OMAHA!!

Several short trips have sabotaged my efforts at updating the blog. At the end of April I ventured to Omaha NE. The trip served a dual purpose, to attend my daughter's Army ROTC annual awards banquet and to make my first appearance at the Berkshire Hathaway annual meeting. For those of you unfamiliar, Berkshire Hathaway's Chairman is Warren Buffett. Buffett, as you know, is concerned the greatest investor in the world. His 50 plus year track record of allocating capital to various private and publicly traded companies is unmatched and most likely never will be replicated. Now before we put Mr. Buffett on too big of a pedestal, his record in terms of compounded annual returns, while outstanding is not a one time outlier. There are a handful of other "Superinvestors" with track records nearly as good. They include, Walter Schloss, Bill Ruane, and Tom Knapp. What makes this an interesting group is that these four investment managers did not come to be by pure randomness. All four (including Buffett) took an investment class back in the 50's taught by the legendary Ben Graham. Graham is considered the pioneer of "value investing" and the first to apply strict quantitative analysis in selecting securities. He is the author of what most consider two of the greatest books ever written on investing. The "Intelligent Investor" is considered the bible for value investors and Buffett considers it the greatest book ever written on the subject. The book is still in print is currently being updated for the next edition. It still sells thousands of copies a year. Any investor who is buying and selling securities for themselves or others that has not read and internalized this book should not be buying and selling securities. Graham's other classic is called "Security Analysis" which is a much more academically based step by step explanation of Graham's methodologies. It is not for the weak kneed! The point of all this is that the greatest investors of the last 50 years have achieved these track records essentially following the same methodologies, with slight individual variations, that have been public knowledge for about 60 years.

I won't rehash the highlights of the meeting. If you are interested, simply google some variation of Berkshire annual meeting and you will find a full recap. The bigger "message" and takeaway from any interaction with Buffett, his meeting, his writings or video archives on the internet is the very simple "guidelines" or investment principles that guide his decision making and how radically different they are from what Wall Street or the media inundates investors on a daily basis. A few examples:


1. Buffett pays no attention to the stock market.

2. Price is the most important factor in purchasing or selling a security.

Most investor mistakes result from some kind of deviation from the the two principles above. To value investors, the market is irrelevant. It's only purpose is to provide a quote for you to act on. Whether the market is up, down, or sideways, tomorrow, next year, or 5 years from now does not matter. It is simply noise to tempt the investor to make a mistake. Price is the bedrock of value investing. The entire desire of the value investor is to seek out assets trading or being quoted at below their intrinsic value. Of course, one must have an idea of what constitutes a security's intrinsic value. My guess is that if you asked the average investor what any stock he or she owns is worth, they have zero idea. In fact, many popular stock trading methods are based on purchasing something with the hopes of selling it at a higher prices with no regard to underlying value.

Market Valuations

Doug Short does some wonderful work on his blog www.dshort.com. He is kind enough let everybody use his information with the only requirement that we credit him. Well done Doug and thanks for your contributions. He recently has had a series of wonderful posts that lends us a "big picture" view of where we might be in this market cycle. Click on the charts to explode them for better viewing.

Is the Stock Market Cheap?
March 3, 2010 monthly update

Here's the latest update of my preferred market valuation method using the most recent Standard & Poor's "as reported" earnings and earnings estimates and the index monthly averages of daily closes through February 2010.

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● TTM P/E ratio = 21.7
● P/E10 ratio = 20.1

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Background
A standard way to investigate market valuation is to study the historic Price-to-Earnings (P/E) ratio using reported earnings for the trailing twelve months (TTM). Proponents of this approach ignore forward estimates because they are often based on wishful thinking, erroneous assumptions, and analyst bias.

The "price" part of the P/E calculation is available in real time on TV and the Internet. The "earnings" part, however, is more difficult to find. The authoritative source is the Standard & Poor's website, where the latest numbers are posted on the earnings page. Click on the Index Earnings link in the right hand column. Free registration is now required to access the data. Once you've downloaded the spreadsheet, see the data in column D.

The table here shows the TTM earnings based on "as reported" earnings and a combination of "as reported" earnings and Standard & Poor's estimates for "as reported" earnings for the next few quarters. The values for the months between are linear interpolations from the quarterly numbers.

The average P/E ratio since the 1870's has been about 15. But the disconnect between price and TTM earnings during much of 2009 was so extreme that the P/E ratio was in triple digits — as high as 122 — in the Spring of 2009. At the top of the Tech Bubble in 2000, the conventional P/E ratio was a mere 30. It peaked north of 47 two years after the market topped out.

As these examples illustrate, in times of critical importance, the conventional P/E ratio often lags the index to the point of being useless as a value indicator. "Why the lag?" you may wonder. "How can the P/E be at a record high after the price has fallen so far?" The explanation is simple. Earnings fell faster than price. In fact, the negative earnings of 2008 Q4 (-$23.25) is something that has never happened before in the history of the S&P 500.

The P/E10 Ratio
Legendary economist and value investor Benjamin Graham noticed the same bizarre P/E behavior during the Roaring Twenties and subsequent market crash. Graham collaborated with David Dodd to devise a more accurate way to calculate the market's value, which they discussed in their 1934 classic book, Security Analysis. They attributed the illogical P/E ratios to temporary and sometimes extreme fluctuations in the business cycle. Their solution was to divide the price by the 10-year average of earnings, which we'll call the P/E10. In recent years, Yale professor Robert Shiller, the author of Irrational Exuberance, has reintroduced the P/E10 to a wider audience of investors. As the accompanying chart illustrates, this ratio closely tracks the real (inflation-adjusted) price of the S&P Composite. The historic P/E10 average is 16.3.

The Current P/E10
After dropping to 13.4 in March 2009, the P/E10 rebounded above 20. The chart below gives us a historical context for these numbers. The ratio in this chart is doubly smoothed (10-year average of earnings and monthly averages of daily closing prices). Thus the fluctuations during the month aren't especially relevant (e.g., the difference between the monthly average and monthly close P/E10).

Of course, the historic P/E10 has never flat-lined on the average. On the contrary, over the long haul it swings dramatically between the over- and under-valued ranges. If we look at the major peaks and troughs in the P/E10, we see that the high during the Tech Bubble was the all-time high of 44 in December 1999. The 1929 high of 32 comes in at a distant second. The secular bottoms in 1921, 1932, 1942 and 1982 saw P/E10 ratios in the single digits.

Where does the current valuation put us?
For a more precise view of how today's P/E10 relates to the past, our chart includes horizontal bands to divide the monthly valuations into quintiles — five groups, each with 20% of the total. Ratios in the top 20% suggest a highly overvalued market, the bottom 20% a highly undervalued market. What can we learn from this analysis? Over the past several months, the decline from the all-time P/E10 high dramatically accelerated toward value territory, with the ratio dropping from the 1st to the upper 4th quintile in March. The price rebound since March has now put the ratio at the top of the 2nd quintile — quite expensive!

A more cautionary observation is that every time the P/E10 has fallen from the first to the fourth quintile, it has ultimately declined to the fifth quintile and bottomed in single digits. Based on the latest 10-year earnings average, to reach a P/E10 in the high single digits would require an S&P 500 price decline below 600. Of course, a happier alternative would be for corporate earnings to make a strong and prolonged surge. When might we see the P/E10 bottom? These secular declines have ranged in length from over 19 years to as few as three. The current decline is now nearing its tenth year.

Confirmation Bias

Confirmation bias is the psychological phenomenon by which the mind seeks information which supports an already previously held belief and shuns information that contradicts the belief. For those of you that were fans of "Hogan's Heros" this is the Sgt. Schultz equivalent of "I see nothing and I know nothing." Despite the various capers perpetrated by Colonel Hogan, Hogan was always able to convince Sgt. Schultz to see what Sgt Schultz wanted to see.

What works in the world of comedy, can spell trouble for investors. Tthe Psy-Fi blog has a wonderful new missive on the confirmation bias:

http://www.psyfitec.com/2010/01/confirmation-bias-investors-curse.html

For those of you interested in the link between the brain and the investment process, there is a treasure trove of information on this blog and I link to it on the right side of the main page.

For those "really" interested, within the blog post is a reference to a paper by Raymond Nickerson. It is very lengthy but well worth the time:

http://psy2.ucsd.edu/~mckenzie/nickersonConfirmationBias.pdf

2010 Forecasts

The Pragmatic Capitalist has aggregated the large institutional forecasts for 2010. Simply follow the links.

http://pragcap.com/the-ultimate-guide-to-2010-investment-predictions-and-outlooks