Newsletter January 25, 2009

InvestorsFriend Inc. Newsletter January 25, 2009

Stocks Versus Government Bonds

Stocks performed terribly in 2008. Almost everyone lost money. It was the worse year in stocks since the great depression! The economy is in a recession that seems to be getting deeper by the day. People are losing their jobs by the thousand. Corporate earnings are falling and many companies will not survive the recession. Therefore it feels like a terrible time to invest in stocks.

On the other hand, based on fundamental valuation, stocks appear to be cheap.

For about 10 years the dividend yield on larger companies had averaged a paltry 2%. Investors began to expect to make almost their total return from price gain, dividends were almost immaterial. Dividend yields fell in the later 90’s not because dividends had been cut. Rather it was because stock prices had increased dramatically while the dividends increased only slowly. Also large tech companies that paid little or no dividend began to become an important component of the Dow Jones Industrial Index and of the S&P 500 index.

But now, after years of low dividend yields, we now (January 25, 2009) have average dividends yield that exceed the yields on 10-year government bonds. This is the first time that has happened in 50 years! This happened mostly because stock prices dropped rather than due to any huge increase in dividends. The earnings yields on the stock indexes are roughly two to three times higher than the yields and earnings on 10-year government bonds.

Consider the following table that shows the earnings, P/E ratio and earnings yield of stock indexes versus 10-year government bonds.

Investment Dividend Yield P/E Ratio (Actual) Earnings Yield (E/P)
TSX Index 4.1% 9.8 10.2%
DOW Jones Industrial Index 3.8% 12.2 8.2%
S&P 500 Index 3.1% 19.8 5.1%
10-year Canadian Government Bond 2.8% 35.7 2.8%
10-Year U.S. Government Bond 2.6% 38.5 2.6%

Which investment (stocks or 10-year government bonds) is likely to earn more over the ten years?

The government bond coupon or yield is guaranteed to be paid. But it will not increase with inflation. The bond is also fully guaranteed to return its face value in ten years. The return, if the bond is held to maturity in ten years will in fact be precisely 2.8% per year  for today’s Canadian investor and 2.6% for today’s U.S. investor; no less, but also no more.

The stock dividends while higher than the bond interest yields could fall. But it seems unlikely that they would not be higher in ten years. In fact they might be expected to double in ten years.  Stock index levels could also be lower in ten years creating a capital loss. But stocks have already declined significantly. It seems very unlikely that stock indexes will be lower in ten years. If they increase at about the level of nominal GDP (real GDP plus inflation) say 4% per year , then stocks would be 48% higher in ten year. Stock indexes earned in 2008, two to three times what government bonds are now yielding. Even with earnings falling in 2009, one has to be extremely pessimistic to conclude that stocks will not provide a higher return to today’s investors than 10-year government bonds over the next ten years.

Investors drove government bond prices up (and consequently their yields down) as they sought safety. They will indeed find safety in terms of knowing exactly what return that they can make if they hold government bonds to majority. For this safety however, they accept a return that by all historic precedence is mediocre and seems almost certain to be lower than that which will accrue to stock investors over the next ten years.

Getting Back to Basics:

After a bad year in the stock markets, investors would be well advised to review the basics of investing.

Check our list of investment books available from Amazon

The most successful investor ever is Warren Buffett. Therefore, why not read his advice which he has freely dispensed in his annual letters. See his annual letters from ’77 – present, from ’69-’76, and from ’59-’68. If you review these letters you will see that Buffett’s basic (Incredibly successful) approach and his personality has remained unchanged for all these years.

Budget Wish List

A well functioning economy is one that works well in terms of the real goods and services that it creates, the average standard of living that it creates and the level of equality or inequality in living standards that it creates. The real economy is not about money. The real economy is about quality of life, the comfort (or lack thereof) in which citizens live and the inequality levels.

In my view, Canada has had a very successful economy over the years. It is an economy that has created an ever increasing amount of goods and services per capita year after year (despite occasional setbacks due to recessions). The average Canadian is well-fed, well-clothed and well-sheltered. It seems self evident that, most Canadians have more food, more cloths and bigger more comfortable houses than their parents had at a similar age. In addition most Canadians have money to spend on entertainment and on occasional travel. Not all Canadians have these things. There is certainly a large amount of inequality. However, when one recognizes that a system needs to reward diligence and hard work and talent, it becomes clear that an optimal economy will always have significant inequality. (An economy with total equality provides no incentive to work hard and invariably leads to equal poverty for all).

Recently the Canadian economy has suffered. Jobs are being lost in an automotive sector that struggles to compete with non-union car builders and with imports from lower wage countries. In addition it appears that the automotive sector may have done such a good job selling cars and making better cars over the past 20 years that frankly very few people need a new car at this time.

The Budget should not rush to cure problems which may not even exist. Subsidies that reward inefficient companies will not help Canada in the long run.

Subsidies to re-train employees that lose their jobs are probably a good investment. Infrastructure spending that create jobs as well as useful public infrastructure is a good idea. Tax cuts to the great majority that still have jobs does not seem like a good idea. Things like large subsidies for making houses more energy efficient are likely to lead to waste and to not be a good investment.

An initiative to cut regulations and red-tape for businesses would be a good idea. It boggles the mind how businesses are supposed to be aware of and compliant with the thousands of laws and regulations that have spewed forth in mind-numbingly complicated and lengthy legislation over the past decades. Everyone wants to tell businesses how to operate; from who to hire, what to pay them, their hours of work, whether they can smoke or not, whether they can be paid for performance, whether the employee must or must not join a union, the list is lengthy. Everyone also wants to impose their favorite regulation on the products produced. No longer must a business primarily keep its customers happy. Now it may be more important to keep a huge army of government inspectors happy. Surely some initiatives could be made to streamline this situation without compromising safety, human rights or common sense.

Overall I think my wish for the budget on Tuesday would be that it do less rather than more, that it keep its nose out of as many areas as possible.

Housing Prices

Here are a few observations on the housing price declines.

My house in a suburb of Edmonton had a tax appraisal of $210,000 in 2006, exactly two years later, in 2008 the tax appraisal was $413,000 for the same house. That is a gain of just over $100,000 per year.

(By the way, this is another topic but my property taxes only went up by 13% over the two years while the house value almost doubled. People often claim that their taxes will rise if the house value goes up but the reality is that municipalities index the tax rates down when average house prices rise. When municipalities impose a 7% tax increase, that is 7% in the dollars to be paid after they first lower the rate (per $1000 of assessed value) to compensate for any increase in average property values.)

In Alberta in 2006 and 2007, most houses “made” more money than their owners did working all year. It was absurd to think that this was “real” wealth creation and even more absurd to think that it was sustainable.

Now it is supposed to be some kind of emergency if houses drop in price by 20% or even 10%. The fact is that a 50% drop in Edmonton would only get us back to  about the prices that prevailed in about 2005. Why should that be an emergency?

Those Canadians that lived in a mortgage-free house saw large gains in the market value of their houses in the mid 2000’s. But the gain was fairly meaningless since they could really only cash it in if they no longer needed a house in their particular City or area. Those Canadians who had little equity in their houses ended up with huge windfall gains. A $200,000 house at 10% down payment or $20,000 equity turned into a $400,000 house with about 55% equity. All of the increase in market value went to the owner’s equity.

All homeowners may have felt richer as the value of their houses doubled. But did it ever really make any sense that everyone could become richer simply because houses could be traded to each other at twice the price as before? There is no such thing as a perpetual motion device and there is no ability to create perpetual wealth by simply having house prices rise and rise.

If houses were now to fall 20% or even 50%, then most mortgage-free Canadians will not really have lost any real wealth. Their house is not worth as much but most had no intention of selling anyhow. And if they do sell then they will find that the replacement house that they move to has also fallen in value, on average, by a similar amount. Sure there were some cases where someone was planning to sell in say Calgary and move to a lower cost area such as Dartmouth, but there are not very many of those cases. Meanwhile, anyone who bought near the peak with little equity is in big trouble. This is the flip-side of the heavily mortgaged folks go got a windfall on the way up. Those folks now simply lose their windfall. But the new buyers who borrowed $360,000 on a $400,000 house that is now worth $320,000 or (perhaps soon) $200,000 have no equity. If he house has “only” fallen 20% to $320,000 then they can probably work through it and keep paying for the house. However if they owe $360,000 on a house worth $200,000 then bankruptcy may have to be considered. In this case the bank that held the mortgage is also in trouble.

In retrospect it seems obvious that house prices could not have kept rising. No tree grows to the sky. House prices rose too far and now they are likely to fall. It is doubtful that any amount of government stimulus will change this.


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Shawn Allen, President
InvestorsFriend Inc.

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