Friday, January 20, 2012

An Inconvenient Disconnect

It is an old Wall Street axiom that the markets in the short run are voting machines, but in the long run weighing machines.

"Nothing But Blue Skies Ahead!"

Stocks or industry sectors can enjoy investor popularity for a period of time based on a particular mood shift among investors.  However, in order to make longer-term investment sense, the fundamentals of the stocks have to catch up with the share price.

The markets continue to have a good tone.  As I noted yesterday, the S&P 500 is off to its best start in 25 years, and most clients seem considerably more relaxed than just a few months ago.

However, I am becoming a little troubled by the disconnect by the rise in the overall market and the increasingly negative tone of analyst comments.

I wrote a long email to some of my fellow colleagues here at Boston Private Bank, reflecting some of my concerns. 

The overriding issue, it seems to me, is that stocks are being bought because the potential returns from most other asset classes are so unappealing. 

The best performers last year, for example, were found in the dividend-rich utility and consumer staples areas.  It's not that the business prospect for these companies is all that great; no, instead the fact that they pay relatively high dividends and are generally household names (think Colgate; Coca-Cola; and Southern Company) make them appealing to investors.

Meanwhile, the Wall Street analysts I respect are saying, "Hey, wait a minute - some of these stocks don't deserve to trade at a premium valuation based on their fundamentals." 

Typically Street analysts are more optimistic than the general public, but now I am getting the impression that we are in an opposite situation.

I got some strong reactions to my mildly cautious email yesterday.

One manager basically told me, look, the markets are a forward-looking animal, and that stocks may be anticipating better economic times ahead.  A better economy will lead to upward revisions in earnings forecasts, which will make today's prices look more reasonable.

Maybe, but I have been through this before, as my email suggested:

Stocks are off to their best start since 1987.  Since I’m probably the only one on the team that was investing 24 years ago, let me tell you what happened.

Stocks kept moving higher for most of the year, but so too did bond yields. The fundamentals did not support the move in stocks, but no one seemed to care.  Then came October 1987 – stocks fell by -25% in one week, if my memory serves. Panic ensued.   Clients were not amused.

I actually have very fond memories of 1987 – as a bond manager, we made huge returns in the fourth quarter, since we were very long our benchmark.  But since I don’t do bonds anymore (directly, at least), I don’t really care to go through all of this again.

They say that famed hedge fund manager Michael Steinhart used to sell all of the stocks in his portfolio at the end of the year, and then start reinvesting the proceeds, to make sure that he really wanted to hold onto the stocks in his accounts.

The market seems very complacent, in my opinion.  I think everyone is sick of talking about the euro, deficits and banks, and are buying stocks because everything else offers essentially no return.

Ned Davis Research reported that stock short interest is at the lowest levels since 2000.  I think the hedge funds got smoked in the fourth quarter – especially October – and are mostly long at this point.

So here’s my problem: While I might agree that stocks will offer superior returns on a longer term basis, I am having trouble getting excited about the near-term prospects:

Consumer staples - +30% premium to historic valuation.  Uninspiring fundamentals. Sector analyst at Citi Wendy Nicholson just said this AM that she would not buy any of the names, and Bryan Spillane at Merrill said basically the same thing on Tuesday when I saw him.

Consumer discretionary – the consumer is probably OK at this point, but names like McDonald's and Nike have already had huge moves.  Are they still a buy?

Health care –  The analysts at the UBS conference we attended a couple of weeks ago were basically negative on everything in each of their eight sectors.

Industrials – I saw analyst Jason Feldman at UBS yesterday, who I think is pretty good.  His point was that to buy his stocks here you have to model a pretty strong second half pick-up in 2012, no European recession, and some euro stability.  Is this likely?

Utilities –  big premium to historic valuations based on good dividend yields.  Fundamentals don’t really support prices – just yield-hungry investors;

Financials – this group is having a strong January, but has anything really changed?  Slow loan growth, bloated infrastructure, and potential legislative headwinds all weigh on the prospects for many financial stocks.  Ned Davis had a piece that noted the short interest on the group fell from 39% seven weeks ago to 27% now.  Also, most managers are underweight, which means like me that are slightly panicky that financials are now working.  But has anything fundamentally changed?

Energy – seems to me this group only works well if Iran closes the Strait of Hormuz.  Natural gas prices are low, and there’s too much inventory.  Warm winter doesn’t help.

Tech – largest weight in the market, at 20%. Everyone loves Apple, but with a market cap of $400 billion it is hard to see this stock continuing to grow as fast as it had been.  Many publicly-traded tech stocks are mature businesses; the faster growing companies like Facebook are all private.

Telecom – do you really think the long term business prospects for AT&T and/or Verizon are all that thrilling?  I think like utilities these stocks are being bought for yield.