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Contrary Investor is written, edited and published by a very small group of "real world" institutional buy-side portfolio managers and analysts with, at minimum, 20…

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Window Pains

Window Pains...Investing in the financial markets necessarily involves one's ability to change perspectives over time. Often the job of assessing what is important at any particular point becomes increasingly difficult in a period of heightened short term volatility. Not difficult in terms of staying focused on the factual reality of the economy, corporate earnings, etc., but difficult in that the financial media feels compelled to come up with rationales for daily movements in asset prices. Possibly the single greatest task of any investor today is filtering out white noise. And there's more of the white stuff than ever before.

Just a month or so ago, many investors seemed convinced that sell side Street analysts were nothing but shills, yet post specific 3Q corporate earnings announcements individual stock prices movements were influenced by results relative to the "expectations" of these very folks. And sometimes those price movements were significant. So now analyst expectations are again important so soon after having been deemed next to worthless? Just a month or so ago, it seemed like conflict with Iraq was a forgone conclusion, at least as reflected by the price of crude. Maybe not so anymore. Who knows where we'll be on this issue next week. Near the July and October equity market lows, folks became pretty convinced that Fed rate cuts were all but ineffective. After all, there has really only been one other time in US history when this type of monetary largesse had been met with as much negative equity market response as we witness today. But the firmer tone in stockland over the past week is clearly in anticipation of a helpful Fed Funds rate decrease next week, right?

We need to remain cognizant of the fact that heightened financial market price volatility accelerates the simple human need to explain daily life as we experience it. Trying to put order and meaning to something that is often random by nature over very short periods of time. We need to continually teach ourselves to look at the financial markets and the economy in simultaneous shorter and longer term windows of perspective. Neither at the exclusion of the other. Quite simply, all we are trying to do is avoid window pain, as translated into the dollar and cents of our investing activities.

Look Here Is That A Teardrop In The Corner Of Your Pane? Now Don't You Try To Tell Me That It's Rain...Looking at financial history in a series of time demarcated windows is often helpful to us in putting current circumstances into context. As you know, many a technically driven investor or trader will look at hourly, daily, weekly and monthly charts with related indicators to get a sense of rhythm. Rhythm of the moment and rhythm of the longer term. Given the October fireworks show put on by many an equity index, we thought it might be worthwhile to look at historical S&P price performance in time sequenced slices. Is the bear market in equities over? Does it get worse from here? Certainly there are no definitive answers to these questions, but rather perspective on human decision making relative to our financial history in this country.

Some of the oldest data we can find comes directly from professor Bob Shiller of "Irrational Exuberance" fame. Bob has tracked the S&P back to its origins and has derived data back to the early 1870's. Now that's what we call long term in perspective. Certainly investors of today are much smarter than their investment forebears given the technological tools of the moment, correct? In our first little look at life, we've simply charted the year over year price change in the S&P starting back in 1872. (As a quick note, in this and all of the related charts that follow we are simplistically looking only at price. No adjustments for dividends, interest rates or inflation. Just simple human decision making in terms of price. Also, in all charts we have used a current S&P value of 835 - somewhere in the middle of the current rally range.):

Certainly the current year has been quite a special occurrence for the S&P 500 as there have only been five years in S&P history dating back to the early 1870's that have witnessed price deceleration on par or in excess of what we have experienced this year. As you can see with a bit more careful look at the chart, years following maximum pain events such as we have seen this year have been followed by years where returns were quite positive, with minimum return experience near 15% and maximum price gain near 45%. Does this mean that 2003 should be a good year for S&P investors if the index does indeed close near 800 this year? Certainly no one can forecast what is to come next year with precision. At best it's a guess. This is simply a history lesson.

In moving ahead to a five year average annual return window certain other observations become obvious:

In looking at life in five year increments, we have not yet experienced the longer term rate of return lows seen in the 1973-74 bear, and are nowhere near the running time period rate of return lows seen during the 1929 aftermath. Do we have to revisit these prior secular bear market lows as our ultimate date with destiny for this cycle? It remains to be seen, but what really stands out to us as possibly very significant in the above chart is the fact that since 1870, never has the market (as measured by the price action in the S&P) seen a five year average annual rate of return peak as was witnessed in the latter part of the 1990's. This suggests to us that the animal spirits on the Street were in hyperdrive like never before. The emotional love affair with equities as being characterized by price was unequalled in financial history. The only other period even close to what we lived through in the late 1990's was the half decade preceding the 1929 mania top. If the current pendulum of emotion is to complete a swing even approximating the post 1929 experience, there are more teardrops to fall ahead.

In looking out the largest picture window over the landscape of our choosing, the following is a ten year rate of return sequence:

To suggest that the above chart is provocative is probably a serious understatement. If this is not as clear a picture of the longer term cyclical pattern of human decision making regarding financial assets as we have seen, then we just don't know what is. Maybe the most impressive message of the above chart is that based on a rolling decade of average annual return experience, equity manias have always ended their almost predictably cyclical journey somewhere in the same general vicinity of zero. We're not quite there yet for this cycle, now are we? Unless it's different this time, we would expect nothing less than a repeat performance of financial history before the present cycle concludes.

How do we get to a zero ten year average annual equity rate of return from here? Is an imminent price collapse dead ahead? That would certainly be one way to accomplish the statistically high probability end game, but not the only path. Our very probable journey to zero could easily be accomplished with low to mid single digit positive experience for a period ahead as the future rolling ten year average annual rate of return loses ever more of the extremely positive influence of the latter 1990's return years as we march forward. Much like the five year window of perspective, never in US history has the ten year average annual return on the S&P peaked at a higher level than was seen in the late 1990's. In fact it is quite interesting to note that every US equity mania in history exhibited consecutively higher rates of ten year average return performance peaks going all the way back over the 130 year span.

We'd suggest that the above charts carry quite a few sobering implications for the baby boom generation in this country. If we indeed repeat the patterns of the past and the running ten year annual average rate of return for the S&P ultimately dips to zero, retirement balances that remain levered to equities are not going to be rebuilt to former levels seen three years ago by sheer price appreciation alone. Even low to high single digit returns at best may not do the trick for most boomers wishing to retire before this decade elapses or early in the following. Are the boomers going to be forced to actually increase their personal savings rate in order to meet the financial hurdles of retirement? It seems a darn good bet. The ten year chart is telling us that it's probably a much better than even money proposition. And that will not be good news to the consumption dependent US economy. Although, again, focusing on too short a time perspective in forming economic and investment assumptions can be a dangerous game, recent patterns of consumer behavior suggest households may be forming opinions about the future much different than their thoughts over the past ten, five and even one year.

Ursus Interruptus...In last month's discussion, we mentioned rising levels of personal stomach acid over the fact that the mood among the investment community had become so glum. Unlike anything we'd seen in years. The contrarian in us was screaming, our heads just wouldn't let us immediately reach for our pocketbooks and throw a few speculative chips on the green felt table. Playing bear market rallies are a matter of personal conjecture and temperament. As you know, linearity on Wall Street is a very rare phenomenon. Where the current bear market rally in equities ends is really anyone's guess at the moment. What we do know is that although the absolute insanity of price levels seen a few years back has experienced a good dose of reconciliation, other bubbles that we have spoken of in past discussions remain to be addressed. The credit reconciliation in the corporate sector is in full bloom, but for households, balance sheets have only ballooned ever larger over the past few years. The consumer in the US has been pushed, prodded, cajoled and poked into further levering to support consumption. Despite the recent rise in the equity market as a potential discounting forecast as to what lies ahead for the economy, a look in the shorter term window of statistical economic life suggests the economy will move in a near term direction opposite to the recent equity rise, at least in the quarter ahead. And most importantly, it may now be the consumer that leads the economy into a certain stagnant mush ahead. No quicksand, at least now now. Just mush.

The very recent Fed Beige book release painted a picture of spreading weakness in retail sales. Quite noticeable relative to prior Beige book commentary, In fact, the tone was a somber as any we've seen since near the academic end of the recession in 2001. Consumer spending was weak in all districts reporting. Unusual in that there have typically been a few districts experiencing strength in prior reports. Last Tuesday's Bank of Tokyo-Mitsubishi chain store sales report revealed a weekly 1.9% tumble in results, putting the index at a low not seen since the first weeks of the year and a one week deceleration rate not seen for almost two years. The vehicle sales report for October revealed a one month unit sales volume number not seen since 1998:

Quite unusual auto sales activity for October given that incentive and financing plans were some of the most generous we have seen yet. It's no secret that auto sales can account for anywhere between 20-25% of retail sales over any period of time. Maybe it's just a post summer buying spree spike in autos that has consumers in hangover mode at the moment. Or maybe a full year of incredible incentives has sated market demand at the margin. Again, although it may be short lived in deceleration, we witnessed the recent week's refi data walk right off the edge of a cliff:

Certainly the near 60 basis point rise in the 10 year Treasury yield that is an approximate de facto reference rate for conventional mortgage activity did not help near term activity any, but refi cycles such as we have witnessed recently are simply not sustainable over any meaningful time period. Hence the term spike. A short term window at best set against the longer term trends of the broad economy. Above and beyond the virtual structural economic supports that have been housing and autos over the past year or more, even the Wal-Mart's of the world are showing signs of potential consumer change as their sales growth trends become more anemic by the month. Although we place very little faith in consumer surveys, we place a tremendous amount of faith in the fact that human patterns of ultimately emotionally driven decision making repeat over time. The "white noise" media was all aflutter, at least for a day or two, over the recent consumer confidence report. The fact is that recent trends were almost totally predictable and it's a very good bet based on past experience that we are still a good way off from the ultimate consumer confidence lows.

Not only has every meaningful consumer confidence cycle of the past three decade perceptual window ended somewhere a bit below the 60 range, but so has every meaningful equity bear market cycle. As you can see above, this chart has simply been uncanny in its ability to almost pinpoint significant equity bear market lows of the past 30+ years. What is also important in the historical message of the consumer confidence report is that the rate of change in personal consumption expenditures has also spiked to a low for each cycle along with the consumer confidence report. Over very short term time windows, the correlation between consumer confidence and retail sales is tenuous at best, but over longer term periods, it is relevant and meaningful. If we have not yet seen the lows in CC, is it also true that we have not yet seen the rate of change lows in personal consumption? We only have history as a guide.

Although equity markets can go anywhere they choose over short periods of time, it's important to keep in mind that factual cracks in the spending armor of consumers is clearly evident. Consumer spending has been propped up over the last year-plus with anomalies in financing possibilities. With easy credit. As the broader corporate credit reconciliation process continues to smolder, the ability of the corporate financial sector to continue creating "cheap" credit is diminishing at the margin. With every ABS (asset backed securitization) downgrade by the bond rating agencies. Unfortunately it is quite apparent that credit has driven the game for household consumers over the recent past as the year over year rate of change in wages and salaries is quite near a four decade low:

As a last few comments, we reiterate the importance of monitoring near term consumer spending dead ahead as recent durable goods, ISM, and other data pertaining to the corporate sector have been deteriorating. In some spots such as manufacturing, deteriorating badly. Deteriorating to the point where the Fed is to be called up from the bullpen for the 12th time in post bull market season play.

I Went 12 Rounds With Jose Cuervo...By the time you read this it may already be a foregone conclusion that the Fed has lowered the Fed Funds rate. After the recent durable goods and consumer confidence reports, the Fed Funds futures aficionados swung into action and immediately discounted an immediate Fed move. From our standpoint, it sure seems that we have arrived at the point in the reconciliation of the credit cycle where cost of capital in terms of an additional dollar of credit generated is becoming more of a moot point than not. It is the dead weight of balance sheet and associated off balance sheet liabilities that is moving to front and center stage in terms of economic and financial importance. Any near term Fed action is largely perceptual in the greater scheme of things. Humble question: Does lowering the Fed Funds rate change the cost of capital for either Ford or GM, the former whose debt is already trading as if it commanded a junk rating and the latter not too far behind? Does lowering the Fed Funds rate guarantee lower mortgage interest rates to continue the bubble in real estate backed credit creation?

It is quite telling to watch credit spreads. When yields along the US Treasury curve were spiking lower in late September and early October, the consensus believed that Treasuries were the "safety trade". It was a natural to witness spreads between Treasury and corporate yields widen as Treasury prices were bid higher in almost a mad frenzy of safety flight. If this was so, then why did the spread between Treasuries and corporate bonds actually widen even further when Treasury yields recently went back up?

As you can see in the chart above, the current yield spread between ten year Treasuries and corporate debt as represented by Moody's Baa rated yields is at near record levels. 11 Fed Funds rate cuts has only witnessed this spread widen, not contract. The last time this yield spread was as wide as we witness today, the Fed had probably 1400 basis points of Fed Fubds wiggle room with which to attempt to lower the cost of capital to corporate America. Today, at least as of this writing, the Fed only has 175 basis points left. As you can see in the following chart, corporate cost of capital is relatively unchanged over the past four years while short term Treasury yields have dropped like a rock. Just what does another Fed rate cut buy the corporate sector? Not a hell of a lot, that's what.

One of the characterizations of the current financial marketplace that is truly different this go around is that the capital markets have played a much more important role in late prior cycle system-wide credit expansion than possibly ever before. Greenspan has gone out of his way to praise the banks for essentially offloading a substantial degree of credit risk onto the capital markets in the form of securitizations, etc. during this cycle. Offloaded right onto the portfolios of many a pension fund and assorted other institutional investors. The problem of the moment being that capital markets are meting out financial justice with a very large and swift emotional sword. For all intents and purposes, they have simply turned their backs on many a company. With a little encouragement from the Moody's and S&P's of the world, of course. A byproduct of simple human fear. Alternatively, as we have shown you in charts during past discussions, bank lending for anything except real estate rests at a multi-decade year over year rate of change low. In aggregate, banks are acting in a very risk averse manner. So the Fed lowers rates. Does that really change the nature of access to capital for the corporate sector? Or for that matter the household sector already dependent for credit on non-bank financial intermediaries? Not when it's in good part been the capital markets that have supplied that credit in the first place. A capital market that is acting scared to death (and rightly so).

Rotten Until The Core?...Although economic fundamentals and financial market price movements are rarely seen in lock step similarity (largely because the markets are anticipatory animals by nature), it's important to keep multiple time perspectives in mind when looking at both the current equity market rally and current fundamental backdrop against which that movement is occurring. Important in that valuations ultimately do matter, regardless of short term supply and demand fluctuations. Something to keep in mind as we move ahead is the movement to simplify and make meaningful corporate earnings reporting. In that effort, S&P recently released their "core earnings" calculation for the S&P 500. Although we spent a good part of an entire discussion on this subject in the subscriber portion of the site, we'll keep it simple. We believe the markets will ultimately (a year or two out) demand moving toward an S&P or similar S&P approach in looking at corporate results. Adjusting for the reality of option expenses and pension obligations have been and will continue to be large issues. The calculation for S&P 500 earnings, as per the recent report, for the 12 month period ended 6/02 was as follows:

S&P 500 Core Earnings Reconciliation
As Reported $26.74
Employee Stock Options (5.21)
Net Pension Adjustments (6.54)
Goodwill Impairment 1.46
Gains/(Losses) On Sale Of Assets 2.15
Other Post-Retirement Benefits (0.42)
Settlements and Litigation 0.43
Reversal Of Prior Period Charges (0.14)

We're not about to scream that the S&P is wildly overvalued based on these numbers and that the world is about to come to an end. We'll skip the melodrama for the moment. Ultimate reconciliation between realistic accounting presentation and macro equity price levels lies in front of us, not behind. In the midst of an equity market currently in "rally" mode, and quite forgiving of a fair chunk of sobering macro economic and company specific fact of the moment, we need to keep in mind that every significant equity bear market of current magnitude bottomed with valuations based on earnings well south of what we now experience on an "as-reported" basis, let alone potentially getting close enough to address S&P's work in the calculation of "core earnings". For ourselves, it makes the "beating the expectations" game of the last few weeks just seem surreal. Isn't this how we got into trouble in the first place?

Fun With Funds...By now it's common knowledge that investors yanked another ($16+) billion out of equity funds in September according to the ICI data. Although the equity mutual fund cash to assets ratio rose to 4.9% as of September month end, it was not because fund managers raised cash. In fact actual cash levels fell $10 billion in September above and beyond redemptions ($10 billion was put to work). The cash to asset ratio rose to 4.9% because the value of the equities held dropped hard. We estimate that through October, the public took another +/- $13 billion out of funds. Let's put it this way, we're not dead sure what happens to autos and housing in the weeks and months ahead, but consumers have certainly stopped "consuming" equity funds over the past four months. Do you think another rate cut will help them change their minds?

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