Still Bottoming

On December 19 our blog post identified five indicators we’re watching to see if the market is set to turn up. We’re still not happy about what these indicators are signaling and the portfolios remain, not coincidentally, more conservatively invested than we would normally be, given the size of sell-off that the markets have experienced.

It’s almost as if there’s no question of whether the market is cheap. It is. Today investors can buy for 50 cents what cost $1 only 16 months ago. The question remains, however, as to whether it deserves to be priced as cheaply as it is.

In the weekend issue of Barron’s, Ron Meisals and Olaf Sztaba’s NA-Market Letter observed that, "bargain hunters should note that a bottom is not a place – it is a process… At the moment, there is no evidence that a process of repair is taking place." The quote reflects my sense that there is not a particular level on the Dow or the S&P 500 at which point the market becomes a "buy." I’m waiting for the market to start going through a process of bottoming, and the economy to begin showing signs of recovery.

We said, in December, that we were waiting for:

• High yield bonds to rally. They did, but in the recent sell-off virtually all of the December and January gains were retraced, so highly leveraged companies still have little or no access to the bond market and have virtually no means of rolling over debt. For most, the bankruptcy courts (distributing equity to creditors) remains the most viable restructuring option.

That the high yield market still hasn’t been able to sustain signs of recovery is my biggest concern about this market. If this financial mess is really turning around, then presumably the threat of bankruptcy is on the decline and junk bond yields should start coming down. The fact that junk bond yields still hover near 20% tells me that the fixed income guys don’t believe that the bank bailout is going to have the desired effect.

• Oil prices to rally. Oil prices have rallied, above $50, which is a reassuring sign that the global economy may be stabilizing. Then again, it may just be signaling that the value of our currency has already begun to falter in the eyes of commodity traders.
• Banks start lending. I believe the doors are still closed. While the guilty parties in the Senate and House reiterate empty promises that the banks are starting to get money flowing again, examiners and regulators on the ground are increasing capital and collateral requirements. Excess reserves – the amount of money being held by the Federal Reserve instead of being invested in the real economy, have climbed back up to $771 billion, almost to the high levels first reported in late November, indicating that the cash injections from taxpayers and deposit flows still coming out of the stock market are not yet finding their way back into the real economy. In just the past two weeks, another $150 billion has found refuge at the Federal Reserve, while real businesses scale back and lay off workers in a desperate struggle to survive. While Washington fiddles, the Chamber of Commerce is burning to the ground.
• Bond markets start working again. In stark contrast to the stock market, equity flows into the bond market are beginning to make a positive impact. Investment grade interest rates have declined, somewhat. More importantly, more creditworthy borrowers have been able to raise money in the bond market to fund bank debt maturing later in the year. This, along with the rally in oil prices, is a clear indication that things are better in the spring of 2009 than they were at the nadir of the crisis in November/December of 2008. We continue to stabilize at recessionary levels, but that remains far preferable to the freefall in which we found ourselves last autumn.
• Volatility to decrease. Unfortunately, volatility remains high. The Volatility Index (the "VIX") measured about 12 in 2005 and 2006, before surging to about 20 in the fall of 2007 and then to nearly 100 during the panic of 2008. The VIX remains elevated, above 40, indicating that markets remain extremely jumpy. A stock market rally would require some normalization of volatility; it must retreat back to less dangerous levels before many investors would even consider coming back into the market.

Instead, equity funds continue to experience outflows, in contrast to normal seasonal trends. Typically, money flows into markets during the first few months of the year, and then dry up during the summer and early fall. During the past four weeks (ending Wednesday, March 25), however, equity funds had outflows averaging $6.8 billion per week according to AMG Data Services. Low prices have not yet enticed investors to return.

The sense that the market is rigged to favor the Goldman Sachs of the world, the fears that business prospects are forever dimmed by regulatory ineptitude, and the need to hold onto cash because the availability of credit has dried up (especially for corporate borrowers) have worsened the situation.

Details of Geithner’s latest Wall Street bailout plan are making the rounds. Optimism surrounding the plan’s ability to benefit anyone (other than the same Wall Street derivatives traders who got us into this mess) is waning. Instead of helping provide credit to the thousands of companies across America who need it, the latest attempt at financial engineering is more oriented to taking lousy assets off the balance sheets of inept bankers in a twisted attempt to provide hedge fund firms with financing. The hedgers get a lopsided risk/return investment opportunity where they benefit from leveraged upside and relatively little downside in order to entice them to manage the government’s "bad bank" portfolio of assets. The government has decided to keep the shell game of securitization going, by inserting itself into the void of lenders willing to finance this activity, instead of letting the shell game draw to a close so that lenders are forced to keep the loans that they underwrite.

He compounded his public policy gaffe by going on "This Week" with ABC’s George Stephanopoulos and creating the headline that "some banks are going to need some large amounts of assistance." Even though he was arguing against the notion that banks needed to be nationalized, now the headline is out there to suggest that a number of banks aren’t going to be able to pass the Treasury’s stress test so the bottom fell out of the sector, again. The markets fell -3.5% today (Monday) on the news, led on the way down by another -8.4% decline in financials.

Many of our client portfolios recently added gold companies to the mix. Like our existing investments in gas exploration and drilling, we believe these gold investments would likely benefit from the administrations’ inflationary policy response to the ongoing banking crisis. The nation continues to print money and increase indebtedness in a fiscal madhouse that must certainly be making our creditors cringe. If we make it through this, it will only because we’ve become the bank customer who is so large and owes the lender so much money that the lender can’t afford to foreclose and send us into bankruptcy.

In addition to gold, we continue to own energy assets. Like gold, they should benefit if the value of the dollar continues to decline. In this week’s Barron’s, the "Safe Harbor in Deep Water" article discusses the prospects for deep water drilling companies like Transocean, Diamond Offshore, and Noble Drilling. Barron’s interviewed Peter Vig, manager of the RoundRock Capital energy hedge fund, who is looking for oil to continue rising to $60 - $65 in 2009 and $65 to $70 in 2010. Demand for gasoline jumped 2% year-over-year last month, even with the market panic late in the year, while oil production has declined in the North Sea and Mexico, and is starting to contract in Russsia.

Our traditional stock market investments comprise a relatively small part of the total portfolio. Excluding our inflationary energy/gold investments and the "muddle through" high yield and preferred investments, perhaps a third of the total portfolio is invested in more traditional stocks, mostly in the technology and biotech industries.

Paul Wick, portfolio manager at Seligman Communications and Information Fund (SLMCX), told Barron’s Eric Savitz that the semiconductor and semi-equipment companies have rallied to the point where they are very risky. "Why stick your neck out with Lam, or ASML or Varian Semi, hoping that 2010 or 2011 will be really good – and [the stocks] might be worth 11 or 12 times 2011 earnings – when you can own Oracle (ORCL) at 10x free cash flow," he asks. "Oracle is Fort Knox. Half the business is recurring maintenance. It’s not ever going to blow up." Oracle was recently the third largest holding in the Fidelity Select Computer Software Fund, owned by our mutual fund model at the time this is being written, behind cash-rich Microsoft and innovative Google, Inc., with those three positions making up nearly 40% of the fund’s holdings.

I continue to pray for 20/20 foresight, but alas that prayer has yet to be answered (and I doubt that it will be answered with a "yes"). Lacking that crystal ball, I continue to see enough danger not to want to be fully invested. However, sentiment is so negative and prices have fallen so far that I think it is foolish not to be making some investments amidst the uncertainty.

It feels to me like we are still early in a bottoming process, waiting for the economy to stabilize, banks to want to lend money to corporate borrowers who desperately need liquidity, and for volatility to take a much needed vacation. I still believe that a recovery will come, but that it’s not here yet.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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