Outlook

”The market can stay irrational longer than you can stay solvent.”  John Maynard Keynes

What’s working?

Hardware, software and underwear.

In what can only be described as an extremely positive start to the year, the overall markets are surprising the skeptics and pushing ahead despite US election year rhetoric, European woes, and fears of a Chinese slowdown.

Stocks like CSCO (hardware), Microsoft (software), and Limited/Victoria’s Secret (underwear) are up double digits percentage-wise…and the economic “green shoots” we were promised several years ago finally seem to be appearing.

However, not all stocks are rising, despite the wind at their backs. 

For example, long-time market darling Amazon has fallen from $246/share to around $180 at the time of this blog.  Therefore, if you owned Amazon in you “diversified” portfolio, its 27% loss dragged down the winners considerably.

Conversely, if you owned Cisco, Apple, Microsoft, and Limited, you were dragged up by these relatively low PE companies.

Timing calls can be extremely important---not timing the overall market (which we view as a tough way to make a living), but timing the purchase and sale of well-researched individual stocks…which we call our “box-kite” stocks.

While Amazon’s stock price had been rising steadily (along with the tech sector) over the past six months, the balance sheet and earnings power weren’t supporting the run-up in the stock price.  It wasn’t that Amazon’s revenues, income, and earnings weren’t growing.  They were.  But, proportionately the stock price was way ahead of the pace of progress in sales and earnings.

The reason for this is investors were imputing a growth rate to Amazon that they believed would eventually allow the balance sheet to “catch up” to the stock price.  This can be a successful strategy to outperform the markets….until it isn’t.

When growth rates peak, and then slow down, margins compress and the music stops.  And instead of the balance sheet catching up to the stock price, the stock price comes back to the balance sheet. Remember it’s not that the company stops growing….it just stops growing as fast as it was.

Savvy investors look for these inflection points to sell and move on to greener pastures.  Others see a 27% drop in Amazon and say, “It’s time to buy!”  

We believe it can be a long, slow slog before the glory days return for this type of stock.  And with Amazon’s PE ratio north of 95 (knowing the long-time market average is around 15), the odds are stacked against the Internet sales giant. There is an entry point, but in our opinion, it is not now.

This is an age old story. 

For instance, back in 2000, (the dark ages) Microsoft looked a lot like Amazon.  It had been growing rapidly for years.  Everyone loved it.  It was selling for $40/share (adjusted price) on 2/3/2000.  This morning the stock opened at $30/share.

It wasn’t that Microsoft “the company” was failing….just the opposite.  The company has become stronger….and more valuable by almost all metrics.  Revenues grew, income grew, & profits were strong.  In fact, in key areas, Microsoft’s balance sheet tripled in strength!  Yet the stock stagnated. 

Microsoft “the company” had to catch up to Microsoft “the stock.”

This phenomenon is called PE compression…and may be the near-term fate of some very successful companies like Amazon and Lululemon…which is why we prefer Apple, Google, and Conoco Phillips. 

History shows that investors are both emotional and consistent. On Wall Street, consistently-emotional isn’t an oxymoron.

You see, investors (and “quant” analysts) are prone to taking past results, extrapolating those results indefinitely into future, and then coming up with “target prices” that make many eyes sparkle.  These “darling stocks” then get over-rewarded.

They tend to do the same to the downside.  Once a stock has been relegated to “yesterday’s news” status, the same thing occurs until the stock has been over-punished and becomes a bargain to buy.  The fundamentals change I the stock’s favor, and while fundamentals rarely create “sizzle,” they certainly count over time.

From start to finish, the process of PE compression can take years/decades to play out.  Experienced traders look for the inflection points on the downside and consider them “the buying opportunities of a lifetime.” 

Of course they don’t always tell you when they see these opportunities; they want to accumulate for themselves at low prices.  Plus, they might be wrong; no need to advertise mistakes. 

Anyway, you get the idea.

So, getting back to our Microsoft example, it seems to us that Microsoft is likely in the over-punished category, and may just now be breaking out of a 12 year slumber.  One clue is that almost every time we mention that we like Microsoft, we hear, “Are you crazy?  That stock has been dead money for over a decade.”  Right.

Microsoft’s PE is no longer 45.  It’s 11.  It pays almost a 3% dividend.  That’s better than most CDs.   It has a solid balance sheet, money in the bank, and new products and ideas that we believe will surprise in 2012 and forward.

Neither Microsoft “the company” nor Microsoft “the stock” are remotely the same today as they were in 2000.  So while many call MSFT a turtle, under its shell can be a nice place to hide in a hail storm!

So we try not to confuse the company’s performance with the stock’s performance. Stick with the company’s performance; over time, it works. 

Moving on, and looking ahead, we at Talbot Financial are both pleased and cautious regarding January’s performance.   We’re happy with the gains, but when you get half the gain you predicted for the year in just one month, it gives pause regarding the next 11 months.

Still, we see the Leading Economic Indicators, Manufacturing Indexes, Fed Surveys, and even housing numbers starting to turn upward.  In fact many of the indicators have been rising steadily since October.  Four months of data doesn’t always verify a trend, but it is the first time in years we’ve seen these indicators moving in unison.

We are dipping our toes into financial companies.  In our view, the solid ones are Wells Fargo, US Bank, Chubb, ACE, and Travelers.  These teams run tight ships.  We are also seeing the consumer wake up a bit, and as things develop, we believe some retailers and consumer goods distributors (such as  Diageo, Coca-Cola, Proctor and Gamble, Pepsi, and Molson) will make nice progress.

Regarding commodities, we believe the correction is over.  As world economies adapt and recover, we see demand for energy, industrial metals, and agriculture stocks picking up.  We also believe the bottom for gold is in as world-wide governmental “easing” policies provide the wind to gold’s back.       

Balancing this optimism, we also see the problems in Europe, and the potential of war with Iran, as “game changers” that could alter market sentiment very quickly.  There is clearly no lack of risk out there!

In closing though, please keep this in mind.  The NASDAQ is down 42% from its 2000 high (5048).  The S & P is trading where it was in April of 1999 (1340).  And, were you to use a modest 3-4% inflation rate over that time, it is not hard to make the case that the S & P is really trading for about half of its 1999 value and the NASDAQ for 30% of its all-time high. 

And while we are well aware that the valuations of 1999-2000 were too high, it seems to us that buying stocks today is much safer than it was then… and well-managed, dividend-paying, strong-balance-sheet companies are far more attractive than the .5% government bonds that investors are racing to as “safe” investments.

Greg