The Buckingham Report

Nice to have additional research and editorial help as Greg Williams has joined Al Frank as our newest Portfolio Manager. Greg graduated cum laude from Washington and Lee University and has an MBA from Southern Methodist University. He was previously a senior analyst at a hedge fund in San Francisco after a number of years in equity research with Banc of America Securities covering multiple industries. Greg began his career in the audit group of BDO Seidman in Washington, DC. He is a CPA and a CFA Level III candidate.

We all wear many hats around here and I charged Greg with the task of updating and expanding upon our discussion of some of the statistics and associated long-term historical equity performance numbers that we have covered in recent Buckingham Reports, Prudent Speculator newsletters and Prudent Speculator Hotlines.

Enjoy…

Financial and economic headlines have by most definitions remained pretty bleak over recent weeks and months. Housing conditions have deteriorated further, a major investment bank was rescued from the brink of bankruptcy and the Federal Reserve has taken a seemingly unprecedented level of action to provide liquidity to various subsets of the panicked credit markets.

With the pummeling the market bore in the wake of the dot.com mania still in the not-too-distant past, it's no surprise the natural human instinct of flight has once again trampled stocks. As of the end of the first quarter, the S&P 500 is down 9.9% YTD and is off 15.3% from its high in October 2007.

In this Buckingham Report we will update and consolidate a theme we have touched upon in recent reports: despite all the bombardment of current negative news and increased levels of uncertainty, patient investors can take heart that equities historically have been a soundly profitable place to be. We reference Morningstar’s excellent tome Stocks, Bonds, Bills and Inflation in noting that from 1926 through 2007 large-cap (think S&P 500) and small-cap (think companies in the smallest quintile of the universe sorted by market capitalization) equities have returned 10.4% and 12.5% per annum, respectively. These performances handily outperformed corporate bonds, government bonds, government bills and inflation as can be seen in the following chart.

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If only those historical returns came without volatility! Alas, economic cycles are necessary to provide the fuel for those solid long-term returns and, frankly, to help keep things interesting. Thus, in the true spirit of “opportunity knocks when we least expect it”, seemingly negative data points on recent or projected elements of the economy historically have served as harbingers of outsized equity returns. Specifically, we use the following list of economic gauges to demonstrate that subsequent stock performance on one-, two-, three- and five-year bases is on average meaningfully better following weak reports of the nature we are reading now:

Gross Domestic Product

Considered the granddaddy indicator of economic output and growth, GDP is compiled and reported by the Department of Commerce. Specifically, it is the market value of goods and services produced by labor and property in the U.S. GDP primarily is watched in real terms, or net of inflation, for easiest comparison among periods. Annual growth of 2.5% to 3.5% is widely viewed as most favorable (not too hot, not too cold), while recession is officially defined as two consecutive quarters of negative growth. As compiling an estimate of this magnitude is no small task, quarterly GDP is released twice, with a preliminary reading followed by a final reading.

That final reading for the fourth quarter of 2007 GDP was released on March 27 and was left unrevised at an annual growth rate of 0.6%. Barely in positive territory, this anemic figure followed the 4.9% number in Q3 '07 and clearly suggests the economy is not exactly humming along and may actually be leaking oil. Yet, as illustrated in the table below, stocks on average have performed exceptionally better subsequent to a weak or recessionary GDP reading. Using the current 0.6% GDP growth as the demarcation line in our analysis, large- and small-cap stocks returned an average 17.3% and 27.9%, respectively, in the subsequent one-year period when the reading was at or below this level. This represents average respective one year outperformance of 4.8% and 13.0% when readings are above the current 0.6% GDP growth. Subsequent two, three and five year performance numbers further affirm our contention that it is often better to buy stocks when the news is grim than when all is rosy.

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Institute for Supply Management’s (ISM’s) Report on Business (PMI)

The Institute for Supply Management (ISM) is the largest trade association of supply and procurement professionals and maintains an index based on a monthly survey of its manufacturing industry members. The ISM was formerly the National Association of Purchasing Managers and the index still is referred to in the headlines as the PMI (Purchasing Managers Index). Chosen for their geographic and industry diversification, surveyed members report whether activity levels have improved or worsened in the following categories: new orders, production, employment, supplier delivery times and inventories.

Based on a scale of 1-100, a reading of 50 would indicate an equal number of survey respondents reported “better” and “worse” conditions, reflecting a neutral reading relative to the prior month. A reading of 50 and above generally indicates a growing manufacturing industry and would ordinarily bode well for the overall economy. Readings since 1948 have been at 50 or better over 68% of the time. Watchers also look for readings above 42, which over time is considered a hurdle indicating general economic expansion beyond just manufacturing. Readings below 42 generally signal recessionary conditions and last fell below this level in 2001. GDP forecasters tend to watch the PMI closely given its monthly readings.

The most current release of the PMI is February’s 48.3. This reading indicates contraction in the manufacturing industry and is cautionary for the broader economy. Yet, as illustrated in the table below, stocks have on average performed better subsequent to a weak PMI reading. Using the 50 as the demarcation line in our analysis, large and small cap stocks returned an average 18.2% and 24.5%, respectively, in the subsequent one-year period when the reading was below this threshold. This represents average respective one-year outperformance of 7.3% and 11.3% when readings are below 50. Subsequent two-, three- and five-year results also show outperformance.

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Unemployment

The unemployment rate is an estimate published by the Department of Labor based upon a monthly household survey. As an economic gauge, unemployment falls squarely in the lagging indicator camp (meaning the data are reflective as opposed to predictive), as employment levels tend to peak just prior to recessions. The bulk of the 'fat' from the prior cycle’s excesses gets trimmed during the early years of the recovery generating a higher unemployment rate (readers may recall all the 'jobless recovery' talk during 2002 through 2004).

Driven in large part by productivity and the boomer generation (think prime working years), the broader economic gains over the last 15-plus years have spoiled us somewhat when it comes to thinking about the unemployment rate. It seems lately that anything higher than 5% raises red flags when unemployment historically has averaged 5.6%. The December 2007 unemployment reading found its way up to 5% and so we used that as our bogey to look at subsequent stock returns. Per the table below, stocks on average have performed better subsequent to readings of 5% or higher, indicating that higher unemployment traditionally has been a foolhardy reason to give pause for the long-term investor.

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Philadelphia Federal Reserve General Activity Index

The Federal Reserve Bank of Philadelphia oversees the Third District (Pennsylvania, New Jersey and Delaware) and publishes a monthly Business Outlook Survey that includes the current and future General Activity Indexes (GAC). Like the PMI above, the GAC is a survey of manufacturing purchasing managers intended to get a read on trends in manufacturing activity levels (orders, shipments, delivery times, prices, employees, workweeks, capital expenses). Manufacturing, while a smaller piece of the economy now than in earlier generations, is more cyclically sensitive than the economy at large and is used as a leading indicator of broader turns in the business environment. The GAC is more timely (comes out a couple of weeks before the PMI) and, while just a regional survey, has proven to be an accurate predictor of national changes in industrial production. Readings above zero reflect that a larger percentage of survey respondents are indicating increasing (improving) activity levels. Negative readings indicate that a larger percentage are seeing declines.

March’s -17.4 reading represented the fourth negative month in a row for the index and immediately followed a couple of readings below -20. Using zero as the demarcation line in our analysis highlighted by the table below, large- and small-cap stocks on average outperformed in the subsequent periods when the reading was below this threshold. Not included in the table below, but still worth highlighting, are the subsequent stock performances when the GAC reading was below -20, as it was in both January and February. Large- and small-cap stocks returned an average 20.4%* and 39.5%*, respectively, in the subsequent one-year period when the reading was below -20. This represents average respective one year outperformance of 9.0%* and 26.0%* vs. readings that were above -20. (In fact, in the 33 instances of a monthly reading below -20 since 1968, in all but only one occasion each for the subsequent one-year and two-year performance periods, small cap stocks produced a positive return.)

*Past performance is not indicative of future results.

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Consumer Price Index (CPI)

Whereas GDP is the granddaddy of economic growth indicators, the Consumer Price Index (CPI), published monthly by the Department of Labor, is the Big Kahuna when it comes to inflation. This benchmark index compares price changes in a representative basket of goods and services on a year-over-year basis. The most widely followed metric is Core CPI, which excludes food and energy prices and is presented with a seasonal adjustment, but the entire CPI publication contains a significant amount of sliced and diced underlying data. The impact of the CPI is far-reaching, with significant effect on federal monetary policy as well as more mundane areas, such as cost of living adjustments, insurance policies and pension assumptions. As such, the CPI has been a notorious short-term headline maker and market mover. While the Fed historically has liked to contain inflation below 3%, from November 2007 through the most recent February reading the CPI has been at 4.0% or higher. Using that as our threshold in the table below, we see that large- and small-cap stocks have tended to outperform following CPI readings at 4.0% or higher, particularly over the subsequent two-, three- and five-year periods.

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American Association of Individual Investors Sentiment

The American Association of Individual Investors (AAII) is a non-profit association of more than 150,000 members. AAII produces a weekly sentiment survey of its members that measures the percentage of individual investors who are bullish, bearish and neutral on the stock market in the short term. With the goal of using investor sentiment as a contrarian indicator, we look at the spread between the bullish percentage and the bearish percentage (bullish minus bearish), where a spread of zero would indicate an even sentiment balance between the two. Earlier this year in January and again on March 19, the AAII sentiment reading was strikingly dour, with weekly spreads below negative 29%. While this indicator can fluctuate quite wildly, prior to these periods there had been only 13 weekly readings below negative 29.1% since the survey’s inception in 1987. Using that threshold in the table below, the subsequent outperformance over all the time periods provided is quite significant. Further, in each of the 13 instances (over half occurred in 1990) the subsequent stock returns were positive across all time periods presented.

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Summing it All Up

So, after no shortage of examples, we have the sense readers will catch our drift. Of course, there is no guarantee that the patterns we noted above will hold true in the future. But to that we paraphrase Mark Twain and suggest that while the past may not repeat itself, it often rhymes.

Interestingly, these are not overly obscure economic gauges that have to be found in the bowels of a number-laden financial journal. These are some of the most widely followed indicators and create no shortage of headlines when they come out. And perhaps that is the key to their powers to conjure such emotional reactions in the average market participant. Fear and greed should continue to blur the value of the readings as contra-indicators for the forward-looking stock market, and therein lies the opportunity in our minds for long-term-oriented investors.

Thus, in addition to the contrarian optimism suggested by the current sour economic data and several decades of market perspective on which to draw, we at Al Frank not surprisingly find many reasons to be excited about investing in what we believe are undervalued companies at the moment. Valuations generally are inexpensive by historical standards (see our final chart below, where the earnings yield from stocks is almost twice that from bonds, a complete reversal of the market-top scenario in 2000), interest rates are accommodatingly low, corporate insiders have stepped up their buying and our buy list for The Prudent Speculator newsletter contains a near-record 240 undervalued stocks, just to name a few.

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Past Performance is no guarantee of future results.

The information contained herein is believed to be reliable. However, such information has not been verified by us and we do not make any representations as to its accuracy or completeness. Neither the information, nor any opinion expressed, shall be construed to be or constitute an offer to sell or a solicitation of an offer to buy any securities.

The opinions expressed in the Buckingham report are subject to change without notice and are not intended to be a forecast of future events, a guarantee of future results, nor investment advice.

S&P 500 is an index consisting of 500 stocks chosen for market size, liquidity and industry grouping, among other factors. The S&P 500 is designed to be a leading indicator of U.S. equities and is meant to reflect the risk/return characteristics of the large-cap universe. Companies included in the index are selected by the S&P Index Committee, a team of analysts and economists at Standard & Poor's. The S&P 500 is a market-value weighted index - each stock's weight in the index is proportionate to its market value.

Indexes are not available for direct investment.

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About Al Frank Asset Management

Al Frank Asset Management, Inc. (Al Frank) is registered an Investment Adviser, editor of The Prudent Speculator (TPS) newsletter, editor and publisher of The Prudent Speculator TechValue Report (TVR) newsletter, and is the Investment Adviser to two value oriented no-load proprietary mutual funds and individually managed accounts.

Al Frank is committed to assisting our customers build wealth. We are a leading resource for value-based investor information in the financial community, where we combine our simple, proven philosophy of buying what we believe are under valued securities for their long-term appreciation with our experience, hard work, and intensive research to give you actionable investment information that can be used on a daily basis.