Darkest Before the Dawn

It’s getting increasingly difficult to find the silver lining among these ugly, gray clouds.  Stocks have fallen for ten of the past twelve weeks.  The stock-price drubbings have taken their toll on the collective confidence of investors as well as this writer.  Each day brings news of tragedy in Israel and Palestine, or of escalation in the Kashmir region, or setbacks in the war on terror.  If the global news abates, there’s plenty of homespun grief to compensate; from political and bureaucratic finger-pointing over potential advance warning of 9/11, and an ever-growing list of blue-chip corporations admitting accounting transgressions, to company rating downgrades, and securities analysts stumbling over each other to get the bad news out first. 

Why stay in stocks?

There are plenty of reasons to cash out and wait on the sidelines.  Indeed, we currently carry over 30% cash in our portfolios.  But, there are compelling reasons to stay the course as well.  The economy continues its recovery; there is little doubt among economists and analysts that the economy is in recovery.  But, its strength and staying power are uncertain.  That question explains, in part, why the market has been so anemic.

Markets generally perform well when economies recover, but not so far this time.  More than 94% of Americans who want to work are employed.  Interest rates remain low and consumer confidence remains high.  As long as these factors remain firmly in place, the consumer portion of the economy should remain healthy.  And the strong increases in productivity and steady evidence of falling inflation bode well for employment and interest rates.  The problem, voiced ad nauseam by national pundits, is that markets are overpriced given weak corporate profits with no real signs of improvement soon.  As pointed out in earlier Briefs, the over-valuation issues continue focus on the largest American corporations that drive the indexes.  But, little is said of the many bargains available beneath the surface.  These companies look even better if economic recovery continues.

Our recent efforts of finding and buying these ‘below-the-radar’ companies are showing signs of promise.  Our model portfolios have increased in value more than the market averages on those rare days when stocks collectively rose, and they have generally declined less when markets fell.  Our retail over-weighting continues to provide buoyancy for the rest of the portfolios, even as healthcare and banking succumbs to selling pressure.

Trust and confidence play a huge role in equities markets, and our markets serve as models for the world.  But daily revelations of greed and malfeasance of corporate managers have taken a toll on stock prices over the past several weeks.  Investors are loosing confidence, not just in the recovery of profits, but also in the reported numbers themselves.  The rally in stock prices following the huge drop after 9/11 has all but evaporated for many companies.  Nineteen of the Dow’s thirty stocks are near or below the lows they reached after September 11th.  A significant part of that decline is due to waning investor confidence in what managers report and say.  That’s a double whammy!

Stocks are quite capable of performing very well even during global conflagrations.  We pointed out last week how quickly equity markets recovered after the Iraqi invasion of Kuwait.  U.S. markets did very well during the early stages of the Asian currency crisis in late 1998.  They also snapped back quickly following the near collapse of Long Term Capital early in the following year.  But confidence in corporate earnings power and the forecasts of their managers was not in question then as it is now.

While the macro economic picture improves the micro (company) news continues to be bad.  Too many major companies are reporting disappointing earnings and downbeat future prospects for their recovery to foster improved investor confidence.   As I write this Brief, investors are reeling from the disappointing news of Intel.  They seem fixated on the bad technology news (which really isn’t news at all) and choose to ignore the just released news that the U.S. unemployment rate declined from 6% to 5.8%.  That’s GREAT NEWS!  But the NASDAQ futures were down 45 points before the unemployment release, they are now down over 52 points.   Talk about the tail wagging the dog!  Intel is an important bellwether for technology, but investors should have long ago accepted the fact that recovery in technology should not be expected until the old economy recovery is much further along.

The really good news though is that Construction Spending, ISM Manufacturing, and Non-Manufacturing were quite positive and well ahead of expectations.  The ‘old economy’ is recovering.  And the the unemployment rate, which is moving right direction, will continue to support the ever-important consumer confidence.

There is no way of knowing exactly when things will improve for investors, but they will because they always have.  Markets do not stay up forever and they do not stay down forever.  Our current stance is to remain cautious, holding significant amounts of cash, selling to stop losses as early as possible, avoiding companies with negative sentiment, and holding quality, reasonably valued companies that make sense in the current and intermediate economic climate.  We are laser-focused and more convinced than ever that excellent results are achievable in the coming months.