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Buy Quality Stocks, Sell Treasuries, Mauboussin Says

Author of Think Twice offers advice on investors and investments.

Russel Kinnel, 10/27/2009

Michael Mauboussin thinks about where you should invest and how you should invest. As chief investment strategist at Legg Mason Capital Management, Mauboussin focuses on the economy, markets, and investor behavior. Mauboussin is also an adjunct professor at Columbia.

His new book, Think Twice, examines why investors make mistakes if they leap to judgment and how they can correct that by carefully examining the possible alternatives and learning from their mistakes. I asked him about where the economy and markets are headed as well as lessons we can learn about how we make decisions. Check out his outlook for inflation, U.S. equities, and Treasuries as well as his advice on how we can all make better investors.

Q. It seems like a company's debt level has been all that mattered the past two years. Have the markets corrected for that enough that they'll be moving on to something else and if so what will that be?

A. If you take a step back, stock prices have two basic drivers: future cash flows and a discount rate that brings future values to the present. If you look back on 2007, we had good levels of cash flow--corporate America was near peaks in historical operating profit margin and return on invested capital--and the perceived levels of risk were very low.

All of that changed in 2008. First, the perception of risk skyrocketed, especially after the failure of Lehman Brothers in September. As a rough proxy for perceived risk in the equity market you can look at the VIX (more formally, the Chicago Board Options Exchange Volatility Index), which measures the implied volatility of S&P 500 Index options. Realized volatility in the past 80 or so years had been roughly 20 percent, but the VIX shot into the 80s. When the perception of risk rises, stock prices go down.

The second shoe to drop was earnings. Also in the fourth quarter of 2008, earnings estimates dropped rapidly. The one-two combination of lower anticipated cash flows and higher risk punished the market--probably to an excessive degree. When investors fear risk, of course, credit spreads--a measure of the interest rate companies have to pay to borrow--also rise and that makes people worry about companies with debt going bankrupt.

Since the March lows, we've seen some retrenchment of the concerns about cash flow and risk. As perceived risk levels drifted back toward more normal levels--the VIX today is in the low 20s--the riskier assets performed very well--the so-called "junk trade." The market got a second lift in the summer on the heels of second-quarter earnings, which on balance came in better than what was expected. Most of the positive surprise came as the result of cost cutting. Companies have aggressively managed their cost structures--which has left the residual of a sluggish labor market--and have been super diligent with working capital as well. But earnings through cost savings cannot go on forever.PAGEBREAK

If the markets are to continue to generate attractive returns, we will need to see good old-fashioned sales growth. In my opinion, the evidence is clearly pointing to a recovery, but naturally the data will show fits and starts.

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