Wednesday, November 30, 2011

Encouraging Bounce, But Will It Last?

The surge in stock prices over the last two days is impressive on the surface.  Will it be a sustainable rally of more than 5-10%, or is it just a technical bounce in an oversold market?

A longstanding adage of investing in the U.S. was "Don't fight the Fed," as monetary conditions in the financial system were considered a key determinant of the direction of stock prices.  But as Alan Greenspan's tenure went up in smoke, the adage became less foolproof.

The news that the developed world's major central banks made concerted efforts in increasing liquidity to preempt further strains in the European banking system--along with better economic news in the U.S.--was the catalyst for the surge in stocks.  But in the U.S. at least, trading volume today was relatively light given the big jump in the indexes, so volume at least today did not corroborate the strength of the move higher in stocks.  That is not a sign of a robust, sustainable move higher.

I've thought recently that stocks were technically oversold and due for a bounce, but was not as confident as I was at the end of September of a major move higher in stock prices.  I erroneously have avoided European stocks because of concerns about potential currency losses if the Euro would fall sharply.  So far I have missed opportunities there.  Yet, the constraints on the European banking system from the need to rebuild capital is curbing credit and constricting economic growth--for an extended time, I'd guess.  There are several European stocks that I find attractively valued, but after gains of nearly 10% in a few days, I'd wait for a correction before making additional purchases.

Steve Lehman

Monday, November 28, 2011

Oil Sands Operations Are Not Worth the Risk

The New York Times reported on research efforts by several start-up companies to reduce the environmental damage caused by oil (or tar) sands extraction.  There is a good reason for this.  Either of the two primary means to extract petroleum from the bitumen--the sticky, heavy oil that is mixed in with sand and clay--results in heavy environmental damage.  

There is enormous consumption of water using one extraction method--three to four times the oil that is extracted.  The other method burns enormous natural gas that causes greenhouse gas emissions to be several times higher than that of producing conventional oil.  Yet, as with the coal industry, the major oil companies with oil sands operations are claiming that these processes do not harm the environment.  

This dirty fuel, like coal, causes health and environmental damage far worse than the energy benefit.  There may be short-term profit opportunities from the tar sands, but it is not asustainable source of energy.  I'd avoid companies that operate in this sector because there are less risky ways to produce energy.

Steve Lehman

Friday, November 25, 2011

Stock Market Return Prospect Improve

The U.S. stock market has completed its worst Thanksgiving week decline since 1932, as the S & P 500 dropped 4.7%.  As a result, market sentiment measures have reversed sharply and have fallen to exceptionally depressed levels.  Consequently, return prospects for stocks have improved enough to warrant cautious buying.

For those investors with no allocation to emerging market equities, now is a reasonable time to initiate a position, with this area falling to a seven-week low.  Valuations on emerging market equities are favorable in absolute terms.  The earnings yield is 1.5 standard deviations above the 16-year average, for example.  Relative to developed markets, however, valuations are not particularly attractive.  Valuations in developed markets are attractive, especially relative to bonds.

A modest addition to emerging markets seems appropriate, with greater purchases of multinationals in the developed markets, notably the U.S.  If cash reserves are insufficient for this, I'd suggest reducing government bond holdings, as U.S. government bond valuations have become quite unattractive, both relative to inflation and relative to equities.

Steve Lehman

S & P 500:  1159
EEM:  36

Tuesday, November 22, 2011

Share Buybacks Are Good, But For Whom?

Free cash flow--when a company generates more cash than is needed in normal business operations--is typically highly valued by professional investors.  Surplus cash, when in the hands of capable management teams, can be used for debt reduction, new business ventures or acquisitions, dividend increases, or share repurchases.  All of those actions are expected to increase returns to investors.

Investors typically have cheered share buyback announcements because when a company enters the stock market to buy its stock, the additional buying demand presumably drives up the share price.  Using surplus cash for share buybacks also prevents managements from making poor capital allocation decisions--such as making expensive acquisitions of other companies--when the basic business lacks expansion opportunities.  But research by Fortuna Advisors found that over the last decade, companies that spent the most on share repurchases had significantly lower returns to shareholders than companies that spent the least.  (I would like to see more information on that, as well as corroboration by another study.)

There is a broader point as well.  What might be good for a single company--or at least its top executive--might not be good for the company's workers, investors, or the country as a whole.  The New York Times reported that as companies often continue to cut jobs and amass cash hordes, they're repurchasing stock in massive amounts--$445 billion authorized just this year.  This shrinkage of shares outstanding can increase reported earnings per share--and enable CEOs to hit bonus goals of eps--even though the underlying business is not growing satisfactorily (Zimmer is a notable example).

Such emphasis on achieving short-term eps targets is antithetical to sustainable investing.  Sustainable investing considers various stakeholders in a business enterprise, including workers and communities, and places a premium on managements who anticipate the long-term environmental and social challenges facing its industry.  Such companies tend to be better managed--period. Companies with superior managements that focus on the long term sustainability of businesses have a competitive advantage.  The evidence supports this, as companies ranked high in sustainability have produced superior returns to investors. So short-term earnings per share goals can produce a conflict between the interests of a handful of top executives and the interests of other stakeholders in the business--and when it's done throughout the economy--against the interests of the country as a whole.

Steve Lehman

Monday, November 21, 2011

Coal and Solar Energy Developments

While politicians in this country grandstand over the bankruptcy of Solyndra, a solar-energy company that received a loan guarantee from the Department of Energy, South Africa is the latest country to see the energy future and act, albeit belatedly, to move toward cleaner sources of energy.  

Eskom, the state-owned South African electric utility, plans to build solar plants at its coal stations.  In the U.S., solar energy is under attack because of the loss from the failure of Solyndra, which while significant at about $500 million, was only about 2.5% of the total loan guarantee program at the Department of Energy.  

Despite the political clout of the fossil fuel industry, renewable energy in the U.S. continues to grow and now exceeds nuclear power as a source of energy.  Coal, whose pollution externalities are not reflected in its price to consumers, must be phased out.  (Remember that there is no such thing as "clean coal," despite the massive advertising campaign of the coal producers.)  

Imagine what progress could be made if the government provided significant, ongoing support for renewable energy sources (as it has done for many years for the oil and coal sectors)?  Though the industrialized world will be reliant on oil for many years, the sooner we can move away from coal the better.  Recent scientific studies add to the incontrovertible evidence of the damage to human health from mercury pollution from burning coal.  

For investors, coal exports may sustain the industry for a while, but in this sector I certainly would not want to invest in the laggards in innovation and would (as I do in other sectors), favor the innovators rather than those who undermine scientific evidence in order to protect the status quo.

Steve Lehman

Thursday, November 17, 2011

Neutral on Stocks, But Further Declines Will Increase Their Appeal

I recently turned neutral on stocks after their extraordinary strength in October.  While there are numerous factors that affect stocks and numerous--and often conflicting--indicators, a good (contrary) indicator of investor sentiment is the VIX Index of option volatility.

In trying to identify market tops, there is little information in a low VIX level (which indicates widespread investor optimism), as low readings can persist and stocks continue rising for an extended time.  

A high VIX reading, however, has been associated with market bottoms over the past fifteen years.  When the VIX has been above 28.5 (less than 20% of the time), the S & P 500 Index has returned 40% annualized.  It closed today at 34.5.  Persistence at this level on the VIX Index, or even higher levels, will increase my confidence that stocks have greater near-term appreciation potential.

Steve Lehman

S & P 500:  1216

Monday, November 14, 2011

Two Quality Investments

Though the sharp rebound in stock prices over the past month has caused me to be cautious about the stock market overall, I still find individual stocks that remain attractive.  Merck and Vodafone are two examples that meet my criteria for competitive and financial strength, attractive valuation, and sustainability.

Last week Merck announced a dividend increase and an positive update of its prospects for important new drugs.  The dividend yield is 5%, which compares quite favorably with the overall stock market and for savings and fixed-income alternatives.  Merck generates significant excess cash after capital spending and dividend outlays, and it sells for less than 10 times estimated 2011 earnings per share. 

Vodafone was featured favorably in this week's Barron's magazine.  Its 45% ownership of Verizon Wireless will soon show tangible results, as Vodafone will receive a $4.5 billion dividend from the joint venture.  Since Vodafone will pass the Verizon Wireless dividend on to shareholders, the total dividend yield by Vodafone will be 7.5%.  That even exceeds the yield on many junk bonds.  Vodafone also has leading market positions in key markets and a management that is committed to returning cash to shareholders through dividends and share buybacks.  The stock sells for only 10 times earnings, despite the substantial stake in Verizon Wireless that is not consolidated on Vodafone's financial statements.

In addition, both Merck and Vodafone are widely recognized as sustainability leaders.  The companies' performance on environmental, social, and governance (ESG) criteria is exceptionally admired.  As positive sustainability assessments are increasingly recognized as an indicator of management quality that leads to superior returns for investors, the prospects for these two investments are indeed bright.

Steve Lehman  

Sunday, November 13, 2011

Cautious About Stocks (Continued)...

Though I can still find individual stocks that sell for attractive valuations based on p/e or  price to free cash flow, the widespread pessimism and oversold nature of the stock market a couple of months ago have been reversed after one of the strongest months for the stock market on record.

Two recent indicators now signal caution at least.  The put/call ratio for the S & P 500 has fallen sharply, indicating growing optimism.  Also, a key survey of individual investors--the American Association of Individual Investors--shows nearly twice as many bullish respondents as bearish ones.  This is almost a complete reversal from a couple of months ago.

So while I continue to encourage the purchase of selected individual stocks that meet strict quality and valuation criteria, I have a neutral position on the stock market overall.

Steve Lehman

S & P 500:  1264

Friday, November 11, 2011

ECRI Leading Economic Indicator Flashes Warning

I generally think that too much emphasis is placed on economic forecasts when making investment decisions.  However, recessions are not good for stock prices.  The Economic Cycle Research Institute's weekly leading index has an excellent record in forecasting recessions--and the latest readings are ominous.

Since 1967, when the ECRI weekly leading index has declined below its longer trend level (the 98-week trendline), a recession has followed.  The only major exception was early last year, when a decline was not followed by recession (though it was hard to tell).

The weekly index has been falling steadily in recent weeks.  So perhaps investors in the stock market should not get too comfortable in the weeks ahead, despite the encouraging news from Europe.

Steve Lehman

S & P 500:  1265

Wednesday, November 9, 2011

Earnings Expectations Remain High

Expectations in investing--as in life--are crucial to satisfactory outcomes.  In investing, high expectations for company performance--earnings growth particularly--tend to lead to disappointment.  Conversely, low expectations tend to lead to positive surprises--and profits.  This is why value investing has superior results over time, as cheap stocks tend not to be as bad as the consensus thinks and expensive stocks reflect the outstanding growth prospects that are obvious to even casual market observers.

Forward earnings growth expectations for the stock market overall are an important indicator of market expectations.  Over the past 32 years, when consensus earnings expectations for the next twelve months for S & P 500 are at least +14.2%, the S & P has had negative returns (excluding dividends).  When earnings growth expectations are moderate (earnings growth of 4%-14.2%), returns have been 7% annualized.  When expectations are low, however (less than 4% growth), the annualized return on the S & P 500 has been 17%.

At the end of October, the consensus earnings growth forecast for the next twelve months was 14.1%.  This is down from a high of more than 21% earnings growth that was forecast early in 2010 (before the big decline in stock prices).  Even further declines in growth forecasts to more realistic levels would help support stock prices.
Steve Lehman

S & P 500:  1276

Tuesday, November 8, 2011

Neutral on Stocks

Amid the frenzy over the U.S. debt ceiling extension and the financial crisis in Europe some weeks ago, I thought the odds favored a significant rebound in stock prices largely because of widespread pessimism among market participants.  With October's returns being among the highest on record, what is the mood among market participants now, and are stocks still attractive?

Not surprisingly, the sharp rebound in stock prices has lifted the mood of investors, as reflected by various sentiment surveys.  One particular indicator of market sentiment is the VIX Index of option volatility.  Low levels of the VIX indicate complacency among market participants, or even high levels of optimism.  This condition does not, however, mean that a sharp market decline in imminent.  Stock prices often have remained at high levels or risen even further when this condition has existed.

The converse has a much better predictive record.  When the VIX Index is at high levels, it indicates high levels of fear, and such periods tend to be followed by a sharp rebound in stock prices.  Specifically, when the VIX is above 28.5, the annualized return on stocks has been 39% on the S & P 500 going back to 1996.  August was a good example, as the VIX was above 40.  A sharp rebound in stock prices followed.   When the VIX is below 28.5, the return on the S & P has been negative (excluding dividends).  Today the VIX is at 29, right on the cusp.

For this and other reasons, I am neutral on stocks at current levels and recommend holding significant cash (outright or in high-yield bonds) in order to have ample resources for the next significant decline in stock prices.

Steve Lehman

S & P 500:  1276

Tuesday, November 1, 2011

Stock Market Thoughts

Stock market results the last two days show that the support for the market is a mile wide but only an inch deep.  Correlations among stocks are at historic highs, so it seems that on any given day, the Big Money either embraces risk or shuns it, driving stocks sharply up or sharply down.  It is so hard to invest in such a market environment that individual investors can be forgiven for shunning the stock market and just buying bonds, or even insurance annuities.

I haven't given up on stocks, at least where there is a real business underneath the stock.  I particularly seek businesses that produce useful products, are managed by individuals with high integrity and foresight, and which seek to ameliorate the adverse effects of their operations on the environment.  Such managers increasingly integrate environmental, social, and governance (ESG) principles in their business operations.  

I also favor companies that generate substantially more cash from their operations than is needed to continue the business.  Good things tend to happen when astute, shareholder-oriented managers have additional capital to allocate by raising dividends, repurchasing shares (at undervalued levels), reducing debt, or making acquisitions that enhance the business prospects.  Of course, as a contrarian, value- and income-oriented investor, I favor such stocks, especially when they have dividend yields of 4% or more and still generate surplus cash.  And such stocks are available.

So with bond yields unusually low and dividend yields on select stocks quite high (though not for the overall stock market), if this correction in stock prices continues, I'll be back in the market buying stocks.

Steve Lehman

S & P 500:  1218