Happy Birthdays - Peter Bernstein - Our 5 Year Forecast

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Happy Birthday America

Each year we as citizens of the United States take a day to celebrate our Independence Day in honor of that day in 1776 when a few people gathered together to place a stamp of approval on the revolution taking place.  For most Americans, the 4^th of July is filled with memories of family, fireworks, barbeques, and a day off from work, even if that day is the day before or a couple days after the actual holiday.  My own 4^th of July memories are similar, but I also have another memory of an Independence Day that perhaps brought me a little closer to the fear and anticipation faced by those "revolutionaries" over 200 years ago. I was inducted in the United States Army on June 30^th thirty eight years ago, so I spent my first few days in the services of Uncle Sam on a holiday. You would think that given the struggle we were in at the time my military training would have begun immediately, but instead I was given four days of pay to do very little.  As a fiscal conservative I could surely point to the fact that our government has a long history of wasteful spending. Of course as a buck private, the cost to the tax payer was minimal. If I remember it was approximately $4.00 per day; however, in order to be honest, I would also have to include the cost of three meals a day, a place to sleep and of course the social security tax levied on my pay.  

For America, our road to independence had a pretty rough start.  But a little pamphlet, 48 pages in length, turned the tide and within seven months of its publication, the Declaration of Independence was issued.  This little pamphlet was written by Thomas Paine and simply titled Common Sense.   His words were not new to the elite of society, but they were written in the language of the common man, the future American.  Common Sense promoted the idea that "sovereignty belongs to the people."  

There are many that will tell you the American Dream of a better financial future for our children and grandchildren is at risk because of the current financial crisis.  Don't believe them.  America began with the belief that "sovereignty belongs to the people."  And we the people still have the ability to shape our own future.  This is still the right of all Americans, and even though times may be hard for many, this right has not been taken away.   I fully believe that the future is bright, that the American Dream is alive and well, and that our children and grandchildren will make their own future the American Way. 

We will share our expectations for you later in this letter but first we want to celebrate another birthday and remember the life of one of the more influential individuals in the financial industry.

Another Birthday

I received a note from the CFA Institute on June 14^th from John Rogers, CFA, the President and CEO of the CFA Institute that began with this message:  "The most recent administration of the CFA examinations on 6-7 June 2009 marked a historic time for our profession.  Aside from a record number of enrollments - 128,600 candidates from 154 countries - this month marks another historic occasion: the 50^th anniversary of the decision to create the CFA Program.  The genesis for this can be attributed to the vision of Benjamin Graham, whose contributions go beyond articulating the fundamental principles of modern security analysis".   

The CFA Institute's beginnings were born out of the stock market crash of 1929.  At that time individuals who dealt in the new profession of Financial Analysis were widely regarded with suspicion.  Suspicion is simply a nice way to say that the common man thought a financial analyst was nothing more than a common criminal and should be treated as such.  Yet Benjamin Graham took it upon himself to change the public's attitude.  He reasoned that the investing public needed to have confidence that an analyst met a minimum level of knowledge and had the competence needed to practice his trade.  In other words, security analysis was more than a trade; it should become a profession.  The CFA Institute has continuously worked towards this goal.  As Charter holder 18,345 I want to say a special Happy Birthday to the Institute and the work it has accomplished over the years. 

Peter Bernstein

On June 5^th, Peter Bernstein of New York City died of pneumonia.  He was 90 years old.  I am pretty sure that the majority of you have little reason to have known or heard of Mr. Bernstein.  Yet Mr. Bernstein has had a tremendous influence on your life through his work in financial services.  He was an economic consultant, economic historian and a prolific writer.  He published Economics & Portfolio Strategy twice monthly beginning in 1973.  In his book Capital Ideas: The Improbable Origins of Modern Wall Street, written during 1989-1991, he delivered the economic theories developed in the halls of academia and practiced in the back rooms of institutional investors in such an easily understood way that these theories are now the basis for the majority of financial advice advocated today.  If you are wondering what those theories are, I believe I will defer that to Mr. Bernstein: 

...Bill Sharpe once said that "Markowitz came along, and there was light." Before Harry Markowitz's 1952 essay on portfolio selection there was no genuine theory of portfolio construction---there were just rules of thumb and folklore.  It was Markowitz who first made risk the centerpiece of portfolio management by focusing on what investing is all about: investing is a bet on an unknown future.  Before Bill Sharpe's articulation of the Capital Asset Pricing Model in 1964, there was no genuine theory of asset pricing in which risk plays a pivotal role-there were just rules of thumb and folklore.  Before Franco Modigliani and Merton Miller's work in 1958, there was no genuine theory of corporate finance and no understanding of what "equilibrium" means in financial markets-there were just rules of thumb and folklore.  Before Eugene Fama set forth the principles of the Efficient Market Hypothesis in 1965, there was no theory to explain why the market is so hard to beat.  There was not even a recognition that such a possibility might exist.  Before Fischer Black, Myron Sholes, and Robert Merton confronted both the valuation and the essential nature of derivative securities in the early 1970s, there was no theory of option pricing-there were just rules of thumb and folklore.

                                                                                                     Capital Ideas Evolving

Peter Bernstein

An updated and revised 5-Year Forecast

Publishing a forecast is treacherous business.  It opens the door to criticism and sets the stage for possible failure, yet it is a necessary evil.  Our primary goal of forecasts is to form some educated guess as to the relative attractiveness or unattractiveness of the current level of the markets.  We are often asked why we give a 5 year forecast.  The time frame is somewhat arbitrary and could just as well be 3 years or 7 years or 10 years. However, we have chosen 5 years because we believe this is long enough to cover most economic cycles yet short enough so that each of us can "see" the end. 

As a reminder, our basic belief is that over longer periods of time, the price of a security or the total market value of all the securities in a market will accurately represent the underlying capital retained and available for earning future income to its owners.  If markets do indeed capture this retained growth, then your individual return as an owner of a business venture will be directly related to the price paid for the existing capital and the future earnings retained by the business or paid to you in the form of a dividend.  To put meaning to this statement I will give an example using Wal-Mart. Almost everyone knows this company and the story of Sam Walton. The business was created in 1962 with a single store.  In 1970, the company issued stock for the first time and raised $3,400,000.  If the market never recognized the value of capital growth over time, then Wal-Mart would only be valued for $3,400,000 instead of the $186 Billion that it is today. 

This is the basis for our projection of both the level of the market five years into the future as well as the expected returns.  As we tell you with all of our forecasts, beware taking this at face value.  Our methods are based on a statistical model which does not take into consideration human emotions, the primary driver of short-term market prices both at the market level and at the individual stock level.  In our January letter we shared with you the following table and expected returns with the S&P 500 at 903.25:

S&P 500 5-Year Estimated Earnings, Dividends and Projected Returns as of 12-31-08

BV = Book Value  P/B = Price to Book  P = Current Price  BVG = Book Value Growth

ROE = Return on Equity  EEPS = Est. Earnings Per Share EBV = Est. Book Value

Prj% = Projected return as %  Div = Dividend Yield

An investor's expected five year compounded return from 12-31-08:                 14.73%

S&P 500 Index level ending five years from 12-31-08:                                            1511.36

This is how we looked on June 29^th with the S&P 500 at 927.23:

S&P 500 5-Year Estimated Earnings, Dividends and Projected Returns as of 06-30-09

BV = Book Value  P/B = Price to Book  P = Current Price  BVG = Book Value Growth

ROE = Return on Equity  EEPS = Est. Earnings Per Share EBV = Est. Book Value

Prj% = Projected return as %  Div = Dividend Yield

An investor's expected five year compounded return from 06-30-09:                 12.72%

S&P 500 Index level ending five years from 06-30-09:                                             1456.79

I am sure you noticed the change in expected returns is a full 2% below our forecast shared with you just six months ago.  The biggest culprit for this differential is simply the Dividend Yield.  Dividends are not mandatory and so far this year we have seen records set both with the lowest number of companies increasing their dividend in the first six months of a year ever and we have seen the largest number of companies decreasing their dividend payment since 1957.  Dividends play an important part in the total return we as investors keep, thus a reduction of this payment compounded over the next five years will by default lower our future returns. 

Secondly, the price paid has increased without a corresponding increase in earnings or book value.  As we stated, returns at the individual level are directly related to the price paid.  Thus a higher price will reduce expected returns. 

However, all is not lost, as an expected return exceeding 12% has been relatively rare in the many years we have been making these calculations. Our January forecast would place fair value for the S&P at this juncture somewhere on either side of 941.  The S&P did reach that level in mid June before a small decline.  Going forward six months, our fair value for the S&P would be near 962, an achievable level excluding dividends.

What about emotions?

Judging emotions is even more treacherous than any statistical study.  Who can really say how we feel other than ourselves?  We will make an educated guess as to what we believe is driving investors' emotions in the short run.  

First and probably the most meaningful is short term price changes.  For whatever reason, people are far more reactive to major changes in short term prices than they are to business results.  If prices drop dramatically and quickly, fear takes over pushing prices lower to bargain levels. If prices rise rapidly, then emotions are on a high, as is the market, and it is an unfavorable time to buy.  The majority of the time prices fluctuate in a relatively mild way with a percent up or a percent down, which at least in our book indicates that rationality is more in control. 

Second, at all times investment alternatives have some emotional control over the level of common stock prices.  The most available alternative, and the most meaningful, is the level of interest rates we can earn on our funds.  This is an easy measure to check.  Simply review the yields on obligations of the U.S. Treasury.  Here are the rates on various maturities as of July 1, 2009:

U.S Treasury Yield Curve Rates July 1, 2009

Source: U.S. Treasury - Daily Treasury Yield Curve Rates 

Third, the current state of the U.S. economy will impact emotions.  There is no question that economic growth and/or contraction will have an impact on our investment results.  However, the price you pay will always be a more important determinant on your investment performance.  As an individual investor, bargains are available during economic turmoil or while our country is in a recession and expectations of recovery are dim.

Using these items as a guide, we will make a judgment as to the current state of emotions.  The fear of continuously falling prices has subsided since the March low, and the fear that we will miss the recovery in stock prices from the rebound has also subsided.  The result is that our primary determinate of the state of emotions has given us zero direction.  Interest rates are obviously low and this is a positive.  However, the state of our economy is dismal and probably will be for some time to come, and this is a negative. 

Some Final Notes and a Request

We have posted a number of new market commentaries on our web site as well as the radio programs that go hand in hand with these messages.  Our web address is www.andersongriggs.com.  We hope you will take the time to visit our site, because we believe you will enjoy the commentaries. 

As many of you know, the majority of our new clients have come to us through your referrals. Justin and I are honored that you take the time to mention us to your friends.  Thank you! 

Until next time, 

Kendall J. Anderson, CFA