In this month’s investing article:
Investing in October. We rallied as earnings season began, but faded quickly as November approached. Fears of Fed tightening caused the dollar to reverse its downward trend and the market to retreat. In the end, the Fed blessed easy money, allowing the market to barely flinch when unemployment hit 10.2%.
The Way Forward. We may still get a run into the 1,120 – 1,200 range on the S&P by the end of the year.In this month’s investing article:
- Investing in October. We rallied as earnings season began, but faded quickly as November approached. Fears of Fed tightening caused the dollar to reverse its downward trend and the market to retreat. In the end, the Fed blessed easy money, allowing the market to barely flinch when unemployment hit 10.2%.
- The Way Forward. We may still get a run into the 1,120 – 1,200 range on the S&P by the end of the year. Still, it’s time to adjust the portfolio and prepare for possible declines in real estate and increases in interest rates.
- Opportunities. Look for the market to be sideways to somewhat down through 2010. Yet winners will be separated from losers, and opportunities remain. A few ideas to whet the palate.
- Apple and Goldman Sachs. I little bit of a deeper look into the prospects of Apple and Goldman Sachs.
The Beginning of October – A Weak Set-Up
October has always been unpredictable, and this year’s October was no different. Obviously, this was nothing compared to last year’s October, but still, the market hasn’t been this confused in a long time. Truth is, it was very hard to know which way things would go. Pundits would appear on TV and say things are going up; the next day, they’d change their mind. The news couldn’t stop talking about Dow 10,000. On the exchange, they donned “Dow 10,000” hats… and took them off… and put them back on – many times. Then the market turned downward, erasing the gains of the month. By the end of October, the Dow was down 6%, and many said there would be a 6-10% correction before it was all over. Last week, the Fed and world governments vowed to continue stimulus, and the market barely flinched as unemployment hit 10.2%. That cleared the way for a rally on Monday, November 9. That day, the Dow jumped 203 points to 10,226.94, a new high for the year.
The Market at the Beginning of October
That’s the news flash version of this month’s events. Let’s take a look at what was going on behind the scenes to move the markets, and why so many were confused.
Remember that we started October hopeful, but a bit afraid:
- At the beginning of October, consensus was that the market was overvalued. The party line was, earnings beats had been based on cost cuts, and improvements in revenue were necessary to keep the market moving upward.
- Liquidity, driven by a generous monetary policy from the Fed, was keeping markets up. That meant any change in that policy would quickly derail the amazing 56% rally we’ve had off the March lows.
- Meanwhile, the technicians were worried about approaching the 50% re-tracement level (50% of the distance between the October 2007 high and the March 2009 low, equal to about 1120 on the S&P), a classic reversal point.
- And not to be left out, funds had their own worries. October 31st is the year-end for most mutual funds, meaning that there was strong pressure to show profits before all the books were closed.
The long and short of it is, there wasn’t much to prop up the markets other than liquidity. Expectations were high, and there were many things to worry about. So while we were optimistic, it wouldn’t be hard to spook the markets either.
Earnings Season
The first half of October was all about earnings. The big guns – Goldman Sachs, JP Morgan, Intel, etc. – the leaders, reported first. And all in all, they did well. That helped push the S&P to a year high of 1,097.91 on October 19, 2009. Still, stocks – even the ones that beat by a wide margin – would jump as earnings were reported, and then sell off immediately. Stock after stock, the story was the same. Stocks couldn’t hold their price levels, and that meant technically, the market was very weak.
Take a look at the following chart of Apple as an example.
As Apple reports earnings on October 19, 2009, it jumps from $189.86 to $198.76, an $8.90 gain. The next day, Apple hits an intraday high of $208.71, but can’t hold that price level and closes at $204.92. It rallies one more day, and then sells off for the next week or so. By November 3rd, the stock has fallen to $188.75 – erasing all the gains attained after earnings. Notice that as the stock sold off, volume dropped off as well and then accelerated the downside move.
The Carry Trade
Low interest rates impact the dollar in another way. With US rates near zero, people start borrowing in dollars to fund their investments. This is known as the carry trade, and it puts additional downward pressure on the dollar. In previous articles, we’ve talked about how the carry trade fueled the recent bubble in real estate prices. Basically, investors would borrow at near-zero interest rates from Japan and re-invest those proceeds into higher-yielding instruments, such as the mortgage-backed securities that led to the credit crisis. At one point, investors could also borrow from Switzerland for 2.5%, and re-invest in the United States, where interest rates were 4.0%. Today, with interest rates are near zero in the US, America has become the perfect funder of the carry trade.
The Short Dollar Trade
And of course, there are plenty of capitalists ready to take advantage of the falling dollar. Many, many investors are short the dollar, and this trade is, as they say, “crowded”.
Declining Dollar Fuels Stocks
The declining dollar has a huge impact on stocks, other markets and other countries. For one thing, the falling dollar fuels the stock market. Low interest rates and low cost of funding encourages investors to take more risk, and the stock market offers better yield than other alternatives such as Treasuries. Also, the lower dollar fuels the commodities trade, because commodities are priced in dollars. So the price of commodities goes up as the dollar goes down. That in turn drives up the earnings and prices of commodity stocks.
Gold and Dollar Diversification
Of course, there’s going to be a reaction to all of this. In recent months, there’s been talk of pricing commodities in a basket of currencies instead of the dollar, and there was even a “secret” meeting of major nations on this subject. Still, not much has come out of those rumblings. Perhaps, in the short-term, there’s really no getting away from the dollar because of its safe haven status. The proof of this is in Treasuries: despite the concerns about the dollar and the US economy, central banks and investors are still buying Treasury bills and notes.
To hedge their exposure to the dollar, what investors have done is buy gold. As everyone knows by now, gold broke the $1,000 level. Last week, the IMF sold 403.3 metric tons of gold to fund lending to poor nations. India bought half of the offer – 200 metric tons – at an estimated price of $1,076.30 per troy ounce. This drove gold higher and supported the thesis that countries were looking for ways to diversify away from the dollar. Take a look at the following chart of GLD, the gold ETF. For a long time, gold had trouble passing the $1,000, but finally did so at the beginning of October.

The Late October Pullback
To recap, by mid-October the market was looking technically very weak as stocks failed to hold on to any gains from earnings. As mentioned, this was driven, in part, by the lack of any upcoming positive catalysts, the belief that a correction was imminent, and investors’ need to book profit. In addition, weakness in the market was driven by fears of a reversal in the dollar.
The Dollar Reversal
If the dollar reversed its downtrend, then the many players that were short the dollar would have to cover their short positions. That means that they would have to exit the trade by buying the dollar, creating more upward pressure on the dollar.
Why would the dollar reverse? In early October, Australia hiked interest rates from 3.0% to 3.25%. By doing so, Australia became the first G20 nation in recent times to raise interest rates. Investors saw this as a sign that the global economy was recovering, and that implied other countries might soon follow, including the United States. If the US raised rates, the dollar would become more attractive, buyers would appear, and the dollar decline would be reversed.
Let’s take a look at the DXY, the dollar index, in a bit more depth. You’ll see from the following chart that the dollar began to reverse on 10/23 as it reached about 75 on the index:

The S&P Pullback
Now let’s examine the S&P 500, below.

This chart is a bit crowded, but let’s try to make some sense of this. You’ll see that the dollar reverses on 10/23 (in red) and the S&P does as well. In fact, the S&P fell for the next five trading sessions, and by 10/30, the S&P had fallen 6% – the biggest pullback in recent months.
By now the technicians were worried. The late October pullback brought us down to the 1,030 range on the S&P – about where we were in late August, and close to where we were at the beginning of October. If the market didn’t hold this resistance level (see chart), we would be headed toward 980, or almost a 12% correction. Notice also the long trend line drawn under the lowest points in the rally since March. We touched this trend line in July, but bounced off it, and the rally continued. In late October, we fell below this trend line, and the technicians declared the trend line officially “broken” (see chart). At that time, we also fell below the 50-day moving average, something that hasn’t happened since July.
Needless to say, the bulls ran for the sidelines while the bears were loudly declaring the end of the rally. As the S&P touched the 1,030 in late October, the technicians were anticipating a “head and shoulders” formation, a classical indication of a market reversal. The head and shoulders is comprised of a high top in the center (the “head”) surrounded by two, somewhat lower, equal-sized “bumps” on each side (the “shoulders”). If you look at the chart of the S&P, you’ll see a possible left shoulder formation appearing in September 2009. The head would be the October “bump” and a possible right shoulder, a mirror of the pattern found in September, could form in November. For the head and shoulder pattern be complete, the two shoulders should be equal size, and the bottom of the shoulder, known as the “neckline”, should be the same. You’ll see that the September shoulder and the October head both, at their lowest levels, approach the 1,030 level on the S&P. So you can see, the technical signs were screaming “reversal!” and the bulls were hiding on the sidelines.
Enter the Fed
You can see that at the beginning of October, it was very hard to decide what to do. If you’re a technician, you’re shorting. If you’re a fundamentalist, then what you should do depends on your view of the dollar.
Throughout the month of October, there were rumblings that the Fed might start changing its stance on quantitative easing, that it might start to withdraw stimulus from the economy. Now most would say, Bernanke, as a student of the Great Depression, would do the exact opposite – he would keep the stimulus going for as long as possible. That’s because during the Great Depression, they made the horrendous mistake of withdrawing stimulus too early. And by doing so, they basically cut off the lifeline that was keeping ailing companies alive. Truth is, it wasn’t the crash of 1929 that caused the Great Depression; it was the withdrawal of stimulus in the 1930s that really killed the economy.
So most doubted that Bernanke would be hawkish and start raising rates. Still, no one would bet on it, and the market lingered around the 1,030 level as it waited for the Fed statement on 11/4.
The Crux of the Matter
Now we come to the crux of the matter, and the reason we went through all these charts about the stock market and the dollar. If you believed that the Fed would be dovish – that is, that the Fed would continue to keep interest rates low and to stimulate the economy, then the reversal in the dollar is temporary. If the Fed continues its policies, then the dollar would continue to decline, and the right decision at the end of September would be to buy stock during the pullback.
If, on the other hand, you believed that the Fed might withdraw stimulus and start raising interest rates, then that means the end of the liquidity-driven rally. The dollar would continue to rise, the carry trade would end, and the market would decline as money got sucked out of the system. So if you thought the Fed would be hawkish, then you would sell, short or do both.
Personally, I want the rally to continue, so I say, fortunately, the Fed was dovish. On Wednesday, 11/4, the Fed announced that it would keep interest rates low and support stimulus for as long as possible. Then on Friday, 11/6, the unemployment report came out. Nonfarm employment continued to decline by 190,000, causing the unemployment rate to rise from 9.8% to 10.2%. Despite this terrible news, the market barely budged on Friday. That might not sound like much, but it holding was a win for the bulls.
Finally, over the weekend, the G20 nations agreed to continue supporting stimulus. That meant interest rates would stay low, and the dollar would continue its decline. All this was bullish for the market, and so on Monday, November 9th, the market rose 206 points on the Dow, hitting a new high of 10,226.94.
The Way Forward
In last month’s article, I wrote that I anticipated 1120-1200 on the S&P by the end of the year. I believe that scenario is still likely. In fact, we may find out very soon if this will be the case.
There are several reasons for this proposition. Last week, the Fed and the G20 basically gave an all clear and sanctioned a continuing decline in the dollar. That, as argued above, would mean continued liquidity and would be bullish for the market. Also, there’s no more significant news to be had. We will get more economic reports in December, but for the most part, nothing is expected to be a nasty surprise. If anything, a continuing rise in unemployment might dampen markets, but that is, in part, expected. And there are no earnings reports until January. Finally, we have fund managers that will continue to chase performance. The mutual funds closed their books on October 31st, but the hedge funds close their books on December 31st. So there will be continued buying pressure to achieve performance.
To be fair, we have to consider the possibility that there will be a downturn. If we look at our chart of the S&P (above), you’ll see that the “top” or “head” of the recent run-up lies at 1,097.91. As of Tuesday, November 10th, we’re at 1,093.01, not very far away. It is possible that we would a hard time breaking 1,100 on the S&P. If we approach this level and the market reverses, then we would have a “double top” – another classical sign that the market is turning downward. But if we can break 1,100 and hold that level, then 1,100 – 1,200 is a very real possibility. We will probably know within a week.
Before we get all giddy about the possibility of a continued rally, we have to re-examine the trends that have been driving this market. And if we do that, I think we’d have to conclude that change is on the horizon. It may be a month out, it may be a quarter or two away, but the forces that have created and sustained this rally cannot continue forever. We don’t need much proof, either. October’s market weakness, combined with the market’s nervousness, should be evidence enough for concern.
Evolving Fundamentals, Evolving Macroeconomic Conditions
Shifting Fundamentals. We are going to have to face several issues over the next several quarters. For one, the problems in real estate aren’t over. There are significant foreclosures in the pipeline – foreclosures that have not yet been recognized by the banks. Instead of initiating the foreclosure process, banks have extended deadlines and payments. This allows the banks to keep these accounts in the active bucket, and out of the foreclosure bucket. This cannot continue, and banks will eventually have to recognize those losses – in both commercial and residential real estate – over the next few quarters. This implies the following for investing:
- Avoid real estate stocks. We may get some benefit from the renewed housing credit and continued low interest rates, and I can’t tell you exactly when these real estate problems will manifest themselves, but I’m staying away from real estate stocks. If we get a rally into the end of the year, it may be a very good opportunity to exit.
- Avoid banks with heavy loan portfolios. As noted in our previous columns, there are “hybrid” banks – those that combine capital markets and lending, and more “pure-play” lenders. I would stay on the sidelines when it comes to the more “pure-play” ones, the banks that are heavily exposed to residential and commercial lending. In fact, even the hybrids that can offset lending losses with investment banking income may take a hit in the coming months.
- Be cautious when it comes to consumer-discretionary stocks. Many analysts like consumer discretionary as we go into the winter holidays. There’s pent-up demand, they argue, for extravagance and spending. They may very well be right. But as we enter 2010, and if real estate problems become more severe, the consumer will take another hit. It’s too early to tell, but here’s another area to consider selling or trimming back as we get into 2010 – especially if you get a lift going into the winter holidays.
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Macroeconomic Shifts. We’re also approaching a period where macroeconomic policies may have to change. Despite the Fed’s dovish stance discussed above, interest rates may have to increase. Consider this: immediately after the Fed declared support for liquidity last week, the 30-year Treasury yield actually went up (meaning that the price went down) after last week’s Fed announcement.
Now, the Fed doesn’t control the interest on the long-end of the yield curve; it controls the short end, and hopes that the long-end, controlled by the market, will follow. The fact that the 30-year Treasury bond yield went up implies that the market sees interest rates rising, irrespective of the Fed’s dovish policy. Investing-wise, that implies the following:
Prepare to exit bond investments. If you have your money with a money manager, and if that manager does any sort of asset allocation, it’s likely that they’ve placed you in a bond fund. But bonds, like stocks, have had a tremendous run. If you’re not familiar with bonds, you only need to know that yields have been very high, and they’ve fallen as the market stabilized. That means prices of bonds, which move inversely to yields, were low, and as fear of Armageddon receded, the prices of those bonds rose. Now, if interest rates rise, yields will rise, and prices will fall. So bond portfolios will suffer if interest rates rise.
Going into 2010, it seems to me that the market as a whole will be moving sideways, or will dip. There are companies that will have revenue growth, and will beat earnings estimates. But I don’t think the market as a whole will do that. More likely, we’re going to get separation, and the strong – “the winners” – will be offset by weak, the “losers”.
The Opportunities
If that’s correct, then there will be opportunities. Here are some of the themes that I like:
Secular product cycles. These are companies that have products that people will buy, even in a down cycle. I’m going to highlight two of these – Apple and Goldman Sachs (both of which I’ve mentioned in past articles), but the quick summary is this: these companies are leaders in their markets; have competitive advantages in industries with high barriers to entry; and they have products that will continue to be used.
There are plenty of other companies in this category, which I’ll label as “ideas to investigate”, and I’ll give the quick thesis on each. Meaning, these are ideas, as opposed to more developed analyses.
- Google. As advertising comes back, Google will be a beneficiary, traditional print media will be the loser. The fundamentals in this market have shifted, and traditional print will have a hard time reaching its former glories. In many ways, it feels like Kodak in the age of digital cameras, though perhaps not as dire. As the smartphone market grows, look for Google to start making money off cellphone clicks. Still, this would be a 2011-2012 event.
- Visa and Mastercard. The key here is that both of these companies are transaction processors, and they don’t carry any credit risk. As the consumer recovers, they’ll start using credit cards again, and these guys will be the beneficiaries. Plastic is the wave of the future, and will increasingly gain share against “cash”. If the consumer takes a hit in 2010, Visa and Mastercard may pull back in sympathy, but it would be a buying opportunity. There’s also a bit of regulatory risk here, although these stocks will be less affected because they’re not actually extending credit. I am long Visa.
- The Windows Upgrade Cycle. I’m not a big fan of Windows, but that doesn’t change the fact that windows has the lion’s share of the market, and that companies will replace their computers. Don’t expect any fireworks here, it’s a longer, slow process, because companies aren’t in a rush on this. Still, it will happen over the next couple years, meaning that companies such as Intel, Microsoft and Hewlett Packard will benefit. I am long INTC and MSFT.
- Boeing. I’ve mentioned Boeing before, and it remains hated because of its failure to deliver. Still, it will someday, and eventually, the 787 will fly. Currently it is scheduled to take to the air in December. If you want to be a risk taker, you can buy before the December flight. Of course, the risk is that Boeing disappoints again. For less risk, buy after the Boeing 787 flies. Over the next 2-3 years, air traffic will rise and so will airplane deliveries.
The Macroeconomic Plays.
There are lots of plays related to macroeconomic trends. Know that generally, these plays have high volatility, and unlike the stocks mentioned above, a consistent long-term trend is less clear. I’ll go through two quick examples.
- Gold. It’s not hard to figure out the reasons for buying gold. Right now, the main reason is the declining dollar. In the future, the reason will be inflation. Many expect gold to reach $1,200 – $1,300, and I tend to agree, I think this price range is likely.
The problem with this as an investment is two-fold. First, there’s the entry price. Now with gold being fairly popular, pullbacks exist for very short periods of time, making timing key. Not necessarily the best situation for the retail investor. The second problem is the volatility. If the dollar reverses, it’s very possible that gold will take a sharp drop before it rises again because of inflation. Now, it’s possible that the dollar rises, and gold also rises. But you have to be ready for either. So basically, this isn’t an investment that you can make and forget about. You have to watch it carefully and have the stomach for it.
- The TBT (2x Short 20-Year Treasuries). I’ve mentioned this trade before, and when I have, I always stated that it’s for the advanced investor. Reason is, volatility is high, and a strong stomach and consistent attention is necessary. So if you don’t have both, I’d skip it.
If you do, this trade is based on the assumption that eventually, money will come out of Treasuries. I’ve been early on this trade, but the volatility actually makes it playable. Also, I would expect this trade to really kick in sometime over the next few quarters – basically as soon as interest rates start to rise. I currently do not have a position in the TBT.
Apple
With the Droid released, we now know the playing field, and consensus is, there’s no iPhone killer in the market. Apple is the clear leader, the Droid is a good phone and will win some followers; RIMM has a franchise, even though it may be deteriorating; PALM has had limited success, and Nokia, Ericsson and other cellphone players do not have a competitively viable smartphone product. People love the iPhone and are addicted; that means to me that people will continue to buy. Keep in mind that distribution will increase as Apple expands beyond AT&T as its main carrier. On the computer side, iMacs are selling well, and slowly but surely gaining share.
On a valuation basis, Apple, currently priced at $202.98, trades at 26x 2010 earnings of 7.78. Now a multiple of 26x may seem high, but it’s not for a company that is growing earnings at 24%. Consider that Apple is expected to grow earnings 21% in 2011, and trades at 21x 2011 earnings of $9.38.
Many people shy away from a stock like Apple simply because of the price tag, and I can’t blame them. It takes a bit of getting used to. Still, Apple is the clear leader, and it doesn’t seem (to me) as if there’s a competitor that can stop them. 12-month price targets for Apple run as high as $280, set by Maynard Um of UBS. The way I look at it, if Apple hits $240 in the next year (~ $9.38 in earnings x 26 PE), I’d be a happy man. Based on today’s price of $202, that would be just under a 20% return. For the record, I am long Apple.
Goldman Sachs
So many people hate Goldman Sachs, but there’s no denying that they’ve done a good job managing risk. They’re the leader in investment banking, and the survivor – the fall of Lehman and Bear is a huge benefit to Goldman because fewer competitors are standing. Moreover, trading and investment banking will continue. Activity in mergers, IPOs and fixed income will continue to drive earnings at Goldman. Finally, keep in mind that Goldman doesn’t have the loan exposure of the commercial banks.
The stock trades today at $176.51, 9x 2009 earnings of $19.30, and 9.4x next year’s expected earnings of $18.84. The last two quarters, Goldman easily beat, earning $4.93 in Q2 , and $5.25 in Q3. I think that Goldman could continue to earn $5 per share per quarter, leading to $20 in annual earnings. With a 10x PE (after Q3 earnings, the stock traded as high as $192, implying a PE of 10.2x on 2010 earnings of 18.84), that would make Goldman a $200 stock sometime in the next year.
Disclaimer. All trades, patterns, charts, systems, etc. discussed in this advertisement are for illustrative purposes only and are not to be construed as specific advisory recommendations. All ideas and material presented are entirely those of the author and do not necessarily reflect those of the publisher. No system or methodology has ever been developed that can guarantee profits or ensure freedom from losses. No representation or implication is being made that using the above approaches will generate profits or ensure freedom from losses. The examples used herein are not intended to represent or guarantee that anyone will achieve the same or similar results. Each individual’s success depends on his or her background, dedication, desire and motivation.
As always, I encourage you to consult your own investment advisors before making any investments. I don’t claim to 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 www.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.