Where Are We?

By Matt Malick and Ben Atwater

There has been an increase in web chatter, television series, movies, books and news reports about various cosmic disaster scenarios including asteroids, solar flares and black holes. David Morrison, the senior scientist at NASA’s Ames Research Center in California and a Harvard PhD in astronomy, recently asked, “Why is our society so focused on potential disasters?”

Dr. Morrison’s question is applicable to not just astronomy, but also the pervasive negativity around virtually everything from politics to economics.

And it is no wonder. Using the U.S. stock market as a barometer of mood, it is at the same depressingly stagnant level as it was a year ago (spring 2011) . . . and fourteen years ago (summer 1998).

Not just that, but during the decade of the 2000s, investors experienced not one, but two drops of about 50% in the U.S. stock market. And after making major progress in 2009, the market has struggled with 20% declines beginning in the springs of 2010 and 2011. Although it rebounded convincingly each time, we are now mired in yet another slump.

After all this, you might assume that nobody would invest in stocks. This is partially correct. Beginning in 2007 and accelerating to this minute, investors have moved over $1.4 trillion from stock funds to bond funds.

Outside of mutual funds, institutional investors are also fleeing equities. Take the massive German insurer Allianz as a prime example. Today its portfolio is 6% stocks, whereas ten years ago it was 20% equities. Given the legal constraints that insurance companies must follow within their portfolios, 20% was a highly aggressive stock position, likely pushing regulatory limits. So at the worst possible time, Allianz had its maximum equity exposure. Now, a decade later, its stock exposure is muted.

This is also true of pension funds, many of which are substantially underfunded. A decade ago, U.S. public pension pools allocated about 70% of their assets to equities, now they have scaled that back to 54%. Not knowing the future, but with an eye toward the past, this is seemingly backward.

To paraphrase Warren Buffett, people tend to invest through the rearview mirror, which he reckons is about as advisable as driving in the same manner.

Chris Puplava, who operates the blog Financial Sense and is a Portfolio Manager with PFS Group in San Diego, CA, elaborates on Buffett’s sentiments:

“What investors must remember is that secular bull market tops are formed at a time when everything couldn’t be better or life brighter. This was the backdrop of the 1929 secular bull market top in which the U.S. industrial giant was firing on all cylinders; or the 1969 secular bull market top in which nothing seemed impossible as the U.S. put the first man on the moon; or the 2000 secular bull market top when we entered a supposed new era of technology and permanent growth. Conversely, when things look like they couldn’t get any worse and that the whole world is going to end, new secular bull markets begin to form.

Right now seems to - once again - fit the description of ultimate pessimism. According to Barron’s, “the 10-year trailing annualized return (excluding dividends) has risen from below zero to a bit over 2%,” a depressing statistic in and of itself. But, what does that potentially tell us about the future?

Barron’s further reports that, “if the S&P 500 is at today’s level on October 9, the tenth anniversary of the 2002 bear-market low, the ten-year trailing return would be 5.5%. That’s similar to post-bear periods in the late ‘40s and late ‘70s – decent times to lay patient bets on equities, but not the start of bull-market manias.” The point Barron’s makes is well illustrated in the below chart from Blackhorse Analytics.


 
Reversion to the mean would indicate that returns will trend substantially higher over the next decade.  But we are hardly suggesting smooth sailing. Instead, we believe that the market will eventually reward patience. You cannot predict the exact day when stocks will begin their next prolonged boom – it is impossible. But you can though invest while the seas are still rough, knowing that if history is any guide, clear skies will return.

So, where are we?

We do not pretend to know what will happen next week, next month or even next year. However, from a long-term perspective, we are likely closer to the end of the market’s doldrums than we are to its beginning.

Thank You Dr. Thaler!

 Economic View

Slippery-Slope Logic, Applied to Health Care

By RICHARD H. THALER

Published: May 12, 2012

The court debate over the new health care law offers yet another example of worrying about imaginary risks.

http://www.nytimes.com/2012/05/13/business/economy/slippery-slope-logic-vs-health-care-law-economic-view.html?smid=pl-share

Interest in Dividends

by Matt Malick

“Do you know the only thing that gives me pleasure?  It's to see my dividends coming in.” - John D. Rockefeller

In the world of investments, everything is cyclical.  Hot trends inevitably cool off and passé ideas return to popularity.  Today, stock dividends have become the latest investment theme to regain favor.

As the last secular bull market was surging in the late 1990s, dividends became a mere afterthought and many analysts even condemned them.  Equities were easily achieving double-digit total returns year after year, making dividends seem relatively insignificant.  Furthermore, many market professionals suggested that corporations were better served using cash to fund acquisitions and other growth opportunities, a sign of rampant optimism.  The logic was that companies had superior internal investment opportunities and to return money to shareholders in the form of a cash dividend was actually a waste.  It was the era of the celebrity CEO who could make no bad decisions.

The next twelve years, however, were an entirely different story.  Equities entered a “lost decade” of relatively flat returns with the S&P 500 at roughly the same level where it peaked in 2000.  And instead of the public considering CEOs to be celebrated allocators of capital, they have gradually become bemoaned fat cats.

Ironically, since 2000, a point in time when dividends were largely ignored, virtually the only return that buy-and-hold equity investors reaped were from dividends.  This “reversion to the mean” phenomenon is not unusual, but always unexpected.

Today, dividends are experiencing renewed appeal throughout the investment community.  In aggregate, U.S. equity mutual funds suffered $103 billion in redemptions in the 12 months ended January 31, 2012, according to Morningstar.  But, nervous investors did not shun dividend stocks.  Just last year, mutual funds that focus on dividends attracted $3 billion in inflows and dividend-themed exchange traded funds took in another $14.3 billion.  There is often an inverse relationship between mutual fund flows and future performance – positive flows can predict underperformance, while negative flows can suggest outperformance.

Investment companies have identified the opportunity to appeal to yield-starved investors, launching 16 brand new dividend-oriented funds in 2011.  Even the Fidelity Equity Income Fund II, which appointed a new manager and increased its exposure to dividend-paying stocks, changed its name to the Fidelity Equity Dividend Income Fund.

Perhaps an interesting sign of the general hunger for dividends is the March 2012 cover of Investment Advisor magazine with its headline, “Dividends, Dividends, Dividends!”.  The assumption among the punditry is that - given below-trend economic growth and, at the same time, strong corporate balance sheets - future returns favor companies that return cash to shareholders.

Despite general enthusiasm, sometimes a contradictory sign, there is actually very sound logic behind dividend stocks.  According to Morningstar, “Since 1927, high-dividend-paying stocks have returned 11% per year, beating the 8% return from nonpayers and resulting in an ending wealth that is 8 times larger.  Better yet, they accomplished this feat while incurring less volatility.”

Furthermore, Ned Davis Research finds that between 1972 and 2005, S&P 500 stocks that had consistently grown their dividends outperformed the nonpayers by 6%.  And presently, the dividend payout ratio (the amount that a corporation distributes in dividends relative to its earnings) is at a historic low of 32 percent.  In the past, the average payout ratio has been over 50 percent.  This statistic implies that companies have plenty of room to raise their dividends in the years ahead.

Moreover, the tax rate on qualified dividend income – currently 15% for most taxpayers – is at an all-time low.

Finally, bond yields have become so paltry that dividends are an increasingly important source of income.  As of today, the yield on the ten-year Treasury stands at 1.97% whereas the dividend yield on the S&P 500 is 1.93% and offers the potential for price appreciation.

Yet, after turning in stellar performance relative to other equities in 2011, dividend stocks have not fared as well through the first two months of 2012.  According to Bespoke Investment Group, the  stocks in the S&P 500 that pay no dividend have outperformed the 50 stocks in the index with the highest dividends by a whopping 12.03%.

In our opinion, dividend-paying stocks serve an important role in a diversified portfolio.  In fact, our managed equity portfolio has a considerably higher average yield than the overall market.  But dividends are not a cure-all for apprehensive investors.  The consensus seems to be that dividend stocks are sure to hold their value, continue paying healthy yields and offer potential capital gains.

We urge caution that dividend-payers are still equities and carry the risk of loss.  And stock dividends are not guaranteed – just ask shareholders in most financial companies during the crisis years of 2007-2009.

Of equal importance, if the market performs well over the next several years, which is our expectation, investors will eventually take notice and start chasing returns.  Dividend stocks could easily trail the overall market if sentiment improves.  This is an important reason to hold a mix of equities in different businesses and with varying market capitalizations, geographic footprints and dividend levels.

The bull market that began in March of 2009 is now the ninth longest bull market since 1928, but the retail investor has still not returned.  For now, dividend paying stocks are the investor’s training wheels to get back into the market.  But if stocks have a big year of gains, greed can take over and folks may think they are riding in the Tour de France and toss the training wheels.

Does It Matter?

It seems like we are obsessed, more than ever, with the idea that redistribution to provide a safety net for the less fortunate in society always generates costs greater than benefits.  When was the last time you heard a story or read an article about someone down on their luck who reluctantly applied to the "system" for help, received that help temporarily, got back on their feet, and left the system?  I cannot recall one.  However, I've heard stories from friends, relatives, and students of the "friend-of-a-friend" who is scamming the system, purposefully doing everything they can to remain on government assistance.  As a result, many are absolutely convinced that these government programs are a waste of money and should be eliminated. 

Why does everything seem to come down to this all-or-nothing option?  Are we incapable of reasoned analysis?  Of compromises that generate net benefits for society?  Or does the mere attempt to use reasoned analysis signal, to a seemingly growing number, of an effort by the intellectual elite to take one step closer to the socialistic revolution of our economic system?

In the article, "Moral Hazard: A Tempest-Tossed Idea," by Shaila Dewan in the NYT on 2/26, Dewan explains how the concept of moral hazard is now used to argue against any form of government assistance.  Most "safety net" programs that redistribute create incentives to engage in behaviors that result in added costs to society, moral hazard.  These costs should be minimized with well designed policy, but they can never be eliminated unless you eliminate the safety net.  Eliminating the safety net will cause even larger social and economic costs than providing a program where some individuals take advantage of others (as the article points out, the costs of moral hazard are likely to be overstated). 

So, does it matter? Does it matter if a social safety net (government redistribution) will cause moral hazard?  Or does it matter that we use reasoned analysis to offer help to the less fortunate and thus compromise on policy that generates greater net benefits for all of society?

Your share of the national debt = $135,000!

Tom Smith is running for Senate in PA.  I saw his commercial on TV this morning.  In the commercial, he states that each person's share of the national debt is $135,000 without any mention as to how he came up with that number.  I had never heard that number used before, so I went looking for the explanation.  I think I found it and wrote the following on Tom Smith's Facebook page regarding the statistic.  http://www.facebook.com/TomSmithForSenate

Mr. Smith,
First of all, thank you for your willingness to serve the public. I saw your TV spot today and viewed it again online. I also took a look at your position on the issues and agree with you in regard to term limits. I also agree that our national debt is a concern; however, I disagree with the way you state the problem in your commercial. I understand that the point of your commercial is to grab people’s attention but you don’t want to misrepresent the facts, right? If you misrepresent the facts and are called out to explain, some might wonder if you purposefully exaggerated the facts for political advantage or if you don’t understand these important issues which call into question your credentials for the job.

You state in the commercial that “everyone’s share” of the national debt is $135,000 but you don’t say who you consider everyone. Everyone would make most people think citizens. If your calculation represented citizens, then each citizen’s share of the national debt is around $49,120. The national debt = $15,355,198,335,393.66 (2/13/2012 – treasury.gov) and the estimated population of the US. = 312,602,730 (12/1/2011 – census.gov). Did you know that the average US citizen has a little over $50,000 of personal debt (mortgage+loans+credit cards) so combined, total debt obligations for each citizen are significantly lower than your number.

I’m assuming your number comes from taking the national debt and dividing it by the number of “individual” taxpayers who paid income tax? Therefore, you’re saying that only taxpaying Americans are unfortunate enough to be on the hook for the entire national debt. Really, is that true or does $135,000 sound a lot worse than $49,000?

Don’t you propose to significantly cut spending to reduce the debt? You would have to if you plan to lower taxes too. Maybe cut a little from Medicare, education, national defense, environmental protection, etc… don’t these policy decisions have the potential to negatively affect all citizens? Don’t all citizens share in the cost of the national debt? Kids don’t pay taxes so they’re not on the hook for the national debt? The poor? I guess you’re also planning to eliminate corporate taxes because your number cannot include corporations who pay taxes.

Again, I don’t disagree with you about the national debt being a growing problem and that decisions to reduce the debt will be difficult, $49,000 is still a lot of money. What I disagree with and find unacceptable of politicians, even politicians who claim "not" to be politicians like you, is their inability to explain the facts to the voters and their reliance on “the party’s” spin to exaggerate the issue for political advantage. You claim to be better than that.