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Take advantage of a market reversal
Everyone knows the market's headed for a drubbing, right? Here's why it might not happen -- and why one savvy pro will likely be buying if it does.
By Jon D. Markman
As the first quarter of 2005 fades into investors rearview mirrors, the financial media has been quick to recap its results with a jaundiced eye. 'Twas bad, to be sure, for all indexes and sectors not related to energy, utilities or basic materials, and it seems that everyone knows now that the bad tidings will continue as the feds bear down on a new round of villainous CEOs.
But will the past quarters travails really continue in a straight line right through into the new quarter, or is a confounding reversal on the horizon?
Its tempting to see the world of finance as if it were on rails, advancing from point A to point B without a squiggle along the route. But unfortunately, it does not work out that way. Bad quarters sometimes lead to good ones, just as one-time heroes like Maurice Greenberg, former head of American International Group (AIG, news, msgs), can morph enigmatically into goats.
Theres little doubt at present that a combination of higher interest rates, higher energy prices, weaker domestic employment and softening global demand will ultimately pummel the market this year. How could it not? Yet before the drubbing begins in earnest, there could be some remarkable trading opportunities in the opposite direction, and soon. And theres always the possibility, remote as it may be, that the recent decline has sufficed to discount market participants expectations of rough stuff ahead.
Is he crazy?
Robert Drach, a cynical but deadly accurate veteran of the investment advisory business, has kept his clients primarily in cash during the past year. But last week, he began a process that took his accounts from 2% in stocks to 26% invested and now 50% invested. Drach revels in market declines, as he crows that they afford him an opportunity to exploit less experienced players negative emotions to his advantage. "At this juncture we prefer the market splat so we can move to full investment without interruption," he said on April 3, recommending the purchase of beaten-up stalwarts such as Doral Financial (DRL, news, msgs) and Citigroup (C, news, msgs). "The process of profit extraction requires taking advantage of fellow market participants. Almost every position we purchase is directly against prevailing sentiment."
Drach went on to repeat two themes he has successfully articulated for 30 years: That successful investors buy wholesale (when stocks are cheap) and sell retail (when theyre back to full price), and that the media stampedes otherwise intelligent people into making loss-inducing emotional decisions based on " after-the-fact" price change.
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Is he crazy? Maybe not. The Nasdaq Composite ($COMPX) is down 9% from New Years Day, which sounds pretty bad. By no means is this sort of slough uncommon, however. Even in a raging bull market, stocks can tumble dramatically for multimonth periods.- In 1995, the Nasdaq Composite was up 39% overall. Yet there was an 8% decline from September through October -- 1,069 to 982.
- In 1996, the Nasdaq Composite was up 22.6% overall. Yet there was a 19% decline from May to July -- 1,251 to 1,017.
- In 1997, the Nasdaq was up 21.6% overall. Yet there was a 13% decline from January to April -- 1,381 to 1,206.
- In 1998, the Nasdaq was up 38% overall. Yet there was a 34% decline from July to October -- 2,028 to 1,343.
- In 1999, the Nasdaq was up 86% overall. Yet there was a 14% decline from July through August -- 2,840 to 2,442.
In 1993, the last time that the University of North Carolina won the NCAA basketball championship, the Nasdaq 100 ($NDX.X) was off 9% through the third week of April as investors reacted to the World Trade Center car-bomb attack and the clumsy start of the first Clinton administration. But the index, a proxy for the shares of big tech companies, went on to rally 16% through the end of the year even as investors were later forced to absorb the countrys tragic loss of pride and military personnel in Somalia.
Watch for dark clouds to lift
Rather than blindly extrapolating the first quarter into the future, therefore, it might be best to stay flexible and prepare mentally for the possibility that the dark mood might lift, at least temporarily. Lets catalog what we think we know for sure:- The China economic boom is for real, sort of. The big Asian country is using 55% of the worlds cement as it barrels toward its plan to triple its network of highways by 2008. Despite having four times more people than the United States, China currently has a third as many railways and one-fifteenth as many airports, according to researcher Jim William of Williams Inference Center. This sounds like a recipe for a continuation of the first quarters rise in the shares of companies that produce commodities such as steel, coal and concrete -- and thus higher raw materials prices and inflation for everyone else. Yet you still have to wonder why, if China is so hot, its stock market is sitting at six-year lows.
- Energy prices are skyrocketing, maybe. The price of crude oil is up more than 60% in the past year as investors come to grips with an issue that I pointed out a year ago: That OPECs ability to pump out excess high-quality petroleum to meet the rising needs of India and China -- not to mention the desire on the part of Japan and the United States to boost stockpiles for a rainy day -- is suspect. Oil prices dampen the world economy on a one-year lag as cheaper inventories are gradually drawn down and replaced by the more expensive stuff, so its about time for the drag line to hit if its going to. Yet its also well-documented that higher prices encourage conservation and sap demand. If oil buyers get a strong whiff of any slackening in end markets, they will almost certainly back away. One experienced oil trader who has made a ton of money long this year told me that hell sell heavily if crude fails to move through $58. He expects to see it in the mid-$40s by summer.
- Interest rates are bound to move higher, perhaps. The conventional wisdom believes that the Federal Reserve will push short-term interest rates a quarter of a percentage point higher at every Federal Open Market Committee meeting from now until Chairman Alan Greenspan presumably leaves his post early next year. That would put the federal funds rate at 4.25%, a level that the central bank has deemed pleasantly "neutral" -- which is to say, neither stimulative to the economy, nor a drain. Yet the Fed has proven itself flexible, if nothing else, and last week at a major economic conference at Princeton University, Fed governors reportedly acknowledged that they are sensitive to short-term economic data and could hold fire if presented with persuasive evidence that tight-money policies were leading to a U.S. slowdown. With companies clearly so fretful about the future that hiring is at an astonishing multiyear low, analysts say another weak employment report could stay the Feds hand -- a move that could cheer investors.
In sum, while there is plenty to fret about in the long term, in the short term there are some potential mood-lifters on the horizon that could bring brave bargain-hunters back into stocks. For some ideas, we can turn, as always, to StockScouter. The 50 picks in our January benchmark portfolio are up 5.4% as a group so far this year, or more than five times better than the market, on the back of successful recommendations of Hawaii-based oil and land conglomerate Barnwell Industries (BRN, news, msgs), up 49%; energy services provider Todco (THE, news, msgs), up 45%; and Gulf of Mexico oil and gas explorer Energy Partners (EPL, news, msgs), up 34%.
The latest benchmark portfolio continues to highlight energy names, but also mixes in some retailers. Some of the top recommendations for the next six months are pipeline provider Holly Energy Partners (HEP, news, msgs), LL&E Royalty Trust (LRT, news, msgs), driller Rowan (RDC, news, msgs), retailer American Eagle Outfitters (AEOS, news, msgs), childrens clothing maker Oshkosh BGosh (GOSHA, news, msgs) and chemical maker American Vanguard (AVD, news, msgs).
Fine Print
Robert Drach does not have a Web site of his own, but maintains a slimmed-down version of his strategy at the site of public televisions National Business Report. He is a frequent guest of host Paul Kangas. Click here for his model portfolio, the list of high-quality stocks he regularly trades in and out of. . . . The last time I featured Drach in my column was just before the Iraq war in February 2003, when he was cheerfully buying as prices plummeted. . . . One of the better places to keep up on energy and oil-shipping news is at the Web site of Tankerworld. The reporters at the site seem to break quite a bit of news. A recent report noted that 100 single-hull ships must be scrapped this month due to international requirements that tankers be doubled-hulled. Their insight was that the massive "ship-breaking" operation, as the process is termed, will flood the world market with scrap steel, probably depressing prices. . . . On Jan. 19, I explained that asbestos legislation was bogging down in Congress, and that companies facing class-action suits would probably not get relief this year. One highlighted company, Owens Corning (OWENQ, news, msgs), got good news and bad news on Friday. A judge decided it likely owed $7 billion in damages. Litigants wanted the number set at around $11 billion, while company creditors had argued for $2 billion to $3 billion. (For further details, read a Miami Herald article here. Registration required.)
Jon D. Markman is publisher of StockTactics Advisor, an independent weekly investment newsletter, as well as senior strategist and portfolio manager at Pinnacle Investment Advisors. While he cannot provide personalized investment advice or recommendations, he welcomes column critiques and comments at jon.markman@gmail.com; put COMMENT in the subject line. At the time of publication, he held no positions in stocks mentioned in this column.
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