Realized gain/loss summaries will be mailed in the next several weeks to all E&A clients for whom we manage one or more taxable account(s). Please compare the information provided to your records before giving the summaries to your CPA. For positions that were purchased prior to E&A’s management inception, we attempt to obtain accurate purchase infomation but defer to clients and your CPA’s for the appropriate tax treatment.
US equity markets opened sharply lower today after being closed yesterday for MLK Day. While our markets were closed Monday, international markets fell – reflecting fears that US economic weakness will lead to a macro global recession. Belatedly, the Federal Reserve made good on Chairman Bernanke’s recent promise to act substantively and in a timely manner with an “emergency” rate cut of 0.75% (and corresponding 0.75% cut in the discount rate). Without the Fed’s action today, equities would almost assuredly be even lower. The inter-meeting cut was all but assumed by markets, but by acting now the Fed left room to ease again when they are scheduled to meet next week.
Canada’s Central Bank also lowered rates today, and European central bankers were out making comments that increase the likelihood of coordinated monetary action. As we said in the recent E&A Perspective, policy makers have the tools and incentive to act to bolster the economy. We think the merits of any short-term fiscal stimulus package can be debated, but it is clear that the President, Treasury Secretary, Fed Chairman, and Congress are all keenly focused on giving the economy a boost before housing-related weakness spills over. US exports continue to provide an important offset to domestic weakness and will continue to benefit from the lagged effects of recent and persistent dollar weakness.
Whether or not today’s accelerated sell-off (down 500 Dow points at the open) marks a short-term bottom is not our call to make. (Typically markets bottom when fear and volatility spike. Incidentally, this morning the CBOE Volatility Index (the “VIX”) matched the high that corresponded with the short-term bottom in August.) We have acted and continue to position portfolios beyond the current environment. The temptation is to “do something.” However, any moves have to be made with an eye on opportunities over the next one to three to ten years – not driven by current market action. While these periods are unpleasant and certainly last longer than anyone would like, they are unquestionably opportunities for investors with appropriate time horizons.
Tuesday the FOMC convenes for the most anticipated monetary policy discussion in years. At a time when economic indicators are mixed and lax subprime lending standards have roiled credit markets, all eyes are on the Fed’s next decision on rates. Virtually everyone agrees at this point that the Fed WILL reduce the Fed Funds target rate. The magnitude of the reduction remains the only interesting question - 1/4 or 1/2 point. (Bear in mind there is nothing that says the Fed can’t cut by 3/8ths of a point - right in the middle - something we wouldn’t put past Chairman Bernanke.) I have maintained until recently that the Fed ought not do anything to the Fed Funds target, and that may still be the right call. However, given the markets’ absolute expectations of at least a 0.25% cut, a do-nothing meeting would go over like Brittney’s recent VMA performance.
What is less often discussed but probably most apropos this time around is the so-called discount rate - the rate banks pay when borrowing from the Fed’s ”discount window.” This is what was cut 0.50% on August 17th, sparking a monster stock rally after hitting bottom and reversing the previous day. While I now begrudgingly agree that the Fed WILL reduce the Fed Funds target, I would be much happier to see the discount rate cut again - or at least cut (by a larger amount) along with a Fed Funds reduction.
By cutting the discount rate, the Fed would effectively reiterate their August 17th message that this “crisis” is a LIQUIDITY event rather than an assessment of a rapidly deteriorating broad economy. The Fed Funds target rate is a much broader instrument and therefore has much wider, longer-lasting effects on the economy. With oil prices near $80 per barrel, food prices soaring, and most economic indicators still showing growth (albeit slower), a sharp rate cut runs the risk of stoking inflationary pressures if the economy is not teetering on the brink of recession. And for that matter, how does an utter mess within a small subsegment of the US mortgage market influence the number of Cisco routers the Chinese will buy for their newly-wired cities? Or how many acres of Monsanto seeds the Brazilian’s plant?
Last, hasty Fed action could be seen as bailing out the most egregious loose lenders - creating a “moral hazard” for the Fed - i.e. providing a safety net for behaviors that would otherwise be punished more severely by markets. Bernanke, I believe will exercise great caution and very deliberately to avoid following the “Greenspan Put” with one of his own.
To this point, I believe Chairman Bernanke has performed admirably. Cutting the Discount Rate last month was a particularly adept move, and I expect more of the same. If I had to bet on the Fed’s decision Tuesday:
Fed Funds: -0.25% (to 5.00%) - with an oustide chance of -0.375%
Discount Rate: -0.50% (to 5.25%) - possibly -0.75% to match Fed Funds at 5%
A 0.25% cut will likely be followed by dovish bias (”Fed stands ready to act if weakness spreads”), whereas a larger 0.50% cut would probably be followed by a hawkish tone (”inflation remains a concern”).
At mid-day the Dow is at it’s low and threatens to post a sixth straight day of losses - down a total of 1,000 points in just six days if the market closes sheds another 200 points today. On a percentage basis, stocks are rapidly approaching a 10% correction from the highs registered July 19th. Whether the correction ends at 10%, 12%, or 15%, we believe the weakness is not the start of a protraced bear market. Economic and corporate fundamentals do not suggest substantially lower equity prices for long. The recent market shake-up is a liquidity event, and investment decisions in the short-term are being driven by emotion and forced liquidations within a number of hedge funds and other leveraged institutions. (Credit markets are frozen so managers cannot sell the debt instruments that got them in trouble in the first place. One of the great benefits of large-cap stocks - liquidity - is a short term negative because they are the only assets that can readily be sold by troubled funds). On the postitive side, the quality companies we own are flush with cash and have no need to tap credit markets - especially while irrationality reigns. Earnings growth roughly doubled expectations again for Q2 - up 9% - and cash flow remains very strong.
Accoring to Citigroup Investment Research, the correction has moved stocks back into what they call the valuation bullseye or sweet spot. Over the past 65 years, the greatest 12-month returns have come when the market P/E is 14-16, where it is currently. This is somewhat counterintuitive as one might assume the cheaper the markets the better the 12-month return - not so. The logic is that much cheaper markets (e.g. 8-9 P/E’s) were priced accurately to project much slower economic growth or even recession. In any event, we think the market is fairly- to under-valued based on economic growth prospects, strength of corporate finances and earnings, and historically low interest rates. Once the focus returns to fundamentals, we’ll look back at this correction as an attractive entry point - just as we did shallower pullbacks early this year in Feb-March and last year in May-June.
Blame it on the elmination of the up-tick rule (explanation below) or the short-sightedness of hedge funds, or the Fed or Jim Cramer on Mad Money or whomever or whatever, stock market volatility is back - with a vengence. Early in July, the SEC repealed a 1934 rule that prohibited shorting stock after a down-tick. In other words, only after a stock traded at a price HIGHER than the previous trade, could you sell short that stock. The goal was to reduce the ability to “pile-on” a sliding stock. No doubt there are other factors at work that add to the recent volatility, but this is in my mind the fuel for the fire. In 1934 (or 1974 or even 1994 for that matter), trading costs were substantially higher than today and market velocity was generally lower. Today, massive hedge funds use trading algorhythms (black boxes) to execute huge volume trades with lightening speed. Market opens down, SHORT IT, market starts to recover, COVER. Market starts down again, SHORT AGAIN. And so on and so forth. Clearly the sub-prime issues and related hedge fund blowups (seemingly daily) do not help, and the ability to trade instantaneoulsy (and virtually without cost) are contributors, but axe-ing the up-tick rule is like starting a coffee-IV for an already gittery market.
Look for a continuation of the multi-hundred point swings on the Dow indefinitely. It seems to me that even after the sub-prime issues pass, other data points will be fodder for big volume traders and black box funds. For what it is worth, the market remains positive for August in spite of down days of 280 and 390 within a span of five trading days. While long-term investors can and should look past near-term volatility, keeping some Pepto Bismol handy can’t hurt.
After much fanfare and several attempts, the Dow breached the 14,000 mark on a closing basis for the first time in history. The broad market keeps chugging along making new highs in spite of a myriad of issues that have been thrown at it. Outstanding fundamentals reflect solid global growth, and markets have chosen (appropriately) to focus on the positives and compartmentalize the subprime mess and Congress’ unfortunate fixation on protectionist rhetoric and higher taxes. Quarterly earnings reporting season is in full swing and results are mostly beating the relatively low hurdles set earlier this year. Although the S&P has gained 10% year-to-date already, surprisingly stong earnings growth in Q2 and the second half can push stocks higher still - without heroic assumptions about multiple expansion and certianly without any help from the Fed.
At mid-year, many of our broad predictions are playing out exceptionally well. Large-caps are outperforming. Growth is beating value. Domestic equity performance has improved relative to individual overseas markets. Corporate earnings growth continues to surprise to the upside. The global synchronous growth story is in full bloom, and emerging market continue to devour resources for infrastructure. Tech is back - big time. And the Fed remains on hold indefinitely.
For those of you who own Dean Foods (DF), the links below should help clarify the “apparent” recent drop in the the stock price. As part of a balance sheet recapitalization (i.e. the company was underleveraged), Dean borrowed to pay shareholders a special one-time dividend of $15.00 per share. Once the dividend was paid, it was reflected as an increase in your money market funds balance and the stock price dropped by $15.00. Therefore, until Dean determines the appropriate tax treatment of the dividend, shareholders should add $15.00 to the current stock price to accurately compare the current total “value” with your cost basis.
For example, if your cost basis is $45 per share and DF stock is currently trading at $34 per share, your DF position has a gain of $4 per share ($34 + $15 cash dividend received = $49) - not a loss of $14 per share as it appears before considering the dividend received.
Soon the cost basis will be adjusted. In the meantime, please contact us if you have questions.
Dean Foods / Investor Relations
FAQ: http://media.corporate-ir.net/media_files/irol/88/88165/3_2_2007832DFSpecialDividendFAQ.pdf
The month of March did not disappoint on the volatility front. The end result of the month’s gyrations was a relatively flat month in terms of stock performance. Including a sharp rally today (4/3), the DJIA is roughly 100 points from levels last seen immediately before the Feb. 27 drop of over 400 points. One quarter into the new year, the S&P 500 has returned 0.63%.
The data continue to confound most economists and market forecasters. As soon as it appears growth is slowing, evidence of a re-acceleration materializes. Just as inflation seems to have cooled, a hot data point is released. The direction of the domestic housing market is less in question. With housing, it is more about magnitude (or contagion) of the downturn. If subprime and Alt-A mortgage problems “filter up” to prime-rated borrowers, the economy might turn decidedly towards the hard landing, or even recession, scenario. I still believe the employment picture is strong enough to make this unlikely. (Friday’s employment report will shed some light on the strenght of the labor market.) The bond market seems to finally be signaling that recession may be less likely as well. After remaining “inverted” for months, the yield curve has returned to its historically normal upward-sloping structure.
In the months ahead, look for key data on the trade deficit and budget deficit as well as the unfolding mortgage meltdown. Continued growth abroad, coupled with a slowing US economy, will likely lead to significant narrowing of the trade deficit - oft cited as an imbalance that cannot persist. Similarly, I suspect tax receipts will surprise on the upside and bring the budget deficit down faster than forecasted - another plus.
Two Tuesdays ago the market registered it’s first 2% plus single-day drop in 900+ days. For good measure, it ripped through 2% on its way to a 416 point, 3.6% rout. 14 days ago, we blamed Alan Greenspan and his comments, however misconstrued, about the possibility of a US recession after a long recovery/expansion. At the same time, Chinese government officials were doing their best impersonation of the Greenspan “Irrational Exhuberance” speech to talk-down their red-hot economy and red-hotter stock market. The Shanghai market coughed up 9% to start the selling – after rising 100% last year and another 30% year-to-date. When the global market meltdown reached New York, US markets used capitalized on the opportunity to hiccup, but not fall apart. Witness emerging market volatility versus relative US stability.
Today’s 240 point selloff couldn’t be blamed on Greenspan or the Chinese. Instead, we will chalk up the second 2% move in two weeks to our own home-grown housing market. But not all of housing by any means — merely a sliver (less than 10% of total mortgage loans) of the mortgage market known as “sub-prime.” Sub-prime is the dressier term for “risky borrower” the same way ”pre-owned vehicle” sounds much better than “used car.” Years of loose lending, dangerous loan structures, and reliance on rising home price have finally caught up with borrowers and the sub-prime lenders. Two public companies, New Century and Accredited, have virtually imploded in short order and there is no doubt more trouble ahead. (Take a look at the 30-day stock charts for NEW and LEND.)
The question for investors lucky enough to have avoided the imploding sub-prime pure plays is just how far up the credit ladder this ugliness goes. Virtually every large-cap financial company has some exposure to prime, alt-A, and sub-prime mortgages. JP Morgan, Wells Fargo, Citigroup, HSBC, GE, even the investment banks Bear Stearns, Lehman Bros, and Goldman Sachs - you name it. In many cases, sheer size, balance sheet fortitude, and guts turns problems for small risky market segments into opportunities for the big guys. No doubt there will be some black eyes along the way. HSBC dramatically increased reserves against sub-prime loans and fired several of the top brass at their Household division – sounding the alarm for the industry as a whole.
But don’t feel sorry for the lenders. After all, this problem was their making. By definition, sub-prime borrowers are the riskiest out there. And doesn’t it make sense that these borrowers would be the most likely to take advantage of zero-doc, interest only, option-ARM mortgages for amounts up to 120% of the “appraised value” of the homes they were stretching to buy? Credit crunches happen to segments that have been operating this way. It may creep a little farther up the ladder as lenders tighten their belts across the board, and markets have taken financials down a few notches just in case there are more shoes to drop. However, as we see it, the US sub-prime market meltdown is a blip in an otherwise healthy global economy and has already had more than its fair share of influence on the markets.
Yesterday’s intense selloff vividly highlighted several of the themes we have been working on for 2007. Unlike Superbowl XLI where a great offense was too much for a good defense, yesterday’s rout was all about defense. On a day when the market is down 500 points, “winner” is strictly a relative term, but if there were any winners yesterday they were the stocks we consider defensive - Consumer Staples and Healthcare primarily. Stocks like Proctor & Gamble, Colgate, Dean Foods, PepsiCo held up relatively well, as did Healthcare stocks Johnson & Johnson, Wyeth, Medtronic, and Roche. Think of these as the stocks that will ”win” the ugly, low-scoring games.
Alternatively, high-powered growth stocks (think Indianapolis Colts’ offense) prefer high-scoring shoot-outs. Over the long run, these stocks will score a lot of points, but they are vulnerable to short-term market selloffs. With underlying company fundamentals in-tact and economic growth solid but moderating, Tuesday’s drop offers long-term investors a chance to add offense on the cheap. Some of our newest holdings are clearly offensive, and we’ll be adding to them when given the opportunity. Volalitily will help us build long-term positions in Akamai, Allergan, Allegheny Tech, China Mobile, and Electronic Arts as examples.
In the end, the best portfolios are just like the best football teams. Superbowl XLI taught us that it’s nice to have a BOTH a good offense AND a good defense (or at the very least a decent defense that is playing well!).