The Prudent Speculator: January 23, 2012 Market Commentary

by: L. Frum

It's now three for three in the New Year as stocks continued to move higher in the holiday-shortened third week of 2012 with the broad-based Russell 3000 index presently showing a year-to-date return of 4.9%, which exceeds the 4.6% return of the S&P 500 and the 4.1% return of the Dow Jones Industrial Average. Recall that it was the 30-stock, blue-chip Dow that won the spoils in 2011, when the average stock took it on the chin, so it is nice to see the broad market outperforming, even if it has just been a few weeks. More importantly, while the Growth component of the Russell 3000 index has nosed ahead of Value in the performance derby, our newsletter portfolios, despite modest cash positions, are up more than 6% on average so far this year.

While we believe that most stocks are still priced well below fair value, such an impressive start to the year (the best in a quarter-century) is hardly a usual occurrence, even as history tells us that January is far and away the best month of the year for Small-Capitalization stocks as well as a very good one for Large-Capitalization stocks. Certainly, it would not be a surprise should the equity markets succumb to a little near-term profit taking, especially as most of the investor sentiment gauges are flashing warning signs. As The Los Angeles Times reported on Friday, "A survey of hedge funds showed that 42% of managers are optimistic vs. 30% who are bearish, the highest level of bullishness since July. Among newsletter writers, 51.1% are bullish, the most since April. And a Bank of America poll of global fund managers showed them to be the most upbeat about U.S. stocks since April 2010. Other technical indicators also point to bullishness among pros. For example, short interest on stocks listed on the New York Stock Exchange fell 10.5% last month to its second-lowest level in two years."

Wall Street has become more optimistic, but investors on Main Street also are starting to stick their heads up out of their foxholes as the most recent (as of 1.11.12) mutual fund flow figures from the Investment Company Institute show that a net $753 million actually came into domestic equity funds, partially reversing the $7.1 billion in net outflows seen the week previously. Of course, the deluge of money flowing into bond funds actually grew larger as a combined $7.9 billion came into taxable and municipal funds, suggesting that there is still not a lot of love for stocks. Interestingly, the number of Bulls in the latest AAII Investor Sentiment Survey (as of 1.18.12) pulled back by 1.9% to 47.2%, while the Bears climbed by 6.4% to 23.6%, but the 23.6% gap is still well above the nine percentage point average advantage that optimists have held in the 25-years that this barometer has been reported.

From a contrarian perspective, we don't like to see a lot of enthusiasm toward stocks, but it is somewhat reassuring that the media is right on top of the warning signs. In addition to the local paper mentioned above, two of my favorite writers for Barron's Magazine, Michael Santoli and Vito Racanelli, both saw fit to mention that a pullback in the next week or two would seem to be in order, citing much of the same data. Not quite a third derivative (you know, if the data is bullish, that is bearish, unless it is bullish because everybody already knows and has positioned their portfolio to expect a contrarian pullback) but we also would not be surprised to see the rally continue for a while longer, especially if the tone of Q4 earnings improves when the results begin to come fast and furious this week.


The hot start to the year has come even with a relatively mediocre start to fourth quarter earnings reporting season. Thus far, of the 72 companies in the S&P 500 that have reported Q4 numbers, 'only' 60% have turned in EPS that topped analyst forecasts, according to data from Thomson Reuters. The data provider also states that the figure is the lowest percentage since early 2009, when companies were announcing results for fourth-quarter 2008, one of the worst periods of all-time for the financial markets. Of course, we also know that stock prices bottomed out less than two months after those disappointing numbers were being reported, with gains over the ensuing two years generally topping 100%. We're certainly not projecting a rally of comparable magnitude, but it would seem that, thus far anyway, investors have had fairly low expectations about Q4 report cards.

As is usually the case, investors care as much about the outlook for the coming quarters as they do the details of the results for the periods just completed. So far the commentary has been mixed. Consider the news out of the banking sector. Citigroup turned in a poor report card and said, "Europe remains the largest overhang on the market at this time. There are a lot of dark clouds…The weak global economy negatively affected market activity, and many of our clients reduced their risk especially in the fourth quarter." But Wells Fargo (NYSE:WFC) - $30.54) topped expectations and explained, "The quality of earnings was really good, and it was broad," as it reduced the expense for its bad-loan reserve by $600 million, while nonperforming loans declined by 20%.

Investment banking powerhouse Goldman Sachs commented, "This past year was dominated by global macro-economic concerns which significantly affected our clients' risk tolerance and willingness to transact," even as it's Q4 EPS topped projections. CEO Lloyd C. Blankfein added, "While our results declined as a consequence, I am pleased that the firm retained its industry-leading positions across our global client franchise while prudently managing risk, capital and expenses. As economies and markets improve - and we see encouraging signs of this - Goldman Sachs is very well positioned to perform for our clients and our shareholders."

Encouraging seemed to be a good word, however, for the outlook for companies in the financial space as BB&T Corp (NYSE:BBT) said, "Our fourth quarter net income available to common shareholders of $391 million reflects our strongest quarterly earnings since mid 2008. The increase was driven by improved revenues, accelerating loan growth and much improved credit quality." JPMorgan Chase (NYSE:JPM) CEO Jamie Dimon said, "Demand is everywhere - Industrial, consumer, Asia, Latin America, trade finance, corporations, all types of corporations." Meanwhile, Citigroup commented, "In the fourth quarter, we began to see some good demand for loans pretty much spread around the world."

While it takes a strong stomach to commit new money to the financial sector, we remain partial to stocks like JPM, Ameriprise Financial (NYSE:AMP), Bank of New York Mellon (NYSE:BK), Credit Suisse (NYSE:CS) and TCF Financial (NYSE:TCB).


The economic stats out last week were actually pretty good, especially as several of the numbers announced the week prior were uninspiring. On Friday, we learned from the National Association of Realtors that sales of previously owned homes rose 5% in December, the third straight monthly advance, though the median price fell by 2.5% to $164,500. On Thursday, the Labor Department reported that the number of first-time claims for unemployment benefits tumbled by nearly 50,000 to 352,000, the biggest decline in more than six years. The latest tally was the lowest since April 2008 and the less-volatile four-week moving average dropped to 379,000, marking the second 'best' read on that gauge in more than three years. And on Wednesday, the Federal Reserve said that factory output jumped 0.9% from November to December, the biggest monthly gain since December 2010, while industrial production climbed 0.4%.

Of course, we also were reminded last week that there remains plenty about which to be concerned on the economic front when the World Bank lowered its projection for global economic growth to 2.5% in 2012, down from a prior estimate of 3.6% set six months ago and the 2.7% rate that is expected to be the final tally for worldwide economic expansion in 2011. The organization argued, "The world economy has entered a very difficult phase characterized by significant downside risks and fragility. The financial turmoil generated by the intensification of the fiscal crisis in Europe has spread to both developing and high-income countries, and is generating significant headwinds. Capital flows to developing countries have declined by almost half as compared with last year, Europe appears to have entered recession, and growth in several major developing countries (Brazil, India, and to a lesser extent Russia, South Africa and Turkey) has slowed partly in reaction to domestic policy tightening. As a result, and despite relatively strong activity in the United States and Japan, global growth and world trade have slowed sharply."


While we expect volatility to remain elevated this year, and we have to concede that the markets have come a long way quickly, we see no reason to alter our 1400 year-end S&P 500 price target. Of course, that level actually might be a little low, considering where we stand today, but we focus our attention on the companies in which we are invested. After all, we own businesses like International Business Machines (NYSE:IBM), Intel (NASDAQ:INTC) and Microsoft (NASDAQ:MSFT) - $29.71), all of which posted impressive Q4 results last week, and not index funds.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.