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While economic figures have been improving, we believe unsustainable stimulus programs are the drivers behind most of the progress to date, and significant moves from current market levels require stronger 3 to 5 year growth than the economy is likely to deliver. We reiterate that the easy money has been made via allocation to equities, and picking stocks will be much more important for the rest of the year, as valuation of the overall market is becoming less attractive.

It has been a great summer. After pausing during the month of June, the S&P500 continued its year-long upswing with monthly gains of 7.4% and 3.4% respectively in July and August. While the July rally was largely attributable to better than expected Q2 corporate profits and the seemingly stalled passing of Cap & Trade legislation and Healthcare overhaul, the August rush resulted largely from better than expected housing data, consumer confidence, and a newly built consensus that the recession is virtually over. Fed Chairman Bernanke was reappointed, but that didn’t surprise anyone. There has indeed been good news on the housing market. New home and re-sales increased for the 4th consecutive month. Resale of U.S. single-family homes and condos grew 7.2% in July, suggesting a seasonally adjusted annual sales rate of 5.24 million, exceeding economists’ projections of 5 million. New US home sales grew 9.6% in July, and suggested a seasonally adjusted annual sales rate of 433,000. There were 271,000 new homes for sale at the end of July, representing 7.5 months of supply at the current sales pace, the lowest since April 2007. Separately, the Conference Board reported that its Consumer Confidence Index rose to 54.1 in August from an upwardly revised 47.4 in July, significantly exceeding the consensus expectation of 48. On August 14, both Germany and France announced Q2 GDP growth of 0.3% from Q1, unexpectedly becoming the first major industrialized nations to technically pull out of the global recession. Naturally, investors are convinced a recovery must be in budding in the US.

While the market seems to concur that many aspects of the economy are positive and indeed improving, we remain skeptical. The market believes: the housing market seems to have bottomed; financial markets have stabilized; the recession’s end is around the corner; and although the unemployment rate will continue to rise and reach double digits, the economy will just adjust to that reality. While those beliefs may not be wrong, there are two powerful offsets that give us pause as to how sustainable the current good news is likely to be. First, the $8,000 tax credit for first-time homebuyers that supported many house sales will expire in November and the Fed’s $300 billion long-term treasury purchase program, which has helped to keep interest rates low, will end in late October. Like our thoughts for the Cash for Clunkers program, we suspect those stimuli have expedited future house purchases to the present. In addition, despite robust sales, foreclosures and short sales reflected 31% of existing homesales in July, and mortgages either in foreclosure or with at least one payment past due hit 13.16% in the second quarter, the highest percentage ever recorded by the Mortgage Bankers Association. The inventory for existing homes still represented a 9.4-month supply at July’s sales pace, unchanged from June. Regarding financial markets, while banks are no longer on the brink of collapse, the FDIC recently announced it had 416 banks on its "problem" list at the end of June, up from 305 at the end of March. Further, the FDIC has closed 87 banks so far this year, on top of the 25 in 2008. Fortunately, the total assets of banks on the problem list was just $299.8 billion, approximately 15% of the total assets of Bank of America, the nation’s largest bank in terms of deposits. Ironically, this speaks volumes of the systematic risks of those mega banks, with one potential failure essentially eqivalent to thousands of small banks. However, such an increse in problem banks does foretell additional problems for the sector.

While Bernanke cheered the economy in advance of his re-appointment, the minutes of the Federal Reserve's Aug. 11-12 policy meeting published last week further fortified the belief that the US economic recovery will start in the 2nd half, though it is likely to be weak. At this point, it is irrelevant arguing about the technicalities of defining the inflection point between a recession and a recovery, as that is best left for politicians pitching their elixirs. We think the important question is: What normalized growth rate can the US economy deliver over the next 3 to 5 years? Given that consumer spending accounts for nearly 2/3 of GDP, we think it is only logical to believe the recent stubborness of a rising unemployment rate suggests things are not yet ok with the economy. Combined with current fiscal policies, present valuation levels indicate things will not be ok for the stock market in the intermediate term.

In last month’s letter we discussed how we believed the easy money in this market is over. Assuming the vast majority of companies would not go bankrupt, heading into Spring 2009, all investors had to do was buy stocks – almost indiscriminately to book impressive gains. For those that were particularly choosey the gains were “generational”. A poster child for such trades is Las Vegas Sands (LVS), which traded at $1.42 in March and now trades above $15, as an improved capital market helped relieve investors’ fears of it going broke and news of the company’s Macau IPO gained traction. As we pointed out during the depth of the market lows, the market irrationally priced fear, symmetrically to how it irrationally priced prosperity just years earlier. During the November and March lows, the average implied 5 year annualized sales growth to the S&P 500 was –8.6% and -6% respectively, saying corporate America would shrink by 36% and 27% respectively 5 years from now. That simply was not realistic. As we wrote in November 2008:

“Fear has dominated the investor mindset and when we look at the factors driving returns in the past month, the past quarter and the past year, we find price momentum, dividend yield, and financial leverage are the most powerful factors. Investors found comfort in stocks with high dividend yeild, low leverage, and bought into the theory that “stocks do well for a reason” by chasing stocks that have done well. In addition, investors also stayed away from companies with poor earings quality, as those stocks consistently underperformed their universes in different time horizons. Our belief is that it is almost impossible to time the bottom but fortunately the important issue is not finding the bottom but finding the point at which as investors we can earn superior returns. If you missed our recent look at this topic, please refer to Investor Psychology and Market Expectations, and Then and Now: Buyer Remorse Versus Sellers Loss, where we discuss this concept in greater detail. The bottom line is that while the emotional cost of commiting capital is very high today, the financial environment has become much more attractive and investors who are willing to take an intermediate perspective and invest now and/or over the next few months in stocks with attractive valuations are likely to be rewarded very nicely in the years ahead.”

Year to date (1/5/09-8/31/09), the AFG’s large cap buys outperformed the S&P500 by 13.4% while the AFG’s mid cap buys outperformed the R2000 by 22.42%, which speaks volumes of the outpeformance of stocks with attractive valuation.

How do we view the market today? Before we share our thoughts, let us frame a few points for perspective. When we look at the price range of the S&P500 index during the past 3 decades, we find that corresponding to the big bull market from the beginning of 1980 to late 2007, the S&P500 grew 15 times from 100 to 1500. During this same period, both US GDP growth and unemployment averaged approximately 6%. In general it was a period of strong economic growth, although marked by many economic upheavals such as four recessions, a tech boom and bust, 9/11, and a rising real estate market. In general, Wall Street and Main Street prospered and suffered together. Thus it is no surprise that as the economy started to sour at the end of Q4 ’07, so did the market. In fact the Great Recession has brought consecutive quarterly GDP declines, and averaged 5.9% in Q4 ’08 and Q1 ’09. Furthermore, unemployment has sky rocketed to 9.4% from 5%. Not surprisingly, the S&P 500 dropped more than 50% to below 700 in early March of 2009. Since then, however, the index has rebounded nearly 50% to 1000. Again, Wall Street and Main Street were more or less aligned. Ultimately, the macro economy will put the conditions in place that lead to overall market valuations as those macro conditions frame two of the long-term value drivers (sales growth and margins) that generate economic profitability and thus market valuations. Examining the growth expectation imbedded in the latest S&P500 prices, we feel valuation levels are rather troubling. Based on Aug 28’s close of 1029, the S&P 500 was priced at an implied sales growth of 5% for the next 5 years. While this is below the long term average expectation of 7%, and not unreasonable relative to the S&P’s historical average 5 year annualized sales growth of 12.5%, we do not think our economy will likely support a nearly 30% expansion of corporate America over the next 5 years, as the curent macro policies coming from Washington are not likely to support such growth.

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First, a 30-year trend of falling income and capital gains tax rates will reverse in the next year. It will be difficult to grow an economy as investors begin charging higher and higher rates to supply capital. It is interesting to note, that during Clinton’s term, capital gains taxes fell approximately 30%, making the cost of capital cheaper and growth easier to finance and not surprisingly a very accommodative period for economic growth and prosperity. While tax policy points to a negative on the growth front, fiscal policy is likely to lead to higher discount rates as well. In late August, the Obama administration raised its 10-year budget deficit projection by $2 trillion to approximately $9 trillion, reversing its earlier protests against the Congressional Budget Office’s (CBO) forecast that deficits between 2010 and 2019 would total $9.1 trillion. Based on the $9 trillion deficit projection, the national debt will likely reach $18 trillion, and account for 80% of the projected GDP in 2019, up from the current 60%. The CBO said deficits would remain high beyond 2013 in large part because of spending on Medicare, Medicaid and Social Security, simply as baby boombers age, rather than being tied to the recession. This will force increasing government borrowing, and in turn “crowd out” private investment. Further, as evidenced by strong increases in the price of gold recently, inflation fears are growing over these projected structural deficits – also likely to drive up the cost of capital. We believe these policy issues and fiscal realities will lead to a period of below average economic growth, which naturally will translate into below average corporate growth as well. Bottom line – we think at 5% required growth rates, the market does not offer superior rates of reutrn relative to the risk of falling short of such expectations. While we do not believe the market is grossly over-valued, we would like to stress the need to carefully pick stocks rather than just buying market exposure through index or ETF purchases. The AFG 50 and 100 portfolios are a great place to start your stock picking research as these are stocks that comply with our long, proven concepts of buying stocks with reasonable expectations, solid fundamentals and non-wealth destroying management teams.

We conclude with an interesting observation from our 2nd Market Forecast Project conducted in mid August. Investment professionals are very torn about where the economy is likely headed. Currently the nod goes to those predicting another dip, with 52% voting that they expect another GDP decline in the year ahead. But note that is not a very convincing majority, and explains why there is still such a feeling of uncertainty about our current economic condition. We continue to get more participants into our survey and welcome your input as well. If you have not seen the results for August, visit AFG’s Market Forecast Project 2 for the complete survey and its results. To participate next month, visit AFG MFP and join our survey roster to receive next month’s questions. For the month of August 2009 (7/31/-8/31), the returns are the following:

For information on AFG's Tools and Research for professional money managers, click here 

Whats Working Russell 1000

What's Working Russell 2000

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ValueExpectations.com has calculated the performance of all the stocks we have recommended as buys since our inception in November of 2008. Below is a table with each blog we have posted that had specific Buy recommendations, along with the average return for each group of stocks compared to the overall market benchmark (S&P 500 or Russell 2000). On average, our Buy recommendations have outperformed the benchmark by 12.49% with a 59% Batting Average on our picks. This spread represents the value that AFG’s valuation techniques and Economic Margin (EM) methodology can add to your portfolio.

In case you are new to our blog, Value Expectations is an interface investors utilize to understand implied sales growth and profitability levels built into latest stock prices and find stock lists that we believe can be turned into actionable ideas for investor’s. Understanding those implied expectations for future operations is important as it helps investors to assess whether or not those expectations are realistic, which will in turn give investors a huge advantage in trying to identify stocks that will be the most likely to outperform or underperform, as AFG’s track record has shown since 1996.

We encourage you to stay up to date with our latest blogs to further your understanding of the EM methodology and to learn about more great investment ideas. We will continue to keep track of the performance of our stock recommendations compared to the market and will provide quarterly updates of our performance.

Total blog performance 11-26-08 to 8-28-09:

Performance Totals:

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By David Lee Berkowitz

"No man's life, liberty, or property is safe while Congress is in session."
-frequently attributed to Mark Twain or, more occasionally, Will Rogers

The second quarter began with stocks rising. Stocks, corporate bonds and commodities all rebounded from what we think will be “generational” March lows. We probably won’t see those prices again in our lifetime.

But the run stalled in late May. The markets fell a bit from their highs in June. It’s one thing to rebound from a generational low, it’s quite another to make up all the lost ground. The asymmetry of returns guarantees that when you go down -50%, you must go up +100% to get even. We are still in the process of restoring our wealth, but we are on the right path. Had we panicked out at the bottom, I have no doubt that many of us would be sitting here wondering if it was the right time to get back in. The market is up around +50% from its bottom.

The long-term growth oriented ValueAligned® Folio account was up +14.2% gross (+13.9% net) in the separately managed accounts. For the year as of June 30, 2009, the ValueAligned® Folio accounts are up +5.2% gross (+4.7% net).

We are doing well because we have tweaked our investment process; we are taking profits sooner and adjusting position sizes to volatility – that way more volatile stocks will not hurt intermediate performance on the downside, but will still contribute to our goal of doubling our money (+100%) in five years on the upside.

Leading indicators of future economic prospects drove the stock market off its March lows. Leading indicators have continued to move higher over the past few months. Just as the rapid and sudden decline in leading indicators and economic prospects tanked stocks last year, this year's improvement is driving them higher. So far in 2009, early expansion factors have dominated returns. Technology, materials and consumer discretionary stocks far outpaced the other sectors.

We recovered most of the losses from some of our smaller consumer discretionary stocks from the first quarter of 2009, and many of the losses from 2008. As we discussed with you last quarter, we believed that our losses in our small special situation stocks like AC Moore (NASDAQ:ACMR), +161%, since March 9th low through June 30th, Borders (NYSE:BGP), +667%, and Tempur-Pedic (NYSE:TPX), +232% were unwarranted by their fundamentals. Many of these stocks traded way below fair value because of low liquidity and investors’ fear of leverage. Since we judged that these companies would survive the recession, their shares were too cheap to sell. Sure enough as financial conditions returned to pre-Lehman bankruptcy levels the stocks rebounded. BGP is up +892% year-to-date; ACMR is up +158%; TPX is up +109%; Coach (NYSE:COH) is up +42.5%; Fossil (NASDAQ:FOSL) is up +58% (as of July 31st).

The stress tests for the banks are now over, and private, as opposed to government capital, is available for some of the largest banks. As private capital went into banks, we saw a little pause in the rally through quarter end. Of course, the market continues to power ahead through the beginning of August. Until we have other reasons to doubt the rally we will remain invested – but with some dry powder to take advantage of lower prices when they come. At the end of July we were

about 85% invested in stocks of ValueAligned® companies and 15% in cash. We were overweight consumer discretionary, technology and healthcare stocks.

The “swing” chart (above) of the bear market starts at the high in October 2007. The “panic” stage of this decline started in September of last year when Lehman Brothers failed.

Notice the latest rally from the March bear market bottom of +41.1% on the chart at above - that’s the biggest rally so far in the bear market. But despite the rally, we are still down -39.0% from the top in 2007.

From Fear to Panic

The severe financial panic that came from the extreme uncertainty of outcomes from the Lehman Brothers bankruptcy and AIG rescue froze economic activity and caused one of the fastest and steepest stock market declines in history. Financial conditions are back to normal recession levels – the conditions that existed prior to the September panic.

The market downturn is now in its 19th month which makes it the longest bear market and recession since World War II. The drivers of the first part of the bear market were the downturn in residential construction, housing price declines and declines in personal and business consumption. That was reflected in the first nine months from October 2007 where the stock market declined by about -22%.

The driver of the second phase was the September 2008 Lehman Brothers bankruptcy which caused a run on the nation’s banking system and on its money market funds that provided liquidity to businesses of all sizes. Credit seized up and economic activity halted. Confidence has returned as trust at least among our financial institutions is slowly returning. The public’s trust is another story. That might take decades to repair.

True financial panic as reflected in stock market volatility has only occurred three times in the last century – 1929, 1987 and 2008. Here I am referring to a financial condition that produces intense fear where trust is driven from the system as participants - businesses, individuals and the banks themselves - don’t understand who is solvent and who is busted.

Panic Back to Fear

Keith Hays of Hays Advisory shows the difference between panic and fear. He points out that fear is a necessary condition for an extended bull market to begin. However, panic erodes trust so much that normal bear market bottoms can’t form and wholesale liquidation of stocks and every other asset starts a cascade price declines – severely and suddenly exterminating the balance sheets of shaky companies and scared consumers.

Normal fear is depicted between the two red lines in the chart above. These tops in volatility – a measure of the degree of uncertainty in stock prices – correspond to normal bear market bottoms. You can see from the chart at the left that sometime in the last three months panic has receded and normal fear is back.

We love normal fear. Many times normal fear is just a misunderstanding about the transition from a terrible economy to a recovering economy. Fear is paralyzing for those without facts and methods to make rational decisions. And fear is the essential ingredient for a new bull market to begin.

A huge market rally off an economic low point is always perceived as just another bear market bounce. The gains are dismissed because the stock market always sniffs out pending economic improvement faster than improving fundamentals appear – and the fear from the previous panic prevents rational action by most investors.

Leading Indicators Point the Way

Since stocks are a discounting mechanism for future activity there is always this lag between stock price performance and a company’s outlook. The lag is usually around six months – the time that Francois Trahan of ISI Portfolio Strategy says is the time between leading indicators and Gross Domestic Product (GDP - the economy). The ECRI Weekly Leading Indicator Annualized Growth Rate topped out in June 2007. Six months later the recession started in December 2007. Many are excited in stock market land because this indicator bottomed out in December 2008. If a six month period holds again, then the economy bottomed out in June or July 2009.

Better Second Quarter Earnings Tell Us That Better (But Not So Good) Economy is Approaching

After the financial panic, the U.S. economy reacted much faster to changes in the economic outlook than ever before. Companies stopped ordering new stuff. Manufactures shut down plants. Consumers stopped buying everything. Then they started buying only the most necessary value oriented goods.

Managements quickly reduced employment, capital expenditures, advertising, travel and unfortunately, the short-sighted ones, probably even cut growth capital investments like research and development. According to ISI, the economic and strategy advisors, management cut employment by a record -4.8% because it looked like we were sliding into depression. The magnitude of the lay-offs was about 35% greater than what the models predicted given the actual decline in GDP. We bet that the other cuts were deeper than ever before too.

During a recession, analysts beat down earnings expectations as corporations drastically cut costs. All through the winter and spring of this year, analysts slashed their estimates of earnings. But they seemed to be much slower in reacting to the shock than were the companies they follow. This dynamic set us up for this current earnings season.

After being beat up so badly at the beginning of the downturn, analysts became overly cautious at the bottom. Therefore, earnings reports typically beat stunningly low expectations this quarter, and then analysts started raising their estimates. It does not mean all is right with the world, but it does mean that investors have pushed many stocks’ prices so low that embedded expectations are way too low. Of course, that means that the market was grossly undervalued in the middle of March, at the beginning of the second quarter.

Look at the example of Texas Instruments (NYSE:TXN) below. The blue line is the stock price (right scale) and the red line is analysts’ estimates. Notice how the analysts’ estimate line is highly correlated with stock prices.

In July earnings for most companies came in much better than expected for the second quarter just ended. Companies are succeeding in cost cutting their way, if not to prosperity, then at least to much better than feared results.

According to Bloomberg, with about 90% of the S&P 500 companies reporting positive surprises lead disappointments by almost a 3.3 to 1 margin. Results are much stronger than expected with the average surprise of those reporting better by +10.0%. This has led to many upward revisions for this year but more importantly for next year.

The bottom-up estimate for the S&P 500 is increasing and is now $59.82 for 2009, and the S&P 500 is now expected to earn $74.48 in 2010. That puts the S&P 500 at 13.2x next year’s currently expected earnings. If sentiment and valuation improve, the S&P 500 should move to its historical multiple of about 16x which would mean a move to 1192 – without any increases in earnings estimates. That would mean another +20% or so for the index.

The fact that analysts and investors underestimated how quickly companies responded to the near universal drop in demand was inevitable. Analysts always miss the economic turns because they are too excited near the top and too cautious at the bottom. Stocks tend to go up as analysts increase their estimates so analysts have an incentive to low ball positive change – when their estimates are too low their stocks go up anyway – and clients are less likely to complain if their stocks are going up.

Some pundits and other assorted market wizards argue that the better-than-expected earnings are simply due to cost cutting and we all should not get too excited. They are right! We should never get too excited or too depressed for that matter. But the first improvements are always cost driven. Nominal demand has not come back yet. The government still must subsidize spending – by paying people to buy cars for instance. Company revenues are weak which shows up in nominal (not adjusted for inflation) GDP. But all the cost cutting means productivity is rapidly increasing – EVA is going up. And that is good because something has to offset the coming tax hikes and government interference. This huge increase in productivity will accomplish some of that but not nearly enough.

Back to a Stock Picker’s Market

The S&P 500 (INDEXSP:.INX) has risen +50% from the market low in March. The huge rise is in sharp contrast to the collapse of almost all asset prices in 2008. As last year's market declined correlations between stocks’ returns rose dramatically – to nearly 90% during the worst of the credit crisis.

Today, stock price movements are returning to more normal correlations, which mean there is differentiation within the market. Consequently, stock returns are being driven less by macro-economic forces, and more by stock specific factors. We are moving towards more of a stock pickers market.

As market volatility decreases, stock price correlation decreases. From a quantitative portfolio management perspective, high market correlation has been a significant problem. This approach tries to separate future outperformers from underperformers using fundamental data. When all stock returns are driven by macro considerations, traditional fundamental factors are less important.

However, with volatility back near historical ranges, the efficiency and value of quantitative screening is rapidly returning. Regardless of the direction of future market returns (barring a complete collapse) we will benefit by having a portfolio of the shares of great ValueAligned® companies.

Insider Selling – A Warning?

After buying heavily in early March as the market collapsed, company insiders (CEO, CFO, Directors and large holders) started selling throughout most of the quarter. Insiderscore.com’s Weekly Score hit its lowest level in over two years as the S&P 500 climbed to its best level since January. Overall, the insider sentiment was very negative for the quarter as insiders used the market bounce to unload boat loads of company stock. So far the market has absorbed this supply in stride and hasn’t taken the selling en masse as a negative signal.

The first two weeks of each quarter show very light insider activity due to the number of insiders constrained from selling because of closed insider windows around the time of earnings reports. We start seeing activity in the fifth and sixth week.

The last time insider sentiment was this bearish three weeks into a quarter was the second quarter of 2007. And the last time the Weekly Score was this bearish for three weeks was the third quarter of 2007. Of course, we reached the market high in that third quarter. Insiders were smart sellers right before the bear market.

But corporate insiders are people too. They are subject to the same emotions that we all are. As the market comes off the “generational low” in March, a bunch of insider selling should be expected. Many of the sellers now were the same people that were worried about their companies going bankrupt just a few months ago. This round of insider selling is likely signaling a pause in the ferocious rally of late – but just a pause to refresh we think.

POLICY UNCERTAINTY MATTERS

This country has come to feel the same when Congress is in session as we do when a baby gets hold of the hammer. It’s just a question of how much damage he can do with it before we take it away from him.

-Will Rogers

The stock market low in March marked the crescendo of panic caused by the chaos and uncertainty of fiscal policy changes going forward. The President and his Congress passed a fiscal stimulus bill that many suggested was not timely or targeted. The House passed the Cap and Trade energy bill which the President endorsed. And healthcare reform is still up in the air, hotly debated for sure, but extremely expensive nonetheless.

The Democrats and President Obama in particular have hammered home the unfairness of the "Bush Tax Cuts" because income inequality has grown so wide. “The rich are getting all the favors from the rich that were in power” goes the story that is told.

This purported fact alone is repeatedly cited without even a peep from the media, the political opposition or concerned citizens. The problem is that "income inequality" is meaningless without context and certainly by itself does not call for a more "progressive" - soak the rich - tax policy.

During the campaign the President famously suggested to Joe-the-Plumber that we need to spread the wealth around. He meant it, but only now are Independents and Republicans that voted for Obama finding out just how much he meant it.

This President does not give a hoot about economic growth, only about redistribution in the name of social justice. But how do we measure "well being" and are the income growth statistics really so flat for the Middle Class? And does economic inequality really translate automatically into social and political injustice as the President seems to believe? The question in the end is: Do the rich dominate politics and make policy to cement their hold on power?

It seems that the election of this President and a very progressive Democratic Congress with a filibuster proof majority would suggest that the rich do not always gravitate toward the party that taxes them less. In fact, there were many more wealthy Americans trying to elect this President while he made crystal clear that his objective was to tax the rich more and redistribute their property/income to the less rich and poor.

What's going on here? Perhaps we do not have an entrenched plutocracy like so many in Congress and in the Democrat party predicted; perhaps instead we have a government by idle elites who feel entitled to experiment with grand policies thought up somewhere in think tanks and academia. These policies happen to entrench their favored special interests’ power.

My point today, though, is to remind my readers that this basic mistake about how well off the Middle Class is and how it has fared under "Free Market Economics" has huge policy and budgetary implications which in turn have growth implications far into the future.

The Stock Market Measures All This

The stock market knows this - as it always does. It is not a coincidence that at the same time that the President's personal poll numbers are moving lower - below Carter's now at this time in his Presidency - that the stock market has moved +50% off its bottom. As the President’s political capital wanes the likelihood of passage of his most progressive policies diminishes. The stock market begins to discount a brighter long-term future return on private capital.

Will Rogers Was Right – Evidence the Market Fears Congress

Way back in 1973 Princeton Professor Burton Malkiel conjectured that regulatory uncertainty is a negative influence on the stock market. He treated Congressional activity as a proxy for this regulatory uncertainty. When Congress is in session uncertainty is high; when Congress is out of session uncertainty is lower. The premise though is that when regulatory change is uncertain and dramatic, the stock market suffers. As the uncertainty about radical change dissipates, the stock market stabilizes and often recoups its losses.

In his 1973 investment book, A Random Walk Down Wall Street, Malkiel contends that "[I]t is not so much the direct cost of regulation that has inhibited investment but rather the unpredictability of future regulatory changes." The financial panic coupled with huge regulatory uncertainty in the President’s first few months led to the March bottom in my view.

Here Comes the Sun, Congress Goes on Recess

In their March 2005 paper entitled Congress and the Stock Market, Michael Ferguson and Douglas Witte showed that stock market returns are lower and more volatile when Congress is in session than when it's in recess. Get this. About 90 percent of capital gains recorded on the Dow Jones Industrial Average (DJIA) index between 1897 and 2001 occurred on days when Congress was not in session, according to the study.

If a dollar was invested in the Dow Jones Industrial Average in 1897 using an “out-of-session” investment strategy, by 2001 it would have grown to $216 (excluding dividends and transaction costs for simplicity’s sake). The same investment would have yielded only $2 using the “in session” strategy! Congress destroys wealth; government is the problem. Ronald Reagan was right!

Also, their study found that stock returns are significantly lower when the Democrats hold a majority in Congress. And returns are significantly higher when a Democratic Congress is not in session than when a Republican Congress is not in session.

The authors’ three possible explanations for their findings suggest that the current bounce has been driven by the public’s relief that Congress did not yet do as much damage to business as first thought as it heads out to August recess.

1. Congressional activity depresses the market. In recent decades the average approval rating for Congress has been extremely low, while lately it has been historically low – in the 20% area. Behavioral finance suggests that investors’ moods or attitudes may affect stock prices in many diverse settings. It turns out that the evaluation of information and attitudes toward risk are greatly affected by mood. Not surprisingly, depression leads to greater risk aversion and more pessimistic forecasts than happier moods. Considering the consistently negative opinion the public has of Congress, it is possible that Congressional activity has a negative impact on stock prices.

2. Congressional activity as a proxy for regulatory uncertainty. As Malkiel predicted, regulatory uncertainty brings down economic performance.

3. Congress acts in favor of concentrated minority interests, instead of the public welfare. We know that regulatory bodies are captured by powerful, concentrated economic interests. And these Democrats are driven by the most destructive kind of special interests for business in our opinion – labor unions (not labor by the way but the guys and gals that get the benefits from running the labor unions), the environmental groups and those in academia that hold the mistaken notion that the U.S. is run by the wealthy for the wealthy systematically leaving behind the middle class.

When Mr. Obama Goes to Washington, Sell!

At the beginning of President Obama’s first term, the CXO Advisory Group set out to measure the new President’s opinion about private versus public capital and his attitudes about the stock market as a way to gauge the likely economic effect of his proposed policies. Overall, these beliefs might mean that the President regards stimulation of private investment in public companies as a relatively ineffective means of achieving his policy objectives and investors are therefore a low-priority constituency. In other words, policy shifts that favor investors are unlikely.

The President of the United States, especially when the President's party controls both houses of Congress, arguably has more power over the economy and financial markets than any other individual. This power derives from influence over legislation, including the tax code, and the latitude of the executive branch to set and implement policies not constitutionally or legislatively/judicially prohibited. What are the current President's beliefs about the stock market, as expressed directly or via proxies? Do these beliefs have implications for investors?

Comments documented on their website suggest that President Obama believes:

• Over the short term, the stock market is not a reliable indicator of whether new policies/tactics will ultimately help or hurt the economy.

• The stock market has recently reacted to a deteriorating global economy and not to new policies/tactics intended to remedy that deterioration.

• The stock market is no higher than fourth (behind the job market, credit market and housing market) as an indicator of socioeconomic conditions.

• Over the short term, the stock market is very noisy, perhaps more sentimental than rational, and people tend to err in reaction to noise.

• Over the long term, the stock market is somewhat predictable, with future returns varying inversely to current price-earnings ratios (P/E). Moreover, government policies can largely control the degree of long-term market volatility.

• P/Es are getting low enough (3/3/09) that they indicate future stock returns are "potentially" a "good deal." (Nice call by the President by the way.)

In summary, the President's statements since taking office indicate that he views the stock market as an unreliable and low-priority indicator of the socioeconomic value of his policies/tactics. Investors beware.

WHAT’S THE LESSON?

Large losses seem to destroy investment programs and retirement plans. Not only must an investment portfolio that suffers a large loss contend with the asymmetry of gains and losses (a -50% loss requires a +100% gain to get back to even), but the time to recover is totally unpredictable. And that causes great anxiety – we understand.

An investment program in stocks started in 1965 in the S&P 500 didn’t begin to make gains until 1989, adjusted for inflation. A diversified portfolio of stocks during that extended period, which contained several large market corrections, destroyed purchasing power for 17 years before the market recovery began in earnest in 1983.

We are facing the same dilemma today. Over the past decade ending at the bottom in March 2009, the stock market has destroyed capital and reduced purchasing power. The real, inflation-adjusted annualized return was a loss of -5.9%. (See chart above). To recover this loss will require about a +100% real increase (real means above inflation). That’s 5 years at an annual real rate of +15%; 10 years at a real rate of +7% and 20 years at a real +3.5% rate.

At first glance you might immediately panic. But wait, what does history tell us? For those of us that did not panic out of the market near the bottom, we are already up some +50% in just 5 months before inflation. Take away 5 months of inflation and it is still right around +50%.

So let’s say we don’t go up or down by the end of the year – how many years left until we get our wealth back in order. Well 7% seems reasonable given the chart above – it’s less than half of the very best 10 year rates of return shown on the peaks. Our +50% already bought us 6 years of 7% real returns. That means we would need much, much smaller real returns for the next 9 years to get to that +100% gain. That seems much less daunting.

But if the past decade has taught us anything, it is that the doctrine of blindly being continuously invested in the stock market has flaws. It really matters when you begin investing. And as the chart above shows investing near the top in prices gets us to negative 10 year returns sometimes.

If we panic and can’t stay on plan with complete faith in the future, it certainly cannot be a strategy for retirees who are drawing down their savings constantly.

We think that simple strategies, like the election cycle strategy recounted above or a simple model based on current market valuations, are good alternatives to the conventional buy and hope doctrine.

By accepting market risk only during the political sweet spot or by investing our savings in great companies, growing their intrinsic value at low valuations, we put the odds in our favor of beating inflation and maintaining purchasing power and dignity into retirement.

IN THE END

In March we suggested it was not the time to exit your long-term plans. In fact, we suggested that you should add to your stock accounts where possible. Even though the market has run up now it is not the time to exit. We’ll continue to actively manage the portfolios by also revaluing the shares of our great companies and then monitoring their buy and sell points. We will also keep track of market risk and Congressional follies to give us the highest probability that we earn the highest returns going forward.

Since we held on and even bought more shares of great companies when others were panicking, we're willing to hold for the next decade or more – we are confident we will be rewarded from these valuations. We think this time is a fantastic opportunity. And what we do today could make the difference between looking back on this market in regret and reaching our financial goals.

We are experienced advisors who have studied for many years the market cycles, corporate strategy and human behavior. We know that all by yourself without the guidance of an experienced advisor, you may believe that this time is very different from all the others. We understand that it temporarily relieves the psychic pain of losses, and relieves the anxiety of an uncertain future.

That’s why we consider that our best service to our clients isn’t our brilliant economic commentary or our economic/market calls, but simply the saving our clients from their own understandable but sometimes destructive behavior.

Best regards,
David Lee Berkowitz
Rapidan Capital, LLC

Other interesting article: On Value Expectations  

Rapidan Capital, LLC is an independent investment firm that manages assets for a broad spectrum of individuals and their families. We provide comprehensive, institutional level investment and family office services that may have been previously unavailable to individual investors. Our pledge to be passionate about long-term performance defines our commitment to client satisfaction. We have eliminated the middlemen and our experienced analysts and portfolio managers have worked to create the latest innovation in growing wealth - the Value-Aligned Investing® system.

Professional investors attempt to find a cognizant u

Healthcare reform has been a hot topic of discussion in the news and on blogsites all over the country as the Obama administration mulls over whether or not a public option for healthcare makes sense and what a plan like that would entail. Any new reform to the current healthcare plan would have a great effect on stocks within the Healthcare sector. Below is a list of stocks we find attractive and a few that we find unattractive within the S&P 500 Health sector. The chart consists of each company’s attractiveness as an investment opportunity using The Applied Finance Group’s (AFG’s) buy/sell criteria (explained below), and also grades each company based on expected Economic Margin (EM) change and valuation ranks within the sector. Companies expected to improve EMs and that have a more attractive valuation than their sector peers have proven through backtests to be more likely to outperform than stocks AFG views as overvalued and that have an expected decline in EMs.

Source (The Applied Finance Group)

*Valuation & EM Change are Ranks within their sector

AFG's Buy/Sell Criteria - factors in Economic Margin, Management Quality, and AFG's Valuation Metric. In order to determine Management Quality, AFG scores management on their growth decisions in accordance with the company’s ability to either create or destroy wealth. AFG's Valuation Metric measures a company's Percent to Target (the deviation between a stock's current trading price and its AFG current default target price). To derive the intrinsic value of a firm, AFG uses its proprietary Valuation Model.

The Applied Finance Group's Value Expectations (VE) interface is useful in understanding the imbedded sales growth a company needs to achieve over the next 5 years to justify its current stock price. Measuring the spread between a company’s imbedded sales growth expectation (Implied Sales Growth) and what it has historically delivered (5 year historical median) provides a basis to determine which stocks have relatively low expectations and thus are more likely to outperform.

When using the VE interface to solve for the implied sales growth for every company within the S&P500, we found that the average implied sales growth for the overall index is 3.49%. This is less than the S&P500’s 5-year median for sales growth of 12.33%, which would suggest the index is still undervalued. The chart below displays this comparison, as well as the implied sales growth vs. historical sales growth for each sector within the index.

Our results indicate that the Energy and Financial sectors have the largest spread between imbedded sales growth expectations and the 5 year median, which would suggest these sectors have relatively low implied sales growth expectations, and thus are more likely to outperform. On the other end of the spectrum, the Utilities and Consumer Non-Durable sectors seem to have the loftiest sales growth expectations embedded in their current stock price. Thus, these sectors seem least likely to outperform based on current expectations.

Sector Expectations for S&P 500: August - 2009

Source: The Applied FInance Group

Below is a chart and table outlining the 2009 year to date performance of the sectors within the S&P 500. The Technology sector has lead the way thus-far while Utilities and Financials have been dragging down the overall average of the index. As previously reported in our Market Forecast Project, Technology was also voted most attractive sector according to our survery of professional investors. These sectors are based on the sector classification created by The Applied Finance Group.

Source(The Applied Finance Group)

Source(The Applied Finance Group)

Source(The Applied Finance Group)

*Valuation & EM Change are Ranks within their sector

AFG's Buy/Sell Criteria - factors in Economic Margin, Management Quality, and AFG's Valuation Metric. In order to determine Management Quality, AFG scores management on their growth decisions in accordance with the company’s ability to either create or destroy wealth. AFG's Valuation Metric measures a company's Percent to Target (the deviation between a stock's current trading price and its AFG current default target price). To derive the intrinsic value of a firm, AFG uses its proprietary Valuation Model.

The Applied Finance Group's Value Expectations interface sets out to understand the imbedded sales growth a company or index needs to earn over the next 5 years to justify an index or company's current price. The chart below gives a look into the Implied Sales Growth priced in to the S&P 500 over the next 5 years. Currently the implied sales growth over the next 5 years is 3.49%.

You can see that back in May 2001, investors were too optimistic in their willingness to pay for the average company in the S&P 500 to generate sales growth of over 17.5% for five years.   Conversely, we can see how stocks went “on sale” in November of 2008.  Investors could buy stocks that were priced to shrink sales by 8% for five years and still be fairly priced.  

Today we can see that investors have regained some confidence by paying for an implied sales growth of 3.5% for the average company in the S&P 500.   This positive sentiment was confirmed by AFG’s Market Forecast Project and the recent market rally we have all missed.

I would like to mention that when we solve for sales growth, we use AFG’s Economic Margin Framework to correct for accounting distortions by taking into account Asset Life, Asset Mix, Asset Age, Capital Structure and Growth, Cost of Capital and Inflation.  In the near future, we will be issuing articles that go into further detail on how we use the Economic Margin as a valuation system. 

Since the stability of the market is still very much in question, the key for investors will be to identify companies those companies that still have low “value expectations” embedded into their stock prices. We will continue to issue articles to identify some of these companies with low expectations and steer you clear of value traps.

Understanding the true intrinsic value of a company is very important when attempting to identify and take advantage of mispriced securities. The Applied Finance Group (AFG) has proven to be successful at helping their clients find attractive investment opportunities and also help avoid potential torpedo stocks by utilizing their Economic Margin Framework. AFG’s Economic Margin (EM) is the measure of the true economic profitability a company is earning after several adjustments to eliminate distortions caused by traditional accounting practices. Understanding a company’s EM levels and expected changes in EMs is important as it has been proven through vigorous back-tests that a company’s expected change in EMs is highly correlated with the company’s future market performance. Companies expected to improve their EM’s have proven to be more likely to outperform than those companies with declining EMs.

Source (The Applied Finance Group)

Now that we are more than halfway through 2009, It is an excellent time to highlight the top performers in the S&P 500 year-to-date and see which companies look the most attractive according to The Applied Finance Group (AFG). AFG’s valuation techniques have proven successful since 1996 at identifying mispriced securities and helping their clients take advantage of those market inefficiencies. Beyond valuation AFG helps clients understand the true economic profitability a company earns by using their Economic Margin methodology.

Economic Margin (EM) corrects distortions caused by traditional accounting policies to give a more accurate assessment of a company's true profitability. It is important to understand the direction a company's EM's are heading because companies expected to improve their Economic Margins have proven to be more likely to outperform than those with EM’s expected to deteriorate. The EM Framework addresses profitability, competition, growth and cost of capital. When factoring in each of these variables, investors can fully assess a company's value.
 

AFG's Buy/Sell criteria factors in Economic Margin, Management Quality, and AFG's Valuation Metric. In order to determine Management Quality, AFG scores management on their growth decisions in accordance with the company’s ability to either create or destroy wealth. AFG's Valuation Metric measures a company's Percent to Target (the deviation between a stock's current trading price and its AFG current default target price). To derive the intrinsic value of a firm, AFG uses its proprietary Valuation Model.

AFG's Valuation Metric – Measures the percent to target (deviation between a stock’s current trading price and its AFG current default target price). To derive the intrinsic value of a firm, AFG uses its proprietary Valuation Model (modified discounted cash flow model).
 

ValueExpectations.com has continued to provide investment ideas to help our readers make better informed investment decisions. In addition to finding Buy opportunities, VE.com also understands the importance of avoiding potential torpedoes given the current market volatility, so we have decided to provide a list of potential sell/short ideas from the S&P500 index (excluding Financials). These companies on our list look “At-Risk” of going bankrupt in the next 2 years according to the Altman Z-score (Z-Score), and look overvalued according to the AFG’s valuation framework.

Here is the list of 15 firms that you may want to avoid for your portfolio.

Overvalued S&P 500 Companies (Ex. Financials) with Poor Z-Scores (Altman Z-Score)

AFG Sell Criteria: When identifying possible sell/short opportunities (torpedoes) The Applied Finance Group (AFG) starts by running a screen using its proprietary Sell Criteria variables starting with Economic Margin. Economic Margin is a measure of corporate performance that identifies how profitable a company is by measuring how much the company earns above or below its cost of capital. In addition to corporate performance, AFG looks to identify those companies that are unattractively priced using our valuation model. Lastly AFG evaluates how well companies run their business using its Management Quality score, identifying companies that have management teams that destroy wealth.

The Altman Z-score - Z-score is a metric that gives insights into the likelihood of a firm going bankrupt in the next 2 years. The model was developed by Professor Edward I. Altman of the NYU’s Stern School of Business and first published in The Journal of FINANCE in September 1968. A common critique to this metric is that it was developed over 40 years ago and is no longer relevant.

In 2001, Professor Joseph D. Piotroski of The University of Chicago Graduate School of Business, published a paper called, Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers. Piotroski showed that value investors were rewarded by looking at a firm’s financial health and he showed that Z-score was a meaningful statistic.

More recently, on December 5, 2008, Dr. Altman was called to testify before a House of Representatives Committee on the condition of U.S. Automakers. In his testimony, he noted that Bloomberg, Inc. reported, “that approximately 1,000 users of their system per day access the Altman Z-Score model.”

The Altman Z-Score breaks down firms into 3 zones:
• >2.99 – Not Likely to Go Bankrupt
• 1.8 - 2.99 – Gray Area
• <1.8 – Likely to Go Bankrupt in the Next 2 Years

On Monday we highlighted several companies from our buy/sell list that represented investment ideas for all types of investors, which included Small and Large Cap stocks as well as Growth and Value stocks. Since Value Expectations tends to provide Large Cap Value Stocks for potential Buy ideas, earlier this week we decided it would be helpful to also highlight some small cap stocks we like from the Russell 2000. Now, moving on to the Growth investor, we will focus on companies we classify as growth stocks and find attractive within the S&P 500 (excluding Financials). By definition, AFG classifies growth stocks as companies with a Market Value/Invested Capital (MV/IC) in the top half of their sector.

In the table below are 10 growth stocks that we find attractive based on AFG’s valuation model, and are ranked neutral or higher based on AFG’s default recommendation.

Attractive Growth Companies - S&P 500 (excluding Financials)

AFG's Valuation Metric – Measures the percent to target (deviation between a stock’s current trading price and its AFG current default target price). To derive the intrinsic value of a firm, AFG uses its proprietary Valuation Model (modified discounted cash flow model).

Economic Margin - A corporate performance measurement that addresses the gaps in GAAP, eliminating distortions caused by accounting policies to measure what a company is truly earning above or below their cost of capital.

Management Quality – Assesses management’s ability to make wealth creating decisions.

AFG's Growth Universe - Companies in the AFG universe, which have MV/IC in the top 50% of the universe and have EPS estimates.

Market Value/Invested Capital (MV/IC) - The firm's average total equity, debt and other obligations divided by net invested capital.
 

As some investors may believe the market is starting to show "signs of recovery", many of the over 200 institutional firms The Applied Finance Group (AFG) works with can always take advantage of identifying mispriced securities. While some of AFG’s clients might have a specific focus on growth or value, most subscribe to the practice of buying growth at a discount (growth at a reasonable price GARP) and avoiding  “value traps.”

In October 2008 AFG released the study, Then and Now, discussing the low expectations priced into the market "Today many world-class franchises are available at expectations reflecting a very bearish future. Over 150 companies in the S&P 500 (industrials) have negative sales growth expectations embedded into their current market valuations". Following that study AFG issued another study, Analyzing Market Troughs and Rebounds, which pointed out that historical market recoveries have been typically dominated by value stocks.

Whether you are looking for value or more growth oriented securities, we have provided a list of  companies in various asset classes, Large Cap Growth, Large Cap Value, Small Cap Growth, Small Cap Value that are currently on AFG’s Buy and Sell list. If you are a professional investor and would like to view a complete buy and sell list or take a trial of AFG's valuation tools CLICK HERE.

Monthly Buy/Sell list Across the Market
The Applied Finance Group has a disciplined approach for identifying companies that are expected to outperform and underperform the market by using proprietary metrics and measurements that have been tested and proven through time. Because AFG’s research is fundamentally derived, AFG’s quantitative analysis spans across growth and value stocks, all sectors, industries, and market caps with over 4,500 covered securities. By using AFG’s proprietary criteria, AFG publishes a monthly buy/sell list to provide clients with a refined focused list as a starting point for all investments. This focus List of stocks has outperformed the market on an annual basis by greater than 10% with our buy portfolio and underperformed the market by 10% with our sell portfolio. AFG clients then use Value Expectations to further analyze the expectations embedded in a security’s price (example of expectations embedded in the entire S&P500 over the next 5 years below) and to build out their own model to refine an intrinsic value of a company based on their own expectations.

Select Companies From AFG's Current Monthly Buy-Sell List

(Source: The Applied Finance Group)

Again, If you are a professional investor and would like to view a complete buy and sell list or take a trial of AFG's valuation tools CLICK HERE.

Model Portfolio Buy/Sell Results

To view how AFG defines the Large/Small and Growth/Value universe Click Here.

A brief description of some other of AFG's insights:

AFG's Valuation Metric – Measures the percent to target (deviation between a stock’s current trading price and its AFG current default target price). To derive the intrinsic value of a firm, AFG uses its proprietary Valuation Model (modified discounted cash flow model).

Economic Margin - A corporate performance measurement that addresses the gaps in GAAP, eliminating distortions caused by accounting policies to measure what a company is truly earning above or below their cost of capital.

Management Quality – Assesses management’s ability to make wealth creating decisions.
AFG's Value Universe - Companies in the AFG universe, which have MV/IC at the bottom 50% of the universe and have EPS estimates.

The AFG 50 is an actively managed model portfolio of 50 stocks, designed to outperform its benchmark (S&P 500) while remaining sector-neutral. The AFG 50 Portfolio serves as an outsourced research team, as our analysts monitor each major economic sector to provide our clients with actionable buy ideas backed by detailed models, reports, updates and a backup list for possible replacements within each sector. Anytime there is a change made to the portfolio, i.e., new stock, reiterated/change of add/drop recommendation or adjustments made to models, our clients are immediately notified via e-mail.

The AFG 50 was launched on June 10, 2004 at AFG’s inaugural client conference. Through June 1st, 2009, our clients have enjoyed the following performance:

Outperforming the Benchmark 4 of 5 years with Cumulative Performance of over 1,100 bps.

• AFG50 and AFG100 are model portfolios and results do not include management fees or transaction costs
• AFG50 and AFG100 are re-balanced at end of each quarter to remain sector neutral vs. their respected benchmark, S&P500 and Russell 2000
• Average Annual Turnover: AFG50 less than 20%, AFG100 less than 40%

AFG 50:
• An actively managed portfolio of 50 stocks, remaining sector-neutral.
• Long-only and targeting turnover of less than 40% annually.

Our Goals:
• To consistently beat the index our clients are most often measured against, the S&P 500.
• To serve as an outsourced research team, distributing relevant content to our clients on a timely basis.
• To provide consistent, actionable buy ideas in each major economic sector.

Here is a sample report from our AFG 50 model portfolio.  The AFG 50 model portfolio provides institutional investment firms access to a devoted research team and investment process with the specific goal of consistently beating the S&P 500.   The AFG 50 leverages our client’s investment process and enables them to focus on their core strengths.  Below is a sample equity research report updating our thoughts on CTSH:

Professional Money Managers, click here to register for a free trial of our AFG 50 Model Portfolio.

The Applied Finance Group's Value Expectations interface sets out to understand the imbedded sales growth a company or index needs to earn over the next 5 years to justify an index or company's current price. The chart below gives a look into the Implied Sales Growth priced in to the S&P 500 over the next 5 years. Currently the implied sales growth over the next 5 years is -0.08%.

Click here to view AFG's Then and Now Study.

*AFG’s Value Expectations allows us to understand the Sales Growth, EBITDA Margin, and Asset Turnover a company has to deliver in the future to justify its current trading price. In theory and in normal circumstances, if the imbedded future performance is very conservative relative to the company’s historical performance, the stock is regarded as undervalued. The table displays the implied future Sales Growth of the list of companies assuming their EBITDA Margins and Asset Turnovers stay at the 5 year median levels.