Just for the heck of it this weekend, try a contrarian investing experiment. Tell friends that you believe we’re past the panic phase because there are a number of overlooked positives that will soon turn things around. People will take pity on you, as if you are a simpleton. Conservatives will treat you like a turncoat. Some will lecture you, hoping to keep you from embarrassing yourself further while many just stare at you in wonder; how you could say such a foolish thing?
I received these looks in 1999 and 2000 when I said that AOL was a great $25 stock, when it was trading above $80 at the time. It is the same sense of shock and guffaw that greeted my concern that Cisco, at 100-times earnings, was over-priced. In 2006, I was quickly dismissed when I mentioned that real estate values can go down as well as up. The crowd, at the extreme, lacks the wisdom required to see both sides of a trade. At tops and bottoms, there is only certainty.
Though I'm not saying we've hit bottom, I am comforted by the degree of certainty that today’s Cassandra’s profess.
True, not all of today’s good news is...good enough. Lending standards are starting to improve, but only because the bankers' response has changed from "Hell no!" to simply "No" over the past few weeks. Banks have drawn down a few of those "excess reserve" dollars sitting in the Federal Reserve Bank, though. Perhaps the logjam is beginning to break. There are a number of overlooked positives that investors, even the bearish ones, should consider.
In the pharmaceutical sector, earnings forecasts remain well above 2007 levels. Stock prices have nonetheless taken a tumble. During the panic, everything sold down. Now we‘ve reached a point where investors are trying to sort through the good, the bad, and the ugly, looking for bargains. The healthcare sector continues to attract a great deal of interest.
The biotechnology firms are acting better as analysts conclude that the big drug companies, desperate to find new engines of earnings growth, will start buying up biotech companies with products close to approval. The pharmaceutical companies tend to have low debt levels and stable cash flows. They are able to squeeze a loan out of the banking sector - no easy thing with bankers hoarding cash to fund the next bonus payout. Biotech stocks have been working hard to make up lost ground.
There are many positives surrounding the junk bond market. Though common wisdom holds that investors are staying on the sidelines, in fact there have recently been inflows of cash into high yield bond funds. Cash is starting to accumulate as fund managers are finding it difficult to buy enough bonds to put this money to work. Sellers have no desire to let go of bonds at current prices. Distress selling in the sector has stopped. Supply/demand factors are starting to turn this into a sellers’ market.
Banks have written down junk bond portfolio prices to the point where, after the end of the first quarter (2009), some are speculating that banks will benefit from being able to write up their portfolios. Junk bond prices increased significantly in December and early January as buyers bought up what bonds were available. In 2009, new issues became possible for the first time in nearly 5 months. The market is still locked up, but with pent up buyers on the sidelines - which suggests that the next significant move will be higher.
In January, our junk bond holdings were our best performing portfolio sector. While stocks, generally, continued their decline, the high yield bonds were starting to recover. The steals and deals available in the high quality corporate market, last November, are gone. In the high-quality sector, investors have seen bond prices appreciate back near prior levels, and the sector is starting to suffer from the general bond market sell-off that has taken government bond investors to task. In the junk bond arena, however, most of the recovery lies ahead and the yields are so high, compared to normal, that junk bond prices can rise even while the broad bond market is selling off.
Another positive to consider, concerning the bank bailout in particular, is that for all the fear and frustration, from a cash flow perspective the government is making money on those investments. It loaned money to the banks at 5% and is only paying 1% to 2% for the bonds sold to fund those investments. On the bank side of those deals, companies like Goldman Sachs and Bank of America would have to loan money out at close to 8% in order to break even on the deal. That is far above the market rate for most borrowers.
Goldman Sachs has said that it intends to give back the TARP funds just as soon as possible. No doubt, the other banks would just as soon not have to report up the line to the triumvirate of Obama, Frank and Pelosi. We’ll never get the stimulus money back. I personally don’t think we’ll ever see the auto loan bailout money again. The TARP bailout might work, though, and eventually taxpayers might get that money back once firms get recapitalized in the private market.
Many experts now claim that the banking system has trillions of dollars in bad loans and cannot be saved, but where were these balance sheet experts two years ago? How do they really know what’s inside the financial black box that we call a bank? When the sub-prime loan fiasco first hit, a hedge fund manager who was shorting the sector was ridiculed when he said that he thought the problem might add up to as much as $100 billion, for the entire sector. Nobody really knew then just how much garbage sat on bank balance sheets at that time. Nobody really knows now, either, so why is it that talking heads who claim that the real figure is in the "trillions" have any credibility whatsoever?
Never get into an argument against a media mogul who buys ink by the barrel, and don’t short the bonds of an industry backed by the U.S.A. printing presses. The government has committed hundreds of billions to save the banking sector, and it will likely succeed - no matter what the cost. Hopefully that is good news for preferred stock holders throughout that industry.
Energy exploration companies have been hard hit by both the unwillingness of banks and the bond market to extend credit, and by the dramatic sell-off in the price of crude oil and natural gas. There is a potential for a political windfall if the nation’s desire for energy independence and "clean energy" converge to help promote the development of Compressed Natural Gas vehicles. In Colorado, Senate Bill 92 is advancing through committees and would require the State of Colorado to buy vehicles that run on CNG.
T. Boone Pickens energy plan promotes the use of CNG powered trucks and claims that, "nearly 20% of every barrel of oil we import is used by 18-wheelers moving goods burning imported diesel fuel." In Colorado, Utah, Arizona and other states, politicians are promoting CNG as a step forward. Washington D.C. has been preoccupied with the recent flip-flop in how partisan non-cooperation works (or, perhaps, doesn’t work), so we haven’t heard much recently from our leaders on the Potomac about CNG. President Obama’s chief of staff, Rahm Emanuel, sponsored legislation in 2007 that mandated that 10% of automakers products be fueled by natural gas. The politics of energy seem ripe to produce a sudden windfall for natural gas exploration companies, and the drillers who support their energy exploration efforts.
The painful process of de-leveraging our economy has caused a lot of investor pain in recent months, but in the long run this trend is also an overlooked positive. The U.S. economy was inextricably linked to debt in recent years. For every 1% growth in Gross Domestic Product, debt levels rose 5%. The country has been borrowing more and more in order to keep growing. This leveraging up of our nation was unhealthy. By the same token, the de-leveraging will eventually leave the U.S. stronger and more self-sufficient.
The flabby U.S. economy is being forced to diet. "Efficiency" and "value" are replacing style, luxury, and "branding power" as the key parameters for success. Wal-Mart is gaining ground at the expense of high end specialty retailers. Declining revenues and rising costs are forcing less efficient competitors out of business. The days of "form over function" are gone. Investors need to go long "frugal" and short "extravagance." I’m not sure these changes are bad, but they are surely painful.
In the meantime, while new borrowers get a cold shoulder from the lending markets, cash is king. Cash rich firms, and here both software and pharmaceutical companies come to mind, are in a position to grow by acquiring cash-strapped fledglings who need money to complete new product development projects while the capital markets remain closed. Hedge funds, private equity funds, and fly-by-night lenders who would securitize the loans and package them for sale to others, were dishing out millions to these companies in recent years. Now risky borrowers have little choice but to turn to larger, better financed industry partners and angel investors for growth capital. Cash rich firms will find plenty of opportunities to allocate capital in exciting new ways during the next few years.
Another overlooked positive is the recent rise in interest rates. During the worst of the crisis, Treasury Bill investors received negative rates of return. Investors bought T-Bills at a premium, knowing they would mature in a few weeks at just par. Treasury bond rates (for bonds with 30-year maturities) fell from nearly 5% to about 2.25%. Imagine - investors are agreeing to take a 3.5% return for the next 30 years! These low yields occurred at the same time that gold prices and gold stocks were beginning to rally, led by investors’ increasing conviction that the price we will pay for the bailouts we’ve announced will be years and years of inflation in the decades to come.
The fact that interest rates have started to climb reflect a reduced level of fear on the part of investors. This reduction in fear is also reflected in a reduction in the level of the "volatility index," which fell from nearly 100 down to the mid-40’s recently. Long-term investors began moving back into the market in December, but abandoned it again in January. The good news is that as the panic subsides, the likelihood that long-term investors do move back into the market increases.
Finally, low inventories - especially in the consumer non-durables sector - means that the economy could turn the corner sooner than doom-and-gloomers realize. If consumers aren’t buying, low inventories aren’t a problem. When we do see signs of recovery, though, manufacturers will have to ramp up quickly because the shelves are close to bare already.
Even in the automotive industry, where acres and acres of imports sit neglected adjacent to the Long Beach Harbor, the average age of cars on the road is higher than it has ever been. This suggests the possibility of a pent up demand for new cars. The government stimulus package, which aims to get buyers back on car lots again, just might actually work.
I expect that 2009 will be sort of a good news/bad news year. The good news is that I don’t believe we are headed for disaster. The bad news is that we will soon stabilize, but in recession. The panic will cease, but the Gross Domestic Product will continue to decline and the unemployment rate will probably continue to climb, leaving consumers wary.
In the midst of this sorry economic state, however, certain investments can pay off. Investments that are priced for disaster (junk bonds yielding roughly 18% and selling for 65 cents on the dollar) have room to rally. Health care companies, with earnings that remain fairly strong but now sell at bargain levels compared to 18 months ago, have a reasonable potential for recovery. Inflation sensitive stocks are likely beneficiaries of trillions of dollars of economic stimulus, worldwide, not to mention the potential windfall available to investors if the political push toward Compressed Natural Gas gains momentum. Finally, if this is a bottom and the economy is ready to turn up, it is hard for me to imagine a recovery that leaves the technology sector in the dust.
Don’t get me wrong. I don’t think that the market will go straight up from here. Do understand, however, that there are two sides to every trade. The folks predicting a 6,000 or 5,000 or 4,000 Dow could be wrong, just as they were in 2003. With the same certainty that many naysayers display today, talking heads prior to the Iraq War issued dire forecasts suggesting that the market could go only one direction - down further. They were dead wrong in 2003.
I’m not saying they’re dead wrong, now. I’m just not convinced that the other side of the trade, a significant rally as long-term investors gradually come back into this market because economic conditions stabilize, isn’t just as likely. This is a market with both upside and downside. The fact that an upside forecast is so quickly and derisively dismissed is what gives me hope that maybe, hopefully, we are at an inflection point that will turn our screens green again as the overlooked positives gain some face time with investors and talking heads on CNBC.
Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.
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