In 2009, the market appeared much like today in one respect-- people were afraid there was no solution to the enormous problems that our country and the world faced. Leading politicians and bureaucrats that created the problems were suddenly powerless, and the situation looked bleak. Banks were in a virtual free fall, and the unwinding of the "global ponzi" seemed inevitable. Every possible solution was ripped apart, as cynics ruled the day.
Green Light Lit
As the world was cascading into the abyss and investors everywhere had lost all hope, along came the policy that changed the whole landscape. Treasury hatched a plan in March 2009 to provide unlimited capital to the banks at above market levels. The policy was based on a formula that took an average of the prior 30 days trading, and thus infusing unlimited capital at higher prices to then market depressed prevailing quotes. In essence, the green light was lit and we were off to the races. While bears rushed to cover, the bulls started their stampede. By the time of the first pause (see chart below), the market had risen nearly 50% without so much as a 10% correction.
Click to enlarge
Fast Forward To Today
While we have argued that 2011 is not a repeat of the past crisis, we do believe that certain flashbacks are creating similar patterns. One of those patterns easy to notice is that the market is generally cynical regarding solutions proffered by both politicians and bureaucrats (collectively "the establishment"). This creates a lack of confidence, which in turn leads to fear that the 'confidence game is coming to an end, which in turn evokes fear of anarchy for those that follow such things. After all, if the world had to suddenly square up and then restart, it would indeed be a very scary situation.
In 2009, the situation was eerily similar to today. They had tried and tried to "fix" the woes we faced, but were met with failures at each turn. Then, magically and suddenly something strange happened, as the establishment managed to get it right. After so many failures most had lost hope, the people in power positively changed the sentiment and economic outlook with the stroke of a pen. One policy from the U.S. Treasury above all others marked this point in time, and for the people that noticed it, this green light was a beacon to extremely lucrative returns.
While we believe that the light is still yellow and flashing caution, we are starting to notice signs that the green light may be coming. As in 2008-9, the establishment is still floundering to "fix" the problems; and each sign of progress is treated with much skepticism. But make no mistake, the system is progressing forward with potential solutions, as demonstrated by Germany's passage of the EFSF bill today. (Note: many skeptics doubted it just months ago).
Also like in 2008-9, the establishment continues to try, and while this need is created by self-preservation, it is still significant nonetheless. We contend that there are many solutions to each problem, so as long as the establishment continues to address the issues, they will eventually find the right solution. It is clear to us that our worldwide debt solutions will be either deflation through depression or inflation through monetary measures. The powers that be (TPTB) bounce about trying to appease public sentiment, but the market is the mechanism that constrains the range of options. The market will push the policymakers around until they eventually make the policies that feeds the machine, and thus keeps the powerful in power.
At this point, we suggest that investors pay close attention to the solutions emanating from capitols all around the world, and focus on finding the green light. There is currently massive movement in the three major assets classes (bonds, stocks, commodities), but as in 2009 those trends can reverse with a single stroke of the pen. We repeat, keep your eyes open.
Know What To Buy
Identifying the green light is only half the equation to making outsized profits going forward. The other half of the equation is having a strategy that understands what to buy when the light goes on. Regarding asset classes, since we believe the central banks will continue to print and politicians will continue to spend, then long commodities, long stocks, and short bonds are generally the right selections. Regarding specific sectors, we believe three groups will perform exceptionally well:
1) Cyclicals and Automakers
3) Precious Metals and Mining Stocks
In part 1 we will cover cyclicals and automakers, and explain why they are primed for 50+% returns, and in the upcoming part 2 we will discuss financial companies upside potential, along with how mining stocks and precious metals are positioning their patterns for the next leg up.
Cyclicals and Automakers:
Cyclicals and Automakers have been two groups that have been unfairly punished by the threat of a double dip recession. As you can see by their lows relative to their 52wk trading range (below), there is much upside if recession fears subside and the market expects forward economic growth. Heavy equipment makers such as Caterpillar (CAT) and Deere (DE) have solid (and growing) earnings and cash flow, and currently trade at 12x and 10x PE multiples. The resumption of their multi-year uptrend will continue once the market believes growth is imminent.
Similarly, stock prices of auto giants General Motors (GM) and Ford (F) have been burdened not by their operating performance, but by the perception that car sales will return to 2009 lows, In fact, both GM and Ford have turned in stellar results over the past two years, and both support pristine balance sheets with mountains of cash ($33B and $22B respectively). Both trade sub-5x PE ratios, and are nearly down 50% from their highs. When the green light is lit and expectations that growth lies ahead, these two pillars of American industrial production will shine and each company has the potential to more than double. (Read more about this in this previous article: "Even in a Recession, GM and Ford Are Easy Doubles")
Finally, we believe the stock prices of economically sensitive producers of steel will recover quickly if the pessimistic environment reverses itself. Currently the threat of recession in the US, economic chaos in Europe, and a China hard-landing have potential investors in this sector frozen with fear. It's hard to be a buyer of these stocks with the bleak outlook on the horizon, and thus most stay on the sidelines. However, when the direction shifts from caution to green, move quickly as this sector is poised for explosion. Individually we like Nucor (NUE) and US Steel (X) as our favorites, as both have 50+% return potential. While Nucor is larger and a bit more stable (trades at less than 10x 2012 earnings), US Steel has more upside leverage due its stock price suffering from less stable earnings (creating a far more attractive 5x PE for 2012).
Caterpillar $73.84, 52wk range 72.60- 116.55, mkt cap $48B
Deere $64.57, 52wk range 64.56- 99.80, mkt cap $27B
US Steel $22.01, 52wk range 21.73- 64.03, mkt cap $3B
Nucor $31.64, 52wk range 30.72- 49.24, mkt cap $10B
General Motors $20.18, 52wk range 19.77- 39.48, mkt cap $32B
Ford $9.67, 52wk range 9.32- 18.97, mkt cap $38B
As in 2009, we believe the market is filled with cynicism and doubt. And while we understand and agree much of it is warranted, we also believe that the establishment will eventually get it right. When they do, it will likely be driven by an event that is noticeable to those that are looking, in essence turning the light from yellow to green. Some may choose to anticipate it, others may wait for the moment, but all should start focusing on what to buy when that light turns green.
Note: If you would like to automatically be notified when Part 2 is released, become a follower. Part 2 will be discussing upside potential for Financials, Precious Metals, and Mining Stocks.