There are many theories out there regarding where the market is headed. I’m going to define the market as the generic Dow and S&P stock indices. Some economists and analysts predict a quick turnaround in 2009, while others predict a much more dire future.

One simple way for us to make an educated guess is to use magazine covers as a contrarian indicator. The theory is that by the time a market’s success or failure reaches the cover page of a major publication, that market will have already been overbought or oversold. The theory plays don the idea of crowd psychology, whereby peaks and troughs occur when the general population gets in or gets out. Thus, all good news are met with underperformance while all bad news are met with overperformance.

The recession has only just begun. The next few quarters will likely show negative to flat growth in the economy. The dollar will likely continue to show strength as the rest of the world falls into turmoil. This means demand for US made products will decrease and manufacturing will continue to slump. The Fed will likely cut interest rates by another 25-50 basis points. Consumer confidence will remain low as inflation persists and unemployment continues to rise.

Indeed, we are entering a critical time with Q3 earnings looming at large, and with the election, the holidays and the winter season all just around the corner. I suspect a few more financial firms will fail before this all ends in 2010. We are certainly forging into new found territory.

The nationalization of Fannie Mae (FNM) and Freddie Mac (FRE), the collapse of Lehman (LEH), the acquisition of Merrill Lynch (MER) and the bailout of AIG (AIG) have all created significant uncertainty in the financial market. There are continued talks of failures, shakeups and bailouts; in fact, deals between a number of financial institutions are being discussed as we speak. Volatility is at the highest in months as a result of heavy speculation on two differing sides, the longs and the (naked) shorts.

It’s hard to read the WSJ these days without hearing something about buybacks. Exxon (XOM) absorbing $102 billion, Citigroup (C) spending $8.3 billion and even Coach (COH) buying back $1 billion. Stock buybacks or share repurchases are known to have powerful effects in building shareholder wealth. To many, it’s often an overlooked measure of the health of a company, trailing stock price appreciation and dividend payouts. The basic theory behind buybacks is that once the shares are absorbed by the company, the value of each outstanding share increases because there are fewer shares floating in the market.  

In the three years ending 2007, companies have bought back around $1.32 trillion in shares, whereas capital expenditures totaled $1.28 trillion and dividends totaled $0.6 trillion.  

I wrote earlier that the pharmaceutical industry as a whole is undervalued. One name that stands out above its peers in this $670 billion market is Pfizer (PFE). The company has taken a severe beating on Wall Street and is a bargain that cannot be ignored. The following are the investment rationale and potential risks to owning this company:

Rationale

• Trailing and forward P/E of 14.56 and 7.72, an all-time low
• Large size is an important competitive advantage over peers – marketing leverage, greater ability to make acquisitions and form alliances
• Deep breadth and depth of drug portfolio
• High foreign diversification – international sales accounted for 52% of 2007 revenues
• Dividend yield of 6.6%, highest in industry. Dividend also backed by $35 billion cash and $7 billion long-term debt
• Strong demographic growth in the elderly - approx. 18% of Pfizer’s sales from drugs for seniors
• Cost restructuring program expected to save $2 billion annually by end of 2008
• Industry and company concerns are already reflected in the stock price and good news are not. Any positive news will likely significantly increase the stock

Risks

• Lipitor patent cliff in 2011-2013, currently accounting for 26% of  total 2007 revenues
• Generics will continue to grow and seize market share
• Potential setback for the entire industry if Democrats win the next office
• Pharmaceuticals is a risky business – investing several hundred million dollars upfront for a short window of opportunity (approx. 10 year patent when you take into account the time to develop a test a drug)
• R&D productivity, pipeline failures and clinical trial risks

Disclosure: Long PFE

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On August 15, an article was published in the Silicon Alley Insider titled “Motorola's Funeral Canceled: On Slow Road To Recovery, Says Citi.” Motorola (MOT) will be spinning off its mobile division, bringing in new management and launching over 30 new products in the near future. Since beating the street on July 31 by 5 cents, the stock price has rallied over 40%. Many analysts remain impressed as this company seems to be getting its act together in its turnaround strategies, at least for one quarter anyway. Carl Icahn even boosted his stake by around 30 million shares.

Once having commanded more than one-fifth of the global handset market, Motorola ended the recent quarter with less than 10% market share. In addition, shelf-space at major carriers is declining rapidly. It seems like Motorola is on track to become a lot more like Nokia (NOK), who does not have one 'great' product, but rather a portfolio of 'good' ones. Hence, that’s why the company is planning to introduce so many new phones. Yet although this strategy has worked for many companies in the past, Motorola has not really developed many phones that people actually want to buy. Case in point, the ROKR partnership between Apple (AAPL) and Motorola didn’t go exactly as planned. What Apple did next is history.

The prices of many pharmaceutical companies have been beaten down by Wall Street in recent months. With companies like Pfizer (PFE), Schering-Plough (SGP) and Bristol-Myers Squibb (BMY) reaching lower lows, one has to wonder when the pain will end as these companies are now significantly undervalued.

The game of Wall Street is far from what many believe is true of the strong-form efficient market hypothesis – that the stock market efficiency causes share pries to always incorporate and reflect all relevant information. Since a majority of the market is comprised of traders’ expectations of future prices based on past information, the underlying human element disputes this theory. What typically happens in an economic cycle is that the stock of a company or even the value of an entire industry grows oscillates beyond fair value.

The Federal Reserve has been busy slashing fund rates for almost a year now, in hope of preventing further damage to banks and financial institutions. Since last summer, the Fed has reduced more than three percentage points off its target short-term lending rate, from 5.25% to the current 2%. This 'quick-fix' approach has been quite lackluster as the market continues to reach lower lows.

The problem is that this time around, the American economy is in a severe state and no government intervention is going to act like a “magic bullet”. Some economists are beginning to think that the economy may have been better off in the long-run if the Fed had not taken the steep cuts beginning last fall at all.

The rage over the past 5 years has been commodities and energy futures. Hundreds of funds were setup to funnel trillions of dollars into these vehicles. For example, the number of commodity hedge funds increased from 36 in 2000 to over 450 this year.

Word on the street is to stay way from the Asian markets and for good reason – high energy prices, high commodity prices and high inflation have caused a level of turmoil in the Asian financial markets over the past year. Most Asian stock exchanges are down by over 30% since the beginning of the year.

Recent studies have shown a direct positive correlation between testosterone levels and financial risk taking, and a direct negative correlation between cortisol levels and risk. This would probably not be a surprise to most people. A study published in PNAS (Proceedings of the National Academy of Sciences) monitored 17 male London traders for eight days. Link: http://www.pnas.org/cgi/content/short/105/16/6167

A new study from the SPAN (Symbiotic Project on Affective Neuroscience) lab at Stanford University describes the endowment effect. Hypothesized by Dr. Richard Thaler, the endowment effect essentially states that people place higher value on objects they own than objects they do not. In a classic experiment for example, people demanded higher price for a coffee mug that had been given to them, but put a lower price on one they did not yet own.

Previous studies have shown that the endowment effect has deep evolutionary roots. In 2006 for example, Keith Chen at Yale Universty gave peanut butter and juice bars as treats to chimps. When presented with a choice, 60 of the chimps preferred peanut better to juice. However, when the chimps were “endowed” with peanut butter, 80% of them chose to keep the peanut better instead of exchanging it for juice. It is as if the peanut butter immediately became more valuable than the juice bar when it was owned.

The presidential election cycle theory was developed by market historian Yale Hirsh. The key assumptions for this theory are that:

• Markets do well in a presidential election year.
• Markets do even better in the year leading up to the election.
• Markets are best performing in years three and four of the current term.
• Markets are worst performing in years one and two of the new term.

Although contended by many economists and financial theorists, this theory has been surprisingly accurate. The following is a look at the annual S&P 500 returns (adjusted for dividends).

Given the uncertainty of the domestic economy, one industry worth considering investing in is commercial shipping. Shipping is the primary means of international transportation of any essential raw material or finished good. Approximately 80% of the cargo and almost 100% of hydrocarbons moved today is by water. The global commercial shipping industry can be classified into the following categories: 

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There is much talk in the media and among investors regarding the recent report by Reuters/Michigan Consumers Index Survey - the index plummeted from a reading of 88.3 a year ago to 59.8, the lowest since June 1980. Much of this decline is attributed to rising prices and a slumping domestic economy, which have made American more cautious about spending.  

Consumers are certainly feeling the pain, what about for investors? Historically, the sentiment index has acted as a relatively reliable contrarian indicator for both the real economy and the stock market. 

Sears Holdings (SHLD), the fourth largest broadline retailer in the US, recently reported a net loss of $56 million, or $0.43 loss per share in Q1 2008 versus net income of $223 million in Q1 of 2007. Total US same-store sales declined 8.6%.

Sears attributed this decline to several reasons: 1. Increasing competition. 2. Weakness in the general economy and housing market. 3. Increased costs in consumer staples such as food and gas. Interim CEO Bruce Johnson said, "Our first quarter results reflect the difficult economic environment and intense competition for consumer business." Following this corporate announcement, a string of business news and media reported exactly what Sears announced, that increased competition and the economy are the major reasons behind Sears' problem.

Business Background

Caterpillar’s (CAT) distinctive yellow machines are in service in nearly every country in the world. The company generated approximately 62% of its revenues from foreign markets in 2007. In addition, 71% of CAT’s independent dealers are located outside of the United States.

Legendary investor George Soros recently released a new book, The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What it Means.

The underlying thesis of the book is that the current financial system has been built on a false paradigm, namely that financial markets tend towards equilibrium. This misleading paradigm has directly resulted in the financial woe that we’re experiencing.

There has been much circulation around the press that the recent retail sales by the Commerce Department, which showed a 0.5% increase (excluding auto) is indicative that the US is not in a recession. To these writers, I say you need to get out more and see the reality of what’s happening in stores! The fact is that a majority of this increase is driven by discounters and wholesale club retailers; indeed Wal-Mart (WMT) and Costco (COST) were among the top performers in April. In addition, April numbers are ‘inflated’ because there was an extra shopping day last month compared to a year ago, depressing March sales and inflating April figures.

We need to be cautious because most Americans right now is contending with rising gas prices, sagging homes and worried about their jobs. Consumers are not spending the way they used to; they’re stretching their dollars – i.e. they want more value for the same dollar they spent a year ago.