Investing – The Forces at Work

In this month’s Investing article….

• Investing in September. Last month, I said that I didn’t expect significant moves in the market in September. After a run-up mid-month, we pretty much ended September where we started. September’s most important event in my opinion was a bit behind the scenes: the Fed saying that it expects to continue quantitative easing.
• Moving Forward: Liquidity, Fundamentals or Technicals? Stocks valuations are high, technicians see a correction in the charts, but everybody is long the market. That’s because we have a battle between fundamentals, technicals and liquidity, and for the moment, liquidity is winning. Barring any major shocks during earnings season, we’re likely to have a moderate run into year-end, followed weakness in 2010.
• So What’s An Investor To Do? After such a great run and high valuations, it’s hard to recommend jumping in now. Instead, watch Q3 earnings; look for indicators of trends and position for 2010.
• Q3 Earnings Season. I’m cautiously optimistic about Q3 earnings. Still, if there’s any significant uncertainty, there’s no shame in managing your position and taking some money off the table.

Investing in September: Money Flow, Window Dressing and the Fed’s Helping Hand

When I last wrote on September 8, 2009, the bears had just made another run at taking the market down. That run failed, and the market rose, reaching 9,830 on the Dow on September 22. As October and earnings season approached, the bears took another bite, driving the Dow to 9,488 on October 2, 2009. That attempt also failed, and we stand at 9,865 as of Friday, October 9 – a new high on the Dow for the year.

By now, it’s an old story. The fundamentals say the market should go down. The technicians see bearish patterns. Hedge funds go short. And the market goes up. The shorts get whacked.

The Chase for Performance.

Of course, the question is, why? We’ve talked about how money flow, the money on the sidelines, has helped drive markets up.

Consider the following. The Dow started the year at 9,035. Last Friday’s close was 9,865. That’s a 9.2% gain for the year, year to date. If you use the S&P – and most fund managers are benchmarked against the S&P because it’s a much broader index – then the market is up 15.0%. So if you’re a fund manager, and you’ve been even somewhat bearish or cautious, it’s very likely that you will have underperformed the market. That is, you’re probably behind the S&P’s 15.0% gain. And if that’s the case, you’re in trouble, because more than likely you were down 30-40%in 2008. So with the possibility of poor performance for two straight years, you’re afraid of being fired.

Window Dressing.

There’s another factor that’s important to consider at this time: window dressing. The year-end for most mutual funds is October 31. We all know there’s a lot of money in mutual funds, so their behavior has a big impact on the market. Many would say most mutual funds that claim to be active managers are actually closet indexers – that is, they may say they try to beat the market, but in reality, they just try to match the market. The logic being that if they do just as well as the market, they can’t get fired and they survive for another year.

So many mutual funds try to do two things: they try to match the performance of the index and, as year-end approaches; they try to show that they hold the stocks that have been the most popular during the year. So if a mutual fund doesn’t already own the year’s most successful stocks, they start buying them as the October 31st year-end approaches. This way, when they show investors their portfolios, these popular stocks show up on their list of holdings. This annual ritual is fondly known as “window dressing”. Each year, it gives the best performing stocks a bit of a lift as we approach the mutual fund year-end on October 31.

And here’s another important quirk of mutual fund behavior. Funds pass on their losses as well as their gains to investors. Funds hate to pass on losses, as they should. But what most of us don’t realize is that there’s also an incentive not to pass on gains as well, because investors will be taxed on those gains. If there are losses that can be used to offset the gains, then the fund won’t end up passing capital gains onto the investor. But many think that those losses have already been recognized. So if stocks are sold for a gain, then the investor will have to pay taxes on those gains. If this is the current situation, then mutual funds have an incentive to buy stocks and not sell them, at least not until after the October 31 year-end. That implies support for the market through October.

So we have major factors supporting the market: money on the sidelines, the chase for performance, and window dressing. In September, we got another helping hand from the Fed.

The Fed’s Helping Hand.

The Fed had originally planned to end the government mortgage bond-purchasing program in late November. On September 24, the Fed announced that it would let the program run until first quarter of 2010.

In effect, the Fed was saying that it remained concerned about the economy and that continued support, in the form of quantitative easing, was necessary. By continuing to buy mortgage bonds, the Fed would keep these bond prices high. Since yields move inversely to prices, interest rates would stay low.

The effect of such an action went far beyond the mortgage bond market. By continuing its policy of quantitative easing, the Fed was saying that the economy would stay weak for some time; that the threat of inflation was low; and that an implicit weak dollar policy would continue. This sent Treasury yields and interest rates to the lowest level in months, drove another rally in commodities and made equities the investment of choice, at least for the moment.

To see why this is so, let’s think for a moment like a money manager. While the retail investor usually thinks in terms of stocks, many money managers think in terms of asset allocation. If you look at the investment world through the eyes of an asset allocator, it turns out that equities are the best option at the moment.

As interest rates go down, debt-related instruments become increasingly unattractive relative to stocks. Treasury bills yield almost nothing, and the 30-year touched 4% last week, the lowest since late April. TIPS, the Treasury Inflation-Protected Securities, aren’t much help either. The rule of thumb is that you should buy TIPS when they are at least 2% above inflation. Right now, the 20-year TIPS are just at that level – 2% above inflation.

Corporate bonds are also expensive. On average, AAA bonds are yielding about 3.84%. Higher risk BAA bonds yield 5.5% or so. On a relative basis, equities look pretty appealing.

Other asset classes are equally unappetizing. Very few think that real estate has bottomed and many are looking at continued problems in the sector. As for commodities such as gold, they’re very popular investments at the moment, but they remain risky and a small portion of a portfolio. Only specialized, high-risk investor, such as hedge funds, would place a big bet on commodities such as gold. The same is true for currencies – they remain high-risk plays and are the domain of higher risk takers, not your average portfolio manager.

The end result is a move into equities, pushing markets higher. The irony is that such actions by the Fed create their own reaction. This week, the continued fall of the dollar raised criticism of US policy from around the world. Bernanke even had to get in front of the cameras and say that the Fed remained poised to raise interest rates. Also this week, weaker Treasury auctions caused interest rates to go back up a bit (the 30-year Treasury is at 4.2%, after dipping just under 4.0% last week). Still, many believe that Bernanke’s speech was a just rhetoric. More than likely the Fed will resist raising rates for as long as possible, and that the dollar will continue to decline. Frankly, a weak dollar is good for US economy and raising rates might damage a fragile recovery that is only in the early stages.

Moving Forward: Liquidity, Fundamentals or Technicals?

So we have a battle of liquidity vs. fundamentals and technicals, and for the moment, liquidity is winning. How long can this go on? Of course, earnings can easily cause a change in market direction, but for the moment, let’s assume we don’t get any major surprises in either direction. If you believe that funds are chasing performance, then we would have support through the fund year-end, or October 31st. If interest rates stay low and the dollar continues to fall, then you would have continued liquidity that would more than likely support the market. That could continue through year-end, or even first quarter, when the Fed has said it would withdraw its mortgage bond purchase program.

What could derail this scenario? Let’s look at the bear fundamental and technical arguments.

The litany of fundamental worries is well-known: a massive, unbroken 61% rally on the S&P since March; an overpriced market based on expected earnings; the withdrawal of quantitative easing; ensuing inflation; government stimulus programs than only take demand away from the future; record real estate foreclosures in the pipeline; massive commercial real estate problems; the withdrawal of consumer credit; rising unemployment; a wounded and barely recovering consumer.

Now I’m very much a fundamentalist, so I do believe all these problems are real. The problem is the fundamental approach is a bit rough; it doesn’t give you a strong sense of timing or severity. For example, I definitely think that inflation is coming. But how much? Will interest rates hit 8%? 12%? Very hard to say. Also, I do think we will have a second dip – a “W” shaped recovery, if you will. Again, the question is, how much of the dip is the second half of the “W”? The doomsday voices say we’ll revisit the lows. Others think it’s more of a “square root” recovery – a “V” followed by a sideways market. And finally, if there’s a second dip, when will it come? Many think it’s coming, but at the moment, no one can say when. Many of those that expect some form of a “W” are long the market today.

Perhaps the technicals can give us a bit of help. Take a look at the following chart of the S&P:

For the technician, there’s a lot of interesting stuff here. First, take a look at (1) the line under the recent rally; and (2) the downward line from the highs of 2007. These two lines create what is called a “wedge” formation in technical analysis. An ascending wedge is considered very bearish, meaning that we should expect to see a downward turn in the near future.

Technicians also like to look at upward resistance – levels that are hard to get past when a stock or index is moving upwards. Today, technicians are looking at two major resistance levels – 1120 and 1200 or so, on the S&P. The 1120 represents a 50% retracement from the high of October 2007 to the low of March 2009 (take the high, subtract the low, divide by two and add back to the low). Now many people wonder about some of these technical levels – why should a 50% retracement be important? Truth is, some of this might very well be self-fulfiling prophecy: it matters because people say it does. There are so many people focused on this number right now that almost certainly, there will be resistance when we get there.

1200 represents the level before the massive drop in October 2008. The idea here is that there were buyers at this level, so when the stock reaches this level, those buyers that haven’t sold will want to sell to get their money back. If you look at the chart, there’s not much happening between 940 and 1200 because of the sudden drop last October. So there’s not a lot of people who bought between 940 and 1200 ready to sell.

In sum, the technicals say that we are likely to face resistance around 1120 and around 1200. In addition, a retreat is coming sometime soon.

So how much attention should we pay to this combination of fundamental and technical signals? How should we weight the balance of fundamental, technical and liquidity factors that drive the market? For the moment, it’s clear by the price action and the current market levels that liquidity is winning out. My simple interpretation is that things are likely to stay this way unless we have reason to change. And those reasons include a myriad of things – weaker earnings, any of the litany of fundamental worries mentioned above. If we don’t get any major shocks during earnings season, we’re likely to find support in the market until the end of the year. As we move into 2010, the liquidity drivers start to fade: there’s no longer as much of a need to chase performance, investors will start anticipating the Fed’s withdrawal of quantitative easing and an increase in interest rates becomes increasingly likely.

Once we’re into 2010, a dip is likely. I’m only moderately bearish, though. I don’t think, as many doomsayers do, that we will revisit the lows in March; we’d really have to be near Armageddon to go that far, in my opinion. I think 2010 will bring a dip or at best, a very sideways market – the “square root” scenario.

So What’s An Investor To Do?

So what’s an investor to do? The first is to realize that over the next couple months, we have a very asymmetric risk/reward scenario. That is, we’re playing for 10-15% on the upside, but this is driven by liquidity, which is not a strong reason for a market to go up. Rather than being the basis for a new leg up, liquidity is the last line of defense against forces that want to go the other way. There are more forces at work pushing for some downside than for any upside. For the moment, they’re just sitting in the wings.

Second, since we’re vulnerable to a correction, playing trades in the next few months is more for traders and risk-takers than for investors. That’s because we have to be nimble and be able to adjust our position if things turn. In contrast to traders, investors can be preparing for the major issues that are now waiting behind the scenes. Many hedge funds are positioned this way. Many of them are long commodities based on a declining dollar; short long-term Treasuries based on the end of quantitative easing; short bonds for the same reason; and negative on real estate based on continued weakness and rising rates in the future.

I generally agree with these approaches:

• Stocks have had a great run and so I find it hard to advocate jumping in now. If the third quarter earnings turn out well (and I’m cautiously optimistic about Q3 earnings), then we can play for a little bit more, but the margin of error is low and downside risk is higher.
  I find many of the stocks that I’ve recommended (e.g., Apple), and the financials (Goldman Sachs, JP Morgan, etc.) in particular, to be in this category. We may still get a little run into the end of the year, but they are vulnerable and we will have to especially careful going into 2010. I am long Apple, Goldman Sachs and JP Morgan.
• The declining dollar and impending inflation bodes well for commodities. That’s because commodities are traded in dollars, so when the dollar declines commodities prices increase. We will have times when the dollar strengthens, and this will weaken commodities, creating a good entry point. One other factor that will affect commodities prices: international demand. Over the summer, China’s stimulus package supported commodities prices. China is now taking a breather. If the dollar strengthens while international demand pauses, this would be an especially good time to buy.
• The declining dollar also favors another sector that I have long supported for their defensive nature: consumer staples with international exposure such as P&G, Coke and Philip Morris International (I am long all three). They used to be great defensive stocks to own in a recession. They still are, but the dynamic has changed; they’re more vulnerable to increased competition, and their international expansion makes them dependent on dollar movements. They’ve moved up in recent weeks and should continue to perform as the dollar declines. If the dollar reverses, they will, of course, take a hit.
• I like tech as we come out of the recession. I don’t expect quick results here, more medium term. Companies are still conserving cash and waiting for the recovery to solidify before spending more. Eventually, they will spend, and tech companies generally have low debt, high cash and good balance sheets; they don’t have toxic assets to worry about. Really, they just have to wait until customers start spending again. On the product side, rapid wireless growth and slower Windows 7 absorption should be bright spots.
• I still like the short long-term Treasuries trade. Again, this is for investors more comfortable with risk and money markets. In recent weeks, the TBT (2x short the 20-year Treasury), has pulled back as rates declined. This last week, they’ve had a bit of a rally after the 30-year touched 4% and bounced back. Longer-term, rates have to rise and Treasury prices have to fall.
• On the real estate side, I continue to expect the market to decline, perhaps another 10% or so. Stimulus, mortgage modifications, banks prolonging recognition of losses have all supported the market and created a temporary floor. All these helping hands will eventually disappear, and increased interest rates will, at some point, hinder demand.

That’s the medium- to longer-term, in my opinion. Let’s turn to the immediate short-term question of Q3 earnings.

The Q3 Earnings Season

So now we know what major forces are at work. Without question, earnings could also be pivotal. This week, JP Morgan, Goldman Sachs, Citigroup, and Bank of America report, and that should tell us a great deal about the banking sector. Intel, Apple, Google and railroad company CSX should give us some sense of the tech leaders and industrials.

Outlook Based on Fundamentals.

As I discussed last month, I like to come up with a “most likely” scenario, which we can call the “base case”. And that’s not to say that we should invest on based on the “base case”, but rather to give us a sense of what variables are at work. Deviations in those variables can also tell us what to do as more information comes out of earnings season.

So what’s the most likely scenario? I think that the big banks, as mentioned in last month’s article, are likely to do well. Capital markets activity has been strong; many banks have pushed losses forward, and prices for assets has actually gone up (this raises the value of “bad” assets and might even have allowed banks to sell some of them). If anything, it’s the regional banks that are heavily exposed to real estate that could have problems. I suspect the bigger issue will be expectations – they’re high, and good but not great results could be a problem. Take Goldman Sachs, for example. In June, the stock traded in the $145 range. If you use a 10x PE, that means expected forward earnings were $14.50 for the year. Today, with the stock at $189, a 10x PE would imply forward earnings of $18.90. That’s a 30% increase in earnings estimates over the last quarter. Anything less than spectacular results would send the stock down (I’m long Goldman Sachs, as mentioned).

Preliminary indications are that retail may not be as terrible as expected. Retail stocks also face easy year-over-year comparisons because last year was so horrific. So the consumer is definitely still weak, but expectations are very low already. As a result, the retail and consumer-related sectors might do alright through earnings season. Now mind you, that doesn’t mean that retail is cheap; I think they’re overpriced relative to fundamentals, but will probably do better than the low expectations that are out there.

As for consumer staples, these stocks are increasingly international and increasingly dollar dependent, as mentioned above. They will probably have minor improvement in the US but will be greatly helped by the declining dollar. So they should fare well on that front. If anything, it’s the consumer discretionary stocks that should remain weak; all indications are that the consumer is still saving (as he or she should).

Finally, if we look on the business side, tech will get a small boost from coming product cycles (e.g., Windows 7), but large capital expenditures are still far away. Here, companies are saving and hoarding cash as well because there’s no real indication that revenue growth is around the corner.

As for industrials and cyclicals, these companies are not the first to come out of a recession. They may be in the trough, but I think it’s too early to say there’s an upswing anywhere nearby. Many have cited international demand as a driver of growth, but I would argue that international demand will take a pause and foreign stimulus packages will take a breather.

All in all, we could get downward pressure, but there’s not a high probability of a drastic move to the downside. Nor is there much reason to expect huge moves up, either. If we don’t get major surprises, non-fundamental factors – such as the chase for performance – could well take over and drive markets up another 10% or so. If there are any nasty surprises, markets are vulnerable and drops would be swift.

Managing the Porfolio Through Earnings Season.

So how should we handle earnings season? When I first started looking at the market, I would get excited and would be inclined to pull the trigger as we entered the earnings window. Nowadays, I’ve come to the opinion that the best opportunities lie in the time between earnings, and that earnings season is actually one of the highest risk periods for a stock.

I’ve come to realize that I was tempted to play earnings season mostly because I wasn’t following a stock on a regular basis, and that the media hype had aroused my interest. This led to the temptation to “play” the earnings period. As I started to follow stocks more regularly, I realized that the time between earnings allows you to assess a stock without the hype, and that you can actually beat the analysts during this time. That’s because analysts start to re-evaluate stocks as earnings season approaches, so upgrades and downgrades come in the weeks before earnings. By the time an earnings announcement comes around, the stock price has adjusted to these revised expectations. At that point, you’re left with making the same bet that everyone else is: whether a stock will beat earnings or not. In my opinion, that’s not a strong way to play.

Unless I have high confidence that earnings estimates are out of whack, I’m inclined these days not to play earnings. And if there is significant uncertainty, then there is no shame in stepping out or taking some money off the table.

Let’s go back to Goldman Sachs as an example. Frankly, I haven’t quite decided what to do yet, but I may take some money off the table. Let’s say Goldman knocks the cover off the ball as it did in the second quarter. Prior to the earnings call on July 14, 2009, Goldman was at $149.66. Goldman wowed the Street and the next day, it closed at $155.26 for a $5.60 gain. So that’s 3.7% on a percentage basis, and by no means anything to sneeze at. But had Goldman missed, the downside move would probably have been much larger than 3.7%.

So it seems to me that a very viable strategy to reduce risk (if there is great uncertainty) would be to sell some, or part of the position just before earnings. If the company beats significantly, you buy it the next day. With our Goldman Sachs example, we would have missed out on the $5.60 gain, but would be positioned for the run after. If the company misses, then we avoid the drop that would have followed. And if the stock only does so-so, you didn’t miss out on much.

Of course, there are tax consequences, but you also don’t have to trade the entire position this way. When there’s great uncertainty you could sell part of the position to minimize the impact of the volatility that comes with earnings. More than likely, I’ll follow this approach for Goldman. I don’t expect earnings to be as much of a surprise as second quarter was, so I might take a little off the table. If Goldman beats, I jump in the next day. If it misses, I would avoid the drop after. If there’s not much reaction to earnings, I only have to deal with the tax consequences on the stock that I had sold before earnings (in this example, I’m only taking some off the table, not the entire position). On a side note, if Goldman misses (or is just in line), I still think Goldman is well positioned for the long-term and would consider that a buying opportunity.

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.