Enjoying the Rally, but not Relaxed

Investors should relax and stop worrying. That’s my job.

I continue to be more worried about preserving wealth than I am about missing the next market upleg. This weekend’s Barron’s reading was a mixed bag.

The good news was an article, “Trampled in the Rush to Riskier Stocks” by Andrew Bary, that featured stocks in the property & casualty insurance sector, which is a new area of investment in many client portfolios. The article noted that most of the P&C stocks command little or no premium to their accounting (book) value, are currently profitable, and have an opportunity to take business away from the wounded giant, AIG. The hurricane season has been kinder and gentler than in years past. The Price/Earnings ratio of the nine stocks profiled in the article range from 5.9X earnings to 10.1X earnings. If earnings power is maintained and the P/E multiples remain stable, these companies would provide an earnings yield of 9.9% to 16.9%. If earnings power grows, as the analyst in the article expects, or if P/E ratios improve from today’s low levels, investors would benefit even more.

We watched the downward spiral in financial stocks from the sidelines. We are no longer convinced that the sidelines is the best place to be when we look at stocks in the insurance industry, but as always we’ll monitor that view and modify it if necessary.

More of concern was the Lipper fund data which continues to show money coming out of equity mutual funds, in contrast to the surge in July and August that coincided with the big run-up in stock prices.

The Federal Reserve released new data on excess reserves, which is money that is hiding in the banking system but not finding its way out into the real economy, where it could help alleviate some of the financial pressures we are still experiencing. The Wall Street bailout, where public dollars are used to buy up illiquid securities to bail out big banks who were caught in the squeeze, has worked pretty well. Unfortunately, even nine months after excess reserves first surged, the money hasn’t yet made its way out into the real economy. Excess reserves jumped from $823 billion up to about $855 billion, near its all-time high. Regardless of today’s low short-term interest rates, it’s hard to conclude that we’ve got an “easy money” policy if the money sits on the sidelines and is unavailable for job creation and capital investment.

The best news, of course, is that the market has wanted to go up in spite of these fundamental concerns. The Vanguard S&P 500 Index Fund, for example, is +17.8% year-to-date through last Friday, September 25th. Though it was hard to justify higher prices in the fearful days of February and early March, now the S&P 500 sits 57% higher than at its nadir in early March.

Clearly, the volatility inspired by widespread fear in the last months of 2008 and the early days of 2009 created a significant opportunity for profit. Similarly, however, the upside volatility we’ve enjoyed as a function of relief spreading throughout the economy has magnified the risks of decline. Just as we did not put all our money to work at the bottom, I am absolutely certain we won’t be able to define and get out at “the top.” What we will do, however, is carry our bias toward wealth preservation and experience in managing our way through volatile markets into the period ahead..

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

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A New Week

Last week in Barron’s Mike Hogan noted that the politicians are finally getting around to considering natural gas as a cleaner burning fuel, suitable to large auto and truck fleets, that might be capable of actually making a dent in our foreign oil dependency sometime this side of the next quarter century. Most energy alternatives are so far out in the development stage that they provide little near-term impact. It would be nice if we could develop the solar and other renewable options, but few barrels of oil will be left on the shores of Saudi Arabia, at least during the next decade, if we limit ourselves to clean green options.

Natural gas, though, is cost effective and available and, with just a little technological sprucing up, could drastically reduce our dependence on areas of the globe which tend not to raise their hands when volunteers for the USA fan club are solicited (unless, of course, the term “citizenship” is dangled as an incentive).

Harry Reid and Obama’s Chief of Staff, Rahm Emanuel, are among those pushing for a political initiative favoring natural gas. How it was left out of the hundreds of pages of middle-of-the-night negotiating for the Cap and Trade bill, is a great question. The Colorado delegation might want to spin up an answer for the next election cycle. For Western Colorado, natural gas stocks, and our current portfolio, however, it’s a plus.

Natural gas and crude oil are diverging in an unprecedented way. Natural gas prices are setting new lows, making this clean substitute for crude ever more cost effective. It reduces the value of reserves, which is a negative for the gas exploration stocks, but it creates an ever greater incentive to lean toward gas as a clean fuel for the future.

I was less enthusiastic when I checked the recent money supply statistics in the tiny print of the Market Laboratory section of the paper. Excess reserves, which is money held in the banking system instead of being available to business and consumer borrowers, rose again – back up to nearly $800 billion. Thus, the money which came screaming out of the stock market, last Fall, and now sits earning practically nothing in certificates of deposit, is not yet finding its way back out into the real economy.

Were it not for the credit crunch, credit-worthy borrowers would abound. As it stands, since no money is going into the real economy and therefore attempts by the Federal Reserve to stimulate the economy using monetary policy isn’t stimulating anything, almost any loan looks like a mistake waiting to happen. It’s a classic “Catch 22,” but without the biting humor that Joseph Heller wrote into his characters.

Finally, money flows into equity funds went negative last week. The last six weeks have been good to stocks, and positive flows into the market helped explain the surge. In many sectors, valuations look stretched. I can find insurance stocks and healthcare stocks whose earnings prospects remains strong, but whose stock prices are a lot lower than a year ago. For the broad market, though, earnings power has fallen at least as much as the stock market itself. We’re rotating into some new sectors, but if the same guy who was telling you to “sell” in March is now telling you to throw caution to the wind and “buy” today, it’s probably time to upgrade your choice of market pundits. Risk is always at least partly a function of price, and today’s market is 50% more risky than when the market that was causing us all to sweat bullets last March.

Clearly the economy is stabilizing, as we said it would. It’s not clear that it’s getting ready to shift into high gear. Or even that it will be able to sustain the momentum it’s got. It’s in low gear, crawling forward through difficult terrain, and valuations ought to reflect this reality.

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

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