Market Bottom?

I see reason to believe that the market bottom was this morning. We won't know for sure until this is confirmed by declining volatility levels (^VIX and ^VXO). The market has fallen over 40% in the past year and over 30% in the past 30 days making this the worst crash since the depression.

Some pundits are saying "you still have time to sell now" - I don't believe this. Market crashes happen near the top - that's why this big decline has come as a day after day grinding rather than a single (or double) day event.

I'm a big believer that "the pendulum swings both ways, and it swings too far". There is good reason to believe it has now swung too far:

1) Historic speed of decline
2) Extreme fear levels (^VIX)
3) Favorable valuation levels (trailing 10 year P/E is now down to 13.6, price to book, dividend yield etc are all at long term lows)
4) Forced selling brings price too low
5) No one wants to own stocks
6) Front page of newspapers and magazines (not financial magazines) is the stock market

I read somewhere today an interesting statement - when markets are going up we all forget what can surprisingly go wrong - now we're all forgetting what can surprisingly go right. I believe there's a lot that may go right that will shock investors (or former investors who have bailed) -- most notably the shocking amounts of liquidity being pumped into markets which could create a major boom.

Will I be right? Not based on my recent predictions.

While I'm not going to update the recommendations (lack of time) I will add MER - Merrill Lynch to the list as of today's close.

The Market is Cheap

Well, in case it wasn’t terribly obvious, I was very wrong in my last posting. I called it “time to buy” – it wasn’t (at least in the short term). I said I thought WaMu would be fine – they weren’t [I will say that looking back on 2008, we will know that Jamie Dimon got the best deal of the year in purchasing WaMu for only $1.9 billion, without assuming any debt].

So I was wrong. However, I believe that the market is a “screaming buy”. We have fallen too fast (fallen faster than in 1987, looking at it month by month, based on percentage below 100 and 200 day moving average). We have cheap valuations. There is an insane amount of stimulus being applied – which lags by 6 to 12 months, but will eventually cause an improvement in the markets. If housing bottoms in the first half of 2009 [as I’ve long predicted], then this will look like a tremendous buying opportunity – and I think it is.

So how did my last recommendations fare? [MMM (-9.92%), UNH (-25.70%), PETS (-9.33%), APA (-20.69%), DPS (-3.00%), ADSK (-17.07%), AIB (-22.70%), PBR (-18.92%), TEX (-37.04%), WM-PK (-100% )] averaging a loss of 26.44%, underperforming the S&P 500 [-15.78%] by a whopping 10.66%. Since inception on 7/31/2007 the recommendations have lost 11.82%, outperforming the S&P 500 [-25.97%] by 14.15%.

I recommend buying stocks at this juncture. Ones I prefer: SSO, QLD, DDM, DIG, UNH, COP, ADSK, AIB, PBR, TEX, ASF, MT, BBY, L, MDR, PCZ, BID, SVU, TXT.

Here are some stocks that hit 52 week lows today that I think are cheap:

TKR – Name P/E P/Book Enterprise Value/Revenue
ASF – Administaff 11.6 3.1 0.3
AET – Aetna 9.3 1.8 0.7
AA – Alcoa 7.5 0.9 0.8
MO – Altria 10.3 10.1 1.2
AXP – American Express 10.4 2.9 2.7
APA – Apache 7.0 1.8 2.7
MT – Arcelor Mittal 4.3 1.0 0.8
ADM – Archer-Daniels-Midland 6.9 0.9 0.3
BJS – BJ Services 7.3 1.5 1.0
BP – BP 5.7 1.4 0.5
BHI – Baker Hughes 9.1 2.3 1.4
BBY – Best Buy 10.3 2.9 0.4
BA – Boeing 9.2 4.7 0.6
BYD – Boyd Gaming 12.2 0.5 1.6
CBS – CBS Corp 7.0 0.4 1.1
CI – Cigna 8.9 1.9 0.6
CVS – CVS 15.0 1.4 0.7
DVR – Cal Dive 10.6 1.7 2.1
CAJ – Canon 10.3 1.6 0.9
KMX – CarMax 25.4 1.7 0.4
CAT – Caterpillar 8.1 3.3 1.3
CX – Cemex 5.1 0.7 1.2
CRL – Charles River Labs 21.1 1.9 3.0
CVX – Chevron 8.2 2.0 0.7
CHS – Chico’s 34.5 0.9 0.4
CBK – Christopher & Banks 18.0 1.1 0.3
XEC – Cimarex Energy 6.0 1.0 2.0
COH – Coach 9.4 4.8 2.1
COP – ConocoPhillips 5.9 1.1 0.6
GLW – Corning 7.8 1.7 3.3
DE – Deere & Co 7.7 2.2 1.4
DVN – Devon Energy 8.5 1.6 2.8
DFS – Discover Financial Services 11.8 0.9 NM
EMC – EMC Corp 13.9 1.9 1.5
FIS – Fidelity Info Services 9.3 0.9 1.4
FRX – Forest Labs 8.0 2.1 1.6
FDP – Fresh Del Monte Produce 7.0 0.9 0.5
FTO – Frontier Oil 4.9 1.4 0.3
GD – General Dynamics 11.4 2.2 0.9
GE – General Electric 10.9 1.8 4.2
GNA – Gerdau AmeriSteel 4.4 0.9 0.8
GSK – Glaxosmithkline 12.7 8.3 3.1
HAL – Halliburton 9.0 3.1 1.5
HES – Hess Corp 9.1 2.1 0.7
HPQ – Hewlett-Packard 12.7 2.7 0.9
IR – Ingersoll-Rand 6.3 0.8 1.4
IBM – IBM 12.4 5.0 1.6
IFF – International Flavor & Frag 14.1 4.6 1.7
KG – King Pharmaceuticals 15.4 0.8 0.7
L – Loews Corp 6.6 0.9 0.6
MAN – Manpower 7.5 1.0 0.2
MRO – Marathon Oil 7.4 1.3 0.5
MDR – McDermott International 7.3 3.1 0.6
MCK – McKesson 13.1 2.2 0.1
MRK – Merck 13.2 3.4 2.6
MCO – Moody’s 14.0 NM 4.2
MOT – Motorola 16.2 1.0 0.4
MUR – Murphy Oil 7.2 1.7 0.4
NYX – NYSE Euronext 10.0 0.9 2.1
NBR – Nabors Industries 6.5 1.2 1.8
NOV – National Oilwell Varco 8.7 1.5 1.5
NWS.A – News Corp 7.4 1.0 1.1
NE – Noble Corp 6.3 2.1 3.2
NUE – Nucor 5.7 1.4 0.6
OXY – Occidental Petroleum 7.1 2.0 2.2
PBY – Pep Boys 19.8 0.7 0.3
PCZ – Petro-Canada 3.8 1.0 0.7
PBR – Petrobras 14.7 2.6 1.9
PLA – Playboy NM 0.6 0.6
PKX – POSCO NM NM 1.0
PCP – Precision Castparts 9.0 2.3 1.4
PRU – Prudential Financial 10.0 1.1 0.9
RTN – Raytheon 13.0 1.8 1.0
RSC – REX Stores 5.1 0.4 0.4
COL – Rockwell Collins 10.6 4.4 1.6
RDC – Rowan Companies 5.2 1.1 1.4
SWY – Safeway 10.5 1.4 0.4
BID – Sothebys 5.9 1.6 1.6
SUN – Sunoco 14.2 1.5 0.1
SVU – SUPERVALU 7.3 0.7 0.3
TGT – Target 12.6 2.5 0.8
TTM – Tata Motors 6.0 1.5 0.6
TEX – Terex Corp 3.7 0.9 0.3
TXT – Textron 6.1 1.7 1.1
MMM – 3M 12.1 3.6 1.9
TWX – Time Warner 11.1 0.7 1.7
TSN – Tyson Foods 60.0 0.9 0.3
USG – USG Corp NM 1.0 0.7
UL – Unilever 14.5 1.2 0.6
VIA.B – Viacom 8.1 2.1 1.6
WAG – Walgreen 12.7 2.2 0.5
WLP – WellPoint 7.7 1.1 0.4
WSM – Williams-Sonoma 13.5 1.3 0.4
WYE – Wyeth 11.1 2.6 2.1
YUM – Yum! Brands 15.0 25.1 1.6
ZMH – Zimmer Holdings 17.1 2.4 3.3
ACMR – AC Moore 14.8 0.6 0.2
AAPL – Apple 19.2 4.4 2.1
BAMM – Books-A-Million 5.4 0.8 0.2
CAKE – Cheesecake Factory 12.9 1.6 0.7
CTXS – Citrix Systems 20.1 2.1 2.3
DELL – Dell 11.1 10.6 0.4
EBAY – eBay 47.0 2.2 2.4
ERTS – Electronic Arts 13.6 2.4 1.9
EXPE – Expedia 13.2 0.8 1.3
FWLT – Foster Wheeler 8.3 5.1 0.6
LOJN – LoJack 8.4 0.8 0.3
MNST – Monster Worldwide 14.1 1.5 0.9
FLWS – 1-800-Flowers.com 15.2 1.4 0.4
OXPS – optionsXpress 10.2 4.3 1.5
RICK – Rick’s Cabaret 7.5 1.2 1.9
RMCF – Rocky Mountain Chocolate 10.3 4.3 1.6
SIGM – Sigma Designs 6.4 1.1 0.8
SPLS – Staples 14.3 2.4 0.9
SBUX – Starbucks 20.7 4.0 1.0
WFMI – Whole Foods 17.1 1.7 0.4

Obviously this is not an exhaustive list of all cheap stocks – these are just the ones that hit new 52 week lows today that I noticed.

It Was Time for a Miss

In case you miss the rest of what I say below, I want to point out that I am calling this "time to buy".

No one is always right. I was very wrong on the Fannie preferred. I thought it was “money good” and it looks like it may well not be. As you are certainly aware the government socialized Fannie and Freddie over the past weekend and eliminated future dividends on the preferred stock. There may be some value in the securities at these prices [assuming 1) housing recovers 2) the government doesn’t run these into the ground and 3) congress doesn’t eliminate the outstanding equity in the future], however the risk is great enough that I would not recommend the preferred stock (and if you own Fannie or Freddie common and want to hold on for the potential gain if the above 3 points are true you should sell, take the tax loss and buy the preferred in the same sized investment rather than holding the common – there’s a far higher chance of the preferred being worth something than the common). At least the government gave us the Q3 dividend on the preferred.

Also I recommended two oil companies which did poorly as oil fell and hedge funds that owned the oil producers have been forced to sell.

My outlook is this: I think this is time to buy. I expect that the July lows will in fact hold for the market and with Fannie/Freddie resolved (and I expect Lehman will be resolved similarly by Monday) there should be a lot less uncertainty. Furthermore I believe that the government took over Fannie and Freddie for the purpose of lowering mortgage rates, which has in fact happened significantly this week. If financing rates are cheaper home prices don’t seem as high and I think this will aid the housing recovery which I see occurring sometime in late Q1 or Q2 of next year (as mentioned here previously). If housing can stabilize this is very good for the stock market. Generally I do not see a global recession in the offing, which most market participants are betting on. If I’m right performance should be good relative to the market for a while, while if I’m wrong it will be poor. Generally I like financials, industrials, and energy companies currently.

Since I now have so much credibility in recommending beaten down financial preferred shares, I am going to recommend WM-PK. This is a preferred stock issued by Washington Mutual. I believe that the rumors of WaMu’s demise have been greatly exaggerated. The stock is somewhat cheap, but I don’t think after the massively diluted capital raise earlier this year that there will be a terrific return for common shareholders anytime soon. However with capital levels that are some of the highest in the industry and fairly solid reserves against losses their current condition is not bad. The concern is that their holdings of option adjustable rate mortgages will sour in the future when those negative amortization minimum payments turn into fully amortizing regular payments (i.e. when people stop being allowed to make a token payment and have to pay their full mortgage principal and interest installments). However, as mentioned above the government is lowering interest rates for mortgages – this has the distinct possibility of causing a turning point in the housing market. And those option ARMs don’t convert to amortizing payments soon for the most part – so there’s plenty of time for recovery in housing. Finally WaMu could always renegotiate the loans and allow for smaller payments from the borrowers which could reduce defaults if markets remain bad.

Energy: OPEC seems to be saying that they will defend $100/barrel oil prices which should be good for oil companies as their shares seem to have priced in much lower levels. Also global demand for commodities has dried up in the recent past as China had loaded up prior to the Olympics and then stopped buying, but I see this reversing as the Chinese pollution controls are returned to normal and the Olympics inventory is burned through. Probably positive for coal, copper, and oil, but I’m not very good at predicting commodity price moves.

Since the last update the recommended stocks [MMM (-1.37%), UNH (-1.12%), PETS (13.62%), APA (-5.94%), OXY (-16.28%), SNY (0.60%), DPS (5.87%), AEO (19.64%), ADSK (-6.28%), AIB (-5.55%), and FNM-PS (-71.02%)] averaged a loss of 6.17%, underperforming the S&P 500 [-2.09%] by 4.07%. Since inception on 7/31/2007 the recommendations have gained 19.87%, outperforming the S&P 500 [-12.10%] by 31.97%.

I recommend at this time: MMM, UNH, PETS, APA, DPS, ADSK, AIB, PBR, TEX, and WM-PK.

Many happy returns.

Crunch Time

Thus far into the credit crunch, we have generally been able to cope with each crisis through a combination of two methods: existing plans [IndyMac and Subprime Lenders] and negotiated solutions [Bear Stearns and Countrywide]. We have now come to the climax of the story – Fannie and Freddie.

The world is scared of Fannie Mae and Freddie Mac – and for good reason. These Government Sponsored Enterprises (GSEs) have significant problems. They are financial guarantee companies, and like the other financial guarantee companies [the monolines ABK, MBI and the mortgage insurers MTG, PMI, RDN, TGIC], they are being thought of as likely to default. The GSEs have negative book value if their portfolios were marked to market – in other words in a timely liquidation scenario there would currently be a loss for debtholders. This is significant in that FNM and FRE have been considered “backed” by the federal government, which is why they have been assigned AAA credit ratings, even though they would not be worthy of such ratings on their own.

It is common thought that Fannie and Freddie really are “too big to fail” – and not just for the United States. Many foreign central banks hold much of their dollar denominated reserves in Fannie and Freddie paper. Unfortunately neither existing plans [bankruptcy] nor a negotiated solution [sale of the companies] would be a viable solution, as the GSEs are too large for a sale and too important for bankruptcy.

There are really only two options if we recognize them as being too big to fail (and therefore rule out bankruptcy) and also assume that they will need assistance:

1) The US government explicitly backs the GSEs debt
2) The US government injects additional capital into FNM and FRE

The first option cannot happen because this would likely cause the national debt to double, and the country would probably lose its AAA credit rating [per Moody’s early 2008]. Therefore the second option is the only logical outcome [also Secretary Paulson has in the past indicated that the government will not back Fannie or Freddie debt].

The capital injection could be completed in a number of different manners – junior (subordinated) debt, preferred stock, or common stock. The public feeling amongst our financial system big wigs is that, to avoid moral hazard, the common shareholders of Fannie and Freddie should pay the consequences of having invested in a GSE and lose the majority of their investment. A common stock capital injection would put the government’s claim at the same level as existing shareholders – moral hazard. Subordinated debt probably would have the effect of propping up the stock price. On the other hand a convertible preferred issue with highly dilutive terms would punish the common shareholders and provide the capital that FNM and FRE are thought to so desperately need.

There are models in past governmental bailouts of what works, and what doesn’t:

Penn Central Railroad 1970 – Penn Central was a failing conglomerate making ill-advised purchases of money losing non-railroad companies in a scheme to borrow ever more money for real estate investments. Eventually the corporation approached the government for $300 million in aid. Nixon approved the package ($750 million for railroads, of which $300 was for Penn Central) but congress did not approve the aid. Penn Central declared bankruptcy in June of 1970 leading to the creation of Conrail and Amtrak.

Lockheed 1971 - $250 million in federal loan guarantees.

New York City 1975 – Billions lent by federal government to the city at a rate of the one year treasury plus 1% on a term of 1 year with annual renewals.

Chrysler 1979 – 1.5 billion in federal loan guarantees, and creditors forced to renegotiate debt at 30 cents on the dollar. Deal allowed Treasury to participate in upside in the stock, and eventually the government made money. Recommended reading: http://www.time.com/time/magazine/article/0,9171,947356,00.html
http://www.heritage.org/research/EnergyandEnvironment/bg276.cfm
http://www.cato.org/pubs/pas/PA00Aes.html

Savings and Loan Intuitions 1980 to 1989 – The rules were changed for Savings and Loans such that insolvent institutions were not identified and shut down quickly by regulators, but rather hidden and allowed to remain open. Capital requirements were lowered, and fake capital (called “capital certificates”) were issued to troubled savings and loans.
http://en.wikipedia.org/wiki/Savings_and_Loan_crisis
http://www.fdic.gov/bank/historical/s&l/

Airline bailout 2001 – Playing the “terrorism killed our industry” card, the airlines received $10 billion in loan guarantees and $5 billion in cash from Congress.

I expect that the final solution to the bailout of Fannie and Freddie will have multiple prongs: 1) The US Government will inject over half of the needed capital through the use of convertible preferreds 2) The US Government will lean on other central banks to inject most of the remaining needed capital, probably through the use of subordinated debt 3) The Fed will ensure liquidity for the GSEs in the event they cannot roll their debt by providing access to the discount window [already known to be the case] 4) Fannie and Freddie will raise additional capital through the issuance of debt and preferred stock in the public markets. Through the provision of additional capital and liquidity Fannie and Freddie will be allowed to remain open for quite some time, and if the housing market turns in 2009, as I expect, the government will again ultimately make money on their bailout.

Dell Stock?

There is an article in the WSJ today that's fairly bullish on Dell stock. Here are excerpts:

Wall Street Journal: HEARD ON THE STREET: Dell Loses Lead, And Investors Can Take Heart
By CHRISTOPHER LAWTONNovember 10, 2006; Page C1
Dell Inc. lost its No. 1 position recently in the world-wide personal-computer market -- and investors have reason to cheer.
For years, the Round Rock, Texas, computer maker was a highflying tech company that churned out healthy profits and consistently grabbed market share with its low-cost business model of selling PCs directly to customers. Over the past year and a half, as that formula has shown its age, Dell has struggled to increase its share and maintain robust profits. It often slashed prices in order to move more PCs.
The price cuts hit Dell's bottom line hard. In August, it reported that fiscal second-quarter profit plunged 51%. Dell's operating margin, once the envy of the industry, also deteriorated. Margin, a measure of profitability that represents the difference between revenue and the cost of production, stood at more than 10% in the late 1990s and above 8% as recently as 2004. It fell to 4.3% in the most recently reported quarter.
Meanwhile, Dell shares have risen more than 9% on Nasdaq since fiscal second quarter results were posted Aug. 17, though the stock is still down nearly 17% for the year. Dell closed at $24.98 yesterday, up 80 cents, giving it a market value of $57 billion.
...
A Dell spokesman declined to comment ahead of next week's earnings report. In remarks to analysts during the company's last earnings call in August, Dell Chief Executive Kevin Rollins acknowledged that the company's pricing has been "overly aggressive." He said Dell would be more careful about its pricing but didn't want to lose market share.
Some are skeptical Dell is on an upward trajectory.
"If Dell just came out and said they are going to focus on profitability and not going to focus on share gains, it would help," says Ken Smith, director of technology research for Munder Capital Management. "They have lost share and become less profitable. I take whatever they say with a grain of salt." He says the PC industry is mature and there aren't huge share gains to be had anymore. Munder Capital Management, which manages $42.2 billion, owned 862,974 shares of Dell as of June 30, according to SEC filings.
...
URL for the full article: http://online.wsj.com/article/SB116311547762619207.html

I wanted to point out a few things about this. I DO NOT LIKE MANUFACTURING COMPANIES!!! I don't understand why people always want to invest in capital intensive companies. The easiest way to explain how this is a bad idea is to look at the airlines (or today, car companies). The only obvious way for one to make a good long-term investment in a capital intensive company is to invest in its early years, while their market is growing, and their market share is also growing. Under those circumstances, companies are typically rewarded with high multiples, and earnings will grow at a rapid pace. The problem comes when the market matures, and the company is no longer able to steal market share. The company will probably irresistibly spend money trying to continue the days of old, which will generate horrible returns for investors.

To be fair, the same can be said about many types of companies, particularly in "growth" industries. For example, this criticism is probably very accurate if applied to Amazon.com, because they continue to invest in non-core businesses, and face tremendous competition and ever-growing capital expense needs. If capital expense as a portion of income or revenue must grow over time, the company is not a good investment.

So, to recap, I don't like DELL, or HPQ, or INTC (particularly Intel - INTC), or any company that must continually spend to stave off stiff competition in the face of a slow-growth market.