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Storm Watch: Bubble Troubles - Part III
(September 27, 2002)

by James J. Puplava / Financial Sense Online

It Ain't Over Yet for the Stock Market

Today's Battle Cry, "Buy Now! Stocks Are Cheap!"

Stocks are cheap and it's time to buy! On Wall Street, the mantra has always been, "It is a good time to be buying." Everything from the standard cliché of "Own stocks for the long-run." and "Rate cuts will bring a second-half recovery." to "Stocks are a bargain." are touted to the investment masses to keep them fully invested. Since the beginning of the year (and the standard argument for the last three years running) we've heard that there will be a second-half recovery. Now that this scenario has been dismissed, the new mantra is "Stocks are cheap."

The summer rally was predicated on the premise of the Fed lowering interest rates. They didn't. The Fed will lower rates during the next financial crisis. And believe me, there are many potential crises in the wings. Today the Fed confronts many challenges: falling stock prices, a slumping US economy, financial derivatives, Latin American debt defaults, an upcoming war, and trouble brewing in the banking and lending sector. Government regulators are now monitoring Fannie Mae's portfolio daily rather than monthly. So, the Fed will keep its last remaining bullets for the next crisis when it emerges. After they fire off the next round of interest rate cuts, the next step could well be one of desperation. If rate cuts don't do the trick, the FOMC would be forced to take drastic measures which might include lowering bank reserves or monetizing debt and other financial assets such as is being done in Japan.

Are Stocks Cheap?

Even with this knowledge of looming crises, Wall Street and the media are reverting to their "stocks are cheap" mantra. On what basis are stocks cheap? If we take standard measures of value: dividend yields, price/earnings ratios, and price/book-value ratios, this market is still grossly over-valued. On what argument does the "stocks are cheap" mantra rest? Well, investors are actually given several compelling arguments. Stock prices have fallen three-years in a row, so they are bound to rally is one reason. Another is that the major indexes have fallen so much, they are now a bargain. They do have a point. The major indexes have dropped significantly as shown below.

On the basis of this rationale, stocks are most certainly cheaper today than they were at the peak of the bull market in 2000. The fact that the NASDAQ has lost over 76%, however, does not make it cheap. Why? The NASDAQ doesn't have earnings. Companies that make up the Index are still losing money. The largest companies in the index, the NASDAQ 100 are currently selling at 37 times earnings, hardly a compelling bargain.

The table below taken from last weekend's Barron's shows the standard measures of value for the Dow and the S&P 500.

Stocks AREN'T Cheap .... Yet

Questionable Earnings - Questionable Bottom Line
There is nothing here that screams, "Buy me!" or tells me that stocks are cheap. With corporate earnings still questionable, as we are constantly reminded each week with new scandals or accounting irregularities, earnings numbers remain questionable. So investors need to take care when buying stocks based on corporate profits. Company officials, Wall Street analysts and network anchors still use pro forma numbers. These numbers don't reflect corporate restructuring charges, interest expenses or large depreciation charges. We are still dealing with numbers that don't reflect the bottom line.

Problematic Fed Model
Another argument that often makes the case for stocks as bargains is the Fed Model, which is based on current interest rates and projected future profits. The major problem with this model is that interest rates are subject to abrupt changes and can be manipulated artificially by the Fed. The S&P500 chart below right shows the Fed Model. Currently, it shows that the S&P 500 has fallen below fair value, implying markets are undervalued.

The other problem with this model is the fact that projected earnings are seldom accurate. They are wrong more than 80% of the time. All you need to do is go back to the beginning of this year and look at forecasted earnings for the S&P 500. In January, they were forecasting over 30% pro forma earnings growth for the third quarter and over 40% earnings growth in the fourth quarter. The reality is third quarter pro forma profits have been cut by over two-thirds and fourth quarter profits have been cut in half. I'm sure those fourth quarter numbers will be cut in half again after third quarter results are reported. The point here is that the two variables that make up the Fed model, interest rates and future earnings, are highly unreliable. The bond market has moved into a bubble state with a booming credit expansion and an influx of institutional money into the bond market. A dollar crisis could quickly bring about a rise in interest rates, changing the fair value calculation in the Fed Model. The other variable, future earnings, is highly unpredictable and inaccurate. Just look at the charts of the major indexes above. Wall Street has forecasted a recovery for the last three years running. Instead of recovery, we have seen the opposite. The economy went into recession and it may do so again. Earnings have fallen and stock prices have plunged.

The simple fact is that after a boom and a bubble bursts, it can take years before markets recover as shown in this graph from Barron's below.

Survivorship Bias Skews Results
After the 1929 Crash, it took 25 years for the Dow and the S&P to get back to their old highs. After the stock market peak of the mid-sixties, it would take sixteen years to surpass previous records. This also ignores the survivorship bias. Many of the companies in the Dow and the S&P did not survive the Depression. The indexes are constantly changed to reflect new businesses and replace companies that have gone under or have merged. The S&P 500 is, in effect, a managed index. Companies are added and deleted from the index periodically. When indexes take time to recover from previous booms, they are oftentimes not the same index because of the changed components. This survivorship bias is often ignored statistically when performance and recovery are discussed.

Forecasted Earnings Unreliable
The problem with forecasted earnings is that they are highly unreliable and subject to constant change. The father of securities analysis, Benjamin Graham, did not believe in predicting earnings for stocks. In his last book, The Intelligent Investor, Graham urged investors to look at stocks based on their investment merit with value measures. Benjamin Graham was an eminent security analyst. The fact that he declined to predict earnings reflects his long experienced view that he did not have much confidence in his own ability or in others in making predictions, especially long-term ones. Graham felt that profit forecasting was too inaccurate to be useful for intelligent investing. Ben Graham believed that future earnings were already incorporated into market prices. Using forecasted earnings for valuation measures gave way to the danger of double-counting for good earnings prospects. Commenting on their inherent inaccuracy, Graham wrote, 

"In forty-four years of Wall Street experience and study I have never seen dependable calculations made about common-stock values, or related investment policies that went beyond simple arithmetic or the most elementary algebra. Whenever calculus is brought in, or higher algebra, you could take it as a warning signal that the operator was trying to substitute theory for experience, and usually also to give to speculation the deceptive guise of investment." 1

In fact, towards the end of his 82-year life, Graham considered his last book "The Intelligent Investor" to be more useful to investors than his acclaimed book "Security Analysis" written in 1934. Security Analysis became the bible of the securities industry. Much of the analytical techniques used today were based on Graham's work back in 1934. Yet towards the end of his life and career, Graham had simplified his knowledge and work into "The Intelligent Investor" which he felt would be more useful to security analysts. In the last and fourth edition to the book, Graham's famous student, Warren Buffett, wrote the preface to the book. Buffett remarks, "I read the first edition of this book in 1950 when I was nineteen. I thought then it was the best book about investing ever written. I still think it is." 2

A Margin of Safety

What Graham gave investors was a framework for making investment decisions. He developed his now famous concept of "Margin of Safety." Graham felt that stocks should be bought like groceries and not like perfume. Stocks should be purchased for less than they were worth. This discount to net worth gave investors their margin of safety. Measures such as dividend yield, price/book ratio and price/earnings ratios were the yardsticks used to measure value. By buying things cheaply, an investor could be expected to achieve better returns and avoid costly mistakes. Investment decisions based on value didn't mean that investors could avoid all risks or that their investments would not fluctuate. What Graham hoped is that by following value principles, investors would experience less risk in their portfolios and over time, achieve superior returns. The best investment managers of the last century, from Warren Buffett and John Neff to Bill Miller, have all followed or built their success on many of Graham's value principles.

With Graham's principles of value in mind, let's look at today's stock market in terms of price/earnings ratios, dividend yield, and price/book-value ratios to determine whether stocks are cheap. I'm going to ignore all of the hype of pro forma estimates for this year or next year as irrelevant. Wall Street earnings estimates are not based on GAAP earnings and even if they were, their track record for forecasting profits has been dismal. These are the same people who have been forecasting a second-half recovery for the last three years. These are the same people who downgraded Enron after it collapsed and the same people that recommended investors buy; while internally they were saying, "Sell." The difficulty of forecasting earnings has already been covered. What we can work with is the here and now and how things really are today.

Value Principle #1  Price/Earnings Ratio

To begin with, price/earnings ratios are still historically high -- as high if not higher than they were in 1929. A current price-earnings multiple of 22 on the Dow, 33 on the S&P 500, and 37 on the NASDAQ 100 (the NASDAQ has no P/E ratio since it has negative earnings) would hardly be considered a bargain. Historically, the major stock indexes have sold at 12-14 times earnings throughout the last century. At bear market bottoms, they have gotten as low as 7-10 times earnings.

In the last decade investors were told that the US economy and financial markets were experiencing a new paradigm. This new paradigm theory was used to justify the mania in stock prices. Investors who believed in this nonsense have now paid a painful price in losses for ever believing the cliché, "This time it is different." What investors are now finding is that there never was a "new era." The "new era" earnings long hailed as justification for higher stock prices was the product of creative accounting, financial engineering, and deceit on the part of many companies. This deceit and bogus fiction is now being investigated. Each week we get new revelations of one company after another that is restating revenues, earnings or both as political and legal pressure is put on companies to come clean. Wall Street firms are also under investigation for their conflicts of interest and their tainted calls on many of their stock recommendations.

Jiggering the "E" (Earnings)
In addition to high P/E multiples, the "E" in P/E needs to be questioned. Most reports where you hear of companies beating estimates are most often based on pro forma numbers. These numbers leave out large restructuring charges due to company writeoffs of goodwill or downsizing the company by scuttling plants and laying off workers. Rising interest expense is also ignored as a result of large debt burdens. Then there are the increase in depreciation charges that are a result of investments in technology. Many technology investments are depreciated over short periods of time because the equipment or machines become obsolete much quicker. So depreciation charges are amortized over a shorter period, resulting in larger expenses. Many analysts ignore this number because it is a non-cash expense. However, the equipment and machines will eventually have to be replaced. Not to account for them is overestimating earnings. To stay competitive today, companies need to innovate and keep their costs down. One way to do that is to invest in better and more modern plants and equipment to remain competitive. Depreciation expense is a real cost of doing business. Machines and plants break down and have to be replaced, so depreciation of plant and equipment is a real expense.

I mentioned earlier that the major indexes were selling at high historical P/E ratios when compared to markets in the past. However, you often hear many analysts mention that companies are cheap based on pro forma projections. It might be useful to examine the income statement taken from an earlier Storm Update, Let the 2002 Goodwill Games Begin! below.

SAMPLE FORMAT OF AN INCOME STATEMENT
Revenue from the sales of goods and services:
+	Other income and revenues
-	Operating expenses
-	Financing costs
+/-	Unusual or infrequent items
=	Pretax earnings from continuing operations
-	Income tax expense
=	Net income from continuing operations *
+/-	Income from discontinued operations (net of tax) *
+/-	Extraordinary items (net of tax) *
+/-	Cumulative effect of accounting changes (net of tax) *
=	Net Income * (The real bottom line)
* Per share amounts are reported for each of these items.

The number often quoted when referring to pro forma numbers could be any of the five asterisk numbers listed in the table on the left. Essentially, there are now five variations of earnings, so you never know if what you hear is the real number. The real number is contained in the 10-Q report filed with the SEC 45 days after the earnings press conference.

P/E Reciprocal: The Earnings Yield

The real issue here is the quality of earnings and what high P/E multiples really mean. The reciprocal of the P/E ratio is the earnings yield. It converts the P/E multiple into a percentage return. If we take the current P/E on the three major averages, the Dow is offering investors a 4.6% return. The S&P 500 is offering a return of 3% and the Nasdaq 100 earnings yield is 2.7%.

These returns are not commensurate with the risk involved in investing in today's volatile and high-risk market. There is hardly any room for a risk premium in these returns and that is what is missing from today's P/E numbers. There are no compensatory returns being offered for poor earnings quality, economic and financial risks, or geopolitical risks. What we can safely assume in looking at today's markets is that stocks aren't cheap, contrary to what you are now being told. From a value investing point of view, since stocks aren't cheap, this bear market has a long way to go before they become bargains again.

Value Principle #2  The Dividend Yield

Another measure of value is dividend yield. Here again the stock market offers no value to compensate for risk. In terms of value, dividend yields are extremely low as this graph of yields over the last 130 years indicates. Looking at this graph shows that during bear markets such as we had in 1907, 1929 and 1974, dividend yields can get quite high as stock prices plunge. The present day investor may find it hard to believe, but throughout most of the last century, stocks paid more income than you could receive on a bond. This was because a stock was considered to be a riskier investment.

Therefore, they offered a higher return to compensate for that risk. This is not the case today as illustrated in this graph. Today's yield of 2.26% on the Dow, 1.77% on the S&P 500, and 0.11% on the NASDAQ 100 means an investor has to pay $44 for every $1 dollar he receives on the Dow, $56 for every dollar on the S&P 500, and $900 for every dollar received on the NASDAQ.

The importance of dividends can't be overestimated. In their book Triumph of the Optimists, Elroy Dimson, Paul Marsh, and Mike Staunton documented the superior returns of dividends. Dividends are a critical element in the long run gains achieved in investment portfolios in accumulating wealth. "Over the course of the last 101 years, a portfolio of US equities with dividends reinvested would have grown to 85 times the value it would have attained if dividends had been squandered." 3 The authors document that dividend yields as shown in the graph above are at a 101 year low. Various reasons have been given for this occurrence noted as the ubiquitous explosion of smaller companies (which seldom pay dividends), the exploding IPO market in the 90's stock market bubble and stock buybacks.

You often hear the reason dividends are so low is because companies choose to invest profits to expand the business instead of paying shareholders in the form of a dividend. This may have been true, but the next question should be, How well did management reinvest your money? Given the amount of impaired risk charges that will be taken, estimated to be $1 trillion over this and next year, shareholders would have been better off receiving the dividends. Instead, profits were squandered in mergers, stock buybacks and option schemes for top executives that fleeced the shareholders. This practice still goes on today.

Dividends Can't Be Fudged

Backed by Reality
The one aspect about dividends versus earnings is that dividends have to be backed by real earnings and cash. They can't be engineered or manipulated like earnings. Either a company has the cash to pay a dividend or they don't. If they don't have the earnings or the cash, the dividend is reduced. Dividend payments tell you a lot about the company's health -- more so than earnings which can be modified, restated or reengineered. How many times over the last year have you heard about companies changing their earnings and revenue numbers because of fraud and deceit? In the words of Geraldine Weiss, author of Dividends Don't Lie,  "Dividends are real money -- not just figures on a balance sheet. Once a dividend is paid it is gone forever from that company. Subterfuge cannot be used in the bookkeeping department over a dividend. Either it is paid or it is not paid. And if not paid, there is a reason." 4

Bankable Returns
Dividends will continue to be a critical element in any investment portfolio. They help to increase the total return from the portfolio when added to share price growth. They also help to stabilize the portfolio in market downturns. Dividend-paying stocks hold up much better in bear markets than the shares of companies that pay no dividends. When those dividends are reinvested, they can also help compound investment returns over a long period of time, substantially increasing investment returns. Dividends also help to produce the virtue of patience in investors, which is sorely lacking today. Most investors live in a fast food world. They expect the stocks they purchase to go up immediately. Most investment courses today are based on constant trading. If a stock doesn't go up immediately, investors have been taught to sell. The nice thing about dividends is that they can reward you for being patient. You get cash every quarter, whether your stock goes up or down. With dividends, you get cash to spend or cash to save. A dividend is bankable. Price appreciation isn't.

Useful Market Monitor
Dividends can be another useful indicator in determining whether stock prices are overvalued. Historically, the markets are considered to be overvalued when dividend yields drop under 3%. The market is considered to be undervalued when dividend yields rise above 6%. As the graph of dividends above illustrates, dividend yields can rise as high as 6-8% in a bear market as share prices tumble. When I got into this business in the late 70's, 7-14% yields were commonplace. The major indexes offered yields of 7-8%; while high quality utilities paid dividends of as much as 12-14%. Interest rates and inflation were much higher then and we were in a bear market.

In my opinion, we are destined to travel that road again as governments burn their currency. The deflation that is coming will occur in the investment markets with stocks and bonds, in real estate and with credit-related consumer goods such as autos and other big ticket items and luxury goods. Elsewhere, we will experience inflation. Deflation in asset prices as it pertains to stocks will mean lower prices and higher dividend yields. In relation to the current bond market bubble, yes, I said "bubble," it will mean higher interest rates.

With a current dividend of $187.46 on the Dow and $15.75 for the S&P 500, this bear market has much further to travel before we get to fair value, much less undervalue. The following table illustrates hypothetical values for both major indexes assuming, and that is a big if, the current dividend holds.

The value to the right reflects where the index would have to fall in order to get to undervalue. When I began my career, the average stock carried a dividend yield of 7-8%. As stock prices continue to fall in the continuation of a bear market, equity risk premiums should rise along with dividend yields as investors price-in greater risks for owning stocks. I believe the numbers reflected above will become more realistic as risk levels rise along with inflation and interest rates. The second phase of this bear market should take us to fair value and below for both the Dow and the S&P 500.

Value Principle #4  Price-to-Book Ratio and Price-to-Sales Ratio

The final measure of value is the price-to-book ratio. Book value is the same as the net asset value of a company. It is computed by taking the company's total assets and subtracting current and long-term liabilities, intangible assets such as goodwill and equity issues with a prior claim. Book value is the bare bones value of a company. It is what a company would be worth if it was liquidated. Book value was one of Ben Graham's favorite valuation yardsticks used to find value in the stock market. One of Graham's favorite rewards criteria (listed in appendix) was to find companies whose stock price was selling at two-thirds of tangible book value per share. This figure can easily found in Value Line. Graham advised investors to focus their attention on buying stocks at less than their book value. It was part of his margin of safety principle. As the graph of book value (or Price/Book) shows, the stock market is still overpriced. Most shares sell at 3-4 times book value. Very few high quality companies sell at discounts to book value. The good news is that this list keeps growing as stock prices continue to fall. Another measure of value is price-to-sales, which measures how many times sales a stock is selling for. This measure is falling, but still remains high.

We're Still in a Stock Market Bubble

If we take all of the standard measures of value of P/E multiples, price-to-book ratios, dividend yield and price-to-sales ratios, this market is hardly a bargain. It is only a bargain if you ignore standard measures of value and other tried and true investment principles. Stocks are cheap only if you think there are other idiots out there willing to pay you even a higher price for the stock you just bought. This "Greater Fool Theory" is what led investors to overpay for tech and Internet stocks based on new valuation measures that were manufactured by Wall Street to pitch overpriced stocks to ignorant investors.

Outside of energy, food, tobacco, maritime, power producers, semiconductors, drug, utilities, and metals & mining, there are very few companies that offer value. In a recent screen I did of the Value Line Index, I found only 20 candidates out of 1700 that meet all five of my valuation measures. That is up from only 7 just four months ago. Things are improving, but we aren't there yet. We still need a washout, gut wrenching, sell-off period to bring stock prices down to fair value.

When Do We Bottom Out?

When your investment club requires fellow members to bring a brown bag to meetings when you discuss the portfolio, you will know we're close. When your neighbor tells you he or she bailed out of their mutual funds, and when mutual fund liquidations start making front page news, we will be getting closer. That will mean the second phase of this bear market will be close to over. Then we will get a recovery. Stock prices will rally, as they did during 1933-34, when the government and the Fed pulled out all stops to rescue the markets and the economy. Deflation in asset values scare governments. It means unhappy voters and less tax revenues as declining asset values follow a declining economy. Their efforts will give us a temporary reprieve, but in the end the market will have its way. It has always been so. In the end, the markets always win despite the best efforts of government to thwart it.

Investors should stay out of stocks other than necessities and issues that provide value. That value should be based on the measures discussed above. If you don't understand fundamental investment value, I would recommend reading Graham's "The Intelligent Investor." This book belongs in every investor's library. I have made it a habit to read it once a year. It reminds me of what is essential and it provides an intellectual framework for investing. It has enabled me to avoid most of the storms over the last decade and especially the last three years. You can be a good chart reader, but if you don't understand the basic fundamentals of the financial markets, those charts won't warn you of a sudden tsunami, white squall or a ten-sigma event. If they could, LTCM would still be a large hedge fund. The stock market bubble of the last century is still with us. The trouble is... most investors and professionals just don't see it.  ~ JP

Part 1  l  Part 2

BENJAMIN GRAHAM'S STOCK SELECTION CRITERIA 

REWARD CRITERIA
  1.  An earnings-to-price yield at least twice the AAA bond yield.
  2.  A P/E ratio less than 40% of the highest P/E ratio the stock had over the past five years.
  3.  A dividend yield of at least two-thirds the AAA bond yield.
  4.  Stock price below two-thirds of tangible book value per share.
  5.  Stock price below two-thirds "net current asset value."

RISK CRITERIA
  6.  Total debt less than book value.
  7.  Current ratio greater than two.
  8.  Total debt less than twice "net current asset."
  9.  Earnings growth of prior 10 years at least at a 7% annual compound rate.
10.  Stability of growth of earnings in that no more than two declines of 5% or more in year-end earnings in the prior 10 years are permissible. 5

Endnotes
Dividend Yield, Price/Book Ratio and Price/Sales Ratio Charts courtesy Sharefin, www.sharelynx.net 

1   Graham, Benjamin, The Intelligent Investor: A Book of Practical Counsel, Harper Collins, 1985, p. 321.
2   Graham, Benjamin & David L. Dodd, Security Analysis, McGraw-Hill, 1968, p.vii.
3   Dimson, Elroy et al, Triumph of the Optimists, Princeton University Press, 2002, p. 161.
4   Weiss, Geraldine, Dividends Don't Lie, Longman Financial Services, 1990, p. 7.
5   Blustein, Paul, "Ben Graham's Last Will and Testament," Forbes, August 1, 1977.

© 2002 James J. Puplava

by James J. Puplava
September 27, 2002

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