Friday, January 23, 2009

Stock Market Update--Things Are Differenter Than They Seem

On the surface it would appear that the stock market has picked up in 2009 right where it left off at the end of last year.
After closing 2008 down by almost 40 percent, most of the market averages have remained weak during the first few weeks of the new year.

It was supposed to be different. I was among those who believed that the downward pressure on stocks during the fourth quarter was exacerbated by forced selling due to liquidations from hedge and mutual funds. That selling is now over and there should be fresh money coming into the market from retirement and 401-K plans--new cash that should provide some demand for stocks. Those factors have seemingly been overwhelmed by the uninterrupted flow of terrible economic news and ongoing concerns regarding the viability of the world's banking system and the markets have continued to fall.

While this might look like more of the same, in fact there are a number of important differences between what's going on now and what happened late last year.

First and foremost, in this market there are actually stocks and sectors that are doing well. I have structured my accounts around two basic themes which seem to be working. The first is that at some point, the market will start to focus on the inflationary implications of the trillions of dollars the government is spending that is not backed by tax receipts. In other words, we are running the printing presses at warp speed to stimulate the economy and keep the banks afloat but the paper being printed is backed by nothing. Our theory is that investors will start to favor hard assets over pieces of paper and we have built positions in gold and energy-related assets which have started to perform very well.

The second theme is that not all companies are created equal. Most of the calls I get are from clients who either want to get out of the market altogether or who want to bottom fish among broken stocks such as Citigroup, Bank of America, and General Motors which have lost more than 90 percent of their value and are trading at the cost of a Happy Meal. I believe that both groups are making a mistake.

We are focusing on solid, cash-rich companies that continue to deliver solid earnings selling products or services that people either want or can't do without. Amid the spate of recent earnings disappointments have been buried great reports from Procter and Gamble, Research in Motion (the maker of Blackberry), Apple, Google, Becton Dickinson (diabetes syringes), Kinder Morgan (natural gas pipelines), IBM, McDonalds, Pepsi, Clean Harbors (waste disposal), Johnson and Johnson, Exxon, and other companies that are cash-rich, have little debt, and seem well-positioned to deliver even higher earnings and dividends going forward. These companies and others like them are down in price and likely to be the true bargains going forward. I'd be happy to share my entire model portfolio with you and talk more.

Many formerly great U.S. banks and companies are on the critical list because they are losing so much money and are so buried in debt that their common stock may no longer have any value at all. The "bailouts" that we hear so much about are rescue packages for their creditors and customers--not for the poor souls who own their common stock. Don't be fooled. If a company is determined to be too big to fail, it doesn't mean its shareholders will not lose all their money.

None of my portfolios contain any long-term U.S. Government bonds which lock in yields in the 2-3 percent range over a 10 to 30 year period. They provide virtually no upside and are very likely to provide investors with low returns that will be paid back over time in dollars that may buy a fraction of the goods and services that they would buy today. It seems very likely that long-term rates will be going higher--perhaps a lot higher--over time and that the value of long and intermediate term bonds and bond funds could drop significantly if that happens.

It is ironic that most people who have gravitated to U.S. government bonds did so to seek a high level of safety. Given the low returns that are being locked in and the likelihood of rising interest rates, they are actually making a very risky investment. High quality municipal and corporate bonds are much better alternatives on a risk adjusted basis. For those who are willing to accept a very low return in exchange for a government guarantee, my advice is to stay as short term as possible and stick with CDs and money market funds. These are not rates that should be locked in for any period of time.

I am more convinced than ever that this is not a time to be bullish and it's not a time to be bearish. It's a time to be smart. There are great risks out there but there are also outstanding risk-reward opportunities.


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