This year is off to a rocky start, with the major indexes already down 3% to 6%. Is this a bad omen for the rest of the year, or will the markets rally for a third consecutive year? I wish I knew. But like most value investors, I tend to worry a lot -- it helps to avoid losing money -- and these days I find plenty to worry about.
Before proceeding, however, I want to share some of the wisest words ever spoken about investing, by (surprise!) Warren Buffett at the 1992 Berkshire Hathaway annual meeting:
"If we find a company we like, the level of the market will not really impact our decisions. We spend essentially no time thinking about macroeconomic factors...We simply try to focus on businesses that we think we understand and where we like the price and management."
I agree with Buffett that one should have a bottom-up approach to stock picking, but when it comes to managing my overall portfolio -- how much to have in cash vs. long positions vs. shorts/puts -- I think it's useful to have a general opinion regarding a few big factors, such as the economy, trade and budget deficits, interest rates, and overall valuation levels in the stock market.
My opinion on these four factors is quite bearish. In contrast to the current cheery consensus, I think that the economy faces significant headwinds, the already-enormous deficits will continue to grow, interest rates have nowhere to go but up, and high stock valuations already reflect a best-case scenario for stocks, so there's little upside and substantial downside.
The bull case for the economy is well known and many indicators are indeed very positive. For example, corporate profitability as a percentage of GDP is near an all-time high (though this can also be viewed as a bearish signal, since this percentage has historically been very cyclical, meaning it's likely to go down). The Commerce Department reported yesterday that orders for durable goods increased 10.9% in 2004, the highest annual increase in 10 years. However, there are some major warning flags as well:
- Consumer spending, which accounts for roughly two-thirds of the nation's economic activity, has been weak since June, when the last of the special tax refund checks arrived and the Fed started raising interest rates. And what will happen to the already overleveraged consumer as the Fed continues raising interest rates in 2005, given that Americans are up to their eyeballs in floating-rate mortgage and credit card debt?
- Wage increases aren't likely to be the answer, as they are barely keeping pace with inflation.
- Our current account deficit is at a run rate of nearly $700 billion annually, and as Fred Hickey notes in the latest High-Tech Strategist: "The national debt is currently at $7.5 trillion, up $1.9 trillion (25%) since the beginning of fiscal year 2001. Foreigners now own more than 40% of all government-issued U.S. Treasury bonds and T-bills, double the level of 10 years ago. The U.S. budget deficit for fiscal year 2004 was a record $412 billion" -- and it continues to rise.
Stock market worries
These economic issues will likely weigh on stocks for some time, but there are other reasons to worry as well:
- According to The Wall Street Journal, the S&P 500 is trading at 20 times trailing earnings and 17 times 2005 estimates. The Nasdaq is at 37 times and 30 times, respectively, while the Russell 2000 is at 67 times and 31 times, respectively. The S&P 500 multiples are meaningfully above historical averages in the mid-teens, and the multiples among tech stocks are simply insane (for more on this point, see The Tech Stock Discount). Historically, when stocks have traded at such multiples, they have delivered mediocre performance -- or worse! Especially mind-boggling to me is that so many investors are piling back into the same sectors that crushed them only a few years ago, like moths drawn to a flame.
- To quote again from The High-Tech Strategist: "Most bear markets begin with the Fed raising rates. The Fed initiated a series of rate hikes in 1973, 1977, 1980, 1987, 1994 and 1999. Significant market declines followed all these hikes shortly thereafter, though the 1994 falloff was short-lived. The worst periods in recent market history (1973-74, Dow Jones down 45%; 1977-1978, Dow down 25.6%; 1987 -- crash, Dow down 36%; 2000-2002, Nasdaq down 78%) were all preceded by these hikes...(Similarly), oil price spikes in 1981, 1990 and 2000 preceded recessions and stock market declines. According to the Federal Reserve Bank of Dallas, rising oil prices have preceded nine of the 10 post-WWII recessions (the 1960 recession was the sole exception)."
Given these concerns, one might think that my advice is to sell everything and sit on cash -- but it's not. Based on my bottoms-up analysis of individual stocks, combined with my big-picture viewpoint, I have five recommendations:
1. As always, focus on owning the stocks of solid, well-run businesses with improving financials. Of course, price is critical as well and true bargains -- let's call them 50-cent dollars -- are exceedingly rare today, but there are always a few, which can be found with enough sleuthing.
2. Avoid speculation and rich valuations at all costs. While I wouldn't characterize the entire market as frothy and wildly overvalued, there are large pockets to avoid, such as the hottest, most popular sectors.
3. Go through your entire portfolio, reevaluating each position. If you're not certain that it's trading at least 10%-20% below your conservative calculation of intrinsic value, sell it!
4. Be extremely careful seeking high yields, whether in bonds or dividend-paying stocks, as investors are rashly chasing yields, driving spreads to near all-time lows. As a result, in general, investors are being paid very little to assume big risks. No wonder Jim Grant of Grant's Interest Rate Observer commented last year that bonds are offering "return-free risk."
5. If you're a sophisticated investor, consider shorts, puts and/or credit default swaps, which are near their highest percentage ever in my portfolio. I've made such bearish bets -- both on specific companies as well as some of the major indices -- primarily to make money, but I also view them as insurance policies that, because volatility is exceptionally low, can be purchased cheaply.
There are times to be conservative and focus on preserving capital, and there are times to be greedy. More so than at any other time in my investing career, now is a time to be patient, avoid risk, and wait for better days, when we might get paid appropriately for taking risk. These days will come, perhaps sooner than we think.
Whitney Tilson is a longtime guest columnist for The Motley Fool. Under no circumstances does this information represent a recommendation to buy, sell, or hold any security. Whitney appreciates your feedback. To read his previous columns for The Motley Fool, as well as other writings, click here. The Motley Fool is investors writing for investors.
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