Market Top

We warned in our 1 June blog that the market was likely to test 1000 (big round number) and then 950 (top of the bear market base) by the fall. We think the evidence, both fundamentally and technically, has grown stronger for more downside testing since our warning. Real money supply, as measured by M-3, is still contracting sharply (May annual real contraction 7.9%). Real retail sales are softening, falling in May by 1.0%. There are indications that the housing market is softening once again and that home prices are likely to turn lower. For instance, May's existing home sales according to the National Association of Realtors (NAR) showed a monthly contraction of 2.2% when a strong upside gain had been expected. The Federal Reserve has taken note of the softening economy by inserting language in its most recent communique that, "Financial conditions have become less supportive of economic growth on balance, largely reflecting developments abroad."

Rumors are already surfacing that the Fed is preparing to reinstate quantitative easing (QE), which would continue to sow the seeds of future strong inflation, but also put a floor under the stock market once again...

Quantitative easing is the process of buying our own debt in order to force more paper money into the economy. The Treasury issues bonds and the Fed buys them with money it prints expressly for that purpose. It is a sure fire way to create inflation.

Technically the market continues to weaken, with a breach of the 1042 level occurring Monday, 29 June. Tops take more time to form than bottoms typically, and the topping action is now about six months old, sufficient time to build up overhead supply to the point where the market is no longer capable of pushing higher without first selling off more substantively. Specifically, there is now stiff resistance in place in the 1100 to 1125 area that isn't likely to give way anytime soon. Meanwhile, downside risk is 800-900 at some point either later this year or by early next year, assuming our forecast of another recession is accurate AND the Fed doesn't go back into full blown QE mode. (Normally, I would acknowledge the likelihood of the S&P 500 moving below fair value - 850ish - as the secular bear market finally plays itself out completely and the market hits its ultimate low, but our activist Fed makes that scenario a remote one)

Investors should continue to proceed with caution in what continues to be a high risk market....

Picking Stocks Revisited

A friend suggested that I write about how to pick stocks in which to invest. Regular readers are aware that I frequently write about the economy and the markets (and have correctly forecast the current market turmoil in 2010). The reason that I shy away from writing about individual stocks is because I don't want my readers going out and purchasing them on their own. Knowing when to buy a stock is only half the investing equation. It is also important to know when to sell, and I can't be there to make that call for you - unless you are already a client of course. Nevertheless, I will update you on a stock I wrote about back in October of 2008 in order to better illustrate the art of stock picking, but first an update on the market.

Our most likely scenario for the remainder of the year is the continuation of an oversold bounce that takes the S&P 500 back to the 1150-1175 area before renewed selling takes us lower into the fall. Of course, it is also possible that the bounce is over already and we are headed lower now. Regardless of the eventual path, it is quite likely that the S&P 500 will test 1000 (big round number) and then 950 (top of the bear market base) before the year is over. Why? Well because it is quite likely that we are headed back into recession as the effect of the fiscal stimulus runs its course and the tremendous burden of U.S. debt reasserts itself. The stock market is merely a reflection of the underlying economy. A weak economy will eventually lead to a weak stock market - absent additional stimulus from the government (which can't be ruled out). Okay, now on to individual stock picking...

Below is an analysis I wrote of Intel in October of 2008. It well illustrates the thought process involved in seeking out good businesses at great prices. (Please skip down to the last couple of paragraphs of the blog for a summary if you aren't into the nitty gritty of analysis).

INTC $14.28 Intel closed today at $14.28 per share, but not before touching $13.37 intraday – a new 52-week low. The company is paying a dividend of $0.55 per share for a current yield of 3.85% and is expected to raise its dividend to $0.61 per share in 2009, according to Value Line – should reality meet expectations INTC will yield 4.27% for anyone buying at the current price, or some 40 basis points or so more than the 10-year Treasury. Now, of course, Intel common stock is riskier than holding a 10-year Treasury to maturity (although that premise seems increasingly uncertain given our government’s loose spending habits). On the other hand, we get much more than a debt instrument that pays par upon maturity when we buy part ownership of a company. We also get a growing stream of shareholder cash flow that can be returned to us by management either with increasing dividends, share buy backs or both.In fact, INTC will pay out around $1.19 per share in 10 years if management raises the dividend 8% per annum during that period – only one quarter the growth rate of the last 5 years. Anyone buying and hold Intel’s stock for the decade will then be earning 8.3% per annum on their original investment. Now compare that juicy 8.3% to the measly 3.85% you can currently earn holding the U.S. 10-year note… and you quickly get it – Intel is a raging buy at the current price as long as the company is around in 10 years and as long as management is able to continue to grow the dividend. And our analysis doesn’t yet include the possibility of additional cash that might be available to oh, say, buy in stock, resulting in the dividend yield rising even faster.In Intel’s case, a quick check of current year estimates reveals that the company will have approximately $0.55 per share in excess cash after paying its dividend and meeting its capital expenditure requirements. A three year average is often useful in ascertaining a company’s ability to throw off excess cash consistently. According to Value Line, Intel has generated approximately $5.66 in cash flow from 2006 to 2008, while making $2.76 per share in capital expenditures and paying out $1.41 per share in dividends, leaving approximately $1.49 per share in excess cash available to buy back shares, or $0.50 per share per annum. Adding the $0.50 in excess cash to the current $0.55 dividend gives you a current dividend yield of 7.35% (what the dividend yield would be if INTC management devoted all of its excess cash to the dividend). Unfortunately, Intel, like many management teams, often choose to buy back shares with excess cash. We think it unfortunate, because managements tend to pay top dollar for their own shares rather than waiting to buy in shares after their stock takes a dive. Nevertheless, buying in $0.50 per share per annum retires 3.5% of the outstanding shares at the current stock price (call it 2.0% net of stock option issuance), raising current and future dividends accordingly.Yet another way to do the math without the distortion of a changing share count: Intel generated $34.2 billion in Cash Flow After Taxes (CFAT) during the three years ending in 2007, against $17 billion in Capital Expenditures (CAPEX), leaving $17.2 billion available to shareholders. The entire company was available for purchase for a mere $154 billion at the beginning of 2008 (you could buy it lock stock and barrel right now for $82.8 billion). Taking the three year average shareholder cash number of $5.7 billion and dividing it into the current fully diluted shares outstanding gets you $0.99 per share in stockholder available cash – a nice current yield of 6.9%, some 3.1% better than the 10-year’s current yield.A couple ways then of looking at the yield to shareholders currently and a decade into the future in comparison to the 10-year Treasury – all favorable. We just need to make a judgment on whether INTC is likely to be around and prospering a decade from now.The company is currently the world’s largest semiconductor chip maker based on revenue, according to its 2007 10K SEC filing. INTC develops advanced integrated digital technology products, primarily integrated circuits, for industries such as computing and communications. Intel also develops platforms, which they define as integrated suites of digital computing technologies that are designed and configured to work together to provide an optimized user computing solution compared to separately. Intel currently controls about 80% of the PC processor market.For starters, Intel has grown revenues from $30.1 billion in 2003 to an estimated $40.4 billion in 2008, or a little over 34% during the five year period. Net profit is forecast to hit $7.3 billion in 2008, up from $7.0 billion in 2007 but well off the company’s peak profit logged in 2000 ($10.7 billion). Nevertheless, profit has grown steadily, albeit erratically, since the bottom fell out during the last recession in 2001 (profits bottomed in 2002 at $3.5 billion).Clearly the company is likely to still be in business and growing earnings given its dominating position in the microprocessor industry and strong balance sheet (almost 13 billion in cash on the balance sheet at the end of 2007). On the other hand, just looking at the increasing variability in earnings leads one to the conclusion that the company is no longer a true growth company and should be bought after business conditions (and the stock price) have weakened and sold when investor enthusiasm carries the share price outside of the realm of reasonable valuation. We believe the current valuation is in the buying zone, given our discussion of dividend and shareholder yields.

Whew! So what did Intel do in the 20 months since I wrote that analysis? Well, it bottomed at around $12 per share
in November of 2008 and retested that low in March of 2009, before marching to a 52-week high of $24.36 in April of 2010. Investors who bought INTC on my recommendation in October of 2008 would have made a pretty penny, earning over 50% on their investment (including the dividend) during the 20-month holding period (assuming they still owned the stock, which currently trades at $20.81). Had they sold the stock last fall when the return hit 50%, they would have earned approximately 55% annualized on their Intel investment. (My personal investment hurdle is the likelihood of earning 50% within two years. I regularly take my profits when I hit my target because business valuations simply don't change that quickly, making it highly likely that my initially undervalued business is no longer cheap enough to hold for the long-term without taking on too much price risk).

One other thing about investing in individual stocks....

You don't find good businesses at great prices among stocks hitting 52-week highs. You do find them among stocks hitting 52-week lows. I'm currently building a rather large position in a big blue chip S&P 500 company that recently lost over half its value due to a short term (in my opinion) problem with its business. My math tells me that I have a high likelihood of earning my 50% hurdle over the next few years.....

Bear Market?

We warned in December of 2009 of a likely correction in 2010 that could reach 20%, writing that it was most likely to occur in the first couple of quarters of 2010. "To summarize, we see a correction in the stock market sometime next year that could hit 20% and is likely to occur sometime in the next few quarters." (December 19th 2009). The S&P 500 has fallen just shy of 15% so far at its May 25th low.

We wrote about the high risk nature of the current U.S. stock market, first in February of 2010 and then again in March. On February 18th we wrote, "Further deterioration in the chart - in particular a breach of the recent 1042 low - will likely cause additional profit taking that could lead to our predicted 20%-30% 2010 decline." Finally, we wrote on May 19th that, "Prudent investors would do well to heed the warning shot that was fired on 6 May 2010, it quite likely presages more trouble to come...." (Six days later the S&P 500 hit a new low for the correction of 1040 inter-day, after falling almost 7% in just four trading days).

The wise guy traders (which includes just about everyone these days it seems like) bounced the market hard off the 1040 level on 25 May, making the 1040 area a line in the sand, a breach of which is likely to trigger a further round of selling. The bad news is that the S&P 500 recently failed to take back the 200-day moving average during last week's three day bounce and is setting up for another test of the now critical 1040 area. A close below 1040 opens the way for further declines, first to the big round number (1,000) and then to support at 950. It is possible that the market will rally out of its current very oversold condition first, which would delay any sell off to the 950-1000 level likely until the fall. (Even if an oversold rally does materialize, taking the S&P 500 back to the 1200 level, it is likely that the market will eventually test 1000 and perhaps 950 in the fall as the stalling economy pressures stocks.)

Now, the technical mumbo jumbo is a useful guide primarily because so many professional money managers utilize it. Mutual funds are speculative vehicles these days, turning their portfolios over 80% per year on average. The short term focus puts pressure on managers to track the technicals, making them a self fulfilling prophecy to some extent. It was no coincidence that the market bounced hard from the 1040 level. Everyone can read a chart and everyone could see that the February 1042 low was sitting out there as support. Likewise, it is no coincidence that the S&P 500 recently traded back to the 200-day and failed. Mutual fund managers see the 200-day there and place sell orders accordingly, creating resistance.

Fair value for the S&P 500 is still in the 850-900 area. A return to that level by the fall is still a real possibility and a decline to 950-1000 a fairly high probability event. Hopefully your advisors haven't ignored the high risk market and kept you fully invested over the last few months. Hopefully they too recognized, by late last year, that risk levels were building and prudent risk management was in order. Wouldn't it be nice if you had some cash built up already with which to buy good companies at great prices? Biechele Royce Advisors values price discipline above all else, knowing that the only sure way to outperform is by consistently buying assets for less than they are actually worth. Cash builds up on our clients balance sheets when we can't find undervalued assets to buy - that cash is available to put to work when assets sell off and good companies can be had again for great prices.... perhaps by this fall.