Investing – Next Steps

Investing in August

For weeks, even months, the market has been looking for the correction that has yet to materialize. The likelihood of a correction is increasing, but a fundamental catalyst is necessary to trigger it.

The Next Few Weeks

Over the next few weeks, I don’t expect significant movements in the market. We’re capped by skepticism above and a floor created by recent buyers unwilling to sell. Still, many in the market are positioned for a correction.

A Vulnerable Q3

A quick scan of sectors shows that we’re likely to have mixed earnings, but there’s no convincing case for a bad quarter. Still, we have to account for the possibility of a negative earnings surprises and given the nervousness of markets, we need to be ready for this possibility.

Managing A Position

A look at managing a position in the TBT (short Treasuries) and Apple. Trading with stops is can be a good thing.

Investing in August – Looking for a Correction

For weeks, and even months, pundits, bears and even bulls have been looking for the much-anticipated correction. And yet, it hasn’t occurred. Everyone agrees that conditions are (technically) overbought and that valuations are high. According to Bespoke Investments, 93% of stocks in the S&P are trading above their 50-day moving averages. When this figure is above 90%, there’s little room for more upward movement. Robert Schiller, the renowned Yale University Professor, reports that in August, the S&P was trading at a price-earnings ratio of 17.7x. This compares with a long-term average of 16x for the S&P, and a multiple of 13x at the recent low in March 2009.

Still, sentiment is bullish. Investors Intelligence recently reported that bullish sentiment among newsletter writers was at its highest reading since January 2008. Bearish sentiment is at its lowest level since late 2007. If you’d like a more concrete indicator, average short interest as a percentage of float for stocks in the S&P 1500 was at 6.9% in the last week of August. This is the lowest reading since February 2007 when the percentage was 6.6%.

All this has caused the bears to say that the market is too bullish. In recent weeks, pundits have regularly appeared to predict a recent market top and short sellers have lined up to drive the market down. The market has pulled back – but only just a little bit. Fact is, the market has held. A week ago Friday on August 28th, the market closed at 1,028.93. By Wednesday of this last week – September 2nd, the S&P had dipped 3.3% to 994.75. But then the market reversed and closed the week (August 4, 2009) at 1,016.40, a little more than 12 points lower.

So the market barely moved this last week. In recent articles, I’ve argued that money flow is holding the market up – that money on the sidelines, afraid of missing out on this rally, has come in, propped up the market, and has even pushed the market higher than many expected. Based on this premise, I’ve suggested, in my last article, that an investor should buy the dips. Of course, the question before us: is that the right strategy going forward?

The Next Few Weeks – Not Much Ado

Over the next few weeks, I don’t think we’re going to get a major correction. Make no mistake, we probably should, based on fundamentals, but that’s not always how the market works. Most likely, we’ll get minor corrections and lots of sideways movement until we hit third quarter earnings season.

My reasoning is simple: the threat of a correction is based on worries and is not yet based on actualized facts. We need to see significant bad news or economic problems reflected in company earnings in order for a major correction to occur in the short term. As I’ve mentioned in past articles, money flow has brought a lot of people into the market in recent weeks. They bought late in the rally, and they have no reason to sell at a loss unless they see significant problems ahead. The bears have tried to put downward pressure on the market, but the market has held. That’s because these recent buyers don’t want to sell. They’ve created a short-term floor in the market. So what I see in the short-term is shallow corrections based on technical worries but not yet confirmed by fundamental facts.

Let me give an example of why we might be in this sideways no man’s land. Recent reports are that prime loans are now facing foreclosure, and this will mean pressure on credit cards as well. Combine that with commercial real estate delinquencies, and that spells problems for the banks. Now, I don’t doubt this trend at all. Still, we don’t know how much will show up on the books in 3rd quarter earnings. Plus, certain banks might actually make money off their investment banking divisions and from continued mortgage refinancings. So will the losses outweigh the gains? Difficult to say. Recent buyers will sell only if they see proof that the losses are high enough to dent expected earnings.

In the meantime, make no mistake, significant parts of the market have positioned themselves for a correction. What makes me say that? Consider the following:

Leadership Is Moving Sideways

Consider Goldman Sachs, the darling of Wall Street. It’s been stuck in a range between $158 and $170. Leadership matters because something, or someone has to lead the market forward.

Rotation.

When leadership stalls, the market rotates into other sectors looking for return. Take the plunge into “trash” stocks AIG, Fannie Mae and Freddie Mac over the last few weeks. This was basically money looking for a return when the leaders, the “quality” stocks, weren’t moving.

Insider Selling

Over the last few weeks, insiders across the board have been selling. While not a perfect indicator (because insiders aren’t always right), the breadth of the selling shows that many believe their stocks are near a short-term high.

Move into Treasuries and Gold

As mentioned, Treasuries are up, meaning that the market is concerned and would rather hold safe Treasuries than riskier stocks. Gold has reached $1,000, which reflects (in part) a similar concern.

Lack of Upward Movement with Good News

Over the last week, we’ve had some “good” news with items such as the ISM and the jobs reports. Still, the market barely budged.

October: A Vulnerable Earnings Period

All this sets us up for a very dangerous 3rd quarter earnings period. And in fact, it can be argued that 4th quarter of 2009 and 1st quarter of 2010 are even more dangerous. But let’s start with Q3 coming in October.

October has been historically been a tough month for the market. In a way, it makes sense, because the market starts looking forward and companies have to re-evaluate their expectations for the next year. This year is no different. Investors are now waiting for hard facts to tell us where the market really stands.

It’s very likely that we’ll get a more mixed quarter, as opposed to the generally favorable quarters that we’ve had so far this year. We’ll briefly go through some sectors in a moment, but as I’ve said in recent articles, stock picking is now more important than calling the market’s direction. I still analyze the macro side, but I’m not making bets on market indices. Rather, I use my assessments of the macro to help me decide what factors are affecting the stocks I’m interested in, and to help me decide when I should buy a stock or sell a stock. This is in contrast to investment managers whose primary approach is asset allocation; they bet on the direction of a sector or the market in general and rely less on the impact of individual stocks.

Let’s take a slight detour and go through a concrete example of why this distinction is important. I think it’s likely that the S&P will end the year somewhat higher than where we are today, but that’s not where I’m placing my bets. That’s because I would only say that the probability of a higher S&P is about 60%. In contrast, I believe the probability that Apple will end the year higher than where it is today is significantly higher than 60%. So I’d much rather own Apple. Even if I’m wrong about year-end, I believe the probability that Apple will outperform the S&P over the longer term is extremely high. So again, better to own Apple (which I do own, by the way, and I don’t own any indices that reflect the S&P at the moment).

So with that in mind – that I’m looking at trends in sectors to help me manage individual stocks, not necessarily to bet on these sectors as a whole – let’s take a look at the variables driving certain sectors.

Financials

In financials, the investment banking side could continue to perform. Trading in government securities, high yield debt and corporate bonds remain strong. Equity underwriting remains slow, but mergers seem to be picking up. Plus, there just aren’t as many investment banks as there were last year pre-Lehman and pre-Bear Stearns. This all bodes well for Goldman Sachs, Morgan Stanley to a lesser extent, and the investment banking divisions of banks such as JP Morgan, Wells Fargo, Bank of America and Citigroup.

The lending side of banks will see weakness as foreclosures for prime loans increase, credit cards problems increase and commercial loans become more troublesome. Banks have tried to delay recognizing these problems, but they are likely to begin showing up in earnings October. So the big diversified banks with both major lending and investment banking operations will have mixed results, and it will be hard to predict which way the scales will go.

Finally, the pure lenders – mid-tier banks and regionals – could be hit by prime loan, credit card and commercial lending losses. They won’t have other sources of income (except mortgage refinancings) to offset any losses. They should see some hit earnings in Q3, but should see an even greater impact when a) refinancings and modifications are no longer possible; b) the first-time home buyer credit ends; and c) when the Fed starts ending its quantitative easing policies.

Given these trends, it’s actually possible that banks in general – particularly the big leaders that everyone watches – could have a decent 3rd quarter. Still, pressure has to mount on these financials going forward, especially as we go into 2010.

Tech

Generally, I expect corporations to be conservative about their tech spending. It’s hard to justify major expenditures until clear evidence of revenue growth is at hand. Still, corporations have held back tech spending all year, and there are two bright spots in tech: smartphones, and to a lesser extent, the Windows product cycle.

Smartphone demand is strong and few would debate that. Corporate demand for smartphones can strengthen as the economy stabilizes and heads toward growth. As for the Windows upgrade cycle, I expect this to be medium term and slow, no one is in a rush on this. Even HP said they expect the cycle to kick in in 2010. Still, this would be cause for optimism, even in Q3, as the market starts looking toward 2010 earnings. In Q3, if companies simply announce the expectation of improved earnings in 2010, that could give a moderate lift to stocks such as Intel, HP and Dell (I’m long Intel and Dell, by the way).

Oil and Commodities

Industrial metals and oil have had a great run, especially as stimulus plans – particularly in China – supported prices. Inventory restocking and longer term fears of inflation should continue to support these markets, but oil and metals could hit some bumps as stimulus is withdrawn. This weekend, the G-20 announced their support for continued stimulus, but stabilization and low political will should work against continued stimulus going into year-end. So we may very well get a dip in commodities before longer-term upward pressures resume.

Retail

The consumer remains weak and most expect that trend to continue for some time. Recent reports show that some retailers, such as Gap and Aeropostale, are making better-than-expected progress, so there may be bright spots for certain retailers. Also, easy comps in the 3rd and primarily in the 4th quarter could brighten upcoming earnings seasons (because sales fell off a cliff in December 2008). So in the short term, markets may actually react better than fundamentals would indicate.

Consumer Staples

The old stalwarts, such as P&G and JNJ (consumer side), have fared better than others over the last year, but have also lagged the market during the recent rally. Truth is, consumers have been trading down, buying private label and continuing to cut wherever possible. A weaker dollar helped many companies in this category (because of their international exposure), but in recent weeks that trend has pulled abated. These stocks should hold, but significant gains may have to wait for the consumer to recover.

Based on this scan of various sectors, we would have a very mixed 3rd quarter earnings seasons. Certain stocks will stand out, but we should see a range of results (again, in contrast to the last two quarters, where a high percentage of results that were better than expected). If we do not have major downside surprises, we could very well have a choppy earnings season following by a moderate rise into the end of the year. Pressure would then build into 2010, where major macro factors – government withdrawal of market support, real estate and credit card losses and inflation would have to be dealt with.

Not a bad scenario, but we also have to recognize the possibility of the downside surprise – which, given the nervousness of markets, could trigger a significant sell-off, say in the 10-20% range. This could be anything from higher than expected losses in banks to higher unemployment, inflation and/or buyers unwilling to buy Treasuries.

Managing Positions

Investing wise, I come back to the recurring theme: pick a stock with an investment thesis that you believe in; use your assessment of the macro environment to manage your investment. The macro factors can give you a sense of when to buy and how much. And if you don’t want to spend the time to monitor an investment but still believe in a stock, you always have the option of dollar cost averaging.

The TBT

Let’s work with some concrete examples. First, let’s start with the TBT, which is basically a short Treasuries trade. The idea is this: in times of fear, Treasuries offer the most security (because they’re government-backed instruments). So in the last year, demand for Treasuries has been very high. When things stabilize, people take their money out of Treasuries and put it back into riskier, but higher-yielding investments such as stocks. We saw a bit of this summer: as the markets rallied, the market was afraid that people would stop buying Treasuries, so the TBT spiked, jumping from the $46 range in April to $58 or so in June. When it came back down into the $51 range, I bought some, but people were still buying Treasuries, and the TBT rose, but didn’t spike as much as it did in June. That told me the market was not quite ready to jump out of Treasuries, so I sold in the $52 range, thinking I could buy it back lower. That’s where we are today; with fear of a correction, people are buying Treasuries again, and the TBT is now at $48 or so, having fallen below $46 last week.

If you believe in this trade, this would be a good time to start a position in the TBT for a long-term investment. But this is a trade that has to be managed. And that’s because the TBT is susceptible to a lot of macro factors that are in flux right now. If we see more fear of a correction coming into the markets, money would move into Treasuries and the TBT would trade down. In that case, you would want to consider stepping out of the trade if it’s approaching your cost basis. If the economy seems to be improving and the markets are doing well, then money should move out of Treasuries and the TBT would rise.

Apple

The TBT trade is a bit esoteric, so let’s pick one that is more familiar to most: Apple. Again, I believe in the long-term thesis: Apple is a leader in must-have consumer technology. Its Macs are growing share, and while the iPod is fading, the iPhone is a game-changer and a tablet in the pipeline could be a big seller as well. There’s enough drivers of growth for Apple to shine for years, in my opinion.

One other factor that makes Apple an interesting stock: it’s proven that even in a recession, people will buy it’s products. So it’s more impervious to macro trends then the TBT that we talked about above. As mentioned, I look at macro trends to see how they will affect specific stocks. To me, it seems that Apple will do well even in a weak environment.

So let’s look at investing in Apple. I’ve been trading in and out of Apple, and I’m afraid I missed the run in Apple from about $100 to the $140 range. Basically, I try to avoid buying during a big run because you often buy late, but in this case I missed out. When the stock was resting in the $140 range, I bought some shares, because I continued to believe in the long-term trend. Since then, the stock has run up into that $160 range, and I seriously considered selling last week because of the possible correction. In the end, I held, because even if there was a correction, I was happy to hold onto Apple for the long term. Fortunately, the stock held and even ended the week at $170.31. Today, it took a jump up to $172.93.

So if you like Apple, how should you handle the stock from here? If you believe in the long-term on Apple (as I do), I would say that it’s a buy on a pullback, especially in the low $160 range. Tomorrow, Apple announces its new products, and because this is an incremental announcement (as opposed to a game-changing announcement, such as the introduction of the iPhone), I think Apple is likely to trade down a bit afterwards. Historically, that’s been the pattern (of course, no guarantee on this). If Apple pulls back into the low-$160 range, I would say that it’s a buying opportunity for the long-term.

Trading with Stops

Let’s add one other dimension to managing investments. I don’t think there’s much downside to using stops on a regular basis. Just to clarify, a stop tells your broker to sell at market once a certain level is reached. Let’s say I buy Apple at $165. It rises to $168 but begins to fall back, and I’m afraid it will fall back below my purchase price. Now I have two choices: I can hold, or I can sell before it falls below more. With Apple, I like the stock so much that I don’t mind holding. But if I were less certain, I could put in a stop order at say, $165, and that would tell my broker to sell at market once the stock fell to $165.

The stop would have worked well with my TBT trade mentioned above. I bought in the $51 range, and could have put a stop in somewhere around my purchase price. The TBT traded up to the $53 range before reversing and heading down toward $46. Now I didn’t have to use a stop, because I was watching the TBT fairly carefully, and so I executed the sell manually. Still, I could have just put in the automatic stop and handled it that way. For the TBT, because it’s more unpredictable than something like Apple, I think using a stop is a good thing. And by the way, stops are usually free when executed online. I recommend stops when there’s some short-term unpredictability (don’t ask me if that’s the right usage, sounds wonky to me).

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.