Investing – Vigilance

In this month’s investing article:

• The February Correction. In late January through early February, we saw an 8% correction (based on the S&P). As of today, we’ve retraced almost all of that 8%.

• The Clouds – China, Europe, Inflation and Interest Rates, and US Regulation. It may seem like the recent correction never happened, but we’ll continue to be dogged by weakness in China, debt problems in Europe, the possibility of higher interest rates and regulation from Washington. The investor needs to be vigilant and watchful of these “clouds”.

• Looking Forward. I continue to expect 2010 to be range-bound, generally. The long-term conservative investor can earn some return by leaning toward defensive, dividend-paying blue chip stocks. For those that can be more active, look to trade around a core position – taking some profits when the stock rallies, and doing some buying on the dips. With the market near it’s recent high, the more active investor should be asking whether it’s time to take some profits.

• Stock Updates. Quick looks at Apple, Goldman and Citi – what opportunities they present, and what they tell us about today’s market.

February Highlights

After a shaky January, February brought us the correction that many had long been waiting for. From the January high of 1,150 on the S&P, the market fell to 1,057 on February 8th – an 8.1% correction. Many feared that the correction would be more severe. Pundits were predicting a drop of 10-15%, and you even had a few at 20%. Still, the market battled back, and as of today, March 19, 2010, the S&P stood at 1,140 – only 10 points away from its January highs.

The late January through February correction was impelled by a trio of worries: the end of stimulus in China; sovereign debt problems in Greece; and fears about fiscal policy and regulatory clampdowns from Washington. For the moment, the market seems content to believe that China’s withdrawal of fiscal stimulus will be gradual; that Greece’s debt problem will not morph into a contagion that spreads across Europe; that the Fed will increase rates slowly; and that banking regulation out of Washington will have less teeth than expected.

When I wrote at the beginning of the year (January’s investing article, entitled “Investing – The Shifting Landscape”), China, Europe, inflation and interest rates, and government regulation were all on my list of risks to monitor in 2010. It’s worth looking at each of these in a bit more detail, because the truth is, theses themes will recur through the remainder of 2010.

China – A Bubble, In My Opinion.

For the last several years, the world has marveled at China’s progress. Economists gush when they talk about China’s growth rate, the press regularly asks why China is the only country where fiscal stimulus has actually worked, and the bulls say, “Why worry if China’s growth drops from 10% to 7%? It’s still far better than the rest of the world.”

I think China is something to worry about, and to understand why, let me go a little deeper into the Chinese economy.

Many look at China and think that it works like the Western economies. Truth is, it’s very, very different. First, as everyone knows, China is a command economy. So when the government says to the banks, “Thou shalt lend,” you’d better believe that the banks will lend. This does make government stimulus more efficient, at least initially.

What many do not understand about China is what happens to government stimulus after a decree has been issued in Beijing. A lot of that money has ended up in the property market and in purchases of raw materials. Let’s talk about property first. The Chinese love real estate (I’m Chinese, I should know), but money ends up in property because of several factors unique to the Chinese economy. In China, there is no property tax, so local municipalities don’t have much revenue. But municipalities can sell land, and that’s what they do to finance their operations and to create growth (remember, Beijing wants everyone to hit growth targets, and no one wants to tell Beijing that they’ve missed the growth target). On the buy side, the West tends to think that it’s individuals and corporations buying, but unless you know China, you forget that state-owned enterprises (SOE’s) are a big factor in the Chinese economy. Yes, individuals and developers are buying, but a large portion of real estate purchases is done by the state-owned enterprises.

If you follow the money, here’s a lot of what’s happening: Beijing says lend, and the banks lend; the banks lend to SOE’s (indirectly through investment vehicles, because SOE’s aren’t supposed to be speculating in land); SOE’s buy land from municipalities and build. That buying and selling adds to GDP, so all this activity does contribute to China’s growth. But there’s a flip side to all this. By now, people are realizing that there’s a lot of real estate not being used. Visitors regularly look around at huge buildings, even cities that have been developed – and are vacant. You can pretty much go on Youtube and see the images if you want. China has built much more than is being used. And the truth is, much of the real estate in China is out of reach of the average person.

Let’s briefly touch on the commodity side. Of course, a lot of commodities go into construction. So it’s easy to understand why China has been buying commodities. But many believe that a lot of what China has bought has gone into storage. Last year, China itself said that it had been buying oil for its own strategic petroleum reserve, and announced that it was unlikely to continue purchasing at its previous pace. For other commodities, such as copper, no one knows exactly where all of China’s purchases went. Best guess, a lot of what China bought is sitting in storage. If that’s true, future purchases of commodities are unlikely to be anything like what we saw in 2008.

Now let’s get to why this is important. There’s been this idea that China is just a better machine, that it is growing so rapidly because Chinese consumers are making a great leap forward into the middle class, and that their appetite for better things is driving all this growth. If you accept the picture I’ve painted above, you see that this is not the case. Make no mistake – the Chinese consumer is leaps and bounds better off now than he or she has been at any time in the past. But to think that they are the driver of unbridled growth (a bit akin to the American consumer) is a mistake. I think that a great deal of the wealth creation is bypassing the average person; it’s going into things – like buildings and commodities – that are far beyond what the what the country is actually using. And if the stuff is not being used, you can’t continue to spend at the same pace. Also keep in mind that in China, domestic consumption is 35% of the economy, and the remaining 65% is exports. In America, the consumer is 70% of the economy.

Back in 2005 or so, I visited Las Vegas in the midst of the real estate boom. Prices were going crazy, but the one thing I remember is that much of Las Vegas real estate was unoccupied. I saw miles and miles of construction, but most of it was empty because Las Vegas was full of second homes and houses bought by speculators. I also remember prices so high that the average person could no longer afford a house on a long-term basis. The only reason people were buying in America back in 2005 was because of low teaser interest rates and lax lending, and we all know how that story ended.

To me, China’s property bubble is very reminiscent of the United States just before the last crash. And something else is also familiar: China is now trying to restrict lending, just like the Fed tried to do starting with interest rate increases in 2004.

If China is in a bubble, does that mean that it will crash like the US did? It’s actually hard to say. I can confidently say that there are imbalances in the Chinese economy that have to be remedied, but how, in what form, and when is hard to say. Keep in mind that it was several years after the Fed started to raise interest rates that cracks actually showed up in America’s real estate bubble. Also note that the United States has relatively clear accounting, legal frameworks and foreclosure processes. In China, accounting is a mystery and law is by decree. So if a state owned enterprise owns a large building that is underwater, and it can’t pay its mortgage payments, does that mean the SOE and the bank will recognize the loss? If they do, then China’s growth rate will fall – and Beijing will do almost anything to avoid this. In a normally functioning market economy, the loss would be recognized, and eventually, prices would find a new, more reasonable equilibrium. China is a command economy with a different set of rules, so its very unclear to me what will happen.

As an investor, this means that you will (well, at least I will) have to continue to monitor China. For the moment, China is trying very gradual measures to pull back lending. It has increased reserve requirements for banks; it has started to increase interest rates; it has announced that the government will nullify loan guarantees that have been provided by local governments. So tightening has begun in earnest. If, or when, that tightening flows through the system and results in substantially less purchasing by China, expect this to affect other Asian economies and commodities exporters such as Brazil, Australia and Canada. The developed economies will also be affected, but here’s a great twist – if this happens later rather than sooner, when the American recovery is well under way, then it’s possible that American purchases of Chinese exports could provide the soft landing that China is trying to achieve.

Sovereign Debt and the Eurozone

The European situation is a bit more straightforward that the China one. The simple picture is this: European economies are still struggling to recover and debt is high. In the past, individual countries would manage their budget problems through a combination of stimulus, interest rates and currency manipulation. Now that Europe is part of one monetary system, those tools have been taken away from the individual countries. That means there’s only one option left: austerity.

This is exactly what happened with Greece. Its economy is in shambles, and before the Euro was created, Greece would have printed money and devalued the currency (so that exports are cheap, bringing in more revenue). With the Euro in place, Greece can’t do that anymore. Instead, fellow European countries declared their “support” and Greece proclaimed that it would cut spending (austerity) so that its finances will eventually be in better shape. The market bought the story, and Greece was able to issue debt, albeit with a higher interest rate. The fear had been that if Greece could not issue debt, the country would default on older debt that was due over the next several months.

Of course, this is not the end of the story. What happened with Greece could easily happen with Spain and Portugal. And we still have to see if Greece will live up to its own rhetoric. It’s kinda like listening to a shopaholic who says he’ll stop spending – you have to see it to believe it.

Here again, the message for the investor is that you have to watch this situation. It’s quite possible that what we saw in January with Greece will happen again. The market is betting that this is the case, and the “smart money” is short the Euro in anticipation of further problems.

US Interest Rates and Regulation

In February, the Fed increased the discount rate. This is the interest rate that the Fed charges depository institutions that borrow reserves from it. To many, this was largely a symbolic move, because few are using the discount window at the moment. The Fed took pains to tell the market that despite the increase in the discount rate, interest rates (specifically, the federal funds rate, the overnight rate that banks charge other banks) would remain low for “an extended period of time”. Meaning that the Fed will keep rates low to make sure that the budding recovery won’t be harmed.

Still, the market is cautious. The Fed will end its purchases of mortgage-backed securities in March, so the market will be watching to see if interest rates, especially on home mortgages, will go up. If rates aren’t significantly affected, the market will breathe a sigh of relief. If interest moves up, the market is likely to fret about damage to the nascent recovery. As with the other issues mentioned above, this will be a recurring fear in the markets, and an investor should monitor Fed policy on interest rates.

Of course, we also have the specter of government regulation. In January, the proposed Volcker Rule – the possible ban on proprietary trading – sent stocks and especially financials reeling. Recently, it seems that any legislation on proprietary trading will not have much teeth. Some have already pronounced the Volcker Rule DOA (dead on arrival).

That’s not the end of regulation, by any means. Pundits regularly joke that when the Obama speaks, the market goes down. While I generally like Obama, the pundits have a point: he can be very bad for markets. More regulation will be coming, especially if the current administration is emboldened by passage of a health care bill.

Looking Forward

This year, the investor will have to be vigilant. We will continue to be dogged by China, Europe, inflation and interest rate concerns, and regulatory fears. We also have to worry about the weak consumer and a double dip caused by further real estate problems. Market watchers will be looking for the key indicator of an economic recovery – several months of job growth (or consistent declines in the unemployment rate) all through the year.

As mentioned, the market is at 1,145 – almost as if the late January correction never happened. As I’ve also mentioned in previous articles, I continue to believe that this market will be more sideways and range-bound than anything else. We may push to 1200 – but we have clouds above us. The market may correct and fall, but we do have some support below, because I do think that the worst is behind us. I still think that 2010 will be very much like 2004, when we moved sideways (and somewhat down, actually) for most of the year before moving upward.

The Defensive Dividend Stock Approach. For the long-term investor, 2010 is a year of patience. It’s a time to pick stocks that you think will perform toward the end of the year and into the next 1-3 years. To get some return in 2010, you can put a decent portion of your portfolio into defensive, blue-chip, dividend-paying stocks. This will stabilize the portfolio and give you some return in this side ways market.

You could easily take this defensive dividend-focused approach through much of 2010 and not do much with your portfolio. And there’s no lack of stocks that fall into the category of defensive, blue-chip dividend paying stocks. Examples include (and I’ve mentioned many of these in my previous articles) Kraft with about a 4% yield; IBM with a 1.8% yield; Altria with a 6.7% yield; Philip Morris International with a 4.6% yield; Clorox with a 3.2% yield; Proctor & Gamble with a 2.8% yield; JNJ with a 3% yield; Wal-mart with a 2.2% yield; Coke with a 3.2% yield; and Pepsi with a 2.8% yield. Some of these also have strong potential for long-term capital appreciation. I am long, by the way, Kraft, Altria and Phillip Morris.

Trading Around A Core Position. For those that want to be a little more active, you can trade around a core position. For those not familiar with this, let’s say you have 200 shares of a stock. All stocks will bounce around, often within a range. When the stock is toward the higher end of its range, you can sell 50 shares. When it falls back to the lower end of the range, you can buy 50 shares. If you want to be aggressive, you can buy more shares when the stock is at the lower end of the range, say 75-100 instead of just 50. This also means that you have to have some cash on the sidelines, ready for such purchases.

Of course, this begs the question, when do I know a stock is at the high end or the low end of its range? There are several techniques for this – fundamental, meaning you look at valuation; and technical, which means you look at trading patterns. Another simple way to think about this is to think about the current market. If the market corrected when we were at 1,150, that means you should be thinking about taking some profits while we are here today at 1,145. You may not, depending on what you think of an individual stock, but you should at least be asking the question. Conversely, if the market falls to the 1,050 level or below, you should be thinking about buying.

This also presumes that you are talking about a stock that is not fundamentally impaired. That means that there is no significant, permanent reason for the stock to decline. For example, IBM has very stable revenue based on service contracts. If it falls, you have to ask, did it fall because its ability to generate revenue has been impaired (e.g. management problems, competitive issues) or because the market is going down, and the stock is moving with the market? Because IBM has long-term service contracts, it’s likely to recover from any downturn, so long as its ability to collect revenue from those service contracts has not been impaired. Generally, the dividend paying stocks I mentioned above are similar to IBM, but of course, you have to examine each individual stock to be certain.

More Aggressive Approaches. If you want to kick up your risk profile a notch, you can go for the stocks that are expected to see capital appreciation because their earnings will reach more normalized levels in the next 1-3 years. Many of the banks fall into this category – the have lots of money sitting in reserve because there might still be significant losses, but at some point, most of the bad loans will have been written off, and their will no longer be a need to maintain those reserves. That leads to a kick in earnings for the banks, plus any excess reserves can but put back to work to make more money. Also, by the time the banks have written off most of their bad loans, the consumer will be in much better shape, and dividends will return. As an example, look at JP Morgan. This year, JP Morgan is expected to earn $3.o1 per share. Next year, it’s expected to earn $4.73, and many believe the company could earn as much as $6 in a “normalized” environment. That’s a huge kick to earnings (in the long term), and likely a significant jump in stock price compared to today. I am long JPM.

If you can handle even more risk, and have some time to research and trade actively, there are trades in Citi (and some of the regional banks, which we’ll talk about in a minute. You also have trades based on macroeconomic trends. For example, if you believe (as I do), that the Eurozone will have more problems, then it makes sense to short the Euro and buy the dollar in the short- to medium-term. If you want to get even fancier, you can be long the Australian or Canadian dollars (because their economies are better) and hedge by shorting the Euro against them. That’s for advanced players only.

Stock Updates

Apple. I continue to be long Apple and am a fan. But let’s do a quick valuation check. Today, the stock trades at $224.84 (let’s say $225). It has $27 of cash on the balance sheet, and many analysts subtract cash from the price before computing PE. Average analyst estimate for year ending September 10, 2010, is $11.58 and $13.37 for 2011. So the PE would be ($225 – $27)/ $11.58, or 17x 2010 earnings and $14.8x 2011 earnings. These are reasonable, and even cheap PE’s compared to the overall market. If you take into consideration Apple’s record of outperformance, and assume that Apple should trade at a premium (as it has historically), the stock is even more inexpensive. Late last fall I argued that Apple could hit $240 this year, and with the iPad launch, I think Apple could easily exceed $240 in the coming year.

Shorter term, Apple has historically run-up prior to a product launch and then sold off at launch and for days or weeks thereafter. Apple has already started a run (it had fallen into the low $190’s in early February) and if it continues, I think it’s very likely that there will be a sell-off after the iPad launch. If you buy into this thinking, that means sell Apple or take some profits just before the launch, you can look to buy back in afterwards.

Goldman Sachs. Late last fall I put a price target of $200 on Goldman Sachs. Since then, Goldman has dropped from $176 to as low as $148 during the latest correction. Many were wondering, what’s wrong with Goldman Sachs, and I think a quick review is very instructive. Stocks go down – but not always for the right reason.

Goldman started to fall, meaning that the “smart money” was exiting. The possible explanations came afterwards, and frankly, the analyst downgrades came last. The first rationale was that Goldman had had record trading profits in 2008 driven by government stimulus, and that this couldn’t be repeated in 2009. Then, a couple high-level Goldman executives sold stock, and this was treated as confirmation of the thesis by people “in the know.” Then, the Volcker Rule was announced in late January, helping drive the stock to its recent lows. In late January and early February, there were also several analyst downgrades of Goldman Sachs.

With a bit of hindsight and perspective, it’s now clear that this picture wasn’t accurate, which is why, I think, that Goldman has had a recent resurgence and is now trading at $171.94 today. I have remained long Goldman, by the way, and continue to expect Goldman to be a $200 stock sometime in 2010 or the first half 2011.

There were several reasons that Goldman fell. First, investment banking is weak in December. With year-end filled with events, closing the quarter and looking toward the next year, companies tend not to be focused on investment banking activities. This is a seasonal effect. Also, it turned out that the Goldman execs were selling because the company was about to announce a change in the compensation structure that would force partners to keep their money in the firm. Hence, some were selling to get some cash before it all got locked away. Second, while it’s likely that Goldman will do less fixed income than in 2008 (because these government programs are being withdrawn), it’s a diversified business model. Some of that lost revenue will be picked up by two major trends this year, corporate bond issuance and mergers and acquisition work. It makes sense if you think about it – many feel that the economy is relatively stable (especially compared to last year), so they can think about buying other companies before the targets are fully recovered and are more expensive. The Fed is also likely to raise rates by the end of the year, so there’s a rush to finance bonds and acquisitions before interest rates rise. Goldman remains one of the best investment banks around, and with the fall of Lehman and Bear, Goldman will only get a larger share of the revival in corporate financing and M&A. Third, and finally, it appears that the Volcker Rule will not have much impact on Goldman. Brad Hintz, the Sanford Bernstein research analyst that covers Goldman, wrote today that “the current share price overly discounts the impact of even the strictest regulation being considered.”

As you can see, the fundamentals at Goldman haven’t really changed. It remains one of the best-managed companies around and has excellent people (helped by the fact that their people are paid well); it has a diversified business model that earns money even as market conditions change; and it has higher volume because Bear and Lehman fell. Goldman will continue to be pushed around by all the “clouds” mentioned in this article, as well as all the bad press it will get. But someday, the clouds will clear, and unless the fundamentals have changed, I continue to be positive on the company.

Citigroup. Back in 2007 I favored Citi, and truth be told, I underestimated how much damage it would take during the 2008 crash and also how much it would be picked apart by the government. Still, Citi is interesting for several reasons.

First, it seems to be emerging from its near-death experience. Let me be clear, it’s a mere shadow of the company that it was before the debacle of 2008. Still, it’s interesting because what happened to the major banks in 2009 is happening to Citi now. The big banks (e.g., JP Morgan), who were and are in much better shape, started their recovery last year. They took the first big steps – they wrote down losses, moved toward profitability and over the last year have repaid TARP. The government is expected to start selling its shares of Citi in a week or so. Investors, encouraged by the thought of Citi without the meddlesome government, have bid up the stock from the $3.15 range to $3.96 today – a 26% increase.

I can’t tell you to jump into Citi as an investor because the company is still a mess and will take a long time to clean up. Even when it’s cleaned up, lots of its best parts have been sold off. Also, it’s already a fair way into a decent run. Still, as a trader, you have to consider that the government exit (if done correctly, and the most important part of that is gradually so that a huge amount of shares don’t get dumped on the market) will be a positive for Citi. Many think that Citi could be $5-6 sometime in 2011. As you can guess, I’m being the trader and I am long Citi, fyi.

The second interesting thing is actually not about Citi, but the regional banks that are like Citi. And this is for aggressive risk takers rather than conservative investors. This week, Citi also raised $2 billion in a preferred offering. As noted above, we’re in a good environment for capital raising. Many regional banks are similar to Citi – they are still troubled, haven’t repaid TARP and are still not out of the woods. A double dip would be terrible for the regional banks. Still, they’re likely to raise capital and repay TARP in the near future. And this would be positive for the regionals.

Worth investigating, I think. Speculative (or only a play for those that cand o the research), but interesting.

Disclaimer. All material presented herein is believed to be accurate but we cannot attest to its accuracy. All trades, patterns, charts, systems, etc. discussed in this artricle 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. All readers are urged to consult with their investment counselors before making any investment decisions.

The author may or may not have investments in the stocks or sectors mentioned.

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 http://mingloinvesting.blogspot.com.

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.