{"id":591,"date":"2014-02-13T02:23:04","date_gmt":"2014-02-13T02:23:04","guid":{"rendered":"http:\/\/www.wallstreetandkstreet.com\/?p=591"},"modified":"2014-02-19T01:45:20","modified_gmt":"2014-02-19T01:45:20","slug":"four-equity-errors","status":"publish","type":"post","link":"https:\/\/www.wallstreetandkstreet.com\/?p=591","title":{"rendered":"Four Equity Errors"},"content":{"rendered":"<p>Secret NIH-funded research at the Wharton School of Finance in Philadelphia has demonstrated that prolonged exposure to the stock market permanently impairs the prosencephalon diecephaion subthalamus, the part of the human brain that governs good sense and logical thinking.\u00a0 I\u2019m just kidding.\u00a0 But it would not surprise me.\u00a0 Consider four egregious equity errors\u00a0(and then take a look at my next post,\u00a0<strong>Three Stock Picking Themes<\/strong> that can make you money).<\/p>\n<p><b>Don\u2019t be Shilled by CAPE<\/b><\/p>\n<p>For some reason financial media treat bearish pundits far more gently than bulls.\u00a0 Robert Shiller\u2019s CAPE (Cyclically Adjusted Price Earnings Ratio) is regularly cited in the <b>Financial Times<\/b> and <b>Wall Street Journal<\/b> even though he has been wrong on the stock market for the past three years.\u00a0 In January 2011 Shiller told CNBC, \u201cI would say the market is overpriced on fundamentals.\u201d It is up 36% since then.\u00a0 And it\u2019s not just the media that dons the CAPE. Asset allocation committees overseeing huge pension funds use CAPE to gauge whether stocks are \u201cexpensive.\u201d \u00a0Shiller\u2019s CAPE is simply<\/p>\n<p>Current price of S&amp;P 500 \/ (average inflation-adjusted GAAP EPS over the past 10 years).<\/p>\n<p>Shiller thinks stocks are \u201coverpriced\u201d if the current CAPE exceeds the historical average CAPE.\u00a0 Here is all you need to know to see that this is a profoundly misleading metric.\u00a0 The average CAPE since 1896 (which marks the inception of the DJIA and a modern stock market with numerous industrial issues) is 16.53x.\u00a0 Now, <b>if you look at the level of the CAPE each month since the start of 1990, there are only 16 months, or 5.6% of the time, when CAPE was below 16.53x and stocks looked \u201cinexpensive\u201d!<\/b>\u00a0 In other words, according to CAPE <b>stocks were \u201coverpriced\u201d more than 94% of the time<\/b>, even though the S&amp;P 500 has quintupled since 1990. CAPE does not work for a few reasons:<\/p>\n<ul>\n<li>Much of the time since 1871 <b>the S&amp;P 500 PE ratio was depressed by lengthy crises<\/b> such as the post-1873 depression, World War I, World War II, the Great Depression, and 1970s inflation. None of those conditions exist now, though we do have Barack Obama to contend with.<\/li>\n<li><b>GAAP EPS can be misleading<\/b>\u2014which is why no analysts use GAAP to value individual stocks.\u00a0 For the last 15 years GAAP EPS has been depressed by new accounting rules (FAS 142) requiring companies to write-down goodwill from mergers if the goodwill seems impaired.\u00a0 Often investors ignore these write-downs, but they reduce S&amp;P 500 GAAP EPS and thus magnify CAPE.\u00a0 The write-downs tend to be concentrated in a handful of failed companies (such as the tech companies that blew up in 2001-2002) that cautious investors can largely avoid.<\/li>\n<li>It is wrong to compare the current PE with the average PE going back to 1871; the stock market has changed a lot since then.\u00a0 <b>Specifically, it has become much cheaper and safer to invest in stocks<\/b>, thanks to lower commissions, tighter spreads, ETFs, lower mutual fund fees, and better regulation.\u00a0 <b>Don\u2019t forget the fraud factor<\/b>\u2014average investors used to be regularly fleeced by corporate insiders and Wall Street operators.\u00a0 The minor classic <i>Frenzied Finance <\/i>describes how in 1904 the \u201cStandard Oil Crowd\u201c manipulated the flotation of a copper trust, Amalgamated Copper, in order to cheat the public. In the 1920s \u201cpools\u201d of big-shot speculators pumped up stocks (usually glamour issues such as RCA), drew in the public, and the sold at an elevated price.<\/li>\n<\/ul>\n<p><b>Buy SBUX?\u00a0 What About Bean Prices?<\/b><\/p>\n<p>In the mid 1990s I travelled to the Midwest and met with the portfolio managers for a large state pension fund.\u00a0 I mentioned that Starbucks looked attractive.\u00a0 My clients demurred; they didn\u2019t like the stock because profit margins might be squeezed by rising coffee bean prices. At the time, SBUX was trading at $2.00-3.00; now it is at $75. If these folks did not buy SBUX because of potential transitory margin pressure from bean prices, it was a very costly mistake.<\/p>\n<p>Investors, especially Wall Street professionals worried about quarterly performance, can be more myopic than Mr. McGoo. They get cute about minor near-term risks while ignoring the Big Picture of a company\u2019s long term growth prospects. \u201cIt\u2019s a great company that could grow 20% per year for a decade, but it\u2019s expensive.\u00a0 Let\u2019s wait for a pull-back.\u201d Frequently, the pull-back never comes and they miss the stock. They end up trying to scalp nickels and dimes on mis-pricings of mediocre companies while leaving $1000 bills on the table.\u00a0 Remember, <b>if<\/b> a company <b>really can<\/b> grow 20% per year for a decade, earnings rise by a factor of six.<\/p>\n<p><b>The CNBC dEffect<\/b><\/p>\n<p>Many (not all) of the people on CNBC and Bloomberg are intelligent and knowledgeable, and I do glean useful information.\u00a0 But for the individual trying to learn how to invest, their programming is <b>systematic disinformation<\/b>\u2014a catalogue of <b>what not to do<\/b> to make money in stocks, including.<\/p>\n<ul>\n<li>Obsessive scrutiny of the economy and Fed policy (Will they taper? How much?\u00a0 All T-bonds or some MBS?). Unless you run a bond desk on Wall Street, it doesn\u2019t matter much. Famed investor Peter Lynch was not all wrong when he quipped, \u201cIf you spend 10 minutes a year worrying about macro issues, you wasted ten minutes.\u201d<\/li>\n<li>Analyzing every twist and turn of the stock market, which boils down to gauging investor \u201csentiment\u201d rather than substantive matters.<\/li>\n<li>A focus on \u201ctrading\u201d not investing.<\/li>\n<li>A fixation on problematic stocks that individuals should avoid.\u00a0 Unless it is a super-expensive high flyer (TSLA, LNKD) or operates in an exotic and risky new industry (FB, TWTR, ZYNG, DDD, GRPN) or is the dumb idea of a famous hedge fund manager (JCP, HLF, SHLD) CNBC is not interested. The honorable exception is AAPL, but it gets way too much attention.<\/li>\n<\/ul>\n<p><b>Harvard Hates America (or at least its Equities)<\/b><\/p>\n<p>Jane Mendillo, the head of Harvard\u2019s $38 billion endowment, was interviewed in the latest <b>Barron\u2019s<\/b>.\u00a0 For many years Harvard and other Ivy endowments have been underweight U.S. stocks even though they were, until recently, trading at or below the levels reached in 2000 (when they were overpriced) and 2007.\u00a0 Today, Mendillo told <b>Barron\u2019s<\/b>, Harvard has 49% of its assets in equities, broken down as follows: U.S. Stocks 11%, Foreign Developed Nation Stocks 11%, Emerging Market Stocks 11%, Private Equity 16%.<\/p>\n<p>The allocation to U.S. equities looks way too low.\u00a0 For one thing, Mendillo admits the Private Equity space has become too crowded, which will lower returns.\u00a0 Harvard significantly underweights U.S. stocks even though A) they are more liquid than emerging market equities, B) they don\u2019t carry the same underlying financial and political risk inherent in emerging markets, C) their corporate governance is better, D) U.S. firms have material exposure to emerging market GDP growth via exports and foreign subsidiaries, E) In many areas such as electronics, aerospace, biotechnology, consumer products, finance, etc. the world\u2019s leading companies\u2014those with the best technology, brands and global franchises\u2014tend to be U.S. or European firms.\u00a0 (On the last point, I will freely grant there are many important exceptions such as Samsung, TSMC, and Alibaba.)<\/p>\n<p>Harvard is guilty of \u201canchoring\u201d\u2014of adhering to a prior view that has lost validity.\u00a0 It became fashionable for college endowments to follow Yale\u2019s lead and overweight private equity and hedge funds while deemphasizing domestic stocks.\u00a0 This bias was smart for a while but not now. Back in 1995 Harvard\u2019s exposure to U.S. public equities was 38%, more than three times what it is today.\u00a0 Look for it to rise back toward (but probably not all the way to) 38% over the next decade.<\/p>\n<p><b>\u00a0Coming Soon: Three Stock-Picking Themes <\/b><\/p>\n<p>Having dissected with unbecoming elan these four equity errors, in my next post I will strike a more constructive tone by discussing three stock-picking themes, all of which tend to be positive for industrial stocks, broadly defined.<\/p>\n<p>Copyright Thomas Doerflinger 2014.\u00a0 All Rights Reserved.<\/p>\n","protected":false},"excerpt":{"rendered":"<p>Secret NIH-funded research at the Wharton School of Finance in Philadelphia has demonstrated that prolonged exposure to the stock market permanently impairs the prosencephalon diecephaion subthalamus, the part of the human brain that governs good sense and logical thinking.\u00a0 I\u2019m &hellip; <a href=\"https:\/\/www.wallstreetandkstreet.com\/?p=591\">Continue reading <span class=\"meta-nav\">&rarr;<\/span><\/a><\/p>\n","protected":false},"author":1,"featured_media":0,"comment_status":"closed","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[1],"tags":[261,262,265,263,264,260],"class_list":["post-591","post","type-post","status-publish","format-standard","hentry","category-uncategorized","tag-cape-valuation","tag-cnbc","tag-frenzied-finance","tag-harvard-endowment","tag-ivy-league-asset-allocation","tag-robert-shiller"],"_links":{"self":[{"href":"https:\/\/www.wallstreetandkstreet.com\/index.php?rest_route=\/wp\/v2\/posts\/591","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/www.wallstreetandkstreet.com\/index.php?rest_route=\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www.wallstreetandkstreet.com\/index.php?rest_route=\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www.wallstreetandkstreet.com\/index.php?rest_route=\/wp\/v2\/users\/1"}],"replies":[{"embeddable":true,"href":"https:\/\/www.wallstreetandkstreet.com\/index.php?rest_route=%2Fwp%2Fv2%2Fcomments&post=591"}],"version-history":[{"count":3,"href":"https:\/\/www.wallstreetandkstreet.com\/index.php?rest_route=\/wp\/v2\/posts\/591\/revisions"}],"predecessor-version":[{"id":600,"href":"https:\/\/www.wallstreetandkstreet.com\/index.php?rest_route=\/wp\/v2\/posts\/591\/revisions\/600"}],"wp:attachment":[{"href":"https:\/\/www.wallstreetandkstreet.com\/index.php?rest_route=%2Fwp%2Fv2%2Fmedia&parent=591"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.wallstreetandkstreet.com\/index.php?rest_route=%2Fwp%2Fv2%2Fcategories&post=591"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.wallstreetandkstreet.com\/index.php?rest_route=%2Fwp%2Fv2%2Ftags&post=591"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}