The Summer Swoon: A Dearth of Value

By: John Mauldin | Sat, May 15, 2004
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I returned very early this morning from the Las Vegas Money Show, where all flights to Dallas were cancelled last night due to the odd tornado or two in the area. I went back to the hotel, had a dinner with friends, went to the room and began to research the hot questions on the minds of many of the 10,000 attendees at the conference: Where is the market going and are we in the beginnings of a bear market? Downloading a ton of recent research into my computer, I took the time in the airport and on the plane to try and give you an updated answer to what I wrote on February 6 in this space:

"As I wrote last month, the markets could continue to move sideways to up, but I think we could see this year as a classic "Sell in May and go away" year. I would have fairy close stops on any trading accounts." (Thoughts from the Frontline, Feb. 6)

Three weeks later in the February 27 letter, I followed that up with:

"I have written in past weeks that this may be a classic "sell in May and go away" year. After a few questions from readers, I should note that I do not think the market will not start to go down before May. It very well could. I am not picking a date (May 1). If May 1 is the top, it would be a pure coincidence. I am simply suggesting that the bull run is getting aged, market valuations seem high and a summer swoon, especially if there is any economic weakness, could be significant."

Over the past few weeks, I have had a number of writers and traders for whom I have a great respect turn either outright bearish or show significant concerns. As I read on my laptop on the plane, I saw what I perceived as a pattern. We are going to look at some high-lighted quotes, and then I will tell you why I think it adds up to a significant summer swoon.

We Shall Sell Strength Short

Dennis Gartman (The Gartman Letter) tracks a universe of 10 stock markets worldwide, creating his own Gartman International Index. After having been bullish for quite some time over the last year, and more neutral for the most recent months, today he is openly advising his clients to take a bearish bias:

"SHARE PRICES CONTINUE TO WEAKEN as the TGL International Index has fallen another .3% in the past twenty four hours. From the Index high at just under 5,900 earlier this year it is now down nearly 8.5%, and like so many other major indices, it is now below its 200 day moving average. We are convinced that a global bear market in equities is now upon us, and we are quite concerned about the broad reaching implications of that fact. Certainly it shall dictate that manner in which we trade, for we shall sell strength short; we shall buy weakness only to cover short positions and we shall act in that fashion until further notice. We trust that is clear enough."

Art Cashin (from UBS and of CNBC fame) notes in his letter this morning: "[Mutual] Funds inflows were actually fund outflows for the second week in a row. Some say the figures should be viewed as a contrary indicator, but the tape runs on money. Like Audrey, the plant in 'Little Shop of Horrors' the market's appetite is insatiable. No new money means no general rise in prices. Let's hope it's an anomaly."

James Montier, head of Global Equity Strategy for Dresdner Kleinwort Wasserstein wrote last week:

"Having been a thorn in my side over most of the last 12 months, our US tactical asset allocation (TAA) model has finally switched to an unfavorable valuation and negative momentum market condition. Both equity and bond market momentum have taken a marked turn for the worse over the last month. This stalling out of equity momentum is particularly important if the US equity market is experiencing a near rational bubble, as we have consistently argued over the last five months. Fading momentum alone could easily catalyze a sharp downturn in the market, as cynical investors make a dash for the door."

The Big Ouch: Rising Rates and Slowing Earnings Growth

Richard Bernstein is the Chief US Strategist for Merrill Lynch. Writing this week, he notes the confluence of two factors which are not beneficial to stock market growth. Let's read this summary and hold the thought, as we will come back to this after we have looked at a few other pieces of information.

"As we have pointed out many times, the profits cycle is likely to decelerate in 2004. The huge cyclical swing in 2003's earnings (which we admittedly grossly underestimated) is not likely to be repeated in 2004... Earnings growth itself will remain healthy (i.e., about 15-20% growth for 2004), but the growth rate will be slowing. Our work has consistently shown that the change in the S&P 500 earnings growth rate determines such things as sector, style, and quality rotation.

"Regardless of how strong the absolute level of growth might be, decelerating earnings strongly favors a rotation toward less cyclical and higher quality stocks. Historically, market performance tended to favor higher quality stocks if the Fed raised rates OR when the profits cycle slowed. It now looks as if we will be faced with both at the same time. History suggests that this might be even a better combination for the performance of higher quality stocks and more defensive sectors.

"The combination of the Fed raising rates and the profits cycle slowing is a rare one indeed. [Let's look at] the relationship between the profits cycle (measured as the year-to-year percent change in S&P 500 earnings on a trailing four-quarter basis) and the year-to-year basis point change in the Fed Funds rate. As we have previously pointed out, there was about an 85% correlation between these two series until the last year or so. The high correlation between Fed Funds and the profits cycle worked as a 'buffer' for equity investors. Although rising short-term interest rates were generally negative for stocks, that negative effect was buffered somewhat by accelerating earnings. Conversely, slowing earnings growth is generally negative for stocks, but that negative effect was buffered somewhat by lower short-term interest rates.

"Thus, if the Fed were to indeed raise rates later this year at the same time the profits cycle decelerated, then that historical "buffered" relationship would be broken. We would be faced with the odd combination of rising interest rates AND slowing profits growth.

"In fact, this odd combination is quite rare ... the combination of rising Fed Funds and slowing profits growth has occurred only about 5% of the time during Alan Greenspan's tenure. Although the stock market rose concurrently with this combination, ultimately problems resulted. The 1989/90 recession, the various 1998 financial crises, and the bubble deflation all occurred subsequent to the combination of positive year-to-year changes in Fed Funds and slowing profits growth."

I have found a new (to me) source of very bright analysis in ECR Research, based in Amsterdam. They are well known in Europe, and my bet is they will soon establish a solid (and deserved) reputation in the US as well. They have been gracious enough to send me several of their weekly reports, and I find them a must read. I am going to quote from the summary of one of their recent reports on the Global Financial Markets (

"After several years of massive monetary stimulation, it seems that the Fed will succeed - with the help of substantial tax cuts - in achieving its primary objective, namely to prevent deflation taking hold.

"In the process it has had to create substantial bubbles in the financial markets, however. And precisely because economic growth and the labour market are improving and because this is convincing the markets that the recovery will be sustained, there is a growing risk that these bubbles will burst.

"This because the surging US economy requires more capital, and this will now probably be pulled out of the financial markets. Moreover, because of the stronger growth and rising inflation, investors and analysts have started to take into account that the Fed will gradually turn off the monetary drip feed to which the whole economic and financial system has been attached.

"In other words, it seems that a considerable tightening of monetary conditions will take place via the financial markets over the coming months. In this respect the combination of movements in bond yields, share prices and the dollar's exchange rate is more important than the movement of short-term interest rate changes.

"The Fed now finds itself in a very awkward situation in our view. We expect US economic growth to remain strong over the coming months. If this fuels expectations that the central bank will raise the fed funds rate, then bond yields will rise sharply. But if the Fed does nothing and the bond market gains the impression that the central bank is running too far 'behind the curve', then bond yields will rise even more.

"Rising bond yields in turn will cause serious problems for already overvalued share prices in our view. In short, there is a serious risk that the bubbles in US bond and equity markets will burst. This, in combination with a stronger dollar, higher oil prices, modest pay increases as well as waning fiscal impulses, should push economic growth below 'potential' again towards the end of this year.

"We expect the Fed to make one or two 0.25% hikes in interest rates this summer, and then expect it to leave rates unchanged for a long time and thus to stick with a very loose monetary policy in order to eliminate the deflation danger. For that it will have to accept rising inflation in the future, however."

What I believe ECR means by a "considerable tightening of monetary conditions will take place via the financial markets" is that falling equity prices acts somewhat like a fall in the money supply. As well, if the markets raise bond interest rates and thus "tighten," housing and consumers will react in the same way as if the Fed was tightening. Thus, the markets will act to slow the economy.

I could add perhaps a half-dozen other writers. While they might find different reasons to be bearish (rising interest rates will stress profits or housing prices or consumer spending), the theme is the same: there is reason to be concerned about the market.

The Summer Swoon: A Dearth of Value

Let's remember a basic principal of stock market investing: when momentum investing starts to fail, value investing rules. But where to find value?

Two weeks ago, at my conference, I was on the stage with the usually bullish Martin Barnes of the Bank Credit Analyst (as well as the bearish Richard Russell and the ebullient George Gilder). I was expressing pessimism about the state of the market and pressing Martin a little, as he does not see a reason for the markets to go down. He turned to me and said (in that wonderful Scottish brogue), "Now, don't get me wrong, John. I look around and I can't find any value."

Although this week, they write, (to give you a bullish view!): "Technically the market is at a critical juncture, with the main indexes close to their 40-week moving average (roughly 1080 for the S&P 500 index), which should provide support. Some measures show that a full-blown correction has already occurred even though the S&P 500 is not far below its peak: the number of NYSE stocks at new 52-week lows has soared because interest rate-sensitive and market-sensitive shares have been hit hard. Similar high readings have occurred at important market lows, as they marked periods of maximum pessimism. Our U.S. Investment Strategy service's Intermediate Indicator is near a trough, which also suggests that a rally may soon develop. The key is for interest rate fears to calm and for oil prices to correct. Stay tuned."

I note, looking at their chart that "similar high readings" also developed late in 1999. I think we are nowhere near maximum pessimism. We are also nowhere near anything which looks like value, at least for the broad markets. We are going to turn to a report sent this week by James Montier (noted above) on the lack of value in the S&P 500.

"The Graham and Dodd PE for the S&P500 is currently around 29x, against a long-term average of 18x. The Hussman PE paints a similar picture, currently 20.5x against a long term average of 12x! Our bottom-up check on these top-down conclusions is provided by a 'deep' value screen created by the 'Dean of Wall Street' and value guru, Ben Graham. Comparing the number of firms passing the various criteria with past results shows that value has almost been completely mined out within the S&P500. For instance, when we first ran the screen in October 2002, we found 12 stocks within the S&P500 trading at prices less than 2/3rds of net current asset value. Today, we find just 2 such stocks! The screen also reveals that there has been very little in the way of balance sheet improvement since October 2002. Yet, spreads on corporate bonds remain exceptionally tight. This looks unsustainable to us. Given that momentum (the foundation of a near rational bubble) appears to have stalled out, the absence of valuation support will increasingly become a binding constraint on the equity market."

Interestingly, if you invested in those 12 stocks in October of 2002, your return to date would have been 291% versus 26% on the S&P 500, a difference of 11 times. In my book, Bull's Eye Investing, I show you seven or eight different ways to approach value investing, including methodology you could use even in this over-valued market. But as Montier points out, you won't find it in the S&P 500!

In October 2002, 9% of the S&P500 had earnings yields greater than twice the AAA bond yield. Now you can only find 2% of firms in such a position!

Ben Graham is the man who literally wrote the book on value investing. I refer to him quite frequently in my book. Upon hindsight, I should have included the following summary of Graham's definition of value, which Montier noted.

"Shortly before his death in the 1970s, Graham was working on a set of criteria for defining value. This list (supplemented by three of Rea's own requirements) was published by Rea [James Rea] in 1977 (in the Journal of Portfolio Management). In order to qualify as a value opportunity the following criteria must be met:-

1. A trailing earnings yield greater than twice the AAA bond yield.
2. A PE ratio of less than 40% of the peak PE ratio based on five years moving average earnings.
3. A dividend yield at least equal to two thirds of the AAA bond yield.
4. A price of less than two thirds of tangible book value.
5. A price of less than two thirds of net current assets.
6. Total debt less than tangible book value.
7. A current ratio greater than two.
8. Total debt less than (or equal to) twice net current assets.
9. Compound earnings growth of at least seven percent over ten years.
10. Two or fewer annual earnings declines of five percent or more in the last ten years.

"Graham and Rea stressed that criteria 1, 3, 5 and 6 were the most important. Sadly, at present no stocks in the S&P500 manage to simultaneously pass tests 1, 3, 5 and 6. The first five criteria are really concerned with the price you pay for a stock. The last five requirements are all about controlling the risk that the stock is cheap for a reason. Now, admittedly this is an 'extreme' deep value screen. But if it was good enough for Ben Graham, then it is certainly good enough for us."

Now, let's return to my earlier assertion: when momentum investing starts to fail, value investing will start to rule. But if there is no value in the S&P 500, except by VERY loose definitions, then where do we turn? Further, it is not just Bernstein who has noted the correlation between slowing earnings growth and a stalled or falling market. David Dreman, among others, has done work in this area.

The mechanism in the various pieces of research seems to suggest that investors project current earnings growth well into the future. When they get "surprised" by slower growth, even if that growth is good, they react by selling, and a bear market ensues. (The opposite happens as well. Earnings surprises on then upside create price increases.)

Let me quote from my book before I summarize with my own take on the markets:

"In later chapters, we will look at some special types of funds that are good ways in which to invest in the stock market. But now, let's look at a few rules of how to directly invest in stocks in a secular bear market.

"First, when I showed you that we are in a long term secular bear market cycle, I used broad market averages which are basically comprised of large companies. In this cycle, we will see the price to earnings ratio (the value) of these index averages slowly come down.

"The two key words here are value and average. If the average P/E is 15, then it means that there are a lot of stocks with P/E ratios of 20 and others with averages of 10. As the index averages come down over time, there are going to be stocks that begin to have low P/E ratios for one reason or another. When the index average P/E is 12, that means there will be stocks with P/E ratios of 5, 6 and 7! There will be real value in our future!

"Many investment advisors and fund managers want you to invest 100% of the time in the stock market. They tell you to buy an index or broad based mutual fund (preferably theirs). You "diversify" by investing in niche stock funds. If you stay the course long enough you will succeed. In a secular bear market, as I have clearly demonstrated, that is a losing proposition.

"Instead of investing in the stock market (broadly defined), Bullseye Investing tells you to invest in particular stocks and strategies. Don't think of equities as a stock market, but rather as a market of stocks. An easy to understand analogy is an Italian restaurant in New York with over 100 items on its menu. You don't order the "Italian menu" and take something of everything. You order specific items that work for your preferences and whatever diet you are currently on.

"Second, by defining a secular bear market in terms of value rather than price, it allows us to begin to re-enter the market as value presents itself. Thus, even as we can believe that the broad stock market has more room to go on the downside, we can still find ways to put money to work in certain stocks that have already fallen to a point where there is now real value.

"Third, there are two basic ways to approach value stock investing. You can buy stocks to generate income or buy stocks which have the potential for growth, or you can hunt for stocks that offer both. No new concepts here, but the way we will define income and growth potential will be somewhat different."

The Summer Swoon

I believe we have further to go in the current market drop this summer. AS momentum fails, I would not be at all surprised to see the Dow below 9,000. However, I also think (and fervently hope) that we will not see the lows of 2002. I expect the market to recover, although not to the recent highs. This is a secular bear, and "lower highs" would fit the trend.

The next real, gut-wrenching, stomach acid producing, nerve wracking bear market will anticipate the next recession and continue well into it. I do not see that recession on the horizon, so we could see a sideways trading pattern (and thus trading opportunities) for the stock market for quite some time. While I agree with ECR we will see a slowing of the economy to growing below potential, it will still be growth. Since the Fed feels "potential" is around 4%, it could still be solid growth, although we will see the job market begin to slow in concert. Rising inflation will not help, although today's numbers may serve to calm nerves until the next large jump. Inflation is in our future.

Bull's Eye Update

I note with some satisfaction that my book, Bull's Eye Investing, is #10 on the New York Times Business Best seller list. All the Barnes and Noble stores are stocked and your local bookstore should have it as well. Or you can order from

It was good to spend some time with a lot of old friends in Las Vegas at the Money Show. Bill Bonner and Addison Wiggin (of the Daily Reckoning), Chuck Butler of Everbank, Porter Stansberry and a host of others. It was especially nice to have Howard Ruff come by. He looks well. He has a new book, "Safely Prosperous or Really Rich," which I will review at length in a few weeks, but I highly recommend it.

It has been an exhausting week, and I am glad to be able to hit the send button and go home to my bride. Enjoy your weekend. I fully intend to.

Your ready to relax analyst,


John Mauldin

Author: John Mauldin

John Mauldin

John Mauldin

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