CWS Market Review – December 30, 2011

There’s just one trading day left in 2011. I, for one, am happy to see this market year end. There’s been way too much Sturm und Drang, not to mention Bernanke und Trichet, for my taste. The next time I read about “European spreads,” I really hope it’s about Nutella.

There has been, of course, one bright spot to this year and that’s been our Buy List. Through Thursday, our Buy List holds a small lead over the S&P 500. For the year, our Buy List is up 1.32% (3.18% including dividends) while the S&P 500 is up 0.43% (2.55% including dividends).

True, that’s hardly a big lead, but remember that the large majority of money managers don’t get this far. Unless disaster strikes on Friday, this will be our fifth year in a row of beating the overall market. In this issue of CWS Market Review, I want to talk about the market’s current mood and explain why our Buy List has stayed so close to the S&P 500.

But first, I want to remind you that on Tuesday, January 3rd, the new Buy List takes the field. The stock exchange will be closed on Monday for New Year’s Day so Tuesday will be the first trading day of the new year. Five new faces will be joining us: CA Technologies ($CA), Hudson City Bancorp ($HCBK), CR Bard ($BCR), Harris ($HRS) and DirecTV ($DTV). Let’s hope 2012 will be our sixth market-beating year in a row! (And let’s hope for a much bigger lead at the end as well.)

One of the frustrating aspects of this market is that stocks have been unusually highly correlated with each other this year. This is a crucial point and every investor needs to understand what’s been happening. Let me explain it in a user-friendly way: Typically most stocks move up and down together but there’s often a minority that swims against the stream. Money managers love to key in on these “dispersion” stocks because they want to show their clients that they can stand apart from the crowd, preferably in a good way. When everybody else is zigging, the big money is going to find the guys who can zag.

The problem is that when there’s too much correlation going on, as there is now, the non-correlated area gets far too much attention. As Yogi Berra once said of a popular restaurant, “No one goes there anymore. It’s too crowded.” In more concrete terms, this helps explain why we‘re seeing such absurd valuations for stocks like ($AMZN) or Starbucks ($SBUX). They’re two of the few zaggers in town, so everybody has latched on.

Earlier this year, shares of Netflix ($NFLX) got a super-atomic wedgie after the company tried to…well, I’m not exactly sure. But it was pretty dumb whatever it was. Anyway, the stock got destroyed. Here’s the key part I want you to understand: The attention is going to the crash but the real story is why anyone was paying $300 for this stock in the first place (that’s 77 times trailing earnings).

That’s nuts especially when you compare it with many stodgy blue chips. For too long, Netflix was one of the few stocks that was “working.” Meanwhile, if the S&P 500 was up, say, 1% on a given day, you could be pretty sure that GE ($GE) or Walmart ($WMT) or Microsoft ($MSFT) was doing pretty much the same thing. That’s frustrating—and frustrated investors are bad investors.

Why has correlation been so high this year? It all comes down to what’s euphemistically called “headline risk,” which is better known as Europe’s unholy mess. As the problems in Europe have grown, the market has increasingly treated our market less as a market of individual equities and more as one giant mass that has a cash flow in U.S. dollars. In this case, the importance of U.S. dollars is that they’re not euros.

What happened is that the dollar trade became highly correlated with every other asset (often negatively), and within assets, stocks have become highly correlated with each other. Ideally, stocks should trade on, oh you know, things like earnings and dividends. Instead, they’re trading on what Angela Merkel may or may not do at the next five summits which will decide on how to lay out an agenda for the next 73 summits. Sorry, but that ain’t much fun. Of course, if you’re an investor in European bonds, then you probably have all the dispersion you can handle.

Since I build the Buy List for long-term performance, I don’t give a whit about being correlated or not. If you’re focused on the long-term, that’s something that comes and goes. In 2011, it’s been here in a big way and it explains why our Buy List is sticking so closely to the S&P 500. It’s just something that you have to deal with. This, too, shall pass.

While high correlation makes stock-picking harder, it also means we should focus on fundamentals all the more, since high correlation is a fleeting thing. The Chicago Board Options Exchange actually has an index that tracks implied correlation. Fortunately, in recent weeks, this index has slowly started to fall, but make no mistake, correlation is still very high.

I suspect that in 2012, we’re going to see more “dispersion trades” fall apart and many won’t be pretty. In fact, that may be happening right now with gold. It recently made a six-month low and I won’t be surprised to see a few hedge funds go under because they were heavily invested in gold and silver futures. The gold sell-off may also signal that the Fed’s “extended period” policy for low interest rates may not be so extended. But it’s just too early to say.

Another emerging “dispersion” story could be in healthcare. In this case, it’s slowly getting stronger. On Thursday, Medtronic ($MDT) closed at its highest level in nearly six months. If you recall, the company had a solid earnings report a few weeks ago and it reiterated its full-year forecast. On Tuesday, Johnson & Johnson closed above $66 for the first time since July. And even though Abbott Labs ($ABT) is set to depart our Buy List, it hit a fresh 52-week high on Thursday.

Frankly, not much has been going on this week on Wall Street. Trading volume is very low. On the economic front, the consumer confidence report was very good and the pending home sales figure was particularly strong.

The slow news will end soon as we have fourth-quarter earnings season on the horizon. Our first Buy List stock to report will be JPMorgan Chase ($JPM) on January 13th. I’m particularly looking forward to a strong earnings report from Ford ($F). Plus, the company will soon pay out its first dividend to shareholders in five years.

That’s all for now. Over the weekend, I’ll post the final numbers for this year’s Buy List. Be sure to keep checking the blog for daily updates. I’ll have more market analysis for you in the next issue of CWS Market Review!

– Eddy

Posted by on December 30th, 2011 at 7:39 am

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.