Thursday, January 19, 2012

The Market Melts Up

Last August, when the stock market was in the midst of one of its worst quarters in the past decade, I wrote several pieces suggesting that investors should look past the concerns of the day and focus on the longer term fundamentals.

Here's an excerpt from a piece I wrote on August 8, 2011, titled "Seven Reasons Not to Panic:

Weak economic data. S&P downgrades US debt. Eurozone in crisis. Gold soars above $1,700.

Stock markets tumble around the world, and the S&P 500 has lost more than 11% since the end of April... 

... Finally, at times like this, it is worth remembering Warren Buffett's axiom to "Be greedy when others are fearful, and fearful when others are greedy".

When you see so-called smart money investors stashing funds in Treasury Bills yielding 0%, or even paying custodian banks like Bank of New York Mellon a fee to place deposits, you have to believe that a lot of bad news is already priced into the markets.

In my opinion, for the longer term investor, stocks represent the best combination of yield and potential capital appreciation.

I see little or no value in shorter maturity bonds yielding less than 1%.

(The S&P finished the quarter with a loss of -14%, so perhaps a little panic in mid-August would have been appropriate.  On the other hand, thanks to a strong stock rally in October 2011, stocks regained all of the prior months' losses to finish the year with a modest +2.1% total return.)

Which brings us to today.

The same factors that were apparently causing the markets to swoon a few months ago - euro crisis; S&P downgrades; financial turmoil - are now being greeted with a collective yawn by the markets.  Indeed, the S&P is off to its best start to a year since 1987, according to Bloomberg:

U.S. stocks are off to the best start in 25 years as investors speculate Federal Reserve Chairman Ben S. Bernanke has done enough to insulate the economy from Europe’s debt crisis. 

The S&P 500 has gained 4 percent, the most since it rose 10 percent over the first 11 days in 1987, according to data compiled by Bloomberg. Stocks are overcoming earnings that trailed estimates by the widest margin in three years as improvements in hiring, manufacturing and car sales extend the biggest fourth-quarter advance since 2003.

Interestingly, despite the ebullient mood on Wall Street, the credit markets are still signalling distress in the global financial system.

Yields on high quality government bonds remain far below the levels of a year ago.  Ten year Treasury notes, for example, offer investors a yield of just 1.9%, almost half the 3.5% yields of a year ago.

Many analysts are warning that the advance in stock prices is not justified by company fundamentals.

For example, industrial analyst Jason Feldman of UBS told me and a few other investors in a meeting yesterday that the recent advance in share prices of names like General Electric reflect overly optimistic assumptions about 2012. 

Consumer staples analysts Wendy Nicholson of Citigroup - one of my favorite analysts - left a voicemail to clients this morning telling them to avoid all of the stocks in her sector.  According to Wendy, stocks like Colgate and Procter and Gamble do not reflect the weakening trends in their underlying fundamentals.

Finally, only 47% of the companies in the S&P that have reported earning thus far have beaten expectations. This is the lowest level in years, according to Bloomberg.

While welcome, this month's rally has occurred on relatively low volume and listless trading.  Like the old western movies - when cowboys would say things like "It's quiet - too quiet, if you ask me" - it is worrisome that complacency seems so widespread.

And as I wrote last August, the second part of Warren Buffett's axiom "be fearful when others are greedy" may in fact be the best advice for now.