Friday, March 30, 2012

Apple: Another Cisco?

Apple is undoubtedly one of the world’s great companies.  Its succession of unique products has customers lining up out the door when new products become available.  In addition, the company is just beginning to penetrate the huge Chinese market.  What’s not to like as a consumer and as an investor?

It is indeed a great story with superior products, esteemed management, and seemingly unbounded prospects for continued growth.  It has become 4% of the S & P 500 stock index and is considered a “must own” stock by individuals and professional investors alike.  With the stock up 49% in the past three months, and 537% in the past five years, competitive pressures and career risk concerns have led fund managers to load up on the stock to avoid being left behind benchmark indexes and peers.  Similarly, Wall Street analysts have embraced the juggernaut, with 46 “buy” ratings, 5 “hold” ratings, and one “sell” rating.  When a stock has seemingly everything going for it, there is too much career risk for investment professionals to be skeptical.

Apple now has a total stock market value of more than $550 billion, making it only the sixth U.S. company on record to be valued at more than $500 billion.  This reminds me of a similar phenomenon in the technology sector more than a decade ago. 

At the peak of the Internet mania in the late 1990’s, Cisco was also valued at more than $500 billion in the stock market.  As the leading producer of networking equipment for the Internet, its revenues and profits soared, along with its shares. 

The top performing funds at the time had large stakes in Cisco.  The soaring stock helped those investment funds produce superior returns, which led investors to pour more and more money into the mutual funds.  The mutual fund managers then bought more Cisco, driving its price up, which lead to even better returns, and so on, producing a “virtuous circle” for Cisco stock.  Early in 2000, the company reported sales growth of 53% and earnings growth of 47%.   With the stock then at $80 per share (split adjusted), it was hard to see what could stop the virtuous circle.

But the virtuous circle did stop.  Today Cisco is a $21 stock, down 75% over the past twelve years.  It’s not that the company prospects collapsed.  Sales tripled and earnings grew approximately 150% during that time.  It’s just that at $500 billion, expectations and valuations were extremely high, and a number that large makes sustaining large percentage gains increasingly difficult.   In early 2000, one could have taken the $500 billion invested in Cisco stock and bought the entire outstanding stock of two dozen of the world’s leading companies.

With Apple stock valued today at more than $550 billion, does Apple face a similar risk?  Yes and no. Yes, since once again the $550 billion invested in Apple could be used to buy the entire outstanding stock of more than 20 leading companies.

No, in that the main difference in Apple’s favor is its valuation compared to Cisco in 2000.  Cisco had a price/earnings ratio of 130, and a price/sales ratio of 30.  Apple sells for 14 times earnings (about average for the S & P 500) and 4 times sales. 

This is a crucial difference, since valuation is the most important determinant of long-term stock market returns.  With Apple fairly valued—if not undervalued—it seems unlikely to face the problems for its investors that Cisco experienced.

But, with the stock up so sharply and with almost unanimous enthusiasm among professional and individual investors alike, it would be prudent to trim holdings.

Steven Lehman

Apple:  600

Wednesday, March 28, 2012

The VIX and Future Returns

Along with the recent optimism among investors and improving news in Europe and the U.S., the VIX index of options volatility has trended lower to multi-year lows.  

A common misperception is that the current low level of the VIX means that lower stock prices are likely.  I think that lower stock prices are likely, but not for that reason.  (My main reason is that other measures of investor sentiment are at high levels, which have had a high correlation with subsequent declines in stock prices.)  

The VIX index can remain at low levels for some time while stock prices continue to rise.  The most recent example was the period from early 2003 to autumn 2007, when the VIX generally stayed below 21.  During this period, the S & P 500 Index nearly doubled (albeit with reversals along the way).

Over the last fifteen years, low levels of the VIX have coincided with slightly negative returns on the S & P 500.  High levels of the VIX are an entirely different matter.  The VIX is high when volatility (and fear) is high.  This is usually the best time to invest, particularly because it goes against human nature.  Over the past fifteen years, when the VIX is high (greater than 30), the S & P has returned nearly six times more than the long-term average return on stocks.

So yes, watch the VIX.  But remember how to interpret it.

Steve Lehman

S & P 500:  1412

Monday, March 26, 2012

A New Era? Not Likely

I don't mean to be unsympathetic about the challenge of being a market forecaster or economist.  After all, the record of supposedly the best in the business is quite poor.  Instead, the evidence is overwhelming that a value-oriented investment approach of buying when individual stocks have cheap valuations (on book value, sales, and earnings) or the stock market overall is historically cheap produces the highest returns.  I know there are exceptions by investors who adeptly use technical analysis or momentum approaches, but value works--not in every period, but over time.  It is hard to follow because it goes against human nature and many of the behavioral biases that work against the average investor.

Though the stock market currently is still historically cheap versus quite overvalued U.S. Government bonds, it is not at all clear to me that now is a good time to make major purchases, after a rise of more than 25% since last October and a more than doubling off the historic low three years ago.  

Yet that is what Goldman, Sachs now recommends in a new report, titled "The Long Good Buy."  Goldman argues that now is the best time in a generation to invest in stocks.  One key argument is that interest rates on savings and government bond holdings are so low that there is no effective alternative to stocks.  

Reports of hedge funds capitulating and throwing money at the stock market to try to make up for trailing the market indexes this year has provided additional power to the recent rally.  This rally, led by Apple's seemingly endless runs to new highs, seems to have little risk.  

But with measures of market sentiment at elevated levels (and stocks technically overbought)  I think risk is greater than is apparent.  

I have never accepted the assumption that if bonds are expensive, one must buy stocks instead.   Cash is always an alternative (though not worth the career risk for many institutional fund managers).  Even when cash yields almost nothing, it provides valuable resources for when better investment opportunities arise.  I have long thought it unfortunate when one must be fully invested in a market selloff and is unable to buy at depressed prices without selling something else that is (similarly) depressed in price.

So, my advice continues to be to raise cash for better values later.

Steve Lehman

 S & P 500:  1400

Thursday, March 22, 2012

Market Correction Likely (Cont.)

Investors often look to news developments to explain moves in investment markets.  Yet, among the venerable market observer Bob Farrell's investment rules, was "The market makes the news, the news does not make the market."  That is, the stock market moves in ways that are not obvious from contemporaneous news items, yet observers demand plausible explanations tied to news items for every move in the market, large or small.   Numerous factors influence stock prices and result, most simply, in a tradeoff between supply (ability and desire to sell stocks) versus demand (ability and desire to buy stocks).

For those who need plausible news to support my argument for a decline in stock prices ahead, three items in today's news may provide a signal to fundamental reasons for lower stock prices in the months ahead.

One, Europe's economy is contracting.  The Eurozone Purchasing Managers' Index was reported today at 48.7.  Two, China also is decelerating.  HSBC's index of Chinese manufacturing was reported today at 48, also indicating contraction.  Three, retail sales in the U.K. fell 0.8%.  These developments will have negative implications for corporate earnings.

Whether it's for my reasons of overheated market sentiment and an overbought market,  or because of fundamental deterioration, I reiterate my advice to raise cash for better future purchase opportunities.

Steve Lehman

S & P 500:  1395

Tuesday, March 20, 2012

Consumer Confidence as a Stock Market Indicator

With consumer confidence on the rise, one might wonder what that might mean for the stock market.

Over the last 45 years, the Conference Board’s index of consumer confidence has been quite reliable at providing buy or sell signals for the stock market—though not how you might think.

On the surface, it might seem that high levels of consumer confidence would be good for the stock market.  Consumers are confident when the economy is growing, unemployment is down and incomes are rising, and corporate profits are booming.  But that historically is when stocks should be sold, not bought.  At such times, stocks already have risen sharply and amply reflect the favorable conditions.  Instead, stock market bottoms typically occur when the reverse is true—consumer confidence is low.  At such times, usually the economy is struggling, unemployment is high and incomes are stagnant, and corporate profits are weak.  Stocks then are cheap and already reflect the bad news. 

The key in the stock market is always what will change.   Peak conditions can’t get much better, while poor conditions can—and often do--get much better.

The Conference Board Index of consumer confidence has an excellent long-term record as a contrary indicator for the stock market.  Periods of unusually low levels of consumer confidence have occurred at major troughs in the stock market, while periods of unusually high levels of confidence have occurred at major peaks in the stock market.  The following table contains major market troughs and peaks over the past 43 years:

                                  High Consumer                     Low Consumer
                                      Confidence                           Confidence
                            (stock market peaks)              (stock market troughs)
                                  October, 2007                         October, 2011
                                  January, 2000                          March, 2009                                          
                                  September, 1987                     March, 2003
                                  December, 1972                      January, 1991
                                  October, 1968                          October, 1982
                                                                                     December, 1974
How does this indicator look now?  Though consumer confidence has risen recently, it is still at historically low levels, which bodes well for gains in stock prices.

Despite the historical reliability of this single indicator, it should be just one input to one’s asset allocation decisions.  With major stock indexes in the U.S. up more than 25% since last October and measures of investor sentiment showing high levels of optimism among investors, I would not increase allocations to stocks at current levels.  Instead, I would raise cash and try to tune out the various good news items, such as the new highs set by Apple stock, and patiently wait for better purchase opportunities.

Steve Lehman

S & P 500:  1400

Monday, March 19, 2012

Sector Performance Divergences and Potential Opportunities

By a number of measures, investor sentiment has risen sharply along with stock prices in recent months.  The increased desire for returns--and tolerance of risk--is evident in the market performance of various sectors of the stock market.  Using Dow Jones Industry Groups, it is apparent that investors are pricing in an economic recovery and the greater market volatility that goes with that.

Industry groups such as paper, autos, home furnishings, hotels, travel, banks, and industrial machinery are leading the market this year (up 20% or more), while pharmaceuticals, food and beverage, telecoms and utilities are roughly flat.  This may simply be a justified reversal of last year's market performance in which stable companies with high dividends provided superior returns.

But there seem to be some anomalies that may provide opportunities--especially assuming the risk tolerance and optimism are warranted.  (I think they are not.)  Though auto stocks are up 20%, tire stocks are down 8%, for example.  A stronger economy would mean that more goods are shipped, yet rail stocks are up only 4%, and truckers are up only 6%.  Is it weakness in coal shipments for the rails and higher fuel costs for the truckers?  I still like the oligopolistic nature of the rail sector and would focus on it after a market decline.  Insurance stocks are up 23%, but insurance brokers are up only 2%.  Similarly, hotels are up 21%, but restaurants and bars are up only 6% and airlines are up less than 5%.

After a market rally that has lifted key indexes more than 25% in the U.S. since last autumn, there are likely few opportunities until prices declines.  But for those who are compelled to be fully invested, there may be opportunities to shift one's emphasis among various industry sectors of the market.

Steve Lehman

Thursday, March 15, 2012

Emerging Market Equity Momentum Continues

The long-term case for emerging market equities is compelling, for reasons that I've covered previously.  A diversified portfolio should have an allocation to this area, with the range dependent on one's risk tolerance and historic valuations.  However, this area has tended to be more volatile than major indexes in developed markets.  

EM equities have been in a sustained uptrend relative to developed markets.  The relative performance of EM equities versus the MSCI World Index in particular continues to be above its 200-day moving average.  But with equity markets rising sharply along with investor sentiment, one should monitor this area closely for signs of a reversal.

With the financial crisis in Europe seeming to abate for now and most U.S. banks passing the "stress test" this week, investors seem unusually complacent.  I still advise raising some cash at current levels.

Steve Lehman

S & P 500:  1398

Wednesday, March 14, 2012

Concerns About the Broad Stock Market--and Apple

There are always many--and often conflicting--indicators pertinent to the likely direction of the stock market.  Despite that, there are three historically reliable ones that currently warrant caution toward stocks.  Transportation stocks have not continued to rise with the broad market and have broken below their uptrend line.  This is consistent with the Dow Theory that new highs in the Industrial Average should be "confirmed" by new highs in the Transportation Average.  Instead of that happening, the transports have broken down, despite signs of improved economic activity.

Second, trading volume has been remarkably light for a market that has been strong in term of percentage gain.  

And third, cumulative breadth (the number of advancing minus declining stocks over time) has been poor.

In addition, the strength in the NASDAQ (+17% over the past year) has been driven largely by Apple, which is now has a 17% weighting in the index.  Apple's 72% gain over the past year accounts for nearly three-fourths of the gain in the NASDAQ.  

Apple is a good example of the challenge of finding reliable guides to the stock market.  Bollinger Bands (a band above and below a stock based on a selected number of standard deviations from a moving average) often are helpful in indicating a stock that is overbought (haven risen quite sharply) or oversold (having fallen quite sharply).  Using Bollinger Bands of two standard deviations above and below Apple's 200-day moving average stock price would have shown the stock to be quite overbought two months ago--at a price of 425.  At today's 590 on Apple, a decision to sell in January would have resulted in missing a further 39% gain.  But for those fortunate enough to own significant Apple shares, its 14-day RSI of 85 (normally 70 is a good sell signal) would suggest selling at least some of the holding.

Steve Lehman

S & P 500:  1393

Tuesday, March 13, 2012

Share Buybacks Are Back: But Why Now?

American Express and Discover Financial are among companies that have recently announced share buybacks.   I like the notion that the generally poor record of corporate acquisitions means that returning accumulated cash to shareholders through dividends or share buybacks is a better use of cash.

However,  companies rarely buy back their shares when the stock market is depressed and their stocks are cheap.  Instead, they usually announce large buybacks when the stock market is near a peak.  (For instance, buyback announcements were historically high in 2007.)  Now, with stocks generally at 52-week highs, is not the time to be buying back shares.  Managements, like investors, should be patient and sit on cash with stocks at these levels.

Steve Lehman

S & P 500:  1395

Tuesday, March 6, 2012

Is Gold Still Attractive?

The conceptual case for gold remains strong.  Central banks in the U.S. and Europe have already created massive amounts of credit out of thin air to prop up the banks in particular and the financial system overall.  They show no signs of changing this behavior.  In addition, real T-Bill yields are significantly negative, which has historically been associated with significant gains in the price of gold.

Recent sentiment measures have indicated high levels of optimism, however, which have been associated with negative returns for gold.  Furthermore, commercial traders report a low level of gold holdings, and the behavior of this "smart money" also has been associated with negative returns for gold.  As a result, I've expected a correction in the price of gold and have reduced my suggested allocation to gold.

The bigger question is whether gold's 11-year bull market is ending.  For now, the uptrend in the price of gold off the lows of 2008 is intact.  But a further decline in the price of gold of several percent will breach the uptrend line and cause serious technical damage to gold's bull market.

For now, I'm staying with gold, but with growing unease.  The gold market is relatively small, and as a result its price can move sharply in either direction.  Don't be complacent if you have large gold holdings.  I think it would be prudent to diversify by adding exposure to agricultural commodities.

Steve Lehman

Gold:  $1675