Hardly a great start to the week. The market fell slightly in listless trading on another low volume day. All three major indexes all finished marginally in the red. Consumer staples, utilities and the telecom sector performed well. Energy and materials led the declining sectors. Market breadth was also mildly negative. More talk of a possible double dip recession or third depression (thanks, Krugman) did not help the market. A declining euro and a financial reform bill back in limbo with the death of Senator Byrd (a poster boy for term limits if there ever was one) did not help either. The market will quite likely meander on lackluster volume until the big monthly jobs report on Friday. Hopefully it at least meets expectations, or we could be testing that S&P 1040 level again quite soon.
I have read a lot of articles lately on how the market is fairly valued or slightly undervalued based on a variety of metrics. Some are quite compelling and provide some useful historical comparisons. I am still not convinced as I think these pieces assume two things that are not true in my opinion.
(a) This will be a somewhat normal if tepid recovery with consensus growth of approximately 3% in the second half of the year. I have already detailed on why I believe growth in the second half of the year will be much lower than consensus (see here). Mauldin also provided an excellent article (see here) on why growth is likely to be anemic at best in the second half of the year. Given that the 10 year Treasury just hit a 14 month low yesterday, I believe this lower growth story is gradually being accepted by the smart money in the market and the flight to safety crowd.
(b) I also believe these articles assume that the world wide debt markets will continue to improve or at least not get noticeably worse. I think that there are several current warning signs that this is not likely to be the case.
- European sovereign debt CDS rates keep creeping up.
- The ECB is scrambling to replace its one year “temporary” funding mechanism to the major European banks as the markets are not healthy enough to allow the banks to stand on their own yet.
- The number of speculative-grade companies worldwide with yields at least 10 percentage points more than government bonds climbed to 399 this month, or 16.7 percent of the total, the highest share since December, according to Bank of America Merrill Lynch index data. The ratio compares with 9.2 percent on April 30, which was the lowest since November 2007.
- Junk bond sales slumped to a 15-month low in June.
Given this backdrop it is important to buy only those equities with pristine balance sheets, rock solid business models, reasonable valuations, and decent dividend yields. Most of the stocks that we are finding using these criteria are in the Large Cap Blue Chip area (VOD, PFE, JNJ, XOM, MSFT, AEP etc). I also would patient in acquiring long positions in this market until the 10 yr Treasury yields increase and the European sovereign debt CDS rates decline. I would also be comfortable in starting to build a position in TBT at these levels on a long term basis (who will lend this government money at 3% for ten years a year from now?). Hopefully yesterday was a harbinger of the sector rotation yet to come. A lot of our highlighted longs (VOD, AEP, JNJ) performed extremely well while our some of our selected shorts (BIDU, LULU, BID) greatly underperformed the market by 2%-8%. Be careful out there and happy hunting.
Disclosure: Author is long VOD, PFE, JNJ, XOM, MSFT, AEP , TBT and short BID, LULU, BIDU