Investing’s Double Standard

John Mauldin | Thoughts from the Frontline
May 31, 2002

I get a lot of reader questions and comments along the following lines:

"John, how can you believe we are in a Muddle Through Economy when (pick a statistic) is so strong? Look at this indicator. Don't you think we are finally in a strong recovery and a new bull market?"

Then, I get even more like this: "John, how can you believe we are in a Muddle Through Market when (pick a statistic) is so disastrous? Look at this number. Don't you think we are headed for a stock market crash?"

But the numbers I read every week keep screaming Muddle Through to me. For new readers, by Muddle Through I mean an economy which is growing, but slowly, and a stock market which is sideways with a downward bias.

Today we are going to look at more evidence of a weak recovery, why the stock market will not enter a new bull phase and then we are going to look at some alternative investments which can help some of you. I am going to explain my biggest frustration as an investment advisor: the rules are stacked against the small investor. I hope I will be able to help you change the odds in your favor. There's a lot cover, so let's jump in.

The Boom Quarter That Wasn't

The economy grew at 5.6% in the first quarter of this year. By normal standards, that is not Muddle Through. That is Red Hot. The number of economists who are calling for a full blown recovery are legion. The cheerleaders on CNBC point to 1991 and tell us it's time to get on the Bull Market Train. Now, however, we are getting a flood of statistics which show that this number is less than it seems.

Stephen Roach points out that fully 73% of the growth in the first quarter was inventory related. That is, companies were bringing their inventories back up to stable levels commensurate with sales. But sales did not increase all that much, so this is a one time pop. Take out that 73% and GDP growth was around 1.6%, which is definitely Muddle Through.

Corporate profit growth was anemic, any way you slice it. "Economic profits" grew at only 2%. These are the profits a company makes from current operations when you take away all the accounting adjustments.

Show Me the Money

A mere 90 days ago, First Call tells us, analysts projected that earnings in the first quarter for the S&P 500 would be $9.11. The number is now in, and it is $4.40, or less than half. For the last 12 months, earnings have been $19.97. That corresponds to a trailing P/E (Price to Earnings) ratio of 53, the highest on record.

Ah, but John, the market is focused on the future. The first quarter is ancient history. Look at the projections for how well we are going to do in the future. First Call tells us analysts project profits of $33 for this year and a rebound to $50 for 2003. That certainly portends well, doesn't it? That means trailing P/E ratios for 2003 will be merely 20 and we can look forward to forward P/E ratios of 14 to 15 by the end of the year based on the price today, so how can we not see a new bull market? We may have to be patient, but earnings will catch up and the bull market will return.

Well, not exactly. If earnings are going to be $33 this year, things need to get better and real soon. Just 90 days ago, analysts were telling us that we would see earnings of $38 in 2002. They are now projecting an almost 75% increase in profits from last year for this quarter, and yet we are getting more and more earnings warnings and downgrades.

Remember the National Bureau of Economic Research study I wrote about a few months ago, which showed analysts were consistently optimistic by about 50%? I see nothing in the recent numbers that tells me they have changed their stripes. With all the current SEC focus on analysts and their forecasts, you would think they would be getting more conservative. The numbers tell me that nothing has changed. As a rule, they are still wide-eyed optimists. You are beginning to see a few change, but not enough.

The 25 year average for P/E ratios is 17.59 and the 50 year ratio is 16.44. We are currently more than 3 times those numbers which are at a nose-bleed height never seen before. Go to http://www.comstockfunds.com/files/NLPP00000/026.pdf and look at the graphs of P/E ratios for the past 70 years. It is quite sobering.

All that being said, I quite expect corporate profits to grow this year, just not at a 50% rate. Profit growth will come under pressure from several areas.

First, corporations are just not showing any ability to raise prices. You can only increase profits if you either lower costs or raise prices or increase sales. All are proving to be difficult.

As an example, import prices for the last quarter were down 2.3%, for the 5th straight quarter. This is imported deflation, and makes it difficult for US companies to raise prices when foreign competition is under-selling them.

Show Me the Jobs

Secondly, as Roach points out, companies have still not gone through serious cost-cutting of their labor. The portion of overhead attributed to labor is still historically quite high, especially coming out of a recession. As management is coming under increasing pressure to increase profits, they are slowly increasing lay-offs. That is why we are seeing the unemployment rate rise. This is a jobless recovery. While help wanted ads are finally rising, the rise is minimal.

Analysts are expecting a big surge in consumer spending to lead the way to robust profits. One of my consistent themes is that consumer confidence and spending is directly related to unemployment. Consumer spending growth is still growing, but at a much smaller rate. This slower growth is a direct result of rising unemployment and job insecurity. Obviously, this does not help profits.

Everywhere one looks, you see growth, but anemic growth. This is a clear prescription for a Muddle Through Economy.

One final factor which is going to hold down profits, and that is the "accounting crisis." Management is seeing company after company get their stock hammered as information leaks about aggressive accounting. Accountants are seeing Arthur Andersen collapse, and are obviously worried about their own firm's credibility. There is going to be pressure from accountants to be more conservative, and management is going to be more willing to listen. No one wants to be accused of cooking the books. The "everybody else is doing it" excuse doesn't work for my teenagers. And investors are telling companies that it won't work for them.

When I examine some of the recent "accounting problem" in the press, I find that the companies used GAAP formulas, thought they were being well within the rules, but the market is no longer willing to trust the numbers.

All this is going to put more pressure on companies to clean up their books. You are going to see more write-offs this year than normal.

Couple this with Standard and Poor's new accounting standards, which among other things will start deducting options from profits, and reported earnings are going to have a very difficult time rising the 50% that analyst's project.

Stock Market Doldrums

Valuations are at an all-time high, and as we move into the year, it will start to become obvious that earnings growth will not be strong enough to bring P/E levels back into normal patterns.

This environment will be accompanied by a decrease in foreign investment in the stock market. IdeaFirst tracks foreign inflows into the US, and their graph shows foreign investments in the stock market are down by over 60% from the high of a few years ago. Notice the talking heads moan about light volume on the stock market? Part of that is directly attributable to a decrease in foreign investment.

Then why don't I think we will have a stock market crash in the near future? Why do I think the stock market Muddles Through, albeit on a downward path?

First, there is still a lot of money flowing into the market from pension plans and 401ks. Major consultants still recommend an allocation of 70% stocks/30% bonds. That will change over time, but for now that is giving some buoyancy to the market.

Second, people are trained to buy the dips. Will we test the recent lows of this market? Absolutely, and probably even go through them. Then I fully expect a rousing chorus from the cheerleading section telling investors this is the Last Train Out. This is the bottom. Look at the improving profit picture, the growth in the economy, the stimulus coming from lower taxes, etc. And I expect this formula to work. Once again, the market will rise, just not to the level of the recent highs.

That is what happens in a long term secular bear market. The market posts increasingly lower lows and lower highs. The trend starts to get ugly.

It is entirely possible that this market trades in a sideways to down pattern for a long time. But when the next recession comes, and it will, then you will see the market begin to drop. Go back and look at the period from 1966 to 1982. It takes numerous recessions to really change the perception of investors, after they have been conditioned to a period of a long term bull market.

(Lack of) Alternative Investment Opportunities

What should an investor do in this type of climate? If you are going to be in the stock market, buy value. Look for dividends and companies that will pay you to own them.

And look for alternative investment opportunities. Which brings me to one of my biggest frustrations as an investment advisor: I can't put the majority of current and potential clients into the best deals I know about. The rules are such that only accredited investors, those who have a net worth of over $1,000,000 are able to look at many of the best alternative investments possibilities.

The following is an essay I recently did for the Daily Reckoning. Read it and understand the problem you face, whether you are an accredited investor or not. I am writing a book on alternative investments and hedge funds, and will start posting chapters next month as I write them. I think you will find this a very useful tool which will help increase your effectiveness as an investor.

I also write a free letter just for accredited investors. If you qualify, I strongly urge you to reply to this email and ask me to send you the simple application form for the Accredited Investor E-letter. And now the essay:

A Double Standard

If you went to court, and found out there were two sets of laws, one for you and a much friendlier set for your opponent, you wouldn't be very happy. We assume we all have the same set of rules. Yet in the investment world, there are in fact two sets of laws: one for the wealthy and one for everyone else.

How would you like access to numerous fixed income funds which average 13% a year for the last five years with 90% positive months? What about stock funds which can go both long and short, and have made money very year for the last five years? What about bond arbitrage funds which have averaged 20% per year for many years? Or very stable funds which deliver 7-10% a year?

The laws now in place prevent American citizens from accessing the best opportunities and best managers unless they are worth at least $1,000,000, and in many cases the investor must by law be worth far more in order to simply qualify to access elite money managers.

Ironically, non-US citizens can access many of these same American managers with no net worth requirements. How can a country so obsessed with equal opportunity under the law come to the place where a citizen of Botswana has more access to the best American investment managers than does a resident of Boston?

The prime culprit which wants to keep you on the farm is the Investment Company Institute (ICI). The ICI is the primary mutual fund industry organization. They lobby vigorously to oppose any change to the rules which they think would mean less money for their members and more opportunities for you other than mutual funds.

To understand how we arrived at this situation, we have to start at the beginning... almost 70 years ago. In the aftermath of the stock market crash and a stagnant economy, Congress began to pass a series of laws designed to protect investors from rampant fraud and corruption. The 1933 Securities Act and the later 1940 Investment Company Act, while modified over time, have served as the backbone of our investment laws. In the main, they have done well.

But like many laws, they also had unintended consequences. In my mind the most ironic of consequences is the creation of a multi-tier class of investors based upon wealth. The simple fact is that the wealthier you are, the better and more varied your investment opportunities.

Wealthy Americans are allowed to invest in private offerings and scores of different types of hedge funds. The rich are pouring billions of dollars into these funds. Why? Because they offer the opportunity for excellent risk-adjusted returns with little or no correlation to the stock and bond markets, and because many have a strong track record of delivering stable profits.

I believe that a large majority of investors would at least like the opportunity to look at these funds, and decide for themselves if they are appropriate for their portfolios. However, there are several reasons they can't.

#1, private offerings must remain private. You cannot read about them in general circulation publications. If you do, then the fund cannot legally take your money. Therefore they work very hard to stay out of the public press. Finding out about these funds usually requires consultants, attending expensive conferences and a lot of networking.

#2, these funds are usually limited to 99 investors. That means if they want to manage $250,000,000, they must get an average of $2,500,000 from each investor. If you are worth $1,000,000, you are what is known as an Accredited Investor. That means if you can find these funds or they can find you, you can investigate them. But for all practical purposes, many of them have minimums which are too high even for multi-millionaires, unless you know how to find alternative ways into these funds.

Yet these same managers often have offshore funds available to non-US citizens with minimums as low as $50,000 (and sometimes lower.)

#3, even if a hedge fund manager wanted to open a mutual fund version of his fund available to the general public, the mutual fund rules generally prohibit the very things that makes his management style so attractive to high net worth investors.

#4, small investors cannot legally invest in a fund which charges an incentive fee. Typically, hedge funds charge 20% of the profits they generate, which is called an incentive fee. Incentive fees represent the major portion of the income to a good manager. Most funds have a practical limit to the amount of money they can manage. If the fund gets too big, the profits start to fall, and the income of the manager drops. The incentive fee helps assure that funds do not grow too big.

Why do you think wealthy investors pay significantly higher fees for the privilege of investing in hedge funds? The answer is the potential for risk-adjusted returns, pure and simple.

#5, every few years someone proposes some minor changes to the laws governing private offerings. And every few years these proposals die.

For instance, many investors would like to see the 99 limit expanded dramatically. That would allow private funds to lower their minimums, and make these offerings more accessible. But the ICI aggressively opposes such a move. Their fear is that even more money would flow from mutual funds into private offerings. Their message to Congress is that small investors simply cannot be exposed to the risk of these funds. They trot out a few scare stories, along with liberal donations, and nothing gets done.

But the risk argument is a canard. Investors are allowed to invest in futures, where studies show 90% of all investors lose money. You can invest in options, where the vast majority of options expire worthless. You can buy Enron and Global Crossing. You can invest in the IPOs of internet companies. You are allowed to invest in mutual funds which can lose 80% or more of their net worth in a short time, and experience wild swings in value. In my opinion, in apples to apples comparisons with the best hedge funds which invest in the same markets, the best mutual funds offer less potential return with more risk. Let's not even discuss comparisons with the worst mutual funds.

What should be done?

Congress should change the rules. The incentive fee rule should be thrown out. It is an anachronism that assumes that Nanny Government must protect you from yourself, but which actually means you cannot get to the best managers. You cannot expect good managers to take less money than the market will pay them.

The 99 investor limit must go. Why are 99 millionaires smart enough to examine a private offering but when 101 of them get together, they suddenly become collectively brain dead and need government assistance? This makes no sense, unless you are a mutual fund trying to protect your turf.

A new class of mutual fund needs to be created, one which allows for managers to pursue whatever legal strategy they wish in the pursuit of profits. Doesn't it make sense to buy long term bonds, to hedge out the directional interest rate risk, add a little leverage and give investors a AA bond fund on steroids? Hedging works, and small investors should have access to those who know how to do it profitably.

This would have the added advantage of allowing mutual fund companies a whole new market, which would hopefully induce them to throw their support to changes. Further, while some hedge fund strategies require a great deal of skill and market knowledge, others are fairly straightforward. For those simpler strategies, access to the broad public market would make fees come down for everyone.

Regulation for these funds should be limited to ascertaining that accounting reports are accurate, that independent custodians assure the money is where it is supposed to be and that the strategy the managers say they are pursuing is actually what they do. By the way, the vast majority of hedge funds already use independent custodians and auditors, and many actually allow investors to see their portfolios on a far more timely and transparent manner than mutual funds. The wealthy are not stupid. They want to see controls.

It is my belief that over the next few years, most of these suggestions will become law. Logic says they should. And this time, political correctness is on the side of the small guy. Small investors should have the same opportunities as large investors to protect and grow their investment portfolios.

The next time you see your congressman, let him know you want to be set free. In the meantime, tell your broker or advisor you want to see the private offerings to which he has access.

For those of you who are accredited investors, you should devote time to learn what opportunities are available. One way is my free Accredited Investor E-letter. Simply reply to this e-letter, tell me you want the application form, and we will send it to you along with a letter outlining the simple process to getting access to this informative and educational e-letter.

For the rest of you, I believe that it is likely you will be able to access hedge funds in a modified fashion within a few years, at the latest. You can begin now to prepare yourself for those opportunities when they do arrive. As I said earlier, I will post chapters of my book beginning next month, which will give you a basic understanding of hedge funds, why you need them, how to evaluate them and where to find them.

This has been a very busy week, and next week will be just as busy, as I travel to New York to speak at the 9th annual Hedge Fund Forum. My topic is "Facing the Hedge Fund Issues of the Future." I have been busy researching the direction in which the industry is going. My research leads me to believe there will be major changes in the future, which will be to the benefit of all investors.

If you would like to see me in New York, I still have some time slots open. Call my office at 800-829-7273.

Your not hedging his opinions analyst,

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