Investing – Directions, Please

This month, we’ve clearly put the worries of financial Armageddon behind us. The market continues to defy the bears and moved higher, although not at the torrid pace of March and April. With a big run behind us and new worries about the dollar, Treasuries and inflation, what to do next is not an easy call.

• May Recap – Stress tests, Chrysler and GM Bankruptcies and new worries about inflation and the dollar strike markets.
• Investing During the Month of May – The market moved sideways, and then up. Bulls rejoiced, bears were surprised, many were confused as the market sent conflicting signals. At the end of the day, money flow from bonds and other sideline sources drove the market up. For investors, stock-picking is back.
• What’s Next – Many things made it hard to call the short-term trend in the market. I believe a correction remains likely, particularly in Q2 or Q3, but in the short term, the market could go either way. This week’s Treasury auction and the announcement of TARP repayments could move markets.
• Investing Strategy – It’s a great time to look for buying opportunities, but with uncertainty before us, picking the right entry point isn’t so easy. Stick with industry leaders, look for pullbacks, and a look at Goldman Sachs and Morgan Stanley in more detail.

May Recap

In May, we saw some major events and a shift to new worries in the markets:

Stress Tests. So the much awaited stress tests results were released, and as promised, no major bank failed. Washington gave each of 19 banks reviewed capital targets, and the banks quickly went into capital-raising overdrive. Good for the markets, because all the banks successfully raised capital. To date, banks have raised about $65 billion, and markets have rallied as confidence in the banking system grew. Issues of potential over-regulation remain, but all the major banks are focused on returning TARP funds and getting out from under the government’s thumb. The government says they will announce a plan for TARP repayments next week. For the banks that can repay, this will be a bullish event.

Chrylser and GM Enter Bankruptcy. For a moment, there was hope that Chrysler would avoid bankruptcy, but with bondholders unwilling to take the losses offered by the government, Chrysler headed for court. With that, GM’s bankruptcy was a foregone conclusion. While a difficult and painful process for all involved, the bankruptcies did not have a major impact on markets because they were expected by the market.

New Worries for the Market. With the market comfortable that banks will survive, it started to move on to new worries. “Green shoots” and “less bad” were the rallying cries of May, meaning the beginnings of a recovery were evident as market indicators were “less bad” than before. Of course, the market turned that into a worry about pending inflation and record deficits. A downgrade of England’s credit rating resulted in endless questions about America’s credit rating in the American business media. Oil and commodities surged, the dollar fell and interest rates rose. All spurred worries that we were on the brink of an inevitable correction – an inevitable correction that has yet to happen.

Investing During the Month of May

The Sideways May Market. Truth be told, the right way to go was a tough call for both traders and investors in May. Let’s take a look at the S&P, below.

A couple weeks into May, the market started to pullback to the trendline. It broke the trend, and it seemed the market was beginning correct. Many are expecting a big downward move, but instead, the market moves sideways. The next high is lower than the previous one, and the technicians believe that this begins to confirm the long-awaited correction. But the market holds the 880 level, and then breaks to the upside, crossing the 200-day moving average (yellow line) and above the previous high in early May.

You can see why the month was tough – it was hard to tell whether you should buy, sell or hold. Strong voices could be heard for both the bull and the bear camps. Some pundits admitted outright that they were confused, and that they just weren’t sure which way to go.

Money Flow and Stock-Picking, Continued.

I don’t mind telling you that things weren’t clear to me either. May was a mixed bag; for the most part, I didn’t do much and gathered cash. In some cases, I missed some nice upside. In Goldman Sachs, for example, I had put in a stop at $129. The stock broke below that for a day, the stop was automatically triggered, and afterwards, Goldman was off to the races and reached $149 or so today. Bummer (one of the minuses of stops if you choose the wrong level). In other cases, I bought on small pullbacks, which was good for some small gains.

One thing I noticed was that you could no longer look at the general market, or at a general sector, to decide where to direct your trades or investments. You had to go back to stock-picking, looking at the specifics of individual stocks to decide what to do. That’s because the market was doing exactly that. It was starting to look forward, toward a time when earnings would be stabilized (meaning, what earnings would look like in a normalized environment vs. today), and it was picking winners and losers. Take financials: for most of the last year, they moved as a group and prices were driven by events. Now, the market is analyzing each individually, looking at revenues, earnings, mix of business, expenses and ability to repay TARP. Yes, stock-picking is back.

Last month, I also talked about money flow. Fact is, neither fundamentals nor technicals helped much to explain the market action in the last month. The fundamentals said that we had moved too far, too fast. The consumer was still weak, and “less bad” doesn’t really mean “recession over”. Fundamentals also said that oil shouldn’t be running but to the $70 range because oil consumption remains weak and supply is sufficient. Still, oil ran broke $70 last week. As for the technicals, several technicians declared corrections were imminent or beginning – only to change their mind within days, and sometimes the next day.

So what explains the continued rally? Money flow, really. Those who had not invested in the recent rally were afraid of getting left behind. And as the news continued to be “less bad” than expected, they threw in the towel on a bigger pullback and jumped in. Last month we talked about how hedge funds threw in the towel on shorting, and conservative money such as mutual funds finally came into the market. This month, it was money coming out of bonds. As the market stabilized, the flight to Treasuries and safer bonds became less necessary. In addition, the growing fear of inflation was making low-yielding, fixed income securities riskier. As a result, investors sold bonds, yields went up, and we had another round of inflows into equities that helped maintain and extend the rally.

What’s Next?

So what’s next? So far, the market has continued to defy the naysayers, the ones that say a correction is imminent. Each time the bears thought the rally was over, new money came into the market.

As much as I’m a fan of analysis, I will be the first to tell you analysis doesn’t tell you much about today’s short-term outlook. The fundamentals would say that we are either fairly valued or overextended in many cases. If you do the math, for many companies we are trading at reasonable market multiples to next year’s earnings. Meaning, in many cases we’re trading at a prices that assume the company will hit next year’s earnings targets. That’s actually a pretty high bar, and anything that gets in the way of that could send a stock in the other direction. In commodities, we’re definitely beyond today’s fundamentals. We’re trading at levels that assume either a rebound in the economy by the end of the year, or inflation that will support the current run in commodities prices. In sum, we’re at prices that assume our future predictions will come true. Knowing all this doesn’t really say a whole lot the short-term direction of the market. As we get higher, the likelihood of a pullback increases. Still we could go higher for a while before that happens, or we could go sideways for a while. Or some event could take the wind out of the market’s sails.

At the moment, I think the technicals are also indeterminate. Take a look at the following longer-term chart of the S&P.

As mentioned, the rally broke below its trendline during the second week of May, traded sideways, and established downward resistance at about 875-885. There’s some minor upward resistance levels of about 950, but significant resistance at about 1,000. So we have a fairly open range of, say 875-950, or perhaps 875-1,000, where the S&P could trade and not bump into significant resistance.

Also notice that the current close of 942.46 is above the 200-day moving average of 921.62. While this is a positive, the market would have to stay above the 200-day moving average for at least a week (based on historical experience) for this to be meaningful. All in all, the technicals don’t indicate that the market would definitively head one direction or the other.

Treasury Auctions. So what could cause the market to move either way? This week, the Treasury will sell $65 billion in 3-, 10- and 30-year securities. In total, the Treasury expects to issue $2 trillion in 2009 to finance its deficit. The market is very worried about the longer-dated Treasuries, the 10- and 30-year notes. If the economy is getting better, the appetite for safe but low-yielding Treasuries diminishes. Also, inflation makes the longer-dates notes riskier, so investors are more likely to buy the short-term notes than the longer-term ones. A weak auction would result in higher interest rates, making it harder for the economy to get back on track. The Fed could try to keep interest rates low by stepping in and buying notes, but that would only be interpreted as a sign of weakness. On the other hand, a successful auction would give the market confidence and could boost the indices. All in all, an important week.

TARP Repayments. Another eagerly anticipated event this week is the TARP repayments. The Treasury is expected to announce which banks can begin repaying the TARP. Those that can repay will get a boost. Among the bigger banks, Goldman Sachs, Morgan Stanley, and JP Morgan are expected to qualify. There’s a small cloud hanging over Wells Fargo because the Fed has said that it can’t rely on earnings to fulfill the Fed’s capital requirements, but Wells Fargo is insisting on using earnings to help make up any shortfall. So it may not get the green light to re-pay TARP, and we will have to see how the Fed responds. As for Bank of America, I actually think the company should hold on to its TARP funds because of looming losses in loans, credit cards and commercial real estate. Here, I actually think returning the TARP funds might be a bit foolish, and I suspect the market may agree. Lastly, Citigroup will be holding on to its TARP funds for a while, and the firm is expected to convert the government’s money into common stock soon. On the whole, the announcement of TARP repayments should be positive, and banks, and perhaps the market as a whole, should get a boost if all goes as expected.

Investment Strategy
So for me, there’s a lot of uncertainty in the short-term. And the thing is, there’s lots of uncertainty in the medium- to long-term, too. As we’ve mentioned for several months now, we still have massive losses in loans, credit cards and commercial real estate coming. If they all hit within a concentrated period of time, then the losses could weaken bank balance sheets and cause significant pullbacks in the financials and the market as a whole. On the other hand, if the losses can be spread out over time, earnings and the recent capital raisings could potentially cover those losses, leading to a more stable market. In that case, pullbacks in the market could be relatively small, and the market is more likely to move sideways or be upward trending.

I’d like to note one other thing that makes the short-term direction of the market unclear. For the short-term investor looking for a run in a stock, most stocks look expensive. After a 30% run in the market, how much more upside can there be? And yet, for the long-term investor, stocks remain cheap. So even after a 25% run in the market, the long-term guys are willing to step in and drive the market to a 30% gain. If the news is good enough, or “less bad” enough as our current mantra goes, the long-term guys could drive us up a few more percent.

What should an investor do in this environment? Despite the uncertainty, it’s still possible to build an investment strategy to fit an uncertain environment.

The first thing I would say is that the long-term outlook remains good, and that in the lens of a 3-5 year time frame, stocks look cheap. That means that we should be looking to buy, not necessarily in the next week but anytime over the next year. So for me, it’s not a question of whether you should buy equities, but a question of when, or what’s the right entry point.

Second, because corrections and pullbacks are likely, especially as we hit the second and third quarters (where it becomes harder to live up to expectations), we should stage our investments rather than buying all at once. If there is a correction, our average cost will be lower, and we may be able to replace the higher cost shares with the lower cost ones.

After that, it’s a question of stock picking – looking at the individual stocks and picking a good entry level. Generally, I would stay with the leaders, the survivors, the ones that will excel in a downturn. Then, look for the pullback. Of course, this is no easy task, because who knows whether a 5%, a 10% or a 15% pullback is right – or will even occur. It can be easy to miss the pullback, or to enter too early in the pullback phase. Still, there are category_idelines that can help us. And keep in mind, I’m of the opinion that it’s very difficult to pick the bottom; a low price is often good enough.

Case Study: Goldman Sachs

If you’ve followed this column, you’ll know that I’m a fan of Goldman Sachs. I used to work there, and I hold some shares. Without a doubt, it’s a sector leader, a survivor and has excelled in this downturn. As much as I think this is a great stock, it’s looking very expensive right now. A quick check of any stock website will tell you that consensus estimates are $12.19 or 2009 and $13.41 for 2010. Put an 11x multiple on that and you’ll get a price per share of $134 for 2009 and $147.51 for 2010. As of Friday, June 5, the stock was at $149. That means it’s trading at a price that assumes the 2010 targets will be achieved. Pricey, or at the least, not discounted at all.

If you look at stock’s chart, you’ll see that it’s had an amazing run from the $60 level. It’s trendline is unbroken, and each time the stock approached its trendline, it bounced off that trendline and moved up. Also, the stock is well above its 50-, 100- and 200-day moving averages.

My guess is that the Goldman run can last just a bit longer, but not a lot longer. It’s just moved too much, and further good news is increasingly unlikely. I think it can get a bump if it is allowed to repay the TARP, but after that some selling pressure has to come in. Others in the market are making the same calculations that I just did, and entry at this level is very hard to justify.

I would always like to buy Goldman on a pullback, but determining how much of a pullback is appropriate depends on the event that caused the pullback. Looking at the chart, there’s some resistance around the $135 level, and more at $120 level. At $135 I would buy some; at $120 I would buy a lot. Again, there’s no magic in these numbers, they’re just category_idelines. With a 3- to 5-year time horizon, both $135 and $120 would be cheap for Goldman Sachs.

Case Study: Morgan Stanley

Here’s another strong company that is a survivor and has done well in the current downturn. It’s very much like Goldman, but is less willing to take risk, and has more exposure to commercial real estate. Morgan Stanley is a good example because its similar to Goldman, and we can also compare the two in this exercise.

A quick check of consensus earnings estimates gives us $0.99 for 2009 and $2.92 for 2010. With an 11x PE, that gives us a price of $10.89 for 2009 and $32.12 for 2010. As of Friday, Morgan Stanley was trading at $30.97, or 3.6% less than the 2010 target of $32.12.

As mentioned earlier in this article, we see that both Goldman and Morgan are trading close to a reasonable multiple to 2010 earnings. Goldman can be said to be the better bank, so it makes sense that Goldman trades at a slight premium to Morgan’s valuation. The 11x PE is reasonable, but you should know it’s not exact – investment banks can trade in the high 9x or 10x PE range, or higher than 11x in a strong market.

A technical check of the stock also shows us a great run from the March low of $9.20. The stock also exceeds its 50-, 100- and 200- day moving averages. A quick look at recent trading shows that there is some resistance around the $28 range, and more at the $26 range.

Two other facts are helpful when considering an entry point for Morgan Stanley. The firm recently raised $2.2 billion by offering stock at $27.44 on June 2, 2009. Before that, Morgan Stanley raised $3.5 billion at $24 per share on May 8, 2009. The thing is, we, the retail investors, don’t have access to the stock at those prices. We actually buy in the secondary market, and at the time of those offerings, Morgan Stanley only dipped to $29.89 and $27.14 (closing prices), respectively.

At the time of the second offering, around June 2, I looked at this and said, given resistance around the $28 range, and the fact that Morgan Stanley never fell to its offering price of $27.44, I decided that a price of about $29 was reasonable in the current environment. And so I bought some shares for $28.95. I know that if events are serious enough, the stock could still fall below this price, so I bought some but not a lot. I also bought thinking that worst case, in 3- to 5-years, the stock should be well above my $29 purchase price. Not an exact science by any means, but in terms of probability, I like the odds.

As always, I encourage you to consult your own investment advisors before making any investments. I don’t claim to always be right; I can only present you my logic, and I hope you will take the time to do your own homework and decide if you agree or disagree with the arguments presented here. Also, if you really feel like spending some more time on stocks, there’s more on my blog at http://mingloinvesting.blogspot.com.

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.