It was another rocky week. The market continued its recent downtrend despite solid earnings reports and encouraging economic data. This bodes well for a healthy turnaround over the winter, something I've been calling for over the past seven weeks as we've built our portfolio. I'm still calling for it.
We're in the thick of earnings season and about two-thirds of companies have beat estimates so far. That's typical. Let's review this week's highlights.
On Tuesday, IBM beat by 13 cents and management was very upbeat in the conference call about the fourth quarter outlook. Johnson & Johnson beat by a penny. United Technologies beat by 2 cents and was cheerful about fourth quarter prospects. Pharmaceutical company Novartis beat by a penny. 3M beat by 4 cents but warned that the fourth quarter might fall slightly short of current estimates. Merrill Lynch beat by 21 cents.
On Wednesday, Dow companies Altria and Honeywell beat by 5 cents and 2 cents respectively. Banks J.P. Morgan Chase and Bank of America beat by 3 cents and 2 cents respectively. Office Depot beat by a penny, General Dynamics by 6 cents, and EMC by a penny. Yahoo! and Motorola both beat by 2 cents.
Technology was a mixed bag.
Shares of computer disk drive makers fell Wednesday after Bear Stearns downgraded three companies in the sector, citing future industry weakness evident in Seagate's dour 2006 outlook. "After the first indication of weakening in July, with Seagate's fourth-quarter results last night, we are seeing additional signs of softness, which raises concern of potential for further weakness," Bear Stearns analyst Andrew Neff wrote in a report to clients. He said concern is not about the demand for disk drives, but more about supply issues among customers. That means that some of the strength in the market might really be an inventory buildup. Now that stores have plenty of stock, they'll stop buying for a while. Bear Stearns cut Seagate, Western Digital, and Maxtor to "Underperform" from "Peer Perform."
Then things brightened up when Intel reported operating earnings a penny ahead of expectations for the third quarter. Revenue was also ahead of expectations but revenue guidance for the current quarter was $10.2 billion to $10.8 billion, putting the mid-point at $10.5 billion. That's less than the current market consensus of $10.65 billion, so people were disappointed. This is par for Intel's course, though. They're usually cautious at the start of the quarter and then sharpen guidance towards the upper range later. I'm pretty sure Intel will meet the $10.65 billion expected.
Standard & Poor's concurs with me and raised its 12-month target price by $1 to $30 based on applying a price/sales below Intel's historical average to their forward sales estimate. They see Intel nearing the bottom of its price channel on p/s and upgraded the stock to buy on that improving valuation picture. Intel moved to 4 STARS (buy) from 3 STARS (hold).
On Thursday, earnings kept rolling in. Beaters were Coca-Cola by 4 cents, SBC by 6 cents, Pfizer by 3 cents (but warned of lower than expected profits for the fourth quarter), Eli Lilly by 2 cents, Ingersoll-Rand by 3 cents, McGraw-Hill by 3 cents, and Baxter by a penny. Nokia just barely beat estimates but said average selling prices were under pressure. UPS met expectations as did eBay, but then the online auction giant warned of a slowing performance this quarter. Ford missed by a penny.
Pfizer killed Thursday's tone on among big caps and eBay killed it among tech and smaller issues. The NYSE had just one up stock for every three down and only one 52-week high for every four 52-week lows. The selling became so intense in the final hour that the exchange implemented trading curbs.
On Friday, missed earnings by a penny, but reported third quarter profits 56% higher than second. That disappointment sent shares down 2.9% today and puts us down 8.2% since investing last month. However, the company adjusted its full-year earnings forecast to a range of $2.14 to $2.24 per share, up substantially from its earlier guidance of a $1.80 to $1.90 per share. Analysts estimate full-year earnings of $1.85 per share. The company is preparing for a strong Christmas season, in part by selling Apple's popular iPod. Standard & Poor's upgraded the stock to 3 STARS (hold) from 2 STARS (sell).
Google blew everybody away by reporting net earnings that grew over sevenfold and beating revenue estimates by $117 million. That sent the stock up 12% Friday to an all-time high of $339.90. First Albany and Lehman Brothers raised their price targets to $450 a share. Google is now up nearly 340% from its initial public offering just 14 months ago.
Caterpillar, meanwhile, missed expectations by 12 cents and fell 10%. The Dow's having a rough October. Both Caterpillar and Pfizer are Dow components.
Still, earnings overall are looking fine. Most companies are ahead of estimates. Few have warned.
Economic reports have been healthy. Inflation remains a potential problem because the data are not consistent.
One good sign is that oil prices are down around $60. Gas prices have also come down and look set to continue that way. The high cost of heating oil was expected to become a problem over the cold winter months, but some good news has arrived from the weatherman. Forecasters at NOAA's Climate Prediction Center predict this winter to be 0.7% warmer than the 30-year norm measured by nationwide heating degree days for December, January and February. If we can get cheaper gas and a lower demand for heating oil, things may not be as bad as previously thought. Keep your fingers crossed, and wear warm clothes instead of turning up the thermostat.
September housing starts rose 2.4%, a very good number. Analysts had expected a decline. Hurricane Katrina is already a waning factor, and this latest bit of good news shows that her impact on the national economy was far less than feared.
Also, unemployment claims dropped to 355,000 from 390,000 the week before. The impact from the hurricanes was 40,000, so the underlying trend is still just above 300,000. This reflects a strong job market.
Looking over the above, you could be forgiven for wondering why stock prices are dropping. If you've been reading my scribblings for any length of time, though, you're not surprised by it. I've been targeting November for the start of a good winter rally. We look to be on track for that to play out.
Consider readings of the Hulbert Stock Newsletter Sentiment Index, which reflects the average stock market exposure among a subset of short-term market timing newsletters tracked by the Hulbert Financial Digest. Last Friday, the index dropped to -30.1%, very close to its lowest level in over six years. (The negative reading means that the average short-term market timing newsletter tracked by Hulbert is recommending that its subscribers be short the stock market.) Besides Friday, the only other time over the last six years when the index got any lower was at the market's mid-April low, and even then it was just barely lower. The index then dropped to -30.6%, and a nearly 600-point rally in the Dow ensued.
Add to that evidence the volatility we saw this week. Stocks were way up on Wednesday and then way down on Thursday. That's a well-understood pattern when bottoming out. The dropping on positive earnings and confusion over economic data are normal, too.
There are brighter days ahead and now is a time that screams for new investment money. All of our portfolio positions are good candidates for initial or additional investment.
That includes our latest purchase, . The stock ended the week at $112, up 23.2 percent today and more than double its Wednesday IPO offer price of $54. I sent a note to subscribers advising them to buy under $110. The Kelly Letter buy price was $107.60. The stock closed Friday at $112, putting us up 4.1% already.
What better way to profit from the market than to buy the exchanges on which everybody trades? They're all either public or going public. You can buy the Nasdaq (NDAQ), the Chicago Mercantile Exchange (CME), and even Archipelago Holdings (AX), the electronic trading platform. The New York Stock Exchange is trying to acquire Archipelago and then go public itself.
The New York Mercantile Exchange is planning to go public. So is the Chicago Board Options Exchange. The Philadelphia Stock Exchange sold 25% stakes to four banks and that might put it on the road to becoming public.
This approach to investing is like buying the casino instead of playing the slots. Every transaction that goes through these places leaves a tiny profit in their coffers. Whether the investor makes money or not, the exchange always profits.
Now, admittedly, this week's pace in our recent buy cannot continue. It'll have to slow down and might even retrace. But if it takes after its larger cousin, the Chicago Mercantile Exchange, it'll be a good investment. CME had its IPO in Dec. 2002 at $43. It closed today at $348. That's a 709% gain in under three years. It basically never looked back from its quick start. Here's the chart.
It's not alone. Nasdaq started the year at $10. It closed Friday at $29. Archipelago started the year at $20 and closed Friday at $40.75. Clearly, this is an industry with wind in its sails.
For our portfolio, this is a welcome diversifier from our value plays. Most of our portfolio was built by purchasing shares on the cheap and waiting for a recovery. This one is not cheap, but is rising quickly and should provide us with a little boost while we wait for our primary holdings to recover.
In addition, there are several names I'm watching for a chance to get good prices toward the end of this down leg. It won't be too long before we see a rising market and the bargains will be gone. I know it's hard to believe amid dark headlines and falling prices. That's why you should believe it.
After a week of steadily sinking lower, the market managed a slight recovery today. The pessimism over inflation still persists, yet the strength of the economy remains clear and I continue to believe we're heading into a solid winter rally.
The consumer price index rose 1.2% in September. That represents the fifth month of 0.1% gains. Put differently, the inflation rate is roughly 1%. Gas prices are lower on the declining price of oil. The inflation worry is not showing up in the numbers.
Also, remember all that talk about a post-Katrina recession? A chorus of investment pundits expected consumers to stop buying. They didn't. Retail sales grew 1.1% in September. That's positive news before holiday shopping gets underway.
The Fed remains fixated on inflation and has set the stage for three more rate hikes before it's finished. That is not good for the stock market. Higher rates have three immediate dampening effects:
- They lower lending spreads and thus lower bank profits
- They make borrowing money for business more expensive and that can lead to a lack of investment which leads to a lack of growth
- They increase the payment on an adjustable-rate mortgage (ARM) which uses up money that could have been spent elsewhere
So, the market has been in sell mode for about a month now. The financial media, true to form, has overblown the extent of the selling, referring to it as "ugly" and "relentless" amid talk of a recession. Bear in mind that we saw a decline of this scope back in early March. Things have gone pretty well since then, I'd say.
Meanwhile, our portfolio is doing roughly what it should be doing. The stocks we bought in the past six weeks are mostly down along with the rest of the market. We then bought again as the market kept dropping. From here, we'll probably be able to pick up more investments before the winter rally starts.
And it will start. As fears and pessimism have driven prices downward, the health of the economy has become clear. What's more, companies are poised to log a solid earnings season. It actually started this week with GE meeting expectations, but the big volume begins on Monday. When investors weigh the figures objectively, as they eventually will, they'll see a cheaper price on a better market, and they'll buy stocks again.
Onto our investments.
are high-risk, potentially high-return investments. The former is up 15% so far and the latter is down just 7%. We caught a glimpse of the explosive potential of these two on Monday when they rose 11% and 7% respectively. The e-commerce company has held on to those gains while the computer storage company gave them back on a J.P. Morgan downgrade to underweight from neutral.
The downgrade report said that the next stage of the company's turnaround story may take longer and be more challenging than the initial one. The broker told clients that the critical milepost for the company is the full revamp of the company's desktop drive cost structure. "Here, we believe that the proof lies in the mid-part of 2006, which places the company in a tough position over the interim," J.P. Morgan said.
It places the whole computer storage sector in a tough position, but we're betting that it will pull through and that our company, as the cheapest of the big players, stands to gain the most in the market.
The rest of our portfolio is cooking along. The recent mainstays are slightly down, led by our footwear investment at -10.1%. Our long-term investments in media and software are up a respective 56% and 10%.
To keep the slightly negative standings in perspective, remember that both the Dow 1 and Double The Dow are down 10% so far this year, and each has a superb long-term track record. Fluctuations are normal, particularly when we're seeking cheap prices in a falling market. We can never get the exact bottom, but getting within about 10% of it is fine.
At this time last year, Double The Dow was down some 16%. It then rose 25% to finish the year at +5%.
So, do not fret. In fact, keep yourself in buy mode. It's always better to commit money when prices are down than when they're up. I consider all of the investments in our portfolio fair game for additional money.
Beyond that, I'm still looking for places to put our additional Japan money. Two stocks I'm watching are . We already have a leveraged position in the Nikkei 225 index. Individual stocks may be the right call for the remaining 2/3 of our Japan strategy. Stay tuned.
If you're looking to read more about Japan's recovery, check out the article from last week's Economist, located at the top of the Japan country briefing page.
Two other companies that I'm researching and watching at the moment are . As always, I'll let subscribers know with plenty of time to act if and when I decide to invest.
Last Thursday brought a big disappointment from UTStarcom, just two days after we finally picked up shares at our target price of $7.75. The company reported three pieces of bad news Thursday night after market hours:
- One of its clients, Softbank Broadband, will not pay $40 million in time for quarterly reporting
- Its gross margin guidance slipped from a midpoint of 16.5% to a midpoint of 10%
- The SEC launched a formal inquiry into the company's past financial disclosures
That led to a Friday opening price of $5.75 before we could do anything. No stop-loss order could save us, even if we'd had one on the books. The damage happened after hours. I sent subscribers a note to saying to place a stop-market order at $5.50.
This latest development casts doubt on management. These issues are similar to the ones reported in January and are exactly what management was supposed to have fixed. Excellent value analysts began liking the stock below $8 for precisely the reason that the earlier bad news had dropped it from $20. Now that the same mistake has happened again, it's hard to have faith in management's ability to turn things around.
The damage had been done and the smart way to manage the trade was to hope for a recovery with a stop-loss in place. The same catalysts that led me to target UTSI in the first place are still present. The company has a healthy marketshare in China, the late $40 million will be paid because the client also owns 12% of UTStarcom, and current UTStarcom management bought a slew of stock between $13 and $16 per share in September of last year. I imagine nobody is more keenly aware of the company's shortcomings and depressed stock price than they are.
Not surprisingly, UTStarcom (UTSI) continued falling on Monday and our stop-loss order to sell at $5.50 filled. That's a loss of 29%. This is extremely disappointing, I know, and particularly hard to take given the tough go we had with PXRE Group last month. For me, too, it was a personal disappointment because it's the second time I've been burned by this stock. I watched it from Feb. 11 after we sold at $15.10 for a 9% loss, looking for reforms to take hold and give us a chance to buy in at a better bargain to ride the recovery. Buying back in again at $7.75 on improved analyst forecasts and positive management guidance seemed prudent. After all, that's a 49% discount from the earlier sale price. However, it turns out that management was not accurate in its guidance, warned last Thursday night, and is now the subject of an SEC probe.
Prior to the PXRE Group disappointment and the UTstarcom letdown, The Kelly Letter had suffered just two losses in the previous three years.
In one month, we've added two more. This does not sit well with me. I'm eager to get my clean record back. To that end, I'm pleased with the rest of our portfolio as we've built it for the winter recovery, and I'm still eyeing potential additions.
As the winter rally commences at the end of this month or beginning of next, we'll enjoy watching all of the slightly negative positions turn positive.
It was a busy week for us in a market that continued to decline. That's fine by us, as we're in the middle of a sustained portfolio-building effort. I've been trying to pick up investments on the cheap that look poised for outperformance over what I still expect to be a strong winter rally.
On Wednesday, we bought .
On Tuesday, we began building a position in Japan with a 1/3 buy into . It's good that we tiptoed in as it fell along with the Japanese market during the latter half of the week. Our initial 1/3 investment is down some 6%. Counterintuitive though it is, we should be happy for this short-term trend. It enables us to get cheaper prices with additional money waiting to go in.
Over the week, the Nikkei 225 fell 2.4%, a move not entirely unexpected, hence our gradual entry. So far, though, the down move has been relatively muted for a market that's up 35% in four months.
"The market is still showing some strength. This is supported by expectations of a further rise," said Mitsushige Akino, chief fund manager at Ichiyoshi Investment Management. "The pattern of the drop [Friday] is very similar to that in spring. But [the economic fundamentals are stronger now]."
Akino said that most investors in Japan were waiting for the U.S. employment report that came out today, adding that if the data came in as expected it might support another rally in Japanese stocks next week.
The employment report came in better than expected. A drop in September payrolls of 150,000 was expected, but they dropped only 35,000. That's a much smaller Katrina impact than analysts foresaw.
A higher-than-expected level of payrolls is also bright news for the economy. The August payroll gain came in at 211,000, a full 42,000 higher than predicted. That means that September was actually higher than August, despite Katrina.
Finally, retailers showed strong same-store sales growth this week, running counter to the ubiquitous theme of higher energy prices clipping annual holiday sales.
So, while the current mood maintains a sour focus on inflation from higher energy prices, that mood is destined to change. The fundamentals of the American economy remain strong, and we're set to see a positive earnings season just ahead.
Getting back to Japan for a moment, there are two items of interest in our growing position there.
First, prompted by a sharp rise in recent stock trading activity, the Tokyo Stock Exchange will increase the capacity of its order-processing system to around 7.5 million trades a day starting next Tuesday. That's important because increased volume is a necessary component for long-term recovery. Also, brokerage firms are setting up new shops in anticipation of Japanese people returning to their own market. So far, the driving force has been foreign money. To get this market up another 40% or 50% in the next two years, we need domestic investor participation. It's good to see the infrastructure being put in place for it.
Second, on Oct. 24 Goldman Sachs Japan will start selling a financial product that will invest in 11 of Japan Post's business partners which are expected to benefit most from the postal privatization plan. In last week's "Kelly Report: The Recovery of Japan" sent to subscribers, I wrote that reform of Japan Post is a critical part of the country's recovery. That Goldman is so confident of its passage that it's creating a new product specifically targeting its beneficiaries is a positive sign. If the investment is available to U.S. investors, I may consider using some of our Japan money there.
Our winter rally portfolio is having a rocky time. We're still in correction mode, so prices are dropping overall. For most of the portfolio, this is perfectly normal and nothing to be concerned about. If you're looking to put new money to work, I suggest , down 6% from our buy price.
Overall, things are looking pretty good for us. There's probably more weakness ahead before we get to a solid winter rally. Both are below our watch prices. We may yet pick them up on sale.
This process is playing out as it usually does. We targeted companies that we wanted to buy at prices that were lower than their market prices. Some were slightly lower, some were significantly lower, and some were far lower. First we picked up the slightly lower-priced ones. The market kept falling and put those in the red, but allowed us to pick up the significantly lower ones next. The market has continued falling and put those in the red, and we are now coming to the next phase of picking up shares that are far lower than when we started watching.
After that, we'll hold tight for the recovery as each phase of acquired investments goes green and we make a good profit over winter.
Last month was busy for us as we sought to build a portfolio for what I expect to be a strong winter in the market.
Since we bought them, have all dipped lower, providing you with an opportunity to get a better deal than I got if you haven't already invested. If you have, don't fret. It's normal during an acquisition phase to see prices fluctuate slightly into the red as the market finds its footing. These companies will more than recover; they'll provide us with good returns.
Our additional shares of and new position in are already up slightly. Our Maximum Midcap strategy is up 16% so far this year. That's after gaining 60% in 2003 and 29% last year. Since I implemented it here at the end of 2002, the Maximum Midcap strategy is up a total of 131%. I'm proud of our permanent portfolios. They beat nearly every investment service and professional, yet are the very picture of simplicity.
The biggest disappointment last month was PXRE Group. My post-Katrina investment idea to buy the reinsurance company went sour as Katrina was followed by Rita. My initial analysis was of PXRE's valuation compared to what I considered to be inflated damage estimates for Katrina. The stock looked to be a bargain. Then Rita's damages entered the equation and the bargain didn't look so cheap anymore. I tried holding out at -9%, but with all eyes on Rita's approach the pressure on the stock was too forceful and I placed a stop order at -11%. It executed, locking in our loss at that level. It is rare for that to happen around here, but looking back we seem to have handled a bad situation intelligently. PXRE Group closed 10/3 at 13.33, a full 21% lower than our sell price of $16.91. Had we not sold, we would now be sitting on a 30% loss. This is a good example of how managing the trade is just as important as choosing the investment.
I never believed that Katrina would have a lasting impact on the U.S. economy, and I still don't. The evidence is coming in strong to support that view. For instance, Wal-Mart said over the weekend that its same store sales were up 3.8% in September. That's entirely post-Katrina, and very encouraging news that consumers are still alive and well in America. There was some fear that U.S. consumers would dry up. How a hurricane in New Orleans would affect shopping habits in, say, New York, New Hampshire, New Jersey, and Nevada was never clear to me. But knee-jerk reactions are common in the market. At least now we have solid numbers showing that fear to have been unreasonable.
The other potential hindrance to the consumer is high energy prices. Whenever I want a mainstream consumer's view of the state of affairs I call my mother, who lives in Colorado. She said last week, "It costs fifty dollars to fill up my tank. Can you believe that? Just two Christmases ago you gave your sister twenty-five dollars for gas and it was enough. Remember? And when I was in college..." You know how that line of thinking ends, with nostalgia for the days of using pocket change to buy gas. While those days are long gone, the doubling in gas prices from "two Christmases ago" is new and dramatic. Will it crimp crucial holiday spending?
The consensus is that an additional 2% of a consumer's overall spending has been added to energy. It was at around 4% two years ago and is around 6% today. That's 2% that won't be going toward shopping.
Does 2% seem terribly high to you? It doesn't to me after two years of higher oil headlines. It becomes even smaller when considered in terms of the national economy. Yes, energy prices have been high for the past two years, yet the economy grew at 4.4% in 2004 and is up 3.5% so far this year. Americans have adjusted to a higher cost of energy, as well they should have. It's here to stay. The economy is also here to stay, though, and has proved resilient.
Meanwhile, business investment is clipping along at a good rate and earnings are coming in strong. Profits have been healthy over the past two-year high-energy time frame. The S&P 500's earnings growth for the third quarter is shaping up to be around 19%. Remove the booming energy sector and earnings still grew at 12%. That's on top of the 12% they grew in the first half of the year. Those figures are not pretty good. They're fantastic.
Yet, the S&P 500 is up a mere 1.4% so far this year. With profits growing and prices remaining flat, valuations have come down. We get more for our money when we invest now than we did at the beginning of the year.
Conditions looked almost exactly this way a year ago and we got a strong November-December rally. I think we're going to see that again this year, which is why I'm buying aggressively.
From the beginning of last November to the end of last December, we rode the winter rally to a 15% gain in our Double The Dow strategy and a 20% gain in our Maximum Midcap strategy. From our early-November 2004 buys, we eventually booked a a 65% gain in Maxtor and a 12% gain in Profunds Ultra Semiconductor. It was a fine time to be in the market.
