Indecisive Decision

The stock market just isn’t behaving itself these days. And no one’s making any money…at least that’s what the pros say. But don’t despair! Here’s the best way to play this market…

Some say it’s a roller coaster. Others like to call it a yo-yo. But the most accurate thing to call the market today is indecisive.

You’ve no doubt noticed it by now – any bit of news can move the market up or down a few hundred points. Then it suddenly heads in the other direction because of another bit of news.

For normal investors, it’s a nightmare. I don’t believe the same is true for value investors. The very definition of value investing is tied up with value, not current price movements. We know there’s a lot of fear behind the impulse buying and selling. That means unpredictability…and value investing isn’t about unpredictability. Even if the market price is jumping around like a headless chicken, we are not lost, because we buy on the basis of the company’s value, which does not fluctuate rapidly.

But even if you only buy undervalued companies, your portfolio is still not bulletproof. Even good companies can go soft. Their products can lose appeal; their production and sales costs can go up while their ability to raise prices doesn’t. New technologies and new services erode old favorites; once-lesser competitors revamp and start stealing customers. CEOs change, commodity prices change…

Few people remember to get out when things change, and sometimes they don’t even notice. This is fatal. When you buy a stock, surely you have a reason. I presume it’s a better one than, "My golf buddies say this is hot." So look at your stocks and recall those reasons. Did you buy a company because you expected it to continue increasing sales 20% a year? And now it’s only increasing sales 5%, and it’s been slowing down for the last four quarters? Man, you shoulda been gone!

Indecisive Market: Don’t Overreact; Don’t Underreact

Value investors are realists. I find most of them are good business people. So they understand that missing an earnings forecast for a quarter may be reasonable. They get it when a key commodity price cuts into margins temporarily. You shouldn’t overreact, but you should know why you bought every stock in your portfolio. And if any of them aren’t still doing what you originally hoped, it’s time to reassess.

Of course, it always helps to stay out of bad markets. This requires timing. Go away and come back when it’s better, in other words.

That would work if you could distinguish between the rallies that are going to succeed and the duds. I can’t, can you?

Nobody does it well. I’m halfway respectable as a market reader, and I don’t try to time the market for investing. I keep at it steadily.

There is something that is very close to timing that you can do, however. Get there first. If you look for values and exceptional companies, you tend to land in the right places. The clue is when your list of good stocks to consider seems to be heavy with clusters of stocks from the same industry or sector.

Indecisive Market: Adding Small-Caps

For instance, last year, I added a series of small-cap companies to the Fleet Street portfolio, because that was what I was finding in my searches for strong values.

I didn’t decide, "Hey! Small caps are it!" though it turned out they were the flavor of the year. But I couldn’t care less what’s popular, since I’d rather bank money than Miss Congeniality statuettes. As a value investor, you don’t have to follow a trend…you can discover one.

Here’s how the world really works: In searching for winning companies last year – the sorts of companies with particularly strong and predictable growth, leadership in at least part of their industry and good profit margins – I came across more small-cap companies than usual. In 1999, it was a handful of transportation companies that passed the test. In 2001, it was midcaps. In late 2002 and early 2003, it was dividend payers.

Essentially, we followed some basic principles. For instance, brand-new companies tend to be riskier investments, so we preferred companies with several years of history to analyze. What we were looking for was a track record that showed success in good and bad years, even when things were difficult for the economy or a company’s industry. That way, we can expect that somebody there knows how to manage well. And whatever this year and the next may bring, the business is in the hands of can-do people. Finding stocks that meet those tests also means you can take time for the stock to work out. When a company’s operating history is short, I put more emphasis on the business strategy and industry outlook when making forecasts. Either way, you don’t have to go the high-risk route of buying stocks that have to move fast before the hype wears off and there’s nothing left.

We also looked at underlying fundamentals carefully. You know what these are – things like sales growth, earnings growth, debt level, return on equity and assets and value ratios like P/E, price to sales, price-to-cash flow and price to book.

Finally, we always forecast what we expect from each company. Most conscientious investors have some method of looking at the track record and fundamentals, though usually much less detailed than ours. But then they go to Money magazine, their brokers or Wall Street analysts for whispers and guidance about what tomorrow will bring. And all they get is a bunch of arrant nonsense: "Company X’s earnings will be 52 cents in Quarter 3." That’s not an outlook – that’s baloney.

Indecisive Market: Even When They’re Right, They’re Wrong

Those estimates are usually wrong. But even when they are right, they’re suspect because savvy companies that manage their stock price a little too sharply play around with the numbers in order to meet or barely beat expectations. Defer a cost here, advance a project there and you have a perfect rob-Peter-pay-Paul system for making the financials come out where analysts expect – and of course, so-called "earnings-guidance" announcements for companies to tell analysts what to expect.

Our forecasts don’t pretend to be as quantitative as they are qualitative.

When weighing the future, I never predict 52 cents in earnings. Instead, I look at the industry, the competition, the economy, the profit margins and estimate reasonable growth rates and the ability to increase or at least hold on to market position.

So even if this petulant market frustrates you, don’t go hiding under the covers. Uncertain markets always have an upside. You just might have to look a little harder. When the other investors are being indecisive, you can be decisive…make tough choices and find bargains.


Lynn Carpenter
for The Daily Reckoning
August 5, 2004

Consumers ran out of juice in June. Federal tax cuts played themselves out…and spending fell. Spending on durables took its biggest hit in 17 years.

What will get this consumer-led expansion back on track? More tax cuts? Not likely. Another round of home refinancing? Hmmm…hard to imagine.

Real wage growth is still negative – raises are averaging less than inflation. Without any further sources of available money, how will consumers continue to spend so much?

Has the end of the beginning of the Great Bust finally come? Maybe…

But no one cares anyway. It’s the summer vacation season. Along with millions of others, we are traveling around, seeing the sights and hardly thinking about what happens in the economy or on Wall Street.

Besides, the Dow has been over 10,000 for so long – and the price of gold is once again under $400 – that few people take our warnings seriously. Nothing can stop this great economy, they say. And nothing does…until something does…

More financial news from Tom…and then notes from a strange city…


Tom Dyson, just a stone’s throw from the Washington Monument…

– It’s going to be a frenetic few days in the bond market. On Friday, we get the reading for July’s nonfarm payrolls. Then on Tuesday, the market will be captivated by the penultimate Federal Open Market Committee meeting before the election.

– "I’ve never seen a Fed tightening cycle where someone didn’t go through the windshield." Stephen Roach was scaring people on a recent conference call. We had dialed into to the call at Morgan Stanley to learn something about the unwinding of carry trades. What transpired was more like a radio creep show.

– With the CPI at 3% and nominal interest rates at 1.4%, Roach reminded us that we are currently living with a negative real interest rate in the region of -1.6%. (Roach uses the median year-over-year change in the CPI versus the fed funds target rate.) We haven’t seen real interest rates at these levels since the late 1970s, he said, drawing a direct connection to the extremely poor equity returns of the period.

– Then in late 1993 and 1994, the last time the Fed raised rates aggressively – from 3% to 6% in under 12 months – we witnessed what Roach labeled "the worst performance ever by the bond market." During the melee, real interest rates had quickly climbed by nearly 5%.

– The stock market has, broadly speaking, been in a sweet spot underpinned by the most "relaxed rates in history," he argued. "But as the potential for another 1994-style bond meltdown gains momentum, this may be about to change."

– Here at The Daily Reckoning, as astute readers are already aware, we, like Roach, argue that bonds have just completed their first year in a secular bear market. However, since reaching 4.90% on May 14, and the lowest bond prices in two years, the 10-year Treasury bond has rallied, clawing back nearly half of its initial decline. Markets are wont to do this.

– There are technical and fundamental reasons for this rebound. In May, bonds became extremely oversold after nine straight weeks of losses. They were due for a bounce. At about the same time, the news turned from being strong to weak, sealing the new direction in prices.

– Again, last week, yields continued their decline on more weak economic news. Yesterday, the 10-year bond closed at 4.43%, unchanged on the day, while 30-year bonds ended the day at 5.17%. The market as a whole, in terms of price, hovers just shy of a four-month high.

– Given that we are in a secular bond bear market, is it the time to start shorting bonds again? Your editor is already short bonds, but at only a cursory level; and for what it’s worth, we’d like to start ramping up our position even more. However, for now, we will exercise caution and urge readers to do the same.

– Overall sentiment towards bonds still seems very bearish. The Commitments of Traders report corroborates this…speculators are now more bearish on bonds than they have ever been.

– And this from PIMCO, the managers of the world’s largest bond fund: "Much of the rate increase associated with expectations of Fed tightening and higher inflation has already occurred. Higher rates should cool the economy in the near term, preventing the benchmark 10-year Treasury yield from climbing much higher than 5%."

– Yesterday, the markets were largely unchanged. The Dow closed at 10,126, gaining 6 points, while the S&P and Nasdaq both fell marginally: The S&P closed 1 point lower, at 1,099, and the Nasdaq lost 4 points, to 1,855.

– In the commodities pits, oil retreated from the prior day’s record, slipping $1.32, to $42.83 a barrel, while gold dropped $1.90, to $391.95. The dollar hardly budged. [Ed. Note: Of course, the currency markets are seldom so simple. If you want to know what true currency traders had to say on yesterday’s market, and why the Bank of England raised rates for the fifth time in seven months, have a look here:

The Daily Pfennig ]

– "Investors seldom get what they expect, yet always get what they deserve," observes the ubiquitous West Coast correspondent Peter Schiff. "Today’s bond buyers, blindly following Government and Wall Street propaganda, while ignoring common sense, will similarly fail to achieve anything near what they expect, but something much closer to what they deserve."

– "At the end of the 1982-2000 super-bull market in stocks, investor optimism on future earnings reached an extreme. At the end of the 1981-2003 super-bull market in bonds, it makes sense that expectations of benign inflation would also be equally absurd."

– Expectations remain largely intact…for now. In the meantime, we watch…we wait…and we wonder who’s going through the windshield this time. Freddie Mac? The dollar? J.P. Morgan? George W. Bush?

– Buckle up…


Bill Bonner, back in Santa Fe…

*** We have visited Santa Fe several times over the years. You’d think we would have taken the city’s measure by now. But it is a city that won’t stand still long enough for you to stretch out a tape.

At one time or another Santa Fe has been a trading post, a religious center, an administrative hub, an arts colony and a western cow town. Now, it is a near-perfect place to have a midlife crisis.

In Santa Fe you can create a new life for yourself. You can get rid of your wife…grow a pony tail…put on some turquoise ornaments…get a pickup truck…take an interest in art…try transcendental meditation…live in a brown house…learn about vigas and chili peppers…drink Dos Equis beer…buy some Georgia O’Keefe pictures to decorate…build piñon fires in the corner fireplace…get a season pass to the opera…wear blue jeans every day…and find a new girlfriend who wears hiking boots and doesn’t paint her fingernails.

"Santa Fe is a very pretty town," Elizabeth opined. "The houses on the hillsides are nearly invisible. There must be strict building codes. All you see is the reflection of the sun off the windows. Everything else is in adobe color – the color of the ground. The style is very attractive. If people put up the usual houses…you know, with vinyl siding and gabled roofs, they would stick up all over the place. The city would be hideous. Instead, it is attractive, sophisticated…and very up-market. The other thing that’s nice about it is that it is small. You can get anywhere you want in about 10 minutes."

Santa Fe is a rich town. It is a place where people come to spend money. Where and how they make it…we don’t know.

*** Our reason for coming to Santa Fe was so that Jules could visit St. John’s College, which has one campus here and another in Annapolis, Maryland. St. John’s is a curious school that makes no pretense of preparing students for careers. Nor does it seem particularly interested in the typical admissions process. There are only 500 students at the Santa Fe installation. There are no research labs. There are no big-name professors. Nor is there a football team; the only sport at which St. John’s competes is croquet.

"We do not really teach anything here at St. John’s," our guide explained. "We merely read and discuss the great ideas that have shaped our Western civilization. We begin with the Bible and pre-Socratic philosophers…and work our way forward, chronologically, in math, music, science and literature, as well as philosophy and religion, until we are discussing Max Planck and Ludwig Wittgenstein and other more modern thinkers."

This appealed to Elizabeth. She saw a chance to turn over the job of improving Jules to someone else.

But Jules was not sure.

If humans were simpler, more rational animals, his father recalled, politics could be studied as though it were a science…the Federal Reserve really could guide the economy…and he could tell Jules what he really thought about St. John’s College. But if he spoke too favorably about it, Jules might decide to go somewhere else – merely to assert his independence. The old man kept quiet.

*** "Would you like to help defeat George Bush?" asked several DNC activists on the town square in Santa Fe.

"Yes," we replied. But before their faces had completed a smile, we added: "And that humbug Kerry, too." *** "The average American college student…" we wrote two days ago, "is about as well educated as a person with an eighth grade education 100 years ago."

"Not so!" says a DR reader:

"Here is the eighth-grade graduation test given in Salina, Kansas, in April 13, 1895:

*Grammar* (Time, one hour)

1. Give nine rules for the use of Capital Letters.

2. Name the Parts of Speech and define those that have no modifications.

The Daily Reckoning