Note: See important disclaimers below article.

Another month, another year, another attempt at a correction and another inevitable bounce. The chart below highlights the sentiments carried by many investors.

All the believers of the mantra that “Nothing ever goes up in a straight line”, have been forced to challenge their beliefs when every attempt at a correction in July, August and September gave way to higher highs and higher lows. Every time the market attempted a correction the blogosphere will be awash with claims of the baseless rally finally ending.

And so here we stand again, in the middle of the most recent bounce from a seemingly major correction when the markets fell for close to 6% in the span of two weeks from Jan 20-29. Is this time any different than every other attempt? Sure, there seem to be more solid, fundamental reasons this time for a proper correction – Obama is attempting to regulate the banking sector into submission, sovereign debt problems around the world occupy the headlines, existing and new home sales came in lower than expectations. But so what? Is this time really any different?  The believers of the above-mentioned mantra, the value investors, the Buffett followers, all gain hope at every market inflexion point that maybe this time the valuations will finally come closer to fundamentals. But as they wait by the sidelines for new lows to buy in, the market bounces and just keeps on going in a straight line.

The winners in the past 9 months have very much been the people who have believe that the market has little to do with fundamentals and will continue to remain disconnected from them. The winners have been those that have used different barometers from traditional fundamentalists in assessing the markets. But will that logic continue to hold weight into the future? Most likely only till the real big correction is upon us. But wait, can that even happen? Have investors already forgotten what it feels like to be in falling market?

For their sake, I hope not, because this time it might be different.

Disclosure: Long stocks, for now.

Disclaimer: Views and opinions expressed on above are those of the author alone and do not in any way represent the official views, positions or opinions of the employers – both past or present – of the author in question, or any other institutions and corporations associated with the author. Neither the information nor any opinions contained or expressed above and elsewhere on Young & Invested constitutes or should be construed as a solicitation or offer by Young & Invested to buy or sell any securities or other financial instruments or to provide any investment advice or recommendations. Young & Invested shall not be liable for any claims or losses of any nature, arising indirectly or directly from use of the information on or accessed through the site. Please see full disclaimers here.

It seems the consensus of bullish investors and authors about 2010 predicts strong emerging markets, glimmering gold, weakening US dollar and weakening bonds, which portrays my outlook for 2010 precisely. Additionally, I’d like to add that in my vision of 2010:

Mr. “Rich” Consumer

Americans will continue to keep finding a way to live above their means. Recently, claims for unemployment and lay-offs have shown to decline to an 18-month low as the economy slowly recovers. This latest employment news has a double-pronged effect. First, a recently reported jump in average weekly working hours means increased income and ability to spend. Secondly, on a more aggregate level, the trend of stabilizing unemployment will improve consumer confidence of job security, a critical factor to assess consumer spending, especially for large-ticket items large cars. Together, these effects will translate into increased consumer spending in 2010.

Mr. “Rich” Consumer without a Job

On the other side of the argument, unemployment will remain relatively high around 9~10% for the entire year due to a prolonged economic recovery. Despite lower layoffs and unemployment claims, which represent incremental increases to unemployment (i.e. the number of unemployed is still increasing but at a slower rate), the overall unemployment rate will slightly decrease from current levels to about 9~10%. Although unemployment may remain high, the stabilization and slight-decrease in the unemployment levels will mildly contribute to increased consumer confidence, but will also generally improve with the economy.

Yes, More Housing

The housing market will stabilize as the S&P/Case-Shiller index has shown uninterrupted growth in price of home sales for the last 6 months; the absolute number of home sales has also increased in the same period. So, homes are being sold more often and for higher values. As shown in the graph below, the Case-Shiller index is barely at its 2003 highs, and down 32.6% from a peak in the second quarter of 2006, so I doubt that any bubble-concerns will arise as the market is still evening out.

Continuing Low Interest Rates from the Fed

Analogous to the notes above, the Fed is obviously aware that economic conditions are showing signs of recovery. The Fed was already noted to exercise some exit-strategies such as ending purchases of Long-Term Treasuries and also stated that debt purchases will significantly decrease into early 2010. But, rates were maintained near 0% during December, 2009. To raise interest rates now, when the level of economic uncertainty is still highly elevated would result in highly-detrimental effects to the economy and the Fed’s reputation – homicide and suicide. Until signs that unemployment levels have definitely peaked and positive economic indicators show long-term trends, rates will be maintained at a low level until 3-rd quarter of 2010 or early 2011.

All of the above point to a pretty good year for the equity markets. Recent analysis I’ve been seeing is consistent with this hypothesis, including increased EPS and operating profits for a majority of companies and all sectors in the S&P500. A recent Wall Street consensus expects forecasts revenue growth in 2010 to be 8%, with improved earnings as well.

I’m a firm believer that history repeats itself, leading me to believe the tradition of the S&P500 index will continue in 2010. Expect a good year for stocks coming up; we’re still about 30% from the market highs of 2007. So, stock market running out of steam? Leave that for 2011.

Disclosure: Long Market

Image Credit: pfala under a Creative Commons license

Young & Invested is THE hub for finance and investing insights from the new generation. Head to our blog for more insights! — http://youngandinvested.com

As we reflect on the lessons learnt from 2009, it’s important to look at which theories have not come to fruition, or at least not yet. I look at the main themes and mantras that we heard echoed by almost every market expert but which we are still waiting to see in reality. In a follow up article, I’ll look at “New Mantras for 2010”.

Volumes will return after the summer

Throughout the summer of 2009, it was a regular occurrence to see the market spike upwards on low volumes and no news, while it fell on higher volumes. And in general, the market volumes were way below the norm. The mantra at that time was that volumes will return to the norm in the months of Sept – Dec. But of course, we didn’t see a major rise volumes while the equity markets continued to rally. Now, entering into 2010, volumes continue to remain low – possible indications that the low volumes are not due to seasonality but in fact due to large amounts of money still on the sidelines.

The big correction is around the corner

Starting from the end of March, 09, by which time markets had already rallied about 20% from their lows, investors/analysts/institutions have been calling and waiting for the big correction to come because the markets just can’t go straight up. But of course, that’s what we’ve seen for most of 2009. The closest we came to a major correction was in early July when the market lost about 7% from its high in June. How far away is this corner that we have to turn?

US savings rate will rise above 10%

When the US savings rate (as a % of income) rose from a low of 0.8% in Apr, 08 to 6.4% in May, 09, the mantra out there became that the US is going to see their savings rate spike to above 10% due to the consumer deleveraging being undertaken. Hence, the consequences for the consumer-driven US economy – roughly 70% of GDP is consumption – would be dire. Here we are in Jan, 2010 and since May, 09, we’ve seen that savings rate back down to 4.7% in Nov, 09. I’m sure waking up every other morning to 100 point gains in the market must have helped improve sentiment!

Insider sales indicate upcoming slump

Starting in the summer, people started noticing that insider sales outweighed insider purchases by quite a margin, with the ratio of sales to buys reaching 60 times on occasions. It was claimed the insider sales are indicative of the upcoming correction as insiders are bailing out on their own companies while they can still get a good return from the rising markets. Half a year later, markets are still rising and the insider sales to buys ratio continues to hover around 50 times.

Deficit will make US debt stink, China will dump debt

The US debt-to-GDP ratio reached roughly 65% and the IMF predicted a rise to 90% and beyond in the coming decade. The alarm bells went off and everyone started predicting failed US Treasury auctions and weak foreign demand as the Treasury auctioned of billions of dollars in debt each week. China, as the biggest foreign holder, was seen representative of the global demand for US debt (even though it holds only 6% of total outstanding US debt). However, the auctions came and went without surprises with some auctions doing better than expected. The current yield on the US 10-yr note has risen back to normal levels of around 3.75% since the crisis months of Jan, 09, but still way below the 5% highs of 2007. The same trend was followed by 30-yr notes which ended the year yielding 4.6%.

What does 2010 hold?

While the above mantras didn’t translate to reality in 2009, they should still be kept in mind looking forward to 2010, as I’ll discuss in a follow up article.

Disclosure: Long market.

Image Credit: Optical Illusion under a Creative Commons license.

Young & Invested is THE hub for finance and investing insights from the new generation. Head to our blog for more insights! — http://youngandinvested.com

Disclaimer: Views and opinions expressed on above are those of the author alone and do not in any way represent the official views, positions or opinions of the employers – both past or present – of the author in question, or any other institutions and corporations associated with the author. Neither the information nor any opinions contained or expressed above and elsewhere on Young & Invested constitutes or should be construed as a solicitation or offer by Young & Invested to buy or sell any securities or other financial instruments or to provide any investment advice or recommendations. Young & Invested shall not be liable for any claims or losses of any nature, arising indirectly or directly from use of the information on or accessed through the site. Please see full disclaimers here.

Qualitatively:
Besides practically inventing electricity, GE is one of today’s largest and most diversified industrial giants in the world. It is certainly a brand with what Buffett likes to call a consumer monopoly. Imagine, if you had all the capital you needed and the best management team in the country, would you be able to start a company that could directly compete with GE? Likely not; their brand name is just too strong.
1. Consumer monopoly – check.
2. Do we understand how it works? The company’s fundamental business is simple: produce most profitable products and sell them – check.
3. Is it conservatively financed? A check of debt-to-equity indicates in 2007 GE had total debt of $577.7K and about $111.5K in equity. In fact, GE is quite aggressively financed with a debt-equity ratio of 5.18, so let us see what else attracted Buffett to GE besides this.

[singlepic=4,320,240,,left]Quantitatively:
1. Are the earnings strong and do they show an upward trend?

A check of GE’s per share earnings indicates that they grew at an annual compounding rate of 10.09% for the period of 1997 to 2007. They can be considered very stable, increase every year with the exception of 2002 and 2005, in which the entire economy was experiencing a recession, which could have been a great buying opportunity then too.

Further investigation indicates GE has been buying back its shares. With 11.142B (adjusted for stock-splits) shares outstanding in 1997, the company has bought back about 1.1 billion shares to end at 9.988B shares outstanding in 2007. This is a sign that management uses its excess retained earnings, when available, to increase shareholder value.

2. Is the return on equity above average?[singlepic=3,320,240,,right]

General Electric has maintained a return on equity that is above average over the past 10 years. Buffett considers it a really good sign that the business is in good hands when it can earn-above average returns on equity. The average of American corporations, if you are wondering, is about 12% for the last 30 years.

This gives GE an annual average rate of return of 23.2%. Despite the fact that the figures have fallen from 2001 to 2004, the latter period of the decade shows another upswing, meaning that management is doing a better job in profitably allocating retained earnings to profitable projects.
3. Projecting annual compounding rate of return using historical EPS figure

General Electric’s average dividend payout rate over the past 10 years is 53% of earnings. We can figure out that if per share earnings continue to grow at a rate of 10.09% annually and if GE continues to pay out dividends at a rate of 53% of per share earnings, then the following EPS and dividend disbursements will develop over the next ten years:[singlepic=2,320,240,,left]

This means that in the year 2018, Buffett can project that General Electric will have per share earnings of about 6.25. With this, we can project GE’s rough price per share in 2018. Conservatively, if we assume that GE will be trading at the extremely low price-to-earnings ratio that it has been lately of about 12, then we can calculate that market price will be $75 (6.25 * 12 = 75). We should also add the dividend pool that we acquired over this time, and our pre-tax return jumps to $98.58 per share (75 + 23.58 = 98.58).

On the other hand, if we decide to be optimistic and use a P/E ratio of about 19, which GE traded at during some times of this year, then we can calculate market price for the stock will be $118.75 in 2018. Add in the dividend we calculated, and our pretax return becomes $142.33 per share.

Putting all this together, we can project that in 10 years, using this method, GE’s stock will be worth with dividends anywhere from $98.58 to $142.33. Let’s finally assume we paid a price of about $24, which the stock has been going for lately. This equates to a pretax annual compounding rate of return of somewhere between 15.18% to 19.48%.

If we put in $1,000,000 into GE today at $24, this means that in ten years’ time we would have anywhere from $4,109,327 to $5,928,560. Think you can find that type of long-term rate of return with any bonds or speculation? Think again.

Until Friday.

On Friday, the markets purged. Or, in a more business savvy term, they capitulated, which means that sellers decided to finally and fully give up on previous gains (or losses) as a final effort to get out of the market to less risky investments. In other words, the bears have all finished selling, and the last seller has sold, so now the bulls will start buying. Whereas in the last few weeks, we have seen stocks decline towards the end of the day as people get rid of their investments to avoid overnight surprises, market capitulation is characterized by very high trading volumes which occur early in the day, which we saw on Friday. The Dow went as low as 7,882 on Friday (loss of nearly 8%) before closing at 8,451.

Based on a CNBC article, about 3B shares traded hands Friday, which may very likely be the volume to achieve the long-awaited capitulation point. You can bet many traders sighed in relief at 4:00. Is this turnaround going to sustain? Jim Cramer didn’t think so, and believed that today would mimic the renowned, Black Monday. Take a look here.

Jim was obviously wrong as the markets are rallying today.