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Wednesday, August 12, 2009

Doom & Gloom Resurfaces to Check Bulls - Who to Believe?

It's a massive tug-of-war: on one side you have technical market specialist Robert Prechter of Elliott Wave International. Mr. Prechter hit the media this week with his August update, appearing on Yahoo! Finance's "tech ticker" yesterday and sharing his current views:
  • "quite sure the next wave down is going to be larger than what we've already experienced"
  • market averages will go 'well below' March 2009 lows
  • 'the late 2007-early 2009 market debacle was just a warm-up to what Prechter believes will be the bear market's main attraction' (Yahoo! text)
Meanwhile, on the other side, money manager and Forbes columnist Ken Fisher. Mr. Fisher's latest Forbes column (8/5/09), "The Bear Market is Over" points out the following:
  • "In my Sept. 29 column last year I wrote about how we're in a reverse bubble. In this mirror image of a buying mania, people can see only the negatives. But the positives are there and will be reflected in stocks before long."
Mr. Fisher then cites a handful of positives he sees:
  1. "housing affordability is now excellent"
  2. "global leading economic indicators in total (such as real money supply and the yield curve's slope) are the highest they've been in a decade"
  3. "Productivity is up 2% from a year ago, an impressive growth rate within a recession's decline."
  4. "The financial crisis is over. Most rate spreads between risky paper like junk bonds to Treasurys have reverted to precrisis levels."
  5. "U.S. bank cash on hand, at a trillion dollars, is (adjusted for inflation) three times what it was before the crisis. Cash in the form of U.S. money market funds comes to 42% of the stock market's capitalization. That ratio is more than twice what it was in 1982 and 2003, as stocks were about to take off."
  6. "stocks are dirt cheap, as measured by the degree to which prospective earnings yields exceed long-term interest rates globally."
Who to believe? Tough call. Honestly, we can't tell you whether we're headed back to DOW 7,000 or to 10,000 over the next year. We agree that fundamentals and forecasting remain challenged in many -- if not most -- industries. Demand remains slack, unemployment rising, and wages declining. Even energy use is down, which is rare and likely a result of weak industrial activity -- see WSJ's "Electricity Prices Plummet" article today. Finally, the government is in hock to the gills and expanding like a blowfish, likely leading to higher interest rates and taxes everywhere.

Fortunately, the credit and equity markets are now open for business -- bankers are busy again (see REIT sector) -- and plenty of companies have proven resilient amidst the recession. Nonetheless, u
ltimately, we believe that any sustainable, upward move by the broader market needs to be underpinned by growing earnings. The deceleration in the pace of economic/earnings decline this spring/summer does not equal growth. Accordingly, we see risk that Wall Street analyst forecasts for a return to growth in 2010 could prove too optimistic, especially for cyclical companies/industries. Time will tell which way the wind truly blows.

In our view, the best approach remains to focus on high quality franchise type businesses that (1) have net cash and (2) generate significant excess cash. We wrote in our 3/23/09 article on Youbet.com (UBET, $2.94) that such an investment strategy arguably appears as attractive as simply holding cash, particularly given extremely high earnings and free cash flow yields. While earnings and FCF yields are no longer as high as they were in March, we still see a meaningful margin of safety offered by some companies. For those playing the short side, focus on the opposite of (1) and (2) with identifiable negative catalysts.

We can add another owner-oriented approach: focus on defensive names/sectors with stable dividends since income is more certain and capital gains less certain. These types of businesses have not been immune to the market swoon, but relatively steady operating profiles provide both comfort and income.

On a related note, we'll soon update our "How's the Economy Doing" post from June.

Happy investing,

Jeffrey Walkenhorst
CommonStock$ense

Disclosure: long UBET.

© 2009 Jeffrey Walkenhorst
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