Friday, October 17, 2008

Is it safe to get back in the water?

In late 2002, I was going to write a book I was going to cal, Is it Safe to Get Back in the Water? In it, I used all kinds of market data to show that stocks were extremely overvalued, even near the bottom price of 2002 and that the buy and holder who got out or the guy looking for a once in a lifetime buy was making a mistake. For one, the PE on the S&P at that time was near 50, most companies having taken losses they were holding during the make the number or crash boom and financing being tough for the junk portion of the market. My reasoning was that the valuations were extremely rich, the dividend yields lower than at any time in history prior to this bull market and this was even true on the exact bottom tick, where there was about a 4 day opportunity to get in. Even so, the market presented a good opportunity to get in at prices not seen since 1997 and 1998, which is one of the reasons I expected the market to go down after a rally, not up. Generally, it has been my experience that if a prior bottom of significance doesn't hold, we go to the next significant bottom. There wasn't a significant bottom in the market until you got back to 1996, when the Dow was in the 5000 range and the SPX in the 500 range.

Being that the S&P internals over recent time had valuations over the long term that presented a value under 500 in 2002, I built a case that the market wasn't going anywhere long term for quite awhile. I didn't count on the extraction of several billion in home equity, the circular lending of credit back to the US for close to a decade from China and other countries and the advent of financial tools that could create marketable debt out of water. The financial bubble was going to get bigger.

What never changed was that stocks remained in ridiculous territory. At the peak, the dividends on the S&P were under 2%. It is true that there were companies in the S&P that spent huge amounts of money buying back their own stock, namely Exxon-Mobil (XOM), the big banks and a few staples like PG and MSFT. These 4 or 5 banks, 2 or 3 oil companies and 4 or 5 consumer companies amounted to over $100 billion a year in buybacks. XOM was buying back huge amounts of stock despite the protests that it wasn't putting its money back into oil exploration. The big banks, Citi, Bank of America and Chase were buying back $30 to $40 billion a year between them. Few would realize they would be going around the world shortly with hat in hand begging capital infusions, finally being part of a big government bailout.

The point of all these buybacks is that they could be used to pay dividends and adding them to dividends would give the market a pretty decent number. But, in my education, this isn't growth, but instead liquidation. In the case of the banks, we are now finding out that paying out all this capital in liquidation was a terrible mistake, as the ownership interest in these entities has been irreverisbly damaged and in fact, I suspect most would have gone broke without government and central bank assistance. In the case of XOM, it was clearly a liquidation of assets and likely vision that prices wouldn't hold at current levels and it would be better to use the money in liquidation than in exploration at that time. In XOM's case, investing in its own stock may have been the best use for the funds. I doubt their cash flow is going to zero any time soon.

Throwing out these entities, the negative and the positive, what do we have. The 3 Dow banks, at the peak, had earnings above $50 billion as a group. XOM has had historic earnings, so large that they have incited class warfare talk in Congress. Combined these 4 entities had close to 1/8 of the earnings in corporate America. Do they continue to generate this kind of income once the credit bubble deflates and quite possibly oil profits decline? I am going to say no for the time being and probably $50 billion or more of the temporary, bubble peak earning capacity of the Dow is gone having been a beneficiary of the biggest financial bubble in history. The other big earners in the Dow, are INTC, MSFT, MRK, PFE and a few others. In fact, all the Dow companies, save GM are high earning companies and between them, probably comprise close to 40% of all corporate profits. They claim MSFT is trading around a PE of 12, meaning their profits are around $20 billion. INTC is around $10 billion and the 2 drugs are probably a combined $20 billion minimum. Throw in another $25 billion for the telecoms (at least this amount, but I am making a mental estimate and not an informed guess). Then we are left with GE, JNJ, PG, WMT, AXP, BA, CVT and IBM. There is easily another $140 billion earnings out of this group. This gives the Dow 30 a top earning capacity of around $350 billion, easily 40% of all corporate earnings in the US at the peak. A bull could easily justify a market cap of $5 trillion for this group that should be able to pay $175 billion in dividends for a 3.5% yield.

This would be a reasonable valuation if we were talking about reasonable times, but I suspect we are on the way down. My past argument was based on SPX earnings and dividends, not the economy, though I knew at the time there was a threat to the economy. I had only an inkling of what the threat was, having digested only a small bit of what actually causes deflation. I did know it had something to do with asset bubbles, but what was supposed to crumble first? It is pretty apparent today what that is.

There are 2 reasons I don't like stocks. One is the low dividends, which I believe is a reflection of the judgement of corporate directors that these companies cannot sustain higher dividends and run the corporate environment they have evolved into, namely paying huge salaries and stock options to management. Another could be contained in the prior sentance, that management and Wall Street are taking advantage of shareholders in fashions that shareholders are only going to be aware of in years to come. Stock buybacks only give money to those that sell the stock, not those that own it, though it serves to concentrate earnings. What do you do for an encore if you need cashflow out of stocks? You don't live off dividends at valuations bulls would have you believe, unless you are very rich. Imagine being a millionaire and drawing less than $20,000 a year income out of your portfolio. I believe that the S&P ETF would pay you about $23,000 net out of todays SPX, roughly 940. $23,000 hardly pays the utilities and rent on a cheap apartment and gasoline and depreciation on a nice car these days. Thus, the holder is caught in a strangle of living below their means or liquidating their principal, neither attractive. The real point is that few are situated with million dollar portfolios and more than likely with less than $250,000. Holding an index fund provides very little in living expenses on this level and holding your portfolio heavily in one stock that pays well or in marginal bonds exposes the holder to market risk, though one could hold a portfolio of several stocks paying in the 5% range now. But, the capacity for this stock to be widely held is not there. Which of the banks do you want to hold now? I figure that 50% of the dividends are paid by 20% of the market capitalization on the SPX, which leaves room for about an $1.6 trillion investment in these stocks. Being that so much of the holdings are held by trusts, this doesn't leave much public float in these companies for the public to concentrate their wealth. The annual outlay for Social Security and Medicare are not much below half this range and I doubt half this stock is available to the public. This really isn't a solution to people looking for retirement savings.

The second reason is the bubble itself. I have looked at dividends and PE's from 1925 to 1930. There was an amazing growth in dividends and earnings between 1925 and 1930, as the financial bubble financed everything. I believe the Dow paid roughly a 3% dividend on the top in 1929 and an 8% dividend on the bottom. It quadrupled between 1925 and 1929 in price. The dividend rate fell from 4.8% to 3%, meaning payments went from roughly $4.80 on the Dow to about $11. If you look at the past 4 years, you will see growth in earnings that are way beyond reasonable and a level of corporate earnings that are the highest against GDP since, you guessed it, 1929. The momentum on these earnings went right into 1930, despite the crash.

It is hard to say how much of the earnings in the market came out of the bubble, but it is a good bet that most of them are going away. The government might be able to save the banks, but are we going to have a return to subprime lending, huge piles of money being borrowed by the financial industry to spin into leverage against a myriad of products, credit cards to homeless people and money for leveraged buyouts to anyone that can show the banks a plan? Remember, all this credit circulates and creates marginal demand. Marginal units are much more profitable than the average unit sold for about all industries other than units that cannot be produced without extensive extra resources. For example, how much do you think MSFT earns off an additional set of Windows or Office? My best guess is the box, disk and instruction book probably costs them $2 in the quantities they manufacture them for. The costs were already paid for the development and the product support is going to be the same whether they sell 20 million copies or 200 million copies. Being the real money is in business licenses, figure that business formation and growth goes down the drain in a burst bubble and they lose 10% of 100 million copies they would otherwise sell. My guess is that a license sells for $100 annually, so we are talking about 10% of MSFT's profits on this one item. Throw in the license of Office, probably 50% of Windows and there goes another 5% of their business. Throw in the fact that consumers aren't buying new PC's to roughly a 30% sales decline and the 200 million copies becomes 140 million copies at $50 each. There goes another $7 billion or 35% of their profits. In these 3 centers alone, there is 50% of MSFT's profits and we aren't even talking about growth.

We have already seen the auto industry implode. Housing is still being peddled at pre bubble records, so it hasn't come apart as it should before we are done. AAPL has some new fangled computers and cellphones, but I find it doubtful that the market for $500 cellphone gadgets is going to hold up and we are going to see a price war between the competitors for a shrinking market. The market may not shrink as much because the prices may fall to the point that the cheap alternatives are no longer attractive. Then throw in the shrinkage in cellphone demand, the shrinkage in business demand for telephones and you see the marginal profits of the telephone companies disappear. You also see a battle to utilize capacity in this field, which could very well erupt in a price war for subscribers. I venture telecom is nearly as big as oil in the US economy.

What is the alternative? Bulls are now claiming that the Dow is priced along historical grounds. Of course, they are looking at a Dow of 8800 and not 14,000. They were bulling the Dow at 14,000 too, but the outlook when it was at 14,000 was much better to the general public than it is now. If they are correct and we get the financial collapse solved, you then own an index that pays about a 3.4% dividend and will grow at inflation plus maybe 1%. This gives an inflation plus 4.4% return, some 1.4% greater than the long term return out of treasuries, but far from the 10% they tell you that stocks return. 7.5% looks good when compared to t-bills and CD's right now, but the CD's and t-bills aren't going to be this low forever and will return inflation plus 3% over the long term.

In taking this alternative, one must realize that if stocks are roughly at long term normal values, using 2.5% inflation, you get a double in 20 year and maybe as long as 24 years. They are telling young people they should stay in the market and old people to get out, why? Is it just risk now? In any case, if you get the double, you are looking at a Dow of 17,600 in 20 to 24 years, which would be a disaster for those that got in near the top. Not exactly a repeat of the last 24 years is it? If the Dow price is higher, it will be due to higher inflation, not better performance, as we are using bubble economics to stand where we are, not a depression. The view on stocks if we go into a deep recession or depression will be entirely different, but look on this perspective as well. If you do get in and this is the result, which it will be the most likely best bull result, remember that capital gains is going to take 20% of your gain, so deduct 2200 from the 17,600 and you will find out that inflation and capital gains has taken part of your principal. I believe we can see this result looking at the price history between 1929 and 1954 and between 1966 and about 1982. In both cases the S&P started out with much higher dividend yields than this S&P peaked or for that matter pays now.

What are the hazards? Look at the Great Depression market. It was a disaster and even the 50% point held the price action for 20 years. If you don't believe the depression will repeat itself, try Japan. This past week, Japan got really close to 8000 on the Nikkei. It has been as low as 7600 and change over the past 10 years, but it started at 39,000 at the end of 1989. We are approaching the end of 2008, meaning that after close to 19 years, the Nikkei is trading near 20% of its peak and has been lower. Money has devalued 30% or more, meaning the current price is closer to 5600 against the peak of 39,000. From what I can tell, business in Japan has been as good as it has in the US, so it isn't like they fell off the face of the earth and they had the worldwide benefit of the US financial bubble to prop them. Imagine what would happen if the bubble hadn't been present?

So where are we? If you believe my figures, we are hung between after tax break even on one side long term and potentially at roughly the same level we are now with devalued money in 20 years or even worse, a Japan situation in 20 years. What happens in the meantime is even more important, as Japan has had some great bull markets over the past 20 years, 50% moves in a year several times. But, what happens if you stay in and have to sell and never have your capital again, something that is more common than you think? Markets bottom when the players give up, not when they get too cheap. We are far from being too cheap or the players giving up right now. They talk about capitulation, but there isn't enough money in the world for the accumulation of players and stock to capitulate in a month, a quarter, a year or maybe even a decade. The smart money will wait for values to appear that cannot even be imagined now and for the edge of the world to appear so they know they won't fall off. Though it appears there are nice values in some stocks, it all depends on financing returning to abnormal, which I don't believe is going to happen. We are going to see a different earnings and dividend picture appear over the next year as financial deflation and capital conservation take hold. It isn't out of the realm of possibility that earnings in retailers implode, that banks all suspend their dividends, that XOM no longer has fuel to buy back stock and that the tech industry has a collapse in high margin business. Being we are only 1 year after the peak, it is highly unlikely the real buys are going to show up for at least another 18 months.

1 comment:

Dividends Anonymous said...

Great Article!

I'm going to include it in my Weekly Dividend Update published later today. If you write future posts on the topic of dividends be sure to let me know for a plug or republish the article (with full acknowledgement) on my site to a dividend audience