Buying Opportunity?

An alternative to the alternatives. And a safer way to stick it out in stocks, if you’re so inclined. "Don’t Panic," says Bruce McWilliams, an editor in our London office, "look beyond the borders…in some cases, this may truly be a buying opportunity."

What havoc will the fallout of WorldCom, Enron, and other high-profile financial disasters wreak on your portfolios? That is a question best left for the talking heads on CNBC.

As for me, I’m actually going to give you three reasons to stay in the market – and even invest more! But not where you might think…

First, the problem: I blame the WorldCom, Enron, and Xerox frauds on top executive options. Over the last decade, options to purchase shares were given to top managers to align their financial interests with shareholders.

Typically, the share option only became valuable as long as the price of the common shares rose above the so- called "strike price."

Now, you can understand why management had such an interest in causing the share price to rise. In fact, while they may be able to nail the chief financial officer with the actual physical acts of transferring accounts, there was certainly a conspiracy of consent within these companies to make the share price hit the strike price by whatever means possible.

Together, all these events have caused a malaise of sentiment by investors. Does this spell the end of capitalism as we know it? Of course not. The magnificent result of capitalism is that while a few companies may go under, thousands of others will step into the void to replace their activities, like water seeping into a crack.

What should you do now? In the new edition of his classic, "Stocks for the Long Run", finance professor Jeremy Siegel gives us three ideas about how and when to invest. He begins by suggesting that over time, the best time to invest is when sentiment is depressed, just as the worst time to invest is when you feel good about investing.

The question is: have we reached that depth of depression yet?

Siegel computed an index of investor sentiment over 40 years by comparing the ratio of bullish newsletters to bearish ones. He then measured subsequent returns on stocks and found that sentiment does well at predicting subsequent returns. When sentiment runs high, subsequent market returns are low and the converse is true as well. He says the index is a "particularly strong predictor of market returns over the next nine to 12 months."

Consider this: the crash of ’87 was accompanied by investor pessimism. The index also fell after the Iraqi invasion of Kuwait, the bond market collapse in 1994, the Asian crisis in 1997, the LTCM bail-out in September 1998. Each of these times proved an excellent time to invest, says Siegel, based on returns 12 months later.

The immediate aftermath of all these frauds and shams will be a tidal wave of pessimism. It has been building for a while, and will most certainly crest in the next few weeks and months. As Siegel says, when investment pessimism grows, later returns are better than average.

The markets are still overvalued. Siegel has a point about this as well. In the UK, the P/E ratio on FTSE All Share hovers around 20/21. The long-term historical average for the market ratio is around 14 or 15, which implies a market return of 6.7% to 7.1%. (This is the reciprocal of the P/E ratio.)

Siegel suggests that there is reason to believe that the long-term average P/E ratio has shifted upward. This is an idea I’m willing to entertain for the sake of the argument, assuming that investors require the same after-tax, after-inflation and after-costs return. These three factors can explain major movements of the market’s P/E ratio over the past 50 years. Over the last decade, taxes have declined, inflation has been tamed and, because of the Internet, transaction costs have significantly declined. Siegel concludes that a P/E ratio in the low 20s (a market return of 5%) is justified based on the decline of inflation and tax rates. And – this is the important bit – taking into account reduced transaction costs gets you a P/E ratio in the high 20s (average market return 3.3%-4.0%).

I know this has the ring of "this time IS different" to justify further investment, but the average market decline lasts two and a half years, and historically speaking, it is time for the current bear market to come to a close.

Siegel makes the point that "small value stocks have significantly outperformed small growth stocks over long periods of time. Dreams of buying a new Microsoft… often compel investors to overpay for these issues."

It is a well-known fact, at least on this side of the Atlantic, that US markets are more overvalued than their UK counterparts. The US stock market has a P/E ratio roughly double the UK’s. In my opinion, the US market still has a long way to fall before it reaches a realistic price, while the UK market has already reached a more reasonable price. We didn’t fly nearly as high… so we’re not as likely to fall as far.

And during the bubble, many telecom companies got carried away by the massive jump in their share prices as investors jumped on the TNT (Techs, ‘Nets and Telecoms) bandwagon both in the US and the UK. But in the States, the mania was also fueled by feverish acquisitions, which ultimately proved to be the downfall of Worldcom, Tyco and the rest.

Reacting to a similar trend of acquiring rivals that happened in the UK in the 1980s, the UK rules were tightened. We have not seen this sort of activity in the UK since…so we’re not likely to see "homegrown" scandals as a result of acquisitions accounts unraveling. The bottom line? It’s just harder to cook the books in the UK.

Since the Robert Maxwell scandal, a well-known affair during its time, UK company accounts try to show the "true" position of the company, rather than using creative techniques and legal jargon to baffle investors and boards alike. In America, home to over 500,000 lawyers, it tends to be the other way around.

So while I would hold out on jumping back into the US market, a well-considered portfolio of stocks outside Wall Street might not be a bad idea. For example, a recent report on small and mid cap firms conducted by the banking concern HSBC points out that if you strip out the tech companies, the remaining UK small caps are holding firm in the bear market. The HSBC comparison shows that UK small caps – stripped of their high tech components – are still on course to achieve an annual earnings per share growth of nearly 14% between 2000- 2004. And while ‘supercaps’ (undefined20bn+) and the FTSE 100 are only slated to grow by 3%-4% respectively, mid-caps minus tech are on pace for 10% earnings per share growth.

In my opinion, these numbers tell the whole story. Small cap figures, market-wide in the UK, have been horribly distorted by the TNT crash, giving the sector an awful hue. But take out tech and telecom companies, famous names which once were big but now are small, and you’ll see that earnings growth for the small cap market in the UK looks pretty rosy…and may provide a viable alternative to ride out the storm of the world’s larger indexes.


Bruce McWilliams,
for The Daily Reckoning
July 22, 2002

P.S. Don’t panic. Believe it or not, the weak stock market has helped create – in select areas – a buying opportunity. Fact is, some of the biggest fortunes of the past century have been made when the market was at its weakest. In 1939, for example, Sir John Templeton borrowed $10,000 from his employer to invest in 104 bargain-basement companies – 34 of which were bankrupt. Within four years he was on his way to becoming one of the wealthiest men in the world.

Weed out your portfolio based on sensible reasons – not blanket fear; seek viable alternatives. And consider broadening your horizons beyond the conventional approach being peddled to you by your 401(k) provider. You’ll thank me in nine to 12 month’s time.

If you’re interested in pursuing investment ideas outside the US, the UK market provides some interesting possibilities.

Editor’s note: Editor of Red Hot Penny Shares, Bruce McWilliams is one of the canniest "share tippers" around. Making use of his extensive contacts and using his own systems Bruce pinpoints shares that will survive and prosper in 2001. To quote the New York Times: "Bruce McWilliams explains how investors of modest means can reap huge profits."

Bruce McWilliams now lives in London. He previously held the position of Vice-President of Citibank and worked in the London, New York and Zurich markets. He is the author of the best-seller Penny Stocks.

The horrors.

Stocks floated downriver yesterday…deeper into the heart of darkness, while investors – who had no business being there in the first place and were beginning to wonder why they came – grew increasingly nervous, weary and desperate.

"There’s panic in the air," notes USA Today.

"I’m far more concerned about going broke than getting rich," said one restless pilgrim whose retirement funds have withered from $600,000 to $380,000. The 53 year-old can’t be alone in wanting to get out of stocks. But so far there has been no panic…no stampede for the exits.

The financial media is clueless. For years, reporters have done nothing other than present one hot new stock recommendation after another. Stocks always go up, don’t they? Now that the S&P has lost nearly half it value, they tell readers to buy…because stocks are cheap! "Time to Stock Up," says a Barron’s headline. "Forget the gloom – equities haven’t been this attractive since the mid-1990s."

Uh huh…But are stocks really cheap…or just relatively cheap? Are stocks good absolute values now? Or just relative values?

"Ben Graham said that you should stay away from stocks when the S&P 500 earnings yield is less than the yield on high-quality bonds," writes Dan Ferris. "The S&P 500 is at 28 times earnings, or an earnings yield of 1/28 = 3.6%. Moody’s forecast for AAA-bond yields in July is 6.9% (won’t be actual ’til July is over).

"Ergo, the S&P 500, in terms of earnings yield, is roughly two times as expensive as Graham’s rule of thumb says it has to be before you should even consider buying it. (6.9 / 3.6 = 1.91, or a little less than 2)."

Barron’s presents a list of stocks that are "now more reasonable" – including Microsoft, GE, and Wal-Mart. (What stocks aren’t more reasonable, we ask ourselves?) We see only one stock we like – Philip Morris, with a dividend yield 5.5%. We’ve had a fondness for Big MO for the last 3 years. Not that we think the price is going up any time soon; it’s just that with that kind of dividend income coming in we don’t care. We can watch the rest of Barron’s recommended list become even more reasonable – and enjoy the show.

Eric, what’s shakin’?


Eric Fry, in New York City:

– Wall Street has become a hardhat area…and there’s not a backhoe or a jackhammer in sight. Stocks of all sorts rained down from the sky again yesterday, crushing many of the bystanders who got a little too close to the action.

– Stocks fell again and they fell a lot. Although the Dow attempted a couple of feeble rallies, it tumbled helplessly late in the day. By the closing bell, the blue chip index had lost another 234 points to 7,784, while the Nasdaq dropped nearly 3% to 1,282.

– Despite the fear and loathing on Wall Street, gold stocks provided no protection whatsoever. Gold stock buyers also took some lumps on the head, as the XAU Index plunged more than 6%.

– Dazed and confused…That’s how most investors are feeling lately. Neither the shell-shocked bulls nor the fat and happy bears know quite what to do next. The market’s extreme volatility is paralyzing both camps – the bulls are afraid to buy and the bears are afraid to sell.

– "This is obviously an extremely painful period for equity investors," Morgan Stanley’s Stephen Roach correctly observes. "Oversold is an understatement in describing current market conditions."

– The pain is spreading far and wide. For many individual investors – especially those who do not read the Daily Reckoning – the personal stock market losses are becoming truly staggering. Meanwhile, the "smart money" isn’t faring much better.

– A lot of professional investors with whom I’ve spoken in recent days have been caught "wrong-footed" by the market’s latest slide. Most admit to having become a bit too bullish a bit too soon. They each had closed out their bearish bets several weeks ago, to prepare for the rally that never arrived.

– Success in markets like these is measured in losses avoided, rather than in profits gained. So treacherous has the market become, that even many of the largest and formerly safest blue chip stocks are fluctuating wildly throughout each trading session and are usually ending the day with large losses.

– "The market can rally any time it likes," says Jeremy Grantham in a recent interview with Barron’s. "But before the smoke really clears, it’s very likely we will overrun to a level below 700 on the S&P and below 1100 on Nasdaq. It’s very scary. The overrun is something of a terra incognita…The only thing you can say with some statistical backing is that there is a strong tendency for the degree of overrun on the downside to be related to the degree of overrun on the upside…The very biggest bubbles – tend to be followed by some of the worst overruns." That’s comforting.

– Grantham acknowledges that some modestly attractive stocks are cropping up in the US stock market. He lightheartedly observes, however, that the S&P would be a better value below 600, an even better value below 500, and an even better value below 390.

– In other words, it’s anyone’s guess how low is low enough…Welcome to the bear market.

– The incredible shrinking stock market is certain to put a huge dent in consumer confidence – and that is almost certain to put a huge dent in economic growth. Therefore, the double-dip recession I predicted in the Daily Reckoning several months ago may well be coming to pass.

– "The case for the double dip is even more compelling today than it was when I first embraced such a prognosis at the start of this year," says Morgan Stanley’s Stephen Roach. "Here’s why…the demand side of the macro equation remains weak and exceedingly vulnerable to a relapse…In my opinion, the sharp recent decline in the stock market increases the odds of a double dip in the US economy. I would now place a little more than a 50% probability on the likelihood that real GDP growth will turn negative before year-end 2002.

– Furthermore, says Roach, "America’s double dip would be the world’s double dip…Dip-buyers beware."


Back in Paris…

*** A news item tells us that mortgage rates are at a 35-year low. Another informs us that the fastest growing occupation in America is mortgage brokering.

Steve Sjuggerud attended a cocktail party recently, and writes, "For the first time in years, nobody talked to me about the stock market…all I heard about was the EASY MONEY now in real estate.

"Recent times couldn’t have been more perfect for mortgage brokers to get rich, as interest rates are low and people are taking money out of the stock market and putting it into real estate.

"It sure is starting to feel like the easy money is in real estate these days. And that’s what’s finally starting to get me worried. When things feel too good to be true, they usually are. And as the old Wall Street saying goes, "nobody rings a bell at the top…"

*** With so many people losing their jobs on Wall Street, you’d think they could hire one of them to ring a bell at the top…but that is not the way of the world. Year after year, the job goes unfilled.

But if there were a bell ringer for the real estate market, he ought to be warming up, in our humble opinion. Nearly three years ago we suggested that the U.S. economy was tracking Japan. At the time, people thought it was a preposterous idea. Most still think so. But, nothing has happened in the last 30 months or so to change our opinion. So, we’re sticking with it.

Now we read in the Economist that Japanese real estate market did not go down immediately after the bear market began in Tokyo in 1990. Instead, even as stocks fell 50%, property prices continued to go up for another 2 years. Then, property collapsed too.

If we’re right about following the Japanese, real estate should be going down pretty soon. But relax. The bottom may not be reached for another 8 years.

*** Larry Summers, formerly of the "committee to save the world" – along with Robert Rubin and Alan Greenspan – is now the president of Harvard. A Daily Reckoning reader, attending an alumni event, reflects on Summer’s comments and how tarting up the numbers became a habit in academia as well as in government and business:

"First, I’ve been a subscriber for four months or so. Your web site has been like a drink of water to a thirsty man. My day is not complete without my Daily Reckoning fix. It is almost like you can read my mind, except you have the ability to verbalize what I often simply cannot put into words. Many thanks for your attention to the details of financial life.

"Second, I graduated from Harvard, Class of 1977. In June, I attended my 25th reunion. There is a reason why Harvard has a $19B endowment, and its care and feeding of alums is the big one. More to the point, the new President of Harvard, Larry Summers – former Treasury Secretary and a recovering Economist, gave a talk in which he noted that over 90% of the current crop, Class of 2002, graduated with honors. He compared this with the Class of 1977, in which about 35% graduated with honors. President Summers said, ‘Quite frankly, I am embarrassed that such a high percentage of students graduated from Harvard with honors this year.’ He added some comments along the lines that when so many receive such laurels, it diminishes and debases the value of the very honor being claimed.

"My thoughts on President Summer’s comment have been stewing for the past month or so. It boils down to this – it’s not just Enron, Global Crossing, Worldcom, etc. that overstated their earnings. It’s a societal issue that has infected even the old line, highest caliber educational institutions. Say it ain’t so, but Harvard has been overstating ‘honors’ amongst its graduates. Really, these young college kids are just not that much smarter than we were. (‘We’ includes Steve Ballmer, H’77 {cum laude, Applied Math}, who has made something of a success of himself. And me too {cum laude, Geological Sciences}, although I have not had the earning curve of Steve.) So absolute standards decline. Form overtakes substance. From Wall Street to Mass Ave, we are living in a hall of mirrors. "Finally, what does it take to give a declining culture its reality check? Airplanes crashing into buildings, not to put too fine a point on it. Would scandals like Enron, Global, Worldcom, etc. have had the impact they did on investor confidence this past year, in the absence of 9/11? Absent 9/11 and its aftermath, wouldn’t these financial scandals have been just a bunch of politicized red meat for the talking heads and posturing pols, a la Monica Lewinski? (‘Heck, everybody lies. What’s the big deal??’ Remember that?)

"But does the American citizenry, if not the investing class, view Wall Street scandal differently now, having watched on TV as US soldiers fought it out with Al Qaeda on the slopes of 12,000 foot mountains in Afghanistan; or by mistake called in air strikes on their own positions? There are some things in human experience that require standards and are unforgiving, like war. And maybe, over the long term, like the inherent value of money. "I can’t help but wonder if the bear market we are seeing is just partly, on its surface, the popping of the bubble economy. The heart and soul of the bear market is the consequence of a culture at war with itself over absolute standards. Just a thought. Best wishes…" – BWK