Sensible Investing

Listening and reading recent reports of mainstream media outlets could make one wonder if a new meltdown of the financial system is at hand.  Headlines about double-dip recession, plummeting housing starts and consumer sentiment dominate the news.  To be sure, latest batch of overall economic reports has not been stellar.  Yesterday, markets dived after Fed Chairman Ben Bernanke said that the outlook for the economy was “unusually uncertain”.  Really?  Has it ever been unusually certain?

Right now, the earnings season is in full swing and company reports so far contradict doom and gloom.  After many bellwether companies, such as Intel, Apple, Alcoa, Morgan Stanley, Caterpillar and others not only beat estimates, but offered higher guidance going forward, investors are finally beginning to take notice.  Ultimately, it is only the earnings that drive the stock prices.

Here’s a quote from one of 20 golden rules by Peter Lynch, that I think is particularly applicable to today’s environment:

“Nobody can predict interest rates, the future direction of the economy, or the stock market.  Dismiss all such forecasts and concentrate on what’s actually happening to the companies in which you are interested”.

Given the rapid bounce of the markets from its March 2009 low to this April high, some commentators were wondering if the economic recovery will be V-shaped as well — that is, sharp and rapid as the right half of the letter V.  Well, it appears that this is not going to be the case.  The culprits are the usual suspects, slow job growth and weak demand for housing.  We can also add European debt problems to that list as well.

Nevertheless, the situation is quite different from 2008.  Unemployment is still high, but it is decreasing, and hiring is definitely picking up.  Housing prices actually increased 3.8% nationwide year-over-year.   So, while this is likely not a V-shaped recovery, it is a recovery nevertheless.  Most likely, however, it is going to feature slow growth rates and will extend over a long period of time.

As usual, the markets react to this or any kind of uncertainty with high volatility.  The traders don’t want to be blindsided like they were in 2008, and so they may be overreacting to any negative piece of news that comes out.   The upcoming second quarter earnings should provide some clarity and guidance for the market going forward.  Ultimately, stock market is a reflection of corporate earnings, and for most companies, earnings are still going higher, and corporate cash is at record levels.

Here’s a good summary of the current state of the market.  The author argues that stocks are still 35% below their 2007 peak and about where they were 11 years ago.  Yet, in that time period, corporate earnings doubled, and interest rates have halved.  Compared to bonds, stocks earnings yield is now the most favorable in the last 30 years.

It seems just yesterday that all of us were enjoying steady market march higher.  Until this week.  All of 2010 gains in S&P500 were erased and it is now in the negative territory for the year.  On Thursday, the intraday swing in the market was over 1,000 points, greatest in history, although the reason for most of that swing appears to be some erroneous trading — the Dow lost some 700 points in 15 minutes, only to recover most of in the next 20.  The VIX index, aka the fear indicator, rose from 2 year low to 1.5 year high.  It seems that not-so-good old days of 2008 are back.  But the main objective reason for market drop is, of course, debt situation in Greece, which I have mentioned several times in my previous communications.

The news that the markets chose to ignore this week were continuing stream of excellent earnings reports and good economic headlines.  Today, for example, the government employment report indicated that 290,000 new jobs were created in April, much better than expected, to the extent that the recovery can no longer be seen as the jobless one.  Nevertheless, selling continued on Friday despite lack of any new developments in Europe.  It seems that the traders were looking for an excuse to sell — and they definitely got one.   And it is not really surprising, as we haven’t had a sizable correction since the markets started their advance in March 2009.   Note that the pullback in January was also caused by Greek worries, but in time markets overcame it.  

While euro zone issues are quite troubling and the euro is likely to slide further, I don’t think Greek problems are a repeat of 2008 Lehman Brothers collapse.  That said, it will take time for confidence to recover, and there is a good chance that volatility may persist in the short term, which I view as an opportunity to add quality companies at good prices.  If the last two years taught us anything, it is that great companies will prosper.

We are in the middle of Q1 earnings season, and so far it is a great one.  Expected growth in first-quarter earnings for companies in the S&P 500 index has now jumped to 50% from 39% in the prior week according to Reuters.  Many companies in various sections of the economy such as Citigroup, Goldman Sachs, Apple, Intel, Netflix, Caterpillar each reported earnings growth far above analysts’ estimates. 

In this coming week the Q1 earnings season culminates with six of the 30 Dow Jones Industrial Average components and a third of the S&P 500 companies scheduled to post their operating results.  In the S&P 500 through Friday, 83% of all companies have already posted results above analysts’ expectations. In an average quarter only 61% of companies beat the street estimates.  Also, companies are not sacrificing revenue growth in order to improve their bottom lines. Revenue too has also bested most analyst estimates.  69% of those companies that have reported thus far have topped their revenue views.  Q1 will now mark two quarters in a row where the S&P 500 has recorded earnings growth.

In October, the Dow crossed 10,000 on its way up from the bear market lows.  It was hardly a case for celebration.  Now, about six months later, the Dow is 1,000 points higher.  Other major indices also crossed milestones of their own: S&P 500 is now above 1,200 and Nasdaq is over 2,500.

Again, while noteworthy, these “accomplishments” are really not that important.  Dow Jones first crossed 11,000 in 1999.  S&P 500 was at 1,200 level in 1998.  Nasdaq traded at 2,500 in 1999.  So while we made excellent progress from the market lows of March 2009, we are still at the levels of 11-12 years ago.

The economic news continues to get better.    Here are some of the highlights:

- Factory orders rose 0.6% in February.
- Manufacturing index is at 58.8, indicating expansion.
- Fewer Americans are filing  jobless claims.
- Auto and retail sales are rising. 
- Inflation remains low at around 1% annual rate.
- TARP funds are being repaid at a much higher than expected rate.  It is now estimated that TARP program cost will be $89 billion, down from $250 estimate one year ago.
- There is evidence of economic recovery abroad.  For example, Chinese GDP rose by 11.9% in the first quarter.

Most importantly for the equities, the first quarter earnings season is off to a good start with excellent reports by Intel and JP Morgan.  While one can argue that at least some of these news are already incorporated into stock prices, and a correction similar to the one in January can happen, the longer-term environment remains benign.

With the exception of news coming from the Euro zone regarding Greek and now possibly Portuguese debt problems, the economic environment this quarter continued to be quite benign.  We had generally positive reports on retail sales, housing market, and consumer spending, while the unemployment remains high.  Some analysts talk about “tortoise market”, referring to the fact that the since the end of January correction, markets moved very slowly but very steadily upwards.  The infamous VIX index, also known as the fear gauge, which measures market volatility, has been consistently trending down and now is at the level of mid-2007.  It appears that there is some complacency in the market, which in itself should warrant caution.  On the other hand, many still view this rally and recovery with considerable skepticism, and fund managers have cash available to invest, which is a positive sign.  While my outlook for the rest of this year remains positive, I would not be surprised to see another correction similar to the one experienced in January.

It appears that the market correction that started in the beginning of the year has run its course, and at this time around the infamous anniversary of 2009 multi-year market lows, the markets are on the rise again.  This year, the economic reports were mixed; they are never overwhelmingly positive in any recovery and this one was no exception.  Some disappointing showings in housing market statistics and new unemployment claims earlier this year, as well as the Greece debt crisis were major catalysts of the correction.  But the latest statistics and especially the Friday unemployment report alleviated the fears.  The Greece situation appears to be at least temporarily under control, but I don’t think that’s the end of it.  There are other countries in the PIGS world (Portugal, Ireland, Greece, Spain) that also have potential to shake the markets with the news of their debt issues; the euro is likely to continue to be pressured against the dollar.

Still, there are many reasons to be optimistic about the markets in 2010, although no one expects repeat performance of 2009.  Most of the stimulus money is still not spent, corporate earnings continue to surprise on the upside, inflation and interest rates are low, and apparently unemployment rate has peaked.   Regular corrections are quite normal during the upward movement, and I don’t think this market is going to be different in this regard.

About of half of S&P 500 companies reported Q4 results, and so far, these results are very similar to those of previous few quarters.  Not only most of the companies are beating estimates, the guidance going forward is also generally exceeding analysts’ expectations.  That had been the case with a number of bellwether companies, such as Intel, Apple, Goldman Sachs, etc.  The economic news have also been fairly positive.  While there were some disappointments in recent employment and housing data, manufacturing and consumer confidence are on the rise.  During the fourth quarter of 2009, U.S. economy grew at 5.7% rate, much higher than expected.

Nevertheless, the markets reacted in decidedly negative fashion to these benign reports and good earnings.  We saw a drop of about 8% from the 15 month market high reached just two weeks ago.  Skeptics are ready to point out that such a negative reaction to positive developments indicates that good news are already reflected in stock prices and that more trouble lies ahead.  Indeed, back in March 2009 the news were overwhelmingly negative, and yet that marked the beginning of the rapid market rise.  On the other hand, a correction such as we are experiencing is normal and is to be expected on a regular basis and especially after a huge rally we had last year.  In fact, since March 2009 there were three corrections already of the similar magnitude and the market kept marching higher after each one.

Who is right this time?  You know that no one can possibly answer this question.  In my view, we have reached a point where easy money has already been made on the way down and on the way up.  Any “dartboard portfolio” lost money in 2008 and made money in 2009.  I think that at present, stocks are reasonably valued and the skill of stock selection will once again become important going forward.

There are some global developments that definitely merit watching.  Financial crisis in Dubai, downgrade of Japanese bonds rating, and high debt obligations of Greece are troubling.  You are probably familiar with the acronym BRIC, which refers to fast-growing developing economies of Brazil, Russia, India and China.  Now we have another acronym: PIIGS.  This one stands for Portugal, Italy, Ireland, Greece, and Spain — countries in European Union that have high debt loads and face a possibility of default that would strain the whole Euro zone.  I even heard views that the euro as a currency may cease to exist within the next five years.  If indeed any of the PIIGS of the world comes even close to a default, you can be quite sure that this will not do wonders for any of the world stock markets.

We do have a lot of uncertainty at this point but this is nothing new.  In my view, a sensible investor must keep a well diversified portfolio of high quality stocks and be always positioned to take advantage of positive market moves.  This has worked extremely well for me last year.  In addition to that, caution and certain downside protection would also be warranted.

Here’s a an interesting article that presents a history of major market tops and also discusses clear signs of one.  An excerpt follows:

We’re nowhere near a market top now, but it pays to remember the signs in advance, like: (1) A general market euphoria, with talk of a “new investment era,” in which major corrections are a thing of the past, with the business cycle being softened or repealed. (2) Books like Dow 36,000 will replace the perennial “beware the coming crash” books on best-seller lists; and (3) market gurus will praise the virtues of “buy-and-hold,” while mocking the futility of “market timing.”

Right now, after a major crash, I can’t find anyone who will defend buy-and-hold.  Newsletter rating guru Mark Hulbert made a study of this phenomenon back in 1996 and found that investors disparage buy-and-hold when buy-and-hold would serve them best (as in the 1990s). Then, they become disciples of buy-and-hold at market peaks, when they should unload their big winners.

Ken Fisher echoed those findings in his 2007 book, The Only Three Questions That Count, saying (on page 277) that “at a bull market peak, there is endless advice saying you should never turn bearish and you should never ‘time the market,’ and that people who do are destined to miss the big returns of bull markets.  In 2000, this advice was rampant. The financial services industry marketed heavily that any professional who turned bearish was a quack or a charlatan.”