Thursday, March 4, 2010

Market Strategy Thoughts

I have several client meetings coming up in the next few weeks, so I have been getting some thoughts together on the markets.

(Warning: This a long post!)

First, in general, I think the markets can move higher.

There seem to be too many people waiting for a significant "market correction" or even a larger downturn.

It seems to me that markets get smacked when no one is expecting it. Now, it seems the papers and blogs are full of bearish and dire predictions.

One of the big reasons I remain on the bullish side is the extremely low level of interest rates. In my opinion, the only really unattractive investment area in the publicly-traded markets today is in the shorter maturity bond area - both taxable and tax-exempts.

If you plunk a large portion of your retirement assets into short maturity bonds, it really is a bet on a market collapse. Again, while I could be wrong, I don't see the wild-eye optimism or outrageous valuations that typically proceed a market downturn.

Also, I think there will be a lot of investors who bought bonds a few years ago that are going to experience "sticker shock" when those bonds mature. Yields were a lot higher a few years ago, and it will be difficult to replace those yields without sacrificing credit quality.

For example, Greece today issued bonds around 6.5% yield, even though Greece is a fiscal disaster waiting to happen. Frankly, unless the Greek government can figure out a miracle, there is at least a significant likelihood of default (after all, Argentina seems to default every decade, and it never seems to have trouble getting money again).

Which all leads back to the stock market. As I mentioned, there remains a huge degree of client skepticism about the prospects for the stock market. Mutual fund flows remain solidly in favor of bond funds, even though the S&P 500 is up over +50% from a year ago.

Moreover, in many cases the common stock of a company is yielding significantly more than the bonds of the same company.

Yesterday, for example, we were shown some 8 year Eli Lilly bonds with a yield of slightly more than 4%. However, the common stock of Lilly yields 5.7%, and trades at a P/E of 7x. I suspect that the owner of Lilly stock will, over the next five years, make considerably more money than the Lilly bond owner.

In terms of stock sectors, here are my thoughts on the sectors:

  • Energy - especially the integrated oil sector, which is trading a single-digit P/E's and offer good dividend yields. However, I also like most other companies here as well, although I think the natural gas names could take longer to "work" than the oil related names. I would be a buyer of Exxon; Chevron; Occidental Petroleum; Apache; Devon; and Total.
  • Consumer staples - this group has lagged somewhat, as the market rally of the last year was focused on lower quality, higher beta names. Still, for a listless market, names like Procter & Gamble; Smucker's; Sysco; and Colgate could be interesting in here.
  • Utilities - this area has significantly underperformed the market mostly due to weak demand. Still, the group in general offers good dividend yields, and low expectations. If the stock market continues to move sideways, we might see this group start acting better. I like the integrated names here, like Exelon.
  • Consumer Discretionary - consumers continue to spend, even though the overall debt burden in our economy remains high. I missed the move in smaller retailers last year, but I don't want to chase them now. I would look at stocks like Disney; Marriott; Nike; McDonald's; and Kohl's.
  • Financials - a tough group, since I think that many of the large debt problems that created the large crisis a few years ago remain on the books of many banks. Still, the Fed and Treasury are determined to nurse the banks back to health, and I would not bet against them. Also, the brokers are making lots of money, with less competition, wider spreads, lots of new issuance, and a pick-up in M&A activity. I have been using the financial SPDR (ticker: XLF) as the lower risk way to play the group. However, if I had to buy stocks, I would go with names like Goldman; JP Morgan; Ace; Chubb; Travelers; and State Street.
  • Industrials- I think this group could surprise on the upside, as investors are missing the huge earnings leverage that many companies have been able to establish by cutting costs and more efficient use of the internet. Rail and trucking volumes have been increasing, as the economy improves, and all the "good news" is not, I believe, built in just yet. Also, I think that defense stocks could surprise on the upside, as it appears that the Obama administration is already committed to increasing spending on hardware. Names I like are Lockheed Martin; L-3; Union Pacific; Emerson; and 3M.
  • Health Care - another tricky area. If the Obama/Senate healthcare bill passes, this group could soar, as usage dramatically increases, but if gridlock remains...well, the fundamentals of alot of the stocks are sluggish, at best. Names I would buy now would be Merck; Cerner; Johnson&Johnson; Novartis; Stryker; and maybe Pfizer.
  • Materials - in a deflationary environment, this group should suffer, but I don't think it will. Demand from Asia and the Middle East remains strong, and even though some of the commodities might suffer, I think metals like copper (which China continues to consume rapidly as it builds) will continue to do well. I am not, by the way, a fan of gold - gold really shines (pardon the pun) when there is concern about inflation or currency depreciation, but I don't believe that either are in the cards. Names here include Monsanto; Praxair; and the global mining ETF (ticker: MXI)
  • Technology - ever since I started this blog, I learn some new and fascinating way that Web 2.0 will change all of our lives. The question remains whether companies can make a lot of money in this revolution. Obvious names like Apple and Google are interesting, but their valuations look full. Old "war horses" in technology like Microsoft and Intel offer dividends and ridiculously strong balance sheets, but uncertain growth prospects. I like Paychex and Automatic Data, but mostly for their dividends and no debt. IBM should be OK, but its size and business model may work against strong growth. Hewlett-Packard should benefit from strong printing demand, and the fact that it is gaining market share vs. Dell. I would avoid Cisco (great company, but no growth propects) and the afore-mentioned Dell (PC's are too much of a commodity).
  • Telecom - John Chambers of Cisco said years ago: "Voice will be free", and that's all you need to know about this group. We all want fast Internet service, and mobile phone connections that are perfect, but we want the cost to continually drop. High capital costs, huge debt, large legacy burdens = mediocre stocks. I would avoid the whole group.
Finally, I would be careful to avoid the obvious bet against the euro. The whole hedge fund community, it seems, is lined up betting on a weak euro, which to mean seems to imply that they are set up for a massive short squeeze. I think international still makes sense for most portfolios, and would use any weakness in global markets to add to positions.