Archive for September, 2011

  • CWS Market Review – September 30, 2011
    , September 30th, 2011 at 7:35 am

    I’m happy to see this ugly third quarter end. This will be the market’s worst quarter for stocks since 2008. For the last several weeks, the stock market has been stuck in a tight trading range. The S&P 500 has now closed inside a 100-point gap—between 1,119 and 1,219—for 40-straight trading sessions.

    Frankly, being caught in a trading range is frustrating. Every rally is quickly met with a sell-off, and every sell-off is quickly turned around. Thursday, in fact, was a microcosm of the last two months. The S&P 500 soared as high as the level of a 2.16% gain early in the session. Then stocks delivered a collapse worthy of the Red Sox. By 3 p.m., the market was down nearly 1%. That’s a peak-to-trough drop of more than 3%. Yet in the last hour, we rallied to close higher for the day by 0.81%.

    In this issue, I’ll explain the dynamic driving this back-and-forth market. Fortunately, this may soon come to an end. By mid-October, the third quarter earnings season will be ramping up and we’ll get a chance to see how well corporate America did during the third three months of the year. This could be what the market needs to finally break out of its trading range. One historical note is that since 1945, whenever the market has tanked by 10% or more in the third quarter, the fourth quarter has gained an average of 7.2%.

    I should warn you that since early June, Wall Street analysts have been paring back their earnings estimates for the third quarter. At one point, the consensus estimate was as high as $25.03 but it’s now down to $24.64 which is still a pretty good number. That’s not a huge downgrade, but analysts are clearly becoming more cautious and they’re lowering their forecast for Q4 and for 2012 as well. Analysts have a tendency to trim their numbers right before earnings season starts. The good news is that earnings have topped expectations for the last 10 quarters in a row. I’m not certain that this will be the 11th, but it may be close.

    As an aside, I should say that I don’t place a great deal of faith in Wall Street’s forecasts. Some people like to dismiss these forecasts out of hand which I think is a mistake. Here’s the key: In the short-term, analysts’ forecasts really aren’t so bad.

    As a general rule, analysts move in two modes. They either slightly underestimate earnings or they vastly overestimate earnings. The former is the rule of thumb during an expansion and the latter happens when the economy falls apart. Where analysts are horrible is in seeing the turning points. As such, I don’t rely on them for that. The analysts are very good at predicting that the trend will continue, which sounds harsher than I mean it to sound.

    For last year’s third quarter, the S&P 500 earned $21.56 so the current estimate translates to having a growth rate of 14.3%. For the fourth quarter, Wall Street sees earnings of $25.98 which would be earnings growth of 18.5% over last year. That strikes me as being too high, so I’ll expect earnings to be cut back over the next several weeks. Either way, the Q3 results will be the determining factor in setting expectations for Q4. I’ll feel a lot better when the S&P 500 breaks above its 50-day moving average which is currently at 1,200.

    Unfortunately, the stock market has been held captive lately by events in Europe—more specifically, the prospects for the Greek economy. The good news is that the German parliament just approved an expanded bailout fund. The bad news is that the fund has to be approved by all 17 countries that use the euro and that’s not going to be easy. Markets around the world have been severely rattled recently. Worldwide, initial public offerings are being shelved at a record pace.

    We’re currently in an “all or nothing market.” Each day, the market tends to shoot up a lot or get hammered hard. Whenever there’s good news out of Europe or from the U.S. Fed, we see all the sectors of the market rally strongly. Usually, financials do the best while gold and bonds do poorly and volatility rises. When the news is bad, the exact opposite happens. It’s as if all the passengers on a boat rush frantically from one side to the next. There’s little in between.

    Look at some of these numbers: In August and September, the S&P 500 closed up or down by more than 2% 17 times. In the 12 months before that, it happened just nine times. In the last two months, stocks and bonds have moved in opposite directions nearly 75% of the time. Only recently has gold broken from bonds and moved downward in a serious way.

    I’ll give you a good example of the irrationality of the “all or nothing market”: Shares of AFLAC, ($AFL) soared 6% on Thursday. I love AFLAC, but I’m sorry: their business is just too boring to move around that much in one day. The problem isn’t the business. The problem is the mindless traders trying to use AFL as a proxy bet on Europe. (AFLAC’s finances are fine as we’ll see when they report next month.)

    Volatility is a topic that causes confusion among many investors and it’s misunderstood by many professionals as well. Increased volatility isn’t necessarily bad for stocks. In this case, the increase in volatility is a reflection of two warring theses for the economy’s future. The market is trying to decide whether investors will rotate out of Treasuries and take on greater risk in stocks or whether stocks will continue to languish as investors seek protection in bonds. It’s this tug-of-war that has kept the S&P 500 locked in its trading range. Given the absurd prices for bonds and depressed earnings multiples for stocks, the smart money is on higher stocks, lower bonds and decreased volatility. Consider that right now, there’s currently over $2.6 trillion sitting in money market funds earning an average of 0.02% per year.

    We’re already seeing signs that one side is starting give way. Gold, for example, has been crushed over the past three weeks. Also, previous “can’t-lose” stocks like Netflix ($NFLX) are feeling the pain. They key is that the trends that were consistently winning no longer are. As a result, investors will start to key in on overlooked trades. I can’t say when this will happen, but earnings season seems like a prime catalyst.

    The Volatility Index ($VIX) closed Thursday at 38.84. That means that the market believes the S&P 500 will swing by an average of plus or minus 11.23% over the next month. Let’s compare that with the recent auction for seven-year Treasuries which went for a record-low yield of 1.496%. That means that the zero-risk return for the next seven years in Treasury debt is roughly equal to the one-month volatility—not return, just average expected swing—of stocks.

    It’s like the old saying that “a bird in the hand is worth two in the bush.” If that saying were revised for today’s market it would be “a bird in the hand is worth 30,000 in the bush!”

    In last week’s CWS Market Review, I highlighted some high-yielding stocks on our Buy List like Abbott Labs ($ABT), Johnson & Johnson ($JNJ) and Reynolds American ($RAI). I still like those stocks a lot. Interestingly, shares of Nicholas Financial ($NICK) have been weak lately. The stock is normally a very strong buy, but it’s exceptionally good if you can get it below $10 per share.

    One of the few cyclical stocks on the Buy List is Moog ($MOG-A). The stock has been trashed along with most other cyclicals, but don’t make the mistake of lumping Moog in with everybody else. This is a very good company. Last quarter, Moog beat earnings and raised guidance. The stock is now going for about 10 times’ guidance. Moog is a very good buy up to $36 per share.

    That’s all for now. Be sure to keep checking the blog for daily updates. Next week, Wall Street will be focused on Friday’s jobs report. Expect more bad news, I’m afraid. I’ll have more market analysis for you in the next issue of CWS Market Review!

    – Eddy

  • Morning News: September 30, 2011
    , September 30th, 2011 at 5:05 am

    Chinese Stocks Plummet on News of Justice Department Inquiry

    Japan’s 10-Year Bonds Fall, Post Weekly Drop, Before Auction

    Germany Approves Bailout Expansion, Leaving Slovakia as Main Hurdle

    German Retail Sales Decline More Than Forecast

    China’s Manufacturing Steady in September

    Ireland Weighs Payback for Averting Bank Default

    S&P, Fitch Downgrade New Zealand, Citing External Debt

    Deal Would Unite S&P With DJIA

    Banks to Make Customers Pay Fee for Using Debit Cards

    Outsize Severance Continues for Executives, Even After Failed Tenures

    McGraw-Hill in Talks to Lead Stock Indexes Joint Venture

    Nokia Cuts 3,500 Manufacturing Jobs

    Sumitomo Mitsui Banking Corp. to Make Consumer Lender Promise Wholly Owned Unit

    Jeff Carter: Environmental Dust Up in Nebraska

    Roger Nusbaum: The Australian Permanent Portfolio?

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  • Michael Lewis on California
    , September 29th, 2011 at 7:00 pm

    In February, I joked: “I’m not saying the Chinese market is a total scam. I’m just saying Michael Lewis may be paying them a visit sometime soon.”

    Lewis is a brilliant writer and he has the ability to shine a light on dysfunctional systems and economies. This time, he looks at the former state-of-the-future, California:

    David Crane, the former economic adviser—at that moment rapidly receding into the distance—could itemize the result: a long list of depressing government financial statistics. The pensions of state employees ate up twice as much of the budget when Schwarzenegger left office as they had when he arrived, for instance. The officially recognized gap between what the state would owe its workers and what it had on hand to pay them was roughly $105 billion, but that, thanks to accounting gimmicks, was probably only about half the real number. “This year the state will directly spend $32 billion on employee pay and benefits, up 65 percent over the past 10 years,” says Crane later. “Compare that to state spending on higher education [down 5 percent], health and human services [up just 5 percent], and parks and recreation [flat], all crowded out in large part by fast-rising employment costs.” Crane is a lifelong Democrat with no particular hostility to government. But the more he looked into the details, the more shocking he found them to be. In 2010, for instance, the state spent $6 billion on fewer than 30,000 guards and other prison-system employees. A prison guard who started his career at the age of 45 could retire after five years with a pension that very nearly equaled his former salary. The head parole psychiatrist for the California prison system was the state’s highest-paid public employee; in 2010 he’d made $838,706. The same fiscal year that the state spent $6 billion on prisons, it had invested just $4.7 billion in its higher education—that is, 33 campuses with 670,000 students. Over the past 30 years the state’s share of the budget for the University of California has fallen from 30 percent to 11 percent, and it is about to fall a lot more. In 1980 a Cal student paid $776 a year in tuition; in 2011 he pays $13,218. Everywhere you turn, the long-term future of the state is being sacrificed.

  • Good Interview with Stryker’s CEO
    , September 29th, 2011 at 1:33 pm

  • Good Economic News
    , September 29th, 2011 at 9:18 am

    This morning we got some positive economic news. The second-quarter GDP growth rate was revised up from 1% to 1.3%. Bear in mind that Q2 began six months ago and ended three months ago.

    Also, jobless claims fell sharply last week from 428,000 to 391,000. Wall Street was expecting 420,000.

    Here’s a look at real GDP over the past few years. As I’ve mentioned before, the economy isn’t doing well but there’s still very little definite evidence that the economy is entering a Double Dip.

  • Morning News: September 29, 2011
    , September 29th, 2011 at 5:21 am

    Germany to Vote on Euro Rescue Fund

    Greek Bonds Lure Some, Despite Risk

    Norway to Cut Bank Support Amid Europe Crisis

    Gold Reverses Losses, Up 1% as Jewelers Buy

    Call by Fed for Money-Fund Curbs

    Bernanke: Unemployment Poses ‘National Crisis’

    Sony Says It Expects ‘Huge Impact’ on Profit From Euro Slump

    Amazon’s Tablet Leads to Its Store

    BOA, Merrill Pledge Support for Lehman Exit Plan

    H&M Profit Drop Beats Estimates as Margin Damage Is Limited

    Facebook, Twitter Usage Increases Companies’ Security Risks

    A Start-Up Takes On Procter & Gamble Over a Name

    Reebok To Pay Settlement Over Health Claims

    Yale Endowment Posts 22% Gain to End Fiscal Year at $19.4 Billion

    Pragmatic Capitalism: More on “Japan in Fast Forward”

    Paul Kedrosky: The Gazillion Euro Question

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  • Oracle Strikes Back
    , September 29th, 2011 at 2:30 am

    This is amusing:

    Oracle Corp. (ORCL) fired back at Autonomy Corp. (AU.LN, AUTNY) Wednesday, saying the British business-analytics company’s chief executive didn’t tell the truth about an April meeting purportedly held to shop the business around.

    The dispute also concerns Oracle rival Hewlett-Packard Corp. (HPQ), which last month agreed to buy Autonomy in a deal valued at about $10.3 billion. Oracle has followed an increasingly common script in Silicon Valley by morphing into one of H-P’s fiercest competitors.

    Oracle on Wednesday repeated its contention that Autonomy approached its executives before H-P publicly made its offer. Oracle has said it rejected the Autonomy deal because the price was too high.

    Autonomy Chief Executive Mike Lynch later disputed Oracle’s version of events, which prompted the California-based software giant to issue a statment late Wednesday.

    According to Oracle, Lynch and investment banker Frank Quattrone met with Oracle mergers-and-acquisitions chief Douglas Kehring and President Mark Hurd. The Autonomy chief pitched his company with a PowerPoint presentation, Oracle said.

    “Either Mr. Lynch has a very poor memory or he’s lying,” Oracle’s statement said. “The Lynch shopping visit to Oracle is easy to verify. We still have his PowerPoint slides.”

    In an emailed statement, Lynch denied that the April meeting was intended to pitch a possible sale of the company.

    “In April there was a 30-40 minute meeting between Autonomy and Mark Hurd, which was set up by Frank Quattrone as an introduction to Mark Hurd,” Lynch said. “Oracle is an Autonomy customer. In the meeting, in response to a joke about Mr. Quattrone’s presence, it was made clear Autonomy was not for sale and there was no process underway.”

    Lynch added that Autonomy hadn’t yet engaged Quattrone’s company at the time and said there has been no contact with Oracle since then.

    Oracle shares were recently up 0.6% at $29.64 in after-hours trading. The stock is up 8.3% over the past year.

  • Minimum Variance Portfolios
    , September 28th, 2011 at 4:58 pm

    Eric Falkenstein is probably the financial blogosphere’s biggest advocate of Minimum Variance Portfolios (MVP). The idea is that in investing risk and reward are not trade-offs. In fact, the lower the risk, the higher the reward. As counter-intuitive as this sounds, the numbers back it up.

    Falkenstein has shown that a portfolio constructed of the lowest-risk stocks in the S&P 500 has outperformed the index. I got the data off his site and here are the returns since 1998:

    Since the beginning of 1998 through August 2011, the S&P 500 has returned 31.59% while the Minimum Variance Portfolio has returned 211.18%. Annualized, that’s a lead of 8.7 to 2%.

    But here’s the kicker: the MVP has accomplished this with…well, minimum variance.

    Get ready for some math.

    In the table below, the blue dots indicate all of the daily changes in the chart above. The X-axis is the changes in the S&P 500. The Y-axis has the changes for the MVP.

    The key is that the MVP doesn’t go as high as the S&P 500 during an up day, nor does it fall as low as the index during a down day. I added the diagonal red line to show the 1-to-1 divide.

    Notice how the blue dots fall below the red line in the upper right quadrant and above the red line in the lower left quadrant. That’s what MVP is all about.

    The black is the linear trend and the formula is the classic linear equation (y=mx+b). The slope of the trend line is 0.558. What this means is that for every one unit the black line moves to the right, it climbs by 0.558 units, and for every one unit it falls, it drops by 0.558 units.

    In finance speak, that’s the beta of the portfolio, 0.558. If a portfolio has a beta of 1.0, it exhibits the same variance as the S&P 500. If it’s greater than 1.0, the portfolio swings greater than the market.

    Historically, our Buy List has a beta of 0.94.

    The b in the equation is the y-intercept, meaning that’s where the trend crosses the Y-axis when x=0. But more importantly for us, this also tells us how well the MVP has done against the S&P 500. Since it’s positive, the MVP has beaten the market by an average of three basis points per share, or 0.03%. (It’s actually about 2.5 basis points but Excel rounded up.)

    So despite having nearly half the variance as the overall market, the MVP has crushed the S&P 500 over the 13 years years.

    If you’re interested in learning more, here’s a link to Eric’s book, Finding Alpha: The Search for Alpha When Risk and Return Break Down. And here are the 47 stocks currently in the MVP (it’s rebalanced every six months):

    Company Symbol
    3M CO MMM
  • The Plunge of Major Financials
    , September 28th, 2011 at 10:23 am

    Check out how sharply Goldman Sachs ($GS), Citigroup ($C), Bank of America ($BAC), and Morgan Stanley ($MS) have fallen since the start of the year:

  • Durable Goods Orders Fell 0.1% in August
    , September 28th, 2011 at 9:49 am

    The futures indicate that the stock market will open modestly higher today. Yesterday was a very good day for stocks although we lost a lot of our gains as the day wore on.

    This morning, the Commerce Department reported that durable goods orders fell in August by 0.1%. This isn’t a huge drop but in July, orders soared by 4.1%.

    The important number to watch in the durable goods report is orders of “non-defense capital goods.” This is a good barometer for telling us how much businesses are spending.

    One of the major problems in this economy is that businesses are sitting on tons of cash but they’re not willing to spend it. The good news is that orders of non-defense capital goods increased by 1.1% in August after falling 0.2% in July.