Overview & Outlook
The first quarter of 2010 was one of extremes and started things out with a bang. The S&P 500 began the year at 1116 and quickly rose to 1150 before undergoing a 9.2% selloff (the steepest since the recovery began in March of 2009) down to 1044. Investors (such as myself) took advantage of the “sale” on stocks during the selloff and used it as an opportunity to add to positions. The ensuing buying pressure caused a 12% rally and the S&P 500 ended the quarter up at 1169.
Optimism abounded during the first quarter as corporate earnings continued to meet or beat expectations; auto sales maintained their upward trend and 4th quarter U.S. Gross Domestic Product (GDP) registered growth at an annual rate of 5.6% (the strongest growth since 2004). The jobs picture also improved in the first quarter with a drop in the unemployment rate down to 9.7% from 10% in December. March was especially strong as the economy added 162,000 jobs, the biggest monthly gain in over three years. Unfortunately, over 40,000 of those jobs were temporary Government hires for the Census and, after dropping to 9.7% in January, the unemployment rate has not fallen any further.
The signing of the health care reform bill by President Obama eliminated some uncertainty in the markets; influencing performance positively. Although the long term effects of this legislation are not yet clear, companies can now move forward with a solid understanding of what the rules of the game will be. Economists had been arguing that until the bill was either signed (or killed) it would be very difficult for companies to hire new employees because they wouldn’t know the true cost of employment.
Credit markets also continued to improve with the spread between corporate and government bond yields falling back to historically normal levels. Inflation was beginning to be a concern for investors towards the end of 2009 but the Consumer Price Index (CPI) data from the first quarter of 2010 allayed those fears by showing very muted gains. This maintains the foundation that the Federal Reserve needs to maintain its “exceptionally low levels of the federal funds rate for an extended period” while also providing financially strapped consumers with lower prices for their everyday items.
Despite the good news, there continue to be significant caveats and reasons for caution:
- Unsustainable GDP Growth
The blistering 5.6% GDP growth rate from the fourth quarter is not likely to be repeated because it was primarily driven by companies stocking up their inventories for the holiday season. Inventory stocking is typical in the fourth quarter but its effects were magnified in this case because companies were being cautious last year and maintained especially low inventories during 2009. To provide some context, we would need three more quarters of 5%+ GDP growth to drive unemployment down just 1%.
- Weak Jobs Market
Although the unemployment rate has fallen from its peak, it is still at historically elevated levels. U-6 Unemployment (a broader and more complete picture of unemployment) had been slowly declining but has now been ticking upward since February and registered at 16.9% in March. The picture gets even worse when you look at the details. Out of all the unemployed Americans, 44.1% have been unemployed for more than six months (almost double the worst level seen in our last recession). Also, many people who have been unemployed for more than a year are no longer being counted in the official statistics. This trend has only been getting worse and could mean that a lot of the jobs that have been lost are not coming back (particularly in construction, manufacturing and financial services). Unemployment rose in 24 states, while California, Florida, Nevada and Georgia all set new records for joblessness in March.
- Rising Oil and Commodities Prices
Over the past couple of years, oil companies have drastically cut their capital expenditure budgets for building new capacity because global demand had significantly slowed. Following strong stimulus programs from around the world – most notably China’s – demand for commodities and oil has been rising and global demand for oil is expected to set all time records in 2011. This strong demand combined with a diminished supply of oil could cause another sustained run-up in oil prices, which would severely dampen the economic recovery taking place.
- Interest Rate Policy and Bank Lending
A key driver of this recovery has been the strength of banks and their ability to keep credit flowing throughout the economy so that consumers can spend (even when they shouldn’t) and companies can expand. The more money banks make, the more credit they can provide. With the Federal Reserve holding their overnight lending rate at effectively zero, it has been extremely easy for banks to make money by borrowing from the Fed (AKA U.S. taxpayers) at a rate of 0% and then lending it out to companies at a rate of 5% or more; essentially providing the banks with windfall profits. Eventually the Fed will need to raise rates to stave off inflation, which will severely crimp the margins of banks, limiting their ability to continue contributing to growth.
- Continued Uncertainty Around Financial Regulation
Now that health care legislation has been passed, the administration and congress can turn their attention toward regulating of the financial services industry There is strong political and popular will to ensure that a financial crises of the magnitude that we saw in 2008 does not repeat but it is still unclear whether it will be done in a way that would impair the ability of banks to provide credit. Major banks made themselves easy targets by taking taxpayer money (whether they claimed to need it or not) and then spent lavishly on employee compensation stoking outrage that continues to smolder.
- The U.S. Budget Deficit and Tax Increases
In combating the recession and reforming the healthcare industry, the U.S. budget deficit has grown to unprecedented levels. This has been exacerbated by falling tax revenues due to lower corporate profits and consumer income. President Obama has already said that taxes will need to be raised for upper class Americans but it is not unreasonable to assume that lower income levels could also see higher taxes. Of particular concern for the stock market is that taxes on capital gains and dividends may also be raised, which would most likely be perceived negatively by the market.The elephant in the room however is looming social security and Medicare expenses that will continue to balloon as the baby boomers retire. Any reform will most likely require a mixture or higher taxes, reduced benefits and tougher eligibility requirements. Faced with the prospect of higher tax rates and decreased social benefits, investor sentiment is likely to wane.
Despite my caution, I am hopeful and optimistic that economic data will continue to improve. I would like to believe the market cheerleaders on CNBC who say that we are in a new long-term bull market but unfortunately, the facts of the situation do not yet support that assertion. After selling off a large portion of my portfolio in December and early January, I have been gradually increasing my exposure to certain areas of the market with a defensive posturing.
During times like this when hope and optimism outweigh the raw data, it’s important to maintain perspective and discipline. Warren Buffett said it best in a letter he wrote to his investors during the stock market frenzy of 1969:
It is possible for and old, overweight ball player, whose legs and batting eye are gone, to tag a fast ball on the nose for a pinch-hit home run, but you don’t change your line-up because of it.
Although very volatile, the S&P 500 continued its upward march, gaining 5.39% in the first quarter of 2010 and bringing its return for the trailing twelve months to 49.76%. However, it is still down more almost 19% from the October 2007 market highs.
The MSCI EAFE (European, Asian & Far East) index continued to underperform U.S. equity markets with a gain of only 0.94% in the first quarter, bringing its’ total return for the past year to 55.19%, slightly above the S&P 500. We feel that the MSCI EAFE is still being held back by a strengthening U.S. Dollar as well as concerns over sovereign debt in countries such as Greece, Ireland and Portugal. Despite these concerns, we maintain a favorable view on foreign/emerging markets as a whole because of their stronger fundamental growth prospects and lower consumer debt to income ratios.
The Barclays Capital U.S. Aggregate Bond Index underperformed equities during the first quarter of 2010 with a gain of 1.78%. The index is now up 7.70% over the past year and yields approximately 3.8% as of the close on March 31. The recent underperformance of bonds is likely due to investors shifting money from bonds (which are relatively safe) into riskier assets such as stocks (which offer greater returns). Another downward force on the price of bonds is speculation regarding when the Federal Reserve will begin to raise interest rates (higher rates tend to depress the price of bonds) and by how much.
We are either at the end of a Great Depression style “fools” rally or entering the second stage of a longer term bull market but it is very difficult to tell which it will be. The market is longer “cheap” by almost any definition with the P/S ratio now solidly over 1.0 and the dividend yield of the S&P 500 back to normal levels below 2%. However, with a forward P/E ratio of 16.95 (as of market close on 4/23/10) the market is not exactly overpriced either. We are now in a valuation limbo of sorts.
The main reason for this is that there is currently an unprecedentedly large divergence in the corporate earnings estimates of top down macroeconomic analysts and bottom up security analysts. Historically, bottom up security analysts have predicted operating earnings 19.25% higher than those predicted by top down macroeconomic analysts. For 2010 and 2011, the difference has widened to over 28%.
It the optimistic bottom up analysts are correct and the S&P 500 has operating earnings of ~$95 in 2011 (up from ~$57 in 2009), then the market is certainly undervalued and could easily run up into the 1,400’s assuming a modest P/E ratio of 16. However, if the top down analysts are closer to the mark and the S&P 500 earns only $70, then using the same P/E of 16 would imply a market correction down into the low 1,100’s.
This being said, I remain long the market and do not see any strong technical resistance other than 1,229 (the 61.8% Fibonacci retracement from 2007 highs to 2009 lows). However, until we break above that line, I am keeping my mind very open to the idea of a deep decline for two reasons. 1.) Selloffs bring lower prices and opportunities to buy great companies that might have been missed earlier during the rally and 2.) The public and political will for strong financial reform (which I feel is absolutely necessary in some areas) has been dwindling with each new month that the market continues to rally. The impetus for reform would be greatly strengthened if the market begins another dramatic selloff and stories continue coming out about issues similar to what went on between Goldman Sachs & Co. (GS) and Paulson & Co.
Bottom Line: Don’t short a market that wants to rally. I’m staying net long until technical long setups start breaking down and if short setups start working before we break above 1,229 then I’ll have to reevaluate and strongly consider going short.
During the year Michael and I issue various opinions about stocks that we feel strongly about. We do this whether we have purchased/sold them in our personal accounts, or just because we feel strongly about the direction a stock will take but aren’t in a position to capitalize. We have been writing this blog for a several months now and feel it would be instructive to analyze our picks and determine what worked and what didn’t, and provide our current insight on those stocks. Current market prices will be taken from the close of market today, January 7th, 2010.
Some That Went Well:
B SHAW @ 28.20: I bought the Shaw Group (SHAW) on October 16, a day where they got hit hard by a number of events. Shaw just announced earnings which beat expectations, taking their stock to $32.36, for a return of about 16% in 3 months. I saw them then, just as I do now, as an undervalued and under-appreciated infrastructure play with a nuclear energy kicker.
B BNI @ 79.20: I bought Burlington Northern Santa Fe (BNI) on October 1. I was looking at a cyclical play as the economy recovered, I figured that rail was going to see a huge rebound as the economy recovered. What would be the chief driver of this? The efficiency of rail, as energy prices rise (another bet I am taking), rail will become more and more attractive relative to other methods of over-land material shipping. Towards the end of last year, Warren Buffet announced that he was buying the rest of the BNI shares he didn’t already own for $100/share, and the stock rose to that level generating a return of 26% in 2 months. I eventually sold that position instead of receiving the equivalent in BRK.B shares.
S PALM @ 17.40: I nailed this one. I didn’t own the stock, so I couldn’t sell it, but had investors heeded my warning they would have saved themselves from 34% of downside given the current price of $11.45. I wrote this as PALM was riding high on the prospects for the Pre smartphone, but I saw the dark clouds on the horizons. With Google releasing their Nexis One yesterday, if puts another nail in the coffin of Palm’s WebOS, as the ability for manufacturers to customize Android, and the immense Apple App store, give massive advantages over Palm’s new system.
S GRMN @ 37.63: This is another one that I didn’t own and so couldn’t sell, but the stock is now 17% below the price at which I recommended selling. Again, this is smartphone related as GRMN released their Nuvi to much hype, but little substance. GRMN is losing marketshare to smartphone applications like on the iPhone, Motorola Droid and Google Nexis One, and this is a trend that will continue. The Nuvi was supposed to help, but it was a confused hybrid between stand-alone GPS and a smartphone that made a mess of both functions. Investors will do well to continue to stay clear.
B RIMM @ 56.60: Mike nailed this price for RIMM. He used discounted cash flows analysis to determine that it was severely undervalued, and that turned out to be the case. RIMM is currently trading at approximately $65, for an upside of about 16% in the 2 months since his article was published. RIMM is the biggest player in the smartphone market, and their strength will likely continue as they release new products that are competitive with the other market leaders.
S RIMM @ 83.60: Again, Mike nailed this one. With a current price of $65, Mike saved himself and any readers who heeded his warning from 28% of downside over the course of 3 months. His hypothesis was that expectations for performance had outstripped actual results, and that was the case as RIMM reported earnings that disappointed.
There was also Mike’s December 17th post, on Meredith Whitney’s calls on Goldman Sachs & Co. (GS), Morgan Stanley (MS), and JP Morgan Chase & Co. (JPM) where he proposed that it would likely be profitable to ignore her calling considering that the stocks had already fallen quite a bit and that even with her lower earnings estimates, they still represented great values at their prices at the time. Mike has so far been proved correct, and all three are up by 10%, 13% and 11% respectively in the two weeks since his post. All returns are more than doubling the 4% gain of the S&P 500.
And Some That Did Not Go So Well:
B VXX @ 48.30: The problem was not the argument, but the vehicle chosen to execute that argument. VXX is an ETF that is designed to follow the short-term VIX futures contract price. The problem is, it doesn’t. Since my article was posted, this ETF is down 37%. Luckily I got out pretty quickly (at $45.96), but in retrospect this was a horrible idea.
S AAPL @ 189.59-190.00: Our hypothesis on this article (which incidentally got us a note from Apple’s lawyers…check out the original post) was that AAPL had fully priced in any future good news, and was excluding the possibility of poor performance. A week after our original article, Apple released record earnings, and the stock shot up to above $200. It has shown volatility since then, but now stands at $210 for a missed upside of about 10%. We stand by our convictions, but with the utmost respect for AAPL’s continued performance.
B RIMM @ 70.07 and 67.20: After RIMM missed earnings on September 25, the stock dropped by 15% in a day. I bought that dip, and Mike bought a few days later. I underestimated the investor disappointment concerning earnings, and bought way too early. The fallout from earnings hadn’t happened yet, and the stock would eventually settle in the mid $50s before recovering. At its current price of $65, the decline isn’t so painful but it definitely hurt for a while.
B BAGL @ 10.12: Mike found this one while searching through relatively unwatched industries for low-beta stocks that were severely undervalued on a cash flow basis to their peers. It is currently down only 4% but this is following a more than 11% gain off of where it fell in the mid-8’s. Einstein Noah Restaurant Group continues to trade at less than half a years revenue even though the company is still growing. Mike still feels it offers a very compelling value especially compared to it’s peers, however, he recognizes that it was probably a mistake to dive in until there was a potential catalyst to drive the stock higher considering that they don’t even pay a dividend.
I hope readers find this constructive. I find it is helpful to go back and learn from both your mistakes and successes. In general, I feel that we have done quite well in picking stocks on both sides of the trade.
Disclosure: Andrew is long RIMM and SHAW. Michael is long BAGL, BAC and net long the market although currently building a position in SH.
Meredith Whitney recently cut her firms earnings estimates over the next couple of years for Goldman Sachs & Co. (GS) and Morgan Stanley (MS). The reduced estimates come in at $19.57 a share in 2009, $19.65 in 2010 and $20.60 in 2011 for Goldman Sachs; reduced from $19.95, $21.73 and $24.04, respectively. Morgan Stanley’s projection for 2010 was cut to $2.60 a share from $2.63, while the 2011’s forecast was cut to $2.75 from $3.28.
Giving each firm fairly conservative p/e valuations of 10 would still value Goldman Sachs at ~$200 and Morgan Stanley in the higher $20’s. I realize this is a very cursory analysis but it shows that Meredith Whitney may have been a little late to her call after Goldman Sachs and Morgan Stanley have already fallen approximately 16% and 18% respectively since their recent highs.
The bottom line is that investors looking for exposure to that end of the market are going to want to invest in the best companies like Goldman and Morgan. Goldman is already starting to look attractive at these levels as a place to start dipping my toes and the downside risk seems rather limited. Goldman Sachs at $150 (a 6.25% fall from current levels) would represent a forward p/e of 7.5 which seems rather low and unlikely.
Jon Ogg over at 24/7 Wall St. wrote a similar post this morning in relation to Meredith Whitney’s new call today lowering her targets on JP Morgan Chase & Co. (JPM). He brings up some of the same points but also reflects a bit on the disconnect between prices today and 2-3 years out, definitely worth a read.
December 17, 2009
Disclosure: No positions in any of the stocks mentioned
Warren Buffett has picked up one of the stocks I have championed before on this blog, railroad stock Burlington Northern Santa Fe (BNI). Berkshire Hathaway (BRK.A, BRK.B) had previously acquired a sizable minority position in BNI, and Mr. Buffett must have liked it a lot because he decided to buy the rest of the company at a price of $100 per share (about a 30% premium from the previous days close).
In addition to the announcement of his largest acquisition ever, Buffet announced a 50-to-1 split of the Baby Berkshire shares, his class B tranche (BRK.B). This announcement, he said, was so that he could offer the small investors some BRK shares, whereas before they couldn’t afford the high prices (somewhat of a contradiction to what he said a few years ago about how a stock split was stupid and would allow inferior investors to own its’ stock…).
This puts BRKB on the radar of both Mike and myself. Previously, we both had looked at BRK as a favorable investment, especially during March when it had reached such a low level, however, the price was cos prohibitive. Now, Warren has offered me the chance to either accept $100 in cash for my shares of BNI, or some of his new, cut price, BRK.B shares. And I am unsure how to act.
On the one hand, BRK is a one stop diversification stop. It has exposure to banks, insurers, manufacturing, transportation, and a host of others. It has a proven track record of providing its investors with outsized gains, and excellent capital preservation. And it is the best way to ride the coattails of the one who is considered the world’s greatest investor.
On the other hand, Mr. Buffett is not a young man anymore. I am aware that there are several remarkably smart people waiting in the wings at Berkshire, but it is a huge risk to assume that the company can continue its remarkable run without its point man at the helm. His deal with Goldman Sachs (GS) during the height of the financial crisis was inspired and hugely profitable, but his similar timing with a similar deal with General Electric (GE) was less so, with the warrants he acquired remaining worthless. Finally, BRK is highly leveraged to the US economy. With this deal, Warren openly admits that he is taking a huge risk on the future of America, which he is undyingly positive about. Add to this his other positions and you have a company which is leveraged to a country with anemic growth, a declining currency, and a government with a huge debt load.
During the course of writing that last paragraph, I have convinced myself that I will take Warren’s offer of cash to the bank. There are too many variables involved in Berkshire, especially as Mr. Buffett gets older. I respect him hugely as an investor, I just think I can achieve a superior Sharpe ratio investing elsewhere.
Disclosure: Long GE, GS and BNI (pending the buyout)
Google’s (GOOG) gravity defying numbers shattered the models of no less than ten major Wall St. Analyst firms causing them to raise price targets. The lowest of these recent ratings implies a 10.5% upside based on Friday’s closing price and the highest estimate would provide a 27.3% gain.
Stifel Nicolaus raised target to $650
Barclays (BCS) raised target to $620
FBR raised target to $680
Piper Jaffray (PJC) raised target to $623
Kaufman Bros. raised target to $645
UBS raised target to $635
JP Morgan & Chase (JPM) raised target to $608
Goldman Sachs (GS) raised target to $635
BofA (BAC) raised target to $640
Citi (C) raised target to $640
Benchmark raised target to $625
Canaccord Adams raised target to $700 (Street High)
Disclosure: Long GOOG
What a week… We saw saw the Dow break above the 10,000 barrier and some of the biggest and most influential names in the market have reported a mixed bag of earnings that have been interpreted in an equally mixed way.
Intel (INTC) posted great numbers and although they rocketed up on the news, they have since given back all of the gain and then some. Buying on the good news would have hurt and they also set the earnings bar high for other reporting companies.
Johnson & Johnson (JNJ) in my opinion posted ‘Good’ or ‘Very Good earnings’. Unfortunately the street was looking for ‘Great’ and the shares received a 2.5% slap on the wrist. I recently purchased JNJ towards the end of September at $61.38 because I have been trying to take a more defensive posture as we continue at these high levels on the S&P 500. I still stand by these convictions although I wouldn’t pull the trigger to buy more unless it fell into the mid 50’s.
Abbott Labs (ABT) is another diversified healthcare company we own that has a nice healthy dividend of % but has been lagging the market since the bottom in March. Their earnings were well received after the lowered bar from JNJ, who stated that consumer defection to generic drugs were a big contributor to the disappointing sales numbers.
J.P. Morgan & Chase (JPM) posted fantastic earnings across the board, setting the bar high for its competitors as earnings season plays out. Revenue leaped to $26.62 billion from $14.74 billion, and their Tier 1 capital ratio jumped to 10.2%, up from 8.9% in the year ago quarter. The bank has expressed some misgivings about the future, and has increased its consumer lending loss provisions by over 60%, and non-performing assets have more than doubled since Q3 2008.
International Business Machines (IBM) reported what I felt were good numbers but not enough to justify the bidding up of their shares leading into earnings. IBM still looks very strong fundamentally and I think this bad reaction to their earnings can be used as an opportunity to accumulate (more on this in a later post).
Google (GOOG) reported fantastic earnings, beating the street in both profitability and revenue. Customer paid “clicks” increased both sequentially and year-over-year, but the average price paid per click by advertisers fell. CEO Eric Schmidt said the worst of the recession is behind them, and that the company could make one or two “big acquisitions” per year from here on out. Their revenues grew substantially and their Traffic Acquisition Costs (TAC) fell during the quarter.
Goldman Sachs (GS) posted fantastic profitability, but revenue levels were enough to concern the street. Nearly all sector revenues were down sequentially, except for trading and asset management which benefited greatly from the 15% rise in the markets during the quarter. Going forward, GS will benefit greatly from being the strongest Investment Bank due to greatly diminished competition, but will be hurt in its strongest business if the markets go south again.
Bank of America (BAC) posted poor earnings, slipping to a loss of $.26 per share compared to a profit of $.15 in the year ago quarter. This highlights the ongoing struggle of consumer banking, as it deals with high unemployment and increasing amounts of non-performing assets. In this light, the company announced it has increased its loan loss provision account to $11.7 bn, up from $6.45 bn a year ago.
General Electric (GE) reported great profitability, but poor revenues causing traders to drive the stock down 5%. GE Capital was the main anchor on the company, with its profit declining 87%, but surprisingly NBC Universal was a bright spot with a 13% rise. Jeff Immelt talked of a tough environment (he noticed!), but that he saw signs of stabilization in GE Cap.
Overall, it looks like the previously strong companies are getting stronger (GS, JPM, GOOG, INTC), while the environment remains troubled for companies who have underlying issues (BAC, GE). IBM dropped after reporting but we view the results positively.
Lucid Markets Team
Disclosure: Long: TSM, JNJ, ABT, IBM, GOOG, GS, BAC, GE, IBKR, JPM