Something is Going on Here...

This morning, The Wall Street Journal highlights the fact that a basket of 18 companies reaching their peaks in the past month are all makers of goods considered necessities should financial calamity hit. The Journal points out that, "the bunker portfolio, while vastly oversimplified, does reflect investors' preference for companies with products that are relatively immune to economic swings, and whose conservative strategies are suited to these uncertain times." Indeed, most of the companies hitting highs are producers of inelastic goods - those whose demand will remain stable even if prices increase.

However, the important thing to note about this group all hitting highs at the same time is not that the underlying companies represent a "Who's Who List of Armageddon Protection Purveyors" (that's a mouthful!). More importantly, it's that they are all true defensive stocks and have histories of paying and increasing their dividends.

As the article hints at, when the economy dips further into recession and the business cycle continues to pound cyclical names, the best area to look at are the steady dividend payers, hence the rise in The Journal's sample portfolio. In fact, the article says that "many of the star performers are steady dividend stocks: At least half of the companies on the list have increased their dividends this year, including Cummins, Dr Pepper Snapple and Airgas." Investors flock to safety when they sense that there's uncertainty in the market and one of the safest places to look among equities for safety are companies that pay a dividend and raise that dividend consistently. Outside of large amounts of free cash flow, a rising dividend is one of the few surefire signs of financial strength at a company.

Interestingly, the only stock on the list that's down year-to-date - JM Smucker - is still up roughly 70% from the bottom it hit during the peak of uncertainty in the financial crisis.

The End of the P/E Ratio? Not so fast

Today, The Wall Street Journal reports on the "Decline of the P/E Ratio", first discussing the reason for the dropping P/E of the overall market (uncertainty) but more importantly, why the P/E is no longer as prominent as it once was. I take exception to the argument that the P/E ratio is no longer relevant and I think the article proves my point. The Journal states that:

"With profit and economic forecasts becoming less reliable, investors are focusing more on global economic events as they make trading decisions, parsing everything from Japanese government-debt statistics to shipping patterns in the Baltic region."

While this trading mentality will no doubt affect short-term prices, the long-term determinant of stock prices remains the earnings that a company can generate. When a company generates earnings over the long-term, it can raise its dividend and it will be a more worthwhile investment.

How do Japanese government debt stats and shipping patterns in the Baltic region affect stock prices over the long-term? They really don't. While markets are becoming more globally-oriented by the day, there is little to no benefit in that information for long-term investors. While short-term investors may be able to exploit such data by trading on that news, the cost of doing so and the lack of expertise most people have in such areas will quickly erase any advantage the trader thinks he has. On the reverse, the long-term investor should be concerned with one thing and one thing only: earnings.

The P/E ratio can be either forward looking (forward P/E based on earnings estimates) or historical (trailing P/E based on EPS in the last 12 months), it holds a wealth of information. After all, with one figure, we are able to gauge both what the market expects a company to earn in the future and how much its willing to pay for $1 of earnings. For example, if XYZ Corp. is trading at a forward P/E of 22, then investors are willing to pay 22x for $1 of XYZ's earnings. Naturally, faster growing companies will have higher P/E ratios than slower growth ones.

The P/E ratio is far from dead. In the end, earnings matter. The P/E ratio is not a means to an end, but it's a good road map because it bridges the gap between a stock's price and earnings expectations based on each trading day.

New GDP Report & Its Trade Data

The revised estimate of Q2 GDP, a broad measure of U.S. economic growth, was released this morning by the Commerce Department. The report was anything but rosy with almost all engines of economic growth either tapering off or growing well below their intended targets. Worse still, because everything from business and consumer spending to the trade imbalance remain weak, it's likely that this will continue to put pressure on the unemployment rate.

The unemployment rate runs countercyclically with a lag, meaning that when the economy is starting to exit a deep recession, the rate can still increase for awhile before it begins to decrease, so we are potentially looking at rates of unemployment near 10%. For some historical perspective, in 1933, in the midst of the Great Depression, unemployment stood at 24.9%! Now, of course, the U.S. economy is a lot larger but this "Great Recession" is indeed still a lingering problem.

However, what worries me the most from the new data is the new, bigger trade imbalance. The trade imbalance (or deficit) occurs when you import more than you export.  Ideally, you would like to export more than you import because goods produced in your country and shipped elsewhere count positively in your nation's GDP report. In Q2, the Yahoo! article points out that, "imports surged 32.4 percent, the most since 1984. That overwhelmed a 9.1 percent increase in exports." This has been the trend for a long time now and likely will continue to be as the U.S. relies less on manufacturing and buys cheaper goods elsewhere. While this is great for international trade, it just means that other areas of the economy will have to make up for this figure in the GDP calculation - that doesn't appear to be happening just yet.

Investing Bubbles & The Media

Fortune recently highlighted what they view as six separate investing bubbles in the making, including the Chinese economy, gold and U.S. Treasury bonds. All of the talk of bubbles can be particularly scary since the bursting of the housing bubble has been one of the primary causes of "The Great Recession" we're currently in.

While I don't have an official position on each of the bubbles Fortune lists, I do think that any time the euphoria and enthusiasm for a particular investment officially gets "called out" by the financial press, it may be time for a reconsideration of whether or not those investments are fairly valued. After all, you normally see the media write glowing stories about assets as they inflate, inflate, inflate until their bubbles burst. When the financial press begins looking at things more closely and pointing out the inflated valuations of those assets, the end of the run may be near. Caveat emptor!

Economics and Investing: Pay Attention to All Data!

Today, the WSJ's Economics Blog has highlighted how an even slower economic recovery would feel. Daily, we are hearing reports of more and more economists who believe that we are going to experience a double-dip recession due to little or no jobs growth, the lack of any real pickup in home buying/construction, reduced consumer confidence & spending and limited business activity. In addition, the blog says that "New orders for non-defense capital goods excluding aircraft plunged 8.0% in July, wiping out the gains of the previous two months." All of this is sure to put a damper on whatever economic optimism is out there.

However, this news is important for Gen Y's because economics is an area that we often overlook, both out of disinterest and the notion of it being boring. After all, why would you want to eagerly follow something that's been labeled the "dismal science"? If there's one thing I have learned from my college econ classes, it's that you have to question all of the data all of the time and you can never believe only one set of numbers.

All of this economics talk helps validate the importance of behavioral economics. I talked about behavioral finance last week but the discipline also applies to economics. It's common for us to overlook or gloss over certain facts or data that's presented to us, either because we're just not interested or it doesn't help validate our case. For example, if we're optimistic seeing that the economy is humming along with GDP growth growing briskly, jobs being added monthly and wages rising then should we necessarily believe that a drop in durable goods orders forecasts a recession? No! But this also hammers home an important point: Never simply look to one data point to validate or invalidate a forecast we may have. You have to look at everything as a whole.

The same is true with investing in stocks - just because one data point (lagging sales growth, for example) might tell us that a stock isn't an attractive investment, it doesn't necessarily mean that this is the case because there's always more to the story. However, when we see multiple data all pointing towards one thing - a further downturn in the case of today's economy - then we should probably take heed.

Interest Rates on Credit Cards Rise

Today's blog post is going to be a quick break from the behavioral finance for Gen Y features I've been posting. The Wall Street Journal reports today that as a result of new credit card rules that took effect Sunday, banks are now limited in how much they can charge customers in penalty fees. This has led to a rise in interest rates on cards and in Q2, the average interest rate rose to 14.7%, up from 13.1% in 2008.

This can be interpreted as sobering news for Gen Y since many of us rely on credit cards to help bridge our month to month financial needs. Credit cards are a great way to build good credit but only if managed effectively. For example, only charge something to your credit card when you know you have the cash to pay off the bill when you get it. This way, you won't be forced to scramble for cash and you'll be sure to build an excellent credit rating while remaining disciplined in the process. So while the new rules that are now in effect will certainly raise borrowing costs for many people, if you remain a disciplined Gen Y saver and spender who only uses a credit card to buy something when you have the cash to pay off the bill, you won't have to worry about any interest charges.

Behavioral Finance for Gen Y: Part 2

I'm back at college for senior year and beginning to think of more and more investing biases that are particularly prevalent among Gen Y - and what you can do to avoid them!

Last week, I highlighted the self-serving bias, where we tend to give ourselves credit for having investing skills when a stock pick goes up, but avoid responsibility for buying it and instead blame bad luck when it goes down. Today, I'm going to highlight risk aversion. Basically, risk aversion is exactly what the term implies: When an investor is given the choice between a risky investment (growth stock) or a less-risky choice (domestic stock index fund), he/she will choose the less risky investment. This is very normal behavior for some people who simply do not recognize the fact that high risk investments can mean high reward, when the possibility for high loss is also understood.

So, if I advocate index funds, why am I highlighting risk aversion here as an investing bias? Ultimately, as Gen Y's, we have a longer investment horizon than Baby Boomers and Gen Xers. As a result, while a balanced allocation of index funds (60%+ of total asset allocation) is ideal, it's rational to own a diversified portfolio of dividend-paying stocks as part of the rest of the allocation, keeping in mind that the individual stock exposure should always be less than the total index fund exposure. With this approach, any bumps from purely buying risky investments (which will lead to risk aversion tendencies should they go down) will be mitigated by the large allocation to index funds. Even better, a diversified basket of stocks in different industries will be less correlated to each other, further lessening risk.

We are lucky in that our time horizon enables us to recover from any particularly poor-performing investment. However, if we diversify well enough and invest in companies that have a long-term history of paying a consistent dividend, the issues that arise because of risk aversion become smaller as the companies we are buying aren't as risky as some of their counterparts. Then, the benefits of this approach are especially notable because of the potential for higher returns in the individual stocks we own, provided we reinvest their dividends. Couple this fact along with the fact that we own a nice portfolio of index funds, and Generation WI$E will be all set.