The Small Cap Watch List (Track at Marketocracy) lost 0.7% this week, but that knocked the socks off the 2.49% decline in the S&P Smallcap and the 2.12% loss for the Russell 2000. It also allowed the watch list to pull back even with the S&P small cap on a cumulative basis.

The 2.84% loss for the Mid Cap Watch List (Track at Marketocracy) was a bit worse than the 2.45% loss for the S&P Midcap, making its cumulative lagg even worse.

The Large Cap Watch List (Track at Marketocracy) was the real stinker, though. It lost 3.11% against just 1.87% on the S&P 500. Even that did not eliminate its cumulative outperformance, though.

The watch lists will get a quarterly refresh at the end of the month.

You haven’t been looking very hard recently if you haven’t seen a chart comparing the rally in the Dow Industrials to what it would be if priced in gold or Euros. Eddy Elfenbein’s got a problem with that.

Don’t let anyone tell you that this rally isn’t for real. And especially, ignore all the phony comparisons (to gold, to euros, to inflation, to Swedish kronor). Who cares? I don’t use euros anyway. Why not compare it to bandwidth? I use lots of that. Anyone can use clever comparisons to show what they want.

It is fair enough to say that for US investors the framework for investing is the US dollar. Why should we care, for example, if European investors aren’t getting a good return? If all our liabilities and our income is dollar-based, why compare our returns to anything else?

Well, fine. Let’s compare the rally to other potential investments in dollar terms. I sorted the Yahoo! ETF browser by 1-year returns and the S&P 500 didn’t even crack the top 100 (it was 101). Instead of earning the (quite respectable) $15 per $100 invested here, wouldn’t you have rather had Malaysia’s $49.22, or even Germany’s $32.38?

Not fair, you say, to look at 1-year returns when it has been more recently that the US markets have been on their record streak? Fine. Year-to-date the S&P 500 ranks 228th among ETFs. Over the last 3 months it is 238th. These rankings are barely average.
The charts comparing the stock return in anything other than dollars is simply a way of showing that other investments performed better. Unfortunately, presenting it that way can prove confusing to those who ask why they should care. It is not a very good illustration when it doesn’t make the point.

Disclosure: Author is long STREETTRACKS GOLD (GLD) at time of publication.

Although the last week managed to shake investor’s (over)confidence, it wasn’t long ago that all the talk was about the new records being set by the Dow. And with all the talk of a bursting housing bubble, one might wonder whether those stocks are still even around.

Which is why we were a bit surprised to see the 5-year performance chart common to SEC filings while we were reviewing the 10K of Small Cap Watch List (Track at Marketocracy), Mid Cap Watch List (Track at Marketocracy) and Large Cap Watch List (Track at Marketocracy) member (yes - all three - blame S&P for their overlapping market caps in the indices, which made it suitable for all three lists) NVR Inc. (NVR - Annual report).

The Dow has done very little over the last five years (though we don’t expect the next five to be much better) and, despite the rocky year the homebuilders had in 2006 there could be more room for declines ahead.

January durable goods orders tumble 7.8 percent - Yahoo! News

New orders for U.S.-made durable goods fell by a much sharper-than-expected 7.8 percent in January as nondefense goods orders saw their biggest monthly decline ever, a government report showed on Tuesday.
A steep drop in orders for Boeing Co. (NYSE:BA - news) airliners helped push down nondefense orders for durable goods, items meant to last three years or more.

Excluding volatile transportation orders, which are heavily skewed by aircraft, durable goods orders fell by 3.1 percent in January, their steepest drop since July 2005, the
Commerce Department reported. That followed a downwardly revised gain of 2.8 percent in December.

Economists polled by Reuters had forecast that orders for durable goods would fall 2.5 percent, orders excluding transport would drop 0.2 percent and orders excluding defense goods would rise 0.3 percent.

Thus read the headline number, which combined with a selloff in China and a bad print or two to send the markets hazzardously close to closing below the December closing low of 12,194. But we always argue that the month-to-month volatility, compounded by seasonal adjustments that may not always make sense, provide the headline number with little value. Instead, we prefer to look at year/year changes before seasonal adjustments are made.

Our analysis has provided a useful advance read, making us more cautious when all appeared well. So what does it tell us now?

Perhaps most importantly, the orders for Durable goods are not plummeting. In fact, it is possible that they are already recovering from the bottom placed in November for orders and December for shipments.

Excluding transportation, however, orders are still declining and likely to lead shipments lower. Particularly worrying are growing inventories, which have outpaced sales and order growth for five consecutive months.

Computers rebounded from a weak December that could have been explained either by tough comparisons to Christmas 2005 or to anticipation of Windows Vista. Problem with the latter interpretation: businesses were able to get Vista in November and account for the better part of spending on computers. Furthermore, the weak January rebound doesn’t exactly look like pent-up demand.

Net result, the market probably over-reacted to the negative headline, but has plenty of catching up to do for all the underreacting it has been doing the last few months.

We are firm believers that analysts should look for discrepancies between earnings and cash flow as one of the key criteria for identifying inferior/superior return candidates. Does a recent academic paper making the rounds shake our faith?

SSRN-Cash Flow is King? Comparing Valuations Based on Cash Flow Versus Earnings Multiples by Jing Liu, Jacob Thomas, Doron Nissim

Abstract:
Contrary to the common perception that operating cash flows are better than accounting earnings at explaining equity valuations, recent studies suggest that valuations derived from industry multiples based on reported earnings are closer to traded prices than those based on reported operating cash flows. We extend those analyses to determine if the balance tilts in favor of cash flows when we consider a) forecasts rather than reported numbers, b) dividends rather than operating cash flows, c) individual industries rather than all industries combined, and d) firms in other markets beyond the U.S. Our main finding is that in all venues cash flows (both operating and dividends) are dominated by earnings. Our results imply that those seeking quick valuations should use multiples based on forecasted earnings, since they are remarkably close to traded prices.

Liu, Jing, Thomas, Jacob K. Kandathil and Nissim, Doron, “Cash Flow is King? Comparing Valuations Based on Cash Flow Versus Earnings Multiples” (August 25, 2006). Available at SSRN: http://ssrn.com/abstract=926428

The last sentence pretty much says it all. Multiples based on forecasted earnings… are remarkably close to traded prices. What this tells us is not that earnings are superior to cash flow. Rather, earnings themselves are hardly any better than the current share price in determining a company’s current valuation. Why shouldn’t those seeking quick valuations simply look at the price itself, since it will be remarkably close to the multiple based on forecasted earnings, and must surely be easier to determine.
Valuation is one thing. Value is quite another. We’ll stick with cash flow to find value.

With the Dow Jones Industrial Average well within striking distance of a new high, it seemed an appropriate time to revisit a theme we consider important enough to get right and sit tight. That theme is the concept that the long-term bull market of the 1980’s was due as much to expanding valuations as it was to improving fundamentals. Under this thesis, valuation tends to move in waves over very long time horizons. The chart below, which was taken from Barron’s (via The Big Picture) provides graphic support to the theory. During the flat periods, earnings growth is largely offset by shrinking multiples the market is willing to pay for those earnings.

It is easy enough to argue over where a given valuation expansion or contraction starts and ends. The point is that we aren’t talking about a matter of days or months, but of years. And more than six of them (eight if one looks at broader market indices), which is our current tally in what we believe to be a contraction cycle. The fact that the market is now back to long-term average P/E multiples suggests that the contraction may be halfway through - which would give us the equal number of periods below and above the average necessary to label it “average.”

So, will breaking above the previous record change our opinion that we are in a long-term contraction phase? Not at all. In the last contraction cycle (roughly 1968-1982) the market reached new highs several times. However, it tended not to stay there and the new highs were at lower earnings multiples (P/E ratios) than the previous ones.

The second chart compares the Dow Jones Industrial Average from 1968-1982 with the same index from 2000-Present (Source: Yahoo! Finance). The point is not to say that the monthly returns should exactly overlay each other, but to demonstrate that they are similar. And just as the Dow made new highs five years into the last P/E compression cycle, doing so six years into the current one would hardly invalidate the thesis.

So, do we stubbornly stick to our guns despite whatever evidence may come along to the contrary? Of course not. We merely set a fairly high bar for what will qualify to knock us off a key belief. For example, a close that exceeded the previous high by maybe 10% would be enough to revisit the thesis. In this case, that would mean a close above 12,895 - heck, let’s call it 13,000 because we like round numbers.

Yet even a 13,001 close wouldn’t necessarily invalidate the thesis. Remember, we aren’t predicting a flat stock market so much as that valuations will compress. They may compress at a slower rate than earnings grow, in which case higher stock markets would still fit into the thesis. Or, they could compress at a faster rate than earnings grow and signal an S&P level of 800.

We know that to some extent this thesis is a gloomy one (although it is possible to make money in any kind of market given the right strategy.) We also know that, after six generally difficult years it is tempting to celebrate new technical highs. So by all means, break out the bubbly when the Dow breaks its previous record. Just don’t drink so much that it goes to your head.