Sunday, June 17, 2007

Excerpts From Barron's Interviews, Pt 2

These are the second set of interviews from the article linked to below.

Archie McCalister offers his assessment of the coming year:

I see 2½% inflation, 2½% GDP growth and profits up maybe 6% or 7% on the year. The S&P 500 trades for just under 17 times earnings. It is a stockpicker's market -- the kind of market I like. When they're selling everything, it's no fun, and when they're buying everything, you can't make a difference. I thought the market would be flat this year, and it is up incredibly. By year end, who knows?

At least you're honest.

If you take a longer-term view, stocks are not that expensive.

I think his assessment of economic growth and inflation is very possible by December. While housing will continue to really hit GDP growth for the remainder of the year, there are other areas of the economy that -- as Mario Gabelli said -- will provide ballast and keep the economy from sinking into a recession.

John Neff offers this overview:

I'm using $100 for S&P 500 earnings in 2008, which would mean a gain of about 8%, based on my '07 estimates. The market sells for 15.3 times my '08 number, which isn't outlandish, particularly relative to the alternatives. The bond market doesn't look attractive, and commercial real estate has had an awfully good move and in some cases looks overdone. The stock market looks OK until we have a recession. An 8% increase in earnings and a 2% dividend yield give you a total return of 10%. That's attractive. A couple of things bother me, though.

Such as?

One is the abundance, if not overabundance, of private-equity deals and leveraged buyouts. You're creating a great deal of debt among target companies, and inviting the possibility of some sort of accident, given that higher leverage. Also, I'm bothered by the outrageous investment fees charged by so-called hedge funds. Twenty percent of profits and 1% or 2% of assets in fees is outlandish in terms of a money manager's ability to succeed by enough of a margin to make a good return for the shareholder. It's just too much to give away. Some funds are going to have to take bigger risks, which could lead to bad headlines that disturb the confidence of the market, as "Wrong-Term" Capital Management did in the 1990s. Having said all that, the subprime-mortgage problem was bad, but didn't affect the market's confidence or performance. I'm still in the market, though I've taken something off the top since stocks moved up. The accounts I manage are 11% to 15% in cash. I can't find anything to buy. But stand by.

Neff is an old hand at investment management. One of the Money Mangers books profiled him back in the late 1980s or early 1990s.

Neff is in agreement with many managers in stating the market isn't cheap but not expensive.

I found his observations about hedge funds very astute and interesting. What he's saying is fund managers are charging fees that are so high they will either prevent solid performance or force managers to take on disproportionate risks to the portfolio. For example, a manager may place too large a bet on a single company or asset class and have the trade backfire, causing tremendous losses for the entire portfolio. Classic investment management says to not put all of your eggs in one basket -- in essence, to diversify.

Marc Faber offers a very sanguine assessment of the overall situation:

Faber: The economies of the rest of the world have been very strong in the first five months of 2007, whereas U.S. consumption has slowed. If GDP and the rate of inflation were measured properly, we would see the U.S. already has reached the no-growth stage, but with some inflation -- in other words, stagflation. The housing downturn has hurt consumers, and retail sales have been disappointing. If nominal GDP is 6% and inflation is 2%, you get 4% real growth. But if inflation is 5%, you get only 1% growth. In other ways, too, the world has a dual economy. A lot of money flows into the pockets of affluent people, as evidenced by the continued rise of London property prices, art prices at auctions, fine wines and so forth. The economy of the middle class and the workers is not doing particularly well.

What does this mean for the stock markets of the world?

The U.S. stock market, like all other asset markets, is in cuckoo land. We have bubbles everywhere, which hasn't happened before. The 19th century saw occasional bubbles in canals and railroads. Share prices entered a bubble in 1929; gold, silver and oil in 1980, and Japan and Taiwan in 1989. In 2000 there was a huge bubble in one sector: TMT, or technology, media and telecommunications. This time around, since 2002, everything has gone up: home prices, real estate and art prices, stock prices, commodity prices and even, until recently, bonds.

We are going to see a gradual narrowing of the bubbles, or perhaps they will all break at the same time. The Dow Jones industrials and the S&P 500 are in an incredible bubble phase. For foreign investors, the rise in the S&P mostly has been offset by weakness in the dollar, so U.S. assets aren't terribly expensive relative to other assets. Sure, the market sells for only 15-16 times forecast earnings. But if you take out the gains in energy and financial-sector earnings, the market is selling above 20 times earnings. Given that you can buy a two-year Treasury note yielding 5%, that is not an attractive valuation. I would rather be a seller of the stocks around the world than a buyer here.

Faber is one of the few money managers who notices or mentions issues of social equity. There has been a fair amount of press about income stratification in the US, and all of the signs are it has increased for the duration of this expansion.

Abbey Joseph Cohen offers this assessment:

When we revised our estimate of operating earnings to $93 from $92, we also adjusted our year-end S&P price target modestly, to 1600 from 1550. First-quarter earnings came in stronger than we had expected, which gave us a higher baseline. More important, 2008 looks to be another year in which inflation is under control and economic growth continues. Toward the end of 2007, investors should be willing to pay for '08 results. That was our main motivation for 1600; the comparable number on the Dow Jones Industrial Average is 14,000. If our numbers are right, total returns this year, including dividends, will be about 15%.

You're more optimistic than most.

Our forecast is a reflection of several things. The market began the year at attractive valuation levels, whether you look at multiples of earnings or sales, or comparable metrics. This is not a market that looks overdone. Our valuations are based on dividend-discount and discounted-cash-flow models. We use eight different mathematical assumptions that we think are reasonable. We are not reaching for the stars, and in some cases we try to be overly conservative. For example, even though intermediate and long-term interest rates have gone up in the past few weeks, they are still below the numbers built into our models. Also, we plug in earnings-growth estimates that are well below historical trends.

Many people who were concerned about 2007 pointed out properly that earnings growth would be slowing. Therefore, they couldn't see how stocks would go much higher. Our position has been different; we thought this might be a long-lasting economic expansion, in which case you could have a period of moderate growth and share prices still could rise. Historically inventory corrections bring U.S. economic cycles to an end, but inventories are under control. The expansion of the late 1990s was brought to an end through too much enthusiasm for business investment. That is not happening now. Globally, most established economies are experiencing moderate growth, and core inflation doesn't seem to be rising rapidly.

Like others (including myself) she does not see the market as overvalued. In addition, she points out that earnings growth in the first quarter was stronger than expected. This means that forward looking estimates are now based on a higher earnings number going forward. This is where the increase in earnings is coming from.