Saturday, October 18, 2008

Let’s Talk Turkey

From the Desk of Joe Rollins

I have never before seen U.S. stocks as cheap as they are today. This may be the greatest buying opportunity in our lifetime! I marvel at how far U.S. stocks have fallen, and now is the time for us to take advantage of these low prices.

I have never seen opportunities to purchase stocks so inexpensively with such incredibly high amounts of cash sitting on the sidelines. Interest rates on money market accounts are now paying somewhere in the 2% range, but you can buy the stocks of some of the titans of American industry with yields that are two to three times the amount that you would earn on cash. Furthermore, these dividend yields come with a favorable tax rate that is one-third that of the income tax on cash.

I feel like the proverbial fox in the henhouse when reviewing these stock buying opportunities. Just look at the following list of stocks that could be purchased on Friday morning and their dividends yields:

General Electric Company6.4%9.8
Merck & Company, Inc.5.7%12.4
Altria (Phlip Morris USA)7.1%4.9
Chevron Corporation4.3%6.7
United States Steel Corporation3.1%4.0
Exxon Mobil Corporation2.6%8.6
Johnson & Johnson3.0%14.0
AT&T, Inc.6.5%11.9

When you invest in cash, you will earn the stated rate of return. However, I think it’s almost a given that the interest rate earned on money market accounts is falling and will soon be in the 1% range. On the other hand, if you invest in the companies above, you not only get paid a significantly higher rate of return, you also receive the potential for the companies to appreciate through the years. In other words, you would be buying stocks of some of the greatest U.S. companies at bargain basement prices and with a dividend yield far in excess of anything you could earn on cash.

Do you know who else thinks that right now is a great opportunity for buying equities? Warren Buffett, who wrote a convincing Op-Ed in Friday’s edition of The New York Times. Click here to read Buffett’s "Buy American. I am." editorial column.

Warren Buffett is probably the most legendary investor of our lifetime, and he is actively buying American stocks in his personal account today. Buffett explains his thought process on why he’s so keen on United States equities right now: “A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful.” No other explanation is needed. With the extraordinary volatility in investing today, no one could argue that fear is quite widespread. Now is the time to buy!

Buffett also explains that, “Today people who hold cash equivalents feel comfortable. They shouldn’t. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value.” You don’t need a higher endorsement to purchase stocks than one from the greatest investor in our lifetime.

I continue to be somewhat confused as exactly why there is such a high fear level surrounding the financial world today. Stocks prices have fallen dramatically, but that is part of investing – stocks go up and stocks go down, but over time it is proven that stocks are the best investment vehicle.

One potential fear was completely resolved on Thursday; the most recent inflation reading indicates that there is no inflation. A clear example of that is the dramatic fall-off in the price of energy. In addition to oil, nearly all commodities have realized 50% to 70% declines in value over the last six months. It is estimated that every penny that the price of gas goes down represents over $10 billion in reduced costs to Americans. While everyone sees the savings at the pump, most people don’t recognize how representative this is of savings across the board. For instance, transportation of food and other commodities are dramatically reduced when the price of oil decreases. Accordingly, the fear of inflation is not an impending issue right now.

Moreover, I see no reason for investors to be fearful of the banking industry anymore. The extraordinary actions of our Federal Reserve have resolved those issues. The Department of Treasury is scheduled to inject $125 billion in cash into our major banks; their futures are now secure. Additionally, the Treasury will soon deploy the remainder of the almost one-half of a trillion dollars to stabilize banking in America.

If you were concerned about your checking account, you should set your mind at ease. The FDIC has increased the insured account amount to $250,000, and there is currently a government guarantee on all non-interest bearing checking in the United States. Therefore, any checking account in any Federally-insured bank is absolutely secure. Other governments around the world have made similar banking guarantees.

The U.S. Treasury is creating a market in loaning to banks. They have guaranteed inter-bank loans effective this past week, and they are now providing direct financing to corporations in the commercial paper market. In fact, the Federal government appears to be guaranteeing anything that resembles cash. Frankly, I believe that they probably have an indirect guarantee on your Sears & Roebuck credit card…

If you are an avid reader of my posts, you know that I’m an ardent supporter of capitalism. In spite of my strong beliefs, the government’s intervention in the banking system was mandatory this time. As I listened to Congress debate regarding the bill to save the banks, I was stunned at the complete ineptitude of our elected officials. Those members of Congress who believe it would’ve been okay for banks and companies to fail just don’t get it! There’s nothing wrong with our government assisting businesses through a rough patch. While nationalization is never pretty, the human suffering and the damage to our economy due to massive unemployment would be a lot less attractive. I think we will see that the money used in this transaction will be quickly repaid and the government will no longer have an ownership interest in our businesses. In this particular case, it was a win-win for all parties.

When listening to the news this morning, I heard several analysts comment that the economy had yet to start recovering. Considering that not one single check was been written by the government yet, these comments were bewildering. It would be astonishing if things started getting better before the money supply was actually funded. However, next week – once this money starts flowing through the system – you will see immediate and significant improvements in liquidity, creditworthiness and, eventually, the economy.

Perhaps you’re assuming from the foregoing that I’m oblivious to the elephant in the room – the upcoming recession. Almost assuredly, there will be some sort of economic slowdown soon. We may already be in a mild recession, but if not, it’s certainly a possibility to happen sometime during this quarter. However, any discussion that it will be a devastating and prolonged recession is just not supported by the facts.

The U.S. Treasury is currently pushing close to $1 trillion through the American banking system. Milton Friedman, the American Nobel Laureate economist, made it very clear: If you want to avoid recessions, you must liquefy America by flooding the cash accounts. Never in the history of American finance has there been such a rush to put liquidity into the system.

Moreover, there is an absolutely unprecedented worldwide coordination going on with the major banks in Asia, Europe, the Americas and others, including interbank guarantees and checking account guarantees. There have been coordinated interest rate cuts around the world, and this enormous and swift international cooperation in resolving a potential economic disaster will prove to be effective.

The only way to assume that the potential recession will be devastating is to first assume that the most basic economic principals no longer work. I am not one who believes that the end of the world is near – the fundamental economic theories of monetary policy are well-proven, and the fact that we have never seen such a coordinated global effort to create positive monetary flow further supports my position.

According to the principal well-respected economists, any forthcoming recession should be short and swift. In fact, most economists are saying that we will only have three negative quarters. The third and fourth quarters of 2008 and the first quarter of 2009 could potentially be negative, but the general consensus among these economists is that the second quarter of 2009 will start to provide a positive economic upturn. If I’m not mistaken, that’s only five months away. I continue to wonder why fear is gripping investors when we are only a short period of time away from potential recovery.

So that you don’t start to think that my ramblings are strictly hyperbole, the following are some supporting facts:

I have previously written on the Federal Reserve’s IBES valuation model. This model was introduced to Congress by former Federal Reserve Chairman Alan Greenspan on July 22, 1997. Essentially, it defined the interaction of common stock equities and risk-free Treasury bonds. Its formula is the current estimate for the 12-month future earnings for the S&P 500 divided by the yield on the 10-year Treasury bond at any one point in time.

Assuming that economic fundamentals are currently working, this formula should give us some direction as to the fair value of stocks. According to the Standard & Poor’s projection of operating earnings from the issue I received on October 14, 2008, operating earnings for the S&P 500 for 2008 are at $76.73. For 2007, the confirmed numbers were at $82.54. In 2008, the banks and financial institutions – which are a large part of the S&P 500 composite – provided a significant draw-down in earnings. Without the banks, operating earnings would be significantly higher.

Today, the 10-year Treasury bond has an approximate interest rate of 4% (it’s actually slightly lower, but for illustration purposes I am using an approximated percentage). If you divide the current estimated earnings for 2008 of $76.73 by .04, the result is a fair value of the S&P at 1,919. The S&P today is at 946, so a move to this level would be over a 100% increase. While this is certainly desirable, it’s probably not realistic.

Cynics argue that earnings will be dramatically reduced by the upcoming recession, but frankly, I do not agree with that assessment. I do, however, understand their concerns, and while it’s perfectly possible that earnings will be reduced in 2009 for some industries in the United States, banks and financial institutions will still be dramatically higher. The corresponding net effect will likely change very little.

In order to satisfy the cynics, I will reduce corporate earnings in my example above by a full 30%. At this level, estimated corporate earnings would be $53.71, which would yield a fair market value of the S&P at 1,343, or a 42% increase from the current level.

As I’ve often said, no one can adequately time the market. In fact, the market may go even lower from where it is right now. Whether the trend is up or down, you can expect extraordinary volatility that will delight you some days and frustrate you others. Don’t misunderstand what I’m saying to mean that we’ve reached the bottom of the market; I’m simply saying that stocks by any measure are extraordinarily cheap – perhaps even legendarily cheap – from an investment standpoint.

It’s time for Americans to step up and support the U.S. financial system. Stocks are cheap and there is a significant investment opportunity available to us all. I can’t predict when stocks will go up, but I am certain that they most assuredly will. Many years from now, we will reflect on these days and realize that it was the greatest stock buying opportunity of our lifetime.

When one of the greatest investors of all time says stocks are looking cheap, it’s time to really reassess the market. Buffett isn’t calling a “bottom,” but he is looking forward one, three, five and 10 years out. If he is investing with his personal money, then shouldn’t we start looking for investments, too?