Sunday, August 22, 2010

Weekend Update: More Stocks Finally Looking Less Bad than the Alternatives

The public continues to be in a sour mood, and continues not to engage in many elective purchases, as shown by Gallup's ongoing polling, which shows that one measure of discretionary spending by consumers remains stuck in the $65 per day range, roughly where it has been since the mild recession of 2008 turned into the nightmare of the Great/Global Financial Crisis. This level was in the $100-125 range well into 2008 per Gallup data no longer shown on the chart, if memory serves. This is a simply amazing drop. To think that this is not a form of a very great recession requires, in my opinion, one to think again.

Governmental retail sales data suggest to me that from peak in 2008 to trough in 2009, per capita inflation-adjusted spending dropped at least 15%, given that nominal sales dropped about 12.3% (Jan. 2008 through Mar. 2009).

Since then, conventional macroeconomists have simply gotten it wrong. The best advice that President Obama obtained early in 2009 indicated that at most unemployment rates would peak at 8%. Wall Street economists concurred. The stock market began anticipating a strong and sustained economic recovery, but personal income absent governmental transfer payments have yet to reach their peak. If it were not for all the millions of unanticipated dropouts from the labor force, the measured unemployment rate would be well over 10%.

Recently (finally), mainstream economists have been substantially lowering their estimates for 2010 and often for 2011 economic performance.

Are the markets are finally discounting, or over-discounting, the economic weakness that many of the Austrian persuasion (and others, such as Nouriel Roubini) have been foreseeing? Now that there is a growing understanding that the paradox of shifting a credit boom/bubble from private to governmental ownership does not induce more profitable economic activities, is there so much gloom that it's time to tack toward a form of optimism as exemplified by buying certain common stocks?

My sense is that there is still more economic pain to go but that the answer to the above question is a "Yes, but" type of answer. For guidance I refer readers to the paper by Reinhard and Rogoff (go to and then click on the first link, to "This Time Is Different"), or read the book of the same name. I also refer readers to a variety of the books on the reading list of Econophile that present an array of viewpoints and historical narratives often from the standpoint of Austrian economics.

Since securities such as stocks and bonds of at least intermediate duration, or assets such as precious metals, are long-term, investors are forced to read tea leaves and look beyond the financial storms that are so common during hurricane season in Florida.

Now that the interest rate structure has come down drastically in a short time, while at the same time the S&P 500 has dropped about 9% since interest rates peaked April 5, common stocks are far more competitive against fixed income than they were this past spring.

While many valuation measures show stocks to be overvalued, that measure assumes a desired positive rate of return, such as 7-9% annually. If, however, one is willing to invest in stocks at a 5 +/- 2% (i.e. 3-7%) annual rate, I suspect that the formulas that indicate overvaluation would no longer do so.

Further, Jeremy Grantham of GMO LLC is out with his famous 7 year predictions as of July 31, suggesting that the best asset class 7 years from now will prove to be high quality U. S. stocks (he does not define high quality, and does not equate that with large cap). He has been pretty darn accurate to date with these predictions to date, so far as I know. He does not like non-high quality small cap U. S. stocks. He gives a 6.1% return from the class of high-quality stocks in real terms, which would be about 9% per year if prices rise 3% annually.

Supporting the idea that a stock market which currently is trading with a high degree of correlation between all stocks can have an identifiable subset with superior risk-adjusted prospective returns is the lfact that when the general stock market was at its most overvalued ever, in 2000, it surprises most people to look at numerous types of stocks and find that they peaked in 1997-8 and bottomed in March 2000 just when the NASDAQ peaked. Think of everybody rushing to the left side of a boat, then some rushing to the right side.

Many of the stocks that bottomed in 2000 made things, as opposed to techs that made vaporware or proposed to be the fifth online pet supplies company, or the recent enthusiasm for financials that made bad loans or bad investments but produced little or nothing or real value. This list of relatively undervalued stocks as of 2000 includes homebuilders and numerous industrial companies. In fact, the Russell 2000 Index, which includes stocks with market cap between 1001-3000 and is thus a proxy for small cap stocks, hit a record early in 2004 when the general averages were far behind their 2000 peak. Thus there is precedent for a large class of stocks to outperform their index.

For stocks, my working hypothesis has been that the process of creative destruction/boom-bust cycles within industries remains in play as follows.

After the energy boom and overvaluation of energy and gold stocks (and gold and oil themselves) in 1980, cheap energy fueled growth for over two decades until oil started a huge price rise about a decade ago. After tech stocks went wild in the late 1990s, the stocks were just as bad buys as oil drillers were in 1980, but the technology revolution fueled growth and efficiency and continues to do so. Tech is the major force in the economy fueling lower prices in a virtuous cycle, as opposed to lower prices simply resulting from oversupply due to malinvestment during the recent boom.

The latest fad was obviously for financials. It is said that about 40% of corporate profits at the bubble peak in 2007 were from financial activities. Of course, these were in many (most?) cases "profits" rather than real, economic profits. Thus the bust.

The analogy I am drawing is that the bust in the financials has the potential to fuel growth, but that the financials and their relatives such as housing- and finance-related businesses are likely to prove as disappointing investments on a multi-year basis as techs and energy stocks were following their busts and rebounds. Trading: OK. Buy and hold; I don't think so.

The special problem now, though, is how inextricably linked with all other financial assets the financial companies are and with the State itself. Thus, teleologically, the historical record per Rogoff and Reinhart of an average of perhaps 6 years post-credit collapse for matters to right themselves. They observed that stock markets bounced back well ahead of the economy as central banks flooded the markets with cash. Thus a bust in the price of energy was viewed as good for most of the country, but a bust in financial intermediaries plays havoc with a macroeconomic world-view in which borrowing and lending, rather than accumulation of true equity, provides a crucial key to growth.

So I believe that industries with real futures, meeting real needs of real people and other real businesses globally, and that are in fields that are as far from leveraged finance as possible, should (broad brush picture here) be optimally positioned to survive and, probably grow, and could be as good investments for years to come as depressed consumer stocks were in 1981 (pre-great recession of 1981-2). At a time of constrained credit, being self-financing is a marvelous situation. As an example, Intel recently announced a deal to buy McAfee (MFE) at about 15X earnings. Zeroing out MFE's cash, that's about a 7% earnings yield; Intel is paying with cash yielding nothing. The Street booed the acquisition. Whether it's a good one or not, just think what price Intel was paying for acquisitions or what Intel's investment portfolio was receiving for IPOs a decade ago.

This buy or potential buy "list" (I have no formal list) could include energy producers and high tech companies, but it really could include almost any company. Said companies would in general be of very high quality, a la Grantham's analysis, and thus would be financially stronger than the banking system itself. If a company were a strong enough multinational, it might be stronger than almost all sovereigns financially as well as somewhat independent of any one sovereign, as well.

So my personal investing strategy is as follows. I am heavily allocated to muni bonds and short-duration Ginnie Maes (yielding as much as long-term Treasuries when bought correctly), as well as to cash. I have sold all my intermediate to long Treasuries which I bought so recently, following the amazing plunge in rates this month. I went to about a zero stock allocation at Dow 13000 in summer 2007 and except for a few months in late 2009 ending in early May this year, have hardly been in stocks at all.

While noting that the chart on all sorts of stocks stinks, the same would have been said for Treasuries at all optimal buy opportunities during this almost 30 year bull market in bonds. Seasonality and the down-pointing charts, and the rise of statism in the economy, make the future of the economy and the public's prospective mood for stocks unusually uncertain and even scary. Nonetheless, in a time of very poor investment choices, as an investor seeking both current income and long-term capital appreciation that at least stays even with inflation, I have started in with a program of purchasing stocks that yield around or over 3% and that often have P/E's in the 10 range. My thinking is that some time within the next 7 years, these companies will at the least probably not cut their dividends and will probably raise them (examples such as BP notwithstanding), and at some point their stock prices will exceed their current prices; thus their total return potential adjusted for risk probably exceeds that of the 7 year Treasury note, currently at 2.05%. Such names include Chubb (CB), McDonald's (MCD)--both of which have strong charts; and Intel (INTC) and ExxonMobil (both of which have weak charts) and/or other oils.

I am avoiding yet higher-yielding pharmaceuticals because so much of their income comes directly and indirectly from governments, which are tapped out and will have to cut somewhere, and because their profit margins are ultra-high as a direct result. But I'm watching them carefully for signs of technical strength and improvement in their R&D productivity.

Barring major financial/economic events such as led up to the collapse in stock prices from 2007-August 2008 (i.e., pre-stock market collapse), in my humble opinion the highest-quality common stocks are finally beginning to merit a significant place in a diversified portfolio with a multi-year horizon and are finally competitive with munis for taxable accounts. I write this, though, with a distinct lack of enthusiasm given the fact that in Japan, there has hardly ever been a good time to go long stocks other than for a trade since the 1980s, and the U. S. is continuing to look Japanese. Nonetheless, analogies are imperfect, America is not Japan, etc. Most importantly, I have signed on to the stagflation rather than price deflation scenario.

Meanwhile, I do not think that stocks are safe and I believe that the rent money should not be entrusted to the stock market. I also continue to believe that gold is the single best investment for funds that will not be needed any time soon, given the apparent commitment of the ancien regime (aka the authorities) to more money printing and other financial maneuvers to "save" us rather than directly face up to the many historical and ongoing malinvestments that plague the U. S. economy. But an all-gold (or all precious metals) portfolio would be quite something else again!

Last but not least, and with the caveat that I know nothing about tech, AAPL appears to be a classic GARP (growth at a reasonable price) special situation stock with a company that is a financial and market share juggernaut. AAPL is very risky, though, and may or may not ever return cash to shareholders.

I am not an investment adviser and am proffering no investment advice in this and my other web posts. No obligation exists to disclose any changes in specific or general views discussed herein or by me elsewhere.

Copyright (C) Long Lake LLC 2010

No comments:

Post a Comment