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|Executive Summary||September 14, 2012|
Economic news has been quite mixed over the past couple weeks, with more positive news in the housing market counterbalanced by a poor August jobs report. Investors, however, seem far more interested in what central banks are doing than in what the economy is doing.
First, markets surged last week after the European Central Bank announced that it is -- finally -- going to implement a bond-purchasing program designed to stabilize the region's financial system. The program is not limited in terms of scope, and the news sent European stocks as well as American stocks jumping upwards several percentage points. There are still some major hurdles, however. Spain's Prime Minister has said he won't allow the Eurozone or the ECB to dictate how his country will cut its budget deficit as part of the bond-buying program. And while Germany's high court approved the creation of the Eurozone's permanent bailout facility this week, it said it is reserving judgment on the bond-buying plan.
At home, the U.S. economy got some bad news in the form of the Labor Department's August jobs report, which showed that the private sector added just 103,000 jobs during the month. But in a way, the report turned out to be bullish news for stocks, as it likely led to the second big central bank move of the past fortnight -- the Federal Reserve's announcement of a new quantitative easing plan. The Fed said this week that in addition to continuing the "Operation Twist" plan through year-end, it will be buying $40 billion in mortgage-backed securities a month. The move is designed to lower long-term interest rates and support mortgage markets, and investors were quite bullish upon hearing the news. The major indices jumped Thursday after the Fed issued its statement.
Back to the hard economic data, particularly the August jobs number. It was both disappointing, given that more than 160,000 jobs were added the previous month, and surprising, as private payroll tracker ADP had said that more than 200,000 jobs were added during the month, according to its data.
The unemployment rate, however, fell to 8.1%, matching its lowest level since January 2009. And, the so-called "U-6" unemployment rate -- which also includes discouraged workers who haven't looked for a job in the past year, and part-time workers who wish to work full-time -- fell three-tenths of a percentage point, to 14.7%. Those rates fell not because of the level of job creation, but instead because the labor force declined by 368,000. Many pundits have cited this as an indication of just how bad the job market is, saying that many workers are finding such little prospects of obtaining a job that they are giving up the search in droves. There may be more to it than that, though. For one thing, the U-6 figure should capture many discouraged workers who have left the workforce.
As Morningstar economist Bob Johnson notes, a more plausible explanation for the workforce dropouts may be the back-to-school season, during which many students leave their summer jobs. "Typically, when students head back to school, these seasonal workers aren't replaced," Johnson notes. "Seasonal adjustment factors are supposed to capture this, but a lot of schools and universities are shifting the start of their school years earlier in August." He notes that a fairly big decline in temporary workers (120,000) supports this thesis. The Wall Street Journal also highlighted some data showing that seasonal hiring may have been a big factor in the August numbers. It cited a report from research firm Stone & McCarthy which found that August jobs numbers have missed economists expectations in 21 of the past 28 years. In all but four years that they missed expectations, the figures were revised upward later on. And the revisions are often quite significant. From 2001 through 2011, Stone & McCarthy found, August payrolls were revised upward by an average of 62,000 -- more than double the average for the next highest month (November). The firm cited seasonal hiring as one potential big factor for this.
A closer look at the August report would seem to further support the student-summer-job theory. For example, while the unemployment rate dropped in August, the unemployment rate for those age 16 to 19 jumped nearly a full percentage point. Bottom line: While the August jobs report was disappointing, I wouldn't read too much into it just yet.
In other areas, good news has continued to come from the housing market. The National Association of Realtors' Pending Home Sales Index, a forward-looking indicator, rose 2.4% in July (vs. June). The index is now 15% higher than it was a year ago.
The manufacturing sector, meanwhile, offered mildly disappointing news. The Institute for Supply Management's manufacturing index showed the sector contracted in August for the third straight month, after having expanded for three years straight. The August reading, like those of the previous two months, showed that the sector was barely in contraction territory, however, coming in at 49.6 (a reading below 50 indicates contraction). There was also a big jump in the prices sub-index, which measures the prices businesses pay for raw materials, something to keep an eye on.
ISM's service sector index rose, however, and remained in expansion territory for the 32nd straight month. Its employment sub-index made a nice gain as well, though its prices sub-index also made a significant jump.
Since our last newsletter, the S&P 500 returned 4.3%, while the Hot List returned 4.2%. So far in 2012, the portfolio has returned 18.0% vs. 16.1% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 166.8% vs. the S&P's 45.9% gain.
The Resilience of Equities
This week marks the fourth anniversary of the event that was at the heart of the 2008 financial crisis and stock market meltdown: the collapse of Lehman Brothers. While the crisis was years in the making -- the result of years of easy money, bubbling housing prices, and bad debt -- the September 15, 2008 bankruptcy filing by Lehman served as the symbolic breaking point for markets. After the giant investment bank's collapse, the S&P 500 fell nearly 30% in a four-week span, with the crisis deepening, policymakers scurrying to come up with the bailout plan to save other banks, and investors panicking.
Since then, stocks have become something of a dirty word. We've heard scores of pundits and prognosticators predict the downfall of both the U.S. economy and the stock market. There's been talk of "new normals", paradigm shifts, and even the "death of equities". For much of the past four years, maligning equities has been the chic thing to do. To be a bull has meant having to do quite a bit of explaining -- and even then, after laying out one's case, to often be derided.
But since the Lehman collapse, just how have stock investors who stuck with equities fared compared to those who cashed out and stuffed their money under their proverbial mattresses? Let's take a look at how buy-and-hold investors have done over the past four years, compared to some hypothetical investors who bailed on stocks when some key pieces of bad news hit.
We'll start with those who would've crashed out the day Lehman collapsed. On September 15, 2008, the S&P closed at 1192.70. Today (as of midafternoon on September 13), the index is trading at about 1449. That means stocks are more than 21% higher than they were the day that Lehman collapsed. That makes for an annualized gain of about 5% over the past four years -- certainly not eye-popping, but not bad at all considering all that has happened in that time.
But while a good deal of investors may have cashed out their chips after Lehman's collapse, more did so the following month. According to Lipper Analytical Services, outflows from stock and mixed equity mutual funds peaked in October 2008, with investors pulling more than $86 billion out of those funds. Let's take the midpoint of that month, October 15, and consider someone who pulled his or her money out of stocks at that point. On October 15, 2008, the S&P closed at 907.84. Using the current S&P level of 1449, that means an investor who cashed out in mid-October 2008 has missed out on a gain of 59.6%. That's an annualized gain of about 12.7%.
Of course, numerous investors hung on to stocks beyond that point. According to Lipper, funds flowed out of stock and mixed equity mutual funds for several more months, before hitting another mini-peak in March 2009, when investors yanked nearly $35 billion from those funds. Again using the midpoint of the month (March 16), an investor who cashed out of stocks at that point would have missed out on a 92.2% gain for the S&P. That's a 20.5% annualized gain.
For the next year or so, fund flows weren't spectacular, but they weren't bad according to Lipper's data. In May 2010, however, after several months of positive flows into stock and mixed equity funds, there was a big shift. Investors pulled nearly $29 billion out of stock and mixed equity mutual and exchange traded funds that month (Lipper started tracking ETF flows in its monthly reports in September 2009). The trigger certainly seems to have been the European debt crisis. In late April, Greece's debt was downgraded twice within a week by rating agencies, rekindling fears that Greece's problems would spill over into the rest of Europe, and beyond. Let's consider a hypothetical investor who bailed on stocks after the second of those two downgrades, which occurred on April 27. The S&P 500 closed at 1183.71 that day. Had our hypothetical investor sold at that price, he or she would've missed out on a gain for the index of 22.4% since then. That's an annualized gain of close to 9%.
For the next year, flows into stock and mixed equity funds again weren't bad. But investors began yanking money from those types of funds in the summer of 2011. The U.S. debt ceiling debacle was dragging on, and then in early August Standard & Poor's downgraded American debt. Investors pulled more than $57 billion from stock and mixed equity mutual and exchange traded funds that month. So, let's take another hypothetical investor, one who bailed on stocks immediately after the U.S. downgrade, which occurred after the markets closed on August 5. Even had that investor been able to sell at the open price the next day (1198.48), he or she would still have missed out on the 20.9% gain for the S&P in the little over a year since then.
While each of the investors described above is hypothetical, their actions no doubt represent how a good many investors reacted to negative news at various points during the past four years. And many more probably engaged in less extreme measures, perhaps simply reducing their equity exposure at those key points, even if they didn't sell all their stocks. In each case, the underlying problems behind the sell decisions -- the European debt crisis, the United States' own debt woes, questions about the financial sector, etc. -- haven't been resolved. And yet, in each case, the investors who sold at those key "bad news" points have left money on the table.
To be sure, the Federal Reserve's dramatic stimulus efforts have played a role in that. But we've also seen genuine, if slow, improvement in the economy, corporate sector, and financial world in the past four years. While things still need to improve, and problems remain, the bottom line is that they are not as bad as many feared they would be. The U.S. has made it through the worst of the crisis, and, while wounded, the economy and stock market are both still on their feet and moving forward.
That's nothing new. Throughout history, investors have feared the worst when crises have hit, and usually their fears turn out to be worse than the reality. One of the gurus I follow, David Dreman, who is featured in this week's Guru Spotlight, provided some very interesting research on this topic in his book Contrarian Investment Strategies: The Generation. In his book, Dreman looked at "11 major postwar crises", which included the Berlin blockade, Korean War, Kennedy assassination, Gulf of Tonkin crisis, 1979-1980 oil crisis, and 1990 Persian Gulf War. He showed how, one year after all but one (the Berlin Blockade, when the market dropped), the market was up between 22.9 percent and 43.6 percent, except for a 7.2 percent rise after the Gulf of Tonkin crisis. The average gain was 25.8 percent. Two years after the crisis, the average gain was 37.5 percent. It's worth noting that following the September 11, 2001 terrorist attacks, which occurred after Dreman wrote Contrarian Investment Strategies, it took just one month for the S&P 500 to climb back to pre-September 11 levels; a year after the attacks, however, the index had fallen below pre-September 11 levels, the dot-com meltdown no doubt being a factor.
All of that doesn't mean that the economy and stock market will bet bounce back smoothly and swiftly after crises. It took the S&P 500 more than a year and a half to climb back to where it was when Lehman Brothers collapsed in September 2008, and it was a rocky ride. It's been a rocky ride since then, too. But the point is that the economy and stock market are both far more resilient than many people give them credit for being. And if you understand that, you can take advantage of other people's knee-jerk reactions. While the crowd is selling, you can be snatching up the bargain priced stocks that they leave in their wake as they flee the market.
It's not easy to exercise that kind of discipline, particularly when it can take some time for those bargain stocks' values to be realized. But it's something that just about all the gurus upon whom I base my strategies practiced while building their impeccable track records. Remember what one of those gurus, mutual fund legend Peter Lynch, said about long-term perspective in an interview with PBS television: "Time is on your side in the stock market. It's on your side. And when stocks go down, if you've got the money, you don't worry about it and you're putting more in, you shouldn't worry about it. You should worry what are stocks going to be 10 years from now, 20 years from now, 30 years from now." Lynch made those comments many years ago, but I think they ring just as true today as they always have. And I think investors who adopt that sort of long-term, disciplined philosophy will end up quite happy with their returns over the long haul.
Guru Spotlight: David Dreman
While all the gurus I follow have built their fame and fortunes using different investment approaches, there is at least one striking similarity that most -- if not all -- of them share: They are contrarians. When the rest of Wall Street is zigging, they are zagging; when Wall Street zags, they zig. By having the strength of conviction to march to their own drummers and not follow the crowd, they have been able to key in on the types of strong, undervalued stocks that have made them -- and their clients or shareholders -- very happy.
But while most of these gurus are contrarians, one in particular is known for being, well, the most contrarian: David Dreman. Throughout his long career, Dreman has sifted through the market's dregs in order to find hidden gems, and he has been very good at it. His Kemper-Dreman High Return Fund was one of the best-performing mutual funds ever, ranking number one out of 255 funds in its peer groups from 1988 to 1998, according to Lipper Analytical Services. And when Dreman published Contrarian Investment Strategies: The Next Generation (the book on which I base my Dreman strategy) in 1998, the fund had been ranked number one in more time periods than any of the 3,175 funds in Lipper's database.
Throughout his career, Dreman has keyed in on down-and-out diamonds in the rough, finding winners in such beaten-up stocks as Altria (after the tobacco stock plummeted amid lawsuit concerns) and Tyco (which had been hit hard by an embarrassing CEO fiasco).
How -- and why -- did Dreman manage to pick winners from groups of stocks that few other investors would touch? Well, Dreman, perhaps more than any other guru I follow, is a student of investor psychology. And at the core of his research is the belief that investors tend to overvalue the "best" stocks -- those "hot" stocks everyone seems to be buying -- and undervalue the "worst" stocks -- those that people are avoiding like the plague, like Altria and Tyco. In addition, he also believed that the market was driven largely by how investors reacted to "surprises", frequent events that include earnings reports that exceed or fall short of expectations, government actions, or news about new products. And, he believed that analysts were more often than not wrong about their earnings forecasts, which leads to a lot of these surprises.
When you put those factors together, you get the crux of Dreman's contrarian philosophy. Surprises happen often, and because the "best" stocks are often overvalued, good surprises can't increase their values that much more. Bad surprises, however, can have a very negative impact on them. The "worst" stocks, meanwhile, are so undervalued that they don't have much further down to go when bad surprises occur. But when good surprises occur, they have a lot of room to grow. By taking a "contrarian" approach -- i.e. targeting out-of-favor stocks and avoiding in-favor stocks -- Dreman found you could make a killing.
Specifically, Dreman compared a stock's price to four fundamentals: earnings, cash flow, book value, and dividend yield. If a stock's price/earnings, price/cash flow, price/book value, or price/dividend ratio was in the bottom 20% of the market, it was a sign that investors weren't paying it much attention. And to Dreman, that was a sign that these stocks could end up becoming winners. (In my Dreman-based model, a firm is required to be in the bottom 20% of the market in at least two of those four categories to earn "contrarian" status.)
But Dreman also realized that just because a stock was overlooked, it wasn't necessarily a good buy. After all, investors sometimes are right to avoid certain poorly performing companies. What Dreman wanted to find were good companies that were being ignored, often because of apathy or overblown fears about the stock or its industry. To find those good firms, he used a variety of fundamental tests. Among them were return on equity (he wanted a stock's ROE to be in the top third of the 1,500 largest stocks in the market); the current ratio (which he wanted to be greater than the stock's industry average, or greater than 2); pre-tax profit margins (which should be at least 8 percent), and the debt/equity ratio (which should be below the industry average, or below 20 percent). By using those and other fundamental tests in conjunction with his contrarian indicator tests (the low P/E, P/CF, P/B, and P/D criteria we reviewed before), he was able to have great success finding strong but unloved firms that had the potential to take off once investors caught on to their true strength.
Because Dreman took advantage of the overreactions of others, he found that one of the best times to invest was during a crisis. "A market crisis presents an outstanding opportunity to profit, because it lets loose overreaction at its wildest," he wrote in Contrarian Investment Strategies. "People no longer examine what a stock is worth; instead, they are fixated by prices cascading ever lower. Further, the event triggering the crisis is always considered to be something entirely new." Dreman's advice: "Buy during a panic, don't sell."
This type of contrarian approach isn't for the faint-of-heart. You never know exactly when fear will subside and investors will wake up to a bargain they've been overlooking. And that means the stocks this model targets may very well keep falling in the short term after you buy them, which, for my Dreman-based portfolio, is what happened during the recent financial crisis and bear market. The portfolio, which had trounced the S&P from its inception through 2006, fell on tough times as fears about the economy grew, lagging the S&P by about 15 percentage points in both 2007 and 2008.
But, as fears abated and the crisis passed, investors began to recognize the strong stocks they'd been shunning. And the Dreman portfolio reaped the benefits, returning more than 37% in 2009 (vs. 23.5% for the S&P) and 23.1% in 2010 (vs. 12.8% for the S&P). Since its July 2003 inception, the 10-stock Dreman-based portfolio has nearly doubled the S&P 500, returning 82.6%, or 6.8% annualized, vs. 43.7%, or just 4.0%, for the S&P (through Sept. 9).
As you might imagine, the portfolio will tread into areas of the market others ignore because of its contrarian bent. Right now, its holdings include some very unloved firms, including several financials and one from China. Here's the full list of its current holdings:
HollyFrontier Corp. (HFC)
AOL, Inc. (AOL)
CYS Investments Inc. (CYS)
Assurant, Inc. (AIZ)
Banco Santander, S.A. (SAN)
Statoil ASA (STO)
Cosan Limited (CZZ)
Yanzhou Coal Mining Co. (YZC)
Bank of America Corp. (BAC)
Exelis Inc. (XLS)
News about Validea Hot List Stocks
The TJX Companies (TJX): TJX reported August sales of $1.9 billion, up 10% over the $1.7 billion in sales from the year-ago period. Consolidated comparable store sales were up 8% over last year. TJX said it now expects its fiscal third-quarter earnings to come in on the high end of its previous estimates of $0.56 to $0.59 per share.
Northrop Grumman (NOC): Grumman said it will be teaming with Flight Technologies Sistemas SA to develop national security technologies for Brazil, the Jacksonville Business Journal reported. The two firms will work on security solutions for Brazil's integrated border monitoring system, which uses radars, communications systems, and drones to detect smuggling, terrorism and drug trafficking activity.
The Next Issue
In two weeks, we will publish another issue of the Hot List, at which time we will rebalance the portfolio. If you have any questions, please feel free to contact us at email@example.com.
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