Updated "Latecomers Portfolio"

As of 1/19/10               S& P 500: 1144.51

 

The stocks listed below reflect the latest revisions to our “Latecomers Portfolio”.  We have eliminated: COP, TRN, and GLD. 

 

SPW 61           EMR 44           RIG 92             BTU 48

DVN 72           OXY 78           MRK 40          SNY 41

ABT 56            DSX 16           UNP 65           SYT 54

MOS 63          FCX 84           TCK 40           TC 14

CSCO 25        LLL 90            UTX 72           FXI 43

EWZ 74           AAPL 213       ARW 29          APD 82

USB 25            ATI 47             FMC 54           PCX 20

MET 38           CI 38               PRU 53            GWW 101

SLB 70            LLY 37            KO 56             RTI 27

"Latecomer's Portfolio"

This model portfolio, which was posted on our website on August 4^th, when the S&P 500 Stock Index was at 1000.24, achieved an appreciation of 17.3% on an equal-weighted basis through the close of business on December 31^st.  This compares with a gain of 11.5% recorded by the S&P 500 over the same time period.

What Could Go Wrong?

Conventional wisdom holds that an expanding economy, with attendant gains in corporate profits, will support a continuing bull market in equities. The evidence of market history suggests this is not always quite so simple. The strongest gains in every new bull market occur even as the economy is still contracting, or at least nearing the end of the contraction phase, but before a recovery gets underway. It is during this period, which occurs long after stocks have discounted the recession and the accompanying decline in profits, that surplus liquidity in the financial system is at its greatest. Because households and businesses are still struggling to reduce their indebtedness, while at the same time monetary policy is flooding the economy with liquidity, the money has no place to go but into financial assets, both bonds and equities.

The U.S. equity market peaked in October 2007, shortly before the recession began, and the final stage of the bear market occurred between September 2008 and March 2009, first reflecting forced liquidation by leveraged investors and finally the capitulation on the part of individuals. Paradoxically, this final sell-off, always the steepest, occurred after the Federal Reserve had begun flooding the system with liquidity, but the fear factor resulting from the credit market freeze, post the Lehman bankruptcy, prevented most investors from taking advantage of bargain basement equity values. Since early March, however, the first stage of a new bull market has carried the Standard & Poors 500 Stock Index up more than 65%, supported by better than expected corporate profit results, reflecting enormous productivity gains, as well as a mountain of uninvested cash, in both the U.S. and abroad, seeking better returns than those offered by short term Treasuries and money market instruments.

There are now two prevailing schools of thought regarding the economic and stock market outlooks going forward. The first expects a long period of below potential economic growth, with Federal Reserve monetary accommodation continuing in place, as unemployment remains high and inflationary pressures subdued. Under this scenario corporate profit growth will be sustained by rapidly growing foreign source revenues, continuing productivity gains, and a weak U.S. dollar. Under this scenario interest rates would remain low and financial market liquidity ample, and stocks should continue to mirror individual company profit gains. A second school of thought expects the economy to give way to a double dip recession sometime next year as fiscal stimulus peaks out and a weak labor market curbs personal income and consumption gains, cutting short any inventory rebuilding and precluding a capital investment cycle. The continuing headwinds from a rising savings rate, tight bank credit, continuing home mortgage foreclosures and commercial real estate refinancing problems prevent a self sustaining recovery from taking hold. If this occurs, equities are likely to sell off for a time and then be range bound, at best.

In my judgment, however, there are two other possible outcomes, neither of which at this point is receiving much attention, but if either occurs, the first impact will be to prompt a significant correction in both the equity and fixed income markets. Both of these revolve around the exchange value of the U.S. dollar.

In the very near term there is the risk that the Dollar, which has just broken long term support, goes into a free fall against the Euro and Yen. The incredibly naïve statement from the Fed in the Minutes of its last meeting, to the effect that the Dollar’s decline has been orderly, could well be the trigger for a much sharper decline. Benign neglect is best left unspoken. What has up to now been viewed as a plus for U.S. exports and a stimulus to an economy in which personal consumption is struggling, would then become a source of considerable fear and uncertainty. The Fed would be reluctant to raise rates at this point in order to stem the decline in view of the nascent, slow recovery. Besides, higher rates rarely support a currency for long. Strong currencies derive from strong economies, not from interest rate differentials. The Fed might intervene in the currency markets, perhaps in concert with other central banks, but history shows that intervention rarely works unless the move is supported by economic fundamentals. A collapse of the Dollar would lead to sharply higher prices for the entire range of precious and industrial metals, energy and agricultural products. The resulting inflation fears would cause longer term interest rates to spike, which would do serious damage to all sectors of the residential and commercial mortgage markets. Finally, it would hasten the diversification by our trade partners into alternative stores of value for their currency reserves. The impact of all this on stocks, bonds and the economy at large would not be pretty.

On the other hand, if the macroeconomic data begin to surprise investors on the upside, the first impact will be to strengthen the U.S. dollar, which by itself will cause liquidation of the highly popular carry trade, resulting in a sharp sell-off in both equities and commodities. If the better data are also accompanied by an upturn in bank lending, then by definition some of the surplus liquidity in the financial system will be diverted back to the real economy, in all likelihood at higher short term interest rates, leaving less available to support financial asset prices.

If, for example, the yield on the 2-Year Treasury Note, currently at about 0.73% were to move above 1.25%, together with a stronger dollar and increased private sector borrowing, the FOMC might well conclude that a self sustaining recovery was underway, even before the unemployment rate peaks out. The Fed has almost always followed interest rates rather than leading them, and under these circumstances a change to a less accommodative monetary policy would be inevitable, particularly given the recent huge expansion of the Fed’s balance sheet. All of this would contribute to the first major correction in the equity market since March. This need not foretell the end of the bull market, however. Once equities stabilize and begin to recover, the market’s leadership will in all probability rotate away from energy, materials, industrials and transports, all of which are major cyclical beneficiaries, in favor of a broader variety of growth stocks including consumer and technology issues.

No one can have high conviction in any of these outcomes at this time. The important thing for investment managers is to be prepared to respond quickly, whichever direction the economy dictates.

Looking Ahead to 2010

History suggests that the stock market leadership of this year is likely to give way to a new crop of outperformers in 2010. There is no doubt that the energy, materials, industrial machinery and equipment, and transportation sectors, which have been the leaders since the March lows, will continue to do well next year, as revenues begin to accelerate and profit margins increase, leading to well above average earnings gains. That said, investors need to recognize that the strong performance of these groups since the market lows has already discounted some of that expected profit performance over the next year or two.

Our Exit Strategy

Since March of this year all the stock markets of the world have been in a new bull trend. Even after a gain of 60% from its capitulation low of 666 on the S&P 500, U.S. equities are still reasonably valued and right in the “sweet spot,” the period of strongest appreciation in any bull market. Indeed, history shows that during the first nine to twelve months of a new bull market, the broad market indexes typically achieve from one-half to two-thirds of their ultimate gain over the cycle. The reasons for this are really quite straightforward. Monetary policy has become extremely stimulative, and at the same time, households and businesses are both paying back their borrowings. There is little in the way of private sector demand for credit. Accordingly, the resulting surplus liquidity needs to find a home, and financial assets are always the logical first stop. The second factor is that after a lag of a year or so from the time monetary policy becomes stimulative, the economy bottoms out, and the outlook for economic recovery and ultimately expansion, becomes more clear. This is now happening on a global scale. Indeed, the economies of Europe, Asia and Latin America are already ahead of the U.S. in terms of recovery. This fact is not lost on those of us who have concentrated our equity investments on multinational U.S. corporations as the most efficient way to participate in economic growth abroad, particularly in the major emerging economies. The “sweet spot” is also fueled by massive short covering and the participation of relatively sophisticated day traders.

Doubters And Skeptics, Go Ye Forth And Multiply

At its annual Partners Dinner the late Leon Levy, Senior Partner of Oppenheimer & Company, always welcomed those newly admitted with the words, "You don't know how lucky you are to become an owner of a business in which the higher the price of the product, the more people want to buy it."  We recall those words every day as we encounter the trauma among wealthy investors, whose real estate and stock portfolios have plunged by an aggregate of $14 trillion over the past two years.  That loss has been unparalleled in human history.  This has been a "Rich Man's Recession and Bear Market" unlike all previous post-war contractions.  Of course, a 10% unemployment rate (15% if one counts the discouraged and the underemployed) has exacted considerable pain on the middle class in America.  This is reflected in a jump in the personal savings rate from virtually zero up to a current range of 5%-6% and is likely headed higher as people struggle to whittle down their debt while enduring a torrent of residential mortgage foreclosures. 

A memo to my friend, Larry Kudlow

On your terrific nightly show, THE KUDLOW REPORT, which I have the privilege of appearing on from time to time, you present regularly a wide array of investment experts who offer advice to your viewers which, in my opinion, is often counterproductive.  Of the approximately 7000 publicly traded companies in the U.S. only a small fraction, less than 5%, are interesting investments at any point in time.  Yet if one listens to all the experts over a month or so, nearly all industries get a recommendation.  Of course, much of the show's dialogue is framed as a debate between opposing points of view, one bullish, the other bearish.  By itself, this is an excellent format, but my critique is based on the fact that most of your guests state their views (a) with only a very short-term, trading-oriented perspective, which in this volatile environment often runs a high risk of whipsawing the viewers, and (b) these experts demonstrate insufficient respect for market-based indicators, which I think you and I agree are far more important in interpreting the present and predicting the future than the opinions of "experts" based on essentially static analysis.  Those pundits who recommend specific investment actions according to analyses that do not give proper weight to such market-based indicators as currency exchange rates, commodity prices, interest rates, etc., are doing your viewers a disservice.  Indeed, all market-based indicators are PRICES, the prices that real people pay in real transactions in the real world.  They occur in real time and are never retroactively revised.

Progress is Our Most Important Product

In the wake of a 26% rally in the S&P 500, the strongest four weeks since 1933, which has taken the index up to its downward trending 100-day moving average line, the overriding question remains:  Was it merely a bear market rally with all the attendant vulnerabilities to follow, or have investors witnessed the beginning of a sustainable bull market in equities?  My bottom line is that the fundamentals are moving in the right direction, but they are not yet strong enough to sustain a bull market, especially in view of the severity and after effects of the worst credit crunch and global recession in modern history.  However, I do believe that a durable double bottom occurred on November 21st and March 9th marking the lows for this bear market.  A great many risks remain, but many "second derivative" metrics are turning less negative.

The Square Root of Recovery

Unfortunately, no one rings a bell to announce the inflection points in either the economy or the stock market.  In our work, in order to get an early jump, we track a number of early-cycle, market-based indicators including various agricultural commodities, several base metals, the Australian Dollar, the Baltic Dry Freight Index, the yield on the 2-Year Treasury Note, etc., etc.  Although each of these experiences significant fluctuations on both an intra-day and a weekly basis, all of them have been in unmistakable uptrends since late last Fall.  In addition, Ed Hyman’s ISI firm surveys a broad mix of companies each week to see how they view their businesses.  These surveys are starting to show a tiny improvement, albeit from very depressed levels.  Also, the four week moving average of unemployment claims has turned lower, several Regional Federal Reserve bank business surveys have improved in January, December sales of existing homes rose 6.5% on a month-to-month basis, reflecting lower prices as well as improved availability of financing.  These signals should not be ignored.

A Fool and His Money are Soon Parted

Recently, a lady friend told us about an acquaintance of hers who had lost everything in the Bernard Madoff scandal.  I replied that it was astounding to me that anyone would invest all of his financial assets with only one manager, particularly one who refused to discuss his methodology, and who acted also as stockbroker, fund administrator, and custodian.  The lady replied, "What's a custodian?"  Therein lies the root of the problem.  Many people who have accumulated wealth in fields other than finance and who now require management of their financial assets rarely have sufficient understanding of either the vocabulary of Wall Street or the workings of the investment management business.  About a decade ago, we were given a summary explanation of Madoff's strategy by one of his investors, and we quickly concluded it would be impossible for this method to produce consistently positive returns regardless of prevailing financial market conditions.  For so many investors to have accepted it on faith seemed incomprehensible.