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St. Patrick's Day and the Dash for Trash

(Guest Commentary by Rick Konrad – March 18, 2010)

Dear Subscribers and Readers,

For those who had want learn more about picking stocks, evaluating companies, industry trends, and other issues related to the stock market, we have brought in our regular guest commentator, Mr. Rick Konrad for a guest commentary.  Rick has been a regular guest commentator for a few years now and offers his unique insights to us in his twice-a-month mid-week commentaries.  We highly appreciate your investment insights and general wisdom, Rick!

In this commentary, Rick discusses the state of the U.S. stock market and provides us a good perspective of the current bull market relative to past recoveries.  While Rick argues that the current recovery is similar to those of the past, he also points out that there are some signs of short-term excesses, such as the excessive trading in stocks like FNE, FRE, AIG, ABK, and MBI, as well as the general overbought condition in the S&P 500.  Without further ado, following is Rick's biography:

Rick is author of the excellent investment blog “Value Discipline,” founder of “Value Architects Asset Management”, and is a regular guest commentator on MarketThoughts.com (please see "Traits of the Successful Investor, and the Changing Nature of Brand Loyalty" for his last guest commentary).  Prior to his current role, Rick has been a professional portfolio manager for institutional investors for over 25 years.  You can view a more complete profile of Rick on his blog.  You can also email Rick at the following address should you have any questions or thoughts for Rick after reading his commentary.  Rick is a very genuine teacher of the financial markets and treats it very seriously.  Case in point: Rick has also been responsible for running the education program for the CFA Society in Toronto (which is the third largest CFA society in the world besides the New York and London Societies) and had also been involved with grading CFA examinations.

Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice.  Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.


Happy St. Patrick's Day! Here's hoping that the luck o' the Irish blesses your portfolio and that you stumble upon the proverbial pot of gold this year.

Clients still find it difficult to believe their good fortune in riding a bull market that though seemingly extended, seems to continue to rise in the face of this skepticism, particularly from the depths of the last two years.

Admittedly, there are signs of excess. The Russell 2000 for example has smartly outperformed the S&P 500 so far this year being up 8.6% as of last night versus 4.0% for the large cap index. Despite numerous investment strategists declaring the relative cheapness of large cap names, the quest for smaller cap stocks seems intact. The dash for trash seems to be prevalent with many low priced stocks dominating market volume. AIG, Citi, MBI, ABK, CT, FNM, FRE, and MPG all have shown considerable volume and robust recoveries from the low. The credit markets are looking better and perhaps the nuclear scenario is off the table. For these credit related companies, if the securitization markets are supportive, equity capital is starting to flow to these weakest players.

Citi in my view is the most plausible of these “garbage” stocks, and is finding respectability at the same time that Vikram Pandit seems to finally be receiving some credit for his strategic plan. Who can argue with the imprimatur of ownership conveyed by John Paulson with 3.5% portfolio exposure to the name, Dan Loeb with 8.2% or Bruce Berkowitz at 7.1%. However, since the beginning of the year, Citi has traded a total of 24.25 Billion shares, which relative to the float of 20.75 Billion seems far less active than it feels.

MBIA (MBI) on the other hand has traded some 2.1 times its float so far this year, and having heard its former major shareholder, Marty Whitman of 3rd Avenue Funds declare this to be one of his “stupid” investments in front of the Columbia Business School Investment Association crowd a few weeks ago. Last year, Marty expressed his disgust:

“What's particularly shocking in MBIA's case is that management has not only materially harmed existing creditors and policyholders, but in my opinion it has made it so no one in the financial community is ever going to want to do business with them again. More fundamentally, given how worried we were about the health of the housing market in 2007, we should have recognized how a collapse there would impact MBIA. I thought the municipal bond guaranty business was so good that it would overcome any problems elsewhere. That obviously has not turned out to be the case.”

It seems the future for the mortgage insurers (MBI and ABK) at this point is dependent on the legal system. Private mortgage insurers are refusing claims based on warranty breaches and mortgage securitization trusts (MBS and CDO) and attempting to force securitization issuers to buybacks for the same reason. In my view, far too much uncertainty! Some years ago, describing a similar legal battle, I described, unfortunately in my vernacular, “in a pi$$ing contest with lawyers, investors generally end up with wet shoes.” It's just too dangerous in my view.

So how different has this recovery been compared to the past? Is it really that terribly extended? In a Citi Global Strategy piece published today there is a most interesting chart:

Equity Market Falls Against Subsequent 12m Recoveries (%, Local)

The MSCI World fell 56% from its October 2007 high to the March 2009 low. The 63% rebound in the 12 months following the bear market bottom is consistent with past relationships. Though we may quibble about the nature of the fundamental recovery in the economy, or to what degree corporate earnings are going to recover, the equity market recovery has taken on the V-shape that it always has. For all the talk of a “new normal,” this market looks decidedly like other recoveries.

Looking at the recovery through the eyes of the Duke University CFO Survey issued earlier this month also provides some useful insight into the outlook.

Chief financial officers in the United States expect strong growth in business spending and earnings this year, but plan only modest hiring and the continued outsourcing of jobs. And several significant risks remain, including tight credit markets, weak consumer demand and decreasing inventory levels.”

Earnings are expected to rise some 12 to 14 percent and capital spending will increase 9 percent in the next 12 months. Research and development and tech spending will increase 4 percent. This marks the first positive movement in these categories in more than a year. To put this in perspective, the increased business spending follows years of belt-tightening and is therefore growth from a relatively low starting point.

Working capital management has exceeded most expectations in this recovery. Yet despite the re-stocking of shelves that has taken place in many sectors, the survey showed some surprising results:

“Forty-seven percent of U.S. CFOs say they will decrease inventory in the first half of the year, compared to only 15 who percent expect an increase. Inventories will decline as a result of supply chain improvements that allow firms to operate with lean inventory and because weak consumer demand has led to a glut of inventory for some products.”

Dividends and share repurchases were expected to grow in excess of 6% versus negative expectations for both just three quarters ago. Also surprising was the attitude of CFO's toward M&A. Fully 31% of CFOs expected to acquire another firm.

Here is a link to the summary of the survey:   http://tinyurl.com/yavgvms

CFOs seem quite content, albeit at levels of earnings growth that seem to be somewhat below Street expectations. Though happy about current year earnings prospects, they are at the same time concerned about the lack of consumer demand and government policy.

The smallest singular metric in the survey to show virtually no improvement was employment with expected growth rate over the next year at 0.2%.  Yet cap ex expected growth registered 8.9%.  Greater reliance on capital spending appears to be the game plan for large corporations ahead as opposed to labor deepening. 

The very same consumers who are paying the price for outstanding productivity and cost cutting that has supported corporate earnings expansion also need to continue deleveraging their balance sheets as the process has barely begun as Henry's Flow of Funds analysis has shown.  CFO's should indeed be worried about consumer demand, but near term reported earnings will keep this perhaps now structural issue at bay. With very easy comparisons in retailing versus those of the “near depression” first quarter of last year, I do not believe it is appropriate to have much weighting in retailers.

Perhaps yesterday's DSW conference call captured this theme. Same-store sales increased 12.9% for the fourth quarter vs. a decrease of 7.2% a year-ago. The significant mid-year turnaround in sales trend was a function of the consumer interest in value priced products and the overall turnaround in retail sales.

As management outlined in its downplayed guidance for 2010:

“So maybe to reframe that up, we do expect and as we said in the script, we believe that all of the earnings increase should be coming out of the first six months of the year, the first two quarters, and that's really based upon the fact that we did extremely well in the second half of the year and we have to be realistic. Also, we have to be realistic on the idea that the low single digit comps that we have during the year will likely be a higher comp in the spring season and a lower comp in the back half, simply because of the comparisons to 2009.”

DSW has dropped about 13% in the last two days.

Overall, we see some excesses as investors extrapolate the past into the hereafter. The S&P 500 is about 2 standard deviations over its 50 day moving average. Some of the retail stocks in particular seem quite extended. The SPY ETF is up 14 days in a row. Though I remain quite positive, particularly with a larger cap names such as AMGN, IBM, and MMM, some smaller names are getting a little pricey. It may be time for a bit of a breather.

Disclaimer: I, my family and clients may hold positions in some of the names mentioned in this post.

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