The Unknown Ideal

The darned old S&P 500 valuation worksheet is showing US stocks pretty much fairly valued in relation to historic price-to-earnings ratios, assuming earnings hold up and assuming that historic mean P/E is not an idiotic benchmark for stock value to begin with.

Using another old, largely discredited model of the reasonableness of US stock prices, the Fed Model, which compares the "earnings yield" (i.e. earnings-to-price ratio) of the S&P 500 (5.89%) with the yield on the 10-year Treasury note (5.12%), stocks look a bit undervalued. Of course one of the reasons the Fed Model has been dismissed in recent years was the distortions to the 10-year's yield resulting from a global liquidity glut.

Taking a tack similar to the Fed Model, and comparing the S&P's earnings yield (5.89%) with today's aggregate yield of 10-year AAA-rated corporate bonds (5.92%), we get almost an even match in yields.

Obviously, with the rise in their yields, bonds seem a much better bargain today than they were with the 10-year Treasury at 4%. Are they as good a bet as US stocks? The uncertainty strengthens the case for diversification between stocks and bonds, and that case is much stronger than it has been in the recent past.

Posted by The Unknown at 3:12 PM | Permalink

First, money manager Seymour Lotsoff argues (though the idea is not new with him) that the shear size of indexed assets presents a threat to the longstanding, well documented superiority of index (passive) investing over active stock picking. Of course Lotsoff is an active manager. And the blindfolded dart-throwing monkey has, no doubt, beaten him before. And the monkey will probably beat Lotsoff again.

Next, Andre Perold joins the Fundamental vs. Cap-weighted (read: Siegel/Arnott vs. Bogle/Malkiel) debate with his draft paper "Fundamentally Flawed Indexing." As Douglas Appell reports for Pensions & Investments:

Mr. Perold said the key point of his paper is that if nothing is known about fair value, then any stock, regardless of capitalization, is just as likely to be overvalued as undervalued. Consequently, holding stocks in proportion to their market capitalization doesn’t systematically result in performance drag, he said.

Quant managers who have seen Mr. Perold’s paper say it’s a strong argument. To make the case for fundamental indexing, you have to presume that “large-cap stocks are overvalued, and you don’t know that,” said Eric H. Sorensen, president and chief executive officer of Boston-based PanAgora Asset Management Inc.

On that note, I can't recall whether it was Benjamin Graham or Warren Buffett who said, "God almighty doesn't know the proper price-to-earnings ratio for a common stock." Maybe it was Burton Malkiel. Probably all three of them said it at one point or other. But that's not going to stop me from pointing out that, based on its historical mean P/E ratio, the S&P 500 still looks to be fairly valued at its current level, if just a little pricier than a couple months ago.

True, stock prices have risen, but so have trailing earnings and estimates of future earnings.

Posted by The Unknown at 2:27 PM | Permalink

Mr. Broken Record here, with his updated US Stock Valuation Worksheet: I know the yellers on CNBC and elsewhere keep calling for a correction, but the current US large-cap stock valuations still look quite reasonable by historical standards.

Today the S&P 500 closed at 1451.19. Assuming a fairly conservative ("as reported") estimate of aggregate earnings of $92.25 for the index, that gives us a Price-to-Earnings (P/E) ratio of 15.73, right in line with the historical average of 15.68 since 1935.

Say we get a little harsher in evaluating earnings, and go with an S&P "core" earnings estimate of $85.70 for 2007. We're still looking at at P/E ratio of 16.93 for the year, still quite reasonable, especially in a period of modest inflation and low interest rates.

Project the high quality of "core" earnings to trailing 12-months earnings measures, and the P/E creeps up a bit to 18.16. Sorry, but that's still not a bad P to be paying for all that E. Bob Shiller would surely disagree, given that he likes to calculate his P/E based on 10-year trailing "smoothed" earnings, but Ed Yardeni would point out that investors don't discount the past, they discount the future.

US large-cap stocks still look reasonably priced at this date. I'm squinting really hard, but I can't see a bubble there (though I can certainly still see bubbles in plenty of neighborhoods in bond world - sorry, is that mixing metaphors?). A correction may come, but it would represent, more than anything else, a buying opportunity.

Posted by The Unknown at 2:55 PM | Permalink

Today's close for the S&P 500 at a six year high of 1393.22 calls loudly for a long overdue update to the Valuation Spreadsheet.

Let's look at price-to-earnings ratios for that index and note that the P/E ratio for 2006 earnings of 16.35 is a bit beyond the average P/E of 15.38 that the index has turned in since 1935. So large-cap stocks seem to be edging toward the pricy side. But if we look at earnings estimates for 2007, a P/E ratio of 15.34 is produced, so large-cap US stocks still seem decently priced.

This simple P/E-comparison method of stock valuation is just that: simple. More sophisticated schemes are used by the likes of the bullish Jeremy Siegel, who compares a variety of earnings metrics to a variety of bond yields and still finds US stocks undervalued. His perennial counterpart on the bearish side, Robert Shiller, uses a "10-year smoothed" trailing P/E and finds shocking overvaluation still baked into the US stock cake.

For the finance dilettante typing this, simpler is better. I think stocks are possibly a little overvalued at this point, after a period of undervaluation, during which it was very good to be on the buying side. And even with stocks a little overvalued, I am comfortable continuing to dollar-cost average into my array of stock index funds for the foreseeable future.

Posted by The Unknown at 3:09 PM | Permalink

The Dow Industrials came within two points of their all-time high today, and the S&P 500 began to test the bounds of P/E-based "fair value", skittering just above the long-term average price-to-earnings ratio for the broad large-cap Index.

From the old Fed Model perspective, US stocks still look extremely undervalued compared with US bonds, but the Fed Model broke when low inflation and the intervention of foreign central banks began pushing medium-term US Treasury yields down.

On the topic of Treasury yields and the famous curve that charts those yields across the range of maturities, the Dallas Fed has some interesting thoughts (via Economist's View)

I should have the year-to-date asset class returns updated shortly after month-end. That will provide even more perspective on what's happening in the race of returns between stocks, bonds, and other asset types.

As Negativland advised, shop as usual and avoid panic buying.

Posted by The Unknown at 2:48 PM | Permalink

Interesting that in the months that have intervened since I last updated the S&P 500 valuation spreadsheet the price level of that index of US stocks has risen from around 1250 to over 1300. One might ask then, are US stocks still a decent value?

Oddly the value appears even better than it did back in June due to a couple of factors: increased corporate earnings have kept the index's price-to-earnings ratio below the historical average (and well below the average of the past 10 years), and bond yields have sunk, making investments to most fixed income instruments far less attractive than investments in a broad index of stocks, at least to those who would compare conventional return prospects for those two asset classes.

What's more, the shrinkage of the gap between "as reported" corporate earnings and Standard & Poors' very strict measure of "core" earnings implies that investors are getting more for their money in terms of the top-line earnings numbers. Nice to see corporate earnings reports tightening to standards.

The Fed meets next week and it seems unlikely that they will raise short-term interest rates given the recent relative weakness in both commodity prices and economic data. The rest of the year could be good for U.S. stocks.

Posted by The Unknown at 2:36 PM | Permalink

DailyII.com reports on a GAO study (available here as a 70 page Acrobat file) with some good news for those concerned about the stock market and with some bad news for those concerned that people aren't saving enough to retire:

Retiring baby boomers are unlikely to sink the stock market by selling off assets, mainly because they have few assets to shed, the Government Accountability Office has found. The GAO says that, unlike previous generations, which had substantial assets squirreled away for retirement, baby boomers have fewer assets. “The good news is a meltdown [in the stock market] is unlikely,” says the GAO’s Barbara Bovbjerg. “The bad news is there is not a lot of retirement savings. Baby boomers need to think about what they’re going to retire on so the rates of return are very important.” The GAO says 5% of baby boomers account for 52% of all assets, in which case, those with massive assets most likely will “sell them slowly.”

Posted by The Unknown at 9:50 AM | Permalink

Pensions & Investments' Douglas Appell reports in the July 10 issue (available online for a fee) that pension funds are screwing pensioners with a very stupid old habit that individual investors are often ridiculed for: chasing performance (a variation of recency bias):

Pension funds that set performance-based hurdles to screen manager searches - such as requiring top-quartile results over the prior three years - might be shooting themselves in the foot.

A recent study of 12,500 institutional strategies by Mercer Investment Consulting Inc., New York, concludes that excellent recent perfromance not only doesn't guarantee future results bug "generally leads to underperformance in the subsequent period."

If so, the widespread use of perfromance-based screens to identify "hot" managers - understandable in organizations where decision-makers have to defend their choices - might be "just about exactly wrong," the study concluded.

Posted by The Unknown at 12:32 PM | Permalink

In yesterday's Wall Street Journal, Wharton prof Jeremy Seigel touted "fundamentally weighted" index funds and ETFs. For those interested in indexing, the efficient market hypothesis, stock fundamentals, and related topics, the entire article is worth a look, so by all means, fish a copy of the WSJ out of somebody's recycling or go have a look at the online edition if you subscribe electronically.

Siegel's interest in publishing this article is more than merely academic: he consults for Wisdom Tree Investments which is on the cusp of releasing some investment products that involve fundamental indexing. Though companies such as iShares, Vanguard, and Powershares have beaten Wisdom Tree out of the blocks with ETFs based on dividend indices, the diversity of Wisdom Tree's offerings should assist that company in differentiating its line. Russell Bailyn has more details on his blog, the look of which should spur me to finally do some design work on this page.

From Siegel's article:

Furthermore, dividend-weighted indexes had better risk and return characteristics than capitalization weighted indexes in each industrial sector and each country that I analyzed. Dividend-weighted indexes even outperformed "value cuts" of the popular capitalization-weighted indexes such as the Russell Value and Barra-S&P Value that attempt to choose those stocks whose prices are low relative to fundamentals.

If you are a fan of indexing, as I and so many other investors are, you are no longer trapped in capitalization weighted indexes which overweight overvalued stocks and underweight undervalued stocks. Devotees of value investing who are searching for a simple, low-cost indexed portfolio in which to hold their stocks need wait no longer. Fundamentally weighted indexes are the next wave of investing.

Posted by The Unknown at 8:16 AM | Permalink

Institutional Investor reports on a new study by Dalbar showing loss aversion to be the culprit in losing a lot of money for small investors:

An aversion to losing money leads mutual fund investors to make decisions that cost them about 77% of their potential gains, according to a new study by Dalbar. The Quantitative Analysis of Investor Behavior study found that, had investors held on to their investment in the Standard & Poor's 500 stock index for 20 years, they would have seen their portfolio grow by 11.9% annually. But in analyzing fund-flow data from the Investment Company Institute, it appears the average investor saw gains of only about 3.9% a year. “Improving investors’ actual returns depends more on correcting behaviors than on the performance of the fund,” according to the study. In other words, investors’ lack of discipline in their investment approach and fear of losing money results in costly mistakes. The report suggests that financial planners and advisers could better guide their clients into making better decisions.

Posted by The Unknown at 1:36 PM | Permalink

The S&P 500 went the last inch toward losing all of its gains for 2006 today. Core inflation is spooking the Fed, and the Fed members are spooking investors. With the Producer Price Index coming out tomorrow morning, and the Consumer Price Index hitting on Wednesday, a lot of traders seem to be running for the exits.

Large-cap U.S. stocks are trading below 15 times 2006 operating earnings. This is the cheapest stocks have been in years. Meanwhile, US bonds are still looking pricey. It may be about time for that portfolio rebalancing act.

Posted by The Unknown at 2:01 PM | Permalink

Charles Biderman of Trimtabs is telling anybody who'll listen that a lot of individual investors, now rushing toward the exits of the US stock market, may be making a big mistake:

Charles Biderman, chief executive of TrimTabs Investment Research, argues that the real answers lie in mutual-fund flows and in whether companies are spending money to buy their own stock or that of other companies as part of a merger.

He noted that at the market peak in early 2000, individual investors piled into equity funds but that companies were net sellers of stock.

Right now, Biderman notes, companies are again net buyers. He calculated that 135 companies announced last month a total of $63 billion in stock buybacks and $40 billion more in stock purchases as part of takeovers.

Posted by The Unknown at 3:18 PM | Permalink

Lots of wailing and gnashing of teeth these days over the grind-down in the US stock market, but nobody notes that year-to-date the S&P 500 is still up, albeit a measly 1.47%, including dividend reinvestment.

Year-over-year, the S&P is up a slightly more respectable 3.04%, again with dividends reinvested. Far short of Siegel's Constant, mind you, but nothing to justify all of the recent whining.

Short-term the market is being pressured by many concerns, of course, including interest rates, commodity prices, and the war of idiocy between Washington and Tehran, but long-term the valuation picture looks pretty, with the S&P trading below its historical average Price-to-Earnings ratios.

We do have an interesting return to volatility, but we do not have anything for an actual stock investor to be crying about. Call me old-fashioned, but I still prefer to buy assets when they're cheaper.

Posted by The Unknown at 3:08 PM | Permalink

Marketwatch's Chuck Jaffe scooped everybody on the stupidity of the Free Enterprise Action Fund. Big snaps to Chuck. And thanks to our correspondent for the timely tip.

Posted by The Unknown at 1:23 PM | Permalink

Hilarious. While "socially responsible" mutual funds have been enjoying good investment performance of late, and corporations are beginning to understand that social and environmental responsibility enhances long-term shareholder value, an intentionally socially irresponsible fund is in the dumpster of investment performance:

The May 2006 Institutional Investor reports:

Right-wing fund managers Steve Milloy and Tom Borelli are grabbing lots of attention for accusing companies of devoting resources to pet causes instead of maximizing profits. Last month they showed up at Goldman Sachs' annual meeting in New York to attack CEO Hank Paulson for, among other things, chairing the Nature Conservancy and authorizing Goldman's donation of land it owned in Chile to the Wildlife Conservation Society. But a look at the returns of the pair's grandly named Free Enterprise Action Fund suggests that their own bottom line could use some help. The $5.6 million fund gained just 2.32 percent from March 1, 2005, its first day in business, through the end of the year, net of expenses. That's well below the S&P 500's 4.72 percent gain during the same period -- and it doesn't hold a candle to the 18 percent appreciation of Goldman shares.

The pair have plenty of experience standing up for corporate America's right to ignore do-gooders. In his spare time Milloy publishes JunkScience.com, a Web site devoted to debunking global warming as a "myth." He formerly ran the Free Enterprise Action Institute, which was funded in part by ExxonMobil. Borelli previously worked as a lobbyist for food and tobacco giant Altria Group. . . .

I'm sure these self-professed champions of capitalism will attract a lot of investors with a fund philosophy like "We're not trying to perform well." Yeah, great idea. The free market's gonna eat that right up.

Li'l Update: Atrios helpfully links to some more eyebrow-raising content on this, um, investment vehicle from Tim Lambert (scroll way way down on this last link).

Posted by The Unknown at 7:57 AM | Permalink | Comments (8)

Here's what jumps out at me from the updated Valuation Worksheet: US stocks are dead-on "fair value" based on historical price-to-earnings ratios. In fact even while harshing one's buzz with S&P's stingy "core earnings" estimates, we see a P/E ratio below the average since 1960. So even if one is really concerned that earnings quality significantly deteriorated during the long bull run of the 80s-90s, as S&P was when it formulated core earnings, one needn't really have concerns about the level of US stock valuations, because even when earnings are stripped the the bone, stocks are looking pretty fairly priced.

Alan Greenspan is concerned about the price levels of global assets, though, because of a "liquidity glut." Gee, where did that come from? This guy is just too much.

I am reminded of nothing so much as his school-marmish finger-waggings to Congress over the massive federal budget deficit, the very budget deficit he helped create with his relentless championing of the irresponsible Bush tax cuts.

Posted by The Unknown at 3:18 PM | Permalink

Not much to say about the updated asset class return worksheet other than isn't it interesting that a TIPS fund didn't beat inflation over the course of the past year, and how about them REITs and International Stocks? And I'm sure that the Gold Bugs will feel vindicated, even though over the long-term, Gold barely beats the rate of inflation.

Here's a summary picture of the returns (note that returns include dividend/interest reinvestment for the period, with the exception of the year-to-date return on Small Cap US Stocks):

Posted by The Unknown at 3:00 PM | Permalink

Institutional Investor reports on a behavioral foible to which even professionals and institutions are not immune:

The most common mistake pension funds make is evaluating managers based on their short-term performance, giving too much praise to managers having a good run and over-criticizing firms experiencing short-term underperformance, according to Michael Oyster, consultant at Fund Evaluation Group. Oyster, who authored a paper on avoiding the pitfalls of investing for FEG's February Research Roundup, said three years is too short a time period in which to assess managers. FEG conducted a study which showed that all the U.S. large-cap managers that posted top quartile returns for the 10 years ending December 2005 ranked below the median for at least one rolling three-year period during that time.

Obviously individuals (and the mobs they join) have a similar problem in evaluating funds, managers, asset classes, and individual securities.

Posted by The Unknown at 2:52 PM | Permalink

After a month with no updates until today, not that much has changed in the valuation picture except that bonds, both on the government and on the corporate side, have become just a little bit more competitive with stocks.

The S&P 500 sits just above 1300, giving it an "earnings yield" (inverse Price-to-earnings ratio) of 5.86% (as always, we're being safe and using 12 months trailing "as reported" earnings in this calculation).

Meanwhile the yield on the 10-Year Treasury note has risen to 4.7%, and may rise higher tomorrow when the Fed raises short rates to 4.75%.

Corporate bonds provide a tighter race for stocks, with the AAA-rated 10 year composite bond rate at roughly 5.44%.

Of course this means that it is becoming more expensive for corporations to borrow money, and this has the potentional to hit bottom lines, thus degrading earnings, thus undercutting stocks.

Asset allocation is a topic that I will soon revisit, but I will say that in this environment I am comfortable enough to be slowly, gradually rebalancing my portfolio to be bringing my allocation to bonds up into line with my target. Certainly something cataclysmic could happen to interest rates, savagely knee-capping the value of my bond portfolio, but if such an event occurs, stocks are likely to take a beating as well, and I'll still be getting my interest payments on the bond funds, reinvested for more shares at the lower prices.

Posted by The Unknown at 2:45 PM | Permalink

The S&P 500 Stock Index today touched 4 year highs, and the high end of what I would call "fair value" level (in terms of its price-to-earnings ratio). And Standard and Poors announced a little good news for shareholders: an increase in the indicated dividend rate for the index.

No need to get too excited just yet, as this represents, at today's level for the 500, an increase in yield of about 10 basis points, from 1.75% to 1.85%.

Still, not to sneeze at it - every bit of yield helps. But I'll continue to try to goose my state-side stock dividend yields with fair helpings of DVY, the Dow Jones Select Dividend Index Fund, at least until I get a good look at Vanguard's forthcoming exchange -traded fund, the Vanguard Dividend Appreciation Index Fund, which I assume will have a lower expense ratio than DVY's 0.40%.

What profiteth it a man to gain in yield and lose in fund expenses?

Posted by The Unknown at 2:02 PM | Permalink

Daniel Altman lends a hand in Why Do Stocks Pay So Much More Than Bonds?

excerpt:

Think about the two types of securities in terms of supply and demand. The market for safe government bonds includes investors who can't buy stocks at all: foreign central banks, other government agencies, some institutional money managers and certain kinds of trusts. Moreover, financial planners may be too eager for their clients to buy safe government bonds. If their paychecks depended solely on whether their clients made or lost money, they might try to avoid losses at all costs.

In other words, it may just be ridiculously easy to raise money for bonds. Or investors' expectations of stock returns may be irrationally low, focused more on crashes than booms. Either way, the equity risk premium wouldn't explain the entire gap in returns.

Yet many financial economists believe that the equity risk premium has been dropping in recent times. "Over the last 20 or 30 years there have been dramatic changes in the financial markets," said John C. Heaton, a professor of finance at the University of Chicago. "Investors have become just more comfortable with the stock market. Part of that is education. The other thing is sort of a classic finance effect, which is that the level of diversification that investors have available to them has increased."

Posted by The Unknown at 10:29 AM | Permalink

My reader may get tired of the repeated references to Burton Malkiel, Jeremy Siegel, and Robert Shiller, but reading each of these guys fills the foul rag and bone shop of my heart with exuberance, sometimes even the rational kind.

Tonight's tale of Shiller comes from a January 14 story in India's Economic Times wherein J. Bradford Delong revisits Shiller's 1996 prediction that the S&P 500 would be a stinker for returns for the decade to come.

Shiller’s arguments were compelling. They persuaded Alan Greenspan to give his famous “irrational exuberance” speech at the American Enterprise Institute in December 1996. They certainly convinced me, too.But Shiller was wrong. Unless the American stock market collapses before the end of January, the past decade will have seen it offer returns that are slightly higher than the historical averages — and much, much greater than zero. Those who invested and reinvested their money in America’s stock market over the past decade have nearly doubled it, even after taking account of inflation.

Not that Shiller's work is discredited by this failure to predict positive, if substandard, returns, as DeLong is good enough to note; but it's fun to see a guy who has the habit of denouncing the theories and ideas of even some of his most reasonable colleagues as "the greatest disaster in the history of finance," (Shiller's CNBC-ready take on both Burton Malkiel's terrific A Random Walk Down Wall Street and the Glassman/Hassett stinker Dow 36,000) get held to account for some of his own predictions.

What is Shiller saying now? He's still saying the US stock market is overvalued, on the basis of a price-to-earnings ratio for the S&P 500 that uses 10-year trailing "smoothed" earnings as its denominator (he justifies his use of this rather arcane P/E by claiming that Benjamin Graham used such a denominator - not too terribly scientific, but okay, Bob, economics isn't too terribly scientific either). And he's still warning of consequences of inflated real estate prices that he highlighted in the second edition of his enjoyable Irrational Exuberance.

Posted by The Unknown at 5:24 PM | Permalink

So that guy Mark Hulbert was saying the other day that Ford Equity Research thinks that the darned old US stock market is overvalued, based on Ford's Price/Intrinsic Value calculations.

P/E ratios for the S&P 500 certainly do tell a different story. In the valuation spreadsheet, we see that stock price-to-earnings ratios are at or below their historical averages across a host of earnings metrics. Borrowing a page from the old Fed Model, we also see that the 5.86% "earnings yield" of the market is well above the 4.54% yield for the 10-year Treasury Note and that it even beats the composite rate for 10-year AAA-rated corporate bonds.

Perhaps some day I will see the guts of the "Intrinsic Value" model and will be enlightened, but since I am a traditional stock investor who is buying shares of the future earnings of these companies, I will settle for some nasty old P/E ratios, which are now showing the overall market spot on fair value, if not undervalued as the Siegel and Yardeni camps insist.

Posted by The Unknown at 1:56 PM | Permalink

Paul Farrell at Marketwatch likes what he sees in Mark Hebner's new lavishly illustrated coffee-table book Index Funds, which also comes in a virtual edition.

Among the lessons that Farrell highlights from the book is the old Malkielian maxim, " indexing and simple asset allocation are the best way to win."

Something to browse and slosh your latte on while waiting for the next edition of A Random Walk Down Wall Street, which is due late this year, and which promises new chapters on behavioral finance.

Posted by The Unknown at 10:24 AM | Permalink

Interesting article this morning from Reuters, showing that fund holders still favor equities over bonds and cash:

Surveys of 44 leading fund management companies in the United States, Japan, Britain and continental Europe showed average stocks holdings at 62.0 percent, barely changed from 61.9 percent in November.

Bond holdings were unchanged at 31.4 percent and cash remained steady at 3.9 percent. Property and alternative investments made up the remainder.

Sadly, fund managers still seem bound up by home-country bias:

The polls also showed that many fund managers were favoring domestic stocks. U.S. investors, for example, lifted exposure to North American stocks while Japanese fund managers edged their Japanese stock holdings higher.
. . .
European fund managers cut U.S. stocks in favor of euro zone equities in December and remained bullish for stock markets overall heading into 2006.

Anybody want to buy these "professionals" a Globalization clue?

Posted by The Unknown at 8:04 AM | Permalink

A happy few minutes were spent updating the Asset Class Returns spreadsheet last Friday after markets closed for 2005. My proxies for the returns discussed below, most of them real-world index mutual funds which any chump can buy, are spelled out in the small spreadsheet linked above, and are also pictured at the bottom of this scintillating post.

Much was made by some that the Dow Jones Industrial Average finished the year down a little over half a percent. Really, though, who cares? The DJIA is a price-weighted average of 30 stocks. A lot of folks mistake the Dow for the stock market when, in actuality, it is a cobbled together price-weighted average of only 30 stocks. It is not much of a proxy for an average investor's experience of the market, and the average investor didn't have too much reason to feel unhappy this year.

US large-cap stocks, as represented by the S&P 500 returned a little under five percent, dividend return/reinvestment included. Small-cap stocks trailed a bit, returning a little over 4.5%.

Real Estate Investment Trusts (REITs), much maligned early in the year, continued to pay out hefty dividends and enjoyed an almost 12 percent return over 2004, assuming dividend reinvestment.

US investors afflicted with home-country bias may have ended the year envious of their more globally-minded counterparts who enjoyed 12.7% returns, if indexing globally, with Asia-Pacific clocking in at 22.6%, Europe chalking up a respectable 9.26%, and Emerging Markets tallying a 32% year-over-year return.

Gold hype prevailed through 2005, and the price appreciation in the Gold ETF GLD was a tasty 17.76%.

Some bond categories didn't manage to return even their yields, though, with TIPS inflation-protected bonds beating their conventional counterparts, still only returning 2.78% themselves.

I felt happy as an investor, then, given that no asset class in my portfolio carried a minus sign ahead of its annual return during the past year. I am sticking with the broad outline of my strategic asset allocation strategy for 2006, and my first buys for the new year will be in International Stocks and in REITs, categories in which I have become slightly underweighted (according to my preferences, which will be spelled out again in a coming post on Asset Allocation) because of the anti-REIT and home-country biases of my 401k's managers.

Posted by The Unknown at 4:20 PM | Permalink

The S&P 500 closed today above 1261, its highest level since the early tides of the bubble bloodbath. The updated valuation worksheet shows a much firmer foundation for today's stock price levels than existed during the bubble days, with even cut-to-the-bone core earnings showing a multiple of 20, far more reasonable than the 30-plus levels reached late in the last century and earlier in this one.

Investors who bought in to hold on while the world was screaming bloody murder, in the wake of ensuing Enron and Worldcom accounting scandals, have enjoyed significant price appreciation. And many investors who have rebalanced periodically in accord with a strategic asset allocation have realized significant profits.

Asset prices will continue to fluctuate, creating realized losses for the many while creating opportunities for the steady. As General Boy once told us, "Few are the shepherds and many the sheep!"

Posted by The Unknown at 7:01 PM | Permalink

It was jarring to see the usually reliable Chet Currier disparage indexing in his Friday column for Bloomberg. Some of Currier's problems: his time frame (bubble's pop through now), his mish-mash of asset classes in his comparison "peer groups," his failure to account for survivorship bias (how many "internet" and growth funds that were around in 2000 are now gone, gone, like a turkey in the corn?), and his complete disregard for fund expenses.

Fortunately, Friday also brought a column from Morningstar's Christine Benz, who is clueful on the issue: passive investors have won out over active managers over the past ten years and even more extended time frames, with Vanguard's Index 500 fund, as one example among many, landing in the top quartile of its peer group, handily beating "active management" as a category and proving the Currier-dissed "academics" as right.

Factor in expenses, and the indexers did even better, keeping more of their returns through lower costs.

Posted by The Unknown at 7:45 AM | Permalink

Looking at S&P sector valuations today is not too terribly different from looking at them last month.

From the table below, one can spot a few changes: Tech and Financial stocks have gotten a bit pricier, while energy stocks have followed the price of oil down.

InfoTech maintains a premium to the market that is ridiculous, even in light of Tech's alleged growth prospects. Energy, meanwhile, finds itself trading at a substantial discount to the overall market.

Dividend yields have fluctuated a bit, with payouts and prices varying, but Telecom remains a generous dividend-paying sector these days, even beating out dividend stalwart Utilities.

As I mentioned last month, I'm not one to wager on sectors for the short run, but a look at that Energy valuation bolsters the case made by the likes of Siegel and Yardeni for overweighting Energy for the longer term. If I were to do such a thing, I would probably employ a low-cost sector ETF, such as Vanguard's Energy Viper, VDE or S&P's Energy Spyder, XLE.

Posted by The Unknown at 10:36 AM | Permalink

Since September was such a volatile month for stocks and bonds, I decided to update the Asset Class Return spreadsheet to see how everything is faring. Here's a blurry picture of it:

Every category of stock got bludgeoned in October, with stocks from developed economies in the Asia/Pacific region taking the least of the beating. By our proxies, only gold and short-term bonds picked up any gain, the latter only through a fluke in posting of interest payments.

Stock-long portfolio managers are happy that most of them billed on Sept. 30 returns. They are also hoping for the traditional fourth quarter rally that has saved so many a bacon strip.

Posted by The Unknown at 3:32 PM | Permalink

Who knows? Maybe everybody has their strategic asset allocations just how they like them now, but I doubt it, since most people don't have strategic asset allocations. Trimtabs says US investors are reining in their foreign equity investments:
. . .
"The exuberance of American investors for foreign stocks is coming to an end," says Charles Biderman, president of fund-flow tracker TrimTabs.

Biderman started seeing the bulk of U.S. dollars flow into international funds last December when Americans grew jittery over a weakening dollar and a shaky U.S. economy. He says many investors took their cues from famed value investor Warren Buffett after he made negative comments on the U.S. economy and placed big bets against the U.S. dollar.
. . .
So many US investors and funds are far too light on international stocks, if you believe people like Burton Malkiel and Jeremy Siegel. A pullback now is a dumb move, particularly for long-term investors. Global growth is going to happen globally. That's why they call it global.

Posted by The Unknown at 9:02 AM | Permalink

It has been an well-known for a long time that many individual investors have a tendency to sabotage their returns by chasing after market leaders, hot-performing mutual funds, stocks, etc., and abandoning laggard investments in favor of newer hot performers. Using this technique, these individuals buy high and sell low.

Well it turns out that a lot of pension plan sponsors are doing a similar thing - losing worker pension money by chasing after hot-performing managers and firing current managers.

Amit Goyal and Sunil Wahal looked at nearly 10,000 hiring decisions by about 4,000 plan sponsors, and published their results in the paper "The Selection and Termination of Investment Management Firms by Plan Sponsors." The authors note, "Using a matched sample of firing and hiring decisions, we find that if plan sponsors had stayed with fired investment managers, their excess returns would be larger than those actually delivered by newly hired managers. "

Posted by The Unknown at 8:34 AM | Permalink

US stocks ground down even lower today, with the S&P 500 closing at 1187.33, leaving it with a price-to-2005-earnings ratio of just about 16, barely above the P/E ratio's historical average since 1935, and almost a full percentage point below the average P/E since 1960. The market may not be screaming "buy" based on its long-term history, but we are at one of the tastier price-to-earnings points in recent history.

The weekend bankruptcy filing of auto parts supplier Delphi both reflected and compounded the trouble of US automakers, and recent earnings guidance by other US companies didn't make anybody smile. Estimate-beating earnings reports by Alcoa and Genentech may lighten the mood tomorrow, but reporting season is just beginning.

More economists and finance types are taking notice of the recent performance divergence between US and foreign stocks, with US stocks flattening out and international stocks, particularly in emerging economies and on the Pacific rim, outshining their stateside couterparts. If only more US portfolio managers could abandon their home country biases and insecurities, perhaps their clients would do better. Many backward-looking stock portfolios are still only allocating a small percentage of their investments to international issues.

The barn-door may be closing on international stock outperformance for the short-term, but a hefty international allocation seems necessary for long-haul success, at least according to the likes of Burton Malkiel, Jeremy Siegel, and anybody else who has been paying attention to the direction of the global economy.

What profiteth it a portfolio manager's clients to beat the S&P 500 when the S&P 500 is getting trounced by the world?

Posted by The Unknown at 2:03 PM | Permalink

"I think I might like to buy me some of them stocks."

Posted by The Unknown at 7:26 PM | Permalink

US Stocks got smacked, and at least some of CNBC's yellers are blaming all the inflation talk from Fed officials these last few days. Others are pointing fingers at the ISM services report. The S&P 500 has lost more than 2.5% of its value this week, putting it below 1200 and below it's starting price for 2005.

Well, at least we still have our dividends. All 1.7% of 'em. Have you reinvested yours?

Naturally, I thought that this would be a really cool moment to update the valuation spreadsheet, which now shows a trailing P/E ratio of 16.76, and a Year-2005-earnings P/E of 16.19 (which might mean something if 2005 earnings don't collapse under the weight of spooked consumers and mounting energy prices). For perspective, the average P/E ratio for US stocks from 1935 through March 2005 was 15.65. From 1960 forward, the average is 17. And from 1996 forward, a period which includes the crazy tech bubble, the average P/E was 28.25.

So today's US stocks are right there in the average price range, and certainly a lot cheaper than they were during the recent period of irrational exuberance.

One thing seems clear to everybody: the Fed isn't going to stop their rate-raising at 4%. Some don't even think they'll stop at 4.25%.

Posted by The Unknown at 2:33 PM | Permalink

(N.B: Even though the title of this post refers to 401k plans, the info is relevant for most any kind of long-term investment portfolio (IRA, Roth IRA, 403b, taxable account, etc.)

A famous study first published in 1986, with a follow-up in 1991, by Brinson, Hood, and Beebower, shows that asset allocation accounts for over 90 percent of a portfolio's return. In other words, the mix of asset classes (stocks, bonds, commodities, etc.) a hypothical investor chose to invest in (for a period of 10 years, in the original study) ultimately accounted for a far greater share of that investor's portfolio performance than other factors, such as the selection of specific stocks in a portfolio.

But it turns out that asset allocation is not the end-all in portfolio performance. There is an even greater factor impacting the ultimate outcome of retirement investments: contributions.

One item that hit my email inbox this week was an article by AP business writer Meg Richards emphasises the contribution imperative forcefully:

Countless studies underscore the fact that successful investors don't wait for the market to inspire them — including a September survey of 401(k) balances conducted by ICI and the Employee Benefit Research Institute. It found that Americans who continuously maintained 401(k) accounts from 1999 to 2004 saw their balances rise by an average 36 percent, despite enduring one of the worst bear markets since the Great Depression. In 2004 alone, the average account balance increased by 15 percent. A big reason for this success was consistent participation, said Jack Van Derhei, EBRI's research director and co-author of the study.

No matter what scenarios were used, "It was absolutely, without a doubt, the case that the most important thing was people just continue to participate in 401(k) plans year over year," Van Derhei said. "Doing that is much more important than just being lucky or being born in the right year."

A summary of a differently constructed study (by Putnam), highlighed on page 38 of the October 3, 2005 Pensions and Investments magazine reached, in a quite ho-hum coincidence, my actual real inbox this week:

Participant contributions to 401k plans have a far greater impact on retirement wealth than mutual fund performance and asset allocation . . . The study, which compared those three components of defined contribution savings over a 15-year period, found that mutual fund performance had the least impact.

However, increasing participant contribution to 4% from 2% of salary had 90 times the impact of changing to top-quartile funds from bottom-quartile, over 15 years.

So one more time: far more important than the individual stock or bonds or funds or whatever one picks for a portfolio, even far more imporant than the asset allocation strategy of a portfolio, the most important factor in a portfolio's success, according to these studies, is consistent participation, steady contribution, year after year, of new investment funds to the portfolio. Saving and investing. That seems to be the boring old truth of the matter.

Posted by The Unknown at 7:05 PM | Permalink

From a letter to Pensions & Investments magazine, October 3, 2005 issue, sent by reader and portfolio manager Kenneth S. Phillips:

"For better returns, free the money managers," by Vince Calio describes a JPMorgan study that advocates directing traditional long-only managers to go short because such flexibility will add more value. The gaping error in this logic is that it assumes the managers have skill, which history has shown to be a spectacular leap of faith.

Posted by The Unknown at 1:46 PM | Permalink

As promised, here's a snapshot of the returns of various asset classes, year-to-date. Observant readers will note that I'm only including those asset classes that are part of my asset allocation strategy, with gold thrown in at the end for fun. The very simple spreadsheet is here, linked under "Site Resources"

International stocks as a group outperformed almost every other asset class on the list, one exception being REITs (Real Estate Investment Trusts), whose high dividend payouts provided not only an income vehicle but also a return enhancement. Emerging Market stocks have really caught fire with investors worldwide, who hope to be where the action is, though, as Jeremy Siegel has pointed out, strategic and tactical overweights in these stocks might lead investors into what the Professor calls the "growth trap."

US stocks have become, at least for the past few months, highly correlated with government inflation-indexed bonds (TIPS), which makes one wonder again whether the Equity Risk Premium might be too high. Worth watching,