|Executive Summary | Portfolio | Guru Analysis | Watch List|
|Executive Summary||October 16, 2009|
The economic news hasn't changed much in the past two weeks, with continued small signs of improvement popping up against a broader backdrop of lingering problems and weakness.
The best example may involve unemployment. New jobless claims dropped for the fifth time in six weeks, according to data released Thursday, and the four-week average is now down to 531,500 -- the lowest level since January. The figure is now almost 20% below the highs it reached in April. Continuing claims, meanwhile, dropped below 6 million for the first time in more than six months.
But while those are good signs, the overall level of unemployment remains high. After declining for two straight months and four out of the last five, job cuts increased in September, the Labor Department reported earlier this month. The 263,000 jobs lost was a far cry from earlier this year, when the figure topped 600,000 throughout the first quarter, but it was still sobering news. The unemployment rate is now 9.8% -- the highest since 1983. In addition, average work week durations are at record lows, and the underemployment rate -- which factors in part-time workers who want, but can't find, full-time jobs -- is at 17%, CNNMoney reports.
But there are signs that the economy is continuing to recover -- a sentiment that most Federal Reserve members expressed in their September meeting, according to minutes released this week. For example, manufacturing numbers continue to improve. Thursday, the New York Fed reported that its manufacturing index nearly doubled in October, rising to its highest level since 2004. It was the third straight month the index indicated an expansion in manufacturing, the first time that has happened in almost two years. The Philadelphia Fed also said its manufacturing index, which measures activity in the mid-Atlantic region, was positive in October for the third straight month.
Two other key areas of the economy offered mixed signals this week. First, housing: While home sales and prices have shown signs of life in recent months, housing foreclosures remain high. They dropped 4% in September compared to August, but were still up almost 30% year-over-year, according to RealtyTrac. For the full third quarter, foreclosures were up 5% compared to the second quarter, though September marked the second straight month-over-month decline, the group said.
The other key area: consumer spending. Retail sales fell in September by 1.5%, the Commerce Department reported this week. But a large chunk of that was due to a big drop in auto sales, which was to be expected given that the government's Cash for Clunkers plan ended. Excluding auto sales, retail sales actually rose 0.5% for the month, a good sign in a country where consumer spending makes up about 70% of the economy.
Finally, we've embarked on earnings season, and thus far the third-quarter results have provided some encouragement. Several big financial firms have been posting strong numbers -- a good sign considering the mess the sector was last year at this time. JPMorgan Chase has reported $3.6 billion in profits for the quarter, while Goldman Sachs raked in about $3.2 billion. Citigroup even posted a $101 million profit, a year after it lost more than $2.8 billion. And chipmaker Intel, which some consider a bellwether for the technology sector, beat earnings and revenue estimates by wide margins, and issued greater than expected fourth-quarter revenue guidance.
On balance, the signs of economic improvement continued to outweigh the lingering concerns, helping send the market higher. For the first time in more than a year, the Dow Jones Industrial Average crossed the 10,000 mark. For the fortnight, the S&P 500 jumped 6.5%, while the Hot List was even better, gaining 10.0%. For the year, the portfolio is now up 49.8%, vs. 21.4% for the S&P. And since its July 2003 inception, the Hot List is far ahead of the index, having gained 145.7% compared to the S&P's 9.6% gain.
Don't Fight the Fed
As the market has kept rising in recent weeks, strategists have continued to debate whether stocks can keep climbing, or whether the rally is running out of steam. On the whole, the strategists I keep my eyes on have leaned toward the bullish side. Among them are some managers with excellent long-term track records, including Steven Leuthold, Liz Ann Sonders, Bob Doll, Jeremy Siegel, James O'Shaughnessy, Kenneth Fisher, and Anthony Bolton.
These top market minds have presented some strong arguments for why they remain high on stocks, and this week I'd like to focus on one of those points. It's one that's close to the heart of one of the gurus upon whom I base my Guru Strategies.
The argument involves interest rates. Currently, interest rates are at or near historic lows -- part of the Federal Reserves "quantitative easing" strategy for stabilizing the economy and keeping credit markets liquid. Now that the economy has shown signs of stabilizing, and improving, many have begun to wonder when the Fed will begin to tighten up its monetary policy.
This week, Australia became the first major nation to raise interest rates, leading to speculation that others -- perhaps even the U.S. -- will soon follow. But it appears we're still a ways away from that. Yesterday, the latest inflation figures from the Labor Department showed that the consumer price index rose just 0.2% in September, and it remains 1.3% lower than year-ago levels. So despite all of the money the government has pumped into the economy, inflation is far from a problem right now. In addition, the difference between 10-year Treasury note rates and Treasury Inflation-Protected Securities -- a gauge of future inflation expectations -- remains in line with what the spread has been over the past five years, according to Bloomberg News.
What would continued low inflation mean for stock investors? It could mean a lot. As the great Martin Zweig astutely observed, interest rates and the stock market's direction tend to have a lot to do with each other.
In his book Winning on Wall Street, Zweig, whose approach is the basis for my Growth Investor model, offers this key maxim: Don't Fight the Fed. "In the stock market, as with horse racing, money makes the mare go," he wrote. "Monetary conditions exert an enormous influence on stock prices."
Zweig found that, generally, high rates or a rising trend in rates was a negative for the market, while low rates or a falling trend in rates was a positive. And right now, rates are low -- very low. For example, the prime rate -- the rate banks charge their best customers -- was at 3.25% in September. Prior to last December, it hadn't been below 4% since 1958. The federal funds rate, meanwhile (the rate at which banks lend money overnight to each other) was at 0.15% in September. Prior to last fall, its monthly reading had been below 1% only once in the previous 50 years. And the September discount rate (which the Fed charges banks looking to borrow from it) was also at all-time low levels, at just 0.5%. (All figures come from the Federal Reserve.)
Why are low rates better for stocks? There are a couple reasons. "First," Zweig said, "falling interest rates reduce the competition on stocks from other investments, especially short-term instruments such as Treasury bills, certificates of deposit, or money market funds." That appears to be what's happening now. As of yesterday, the 10-year Treasury note was yielding under 3.5%. While that's up from last fall, when investors flocked to the safety of T-bills amid the financial crisis, it's still far below historic norms. In fact, from 1959 through 2007, the monthly reading on 10-year T-bills was below 3.5% just once, in June 2003, according to the Federal Reserve.
In other words, if you want to find impressive returns in today's investment climate, stocks -- not bills or bonds -- are probably your best bet.
The other factor is that low or falling rates allow corporations to borrow money for less. "That reduces a major expense, especially for companies that are heavy borrowers such as airlines, public utilities, or savings and loans," Zweig wrote. And that means more profits for companies. "Wall Street loves the idea that future earnings will go up," Zweig says. "So, as interest rates drop, investors tend to bid prices higher, partly on the expectation of better earnings."
Current rates are already so low that it's unlikely we'll see them decrease much more. But it seems likely that they'll stay low for a while. One reason is the low inflation readings I discussed earlier. Another is the sheer size of the government's efforts to stimulate the economy. One would think that, given the depth of the recession and the massive efforts to jumpstart the economy, the Fed will want to err on the side of caution and not jump the gun on rate increases, lest it risk another economic turn for the worse.
One important related factor in all of this involves the slow recovery many strategists and pundits are predicting for the U.S. economy. Many assume that a slow economic recovery would be a negative for stocks. But looked at through the interest rate lens, you can see that the opposite may well be true. If growth is indeed slower, the government will likely keep rates low, which could help boost stocks.
If we do go through a slow-growth environment, investors who can find those companies that are producing strong growth could really benefit. And that's what my models are designed to do -- find companies that are producing strong results, regardless of the economic climate.
Of course, the Fed and interest rates are just part of the investment landscape picture. Zweig's "don't fight the fed" maxim doesn't always work -- during last year's market collapse, rates were also quite low and the market kept falling while they were cut further. But then again, no one variable will always work; Zweig himself looked at a myriad of other factors. But the "don't fight the Fed" advice does have a good track record, and in a broader market context which includes strong valuations, an improving economy, and huge amounts of government aid designed to bolster the economy and markets, it's a key reason to be optimistic that stocks can continue to climb higher.
Guru Spotlight: Kenneth Fisher
For decades, the price-to-earnings ratio has been the most widely used valuation measure for stock investors, and a key tool in the arsenals of many of the gurus I follow. While legendary investors like Benjamin Graham, Peter Lynch, and John Neff all used the ratio differently, they and many others agreed that the ratio itself was a key to finding bargain-priced stocks. The investing public and media seems to share their view, with the P/E ratio having long been the only valuation metric that most newspapers include in their daily stock listings.
But in 1984, Kenneth Fisher sent a shockwave through the P/E-conscious investment world. Fisher -- the son of Phillip Fisher, who is known as the "Father of Growth Stock Investing" -- thought there was a major hole in the P/E ratio's usefulness. Part of the problem, he explained in his book Super Stocks, is that earnings -- even earnings of good companies -- can fluctuate greatly from year to year. The decision to replace equipment or facilities in one year rather than in another, the use of money for new research that will help the company reap profits later on, and changes in accounting methods can all turn one quarter's profits into the next quarter's losses, without regard for what Fisher thought was truly important in the long term -- how well or poorly the company's underlying business was performing.
While earnings can fluctuate, Fisher found that sales were far more stable. In fact, he found that the sales of what he termed "Super Companies" -- those that were capable of growing their stock price 3 to 10 times in value in a period of 3 to 5 years -- rarely decline significantly. Because of that, he pioneered the use of a new way to value stocks: the price-to-sales ratio (PSR), which compared the total price of a company's stock to the sales the company generated.
Fisher's findings -- and his results -- helped make the PSR a common part of investment parlance, and helped make him one of the most well-known investors in the world. (He is a perennial member of Forbes' list of "The 400 Richest Americans", his money management firm oversees tens of billions of dollars, and he is one of Forbes' longest running magazine columnists.) The common sense, mostly quantitative approach he laid out in Super Stocks also caught my attention, and led me to create my Fisher-based Guru Strategy.
It's important to note that today, Fisher says his approach to investing has evolved quite a bit since Super Stocks. The key to winning big on Wall Street is knowing something that other people don't, he believes, and when too many people became familiar with PSR investing, he says he needed to find other ways to exploit the market.
So why have I continued to use my Super Stocks-based model? Two reasons: First, Fisher's publisher reissued the book in 2007, with the same PSR focus. Second, the strategy flat out works. Since its July 2003 inception, my 10-stock Fisher-based portfolio has gained 120.2% (13.4% annualized), while the S&P 500 has gained just 9.6% (1.5% annualized). That makes it one of my most successful long-term strategies.
Price-to-Sales and "The Glitch"
Fisher is a student of investor psychology, and his observations about investor behavior are what led to his PSR discovery. Often, he found, companies will have a period of strong early growth and become the darlings of Wall Street, raising expectations to unrealistic levels. Then, they then have a setback. Their earnings drop, or continue to grow but simply don't keep pace with Wall Street's lofty expectations. Their stocks can then plummet as investors overreact and sell, thinking they've been led astray.
But while investors overreact, Fisher believed that these "glitches" are often simply a part of a firm's maturation. Good companies with good management identify the problems, solve them, and move forward, and as they do the stock's price begins to rise again. If you can buy a stock when it hits a glitch and its price is down, you can make a bundle by sticking with it until it rights the ship and other investors jump on board.
The key in all of this was finding a way to evaluate a firm when its earnings were down, or when it was losing money (remember, you can't use a P/E ratio to evaluate a company that is losing money, because it has no earnings). The answer: by looking at sales, and the PSR.
According to the model I base on Fisher's writings, stocks with PSRs below 1.5 are good values. And the real winners are those with PSR values under 0.75 -- that's the sign of a Super Stock. To find the PSR, Fisher says to take the total value of a company's stock, i.e. its market cap (the per-share price multiplied by the number of shares outstanding). We then divide that number by the firm's trailing 12-month sales.
One note: Because companies in what Fisher called "smokestack" industries -- that is, industrial or manufacturing type firms that make the everyday products we use -- grow slowly and don't earn exceptionally high margins, they don't generate a lot of excitement or command high prices on Wall Street. Their PSRs thus tend to be lower than those of companies that produce more exciting products, Fisher said. He adjusted his PSR target for these firms, and the model I base on his writings looks for smokestack firms with PSRs between 0.4 and 0.8; it is particularly high on those with PSR values under 0.4.
More than the PSR
While the PSR was key to Fisher's strategy, he warned not to rely exclusively on it. Terrible companies can have low PSRs simply because the investment world knows they are headed for financial ruin.
Other quantitative measures Fisher used include profit margins (he wanted three-year average net margins to be at least 5 percent; the debt/equity ratio (this should be no greater than 40 percent, and is not applied to financial firms); and earnings growth (the inflation-adjusted long-term EPS growth rate should be at least 15 percent per year).
Fisher also made an interesting observation about companies in the technology and medical industries. He saw research as a commodity, and to measure how much Wall Street valued the research that a company did, he compared the value of the company's stock (its market cap) to the money it spends on research. Price/research ratios less than 5 percent were the best case, and those between 5 and 10 percent were still indicative of bargains. Those between 10 and 15 percent were borderline, while those over 15 percent should be avoided.
The variety of variables in my Fisher-based model are a big part of why I think it continues to work, long after the PSR has become a well-known stock analysis tool. While it uses the PSR as its focal point, it also makes sure firms have strong profit margins, earnings growth, and cash flows, and low debt/equity ratios. That well-rounded approach is has helped it rebound from a tough 2008 and remain far ahead of the broader market since its inception, and it's why I expect it to continue to produce solid returns over the long run.
Now, here's a look at the stocks that currently make up my 10-stock Fisher-based portfolio. As you'll see, it's particularly high on oil firms right now -- an interesting trend given that, in his September column for Forbes, Fisher himself said fossil fuels aren't leaving the energy landscape anytime soon, and recommended that investors dedicate a sizeable chunk of their portfolios to fossil fuel stocks.
Oil States International, Inc. (OIS)
Frontier Oil Corporation (FTO)
Sierra Wireless, Inc. (SWIR)
Schnitzer Steel Industries, Inc. (SCHN)
General Dynamics Corporation (GD)
Chevron Corporation (CVX)
Aeropostale, Inc. (ARO)
World Fuel Services Corporation (INT)
National Presto Industries Inc. (NPK)
AAON, Inc. (AAON)
News about Validea Hot List Stocks
Chevron Corp. (CVX): Chevron said on Oct. 8 that it expects third-quarter earnings to be significantly higher than the second quarter, due to higher crude oil prices and gains from asset sales and tax items, the Associated Press reported. The company didn't offer a specific estimate for third-quarter earnings, which are due on Oct. 30. Earnings were $1.75 billion, or 87 cents per share, in the second quarter.
Aeropostale (ARO): The teen clothing retailer reported that sales jumped 19% in September vs. a year ago, beating estimates, according to Investor's Business Daily. Aeropostale also raised Q3 earnings per share guidance.
The Next Issue
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