Saturday, December 26, 2009

Stocks for the Intermediate Run

One of the good things about markets is the ability to look for relative undervaluation. Readers know that I believe that we are in an era where labor is undervalued relative to financial assets, and a re-equilibration is likely to occur. Once that is said, what is the manager of money to do?

Yours truly took the long view about 28 months ago to exit stocks for cash and bonds. This winter, when it looked likely that a fragile technical stock market bottom and bond interest rate bottom was made, specific stocks were mentioned along with gold. The stocks have all done well with limited risk: Teva (TEVA), Ross Stores (ROST), and National Presto (NPK) all made all-time highs, and all remain in all-time high territory. The other specific stock was McDonald's (MCD), which has done well but did not hit an all-time high and has to be sure lagged the market. This lagging is specifically related not to any special failing of the company, which kept exceeding earnings expectations and had a substantial dividend increase, but due to the catch-up nature of the stock rally.

Regular readers know of my consistent kind words for gold all year, whether the metal was priced in the $800s or the $1000s, and of the tactical sell when GTU reached about a 7-8% premium over NAV when the physical metal was around $1200. The recent strength of the dollar per the DXY index is seen much less using the St. Louis Fed's trade-weighted index.

Any number of technicians and fundamentalists are both positive on gold longer-term but cautious to bearish short-term.

In a primary bull market, the trend is your friend. Either gold has gotten too popular and should be avoided for some time to come, or the recent strength of the dollar against the Euro is just that one drunk is a little more upright than the other this spree. On Christmas Eve, more support for Fannie/Freddie came out, along with the revelation that Treasury also spent hundreds of billions of dollars buying mortgage-backed securities this past year. Yikes, as they say.

This is all gold-friendly.

What happened technically to gold this summer and fall was that while the price remained below its winter 2008 highs, its moving averages went t0 new highs-- and quietly.

A similar thing appears to be happening with certain individual stocks which meet the criteria for reasonable valuation (little is cheap!) and strength not just in the stock price but in the 50 and 200 day moving averages, along with upside earning surprises or at least rising earnings estimates. Unsurprisingly, these companies are global and are self-financing. In addition to all the ones listed above except MCD, these include Oracle (ORCL), IBM and TJX, all of which have consistent records of shrinking shares outstanding; though ORCL has turned into such a serial acquirer that it pays dividends instead.

One perhaps fundamentally undervalued group of stocks includes some insurers. Chubb (CB) and Everest Re (RE) are off of their panic lows but have global franchises, high quality financial bona fides, and limited to no premium to tangible book value. In normal financial times, these stocks trade at premiums to book value. Their P/E's are single digits. There is nothing exciting at all about their financials, and they are well off their bear market lows, so purchase of them is likely to be boring. But assuming a muddle-through economy this year, I believe we are seeing the market neglect certain sectors and be over-excited about others.

What, you ask, are those companies?

Look at Barron's this week, with a lead article warning about Burlington Northern.

It appears that the "Street" is much more optimistic about BNI's 2010 earnings than even the best-case scenario of the company itself.

Many industrial companies have declining consensus earnings estimates, high P/E's and stock prices double their low of the bear market. Methinks the risk-reward is better with the above-mentioned names that pay dividends, have controlled but positive stock charts, and a true valuation story so that barring an AIG-type collapse, one can hold the stock should it drop after purchase and not feel compelled to sell if it goes up the way one might if one bought Amazon at 80 times earnings.

The above is stated with the repeated caveat that there is a reason why short term interest rates are near zero.
That reason is that there really is a financial crisis, and the government wants real interest rates to be negative. Now that they have in fact have crossed that threshold and the ECRI data continue to be strong, we may be at that point in the economy and markets where everything seems to work. Inflation is cyclically low, as labor is by far the most important input to prices and labor has zero pricing power; therefore profits rise; the Federal deficit surprises people by being less than expected, yet the Fed does not take away the punch bowl.

We are in a make-believe financial world, where a roll-up like Teva with no tangible book value and a minimal dividend can be a powerhouse company and trillions of Federal or Fed dollars just appear at will. No asset is good or bad, it's just what is the flavor du jour and what was yesterday's flavor. If ORCL is at an 8 year high in stock price on good news and also on its moving averages, a melt-up is possible. That ORCL also has no tangible book value and almost no dividend yield means something in a bear market. It means nothing when stock buyers ignore those fundamentals. If you buy the stock or own it already, you must remember there is no large stash of gold carried at $42.20 per ounce in the company coffers to provide fundamental value. Oracle is a strong company that just might be a good speculative asset play for the months ahead.

Anyone owning stocks should in my opinion be able to follow Mr. Buffett's rule and be able to financially and psychologically withstand a 50% fall in the stock averages.

No guarantees, but all the stocks mentioned above are of very high apparent quality and thus should drop less than the market in a general collapse. When and from what level and with what degree of warning the next market downturn will occur is unknown. Perhaps it will start Monday.

Caveat emptor and owner.

Copyright (C) Long Lake LLC 2009

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