Wednesday, June 27, 2012

Market Headed Higher?

Despite the Dow Jones Industrial, Transportation, and Utility averages all having broken their uptrends from their recent lows, I still think stock prices are headed higher.

Market sentiment has been unusually gloomy on a number of measures, which historically has preceded gains in stock prices.  It is no longer news that the economy is sluggish, and valuations relative to bonds are quite attractive.  Historic valuations on earnings, book value, and revenues are moderately attractive.

I would still maintain significant cash reserves for unanticipated further declines in stock prices, but I also would have enough in the market to participate in what I expect will be higher prices over the short term at least.

Steve Lehman

S & P 500:  1332

Tuesday, June 26, 2012

Market Rationality

Though I'm a contrarian by nature, I realize it is insufficient to simply go against the crowd all the time. A significant part of the time, the consensus view is right--or at least it makes sense.  

I reviewed the 100 largest S & P holdings the other day and scanned where the current prices fell within the 52-week range for each stock.  Despite the huge risks in Europe and the economic and political uncertainty in the U.S., a number of the stocks are at or near their highs over the past 52 weeks.  It is not surprising that most are health care stocks such as Abbott and Merck, or consumer staples stocks such as Coca-Cola, Colgate, and CVS.  Stocks at the bottom are energy stocks (with oil prices down sharply recently and gas prices down for a while), financials, and those with company-specific problems (such as Dell, Hewlett-Packard, and Walgreen).

The investment question that matters most is what comes next?  I am not optimistic about economic growth being stronger than expected, but I have an aversion to buying "defensive" (or any) stocks at 52-week highs.  I'd rather keep money in cash and buy companies with more cyclical businesses when their stocks are especially depressed or there are early signs of earnings estimates bottoming.

Steve Lehman

Monday, June 25, 2012

Gold: A Major Change in My Thinking

I am not a market technician.  I don't base my investment decisions on the price history of an asset.  That is not to say that I do not pay attention to price, as the entry price is crucial in determining the return on an asset.  It's just that I tend not to find much predictive value in scrutinizing the price chart of an asset.

I do, however, pay attention when a price has repeatedly bounced off a low level, as potential price support is corroborated by an attractive valuation.  I also am a proponent of "reversion to the mean," the notion that when a price deviates from its mean level over time by a substantial amount--especially if by two standard deviations or more--it is likely over time to revert to its normal, or mean, level.

Rather than looking at price charts, I am much more comfortable when I can assess the value of an asset using cash flows that are generated relative to the asset's price.

But with some assets, such as commodities, that is not possible.  Granted, one can estimate supply and demand to get a sense of whether the price will likely rise or fall over time.

But gold is different.  I have considered it to be a form of money, not a commodity like petroleum or wheat.  One unique (and challenging) feature of gold is that unlike commodities, it is not consumed.  Most of the gold that has been mined over the centuries still exists.  So unlike a commodity like wheat that might be in surplus at the moment but which will be consumed over time, gold lacks that.

I think that the price action, or technicals, of commodities and of gold matter more than for assets like stocks.  And it is the price action of gold that has caused a major change in my thinking.

Since 2000, I've thought of gold as separate from commodities.  After all, it was a stronger form of money than the U.S. Dollar.  Yet for some time now, it has performed like other commodities, rising in price when market participants embrace risk and falling in price when they shun risk.

More troubling is that the rising trend line of support (connecting the higher lows) since the November, 2008 bottom in the gold price has been broken.  Since gold peaked at $1,925 an ounce last year, the price has been in a clear downtrend (evident by connecting the successively lower high prices).

At $1,566 an ounce today, gold is only about 3% above what appears to be a key level of technical support, approximately $1,520 an ounce.  If that level is broken, it would seem that gold could fall to about $1,300 an ounce, for a further 15% decline.  A decline to that level would still be within the bounds of the rising trend for the price of gold since 2000.

I am concerned about the possibility of being whipsawed by turning tactically negative on gold at current levels.  The gold market is small, and it doesn't take much to cause sharp price reversals.  And the next several months have historically been strong months for the price of gold.  Furthermore, real short-term interest rates remain negative in the U.S. and in many countries, which historically has been positive for the gold price.  With the price of gold now 19% below its record high, it seems late to turn negative.

Let's say instead that I've become cautious on an asset that has risen in price for eleven straight years.  Unlike my usual skepticism about technical analysis, I will wait for price confirmation that gold has broken above the declining trend that began last autumn.  I am willing to miss a near-term gain in order to have more confidence that the bull market that began for gold in 2000 has not ended.

Steve Lehman

Gold:  $1,566

Tuesday, June 19, 2012

Earnings Risks Ahead?

Market observers have noted that the challenges in Europe will also affect U.S. multinational companies and their earnings.  I don't know, however, whether analysts have sufficiently factored in reduced European sales by U.S. companies in their earnings estimates.

Oracle gave a hint about what the effects of Europe's struggles might be as it released its quarterly earnings report yesterday.  Though overall the quarterly results exceeded consensus analyst estimates and the stock rose, sales to Europe, Africa, and the Middle East declined 7%.  Overall revenues at the company rose only 1% in the quarter.  One percent revenue growth for a growth company is not impressive, though Oracle is a fine company that is fairly valued.

While the market rebound has been welcome (and probable--note my 5/20 blog with the S & P 500 at 1295), I'd not get too comfortable.  There are superior companies still selling at attractive valuations that should remain core holdings.  But I still think this is more of a "guerrilla warfare" market that requires more of a nimble, trading mindset than a buy-and-hold approach.

Steve Lehman

S & P 500:  1358

Monday, June 18, 2012

The Return of the Bond Vigilantes

A generation ago, when government budget deficits swelled to troubling levels, elected officials failed to take responsible action to cut spending or increase revenues.  But another group of actors appeared, dubbed the "Bond Vigilantes," to force action.  Participants in the U.S. government bond market sold bonds and drove interest rates higher because of a lack of confidence in elected officials.  This continued to the point where even the elected officials knew they had to act because the borrowing costs for the government were rising sharply.

In the last decade, observers have lamented the disappearance of the Vigilantes, as budget deficits exploded in both the Bush and Obama Administrations, yet interest rates kept falling (not rising).  With interest rates on U.S. Treasury 10-year notes at only 1.6%, the vigilantes have not returned to the U.S.  

But they have returned to Europe, as despite a 100 billion Euro bailout for Spanish banks, yields on Spanish government notes today rose to 7.15%, a dangerous level that preceded collapses in Ireland and Greece.  When confidence goes, whether in a bank or a government, it is hard to keep the situation from spinning out of control.

When the Vigilantes act in unison, their momentum is difficult to reverse.  It will probably require coordinated central bank intervention, along with significant European policy coordination, can stanch the unraveling and lead to higher asset prices.

Steve Lehman

Thursday, June 14, 2012

Trouble in... Switzerland?

Everyone by now knows that the financial crisis in Europe is worrisome, even if they don't know exactly how it might affect others if Greece drops out of the Euro zone or Spain's banks go bust.

A news item today gives a concrete example.  It is widely known that Greece has been profligate, Spain had a housing bubble even greater than that in the U.S., and Italy has an imprudent level of government debt.

But what about Switzerland?  Why would this matter to Switzerland, which doesn't use the Euro, and which has long been considered one of the safest places in the world to keep one's money.  

Shares of Credit Suisse, one of the two leading Swiss banks, fell 10% today after the Swiss central bank issued a statement that Credit Suisse needed to stop paying dividends to shareholders or else issue more shares to bolster its financial condition because of credit losses.  (The other leading bank, UBS, had to be bailed out by the government in 2008.)  

So when top banks in Switzerland need help, it really is serious.  

At a time like this, it doesn't hurt to own some gold--just in case.

Steve Lehman

Gold:  $1,625

Wednesday, June 13, 2012


Those with a sense of market history have known for a long time that dividends have been an important part of stock market returns.  Approximately 40% of the long-term return from investing in stocks has come from dividends.  What's more, the highest-yielding quintile has had substantially higher returns than the lowest.

Now in this era of extremely low interest rates and especially with the retirement of the Baby Boomer generation, it seems that everyone has learned the value of dividends.  Dividend-oriented mutual fund have had net inflows for 44 straight weeks.                                                                                                            

Has this gone too far?  Researchers at Merrill Lynch recently found that the highest-yielding shares in the S & P 500 now trade at the biggest premium in at least 20 years versus those with the best dividend growth.

I still think it makes sense to invest in high-yielding stocks (except electric utilities).  I also would allocate a portion of assets to stocks with significant cyclicality, in case the U.S. stock market rallies as I expect.

Steve Lehman

S & P 500:  1315

Tuesday, June 12, 2012

Question Authority (ies)

So much has been written about the European financial crisis that I doubt I can contribute anything.  

But I am struck again, as I was with the U.S. housing bubble, by the need to be highly skeptical of the authorities.  Alan Greenspan and Ben Bernanke dismissed concerns about the consequences of the housing bubble in the U.S.--and later of the collapse of Bear Stearns.  

Now in Europe, as concerns have shifted to Spain (after Ireland, Greece, and Portugal), the authorities have similar, dubious credibility.

The Spanish Prime Minister had recently estimated that the capital shortfall of the entire Spanish banking system was no more than $19 billion.  But one bank alone--Bankia--required $24 billion in additional capital.

Developments in Europe do indeed seem to be, as one observer noted, "like a slow-moving train wreck."  But I continue to think that stock market sentiment had become so depressed that a significant rally is likely, especially in the U.S.

Steve Lehman

S & P 500:  1324

Wednesday, June 6, 2012

Stocks Versus Bonds

Bonds have been superior investments for some time, particularly on a risk-adjusted basis.  As a result, there has been a torrent of withdrawals by individual investors from equity funds into bond funds.  Stock performance relative to bond performance peaked in 2000 and has been in a declining trend ever since.  With interest rates at historic low levels, might this relative performance reverse?

Dividend yields on stocks now exceed the yield on Government notes, which hadn't happened since the 1950's.  With yields on 10-year U.S. Treasury Notes at only 1.5% versus more than 2% on the S & P 500 stock index, on an income yield basis stocks are as cheap versus bonds as they were in early 2009, before stock prices generally doubled.

Despite bonds being a haven when investors are fearful these days, I suggest beginning to draw down cash and also shift from U.S. government bonds to buy some depressed stocks.

Steve Lehman

 S & P 500:  1278

Tuesday, June 5, 2012

International Equity Valuation Update

Foreign stock markets have not been the place to be over the past year.  Developed and emerging markets have been weak, and the strength in the U.S. dollar has made losses to U.S. investors overseas even greater.  So how do foreign valuations look now?

The weakness in emerging stock markets has left them historically undervalued.  On a dividend yield basis, markets are two standard deviations below historic valuations.  But relative to developed markets, emerging market equities are only at fair value.

As might be expected, European equities are quite undervalued (on a book value and on a dividend yield basis), but valuations are still far from the extremely depressed levels of early 2009.

At this point, I'd begin buying European equities and would have only a token holding of emerging markets.  Emerging market governments will likely reduce interest rates to stimulate economic growth, and the resulting currency weakness would be a headwind amidst global economic weakness.

Steve Lehman