Charles Rotblut's Blog

Bonds’ 30-Year Run

In 30-Year Race, Bonds Beat Stocks,? read a headline on Blooomberg.com earlier this week.

No, you did not read that wrong. Jim Bianco, president of Bianco Research, calculated an average annual gain of 11.8% for long-term bonds. Stocks lagged with an average gain of 10.8%. This has not happened since the Civil War, when the U.S. had a very different economy.

If you thought stocks, not bonds, were the best investment vehicles for beating long-term inflation, you’re right. This is still the case. The performance record of the past 30 years reflects two different events that combined to create a favorable environment for bond prices.

The first was interest rates. Ten-year treasury bonds yielded 15.8% on September 30, 1981, according to Bianco. Yesterday, the 10-year bond yielded 2.06%. Bond prices and interest rates are inversely related, meaning that as yields fell over the past three decades, bond prices rose.

The second was the stock market. Since 1998, the S&P 500 has experienced three severe market corrections and two nasty bear markets. These events hurt the long-term record for stocks, giving bonds an edge.

I would be remiss if I didn’t mention the Federal Reserve’s role in helping bonds. Alan Greenspan kept the interest rate environment favorable for the housing bubble. Ben Bernanke is intent on keeping long-term interest rates low for the foreseeable future, as he reiterated yesterday. Fed policy has helped, and continues to help, bonds.

At some point, Federal Reserve policy will have to change from trying to stimulate the economy to being more focused on controlling inflation. We don’t know when. We also don’t know to what extent interest rates, and thereby bond yields, will rise.

What history does tell us is that both stocks and bonds still play a role in your portfolio. Bond returns are uncorrelated with stock returns over the long term. This means that diversification benefits can still be realized by combining stocks and bonds. Inflation will be a threat, but then again, 30 years ago, the outlook for bonds was also uncertain.

Excerpted from my weekly AAII Investor Update newsletter.

Bonds' 30-Year Run

In 30-Year Race, Bonds Beat Stocks,? read a headline on Blooomberg.com earlier this week.

No, you did not read that wrong. Jim Bianco, president of Bianco Research, calculated an average annual gain of 11.8% for long-term bonds. Stocks lagged with an average gain of 10.8%. This has not happened since the Civil War, when the U.S. had a very different economy.

If you thought stocks, not bonds, were the best investment vehicles for beating long-term inflation, you're right. This is still the case. The performance record of the past 30 years reflects two different events that combined to create a favorable environment for bond prices.

The first was interest rates. Ten-year treasury bonds yielded 15.8% on September 30, 1981, according to Bianco. Yesterday, the 10-year bond yielded 2.06%. Bond prices and interest rates are inversely related, meaning that as yields fell over the past three decades, bond prices rose.

The second was the stock market. Since 1998, the S&P 500 has experienced three severe market corrections and two nasty bear markets. These events hurt the long-term record for stocks, giving bonds an edge.

I would be remiss if I didn't mention the Federal Reserve's role in helping bonds. Alan Greenspan kept the interest rate environment favorable for the housing bubble. Ben Bernanke is intent on keeping long-term interest rates low for the foreseeable future, as he reiterated yesterday. Fed policy has helped, and continues to help, bonds.

At some point, Federal Reserve policy will have to change from trying to stimulate the economy to being more focused on controlling inflation. We don't know when. We also don't know to what extent interest rates, and thereby bond yields, will rise.

What history does tell us is that both stocks and bonds still play a role in your portfolio. Bond returns are uncorrelated with stock returns over the long term. This means that diversification benefits can still be realized by combining stocks and bonds. Inflation will be a threat, but then again, 30 years ago, the outlook for bonds was also uncertain.

Excerpted from my weekly AAII Investor Update newsletter.

High Valuations Increase Downside Risk

High Valuations = Greater Expectations = More Downside Risk

If there was any single financial concept I think investors should remember, it is the one above. The more investors bid up a stock's valuation, the less room the company has for error. When a highly valued company does disappoint, the drop in a stock's price can be significant. Netflix (NFLX) and Amazon.com (AMZN) are two examples.

Netflix has been a poster child of how poor management decisions can simultaneously anger both customers and shareholders. As many of you know, the company has been stumbling since July when it announced separate price plans for DVD rentals and online video streaming. (The stock's price-earning ratio at that time was a pricey 85.) In September, CEO Reed Hastings threw gasoline on the fire by saying DVD rentals would be split into a separate business named ?Qwikster.?

This past Monday, Netflix surprised shareholders yet again. The company reported a decline in unique domestic subscribers; in other words, customers canceled their subscriptions. Investors reacted by sending the stock down 35% on Tuesday.

The chart below shows just how much shares of NFLX have fallen. Note that how the upward price movement prior to July 2011 in no way forecast what has happened since mid-July.

Shares of Amazon.com lost 11% of their value yesterday after missing third-quarter earnings expectations and giving disappointing profit guidance. Investors were unnerved by the company's expenditures, such as the money spent on increasing the number of fulfillment centers. Amazon's new Kindle Fire tablet computer, which was launched last month, also increased costs.

The spending may boost future profits, but with a price-earnings ratio of 103, investors wanted good earnings numbers now. It's a classic case of a slim margin for error caused by high expectations.

None of this is to say that a highly valued stock can't rise even further, but rather that with each move higher, the risks also increase. If you are going to ignore a high price-earnings ratio (or a high price-to-book ratio), be cognizant of the potential downside. Eventually, there will be a time when would-be buyers refuse to pay a higher price for the stock.

Excerpted from my weekly AAII Investor Update newsletter.

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Stock Funds Stumble, But Don’t Fail

The third quarter was not kind to stock-oriented mutual funds. Out of the approximate 800 stock funds covered by our Quarterly Low-Load Mutual Fund Update newsletter, relatively few showed gains. Worse, among the winners, just one uses the traditional strategy of buying stocks; the rest invest in both stocks and bonds, are designed to move inversely to stock prices, or use other hedging strategies.

Despite the performance, stock funds did not fail their shareholders. Rather stock funds were victims of the securities that investors pay them to invest in. Stock prices fell globally last quarter. For a fund whose objective is to invest in stocks, losses were unavoidable.

The only options for investors were to buy contra funds or strategically shift to holding bond funds, particularly long-term government bond funds. Doing either would have required successfully timing the market. Unwinding these trades and moving back into stock funds require successfully timing the market a second time–a feat that is much easier said than done.

If you held a mix of stock and bond funds (or just stocks and bonds), your portfolio’s decline was cushioned. Diversification did not prevent you from losing money last quarter, but it did lessen the blow as it is designed to do.

If you own stock mutual funds, particularly actively managed funds, look at the returns relative to those of their category peers. Though mutual funds like to tout their performance in advertisements, a fund’s absolute return is not the first thing you should look at. Rather, figure out what asset classes and subclasses your portfolio needs (e.g., U.S. small-cap stocks, emerging market stocks, bonds, etc.) and then find the best funds that fulfill those needs. Tax efficiency, expense ratios, yield and risk all should be considered when evaluating a fund.

Once you buy a fund, have patience with it and understand the factors that impact its performance. A good manager can have a bad quarter for reasons beyond his control. Such was the case for many funds over the past three months when narrowing correlations reduced the potential advantages of active management. This said, don’t stick with a poorly performing fund if the manager consistently underperforms his peers.

Hedge Funds Struggled Too

I realize that this is not much in the way of consolation, but hedge funds also fared poorly last quarter. Industry consultant Henessee Group calculated that hedge funds suffered their worst quarter since the fourth quarter of 2008. Henessee Group’s hedge fund index fell 3.78% in September and is down 5.53% year-to-date.

Excerpted from my weekly AAII Investor Update newsletter.

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Stock Funds Stumble, But Don't Fail

The third quarter was not kind to stock-oriented mutual funds. Out of the approximate 800 stock funds covered by our Quarterly Low-Load Mutual Fund Update newsletter, relatively few showed gains. Worse, among the winners, just one uses the traditional strategy of buying stocks; the rest invest in both stocks and bonds, are designed to move inversely to stock prices, or use other hedging strategies.

Despite the performance, stock funds did not fail their shareholders. Rather stock funds were victims of the securities that investors pay them to invest in. Stock prices fell globally last quarter. For a fund whose objective is to invest in stocks, losses were unavoidable.

The only options for investors were to buy contra funds or strategically shift to holding bond funds, particularly long-term government bond funds. Doing either would have required successfully timing the market. Unwinding these trades and moving back into stock funds require successfully timing the market a second time–a feat that is much easier said than done.

If you held a mix of stock and bond funds (or just stocks and bonds), your portfolio's decline was cushioned. Diversification did not prevent you from losing money last quarter, but it did lessen the blow as it is designed to do.

If you own stock mutual funds, particularly actively managed funds, look at the returns relative to those of their category peers. Though mutual funds like to tout their performance in advertisements, a fund's absolute return is not the first thing you should look at. Rather, figure out what asset classes and subclasses your portfolio needs (e.g., U.S. small-cap stocks, emerging market stocks, bonds, etc.) and then find the best funds that fulfill those needs. Tax efficiency, expense ratios, yield and risk all should be considered when evaluating a fund.

Once you buy a fund, have patience with it and understand the factors that impact its performance. A good manager can have a bad quarter for reasons beyond his control. Such was the case for many funds over the past three months when narrowing correlations reduced the potential advantages of active management. This said, don't stick with a poorly performing fund if the manager consistently underperforms his peers.

Hedge Funds Struggled Too

I realize that this is not much in the way of consolation, but hedge funds also fared poorly last quarter. Industry consultant Henessee Group calculated that hedge funds suffered their worst quarter since the fourth quarter of 2008. Henessee Group's hedge fund index fell 3.78% in September and is down 5.53% year-to-date.

Excerpted from my weekly AAII Investor Update newsletter.

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Don’t Rely on a Single Indicator

Yesterday was another rough day for the markets. My crystal ball is not good enough to predict where a bottom will be but, so far, the fear about what could happen (e.g., a double-dip recession) has been worse than what is happening. Fear brings opportunities, so I would use the current weakness to consider rebalancing and look for bargains. At the very least, you should create a shopping list of stocks and ETFs you would buy if they got cheap enough.

I always encourage investors to look at a variety of indicators. By itself, any single indicator can lead you astray. More importantly, many indicators sound like they would be predictive, but are actually not very profitable.

An example is the “death cross,” which appeared on S&P 500 charts this week. The ominous-sounding event occurs when the 50-day moving average crosses below the 200-day moving average. For those of you who are not chartists, a moving average calculates the average price over a specified number of days, such as 50 days. The next day, a new average price is calculated based on the new set of 50 days, which now starts one day later than the last set. (Hence, the average moves one day forward.) This forms a series of dots, one for each day, which is tracked with a line on charts.

A death cross means the average price for the last 50 days is less than the average price for the last 200 days, a sign that the short-term trend in stock prices is negative.

This may sound somewhat scientific, but the event is not really as bad as the name sounds. A short-term downward drop in stock prices can be painful, but it does not tell you if stock prices will keep falling. Back in July 2010, Mark Hulbert looked at the historical performance of the death cross and found that it has not been reliable over the past two decades. “Overall, in fact, there has been no statistically significant difference since 1990 between the average performance following death crosses and all other market sessions,” Hulbert concluded.

Plus, I would add that today’s weakness was attributable to anxiety about global economic growth, not to any particular chart pattern.

It’s not just the death cross. There are various indicators that people tout as reliable or at least indicative of where stock prices are headed. For example, on the fundamental side, there is Robert Shiller’s CAPE ratio. This number calculates the S&P 500’s valuation based on the index’s inflation-adjusted price and average 10-year earnings. As an article in next month’s AAII Journal will point out, this indicator has its flaws.

I should also mention that even when a stock, or any asset, appears to be excessively cheap or expensive, it can stay that way for a while. As many traders can attest, the market can remain irrational far longer than you can remain solvent.

This is why, when trying to predict a trend or go against an existing trend, you want to have as many indicators in your favor as possible. You want outside confirmation that your opinion is correct because there is always someone on the other side of the trade with a different opinion than yours. The need for confirmation applies to both calls on the market and decisions on whether a specific security is a bargain or not. You can still end up being wrong, but if you stack the deck in your favor, the odds of being wrong will be smaller than if you based your decision on a single indicator.

This Week’s Gratis Tip

A better approach than relying on a timing indicator to tell you when to get into and out of a stock is to stay focused on maintaining an appropriate allocation to stocks and bonds in your portfolio. What Different Conditions Will Affect My Asset Allocation? lists the three major factors affecting how your portfolio should be constructed.

The Week Ahead

Only six S&P 500 companies are currently scheduled to report earnings next week. They are H.J. Heinz (HNZ) and Medtronic (MDT) on Tuesday, Applied Materials (AMAT) on Wednesday, Hormel Food (HRL) and Patterson Companies (PDCO) on Thursday, and Tiffany (TIF) on Friday.

July new home sales data will be released on Tuesday. Wednesday will feature July durable goods orders. The final August University of Michigan consumer confidence survey and the first revision to second-quarter GDP will be published on Friday.

Federal Reserve Chairman Ben Bernanke will speak at the Kansas City Federal Reserve Bank conference in Jackson Hole, Wyoming, on Friday. This is the same venue where he announced the last round of monetary stimulus. Given current dissent among Federal Open Market Committee members, it is unclear whether a new quantitative easing program will be announced.

The Treasury Department will auction $35 billion of two-year notes on Tuesday, $35 billion of five-year notes on Wednesday and $29 billion of seven-year notes on Thursday.

Charles Rotblut, CFA is a Vice President with the American Association of Individual Investors and editor of the AAII Journal.



Excerpted from my weekly AAII Investor Update email. For more information about the American Association of Individual Investors, visit www.aaii.com

Don't Rely on a Single Indicator

Yesterday was another rough day for the markets. My crystal ball is not good enough to predict where a bottom will be but, so far, the fear about what could happen (e.g., a double-dip recession) has been worse than what is happening. Fear brings opportunities, so I would use the current weakness to consider rebalancing and look for bargains. At the very least, you should create a shopping list of stocks and ETFs you would buy if they got cheap enough.

I always encourage investors to look at a variety of indicators. By itself, any single indicator can lead you astray. More importantly, many indicators sound like they would be predictive, but are actually not very profitable.

An example is the "death cross," which appeared on S&P 500 charts this week. The ominous-sounding event occurs when the 50-day moving average crosses below the 200-day moving average. For those of you who are not chartists, a moving average calculates the average price over a specified number of days, such as 50 days. The next day, a new average price is calculated based on the new set of 50 days, which now starts one day later than the last set. (Hence, the average moves one day forward.) This forms a series of dots, one for each day, which is tracked with a line on charts.

A death cross means the average price for the last 50 days is less than the average price for the last 200 days, a sign that the short-term trend in stock prices is negative.

This may sound somewhat scientific, but the event is not really as bad as the name sounds. A short-term downward drop in stock prices can be painful, but it does not tell you if stock prices will keep falling. Back in July 2010, Mark Hulbert looked at the historical performance of the death cross and found that it has not been reliable over the past two decades. "Overall, in fact, there has been no statistically significant difference since 1990 between the average performance following death crosses and all other market sessions," Hulbert concluded.

Plus, I would add that today's weakness was attributable to anxiety about global economic growth, not to any particular chart pattern.

It's not just the death cross. There are various indicators that people tout as reliable or at least indicative of where stock prices are headed. For example, on the fundamental side, there is Robert Shiller's CAPE ratio. This number calculates the S&P 500′s valuation based on the index's inflation-adjusted price and average 10-year earnings. As an article in next month's AAII Journal will point out, this indicator has its flaws.

I should also mention that even when a stock, or any asset, appears to be excessively cheap or expensive, it can stay that way for a while. As many traders can attest, the market can remain irrational far longer than you can remain solvent.

This is why, when trying to predict a trend or go against an existing trend, you want to have as many indicators in your favor as possible. You want outside confirmation that your opinion is correct because there is always someone on the other side of the trade with a different opinion than yours. The need for confirmation applies to both calls on the market and decisions on whether a specific security is a bargain or not. You can still end up being wrong, but if you stack the deck in your favor, the odds of being wrong will be smaller than if you based your decision on a single indicator.

This Week's Gratis Tip

A better approach than relying on a timing indicator to tell you when to get into and out of a stock is to stay focused on maintaining an appropriate allocation to stocks and bonds in your portfolio. What Different Conditions Will Affect My Asset Allocation? lists the three major factors affecting how your portfolio should be constructed.

The Week Ahead

Only six S&P 500 companies are currently scheduled to report earnings next week. They are H.J. Heinz (HNZ) and Medtronic (MDT) on Tuesday, Applied Materials (AMAT) on Wednesday, Hormel Food (HRL) and Patterson Companies (PDCO) on Thursday, and Tiffany (TIF) on Friday.

July new home sales data will be released on Tuesday. Wednesday will feature July durable goods orders. The final August University of Michigan consumer confidence survey and the first revision to second-quarter GDP will be published on Friday.

Federal Reserve Chairman Ben Bernanke will speak at the Kansas City Federal Reserve Bank conference in Jackson Hole, Wyoming, on Friday. This is the same venue where he announced the last round of monetary stimulus. Given current dissent among Federal Open Market Committee members, it is unclear whether a new quantitative easing program will be announced.

The Treasury Department will auction $35 billion of two-year notes on Tuesday, $35 billion of five-year notes on Wednesday and $29 billion of seven-year notes on Thursday.

Charles Rotblut, CFA is a Vice President with the American Association of Individual Investors and editor of the AAII Journal.



Excerpted from my weekly AAII Investor Update email. For more information about the American Association of Individual Investors, visit www.aaii.com

The Debt Ceiling and Your Portfolio

Judging by this week's auctions, the bond markets aren't too farklemt about the August 2 deadline for raising the debt ceiling. Tuesday's auction for two-year notes went fairly well and Wednesday's five-year note and today's seven-year note auctions drew decent demand. This suggests that bond buyers expect a resolution to be reached.

Politicians should not view such results as an excuse to let themselves off of the hook. Presuming a resolution is not reached by the time you read this, the auctions also don't mean that we'll able to avoid seeing those debt ceiling countdown clocks that the news channels are airing. The auctions certainly don't suggest that frustrated voters can stop being frustrated.

What the auctions do suggest is that the financial markets anticipate that the Treasury Department will pay its bills. It is uncertain which bills will be paid on the days following August 2 and which will be postponed, but the financial markets do not expect Uncle Sam to become a deadbeat. For owners of Treasury bonds, U.S. savings bonds and other U.S-backed debt, this week's auctions show a belief that you won't be left holding the bag.

This is not to say that there won't be an adverse impact on the financial markets if the crisis drags on. The whims of politicians even manage to befuddle Washington experts. Financial analysts' models predict future cash flows, not Congressional votes. Should the August 2 deadline arrive with more posturing than compromise, we all might be reaching for aspirin and Rolaids. My crystal ball is not good enough to predict when the current stalemate will end, but it seems likely that a resolution will be reached. The problem with trying to time a trade based on the crisis is that we don't know when it will end or whether there will be a sizable relief rally in response.

It is important to realize that in the backdrop of the debt talks, the pace of the economic expansion has slowed. (This morning's estimate of second-quarter GDP was well below the consensus estimate. Furthermore, the rate of first-quarter growth was cut significantly.) Thus, Wall Street's focus will be on the economy, not the eventual debt ceiling resolution, in the weeks to come. Furthermore, in the one- and three-month periods following a raise in the debt ceiling since 1969, the median increase in the S&P 500 has been 0.6% and 0.9%, according to Sam Stovall, chief investment strategist at Standard & Poor's. This compares to a median monthly gain of 0.9% and a median three-month gain of 2.2% for all months since 1969. Furthermore, August and September rank among the worst two months for the major stock market indexes according to The Stock Trader's Almanac. Just keep in mind that the future is rarely what we expect it to be.

What we do know is that any resolution is likely to include budget cuts. If you are invested in companies that depend on government spending, you should gauge the impact that such cuts will have on future revenues and earnings. If you find it difficult to ascertain the impact, monitor earnings estimates for this year and next. Brokerage analysts should adjust their earnings downward if the company will be adversely affected.

Watch Out for Scams

This is not to say that there won't be an adverse impact on the financial markets if the crisis drags on. The whims of politicians even manage to befuddle Washington experts. Financial analysts' models predict future cash flows, not Congressional votes. Should the August 2 deadline arrive with more posturing than compromise, we all might be reaching for aspirin and Rolaids. My crystal ball is not good enough to predict when the current stalemate will end, but it seems likely that a resolution will be reached. The problem with trying to time a trade based on the crisis is that we don't know when it will end or whether there will be a sizable relief rally in response.

It is important to realize that in the backdrop of the debt talks, the pace of the economic expansion has slowed. (This morning's estimate of second-quarter GDP was well below the consensus estimate. Furthermore, the rate of first-quarter growth was cut significantly.) Thus, Wall Street's focus will be on the economy, not the eventual debt ceiling resolution, in the weeks to come. Furthermore, in the one- and three-month periods following a raise in the debt ceiling since 1969, the median increase in the S&P 500 has been 0.6% and 0.9%, according to Sam Stovall, chief investment strategist at Standard & Poor's. This compares to a median monthly gain of 0.9% and a median three-month gain of 2.2% for all months since 1969. Furthermore, August and September rank among the worst two months for the major stock market indexes according to The Stock Trader's Almanac. Just keep in mind that the future is rarely what we expect it to be.

What we do know is that any resolution is likely to include budget cuts. If you are invested in companies that depend on government spending, you should gauge the impact that such cuts will have on future revenues and earnings. If you find it difficult to ascertain the impact, monitor earnings estimates for this year and next. Brokerage analysts should adjust their earnings downward if the company will be adversely affected.

Con men use crises, such as the debt ceiling situation, to scam people. They will use scare tactics to separate you from your money. Due Diligence: 10 Steps to Avoiding Ponzi Schemes and Financial Fraud gives easy-to-follow guidelines to keep you from becoming a victim.

If you are approached with an investment strategy relating to the debt ceiling, ask the adviser if you can call him back in a few weeks. A reputable adviser will not pressure you to act now and will give you all of the necessary information-including full contact information; a criminal looking to make a quick buck won't.

What Happens on August 2?

On Tuesday, August 2, if a resolution to the debt ceiling issue is not reached, the reaction in the U.S. financial markets will likely depend on how close traders think Congress and the White House are to a resolution.

The Treasury Department will have to prioritize payments. Social Security checks are scheduled to be sent on August 3, and this will be one benchmark that many people will be watching. A likely outcome if a debt ceiling resolution is not reached would be some type of government shutdown. This could impact the Securities and Exchange Commission, halting mergers, stock and bond offerings, the launch of new ETFs and other actions that require regulatory approval.

I have seen news reports that say that money market funds have taken measures to protect themselves over the short term. If you have concerns, I would contact a representative of the fund you are invested in.

Excerpted from my weekly AAII Investor Update email. For more information about the American Association of Individual Investors, visit www.aaii.com

Second-Quarter Earnings Preview

Analysts project profits for S&P 500 companies to rise 10%, according to the consensus estimate compiled by Thomson Reuters. Given analysts' propensity to under-estimate and corporations' tendency to over-deliver, actual earnings could turn out to be better than forecast.

This trend has already started according to Dirk van Dijk at Zacks. My former colleague calculates that positive profit surprises are outnumbering negative ones by a ratio of better than 3:1. Only a small fraction of all S&P 500 members have reported, however, so the ratio will change.

Shareholders of individual companies want good news at the micro level, in addition to the macro level, and this where things could get a bit more troublesome. Thomson Reuters says the ratio of negative-to-positive earnings preannouncements is 2.6. The ratio was 1.8 for the first quarter of 2011 and 1.2 for the second quarter of 2010. In other words, a higher proportion of large-cap companies warned that profits won't be as good as originally thought for the most recently completed quarter compared to last quarter and the same quarter one year ago.

Executives will have a long list of excuses to point to should their companies' profits not be as good as shareholders had hoped. Among the excuses will be disruptions caused by disaster in Japan, bad weather in the United States, higher commodity prices and the economy. For some companies these will be legitimate reasons as to why profits were disappointing; for others, it will be a way of covering up poor execution.

It is not often clear where the influence of external factors ends (e.g., slowing economic growth, higher commodity prices, etc.) and where failure by management begins. A look at competitors' earnings reports and financial statements can give some insight, however. You will want to compare changes in revenues and earnings growth rates as well as changes in profit margins.

External factors should impact revenues and profits for several related companies. If the company you are invested in disappoints and its peers had a good quarter, the problem could be with company itself–regardless of what the executives would like you to believe.

When evaluating earnings, you should also consider the reason you bought a stock. If you bought a stock for its growth characteristics and the rate of growth is showing signs of slowing, that would be a cause for concern. (This would particularly be the case if it looks like internal factors had an adverse affect.) Conversely, if you bought a stock because the valuation was cheap, a merely decent (as opposed to a great) report might be acceptable. In either case, be wary if profits are falling and are at risk of falling again next quarter.

Stocks, Earnings and Washington, D.C.

July has historically been an okay month for stocks. Presuming that most companies do top expectations, it would seem that the markets should react positively. Plus many stocks went on sale last month, though the late-June rally removed a good part of the comparative discounts.

The big elephant in the room, however, is the debt ceiling. I cannot predict when our elected officials will reach an agreement, though it does seem that some progress has recently been made. The danger of selling stocks now with the intention of getting back in after an agreement has been reached is that you could miss out on any gains that do occur between now and then. Yes, you might also avoid any downside volatility, but it will take a better crystal ball than mine to predict how the markets will react between now and the August 2 deadline for raising the debt ceiling.

Excerpted from my weekly AAII Investor Update email. For more information about the American Association of Individual Investors, visit www.aaii.com

Look Beyond the Numbers for Risk

Investors are told to look for a combination of growth, profitability, fiscal strength and low valuation. A stock possessing all of these characteristics should be an attractive candidate. In theory, this holds true. In practice, you need to take your analysis a step further and consider qualitative factors.

Some of these qualitative risks are easy to identify; for example intensifying competition. Others require an understanding of the broad trends that impact an industry's revenues. Many qualitative factors are subjective; for instance, you may not understand what a company does or you might find something in a company's SEC filings that just does not sound right.

This type of analysis does not adhere to strict rules, but it does play an important role in determining whether a stock is merely cheap or a bargain. To help you apply the analysis, I'm going to give you a few examples.

A good place to start is with Best Buy (BBY), which does have some appealing characteristics:

Revenues have increased for several years
The company has a history of profits and positive cash flow
The balance sheet is strong, with a very manageable level of debt
Dividends have been rising, and the company recently announced plans to further increase its dividend
The price-earnings (P/E) ratio is 10.2 and the price-to-book (P/B) ratio is 1.8

What is not included in the numbers above is the decline in same-store sales, a key metric for retailers. Sales at domestic stores open for more than a year fell 2.4% for the recently completed fiscal first quarter. This followed declines of 5.0% and 5.5% for the third and fourth quarters of fiscal 2011, respectively.

Though the sluggish economy is not helping, the bigger threat is competition. Even the demise of Circuit City has not stopped competition from intensifying. My experience is typical of what is occurring. Though I'm a member of the company's customer loyalty program, Best Buy Rewards, I bought a TV from Costco (COST), accessories for my cell phone from Amazon.com (AMZN) and an external hard drive from Target (TGT) within the past 12 months.

In addition to competition, reliance on a single customer can increase risk. Amtech Systems (ASYS), a semiconductor stock that is currently passing my Risk/Reward stock screen, is highly dependant on a Chinese solar company for revenues. The screen did its job of finding stocks with low quantitative risk. However, because it does not consider qualitative risk, a company with higher levels of business risk can still pass. (No stock screen considers factors outside of its specific filtering criteria.)

Being able to step back and assess the industry itself is also important. Oil rig operators and oilfield equipment companies are significantly impacted by the price of oil?a factor over which they have no control. Thus, while a stock such as ENSCO (ESV) may have a low valuation (a P/B ratio of 1.3), it is also at risk of large revenue declines should oil prices fall.

In SEC filings, what may appear as a risk varies by company. It can be the way a company records revenues or handles costs. (An example would be a firm that constantly claims extraordinary or one-time write-downs.) It could be that you are just not comfortable with the amount of money a company paid for an acquisition relative to the size of its balance sheet. You are mostly looking for something that appears to be unusual or, more importantly, just does not seem right.

These are subjective criteria, but risk is ultimately risk. If you don't feel comfortable investing in a certain company, don't buy the stock (or bond).

Realize that some risk factors will not be apparent when basic quantitative analysis is performed. Rather, you need to perform qualitative analysis as well, including reading a company's SEC filings. It's an extra step, but one that can help you differentiate the true bargain stocks and bonds from those that are merely cheap.

Excerpted from my weekly AAII Investor Update email. For more information about the American Association of Individual Investors, visit www.aaii.com