Month: September 2009

Benchmarks

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When evaluating stock prices, it is helpful to know some historical benchmarks.

For the S&P 500, the index of the 500 largest companies trading in the U.S., the average Price Earning ratio (P/E) since 1936 is 16 for TTM (Trailing Twelve Months, or the past year) earnings. Standard and Poors offers a spreadsheet of quarterly historical P/E ratios.

The Price To Book (P/B) ratio over the past 40 years averaged 2.4. The Return On Equity (ROE) averages 12% but the past 15 years have seen an ROE closer to 16%.

In an FT column 9/23/09, the book value of the S&P 500 was calculated at $451. If the S&P 500 were to trade at historical averages of price to book, it would be 867. The index closed at 1044 this past Friday.

Finance Tax

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In a 9/25/09 FT op-ed, Peer Steinbrück, Germany’s finance minister, argues for “a global financial-transaction tax, applied uniformly across the G20 countries.” His proposal encompasses all financial products, not just those that are traded on exchanges, and would presumably include the more exotic private contracts like credit default swaps (CDS) and credit default obligations (CDO).

Using calculations by the Austrian Institute for Economic Research, Steinbrück proposes that a .05% (20 basis points) tax on financial products would raise $690B a year, about 1.4% of world GDP. Applied uniformly across the G20 nations, it would create a level playing field for all market participants.

But wouldn’t this give those markets outside of the G20 an unfair advantage? Steinbrück relates that G20 and EU exchanges account for 97% of equity and 94% of bond trading volume in the world.

In essence, this tax would be an insurance fee paid to the taxpayers of the G20 countries who have proven to be the insurer of last resort for “Too Big To Fail” institutions throughout the world.

Bond Surge

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In a 9/22/09 FT article, Sam Jones compares hedge fund participation in the market for the past three years. In the fixed income sector, hedge funds that used to comprise almost a third of the trading volume are now only an eighth of the volume. So what is driving the huge inflow of money into bonds in the past few months? Money market rates that are close to zero. Many market funds that paid over 2% interest at the end of last year are paying about a tenth of 1%.

In a 9/19/09 WSJ article, Jason Zweig examines this flood of money out of money market funds and into bonds. He notes that “investors sank over $40B into bond funds in August, an all-time high for a single month, and are on pace to break that record again in September.” Zweig cautions investors not to chase yield by loading up on long term bonds, which will decline in price much faster than shorter term bonds when interest rates rise. Zweig briefly explains the concept of duration and how it affects bond prices and risk exposure.

At gurufocus.com, David Dietze compares money inflows into bond and stock funds this year with the bull market of 2003 – 2006. Since March of this year, $20 has been invested in bond funds for every dollar in equity funds. Dietze notes “More money has found its way into bond mutual funds this year than in the bull market from 2003 to 2006.”

Options to hedge against both inflation and rising interest rates include buying shorter term bonds, stocks that pay consistent dividends, and Treasury Inflation Protected bonds (TIPS).

Unemployed

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In a 9/25/09 WSJ article, Conor Dougherty examines the growing numbers of the long term unemployed, those who have been out of work for 6 months or more. They total 5 million, a third of the 15 million unemployed, and these long term unemployed constitute the highest percentage of unemployed since the Labor Dept started keeping track after WW2.

Conor relates several stories, each story an aspect of the larger problem of the long term unemployed: “Skills atrophy. Demoralization sets in and can become permanent. Some potential employers shy away.” A person’s chances of becoming employed decline with each month that they are unemployed. Wages are lower for those that do find jobs. The article is well worth reading.

Immigration

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In a 5/14/09 WSJ article, Conor Dougherty reports on several Census Bureau studies.
“Four states, including California, Texas, New Mexico and Hawaii, already are majority minority,” meaning that there are more non-whites than whites in those states. Florida and New York are approaching the halfway point. Arizona and Nevada are not too far behind. In 2000, 40% of Californians and 37% of New Mexicans reported speaking a language other than English in their home.

The 1900 census counted a total population of 78 million, more than 10 million of them foreign born, or approx 13%. Responding to a growing hostility toward immigrants, Congress passed strict quota laws for immigrants in 1921 and 1924. During the 1920s, the foreign born population began to decline and, beginning with the 1950 census, stayed below 8% for 40 years.

However, the 2000 census counted 11% of the population as foreign born. The 2010 census will probably show an increase in foreign born, so that the composition of native born to foreign born becomes similar to that of the early 20th century.

It is hardly surprising then to see a growing antipathy towards immigrants in the past decade. Characterized by some as bigotry, this resentment towards immigrants may be little more than the natural reaction of human beings as herd animals. We will tolerate “others” as long as their percentage of the herd remains relatively small. In America, that tolerance limit seems to be 10% foreign born. What would a study of the immigration tolerance limits in other countries reveal?

For many of us born in this country, our foreign born ancestors were once regarded as lazy, shiftless, boorish, stupid, unpatriotic or criminal. In the 1800s, American Protestants, fearful of a takeover of the United States by the Vatican, tried to pass laws banning Catholics from entering the country.

As Kermit, the frog, once said, “It’s not easy being green.”

Leverage And Risk

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In a 9/23/09 WSJ op-ed, Andy Kessler, a former hedge fund manager, argues against the current administrations proposal to curtail excess bonuses that reward employees of banks and investment firms for taking excessive risks.

Mr. Kessler writes “It wasn’t reckless schemes and excessive risk that sunk banks and Wall Street; it was excessive leverage.” Wall Street investment firms had used that excessive leverage to make what they thought were fairly low risk bets. The complexity of oversight and of rule making to control employee pay makes it difficult to manage.

Kessler’s proposal is a sound one. Instead of a cap on bonuses, Wall Street firms should be charged appropriately for the “insurance” that the Federal Reserve and the FDIC provide Wall Street. That risk adjusted insurance charge will reduce the profit for more leveraged trades, effectively squeezing an employee’s pay on the trade. Kessler argues “let the Fed and the FDIC use to market to protect the market.”

The Gap And The GAAP

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GAAP – it’s not the clothing store but an acronym for Generally Accepted Accounting Principles, or guidelines for companies to follow when figuring up their financials, including their earnings. It is those earnings that are usually the basis for how much a company’s stock sells for. Public companies report their earnings to the government each quarter according to GAAP principles, and are called net earnings. From these earnings companies pay out dividends to their shareholders.

There is another common form of earnings, called operating earnings, which are higher than net earnings. Naturally, company officers refer to those higher earnings in conference calls to investors each quarter. Operating earnings do give a better sense of the long term viability and profitably of a company. What’s the difference?

Operating earnings are what’s left after paying employees, material costs and operating expenses, lease or loan payments and depreciation on buildings and equipment and so on. There are two costs that it doesn’t account for: taxes and interest. Net earnings are lower because that’s what left after paying taxes and interest. Net earnings will also include adjustments for what are called extraordinary items: one-time expenses that should not be recurring.

In a 9/18/09 “Ahead of the Tape” WSJ column, Mark Gongloff reports that the gap has narrowed between these two measures, operating and net earnings. The gap was about 2% and that narrow gap signals stability – for now. Mark notes that the last time the gap was this narrow was in the quarter ending March 2000. What he doesn’t mention is that, shortly after that date, the stock market started a long swan dive. Over the past 15 years, the cumulative gap between these two earning figures has been increasing each quarter. From past experience, we know that the gap widens during a recession. I suspect that this long term trend shows that there have too many aggressive accounting tactics so that management could paint a rosier picture of a company’s future earning potential, thus driving up the price of the stock.

Lastly, these two measures play an important part in evaluating the price of a stock. The P/E ratio, a common yardstick to measure stock price, is the price of a stock divided by the earnings per share. There are two common P/E ratios: TTM, or stock price divided by earnings during the trailing, or past, twelve months; and forward P/E, which is the stock price divided by the estimated earnings for the next twelve months. However, the two P/E ratios are based on two different earnings. The TTM ratio is based on net earnings. Forward P/E is based on estimates of operating, not net, earnings. Even if estimates prove to be accurate (which is unlikely a year in advance), the net earnings will be lower when they actually happen. If a 2% gap in these two measures is unusual, then a cautious investor might add another 4% to a estimate of future P/E to get a more realistic estimate.

Cities In Crisis

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Many cities in the U.S. rely on sales tax for revenues and are facing budget shortfalls as consumers cut back their purchases and businesses reduce their inventories. In a 9/18/09 WSJ article, Leslie Eaton takes a deeper look into the financial woes of cities.

Big cities are having the greatest difficulty. The Pew Charitable Trust analyzed 13 major cities and found budget gaps averaging 5%. However, city payrolls have become bloated over the past 15 years. Technological improvements during that time have led to great productivity increases in the private sector but that efficiency has apparently escaped city governments. During that period city government employees, excluding teachers, have increased 13%.

Solutions to city budget woes have included layoffs and mandatory furloughs, sales tax increases, deferring pension obligations and closing libraries. Several years ago Chicago had privatized their parking meters, forgoing that continuing revenue stream for a one time payment of $1.15B. At least they had the prudence to put the money into a rainy day fund, which they raided this year to close their budget gap.

As unemployment rates stay high and consumers pay down debt, the budget problems of many cities will continue. Property taxes are a fairly stable source of revenue for many cities but reduced housing valuations will cut those revenues as well. For city officials this downturn has prompted a soul searching look at what are the core responsibilities and priorities of a city government.

Total Place

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Here’s an idea from Britain that American taxpayers might want to adopt. In a 9/2/09 Financial Times article, Nicholas Timmins, the public policy editor, summarizes a concept called Total Place, a comprehensive analysis that adds up all the public money spent in a region. In Britain, the results of two pilot studies has raised some eyebrows and led to the call for several more studies.

In the U.S., the Census Bureau maintains statistics on the amount of funds that state sends to and gets from the Federal Government. But there is no comprehensive analysis of total Federal, State and local public spending. Would we find the same disparities in per capita spending in regions of similar population density and how would we react if there were striking differences?

NHS vs US Health

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The good, bad and ugly of the American and British health care systems. In an 8/15/09 FT article, Nicholas Timmins gives a brief comparison of the two systems.

In a 9/15/09 PBS program, “Retirement Revolution”, host Paula Zahn spoke with a doctor who has worked in both systems. The doctor summed it up: The British NHS works well for most patients whose disease presents no particularly difficult or unusual complications. The American system, with much more emphasis on advanced technology and public funding for academic institutions, is better for those patients who do have unusual complications.

At town hall meetings this summer, some Americans touted the U.S. health care system as the best in the world, citing the estimated 400,000 people who come here each year to get medical care. An 8/24/09 AP article cites a 2007 estimate that almost twice that number, 750,000 U.S. citizens left the country to get medical care elsewhere. Estimates by the Medical Tourism Board for 2010 are that 1.6M patients will leave the U.S. for care outside the country.