Ramblings of a Portfolio Manager

Stock Ideas from Punxsutawney Phil

Well, so far it seems we got it half right. Earlier this year we posited that good economic data would be taken by the market as negative and that bad news would be taken as good--as this information would signal the timing of the Fed’s pending rate hike--but that individual stocks would trade based on earnings surprises and guidance. Everything is just going down on good news now. There hasn’t been a great deal of bad news in either earnings or economic data but (and this may all be due to timing) for stocks and the market as a whole, bad news seems to be greeted with better price action than good news. Like the Groundhog, investors are running from their own shadows and using positive data as the opportunity to sell.

Is this the long-awaited correction and if so how long and deep will it be? The Dow and S&P are now off more than 6% from their January 19th highs while the NASDAQ and Russell 2000 are down over 7% from their peaks of the same day. That’s a lot of carnage for 8 trading days. According to S&P data the average post-war correction is about 8.5% and lasts 45 days so in magnitude, but not duration, we’re getting close to the long term average pullback. A couple of more days like last week’s and we’ll be there. However, to answer the question on everyone’s lips—if and when to buy or sell--we need to ascertain why stocks are selling off. Certainly some of the price action in individual stocks is “sell on the news” reaction, particularly in technology, which had a great run last year and is thus already discounting a fair amount of good results. And then there is the “noise factor,” which we discussed last week. Some of that noise, such as Bernanke’s renomination and the President’s State of the Union message, is already out of the way and probably discounted. Others, like China’s fate and populist attacks on financial institutions, are still being debated and digested. Noise that we neglected to mention is now coming from technicians who have all sorts of pins in their voodoo dolls in the form of points on the charts at which things are going to either bottom, rebound or fall further. Finally, there is the ever-present fear of a double-dip recession, something the President’s level of noise only serves to amplify. Taking all of the above together, investors would rather just take their dice and go play elsewhere.

Assuming we’re right on the above and that it captures the bulk of the motivation behind the recent sell-off, then we see nothing in it that is based on earnings fundamentals, which, over the long run, are what drives stock prices. The wild card is the last point on the rhetoric coming out of Capitol Hill. Will the anti-business populist sentiment be enough to jawbone us back into recession? On this point we think not for the simple reason than nothing coming out of Washington has changed in tone since the new administration moved in. Was it really a surprise to anyone that Obama would propose anti-Wall Street initiatives? If anything, what is surprising is the level to which even his own confidants disagree with him on that point. So we think businesses are already expecting the worst from DC and at some point will most likely just discount the new pap and move ahead. That being the case, at some point one should one buy, but when? The answer to this is why the technicians are now getting some attention.

When markets are moving on noise and sentiment rather than fundamentals it’s very difficult to pick buy and sell points, which is why investors often turn to charts. Retail brokers often use the acronym DEAD, or Don’t Ever Average Down a strategy with which we don’t always agree. Given the rapidity of the sell-off and the spike in the VIX we have just seen, there is still a good deal of fear in the market so plunging in headfirst probably isn’t the best strategy. We would suggest focusing on companies with good near to intermediate-term fundamentals and slowly accumulating positions over the next month as things sort themselves out. Technology is probably a good place to start after the drubbing it has received in the face of positive information. Non-bank financials are also a good place to look. We don’t agree with the run-up in regional banks on the woes of the multinationals as we expect the yield curve to flatten this year in a rising rate environment. Energy stocks also look interesting to us since they did not keep pace with the prices of the underlying commodities last year yet have sold off along with energy prices this year. In our opinion the groundhog approach taken by institutions over the last two weeks has presented investors who have avoided chasing the market over the last 8 months a good chance to get invested at better prices. Happy Groundhog Day!