Neither far out nor in deep

There’s an old Turkish story about a village wise man who appealed to the Sultan to reduce the crushing taxes he had levied after conquering the province. “If you’ll reduce your taxes,” the wise man said, “I will teach this donkey to talk, and I’ll present him to you.”

The throne room in Topkapi Palace, Istanbul.
The throne room in Topkapi Palace, Istanbul.

The Sultan, amused, said, “How long will you need to teach the donkey to talk?”

The wise man considered, and said, “This is no easy thing. I’ll need five years.”

The Sultan said, “Fine. But if you don’t have this donkey talking in five years, I’ll have you skinned alive.”

Afterwards, the villagers crowded around the wise man and said, “How can you promise such a thing? The Sultan will skin you alive!” The wise man shrugged. “Many things could happen in five years. I could die, the Sultan could die, or the donkey could die.” As it turned out, the Sultan died three years later.

The moral of the story is that no one can promise that anything will happen in the reasonably far-off future. Everyone would like to know what the stock market will do in the next five years. But it’s more likely that someone will teach a donkey to talk than be able to predict the market accurately in five years.

And right now is a particularly difficult time to prognosticate. An old rule of thumb is that if you take the inflation rate and subtract it from 20, you’ll get the market’s fair value price to earnings ratio. (The PE ratio — price divided by earnings — is a measure of how expensive a stock or index is. The higher the PE, the more expensive the stock market is, and vice-versa.)

The core inflation rate is 1.9%, meaning the market’s fair value is 18.1 times earnings. Standard and Poor’s says the estimate for the 2015 price-to-earnings ratio is 17.3 on an operating basis, which would make the market slightly undervalued. On an as-reported basis, which is probably less accurate, the estimate is 19.3 times earnings, which makes it slightly overvalued. We may as well split the difference and call the market fully valued.

Naturally, there are all sorts of ominous things on the horizon that could push prices lower. For example, manufacturing seems to be slowing down dramatically, partly because the global economy is so weak. Then there’s the Middle East. And Russia.

Less apocalyptic would be a slowdown in earnings, and there are signs of that already, Rather than pay employees more or invest more heavily in their own businesses, companies are electing to buy back shares — a useless exercise for anything except making your company’s earnings look better than they really are.

sentimentOn the other hand, housing prices are rising at a moderate and sustainable pace. The Case-Shiller 10-city composite home price index rose 4.7% the past 12 months ended August, and consumer sentiment is also fairly chipper. The unemployment rate is 5.1% (albeit still unstatisfying), interest rates are low, and the economy is growing modestly. We have no boom, but no bust, either.

But here’s the thing: If you’re investing for a goal in the next five years, you’re about as likely to forecast the stock market correctly as you are to find a talking donkey. Typically, stocks are a good investment for the long-term, patient investor. If you’re spending your days fretting over the next jobless report, you probably have too much money in the stock market.

Checking the temperature

Most people have favorite market indicators, ranging from the useful, such as moving averages, to the silly, such as the Super Bowl Indicator. (Supposedly, this will be an up year, depending on whether you think the Patriots won the game legitimately.)

thermostatHere’s one that’s not only useful, but has a fairly long history: The Thermostat fund (CTFAX). Invented by legendary Ralph Wanger, founder of the Acorn funds, it has a reasonably simple premise: It adds bonds as the market heats up, and adds stocks when the market cools down. It gauges the market’s temperature by looking at its price vs. long-term earnings.

The fund has averaged a 6.33% gain the past 10 years, which is pretty good for a conservative allocation fund. The S&P 500, by way of contrast, has gained 6.8% a year with dividends reinvested.

What’s the current temperature? Pretty warm. The fund has about 75% of its assets in bonds and another 5% in cash.

If you’re trying to gauge the market, you should never use just one indicator. (And trying to time the market with any success is generally a waste of time.) But if you’re wondering whether the market is overheated, the Thermostat fund says it’s getting hot in here.

On deck this week: Housing ‘n’ earnings

If you own a home, you’ve probably become addicted to real estate porn. This is not, as you might suspect, movies about bodice-ripping real estate agents and muscular roofers. Instead, it’s any of a number of real estate sites, such as Zillow, that let you find out what your neighbors are asking for their homes, what they paid for it, and, sometimes, what their taste in kitchen flooring is like. “Really? Bamboo? Oh. My. God.”

We’re fascinated by housing in part because we’re Americans, and owning a home is still a part of the American Dream. And we’re also convinced, despite compelling evidence to the contrary, that real estate is the road to riches, even if tapping those riches means living in the woods.  This week, there’s plenty of news coming about housing, and it’s worth paying attention to, even as companies continue to trot out their third-quarter earnings.

housingWhy look at housing stats when you can have more fun gasping at your neighbor’s marble Jacuzzi? Housing is a powerful engine for the economy. When you build a home, you’re employing dozens of people in well-paying jobs, racking up enormous purchases in timber, wire, and shingles, and setting yourself up for substantial further purchases for furniture, housewares and lawn gnomes.

Furthermore, the housing industry has yet to recover from the 2007-2009 financial crisis.  New housing starts are at 1993 levels. And the median home price — half higher, half lower — has yet to break its 2006 peak.

This week, we’ll get several views of the housing market, starting with the Housing Market Index from the National Association of Home Builders, released Monday. The index is based on a survey of the association’s members, and it has been fairly chipper lately. The supply of new houses is low, as are mortgage rates — now averaging 3.82% for a 30-year mortgage.

Tuesday, the Bureau of the Census releases its housing starts data. As you can see, it still has a long way to go before it climbs out of its deepest hole since the series started.

Thursday comes existing home sales from the National Association of Realtors. Calculated Risk, one of the best blogs on housing and the economy, thinks the number will be stronger than most economists predict. For home price voyeurs, The Federal Housing Finance Agency House Price Index gives a read on how single-family home prices are doing. They have risen about 6% the past 12 months.

Long-term investors should keep their eye on housing data, because it’s so important to the economy. But it will be earnings that catch the market’s eye first. It’s peak earnings week, with 110 companies reporting:

  • Monday, Haliburton will likely release a woeful earnings report; IBM, Morgan Stanley and Broadcom are also on deck.
  • Tuesday: Yahoo!, Verizon and Lockheed Martin
  • Wednesday: Abbott Labs, American Express, eBay, Boeing, General Motors, and Texas Instruments
  • Thursday: 3M, Amazon, Caterpillar, Southwest Air
  • Friday: Procter & Gamble, State Street, American Airlines

So far this year, earnings haven’t been great. They’re down 5.14% from the third quarter of 2014, the first year-over-year decline since 2009. It will take a lot of happy housing news to counter any major earnings disappointments this week.

 

The joys of being in the crowd

check-out-the-new-york-times-cover-from-the-day-after-black-monday--this-is-what-panic-looks-likeFor those who like to commemorate unfortunate events, next Monday is the 28th anniversary of the crash of 1987, which sent the Dow Jones industrial average tumbling 22.61% in a single day. A similar drop today would push the Dow down 3,862 points.

Since then, the stock market — measured this time by the Standard and Poor’s 500 stock index — has gained an average 10.61% a year, including reinvested dividends, according to Howard Silverblatt, god of S&P Dow Jones indexes. What’s particularly interesting, though, is what would have happened if you had owned individual stocks, rather than an index-tracking fund.

For example, let’s suppose you’d owned American International Group, one of the 289 surviving members of the S&P 500 from October 1987. You would have lost an average 1.02% a year, including reinvested dividends. Newmont Mining? Down 0.43% a year since 1987. Citigroup has gained 5.6%.

Naturally, some stocks have fared quite well since then. UnitedHealth Group has soared 27.54% a year since the Big One. But clearly, choosing among the largest stocks of the time meant that you had the possibility of very different outcomes.

The average surviving U.S. diversified stock fund has gained 9.28% since The Big One, which isn’t great compared to the S&P 500. None gained more than 15%. On the other hand, no funds have actually lost money since Black Monday. Nor have any gone to zero, a la Enron. While many people love to tout performance for investing in stock funds, the real benefit is the (relative) safety of a diversified portfolio.

Dividends and the deflation nation

If you grew up in the 1970s, you generally expect prices to rise every week. You probably remember your parents complaining about the cost of living. You might even remember wage and price controls. The ’70s were annoying in so many ways.

RosieTheRiveter_RosieBut even now, six years after the bottom of the financial crisis, the economy’s main enemy is deflation, not inflation. And that requires Boomers who lived through hyperinflation to think more like their parents — the last generation to live through deflationary times.

First, a word about inflation. Yes, many things have risen in cost in the past six years, most notably college education and Daraprim, the drug produced by the company run by the vile Martin Shkreli.

But a wage-price spiral requires higher wages, and despite the current 5.1% unemployment rate, there doesn’t seem to be any improvement in wages. For most workers, the only real relief has come from lower gasoline prices, which have fallen to an average $2.31 cents a gallon from $3.25 a year ago. (Costco in Fairfaxx, Virginia, was selling unleaded for $3.02 yesterday.)

Oil prices aren’t the only things that have fallen. Unlike the 1970s, most commodity prices are tumbling. This is good for keeping prices low. The Consumer Price Index has risen just 0.2% the 12 months ended August. If you subtract out food and oil, however, the index is up 1.8%.

And, unfortunately, we’re importing deflation from abroad. As long as foreign workers can make things more cheaply than U.S. workers, U.S. companies are going to export manufacturing there, all other things being equal. (Apple now seems to be counting on China not only for manufacturing its products, but purchasing them as well.) It may be a long time before the world achieves some kind of rough parity in wages.

Finally, technology is a profoundly deflationary force. Those self-scanning stations at the grocery store used to be manned by people — as did gas pumps and bank teller windows, for that matter. Companies like Amazon and Uber, while convenient and disruptive, also keep wages low.

Those of us who watched constantly soaring prices in the 1970s — coffee and sugar come to mind — learned financial lessons that aren’t much good today. Back in the 1970s, it made sense to borrow lots of money. After all, when inflation is raging, you get to pay with increasingly devalued dollars.

The opposite is true in a deflationary period. If your wages fall, debt becomes progressively onerous. This accounts for, in large part, the Greatest Generation’s aversion to debt.

You probably know that too much debt is a bad thing. But for investors, a steady stream of income in a deflationary period is a wonderful thing, because a fixed payment will have increasing buying power. The Greatest Generation — those who could shake their distrust of banks — tended to be savers, because bank CDs offered a reasonable rate of return with no risk.

And this brings us to dividends, which not only offer a steady stream of income, but one that could potentially rise as well. In theory, dividends should be particularly valuable in a deflationary period. The most recent stock pullback was a good time to load up on large-company dividend-paying stocks with relatively low payout ratios. The payout ratio is the percent of revenue that goes towards paying dividends; the lower the better.

Clearly, stocks have risen again, but these days, there’s always another spate of volatility ahead. Here’s a list of 10 high-quality large-company dividend stocks with yields above 3% and very low payout ratios. Keep an eye on them in the next downturn.

Obviously, there’s more to a stock than a healthy dividend. But dividends always give you and edge — and it’s one that the Greatest Generation might have approved.

Company Ticker Price Dividend yield
Exxon Mobil XOM  $    79.26 3.65%
Johnson & Johnson JNJ  $    95.37 3.16%
IBM IBM  $  152.39 3.41%
Cisco CSCO  $    27.91 3.01%
QUALCOMM QCOM  $    57.78 3.33%
MetLife MET  $    48.39 3.09%
Exelon EXC  $    30.82 4.02%
Cummins CMI  $  113.09 3.41%
Principal Financial PFG  $    49.46 3.06%
Invesco IVZ  $    32.88 3.26%

Source: S&P Capital IQ. Data as of 10/9/2015