A Leading Bear Turns Bullish, Sort of

SATURDAY, DECEMBER 6, 2008
INTERVIEW

A Leading Bear Turns Bullish, Sort of
Barry Ritholtz, CEO and Director of Equity Research, FusionIQ
By ROBIN GOLDWYN BLUMENTHAL

AN INTERVIEW WITH BARRY RITHOLTZ: Getting ready for a "significant" rally.

FOR THE PAST FIVE YEARS, BARRY RITHOLTZ HAS BEEN entertaining, educating and elucidating readers of his blog, The Big Picture (http://bigpicture.typepad.com/). Among the noteworthy calls that the savvy lawyer and sometime-trader has made: identifying a credit bubble a few years ago, and a recommendation to short AIG back in February, when the share price was flirting with $80; it's now about $1.80.

Chris Casaburi for Barron's

"There's upside here for a trade. Over the past 100 years, we've only seen the relative strength of the S&P 500 drop to this level five times…Each time, it has been a major buying opportunity, although not necessarily a major bottom." –Barry Rithotlz

Lately, the 47-year-old Ritholtz, with his business partner, Kevin Lane, has had a chance to put some of those ideas to work at FusionIQ, a firm that manages nearly $100 million in separate accounts. Amid the wholesale destruction on Wall Street, Fusion has produced single-digit gains on its long-short portfolios, and has kept the average losses on its long-only accounts to single digits. Ritholtz, whose book Bailout Nation is due early next year from McGraw-Hill, can be trusted to call 'em as he sees 'em. To find out what the contrarian is now warming up to, read on.
Barron's: What's your global outlook?

Ritholtz: In 2006, I was probably the most bearish guy on the Street; now at a table of industry people, I'm the bullish guy. We've cut this market in half; that doesn't mean it can't go lower. We're in a medium recession. If this turns into a deeper, more prolonged recession, all bets are off.

Are we are testing a real low here?

There's no doubt we're looking at an extremely oversold market. But by the end of the week, that oversold condition could be worked off. There's upside here for a trade. Over the past 100 years, we've only seen the relative strength of the S&P 500 drop to this level five times, and each time, it has been a major buying opportunity, although not necessarily a major bottom. If you look at 1929, it was a low but it wasn't the low, and there was a bounce. It was the same thing after Sept. 11 -- from Sept. 21, you had a 40% bounce in the Nasdaq before you went down to make all-time lows.

Will the market drift?

It's flapping up and down. There is a significant rally, 20% or 30%, waiting to happen. But there's also the possibility of a lower low, as we get deeper into the recession, if things take a terrible turn for the worse.

Whenever you're fragile, you don't have the ability to absorb that next blow. My fear is that some economic issue arises and you don't have the resiliency to deal with it. We're economically stretched very, very thin. Things seem to be getting healthier at an ungodly cost, one which we will be dealing with the unintended consequences of for decades. We're really at the fork in the road. Everybody on Wall Street is wondering if we're going to see a year-end rally of any substance, or, if we're heading down to 7100 on the Dow, or 850 on the Nasdaq. [On Friday, those indexes were at about 8200 and about 1430, respectively.]

What say you?

We're waiting for a couple more things to line up: Some clarity on earnings, which we won't have for a while, some sort of resolution on these bailouts, and some sign from the new administration that, unlike the outgoing group, we have a plan -- "Here's what we're going to do about credit, banks, the economy, GM." We wouldn't be surprised to see earnings seriously damaged.
Wall Street is still way too high. They started out the year at earnings of $103 a share on the S&P 500 for 2008, which got them to 1600 on the index. We came in at $65 a share, and that may have been too bullish. The good news is that most of corporate America outside of the financial sector has healthy balance sheets, lots of cash, and is running very lean.

Except for the auto industry.

The auto industry is a whole other story. The auto industry is a story of terrible management, misguided unions, and government intervention.

What's your impression of the bank bailout?

[Treasury Secretary] Hank Paulson is really the imperfect messenger for this bailout. Remember that Paulson is one of the five executives who went to the SEC in 2004 to beg, 'Please, let us lever up more. Please let us go to [a leverage ratio of] 30 or 40.' It is bad enough that he helped create the crisis. It appears that this whole response is completely ad hoc.

Do you see any guiding principle?

It is, how do you give money to banks who need capital and not say, 'By the way, you're cutting your dividend.' What's happening instead is they're saying, 'Here is money: Give it out as dividends and bonuses.' It is unbelievable. There is no clawback. It is unconscionable.
So, what does it take to invest in this kind of world? How do you stay out of trouble?

We have a number of internal rules. The most important is that we always have a stop-loss. When the trade is working out, we use trailing stop-loss, meaning that the higher the stock goes, the higher the stop-loss. When the market starts heading south, we get taken out. We screen for short squeezes, and we've found that they're very often present at the beginning of a major move up.

We back-tested [price/earnings ratios] and found they have no forecasting ability. Whenever people do an analysis of a stock, the tendency is to create a snapshot at a given moment. We try to build a moving picture of a stock. For instance, if you know you're in an all-time peak in home sales, and the Fed is in a tightening regime, why own a stock in a homebuilder?

The builders have been pretty beaten down, though.

I've been the biggest bear on housing on the Street for four years now. Housing is halfway through. We're not even close to the bottom in housing. The stocks were always cheap, so it's not a valuation question.

Given the uncertainty in the market at large, what appeals to you right now?

We've been trading the two-to-one leveraged [exchange-traded funds].

One is the Ultra S&P ProShares [ticker: SSO] -- for every dollar the Standard & Poor's 500 moves, it moves two dollars. And there's also Ultra Triple Q ProShares [QLD], the Nasdaq 100-version of the SSO. The flip of the QLDs are the QIDs, which are the negative two-for-ones on the Nasdaq. We're starting to look at that. We are now running about 70% cash, which is inordinately high, but some of the names we're watching, and have owned in the past, are NuVasive [NUVA], a medical-device company, Stanley Works [SWK], a great infrastructure story, LG Display [LPL] and Luminex [LMNX]. Industries we like are infrastructure, defense, biotech and medical devices.

Why ETFs?

We're normally bottom-up stockpickers. But when we're looking at all these individual stocks and war-game them, we end up saying there's this risk and that risk. Here's an example: JPMorgan [JPM] is probably the best house in a bad neighborhood. It had a nice run, then it pulled back; do we want to own JP Morgan? What's the risk? They've already acquired Bear Stearns. They have to be looking at Goldman Sachs [GS]. They have to be looking at putting the house of Morgan back together. If that happens, what happens to the stock price of JPMorgan? You could lose 15%, 20% overnight. Every time we look at individual stocks, we end up with that analysis.

We spent a lot of the year running a good chunk of cash. Some of that is discipline; a lot of that is staying away from things that are really trouble. The trade that caused so much trouble for people -- long financials -- we're at the point where some of the financials are starting to look attractive.

Would you give us a name?

Citigroup [C] at $5. The interesting thing about Citigroup is that if there's anything that's legitimately too big to fail, Citigroup is it. If you think the consumer and retail sector are having a hard time, imagine if Citigroup were allowed to go belly-up. People would hunker down in their homes and stop buying all but the necessities.

I didn't really buy that Bear Stearns was too big to fail, although there was the argument that they could take JPMorgan down. Citibank is one of those things that cannot be allowed to go belly-up. It's enormous. It's the equivalent of AIG.

What else do you like?

We like infrastructure, plays like Stanley Works, and we expect there will be some stimulus to build ports, bridges, and expand the electrical grid. Defense is another sector we like, though it's less so of the Boeing s [BA] and more of the specialty-defense names, like AeroVironment [AVAV], which makes small, pilotless drones.

There's a list of interesting biotech and medical-devices companies, which are insulated from the economic cycle. We just bought Cubist Pharmaceuticals [CBST], which addresses the anti-infective market. In the same way the Internet bubble gave rise to Web 2.0, Facebook and blogs, the Genentechs of the world and all the developments that took place throughout the 1990s have led to the current new wave of specialized therapeutics. Over the next 10 years, we're going to see a universe of breakthroughs based on the previous 20 years' work. The first order of business on Jan. 20 [presidential-inauguration day] is allowing stem-cell research, and that's going to lead to a number of significant breakthroughs. Medical devices and gene therapies are ripe areas. The problem is, they're very volatile and very speculative, and not necessarily safe for the ordinary household.

What stocks are you shorting?

We've been short Jefferies & Co. [JEF] for a while. They're similar to the various asset gatherers: In this environment, it becomes very challenging to hold on to key people. The best guess is, they're suffering along with the rest of the sector, only they don't have the strength or the size to do things that a Goldman Sachs or a Morgan Stanley or Wachovia can.
Table: Ritholtz's Picks

What about gold?

Gold is really quite interesting here, as are the gold miners. We own no gold now, and we own no gold mines, but we are watching them. The question is, at what point does this deflationary cycle roll over to the point where things start to get better?

We were among the loudest inflation hawks for the past few years. When oil was $147 a barrel the joke was, which was going to hit $6 a gallon first, premium gasoline or skim milk?

In March, we said we are through the worst part of the inflation cycle and now we should see deflation as the economy starts to roll over. And that is pretty much playing out. The bugaboo with all that is you just had the Fed triple its balance sheet. The Bernanke printing presses are running full speed. That ultimately has to hurt the U.S. dollar; it ultimately has to be inflationary.

Has gold bottomed?

I don't know where gold bottoms. We recommended gold for the first time in 2002 or 2003. It was strictly an inflation trade, thanks to Greenspan. And then when the GLD gold ETF first came out, we recommended that. Gold has a date with $1,500 somewhere in the future [up from $763 an ounce now], but whether it makes that move from 700 or from 400, I have no idea. You just can't print that much paper and debase the currency and not see some sort of reaction.
Anything else look interesting?

We always tell people when things are really good you have to make emergency plans. You know, the time to read that card on the seatback in front of you is not when the plane is heading down. When things are really awful like they are now, that's when you start making your wish list. I have never owned Berkshire Hathaway [BRK], but if it was cheap enough I'd buy it.

A level, please?

$85,000 to $95,000 [versus $98,000 recently].

Where else might you be deploying some of that cash?

One client said to me, "I'm tired of hearing bad news. I don't care what it is, what can you tell me that is good?" I told him to make a list of things he's wanted to own, but has been afraid to buy or unable to because of the cost. I don't care if it is art, trophy properties, vacation homes, collectible automobiles or boats. Figure out what you are willing to pay, and I can all but guarantee you that by the time we are done with this deflationary cycle, many of those objects will be available at your price. I wouldn't be surprised if, when everything is said and done, a lot of these things are off by 50% or worse.

Thanks, Barry.

http://online.barrons.com/article/SB122852213723784245.html?mod=rss_barrons_this_week_magazine&page=sp

How You Can Rebuild Your Wealth

Investments

How You Can Rebuild Your Wealth

History shows that the best way to rebuild portfolios is to stay in the stock market. Over the past nine recessions, the Standard & Poor's 500-stock index has gained 13%, on average, during the second half of a downturn and another 13% the year after it ended.

"This is likely to be one of the best buying opportunities, if not in the last decade, then in the last century," says financial planner Harold Evensky.

Strategists favor cash-rich blue chips in defensive sectors like consumer staples and health care, and technology giants. Exposure abroad also will be crucial to rebuilding wealth. Among foreign markets to watch, veteran global managers cite Japan, China, Brazil and parts of Europe outside the U.K. and Spain. (Both of these countries face their own real-estate woes.)

But it's worth keeping a portion of your portfolio in cash and bonds just in case; planners such as Mr. Evensky are keeping at least 15% in cash for their clients. For now, limit bond exposure to shorter-term, high-quality issues.

Additionally, you can ward off inflation concerns, which many economists expect will re-emerge in a year or two, by purchasing Treasury Inflation-Protected Securities, or TIPS.

http://online.wsj.com/article/SB122862515245785795.html

Mutual Funds: Saner Markets Ahead

Industry Insights

Mutual Funds: Saner Markets Ahead

Michael Maiello 12.05.08, 6:00 AM ET

In the December issue of Dan Wiener's newsletter, "The Independent Adviser for Vanguard Investors," Wiener interviews James Barrow, lead manager for $31 billion Vanguard Windsor II, and learns that the venerated value manager believes that hedge fund liquidations should cease by the end of the year, taking a good deal of volatility and downward pressure out of the markets.

Barrow told Wiener that: "All of that money the banks loaned the hedge funds is getting called in. They are selling these guys out. Not only are these guys getting redeemed by their investors, they're getting redeemed by their lenders. I don't know how long this has to go on--it'll obviously be over by the end of the year, but it could be pretty bloody between now and then."

This served as the topic of this week's mutual fund discussion between Dan Wiener, Adam Bold of The Mutual Fund Store and Richard Gates of TFS Capital. The consensus was that 2009 will bring smoother markets and it's time for investors to prepare for a market, if not an economic recovery.

The Forbes.com mutual fund panelists are:
Daniel P. Wiener, editor of Independent Adviser for Vanguard Investors and CEO of Adviser Investments.
Adam Bold, founder and chief investment officer of the Mutual Fund Store.
Richard Gates, portfolio manager for TFS Capital.

Hedge Funds, Mutual Funds and Volatility

Wiener: Barrow has been around the block many times, and his contacts within the financial community are quite broad, so when he says he thinks the hedge fund selling is about complete I have to think he's on to something. In addition, I have at least one source within one of the big clearing banks that thinks the worst is behind us.

With the last two big recessions (73 to 75, and 81 to 82) having lasted 16 months each, and the current recession now having been date-stamped as starting December 2007, there is some historical precedent for assuming we are at worst midway through the economic crisis. And since we know that markets are discounting mechanisms and will begin to discount the recovery before it arrives, it's probably safe to assume that we'll see the markets move higher sometime in 2009.

The X factor right now is employment and of course Friday's report will almost certainly set a negative tone. But remember that unemployment rises, and continues rising after recessions end. Unemployment peaked at 8.6% two months after the end of the 75 recession and peaked at 6.8% 15 months after the 91 recession. The last recession, from Mar '01 to Nov '01 saw unemployment continue to rise to a high of 5.7% for 19 months after the official end.

Gates: I agree the recent market dynamics are primarily caused by a massive de-leveraging process. Hedge funds, firms formerly known as investment banks, and other big institutional investors have been fighting for their lives trying to stay solvent. During this process, fundamentals and valuations have been thrown out the window and spectacular volatility has been thrust onto the market. This makes this market relatively unique from anything we have seen since the 1930s. It is very scary for many investors.

Mr. Barrow could be right that the de-leveraging process may be near its end. In fact, TFS has seen many of our long-short equity and other hedge fund trading strategies normalize a bit recently after months of unprecedented volatility. Of course, though, nobody really knows when the forced selling will stop. For instance, year-end hedge fund liquidations may come in larger than anticipated and may force managers to raise additional cash. But the important thing that investors need to realize is that sooner or later it will pass.

On a positive note, the indiscriminate selling and short covering has produced wonderful opportunities in the markets. Look at the short squeeze that recently occurred in Volkswagen! Owners of that stock had a once in a lifetime opportunity to sell at hugely inflated prices. Also, many closed-end mutual funds owned by retail investors are trading at steep discounts not seen in decades. Investors have the opportunity to buy many of these funds for 70 cents or less on the dollar.

If Mr. Barrow believes that the de-leveraging is about to end, I am surprised that he is not more active in taking advantage of the dislocations that are clearly prevalent in the market. For instance, he could be selling stocks that have been artificially buoyed by short-covering and using the proceeds to buy stocks that have been grossly oversold. These dislocations will go away once the forced trading ends.

Bold: We're not hearing any predictions in our conversations with fund managers. No one we've spoken to is comfortable making any predictions at this point. As prices would indicate, most managers have strong levels of optimism toward future prospects but can't say when things will turn in a positive direction. History tells us the market will advance well in advance of the recession's end, and with Monday's declaration by the NBER that our economy has been in recession since last December, I'm hopeful we're closer to its end than its beginning.

Most managers we're talking to are hopeful that the current projections being made by many economists that the recession will end late in the second quarter next year or sometime mid-year are accurate. Of course, those projections are made with the knowledge that no one knows for certain, and can't possibly take into account any events that are unforeseen. Just [Monday], Bernanke was discussing the impact of the financial crisis on this recession and how it will continue to be intertwined in the recovery as that unfolds.

Gates: In 2009, I think the markets will be less volatile than what we have seen in recent months and that some semblance of rationality will be regained. The reason for this is that I think the highly levered investors have been wiped out already. Plus, the government has had time to put in some backstops to shore up the financial industry.

To capitalize on this belief, we have been gradually increasing our exposure to various trading strategies. In addition, we are actively trading our portfolios to attempt to sell positions that we think our overvalued and to buy positions that we believe are undervalued.

Wiener: Consider that the Dow has seen 27 days this year when the swing from low to high was 5% or more of the prior day's close. Over the past dozen years there were a total of 14 such days. We've had 122 days of 1% moves or greater in the Dow this year. This comes close to the 128 days we saw in 2002, which as you know was the final year of that bear market.

Gates: For undervalued names, I will mention closed-end funds. The median discounts of these securities were 18% as of [Tuesday's] close. In other words, you could spend 82 cents to get something worth $1. Prior to this last summer, we got really excited when the discounts got close to 10%.

For overvalued names, I would look at positions that had large short interest positions over the summer and have outperformed the market since that time. The outperformance could be primarily attributed to short covering.


http://www.forbes.com/intelligentinvesting/2008/12/04/industry-insights-mutual-fund-panelDec5.html

25-11-2008: Deeper downturn in the offing, says Moody Economy.Com

25-11-2008: Deeper downturn in the offing, says Moody Economy.Com
Email us your feedback at fd@bizedge.com

SYDNEY: Although policymakers around Asia insist the region is well-placed to withstand global financial instability, risks of a deeper downturn are rising, said Moody Economy.Com associate economist Alaistair Chan.

He said a number of third quarter (3Q) gross domestic product (GDP) releases highlighted the already-deteriorating situation and Asian countries might face a future of lower potential growth.

“Conditions across Asia continue to worsen. Japan and Singapore are ‘officially’ in recession, and growth in most other countries is slowing. Exports are slowing sharply, and investment is also weak.

“There is a growing realisation that problems in the US are more protracted than first thought and that conditions will not return to the way they were a few years ago any time soon, if ever,” he said in a report yesterday.

Chan said there was a case to be made that a global downturn would hurt Asia more than it would the United States.

“The reason is that Asian countries run current account surpluses, while the US runs a current account deficit. This seems counterintuitive. But it matters because it means Asian countries are mostly net producers, while the US is a net consumer.

“A reduction in global demand means a reduction in global supply, so although the US downturn will trigger this reduced global demand, Asia could bear the brunt of the problem through reduced global supply,” he said.

Chan said much research had been done on the Great Depression and one overlooked reason for why the United States was so affected during the Great Depression was that in the 1930s, the US was the world’s largest exporter and ran the world’s largest current account surplus, while Europe had the place of the US today, running a trade deficit and consuming American goods.

“So when demand collapsed, there was overcapacity, mostly in the United States. Rather than boost domestic demand to absorb the excess production, the government imposed import tariffs, notably the Smoot-Hawley Act. This led other countries to retaliate, further blocking off markets for American goods.

“This resulted in a painful adjustment period, when production had to fall to the level of consumption, which was ultimately corrected with the onset of government spending for World War II,” he said.

Chan said the US now was undergoing another period of adjustment in which consumption and investment relative to GDP fall while saving increased.

Among other things, he said this implied a reduction in the US current account deficit and hence a reduction in Asian current account and trade surpluses. “Given that China is its second biggest import supplier and the country with which it has the largest bilateral trade deficit, it is likely to bear a large part of the adjustment.”

Many commentators claim to know the solution for Asia — stimulate domestic demand. But if the process were straightforward, governments would likely have done so already. The flip side is that they have no other choice. With little demand in Western markets, either domestic demand must compensate, or supply must shrink.

Chan said If the adjustment in consumption and saving in the US was part of a long-term correction, there would be major implications for Asia.

“For one thing, entire export industries will have to be retooled to serve domestic sectors.
“Retooling, say, factories in Shenzhen from assembling iPods and mobile phones toward products that Chinese consumers would buy would require a long process of reconfiguring supply chains across Asia, affecting, among other things, semiconductor production in Taiwan, memory production in Korea and hard drive production in Singapore.”

Chan said the process was likely to take decades. and in terms of government policy, to boost domestic consumption, saving would have to be discouraged.

Is Buffett Insane?

Is Buffett Insane?
By Richard Gibbons November 28, 2008 Comments (38)

In the midst of economic chaos, Warren Buffett recently made a bold prediction. He said that now is the time to buy American stocks.

Of course, this call seems utterly insane. Banks are failing, the credit markets are deadlocked, unemployment is skyrocketing, and there's likely to be terrible news for months.

On the other hand, this is Warren Buffett, and he's made these sorts of predictions before.

1974: Stagflation

The years 1973 and 1974 were two very bad ones for the market. OPEC had started flexing its muscles, causing oil to quadruple. This resulted in a long recession, with inflation spiking to 12.3% in 1974, while real GDP growth fell by 0.5%. America experienced stagflation -- the ugly combination of a recession and high inflation rates -- and people were terrified. The situation was even worse in the United Kingdom, where the government was bailing out banks after real estate crashed. Over those two years, the S&P 500 plunged by 42%.

It was then, on Nov. 1, 1974, at the height of the pessimism, that Buffett made his first well-publicized bullish market call. He noted that he was well aware that the world was in a mess, but that stocks were simply too cheap. "If you're only worried about corporate profits, panic or depression, these things don't bother me at these prices."

To be totally clear, Buffett made one of the most direct predictions of his entire career: "Now is the time to invest and get rich." Buffett himself was buying shares of The Washington Post (NYSE: WPO) and advertising agency Interpublic (NYSE: IPG).

It worked out pretty well for him. The market jumped 32% in 1975, and another 19% the next year. Even today, the Dow Jones Industrial Average's 38% gain in 1975 stands up as its biggest increase since 1955.

1979: An oil crisis

That excellent performance was followed by two poor years. Once again, we were experiencing double-digit inflation and falling GDP growth. Again, we were going through an oil crisis, this one coming in the wake of the Iranian Revolution. As a result, when Buffett made his next call on Aug. 6, 1979, the Dow Jones Average was actually trading lower than it was at the end of 1975.

This time, Buffett noted that stocks were far more attractive than bonds. He believed that pension managers, who were piling into bonds yielding 9.5%, were investing using the rearview mirror. They were avoiding the equities that had recently lost them money. But Buffett recognized that the underlying businesses were actually performing well. A combination of falling stock prices and improving business fundamentals made stocks an attractive investment.

Buffett figured that stocks were probably offering long-term returns of 13% or better. He bought oil producer Hess (NYSE: HES), GEICO, and General Foods, which later became part of Kraft (NYSE: KFT).

This time, Buffett's timing wasn't perfect -- the S&P 500 fell a bit more over the next few months. But his long-term prediction was spot-on. During the 1980s, the S&P 500 rose 13% annually before dividends.

1999: The Internet bubble

In November 1999, during the height of the Internet bubble, Buffett made his only bearish call. At the time, the market was in a speculative fervor, with Internet stocks showing huge price increases seemingly every day. In the five years between 1995 and 1999, the S&P 500 tripled, with compound annual returns of 26%. Many considered Buffett a relic for refusing to buy into the technology boom.

Buffett, however, noted that, because of a combination of cheap initial valuations and falling interest rates, stocks had achieved unprecedented annual returns of 19% over a 17-year period. These results made investors unreasonably optimistic. New investors were expecting 10-year annual returns of 22.6%, while even experienced investors predicted 12.9%. But the huge boom was only supported by modest GDP growth, and therefore wasn't sustainable. So, Buffett expected about 4% real returns.

He continued to hold Coca-Cola (NYSE: KO), Wells Fargo (NYSE: WFC), and M&T Bank (NYSE: MTB), though he noted in the 2004 annual report that he should have sold some of Berkshire Hathaway's overvalued holdings.

Buffett's bearish prediction proved optimistic. The market continued to rise for a few months, with the S&P 500 topping out 9% above where it was when Buffett made the call. But that was followed by a crash. Since his call, the S&P 500 has dropped by 39%, for average annual losses of about 5%, well below Buffett's estimates.

The Foolish bottom line

The common theme of all these predictions is that Buffett didn't care about short-term fears. He wasn't worried about stagflation in the 1970s, and he didn't buy into the unrealistic optimism of the late 1990s. Instead, he rationally valued stocks, and made the right long-term calls. His biggest mistake was the 4% number he threw out in 1999 -- long-term returns have been much worse than his bearish prediction.

But that prediction was too optimistic partly because stocks are so unreasonably cheap right now. And that's why Buffett's buying today.

If you're a short-term speculator, now is a bad time to gamble. But if you're truly in it for the long term, Warren Buffett has made the call. He thinks stocks are cheap. And we agree with him.

Our Motley Fool Inside Value team is astounded at the bargains that we're finding right now. You can read about them by taking a 30-day free test-drive.

Fool contributor Richard Gibbons is terrified, but still thinks this is the time to invest and get rich. Kraft is an Income Investor recommendation. Coca-Cola and Berkshire Hathaway are Inside Value picks. Berkshire Hathaway is also a Stock Advisor selection and Motley Fool holding. The Fool's disclosure policy predicted a McCain victory.

http://www.fool.com/investing/value/2008/11/28/is-buffett-insane.aspx

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Dividend stocks for low excitement, high returns

The Basics

Dividend stocks for low excitement, high returns
Boring? Maybe. But here's a screen for finding dividend stocks that will have you yawning all the way to the bank.


By Harry Domash (Author of "Fire Your Stock Analyst")

It's time to make the case for "boring" dividend stocks.

From a tax perspective, they're hard to beat: Thanks to recent tax-law changes, most dividends are taxed at only 15%. Previously, dividends were hit at full income-tax rates.

And these stocks have been anything but boring when it comes to returns. According to Standard & Poor's, dividend-paying companies returned 18.4% last year, compared with 13.7% for those that didn't pay dividends and 8.6% for the Nasdaq, home to so many of the tech stocks investors find so exciting.

I've devised a screen for finding promising -- and, yes, boring, but only in the sense that they won't keep you up at night -- dividend-paying candidates. The screen pinpoints well-established companies that have solid earnings and dividend growth track records.

You won't get-rich-quick with these stocks. But most are expected to grow earnings between 10% and 15% annually over the next five years. So, over time, you can expect their share prices to move up at about the same rate. Combine that expected -- though by no means guaranteed -- price appreciation with 2% to 5% dividend yields, and you can expect annual returns in the 12% to 20% range, or roughly 16% per year.

To put that in perspective, at a 16% compounded annual return, $1,000 turns into $2,100 in 5 years. The S&P 500 ($INX) managed less than an 11% average annual return, and the Nasdaq Composite ($COMPX) returned around 4% over the past 10 years.

I've intentionally excluded higher-yielding stocks such as mortgage REITs (real-estate investment trusts that invest in mortgages) and royalty trusts (trusts, frequently based in Canada, that invest in oil and natural-gas resources) that often pay dividends equating to double-digit yields. These may be worthwhile investments, but require special analysis that I don't have room to cover here.

Here's how the screen works. You can use it as is, or as a starting point which you can revise to suit your needs.

Dividend yield: Set upper limits, too

If you're rusty on your stock-market math, dividend yield is a company's next 12 months' dividends divided by its current share price. For example, your yield would be 10% if you paid $10 per share for a stock expected to pay out $1 per share over the next year ($1/$10). However, another investor's yield would only be 9.1% if he bought the same stock a week later for $11 per share ($1/$11).

I arbitrarily set my minimum yield at 2.25%, which was the prevailing return on low-risk money market funds when I researched this column. Obviously, the lower the minimum yield, the more stocks you'll get. For example, 1,688 U.S.-listed stocks currently pay at least 2.25%. But reducing the minimum to 1.5% increases the field to more than 2,200 stocks.

Screening Parameter: Current Dividend Yield >= 2.25

For dividend yield, higher is not always better. High-yielding stocks get that way because many investors see them as risky.

Think about it.

Say a stock is expected to pay $1 per share in dividends over the next year and is changing hands at $10 per share, equating to a 10% yield. Given current money market rates, buyers would flock to buy a stock yielding 10% if they thought the dividend was rock-solid. The buying pressure would push the share price up until the yield dropped closer to market rates. In my experience, stocks with dividends seen as safe don't trade at yields much above the 4% to 4.5% range.

So I set my maximum acceptable dividend yield at 5%. Increase the maximum to 8% if you want to see riskier stocks. Sometimes cigarette makers such as Altria Group (MO, news, msgs) pay yields in the 7% range.

Screening Parameter: Current Dividend Yield <= 5

Look for dividend growth
You win two ways if one of your stocks ups its dividend. The higher payouts increase your yield and the dividend hike usually drives the share price higher.

History is truly the best teacher when it comes to evaluating dividend growth prospects. Companies with a record of strong historical dividend growth usually are committed to continuing that policy. Conversely, companies that haven't consistently increased dividends probably prefer to use their extra cash for other purposes.

I require at least 5% average annual dividend growth over the past five years. Ideally, you'd like to see even higher growth, but the recent recession prevented many firms from increasing their payouts. Increase the requirement to 7% or 8% if your screen turns up too many candidates.

Screening Parameter: 5-Year Dividend Growth >= 5

Profits power dividends

Since dividends come from earnings, you should draw your dividend candidates from the ranks of profitable companies. Return on equity (ROE), which is net income divided by shareholders equity (book value), is a widely used profitability gauge. But profitability standards vary between industries. So instead of setting an arbitrary minimum, I require that passing candidates must at least equal their industry average ROE.

Screening Parameter: Return on Equity >= Industry Average ROE

Stick to the strongest banks

Banks have been good dividend-payers in recent years, so my first try using this screen turned up several bank stocks. However, many small or regional banks enjoyed exceptionally strong profits from making and servicing home mortgages. Rising interest rates are squeezing their mortgage profit margins and reducing the demand for new mortgages. So this phase of the economic cycle is not the time to bet heavily on banks.

The leverage ratio measures debt by dividing total assets by shareholder's equity, and it's useful here. A company with no debt would have a 1.0 leverage ratio. The higher the debt, the higher the ratio. Banks are often highly leveraged, many with ratios in the 10-to-15 range, which is understandable, considering that cash is a bank's inventory.

I set my maximum allowable leverage at 10, in order to find only those banks with relatively strong balance sheets. Adjust that limit up if you want your screen to turn up more banks, and down for fewer banks.

Screening Parameter: Leverage Ratio <=- 10

Avoid future losers

A company like General Motors (GM, news, msgs) may have great dividend history, but a dismal outlook. In fact, many analysts expect GM to cut its dividend in the not-too-distant future.

You don't need to spend your time evaluating each candidate's future prospects because stock analysts do that all day long. So I piggyback on their efforts and rely on analysts' long-term earnings forecasts and buy/sell recommendations to rule out stocks likely to cut future dividends.

First, since dividends come from earnings, I look for consensus forecasts calling for at least 10% minimum average annual earnings growth over the next five years. Even if the forecasts are wrong, the likes of GM and Eastman Kodak (EK, news, msgs) are unlikely to pass this test.

Screening Parameter: EPS Growth Next 5Yr >= 10

As a backup check, I also look at analyst's consensus buy/sell recommendations.
Something's fishy if analysts are forecasting strong long-term earnings growth, but advising investors to sell the stock. Dividend investing is about avoiding unnecessary risk. It doesn't make sense to consider stocks that analysts say you should sell.

Screening Parameter: Mean Recommendation >= Hold

Follow the pros

Institutional buyers such as mutual funds and pension plans more tuned-in to what's happening in the market than you and I will ever be. If the big boys won't own a stock, we shouldn't either.

Institutional ownership is measured as a percentage of outstanding shares and can range from zero to 95%. There's no cast-in-concrete number that says a stock has enough institutional ownership. As a rule of thumb, I set a 40% minimum. Reduce the minimum to as low as 30% if you don't get enough candidates.

Screening Parameter: % Institutional Ownership >= 40

My screen turned up 19 stocks in a variety of industries. The list included one savings and loan and three regional banks. However, MBNA (KRB, news, msgs), which is listed as a regional bank, is primarily a credit card issuer. As always, the results of this or any screen should be considered research candidates, not a buy list.

Dividend Winners

Company----Price*----Industry

Abbott Laboratories (ABT, news, msgs)
47.2
Drug manufacturers - major

Allstate (ALL, news, msgs)
54.63
Property & casualty insurance

Autoliv (ALV, news, msgs)
46.9
Autoparts

Avery Dennison (AVY, news, msgs)
61.21
Paper & paper products

Bemis (BMS, news, msgs)
31
Packaging & containers

Eaton Vance (EV, news, msgs)
23.08
Asset management

Fidelity National Financial (FNF, news, msgs)
32.45
Surety & title insurance

General Electric (GE, news, msgs)
35.5
Conglomerates

Harbor Florida Bancshares (HARB, news, msgs)
33.59
Savings & loans

Kinder Morgan (KMI, news, msgs)
76.24
Gas utilities

Limited Brands (LTD, news, msgs)
24.65
Apparel stores

Lincoln Electric Holdings (LECO, news, msgs)
29.56
Machine tools & accessories

Masco (MAS, news, msgs)
34.65
Industrial equipment & components

MBNA (KRB, news, msgs)
24.9
Regional - mid-Atlantic banks

PartnerRe (PRE, news, msgs)
64.27
Property & casualty insurance

Spartech (SEH, news, msgs)
19.32
Rubber & plastics

Synovus Financial (SNV, news, msgs)
27.78
Regional - mid-Atlantic banks

U.S. Bancorp (USB, news, msgs)
28.57
Regional - Midwest banks

Worthington Industries (WOR, news, msgs)
19.2
Steel & iron

*Price of position at the time of original publish date.

Even though these stocks look good now, circumstances change over time. Check your stocks every six months or so, and sell any that analysts are advising selling or that no longer have strong long-term earnings-growth forecasts.

At the time of publication, Harry Domash did not own or control positions in any of the stocks mentioned in this article. Domash publishes the Winning Investing stock and mutual fund advisory newsletter and writes the online investing column for the San Francisco Chronicle. Harry has two investing books out, the most recent being "Fire Your Stock Analyst," published by Financial Times Prentice Hall.

http://articles.moneycentral.msn.com/Investing/InvestingForIncome/DividendStocksForLowExcitementHighReturns.aspx

US Job Losses by month in 2008 (A Lagging Indicator)

Job losses by month in 2008

Month---Jobs lost

November* -533,000
October * -320,000
September -403,000
August -127,000
July -67,000
June -100,000
May -47,000
April -67,000
March -88,000
February -83,000
January -76,000


Total 2008 1,911,000

* Preliminary.

Source:

Bureau of Labor Statistics

DECEMBER 6, 2008: Job Losses Worst Since '74: 533,000 Shed in November

http://online.wsj.com/article/SB122848262764182657.html

China lectures US on economy

China lectures US on economy
By Geoff Dyer in Beijing
Published: December 4 2008 04:32

The US was lectured about its economic fragilities on Thursday as senior Chinese officials urged the administration to stabilise its economy, boost its savings rate and protect Chinese investments.

The message went to Hank Paulson, the US Treasury secretary, in Beijing for the strategic economic dialogue he helped launch to discuss long-term issues between the two countries.

EDITOR’S CHOICE
Lex: US-China dialogue - Dec-04
US rescue plan to push down home loan rates - Dec-04
Treasury tackled over Tarp concerns - Dec-03
Record contraction in US services sector - Dec-03
Paulson in last stand against weaker renminbi - Dec-03

As expected, Mr Paulson urged Beijing not to abandon efforts to let the renminbi appreciate, said US officials, amid fears China might want to let its currency weaken to help local exporters weather the global slowdown.

But Mr Paulson also found himself facing calls for the US to address its own economic problems. Wang Qishan, a vice-premier and leader of the Chinese delegation at the two-day talks, called on the US to take swift action to address the crisis.

“We hope the US side will take the necessary measures to stabilise the economy and financial markets as well as guarantee the safety of China’s assets and investments in the US,” he said.
The dialogue was dominated by the global crisis. Zhou Xiaochuan, governor of the Chinese central bank, urged the US to rebalance its economy. “Over-consumption and a high reliance on credit is the cause of the US financial crisis,” he said. “As the largest and most important economy in the world, the US should take the initiative to adjust its policies, raise its savings ratio appropriately and reduce its trade and fiscal deficits.”

Although China also faces a rapidly slowing economy and rising unemployment, the tone of the comments reflected an underlying shift in power.

Eswar Prasad, a senior fellow at the Brookings Institution, said: “One result of the crisis is that the US no longer holds the high ground to lecture China on financial or macroeconomic policies.”

Copyright
The Financial Times Limited 2008

http://www.ft.com/cms/s/0/48ac15fc-c1bc-11dd-831e-000077b07658.html

Enterprise Value

Enterprise Value

Enterprise value (EV) is a company’s market capitalization plus net interest-bearing debt.


In other words, it is the amount of cash required to buy the company at its current price and retire all interest-bearing debt less the cash assets of the business.

EV = Market Capitalization + Net interest-bearing Debt

or

EV = Market Capitalization + Borrowings - Cash


Although used for various reasons by stock analysts, the only useful purpose for calculating EV is as a tool to determine the maximum price a company is prepared to pay to acquire another business.


For instance, one company had a policy of limiting the EV it was prepared to pay to an EBIT multiple of 5. So if EBIT was $20 million, EV should be no more than $100 million. If interest-bearing debt happened to be $50 million, then $50 million would be the maximum price it would pay for the equity of the business.


EV = Market Capitalization + Borrowings - Cash
$100m = Market Capitalization + $50m - $0
Market Capitalization = $100 m - $50 m + $0 = $50 m



-----

Let’s see the ROE on the acquisition cost of $50 million.


Acquisition cost = $50 million. Calculate ROE


EBIT = $20 m
Interest-bearing debt = $50 m
Interest cost of 8 percent on the debt
Corporate tax rate = 30 percent


Interest cost = $50 m x 8 percent = $4 m


Post-tax profit = EBIT x (100 percent – Corporate tax rate) = [($20 m - $4 m) x (70 percent)] = $11.2 m


ROE = ($11.2 m/ $50 m) = 22.4 percent on an equity cost of $50 million.

-----



If the company to be acquired had no debt and
acqusition cost was $50 million:



Interest-bearing debt = $ 0
Post-tax profit = EBIT x 70 percent = $20 million x 70 percent = $14 million
Return on cost of $100 million would be 14 percent.


The acquired company would then be geared up by borrowing $50 million.
Interest cost = $50 m x 8 percent = $4 m


Post-tax profit = EBIT x (100 percent – Corporate tax rate) = (20m – 4m) x (70 percent) = $11.2 m


ROE = $11.2m / $50m = 22.4 percent return on the net $50 million acquisition cost.

-----



EBIT multiple and ROE


From the examples above:

EV = EBIT x EBIT multiple
EBIT multiple = EV/EBIT

EBIT multiple of 5 produces a ROE of 22.4 percent.


Determine the EBIT multiple beyond which debt of 8 percent would produce a return (ROE) of less than 8 percent.
Answer: 1 / (8 percent) = 12.5


Therefore,

Paying an EBIT multiple MORE THAN 12.5, produces Return on Equity (ROE) LESS THAN the interest cost of debt of 8 percent.

Paying an EBIT multiple LESS THAN 12.5, produces Return on Equity (ROE) MORE THAN the interest cost of debt of 8 percent.

-----

Also read:

http://www.horizon.my/2008/12/malaysian-airlines-is-mas-cheaper-than-air-asia/
Malaysian Airlines – Is MAS Cheaper than Air Asia?

**Why Stocks Are Dirt Cheap

Jeremy Siegel, Ph.D. The Future for Investors

Why Stocks Are Dirt Cheap
by Jeremy Siegel, Ph.D.
Posted on Friday, October 31, 2008, 12:00AM

No one can guarantee the future of the stock market. But I believe that stock prices are now so extraordinarily cheap that I would be very surprised that if an investor who bought a diversified portfolio today did not make at least 20% or more on his investment in the next twelve months.

Valuations Low Worldwide

The case for equities at these levels is compelling. The last time we have seen prices this low was more than 30 years ago, when the US economy was in far worse shape than today.

The table below lists the price-to-earnings ratios of the world's major stock markets as of October 29. It is taken directly from the Bloomberg World P-E Ratio (WPE) screen. These P-E ratios are calculated based on 2008 earnings, of which the first two quarters have already been reported and the 3rd and 4th quarters' earnings are estimated. Keep in mind that the average historical P-E ratio of the US stock market has been 15 and that when P-E ratios are ten or lower, investors have reaped generous rewards from investing in stocks.

COUNTRY/INDEX----P-E RATIO

North America

Dow Jones Industrials....10.7
S&P 500 Index....11.7
Nasdaq....16.6

Canada ....9.3
Mexico ....9.7


Europe

Euro Stoxx 50 ....7.9
UK....7.3
France....7.8
Germany....9.5
Spain....7.7
Italy....7.2
Netherlands....5.7
Switzerland....17.3


ASIA

Nikkei (Japan)....11.4
Hong Kong....8.8
Shanghai....12.3
Australia....8.9
Singapore....8.2

Except for the tech-laden Nasdaq, the US markets are selling at 10 to 11 times 2008 estimated earnings while European markets, save Switzerland, are selling between 7 and 9 times earnings. Asian stocks are also very cheap, as the Japanese Nikkei Index is selling at 11.4 times earnings, not much different than stocks in Hong Kong, Australia, and Singapore. The Chinese market, which had been selling at over 50 times earnings last year is now selling at a far more modest 15 times earnings.

Bears will claim that these P-E ratios are too low, since earnings will sharply deteriorate over the next twelve months. Indeed, the last 12 months of reported earnings on the S&P 500 Index have fallen to $51.37 from $84.92 a year earlier. On those numbers, the US market is selling at about an 18 multiple.

But this gives a very distorted picture of the market. Aggregate earnings over the past year are greatly depressed by huge write-offs not only in the financial sector but in other firms. For example, Ford, GM, and Sprint, whose aggregate market value is less than 0.2% of the S&P 500 Index, lowered the S&P's reported earnings by about $12.00, more than 20% of the current aggregate earnings.

Even if these firms all go bankrupt and their stock prices go to zero, it would have a negligible impact on the market value of a well-diversified stock portfolio. The same is true of the financial sector as S&P adds the huge losses in banks that now have almost no value today to the earnings of profitable firms. This means that the P-E ratio of firms that are still profitable is far lower than the ratio calculated for the whole index.

Furthermore, it is a major mistake to use earnings in a recession when calculating the right valuation of the market going forward. That is because stock values are dependent on earnings far in the future, not just those estimated over the next 12 month. (Comment: An important point to note.)

Since stocks have historically sold at 15 times annual earnings, the earnings of the next twelve months contribute only 1/15 of the value of the firm, or less than 7%. The other 93% of the value of stock is realized beyond the next twelve months. Right now the "normal" level of earnings, based on trend analysis of past 15 years of earnings on the S&P 500 Index is $92 a share.

If the average 15 price-earnings ratio applied to these $92 per share normalized earnings, the S&P 500 Index would be selling at 1380, which is almost 50% above its current level. Even if it takes two, or even three years for earnings to return to the trend line, the normalized valuation of the market is far above what it is today.

Worse Economy in the 1970s

The last time the market was at ten times earnings or less was in the late 1970s and early 1980s. Although the financial stocks are more stressed today, the economy was in much worse shape then. Inflation hit 14.8% in the early 1980s and interest rates on perfectly safe, long-term government securities soared to 15.9%. It is little wonder that nobody wanted stocks when you could pocket nearly 16% per year by just investing in treasury bonds. Short term interest rates soared even higher and some money funds were offering yields near 20%.

To get inflation down from these wrenching levels required an extreme tightening by the Fed, which set the Fed funds target at 20% in both 1980 and 1981. These high rates caused a severe recession and the unemployment rate soared to 10.8%, more than 4 ½ percentage points higher than the current level. As soon as inflation abated and interest rates eased, the stock market soared. From 1982 onward began the biggest bull market in the history of stocks.

Final Word

Markets go to extremes in both directions. The prices of tech and internet stocks were unjustified in 1999 and 2000, as the Nasdaq soared beyond 5000. But the Nasdaq fell too low in 2002 when it sank to 1100. Similarly, the irrational exuberance in the housing market in 2005 has turned to unjustified despondency for all world stock markets in the fall of 2008. Chew on this fact: The total losses in the world stock markets have been over $30 trillion dollars over the past year. That is about ten times the entire size of subprime mortgages issued over the past five years, the purported cause of the current crisis. I believe a year from now we will be looking back on this October, kicking ourselves for not having the courage to buy stocks.

Source:
http://finance.yahoo.com/expert/article/futureinvest/118916

Also read:
20.11.2008 - KLSE MARKET PE

Yes, Stocks Are Dirt Cheap

Jeremy Siegel, Ph.D. The Future for Investors

Yes, Stocks Are Dirt Cheap
by Jeremy Siegel, Ph.D.
Posted on Monday, December 1, 2008, 12:00AM

I knew that my last article in Yahoo! Finance, “Why Stocks are Dirt Cheap,” would elicit strong opinions, but little did I imagine how controversial it would prove to be! The column attracted comments ranging from “Off with his head!” to “Bravo!”

The article also attracted considerable attention from finance professionals. Henry Blodget disagreed with my analysis, stating that other well-known financial analysts, such as Jeremy Grantham, John Hussman, Andrew Smithers, and my good friend Robert Shiller of Yale University, put fair value of the S&P 500 Index around 1000, far below where I think it should trade. Ned Davis Research, a well known and respected research firm, also took exception to my earnings estimates.

I have nothing but the highest respect for all these individuals and I believe their work must be taken seriously. But I believe their criticisms are wrong and here I explain why I get a significantly higher fair value estimate for stock values than they do.

Trend Earnings

In last month’s article, my fair-value estimate for the S&P 500 Index was derived from a “normalized” earnings of $92 a share for the S&P 500 Index times a 15 average price-to-earnings ratio for the stock market. “Normalized” earnings are earnings stripping away the effects of business cycle, so that normalized earnings are higher than actual earnings in recessions, such as now, and lower at the top of booms. Currently, Standard and Poor’s is projecting that operating earnings for the S&P 500 Index in 2008 will be $64.14 while reported earnings, which contains very large write-offs from a few firms, are at $49 per share.

My estimate of $92 for normalized earnings drew considerable criticism, partially because it was based only on earnings over the past 18 years. If one looks at considerably longer-term time spans, some believe the trends forecast much lower earnings.

The farthest back we have historical earnings is 1872, based on valuable data that Prof. Robert Shiller brought to light in his book Market Volatility, published in 1989. These historical data are based on splicing together data from Standard and Poor’s that goes back to 1928 to earlier data compiled by Cowles Foundation researchers.

The graph below depicts those earnings per share data for the US stock market from 1872 through the present, corrected for inflation. Looking at this graph, it certainly appears that earnings over most of the past 20 years have been far above average and that these earnings may now correct to the mean of only $56.40 per share, not far from reported earnings projections this year. If we apply the historical P-E ratio of 15 to $56.40, we get a projected level of the S&P 500 Index of only 840.

Flaw in Analysis

But there is an important flaw in using a single trend line to project the future. Doing so assumes that there has been a constant growth rate of real per share earnings over the entire period, an assumption that depends, among other factors, on an unchanging dividend policy of firms.

Yet dividend policy of firms has changed dramatically. The ratio of dividends paid to earnings, called the payout ratio, has dropped significantly over the past thirty years. The decline in the payout ratio has substantially boosted the growth rate of earnings per share. Failure to take this into account will result in a serious underestimate of trend earnings.

The table below confirms that the fall in the payout ratio has boosted earnings growth. The shift in dividend policy took place in the early 1980s when firms, because of liberalized rules for share repurchases, taxes favoring capital gains, and the proliferation of management stock options, reduced the amount of earnings paid out as dividends. The average payout ratio before 1982 was 64.7%, about 40% higher than the 46.6% payout ratio after 1982. As the payout ratio declined, the dividend yield declined and the growth of earnings accelerated.

Finance theory predicts, and historical data confirms, that if a firm pays a lower proportion of its earnings as dividends, then these unpaid earnings must be used to either repurchase shares, lower debt, or invest in capital. In any of these cases, per share earnings growth will increase.

Table 1. Selected Stock Market Variables
Financial Variable
1871-2007...1871-1981...1982-2007
Payout Ratio
61.2%...64.7%...46.6%
Dividend Yield
4.52%...4.96%...2.66%
EPS Growth
1.56%...1.41%...4.5%

A higher rate of earnings growth from lowering the dividend does not imply that investors obtain a higher return on their investment when management lowers the dividend payout. The return to shareholders is the sum of the dividend yield and price appreciation. On average, a dollar of retained earnings will yield investors a return that compensates the investor for the lost dividend income. But dividend policy will impact earnings growth.

A higher rate of earnings growth also means that using “smoothed” earnings, derived by averaging ten years’ of past data as Prof. Shiller and others advocate, will yield a distorted valuation of the market. If earnings growth has accelerated, the average of the past ten years will result in a greater underestimate of earnings in more recent decades.

Look back at the long-term chart again. A new trend line has been drawn covering the period of faster earnings growth that occurs after 1981. According to the new trend, the normalized level of 2009 earnings is a far higher $87.66 than predicted by the single trend line. This earnings figure is slightly below the $92.00 that I estimated in my previous article using analysis over the past 18 years, but it is not appreciably different.

If we apply a 15 P-E ratio to $87.66 level of earnings, we get a fair value of the S&P 500 Index at 1315, almost 50% above the level the market closed on the Wednesday before Thanksgiving. Furthermore, with the ten year government bond rate falling below 3%, we are in the lowest interest rate environment we have had over the past 50 years. Normally, when interest rates are this low, stocks sell for a higher-than-average P-E ratio. To obtain 1380 fair value of the market that I estimated last month, the P-E ratio would need to be less than one point above its long run average of 15.

Objections to My Analysis

Some analysts, such as Robert Arnott and Peter Bernstein have claimed that earnings do not grow faster when the payout ratio is reduced since the retained earnings are wasted on unproductive investment and excess executive compensation. Yet the higher earnings growth from 1981-2007 contradicts their objections.

Others may object to my use of “operating earnings” rather than reported earnings, in making my projection. Operating earnings exclude some of the big write-offs that arise from restructuring, pension revaluations, impairment charges, and portfolio losses, although they do include many of the recent write-offs of financial firms.

Although operating earnings are only reported back to 1988, the earnings data before that date are, according to sources I have contacted at Standard and Poor’s, closer to the concept of operating earnings than reported earnings. This is because FASB has sharply increased the number and type of charges that firms must write off and this has depressed reported income, especially during recessions.

Other Distortions in Earnings Data

The increasing number of large write-offs has also led to a distorted look at the earnings levels for the S&P 500 Index. In another article, I have discussed how there are major distortions in the official earnings numbers provided by index providers like S&P. Six firms (AIG, Wachovia, Sprint, GM, Merrill Lynch, and Citigroup) with over $170 billion dollars in losses over the past year, lowered aggregate earnings on the S&P 500 Index by nearly $20 per share. Yet these firms are tiny and represent less than 1% of the S&P 500 by weight. That is to say over 99% of the S&P 500 had earnings that were closer to $70 per share when the officially reported results are more like $50 per share.

I have proposed a new method for calculating earnings for the index that more logically takes into account the weight of each firm in the index when considering their earnings or losses. Using a weighted average method for estimating earnings for the S&P 500 index, I find that trailing 12-month reported earnings on the S&P 500 are closer to $78 per share and operating earnings are $83, despite the economic slump. Using the $83 figure and my 1380 fair value estimate of the S&P 500, would give only a 16.6 times P/E ratio, a conservative valuations given the very low interest rate environment.

Bottom Line

I maintain that the stock market is significantly undervalued even when you use very long-term trends to analyze earnings growth. Moreover, the officially reported results are understating the true profitability of the market. The low level of stocks today is not a result of investors expecting current depressed levels of earnings will persist, but rather a result of record risk premiums in the debt and equity markets. When these extraordinary risk levels return to normal, we can expect much higher stock prices.

http://finance.yahoo.com/expert/article/futureinvest/125716;_ylt=AmwrtKOlnT2MVb96fZuYuiC7YWsA

**Exploring Durable Competitive Advantage

Company with Durable Competitive Advantage 1
Selling a unique product 2
Selling a unique service 3
Low-cost buyer and seller of a product or service 4...
Warren's durable competitive advantage companies 5...
Buffett versus Graham 6
Durability is the Ticket to Riches 7
Financial Statement: Where the Gold is Hidden 8
Durable Competititve Advantage - Conclusion 9

Calling a bottom more than once!

Reuters

"Bottom's been made" in stocks: Legg Mason's Miller
Wednesday December 3, 5:05 pm ET

By Jennifer Ablan and Herbert Lash

NEW YORK (Reuters) - Legg Mason's (NYSE:LM - News) Bill Miller, a celebrated value investor but whose stock picking is far off the mark this year, said on Wednesday the "bottom has been made" in U.S. equities, and forecast opportunities for strong gains once markets rally.

He said the Federal Reserve should buy stocks and junk bonds to avert a deeper financial crisis, adding "the taxpayer would make a killing" as markets rebound. (!!!!!!)

Speaking at Legg Mason's annual luncheon for media, Miller said that all long-term investors believe that stocks today are cheap, but credit markets must regain health before equity markets can rally.

It "looks as if the bottom has been made" in U.S. stocks, he said.

Miller's comments were given partial credit for Wednesday's 172.60-point rise in the Dow Jones industrial average (DJI:^DJI - News).

Miller, who runs Legg Mason's $7.6 billion Value Trust fund, told Reuters the year has been "terrible, a disaster and awful," yet he held out his past performance in down markets as a reason why he should not be counted out.

"We've performed in most of the financial panics that we've had -- the last one being the three-year bear market ending in 2002 -- we outperformed all the way through that," he said.

"So even though we lost money, we lost a lot less money than the market did," Miller added.
However, Miller acknowledged that his performance has been worse than in past downturns.
"When you're underperforming and losing more money than the market in a down market, then that's a much more problematic situation. We've performed far worse than I would've predicted we would," he said.

For the year, Miller's flagship Value Trust (NASDAQ:LMVTX - News) fund was down 59.7 percent as of Tuesday, compared to a 41 percent decline in the reinvested returns of the S&P 500 index, according to Lipper Inc., a unit of Thomson Reuters.

Performance over the year-to-date, one-, three- and five-year periods for Value Trust put it at the bottom of the barrel among its peers, Lipper data shows.

Miller's track record of calling market bottoms also hasn't been so hot.

In late April, one month after Bear Stearns' spectacular fall, Miller told his shareholders: "I think we will do better from here on, and that by far the worst is behind us."

All told, the severe market sell-off has provided ample opportunities.

"This market is very unusual because since the end of the second quarter, it has been a pure scramble for liquidity, which accelerated obviously post-Lehman Brothers and people sold without regard to value at all," Miller said.

"So at the end of the end of this quarter, every sector in the market has companies that represent what we think are exceptional value."

(Editing by Leslie Adler)

http://biz.yahoo.com/rb/081203/business_us_funds_leggmason.html?.v=4

Comment: The experts are so divided. The market remains extremely volatile. It is difficult to know that the market has reached the bottom, but one can agree that there are many stocks that are trading at fair or exceptional bargain valuation.

Home Prices Seem Far From Bottom

Home Prices Seem Far From Bottom
by Vikas Bajaj
Friday, October 17, 2008

The American housing market, where the global economic crisis began, is far from hitting bottom.

Home prices across much of the country are likely to fall through late 2009, economists say, and in some markets the trend could last even longer depending on the severity of the anticipated recession.

In hard-hit areas like California, Florida and Arizona, the grim calculus is the same: More and more homes are going up for sale, but fewer and fewer people are willing or able to buy them.

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Adding to the worries nationwide are rising unemployment, falling wages and escalating mortgage rates -- all of which will reduce the already diminished pool of would-be buyers.
"The No. 1 thing that drives housing values is incomes," said Todd Sinai, an associate professor of real estate at the Wharton School at the University of Pennsylvania. "When incomes fall, demand for housing falls."

Despite the government's move to bolster the banking industry, home loan rates rose again on Tuesday, reflecting concern that the Treasury will borrow heavily to finance the rescue.
On Wednesday, the average rate for 30-year fixed rate mortgages was 6.75 percent, up from 6.06 percent last week. While banks are moving aggressively to sell foreclosed properties, the number of empty homes is hovering near its highest level in more than half a century.

As of June, 2.8 percent of homes previously occupied by an owner were vacant. Nearly 1 in 10 rentals was without a tenant. Both numbers are near their highest levels since 1956, the earliest year for which the Census Bureau has such data.

At the same time, the number of people who are losing jobs or seeing their incomes decline is rising. The unemployment rate has climbed to 6.1 percent, from 4.4 percent at the end of 2007, and wages for those who still have a job have barely kept up with inflation.

In New York and other cities that rely heavily on the financial sector, economists expect that job losses will increase and that pay heavily tied to year-end bonuses will decline significantly.
One reliable proxy of housing values -- the ratio of home prices to rents -- indicates that in many cities prices are still too high relative to historical norms.

In Miami, for instance, home prices are about 22 times annual rents, according to analysis by Moody's Economy.com. The average figure for the last 20 years is just 15 times annual rents. The difference between those two numbers suggests that a home valued at $500,000 today might be worth only $341,000 based on the long-term relationship between prices and rents.

The price-to-rent ratio, which provides one measure of how much of a premium home buyers place on owning rather than renting, spiked across the country earlier this decade.

It increased the most on the coasts and somewhat less in the middle of the country.

Economy.com's calculations show that while it remains elevated in many places, the ratio has fallen sharply to more normal levels in places like Sacramento, Dallas and Riverside, Calif.
The current housing downturn is much more national in scope and severe than any other in the postwar period, partly because of the proliferation of risky lending practices. Today, foreclosures are running ahead of the downturn in the economy, a reversal of previous housing slumps.

"We are in uncharted waters," said Brian A. Bethune, an economist at Global Insight, a research firm.

Colleen Pestana, a real estate agent in Orange County in California, said many people losing their homes in Southern California used to work at mortgage and real estate companies. Many of them bet heavily on real estate by upgrading to bigger houses every few years. Now, many are losing their homes.

At the same time, Ms. Pestana said, her clients who are looking to buy are having a harder time lining up financing. One of her clients recently had to give up on a home after the lender that had offered a pre-approved loan changed its mind -- a frequent occurrence, according to real estate agents and mortgage brokers.

"I am working harder than I have ever had to work to get a deal together and keep it together," said Ms. Pestana, who has been a real estate agent for seven years.

To cushion themselves from potential losses if homes lose value, Fannie Mae and Freddie Mac, the mortgage finance companies that the government took over in September, have increased fees on loans made to borrowers who have good but not excellent credit records, even those who are making down payments as big as 30 percent.

Those higher fees are generally invisible to borrowers because banks factor them into mortgage interest rates. While the national average rate for a 30-year fixed-rate mortgage is now 6.75 percent, according to HSH Associates, mortgage brokers say the rates for many borrowers in the Southwest or Florida can be as high as 8 percent, especially for so-called jumbo loans that are too big to be sold to Fannie Mae and Freddie Mac. (Those loan limits vary by area from $417,000 to roughly $650,000.)

Higher interest rates result in bigger monthly payments, pricing some potential buyers out of the market. For example, monthly payments are $2,700 on a 6 percent 30-year, fixed-rate loan of $450,000. If the interest rate rises to 7 percent, those monthly payments jump to $3,000. All things being equal, when rates rise prices generally fall.

This month, Fannie and Freddie canceled a fee increase that would have applied to markets where home prices are falling, but the companies still have many other fees in place. In an effort to help drive down rates, the Treasury Department has announced plans to buy mortgage-backed securities issued by Fannie and Freddie. The government also recently increased the amount of loans the companies can buy and hold.

Still, those efforts will take time to have an impact and it is not clear whether they will be sufficient to get banks to lend more freely, especially in areas where jumbo loans make up a bigger percentage of lending, like New York and parts of California and Florida. Economists say that prices in those places will probably fall further.

In some of those places, price declines are being driven by a sharp increase in sales of foreclosed homes.

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Hudson & Marshall, a Dallas-based auctioneer that holds sales for lenders, reports that banks are accepting prices that they refused to consider just 12 months earlier. In a recent auction of 110 foreclosed homes in the Las Vegas area, for instance, the auctioneer's clients accepted 90 percent of the bids submitted by buyers, up from 60 percent a year earlier, said David T. Webb, a co-owner of the company.

Single-family home prices in Las Vegas have already fallen 34 percent from their peak in the summer of 2006, according to the Standard & Poor's Case-Shiller home price index. Prices in San Diego have fallen 31 percent since late 2005.

While those declines have been painful to homeowners in those cities, economists said the quick decline might help the markets reach bottom faster than in previous housing cycles, said Edward E. Leamer, an economist at the University of California, Los Angeles. In a previous boom, home prices peaked in the Los Angeles area in 1990 but did not hit bottom until 1996. Prices remained near that low for more than a year before starting to climb again.

"In some areas of California, we are really at appropriate levels," Mr. Leamer said of current home prices. But he added: "The risk is that we are going to get some overshooting, meaning that prices will be lower than they ought to be."

In Florida, Jack McCabe, a real estate consultant, said that while some cities, like Fort Myers, are showing tentative signs of a rebound, others like Miami and Fort Lauderdale are still under pressure. Two homes on his street in Fort Lauderdale that sold for about $730,000 apiece in 2005 recently sold for $400,000 -- a 44 percent decline.

"The rocket has run out of fuel, and now it's plunged back down to earth," he said.
Tara Siegel Bernard contributed reporting.

http://finance.yahoo.com/real-estate/article/105964/Home-Prices-Seem-Far-From-Bottom