There's a Sale in the Stock Department

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Includes: DIA, QQQ, SPY
by: Dan Weiss

The year has begun with a loud GRRRR as domestic markets have declined by 5% (large cap) to 8% (small cap) over the course of just five trading days. Although I never like to lose money (my portfolio is down 2.5% so far this year), I do believe that these types of declines are healthy for markets and create opportunities for intermediate and long term investors.

One very important thing to remember is that as stock prices fall, the valuations of the stocks become more attractive, all else being equal. In fact, in a recent Lehman Brothers report, the firm calculated that the stock market is now at its most attractive valuation since 1974 based on P/E ratios in the mid teens and 10 year bond yields at the very low historical level of about 3.8%.

I am personally not as bullish as Lehman, as they state in their report that the market is about 60% undervalued, but I do remain optimistic on the year ahead (especially into the second half of the year) and remain very positive on the securities in my portfolio as well as closely monitoring several other potential candidates.

A couple of items I like to watch, as readers of prior columns are aware, are the Fed Funds futures contracts as well as the domestic yield curve, to see what bond markets are telling us about the future. The Fed funds futures are currently pricing in a decline in the fed funds rate to 3% (from the current 4.25%) by September. Interestingly, just a week ago the same Fed Funds futures were pricing in a rate of 3.32% and three months ago a rate of 4.2% for September 2008, so clearly investors are saying that the economy is weaker than what had been anticipated and that the Fed will actively cut rates to stimulate the economy.

In terms of the yield curve, we have seen a significant steepening in the spread between 2 year and 10 year Treasuries to a level of 110 basis points from 60 basis points three months ago and just 16 basis points at the end of June 2007. Overall, the widening of spreads is a net positive for financials and banks as they are able to better collect the spread of short term vs. long term bonds. On the negative side, spreads of 10-year corporate bonds to Treasuries have also widened as witnessed by an increase in AA corporates from 84 basis points to 160 basis points and from 124 to 209 basis points for BBB securities.

I would note that bond spreads had reached unsustainably low levels in 2007 so the widening is not a huge surprise, although it does mean that the cost of raising funds for corporations have increased. Finally, the fear gauges such as the VIX, VXN and put/call ratios are all showing that the market is potentially oversold as they have increased markedly in recent days.