Fishing in Troubled Waters
Investing in the stock market today
is truly like fishing in troubled waters. Buyers of
stocks are beset daily with apocalyptic commentary
concerning the many currents that course through our
world, political (Iraq, al Qaeda), economic (deficits,
easy money) and speculative (real estate, hedge funds).
The terrorist attack in the heart of London, while not
surprising, nonetheless reminds us that we are in the
midst of a protracted war.
Seldom has the traditional stock
market investor experienced such competition for his
investment dollars. Hedge funds promise returns
regardless of whether the market goes up or down (Wanna
buy the Brooklyn Bridge?) and some actually deliver.
That business has gotten so big that over 50% of the
volume on the New York Stock Exchange is driven by
program trading, largely generated by hedge funds. Real
estate offers speculators and others what appears to be
low cost, no money down financing while the stock
investor has to put up at least 50%. The stock market
seems so out of the action. Yet, investing in stocks is
a big part of what we do and we like to think that our
clients are the better off for our efforts.
Reflecting the above currents,
perhaps, the stock market has rallied and sold off
repeatedly over the last six months during which the S&P
500 declined -0.8% (with dividends included) as of June
30. From one perspective perhaps this is not surprising.
We seem to be in a low return world. The market has
adjusted to low interest rates, 4% for the 10-year
treasury note, so double-digit gains by the broad stock
market seem improbable. Nonetheless, we remain as fully
invested as possible since the market seems to stall for
long periods of time punctuated by brief but robust
rallies. As we have said repeatedly in the past, success
going forward will depend on successful stock picking
and limiting losses. To limit risk, we continue to
examine beat down issues for signs of long term value...
fishing in troubled waters.
The economic scene has changed
little since our last letter. Growth of the US gross
domestic product (GDP) continues at between 3% and 4%,
robust for a mature economy. Inflation remains low and
interest rates continue to bounce along a multi-year
bottom. One new development seems to be a nascent
stirring of growth in Japan. Japanese banks are largely
back on a sound footing and real estate prices have
begun to rise for the first time since the late 1980s.
Importantly, growth is being driven by domestic demand
rather than exports alone. Should the expansion
continue, it would be good news for the world economy,
easing the US trade deficit and relieving some of the
pressure on the US to be an engine of world growth.
Clients may note that sell
confirmations are starting to pile up for long-held
stocks that have had outstanding performance over the
years. Real estate related stocks such as Forest City
Enterprises, Centex, Fidelity National Financial and
PICO continue to make new highs. Like the technology
stocks during the bubble, they may go higher but we
question whether the economic fundamentals support such
lofty, underlying real estate values. Similarly, we
watch oil stocks with a skeptical eye. Though the stocks
seem reasonably priced on earnings, those earnings are
inflated by what may turn out to be an unsustainably
high price of the underlying commodity, oil. Our hat is
on and our eye wanders toward the exitů but we are
moving cautiously. We are mindful of the gold (read:
commodity) boom of 25 years ago. Then, gold stocks did
not hit their highs until the year after gold topped out
at $800/oz. The average annual price of gold received by
the mines continued to climb after the peak, driving up
earnings and share prices.
Taking profits is fine. However, we
are then presented with the challenge of redeploying the
investment funds effectively. Unfortunately, we do not
now see any sectors that could replicate the performance
over the past five years of oil and real estate stocks.
Going forward, investors should expect more modest
returns and a shorter holding period.
A recent purchase of selected steel
stocks holds the promise of competitive returns though
we doubt that they will be multi-year holdings. The
stocks are currently down 40% or more from their peaks
and trading at about 7 times earnings. After struggling
through years of bankruptcy proceedings, the steel
industry consolidated and cut capacity, then enjoyed a
boost from increasing demand from China and an improving
domestic economy. By early 2005, however, demand began
to cool, prices weakened and inventories began to rise
as China brought on domestic capacity. Steel stocks took
a tumble as investors anticipated another typical
boom/bust cycle. However, the situation may not as bad
as it appears. Unlike previous cycles, a smaller
domestic industry with a better balance sheet has
curtailed production to support pricing. Contrary to
fears of some, China has indicated that it does not
intend to become a net exporter of steel. More
fundamentally, long term underinvestment in
infrastructure worldwide has made it difficult to get
raw materials to the mills and finished product out to
customers. Transportation bottlenecks suggest that few
new steel plants will be built as growth through
capacity expansion is unrealistic. Restraints on
capacity and continued demand due to economic growth
could trim excess inventories, firm up product pricing
and lead to a rebound in share prices.
By the time clients receive this letter, we will have
completed our move to Pershing, LLC, our new clearing
firm. We look forward to a long and productive
association with them. We apologize for any
inconvenience the move may have caused. Do not hesitate to
call us if you have any questions.
Please read our important notice
about these letters and the securities they mention.