Friday, August 26, 2011

Q&A Series: Quantitative Easing’s Effect on the Stock Market

From the Desk of Joe Rollins

Uncle Ben to the Rescue? Probably not!

You may have heard a certain Republican presidential candidate spewing rhetoric that may lead supporters to believe the Federal Reserve is the devil incarnate. Rick Perry is calling any moves undertaken by Chairman Ben Bernanke to expand the money supply “treasonous,” a statement Sarah Palin agreed with during an appearance on Fox Business. (“printing more money to play politics at this particular time in American history is almost…treasonous in my opinion.”) Clearly, neither the Texas governor/presidential candidate nor the former half-term Alaska governor/Fox pundit has any idea what the Federal Reserve’s economic goals are or how it operates. I’m not saying they’re debauched, just uninformed.

The Federal Reserve System was created by Congress in 1913 after a series of financial panics. The role of the Fed has evolved over time, but its two primary goals are to maintain price stability and increase employment. The main way the Fed controls economic activity is through interest rates, under the theory that the lower the interest rates, the better the economy. If interest rates are low, businesses can borrow inexpensively, build plants and equipment, employ more people, and expand. Likewise, consumers can buy cars, TVs and other products and services with low interest rates and easy credit.

In 2008, the Fed reduced the Federal Funds Rate and the primary interest rate to almost zero. Since they couldn’t go any lower than that, in 2009 they began utilizing a less conventional technique to stimulate the economy – quantitative easing. This leads to today’s Q&A, as follows:

Today’s question comes from Mike, a client who is wondering about the effect of quantitative easing on the stock market.

Q: The Fed has instituted quantitative easing policies twice to stimulate the economy. Have those efforts artificially propped up the stock market?

Considering all the talk in the press that Fed Chairman Ben Bernanke may announce another round of quantitative easing (QE3) tomorrow during the Fed’s annual symposium in Jackson Hole, Wyoming – and commentary as to whether or not QE1 and QE2 were effective – this question is on the minds of many investors.

The Background

In simple terms, quantitative easing is when unconventional methods are used to pump money into an economy to drive down interest rates and encourage more borrowing and growth when typical monetary policy isn’t working.

In the U.S., the first round of quantitative easing, “QE1”, introduced “credit easing” – wherein the Fed purchased government-sponsored bonds, mortgage-backed securities and Treasuries, and recorded that it had done so. This is called “expanding the balance sheet”. This money is then made available for banks to borrow in the hopes that it will increase the amount of money in the economy and, therefore, reduce long-term interest rates.

QE1 ended in the spring of 2010, but the economy continued to waver. And so, in the fall of 2010, the Fed indicated that they would take on new quantitative easing measures in an effort to combat persisting high unemployment and low inflation – actions that came to be known as QE2.

QE2 was a different animal than QE1. Whereas QE1 utilized credit easing to increase money in the economy and reduce long-term interest rates, in QE2, the central bank reinvested proceeds from its mortgage-related holdings to buy Treasury debt and also purchased additional long-term Treasury securities. The QE2 efforts ended on June 30th, with economists giving it mixed reviews.

QE’s Impact on the Economy and the Stock Market

So, has QE provided any benefit to the economy? It’s hard to say for certain, and as stated above, economists’ opinions have varied on the subject. When the Fed buys bonds from the public and private sectors, one would intuitively think it would force interest rates down; and that when the Fed quits buying these bonds, it would force interest rates back up. On the contrary, almost exactly the opposite has happened.

When QE1 began, interest rates actually started to rise, although from a very low level and only to moderate rates. It was generally presumed by the markets and the so-called experts that as soon as QE2 was scheduled to end on June 30th, interest rates would almost assuredly skyrocket. In fact, since June 30th, the 10-year Treasury bond – the benchmark bond issued by the Federal government – has plummeted to 2%, a record low for the last 60 years. Oddly, quantitative easing actually caused interest rates to increase when implemented, and rates to decrease when the program stopped.

Politicians often speak of the Fed “turning on the printing press.” It’s true that the Department of Treasury has the ability to print new money, and therefore, it’s possible to produce new money to pay off old debts. In fact, quantitative easing’s effect was basically the same as printing new money without ever turning on the printing press. The Fed’s purchase of public and private sector debt instruments put tons of cash into the U.S. monetary system which, in theory, should have increased economic activity. This is what Governor Perry was criticizing as being political.

It’s a misconception by many Americans – including some politicians – that the monetary base is diluted when the Fed prints money. But as the above example indicates, even though printed money was utilized, the Fed actually purchased assets. There’s no net increase in assets owned by the U.S. by substituting cash for bonds – it’s a one-for-one transfer. The Fed simply has the bonds on their balance sheet which can be sold at any time and the cash put into the economy. It’s a form of putting excess cash into the economy rather than bonds in the hopes that people holding the cash will use it for the betterment of the economy. This method has been used by central banks worldwide throughout history.

For example, U.S. banks currently have $1.7 trillion in cash on deposit with the Federal Reserve. U.S. corporations are said to own over $2 trillion in cash that’s accumulated on their balance sheets. There’s no question that the monetary base has exploded by the Fed’s actions of taking money from its pockets and putting it into the pockets of consumers, companies and banks in the U.S.

Theoretically, once this money is in the system it will be utilized to create commerce. Unfortunately, this is where the theory has failed. In a nutshell, a combination of economic uncertainty, a distrust of Washington, and conservatism are causing U.S. corporations to refuse to spend their hoards of cash. Banks are covered up in cash right now, and the reason CD rates are so low today is because banks have little interest in more deposits since they received more than they could ever loan to the general public and businesses. Likewise, businesses are also covered up in money and have no desire to borrow from banks.

While approximately 10 million people in the U.S. would benefit from refinancing their mortgages to lower interest rates – which would, in turn, help the economy – banks are unwilling to lend to these potential borrowers – even those with good credit. This is a Catch-22 – money is everywhere, but no one is willing to loan it or utilize it due to the uncertainties. And although there’s a lot of talk of the potential for the Fed to go forward with another round of quantitative easing, (“QE3”), for the foregoing reasons, I just don’t think that announcement is in the cards for Bernanke’s speech this Friday.

Those who are critical of the Fed’s QE efforts thus far must remember that just as easily as they were able to put money into the system, they are able to remove it from the system. To do so, the Fed would reverse the effects of QE by selling the bonds that they currently hold on the open market and withdrawing the cash. To the extent that the Fed is holding Treasury bonds, they would simply force the banks to buy them and remove that cash from circulation. As such, if you believe that the Fed’s flooding of the economy with cash is a negative, the argument could easily be made that the positives far outweigh the negatives. But if the Fed doesn’t retire that cash and take it from the monetary system at some point in the future in an effort to shrink the money supply, it would undoubtedly be inflationary and would decrease the value of the dollar.

It could be argued that since the beginning of the Fed’s efforts, QE has been successful since it has kept interest rates very low; it has forced the value of the dollar down (helping exporters); it hasn’t created inflation in a broad sense to this point, and; it hasn’t diminished the value of most assets in the U.S. (depreciation). On the other hand, QE has been unsuccessful in that it created very little economic activity. In fact, the economy slowed dramatically during the period of time QE was in effect. It has also forced down the value of the dollar, increasing the value of all commodities. Oil and other needed commodities move inversely to the value of the dollar. This means that oil and commodity prices have increased. Higher gas and food costs are a drag on the U.S. economy in some way or another.

There are also those who argue that quantitative easing has made the stock market soar, but it’s hard to draw a direct parallel between quantitative easing and the stock market. There’s an indirect parallel in that quantitative easing was very successful in keeping interest rates low. With interest rates as low as they are, there’s virtually no incentive to buy interest-bearing certificates. For example, the dividend yield today for the S&P 500 index is actually higher than the 10-year Treasury bond yield. Therefore, if quantitative easing was successful in making interest-bearing certificates unattractive, then it could be argued that it’s inflated the stock market. However, the real reason stock prices are higher is because earnings are clearly superior and getting better. I’m not sure there’s any direct correlation to earnings being great and quantitative easing, and therefore, I question whether QE has caused higher stock prices. Perhaps the best answer is, “It depends.”

So, if you’re anticipating Uncle Ben to wave his magic wand on Friday and announce QE3, it’s unlikely that fantasy will be unfulfilled. My guess is that Bernanke, as always, will talk thoughtfully about the many options that are available to the Fed to stimulate the economy. But it appears that the moves in monetary policy to stimulate the economy are few and far between. Hopefully, Bernanke will state that they’ve done all they can do, and it’s now time for Congress to do something positive. But I wouldn’t count on that, either – they’ve already proven themselves to be incompetent.

My guess is that rather than Bernanke announcing QE3, he will simply extend the maturities on the bonds held by the Federal Reserve which now amount to $2.7 trillion, successfully reducing long-term interest rates. Since a change of that nature would be subtle and doesn’t constitute a direct intervention in the economy, I suspect we’ll see a market sell-off on Friday following Bernanke’s speech since the traders will want much more.

At the end of the day, none of Bernanke’s comments have much effect on the stock market. Rather, the stock market is driven by the economy and corporate earnings, and all this talk is distracting. Even though the stock market has sold off 15% from its high, as of today, nothing has changed fundamentally. Corporate earnings are still extraordinarily high and interest rates are extraordinarily low. Gold is now selling off and is correcting, and interest rates are starting to rise. Each and every one of these indications almost assuredly indicates a higher stock market in the future.

While the traders are working their way into a frenzy over what Bernanke will potentially do, none of it will really matter come next week since it’s earnings that control the stock market’s future. Currently, our future seems to be better invested in stocks than anywhere else.

Thanks for your question, Mike. We’ll have to wait and see if the Fed has decided to go forward with QE3 this Friday when Bernanke speaks at the Jackson Hole symposium – and what the market does after his speech.

We encourage our clients and readers to send us questions for our Q&A series at And as always, we hope you will keep Rollins Financial in mind when seeking professional advice on financial planning and investing.

Best regards,
Joe Rollins

Saturday, August 20, 2011

When the Cops Raid the Brothel, Everyone is Arrested -- Including the Piano Player

From the Desk of Joe Rollins

I’ve spent many hours over the last several days watching the stock market reports and the carnage taking place in the international equity markets. On Thursday – due to a rumor that was reported – the U.S. stock market also suffered a major decline. The rumor basically asserted that the European banks were suffering liquidity issues and had to borrow money from the EU in order to meet their current liquidity needs. In a market as jumpy as this one, all it takes is an unfounded rumor to create a massive sell-off.

I am amazed by the bargains currently available on the stock market. The only two asset classes that have increased in recent weeks are U.S. Treasury bonds and, of all things, the commodity gold. About two weeks ago, the S&P downgraded the U.S.’s credit rating, and ever since that day U.S. Treasury bonds have (counter-intuitively) rallied dramatically. At one point on Thursday afternoon, a 10-year Treasury bond was selling below 2%, a rate so low that it hasn’t been seen in the U.S. since just after WWII.

Additionally, gold continues to skyrocket beyond any reasonable level. No one has been able to give any economic explanation for the rally in gold; it’s so overdone at this point that it’s almost laughable. It’s hard to laugh, however, when U.S. Treasury bonds and gold are the only two financial assets to have increased while everything else has seemingly thrown the baby out with the bath water. Who is going to buy your gold when all other assets are worthless?

It’s fairly easy to see that those who are selling the market nowadays are doing so indiscriminately. It makes no difference whether you have a high performing stock like Apple or a low performing stock like Hewlett-Packard – they’re all being sold. It also makes no difference whether a country is financially strong like Germany or if it is a weak, essentially bankrupt country like Greece – they’ve all suffered the same selling pressures. The point I’m trying to make is that it would be an unusual time, indeed, if every financial asset other than Treasury bonds and gold were essentially worthless. I’ve never believed that before and I don’t believe it today.

I couldn’t help but look into the valuations of two of the major bank stocks – CitiBank and Bank of America. CitiBank has an international franchise and $273 of cash for every share of its stock. Cash today on CitiBank’s balance sheet is approximately $800 billion. The book value per share of its common stock is $60.33. However, today it’s selling for $27.84/share – less than 50% of its book value.

Bank of America’s valuation is even more pronounced. It has $63 per share of cash on its balance sheet equaling $640 billion. Its book value is $20/share, and it’s selling at $7/share – a mere 35% of its book value.

It should be fairly clear to anyone who even attempts to understand the value of these bank stocks that they are ridiculously low. There’s no question that banks face potential liabilities, but it’s unreasonable to believe that 35% to 50% of their net worth will be wiped out in unaccrued liabilities.

This week’s sell-off occurred when it was decided that the EU couldn’t possibly fund its debts. Clearly, in the eyes of many, the entire region was falling into a recession. While it’s true that Germany’s Q2 GDP was only marginally positive, it would be a mistake to dismiss that country as being financially weak. It’s one of the greatest engineering exporters in the world. Even if other countries in the EU fall into a severe recession, Germany will likely avoid it. If that’s the case, however, then why did Germany’s stock market index fall 10% this week?

The major market movers are again forecasting a severe and prolonged recession in the United States, but with very few facts to support their forecast. While it’s true that GDP has been low, very few economists are actually projecting a recession in the second half of this year. In fact, earnings projections for the largest companies have remained stable. It’s certainly not a guarantee that earnings wouldn’t be diminished if the U.S. fell into a recession. Since most of the Fortune 500 companies sell almost 50% of their products overseas, a recession in the United States wouldn’t necessarily impact valuations.

It was announced this morning that many of the major money market accounts are having a hard time showing a positive rate of return. Interest rates are so low right now that sponsors of money market accounts can’t even cover their own operating costs. A 10-year Treasury bond is selling at 2.1% today despite the fact that nearly everyone believes the rate of inflation will be greater than 2% over the next decade. Isn’t it interesting that people are willing to invest in money markets earning zero and 10-year Treasury bonds with a negative real return over inflation rather than a stock like AT&T with a fairly secure dividend yield of 6.1%?

My point is that reason has been abandoned because of fear. There’s a fear sweeping the world that is unsupported by the economic facts. After my most recent post, a client pointed out that I was perhaps missing a major component of stock market valuation – investor sentiment. While investor sentiment is undoubtedly impacted by Washington’s incompetence and the lack of leadership out of the Executive Branch, I still think our current issues have more to do with fear than with reality (although I’m not so sure I understand the root of that fear).

Today, it’s perfectly possible to buy a large number of utility and other stocks with dividend yields in excess of 5%. You can also very easily buy high-yield bonds yielding 8% or greater from very strong financial companies. Valuations on U.S. stocks are at multi-year lows and there are essentially no better alternatives for investing. Despite those positives, the market consistently goes through waves of fear. When investors are fearful, they do not sell based upon reason.

It’s also possible that – due to the extraordinarily negative investor confidence and the reductions suffered by the stock market over the last few months – the consumer could completely shut down. However, I really doubt that will happen. Retail sales for the last three months have been up consistently higher and car sales have been okay over the last six months, but will likely accelerate moving towards the end of the year. In the U.S., we are junking far more cars than we are selling new ones to replace them. With interest rates as low as they are, 30-year mortgages are now bordering on 4%. If you have contemplating refinancing your mortgage, now is the time to do so.

I turned off the financial news for a while to evaluate the facts and see if I was missing something in this market sell-off. It’s true that the cost of oil has decreased almost $20/barrel in the last month or so. The price of gasoline is $1/gallon cheaper, which provides an enormous windfall for consumers. Corporate earnings – rather than being diminished – have actually increased. Corporate earnings for Q3 were significantly higher than they were in the 3rd quarter one year ago, and projections for next year are even higher. The cost of buying almost everything is significantly lower due to lower interest rates. While unemployment is high, it is now trending lower. While the economy is flat, it’s a long way from being negative. The number of known positive facts to the number of known negative facts appears to be significantly greater. I can’t evaluate rumors, suspicions or even scare tactics, but evaluating only the facts doesn’t leave me feeling all that bad.

Before arriving at the office this morning, my anxiety was high. I was feeling a need to reallocate our portfolios, but after reviewing how they are currently invested I came to the conclusion that there was nowhere better to go. Our portfolios are invested with the best money managers in the world – all of them didn’t just wake up stupid! Valuations are extremely cheap right now and I believe the market will rebound very soon. Hopefully, you will be patient enough to enjoy the upturn.

As always, the foregoing are my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.

Best regards,
Joe Rollins

Friday, August 12, 2011


From the Desk of Joe Rollins

There was a massive selloff on the stock market on Monday due to the reported S&P downgrade of the American credit. This action by S&P defies any practical explanation, and the selloff in the equity markets is even further suspect. To give you some point of reference, I will try to explain what should have happened as compared to what actually did happen.

In theory, if someone were to downgrade your ability to repay your debts, under every situation I can think of, the borrower would be required to pay higher interest rates in order to obtain the debt. If I am a lender, I certainly would want higher interest rates to compensate for the possibility that the borrower would not or could not repay me when the debt becomes due. Over the weekend, when S&P downgraded the credit rating of the United States, presumably, we should have had seen higher interest rates, but that is almost exactly the opposite of what happened.

When news of the downgraded credit was announced, interest rates did not skyrocket, they plummeted. On Monday evening, the ten year treasury note was at 2.37% which is very near the rate of inflation for the ten year cycle. This move from equities into Treasuries is totally without any type of financial basis.

To illustrate my point, a few quotes from Warren Buffett seem to shed light on the matter at hand:

“Our currency is not AAA, and in recent months the performance of our government has not been AAA, but our debt is AAA.”

“I can go out drinking all night, but if I've got a printing press, my debt is good.”

“If anything, it may change my opinion on S&P.”

There is no conceivable way the United States could ever default on its obligations. If the day came when there was zero money to pay the debts, the Federal Reserve could simply print up some new money. Of course that would create massive inflation and would put us close to the definition of a banana republic. Even though S&P made a “slight” $2 trillion arithmetic error (caught by Treasury officials and acknowledged by S&P) when they downgraded the debt of the United States, any thought that there would be a default by the U.S. government is almost ludicrous. Furthermore, we are talking about the second highest rating of only one of three credit agencies. In fact, last Tuesday in light of the debt ceiling deal, Moody’s confirmed their AAA rating for the U.S. debt.

I was also amused by Buffet’s retort regarding the S&P. Not that it has anything to do with finances, but Buffett reminds me so much of Sir Winston Churchill in his later years. I love to quote Churchill in his short and witty responses. My favorite is from the time a belligerent dinner partner of Churchill exclaimed in a loud voice for everyone to hear, “Winston you’re drunk!” Sir Winston’s quick response was, “Madam, you’re ugly, but tomorrow I’ll be sober.” And, now that I think about it, that does describe the equity markets from one day to the next.

What also got my attention was a segment from a press release from Goldman Sachs. I am positive that Goldman Sachs was right in the middle of the massive selloff when their research department put out a notice that they were reducing their year-end target for the S&P 500 Index stocks from 1450 to 1400 due to lower GDP growth estimates. On Monday, the S&P Index closed at 1,119. Whether you realize it or not, Goldman Sachs was telling you that they believe that from now until the end of 2011, they expect the S&P Index to rise 25%. Despite the irrational selloff in equities on Monday, Goldman Sachs is reinforcing that the investing public will return to caring about what is really important - earnings.

Yes, we have received some calls in the office from clients expressing concern. Who would not be concerned when you have a completely dysfunctional government with zero leadership in the White House? However, I am a true believer in the glass half full approach. The economy, while weak, is certainly is not a 2008 economy. Interest rates cannot get any lower, and the price of oil has plunged 20% in just the past month. The reduced cost of oil and interest rates nearing zero have produced two major stimulants for our economy - lower gas prices and lower mortgage costs. With these two stimulants and without governmental intervention, it would seem to me that the second part of 2011 may even better then the first half of the year.

In another segment of the Goldman Sachs press release, they indicated that they were lowering 2012 earnings estimates for the S&P 500 from $104 to $102 per year. If you use Greenspan’s calculation of fair value of the S&P that I discussed in my post on Saturday, August 6th, using the new estimate of $102 and the ten year treasury at 2.37%, the fair value for the S&P 500 would be 4,403 (350% above of today’s level). While those numbers are obviously ridiculous due to the low interest rates, I think it magnifies an important point. Notwithstanding the enormous volatility and the inadequacies of our government, earnings have not changed, and they will most likely stay at elevated levels through 2012.

It is highly likely that the market, once the current volatility passes, will return to its slow but steadily increasing path until the end of the year. In light of all of the current activity, I still maintain my estimate of a 10% return on the equity markets for 2011. It is nice to know that Goldman Sachs agrees with me.

As always, the foregoing are my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.

Best regards,
Joe Rollins

Sunday, August 7, 2011

Stock Market Sell-Off

From the Desk of Joe Rollins

When investing assets on behalf of our clients, I aim to evaluate the facts and disregard emotions in my decision-making process. In doing so, I spend an enormous amount of time researching various subjects that effect the marketplace. In the end, market performance is represented by correct valuations and not by daily emotions. I can’t help but think that Thursday’s massive sell-off of over 500 points was driven by emotions instead of clear thinking.

As I mentioned in yesterday’s post, the sell-off basically occurred when the European Union bucked Italy and Spain by refusing to help them out of their financial malaise. You may recall that when Greece, Portugal and Ireland fell into financial despair, the EU offered to bail out each of those countries if they cleaned up their mounting sovereign debt woes. Of course, the bailout process for these countries is ongoing: the EU finalized another bailout package for Greece last month; Ireland’s debt was downgraded to junk by Moody’s on July 12th, and; Moody’s, citing concerns of a second bailout, also downgraded Portugal to junk status last month.

On the other hand, Italy and Spain, with the Eurozone’s third- and fourth-largest economies, respectively, are too costly for Europe’s bailout fund. Even though the sovereign debt of each of these countries is moving higher exponentially, they have so far managed to avoid the kind of aid given to Greece, Ireland and Portugal. Basically, all of the Eurozone banks are holding the sovereign debt of their fellow European countries. While the banks appear to be solvent on paper, if the debt was discounted to an appropriate level, all of the major European banks would be essentially insolvent.

The theory regarding Thursday’s sell-off is that if all of Europe’s banks can’t afford to lend to businesses, then the Eurozone countries would fall into a recession. Of course, the U.S. might also be impacted due to its financial institutions’ considerable holding of European financial assets. Exports to Europe from the U.S. and Asia would also be impacted due to Europe’s reduced borrowing capacity and spending cuts. Therefore, the true catalyst for the major sell-off had less to do with the U.S. economy and more to do with the ongoing European debt crisis.

Thursday’s trading day brought continuing reports of the plight of the U.S. economy. I reiterate that while the U.S. economy certainly isn’t robust, it is nowhere near recession territory. While we undoubtedly suffered through a financial crisis during 2008 and 2009, we are still on the long road to recovery. Moreover, Europe was never as far down from a recession standpoint as the U.S., and they’ve not fully recovered, either.

It’s true that the GDP for the first quarter of 2011 was revised down to a miniscule 0.4%. Furthermore, growth in GDP for the second quarter of 2011 rose at a 1.3% rate. Undeniably, this isn’t very high, but it’s still positive. Regardless of the commentary, the U.S. GDP has been continuously positive since the second quarter of 2009 through the current date.

Until recently, nearly all of the major economists, including those with the Federal Reserve, were forecasting GDP growth in the second half of 2011 at 3%. Within the past few days, however, many of those same economists have lowered their predictions to 1.5%. While the predicted lower growth is disappointing, it’s still not negative.

It was announced yesterday morning by the Department of Labor that payroll employment rose 117,000 in July. More importantly, the U.S. private sector jobs increased by 154,000 during July, which was nearly double the projections that were being reported before the numbers were released. Furthermore, the change in total non-farm payroll employment for May was revised from 25,000 to 53,000, and the change for June was revised from 18,000 to 46,000. Even with the unemployment rate changing little in July (a dismal 9.1%), it is still clear that the economy is trending up and not down. If the GDP were 0.4% for the first quarter, 1.3% for the second quarter, and winds up being 1.5% for the second half of 2011, those are upward – not downward – moves by anyone’s definition.

A contributing factor in Thursday’s sell-off and the high volatility in yesterday’s market performance is the “high frequency” trading effect on the market. Basically, this is where computers trade with high frequency when certain market events occur. By far, most of the volume each day on the markets comes from these types of trades. No human is involved, and the computer reacts to events, not reality. On Thursday, the S&P index broke its 200-day moving average, creating a massive sell order from the high frequency traders. The enormous sell-off towards the end of the day was undoubtedly attributable to computers thinking they know more than individuals. Maybe they do, but I doubt it.

As I’ve stated in prior posts, stock market valuation consists of three major components:

  • Interest rates impact stock market valuation since alternatives for money compete with interest rates and stock prices. Today, the 10-year Treasury is selling for a miniscule 2.5%, which is practically an all-time low. There are several stocks that can be bought with dividend rates in excess of 5% that constitute a much better value than the 10-year Treasury bond. Isn’t it ironic that during the first part of this week, investors were concerning themselves with a potential default on U.S. Treasury bonds while the last part of the week, they were stunned by the 10-year Treasury winding up at nearly its lowest yield ever. This is just another inconsistency to confuse the issue.

  • Earnings continue to be extraordinary. With earnings projected to be over $100 per share for 2012, unprecedented records will be set. It’s unlikely for the U.S. to fall into a recession with the current strong earnings and the forecasted earnings for 2012 being even stronger. With close to $2 trillion in cash currently held by U.S. corporations, there’s rarely been another time in our financial history that U.S. corporations were so well-prepared for the future.

  • Public sentiment is unquestionably waning at this time. With Washington’s failure to accomplish anything worthwhile, many consumers are sitting on their hands while many investors with cash to invest are unwilling to do so. It’s certainly a time where the public’s negative emotions are impacting stock market valuation. What other explanations can there be for the never-ending gold commercials? Gold investments are made for emotional – not financial – reasons. It offers no dividends, has a lack of marketability, and isn’t even scarce. Yet given the negative attitude of investors, gold has hit record high prices. Not much can be done to improve public confidence until Washington leadership improves.

  • Those of you who were readers of my quarterly newsletter, The Rollins Report, may recall an edition published in 2003 in which I explained how former Federal Reserve Chairman Dr. Alan Greenspan calculated the fair value of the S&P 500. Compared to today’s economy, the economy was more normal in those days. At that time, the projected earnings for the S&P 500 was $61.83. Also at that time, the 10-year Treasury rate was 4.07%. To get the fair value of the S&P 500, you divided the projected earnings by the 10-year Treasury rate, which provided a result at that time of 1,519. At the time the newsletter was published, the current value of the S&P 500 was 1,142, which indicated a significant undervaluation of 33%. Was that calculation accurate? The S&P 500 for 2003 made a total return of 28.7%.

    To illustrate how crazy the numbers are today – with earnings so high and interest rates so low – the same calculation would play out as follows: Estimated earnings today are at $100 and the 10-year Treasury is at 2.5% today. This provides a fair value of the S&P 500 of 4,000. This represents a 340% increase which, of course, would be irrational.

    Part of the problem with the calculation today is that interest rates are much too low from market prices. If you used a more normal interest rate of 4%, the S&P 500 would still have a fair value of 2,500 – basically double what it is today. Given that interest bearing accounts are essentially earning zero, there are a wealth of stable dividend stocks paying 5% and higher and any standard valuation of the stock market is cheap, I can see no real economic reasons for yesterday’s sell-off.

    Therefore, the conclusion should be drawn that yesterday’s sell-off was unwarranted. However, it can’t be denied that it actually happened. Our loss in wealth yesterday was real, not perceived. It happened even though it shouldn’t have.

    It’s difficult to invest from an emotional standpoint, for emotions run hot and cold based upon what the media reports each day. By any standard definition, the stock market is cheap and alternative investments are lacking. While losses like what we endured yesterday certainly hurt, the best course of action is to continue to stay invested for the long-term.

    Again, while it’s true that the U.S. economy is weak and has suffered a short-term soft spot, there’s no evidence of another downward spiral. Stay tuned!

    As always, the foregoing are my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.

    Best regards,
    Joe Rollins

    Saturday, August 6, 2011

    So Predictable

    From the Desk of Joe Rollins

    While readers of the Rollins Financial Blog are probably interested in my thoughts regarding yesterday’s substantial market sell-off, I’d already written the following month-end report. Blogs must be posted by 3:00 p.m. to be emailed to subscribers the same day, so my thoughts regarding the market sell-off will be published tomorrow, Saturday, August 6th. In the meantime, I thought it was still relevant to provide you with my opinions concerning the debt ceiling crisis and the market results for the month of July. So without further ado…

    As I accurately predicted in my STAY FOCUSED post, on August 2nd Congress and White House leaders finally came to an agreement on increasing the debt ceiling just in the nick of time. Our incompetent leaders made it very easy for me to forecast that turn of events, as it seems like the most important agenda item for each of them is campaigning for another term and not looking out for what’s best for our country.

    While the Tea Party members of Congress have been greatly criticized, I am grateful to them. Without them, there would be no conversation regarding reducing federal expenditures. Even though the amount approved was essentially just a token amount, it at least started the conversation that will ultimately have to be addressed in the upcoming budget conversations.

    What bothers me the most is that on Tuesday, the Democrats, Republicans and the President were all in a circle singing “Kumbaya” about the great job they did in reducing federal expenditures. I think a more important discussion would be exactly what they really did. If you recall, the federal debt limit was increased by $2.4 trillion just to get through the 1st of November, 2012 election. Think about that reality for a second. If they needed to increase the federal deficit by $2.4 trillion over the next 15 months, that tells you they really intend to spend exactly that much money – more than they receive – between now and then. This means more debt.

    Without the Tea Party’s intervention, I am sure the amounts would have been even greater, but at least there is a conversation and discussion regarding bringing these amounts under control. I will discuss the budgetary process for the next fiscal year later in this post, but I also wanted to discuss the month of July and the equity markets.

    For the month of July, the S&P 500 was down 2% along with the Dow Industrial Average down a like amount. The NASDAQ was down .6% for the month. What’s interesting about the results of the month of July is that for the final week of July, the S&P 500 was down approximately 4%. If it hadn’t been for this severe sell-off, the month of July actually would’ve been up. With all you hear in the media regarding the negative stock market, I doubt you rarely hear anyone indicate that July was still a very satisfactory month for stock market performance.

    The first week of August has been an altogether different situation. Due to the complete incompetence of Congress, the markets have essentially lost confidence in Washington’s ability to govern. Even though the debt ceiling was increased and signed on Tuesday, the major market indices sold off at 264 points on the same day. I received a great many questions asking why the market continues its massive sell-off when the deal was done.

    In fact, the reason had nothing to do with an event that was totally predictable, but had everything to do with the banks in Italy announcing that they were essentially insolvent. It appears now that all of Europe is on the verge of financial calamity, and only Germany and France have the financial resources to support the rest. Isn’t it interesting that so many in the United States want us to be like Europe, but if anything, Europe is much worse off than we are.

    I always wonder why people who invest in Treasury bonds wouldn’t make a similar investment in something like the Coca-Cola Company. The dividend rate on the Coca-Cola Company is 2.8%, which is higher than the current return on the 10-year Treasury. Additionally, you would be buying one of the great franchises in the world along with the potential for the stock price to go up. People who are making financial decisions to buy 10-year Treasury bonds today are not making that decision for investment purposes, but rather, for trading purposes. We focus our practice on investing, not on trading.

    Even though Congress has approved “reductions of federal expenditures of over $2 trillion over the next decade,” even with these cuts, the federal deficit is projected to exceed $18 trillion over this timeframe. Essentially, this country is running the risk of financial calamity if it doesn’t address the massive overspending that has occurred in Congress over the last five or six years. It should also be very clear to you from this most recent debate on increasing the debt limit that the administration and the Democrats in Congress intend to keep spending as quickly as they can for as long as they have electoral control. It’s going to be interesting to see the new federal budget debate, which must be completed before September 30th, and exactly what the Congress approves.

    What is most interesting about the budget debate is that there was never a federal budget approved for the fiscal year in which we are in. While the President submitted a budget to Congress in February for 2012, it was voted down in the Senate by a majority vote, including all members of his own party. The House approved a budget which was not even considered in the Senate. Now we are facing a deadline of September 30th for a new budget and Congress will not even be back in session until after Labor Day. If you thought political theater was bad on this most recent national debt increase, wait until the budget comes up in September.

    You may rest assured that the political theater that we suffered through during the debt ceiling increase will only be a token amount as compared to what we see in the budgetary process. Since the country so clearly desires a smaller federal government, it should be a gigantic struggle between those that want to spend and those that want to save.

    It appears that the U.S. economy is, in fact, quite stable. Contrary to what is being reported in the media, employment is improving, interest rates are low, and profits are skyrocketing. It is almost exactly the opposite of what is going on in the Eurozone. Seemingly, all of the European countries that have supported the “cradle to grave” mentality of the government taking care of its citizens are now failing one at a time – first Greece, Portugal and Ireland, and now the larger economies of Spain and Italy. The major effect on our markets has more to do with the failure of Europe than the failure of the U.S. economy.

    Isn’t it fascinating that 2009 began with the political commitment to make the U.S. more like Europe? Fortunately for us, before Washington could implement a “cradle to grave” philosophy in the United States, the model on which it was based has completely imploded. It doesn’t take a rocket scientist to understand that bigger and bigger government can’t be financed by fewer and fewer taxpayers. Now that they’ve discovered that in Greece, Portugal, Ireland, Spain and Italy, maybe we’ll get the hint here in the U.S. without going through the destructive phases.

    Unlike the European banks, the United States recapitalized all of its banks in the last three years that are ultra-strong and ultra-well-funded. Virtually none of the banks in Europe have that economic cushion.

    This is not to say that things are rosy in the United States, but they are stable. As I view things today, it’s almost impossible to assume that the U.S. would fall into another recession given the economic conditions of today. However, it would not be unheard of for the recession occurring in other parts of the world to drag the U.S. “kicking and screaming” into a like financial situation. But that’s not something I am foreseeing.

    More tomorrow…

    As always, the foregoing are my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.

    Best regards,
    Joe Rollins