2/07 Kelly Letter Topics
Weekly market review
European crash
Moody's warns
Treasury hits limit
Rising unemployment
Rising dollar
Falling oil et al.
Sovereign debt!
Bankrupt USA
Banks beat Obama
Bond market angst
TARP a failure so far
Supreme Court
Salinger
2010 EDITION
Much has changed; good investing has not
The Neatest Little Guide to Stock Market Investing, 2010 Edition
For more than a year now, fundamental analysis of companies has been a waste of time. Stocks have traded as a block, first plummeting in tandem a year ago to March as banks froze up the financial system, then soaring in tandem as the Federal Reserve expanded the monetary supply and made cash worthless as an asset with near zero interest. The latter sent liquidity flooding into stocks, lifting all of them together.
We've seen evidence of this recently. Last week, Apple delivered a superb earnings report that announced its most profitable quarter ever. It sold 10.2 million iPods, 7.4 million iPhones, and 3.1 million Macintosh computers in the quarter. Reports just don't get any better.
Since the March low, Apple's stock has risen nearly 150% and the easy explanation is its phenomenal business execution. Was it that bad before, though? No. Here's how Apple CEO Peter Oppenheimer began the earnings report conference call a year ago, on Oct. 21, 2008: "We are very pleased to report our September quarter results, which were record-breaking on a number of fronts. First, we sold more Macs than we have in any other quarter in Apple's history. Second, we sold more iPhones in the September quarter than in all previous quarters combined. Third, we sold more iPods than in any prior non-holiday quarter and finally, we generated more revenue and earnings than in any previous September quarter in Apple's history." Remember, that was a year ago. During that record-breaking quarter, Apple's stock declined 40%.
All Apple's recent stock price rise has done is return the stock to where it was in December 2007 before it dropped 59% to its low last March. It was a solid company with strong fundamentals all through the drop, and it's been a solid company with strong fundamentals in this year's rise. Those fundamentals didn't matter a wit. What mattered was the macro backdrop.
Also, since the March low, stocks of other companies -- both healthy and sick alike -- have risen remarkably, too. Citigroup is up 350% and Crocs is up 500%.
Judging by correspondence I've received from book readers and subscribers to my newsletter, the latest shenanigans from government, banks, and big business may have had a lasting impact on the character of the market. I sense that many individuals have finally had it. The ruse is over, the curtain is drawn back, and what's revealed is that Wall Street is no longer about companies using public markets to raise capital in an efficient way that allocates it to those with the best prospects.
Nope, it's a fraud in which you can spend all of your free time (or work time, as the case may be) analyzing product plans, marketing plans, management history, and so on just to be laid low by a bank that levers up too far or a single pen stroke from the Federal Reserve chairman. It finally became plain as day that individual investors are up against the Goldmans of the world, and the Goldmans own the casino via their connections to government and government's connections to the Fed. When the investment banks control the Treasury and the Federal Reserve, observing their actions alone is all that matters to the performance of a stock portfolio. Enough individual investors have seen that and realized that they stand little chance against such collusion that a crowd of former market participants would rather take their chances against inflation than the casino owners.
Sadly, those are the alternatives. Deciding to walk away from the stock market is barely an option for Americans because the money supply has been constantly inflating since the Fed's creation in 1913. Americans face two crummy choices: risk another cliff dive in stocks when the powers that be speculate the whole sham into another crisis, or try outpacing inflation in non-stock investments that are less vulnerable to Washington's whimsy. Lovely.
Individuals used to take solace in looking at fundamental factors, thinking they could find an edge with personal shopping experience as Peter Lynch taught, inside their own circle of competence as Philip Fisher taught, or culling the attributes of quality companies as Warren Buffett demonstrated. Now that even that impression has been rendered cock and bull, what's left?
About the best anybody can do is stick with broad index ETFs and try to sense the waves of pressure on the stock block. Good luck with that. Nobody can do it consistently, as has been widely demonstrated in the literature. Given the increasingly dice-like nature of stocks as the number of factors that individuals can analyze to make a difference dwindles, no wonder so many look to be placing their money elsewhere.
Trading is still alive and well. However, most stock market participants weren't in it for the slot machine aspect of speculating on stocks. They were in it for the steady average 10% per year growth they were told by the industry to expect, which is obviously not part of the bargain. It was made clear that past performance was no guarantee of future results. At last, it looks like people are paying attention to that. Instead of accepting the risk as they used to do, however, they're now concluding that they would like a few more guarantees in their financial future, and are more trusting of just about anything other than stocks.
One reason so many Americans face personal financial difficulty is that they live in a culture of excess designed to discourage saving and encourage spending. At the root of that culture lies the Federal Reserve and its expansionist monetary policy, which has reduced the value of a dollar from $1.00 in 1913 when the Fed was created to just $0.05 today.
The following excerpts are from Texas Republican Congressman Ron Paul's new book, End The Fed.
Artificially low interest rates are achieved by inflating the money supply, and they penalize the thrifty and cheat those who save. They promote consumption and borrowing over saving and investing. Manipulating interest rates is an immoral act. It's economically destructive.
p. 133
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The Fed encourages irresponsible accumulation of personal debt. People live beyond their means with the help of an expansionist monetary policy. They trade in their futures for the present. They neglect the need to save in order to consume more and more. In this sense, the Fed is the ultimate promoter of consumerism and living for the present. This amounts to a terrible cultural distortion in which short-term thinking wins out over long-term planning.
p. 151
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Excessive debt of a country or a people, once it reaches a certain point, is unpayable and must be liquidated. That point is almost impossible to accurately predict, since it will vary from one situation or country to another. One thing certain is that we as a country, and probably the world, have reached that point.
Individuals and corporations can default and debt is liquidated. When the need arises, liquidation is necessary and beneficial. The market today is demanding this liquidation; the politicians and the Fed are doing everything conceivable to prevent it, but they are only prolonging the agony.
Today's somewhat whimsical article comes courtesy of frequent contributor Dave Van Knapp. His site, SensibleStocks.com, is chock full of clear-headed ways to pick stocks and explains the oft-unappreciated role of dividends.
I enjoy playing poker, and there are many parallels between poker and investing. I play online on PokerStars.com. They have a tab called "Poker Strategy" for new players. I clicked on it, and I was struck by how much of their simple strategies and tactics apply equally to stock investing.
So I decided to translate their "Poker Strategy" into investment insights. While I have freely substituted investment terminology and added a few thoughts of my own, the basic structure of the following and most of its main points come directly from the PokerStars discussion.
Decisions for the New Stock Investor
To invest at a consistently winning level requires both time and effort. In other words, it takes work. To the extent you can, deciding which type of stock investor you want to be before you start will make your decisions easier. By "type of investor," I refer to such choices as investing for growth, investing for dividends, using fundamentals, using technical analysis, and the like. There is nothing wrong with combining disciplines into a hybrid approach, or using different portfolios to pursue different strategies. But getting your basic strategies down -- I recommend writing them out -- is important.
Make Good Decisions -- the Results Will Follow
Even the best investors in the world have losing periods. Don't make the mistake of expecting to win every time you invest. Your goal should be to make decisions to the best of of your ability at all times. If you do, the total return on your investing will take care of itself, and it will improve as you improve the quality of your decions. Many investors make the mistake of judging their ability based on the results of each decision. Your goal should be to make the best possible play every time. The closer you come to this, the better your results will be.
By "decisions," I refer to decisions to buy, hold, sell, or stay away entirely. Selling or staying away are investing's equivalents to folding a hand.
The Mathematics of Poker
Investing is a mathematical game, and it's a game of incomplete information. That may sound complicated, but it really isn't. On a very basic level, winning investing starts with the selection of which stocks or ETFs to buy or (more importantly) to avoid. This is called "stock selection." If you embark with the best decisions as well as you can determine them, you will increase your odds of overall investing success. In this context, stock selection includes not only identifying excellent companies or ETFs, but also determining favorable prices at which to buy them ("valuation").
Beyond Starting Hands
Stock selection is fundamentally important, but it's only one piece of the puzzle. Once you have mastered solid guidelines for purchase decisions, the next area you should work on is your play for the rest of the time. I call this "portfolio management." The area that separates better investors from the rest is that the better investors tend to play much better during the remainder of the process, after the starting stock or ETF selections are made. This is especially true concerning the decisions made about when to end the holding period for every stock or ETF purchased. These skills involve risk management, stop-loss techniques, deciding when a trend has played out, recognizing red flags, knowing what to do when a company cuts its dividend, and the like. Even small improvements in an investor's portfolio management can have a tremendous effect on that investor's lifetime success.
Avoiding Tilt
Another meta-skill that should be part of a winning investor's strategy is avoiding tilt. ("Tilt" is a poker term for someone who has gotten emotional -- perhaps because of a bad result -- and starts making bad decisions, perhaps in an effort to make it all back at once.) Your emotions can work against you, but only if you let them. Emotional play results in poor decisions and lost money. Tilting and steaming can happen to anyone, and sometimes the only cure is a break from the game. That's okay; the game will still be there tomorrow.
Unemployment hit 9.8% last month, and most analysts consider it all but guaranteed that it will exceed 10% by the end of the year. The following excerpt from Charles Gasparino's column yesterday shows how a rising unemployment rate could cause another banking crisis:
[Banks are] still holding trillions of dollars in ailing mortgage loans and commercial-real-estate debt that they have yet to fully write down. They're hoping they won't have to -- but continued joblessness is squeezing those portfolios.
The banks will tell you that they've written down a good chunk of their consumer loans. But the problem, according to banking analysts like Mike Mayo, becomes acute if unemployment passes 10% and nears 11%.
That's the point, according to many economic models, that American consumers start defaulting on loans in such a way that trillions of dollars in consumer-related loans and debt that haven't been written down start to implode.
And that doesn't account for the trillions in commercial-real-estate loans and bonds that have yet to take any significant hit at all -- but (most analysts predict) will be crashing in the months ahead even if unemployment stabilizes at 10%.
Bottom line: If unemployment goes higher than 10%, the banks' numbers get even worse. As losses begin to mount, the big banks may well find themselves back begging the government for more bailout money.
As one major Wall Street CEO told me: "If the consumer comes back, the banks will be safe -- but if the consumer begins to implode, so will the banks."
But will unemployment head toward 11%? Well, former Fed Chairman Alan Greenspan (whose lax monetary policy helped lead us into the financial crisis) warned last week that America should brace for it to cross the 10% level.
Prominent banking analyst Meredith Whitney, who all but predicted the banking crisis, recently laid out why unemployment is likely to keep rising: For all the talk of recovery, banks are cutting back on loans to small businesses, which make up nearly half of the country's workforce and a massive chunk of the GDP -- close to 40%.
Of course, President Obama and the stock market might be right -- unemployment isn't climbing as fast, so jobs will start coming back as business profits return. Problem is, President Herbert Hoover said just about the same thing back in 1932.
As the following chart from Econoday shows, the recent trends of rising unemployment and falling average hourly earnings aren't encouraging:
Last week saw a subtle but important shift in the way economic data were interpreted. During most of the rally, any improvement in data was heralded as proof that the worst was behind us and the future a ramp upwards with only the degree of incline in question. Merely an upward bias in economic data was enough to give stocks an upward bias as well. Last week, however, more attention was paid to the strength of the data instead of its direction alone. Finally, the market may be asking if the recovery is good enough to justify high stock prices. Over the past two weeks the answer has been, "No."
What could follow on the heels of such a shift is a further backing up from debating the incline of recovery to questioning whether an upward bias is guaranteed after all. With loan defaults rising, jobs about as common as sense in Congress, and central banks eager to pare back stimulus, more people appear to be wondering if another leg down is inevitable.
Let's look at the technical picture for the main stock indexes of the world's four financial centers: the S&P 500 in New York, the Nikkei 225 in Tokyo, the SSE Composite in Shanghai, and the FTSE 100 in London.
It looks like the Iran nuclear stand-off as an oil price mover has been pushed out a few weeks. I wrote on Tuesday that the risk of military action against Iran by either the US, Israel, or both is growing, and that such action would cause oil prices to spike.
The Geneva talks concluded yesterday. Iran will admit inspectors from the International Atomic Energy Agency (IAEA) to look at its previously secret enrichment facility near Qom by the middle of this month. While some are pointing to that as major progress, it's not too impressive when you consider that as a signatory to the Nuclear Nonproliferation Treaty (NPT) Iran was already obligated to allow such inspections.
Nonetheless, to get Iran to merely comply with the terms of the NPT that it signed, the P-5+1 nations (UN Security Council plus Germany) granted Iran the right to transfer low-enriched (about 4%) uranium to a third country for enrichment to the 20% level needed to make medical isotopes. That mixture will be shipped back to Iran for medical usage. Nuclear weapons require 90% enrichment levels, so the idea here is that the third party can guarantee that Iran is not using anything that would enable it to make a nuclear weapon.
Yet, the whole reason we came to this moment of truth is that Iran was not cooperating on inspections. Where's the guarantee that it will this time? Rather than having solved anything or put down any firm deadlines for progress, the talks appear to have just postponed the day of reckoning.
For countries far from the hot zone around Iran, ignoring the lack of real progress is a luxury that Israel does not share. It has said repeatedly that it can't survive a nuclear engagement of any kind because of its small size. It can't bear even a tiny risk of attack by nations that want it to disappear, so it cannot be as patient with Iran's maneuverings as other members of the UN can be. Thus, we need to see how Israel reacts to the situation. Remember, its decision to strike would cause Iran to disrupt shipping traffic in the Strait of Hormuz, thereby drawing in the US and bringing about the oil price spike previously discussed.
The granting of full IAEA access for inspection was one of Israel's requirements. That part should make it happy for now. Whether it believes the validity of the results of the inspections for a variety of reasons, such as whether Iran really showed all of its facilities, is another matter.
It all comes down to how Israel reacts. So far, it has said nothing, and that's worrisome. It might be willing to give diplomacy a chance, but probably not much of one.
The International Monetary Fund updated its Global Financial Stability Report yesterday. I received a barrage of emails from analyst cohorts telling me about the green lights provided by the report. I dove in, and came away with less an impression of green lights than a slight flickering of the red from being lit up so brightly for so long. I'll go through some highlights with you, and let you make up your own mind.
The GFSR thinks overall financial sector losses are less than it expected six months ago, but still staggering. "For both banks and other financial institutions, the GFSR calculates that actual and potential writedowns from bad assets such as loans and securities have fallen by some $600 billion over the past six months -- from about $4 trillion to $3.4 trillion, as a lessening in financial stress has narrowed spreads." When was the last time writedowns of $3.4 trillion were considered a pop-the-champagne moment in your experience? It expects US banks to lead the debtors list by incurring about $1 trillion of that sum.
It estimates that commercial banks have already written off $1.3 trillion so far in 2009, but still have another $1.5 trillion to go. In other words, we're not even halfway through this collapsing card house yet!
From the report: "Even though bank earnings are recovering, they are not expected to be big enough to offset fully the anticipated writedowns over the next 18 months. The insufficient earnings, combined with continuing deleveraging pressure, means banks will have to raise more capital." You think? Anybody running a spreadsheet through this crisis has been aware of that for about eighteen months, and wondering what all the stock market excitement has been about.
Despite being only halfway done, "Many private sector financial risks were transferred to the public sector during government rescue operations, leaving the governments vulnerable to future shocks. Countries with high debt-to-GDP ratios and large contingent liabilities (such as bank asset or liability guarantees) are particularly vulnerable." In other words, the United States. This means that if we do see a double-dip, there isn't a whole lot more left in the government tank to stimulate the economy into another false bubble. On the next leg down, we shouldn't expect another liquidity rescue like we got last time.
Those saying that the crisis is over and the economy on the mend will enjoy this next part: "Although banks' balance sheets have been stabilized, some of it because governments have injected capital, banks are not yet in a strong position to lend support to the economic recovery." No kidding, and maybe that's why we haven't seen lending tick up yet. Trillions into the black holes of banking, nothing out, sounds like just the recipe that created a two-decade recession in Japan -- so far.
If that's what passes for good news these days, brace yourself for the bad.
