Value's Rule

In an article published in January of 2002 entitled What the Federal Reserve System and Federal Government Want, Market Watch wrote: “Dividends are averaging less than 1.4% of the cost of stocks, which is the lowest dividend yield in history. Price earnings ratios are in excess of 30 times earnings concluding this is not a market for “value oriented” investors. The prudent investor will keep their cash in short term, and medium term, money market securities and sit on the sidelines to wait for future opportunities.”

Last week, four and a half years later, Dr. John Hussman (www.Hussmanfunds.com) published a paper showing that “the S & P 500 has underperformed the lowly three month treasury bill since 1999. The T-Bill has earned an annual total return of 3.2%”. Hussman further states that, “the S & P 500, currently selling around 1250, would lose 36% of its current value, and be around 800, based upon historical average yields and price earnings ratios”.

None of this is very shocking. In June 1999 the Dow sold at 11,565 and today the Dow is just under 11,000 points. Corporate earnings have increased, and dividend payouts have increased. But the market has gone nowhere. Why? Because we are in a long term Bear market. Price earnings ratios have come down substantially and yields on stocks have increased substantially, but most stocks are still not a buy. Bank stocks and drug stocks are selling at a price producing about a 4% yield with price earnings ratios of 15 times earnings or less. Those are the only groups of stocks that are ready at this point to be accumulated. As famous professor Jeremy Siegel of Wharton writes, “I have long advocated the use of dividends in evaluating stocks. Dividends are the only fundamental variable that is completely objective, transparent and unable to be manipulated by managers who tinker with accounting assumptions. According to my research, dividend weighted indexes out perform capitalization weighted indexes and are particularly valuable at withstanding bear markets.”

	PE Ratio		EPS
Stock	1999	Now	1999	Now
XOM	32X	10X	$1.19	$5.75
GE	36	21	1.07	2.00
C	16	10	2.15	4.00
BAC	14	12	2.34	4.25
MSFT	50	18	.70	1.27

There has been a good deal of improvement in values since the market topped 11,700 points several years ago. The five largest companies in the S & P 500 represent 13% of the value of that index. They are Exxon Mobil, General Electric, Citigroup, Bank of America and Microsoft. Look at the chart and pay particular attention to the improvements in values for the investor. These five companies lead their industries and have a record of increasing earnings. While their average earnings have increased 232% since 1999, their average price earnings ratios have decreased from 30 times earnings to 14 times earnings. 14 times earnings are the market’s average from 1920 to the present.

Market Watch recently opined that the ugly 1970s economic situation of “stagflation” was rearing its ugly head. We see no present reasons for the condition of the market to improve. The prudent investor would be better off in short term and intermediate term, treasury securities, and a few stocks, that are A-rated, yield more than 4%, and that sell at 14 times earnings or less. The following economic dislocations must be addressed before another major growth spurt may occur in the U. S. stock markets

1)		Expanding trade deficits;

2)		Expanding Federal Government current account deficits;

3)		Resetting of $2.7 trillion of variable rate mortgages in the next 13 months. That is likely to put a damper on consumer spending which represents 70% of GDP;

4)		Future outsized Social Security and Medicaid obligations must be addressed and reasonably worked out;

5)		The need to absorb 50% increases in housing prices over the last five years. And, the further need for the economy to re-consume 40% of home and condo purchases last year that were speculative, second home purchases, many of which purchases were made with no cash down;

6)		Competition for energy sources that is exploding with the unleashing of huge demand from Chinese and Indian populations, who are trading in their rickshaws for cars;

7)		The sinking dollar which may be heading for major trouble. Foreigners are beginning to look askance at the debt structure of the United States. Representing 70% of the world’s money, a decreasing dollar discourages trading partners from an interest in holding a currency that is going down;

8)		Unresolved conflicts in the Middle East.

The six year bear market in stocks has been fought tooth and nail by the Fed. The result of the Fed’s actions is the massive maladjustments mentioned above and the excesses, like debts, built into our economy. The Fed is likely to continue to hope their manipulations of the money supply and interest rates will at least keep the stock markets at their current levels while we are working out current dislocations in the economy. Whether or not they have the power and the skills, to properly address these problems, is beyond speculation. The judicious investor will remain highly liquid and they will be highly discerning in building back a base of stocks.

The U. S. economy is extremely lucky to be doing as well as it is considering the tremendous challenges of debt accumulation and increasing world demand for resources. It is a credit to the power of our economy that the market remains as high as 11,000 points on the Dow. The Fed will do anything to keep a collapse in the market from occurring. A review of the last six years of Fed interaction with the markets indicates they have done a laudable job. And while stagflation may not be welcomed back, the stagflation of the 1970s helped straighten out the economic dislocations of that time. This led to a vibrant and growing U. S. stock market from 1982 to 2000. We need to count our blessings, and be very patient over the next several years, in preparation for the next great run up in the stock markets.

Caveat Emptor.
George Rauch
June 30, 2006

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