When Markets Are Oversold, Not Much Needed For 500 Point Rallies

Today is a perfect example of why I do not recommend that long term investors, regardless of how afraid they are right now, sell their stocks into oversold equity markets to minimize short term pain. When sentiment is so negative, the mere nomination of a new Treasury Secretary can result in a 500 point Dow rally within hours.

All of this announcement did was lift some uncertainty from the market, but traders hate uncertainty. Does it matter that Geithner was one of the two or three people most talked about for this job? Not at all. All that matters is that now we know who it will be.

Now, does this mean we won't be down 500 points on Monday? Of course not. The point is, when markets are down so much and have priced in so much negative information, it does not take much to get a massive rally. Imagine what would happen if economic data begins to improve sometime next year?

Unless you are psychic it is very difficult to get out of the market and get back in time to catch most of the rebound. With electronic trading and instant dissemination of information these days, the market can move a couple thousand points in a matter of days (which nowadays is a 20-30% move). The odds are against you being able to get back in fast enough, which is why I don't even try.

Citigroup Management Looks Overmatched

From the WSJ:

"The selloff in Citigroup shares has led executives to start laying out possible contingency plans. In addition to pondering a move to sell the entire company to another bank, executives have started exploring the possibility of selling off parts of the firm, including the Smith Barney retail brokerage, the global credit-card division and the transaction-services unit, which is one of Citigroup's most lucrative and fast-growing businesses, the people said."

Sound familiar? Lehman Brothers was stunned by their tremendous stock price decline and considered selling off Neuberger Berman, its most prized and valuable unit. Citi executives are obviously clueless right now. After all, their CEO is a former hedge fund manager and has no banking experience whatsoever. Conversely, the top brass at the other major banks are all seasoned bankers.

Selling off their valuable assets to raise money to burn in their worst units is not a good strategy. It is hard enough to operate Citi if you are a great CEO, due to its immense size, but the situation nowadays only further reinforces the notion that Citi should be broken up. Nobody with a clear head would argue that Citi's breakup value is worth less than the current $4.71 share quote. That said, when management looks incapable and nobody can really get a clear view of what exactly Citi's financial picture looks like with everything lumped together, it is hard to have confidence that the underlying value of the firm's assets will be realized anytime soon. Hence, people just sell the stock.

Full Disclosure: No position in Citigroup at the time of writing, but positions may change at any time

So Far, Technical Support Levels Holding Up Well

During crazy market times like this I can talk my head off about fundamental issues that show the market is undervalued, but fundamentals don't matter right now. Stock prices are claims on future corporate profits forever? Who cares, earnings are going to be terrible in 2008, 2009, and maybe even 2010. Rather than trying to convince people (correctly) that earnings this year or next really don't have a material impact on a company's long term equity value, let's focus on what does seem to be working right now... technical analysis!

Long time readers of this blog know I don't use technical analysis because for a long term investor, charts don't tell us what stocks will do, earnings and valuations will. Still, technicals do work quite often in the short term because thousands of people are looking at the same thing and acting in the same way. Today was no exception, as the 10-yer S&P 500 chart below shows.

The 2002 closing low for the index was 776. Today we sank at the open, hit 776 and bounced significantly (818 as I write this). The long-term 2002 support level has held, which is crucial for the short term market environment. I might not care where the market trades today, next week, or next month, but a lot of people do.

Unemployment Rate Likely Heading Above 8%

I was quite surprised to learn that the most recent monthly unemployment rate of 6.5% was the highest since the mid 1990's. That number, while up significantly from the recent past, just did not strike me as being all that terrible considering the economic deterioration our country has seen recently. As you can see below, the unemployment rate would likely rise above 8% if this recession is as bad as many expect it to be, rivaling the downturns of the mid 1970's and early 1980's.

It looks like bad news on the economic front will last well into 2009, but that should not be a much of a surprise to market watchers.

Down 45%, Warren Buffett & Berkshire Hathaway Are On Sale

About a year ago, I commented on an article that appeared in Barron's which argued that Warren Buffett's Berkshire Hathaway (BRKA) was overvalued. In my post, entitled Barron's Pans Buffett's Berkshire, I agreed with the article that Berkshire Hathaway stock looked overvalued. A lot has changed since then. Berkshire shares have fallen 45% from their high and hit a fresh yearly low on Wednesday at $84,000 per share. At that price, the stock looks cheap.

As I discussed in my 2007 post, the best way to value Berkshire Hathaway looks to be on a price-to-book basis. Berkshire's core business is insurance (which is valued with price-to-book) and the company's assets are largely in publicly traded securities, whether it be common stocks or various types of debt instruments. Going a bit further, I would use tangible book value, rather than total shareholder's equity, because Berkshire has more than $30 billion of goodwill on its books.

The essential question is, at what price would Berkshire Hathaway be cheap? I would love to purchase the stock at tangible book value of $56,000 per share, but that appears to be a long shot, as one might expect given Buffett's track record and the strong management team he has assembled there.

Accordingly, wouldn't you agree that even 1.5 times tangible book would be a solid entry point for a long term investment in Berkshire Hathaway? I certainly think so. Well, guess what? Today the stock closed at $84,000 per share, which just happens to be both a new 52-week low and exactly 1.5 times tangible book value of $86.6 billion. Not only does that look cheap, but all of us non-billionaires can buy the class "B" shares for only $2,783 each.

Full Disclosure: No position in Berkshire Hathaway at the time of writing, but positions may change at any time

Congress Should Address Corporate and Capital Gains Taxes Differently

Tax policy is going to be a hot debate in Congress once President-Elect Obama's term begins in January. Although Obama won the tax debate with McCain in the voter's eyes (polls show voters preferred Obama's plan, despite McCain's continuous attacks on it), his administration will still have to work across party lines to pass tax reform next year.

Two areas getting a lot of attention are capital gains taxes and corporate income taxes. The argument for the former is that lower tax rates induce more investment capital into the system. For the latter it is that companies with extra cash flow will hire workers and buy new equipment. I actually don't think either one of those arguments is true to any significant degree.

For instance, I don't know anybody who has not invested in the stock market because of the 15% capital gains tax. The notion that if we lower that rate to 10% it would cause billions of dollars to rush into the market seems downright silly to me. Conversely, if Obama was to raise the rate to 20%, it should not result in excessive selling of financial assets because it is hard to argue 15% is fine but 20% is overkill given the small differential. Tax rates are simply not a core determinant of whether people invest or not, at least not when the rate changes we are talking about are so minimal (if tax rates were 50% and dropped to 10%, then my opinion might change).

On the corporate side, it is my belief that a tax cut alone does not directly result in additional hiring and capital expenditures. A corporate executive does not decide to hire more people or invest in new projects just because they have the money available to do so. There needs to be a business reason for the move, i.e. the demand for their products is growing, which makes the investment in new people and equipment worthwhile in return on the investment terms. I disagree with the idea that tax cuts cause job creation. Real increases in demand from a growing economy results in job creation because more people are needed to meet the demand.

All of that said, I think that given a choice between the two, a cut in the corporate tax rate would be far more beneficial than reducing the capital gains rate. Simply speaking, lower corporate taxes directly impact stock prices positively by increasing corporate earnings. Since a majority of Americans own stocks (I think the number is between 60 and 70 percent, I can't recall the exact figure), lower corporate tax rates would benefit most Americans.

Many people make the same argument for reducing the capital gains tax rate, but it ignores a very crucial fact. While it is true that 60 to 70 percent of Americans own stocks, the vast majority of those people hold their investments in IRA and/or 401(k) plans, which of course are not subject to capital gains taxes. More often than not, those who own stocks in taxable accounts to any significant degree are the wealthiest Americans (entrepreneurs who retained large ownership stakes in the companies they founded, or executives who were granted stock options are part of their compensation plans).

Since our country has seen an acceleration in the recent trend of the rich getting richer while the poor get poorer, I would much prefer to help the majority of Americans through a corporate tax reduction, versus helping the top 5 or 10 percent of the country, who would see most of the benefit from a reduction in the capital gains tax rate.

Now, one can certainly make the case that personal income tax rate reductions would have a more positive impact on the economy (boosting incomes will increase end demand for products that corporations sell to consumers, thereby boosting job creation and new capital projects), but given the budget deficit problems we are facing, a corporate tax cut would be far less costly. The U.S. gets the bulk of its revenue from personal income taxes, whereas corporate tax collections are a much smaller fraction of overall federal revenues.

Analyzing Stock Valuations During Recessions

Now that third quarter earnings reports have largely been released, I thought I would write a bit about valuing stocks during a recession. Having seen all of the numbers and listened to all of the conference calls, I am beginning the process of going through my client accounts and making adjustments, if necessary, based on what information has come out during earnings season.

Drastic business model shifts are rare, so this analysis largely involves looking at management's execution of a company's particular strategy (are they doing what an investor would expect) coupled with valuation analysis (what price is the market assigning to the business and what assumptions are embedded in those assumptions).

Valuation analysis is a bit trickier during a recession because earnings are at depressed levels. The key is to understand that a stock price is supposed to equate to the present value of expected future cash flows in perpetuity. As a result, corporate profits for any given single year are not always indicative of value, meaning that valuations using earnings during a recession will likely underestimate a company's fair market value and vice versa during boom times.

A lot of people these days remain negative on stocks, despite the recent crash in prices, because they are assigning a low multiple to depressed earnings and are concluding that stocks aren't very cheap, when in fact, they have not been this cheap since the early 1980's. For instance, many expect earnings for the S&P 500 to dip to $60 in 2009. Market bears will assign a "bear market" P/E of 10 to those earnings and insist the S&P 500 should be at 600 (versus 865 today). More aggressive projections might use a P/E of 15 (the historical average) and conclude that the market is about fairly valued right now (15 x 60 = 900).

The problem with this analysis, of course, is that it assumes the economy is normally in a recession and a $60 earnings target for the S&P 500 is a reasonable and sustainable estimate for the future. In fact, it represents a trough level of earnings, which is not very helpful in determining the present value of all future cash flows a firm will generate, unless of course the economy never expands again.

Consider an entrepreneur who sells winter coats, gloves, and hats in an area that has normal seasonal weather patterns. If this person wanted to sell their business and a potential buyer offered a price based on the company's profits during the month of June (rather than the entire year as a whole), the offer price would be absurdly low.

Because of that, you will often hear the term "normalized" earnings power. In other words, when valuing a stock investors should focus on what the company might earn in normal times, rather than at the extremes.

Take Goldman Sachs (GS) for example. Wall Street expects GS to earn $0.28 per share in the current quarter, whereas in the same quarter last year they earned $7.01 per share. Just as one should not use a $7 per quarter run rate to determine fair value for GS (the stars were aligned perfectly for them last year), one should also not use a $0.28 per share run rate either, because today represents close to the worst of times for the company's business.

Investors need to value stocks using a reasonable estimate of normalized earnings power and apply a reasonable multiple to those earnings. With cyclical stocks, oftentimes you will see share prices trading at elevated P/E multiples during the down leg of the cycle because earnings are temporarily depressed. Investors are willing to pay a higher price for each dollar of earnings (as shown by high P/E's) because they don't expect earnings to remain at trough levels longer term.

One of the reasons stocks are so cheap today in historical terms is because many firms are trading at single digit P/E multiples based on recessionary profit levels. Buying trough earnings streams for trough valuations has always been a winning investment strategy throughout history, which is why so many long time bears are finally stepping up and starting to buy stocks again.

Take a very recent purchase of mine, Abercrombie & Fitch (ANF), as an example. The stock is trading at $16, down from $84. ANF typically trades for between 10 and 15 times earnings. They earned $5.20 per share last year but profits are expected to drop to $3.30 this year and to below $3 in 2009. The 2007 level of profitability is not what I would consider a "normalized" number, but earnings could drop 50% from the peak by 2009 (to $2.60) and that would not be normalized either.

The great thing about today's market for long term value investors is that we can buy a company like ANF for only 6 times earnings, even after taking their 2007 profits and slicing that number by 50% to account for the recession! When the economy recovers, isn't ANF going to earn more than $2.60 per share and trade at more than 6 times earnings? If one believes that, then ANF is a steal (as is any other stock that is trading at a similar price) as long as one is willing to be a long term investor and wait out the full economic cycle.

Full Disclosure: Peridot was long shares of ANF at the time of writing, but positions may change any time

Maybe I Should Apply For Bank Holding Company Status

I mean, everybody else is, right? Now that many short-term funding sources have dried up it is amazing to see how many different types of companies are applying to become banks. First it was the investment banks (Goldman Sachs and Morgan Stanley), then credit card companies (American Express), and today we can add insurance companies (Hartford) to the mix. Who knew?

Well, Capital One (COF) for one. You may remember that COF bought Hibernia Bank of Louisiana right after Hurricane Katrina hit the Gulf Coast (and North Fork Bank of New York after that). Many analysts questioned the move, even before the storm forced COF to renegotiate the purchase lower, citing the riskiness of a pure credit card company venturing out into waters it was less familiar with (retail banking). Capital One management insisted, though, that deposits were a less risky and cheaper funding source that would allow them to more easily expand their financial service product offerings nationwide. And these conversations were taking place way back in 2005.

Now I am talking my own book here, as Peridot owns shares of COF in client accounts, but I think the company deserves kudos for being years ahead of this trend. Rather than needing to become a bank out of necessity, they did it because they saw the need to sure up their funding sources in a world awash in structured products.

Not surprisingly, Capital One has weathered the credit crisis far better than most. COF's earnings should come in around $4 per share in 2008, on par with 2007 levels. Tangible book value per share has risen from $28 in 2006 to $30 in 2007 and to $32 today. COF shares have fallen along with the entire sector, but that has been due to multiple compression (they now trade slightly below tangible book value) not a deterioration in shareholder value.

The consumer credit environment will undoubtedly be rough in 2009 as the unemployment peaks for this cycle, but with a strong management team, there is little doubt that COF will be a long term winner when the storm passes.

Full Disclosure: Peridot was long COF at the time of writing but positions may change at any time

"Buy & Hold" Is Dead? I Think Not.

I find it rather amusing that six weeks of a horrendous market can lead so many people to declare that a "buy and hold" investment strategy is no longer viable. The evidence for such a claim is quite unimpressive, in my view. They assert that people who invested in the broad U.S. equity ten years have lost money so far, so "buy and hold" doesn't work.

Seriously? Yes, if you made a lump sum index fund investment in November 1998, waited a decade, never invested another penny, and sold today, you would have lost money over that time. "You would have made more by putting your money in the bank!" True again, but none of these arguments are very convincing. Let me explain why.

The stock market in the late 1990's traded at the highest valuation ever recorded. That was not a good time to invest in the market with only a lump sum. Conversely, today stocks are trading at the lowest relative valuation since the early 1980's. Those who use the last decade as evidence that "buy and hold" does not work anymore are simply telling us that buying high and selling low is a losing strategy. We already know that.

How many investors invested a lump sum in the late 1990's, never added to their investment, and sold recently? I don't doubt that some people did that (because they traded on emotion, not analysis) but to conclude that those few instances prove that a long term passive investment strategy is a bad idea is nonsense.

One way to avoid buying high and selling low is by dollar cost averaging into the market by adding to one's investments over time. 401(k) investors contribute a certain percentage of their income to their plans in equal (typically bi-weekly) amounts. Other investors try to max out an IRA every year to ensure they are always adding to their investments in order to build wealth faster over time. For people who follow those investment principles, even if they choose an index fund rather than active portfolio management, the fact that the market trades lower today than it did in November 1998 is irrelevant.

People are misguided if they believe they will always get rich by investing a lump sum of money in the market, regardless of price, by not following the investment or adding to it over time. Just because some investors have learned that lesson the hard way, it certainly does not mean we should proclaim that "buy and hold" is dead.

One final point. Unlike ten years ago, stocks today are quite cheap on a historical basis. As a result, I would be willing to bet that ten years from now the market will be meaningfully higher than it is today. Ironically, naysayers are out there advising people against doing just that.

Readers Were Right, Paulson Nixes Asset Auctions

Has anyone else noticed that whenever Treasury Secretary Henry Paulson speaks the market goes down? Today is no exception, as we learned that Paulson has abandoned the idea of using the TARP funds to buy bad assets from banks using a reverse auction process. When the idea of auctions first came to light I was very keen on the idea, but others preferred direct capital injections into the banks, in return for preferred shares as well as common stock warrants. Readers pointed out that there was no assurance that an auction would actually happen. They were right.

Instead, TARP money was used to buy stakes in banks and now Paulson says the auctions are no longer a priority. I still believe that auctions address the core problem far better than direct capital injections. As we have seen, the financial institutions can do whatever they want with money if you just hand it to them. Heck, they might even use it to buy other banks or invite their top salespeople on expensive resort getaways. That wouldn't go over too well, would it?

The root cause of the problem, huge losses resulting from bad loans (and the need to raise more capital after losing much of what they had), could be addressed by buying the assets from the banks for pennies on the dollar. Future bank losses would be reduced because the assets causing the largest losses would be jettisoned, and the banks would have cash to make new, hopefully better, loans. The direct capital injections have done nothing to reduce bank losses or help the housing market.

At this point, the remaining TARP money would be best-served by tackling the problem directly. If the Treasury prefers not to go the auction route, then you have to do something to address the home foreclosure problem. On that front, why don't we just use the money to pay mortgage servicers a fixed amount for each loan they modify for borrowers who are struggling to make their monthly payment? Such a move would incentivize the lenders to work with their customers and stem the housing downturn, which is a major impediment to financial stability in the system.

It is in the best interest of everyone involved if the banks agree to take a little less money back on their loans rather than become a real estate developer by foreclosing on properties. If home supply and demand imbalances are corrected, and home prices stabilize, the economy would benefit tremendously.