Thursday, December 29, 2011

Gold Is at a Critical Level

For those who have had a significant holding of gold bullion over the past decade, congratulations!  Since the central bank of England sold the bulk of its gold from 1999-2002 at roughly $250 an ounce (oops!), the price of gold has risen eightfold.  Despite recent weakness, the price of gold has risen for 11 straight years.  Over just the past five years, the price of gold has risen 134%.  How long can this go on?

While I take technical analysis with a grain of salt, the price of gold is now at a critical level.  Since the major low in the fall of 2008, the price of gold has held above the line drawn through the lows during this period, as well as holding at or near its 200-day moving average.  

The recent weakness in the price of gold, which has fallen from more than $1,900 an ounce to $1,560 now, has shaken the faith of many in the gold bull market.  Prominent technician Dennis Gartman, for example, declared the bull market in gold over and said the price could fall to as low as about $1,150-$1,200.  

Broad sentiment measures now reflect pessimism toward gold, which historically has led to large price gains for gold.  In addition, commercial participants in the gold market (the “smart money”) have recently been buyers, which historically has led to annualized returns of 26% over more than forty years.

Furthermore, gold historically has risen in price when real T-Bill yields are negative—that is, when T Bill yields minus inflation are less than zero.  Such an environment reflects monetary laxity as well as no opportunity cost (from interest-bearing instruments) from holding gold.  And real T-Bill yields are now well into negative territory.

Despite these bullish reasons and the conceptual merit in owning gold amid rampant "money printing" as governments seek to stimulate economic growth, I am wondering when the bull market in gold will end.  

The weight of the evidence supports holding or buying gold for the time being.  But after 11 straight years of higher gold prices that have culminated in an eightfold rise, be thinking about when to leave.  After all, gold prices fell for 20 years, from 1980-2000.

Steve Lehman

Gold:  $1,560

Friday, December 23, 2011

Thanks and Happy Holidays!

I appreciate the level of interest that readers of the blog have shown since I launched it last February.  While it has helped me to keep up with financial markets and express my opinions primarily about broad market issues, I am contemplating a more specific offering of investment ideas in the year ahead.  

But more on that later.  For now, I wish all the readers of this blog peaceful, safe, and happy  holidays and good wishes for the year ahead.

Steve Lehman

Thursday, December 22, 2011

Investment Discipline Needed Now More Than Ever (Cont.)

I remain wary of the possibility of a "melt up" or a "melt down" in major stock markets.  Given the simple arithmetic of the difficulty of recovering from large losses, I am biased toward capital protection.

I have favored the shares of some of the world's leading companies, which have attractive dividend yields and moderate growth prospects for earnings and dividends.  There also are a number of depressed stocks that are quite cheap based on earnings and cash flows.  I am concerned, however, about the solidity of those earnings and earnings estimates for 2012.  Expectations are crucial to investment success.  High expectations for profit growth--for a single company or the market as a whole--are likely to produce disappointment and losses.  The converse is true for low expectations.

When aggregate expectations for earnings growth are low, the return on stocks has generally been in the high teens on an annual basis.  Conversely, when forecasts are for high growth, the return on stocks is about zero.  I am pleased that the 2012 consensus earnings growth for the S & P 500 has been easing, but it is fairly high, at 12%.  With Europe, Japan, and the U.K. likely to be in recession and the possibility of China suffering a hard landing in 2012, 12% growth seems too high.

When profits don't meet expectations for individual companies, investors in those stocks pay a high price.  Oracle, for example, yesterday had a significant profit shortfall and its stock fell 12%.  Concerns about the company's exposure to a sluggish Europe might signal broader concerns for the earnings prospects for other multinational companies, as well as for European companies.  

Deciphering whether a company will miss its earnings target is not easy.  In general, I try to avoid stocks that have a preponderance of "buy" ratings by Wall Street analysts, as there is much greater room for disappointment than when there are comparatively few buy ratings versus "hold" or even "sell."

There are few individual stocks that I would aggressively buy at current levels.  While there are a significant number that are quite depressed and seemingly undervalued, I am eagerly waiting for fourth-quarter results to be reported so I can do further analysis before committing substantial cash reserves.

Steve Lehman

S & P 500:  1252

Wednesday, December 21, 2011

A Bullish Composite Indicator

There are numerous indicators of the stock market, many of which have tended to work well over time.  Unfortunately, they don't work all of the time, and they often conflict with one another.  That is why investing is so challenging.

One of the most reliable indicators over the years was the dividend yield on the U.S. stock market.  When the dividend yield on U.S. stocks was 6% or higher, it was a buy signal.  When it fell to 3% or less, it was a sell signal.  Successful market technician Edson Gould called this his market "sentimeter."  But in the 1990's, the dividend yield on stocks fell to 3%--and kept on falling, as the technology stock mania rolled on.   I admit to having relied  too heavily on this indicator at the time and becoming too cautious.  Since then, I've tried to take each indicator on its own with a grain of salt and instead emphasize the weight of the evidence.

Today I came across a composite indicator by a prominent investment research firm.  This indicator includes monetary, economic, sentiment, and valuation components.  Its record using more than 40 years of data would have outperformed the S & P 500 by nearly 600 basis points annually.  Aside from a major faulty signal late in 2000 when it turned bullish before a big drop in stock prices, its record since then is particularly good.

This indicator now is in bullish territory, which has returned 15% annually on the S & P 500 since 1965 when at its current level.  That is interesting, but I remain neutral on equities for various reasons, including the investor complacency that is indicated by a VIX Index (of option volatility) reading of only 21.

Steve Lehman

S & P 500:  1244

Tuesday, December 20, 2011

Investment Discipline Needed Now More Than Ever

Today's explosive rise in stock prices was welcome in a year with little net gain to show for nearly twelve months of often sharp moves.  Yet, while on a short-term basis stock prices seemed oversold and likely to have a rebound, today's move was lacking in confirmation by trading volume and fundamental news.  

While better demand for Spanish bonds was good news for now, unexpectedly higher housing starts in the U.S. is not necessarily positive.  With an enormous overhang of housing supply still on the market--or being withheld until conditions improve--additional housing supply is not what will give the U.S. economy a sustainable lift.  

Many people seem to think that sustainable U.S. economic growth cannot occur until the housing and banking sectors turn the corner.  That is probably true, but banks continue to conceal the extent of their impaired mortgage-related (and European?) assets.  And as I noted, the housing market needs to work through the excess supply before it can return to even moderate growth, as prior levels of high volumes of unprecedentedly large houses will probably never occur again, largely for demographic reasons.

The investment implications of this are that one should set limits for purchases and sales, while using conservative assumptions about earnings growth over the next year.  If the ECRI leading economic indicator's forecast of a recession is incorrect and growth in the U.S. leads the developed world, then the conservative assumptions used in setting reasonable valuation buying levels will simply have provided a "margin of safety," which is always a prudent approach to investing.

Steve Lehman

Monday, December 19, 2011

Recent Market Weakness Increases Opportunities

The recent softness in the stock market has produced even greater declines in a number of stocks.  I am emphasizing high-quality multinationals with high dividend yields and dividend growth prospects, but I also am looking more closely at cheap stocks with low expectations.

If sentiment indicators become more pessimistic than they are now, I will be buying stocks selectively.  I continue to avoid European stocks because of headline risk for the Eurozone and the possibility of large declines in the Euro and losses for U.S.-based investors.  There are, however, a number of high-quality European companies with increasingly attractive valuations and dividend yields that are approaching very attractive levels.

A portfolio of core stocks of market leaders with high dividend yields and/or dividend growth and a small allocation to non or low-dividend yielding stocks, with high-yield bonds will produce an attractive level of current income, income growth, and total return prospects.

Steve Lehman

Thursday, December 15, 2011

Neutral on Equities Cont.

I remain neutral on equities, but I would tilt portfolios.  Within equities, I would favor U.S. equities, followed by modest tilts toward U.K. and Canadian equities.  I would tilt away from European and Japanese equities.  Growth in Europe will likely be sluggish for some time, and the booming export market to China will slow along with Chinese growth.  Japanese equities are quite inexpensive on a price to book value basis, but I now think they could well remain cheap--as they have for years.  Secular Japanese problems will likely weigh on stocks, and managements (though better than they used to be) are not generally shareholder-oriented.  Many Japanese firms do, however, score well in sustainability measures of management quality.

Within fixed income, I would move out of U.S. government issues into corporate issues, both investment grade and high yield.  Yield spreads are historically attractive, and corporate finances are generally sound.

Elsewhere, sentiment toward the U.S. dollar is quite elevated.  The converse is gold, which has taken quite a hit lately.  It is plausible that gold's success this year has led to profit taking.  I have been uneasy that gold has risen in 11 consecutive years.  I've thought that it could have one final burst, in a speculative blow off that would mark the end of its bull market.  I also have been uneasy about anecdotal reports of vending machines in the middle east that sell gold bullion, and central bank buying of gold (CB's tend to be good contrary indicators).  Yet, gold is still a small fraction of the typical institutional portfolio.  I think the recent decline is not enough to warrant buying gold, and it is worth waiting for a higher price for selling gold. Within a range of 0-20% of a portfolio allocation to gold, I'd be at about 10% here.

Steve Lehman

Monday, December 12, 2011

Still Neutral on Stocks

I continue to think that in general, stock prices are too high for significant new purchases, and they are too low for significant new sales.  

I recommend holding significant cash reserves and to set limit orders for both purchases and sales.  It is too easy to be swept up in the emotions of the day and to lose the discipline that I think is imperative in markets these days.  It no longer seems like a fair market for individual investors and their advisors, so disciplined buying and selling is critical in order to have a reasonable chance for success.  

Though high-quality stocks with attractive dividend yields have outperformed this year and are comparatively fully valued, given the volatility of markets and the still significant macro risks ahead, I'd build my portfolio core around such stocks.  With interest rates on savings and U.S. government debt in the 0-2% range, owning a portfolio of stocks of global industry leaders that offer dividend yields of 3.5%-5.5% is the way to go.  Such a portfolio will offer income growth that will likely keep up with inflation over time.

Steve Lehman

Thursday, December 8, 2011

Avoid U.S. Financial Stocks--With Few Exceptions

I long have had a bias against investing in bank stocks.  The main reason is that I don't have confidence in the reliability of their financial statements.  It was difficult enough when banks primarily took in deposits and made loans.  Even then, it was difficult to ascertain the soundness of the loan books.  One could get a sense of the conservatism of management's accounting practices by comparing loss reserves to non-performing loans, and noting the rate of loan charge offs.  

But as major banks became effective hedge funds with leverage of about 20:1 (common equity ratios of about 5%), it has become nearly impossible.  Banks not only hold loans and investments in various securities (some quite arcane with no reliable market values), but they have extensive derivatives holdings as well.

As U.S. banks struggle to emerge from the U.S. financial collapse in 2008, they still have substantial risk exposure to the European financial crisis.  According to the Institute of International Finance, American financial institutions have $767 billion of exposure through bonds, credit derivatives, and other guarantees to private and public-sector borrowers in the Eurozone's weakest economies.

Owning shares in the major U.S. banks at this point is highly speculative, as a positive outcome in Europe will likely send share prices sharply higher, while an unfavorable outcome will cause the opposite.  I don't have a strong view on either outcome and am generally avoiding Euro-related investments now.  

Instead, I'd favor major Canadian banks, which are rated as the most financially sound in the world.  They have dividend yields of 4-5% and reasonable long-term growth prospects.  I would favor buying these on a pullback, as they have rebounded with markets recently.

Steve Lehman

Monday, December 5, 2011

Portfolio Allocations Should Favor Equities Over U.S. Treasuries

When comparing the appeal of equities to U.S. Government bonds, the conventional approach is to compare the "earnings yield" on equities (the inverse of the price/earnings ratio) to the yield on Government bonds.  But as I have argued repeatedly over the years, the return on equities is not the "earnings yield" but is instead the dividend yield, plus the growth in dividends, plus (or minus) the change in valuations.  

So I prefer to compare the dividend yield on equities to the yield on Government bonds, after subtracting inflation.  On this basis, equities today are the most attractive relative to the "real" (after inflation) yield on government bonds in the 30 years of my records.  The only exception was early in 2009, when equities were even more attractive than they are today.  Note, though, that this attraction is RELATIVE to U.S. Government bonds, not the overall bond market that includes the mortgage, corporate, high yield, and international sectors.  I'll address those sectors another time.

I would hold little to no U.S. Government bonds at current levels, as I think that current yields are wholly inadequate to compensate investors for the potential risks down the road.

Steve Lehman

Saturday, December 3, 2011

Expectations Are Coming Down--Good!

Expectations in investing--as in life--are crucial to satisfactory outcomes.  Low expectations in investing tend to result in high returns, as people are pessimistic or cautious about prospective returns (or the economy, or corporate earnings) and are more likely to be pleasantly surprised.  Earnings expectations are particularly important, because it is surprises--positive or negative--that tend to really drive stock prices.

One reason for my neutral position toward stocks--aside from my optimism after the sharp selloff in August and September--has been high expectations for earnings on S & P 500 companies over the coming twelve months.

At the market bottom in spring 2009, the consensus estimate for S & P 500 earnings for the coming twelve months was for earnings to decline 20%.  Now those are low expectations!  Going back to 1979, when consensus estimates for S & P 500 earnings have been for less than 4.2% earnings growth, the annualized return on the S & P 500 has been 17%.  Conversely, when consensus estimates for earnings growth have been above 14.2% growth, the S & P has had a slightly negative return.

Consensus estimates have recently come down as economic growth forecasts for 2012 have moderated, particularly because of stagnant economic activity in Europe.  The latest estimate for S & P 500 earnings for the coming twelve months is 13%, which is in the middle range that has produced average annual stock returns of 7% back to 1979.

So for economically sensitive stocks such as ABB or G.E., I've been waiting for earnings estimates to come down to more reasonable levels before buying them.  The changes in consensus expectations are in the right direction.  But given this week's surge in stock prices, I am neutral on stocks now.

Steve Lehman

S & P 500:  1244

Thursday, December 1, 2011

Companies Move Toward a Greener Future, Despite Entrenched Interests

The entrenched interest and political clout of the industries that promote 19th-century, dirty fuels--the coal and oil industries--remains dismayingly powerful in the U.S.   Yet individual companies that have innovative managements in anticipating the future continue to move toward a cleaner energy future.

Germany's BASF is making a concerted push toward developing lighter, less expensive lithium-ion batteries to help reduce the cost of electric cars.  BASF's management anticipates stricter greenhouse gas laws, depleting fossil fuels, and rising oil costs.  Part of the initiative is the construction of a battery manufacturing plant in Ohio.  So while the coal industry in particular spends millions of dollars on advertising to distort the reality of climate change and the need to move beyond 19th century fuels, companies like BASF are forging ahead.  Such companies will likely continue to be leaders with competitive advantages because of the foresight of their top executives and boards.  They are the types of companies that a long-term investor should want to invest in.

Steve Lehman