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THE BLUE MONEY REPORT.
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The Blue Money Report
"Freedom of movement of capital is fundamentally good and positive for the world, provided it applies to economies in good shape."
~ Michel Camdessus
managing director of the International Monetary Fund,
in National Journal, Feb, 14, 1998
Welcome to the Blue Money Report
Today's Commentary: 09.04.02 When I return from vacation, most of which aren't spent in the rich style of the big guns from Wall Street, I come back with a new or should I say, renewed perspective. I am relaxed and through relaxation, I can see clearly. Are we to interpret the reaction to this clearer perspective, as a reason for the continued erratic behavior threatening the markets?
This time, the selling was based on negative news, which, when viewed clearly, could have spurred on these returning vacationers to wait out the historically poor month of September.
The manufacturing number at the level of 50.5 was not an expected result of a growing economy. Estimated to be higher, and somewhat peeved when it it was not, traders decided that participation in such a climate is not much fun and sold. They sold ahead of the unemployment numbers on Friday. They sold ahead of talk of earnings which is called preannouncement season. They sold ahead of the 9.11 anniversary. They sold knowing that the great run-up of the nineties was based on their ability to sell a notion and not, at least according to Alan Greenspan, his talent as a market cheerleader.
Before September gets completely out of hand, and I suspect that it will, let's wrap up summer, dispelling a few myths first.
We are not alone. The world decided that selling was better than buying and following Japans lead, Europe fell, and then we followed as participants in a global fallout of sorts. The reasons that rack the markets overseas are decidedly different (sometimes) and their markets sold off based on that difference. Here at home, the traders sold because weakness is not perceived as a sign that things are getting better.
Manufacturing as I mentioned before, started the week off with a lackluster number. Retail sales, which is published on Thursday will show Wall Street that the consumer is not continuing to keep things in shape. Since the end of July, sales have been cooling off, and August found many retailers scratching their heads wondering when shoppers would return.
The folks who chart these kinds of moves in the markets are seeing higher highs and higher lows, and this is a reason for optimism. But we are not out of the woods yet. Things are not improving enough to be noticeable. There is simply no incentive for capital investment to suddenly begin. The holders of the corporate purse strings are reluctant to make any sort of commitment based on what they see and hear. And who can blame them.
The unemployment number that will be released on Friday has received a new perspective that should be considered a negative weight even if the number improves slightly. The number of disparaged workers has finally started to show up in another economic indicator, Social Security's Disability list.
I once bought a disability policy that had a Social Security rider attached. This rider relieved the insurance company of 80% of its obligation should the Social Security office deem me disabled. That, I was told, should happen only if death's door was clearly an option. But now, that seems to have changed. Death does not need be the only option as the rules have gradually relaxed enough to increase claims based on workers inability to continue to work.
According to a report written by Louis Uchitelle appearing in the Monday New York Times, unskilled workers, those who have little choice of jobs after a layoff and whose presence on the unemployment line has been a fixture throughout even the boom time of the late nineties, have discovered the relative ease of collecting benefits from Social Security when their unemployment benefits run out. With the average monthly payment falling on the other side of eight hundred dollars a month, these displaced workers have found a way to continue to receive money and in some cases, health insurance (Medicare kicks in after two years). They are no longer counted among the unemployed once this shift in benefits takes place. Instead, they have taxed the resources of another federal agency to the estimated tune of $60 billion. These "through the cracks" numbers, had they been added to the current unemployment numbers would have shown a better based reality.
There are some folks who are on disability that truly need the benefits awarded, but if half of those of the 5.42 million recipients fall into the category of disparaged workers, unemployment figures would swell by half again. So the myth that the economy is growing with the unemployment numbers gradually decreasing is not based on a rehiring at all. It is based on those left in line that are still eligible for unemployment.
The housing bubble does not exist. This should relieve those of us who are beginning to wonder about the roof over our heads. The current way it is portrayed, trotted out by so many analysts whose reputation has need of a good solid prediction, things look incredibly dire. This is simply not the case.
I recall a conversation that I had several years back with my cousin in California. He is a holder of a jumbo mortgage and was concerned about a play structure his neighbor had erected in the back yard. To me, it gave the guy's kids something to do. To him, it was a clear sign that his property value would be diminished considerably.
In many places in this country, we have seen the "estimated selling prices" of our homes appreciate considerably. Many of us have used these higher than average estimates to march into the office of our favorite lender and request that this new found equity be translated into real dollars. Last year, those dollars were used to keep the economy pumped as we spent excessive amounts of equity on more than home improvements. This year, however, with interest rates staying low, and with housing prices staying higher, at least regionally, millions of folks borrowed again to pay debts. This failure to pour more money into the economy has left many worried that the consumer is tapped.
The truth is that consumer now has upgraded their home, become satisfied that they can pay off their mortgages, and has decided to sit back and wait. Bubbles occur when selling takes place at a higher price than true worth. Homes may be overvalued, but home owners realize one simple thing. The increased value of their home will only be beneficial to them if they are downsizing. Otherwise, they are forced into the same market that they just sold into. In many cases, it boils down to, "where will we go if we sold?"
The consumer is still spending, although on a limited basis. They are no longer confident that things are getting better anytime soon. This is not a pull back but a realization that things cannot continue on without bills coming due.
Today's Commentary: 09.03.02
Mr. Swedroe was kind enough to contribute this excellent article for the readers of this column. His take on the markets is both profound and insightful. He is, although, writing here about owning stocks on an individual basis. If you translate what he has written into the realm of mutual funds, you will have no difficulty understanding the problems that face investors purchasing funds categorized as value or growth, or the obstacles that face managers of those funds.
Explaining The Value Premium
The historical evidence is that there is a very strong and persistent value premium. From 1964 to 2000 large value stocks outperformed large growth stocks 14.5 percent to 11.1 percent, and small value stocks outperformed small growth stocks 16.6 percent to 12 percent. Not only has the value premium been very large, but it has also been very persistent about as, or even more persistent than even the equity premium. In addition to providing greater returns the standard deviation of value stocks has been lower than the standard deviation of growth stocks. From 1964 to 2000 the standard deviation of large value and large growth was 16.7 and 17.5, respectively. The standard deviation for small value and small growth was 23.8 and 27.2, respectively.*
Unfortunately, many investors looking at the data come to the conclusion that the value premium is a free lunch greater returns with less risk (lower volatility). The problem with this conclusion is very simple: The risk of value stocks just didn’t show up in that period.
Since the publication of the study by Eugene F. Fama and Kenneth R. French, "The Cross-section of Expected Stock Returns" in the Journal of Finance in June 1992, financial economists have been trying to discover the source of the value premium. The October 1998 edition of The Journal of Business contains a study, Risk and Return of Value Stocks, by Naifu Cheng and Feng Zhang, that makes the case that value stocks contain a distress (risk) factor. The authors make their case by examining three factors of distress present in value companies:
The authors found that the three factors all captured the returns information (produced high correlations) contained in portfolios as ranked by book-to-market value. When these three factors were present, returns were greater. Since all three factors have simple intuitive risk interpretations (are associated with firms in distress), they state that it isn't surprising that the risk factors they studied were highly correlated and were also highly correlated with book-to-market rankings. Their conclusion was that value stocks are cheap because they tend to be firms in distress, with high leverage, and face substantial earnings risk and thus they provide higher returns due to the greater risks facing value investors.
Another conclusion is that the risks of value stocks are most likely to show up at the worst of times for investors in times of economic distress. A perfect example of this is the period from 1929 through 1932. During this period while the S&P 500 Index fell 22.7 percent per annum risky large value stocks fell 31.8 percent per annum. The even riskier small value stocks fell 36.5 percent, underperforming the S&P 500 Index by almost 14 percent per annum for four years. Since investors are on average highly risk averse the value premium has been quite large.
A study, "The Value Premium", by Lu Zhang provides further support to this risk story. His study concluded that the value premium can be explained by the asymmetric risk of value stocks "they are more risky than growth stocks in bad times and less risky in good times, but to a much lesser extent".** Zhang explains that asymmetric risk of value companies exists because value stocks are typically companies with unproductive capital. Asymmetric risk is important because:
Zhang also observes that:
It is important to point out that the risk of value stocks does not show up in all recessions. While value underperformed in the period 1929-32, the risk of value stocks did not appear in the recession of 1973-74. During this period, while the S&P 500 Index fell 20.8 percent per annum and small value stocks fell 22.2 percent per annum, large value stocks fell just 12.3 percent per annum. Why did the risk of large value stocks not show up in this recession? The answer probably lies in the fact that the 1973-74 recession was an unusual one in that inflation actually rose during this period. The CPI rose from 3.4 percent in 1972 to 8.8 percent in 1973. It rose again in 1974 to 12 percent. As noted earlier, the average value stock is highly leveraged. Inflation reduces the real cost of debt, thus reducing the risk of value companies. In fact, the size of the value premium has been highly correlated with inflation.
Before concluding we need to address one more issue that puzzles many investors. How can growth stocks, with their very high prices, be considered safe investments? Investors who wonder how stocks that have such a high valuation can be considered safe are confusing business (operating) risk with price risk. Value companies have more perceived business risk than do growth companies. Therefore, the price of value stocks must be low enough so that investors are compensated for the greater business risk. The distinction is in the risk of the companies, not the risk of their stock prices.
There is another reason that growth stocks might be considered to have more price risk. The less the perceived likelihood of a company failing to reach its projected earnings, the lower will be the risk premium, and the higher the stock price.
Taken to an extreme, a stock with very little perceived risk might be said to be "priced for perfection". Simply put, there is little room for any upside surprise. If everything goes as expected, you get low returns (because of the low-risk premium). On the other hand, if almost anything goes wrong, the risk premium might rise sharply, and the stock could fall dramatically. This is the type of price risk that existed in the NASDAQ 100 stocks that were trading at astronomical P/E ratios prior to our entering the new millennium. Conversely, with value stocks being so distressed, there is far less likelihood of disappointment (when the risk premium would rise further) and lots of opportunity for upside surprise (the risk premium would fall and the price would rise dramatically). Some value stocks are so distressed, due to such high perception of risk, that almost nothing else can go wrong that has not been anticipated already. Thus the stock might have a high upside potential should the risk premium fall.
To summarize, it is the perception of a high degree of business risk, and thus a high-risk premium applied to valuations, that causes the price of value companies to be distressed. The same high-risk premium creates high expected future returns. It is the perception of low business risk, and thus a low-risk premium applied to valuations, that causes the price of growth stocks to be elevated. It is high prices that create much higher price risk in the growth stocks than in value stocks.
In conclusion, the value premium has been large and persistent for a very logical reason value stocks are not only risky, their risk is highly correlated with economic cycle risk, tending to manifest itself during recessions that are also deflationary periods. While we do not have a perfect model to explain the risk of value stocks, investors should not make the mistake of believing that just because value stocks have had a lower standard deviation than growth stocks that the value premium is a free lunch.
*Dimensional Fund Advisors.
Larry Swedroe is the author of "What Wall Street Doesn't Want You to Know," "The Only Guide To A Winning Investment Strategy You Will Ever Need," and "Rational Investing In Irrational Times, How to Avoid the Costly Mistakes Even Smart People Make Today," was published in June by St. Martins Press. Larry is also the Director of Research for and a Principal of both Buckingham Asset Management, Inc. and BAM Advisor Services in St. Louis, Missouri. However, his opinions and comments expressed within this column are his own, and may not accurately reflect those of Buckingham Asset Management or BAM Advisor Services.
Today's Commentary: 09.01.02 AFL-CIO released the results of a poll commissioned by the union on Thursday. The poll done annually for Labor Day showed signs of a weakening sense of security in the American workplace, a loss of faith in the governance of both companies and the administration, and a growing concern over the fate of health and welfare programs. The company hired to conduct the survey Peter D. Hart Research Associates, did so by phone from August 10 to 12, 2002 using a representative sample of 800 adults, plus an over sample of 100 non-managerial workers. The findings, while not necessarily surprising, should help with any efforts an elected politician might have on his plate in the upcoming elections.
It seems that 38 percent of those surveyed are satisfied with the economy today. This is in dramatic comparison to the 63% that were thrilled with the way things were going last year. This is an alarming drop in confidence that is not clearly reflected in most statistics. The economy, most felt last year, was stable. This feeling carried over made those surveyed comfortable about the security of their jobs. Even as unemployment numbers grew steadily, job security seemed to be a non-issue last summer. The pollsters found this year to be quite another story. Forty four percent reported that they felt less secure while some 34 % saying they feel more secure.
On the eve of Labor Day, the popularity of unionism, often described in terms of a swinging pendulum, is moving in the opposite direction. Larry Kudlow, CNBC economic commentator once suggested at the height of the nineties boom that the name should be changed to "Capitalist Day". His reasoning was based on the belief that it was the efforts of those with money, the dreams of those willing to take entrepreneurial risks in the marketplace, that created the jobs that labor celebrates on this holiday. The logic is somewhat circular. The jobs created by those with ideas, also create customers that support those products produced as a result.
But capitalism has taken somewhat of a confidence hit and the poll shows the results as having turned negative since the last time it was conducted a year ago. The negative view of CEOs has climbed to 58% with the dissatisfaction, according to the poll, with the grumbling at executive actions being largely bipartisan. In the nine years of the survey using this type of format, this is the highest feeling of corporate mistrust.
The poll found the people don't trust their employers to treat them fairly, or to think about their security. The growing sentiment that corporation's pursuit of profits at the expense of loyalty to employees has risen significantly with 57 % saying that employers fall short when it comes to providing permanent jobs that offer benefits and job security.
This sentiment has grown not just from the steady stream of CEO's being called on the carpet about their compensation or even from the falling stock market. The feeling has grown internally and is fostered behind closed doors. Employees feel as though they have become dispensable in light of the well publicized unemployment numbers. A growing number of corporations feel that the amount of available workers is a now an inexpensive pool of replacement help. No longer faced with trying to keep quality employees, those who answer to shareholders are looking to one of the few tools they feel they have to align profits to Wall Streets whims.
Voters in the upcoming elections will find politicians trying to retune their campaigns to this changing feeling among American workers. Seventy percent of Americans think the rising costs of health care and prescription drugs is a serious problem and is not being addressed by their companies or the administration properly. It has become the cornerstone for many labor disputes, both settled and in negotiation. Fat retirement plans for corporate execs has also become a major point of dissatisfaction among workers with twice as many in previous years polled expressing concern for not only that but corporate accountability and the protection of workers' pay.
On Labor Day it is important to understand that those folks that you depend on, the ones who do not have the holiday off, are not as happy as the seem. The kid at the gas station may not be a kid but a man who is making ends meet with a family that depends on him. The checker at the grocery store, the one with the friendly smile whisking you through the line with your beer and chips on your way to your outing may be worried about what her company is going to do about health benefits in her upcoming contract. If it is a WalMart worker, she probably has no contract, makes less than her union counterpart and uses the health benefits that low income folks use. The very benefits that your tax dollars support. The policeman, or the fireman, or the park worker at their post over the holiday has the same set of worries that you do. Only you are on holiday. The counterperson serving up the hotdogs on the boardwalk or whipping up a Sunday morning latte is also working in a service industry that is supposed to be celebrating labor, not working. In a land where the American worker and their families once celebrated and relaxed together as a result of the obsolete Sunday Blue Laws, most will find themselves working on the one holiday left for them.
When Mr. Kudlow made that remark, I wonder if he thought about the guy behind the camera, or the make-up technician, or even the driver of his car when he made such a crass comment. Admittedly, workers need work and capitalists provide it. This Labor Day, let's just not take it for granted that everyone is as happy in their employment, many of whom have found themselves picked by their need for their jobs.
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