Tuesday, December 29, 2009

Quality for the Short Run

The airwaves (read CNBC) are full of "worst 10-year period for stocks ever" in this country. Actually, it's worse than that. The dividend yields in other poor decades (e.g. 1928-38) were much higher. A buy and hold investor owning the Dow 30 in 1928 did fine after deflation a decade later, including dividends. Not so lately. But that's irrelevant to the future. Something about past vs. future performance meaning little. Obviously, Japan a decade from its 1989 bubble peak had a long, major bear market to go.

What yours truly looks for personally is the right combination of value and technicals. I have personally also learned to sell quickly if the market simply misperceives the brilliance of my purchase of a tradeable security.

What's going on now in the markets is unprecedented and calls for fresh thinking. Zero percent interest rates should be associated with Depression-like conditions, one might naively think. But there is no Great Depression today, not with a Starbucks seemingly near every other midtown Manhattan intersection.

The single best analogy to our economy and markets, in this commentator's opinion, is Japan 1990s. The Establishment has created weak, large surviving financial institutions. These include Citigroup et al plus AIG and of course Fannie/Freddie, the unending bailout kings. The stock prices of these companies reflect their travails and trade as options given the long-term upside potential.

On what I consider to be an overvalued stock market, one can find reasonably-valued companies and assets as discussed here recently. These include IBM, Oracle, Ross Stores, TJX, Wal-Mart, McDonald's, Teva, National Presto and gold. All of these have strong long-term charts, record earnings (gold has no earnings, of course), and all have good 1- and 2-year charts as well. Then there are a few reasonable value, low P/E companies such as Chubb and Everest Re (CB and RE).

Meanwhile one sees a host of true experts such as John Hussman and bloggers who called the top a couple of years ago who warn of possible dire consequences of a stock market break, a financial collapse, etc.

Breathes one with soul so dead who isn't aware of that possibility?

The argument a year ago at EBR when founded one year ago was that stocks were dangerous, and indeed they proceeded to drop about 40% before beginning this historic rally. While this site does not give investment advice, it does comment on investments and focuses on risk vs. reward. The feeling here a year ago and well into the last few months was that gold under $1000 and especially earlier this year under about (say) $930 was the best risk-reward asset, as the only certainty was money-printing.

With gold around $1100 and the key India market not loving that price, gold is up (say) 20%, or twenty years of 1% interest on money in the bank (I know that's an odd comparison); holders or buyers of GLD may want to sell covered calls on price strength; or brave souls may want to sell puts. Gold will endure. It cannot default. Can it go out of favor permanently? In my opinion, that's highly unlikely. Can it rest in price or drop? Sure. But methinks the aggregate credit mess is actually worse now than ever (covered up for now with money-printing and the favorable nature of the business cycle) and so gold is core in my opinion.

Treasuries are lining up in an uber-bearish technical configuration. I read somewhere today that short interest in them on the futures markets is the highest since October 2008. But wait, that was the best time ever to buy Treasuries and sell stocks! (I' m not sure what day/week in October the data is from). In yours truly's trading position in TLT, I note that a price rebound to 92 would be unremarkable in the context of a true bear market, and also note that TLT is sitting on 2-year price support (high yield) and is well within its multi-year trading range.

Even more relevant, the 30-year T-bond closed yesterday at 4.70%. This is its 2-century average according to a chart from a few years ago put together by Louise Yamada. Remember that 10 years ago, the talk was of a shortage of Treasuries. Extrapolating too many years out from the current promiscuous marketing of Federal debt is difficult; remember Japan as the best analogy I know. Given that labor costs are dominant in pricing of consumer products, there should be limited inflation of prices in the next year or more. Treasuries may surprise with lower interest rates. I have no fixed views, but try as FDR did to inflate and grow the economy, Treasury rates kept going lower and bottomed only early in the 1940s. For now I am comfortable with Treasuries and Ginnie Maes (full faith and credit securities) on a buy and hold basis for a portion of my assets. Might the yield be negative after inflation? Sure. But it will be positive in nominal terms, and this would beat a second decade of Japan-like stock market returns.

Amongst stocks, a key question is, what is the structure of the economy?

Clearly it is that credit flows most easily to companies or individuals with a high likelihood of repayment of said credit, except for mortgage debt that the Feds have made a special case.

So from an investment standpoint, one must go with that flow and avoid the stocks of needy borrowers.

Companies such as IBM, Chubb, Oracle and Ross Stores often trade at mid-teens multiples of free cash flow. Free cash flow is a great asset now. Citigroup would love to have it for itself, that's for sure!

Self-financing companies, which have free cash flow, can take on or pay down debt as they desire. They can sell the company (IBM is too large), break it up or spin out a sexy sub (think McDonald's with Chipotle), raise dividends, continue the game of share buybacks, make acquisitions (Oracle's latest m. o.), or just keep on keeping on. They don't need to sell stock. They are in a sweet spot in the financial firmament right now.

Barring another systemic collapse, which is probably unlikely since everyone's on guard for that (I hope!), it appears here that in a world starved for yield, the powers that be are going to continue to continue to pursue policies that buoy the weak financial sector. The equal and opposite reaction may be to send certain asset prices "too" high. Unlike the moon shots off depressed bases in low-priced stocks off the bottom in 2009, the bet here based on theory and current market behavior is that there could be a surprising "melt-up" in some of the above names, as has already happened for NPK (National Presto).

The 1973-4 brutal generational bear market, which took the averages to about 12-year lows at its bottom and was thus similar to the 2008-9 lows, was followed by nominal new highs (not inflation-adjusted highs, though) in the stock market due to the drop in oil prices and interest rates; many trend-followers who were willing to avoid large-cap stocks did pretty well in the several bear markets that followed the 1976 market top until the final bottom of the secular bear market in 1982.

The Fed wants investors to gamble. It is doing its part by owning junk mortgage-backed securities and other dodgy assets.

Don't fight the Fed. Don't fight the tape, either. The Fed and the Feds will do all the markets let them do to create at least the perception of economic strength. I suspect that one of these days, we will see sharply lower Treasury rates, but when and to what level I have no idea, and whether this will be the final opportunity to sell Treasuries as the multi-decade bull market finally dies is to be evaluated at the time should it occur. That said, the thinking here is that the best values and the best stock charts are in self-financing dividend paying stocks such as those mentioned above. For now. Stocks for the long run? No, never, no-how. Stocks with the "right" risk-reward? Always in fashion. For the season, at least.

Copyright (C) Long Lake LLC 2009

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