Why I Am So Bearish: Time to Be a Deep Value Investor

by: Friedrich Research

The last four years in the stock market have given us an amazing rollercoaster ride of extremes in both directions and I have had many new clients show up at my doorstep because they are not happy with their performance since 2007, as they are basically at the same place financially that they were then.

They unfortunately are not alone as the S&P 500 is still 15% below its July 2007 level.

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Not to pour salt in index investors wounds, but the S&P 500 Index is basically where it was on April 1, 1999, so as an index investor you basically would not have made a dime since 1999 and not only that but would have gone through not one, but two rollercoaster rides that would have caused you some serious stress.

Therefore being a passive investor has proven to be the wrong policy to take in the last decade. Sure you can also have a rip roaring time when markets explode to the upside, as they did in 1981-1999 and you would have made an absolute killing then, but if you go back another 17 years further, you would not have made a dime investing in the DJIA from 1964-1981 as the DJIA was 874.12 on December 31, 1964 and was 875 on December 31, 1981, even with the economy and the sales of the Fortune 500 companies growing fivefold during those years (Source: Warren Buffett Sun Valley speech July 1999). So the answer clearly is to become an active investor, but that requires work on your part as investing successfully and beating the crowd requires 1% inspiration and 99% perspiration.

The secret to this game is to know when to be a growth investor and when to be a value investor, because both schools work very well, but not all the time. So the important thing to do is to be flexible and use each methodology when it is smart to do so. But more importantly one must also be a macro economic news junkie as well, for in the end macro analysis is what saves you from large losses. This article will attempt to show you how to use macro-economic analysis in your work.

In 2006 I became quite bearish and wrote this article about the real estate bubble that I saw coming. In the article I clearly demonstrated that if you looked at the homebuilder stocks at the time you would have seen all of them booming and putting up amazing numbers, but what investors failed to do as they were piling into the homebuilder stocks was that they totally ignored Main Street or the macro-economic signs that I clearly showed were turning very negative. I demonstrated that "For Sale" signs were starting to pop up everywhere and that there were very few home buyers compared to just a few years prior when we had the ultimate sellers market and homes had multiple bids on them a week after they went on sale.

So the time to become a growth investor is when there is blood in the street and the time to become a Value Investor is when times look rosy and sit and wait to attack. Currently I have gone one step further and I have switched to pure "Deep Value Investing" as I am finding that investors are totally ignoring the multiple negative catalysts that are showing up in droves. When you have the type of "Window Dressing" events like we experienced in the last three weeks it clearly shows that not only the individual investor is ignoring the macro-economic events, but that hedge fund managers, investment advisers and stock brokers, as a group, are doing so as well. This sends out some serious red flags in my book, since perhaps ninety percent of the price movement in the equity markets is the result of institutional trading and even worse flash trading. When everyone moves in one direction I like to move in the other direction, as I like to try to be the first in and the first out if I can, in order to protect my clients as my motto is "capital appreciation through capital preservation."

In March 2009 it was clearly a time to go 100% growth as stocks had fallen to amazingly low levels and one could steal them then. For example Coach (NYSE:COH) on March 2, 2009 was trading at $11.80 a share after having fallen from its previous high of $53.79 on April 16, 2007. Currently it is trading at $52.70 but the macro-economic events surrounding the business are quite negative as raw materials have gone through the roof and one of their biggest markets Japan is in dire straights right now and the last thing Japanese purse shoppers are thinking about is the new line of Coach purses coming up. Coach in my opinion is one of the best managed retailers on earth, but if your customers are worrying about radiation in their drinking water, it makes no difference how well managed the firm is. There is a high probability that Coach may miss estimates and even worse management may need to guide lower, which sets the piranha flash traders on the scent, as happened with Logitech (NASDAQ:LOGI) last week, when the stock had its clock cleaned after the company’s management guided lower because of weakness in Europe and Asia. Companies like Aeropostale (NYSE:ARO), another one of my favorite growth stocks, will probably not do well going forward as cotton prices have skyrocketed:

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So as you can see, you don’t need to be an Einstein in financial analysis to figure out that if Aeropostale’s raw materials costs have gone up five fold since 2009, that they should not be able to raise their prices 500% to cover their costs. This chart also allows us to analyze the entire Apparel industry as well in one shot as you know Macy’s (NYSE:M), The Gap (NYSE:GPS), The Buckle (NYSE:BKE), American Eagle (NYSE:AEO), Limited Brands (LTD) etc. are probably going to have to warn as well. But by looking at the one year chart of the Apparel Industry Index you will notice that Wall Street is totally ignoring the fact that the main raw material going into apparel has gone up 500% in the last two years:

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Maybe investors are fooled into believing that these retailers can raise prices and that will improve earnings, but if the raw material prices that go into making a dress just went up 500%, there is no way they can eat that cost and still stay profitable. On top of that Wal-Mart (NYSE:WMT) CEO Bill Simon recently was quoted as saying that rising inflation in the United States is "going to be serious" and that Wal-Mart is "seeing cost increases starting to come through at a pretty rapid rate."

The Federal Reserve is not helping the situation and hopefully they will not be kicking the can down the road anymore with a new QE3, as they are just going to fuel runaway inflation if they do. As the chart below shows the Fed has just been printing so much money that they are soon going to run out of trees:

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Now I can understand that the money printing was done to avoid a deflationary environment and that they wanted to help solve the unemployment problem, but unless housing starts to comeback, we are not going to see unemployment go down by much. This is because when one buys a house they need to buy all the things that go with it, beds, chairs, dishes, appliances etc. but if one looks at the housing environment today it is exactly 100% the opposite of what I wrote about in my homebuilder analysis in 2006. Should I buy housing stocks now? Not yet as the U6 enemployment rate is still way too high for my tastes and despite the Federal Reserve flooding the world with dollars, we still have a long way to go as the U-6 chart shows below:

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I don’t waste my time with the 8.8% U-3 unemployment rate that is quoted by the media as those numbers can be manipulated. The U-6 unemployment rate counts not only people without work seeking full-time employment (the more familiar U-3 rate), but also counts "marginally attached workers and those working part-time for economic reasons." Note that some of these part-time workers counted as employed by U-3 could be working as little as an hour a week. And the "marginally attached workers" include those who have gotten discouraged and stopped looking, but still want to work. The age considered for this calculation is 16 years and over. So when Congress, the President and the press tell us that the Unemployment rate is only 8.8%, remember that they are not too good with the numbers or with balancing the books for that matter. They cannot be trusted, as they are the same ones who don’t factor in food and energy prices in their measurements of inflation, though my food and energy bills have skyrocketed in the last couple of years.

Well I should stop here otherwise I will end up writing a book. To prove to you that I was also a growth investor before now becoming a deep value investor, I welcome you to view my articles on NetFlix (NASDAQ:NFLX) and Apple (NASDAQ:AAPL), which should show you that I believe there are times to fish (growth investing) and times to mend the nets (value investing).

I have not given up fishing altogether, though I am very bearish right now, but just fish in a different pond these days from everyone else and am buying domestic deep value plays like Radio Shack (NYSE:RSH), GenCorp (GY), Medallion Financial (TAXI) and Value Line (NASDAQ:VALU) in the tradition of Benjamin Graham and Walter Schloss. Many of these stocks are illiquid and have a very small float and should not be invested in unless one has a three to five year time horizon and diversifies heavily over many such investments. I also believe that "cash is king" right now and have over a 50% cash position in most accounts with a 2% position in the Active Bear ETF (NYSEARCA:HDGE), which I use as a type of portfolio insurance for my clients, similar to how I have insurance for my homes and cars.

Disclaimer: Always remember that these are the results of our research based on the methodology that I have outlined above and in other articles previously published. This research is provided as an educational tool and should not be considered investment advice, but just the results of our research. There are many ways to analyze a stock and you should never blindly follow anyone’s work without doing your own due diligence or by seeking the help of an investment advisor, if you so need one. As registered investment advisors, we see it as our responsibility to advise the following: We take our research seriously, we do our best to get it right, and we "eat our own cooking," but we could be wrong. Please note, investments involve risk and unless otherwise stated, are not guaranteed. Past performance cannot be used as an indicator to determine future results. Strategies mentioned may not be suitable for everyone. We do not know your personal financial situation, so the information contained in this communiqué represents the opinions of Peter "Mycroft" Psaras, and should not be construed as personalized investment advice. Information expressed does not take into account your specific situation or objectives, and is not intended as recommendations appropriate for you. Before acting on any information mentioned, it is recommended to seek advice from a qualified tax or investment adviser to determine whether it is suitable for your specific situation.

Disclosure: I am long RSH, GY, TAXI, VALU.