Friday, October 10, 2008 0 comments ++[ CLICK TO COMMENT ]++

Don't Expect The Stock Market To Do Well

The stock market may rally strongly--I can see it rising 15% within a short period of time--but don't expect it to do well. Most of you reading this are stockpickers or sector investors so it doesn't necessarily matter what "the market" does. However, it influnces individual securities. I would still buy and sell based on valuations--and seemingly solid companies are selling at low prices right now--but do keep the macro scenario in mind. There are three "issues" that will hurt the market over the next 6 months.

The first thing I don't like about the market is the fact that everyone is putting too much hope into the various bailouts/interest rate cuts/etc being considered. People are looking for a silver bullet that will solve everything but we are not slaying a single vampire but countless numbers of them. The bailout bill from last week was a good example of the market having too much of an expectation. The market sold off and has been heading down ever since the bill was passed. Admittedly, the removal of the short-selling ban and a few other issues played a role as well, but what happened to the view that the bailout will solve our problems? It turned out to be completely wrong.

I am typical of a left-leaning liberal in that I am often in favour of government intervention. Yet, even I would say that the government can only mitigate issues. They can't prevent a collapse of prices when the underlying assets have little value. It's remarkable how many investors were critical of government intervention over the years yet are expecting it to save the day now.

The second item to note is that, government intervention implies enormous dilution for shareholders of financial institutions. Some investors seem to think the capital injections will save the day but forget that they will face dilution. This essentially means that financial stocks will be weak for a while. Sure, there will be huge rallies on rumour but I suspect they will be sold when the news comes out and details the hit to shareholders.

Since financials were one of the top 3 sectors in the S&P 500, it is hard to see how the broad market will do well with all this dilution, not to mention bankruptcies for the worst banks. This does not mean that stockpickers or sector rotators need to stay out of the markets. If my understanding is correct, when the dot-com bubble burst, investors in consumer staples, real estate, and so on, actually did ok. But since the technology sector was a big component of the S&P 500 at that time, the broad markets kept declining even though some sectors were fine. Similarly, some sectors should do ok. I have to dig deeper but I would guess the underperformers in the past--maybe telecom or media--may do ok.

Finally, the economy will likely weaken. This is an entirely separate issue and has nothing to do with the credit crisis per se. As Marc Faber has said many times, forward earnings estimates look high and will likely be cut. This will pressure the market for a while. Some sectors, such as consumer discretionary, seem to discount a grim scenario already so it's not clear if there is much downside.

Believe it or not, the current crisis hasn't changed my macro views very much (except for the fact that some emerging markets are finally starting to be attractive.) I am still bullish on Japan (and the Yen) and if you want to get away from the US, do check out Japan. Yes, their corporations are not shareholder-friendly and the concept of return on equity seems like a foreign concept over there. Nevertheless, some of their world-class, blue chip, companies are being sold off with the rest. I'm not recommending them but if someone wasn't happy with the share price declines in GM and Ford, they clearly haven't been paying attention to Toyota and Honda. Toyota and Honda are down around 40% and are trading with a trailing and forward P/Es around 8 (note that these are cyclical high earnings.) There is bankruptcy risk, questionable brand strength, and so forth, with many other car companies but not so with these leading Japanese companies. These companies aren't going bankrupt any time soon and would in fact gain market share if one of the American car companies goes bankrupt.


This is the time that separates the best from the rest. Contrarians in particular will go bankrupt or make a killing in these markets. Just play safe. No need to dabble in high risk stuff (unless you feel it's worth it) when blue chip stocks are being sold off. For example, I had been tracking Toyota Industries because it was cheaper but, right now, it's safer to consider Toyota Motors at these prices. Similarly, anyone who avoided technology stocks because they were too expensive (note that this is different from avoiding them because you don't understand them) can pick up Microsoft, Oracle, Dell, Intel, and other leading companies for P/Es around 10. Unlike many cyclicals (autos, commodity businesses, etc) these earnings are not cyclical peaks. They may decline somewhat during a recession but these are all growth stocks--although not as growthy as when they were young--that should be able to keep increasing earnings for a long time. (the big risk for technology companies isn't necessarily the inability to find a growing market; rather, it is the risk of their products becoming obsolete. Blue chips spend a ton on R&D and generally overcome the obsolescence risk.)

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