2008: A Disjointed Market

2 Jan

As I did last year, I wanted to set forth my views on the markets as we head into a new year. Again, I offer the caveat that predictions, in general, are worthless. The future is necessarily unpredictable. This doesn’t stop people from predicting that, for instance, the S&P 500 will end the year at 1,650 or that oil will top $150. I take a more measured approach, preferring to indicate ranges of possibilities rather than precise estimates. Note that I don’t trade based solely on these macro viewpoints, as I prefer to concentrate on individual names.

Let’s first consider what I said last year: I said I liked two of the Dow’s worst 2006 performers, a statement which is still true (though there are much better bargains out there than these). In fact, I like them even more than last year (since they’re cheaper), as Home Depot (HD)was the Dow’s second-largest decliner [after Citigroup (C)]. Wal-Mart (WMT) stayed about where it was at the end of 2006, but business value grew more than its stock price. I said domestic markets may do better than developed international markets. This was partially right: the MSCI EAFE was up 11.2% on the year in dollar terms, but only 3.5% in local currency terms. The S&P 500’s 5.5% gain bested the EAFE’s apples-to-apples return. But the dollar continued to decline (and help international investor returns) while I expected it to rise.

I still believe the dollar is due to rise. On a purchasing power parity basis against major currencies, the dollar is probably 10-30% undervalued. Of course, over long periods currency fluctuations even out, but the dollar has added to returns substantially over the past five years, and I don’t think that trend should be extrapolated too far into the future. Add that to the popular sentiment against the dollar – virtually all of it negative. Add also that a to-remain-nameless supermodel announced publicly that she no longer wants to be paid in dollars. When the least knowledgeable person or group appears, through the lens of popular sentiment, to be making a brilliant decision, it may be time to take a fresh look at the alternate scenario. I now believe it prudent to hedge back to the dollar, if possible. Several very good mutual funds, recently reopened, hedge their currency exposure.

Where is the stock market today? The spread between the forward earnings yield on stocks and the yield on 10-year Treasuries is about 1.6% at today’s levels. As I’ve mentioned in a previous post, this spread has averaged 0.4% but has varied between –4% and +7% over that time period as well. At this point, I would rather have my money in stocks than in Treasuries.

The worst performing sectors in 2007, Financials (down 20.8%) and Consumer Discretionary (down 14.3%), look to be the leaders over the next few years. Financial stocks look the cheapest and thus the most likely to rise from current levels. In addition, many of these stocks trade below book or at historically low premiums to book. Several consumer discretionary stocks, this year’s second-worst performing sector in the S&P 500, also look to be better performers in the year-ahead. Homebuilders may have a little farther to fall, but the risk-reward tradeoff is very favorable from here. I looked at one homebuilder recently that is generating a 25% free cash flow yield. Several REITs have been caught in the “financials” mess and now trade below book value while paying hefty dividends. I look to the beaten-down areas for future standout performers. I am choosing to stay away from some of the Nasdaq’s best performers such as Amazon (AMZN), Apple (AAPL), and Research in Motion (RIMM), which were up 139%, and 137% and 165%, respectively, in 2007. These stocks seem too popular to be cheap.

Utilities are probably priced too expensively for their fundamentals. Consider that the utilities sector has risen 121% in the past five years and is the second best performing sector in the S&P 500 over that period, after Energy, which is up 230% over that same timeframe. Consumer Discretionary, Health Care, and Financials, by contrast, are the worst performing, up 42%, 33%, and 32%, respectively, over the past five years. Continuing to bet on Energy, Utilities, and Materials seems to me to be more a bet on hope than on fundamentals. I could be wrong, but it is not within my circle of competence to project from where such high future returns will come.

The market, for the first time in a couple years, is quite disjointed. In 2004, 2005, 2006, the worst performing and top-performing sector were all positive and the spread between best and worst was between 34% and 16%. We had a pretty homogenous, steady march upward. In 2007 that changed, as the spread between the best performing (Energy) and worst performing (Financials) was 53%, with Energy up 32% and Financials down 21%. In such disjointed markets, it is likely that the best performing are expensive, the worst performing are cheap, or both (think technology in 1998-2000). In this case, I’d much rather dive into very cheap financials than ride energy and materials stocks on the hope that commodity prices continue to rise.

I, nor anyone else, can know for sure if a recession is coming. To be honest, I wouldn’t be surprised if one is already here, a feeling I get after reading third quarter earnings reports and listening to company conference calls. Jobs data, as a lagging indicator, has not yet declined to reflect this, and unemployment is still at a level many consider “full.” Two sectors – financials and consumer discretionary – probably already reflect recessionary conditions and thus stocks in these sectors should be hurt less by an actual downturn. The sectors that will really be hurt by a recession are precisely 2007’s winners – energy, materials, utilities and industrials. While utility companies will be okay, their stocks look to be pricing in uninterrupted, strong global growth.

In 2006, oil prices were essentially flat. This year they rose almost 30%. I think in 2008 we’ll average the year at a lower price that where we began. This is especially true if the worldwide economy really slows down. I don’t have any special insight into the marginal cost of production of a barrel of oil, but some very credible sources lead me to believe it’s now over $50 but under $70 per barrel (which is quite a bit higher than I thought last year). So somewhere in that range doesn’t seem like a bad place to consider as a fair price for oil. Regardless of the oil price fluctuations, I would like to see some of these oil companies trading at a 6 times earnings like we saw in mid-2006 again in 2008. But we’ll have to see if I get my wish.

What I am worried about is inflation and a lot of others are too (gold was up substantially in 2007, as were TIPS). Nevertheless, I think is healthy to worry about it because it is an ever-present threat to wealth. From what I’ve read, inflation (as measured by the CPI) if calculated the old way, would be substantially higher than at present (8-10% versus just 2-4%). This is not hard to believe. I see higher prices or similar prices but smaller packages (stealth inflation) almost everywhere I shop. Food price inflation is rampant in fast-growing countries like China and in the U.S.. I’m sure the artificial (read: subsidies necessary to survive) market for ethanol is playing a role here. I must note that deflation continues in certain areas, such as consumer electronics. Why worry about inflation? Higher (especially higher than expected) inflation means higher interest rates which leads to higher bond yields (lower prices) and may hurt stock market values. Companies with pricing power will be the best positioned. Also, real estate values tend to rise with inflation though it pays to be selective here.

Well, I’m sure I could write several more paragraphs on what I’m currently thinking but I’ll cut it off here. These are some overarching views on the year ahead. As usual, it is bound to be interesting. If your investments get cheaper and nothing fundamental has changed, buy more! Be greedy when others are fearful and fearful when others are greedy. Happy investing in 2008.

Disclosure: Long shares of C, HD, WMT.

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