Book Reviews

1 Great Book to Read
by Joseph Dancy
LSGI Advisors, Inc.
December 17, 2007

It Was A Very Good Year -
Extraordinary Moments in Stock Market History
by Martin S. Fridson
256 pages, Wiley Publishing; (1997)
List: $19.95 at Amazon.com

Long term investment returns from U.S. stocks have been roughly 11% per year according to a study by Ibbotson Associates, however in some situations the markets have returned a multiple of this average.

Examining the last 105 years of historical stock market data we find some years yielded extraordinary returns for investors. In fact, as measured by the Standard & Poor�s 500 index and the Cowles Commission indexes (used for the period prior to 1915), the overall market returned in excess of 35% in ten of those yearly periods.

The best years from a total performance basis include the following periods, listed by total return:

If investors examine the historical data and identify the economic and policy elements that were present during those periods of excess returns they can determine when the market is most attractive. That was the premise of the study authored by Martin S. Fridson in his book �It Was a Very Good Year � Extraordinary Moments in Stock Market History�, 256 p, Wiley Publishing (1997).

Fridson analyses various theories as to what cases very good years for investors. He concludes two factors predominate: (1) stock prices trade at depressed levels reflecting fears of economic recession or economic contraction, and (2) central bankers were aggressively easing credit conditions and increasing the money supply.

Fridson summarizes his findings as follows:

The Winning Combination: Depressed Prices + Sudden Credit Easing

Looking ahead, the most likely formulas for the next very good year emerges from the pattern of the two most recent occurrences: Stock prices begin at a depressed level, reflecting fears that inflation-conscious central bankers will inflict more pain.

Suddenly a financial crisis reduces the price level to a secondary public policy consideration. As the Fed liquefies to the system, the stock market quickly and radically adjusts to the changed circumstances. In their eagerness to prevent a meltdown, the monetary authorities unavoidably give stock investors a windfall. . . .

All in all, it’s reasonable to infer that Federal Reserve chairmen feel justified in temporarily setting aside the battle for price stability when some overriding economic concern arises. Spotting such an overriding concern, at a time when stock prices happen to be depressed, represents the best hope for getting a jump on a very good year in the stock market. [emphasis in original] 

In light of Fridson�s finds, we decided to examine if we are in a period where the two major factors for outstanding stock market performance are present. Specifically, are (1) equities undervalued, and are (2) the central bankers aggressively easing credit conditions and growing the money supply?

Stock Market Valuation

One valuation methodology that has been utilized by a number of analysts is the IBES Valuation Model. This model can provide a quantitative measure of whether stocks are over- or under- valued. The data originates from the Institutional Brokers� Estimate System which was created in 1976 for U.S. listed equities. IBES is a huge database that gathers the different estimates of earnings by stock analysts for the majority of the larger U.S. publicly traded companies.

IBES model. The IBES valuation model compares the 12-month forward estimate earnings yield of companies in the Standard & Poor�s 500 index to the current yield of the 10-year Treasury note. Over the last several decades these parameters have closely tracked each other, correlating very closely.

When one of the variables strays it produces either an over- or under-valued condition which can be graphically represented. Clif Droke and Don Hays, well known market analysts, recently noted the U.S. stock market was recently 47% undervalued according to the IBES measures. According to their IBES model the market � as measured by the S&P 500 index - is �extremely undervalued�. Hays notes the market has only been this undervalued 5 days in the last 28 years.

While we are skeptical of many valuation models, one analyst noted the IBES model would have generated the following signals (see chart):

• investors would have gotten a �extremely undervalued� buy signal at the start of the bull market in the 1980's 
• the model issued an �extremely overvalued� signal just before the crash of 1987 
• it flashed an overvaluation warning again in late 1991, but the signal was premature
• the signal was again bullish in late 1993 and 1995 - before another market liftoff and one of the best years for investors in the last century (see chart and table above � the market returned almost 37% in 1995)
• the IBES model signaled caution that stocks were extremely overvalued in 1997 and again during the bubble years of 1999 and 2000
• it generated an �extremely undervalued� buy signal again in mid 2002 and has been flashing a continuous buy signal ever since. Over the last five years the S&P 500 index has returned 11.9% annually.

Clif Droke summarized the IBES model as follows: �It predicted the 1987 stock market crash. It predicted at least one year in advance the bear market of 2000-2002. And it announced an end to that bear market in 2002 and has remained in an exceptionally bullish posture ever since.�

While the IBES model has been criticized for relying on analyst earning estimates for future quarters � analysts who may have conflicts and who are not always accurate � we find the historical signals and subsequent market performance quite impressive.

Historical Price-Earning Ratio. One method to address the analyst bias/conflict argument of the IBES model is to review the market's valuation based on historical earnings, earnings that have been reported under the more stringent accounting rules adopted in the U.S. over the last few years.

If we review a chart of the trailing price-earnings ratio of the S&P 500 index for the last ten years from BusinessWeek we find that stocks �still appear to be modestly valued� � in fact the price-earnings ratio appears to be at or near a decade long low.

Insider buying. Another measure of valuation can include the activity of �insiders� in buying their stock. An insider might sell for many reasons but generally only buy for one � the fact that they think their company�s stock is undervalued.

One measure of insider interest is the �Gambill Oscillator� � a measure of insider buys to sells for companies in the Russell 3000 index. When insider buys exceed 25% of insider sells the Oscillator considers this a strong buy signal.

Historically this signal has correlated very closely with market out-performance. Since 2002 when this indicator was first created, whenever the Oscillator exceeded 25% the stock market has been up over 10% in the following six months and up 22% over the next year.

Right now the Oscillator is at a reading of roughly 60% � the most bullish reading in over 5 years � meaning that insiders find stock valuations extremely attractive.

Historical returns. Last, if we compare the performance of the S&P 500 index over the last eight years against many other assets we find that stock price appreciation has lagged considerably. While not a direct measure of over- or under- valuation, the lack of relative stock price appreciation seems to indicate that the other asset classes are becoming more fully valued as compared to the valuation of equities:

The performance of the S&P 500 index, or lack thereof, compared to alternative asset classes is stunning. The fact that many public mutual funds benchmark their performance against that index of large company stocks � and failed to outperform that benchmark � is also striking.

Central Bank Actions

The second element present in those years where the stock market grossly outperformed historical averages was a sudden easing of credit by the central bank with an associated increase in money supply. Many times this monetary easing was unexpected, and was associated with what Fridson characterized as a �financial crisis�.

Financial crisis. An unexpected financial crisis focuses the attention of the Federal Reserve on maintaining the health of the economy according to Fridson, as they overlook their role in containing inflationary pressures. The ongoing issues with regard to the credit and real estate markets since last August certainly qualify as an unexpected financial crisis:

• Wells Fargo, the fifth-largest U.S. bank, announced it will recognize $1.4 billion in losses in the fourth quarter on home equity loans that aren't being repaid as the real estate slump deepens 
• Citigroup announced roughly $6.8 billion in write-downs and losses in the third quarter, and said that it could write down another $8 billion to $11 billion in repackaged consumer debt in the fourth quarter
• Standard & Poor�s expects Morgan Stanley will take a $4.2 billion charge on bad loans, up from an earlier $3.7 billion estimate. They also projected Merrill Lynch will write down 25 percent to 30 percent of its $21 billion of such assets in the fourth quarter
• Freddie Mac, a government-sponsored lender to the mortgage sector, said it would write off $1.2 billion in bad mortgage debt
• Goldman Sachs estimated HSBC Holdings faces $12 billion in additional write-downs on their mortgage holdings

These credit write-down announcements do not include the potential write-downs from hedge funds and other investment entities such as endowment and/or pension funds.

Credit easing. In response to the credit problems, the U.S. Federal Reserve cut the Discount and Federal funds rates in back-to-back cuts in September and October, lowering the Federal funds rate from 5.25% to 4.50%. This is not an event that occurs on a regular monthly basis. Going back to 1970 � 37 years of data � the number of times the Fed has cut rates twice in a row is 18. It is in these easing phases of monetary policy where Fridson asserts that equities outperform.

Tom Butenhoff of Stifel Nicolaus & Company notes the S&P 500 index six months after the Fed's second rate cut, delivered an average gain of +11 percent � about double the historical return. Butenhoff additionally adds the S&P 500 index only declined in three of those 18 times this occurred.

Late last month it was announced that the New York Federal Reserve will arrange $8 billion of long-term repurchase agreements in a bid to hold down banks' borrowing costs. The Fed's move, the first such operation since 2005, follows the European Central Bank's announcement last week that it will make extra cash available to banks to ''counter the re-emerging risk of volatility'' in money markets. The average U.S. overnight rate has been above the Fed's 4.5 percent target almost every day since early November, suggesting banks are reluctant to lend.

''The Fed is pulling out all stops to try to alleviate funding pressures in the money and financing markets as the markets lurch into year-end,'' said Chris Rupkey, senior financial economist at Bank of Tokyo-Mitsubishi UFJ Ltd.

Money Supply. MZM has become one of the preferred measures of money supply because it best represents money readily available within the economy for spending and consumption. This measurement derives its name from its mixture of all the liquid and zero maturity money found within the three "M's."

The faster the growth of this monetary measure, the more liquidity will be available in the economy to stimulate business activity.

As can be seen in the MZM Money Stock chart the 13 week growth rate of this measure is at levels seen only rarely in the last decade. The longer term 52 week measure is trending upward and accelerating.

Bank Lending. Financial regulations in developed economies require lending institutions to maintain certain capital to liquidity ratios. Such capital ratios have been quantified on an international basis in what is known as the Basel Accords. When a bank�s capital falls below certain levels its� ability to lend is restricted, and in certain instances the bank might be required to re-capitalize.

The massive write-down of questionable mortgage related credit now being taken against capital will reduce the ability of the financial institutions to extend credit to the degree they could have earlier this year. While the Federal Reserve and other central banks add liquidity to the system, lending institutions could be hamstrung in their ability to offer credit or loans to businesses and consumers.

Summary

Of the elements identified by Fridson as present when stock markets perform well we can conclude that: (1) stocks are arguably undervalued as measured by several quantitative factors, (2) the unexpected financial crisis in the credit sector this summer has focused the global central bank�s attention on increasing liquidity and the money supply.

It may take 6-12 months for the monetary easing decisions now being made by the Federal Reserve and other global central bankers to impact the market and for many of the difficult credit issues to be addressed. But if history is any guide, eventually the increased liquidity will in Fridson�s words �unavoidably give stock investors a windfall�.

© 2006 Joseph Dancy
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Joseph Dancy, Adjunct Professor
Oil & Gas Law, SMU School of Law
Advisor, LSGI Market Letter
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