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Personal Finance—More Than One Way to Tell When Market Hits Bottom

When will it end? That’s question No. 1, Main Street or Wall Street. So try this answer: Stocks will bottom on Wednesday afternoon, Aug. 15, after a market panic induced by flat-tire blackouts (as opposed to the rolling kind) in California. Feel better? Probably not. No one knows the future. All we can do is check history and work some numbers. We can measure the sources of decline. I think there are three: – Descent from overvaluation to fair valuation; – Descent to lower projected earnings; – Descent from fair valuation to undervaluation. Now let’s take a closer look at each one. Economist Ed Yardini uses an equity valuation model developed by the Federal Reserve. The model says the “fair” value for stocks is equal to projected earnings for the coming year divided by the current yield on a 10-year Treasury. In January 2000, for instance, the model said that stocks were overvalued by 70 percent. Then and now you could check it out for yourself by visiting his Web site (www.yardeni.com) and putting figures into his model. (You can access the valuation model at www.yardeni.com/stocklab.asp#smcalc and download his paper on valuation from www.yardeni.com/public/sktvalu.pdf.) I went to the Web site and found this: Based on the analysts’ consensus estimate for S & P; 500 earnings in the next 12 months , expected to rise 2.9 percent to $58.63 and a 10-year Treasury yield of 4.93 percent, stocks were undervalued by a slender 0.8 percent. If interest rates decline by another 100 basis points , as many expect , stocks will be undervalued. For the broad market index, the decline from overvaluation was painful. But it’s over. Mr. Yardeni also documents how routinely the analyst community starts every year with optimistic projections of earnings. Then earnings projections are lowered through the year. We’re not talking about last year. He shows it for each of the last 20 years. Yardeni is too polite to say it, but the analyst community is no better than you or I about predicting the future , clueless. Corporate America overstates earnings even more than analysts overestimate them. According to one study, about 20 percent of reported earnings are likely to vanish within five years due to corporate write-offs. Add the cost of stock options to corporate earnings statements, and earnings will be reduced by another 20 percent. Plug those two things into the Yardeni model , an earnings decline of 36 percent (multiply 80 percent times 80 percent to avoid overstating the combined effect) and an interest rate decline to 4.0 percent , and stocks are overvalued by 36 percent. It’s not a pretty picture. Finally, there is the unspeakable. If stocks can have periods of overvaluation, they can also have periods of undervaluation. According to the Federal Reserve fair value model, stocks were 30 percent undervalued in 1979 and 1980. They were 10 percent undervalued in 1982, the start of the great bull market. More recently, they were undervalued in 1993, 1994 and 1995. They suffered a brief period of undervaluation in 1998. Stock prices may not stop falling just because they have achieved “fair value.” They could continue to decline until they are raging bargains. Put it all together: The red light is off, but the caution light is still on. Credit Card Use Question: We underestimated the cash we would need in purchasing our new home and the associated costs. We do not qualify for a home equity loan, but we are approaching the need for approximately $15,000 to go toward home improvements. I have narrowed the options to the following: – Sell mutual fund shares at depressed prices, although it would still generate capital gains in excess of 50 percent of the proceeds. – Borrow on a Platinum Visa at 9.75 percent. – Borrow from my 401(k) at 10.5 percent. (My 401(k) loan would come from my cash balance in the account, and it permits repayment in installments even if I lose my job.) Which source of money would be preferable? We plan to repay any loan in one year or less. We have no debt other than our mortgage, which consumes less than 15 percent of our monthly take-home pay. We are in the 28 percent tax bracket.,C.D., via e-mail Answer: Use your credit card. Here’s why. First, eliminate the 401(k) loan. You should borrow from a 401(k) plan only in “hardship” situations. This isn’t a hardship situation; it’s a convenience situation. Second, if you pay 20-percent tax on 50 percent of the mutual fund shares you redeem, it will cost you 10 percent of your money. Worse, it will take the entire amount out of the market, and it may never get back. The cost of borrowing on your credit card, however, could be much less than 9.75 percent of the amount borrowed because your intention is to pay off the loan in a year or less. Q: With returns sinking, what are the mutual fund managers doing to earn their income? A year or so ago, I watched the Kaufmann fund go into the basement (including my contribution) while those guys were paid millions for managing the fund during the same period. Last year, another well-known fund that I invest in lost almost 30 percent over the calendar year. My 401(k), which I could adjust only quarterly, ended with the same results. They stood by and watched both go down, down, down. Where were the “managers” during this time? My question: If someone is investing in mutual funds and his “managers” don’t make reasonable moves, what options does he have, excluding legal action, of course? Do we just go with the 50/50 stock index fund/bonds fund program you suggest and trust that all will be well when retirement occurs? , G.M., by e-maill A: Let’s start by recognizing that money managers are always between a rock and a hard place. If they decide that stocks are overpriced and move to cash, professional financial advisers will chide them because they aren’t picking stocks. Others will say that they don’t want to pay them for sitting on cash. Still others will say they don’t want to lose exposure to opportunity. The punishment can be terrible. How terrible? When Foster Freiss, manager of the Brandywine fund, felt the market was overpriced in 1997 and put nearly half his $8.4 billion fund in cash, investors rewarded him by taking their money out. By the end of 1998, the fund was down to $4.9 billion in assets. Much the same happened a few years earlier when Jeff Vinik, then portfolio manager for Fidelity Magellan fund, decided to move a hefty portion of the portfolio to bonds. Basically, fund managers are told to invest in an asset class and stay invested, regardless of price levels. If they wander, the professional advisers who help people manage their portfolios say the fund is suffering from “style drift” or is just not doing its job. Questions about personal finance and investments may be sent to Scott Burns, The Dallas Morning News, P.O. Box 655237, Dallas, TX 75265; or by fax: (214) 977-8776; or by e-mail: scott(at)scottburns.com. Check the Web site: www.scottburns.com.

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