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Things look bad... The stock market is down... Everybody hates Komrade Obama... Everybody hates BP... Is it time to buy stocks again?
If sentiment is your guide, possibly... According to the AAII Sentiment Survey, 32% of individual investors are bearish, still more than the 30% long-term average, while 34.5% of investors are bullish, down 8% from last week and below the long-term average of 39%.
Mr. Market is still feeling down in the dumps. You never want to buy when he's happy because that's when stocks tend to be overpriced and ripe for a disappointing performance.
But sentiment doesn't rule. Valuation rules. That's the defining characteristic of the market's big trends. Stocks are down lately, and investors are still quite bearish because they look in the rearview mirror... But the overall market is still trading around 18 times earnings or so, with dividend yields averaging around 2%. Stocks don't get really undervalued until they're in the low teens or even single digits, and yielding 5%-6%.
With sentiment bearish and stocks expensive, I have to conclude Mr. Market is in one of his rare rational moods. Sometimes, it's right to be bearish.
One of the areas I'm becoming more bearish on is municipal bonds. In his testimony on the credit-ratings agencies – which rate most muni bonds triple-A – Warren Buffett said, "If you are looking now at something where you could look back later on and say, 'These ratings were crazy,'" it would be muni bonds. Buffett continued, "state and municipal finance five or 10 years from now... will be a terrible problem..."
Buffett's company sells more insurance than anything else. It once insured hundreds of millions of dollars in new municipal bond issues a year. Last year, that shrank to just $40 million. With his dire commentary before Congress, would it surprise us to see his beloved Berkshire exit entirely from the muni bond insurance business?
The tragedy is investors have come to think of bonds in general, especially municipal bonds, as a safe haven. They don't pay much in yield, but – and this might sound familiar – they're viewed as safe because most of them are rated triple-A by the ratings agencies. We learned from the subprime debacle that garbage is garbage, triple-A rating or not.
Hopefully, many investors also learned something about the fancy math and sophisticated modeling ratings agencies used to "manage" and "assess" risk in securities. A contrary view of the notion of risk management via modeling, written by an engineer, appears below in today's reader feedback. His conclusion is sound: Complex statistical models are no substitute for sound judgment based on experience and know-how.
For example, suppose a friend came to you and said he invented a pair of shoes that will tone your butt and help you lose weight while you walk. Suppose he says folks are lining up around the block to pay $100 a pair for them, and he's looking for some new investors. Would you bite? Many already have...
A $100 pair of shoes that tones your butt and helps you lose weight?! It sounds ridiculous, but it's true. No one ever went broke underestimating the intelligence of the American people, nor their desire for a no-exercise/no-diet weight-loss plan. So Skechers and Adidas-owned Reebok have turned so-called "toning shoes" into a nearly $1-billion-a-year business. Skechers' toning shoes, known as Shape Ups, helped the company triple its market share in U.S. women's athletic shoes this year to 17%, or $225.7 million.
The shoes, according to Skechers, "are designed to simulate the feeling of walking on sand and make wearers stabilize their steps, leading to stronger leg, buttock, back, and abdominal muscles." Walking with regular shoes also strengthens the legs, buttocks, back, and abs. In fact, I'm pretty sure walking with no shoes does a good job of this, too.
Regardless, toning shoe sales in the U.S. was just $17 million in 2008. Sales increased eightfold last year when Reebok and Skechers introduced their models. In the first four months of this year, toning shoes sales hit $252 million – 75% more than the total for all of 2009...
"The explosion of growth in this space in such a short period of time eclipses everything I have witnessed in the industry over the last 25 years," said Adidas CEO Herbert Hainer. He believes Reebok could sell 5 million pairs of toning shoes in the U.S. this year. And there's plenty of optimism priced into these companies. Shares of Skechers bottomed at less than $6 in March 2009. Today, they're trading for more than $40 – a 600% increase.
It's dangerous to fight against the trend, which is undoubtedly "up," with these two companies, but at some point, the "tight-butt shoe bubble" will make a fantastic short sale.
To add to our comments from Tuesday regarding Wall Street's abhorrence of the "sell" rating, check out this chart from JPMorgan. It shows the percentage of S&P 500 stocks with a mean analyst rating of "sell" or "hold/sell." Notice the line doesn't change much...
Fannie Mae is really cracking down on "strategic defaults," in which underwater homeowners who can afford their mortgage payment decide to walk away. According to the new penalty, these "jingle mailers" won't be eligible for a Fannie Mae loan for seven years after foreclosure. Of course, this assumes Fannie Mae exists in seven years – which we doubt. Once the government financial guarantee expires in 2012, Fannie is toast.
And we don't see how this punishment is any different from the defaulter's normal punishment. Perhaps a reader/attorney can correct me, but not too long ago, any bankruptcy lawyer would have told a client he's going to have trouble getting a loan for seven to 10 years. Finally, we'd be surprised if the recently defaulted wanted to own a home again... Prices are still too high, and they can easily rent. In other words, the government is trying to shake an iron fist, but it's really just spinning useless rhetoric. Read the official Fannie press release here.
New high: ATAC Resources (ATC.V).
There wasn't much in the mailbag today. If you've got something on your mind, or you'd like to comment on the bullet above, please share it with us at feedback@stansberryresearch.com.
"I'm not sure I understand why inflation would be good for big banks. Of course, if they can borrow at 0% and loan out at 4%, they can hardly help but profit. But that situation is caused by government intervention, not inflation. With inflation, it is the borrower that comes out ahead; the bankers, being lenders, get paid back with deflated dollars, which can't be good." – Paid-up subscriber Al C.
Ferris comment: The part I didn't include on Tuesday is Bank of America, Wells Fargo, Citigroup, and JPMorganChase are all entrenched in cozy relationships with the government. The view that they'll suffer under the new financial services reform is false. They have more of the financial resources and personnel necessary to cope with new rules and regulations than any other banks in the country. Their competitive position will gain from the new legislation. That ought to preserve their share of the country's deposits, which I believe is close to 50% of the nation's deposits. It's a government-created oligarchy. Deposits equal lending and earnings power. The more currency units in existence, the more deposits there are... the more earnings power. If you have 50% of, say, $7 trillion in deposits, you have a certain amount of lending power. If all of a sudden, global deposits jump to $10 trillion and your share remains the same, you'll have $5 trillion of deposits to lend.
This is Murray Stahl's croupier idea. Stahl is a fund manager who likes companies that benefit from the number of currency units in existence. Most of them are rather large financial institutions. Visa and MasterCard are on the list. I think Visa has about 60% or so of global payments. It's just like with deposits. If you have 60% of something that's growing... you're going to grow, too.
The following is a rare treat in our reader feedback, a reader who has carefully crafted a thoughtful but critical letter on an important subject for investors: Risk.
Paid-up S&A subscriber Jay Lipeles wrote to the editor of Mechanical Engineering magazine, but the magazine declined to publish (according to the letter's author) his piece. Lipeles begins:
I read with alarm, the cover story in your current issue [of Mechanical Engineering]: "Risk – Informed Decision Making." The basic message that risk can be managed is wrong and extremely dangerous.
Lipeles then cites three examples of risk-management gone horribly wrong: The Challenger space shuttle disaster, the Long Term Capital Management blowup, and the subprime-mortgage debacle. Lipeles' conclusion sounds like it was written for investors, not engineers:
Greater reliance on risk management really implies (and demands) reduced reliance on judgment (engineering, financial or whatever). It is a very bad strategy based as it is on an assumption known to be wrong. It is an extremely dangerous strategy. We should instead be relying more heavily on, and developing the people, who possess good judgment.
Note: Lipeles uses the word "ergodic" several times in his letter. Ergodic is a math/statistics term that describes systems that return to their previous states after a suitable interval of time. Markets might be like that, but leveraged hedge funds and financial institutions aren't like that at all.
Risk Management
By Paid-up S&A subscriber Jay Lipeles
To the Editor:
I read with alarm, the cover story in your current issue: "Risk – Informed Decision Making". The basic message that risk can be managed is wrong and extremely dangerous. Mechanical Engineering does a great disservice to its readership and the engineering community at large by promoting such nonsense.
To site a few examples: In the investigation that followed the Challenger disaster, NASA testified as to its risk assessment made prior to the event. The assessment was wrong. Seven astronauts died, and it cost the nation millions of dollars and several years to recover. To my mind, NASA never has, witness your article. Bad thinking remains. The error in NASA's assessment (and related risk management theories) is that inherent in the theory (and usually unstated, as in your article) is the assumption that the situation is ergodic. NASA's assessment was based on (among other things) test data taken at room temperature. The probability of failure of the O rings was based on that data and it was incorrect. The situation was non-ergodic. The theory was inapplicable. The analysis was wrong and disaster followed.
Long Term Capital Management (LTCM) lost $ 4.6 billion in 1998 and subsequently failed. Among the reasons for its failure was it assessed its risk with an analysis similar to the one in your article, which assumed that the situation was ergodic. It was not. When Russia defaulted on its debt, the mistake was revealed and LTCM went down.
Now we are struggling through the worst recession since the Great Depression. It was initiated by the collapse of the subprime market. It goes without saying, that there were a number of contributing causes. Among them was the bundling of mortgages into securities backed up by risk analyses that predicted the risk to be very low. The analyses assumed that the situation was ergodic. Whoops! In all of history, was there ever a more costly mistake?
Inherent in all analyses of this type is the assumption that the situation is ergodic. It almost never is. What the authors would have us believe is that a careful, thorough risk analysis can be helpful in reducing risk. Nonsense! What such an analysis does is provide a sense that risk is being addressed when it is not. It contributes to a false sense of security.
The most important quality an engineer brings to the game is his judgment. Greater reliance on risk management really implies (and demands) reduced reliance on judgment (engineering, financial or whatever). It is a very bad strategy, based as it is on an assumption known to be wrong. It is an extremely dangerous strategy. We should instead be relying more heavily on, and developing the people, who possess good judgment.
Ferris comment: Thank you, Jay, for this intelligently crafted letter, which I believe is right on the money. Judgment is what investors need, not fancy math models that contribute, as you point out, "to a false sense of security." Well done.
Regards,
Dan Ferris and Sean Goldsmith
Medford, Oregon and Baltimore, Maryland
June 24, 2010