"Equities - Is it Time to Consider Behavior?"

Sydney M. Williams

Thought of the Day

“Equities – Is it Time to Consider Behavior?”

September 28, 2010

Fundamental investors determine stock values to be the present value of its future earnings. To do so one uses a discounted cash flow model, into which one enters estimated earnings growth over a specific period of years. The model provides for a “leveled-off” annual growth rate. The discount rate, an estimated (and theoretically appropriate) benchmark return, is then used to calculate the present value. Since the model incorporates numerous estimates, the system works best when confidence is high. At times like the present when confidence ebbs, investors often turn to technical analysis to calculate resistance and support for individual stocks. The language of technicians can be arcane, tossing out words like oscillators, flags, double tops and candlestick charts – words that are off-putting to many individuals.

However, a good friend, and successful investor, suggests that in times like the present studying investor behavior may trump both fundamentals and technicals. The concept assumes that, while the future is unknowable, people act in ways that may be anticipated. Patterns emerge. For example, as my friend pointed out, during the early years of the Depression many out-of-work men would don their suits and head downtown, only to sit all day in the Automat sipping coffee and reading the papers. It was an attempt at “normalization”. Similarly, he suspects, people early on in the current downturn continued to spend on consumer products, in spite of their altered financial situation. They were stuck in denial, fervently hoping that what was happening was not. Reflecting that mood, he points out, retail stocks did well in the first part of this year.

The past ten years have been tough for equity buyers. In 2000-2002 investors were “slaughtered”. In 2003-2007, stocks recovered and home prices levitated. In 2008, investors were “killed” as both stocks and home prices plummeted. And now, in 2010, the markets seem unable to make up its mind. The 2003-2007 is now seen by many as a “fake” recovery. Rising stock prices lifted 401Ks and soaring home prices provided a false sense of security, akin to England in the glorious summer preceding World War I. Debt proliferated. Home equity loans became ubiquitous; the proceeds were used to continue the “good life” that commonsense said had ended in March 2000.

While stocks and home prices collapsed, debt initially continued to rise, lifting to 130% of disposable income. (It has since declined modestly to 126%.) Today people, if they have not lost their job, they worry that it is in jeopardy. They realize their savings is inadequate. (Savings has now risen to 6% from 1% at its low.) What savings they do have – Treasury Bills, Money Market Funds and savings account – provides little return. A million dollars in T-Bills pays $1300 annually. (Three years ago that million dollars paid $50,000 annually. To generate the same level of income today, one would need $38 million in T-Bills.) Remarkably, a retired person today on Social Security, with two million dollars in Treasuries would have an income placing them substantially below the poverty line.

So people, understandably, are nervous and cautious. They are focused on their jobs (if they have one) and on saving. De minimis returns have meant that retirees have had to buy riskier securities and/or extend maturities. As witness to this trend, money market funds have declined from $3.8 trillion in December 2008 to $2.8 trillion today. Yields on High Yield securities, over the same time, have declined from 17.4% to 8.3% today. Since the start of the current year, the Treasury yield curve has flattened from 373 basis points to 241 basis points today.

My friend draws the obvious conclusion that investors, especially the elderly, are scared. They worry where they will live and how they will survive. Even if their assets survived the double onslaught of house and stock price declines, their income is only a fraction of what it was. They want safety, but they need income. He cites a recent survey, which suggests that 90% of people’s concern today is about money. Additionally he assumes that the CEOs of companies sitting on cash hoards are just as worried, and those concerns prevent them from investing that money in new jobs.

Compounding the problem is that many individuals see Wall Street as a “rigged” game. They note that no blame has been assigned for the “flash crash” in May, despite the obvious “usual suspects”. They read of Wall Street getting bailouts; yet they hear the same politicians who voted for those bailouts demonizing “greedy” bankers and speculators. They distrust the “system”. Blaming others and instigating class warfare does little to restore confidence and serenity.

My friend concludes that while momentum is in bonds, opportunities lie in stocks, and suggests that the recent rally is the dawning of that knowledge. In terms of stocks, the characteristics he looks for include:

• Dividend payers that have a history of annually increasing payouts.
• Businesses that are global, as future growth will assuredly come from Asia and the developing world.
• Companies that are dominant in their industry and are gaining market share.
• Companies that are cash rich, providing the flexibility to make acquisitions, increase dividends, or buy back stock.

There are no seers on Wall Street (a lot of pretenders, perhaps, but none that have the ability to foretell the future), but one could do worse than be an observer of people, especially in times of distress. Interestingly, much of what people are instinctively doing – increasing savings, reducing consumption, paying down debt – sows the seeds of ultimate recovery. What is needed more than anything are leaders in Washington who will work to restore people’s faith and confidence in themselves. That we have not yet seen.