year, compared with the record $162.7 billion in all of 2009, data compiled by Bloomberg show.

Investors are also snapping up junk bonds as Federal Reserve policy makers pledge to hold interest rates near zero for an “extended period” to stoke the economy. Of the 460 companies in the S&P 500 that reported first-quarter results, 77 percent said earnings exceeded analysts’ estimates, Bloomberg data show.

Gross domestic product may expand 3.2 percent this year, after contracting 2.4 percent in 2009, according to the median estimate of 72 economists surveyed by Bloomberg. Housing starts climbed to an annual rate of 626,000 in March, up 1.6 percent from February’s 616,000 pace, though still half the level from October 2007, according to Commerce Department data.

....

No End

Martin Fridson, the chief executive officer of New York- based money manager Fridson Investment Advisors, said the loosening of covenants isn’t at a level yet that would signal the end of the bull market in junk bonds.

Covenants are typically strengthened following periods in which high-yield issuers are blocked from the market, “and at the end of that cycle, there’s an ‘anything goes’ mentality,” said Fridson, 57, who was Merrill Lynch’s head high-yield strategist before leaving to form his own firm in 2002. “We haven’t reached that final stage.”

Cracks in the junk bond rally are emerging on speculation that rising budget deficits in European countries such as Greece, Spain and Portugal may cause lawmakers to curb spending, slowing the global economy.

Bond Losses

High-yield bonds in the U.S. have lost 2 percent this month, according to Bank of America Merrill Lynch index data. This would be the first down month since February 2009, when they fell 3.47 percent.

....

‘Like a Meme’

“Once you get a structure into the market, it replicates itself like a meme and it survives because the investors keep buying it,” Dill said.

Rising demand for junk bonds has also allowed companies emerging from bankruptcy, including Houston-based Lyondell Chemical Co., which sold $2.75 billion of debt in dollars and euros on March 24 and Lear Corp. of Southfield, Michigan, which issued $700 million of notes on March 23, to borrow with few restrictions, Covenant Review’s Cohen said.

Lyondell’s covenants offer no clear limits on the amount of additional secured debt the company can sell and permit it to shift as much as $1.25 billion of assets to units that aren’t covered by the bonds’ limitations, reducing the collateral available to creditors, according to a Covenant Review report.

“In 2008, all the companies that we said would screw the bondholders did it,” said Cohen of Covenant Review. “Now, it feels like 2007 to me. We’re telling them they’re going to get screwed and they’re not paying attention.”

An Annuity Bubble?

In an article entitled "Annuities: Their Surprising Comeback" Elizabeth O'Brien of SmartMoney chronicled the "surprising" explosion of annuity purchases, especially by boomers. It seems that boomers, having been twice burned by the stock market in their peak investing years, are now twice shy. We have talked about this phenomenon before. My take? The push for yield continues and investors expectations for this asset need to be moderate at best. Maybe something on the order of 6-7% per annum, barring further financial distress.

The link is found here.

When Karin Kuder retired in 2007 from her career as an occupational nurse, she hardly imagined she’d wind up writing a six-figure check to an insurance company and signing away control of her nest egg. But after she lost tens of thousands of dollars in one scary swoop in 2008, she found herself enduring sleepless nights. So Kuder, who’s 62, put more than $150,000 in a fixed annuity, where it grows at a steady rate and can’t shrink if the market drops. “I don’t worry about that money,” Kuder says. “It’s safe.”

They can be a nightmare to understand, even harder to shop for. And yet the inscrutable annuity, a product that’s been around for centuries, is fast becoming the country’s most tempting retirement investment, offering the kind of security that financial advisers say aging baby boomers are grasping for. For years, of course, annuities have been picked apart by critics, and even by some advisers who sell them, for their high fees and bewildering rules. (The number of pages in a typical prospectus for one kind of annuity: 700.) But as economic insecurity lingers, some experts are seeing annuities as a product that can deliver the kind of guaranteed monthly paycheck—in good times and bad—that our parents enjoyed in the age of the company pension.

In a twist that fits a cautious era, it’s the least sexy of these investments that have fared the best. In 2009 so-called fixed annuities attracted $108 billion in assets, 48 percent more than they did two years prior, according to Limra, an insurance trade organization. Although sales slacked off somewhat as the stock market recovered, Americans have still sunk their money into these investments at a rate of about $300 million a day, and the insurers that sell them are pouncing. Major annuity sellers have stepped up their efforts to get employers and mutual fund companies to include annuities in workers’ 401(k) plans. And advisers who’ve backed annuities all along are saying they told us so. Jean Fullerton, a planner in Manchester, N.H., says the number of her clients buying annuities has surged in the past year. “Now that we’ve had the market crash,” she says, “they’ve finally caught up to my thinking.”

The industry certainly has momentum on its side. Most investors haven’t recouped the savings they lost in the crash. In a recent survey by the Employee Benefit Research Institute, roughly one in four people said they might postpone retirement for financial reasons. Annuity providers say they’re prepared to cover that gap; they often cite a study by Wharton School professor David Babbel, who concluded that a retiree who didn’t annuitize some savings would need a nest egg 25 to 40 percent larger than someone with annuities in his portfolio. That study was financed by the insurance industry, but it has swayed some skeptics—even the Obama administration has since given annuities an implicit endorsement.

Still, annuities haven’t gotten any less complicated, and there’s no easy way to compare investments whose features and costs vary depending on who’s selling them and whose prospectuses can rival War and Peace. With these issues in mind, we put together our first-ever ranking of the top annuities. We combed through more than 100 annuity offerings from two dozen major insurers, ferreting out details about their prices and features; we also turned to researchers at Morningstar and A.M. Best to help us gauge their financial strength and uncover hidden fees.
Making the “mortality” wager

For many years, basic annuities were an afterthought: They were briefly in vogue after the tech bust, but as stocks heated up mid-decade, their popularity receded. The latest crash, of course, changed investors’ attitudes—and prompted an unexpected shout-out from the White House. In January the president’s Middle Class Task Force, charged with helping average Joes repair their bank accounts, said that fixed annuities could reduce the “risks that retirees will outlive their savings, or that their living standards will be eroded by investment losses or inflation.” Today the Labor and Treasury departments are mulling over proposals for bringing annuities into the retirement-savings mainstream.

Fixed annuities play a security-blanket role by setting up a slightly creepy wager: The customer gives the insurer a chunk of money, the insurer bets that the customer will die before she gets her money back, and the customer bets she’ll outlive her money and then some. The older the customer is, the more likely it is the insurer will win. That calculus gets converted into a payout through “mortality credits,” explains Chris Blunt, executive vice president of annuity giant New York Life. So a man who buys an annuity at age 70 might get paid 8 percent a year, while a man who buys at 50 would earn less than 6 percent.

What troubles some investors is that fixed really means fixed—as in set in stone, like Medusa’s victims. If the stock market goes up 50 percent, an annuity owner’s annual 8 percent can feel measly by comparison. That’s why for most of the past decade, variable annuities, which invest the customer’s money in mutual funds and potentially pay more, were the hotter investment. Though still an option, those annuities got into some hot water during the crash, inflicting losses on companies that sold them. Today many advisers look more carefully at an insurance company’s financial strength. These ratings are issued by third-party companies; advisers and insurers will disclose them to customers who ask. Grade inflation is rampant in this world, however: B or B+ is the lowest score that most insurers post, and there can be a big difference between a single-A-rated company and a top-rated, A++ company, says Clifford Michaels, a financial adviser in New York City.

Experts also say that fixed annuities aren’t always quite as restrictive as they sound. More companies now allow the buyer’s heirs to keep receiving payments if the buyer dies earlier than expected. Investors can also get payments that rise to adjust for inflation. These features come at a price, in the form of lower monthly income, notes Judith Alexander, director of sales and marketing at annuity consultants Beacon Research. But annuity companies, including New York Life and Nationwide Financial, say they’re doing more to make those features more flexible and, potentially, cheaper.

Still, even financial planners who love annuities don’t sell them to all their customers. They seldom make sense for people in poor health. And for younger buyers, the meager payouts aren’t usually worth the loss of control. The sweet spot for investors begins when they’re in their early 60s. But advisers stress that even then most investors should stash, at most, 40 percent of their assets in annuities, with the remainder in other investments—they need to keep their portfolios growing and have cash on hand for emergencies. Indeed, for a long time, advisers and investors thought of annuities and other investments as an either-or proposition, says Eric Henderson, senior vice president for individual investments at Nationwide: “More and more, people are saying it’s ‘this-and.’”

Here's the takeaway. Annuities become very popular after crises like the tech bust and 2008. They have a role in a portfolio but it's limited. When an advisor legitimatelt believes that his client may outlive his money, AND A PRODUCT IS AVAILABLE, AFFORDABLE AND SUITABLE, then an annuity my be introduced into the investment mix to maximize the probability of funding retirement. (Nothing in life is guaranteed, folks.) Otherwise, annuities are an insurance policy that most can't afford at a time when least desirable, i.e. right when the asset class you were frightened out of (stocks) have the highest return probabilities.

The Rush to Safety

We have been talking about this dynamic for over a year now. The public usually rushes into an investment class at precisely the wrong time. For the tail end of 2008 and 2009, that asset class was fixed income.

Bond fund inflows reached record levels in 2009. The story is here.

Full-year inflows to bond funds in 2009, including traditional mutual funds and ETFs, reached a record high of $396 billion, according to a report by research firm Strategic Insight.

Long-term mutual funds, including stocks, bond funds and ETFs, experienced net inflows of $425 billion last year, according to the report.

Taxable bond funds had the highest net inflows in 2009, at $324 billion, followed by equity funds with $75 billion and U.S. equity funds with $6 billion.

Emerging markets saw net inflows of $55 billion; ETFs, $114 billion; and traditional index funds, $54 billion.

“There was a lot of demand for bond mutual funds last year,” Avi Nachmany, Strategic Insight director of research, said in a conference call, noting that the total return for bond funds averaged 17% in 2009.

Returns for the asset class were very good last year as the interest rate environment turned out to be very supportive. This year, not so much so. Rates are rising. I expect them to eventually rise much further. When? As soon as the deflationary forces abate. When will we see that? When credit contraction stops and an economic recovery unfolds. Does that exist now? No way.

Investors hated equities in 2008. They will hate bonds at some point too.

Of Two Disconnects: The Economy and Portfolio Performance

I usually try to refrain from commentary strictly on economics and this post-- while close-- is no exception. There's a huge disconnect between Main Street and Wall Street that exists today and it isn't getting any better. For us to overcome this financial crisis these two sides must meet. We can't long exist in a dichotomous society. From Bloomberg:

Americans are down on the economy and the markets even as stocks and growth indicators are up.

By an almost 2-to-1 margin Americans believe the economy has worsened rather than improved during the past year, according to a Bloomberg National Poll conducted March 19-22. Among those who own stocks, bonds or mutual funds, only three of 10 people say the value of their portfolio has risen since a year ago.

During that period, a bull market has driven up the benchmark Standard & Poor’s 500 Index more than 73 percent since its low on March 9, 2009. The economy grew at a 5.9 percent annual pace during last year’s fourth quarter.

“It’s very difficult to turn perceptions around once you’ve been through the proverbial economic wringer,” says Mark Zandi, chief economist for Moody’s Economy.com. “Everything is colored by the fact that unemployment is near 10 percent. It doesn’t really matter what you ask, you’re going to get the same answer.”

Zandi says the poor performance people report on their investments “is very telling. It’s just a fact that everyone’s stock portfolio is up, or nearly everyone’s.”

Even among investors with annual incomes exceeding $100,000, and who might be expected to follow their financial holdings’ performance, more say they have lost money compared with a year ago than say they have made money.

J. Ann Selzer, president of Selzer & Co., a Des Moines, Iowa-based company that conducted the survey, says the disconnect is typical of the way Americans think about the economy.

‘Everyday Life’ Indicators

“Economists look at their indicators and the American people see indicators in their everyday life,” she says. “It is hard to argue with what people observe in their own communities.”

The poll also finds that Americans remain skeptical about the health-care overhaul even after the U.S. House passed the legislation March 21, with fewer than 40 percent of respondents saying they favor the plan. While most say the government should play a role in ensuring everyone has access to affordable care, a majority say health care is a private matter and consider the new rules approved by Congress to be a government takeover.

Wrong Track

A sense of despair pervades perceptions of the economy and nation. Barely one-in-three Americans say the country is on the right track. Fewer than one in 10 say they believe the economy will be strong again within a year. Just 4 percent of Americans who cut back on spending during the recession now say they are confident enough to open their wallets, according to the poll, which has a margin of error of plus or minus 3.1 percentage points.

Poll respondent Lynn Heath, 31, a Belleville, Illinois, stay-at-home mom with four children whose husband lost his job 18 months ago and since has only been able to find part-time work, says her family has nearly depleted its savings.

“We don’t have cable. We don’t have internet. I just learned how to make laundry soap. For $4, I can make two-and- half gallons,” Heath says.

The Obama Administration has made no progress over the past three months convincing the public that the $787 billion stimulus package passed last year either helped the economy or prevented greater deterioration. Only 37 percent of the public say they see positive effects, the same portion who said so in a December poll.

Economic Deterioration

Asked about a range of economic measures, people say they have seen deterioration over the past year: 54 percent say the condition of businesses in their community has worsened and 56 percent say the value of homes in their community dropped during the period.

Poll respondent Jim Buyer, 47, an electric utility lineman from Syracuse, Indiana, says that his impression of a worsening economy comes from cutbacks in overtime on his job and his observations as he drives to and from work along an industrial road that services home suppliers, toolmakers and recreational- vehicle manufacturers. Media reporting on the economy may be “slanted,” he says, and what he sees has greater credibility.

“We see the traffic in front of where we work,” Buyer says. “A couple of years ago it was hard to pull out at quitting time. Now you almost don’t even have to look because the traffic is so slim.”

Most Important Issue

Half of Americans say they believe the economy or unemployment is the most important issue facing the country. Health care was cited by 22 percent, followed by 20 percent who cite the federal deficit and government spending. Just 5 percent say the war in Afghanistan.

Unemployment in February was 9.7 percent. Payrolls in the U.S. have dropped every month except one since December 2007. Economists expect job growth to turn around in March, with a median forecast that payrolls will rise by 192,000.

Poll respondents rate persistently high unemployment the greatest threat to the economy over the next two years, with 75 percent calling it a high threat. Chronically high budget deficits are cited as a high threat by 70 percent, followed by homeowners who can’t pay their mortgages, which is cited by 58 percent. Higher taxes are deemed a high threat by 57 percent.

Nine of 10 Americans believe that cutting the deficit, which is projected to reach a record $1.5 trillion this year, will require sacrifices from middle-class Americans. Still, when asked about a range of potential tax increases and spending cuts to address the problem, the large majorities of Americans favor tax increases that only affect the wealthy.

More than three of four Americans say deficit-cutters should consider removing the cap on earnings covered by the Social Security tax, currently set at just under $107,000. More than two-thirds say repealing the tax cuts for wealthy Americans enacted by President George W. Bush should be considered.

Smaller majorities favor considering three other options: a reduction in annual cost of living increases for Social Security recipients, which 52 percent say should be considered; cuts in spending on public works, which 54 percent say should be considered; and a penny-an-ounce tax on sugar-sweetened drinks amounting to 12 cents on a 12-ounce can of soda, which 57 percent say should be considered.

Majorities say other options shouldn’t even be on the table. Among them are higher out-of-pocket payments for Medicare services beyond basic care, an increase in the eligibility age for Medicare, a 2 percent increase in income-tax rates on middle-class Americans, and elimination of the home-mortgage interest deduction.

What Hath the Rally Wrought?

This rally in financial assets is relentless. Perhaps the non-professional doesn't appreciate just how extraordinary it has been but friend Barry Ritholtz of The Big Picture blog has ranked it in terms of return over time and it's in the upper 1% of rallies.

Everyone needs to assess their risk tolerance. This has been a risky market since the Lehman Brothers blowup (and really for some time before that) and it's a risky market now. The difference has been that this is a risky market that's rising at an incredible pace whereas in Fall of 2008 it was a risky market that was falling at an incredible pace. Nimble traders LOVE these kinds of markets.

I don't pen my thoughts in this area for traders. I do it for investors. Big difference. Traders can trade ANYTHING. Investors look at what is possible over their relevant timeframe and allocate capital or decide not to.

What is one of my favorite sources of long term valuation (Smithers & Co.) saying about this market? Take a look:


US CAPE and q chart

With the publication of the Flow of Funds data up to the end of 2009 (on 11th March 2010) we have updated our calculations for q and CAPE, which show very little change from our previous calculations.

Non-financial companies, including both quoted and unquoted, were 52% overvalued according to q at the end of 2009. Net worth is virtually unchanged from Q3 to Q4. Domestic net worth fell through dividends ($83 bn.) plus net equity buy-backs ($95 bn.) being greater than net domestic profits after tax ($164 bn.), but this was offset by some small upward revisions to asset values. There was a small increase in the value of US foreign investment abroad ($27bn.), but this was less than the amount of foreign earnings retained abroad, probably due to currency adjustments.

The listed companies in the S&P 500 index, which include financials, were 50% overvalued according to our calculations for CAPE, based on the data from Professor Robert Shiller’s website.

Can you make money in overvalued markets? Absolutely. These conditions can persist for years just as they did in the period 1995-1999 and 2004-2007. Investors who were out of the market in those years due to overvaluation concerns missed some very nice returns. They also missed some horrendous subsequent declines. Those declines have the unfortunate effect of shaking a lot of investors out of their positions in the market. They then miss the subsequent gains. We have spoken of this before.

I am just sharing a valuable source of information. That being said, I am constructively long here with a good deal of risk management in place. It will be interesting to see how this resolves itself.