The economy continues to offer a mixed bag of fear and hope. But compared to the fear-filled bag it was giving us not too long ago, this new mixed bag has offered some real encouragement over the past couple weeks -- enough to keep the markets trending upward, at least.
On the positive side, first-quarter earnings are rolling in, and several financials -- the most maligned group of stocks in the market -- have been dishing out some pleasant surprises. It started last week with Wells Fargo, which announced a profit of $3 billion, up 50% from a year earlier and more than double analysts' expectations. Then this week, Goldman Sachs reported a first-quarter profit of $1.8 billion. And just yesterday, JPMorgan Chase announced that it took in more than $2 billion in profits in the first quarter, down about 10% from last year's first quarter, but significantly higher than analysts had expected. The three firms' results were a big part of why financials in general have had a big bounce in the past two weeks.
But before we get too excited, not all the news in the financial sector has been good. Other banks continue to rack up losses -- UBS this week reported a $1.7 billion first-quarter loss, and said it would be slashing close to 9,000 more jobs. And those first-quarter figures from Wells, Goldman, and JPMorgan come with some caveats. Part of the reason for the big numbers was a surge of refinancings caused by historically low mortgage rates, which won't last forever, notes BusinessWeek's Theo Francis. In addition, the relaxing of market-to-market rules may well have led banks to boost the valuation of beaten-down assets, giving a nice but not repeatable "pop" in earnings. And, as Francis also notes, Goldman Sachs' change from a Nov. 30 year-end fiscal year to a Dec. 31 year-end fiscal year meant its Q4 results from last year went through November, and its Q1 results from this year started in January -- somewhat ridiculously leaving the firm's $780 million December loss out of the equation.
Early next month, when the results of the government's bank "stress tests" come in, we may get a better picture of just how well-positioned a lot of the big banks are.
Despite those caveats, the profit reports were welcomed, as is other economic news. New claims for unemployment fell about 8% in the week ending April 11, for example. They are still high, but given the current conditions, any decrease is certainly good to see. Wednesday, we saw two of the biggest junk bond deals we've seen in months, showing that lower-rated companies are better able to raise capital and that investors are increasing their appetites for risk. And this week the National Association of Home Builders said its housing index sentiment measurement jumped by more than 50% over the past month, as builders grew more optimistic given low mortgage rates and government home-buying incentives. Some said that was a sign that the housing market could be nearing -- or even at -- a bottom.
Of course, the rays of light have been matched by some more clouds. While sentiment in the homebuilding industry rose, it did so as the government reported a 10.8% decline in new housing starts for the month of March, reversing trend after a big jump upward in February. Industrial production also fell 1.5% in March, the government reported this week, as industry continued to contract, while retail sales dropped 1.1% in March, failing to build on the gains of the two previous months.
Another concern: commercial real estate. Yesterday, General Growth Properties -- the U.S.'s second-largest mall operator -- filed for bankruptcy amid a weakening commercial real estate market. How widespread problems in that market become is something to keep an eye on.
All in all, however, the news of the past two weeks involved enough signs of potential stability and recovery to keep investors feeling bullish. The S&P 500, Dow Jones Industrial Average, and Nasdaq Composite all posted gains for the fortnight, and the Hot List also had a solid two weeks, gaining 6%. That puts the portfolio back in the black for 2009, up 3.4% vs. the S&P's 4.2% decline. Since its inception almost six years ago, the Hot List has gained 69.6%, while the S&P remains well in the red, down 13.5%.
This rebalancing, the Hot List is making some minor changes, and taking some major profits. It's selling three stocks -- The Dress Barn, on which it made a 70% profit in less than three months, as well as Exxon Mobil and Lufkin Industries. The portfolio is replacing those with a couple industrial-type stocks (Lincoln Electric and Kennametal) and an oil services company (BJ Services). All three of the new stocks have exceptional fundamentals, getting approval from three of my most successful Guru Strategies: those I base on the writings of Benjamin Graham, Peter Lynch, and Kenneth Fisher.
The Road Back
The fact that the market continued to push upward these past two weeks and didn't give back the huge gains it made over the previous month was no doubt a good sign. And there are some real indications that this move could stick. As Francois Trahan of the research firm ISI Group recently noted, the current bullish turn is the fifth 10%-plus gain we've seen during this nasty bear -- but the first that has been accompanied by an increase in leading economic indicators. "This is not just an oversold pop like the other ones," he told Consuelo Mack of WealthTrack. "This is one that is about better economic prospects down the road. So I think it's legitimate, essentially is the way to think about it. And I think it's the first inning of something that's going to last quite a while."
That doesn't mean the road to recovery will be an easy ride, and there are certainly other strategists who don't share Trahan's view. With more earnings reports to come -- not to mention the first round of bank stress tests in the coming weeks -- a lot could change in the short term. Nothing guarantees that the economy will keep gaining traction, or that the market will keep gaining ground (doomsday-sayers like Nouriel Roubini and Peter Schiff won't let us forget that). Investors should continue to keep in mind that the depth of breadth of the crisis (i.e., the depth and breadth of the deleveraging and unwinding of bad debt) are great.
But while it will take time, I continue to believe that the economy will recover, and recover fully, and that we are not headed into some sort of financial apocalypse that will decimate stocks for the long term. Some great data on this topic comes from Ben Inker of GMO (the investment firm of Jeremy Grantham, whose name I've referenced in other Hot Lists).
In a recent report, Inker writes that the he believes the current economic conditions are, in fact, temporary -- not permanent. In justifying his view, he highlighted the long-term productivity of the economy, and the long-term dividend stream that stocks have provided investors throughout history. Both, he says, have proved quite stable over the long run, and have shown a clear tendency to revert to a mean, even after terrible crises.
To understand why such mean reversion occurs, one needs to understand just what the economy is, and how it works. Writes Inker, "The productive capacity of the economy comes from the skills and size of the workforce and the country's accumulated intellectual and physical capital. If GDP were to fall by 5%, it would not be because our ability to produce goods and services had fallen by 5%, but because aggregate demand for those goods and services had fallen. When the demand returns, the economy will be able to ramp up production quite quickly."
As proof, Inker points to the Great Depression. GDP dropped 25% from 1929 to 1933, he says, a staggering decline. "But that fall, as extraordinary as it was, was a fall in demand relative to potential GDP, not a fall in the economy's productive capacity, and so the economy eventually got back onto its previous growth trend as if the Depression had never happened."
There are more extreme examples of economic production reverting to a mean in other countries. World War II, for example, caused incredible devastation in Germany and Japan. But, Inker says, that devastation eventually left the German and Japanese economies "without a noticeable trace", as GDP recovered and settled back into the long-term trend it had been on before the war.
Inker's conclusion, with regard to American economic production: "If the Great Depression and two world wars failed to materially change the long run path of GDP or dividends," he says, "then it seems that the safest assumption is that the credit crisis will not, either."
I agree. As I've noted in past newsletters, David Dreman and Jeremy Siegel have both presented similar evidence on the resiliency of both the U.S. economy and stock market. Dreman, you'll recall, found stocks showed a remarkable ability to bounce back following traumatic events, including wars and presidential assassinations. Siegel's data showed that, over more than two centuries, the stock market has continued to revert to after-inflation returns of 7%. That covers a period in which huge changes -- the Industrial Revolution, the introduction of the automobile, airplane, television, and Internet, the rise and fall of many different nations -- occurred throughout the globe. I think Inker's data and observations build on Siegel's and Dreman's findings about the resiliency of the economy and stock market.
If you believe, as I do, that we'll make it through this crisis without some sort of irreparable harm, the question for the long-term investor thus centers on one thing: value. And I continue to see quite a bit of it in the market. Could valuations get cheaper? Of course. While stocks are cheap based on measures like the 10-year P/E ratio, stock market value/GNP ratio, and Tobin's Q, they are not as inexpensive as they've been at the bottom of past downturns, such as 1932 or 1982. Many are waiting for stocks to turn back down and reach, or come close to reaching, those all-time low levels. Will they? It's a close-to-impossible question to answer, particularly in light of the fact that this downturn involves an unprecedented multi-trillion-dollar government stimulus plan, the full impact of which is yet to be seen.
The bottom line is that when stocks are cheap compared to historical standards, it's a good time to buy. And, while they might not be at all-time lows in terms of valuations, stocks are cheap -- and may actually be cheaper than you think. That's what Siegel said in one of his recent columns, in which he contended that Standard & Poor's inaccurately calculates the earnings of the S&P 500. Siegel has taken some hits in the media lately as buy-and-hold strategies have been criticized, but I continue to respect his opinions, both because of his long-term, data-driven approach and his sharp intellect. And in regard to the earnings issue, he raises an intriguing point.
Siegel notes that S&P calculates the price of the S&P 500 index by a market-cap-weighted formula. The greater the company's market value, the more impact its price movements have on the index. In calculating earnings, however, S&P weights all earnings equally, simply adding up each of the 500 companies per-share figures. "as a result," he writes, "the billions of dollars of losses racked up by, say, AIG, whose market value is extremely low, is added dollar for dollar to the earnings of the profitable firms, such as Exxon Mobil, whose market value is more than 20 times larger." S&P's methodology [gives] far too much influence to firms with big losses and low market values, and thereby gave a distorted valuation to the S&P 500 Index."
S&P says reported earnings for the index for 2008 were just $14.97 per share, Siegel notes, which means the S&P 500 index was selling at 53.3 times earnings as of March 31, when it was valued at 798. Using Siegel's market-weighted earnings method, the index's reported per-share earnings would be $71.50, making for a P/E of just over 11.
Using operating earnings, S&P said earnings per share for the index were $49.49 in 2008, resulting in a 16 P/E ratio as of March 31, Siegel says. Using his method, operating earnings were $79.40 per share, making for a P/E of 10.
One interesting point in all of this: "Back in 2002 the aggregate earnings of the S&P 500 Index also plummeted when a few firms, such as AOL and JDS Uniphase, took huge writedowns on some of their Internet investments," Siegel writes. "Reported P/E ratios soared into the 60s in the second quarter of 2002, yet rather than being overvalued, the market was just approaching its bear market low."
Could we have just come through a similar scenario? Let's hope so. But I think there's a broader point here, that being how the debate between Siegel and S&P (which has tried to refute his argument) highlights just how hard it is to pinpoint an exact valuation for stocks, and for the market as a whole. Can you get a general idea of the market's valuation? Sure, by examining historical data and using any number of valuation metrics, like the 10-year P/E. But there's a margin of error in any valuation assessment. (In fact, in the GMO report I referenced earlier, Inker estimates that about half of the market's "intrinsic value" comes from cash flows that will occur more than 25 years out into the future.) That's something to keep in mind if you're waiting for those "all-time low" valuations to appear before jumping into stocks.
I won't be. Stocks are cheap by a number of historical standards, and history shows that investors who buy at times like these far more often than not end up with excellent long-term returns. Could that mean some short-term losses if the market does, in fact, turn around and head lower? Yes. But to me, the alternative -- missing out on a big chunk of a bull market surge -- is a far more dangerous proposition.
|Editor-in-Chief: John Reese
As we rebalance the Validea Hot List, 3 stocks leave our portfolio. These include:
The Dress Barn, Inc. (DBRN), Lufkin Industries, Inc. (LUFK)
Exxon Mobil Corporation (XOM).
7 stocks remain in the portfolio. They are:
Ameron International Corporation (AMN), Ceradyne, Inc. (CRDN), Fossil, Inc. (FOSL), Jos. A. Bank Clothiers, Inc. (JOSB), Schnitzer Steel Industries, Inc. (SCHN), World Fuel Services Corporation (INT)
Oil States International, Inc. (OIS).
We are adding 3 stocks to the portfolio. These include:
Bj Services Company (BJS), Kennametal Inc. (KMT)
Lincoln Electric Holdings, Inc. (LECO).
Newcomers to the Validea Hot List
Lincoln Electric Holdings, Inc. (LECO): This 114-year-old welding specialist makes a variety of industrial-type products, including arc welding tools, robotic welding systems, and plasma and oxyfuel cutting equipments. Based in Cleveland, it has a presence in more than 160 countries, more than 9,000 employees, and has taken in almost $2.5 billion in sales in the past year. It has a market cap of about $1.5 billion.
Lincoln gets approval from three of my Guru Strategies -- those I base on the writings of Peter Lynch, Benjamin Graham, and Kenneth Fisher. To find out why, see the "Detailed Stock Analysis" section below.
Kennametal Inc. (KMT): Based in Latrobe, Pennsylvania, Kennametal makes industrial tools and tooling systems, including products involving tungsten carbide powders, high-speed steels, ceramics, industrial diamond, and other materials that are highly durable and heat resistant. The 71-year-old company's products are used by firms in the aerospace, auto, construction, power generation, and oil and gas industries, to name a few. Kennametal ($1.4 billion market cap) is represented in more than 60 countries, and has taken in more than $2.7 billion in sales in the past year.
Industrial-type stocks have been hit hard during the global economic slowdown, but three of my models say Kennametal has been hit too hard. Like Lincoln Electric, the stock gets approval from my Benjamin Graham-, Peter Lynch-, and Kenneth Fisher-based approaches. Scroll down to the "Detailed Stock Analysis" section below to find out why.
BJ Services (BJS): Based in Houston, BJ Services provides field development and production enhancement services to the energy industry, with particular expertise in shale fracturing for oil and gas firms trying to tap into shale oil and gas wells. It also deals with industrial chemicals and commissioning, and inspection of refineries, pipelines and offshore platforms. BJ has more than 18,000 employees across 50 countries, and over the past year it has taken in more than $5.5 billion in sales. The firm has a $3.4 billion market cap.
BJ Services is yet another stock that gets approval from my Benjamin Graham-, Peter Lynch-, and Kenneth Fisher-based models. To see why, check out the "Detailed Stock Analysis" section below.
News about Validea Hot List Stocks
Jos. A. Bank Clothiers (JOSB): Bank announced on April 8 that its fiscal full-year profit rose 16 percent on the strength of increased sales, despite a woeful retail environment. Bank's earnings for the year ending Jan. 31 were $58.4 million, or $3.17 per share, up from $50.2 million, or $2.72 per share, a year earlier, the Associated Press reported. Sales jumped to $695.9 million from $604 million, as same-store sales rose almost 9 percent, AP stated, adding that analysts expected net income of $3.06 per share on revenue of $674.8 million. Shares soared more than 25 percent from April 7-April 9.
Kennametal Inc. (KMT): On April 15, Kennametal announced that it had cut its fiscal third-quarter profit estimate, due to a worse-than-expected downturn in global markets, Reuters reported. The firm now expects earnings per share of about 1 cent, excluding charges, for the quarter ending March 31. It had forecast profit of 5 cents to 15 cents a share before items back in January, and analysts expected earnings of 5 cents, according to Reuters. Shares fell about 7 percent, but are still up more than 25 percent over the past month.
The Next Issue
In two weeks, we will publish another issue of the Hot List, at which time we will take a closer look at one of my individual Guru Strategies. If you have any questions, please feel free to contact us at email@example.com.