No doubt, this past week was a tough week for the market. One of my favorite indicators, though not widely known, turned negative, as Investors Business Daily changed its market outlook from "confirmed rally" to "market correction". They don't always get it right, but I don't take it lightly that the recent number of high-volume sell-offs (primarily outside of the NASDAQ) has triggered this concern. As someone who recently declared that the bear market is over, I am, of course, somewhat concerned that perhaps my judgment is incorrect. For now, though, I stand by my call.
For those who didn't read that article, I went from being a "tactical bull/strategic bear" to a "strategic non-bear" - I wasn't covering a bad position. Rather, I decided to ditch my previous strategy of being prepared to short the market again and to remain long, though I expected some resistance about where we encountered it. Specifically, I don't expect a new low or even a test of the old lows, but I am not ready to declare it a bull market either.
Count me in the modestly positive camp, as I expect that the market will surge higher shortly but then trade in a range for a while. While I know that the adage "sell in May and go away" is not only popular but also often correct, I'll point out that it isn't infallible. Driving my "not bearish" views are several observations that suggest to me that too many people want the market to go down - more below. In the last 5 years, selling in May hasn't been especially productive unless you acted fast to cover when right and didn't panic when wrong:
- 2003: You were toast if you sold on any day in May, and you NEVER got a chance to buy at a lower price
- 2004: You were brilliant by August (if you didn't cover in June) but not by the end of the summer
- 2005: Ouch!
- 2006: If you sold at the beginning of May, you had a good chance to make money, but not if at the end of May
- 2007: You would have been happy in August - some pain by July, little gain by October
In all fairness, though, May was a great sale in both 2001 and 2002, the last time we were in a bear market. Of course, valuations were much higher on a PE basis, and the market had experienced extremely large rallies from very oversold conditions at the beginning of 2001 when the NASDAQ plunged and post-9/11.
While I won't specifically make a prediction about how decisively Obama will prevail (I don't support him, Clinton or McCain, so please don't turn this into a political thread), I will point out that the markets historically do better under Democrats controlling the White House. While there is historical data to quantify it more precisely, it is fairly obvious. Bush has had two bear markets (though Clinton handed him one in my opinion), before that it was Papa Bush, before that Reagan, and before that Nixon. Of course, the market soared during the terms of Clinton, Johnson and Kennedy. Even under Carter, while it muddled along for most of the term, it ended up much higher than where it started.
While this simple view doesn't incorporate control of Congress and many other factors, the point is that fearing a Democrat may not be the best move from an investor's perspective. As I look out this year, I see a number of factors that could lead to a rally that picks up as the election nears and Bush's departure becomes more imminent. Often change is feared, but I think that this time it is probably welcome by many. Just like 1980.
Why the Bears Doubt the Rally
My readings and conversations point to three major reasons to find fault with this rally (besides the "fact" that we are headed for financial and economic ruin). First, breadth hadn't been very good - until recently. Specifically, the narrow leadership, which is a different point, contributed somewhat - the market rally was being driven by the performance of just a few stocks. In the past several weeks though, the advance/decline line has improved a lot, and the R2000 stocks have outperformed the S&P 500 (after a 2 year lag that bottomed officially in January but flat-lined until this month).
The second point is one that I don't take lightly: Concentrated leadership by industry. Sure, the market can rally on the basis of one sector being the driver, but it is implausible for that sector to be Energy in my opinion. While the vast majority of market leaders of late have certainly continued to come from the Energy sector, there have been several companies from a broad array of sectors that have begun to significantly outperform the market. A few that come to mind: IBM (IBM), a business services company masking as a technology company, Walmart (WMT), the store for the masses, Disney (DIS) and many smaller Industrial companies.
Finally, many purport that the rally has had low volume. This doesn't bother me at all, as I look at increasing short-interest levels and very high levels of cash and realize that the reason the volume is low is that shorts aren't yet covering and longs aren't emptying their wallets. After all, though, we have had tremendous volume at several points over the last year, especially early this year. While I will not chase the market if we break through 1455 on low volume, so far there hasn't been much of a reason to have high volume.
What Could Go Right
We read everyday about what's wrong - deleveraging financial institutions, plunging home prices and turnover, soaring energy costs, rising agricultural commodity prices, the evaporating dollar. Many expect some or all of these to get worse, which they certainly may do. As a student of history, economics and psychology, I see it differently. First, I know that historically the market tends to climb a "wall of worry". Conversely, when everything is great, like at the turn of the century for U.S. stocks, or more recently perhaps for the stocks in booming China (and perhaps the parabolic Energy stocks now), things don't always work out for investors.
Economically, I know that the markets look forward and that as investors, we have to know what is priced in. Finally, the contrarian in me knows that when the front page is filled with the headlines and when most professionals I talk to are neutral at best (with lots of cash), it is most likely a good time to be a contrarian. So, let's briefly hit a few of these areas, keeping in mind that these aren't my predictions, but rather suggestions of what could go right.
The problems are widely known, it's just we don't know the depth and duration. The recent write-downs could end up being too great. It is possible that the mark-to-model pendulum has swung the other way, as many pricing proxies have fallen perhaps too much. Let's face it. We don't know what the ultimate default levels will be. Additionally, the capital raising has taken a toll on prices due to dilution - perhaps that is behind us now (certainly dependent upon the first point!).
What goes up and up will obviously keep going up - call it the Energizer Bunny rule. Except, we know it's not true. At the beginning of the year, few expected oil to rise above $100. Now, few expect it to fall below $100. I confess to shorting energy stocks for the first time ever this past week - I bought the double-inverse ETF, UltraShort Oil & Gas ProShares (DUG), at 26 and then 25.6, but I sold out that same day. On this point, I will actually make a prediction: Energy stocks will endure a big correction, taking out the most recent lows. After that, who knows? I expect that their leadership has ended for the balance of the year.
Yes, I understand the very positive fundamentals, but I am almost certain we just had a blow-off top. The number of Seeking Alpha articles (almost all bullish), the pictures in the newspapers of the "trees", the incredible volume on the previously mentioned DUG (similar to the volume peak on Ultra Financials ProShares (UYG) at the bottom) and the sentiment in general all lead me to this conclusion. Just stopping going up would be great, but falling prices could be fantastic for the rest of the market. The first action is for the market to fall as speculative investors dump energy stocks, but the secondary action is positive as they reinvest later.
Rice shortages, surging corn due to bad ethanol politics, hungry foreigners, get that fertilizer while you can. I don't have a firm conviction here, but after quadrupling, wheat has plunged. Soybeans have consolidated. Cattle prices have leveled. I think that one of the big problems is that these increases, which have been at play now for about 2 years, are finally impacting prices at the consumer level and thus drawing a lot of attention and angst. I say, avoid cornflakes by substituting Wheaties, and you'll be fine. The point here too is that leveling will be good, and a decline, though probably not so likely, will be fantastic.
I know that there is a ton of debate. I live in Houston, where things are fine, as I imagine they are for most markets out there. The ones that had the huge run-ups are the ones that remain at risk (CA and FL primarily, though many others as well like Las Vegas and Phoenix). In the long-run, affordability is what drives the price of housing. Rates are low and should stay low, even if Treasuries rise as I expect. Income growth isn't great, but wages continue to increase in what remains a fairly tight labor market. Part of the problem with housing (besides the greater fool theory ending) is that credit standards have tightened and availability has shrunken. Take a look at the volumes out of the GSEs last week, though, and I think that you might agree with me that capital is available for mortgages underwritten at "normal" standards.
I wouldn't touch a homebuilder stock, but I do expect that the news a year from now will be fair to good in general. As someone who saw this coming and kept expecting it to get worse, I find myself much more optimistic now. I even just purchased a new house.
I expect that the dollar's depreciation has ended, along with our rate cuts. Further, I expect that while short-rates may stay low for a while, our longer-term risk-free rates will rise (though credit spread narrowing will help other types of bonds to some degree). In this environment of a stable stock market, better long-term bond rates in a few months and a more balanced view regarding our financial system and economic outlook, the dollar could appreciate a lot. I predict that it will at least appreciate a little.
Where to Invest
I think that this environment will be great for smaller-cap names. Better liquidity, less interest in names with huge international exposure and continuing favorable relative long-term growth prospects lead me to want to focus there. I would continue to be extremely cautious on companies that have to access the capital markets - it is too early to buy companies in balance-sheet distress in my opinion. Here are 4 sector themes that I favor:
- Small-Cap Aerospace: I wrote about this theme earlier this month and have committed my own capital further, adding Ladish (LDSH) to my recent purchases of Titanium Metals (TIE) and Carpenter Technology (CRS). The basic argument is that the secular theme is intact, but the delays, as well as certain other factors like high energy costs, have just killed these players down in the supply chain. Increased energy efficiency, safety issues and age of the fleets all suggest that we will see years and years of newbuild.
- Financials: I have shared my views on several financial companies in the small-cap space and my affinity for both Fannie Mae (FNM) as well as the SPDR Financial ETF (XLF). I have to admit to being a little concerned with the weakness of the latter and may have to give further thought to my investment strategies if we see much more of a decline. Among smaller companies, I have written about several, a couple of which have done very well and don't have as much appeal as when I wrote about them (Biomed Realty (BMR) and Cullen/Frost (CFR)). One that does is EZCORP (EZPW), the pawn shop operator and payday lender. I have recently added two other names, Federated Investors (FII) and Americredit (ACF). FII is one of the cheaper names in the cheap asset management group. It's on the smaller side compared to most in the industry. With no credit issues, I like the group. FII does have a large money-market area which seems like it could be somewhat of a drag, but recovering markets could be the catalyst to get this one and its industry out of what I view as unsustainably low valuations. Truthfully, it isn't an area I know very well. I paid 11 for ACF when it gapped up recently and sold it in the high 14s not too much later. I would be a liar if I claimed to have a lot of insight into this sub-prime auto lender, but I would note insider buying, a huge investment from Leucadia (LUK) - which knows that industry well, high market share and tremendous relative metrics in an industry where I expect to see a lot of exits by smaller players, and some recent signs that they won't get cut off from securitization. This one is extremely risky! My target, though, is 17-19 now - this time it gets through 15.
- Industrials with Low but Increasing International Sales: These tend to be smaller companies that are early in the curve in becoming more international, with the potential to ramp it up significantly. I would throw out two that I own, but there are many, many more of these. Mine are Middleby (MIDD), which is a leader in commercial equipment for restaurants, prisons and schools, and Astec Industries (ASTE), which is primarily an asphalt equipment company. I wrote about MIDD in July, and it has declined, but slightly less than the R2000. The company has continued to build out its offerings internationally and is doing well, but the domestic headwinds recently led their CEO, who I believe is one of the best ones that I have encountered over the years, to reset expectations for 2008, creating a buy opportunity for me (and for you).
- Consumer Names, Especially Home-Related: I wrote recently about high-quality retailers beaten down to very attractive levels and a bit earlier about some big-box retailers leveraged to the home. The basic theme here is that margins are depressed as sales have plunged, and we get a chance to buy high quality names on sale. Watch for excessive inventory, but I expect small-cap retailers as well as the names I mentioned in the home-related retailer article to do well the rest of this year. I ended up adding Timberland (TBL) subsequent to the article I recently wrote that included the name.
Every time I have written a bullish article this year, the market has responded by immediately declining sharply. First, I wrote right before MLK Day. Then, right before Bear (BSC) blew up. Finally, the article I mentioned at the beginning of this one encountered a HUGE sell-off the very next morning - look at the comments on Seeking Alpha. I should probably have bought a bunch of puts late Friday! As I stated in that article earlier this month, I think that we could drop on the S&P 500 as low as 1340 (it already broke the top-end of my suggested range of 1380). Below that, I check my thesis. We have month-end this week, and not too much more. Will we get our 2nd straight monthly improvement in the market? The S&P 500 is slightly negative, but the Russell 2000 is up 1% with just four trading sessions to go.
Looking out, I expect us to test slightly higher levels than the recent peak of 1425 on the S&P 500, with another pause as we move close to 1455. A break of 1455 would be technically significant in my opinion, and a move through the year-end close of 1468 could lead to a stampede. That may not occur at all - we could just muddle along at slightly higher levels until much later this year as the market digests the Q2 and Q3 earnings reports and then the election (or I could just be plain wrong about the bear market being over).
Disclosure: As always, feel free to view all of my holdings, but specifically I am long the following stocks mentioned here: ACF, ASTE, BMR, CFR, CRS, EZPW, FII, FNM, LDSH, MIDD, TBL and TIE.