Major Brand Names Still Not Confirming
(September 8, 2005)
Dear Subscribers and Readers,
We switched from a neutral position to a 25% short position in our DJIA Timing System on the morning of July 14th at DJIA 10,616. As of Wednesday at the close, the Dow Industrials stood at 10,633.50 - putting us at a slight loss of 17.50 points. The market was oversold and it was ready to rally - but this author is still more skeptical than most. In a perfect world, we would have covered our 25% short position in our DJIA Timing System at a respectable gain on Friday or even go long. However, keep in mind that the recent bottom in the last couple of weeks occurred in the face of only a semi-oversold condition - suggesting that any upcoming rally will remain weak. Moreover, the action of the major brand names (please see our April 24, 2005 and July 7, 2005 commentaries for previous discussions of this theme) is still not confirming the recent rally - which is really the main gist of this article. For now, the most recent rally in the equity markets have actually rendered some of our indicators semi-overbought, including the percentage of stocks in the NYSE above their 20 EMAs, and the VIX, etc. We will continue to remain 25% short in our DJIA Timing System until further notice.
What's New: While not all our subscribers are fans of globalization or Thomas Friedman, I would highly recommend reading his latest work: "The World Is Flat: A Brief History of the Twenty-First Century." If anything, it is a very easy and entertaining read. Please see our latest review of the book in our Favorite Books section.
Here is a thought to start our commentary: During my younger days, I used to be a fan of the PC strategy game genre - with an affinity to titles such as "Civilization" and "Romance of the Three Kingdoms." The thought of virtually building a global empire or conquering ancient China had always been fun, but ever since my younger days, I have always been a cautious one. Before I would conquer a city or a state, I would always make sure I have overwhelming force and/or technology - such that winning would always been a foregone conclusion. Alas, this is not what goes on in the real world, but I think having this trait has allowed me to excel in the stock and financial markets (at least whenever I dispassionately analyze the situation anyway). Most of the time, succeeding in the stock market just requires a lot of patience and taking advantage of the opportunity when it finally comes. It also means being able to gauge all the different probabilities and weaving them altogether in a coherent manner. That is, one would only want to speculate when one has virtually all the factors lined up in his or her favor. And it means having patience. Lots of it.
Readers who read our commentaries and frequent our discussion forum should know that one of our favorite discussions is the performance of the housing market over the last few years. Why? Well, for one, the housing market in various regions of the United States is highly overvalued on a historical basis. But more importantly, the housing market has been directly (e.g. 40% of all new jobs created since the 2001 recession is related to the housing market) and indirectly (according to the IMF, the "wealth effect" from the rise in housing prices is twice as more effective from the rise in equity prices) responsible for both economic and job growth since 2001. Why is this important, you may ask? Well, in every bull market, there is always a sector responsible for carrying the economy - and a sector that captures the public's imagination. Automobiles and radio was all the rage in the 1920s. Conglomerates in the 1960s. The Nifty Fifty in the early 1970s. Internet and telecom in the late 1990s. And now the homebuilding stocks - which collectively as a group is a reflection of both the health and the speculative interest in the housing market. While the Dow Theory has withstood the test of time, it may be too simplified a theory to use on a stand-alone basis. Combined with a theory that also looks at the leading sectors or stocks of the economy, however, it is unbeatable. And no doubt the leading stocks to watch today are the homebuilding stocks.
I would save my readers the effort of going through the charts. But a cursory look at the five homebuilding stocks in the United States with the largest market capitalizations (LEN, KBH, DHI, CTX, and PHM) shows that they are all trading at or below their 50-day moving averages. The action of the homebuilders has been surprisingly weak - given that the market has not suffered any bouts of serious selling since April and given that the yield of the long bond has stayed relatively low. The questions to ask are: Is the bull market in homebuilders and in the housing market about to exhaust itself? Is the continuing hike in the Fed Funds rate and the subsequent cost of holding an adjustable-rate mortgage proving too much for homeowners or investors (this will reinforce the belief that the bull market is about to exhaust itself)? Readers should note that one of the biggest homebuilders in the country, Hovnanian Enterprises, just announced an earnings miss earlier tonight at the close. This is the first time a major homebuilder has missed in awhile. Is the housing market turning? If so, then this would not be good for the major market indices either.
Please continue to vote in our latest Market Poll on the U.S. Housing Bubble: This week's question is: Is the U.S. housing bubble finally topping out? Please be objective and don't let our opinions change your minds! Also, note that a "slow down" does not mean U.S. housing prices will in general collapse from here. Rather, various commentators are just calling for a flattening of the recent appreciation in prices in markets such as Nevada, Arizona, California, etc. Please vote as well as let us know what your thoughts are by replying to our post in our discussion forum.
The annual list of the Top 100 Global Brands was recently released by Interbrand.com in conjunction with Business Week. This article is a must-read. For those who are unfamiliar with our work on brand names, please refer to our initial April 24, 2005 commentary "The Importance of Brand Name Watching" on this topic. In that article, I stated: "Readers who are familiar with our work could probably recall the tremendous amount of importance I put on the concept of "a brand name" when it comes to evaluating a company or an investment in a company. A brand name is part reputation, part familiarity - not to mention the unquantifiable/psychological thrills that a consumer gets when he or she purchases something that bears his or her favorite brand name (such as a Porsche or a LV handbag). The concept of the brand name first arose with the advent of advertising and mass media in the 1930s - further compounded by the advent of the 40-hour work week - which allowed consumers more time to enjoy the things that they bought (it is not a coincidence that Disney was founded during this time - as people were working too much to watch cartoons prior to the 1930s and as its major asset was its brand name). For readers who are interested in reading more about "branding," you can surf to the Interbrand.com website . One of the important theses of this week's commentary is this: In a healthy, cyclical bull market, the shares of most of the biggest brand names or the fastest-growing brand names in America should be doing extremely well - i.e. the relative strength (vs. a major index such as the S&P 500) of most of these companies should be rising. At the very least, the share price of these companies shouldn't be falling."
While watching the homebuilding stocks (and indices such as the Philadelphia Bank Index) is important, this author believes that the bull market is just not sustainable without the participation of major brand names - the companies which have helped found the modern economy and who are still responsible for driving the global economy. These companies include global brand names such as Coca-Cola, Microsoft, IBM, GE, Intel, Nokia, Toyota, Sony, Samsung, BMW, Louis Vuitton, HSBC, UPS, SAP, Apple Computer, eBay, Google, and Starbucks.
As measured by Interbrand.com, the top ten list actually does not change much this year. Nokia moved up two places from No. 8 to No. 6 while both Disney and McDonald's declined one place, to No. 7 and No. 8, respectively. The rest of the top ten list does not change. More importantly, the top five list actually remains the same from last year. This list contains (in order of most to least valuable) Coca-Cola (KO), Microsoft (MSFT), IBM, GE, and Intel (INTC). Comparing the recent action of these five stocks to their action back in late April and early July, one will find that there has been a general slight improvement. However, the gist of this message does not change. That is, the performance of the major brand name stocks is still not up to par. Whenever this is the case, any rally in the stock market should be treated with caution - as this means (especially when combined with the fact that both the homebuilders and financial stocks are underperforming) that the market is driven by fads and hope more than anything else. Unlike our previous "brand name" commentaries, I will not throw in a discussion of other up and coming brand names - on the basis that my personal favorites may be too biased. I will attempt, however, to take a look at my personal brand name list during this weekend's commentary instead.
As mentioned earlier, the most valuable global brand name remains that of Coca-Cola's (KO) - where approximately two-thirds of its value (according to Interbrand.com) is derived from its world-renowned global brand name. KO was truly the first global company - having operations in most of the world's countries before Thomas Friedman was even born. The following paragraph from Mark Pendergrast's "For God, Country & Coca-Cola" contains a famous anecdote about the wide-reaching arms of Coca-Cola - even in Germany during World War II:
In early 1945, a group of German prisoners of war debarked in Hoboken, New Jersey, apprehensive and lonely in a foreign land. When one of them pointed to a Coca-Cola sign on a nearby building, the prisoners began excitedly gesticulating and talking among themselves. Taken aback, the guard yelled for order, demanding an explanation from a prisoner who spoke English. "We are surprised," he answered, "that you have Coca-Cola here too."
Such a global reach - especially during the dark days of World War II, is no small feat. This is the main reason why KO remains the number one global brand name today - with a market value of $67.5 billion. As we also mentioned in our July 7th commentary: "Moreover, its Coke bottlers aside, KO has one of the best business models around, as it is mostly a syrup producer and manufacturer and has a return to equity ratio of more than 30%. Like I said in our April 24th commentary, however, the more immediate point is the fact that KO (regarded as a growth stock at the time - just after the legendary CEO, Robert Goizueta, died in 1997) actually topped out in early 1998 at the same time the NYSE A/D line topped out - signaling the imminent end of the great secular bull market from December 1974 to early 2000." Following is an update of the chart that I posted in our April 24th and July 7th commentary - a weekly chart of KO (along with relative strength vs. the S&P 500) dating back to January 2002
(courtesy of Decisionpoint.com):
Please note that KO actually topped out relatively early in this cyclical bull market - at a price of approximately $52.50 during April 2004. Even with the most recent bounce in the stock price, the stock is still nearly 15% below the price that it was in April 2004. This is consistent with the action in KO during the late 1990s bull market - when KO topped out approximately two years before the peak of the S&P 500 and the NASDAQ (and 21 months before the peak in the Dow Industrials). While I do not believe the cyclical bull market has ended yet, the fact that KO has been significantly underperforming during the last 16 months tells me that we are very close - give or take six months.
The second name on our Top five list is MSFT - the leading in operating systems and in office productivity software. The competition in the internet search market and in collaboration software is still ongoing - and whether MSFT can continue to be the dominant player going forward is an open end question. However, MSFT has beaten many formidable players in its short 30-year history - and at the same time, its financials continue to be impressive, with annual revenue at close to $40 billion with an ROE of approximately 20%. The following weekly chart signals an improvement since our July 7th commentary, but the action continues to be frustrating, especially for a software company with such high margins and domination of the world PC market:
Whatever happened to the $30 stock price that many analysts were calling for in light of the huge one-time dividend that was announced at the end of last year? The bulls continue to be frustrated, even as MSFT made a new rally high in late July. Note that MSFT was essentially trading at $27 a share in September 2003 - meaning (one-time dividend not withstanding) that the stock hasn't really moved much in two years. As we said in the above chart, relative strength vs. the S&P 500 continues to be dismal.
Since the early 1990s, the company has continued to re-invent itself in order to first survive and then to thrive. Today, IBM is no longer a computer company - but mainly a global services, IT outsourcing and software company. In today's globalized world where outsourcing is all the rave, IBM should be one of the main benefactors. Actually, it is - so why has the stock been underperforming since December 2004?
While the bounce above its 20-week moving average during July is encouraging, the fact that the third most valuable global brand name is still underperforming and is 20% below its most recent rally high should be a cautious sign for anyone wanting to go long here. With a forward P/E of less than 15, IBM should offer a compelling value - so why aren't investors biting? And if investors are not biting into IBM shares, what does that say about the broad market in general?
The following weekly chart of GE certainly speaks volumes. Judging from the following chart, readers can easily see that the conditions at GE have continued to deteriorate since both our April 24th and July 7th commentaries. Note that the stock is now trading near a ten-month low and has convincingly broken below both its 20-week and 40-week moving averages:
As the above chart mentioned, the fact that the 20-week moving average has again declined below its 40-week moving average is a significant development - given that GE is the second largest company in the world (by market capitalization behind Exxon Mobil) and given this hasn't happened since the end of the last cyclical bear market during May 2003. That is, the 20 WMA of GE's share price has not declined below its 40 WMA at any time since the cyclical bull market began. Could the recent breakdown of GE be signaling the imminent end of this cyclical bull market? Time will tell.
Surprisingly, this is the first time we are covering Intel in our "brand name watching" articles - but this does not make it less important. In fact, readers should keep in mind that Intel supplies over 80% of the world's computer processors, as well as serving as a benchmark for the global semiconductor industry.
The performance of Intel has more or less tracked the performance of the Philadelphia Semiconductor Index during the last 20 months. That is, the performance of Intel has been relatively dismal - suggesting that investors are still ignoring the proven, brand name stocks in favor of mid caps, small caps, and energy stocks. Going forward, this should continue to be the case, although the recent breakdown of the homebuilders has removed a significant pillar to the bull's case. Readers who keep an eye on the futures market should also note that the October contract for lumber closed down $10 yesterday (limit down).
Conclusion: Looking at the dismal performance of the major brand names in the last 12 to 24 months, this author is still signaling "caution." This is all the more important given that the leading sector (homebuilding as well as the housing market) of the stock market and the economy is now losing steam. I will attempt to look at more of these brand names in next weekend's commentary - most probably brand names I have covered before but which should also include new ones, such as Citigroup (the most valuable brand name in financial services) and Nokia (the most valuable brand name outside the U.S.). For now, we will remain 25% short in our DJIA Timing System - and possibly looking to go 50% short in the coming weeks should the major market indices continue to rally during that time.
Henry K. To, CFA
P.S. Please participate in our latest poll on the U.S. Housing Bubble.