Home l Broadcast l WrapUp l Top 10 l Storm Watch l Perspectives l Sitemap l About Us
|
|
Today's Market WrapUp |
Managing OPM (Other People's Money)
Where Have All The Value Stocks Gone?
Each week we run a screen on a universe of over 2,000 stocks. Specifically we are looking for stocks with high dividends, stocks selling at below book value, or companies that are selling at low P/E’s. The last category is my least favorite, because you never know what you are getting with earnings these days. Most companies are still playing with numbers and are not fully accounting for all expenses. We still live in a pro forma world where numbers can no longer be accepted at face value. There are always caveats. You have to look closer at earnings, because what passes for profits these days is more fiction than non-fiction.
REITs, tobacco, and pipelines appear at the top of the list. The REITs pose a danger, if you believe the housing market is in a bubble and subject to declining rents as vacancies rise. Where I live, they are building another 200,000 sq. ft. office building across the street from a 150,000 sq. ft. building that is still unleased. Our office building is surrounded by what I call see-through buildings. They are see-through because they have no tenants. This hasn’t stopped the construction of even more and bigger buildings around our office and home. The glut of new buildings has brought down rents and it is now possible to get free rent plus improvements added into a lease.
Tobacco is coming under an assault as more states look to raise tobacco taxes on the poor as the least offensive route to raising taxes. The wealthy smoke cigars. Here in the People's Republic of California, they have nearly doubled the tax on cigars. Cigar smokers buy their cigars online to escape this punitive tax. This has caused the local merchants to suffer or go out of business. Cigarette smokers now make trips to Mexico to support their habit. The smuggling trade is now thriving. One can well imagine the day when the People’s Republic looks for a modern day Elliott Ness to fight this new menace to our society.
Pipeline companies have problems with accounting and greed in management fees. Several of the more prominent companies in this group not only have accounting issues, but also charge shareholders exorbitant fees. We have only been able to find two companies in this group worth buying.
Stocks selling at below book value show the greatest promise, but the more obvious ones such as power producers, may take years to play out. This is an instant gratification society with few long-term players. The days of John Templeton’s "Buy undervalued stocks and wait 3-5 years for the markets to realize its value" went out with the 90’s.
Low P/E stocks remain suspect because of earnings. Many companies, such as Ford, may be far too risky given the uncertainty of this economy and Ford’s balance sheet issues. The promising area we have found lies in the area of dividends. Dividends provide an investor with cash flow that enables an investor to remain patient until value can be realized. Dividends also offer a better and safer way to evaluate earnings since you can’t pay a dividend unless you have the actual earnings and cash to do so. In this area we have identified promising issues in the area of oil and gas, drug companies, consumer staples, defense, and gold. However, since we remain suspect of this rally, we have set potential target prices on these issues before we will buy them. The present rally lacks much to be desired, It remains helter skelter and more dangerous than previous rallies because it is all built on hot air and false premises.
Looking for Value in Sectors
Having examined our traditional value yardsticks we turned our attention to the present rally. Specifically, we wanted to examine the sectors that were leading it in order to find out if there were potentials that we had missed or if there was substance behind it. The strength in this rally has come from the tech, Internet, telecom, and the financial sector. These sectors have all been hammered hard this year with the entire sector still down double digits, despite the near doubling of this sector over the last six weeks.
We then looked at many of these stocks to find a compelling story that would have caused these stocks to rally as they have. For example, is business embarking on a new capital-spending boom that would drive profits in this sector? Are the business prospects improving, and has pricing power been restored within the industry? In each case we found the answer to be a resounding no. We then asked why should stocks be rallying to this degree. Is there something on the horizon that we have missed? Is there a new killer application that will drive earnings and revolutionize the industry? Have company CEO’s been guiding earnings higher? In each case the answer was, "No." Pro forma profits were higher year-over-year, but comparisons were made all the more easier due to last fall’s tragedy. Those companies that did improve, did so mainly through cost cutting and will face a tough year next year. Next year’s earnings will be made against tougher comparisons. Next year will also be impacted by larger than normal pension contributions that will be necessary to make up for pension losses.
Even those companies who did report improvements have failed to account for all expenses. Cisco, by its own admission, said its profits would be 60% lower in its most recent quarter had the company had to account for expensing stock options. In the case of GE, the company will report lower earnings growth this year and next. For the first time in almost a decade, the company will experience back-to-back single digit growth. On the day the cGE reported this dismal news, they announced an increase of the dividend by one penny. On that bit of news, the stock rallied 10%.
What, if anything, has accounted for this rally’s extension? The answer to that is a momentum rally that followed intervention into the markets to prevent a further decline. Stocks gapped up on three days in what appeared to be intervention by a large unnamed buyer in the futures market, buying futures at any price. From that point momentum took over and helped the markets to climb further. Money then shifted out of bonds, which is one reason bonds have tanked and rates are rising. Fund mangers sold most of their defensive stocks and then piled into the same select group of tech stocks, Internet stocks, and beaten down financials. They moved in a herd-like mentality, chasing the same group of stocks, bidding them up in spectacular fashion. A graph of the SOX and Amazon.com are illustrative of this trend. In what has appeared to be a collective leave of their senses, the fund industry embarked on a large speculative gamble. Their own buying in mass, along with momentum players, drove these issues up in a maniacal fashion similar to Internet IPO’s in the late 90’s.
Looking For John Q and Herbie Homeowner
What we have been looking for in this rally is the appearance of fresh money coming into this market off the sidelines by the investment public. Outside Tommy Trader, most investors have remained on the fence not sure what to make of it. Many remain suspicious of what Wall Street has been telling them, "If stocks go up, the recovery is around the corner," and "The economy is improving." Interspersed with these predictions has been a series of retractions, scandals, and disappointing economic news, the opposite of what analysts and anchors are telling them. Another divergence that is emerging is what CEO’s are saying about the future and how analysts interpret what they say. The message coming from most CEO’s is one of hope and not one of promise. They hope things will get better. Profits peaked in 1997 and have headed down ever since.
Once again we find ourselves in the minority in failing to believe the spin. The fact that GE’s earnings are trending down is a more telling story than a penny increase in their dividend. In the case of GE, which gets the majority of its revenues from its finance unit, is even more telling. We don’t doubt that Cisco will end up being a survivor and so will Dell. What we question is Cisco’s accounting. The company’s failure to account for stock options, which by its own admission would have lowered earnings by over 60%, and the fact that they chose to buy back their overvalued stock, says much more about their business prospects. You don’t buy back your stock at inflated prices, if there are numerous business opportunities.
Looks Like a Trend-Following Rally to Me
As far as this rally is concerned, we can only say that it has been a rally generated by the industry itself. It has been a trend-following rally whereby the same managers jump on board the same stocks regardless of earnings fundamentals or business valuations. It has also been a rally where most clients of the fund have chosen not to participate by the failure to add new money to the market, and in fact, money has been slowly exiting. By and large most owners of mutual funds have been sitting on the fence not knowing what to believe, and for good reason; there hasn’t been much to believe in. This has been another grand experiment with fund managers playing with shareholder money in an effort to salvage another bad year hoping in that effort to generate an influx of new money.
This tendency of the industry to experiment with other people’s money might not be so reckless if it was their own money they were playing with instead of others. In fact, only the continuous stream of bullish pronouncements coming from analysts on ever-worsening news matches the frequency in which the herd takes collective leave of their senses. It seems that Wall Street is in the business of turning lemons into lemonade. It is symptomatic of a new disease that is spreading called pen-a-sideness. The symptoms of this new disease stem from the failure of money managers to distinguish EBITDA (earnings before interest, taxes, depreciation and adjustments) and EBIDTAS (earnings before investigation, deposition, trial and sentencing). It may behoove analysts and fund managers to take a closer look at least “core” earnings as defined by Standard & Poor’s which show that stocks, contrary to present hype, are still selling at multiples closer to 50 times earnings than the current estimate of the high teens or mid-20’s. There are so many pro forma variations these days that it is very hard to know which multiple analysts are referring to other than to say it isn’t GAAP earnings.
In summary, we see nothing in this rally that would give us great confidence that it was anything other than a bear market rally. As the folks at Elliott Wave have pointed out recently, this rally has been weaker than previous rallies. It also falls within the parameters of most bear market counter rallies. Gains are limited to about 20-24%, and the days the market rallies are getting shorter in time span, averaging about 30-35 days. What should be a warning to the alert investor is the number of growing bullish pronouncements by the financial press. The increasing frequency of these new calls for a new bull market in stocks have a tendency of occurring just as the rally is about to fade.
As this morning’s Wall Street Journal points out, December could be a pivotal month for investors. Earnings warnings for this quarter should start appearing next month as big companies warn of disappointments this quarter. Already, profit projections are coming down quite rapidly. I have no doubt they will come down more rapidly as we get closer to the end of the quarter. It is with great assurance that I believe that they will get so low that companies will once again be able to beat them when actual earnings are reported. It is all part of the earnings game played each quarter. As the WSJ reports in E.S. Browning’s column, earnings won’t be the only worries. As listed below the market will have plenty to worry about:
-
Earnings warnings for Q4 and 2003.
-
Deadlines for Iraq to comply in order to avoid war.
-
Sales for the make or break Christmas Season.
-
Economic reports out on manufacturing and capital investment.
-
Year-end tax selling.
Hopes for a rebound in profits are what have been driving this rally. It is another hope-driven rally interspersed with a lot of hype and hyperbole. A clue as to what is coming may be taken from the current rush to lower estimates. When estimates are lowered, it is a good sign that the trend is worse than forecasted. Why else would the forecasts be coming down if they were confident they were accurate?
  |
As far as the great hope based on the consumer going even further into debt, we would like to point out the graph of interest rates on the 10-year note and the 30-year bond. The last refi boom occurred in September and has yet to show up in the retail numbers. It just may be that the consumer is holding on to cash either out of fear of losing their job, or waiting for better bargains ahead. And as far as the consumer is concerned, we think we have spotted a potential cure for his overspending. What discretionary shekels are left after debt payments are made may be getting even scarcer as more cities and states are rushing to hike taxes. We have no finer example than our own Governor here in the People’s Republic of California. Having just passed a phased-in tax bill that will penalize the buyers of SUV’s, we will also have a new gas tax and mileage tax that will also be phased in. California is now running its second year of $20 billion plus in deficits with no end in sight. The Governor has been playing accounting games with the budget deficit that would make the boys at Enron, WorldCom and Global Crossing look like altar boys. There are rumors, which are becoming more numerous since the Governor won the election, that we - the people - are about to get sheared again by new income taxes, sales taxes and fees. |
Increased Taxes in the Cards?
I’m more than confident that at a time of debt distress by consumers, that state and local governments will do their fair share to make matters worse by again increasing the tax burden on us lowly surfs. Washington is also toying with the idea with tax reform. The bate is lower income tax rates, much like Reagan did in 1986. In exchange for lower income taxes, the government would also impose a consumption tax. The income tax would remain, but in addition to the income tax, a value-added tax similar to VAT in Europe would then be imposed on all citizens. Once the new consumption tax was hidden and forgotten, then the income tax rates would gradually be raised. Reagan’s lower tax rates were phased in over a three-year period; while the elimination of tax deductions, higher capital gains taxes, and the elimination of tax shelter deductions were eliminated up front. Once the lower taxes were phased in, the government began to raise them. George Bush Sr. raised the 28% bracket to 31%. Then Bill Clinton raised them to 39.6%, made the increase in Medicare taxes permanent on all earned income, and raised the tax on social security to include 85% of social security income. It is with great suspicion that I view next year’s bold move to reform the tax code. Translation: reform = tax increase. Beware of Greeks bearing gifts.
Today's Market
Back at the casino, markets rose for the third day out of four on a report that showed housing sales rose more than expected. Shares of Intel and Novellus rose on hopes the worst is over for the industry. Share volume declined with 1.54 billion shares on the NYSE and 1.95 on the Nasdaq. Market breath was positive by 19-14 on the big board and by 21-14 on the Nasdaq. The VIX rose by .22 to 26.95 and the VXN fell by .81 to 45.68.
Continue to pour into tech on the belief a recovery is right around the corner. Networking and chip stocks are at the top of the list with airlines, paper and chemical stocks followed by natural gas stocks. On the losing end were defensive issues such as gold, defense contractors, and oil. Gold got hit again after jumping Friday, despite a sharp run up in lease rates as shown in these charts. Seasonality factors are now coming into play. It is this season factor that has been behind the recent rallies upsurge. However, given the reality of this rally moving so quickly into a handful of sectors raises suspicions as to its durability. The markets have priced in no surprises. In the words of one veteran, “The markets are priced for perfection.” Caveat Emptor.