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Wednesday, 28 January 2009

Semi-smart money stays at home

By Robert Armstrong, contributing writer

NEW YORK (Fortune) -- In his inaugural address President Obama took just a few sentences to make the simplest and most compelling possible argument for buying stocks now:

"Our workers are no less productive than when this crisis began. Our minds are no less inventive, our goods and services no less needed than they were last week or last month or last year."

He may be on to something. The S&P 500 closed at 837 Monday, having lost almost half its value since October of 2007. It looks like a fire sale, and investors with cash on hand - if any are left - should think seriously about buying.

Even Robert Shiller, the noted market bear who called the dot-com and housing bubbles, has recently said that the market is cheap by historical standards for the first time in years.

But there is a simple argument for ignoring the President and Professor Shiller and staying out of the market: The lower valuations still don't reflect risk levels during the market's decline.

Flipping the ratio
Suppose companies making up the S&P 500 are going to produce, in aggregate, $60 in earnings per share in 2009 (as this would be down only slightly from expected 2008 earnings, it could prove optimistic). This $60 projection would make the market's price/earnings ratio 13.9 - low by historical standards, and attractive to be sure.

But flip the ratio over. The earnings/price ratio, aka the earnings yield, is 7.2%. What this number says is this: For every dollar I give to the companies that make up the market, those companies are going to produce a little over seven cents in earnings.

The earnings yield is a very rough proxy for estimated return on investment in equities, but is a 7% estimated return enough to get smart investors aggressively into the market? Is it worth the risk - especially when companies don't seem to have a clue as to what comes next?

Consider the earnings reports that came out Tuesday morning. Chemicals giant DuPont's projection for this year's earnings was 10% lower than the estimate it gave in early December. In this dreary season, a guidance cut won't shock anyone. What is more interesting, given that we are looking for measures of market risk, is the difference between this year's guidance and what the company said last year.

DuPont's (DD, Fortune 500) estimate for 2009 is $2 to $2.50 per share - a fifty-cent range of possibilities. At this time in 2008, the company saw the year ahead coming in between $3.35 to 3.55 - a twenty cent range, and less than half the size of this year's. It looks like DuPont is much more uncertain about what the future holds.

A realist would see a jump in uncertainty here. A cynic would say that the company's ability to predict the future has not changed since last year, but given what it can see of 2009, DuPont has provided a big range it can finish at the low end of - and still claim to have "hit its guidance."

Verizon also reported and delivered on the telecom industry's reputation for relative defensiveness. Earnings fell in line with expectations and were roughly flat with last year. But Verizon's (VZ, Fortune 500) most watched operational number, wireless retail customer adds, shows a nasty decelerating trend - the company added 40% less subscribers than it did in the fourth quarter of last year.

The stock looks inexpensive, but I don't see how an investor - or company management for that matter - could make a well-grounded guess as to where the trend was headed, given the rate of change we saw this quarter.

In the last week or so, the long list of companies that have signaled their extreme uncertainly by announcing cuts in guidance, jobs, stock buybacks, or dividends also includes international monsters like Microsoft (MSFT, Fortune 500), Nokia (NOK), and Caterpillar (CAT, Fortune 500). They all sound like companies with no clue what's going to happen - or who see a future they would rather not talk about.

This makes 7% estimated equity returns sound like they're not worth the risk.

Where the heart is
Smart equity traders and investors always find a way to make money even in volatile markets like these. Alas, I am only semi-smart, and like most people I am not in a position to watch my investments all day long, which is a requirement stock pickers must honor in turbulent times.

What I can do, given the limits on my lifestyle and my brains, is try to allocate assets intelligently. And I can't figure out how allocating heavily to equity would be intelligent right now.

Like a lot of people, I've got a mortgage. My fixed rate is 5.75%. This means that I have the option of putting money into my house (paying down the mortgage) and getting an absolutely guaranteed nominal return of 5.75% - all of 1.25% lower than the earnings yield of the S&P.

Again, the earnings yield is a rough proxy for stock market returns. And, depending on one's specific circumstances, the tax deduction for mortgage interest may provide reason to hold a good chunk of mortgage debt.

But the basic point is clear: Why would I give up a guaranteed return for a wildly uncertain one in exchange for a few miserable percentage points? Add to this the fact that mortgage rates have fallen lately, so if I put more equity into my home, it brings my "loan-to-value" ratio down, making it easier for me to refinance the mortgage at a lower rate, freeing up more money to...pay down my mortgage.

Smart money may be re-entering the market. Semi-smart money, like mine, is staying home - figuratively and literally.

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