The chart below places MarketCap/GVA on an inverted log scale (blue line, left scale), along with the actual S&P 500 nominal annual total return over the following 12-year period (red line, right scale). Note that current valuations imply a 12-year total return of only about 1% annually. Given that all of this return is likely to come from dividends, current valuations also support the expectation that the S&P 500 Index will be lower 12 years from now than it is today. While that outcome may seem preposterous, recall that the same outcome was also realized in the 12-year period following the 2000 peak.
Caterpillar, one of the icons of American industrial might and a “bellwether” for the global economy, has been having a hard time. It forecast that sales would drop 5% in 2016, an IBM-like fourth year in a row of declining sales, the worst such spell in its history.Now Caterpillar threw in the towel on its formerly most promising market, China. Not for the current year, or even next year – those are already toast. But for future years. And for the entire industry.
It isn’t just CAT’s problem; the industry as a whole is getting whacked in China because of China’s economy. That’s Tom Pellette, Group President of Caterpillar Inc., with administrative responsibility for Construction Industries, told the Financial Times in an interview.
He cited some terrible industry-wide numbers for China, without disclosing Caterpillar’s own: in 2015, sales of hydraulic excavators between 10-90 tons are expected to be in the “23,000 range,” he said. Back during the China heyday in 2010, the industry sold over five times as many: 120,000 excavators. This would include excavators from Japanese, German, and Chinese competitors. In March 2011, the industry sold 27,000 units – in just that month! – more than in the entire year 2015!Those were the good times when China’s huge stimulus program from the Financial Crisis was reaching corporate pockets.
“That shows how far off the peak we are,” Pellette said. The market might never get back to where it once had been, despite the official GDP growth rate in the third quarter of 6.9%, which would be considered a blistering hot pace in other major economies that have somewhat less opaque economic reporting.
On September 24, Caterpillar had already warned of another round of big trouble. Its statement – evocatively titled in perfect corporate speak, “Building for a Stronger Future, Caterpillar Announces Restructuring and Cost Reduction Plans” – announced “a total possible workforce reduction of more than 10,000 people…” and “the contemplated consolidation and closures of manufacturing facilities occurring through 2018.”
“At this point, we are experiencing continued weakness in key industries that we serve,” it said, with sales declining “in all three of our large segments,” namely Construction Industries, Energy & Transportation, and Resource Industries.
Shrinkage, shrinkage, shrinkage. Because of the global economy. Because of collapsing investment in mining and energy. Because of “a convergence of challenging marketplace conditions in key regions and industry sectors.” Because of China.
When it comes to using stock buybacks for management to compensate itself, the crown might belong to Dell. From 1998 to 2006, according to the New York Times’ Floyd Norris, “Dell reported net income of $17.9 billion — and it spent $24.1 billion buying back stock.” The longer the time period you look at the worse it gets. From 1997 to 2012, Dell purchased $39 billion in shares — more than the company has reported in net income over the entire course of its existence.No wonder it went private.The timing of Dell’s buybacks was consistently terrible, but since the costs were paid by shareholders and the proceeds went to management, the C suite never seemed to care much. Harvard Business Review looked at the phenomena and called it “Profits Without Prosperity.” The runner up to Dell might be Qualcomm. As the Times’ Gretchen Morgenson noted this summer, during the past five fiscal years, Qualcomm repurchased 238 million shares at a cost of $13.6 billion.Despite that huge buyback program, the Times wrote, “Qualcomm’s average diluted share count has actually increased over the period by almost 41 million shares. That’s a 2 percent rise since 2010…because the company has been granting a treasure trove of stock and option awards to its executives.”Qualcomm paid an average of $56.14 a share for stock that now trades for about $4 less. In other words, it overpaid by almost $1 billion.This is a pattern we see over and over. Here’s another pattern: Although many companies seem to buy shares just before they start falling, managers tend to do much better at the timing game, selling their own shares right before the slide begins. Just a coincidence, I suppose. Given a choice between dividends or buybacks, I’ll take the quarterly check. But the bigger question is simply this: Why is management at so many companies bereft of better ideas and more productive uses for corporate cash?Maybe it’s because so much of the proceeds of buybacks end up in their own pockets.
As an addition to my Optimal Asset Allocation post yesterday, I thought I’d share this graph which helps explain how I view the current investment landscape.
Principle #1: The goal of investment is to beat inflation over the time period which the investment is held. To paraphrase a Warren Buffett article from 2012 -” investing is the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power in the future. More succinctly, investing is forgoing consumption now in order to have the ability to consume more at a later date. From this definition there flows an important corollary: The riskiness of an investment should be measured by the probability — the reasoned probability — of that investment causing its owner a loss of purchasing power over his contemplated holding period. Assets can fluctuate greatly in price and not be risky as long as they are reasonably certain to deliver increased purchasing power over their holding period.”
Principle #2: Again to paraphrase Buffett – investors should put more money into their best ideas – those which offer a higher risk-adjusted return. And the corollary to this principle is “Wait for the fat pitch”, ie. be patient, ignore the daily market moves, and then load up when the market offers a bargain.
With these two principles in mind, the graph below presents my projected asset class returns compared against the expected future inflation rate. Then I allocate among assets using 1) the Standard Deviation and Sharpe Ratio of returns – as risk measures, and 2) the Kelly Formula – to make sure the best ideas get more money applied to them.
The results of my calculations are displayed in the chart on the Optimal Asset Allocation page.
Mid-October is the perfect time to revisit and adjust your portfolio’s allocation to bonds, stocks, TIPS, REITs and Commodities. On October 16th I recalculated the preferred allocation to these asset classes and keep an updated chart on the Optimal Asset Allocation page. Most significantly, I am putting a little more money to work in international and emerging stocks. Emerging stock indexes (I recommend Vanguards ‘VWO’ ETF) are trading near 6-year lows due to currency and commodity bear markets, and offer decent risk-adjusted returns – which is about all I can say, no asset class is particularly compelling right now.
For my IRA and 401(K) accounts, I update these allocations twice a year – in mid-October and mid-April. This timing accords with the well-known seasonal timing strategy proven to beat the market with less risk.
Why focus on Asset Allocation?: One study suggests that more than 91.5% of a portfolio’s return is attributable to its mix of asset classes. Individual stock selection and market timing accounted for less than 7% of a diversified portfolio’s return. William Bernstein says in his book The Four Pillars of Investing, that: “The ability to estimate the long-term future returns of the major asset classes is perhaps the most important investment skill that an individual can possess.”
See the Optimal Asset Allocation page for the percentages.
A monthly S&P 500 closing price which is higher than the close 4 months prior is a measure of market momentum made popular by Tom Demark. The markets often swing in approximate 9 month moves. An uptrend lasting 34 months has only happened twice since 1950. Until June of this year, The S&P 500 went 34 consecutive months with each monthly close higher than that 4 months prior. The last time the S&P 500 went this long (exactly 34 months ending July of 1956), it subsequently fell 20% over the following year. These two episodes are the longest such streaks since 1950.
Here’s a picture of this historic market momentum, now broken:
This historic momentum was discussed in: Stock Market Uptrend is the Most Overbought in 40 Years.
The S&P 500 recovered in July to record a new tick in the positive direction, however the overall back of the market’s momentum has been broken. (a 1-month false recovery also happened in 1956 before the market fell hard.)
These signals can be followed with my Trend Exhaustion Stock Market Timing Excel Spreadsheet.
I’ve been moving to cash over the last year, so am looking forward to picking up some stock market bargains if the opportunity presents itself.
I’m proud to release the Fix-N-Flip Rehab Program For Excel. This Excel calculation tool provides a comprehensive look at the buying, holding, selling and repair costs in order to determine the Maximum Purchase Price you should offer on rehab real estate projects. You can Fix and Flip real estate for great profits if you enjoy doing the research to analyze good candidate properties. Use the program to analyze your profits and minimize risks! The Program includes the popular “70% Rule” for house flipping. The accompanying article contains a short video tutorial and screenshots.
Full Article: Fix-N-Flip Rehab Program For Excel
The Fix-N-Flip Program is available from the Research Offers Page.
In other site News:
- The Rental Income Property Analysis Excel Spreadsheet has been updated! Version 4 includes an accurate ‘Return On Investment’ tab sheet. Standard Real Estate ‘returns’ have weaknesses (ie. the ‘Cap Rate’ does not account for your initial investments). The new Version of the Rental Income spreadsheet evaluates ALL projected cash flows for a more realistic analysis. See the article for a video tutorial!
- The Net Worth Calculation Spreadsheet has also been updated! I’ve added a ‘Return On Personal Equity’ (ROPE) analysis. The ROPE measures your personal profitability by revealing how much profit you generate with the money you have invested thru saving and paying down debt. The historic average ROE of the Dow Jones Industrials is about 11%. Can you beat that?
Warren Buffett in his 1998 Letter to Shareholders:
When we consider investing in an option-issuing company, we make an appropriate downward adjustment to reported earnings, simply subtracting an amount equal to what the company could have realized by publicly selling options of like quantity and structure. Similarly, if we contemplate an acquisition, we include in our evaluation the cost of replacing any option plan. Then, if we make a deal, we promptly take that cost out of hiding.
Paying employees with stock options is an expense that affects the intrinsic value of a firm. Be sure you are fully accounting for them. Thankfully in 2004, the Financial Accounting Standards Board (FASB) mandated that the cost of options be reflected in the Income Statement, not buried in the footnotes. Investor’s however must still be on guard:
1) Unfortunately almost every company still reports their quarterly earnings to the media as excluding the cost of stock-based compensation. These non-GAAP earnings do not follow the FASB principles. Do not base your P/E multiples off those earnings. See this Fortune article for a description of the problem. This means investors must analyze the Income statement to determine true economic earnings.
2) Use Diluted Shares Outstanding – these account for current in-the-money stock-based compensation (and convertible preferreds) that are outstanding and not yet exercised.
3) Finally, refer to the Notes to Financial Statements to see the Fair Value of remaining unexercised options and other share-based plans (ie. Restricted Stock Units – RSU’s). Reduce your intrinsic value estimate of the firm by this amount. Search for the term “unrecognized compensation cost” within the 10-k or annual report to locate. Add up all values for remaining stock options, RSU’s, etc. For example, Google has $9.7 Billion (about $14 per share) of “unrecognized compensation”, which are future earnings that will go to employees rather than shareholders.
For some companies this is a gigantic expense. From the Fortune article:
over the past two decades, Adobe has spent almost $11 billion repurchasing shares, mainly to offset the dilution resulting from the exercise of employee stock options. Despite all the cash that has gone out the door, the share count is not much lower than it was 20 years ago. If you consider that cash as an expense of running the business (offset by the proceeds and the tax benefits from the stock issuance) then Adobe’s free cash flow over the last two decades is not a robust $9.3 billion, but rather a meager $2.3 billion.
The historic average Return on Equity (ROE) of the Dow Jones Industrials is about 11%. Can you beat that? I mean in your personal financial life. This is a statistic I recommend you follow – your Return On ‘Personal’ Equity, or ROPE. Much like a business ROE, your personal return tells you how much income is returned to you as a percentage of your equity. The ROPE measures your personal profitability by revealing how much profit you generate with the money you have invested by saving and paying down debt.
The Net Worth spreadsheet available on my Research Offers page, calculates your ROPE as you track your Net Worth. Here’s a close-up to show how the mechanics of your ROPE might look:
By the way – why aren’t you tracking your Net Worth? As an investor, you should have only one goal: To increase your Net Worth over time. Unless you regularly evaluate (Total Assets minus Total Liabilities), you will not know what financial direction you are going in.
Net Worth is essential as a personal finance tool. It’s the ultimate measure of financial health. By reviewing your finances on a regular basis you can get a good feel for your financial well-being. If your Net Worth is rising, you’re probably in good financial health. If you’re net worth is shrinking, you’ll want to take a closer look at your finances to see what’s wrong.
My goal is to increase my Net Worth over the previous quarter, which means that either my expenses for the quarter were less than my income, and/or my investments have increased in market value.
The exercise of calculating your Net Worth and ROPE is really powerful. It will help you consider every major purchase you make and every loan you take or investment you make. It will have you asking a very simple question… what am I spending my money on that is increasing my net worth or decreasing my net worth?
Again, the spreadsheet is available on the Research Offers page. Keep using the spreadsheet for years and it will help you reach your financial goals.
Rob Arnott on buying inflation hedges [ie. TIPS] in his April 2015 letter:
“Inflation expectations are now 24 months into a severe bear market,
having fallen by nearly 40% from more than 2.5% in March 2013 to
a low of 1.5% in January 2015. I’ve previously said that in such an
environment, a conventional response – especially from those who
are anchored on mainstream stocks – is to question the need for
inflation hedges. The correct response is the opposite. “
[My ‘Optimal Asset Allocation’ model agrees with this. TIPS are the largest holding.]
Warren Buffett: Had missed this but apparently Buffett said in February: “”The last asset I would want to buy is a 30-year government bond”
He must not be in US long-term bonds at the moment: http://dailyreckoning.com/warning-warren-buffett/
Original interview was early February 2015 Fox Business News: http://insider.foxnews.com/2015/02/04/what-we-learned-warren-buffetts-sit-down-fox-business-liz-claman
[My asset allocation model sold out our successful position in long-term bonds in October 2014]