VIX Showing a Lot of Optimism but Is not Necessarily Signaling a Market Top

The S&P 500 volatility index, VIX, more or less hit new lows for this move, closing at 17.66. What the VIX actually measures is more complex than the common interpretation, which is that is acts as a fear index. At the peak of what now looks to have been a credit bubble, the VIX briefly went under 10, which was perhaps as extreme a sign of optimism as the post-Lehman panic highs in the VIX were signs of fear.

A 5-year snapshot of the VIX is shown; click on it to enlarge.

Also shown is a Yahoo/Finance chart of the VIX since 1988.

The prior pattern has been for a post-recession multi-year drop in the VIX, followed by a turn upward before the next recession.

The VIX has correlated very well with the Fed funds rate with a substantial lag, perhaps up to 2 years.

This correlation is well known and emboldens the bulls.

My sense is that this trend is your friend till it is not. Numerous stocks look rich on various measures; others look OK such as those mentioned here recently (TJX, for example).

Overall, though, my sense is that this labor market is much less V-shaped than is GDP. For whatever reason(s), I suspect that uncertainty over the Obama agenda is contributing to a freezing of hiring in small business, which has plenty of business reasons to be cautious anyway.

With the S&P 500 having a dividend yield about 2%, I have this nagging sense that people who are not good stockpickers will ultimately do as well purchasing 3-5 year secure debt obligations and buying in when the VIX finally moves up. It won't matter, unless dividends soar, if the indices soar on speculative buying. There is a lot of drop that can happen again, either in absolute numbers or adjusted for whatever inflation is coming.

Now that the VIX is finally reported on the CNBC ticker, it is guaranteed to be less useful as a tool in understanding the stock market than previously. It is not, however, anywhere close to a household index, so it still makes sense to time one's stock portfolio by using surges up in the VIX to buy and big drops to sell. If in March or April the VIX drops to 15, selling in or before May and going away till it at least moves up to 20 may be a smart strategy for non-core positions.

In other words, we of course may be at a market top, but the VIX is merely in a zone which has allowed multi-year advances in stock prices and should not be used as more than a timing tool.

Copyright (C) Long Lake LLC 2010

Dividend Matters

In this speculative set of markets, it's nice to see a reasoned discussion of dividends as in the linked Business Week article. In the early stages of the Great Depression, dividends were high single digits. Now the S&P 500 yields about 2% (exact rate depends on how you measure the yield of 500 stocks weighted by float.)

My basic take is that if we are years away from surpassing the total dividend payout set at peak, it is anyone's wild guess as to what competing interest rates will be, what P/E's will be, etc.

People such as David Kotok of Cumberland Advisors who have been quite right this year to be long continue to be long, citing liquidity and absence of labor cost pressures. So, sales should rise and margins should be strong.

The novel problem is the eerieness of 0% interest rates, which are occurring allegedly because there is still a financial crisis going on. Meanwhile, the rest of the financial community is partying. What is this liquidity then other than leverage similar to that which ultimately imploded the system a year ago? Will stocks double so that the dividend yield on the SPY is only 1%, but that still is as good as cash? Will the trick for the next bear market be that stocks peak well before the Fed truly tightens?

Stay tuned. Whether it's a Ginnie Mae, a 10-year Treasury, or even Teva yielding 1.1% or ownership of GLD or SLV with covered call selling, investors should focus on income precisely because most of the media are not doing so.

Copyright (C) Long Lake LLC 2009

S&P 500 Valuations and Stock Prices

The total market capitalization of the S&P 500 is about $13.5 T. Per Zero Hedge and CapIQ, total shareholder equity of the companies in the index is $4.8 T. Goodwill is $1.6 T. These are high ratios historically. In addition, the dividend yield is slightly under 2%.

Click HERE for a list of dividend yields on the S&P 500 index going back to the 1800s (synthetic index for long-ago years, I believe).

Note the high yields from the 1930s well into the 1950s. It was that era that really provided the upside to stock returns vs. bonds. If one looks at the 1970s and then especially the early 1980s, it is easy to demonstrate that an investment in zero coupon 30-year Treasuries in 1982 did just as well as the stock market with less volatility and fewer ongoing costs. Depending on the exact interest rate at the time, a long-term Treasury bought when inflation was raging but Mr. Volcker had tightened money severely was only a few dollars, destined to turn in a few years (2012 if bought in 1982) into one hundred dollars.

Conclusion: The above is a simple way to look at stock valuations including comparative valuations during times of very low Federal debt interest rates. The results are consistent with Andrew Smithers' analysis and that of Jeremy Grantham.

The Smithers analysis is that the stock market is almost 50% overvalued. This would imply that fair value for the S&P 500 index is not much about 700. Given that the averages spend as much time below fair value as above it, and given that even a rising dividend payout stream could be consistent with a 50% decline in stock prices to allow (say) a 5% dividend yield for the index, my conclusion is that there is substantial downside risk in stock prices, even under a decent scenario for economic performance.

The above analysis recognizes that all financial assets are correlated. In retrospect we look back at post-War World II low stock valuations and low Treasury yields and see the value in stocks, but in those days, the general worry was that a deflationary Depression would return. Now the worry is that an inflationary period will return; but there is no high-yielding secure government debt to flee to as there was in the 1980s. All is at risk. In this environment, Ginnie Maes, which pay back principal as well as pay interest, may be the best investment for a substantial chunk of retirement money.

Copyright (C) Long Lake LLC 2009

What a Difference a Year Makes! Twelve Little Months . . .

A year ago-- or 8 months ago-- who could expected the following out of a Bloomberg.com article?

. . . equities rallied around the world on the Group of 20’s agreement to keep stimulating the economy. . .

“There’s nothing much to be fearful of in the short term and the market’s been in a nice uptrend, so it makes sense volatility would taper off,” said Yu-Dee Chang . . .

U.S. stocks extended a global rally after U.K. Chancellor of the Exchequer Alistair Darling, hosting a meeting of finance ministers from G-20 nations, said his colleagues decided to keep interest rates low and maintain record budget deficits until economic recoveries take hold. Commodities climbed, sending gold to a record above $1,100 an ounce. . .

“As soon as the market shows any signs of stability people are willing to sell options,” said Steve Claussen . . .

Please note that I am going to stop listing the companies the quotees work for as much as I can, to avoid advertising and because the writer is simply finding people to say whatever the writer/Bloomberg wants to push as a theme for the article.

In any case, one year ago, if someone had said that the G20 would be locked limit down in a zero interest-rate world because the economy was so horrible, the idea that the stock market would be surging to well above the level it was at a year ago would have sounded surprising. It was only 9 months ago, after all, that Barack Obama's economists predicted that unemployment would peak at 8.0% after the passage of the ARRA "stimulus" bill. We would already be at 11% if not for all the labor force dropouts.

Speculation in financial markets is back. It is back because leverage is back (or, never really went away). As with the Gold Rush, it is the middlemen who prosper during the leveraged moves. However, in the real world, few people are speculating on a better economy by investing for growth. When that happens in a big way, rates will rise, perhaps rapidly, and asset prices may fall.

The average dividend yield for all S&P 500 stocks is 1.8%; by S&P's calculations it is 2.05% or so (the higher number is weighted, not average, I believe). 140 stocks of the 500 have no dividend yield at all, something that was almost anathema in more conservative times. Stocks such as McDonald's that have decent dividends have virtually no insider buying year after year. When I was growing up and when long-term Treasury rates were also "low", a dividend yield of 3% was considered a sign of a stock market top and 6% the sign of a bottom. These days could well return. In other words, dividend yields could triple and the averages could be exactly where they are today -- in nominal terms.

As PIMCO recently calculated, financial asset prices have been on a long-term tear starting from 1957. Tobin's "q" ratio per Fed data suggests that a fair value for the Dow is around 7000-- around the March lows.

This is the opposite of 25-30 years ago, when labor was arguably overpriced, and as an intern earning less than minimum wage and with tens of thousands of dollars of medical school debts, I was happy when PATCO was slapped down by President Reagan. Things have come full circle. Labor needs work and needs better real wages, and the overfinancialized world needs simplification and prices of financial assets that are legitimately attractive to buyers, including insiders in corporations.

"Money" is "cheap" because the banks and borrowers don't know what to do with it.

Gambling in the markets remains best suited for pros.

Copyright (C) Long Lake LLC 2009

Friday Afternoon Wrap

CR reports that: S&P heads to first quarter ever of negative earnings.

(MarketWatch) - As Wall Street tracks Washington's moves to help the beleaguered banking sector and pass more economic stimulus, nearly 400 of the S&P's 500 companies have weighed in and reported a collective loss -- even excluding financials.

That's not all:

This is the worst, after the sixth quarter of negative growth, it will be the first quarter ever of negative earnings," said Howard Silverblatt, senior index analyst, at Standard & Poor's.

A sixth quarter of negative growth ties the prior record set when Harry Truman was president, and ran from the first quarter of 1951 to the second quarter of 1952.

"And next quarter we're expected a new record of seven quarters of negative growth," Silverblatt said.

As of the close of business Thursday, Silverblatt calculates S&P earnings-per-share, on a reported basis, at a loss of $10.44 for the quarter. If financials were taken out of the equation, that EPS deficit would drop to $2.35.

Comment: When profits vanish, the emphasis placed here on tangible book value becomes paramount. More specifically, cash in the bank and high-grade financial instruments are safer from an investor's standpoint than the book value of plant and equipment. After all, there's no law that a stock cannot sell for prolonged periods of time below tangible book value. In fact, many companies have sold for less than the value of their net working capital, with patents, trademarks, and physical assets net of debt thrown in. Under the "We are Japan" hypothesis, there could be many more years of a grinding down of stock prices before a secular bull market occurs, kickback rallies notwithstanding.

Additionally, the Economic Cycle Research Institute finds that:

Business Cycle Recovery Remains Elusive

Reuters February 13, 2009

(Reuters): A measure of U.S. future economic growth slipped further along with its annualized growth rate in the latest week, indicating a hazy reading of economic recovery, a research group said on Friday.

The Economic Cycle Research Institute, a New York-based independent forecasting group, said its Weekly Leading Index fell to 106.1 for the week ending Feb. 6, from a revised 106.6 in the previous week.

The index's annualized growth rate fell to minus 24.8 percent from a revised minus 24.5 percent, hitting its four-week low since Jan. 9 when it read negative 25.2 percent.

"With WLI growth falling once again, a business cycle recovery remains elusive," said Lakshman Achuthan, the Managing Director at ECRI.

The index fell to a nine-week low, the lowest reading since Dec. 5, 2008, when it was 105.7.

Comment: The ECRI has a marvelous track record. On an absolute basis, the WLI is about at a 1995 level. The Dow Jones was then much lower than today. In addition, a technical analysis of the WLI going back to 1974 shows that for the first time, a recovery in the economy/bull market in stocks both pushed to a new high in the WLI (in 2007) and then dropped to a low that was below the prior cycle's low (in 2001).

In addition, the Commerce Department reported an unprecedented 9% year on year drop in retail sales yesterday. With some or many money center banks feared to be insolvent, more and more factual news items keep piling up that have not happened since the early 1930s.

In any case, Monday is President's Day. Both America's George the First and Honest Abe faced tougher times than do we.

Copyright (C) Long Lake LLC 2009

FInancial Crisis Good for Business?

In "Fed Calls Emergency Consultants to Treat AIG, Stricken Markets," some startling news. This crisis is a big revenue generator for financial companies:

In addition to hiring consultants, the Fed and the Treasury have retained Wall Street firms to help manage more than $2 trillion in bailout and emergency-loan programs.

Pacific Investment Management Co. runs a $259 billion program to backstop the commercial-paper market. Blackrock Inc., Goldman Sachs Asset Management, Pimco and Wellington Management Co. are managing the Fed’s purchases of up to $500 billion of mortgage-backed securities. JPMorgan Chase & Co. oversees a separate program under which the Fed may lend up to $540 billion to support money market mutual funds.

No comment.

All this while (also Bloomberg.com):

S&P 500 Dividends May Decrease 13.3%, Most Since 1942

Dividends for Standard & Poor’s 500 Index companies will probably plunge 13.3 percent this year, the steepest annual decline since 1942, S&P forecast.

Companies in the 500-stock index are on pace to make $214.7 billion in payouts in 2009, compared with $247.9 billion, S&P projected in a statement today.

This is not war-time in any way similar to 1942. What is going now is largely self-inflicted. It is a mess. Anyone who tries to pick a bottom in the economy or the markets is a gambler. Anyone who has a lot of confidence in the right things to do with money in these circumstances has a strong ego.

Copyright (C) Long Lake LLC 2009