Investing: The Outlook

It’s October 1, and in stock world, the day is about to go into the history books, because the Dow is about to close at a record high. With an hour an half of trading to go, the Dow is up 198 points to 14,093, besting the previous high of 14,0000 reached in mid-July.

If you had gone on vacation, and had turned a blind eye to the business news, you would think not much had happened in the last two and half months. You would be blissfully ignorant of the fact that a month and a half ago, the markets were in a freefall, panic was around the corner, and rumors of bankruptcy were the norm every morning. You wouldn’t even realize that the Fed (aka, the Federal Reserve Bank) had saved the day… by cutting the Fed Funds rate by 50 basis points. Even those of us that “lived” through it, that watched our stocks and the business news every nail-biting day, have begun to forget the dog days of August. Credit crunch? That was so yesterday. Much better to think about Christmas, the television’s fall season premieres, and Britney’s latest debacle (see, I can be hip).

And really, has anything changed? Pundits are proclaiming a fundamentally strong, albeit slowing economy. Predictions of a record year-end close for the Dow are common, and well, lots of portfolios look pretty happy (uh, with a sigh of relief, of course).

I think this is a good time to step back and look at the big picture. Something that’s always good to do – you know, always good to double check. But also good because, I think lots has changed. Especially if you look under the surface.

So let’s jump in, take a look at what’s happened, and where that takes us. But one caveat first. I’m not a prognosticator of any sort – “ no Dow predictions, no proclamations of whether the Fed will raise or cut. I don’t think that’s particularly useful, or accurate. It might be right for someone else, but for me, it’s kinda like trying to be a weatherman. Instead, I like to figure out trends, and as for figuring out where those trends lead? Well, that’s useful.

Where We’ve Been

You’ll remember that this whole thing started when Bear Stearns announced that two of their subprime related funds were in trouble. And after that, it was one domino after another. Things finally turned around when the Fed surprised the markets by lowering the Fed Funds rate 50 basis points to 4.75%, instead of the expected 25 basis points (by the way, they also lowered the discount rate, but for the moment, we’ll focus primarily on the Fed Funds rate. That’s the more important one).

If you’re watching on the sidelines, you’d be tempted to think that the Fed thought that the subprime problem was so bad that they had to do something. And I would argue that is not the case. In reality, there are two separate and distinct problems: subprime debt, and liquidity. Let me explain.

Businesses need money to fund their daily operations. Finance companies, such as Countrywide (the mortgage company), need cash to make new loans. Usually, these companies fund these operations with commercial paper, which is basically short-term debt backed by the credit or assets of the company.

So here’s the problem.

Let’s assume that Company A, like many firms, has invested in a bunch of securities. Within that basket of investments are some subprime investments. Before subprime became a problem, Company A would issue commercial paper backed by its investments (some part of which is subprime) to fund its normal operations. Then, Bear Stearns ran into trouble, and suddenly, the value of all subprime investments is called into question. And here’s the kicker – everyone knows that the value of subprime securities has dropped, but no one knows exactly how much. No one knows where the bottom is (that’s the subprime part).

And here’s the liquidity part.

If you are Company A, you’ve got a major problem, because now, no one wants to lend you money. Even though Company A isn’t a subprime company, it has subprime investments, and it’s trying to use those investments as collateral. Only thing is, nobody wants that collateral anymore. Ergo, no loans for Company A.

Step back from this, and now you can see the liquidity problem. All these companies, like Company A, want to borrow short-term money to fund their everyday operations, but they can’t, because no one wants to lend them money. In other words, the system of short-term lending isn’t working and this is what the Fed is worried about.

By lowering the Fed Funds rate, the Fed did two things for the market. First, the Fed, by reducing the cost of money, made more people willing to lend money to entities such as Company A. And second, the Fed is telling the market that it will do whatever it takes to keep the system greased.

And Now, The Implications… and Consequences

In the short term, you see the effect of the Fed’s action – “ the markets are calmer, companies are lending to each other and the markets are up. Yes, the system is working again. And hey, you might even go out for a few drinks, celebrate the new market high, and take some profits in stocks that have recovered.

In the short term we are happy. But we have to realize that the landscape, and the horizon, has changed. Keep in mind that what had driven the economy for the last few years has been cheap money, tremendous liquidity and international growth.

Cheap money fueled record buyouts, stock repurchases, hedge fund earnings and the housing boom. Now, much of that activity is barely what it used to be. Buyouts and stock repurchases will continue, but nowhere near the levels of the last couple years. Many hedge funds are pulling back, and well, we all know the story with housing.

Financials.

That means financials, which make up almost 21% of the market, will have a fairly long period of figuring out how to grow in this environment. Prime example: the investment banks. Their previous engines of growth – “ subprime securities, mergers and acquisitions, private equity, prime brokerage – “ have taken several steps back. And don’t forget, some of that subprime slime is still lurking in the shadows. For money center banks, such as Citigroup, the picture is mixed. The plus is that they’re large, diversified and will benefit from continued international growth. The flipside is that they still have to deal with the subprime fallout, expensive merger financing commitments, and evaporating deal markets. As for anything related to mortgages, I don’t think you need me to tell you to stay away. Unless you’re a really good bottom fisher, avoid mortgage companies like the plague. (By the way, I hold several financial stocks, including Citigroup, JP Morgan, Merrill Lynch and Morgan Stanley).

Housing.

Housing will continue to be a problem. Earlier this year, you would have heard people say that we might be close to the bottom, that the real estate market might turn by the end of the year. Now, even the homebuilders have thrown in the towel and admitted that things won’t look good for some time. Last week, Jeffrey Metzger, President and CEO of KB Homes, one of the largest US homebuilders, said, “We see no signs that the housing market is stabilizing and believe it will be sometime before the recovery begins.” I think we’re several years away from calling a bottom in real estate. Inventory is very high, credit is hard to get, and in major bubble markets, housing is still not affordable. Plus, you can expect more problems as adjustable rate mortgages continue to reset over the next few years.

Inflation & The Dollar.

You’ll remember that the Fed has been very concerned about inflation, and that’s why it was so reluctant to cut rates. In fact, everyone thought the Fed would only cut 25 basis points because the Fed, in previous announcements, had been so ardent about keeping inflation in check. By raising 50 basis points instead of 25, the Fed is saying that the current credit crunch, and the possible economic slowdown, is a bigger problem than inflation. That’s a reversal of their previous position.

While inflation has been pushed back on the agenda, that doesn’t mean it’s gone away. Oil is at $83 a barrel, and the cost of basic commodities is at all time highs. Illinois corn and soybeans are up 40% and 75% over the last year, and Kansas wheat is up more than 70%. The costs of barley, sorghum, eggs, cheese, oasts, rice, peas, sunflower and lentils are following. That means the price of all sorts of foods, such as bread, yogurt, popcorn, breakfast cereals, fast food french fries, milk, and everything that uses corn syrup as a sweetner, is up.

Lowering rates also makes the dollar less attractive to foreign investors, so the value of the dollar falls. Last week, the dollar, which has always been stronger than the Canadian dollar, reached parity with the Canadian dollar for the first time. Very simply, everything foreign, and everything imported, is expensive.

And eventually, lowering the Fed Funds rate will only exacerbate the inflation problem. Cutting rates is basically inflationary, so while the Fed solved a few problems today, in the longer term, it’s only going have to face the consequences of its actions.

The Consumer & Retail.

The consumer, with no stock boom, no real estate boom and tight credit, will not be the big spender he or she has been in previous years. On the expense side, increased prices of basic staples and oil can only force a pullback. And don’t forget, the sliding dollar will make the cost of all things imported higher. The consumer is going to get hit; several retail stocks have already warned that earnings will fall short of expectations.

Recession?

And now the kicker… a recession? The probability of one is increasing. Even Greenspan, and Richard Syron, the head of Freddie Mac, pegs the probability of recession in the 40-45% range. Put that together with inflation, and you have the possibility of stagflation, something not really seen since the 1970s and early 1980s. Now, as I said earlier, I’m not a prognosticator, so for the record, I’m not saying there will be either a recession or stagflation. Let’s just call it something to look out for (by the way, did they ever tell you never to end a sentence with a preposition?).

What’s Working

Emerging Markets, Commodities and Infrastructure.

So while the industries driven by cheap money are no longer as attractive, the international growth story remains compelling. Emerging markets, which include the BRIC countries (Brazil, Russia, India and China) and its variations, (which can include Mexico, Eastern Europe and Turkey), – “ remain solid growth stories. Likewise, commodities (farm products, metals, oil) and infrastructure plays (engineering and construction firms) continue to perform well. Companies with a significant portion of their income from abroad are also doing well. The problem: all these sectors have had a great run and are near multi-year highs. And as I’m sure you know, the higher something gets, the greater the likelihood of a correction. And no one knows whether the bull market in these stocks will last a day, a month or a year. Many would recommend taking profits in these stocks, or hedging a profitable position with puts to protect the downside.

Tech.

After nearly seven years in the ugly step child seat, tech is now back in favor. Upgrades, refurbishments, new technologies, and international growth are all driving renewed spending. Cisco’s chief John Chambers has been quoted as saying that it’s the best environment that he’s seen in years. Even through the chaos of August, one of the best performing sectors was tech. I own several tech companies, including Akamai, Anadigics, Cisco, Dell, Intel Microsoft and Oracle. I think tech still has a ways to go, and am holding on to my tech stocks.

Consumer Staples.

Another area that has seen strength is the secular consumer staples – “ the P&Gs of the world (which I own P&G, by the way). These are consumer products people always need and replace on a regular basis. These stocks grow at a solid and steady pace. In boom times, these stocks are often ignored, because other stocks have higher growth prospects. In times of uncertainty, or when the economy is likely slowdown, these stocks do well because they are defensive.

In August, you could have observed a rotation out the stocks that had been doing well (e.g., financials), into more favored sectors, such as tech and consumer staples. For most of the year, P&G’s stock floated in the $60-64 range, with a brief high of $66 in January to March of this year. In August, amid the market turmoil, P&G’s stock took off, and now sits at nearly $71. Truth is, there haven’t been major changes in the company; what’s changed is market sentiment toward the sector.

Looking Ahead

So, that’s it for a rapid fire review of trends. This is by no means comprehensive – “ I would be the last to claim to know all these industries, much less all these markets. Moreover, I’ve skipped several sectors. But keep in mind investing is about placing bets on what you know, or what you can understand. And placing some bets on a few things is all you need.

For me, I am happy to stay away from real estate and mortgage stocks. The financial stocks I hold I view as long term investments, so while I believe it’s no longer the growth sector that it has been in the last few years, they’re solid companies that can be held over time. Tech is also a fair portion of my portfolio; it has performed well in recent months, and I believe the trend will continue. As for commodities, oil and infrastructure, I’m cautious, and am looking for further evidence of continued growth. Other than that, I believe there are opportunities in specific situations, such as spin-offs and merger arbitrages, and in specific stocks, all of which I will continue to detail in future articles as I find them.

I don’t mind admitting that I find the near term hard to call. Over the next month, the market should do well because of the Fed rate cuts. The market will stabilize and a sense of normalcy will return. But beyond that, it gets a little less clear. The Fed could choose to cut again, or not at all. It’s likely that some part of the market will expect a rate cut, and will be disappointed if there isn’t one.

In the medium term, say six months to a year, housing problems, a weakened consumer, and the lack of major growth drivers is likely to cause the economy to slow. If inflation becomes a major problem, then rates will increase somewhere down the line, but that could be some time away. In the meantime, it’s best to be aware of the possible scenarios, and be prepared.

Thanks for reading, and until the next time, sleep well.

Ming Lo is an actor, director and investor. He has an A.B. from Harvard College, Cum Laude, and an MBA and an MA Political Science from Stanford University. Prior to going into entertainment, Ming worked at Goldman, Sachs & Co. in New York and at McKinsey & Co. in Los Angeles.

All material presented herein is believed to be accurate but we cannot attest to its accuracy. The writings above represent the opinions of the author, and all readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed may change without prior notice. The author may or may not have investments in the stocks or sectors mentioned.