June '08: A Stock Picker's Environment

by: Jason Schwarz

What are the conditions of a stock picker's environment?

  • Condition #1-Fear of economic calamity has been taken off the table.
  • Condition #2-Positive catalysts for recovery are identifiable but will take time to develop.

In such an environment, investors are anxious to put their money to work but are leery of further weakness spreading from the damaged sectors. Welcome to June 08. In case you've forgotten, the Fed will rescue any large financial institution whose collapse poses a risk to the economy (I had to throw that in there for all of you who started to panic over the Lehman (LEH) news from Tuesday).

In my last article, I compiled various quotes from big-time market participants who suggest that we are in the final stages of the credit crisis, the oil spike and the bottomed-out dollar, representing three major components of market weakness whose recovery would provide positive catalysts to the upside. However, I don't think anybody expects these three issues to rapidly improve in the short term. It is going to take some time as they work out the remaining obstacles.

Let's look at financials as an example: further declines in real estate valuations will put continued pressure on the financials (NYSEARCA:XLF). Standard & Poor's agrees. On Monday they lowered their ratings on Lehman Brothers, Merrill Lynch (MER) and Morgan Stanley (NYSE:MS) on concerns about further write-downs in their holdings of U.S. mortgage and residential construction loans. Who wants to invest in a balance sheet with sinking collateral?

The mark-to-market disclosure requirements of Sarbanes Oxley have fundamentally changed the way financials do business. As they adapt their business models to deal with the new transparency, a long term recovery in the sector cannot happen until real estate finds its bottom. It seems logical that a bottom won't happen until prices give back 50% of the 2003-2006 'easy lending' gains. Data from a typical California neighborhood like Thousand Oaks show us that median home prices jumped from $425,000 in 2003 to $770,000 in 2006/2007. Current prices are $669,000. That leaves us with another 12% to drop before we start to bottom out. We're headed in the right direction but we're not through all of the pain yet.

With an ultra-sensitive, election-year government working to avoid a widespread calamity we find ourselves in the midst of a perfect setup for robust stock picker returns. Anxious money will pour into the best-of-breed growers over the next few months. Back in January, when hedge fund manager Doug Kass correctly forecast the current market climate, #11 on his list of predictions was "investors pay up -real up -for growth. The three horsemen -- Research In Motion (RIMM), Apple Computer (NASDAQ:AAPL), and Google (NASDAQ:GOOG) move into bubble status. Their shares double in 2008 even as most equities decline." (thestreet.com)

Picking the obvious growth stories is the best way to play the beginning of the 2nd half recovery that Ben Bernanke spoke of on Tuesday. Low domestic interest rates, emerging market weakness, a low US dollar and declining real estate all lead us to the same conclusion-there aren't any investment alternatives. People have to put their money somewhere. I recommend staying away from the indexes as they sort out the final stages of weakness. Instead, focus on those companies who have a story to tell, a catalyst that will fundamentally carry them through the remaining rough period.

Our firm, Lone Peak Asset Management, is increasingly shifting client funds away from general sector funds and into unit trust portfolios that can more efficiently capitalize in a stock picker's environment. Such portfolio's are built around specific growth catalysts like the China Rebuild Portfolio, the Apple iPhone Portfolio, the Hybrid Automotive Portfolio and the McCain/Obama Portfolios. Cherry pick the high growth companies when the broad market takes them down. Respect the phase. The overall market is setting up to run again, but now is the time to be invested in the proven winners.

Disclosure: Long AAPL