Avoid the Crap Stocks

With the Dow at all-time highs, the average investor think that there is no way he can lose. But what he fails to understand a couple things: after a rally stocks generally fall. A lot. And second, most of these stocks are discarded cast offs, or "crap." James Boric explores…

"Stocks just keeping making money – a lot of money. They are on a roll."

That is what a priest said to me last night at a dinner before mass in West Baltimore. He told me he was thinking about investing now that everything seemed to be humming right along. The only key to success, Father told me proudly, is diversification. "As long as you are diversified, you should be ok."

I cringed when he uttered those words. Warren Buffett, John Templeton and every other billionaire investor who still lives would be appalled! But Fr. (we’ll call him Joe), is like 99% of all investors in America. They don’t get excited about stocks until the market is making new all-time highs.

Pour souls.

In his weekly commentary, Dr. John Hussman noted that, "…the market climate in stocks remained characterized by unfavorable valuations and moderately favorable market action." He went on to explain that since the start of this recent bull-run, stocks have already gained a full 85.1% since their 2002 lows.

If the stock market were to close up shop today, this current rally would be the third most profitable run since 1947. But the stock market isn’t going to close shop any time soon. And more than likely, the average investor will not be 85% richer in a year from now. Not even close.

What the average investor fails to ever understand is what happens after a large rally. Stocks fall – usually a lot.

Hussman examined every major market rally from 1947 to today. First, he measured how much stocks advanced to at the top of every bull-run. Second, he calculated their returns after a full market cycle – in other words, once the bottom fell out. And third, he noted the P/E of the S&P 500 at its low and high throughout each cycle. For instance…

Between June 10, 1949 and July 27, 1956 stocks rose vigorously. At the beginning of the rally, stocks traded for just 5.8 times earnings. They were cheap and ripe for the picking. After a 434.4% rise (marking the peak of the rally), stocks traded for a much loftier 13.3 times earnings. It is at that point that everyone and their uncle (or priest-friend) was giddy with greed. And of course that is about the time that stocks sold off.

By the end of the full market cycle, stocks were only up 354.1% (a far cry from the 434% marking the peak). And a lot of people – all of those who invested at the top — lost more than their shirt.

More recently, you can look to the rally from 1990 to 1998. At the beginning of this bull-run stocks traded for 11.3 times earnings. While they were not as cheap as in 1949, they were still attractive on a historical basis. And slowly but surely, investors started to jump in. By its peak, stocks were up 374% and trading for 28 times earnings. It is at this point that the fools jumped in and the bear came a calling…

By the end of the market cycle, the total gains were 244.8%, not 374%. And once again, a lot of people lost a lot of money despite the overall bullish trend.

Now fast forward to today.

Since Oct. 4, 2002 stocks have shot up 85%. As I said earlier, if stocks simply stopped trading today and investors walked away with their gains, this would be the third most lucrative stock market rally in the last 60 years. But no rally is without a corresponding fallout. This one included.

Unlike all previous rallies before this one, stocks were not cheap at the beginning of the bull cycle. The average stock traded for 15.3 times earnings in late 2002. The last time stocks were this expensive at the beginning of a cycle was in 1987. We all know what happened then…in a single day the stock market lost 20%.

Folks, a fall is coming this time around. I guarantee that. All the signs are there.

Corporate earnings growth is at an all time high – an unsustainable high at that. Valuations, while not super expensive, are certainly not cheap either. The average company on the S&P 500 currently trades for 20.9 times earnings. And the average small-cap stock in the Russell 2000 (excluding those that don’t have earnings!) trades for 19.7 times earnings.

Finally, as I have preached for the last six months, the stocks that average investors are buying these days are garbage. Here’s how I know:

I created two screens several months ago. The first screen is what I call my "good stocks" screen. It looks for small-cap companies on the NYSE that trade for (or have):

• 15 times earnings or less
• 1.5 times book value or less
• 1.5 times sales or less
• positive free cash flow
• revenue growth
• net income growth

Who can argue that cash flow, earnings and sales growth are not good. Yet the 17 "good" stocks that fit the bill are only up an average of 6.1% over the last year.

The second screen I created is called my "crap" stock screen. Now, before you get offended by my use of the word, I mean it only the way it originated back in the 1400’s; one of a group of nouns applied to discarded cast offs, like "residue from renderings." Anyway, my crap stock screen searches out the worst of the worst. Namely, small-caps on the NYSE that trade for (or have):

• Minute sales growth but no earnings to speak of
• No free cash flow
• 2 time book value of more

Turns out, there are 19 crap stocks on the NYSE right now. And guess what? They are up an average of 51% over the last year – nearly nine times better than the 17 fundamentally sound stocks. What does this tell you about today’s market?

It says people who are buying stocks are chasing the crap companies – those with no earnings, zero FCF, barely any sales growth and lofty valuations to top it all off.

When stocks like this are leading the way, it is only a matter of time before the Grizzly Stock Market Bear hunts you down. As Hussman writes:

"With stocks still near their recent highs, I think it’s useful to remember the tendency of bull markets to surrender large portions of their gains over the full market cycle. Without that understanding, investors are vulnerable to the temptation to ‘chase’ returns in what is already a richly valued, aged bull market advance, where recession risks continue to gradually increase."

Now is not the time to be chasing crap stocks. And now is not time to blindly invest just because stocks are on a roll – even if you are a priest. They don’t always "keep making money." Just wait, you’ll see.

Regards,

James Boric
for The Daily Reckoning
November 9, 2006

P.S. If you find yourself holding onto some stocks that fall into the "crap" sector, now is the time to dump them…because I have found two stocks that are set to outpace the market 19-fold in the next six months. As a loyal Daily Reckoning member, you are eligible to become a member of my Small-Cap Insider research service.

Click the link below to become part of an exclusive and tight-knit inner circle of individuals who share a common goal: to safely make a lot of money in the small-cap market using the most proven investment strategy of all time.

Small-Cap Insider

Editor’s Note: James Boric is Small-Cap Strategy Report’s editor in chief. Throughout his career, he has focused on fundamentally sound small-cap companies with market capitalizations of $1.5 billion or less.

Thanks to his renowned insights into the small-cap market, Boric has been featured in John Mauldin’s best-selling book Bull’s Eye Investing. He’s also been published on dozens of well-known investment sites, including The Daily Reckoning, Rude Awakening, www.Gold-Eagle.com, www.financialsense.com and Tradersedge.com.

Today, Boric travels the world searching for the finest investment opportunities for his readers and writes about them in Small-Cap Strategy Report, Sleuth and Small-Cap Insider.

If he had any sense of grace or integrity, Donald Rumsfeld would fall on his sword.

The man was instrumental in getting the United States into the biggest military and financial blunder in its history.

Saddam Hussein is to be hung for killing 148 people. The Washington Post quotes an Iraqi Sunni as saying, "Now, more than 148 innocent people are getting killed in Iraq every day."

Rumsfeld’s war has resulted in as many as a million – estimates vary wildly – Iraqi dead and nearly 50,000 wounded and dead Americans. And as for the financial costs, don’t even bring it up. The latest guesses say that the entire bill could run as high as $2 trillion. Where does a nation that is already $65 trillion short get that kind of money?

Roman bridge-builders used to stand under their arches as the scaffolding was removed. If they made a mistake, the whole thing would come down on their heads.

And military commanders who made serious blunders were expected to pay the price. In the disaster of the Teutoburg Forest, Roman governor Publius Quinctilius Varus probably had one of his officers run him through with his sword.

At Carrhae, Marcus Crassus, was responsible for another of Rome’s major defeats. But at least he died honorably – on the field of battle. Some reports say the Parthians killed him by pouring molten gold down his throat…but this may be apocryphal – Crassus had been the richest man in Rome.

Of course, the Romans weren’t the only ones.

At Iwo Jima, the Japanese commander, General Kuribayashi, committed ritual seppuku, cutting open his belly to remove his intestines and dying in agony.

In Anglo-Saxon common law, there is a rule: He who undertakes a project is responsible for the outcome. This is the obverse of the familiar saying: He who pays the fiddler calls the tune.

He who calls the tune pays the fiddler!

The ancient rule has a sensible, timeless elegance to it, especially when applied to government, because it discourages mistakes. That is the big difference between private life and public life. In private, a man pays for his mistakes. In public, it is usually someone else who pays.

Mao lived in fat luxury, while his subjects starved – thanks to his cockamamie theories and illusions. Lincoln went to the theatre, while his soldiers shivered in their trenches or died in front of confederate cannons. Greenspan was given the Order of Merit from the French and knighted by the Queen of England while his ’emergency’ interest rates enticed an entire generation of householders into ruinous debt.

Yes, the papers have finally picked up the story:

"Oops! Miscalculation led Fed to keep money cheap too long," says a headline in the Philadelphia Inquirer. "We’re all human. Everybody makes mistakes. It’s just that some people’s mistakes are, well, more consequential than others.

"Exhibit A for that point surfaced last week, when the president of the Federal Reserve Bank of Dallas gave a speech containing what has to rank as one of the biggest ‘oops’es of the decade."

"Speaking to a group of New York economists last Thursday, Richard W. Fisher acknowledged that some bad data on inflation caused the Fed to hold interest rates too low for too long, fueling the house-price bubble of the last few years.

"As a consequence, Fisher said, ‘today… the housing market is undergoing a substantial correction and inflicting real costs to millions of homeowners across the country.’

"Oops."

Jesus once remarked, "What you do to the least of them, you do unto me." If only leaders had to suffer the fate of their followers! How long would the ‘Long March’ have been if Mao had had to march with his troops, rather than be carried on their shoulders in a sedan chair? How long would the Ukrainian peasants have gone hungry if Stalin had had to eat the same rations? How long would the war in Iraq go on if the neo-cons had to pay for it with their own money?

After he had been a U.S. Senator and the Democrat party candidate for president in 1968, George McGovern re-entered the private sector. As an entrepreneur and businessman he gained a remarkable new perspective. He later remarked that if he had had any idea how much nuisance was caused by the laws passed when he was in the Senate, he never would have voted for them.

Political leaders are generally protected from the world they are responsible for. U.S. Congressmen, for example, earn comfortable salaries. But then they fluff up their pay with a little extra loot that is invisible to the voters: Free parking. Free health care. Free travel. Allowances for this and stipends for that. Sycophantic aides and staff flunkeys to flatter them and run interference. A retirement program that makes them millionaires. Rarely do they ever have to live in the real world.

This was not always so. In the beginning of the republic – in the United States as well as in Rome – representatives had real professions and businesses, and they had lives outside of politics. But as the empire grew, so did the class of professional fixers, meddlers, and profiteers who were able to take advantage of it. Now they live like Roman noblemen…housed in grand marble buildings, surrounded by armies of attentive factotums and praetorian guards, and enjoying every privilege and luxury they can get away with.

And why not? For when a man’s actions are cut off from their consequences, it makes sense for him to be a little reckless and irresponsible. This is true whether you talk about individual actions or collective ones. A man who can drink without getting a hangover is more in danger of becoming a habitual drunk than one whose every sip is quickly punished. A man who can start a war without getting shot is more likely to stir up trouble than one in the line of fire. And just as a teenager with his mother’s credit card is always a hazard, so is an entire nation of taxpayers that has the wherewithal to push its debts onto the next generation.

So, America’s elite corporate managers enjoy the pleasure of higher wages while shareholders suffer the pain of lower dividends. Even when the share price goes down, the managers walk away with millions in salary and back-dated options. How do they get away with it? Why don’t shareholders revolt? Because they’re so focused on higher stock prices…and so blinded by the razzle-dazzle of celebrity CEOs…they hardly notice. Besides, each shareholder has such a small holding, it doesn’t seem worth his while to complain.

Hedge fund managers, too, are protected against their own mistakes. The managers call the tune, but it is the investors who pay the fiddler. If it is a pretty tune, both enjoy it. But if it threatens to sound like rap, rave, or a modern opera, only the investors are forced to listen. The managers get their 2% and tune out. The investors get split eardrums.

What we are talking about is cause and effect. Left together, they keep us on the straight and narrow. Separate the two, and you enter the broad road to self-destruction. You get irresponsible, absurd outcomes…bubbles…wars of ‘choice’…preposterous fads, fashions, and legislation…panics, hysterias – all the great public spectacles that make our job so entertaining.

And now, here is Donald Rumsfeld. He ‘doesn’t do quagmires,’ he once told us. But now, after getting the United States into the biggest foreign policy quagmire in history, he is off to a comfortable retirement…or maybe a multi-million dollar career – probably peddling arms, energy or state secrets.

Meanwhile, the Democrats are taking over both the House and the Senate. These are the same shirkers and hacks who breathed not a word of protest but went along every step of the way…never so much as raising a question…or lifting a phalange to protect America’s military from a foolish war and its finances from foolish waste.

The gallows are too good for all them.

More news:

————–

Eric Fry, reporting from Laguna Beach…

"’Dirty, insecure and expensive’ are not merely the adjectives that describe most of your California editor’s past girlfriends…"

For the rest of this story, and for more market insights, see today’s issue of The Rude Awakening.

————–

And more thoughts:

*** "Every news station, newspaper and Internet site I see these days mentions the market is just humming right along," small-cap superstar James Boric reports.

"Stocks are making people money – and lots of it. But what the talking heads aren’t reporting to you is that the stocks leading the charge are absolute crap. It is not the fundamentally sound companies leading the way in this most recent run-up. Rather the companies with no earnings, no cash and high valuations that people are ‘investing’ in these days. They are trouncing the fundamentally sound companies with tons of cash, low valuations and strong earning.

"Anyone holding these ‘crap’ stocks is going to pay dearly. It’s just a matter of time.

"Since 1947, every rally like this one has ended the same way. Stocks peak…the herd buys…and then they lose their shirts.

"Today you are at a crossroad, dear reader. You can either unload your crap stocks now. Or you can load up on shirts. You’ll need ’em later."

*** We see that our friend Martin O’Malley, mayor of Baltimore, won the race for governor.

And Nancy Pelosi is the new Speaker of the House – the first woman to hold the job. She got her start in Baltimore too, where her father was mayor.

*** Every serious empire, in the Western world, eventually takes Baghdad, we recall writing three years ago. Each one later comes to regret it.

Of course, empires tend to regret all their conquests – eventually. For they are all finally driven out…and forced to return to their homelands, usually just before they are gobbled up by the succeeding empire. But Mesopotamia is a special case. It is a hard place to control…even for a tyrant.

Western democracies have a difficult time fighting civil insurgencies in woebegone foreign countries. They don’t have the stomach for it. France tried it in Algeria. Though her armies were masters of the field, she still had to retire. The war was draining her treasury and turning her soldiers into torturers.

Even against more conventional enemies in Indochina, the French had to give up…followed by the Americans 15 years later.

The press reports say that Saddam appeared in court on Tuesday, looking remarkably composed. There was a trace of a smile on his face, something you wouldn’t expect from a man who had just been sentenced to hang.

Why the smile? We don’t know, but we have a guess; Saddam believes he is winning. He was condemned for killing 148 people. But 148 people is beginning to seem like small change in that part of the world. "Well worth it," a statesman might say of Saddam’s murders…if that’s what it takes to maintain order in that godforsaken place. "A bargain," a tactician could figure, if it helps control the spread of terrorists in that part of the world. "Indispensable," a strategist might conclude, if it provides a counterweight to Iran’s ambitions.

Looked at through the dark glass of America’s stated foreign policy interests – regional stability, opposition to Iran, control of terrorists – it looks as though the Baghdad court got the wrong man. It could have just as well condemned Rumsfeld to hang…and restored Saddam to power.

*** "Zis is Mister Bonner?" said a very Teutonic voice on the phone Tuesday.

"Zis is Mrs. Zimmer…I haf your son Edward wif me here. Yah…dere is no problem but…"

Edward has gone off to Germany with his class. He is a ‘Germanist,’ meaning his second language in school is German. So, he is spending a week with the Zimmer family, and going to school with his own French classmates…and their German hosts.

"Don’t worry. But has he had a tetanus vaccination? We take him to the doctor. It is nothing important. Our dog bit Edward on the mouth…on the lip."

It did not sound very serious. We felt sorry for the Frau Zimmer.

Tuesday was also Edward’s birthday; he turned 13.

*** Meanwhile, Henry, 16, is struggling with 11-grade math. He is up almost every night until after midnight working on his math homework.

Henry is in a school where they take math very seriously. And he has set himself up to take the ‘Bac S’ – roughly the equivalent of junior college degree with an emphasis on science.

"How is it going?" we asked yesterday.

"Oh…not too bad…not too good."

"I wish I could help you."

"Don’t worry about it Dad; I’ll be all right."

But worrying is about all we can do, because the math he is doing is so far beyond anything we ever came across, let alone did, it is incomprehensible.