What Goes Up Must Come Down


If What I'm Saying Is Correct, Why Hasn't It Already Happened?
    Generally, in the stock market, by the time I figure something out, the stock market has long since incorporated it. So why is the stock market still up?
    Today, I think I've gotten some answers. My latest copy of Mutual Funds magazine interviews Bill Miller, the manager of the index-beating Legg Mason Value Trust. The magazine quotes Mr. Miller as saying that, "trying to draw conclusions about what has happened is nonsense. You have to look at the context. People will tell you that the market currently has a P/E of 22, and its average, since 1926, is about 15. So many people say, 'Oh, the market's overvalued.' But P/E multiples are inextricably connected to interest rates and inflation. And when interest rates and inflation have been as low as they are now, the average P/E of the market is about 26. So maybe P/E's are lower than they should be."
    Mr. Miller continues,. Since the end of WW II, "the spaces between periods of economic weakness have gotten longer than they used to be." Therefore, he says, "Corporate profits have---at least theoretically---become more sustainable," and it's become less likely, in any given period, that these profits will decline." P/E multiples, he concludes, "should  therefore be higher than long-term averages would tend to indicate."
    Now let's fast forward to Mutual Fund magazine's interview with Bill Gross, who specializes in interest rates, and who is the third of the three pundits interviewed by Mutual Funds magamzin. Mr. Gross says, "We're in a perverse situation. The Fed has been merrily slashing short-term rates, but longer-term rates have actually gone higher" (to about 5½ %). Part of the blame goes to our rock-bottom level of inflation, which "can pretty much only go up from here." That makes long bonds unappealing, keeping their yields high. 
    Michael Sivy says, in his January, 2002, Money Magazine article, pg. 62-63,
    "To sum up: the powerful decline in inflation that lasted from the early 1980's to 1998 is over. So is the extended bull market that lasted into 2000. A new era is beginning. Oil prices, inflation and interest rates are all likely to rise.. Returns for the stock market as a whole will be lower over the next decade than they were in the overheated 1990s." He observes that in 1998, inflation fell to 1.6%, the lowest since 1965. From there, it has nowhere to go but up. He says that the Fed has had to soft-pedal its inflation-fighting stance--first to combat the Asian financial crisis in 1998, and more recently, to keep the economy from sliding into economic collapse.
    He also says that none of the other influences that hold down inflation are liable to continue helping much longer. Consumer prices have been held in check by rising productivity, but there must inevitably be some pause. Productivity may rise rapidly in the first stages of the imminent recovery, but farther out, they appear to be more difficult to achieve.
    It also seems likely (says Michael Sivy) that oil and gas prices will rise over the coming decade. It takes a long time for increased demand to open new sources, and in the meantime, prices will be set by demand. Demand is liable to pick up, given recovery. Furthermore, the outputs of existing oil fields are likely to peak within the next five or six years. And any disruptions in oil supply could lead to temporary shortages. Oil is currently less than $30 a barrel. Strong demand or spot shortages will surely push prices above $30 a barrel.
    "....In addition, one sector that has long been neglected is going to come back into vogue. natural-resources stocks and other inflation hedges could be hot for the first time in a generation. So it's worth including mining stocks, oil and gas producers and real estate investment trusts.
    "Finally, I'd avoid long bonds, because of the likelihood of rising interest rates. Instead, I'd favor bonds with maturities of less than 10 years and other income choices such as electric utilities and preferred shares."
    Michael Sivy says earlier that "consumer price increases are projected to average less than 3% annually for at least the next two or three years. After that, though, there's a good chance inflation will accelerate... to 4% or 5% annually.
    So we have Mr. Miller saying that "when interest rates and inflation have been as low as they are now, the average P/E of the market is about 26. So maybe P/E's are lower than they should be", and Mr. Gross and Mr. Sivy saying that inflation and interest rates "can pretty much only go up from here.", and that these expectations are serious enough that they've caused long bond yields to rise somewhat in anticipation of this expectation among professional traders.
    Returning to Mr. Miller, the article says that Miller's not exactly bullish. he thinks the market's fully valued. He also takes issue with the idea that since the stock market has returned 10.7% since 1926(?!), we'll have to make up for the sizzling growth of the 90's with a protracted period of tepid gains. "What a silly notion! Remove the Depression from your calculations, or the market's four best years, and your 'average annual return' looks very different. So to replicate the 'average return', you'd have to have the exact same events repeat---a depression, followed by a war, etc. It makes no sense."
    The article lists the average annual return from 1926 to 2001 as 10.7% per year. If you start at the bottom of the Depression in 1932, the average becomes 12.9%. If you run it from 1926 to the bottom of the 1982 super-bear market, the average annual return is only 9.1%
    This gets into the "apples and oranges" comparisons to which I referred in yesterday's editorial. (I don't know how they arrive at the 10.7% per year number they quote from 1926 to 2001 unless it's because I'm using exponentials to calculate returns continuously instead of year-over-year stepwise compounding of interest (the difference between compounding interest daily versus compounding it annually).
    I think that a valid way to calculate this might be to try to match up P/B, P/D, and P/E ratios at different market peaks or at different market valleys so that we're comparing apples with apples. If we do this, we find that the numbers in 1929 were reasonable, at a P/E ratio of 19.12 to 1, and a dividend yield of 3.3%. (The book value isn't listed.) The corresponding values at the end of 1965 were 18.06 and 3.0%---again, reasonable values.
    An argument against using my "apples and apples" comparison is that if you look at Harry Rood's chart (below),

you see that in order to get his trend lines to fit the turn-of-the-century stock market peaks, Mr. Rood had to run his trend line a little below the 1929 peak. This also leads to slightly steeper trend lines than an "apples-and-apples" model would give. Mr. Rood's model forecasts a DJIA index of about 8000 (in 1997$) for the year 2000.  In 1997, the Dow ended the year at about 7900, with a P/E of 20.21, a dividend yield of 1.7%, and a price-to-book-value of an eye-popping 5-to-1.
    Another article in Mutual Funds (pg. 18 is entitled, "The Demise of P/E", by Janice Revell. The article begins,
    "For decades, hordes of investors, seeking to divine a stock's future prospects, worshipped at the marble altar of price-earnings multiples. Today, as evidence of corporate earnings manipulation abounds, investors are losing faith in the denominator of that key ratio---and the case for relying on P/E's is crumbling. "Earnings," argues Professor Robert Howell of Dartmouth College, "are anything accountants want them to be." Moreover, the fiscal soundness of blue-chip companies like General Electric is being questioned, something P/E doesn't even attempt to measure. Result: "The primacy of the P/E is in ruins."
    The article goes on to state that valuation methods drift in and out of fashion. During the Depression, Benjamin Graham argued that stocks should be bought only if they traded below their book value. In the 1950's, return on equity (ROE)---profits divided by book values---became trendy. But ROE and price-to-book fell from grace as inflation diminished the importance of book value. "Both are still being reported today, but observers like Howell dismiss book value as deflated and skewed by share buybacks and charges. Companies today are blowing smoke in the faces of shareholders when they report ROE's of 25%,' he says." 
    The article continues,
    "During the Internet bubble, profitless dot.coms and the analysts who flogged them touted sales growth, price-to-sales, and even "price per eyeball". As the NASDAQ spiraled higher, some fretted about the astronomical P/E, but stock analysts largely dismissed it. Given that the P/E watchers were ultimately vindicated, it is ironic that P/Es have not regained primacy. Blame earnings (the 'e' in P/E) scandals on that."
    Another excellent article in the June, 2002, issue of Mutual Funds (pg. 86) is entitled, "First, Show Me the Money", by Ralph Wanger. Mr. Wanger is the CEO of Liberty Acorn Asset Management, and the Manager of the Liberty Acorn Fund. Mr. Wanger is known for the entertaining essays that he sends to the shareholders in his funds. Mr. Wanger says,
    "The media is shocked to discover that companies have put false spins on their earnings, auditors blithely certified the numbers, analysts bought into the inflated valuations, and shareholders applauded.
    "You'd think that after the likes of Enron and Global Crossing, thing might change. Not likely.
    "So how can an investor see past the smoke and mirrors? Well, ask yourself: What is the one thing a company can't lie about to its shareholders? Answer: A dividend check---a specific dollar amount per share of cash flow.
    ""From 1960 to 1994, companies paid out 43% to 64% of their earnings on average as dividends. But after 1994, dividends went out of fashion. By 2001, only 31% of earnings were paid as dividends, Where dividend yields had been 3% to 5% for many decades, they fell to 1.2% by 2000.
    "In December 1994 the Financial Accounting Standards Board, under massive pressure from corporations and Congress, dropped its proposal to classify stock option grants as a form of pay---an expense that would cut into profits.
    "It took management several seconds to realize that if their stock prices went up, they could make fortunes on their options. Management also understood that dividend payouts would only slow the process. So companies stopped paying dividends and used the money to build new factories or repurchase stock.
    "It worked beautifully. The Nasdaq average went from 770 at the end of 1994 to 4155 at the end of 1999. We all enjoyed the greatest bull market in American history, and many CEO's made hundreds of millions of dollars by exercising their stock options."

    You remember our last Financial Accounting Standards Board change in 1987 "Warren Buffett mentions that in 1987, a change in Financial Accounting Standards Board accounting rules allowed companies to add pension income to their reported earnings. GE got 9% of last year's income from pension credit, versus a 20% pension charge in 1982. Mr. Buffett says, "Last year, according to Goldman Sachs, 35 companies in the S&P 500 got more than 10% of their earnings from pension credits, even as, in many cases, the value of their pension investments shrank."
    Somehow, assumptions about future investment rates of return affect the reported pension fund income. Mr. Buffett continues,
    "'Heroic assumptions do wonders, however, for the bottom line. By embracing those expectation rates shown in the far right column, these companies report much higher earnings--much higher--than if they were using lower rates. And that's certainly not lost on the people who set the rates. The actuaries who have roles in this game know nothing special about future investment returns. What they do know, however, is that their clients desire rates that are high. And a happy client is a continuing client.'"
    Can you imagine the forces acting upon watchdog agencies and their employees? How could ordinary Civil Servants resist the pressures exerted upon them by the titans of industry. Congress, and probably, their own political management? 

    As luck would have it, today's issue of The Huntsville Times has an article written by Martin Crutsinger, AP Economics Writer, entitled, "Treat stock options as business expenses, Greenspan urges". The article says,

    "Federal Reserve Chairman Alan Greenspan on Friday argued to help deal with problems raised by the costly collapse of Enron Corp., regulations should be changed to force companies to treat lucrative stock options for top executives as a business expense.
    "Greenspan said without that change, which is opposed by the business community, investors will continue to receive inaccurate information on the true financial status of a company.
    "The debate over stock options has taken on new urgency since the December collapse of Enron Corp., the largest corporate bankruptcy ever. Enron executives reaped millions of dollars in profits by cashing in their stock options before the company's share price plummeted.
    "The failure to expense stock option grants has introduced a significant distortion in reported earnings and one that has grown with the increasing prevalence of this form of compensation," Greenspan said in a speech to a financial markets conference convened by the Federal Reserve Bank of Atlanta.
    "In his comments, Greenspan expanded on arguments he made in late March that the current practice of not counting stock options as a business expense was inflating corporate profits and giving investors a false impression of a company's true value.
    "His campaign for changes represents a rare break for the Republican chairman of the Fed with the Bush administration.
    "President Bush, in an April newspaper interview, said "while I hate to get into a debate" with Greenspan, he did not believe stock options should be treated as a business expense.
    That puts the Bush administration in line with the views of corporate executives, who are lining up to fight legislation sponsored by Sen. Carl Levin, D-Michigan, that would make such a change.
    "The seemingly arcane accounting debate would have a huge impact on U. S. companies. The Fed has estimated that annual corporate earnings growth was 2.5 percentage points higher for big companies because they didn't have to count options as expenses subtracting from earnings.
    "Stock options give employees the right to buy a company's stock, in the future, at a predetermined price. The more the Company's stock price rises, the more valuable the stock option becomes.
    "Greenspan said Friday that the failure to treat the options as a business expense was not giving investors a true reflection of a company's financial status, which he called central to the functioning of a free-market economic system.
    "While expanding in his arguments for a need to switch to expensing stock options, Greenspan said that he would prefer that the change be accomplished through decisions of regulatory groups that set standards for the accounting industry.
    "Greenspan also argued that companies should change the way they grant options to tie their value not just to how the company's stock price is doing but to some measurement of how well the company is performing relative to competitors.
    "He said such a change would limit the temptation of executives to make questionable business judgments simply to drive up the price of the company's stock, an allegation made against former Enron executives.
    "'There have been a few dismaying examples of CEOs who nearly drove their companies to the wall and presided over a significant fall in the price of the companies' stock relative to those of their competitors,' Greenspan said. 'They nonetheless reaped large rewards because the strong performance of the stock market as a whole dragged the prices of the forlorn companies' stock along with it.'

    So there we have it. In 1994, under intense pressure from Congress, industrial leaders, and no doubt, the Clinton Administration, the hired watchmen in the Financial Accounting Standards Board caved in and approved an esoteric accounting rule that opened the floodgates to immense wealth for company management. All corporate managements had to do was boost the prices of their stock. One way to accomplish that was to reduce dividends and plough that money back into corporate expansion.
    The "pitch" in the latter nineties was that investors, instead of making money from dividends, would make money from stock appreciation. Small, fast-growing companies have eschewed dividends routinely in order to fund rapid growth. . Larger companies during the nineties may have argued that with the enormous structural improvements that technology was creating, and with globalization and its opportunities for overseas markets, blue-chip U. S. industry was in a new growth phase and needed to retain earnings to expand. Earnings began to march upward as money that would normally have been distributed as dividends showed up as retained earnings. Meanwhile, corporate managements got rich as the price of their stock soared on the strength of steadily rising earnings. The dividend rate fell to 1.2% in early 2000. It might have gone all the way to 0%, boosting the Dow to (I'm guessing) 18000 to 20000, except that the economy began to overheat. The Fed started raising interest rates, interrupting the party. Then in 2002, came Enron and Global Crossing, and corporate managements' callous lack of concern about their companies and their employees hit the fan.
    So what's next? One scenario would be that in which the party continues until the dividend rate reaches zero. However,  the problem with this would seem to me to be that the cat is out of the bag. Investors are seeing now how termite-ridden are the foundations of this shaky edifice. They may not be foolish enough to build on top of this cheesy structure until the termites have been removed, and the structure recertified. That may be why the stock market isn't advancing even though unmistakable signs of a strong recovery are visible.
    The problem with this whole thing is that money that was made during the five years from 1995 through 1999 or 1996 through 1999 was a one-time affair. It occurred because of a doubling of stock prices above their already dangerously inflated 1994 price levels. The long-term rate of rise of the S&P 500 is basically the rate of rise of the economy that it serves, because basically, it is the economy that it serves. The reason large companies issue dividends is because they've saturated their markets. Eventually, a company like Coca Cola can no longer grow its profits at 20% a year. When that time comes, then in the past, the company has issued dividends to compensate for the fact that its stock can't appreciate (in real dollars) more than its annual profit growth rate, and its annual profit growth rate must eventually approach the annual growth rate of the world economy... perhaps a few percent a year. Without dividends, no one would buy the stock when they could, say, get 5% out of a money market fund. 
    As we've seen, most of the long-term returns from stocks have been from dividends. 

(To be continued)