Review and Outlook
My Clients, Friends & Observers:
October 25th, 2002
As a trend, better market performance runs from November through
April, worse is the period May through October. Welcome, November!
The mutual fund companies tend to complete tax-loss selling and portfolio
adjustments in October. The clear trend since October 10th has been
the reappearance of buyers –en masse- in the equity markets.
This has coincided with a significant drop in the bond markets, evidenced
by increases in yields from the five, ten and thirty-year treasuries.
Fed Funds remain at 1¾% with no increases in sight. In fact,
as recently as last month there were noises from the Fed of yet another
decrease to 1½% by year-end, which was my target for this year.
So the yield curve is very positive, indicative to me of a sanguine
if not ebullient economy. There is no consensus as to inflationary
or deflationary probabilities and I offer no opinion. The war cry
during the first Clinton campaign was, “It’s the economy,
stupid!” To my investors I offer, “It’s not the
economy.” It’s what you own in any economy. Corporate
earnings and valuations are generally improving. The S&P 500 currently
trades at a P/E of 33 and the “earnings” used in the P/E
are “annualized, as-reported earnings” to quote S&P,
not expected, pro-forma earnings favored by the presently disfavored
analysts. In my April Commentary I noted that the S&P was trading
at a P/E of 61. Prices have declined (DJIA down 18%, S&P 500 down
24%, NASDAQ down 34%, year-to-date) and earnings have improved.
One of the reports we watch closely is the Investors Intelligence
Advisors’ Sentiment which is released Wednesdays. It is a poll
of approximately 130 independent financial market newsletters and
is a good contra-indicator. One of the problems with the stock market
is that, despite the long and steady price erosion of the last 2½
years, sentiment has remained unflaggingly bullish, coining the term
“perma-bulls.” Now look at the reports of the last three
The figures reported reflect the survey of the prior week. So the
big bearish percentage of 10/16 reflects the survey taken the prior
week. October 9 was a multi-swing day of consolidation in the market
and October 10th was the first of the many 200 point up days since.
Ralph Bloch, the award-winning senior vice president and chief technical
analyst for Raymond James Financial Services, Inc., makes the point
that the bearish level of 43.2% is the highest since October 1998
and the bullish level of 28.4% is the lowest since July 1994, when
it was 27.6%. In other words on exactly the day that the market commenced
its buying rally the independent analysts’ sentiment reached
an eight-year bullish low and a four-year bearish high. This is why
the I.I. report is such a good contra-indicator and it is on such
negative sentiment that bear markets can be broken. We are in the
longest bear market since 1938.
Oil prices have backed off to $28 from recent highs of $31 and we
should hope for a trend here. If, as and when we have a war in Iraq
we should expect a few days of market free-fall, from which a victory
would generate a huge rally. We can use Iraq War One as a guide.
Current Portfolio Posture
As the white noise from accounting scandals subsides it’s become
a little easier to go back to screening companies for growth at fair
value. Many of the pharmaceuticals represent compelling values. I
have the personal observation from a former senior Washington official
that the drug companies have lost much of their lobbying clout at
the Capitol. That’s just her opinion of course, but if in fact
the drug companies have to yield five or ten percent of their margins,
many are still companies that are trading at mid-to- high-teen multiples,
that return 25% to 30% return on equity year after year, and post
net incomes of 15% to 20% and more. They are compelling portfolio
assets. We’ve positioned additional Schering Plough at $18 and
up. In other industries we’ve repositioned DuPont, Lawson Products,
Questar, Superior Industries, and Diebold.
In the utilities sector we like Duke and, for aggressive speculation,
In the fixed income sector we are standing pat awaiting yields to
rise in paper rated (A-) or better. We expect an increase in new muni
paper brought to market in the next 6 to 12 months. Increasingly we
are using tax-free auction rate preferreds for short-term money market
instruments. The spread to tax-free money funds is practically a full
percentage point. Properly positioned, good things come to those who
wait. Patience is a virtue and no team can keep the ball on offense
for the entire game.