by C.S. Jefferson
Buy, Hold Or Fold?
It seems that every single trading session bares witness to commentators and analysts on the financial news infomercials promulgating this idea of retesting the market bottom in order to validate the run to the upside. Perhaps, it highlights the conversation as a major benchmark and level of theoretical risk to the downside. Market memory, anniversaries and the unknown will always cause varying degrees of consternation that provokes one to question reflections seen in the rearview mirror. However, there are so many traders that have missed capturing the upside and full potential move off the lows that a viral contagion of sour grapes has spread in hopes that the market will sell off, simply to allow a safe entry point or second chance for all those that missed the move to begin with.
This, in of itself, is very disingenuous and suspect analysis by many reasoned professionals that have motive to draw this market down again either by being unbearably short, or by having itchy trigger fingers waiting for opportunities to buy. I’m not entirely convinced they’ll get an easy entry point anytime soon, which actually can cause this market to push much higher long before there is complete confirmation of a sustainable economic recovery. In fact, if you ever wanted a catalyst to push these markets even higher, it would be that fund managers are underinvested and being forced to chase performance to close out the year. Six months ago fund managers could get away with adopting the mantra “less worse” while losing money by a smaller percentage than the drop in the S&P 500 or being on the sidelines with cash; but now with the last quarter of the year approaching, those that missed the move and have underperformed are feeling the squeeze to demonstrate positive returns, otherwise, face the certainty of redemptions and withdrawals.
But being a contrarian does not mean you can afford to stand against the tide when the market does shift dramatically and finally sell off into a major correction. Not if, but when we sell off and, without question, there are legitimate reasons to doubt this market going forward, for fear of the unknown is only part of the major headwinds that we face. The real albatross hanging over this market is continuing job losses and deteriorating consumer spending that has the potential encumbrance to stall out any positive momentum. Tax selling may be another real driver toward the end of the year with the guaranteed prospect of capital gains rates expiring. Probably, more concrete, is the changing sentiment when macro-economic numbers can no longer sustain the unrealistic expectations and traders begin to pay attention to a struggling recovery. I, personally, don’t see how job growth--let alone job replacement--can even occur anytime soon, and playing these monthly unemployment lottery numbers as the economic bellwether sets the market up for a serious move up or down.
I hope I’m wrong on this issue, but in a global financial system the changing dynamics in our competitive landscape makes those that yearn to turn back the clock to yesteryear incapable of direct participation, who will only find themselves as relics in the context of history. What is impaired may be forever damaged, and what has changed may have forever changed us all. Yes, the overall economic data is showing signs of improvement off the bottom, but where is the sustainable growth coming from? People still refuse to accept that we are in a credit contraction and that the old rules of borrowing equity off leveraged assets in home values has all but disappeared from the market. The operational mechanics that provided this supplemental household wealth has simply evaporated into someone else’s pockets--let alone thin air--as this global paper asset Ponzi scheme unraveled which seems less likely to return wholesale anytime soon.
Of course, earnings power by companies left standing will handily beat lowered expectations even with margin compressions due to a greater percentage of overall market share, or aggressive shredding of liabilities through labor cuts and less competition which will make best-of-breed stocks very good investments based on survival, not necessarily growth. It seems very likely we will see this divergent pattern to the overall economic conditions for some time to come. However, these are merely my assumptions based on events that are yet to fully transpire with definitive results and, regardless, as a trader you must be willing to maintain risk protection while navigating a course through uncharted territory.
So when we continue to hear hyperbolic references to the absolute market bottom on the financial news, and as reported in most financial journals, keep it in mind to ask which bottom are they referring to? Look, I’m still shocked the market fell as low as it did back in March, breaking the October and November lows of last year which I believed and still maintain were the true bottom. However, to be clear, it was a very misleading decline that took the S&P in the 660 range back in early March of this year compared to what occurred during the calamity of last year when no one could guarantee an absolute end to the madness. For me, personally, the market truly bottomed last fall throughout the crisis in October and November of 2008, even as the overall indices were trading much lower several months later in March 2009. Look at the performance of some of the individual companies as validation when it was estimated nearly 40% of the underlying stocks within the S&P 500 were higher in March of 2009, despite the overall index itself being lower--mainly due to weak counterparts in the financial arena. This was a critical inflection point that demonstrated strength and real buying support in specific sectors without regard to the same media crying about another meltdown and scaring people out of the market. It’s important to understand that while the S&P 500 is highly regarded as the overall market barometer, or the benchmark to measure a fund manager’s performance, this market rally has proven to be much more specific to individual stocks, sectors and themes.
I think too many people in the media were continually miscalculating the strength in the market as it afforded tremendous opportunities throughout the crisis. By relying on the major indices as a whole, it became a matter of convenience to tell the story through the generalized market averages as front page news or breaking headlines, and by exploiting this defect the financial media was neglecting the fact that sector specific performance within the S&P, DJIA and Nasdaq told a completely different tale than the numbers printed on the tape at the big board. The weaker speculative plays were definitely capped with constricted p/e multiples, but real earnings power and revenue growth was in play and money has been put to work since the debacle began by buying companies trading at historic discount prices.
The rise since pushing the S&P 500 back up across 1,000 daring to break higher on the upside has been dramatic and cautions people to believe we have achieved too much too fast, such that we’re due for a serious meltdown and pullback in the markets. I assume there are a lot of professionals that are trying to be too cute in timing the markets and have completely missed the majority of the move to the upside. Their bearish sentiment and pessimism strikes as covertly insincere, but you cannot ignore their presence or ability in manifesting eventual outcomes. If you can listen beyond the white noise, many fund managers admit at certain price levels they would be licking their chops as buyers of the market which implies they are currently underinvested and are begging for a retest just so they can have a second chance opportunity. I hope they never get that chance because it would only mean an outcome of more chaos and panic after working so hard to stabilize the global financial markets. And since the political rhetoric has reached bailout fatigue, it would be difficult to orchestrate another wave of wide scale monetary injections to boost the economy and prop the markets with cartoon, superhero-like “plunge protection teams” in the cover of darkness. This means that any potential retest of the March lows would only mean further deterioration in the economy and disastrous results in the market that could send the S&P 500 well below 600--forget the notion of a retest, it would be financial Armageddon. Let’s hope this is not the outcome because it would mean that all the stimulus and monetary easing has failed such that even the bearish argument is inadequate in recognizing the severity of what may come. Since I’m actually bullish on the markets such that I really don’t subscribe to the March retest idea and, personally, give it a less than 10% chance of happening, as an investor I can’t afford to be wrong so I will never underestimate the risk, no matter how slight. In fact, I distrust my own optimism to remain cautious enough to always maintain active hedging strategies intended to mitigate risk to the downside.
Where I’m Invested Long-Term
If you want to be invested in the market now after such an incredible run up from the lows, then you better buy only what you are willing to own even if the market collapses and sells off again. Don’t chase anything and definitely don’t hold high beta junk unless it’s speculative money you can afford to lose. Personally, I wouldn’t touch 80 plus percent of the S&P 500 as I really try to streamline my portfolio to story specific stocks against the backdrop of an overall macro-economic theme. Within my own portfolio, I continue to hold a substantial overweight position in commodities and base metals that I’ve written about previously and played very aggressively since the collapse in the markets last year. In particular, stocks such as Freeport McMoran (NYSE:FCX), BHP Billiton (NYSE:BHP), U.S. Steel (NYSE:X), Anglo-American (OTCPK:AAUKY), Alcoa (NYSE:AA), and Aluminum Corp. of China (NYSE:ACH) have never looked back by trading anywhere near their 52-week lows, most of these companies hitting that bottom mark in the fall of 2008, despite the much deeper overall index lows this past March. With respect to commodities in general, the real bottom in the market was in the fall of 2008, not March of 2009, which is why I continue to argue that there were no less than two market bottoms within the last year depending on what your positions and exposure to risk were specific to sectors.
These stocks in particular are positions that have returned triple-digit returns off their lows and I continue to hold them as long-term investments. While I haven’t closed out any of these core positions, nor do I intend to, I maintain a defensive posture by implementing hedging strategies to protect against any potential or impending selloff. I cannot, in good conscience, recommend to anyone that isn’t already invested in these sectors to chase performance. This being especially anxiety ridden the more I hear analysts coming on late to the trade which begs me to question: Are we nearing a blowoff top in the commodity trade? The run has been incredible, but buying now is tremendously risky unless you enter the trade as a collar (buy shares against covered calls to finance put protection) or, at a minimum, add-in protective puts along the way. I think these stocks can go much higher, no question, but the risk to reward ratio must be respected to the downside at these levels from this point forward. I won’t go so far to say they are overpriced at current market levels, but they certainly aren’t cheap like they were last fall even though I am biased to the upside by not being remotely tempted to close out the positions.
In fact, the weaker dollar higher commodity theme based on global infrastructure demand and China stockpiling commodities in lieu of currency weakness is one of the main drivers in the market since last year. Since commodities tend to be dollar denominated, stockpiling not only serves as a currency hedge against inflationary policy, it also underscores savvy asset allocation by utilizing universal resources and raw materials as a currency in of themselves. These are all high beta plays and the market overall is doubtful to continue higher if this theme is ever broken. Dollar denominated commodities including petroleum have truly become a means to stockpile global currency protection and may be less about actual infrastructure demand. Somewhere down the line, supply and demand must be in synchronicity, otherwise, the commodities could crash just like they did last year and that would not portend well for the entire market overall. Until then, even though I hope this negative scenario never winds itself out, play what works until the game is broken.
To be clear, I would characterize the March lows as a deeper financial sector sell off which I really minimize by limiting exposure to the payment processors, and not the credit issuers. I’ve written about this in an article previously, but the only “safe financials” to me are the payment processors that don’t hold direct consumer debt exposure. More specifically, relating to stocks such as Visa (NYSE:V), Mastercard (NYSE:MA), and, of course, the exchange bourses: Chicago Mercantile Exchange (NASDAQ:CME), InterContinental Exchange (NYSE:ICE), New York Stock Exchange (NYSE:NYX), and the Nasdaq (NASDAQ:NDAQ). Other than that, banking stocks don’t interest me other than an option trade and certainly not as a long-term hold.
Allow me to list some more of the best stocks I believe are worth owning long-term that I continue to hold no matter where the market trades on any given day. In addition to those aforementioned holdings, stocks such as Dupont (DD), Dow Chemical (DOW), Boeing (NYSE:BA), and Lockheed Martin (NYSE:LMT) are also major components of my core portfolio. All of which, despite moving higher, still remain at very attractive entry levels to long-term investors.
In fact, if I were to advise someone who was itching to play catch up to the market and didn’t know where to place money by being unwilling to stand on the sidelines anymore, these four stocks would allow conservative participation if the market continues higher without chasing by overpaying for momentum. More specifically, Boeing (BA) and Lockheed Martin (LMT) offer a serious defensive posture outside of the obvious nature of their business models with an extremely significant cash dividend. Boeing, in particular, is probably one of the best plays to the long-term investor by being undervalued anywhere below 55 dollars. While it isn’t as cheap as it was in the low 30’s recently, the downside seems limited now to the mid-40’s unless the entire market breaks down or fundamentals change radically. And (LMT) is underpriced below 85 dollars where it seems to find resistance.
Just last week we saw (BA) make a nice intraday pop based on formally announced scheduling with respect to the 787 Dreamliner. It paid off handsomely on some front month options I was holding--ironically, I had this same trade applied a few months ago and mistakenly left a lot of money on the table when they disappointed the markets by delaying their test flight prior to the Paris air show. Not wanting to repeat this mistake again, I sold off 2/3 of my front month 50 and 55 strike September call options and 1/3 of my back month 60 and 65 strike November call options, simply to take the entire cost of the trade and some significant profits off the table. This still keeps me in the trade, but maintains the discipline to take profits when they are dangled in front of your face. With less than three weeks until September option expiration, premium decay is no joke and unless it continues to move higher within the next several trading sessions, my remaining front month calls will most likely be ripped up tickets at the race track. However, I did not sell any of my 2011 55 strike LEAP positions because I truly believe there is serious upside in this story. There still is a relatively lower implied volatility in the options when you compare them to other storied stocks, and remains one of the few long call options positions I’m willing to take in this current market climate that has run so far so fast. Very few long call option plays look cheap to me anymore the higher the market climbs. In fact, writing covered calls and buying puts on most sectors of the market becomes strategically defensive and more appealing day by day if you haven’t done so already.
As far as the underlying security itself, I continue to hold (BA) stocks as a long-term investment and have no inclination whatsoever to sell out of this position. My cost basis is low and the dividend yield is significant when you consider many other companies have suspended or reduced their cash payout as a result of the crisis. The only reason I am not adding to this position in shares is because I already made my commitment throughout the last year and remain overweight. If you don’t play the options, keep it simple and buy the stock by averaging in up or down. Or, add some inexpensive put options against purchased shares simply to protect your positions. If I were making a projection on where this stock will trade, you have to rule out short-term volatility, or worse, stagnation. However, 75 is a target I think it can achieve with relative ease by mid-2010 and, if you press me on the long-term, I don’t think crossing the century mark above 100 is out of the realm of reasonable expectation if, and only if, our global economy truly recovers into 2011.
Unlike many of the commodity stocks I hold in the core portfolio and can’t recommend people chasing if they aren’t already invested at this point, Boeing has tremendous, yet sustainable, upside whenever they have a successful test flight of the Dreamliner and ramp up production for their scheduled 2010 delivery. Unfortunately, timing this trade has been very difficult due to multiple delays and one let down after another, but you will see another major upside move in this stock and the options based on two conditions: The first being the successful test flight of the Dreamliner with strong reaffirmation of guidance for existing orders on their books and, second, a continued run higher in the overall market. Remember, (BA) is a major S&P/DJIA component and aside from aberrations due to intraday pops like last Thursday, Boeing cannot move higher with an inverse relationship to the overall market. It represents a play on expanding global economic demand, a replacement cycle in the airline travel industry, and capital goods strength which require better and more favorable market conditions.
While I believe there are at least several more significant pops in the stock down the line, the stock could easily drift lower which means these pops will be on a relative basis from where the stock settles over a period of time prior to headline breaking news. The test flight will be a catalyst, but you must recognize that their delivery schedule isn’t slated until late 2010. Of course, if markets are behaving, then the stock will run well ahead of schedule. And don’t forget that (BA) is still the second largest defense contractor behind (LMT) so, to be sure, this company is not a one trick pony which is further validated by pretty impressive earnings reports. If you are not a day trader or tempted to time this stock to perfection, you will be afforded opportunities of multiple entry points along the way.
Filtering Out The Noise
I tend to believe if you listen to too much background noise you can become distracted and lose focus, perhaps even trade yourself out of a good position, or miss opportunity as fear takes grip and refuses to let go of its hold. You can watch a trade move higher waiting for a pull back or sell off that never comes. Regardless, try to pick your positions based on companies you have conviction about buying and holding or are simply willing to own regardless of the price action during crisis and volatility. I have not sold any of my core holdings despite the market crisis throughout the past year and, in fact, made very aggressive accumulations of stocks throughout this debacle to bring my cost basis down considerably. While I will trade in and out of options and speculative stocks in a heartbeat, I believe that as a long-term investor you continue to hold certain stocks with solid balance sheets, fundamentals and projected dividend yields that comprise your core portfolio if, and only if, you can effectively manage the risk to the downside.
While any stock is good for a trade, I would repeat, in my opinion, that more than 80% of the entire S&P 500 is not even worth holding as a long-term investment. Many have had their dividends shredded and retain significant credit risk exposure, on top of which, the landscape is much more competitive for fewer consumer driven spending dollars, such that this is about an almost dystopian Darwinistic survival of the fittest. Namely, those with bailout TARP money, and those without; those with access to the Federal Reserve’s balance sheet, and those without; those too big to fail, and those that simply aren’t. And since I don’t, as well as most retail investors, have to mimic the underlying performance of the entire S&P 500, you can be more of a discretionary and selective stock picker rather than a broad based participant.
After all, for a money manager to say they beat the S&P 500 last year doesn’t mean they made money--it just means they didn’t lose as much on a percentage basis as the overall index. Losing less money was the new mantra and threshold of financial genius until the market started performing. Now, with the S&P 500 up significantly, a lot of last year’s geniuses that went to cash on the sidelines will be underperforming the benchmark index. Make no mistake, this is a stock picker’s market. And those that need to hold baskets of stocks or broad based index trades will probably underperform nimbler and swifter hedge funds. In this respect, retail investors can serve themselves up a much better performance by picking best-of-breed stocks in each sector and ignoring anything less. Add to this cocktail recipe a tight dose of basic hedging with put protection, covered calls and collars, you should be able to ride the bull. This is why even long-term holders of index or sector specific ETF’s may be less appropriate for retail traders who may try to opt for safety and, instead, find that like any cumulative fund there’s a lot of garbage collecting going on along with the few remaining diamonds in the rough.
I’ve been very bullish on the stock market since the collapse last year because, to me, that was the “once-in-a-lifetime buying opportunity.” But such opportunities occur more frequently than we’d anticipate, and I do feel much more trepidation as cheerleaders in the media start waving their pom-poms by calling the end of the recession. Of course, history tends to repeat itself and there are always moments of opportunity which all depends on which stocks you were buying. Which is why I say, contrary to how the financial news seems to characterize their version of the market bottom, there were really two different market bottoms depending on which stocks you were playing. From a technical point of view, it would be more accurate to state those March lows were the proverbial “retest”--make no mistake about it that was a market crash in 2008--that many myopic professionals have been looking for and missed by shorting, or staying on the sidelines since then as the market ran to the upside!
Can we have another major sell off that exceeds everything we’ve seen so far? Absolutely. I don’t deny it and have had many sleepless nights about playing Bear market limbo: How low can you go? There are plenty of soothsayers calling for markets to revisit the March lows hoping to make a name for themselves by saying, “I told you so.” I think the percentages are far less in favor of anything close to a significant market retest of the lows, but still the possibility exists and we have yet to fully recover with respect to the “real economy,” despite some very effective consolidation in the market. I suppose what I’m really saying is that these so-called “market bottoms” are headline worthy news items, but don’t necessarily convey individual stories of stocks. We could pull back dramatically in the S&P 500 while certain stocks would hold up better than most others which means, quite confidently, there is money that can be put to work with the correct asset allocation. And as a long-term investor, there isn’t any time that I am not invested in the market. I don’t run to cash by liquidating everything as the market sells off, nor do I feel complacent or compelled to chase when things rise. The difference is that in order to manage a portfolio I must maintain hedging strategies that allow me to stay invested in the market no matter where it trades.
But as stated before, calling the exact bottom of any market is a fool’s game because it is not a singular reflexive pivot point--the bottom of the market is a process that is formulated over time. Looking through the rearview mirror is easy to mark a moment in history, or graph it on a chart, but the struggle to endure and stay in the game so that you can actually exploit opportunity is the true measure of calling a bottom that can only come by realized returns in your portfolio; otherwise it’s all just conjecture and academic conversation.
Author’s disclosure: Long BHP, FCX, AAUKY, AA, ACH, X, V, NYX, NDAQ, DOW, DD, LMT, BA.