A recent article in the New York Times Magazine “Why Do We Still Care about the Dow?” goes a step further and makes the case the Dow itself is an outdated measure of market and the economy:

In the postwar boom of the 1950s, the economy was growing so fast, and the benefits were so widely shared, that following 30 large American companies was a solid measure of most everyone’s personal economy. Back then, the U.S. was a largely self-sufficient country, so Asian or European economic troubles didn’t matter much. … [Now] rather than being a useful indicator, [the index] is an anxiety-amplification device. It reflects investors’ own reactions, and often hysterical overreactions, as they progress through the turmoil.

Any index will have limitations, and the Dow is certainly not perfect. The real problem, however, is not so much the indices as the way the media tends to abuse them, announcing their fluctuations with great hype hundreds of times a day. The Times says that Charles Dow, who founded the index in 1896, believed that the index should be checked and studied on a quarterly basis. This sounds about right. While it’s hard to avoid following the indices more frequently these days, investors shouldn’t attach too much importance to them except over quarters and years. Nor should they get too worked up about the index reaching a round number.

Ben O’Brien

My own preference — and you knew this was coming — is our third category: investment in productive assets, whether businesses, farms, or real estate. Ideally, these assets should have the ability in inflationary times to deliver output that will retain its purchasing-power value while requiring a minimum of new capital investment. Farms, real estate, and many businesses such as Coca-Cola, IBM, and our own See’s Candy meet that double-barreled test. Certain other companies — think of our regulated utilities, for example — fail it because inflation places heavy capital requirements on them. To earn more, their owners must invest more. Even so, these investments will remain superior to nonproductive or currency-based assets.

Whether the currency a century from now is based on gold, seashells, shark teeth, or a piece of paper (as today), people will be willing to exchange a couple of minutes of their daily labor for a Coca-Cola or some See’s peanut brittle. In the future the U.S. population will move more goods, consume more food, and require more living space than it does now. People will forever exchange what they produce for what others produce.

Our country’s businesses will continue to efficiently deliver goods and services wanted by our citizens. Metaphorically, these commercial “cows” will live for centuries and give ever greater quantities of “milk” to boot. Their value will be determined not by the medium of exchange but rather by their capacity to deliver milk. Proceeds from the sale of the milk will compound for the owners of the cows, just as they did during the 20th century when the Dow increased from 66 to 11,497 (and paid loads of dividends as well).

Berkshire’s goal will be to increase its ownership of first-class businesses. Our first choice will be to own them in their entirety — but we will also be owners by way of holding sizable amounts of marketable stocks. I believe that over any extended period of time this category of investing will prove to be the runaway winner among the three we’ve examined. More important, it will be by far the safest.

Whether or not you attribute it to the January Effect, there has been an abrupt shift in market behavior that coincided with the beginning of 2012. One big change this year has been a drop off in volatility. One measure of volatility is how many “all-or-nothing” days there are in the market. These are defined as days when at least 400 of the 500 companies in the S&P 500 moved up or down together. In 2011, according to Bespoke Investment Group, there were 70 all-or-nothing days, the most in recent memory. In 2012 so far there have been none.

Volatility tends to go along with correlation—when stocks swing wildly up and down it tends to be in reaction to large-scale macroeconomic forces that move all stocks together regardless of their individual characteristics. This was the case for much of 2011. To the frustration of stock pickers, everything moved up and down together. This too has changed in 2012. Correlations between different types of stocks swung from record highs in 2011 to record lows so far in 2012. Materials, tech, and financial stocks have soared, for example, while utilities and consumer staples stocks have sunk.

In the new year there has also been an abrupt shift in leadership from large cap stocks to small caps. In 2011 large caps rose 5% while small caps fell 5% as investors focused on the safety of large dividend-paying stocks, but now as investors have become somewhat less risk-averse small caps are up more than 11% compared to 5% for large caps. The tech-heavy Nasdaq Composite which lagged in 2011 is now in the lead, up more than 13% year-to-date. Similarly the lead has shifted from the U.S., which outpaced all major stock markets in 2011, to emerging markets where Brazil is up 18% and Singapore 17% so far this year.

With the strong market performance and the economy showing some signs of strength investors are beginning to feel optimistic again. According to the American Association of Individual Investors survey, bulls now outnumber bears by 51.6% compared to 28.3%, the highest measure in over a year. Whether the market will follow the pattern of last year (when a strong first quarter was followed by a large correction) or whether the market will continue on its present course is still unclear. Certainly there are plenty of headwinds in Europe, China, and the Middle East that could sink the current rally. Either way, the abrupt change in market behavior confirms the wisdom of owning a diversified portfolio of high quality stocks across different sectors and economies, market capitalizations and asset classes, and holding on to them for the long run. This year the market has shown once again that jumping on the bandwagon of the latest trend is a losing strategy.

Ben O’Brien

In the article Malkiel writes:

For years, investors have been urged to diversify their investments by including asset classes in their portfolios that may be relatively uncorrelated with the stock market. Over the 2000s, bonds have been an excellent diversifier by performing particularly well when the stock market declined and providing stability to an investor’s overall returns. But bond yields today are unusually low. Are we in an era now when many bondholders are likely to experience very unsatisfactory investment results? I think the answer is “yes” for many types of bonds—and that this will remain true for some time to come.

The gist of Malkiel’s argument is that things look a lot like 1946 in terms of debt levels and GDP. Back then debt was 126% of GDP; today it’s in the range of 100% and moving higher. The government inflated its way out of the debt in the period 1946 – 1979 at the expense of bond holders.

Today, says Malkiel, the US government (as well as governments around the world) is likely to work down the debt the same way. In response, he says, lower credit quality a bit when buying corporates, buy munis(we did last year when they were cheap), buy dividend-paying stocks, be very cautious about US government bonds. Just what I have been saying. Maybe he should change my grade.

Mark O’Brien

• Total earnings growth for the S&P 500 was 14.9% over last year’s third quarter and 17.8% if you leave out the troubled financial sector.
• Sales grew 11.89%. This is important because it shows that earnings are coming from companies doing more business and not only from cutting costs.
• 64.9% of companies beat the official earnings estimates published  by Wall Street brokerage firms. 58.3% beat revenue estimates.
• Net margins expanded to 9.36% from 9.06% a year ago. This shows companies are adapting and cutting costs to become more profitable.

These results reflect the relatively healthy condition of the corporate sector, despite our many economic challenges. As earnings grow and the market remains relatively flat (despite its many fluctuations) for the year, stocks look increasingly attractive, especially in comparison to bonds which have record low yields. Taking third quarter earnings into account puts P/E ratios for the S&P 500 at 13.05 for 2011 and only 11.87 for 2012.

As we get down to the homestretch for the year there are some big questions outstanding. What will be the effect of the European crisis on fourth quarter earnings? What is the effect of the slight slowdown in emerging markets?

This quarter’s earnings reports show that U.S. companies remain resilient. While our economy is still just emerging from the trough of a long “U-shaped” recovery, corporate profits have bounced back from the recession with a sharply “V-shaped” rebound as companies have tightened their belts at home and tapped into faster-growing markets abroad. Companies have record high profitability, record cash levels. They are increasingly paying out dividends and buying back shares. Many are restructuring and coming up with new strategies to prosper in a time of somewhat slower growth.

Right now the third quarter earnings season, when companies report results for the three months ending September 30^th, is coming to a close. How does it look? This quarter was strong but a bit more of a mixed bag than last quarter when virtually all of the major blue chip companies reported solid earnings. There were some high profile misses with companies such as Netflix, Amazon, Apple and Goldman Sachs. But for each of these headline-grabbing disappointments there were many more companies like Google, VF Corp, Intuitive Surgical, McDonalds and Chevron to name just a few of the many companies that beat expectations and posted high double-digit growth over last year.

Of the S&P 500 companies that have reported so far (about 87% of the total) around 70% beat earnings estimates, 10% matched estimates and 20% came in lower than expected. These percentages were pretty much on par with last quarter and just slightly below the average for the last five years according to Zacks Investment Research.

Perhaps more important than how many companies beat analyst estimates, though, is how much earnings grew.  Earnings of S&P 500 companies that reported so far have grown 18% over the third quarter of 2010. This is not as strong as last year’s third quarter earnings growth of 39.4%, though, this deceleration is to be expected now that we are no longer measuring earnings against recession numbers as we were last year. Earnings growth of 18% is a healthy gain, especially considering the headwinds our economy faces. The third quarter is on pace to be the eighth consecutive quarter of double-digit earnings growth.

Taking a look at full year earnings, the S&P 500 companies grew 45.3% in 2010 to 789.2 billion from $543.3 billion. For 2011 these companies are projected to earn 909.8 billion, an increase of 15.3% over last year. Next year estimates predict growth of 11.5% to a total of a little over $1 trillion.  In 2012 the average per share earnings of the S&P companies will likely top $100 for the first time.

In part two we will take a closer look and economic sectors and individual companies and discuss what these earnings reports tell us about the economy and the market.

Ben O’Brien

The real excess right now is going on in the bond market, not the stock market. That is to say, investors are selling stocks that are historically cheap to buy bonds that have never been more expensive – - yields have never been this low.

Most times the markets are about investing for the long term. This is not one of them. So what do I do during these periods of market insanity? Clean the fish tank. It’s is sparkling clean. If you do not have a fish tank to clean, you should do the equivalent and just step away from the news (I almost said ticker tape) and the false sense of calamity and urgency. Focus on the long term and you will avoid costly mistakes.

Mark O’Brien

Right now the average stock dividend in the Standard & Poor’s 500-stock index pays somewhat more than 2%, which is more than the 10-year Treasury bond pays. How remarkable is that?  I entered the investment business in 1975 and I have never before seen the average stock dividend exceed bond yields.  The average one-year certificate of deposit yields .4%.  The average money market fund yields about .1%

But how safe are these relatively big dividends?  Quite safe, in my opinion.  Over most of my career the rule of thumb was this: a stock dividend was safe so long as it did not exceed 40% of a company’s average net income.  Right now dividends on average amount to about 30% of corporate net income.  To be sure one can get into trouble reaching for dividend income.  One must be prudential.  For instance, the most-at-risk sector is the financial sector; we would probably steer clear of it regardless of the dividends.  But the rest of corporate America is making record profits and the dividend payout is on the low end of the historical scale.

Mark O’Brien

A strong dose of modesty is clearly in order. We all need to be aware of the limits of our ability to forecast future stock prices. No one can tell you when the stock market will end its decline, but there are some things that we do know. Investors who have sold out their stocks at times when there have been very large declines in the market have invariably been wrong. We have abundant evidence that the average investor tends to put money into the market at or near the top and tends to sell out during periods of extreme decline and volatility. Over long periods of time, the U.S. equity market has provided generous average annual returns. But the average investor has earned substantially less than the market return, in part from bad timing decisions.

Presently we are bombarded with advertisements for investment strategies and products that are inadequate protections even though they are quite expensive.  They are like the high stone wall that goes two-thirds of the way around the chicken coop.  The wolf is still going to get in.  Into this category goes gold and annuities.  They are very costly vehicles but more to the point they are insufficient certainly as compared to a portfolio of carefully selected high-quality stocks and bonds, such as we construct.

As to the time to act, we already did.  We crash-proofed (again, that term) the portfolio when it was inexpensive to do so, back when the markets were stable.  At that time it was difficult to accept subdued returns when junk stocks and bonds were soaring, as they were in 2009 -10, but that is when you want to design an all-weather diversification against recession and hyper-inflation – - when it is inexpensive.  In any event, we are ready for whatever happens in coming sessions.

Mark O’Brien