q4 '07 rally hasn't materialized: financials still feeling pain

It has been almost 3 months that we have published to the blog, so my sincere apologies for the absence. We are currently posting our daily thoughts to Jim Cramer's "TheStreet.com" in the RealMoney section, to which you can subscribe for a reasonable cost. TheStreet.com is a great site, with some quality research, and trading ideas. Give it a look - you won't be disappointed.

The q4 '07 rally that we expected with the first Fed ease in mid-September '07 hasn't resulted in the rally we had expected. We have sold Moody's (MCO) and Washington Mutual (WM) at higher prices than they are trading at today, since the stocks didn't rise on good news: We sold our WM in the low to mid $30's and we sold Moody's (MCO) around $40.

Our financials that have performed well are Goldman Sachs (GS), Lehman Brothers (LEH) of which we still have a modest position, Northern Trust (NTRS), Morningstar (MORN) Charles Schwab (SCHW) and until recently, American Express (AXP).

The Fed is in a tough spot, with this week's inflation data being the strongest in years, it implies that the Fed can be much less aggressive than maybe they should with the gridlock in the financial system.

A less discussed aspect of hte market action of late has been the stronger dollar: the dollar has stopped weakening, and that could have implications for energy stocks, basic materials, and other commodity-related sectors, which action of the last few years has been correlated with the dollar action.

With the S&P 500 closing Friday at 1,467, the S&P 500 is trading below where it was on September 15th, when the Fed cut rates 50 bp's to get the monetary policy easing started. That isn't a good sign.

With the Fed taking action, and the Treasury putting in place actions to help extended borrowers of subprime loans, you would think the bottom would be in soon, but let the market tell you first.

Fed easing and stock price performance - not a clean history

Conventional wisdon tells us that the stock market, and by the market I mean the S&P 500, typically marches higher under easier monetary policy, meaning that when the FOMC is cutting the fed funds rate, and liquidity is being supplied to the banking system, stock prices work higher for any number of reasons. Some of these reasons include a lower cost of capital for corporations, a lower discount rate on stock market valuation models, higher corporate earnings as higher-coupon debt is re-financed, corporations tend to borrow more at lower rates, as capex projects have lower hurdle rates with lower interest rates, dividend yields begin to look more favorable under lower interest rates, etc. etc.

Lab Thomson, a research segment of Thomson Financial First Call and one of our research providers, published a piece this weekend (weekend of 9/15/07) discussing what past rate cuts have meant for the equity markets: "when examining how equity prices have fared in the one-month period following a recent reduction in the fed funds rate, there was a slight positive bias as equity prices gained in eight instances and fell in five.The average change in the one-month period for the thirteen episodes was -0.19%." If we exclude the aftermath of the 9/11 attack (one episode) then the one-month change in equity prices was a positive 1.17%.

Thomson looked at the most recent round of rate cuts that occurred from January 3rd, 2001 to June 25th, of 2003, and what bothers me about that period is the heavy influence of technology and large-cap growth on the S&P 500 in the late 1990's and early 2000's. Intel, Microsoft, AIG, GE, Pfizer - all the mega-cap winners of 1995 - 1999, had the opposite and negative influence on the S&P 500 during the bear market, as they did positively in the late 1990's.

In other words, even though following 9/11 we had a brief and shallow recession, the equity bear market from March, 2000 to March, 2003, was in my opinion, and with the benefit of great hindsight, simply a valuation correction, or a valuation bear market, rather than a function of any great economic malaise.

My point is that easier monetary policy has in the past lifted stock prices for mainly economic reasons, but that the period from January '01 to June, '03 is not really a representative period given the undue influence of large-cap tech and large-cap growth, and the overvaluation of such during the 1990's. Or saying it another way, if Thomson had looked at the period from 1990 to 1993, then the average gain would likely be much greater than 1.17%.

To conclude, with a 14(x) forward P/E on the S&P 500, the S&P 500 is trading at a much cheaper valuation than in January 2001, and the financials will likely benefit from a return to a normally-sloped yield curve, to a greater degree today than earlier in this decade.

I like the prospects of a strong stock market rally into the 4th quarter of 2007. The market valuation and the leadership groups today are very different than the old leadership of the 1990's and thus are in a better position to benefit favorably from lower interest rates.

long SPY, many large-cap leaders mentioned above

Stryker - getting interesting again

Stryker (SYK) looks to be finishing its 6 month consolidation, and looks to be ready to break out again, if the stock can move above $72 on volume over the near future.



Technically, SYK touched $70 per share in late April, right around the date of its first quarter '07 earnings report and then touched $70 again on August 15th. We were trying to accumulate the stock under $60 but during this market correction SYK never traded below $63 and then for only a brief period of time.



Stryker is an exceptional company: a leader in orthopaedic surgical products and hospital beds, SYK has a compounded annual earnings growth rate of 25% for the last 30 years, with a pristine balance sheet, and very healthy cash flow. While the stock has been stuck in a trading range for the past 6 months it only recently broke out of a 2.5 year consolidation which saw SYK trade between $55 at the highs and the low $40's near the bottom between July '04 and late 2006. Thus even with the breakout above $57 in late '06, the stock hasn't acted like the typical growth stock such as an AAPL or RIMM.



Part of the problem could be that SYK sports the "large-cap growth" moniker, which is an asset class that continues to be out of favor these days, despite the litany of guru's and prognosticators on CNBC telling viewers how attractive the large-cap sector, and large-cap growth in particular, remains. Another reason for the underperformance is that healthcare despite its supposedly favorable demographics, is a sector of the S&P 500 that has underperformed since the March, 2003 bottom. Thus not only is SYK in an unfavorable sector, it is also part of an out-of-favor asset class. (Healthcare - as a sector - has returned just 5% and 6% respectively the last two years within the S&P 500, well short of 2006's 15% return for the S&P 500.)



Fundamentally, SYK continues to grow earnings between 15% - 20% with organic growth between 14% - 16%. While pricing has been challenging the last few years contributing just 1% - 2% to orginic growth, volume continues to grow at mid-teens rates and is expected to continue at that rate for the foreseeable future.



Of the major orthopaedic device makers, i.e. Zimmer, Stryker, Smith & Nephew and Biomet (Biomet has since gone private), Stryker in our eyes continues to be the best of the group. While ZMH sports a higher operating margin than SYK, SYK has a better Return on Invested Capital (ROIC) and a higher return on equity (ROE). In addition, the recent Justice Department investigation which has cast a poor light on the consulting arrangments between the device makers and doctor's, leaves SYK in a somewhat better position according to our industry contacts, since SYK didn't abuse these relationships to the extent others did.

Finally, as a portfolio manager, it is always about the cash flow and free-cash-flow generation: currently over the last three years SYK has had a free-cash-flow yield of between 7% - 14% which is pretty extraordinary. Currently SYK's 4q trailing free-cash flow as of June 30 '07 was $826 ml on $5.7 bl in 4q trailing revenues for a 14% "yield" on SYK.

Rumor has it SYK is going to be in the market for an acquisition, and they could likely afford to pay cash for it given the cash generation.

To conclude, SYK a wonderful company in an out-of-favor sector and asset class. I'd love to buy it under $60 but watch for the breakout over $71 - $72 to confirm the next move higher. A large acquisition would cause the stock to come down no doubt, but it would present another buying opportunity for sure.

We'll try and get a chart posted to on SYK shortly.

position in SYK, AAPL, etc.

Goldman Sachs and the Fed

Goldman Sachs and the Fed

With the 10-year Treasury trading at 4.29% this morning, and the fed funds rate at 5.25% the Treasury yield curve is telling us that the Fed, Chairman Bernanke, and the FOMC is WAY (!) behind the curve in terms of reacting to economic data.

However before you panic and conclude economic Armageddon is just around the corner, this is the modus operandi of the Fed, if you study historical monetary policy changes: Chairman Greenspan didn't move until January 2001, well after the economy had turned down and the Nasdaq bubble burst, and even back in 1990 - 1991 around the time of the first Gulf War, Chairman Greenspan waited unto employment caved (and caved badly) before cutting the short-term rate.

The Fed waits until the data looks dire, and then they cut aggressively.

Goldman Sachs trading action is much improved: Goldman will report earnings next week for the quarter ended August 31, and the stock hasn't made a new low since August 16th. GS's trading action is much better than Lehman or Bear Stearns right now.

Goldman's trading action is telling us that - relative to the other white-shoe firms - their quarter should be less painful, and that the Fed will likely cut rates aggressively over the next few months.

Goldman is the bellwether of the investment banking firms: it's trading action of late is definite positive and we are edging back into the stock after selling our last bit at $204.

position in GS, LEH, index funds, Treasury bond funds, etc. etc.

Watching the equity market leadership groups

Each bull market has its own singular leadership stocks or sectors: in the 1980's and 1990's it was technology, financial services and healthcare for sure, particularly large-cap pharma within healthcare during the 1980's and 1990's, but since March of 2000, or rather since March, 2003, the energy, basic materials, telecom and utility sectors have been the market leadership groups, and of those 4 groups, energy, basic materials and utilities have led the way.

With this morning's weak August jobs report of 4,000 jobs being lost by the economy, and the sharp downward revisions to job growth in June and July, it is very clear that we will get a set of fed funds rate reductions as Chairman Bernanke and the Fed will prevent the economy from sinking deeper into a recession.

The market keys for us will be how the former leadership groups act: of the above-mentioned 4 groups, energy continues to look the best technically as the XLE (energy sector ETF), and XOM have consolidated 2007 gains and look to be on the verge of breaking out again, if the price of a barrel of crude oil can move above $78. As a percentage of the S&P 500, energy's earnings weight is 14% of the S&P 500, while the sector's price weight is about 10%.

Utilities, telecom and basic materials each represent about 3% - 4% of the S&P 500 by earnings weight and market cap, and of the 3 groups, basic materials looks to be in the best shape, since precious metals are about half the weighting within the sector, and gold has broken out above $700 on the prospects for easier Fed monetary policy.

Utility action will be contingent on what happens with the TXU deal: I do think a lot of these private equity deals will get done as we move into the fall '07 since an easier Fed will loosen credit spreads and give us a chance to have a normally-shaped yield curve, both of which will restore some stability and sanity to credit and fixed-income markets.

To conclude, watch the market leadership groups for changes therein: the laggards of the last three years have been technology, financials, and consumer staples (the mainstay's of consumer staples being housing and auto's, not exactly two growth groups), and these three sectors comprise about 50% of the S&P 500 by earnings weight and market cap.

Thus, the sector leadership within the S&P 500 is coming from the smallest sectors within the index, which isn't a bad thing, it is just unusual. Financials represent almost 27% of the S&P 500 by earnings weight in and of itself. An easier Fed with a yield curve that is normally sloped can be earnings nirvana for the financial sector.

position in most/all sectors mentioned above

Fixed-income strategy: two interesting closed-end funds

With the discount rate reduction announced late last week, we are slowly changing our fixed-income or balanced accounts to take more interest rate and credit risk, after keeping all of our fixed-income money in a higher-yielding Schwab money market the last year. Thanks to the inverted yield curve, there was little incentive to take either interest rate or credit risk, a strategy that has paid off handsomely the last eight weeks.

However, with the discount rate announcement, the unlocking of the credit spreads and the expected new liquidity from coming fed funds rate reductions should have a beneficial effect on credit instruments, so here are two closed-end funds we have been buying for client accounts:

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The DUC or the Duff & Phelp's Utility and Corporate Bond Trust is a closed-end utility and corporate bond fund that is currently trading at a 7% discount to NAV (as of this posting) and is yielding north of 7%. The chart is WAY interesting (to paraphrase a West Coast Valley girl): on a monthly chart (attached and compliments of http://www.wordencom/) DUC has historically bottomed with the end of Fed tightenings: in November and December, 1994 DUC bottomed at $10.25 and $10.50 per share which marked the end of the 1994 round of tightenings by then-Chairman Alan Greenspan, and then again in March and June of 2000, DUC bottomed at $10.69 and $10.56, and on both occasions, DUC - over the next two years - traded from these fed-induced lows to a high of $15 per share as the Fed reversed course and provided for an easier monetary policy. (See attached monthly chart above, and note the low coincident with Fed tightening cycles.)

Fundamentally, DUC's holdings consist of a 10 3/8th's Treasury maturing on 11/15/12 (essentially a 5-year Treasury) which is 8% of the closed-end fund, with 33% of the corporate's being utility credits and 28% financial credits. From a rating perspective, 18% of the funds credits are AAA/AA, and 48% are BBB+ or below. (Statistics compliments of etfconnect.com).

The monthly distribution is $0.065 per share (six and a half cents).

Our target price is between $14 - $15 per share, which given historical technical patterns, DUC should make easily. The DUC fund is WAY (!) oversold on the daily, weekly and monthly charts, so the technicals and fundamentals are lining up nicely.

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The second interesting closed-end fund we have been buying is the JRO, or John Nuveen closed-end leveraged loan fund. The JRO is trading between a 3% - 4% discount to NAV, and its current distribution rate is close to 10% (again, the current stats courtesy of ETFconnect.com).

20% of JRO's credits are from the media sector, with the 2nd largest holding at 3% of the fund being a Chicago Tribune credit, which saw its acquisition by Sam Zell close yesterday.

Consider this closed-end ETF to be a spicier credit play on the CLO/CDO, leveraged-loan lock-up frenzy, thus be more careful with JRO and buy in over time as we are doing. ETFconnect.com did NOT provide a ratings distribution on JRO as of this posting so assume that all credits are below investment grade.

Last week, just prior to the Fed's discount rate announcement, JRO fell below the late 2005 lows of $12.15 - $12.17 per share and gapped down to as low as $10.74 on the illiquidity issues surrounding high yield paper. The fund has subsequently bounced and will benefit handsomely from the slow unlocking and re-pricing of credit spreads over the next 6 months.

Our price target is alos $14 - $15 per share. The JRO fund is now very oversold on a weekly chart and can bounce nicely with further fed rate cuts in our opinion.

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To conclude, I think these closed-end funds provide a diversified vehicle to add credit risk to client accounts and yet remain diversified and liquid. Right now, the two aforementioned funds are a couple of our favorites, but we're always looking for more.

We'll try and keep readers updated on our thoughts on these funds but we may sell out entirely or even add more to the positions without updating the blog. However, we'll do our level best to keep readers updated. I think these two funds are better longer-term plays on what we hope will be improving liquidity and credit spreads in the corporate bond markets.

position in DUC, JRO

Trinity Asset Management, Inc. by:

Brian Gilmartin, CFA

Portfolio manager

Trinity's fixed-income strategy

With Walmart's (WMT) earnings this morning, it is clear that the consumer is slowing. (We owe readers an apology: I thought WMT would report earnings last Thursday, August 8th, but instead WMT reported this morning.)

With WMT lowering guidance thanks to a weakened consumer, and WMT accounting for 10% of all retail sales, and consumption 2/3rd's of GDP, it doesn't take a genius to figure out that GDP could suffer in coming months.

With a Fed that could start cutting rates before we see the end of August or September, here is how we are positioning our fixed-income accounts regarding interest rate risk, and credit risk:

If and when the Fed cuts rates, I think the yield curve will in fact steepen, and I would expect the 10-year to trade above 5% and begin returning to more normal slope. Ex fed funds, the 2 - 10 year spread is now back to a positive +35 bp's thus the steepening is beginning already.

We are positioning muni portfolios in the 5 - 7 year maturity range (non-callable), in high quality insured or AA notes, with no credit risk being taken. I think the 5-7 year maturities will outperform in an environment where the Fed is friendlier and where we are moving from an inverted to a normally-sloped curve. The 2-year Treasury is currently yielding 4.44%, thus it has discounted three Fed easings already, which is why we are positioning within 5 - 7 year maturity. We would buy 10-year paper if we get over 5.25%.

In terms of credit risk, I think it is is still too early as credit spreads could continue to widen through September - October, '07. Corporate high yield is getting more interesting, but we have not put any money back into high yield (after selling all of our exposure in early 2005).

All of our taxable bond accounts have been 100% money market the last two years, which didn't look so hot when high yield was trading at +150 Treasuries, but it looks much better now.

Given the currency risk, we have never been international fixed-income investors, preferring to take interest rate and credit risk, and leaving currency risk for others.

I think over the next year we will see some great opportunities to put money to work in high yield, corporate high grade,mortgage-backed (MBS) and asset-backed (ABS), but now is not yet the time.

position in WMT

Walmart reports earnings this week - critical read of consumer

WalMart (WMT) reports earnings later this week, and unlike Exxon-Mobil which some people think is the key stock for this market given that XOM is the largest market cap name in the best performing sector of the past three years, I think WalMart is the key "tell" for this market, given its importance in deciphering the behavior of the US consumer.

Most people failed to notice that on the day that the Dow closed above 14,000 and the S&P 500 closed at 1,555, was the same day that WalMart announced June comp's that were 2% - 3% versus the less than 1% expected, which was a pleasant upside surprise that Thursday morning, July 14th (I think that was the date of the most recent highs.)

The point is that consumption is 2/3rd's of GDP, and WalMart accounts for 10% of all retail sales in a year, thus if mortgage worries and higher gas prices and consumer confidence were to impair the consumer to any great degree than the equity market is currently discounting, it would likely show up in WalMart's revenues, earnings, comp's and guidance.

My own personal opinion is that WalMart is a cheap stock: trading at 9(x) earnings for a mid-single-digit earnings grower, and just .5(x) 4q trailing sales (yes, WMT is trading at a market cap that is close to half of its 4q trailing sales) and just 11(x) cash flow from operations, with a AA-credit rating indicative of a solid balance sheet , I consider the stock to be a safe haven not only within retail but within the large-cap sector in general.

WMT as an investment is now the antithesis of what it was in the late 1990's: it is unloved, with few advocates on Wall Street pushing the stock, and it gets bashed with unrelenting frequency (and rather unjustifiably in my opinion) when the press needs a capitalist fall-guy to pick on for a story.

After reaching a high of $70 per share in late 1999, early 2000, the stock has traded as low as $40, but it has essentially been trapped in a 7 - 8 year trading range. Although we are currently long the stock and consider WMT a core position in our client portfolios, I am waiting for the stock to take out $50 per share on heavy volume, before we add to the name.

Current analyst consensus for this coming week's earnings report is $0.77 per share and $92.7 bl in revenues for year-over-year growth of 7% and 8.5% respectively, thus coming into this week's results, expectations are tempered.

One interesting aspect of WMT's fundamental story is the growing importance of the international operations to the core business: once just a single-digit percentage of revenues and operating income, WMT International is now higher than 20% of total revenues while international operating income as a percentage of WMT's total operating income gravitates above and below the 20% figure. (Frankly given that investors and strategists are falling all over themselves to have international in their portfolios, I thought WMT would have been afforded a higher multiple for its international growth, which has averaged between 10% and 30% the last five years (i.e. WMT's international operating income has varied between those two figures since the early 2000's.)

To conclude, WMT is a company that generates $350 bl in annual revenues, which is a truly remarkable figure when you come to think of it, and they have achieved this success by having one single mantra: be the low-price retailer to their customers, and they have managed to accomplish this by assembling a coordinating a logistics and distribution network that would put the US Army and National Guard to shame. (Rumor has it that just after Hurricane Katrina devastated New Orleans, WMT's trucks were the first to penetrate the devastation and get to their stores. Joe Nocera, who writes the main column for the New York Times business section Saturday edition once wrote that WMT could be the single biggest reason inflation remained contained during the 1990's.)

I don't know, nor want to speculate that this week's earnings report will push the stock higher, and above key technical levels, but WalMart will give us some good clues to the state of the US consumer, and how this mortgage crisis is impacting mainstream America.

position in WMT, XOM

Subprime mess: what the financial press might have missed

What has struck me about the recent decline in the financials relative to the subprime mess, and the comparisons to both the 1990 commercial real estate crunch and the October, 1998 Long-Term Capital mess is that credit cycle is different, and could very well be worse.

In the late 1980's and early 1990's our banking system was choked with bad commercial real estate loans sitting on bank and insurance company balance sheets as a result of the passive income tax loss deduction that was eliminated by then President Reagan in the 1986 Omnibus Budget Reconciliation Bill. Banks, insurance companies, brokerage houses and other financial intermediaries bought these illiquid commercial real estate mortgages and then watched as they went belly up, and put banks in particular in a bad capital position. (10% of all banks and S&L's were declared insolvent in 1988.)

However in the early 1990's, the RTC bailed out the banking system as did the new financial engineering tool known as securitization. Securitization was in its infancy in the late 1980's and the subsequent explosion of credit-cards, auto loans, home mortgages and any other asset that could be wrapped into a pool and dropped into a trust allowed financial institutions to rebuild capital. The positively sloped yield curve, the easing of monetary policy by then Chairman Greenspan from 1990 - 1993 and the rebuilding of consumer balance sheets all contributed to the regeneration of the banking and financial system, all of which helped as we moved therough the 1990's...

Now fast-forward to 1998: LongTerm Capital blows sky highs thanks to leverage and bad risk arb bets, and our capital markets seize up, as evidenced by Chairman Greenspan noting the difference in spread between on the run and off-the-run Treasuries that occurred in August and September, 1998. Chairman Greenspan reduced the fed funds rate in October, 1998 to take pressure off of the capital markets as he arranged a bailout by the then very healthy and well capitalized banking system. What exacerbated this seizing of the capital markets was that many brokerage firms had emulated or replicated the LongTerm Capital positions on their own balance sheets, thus you had many major Wall Street players leaning the same way as a global run on credit started.

The point being that in the early 1990's, the capital markets were the relief valve to rebuild and recapitalize the banking system, and the banking system was the relief valve or safety net for the capital markets during the 1998 LongTerm Capital crisis.

Today, with high yield spreads so tight and the private equity market choking, and now the banks hindered by rising single-family mortgage delinquencies both the capital markets and the banking system are hindered.

Even the consumer is feeling the pinch as mortgage refi's from the earlier part of this decade have flowed through spending already.

Still, our Thomson Financial market timing model (see earlier posts to this blog) rose to over 9% this past weekend thanks to the lower 10-year bond yield and the fact that forward 4-quarter earnings continue to rise. At just over 9%, the equity market timing model, particularly the S&P 500 looks very attractive relative to bond yields and earnings. The Thomson market timing model hit a high of 9.8% in October, 2005, and a low of 4% in the spring of 2000.

This credit cycle might not end until we get a bankruptcy or financial failure of enough size for the market and the Fed to take notice.

position in spy, S&P 500 index funds

Market timing: when do we get out

One of my favorite B-school professors (this prof taught Money & Banking and Bond Management, and did a great job at both) once said that "if it's good in theory and not in practice, well then it's not really good in theory, either", and after 12 years of managing money, and 20 years in the investment business, I have to agree with him.

In academic theory, at least in most textbooks, a student is taught not to "market-time" i.e. to move in and out of cash and stocks in order to maximize gains and minimize losses. In fact many studies have been done that have shown that if an investor misses, or is out of the market and in cash, just two of the best days of a rally off a major market bottom, then they may see their holding-period return cut almost in half.

A case can be made for both market-timing and not market-timing: however if there is one lesson we learned in the 2000 - 2003 bear market, it is that client's like "absolute return" in a down market, meaning they don't want declines in the stock or equity portions of their portfolios (which makes sense) but client's like relative returns in up markets, meaning that clients not only want to see gains, but better than benchmark gains, in good markets (and again, that makes sense.)

In other words, in order to be an effective money manager, you have to time the market in some form or fashion. You have to take gains for clients at some point, and cut losses at some point.

Since we are entering the 4th year of this bull market in equities since the March, 2003, market bottom, I needed to update clients on our thinking about market-timing and let clients know that we are using market-timing tools so as to not repeat the mistakes of the early 2000's:

1.) The first "market-timing" barometer we are using is the Thomson Financial Market Risk Premium (TMRP) calculation, updated every week, which is a combination or derivation of the Fed model, and quantifies in one number, whether stocks are "rich" or "cheap" relative to historical norms.

On Friday, May 25th, 2007, the TMRP showed that the S&P 500 has a risk premium of 8.6% (this is not technically an equity risk premium, but it is close, and I'd show clients the calculation, but I think you'd get lost in some of the math and the logic, and you'd lose the essence of the calculation ). The TMRP hit a high of 9.8% in October, 2005, and a low of 4% in March of 2000, thus as you can tell from Friday's reading, the TMRP "range" is much closer to the historical high showing that the S&P 500 is still relatively, attractively valued, versus the low in March of 2000 when the TMRP showed the S&P 500 historically overvalued. The TMRP is not a "precision" timing model, it gives a signal over time based on a number of factors, and it is more like an hourglass than an alarm bell.

2.) The second marketting tool we are using is Bob Brinker's monthly Markettimer newsletter. Bob Brinker is rated one of the top marketimers in the last 5 and 10 year time periods per the Hulbert Financial newsletter tracking service. When Bob says get out, we'll get out (with a caveat to be discussed below) and we'll do it quickly, particularly if the Markettimer market call coincides with the TMRP signal, and without regard for capital gains (unless a client specifically asks us not to sell). Bob Brinker is currently bullish on the state of this cyclical bull market, primarily due to the high pessimism seen in the 60-day put-call ratio, and the relatively low P/E ratio for the S&P 500 relative to previous market tops. The put-call ratio is currently skewed to a high number of puts versus calls as investors look for downside protection.

Finally, just because the market gives a sell-signal doesn't mean that we need to get out of equity or sectors, or individual stocks entirely. In 2000, housing and homebuilding sectors, and gold and precious metals started to break out of long-term technical consolidations, thus it could warrant some equity exposure in long-out-of-favor groups, should the market start to roll over.

My guess is that if and when this bull market peters out, we will likely first sell the current leadership groups like energy, like commodities and utilities and telecom (since these sectors will have the most downside risk) and we will likely see the old growth babies of the 1990's, like GE, like AIG, and large-cap tech and financials, possibly become the "safe-havens" of the next bear market.

Right now though, it is too early too tell what the next bear market might look like, and we are staying invested in a combination of sector ETF's and individual stocks. Higher interest rates, particularly the 10-year Treasury yield, will push that TMRP lower, thus I do believe that higher rates and slower earnings are the biggest threat to this current bull market.

If clients want to see the actual TMRP calculation, let me know.

To conclude, we are using the "belt and suspenders" methodology in terms of market-timing.
One sell signal will be a yellow light, and we'll alert clients accordingly and two sell signals - one from each service - will result in a major shift in our holdings for clients.


position in S&P 500 index funds, SPY, ETF's, GE, AIG

Avoiding China, Russell 2000, and REIT's

Michael Santoli's editorial column this weekend (within Barron's) was right on target in my opinion, as China has now become to the decade of the 2000's, what Japan was to the 1980's, i.e. the hot market, the economic model to be worshipped and the "it" economy, kind of the Paris Hilton of global economies, and you really can understand why when the latest "reported" GDP growth for q1 '07 for China was north of 10%.

Michael Santoli talked about the P/E multiple of the Shanghai Stock Exchange being "50(x) earnings" which one could deem as an expensive valuation, but my thought when I read that was "what constitutes earnings" ? Throughout my career when I've heard analysts or portfolio managers or whoever talk about the valuation of a foreign stock or foreign market, you don't often hear them talk about the quality of those earnings.

Because of the global economy, the world seems to be moving towards a uniform set of accounting standards, which would leave companies from different countries with a more uniform set of financial statements for analysis. In fact if we dissected China's corporate earnings, we could find the Shanghai trading at 100(x) earnings or 20(x). (I'll let you guess which valuation is more likely.) Most people, if you listen solely to the news, probbaly have forgotten that China is still a Communist country, and although unlikely, could still wake up one day and see that the government has "appropriated or nationalized" the country's asset base. (The risk is small, but it is there, or maybe some derivation thereof...)

For present clients, we are staying away from international in general, and China in particular for the time being, given the enormous popularity of investing "internationally" and given that if China should crack, there is a high likelihood of a contagion effect throughout Southeast Asia. According to one source, over 90% of all mutual fund inflows in 2006 (can't remember if it was an Investor's Business Daily article, or an IBD article referencing a Citigroup research piece where we read the statistic) went into "international" funds, and we'd love to own this asset class, just not now.

Regarding the Russell 2000, small-caps have outperformed large-caps, particularly the S&P 500 for 6 - 7 years running, and the valuation of the Russell 2000 is almost twice that of the S&P 500, interms of the P/E ratio.

Tony Dwyer, the equity strategist at FTN Midwest and a frequent CNBC contributor, e-mailed me some data on Friday showing that the Russell 2000's P/E is 28(x) trailing earnings for 15% y/y growth, or almost 2(x) PEG. In and of themseleves these statistics aren't bad, but when compared to the S&P 500's 16(x) forward eps for what has been quarterly growth of 10% - 15% year-over-year year earnings since the March, 2003 bottom, you can quickly see that the S&P 500 is more attractively valued than the R2K, and the S&P 100 (or the top 100 stocks in the S&P 500) is even cheaper than the entire index. (In April, '07, the S&P 500 rose 4.43% while the Russell 2000 increased just +1.80%; I don't know or want to say that that is a trend, just the amount of underpeformance was surprising. You would think - at some point - that large-caps would "mean-revert" and start to outperform small-caps.)

Finally, although we have recently bought the XHB (homebuilder's ETF) for some client accounts, we are staying away from REIT's in their entirety, although commercial property REIT's still seem to have a decent valuation given the strength of corporate cash flow.

We'd love to own all these groups once again, particularly international via Oak Mark's David Herro's International Fund, David being one of the best portfolio managers in the international asset class today, but I would prefer to wait until we get an inevitable currency disruption or exogenous event to take hot money out of these groups.

To conclude, we sold our Russell 2000 too early in 2004, 2005, and we sold our REIT's too early as well, and we continue to think that the S&P 500 remains relatively cheap, and unloved relative to the rest of the world.

long S&P 500 index funds, SPY

McDonald's: within a $1 of all-time high

Technically, you could say that MCD's is ready to break-out to an all-time high, or is putting in an 8-year double-top (a technical term meaning that a long-term topping formation is being put in place) for the king of Big Mac's, but if we had to fall into one bucker or the other, we'd say that MCD's still has some room to run.

Since its previous peak at $49.56 in December, 1999, MCD's fell all the way to $12 per share in mid-March, 2003, and then finding a bottom with the rest of the stock market at that point, MCD's has climbed steadily higher to its current price of $48 and change, however the stock price appreciation isn't all market related.

MCD's grew earnings between 4% and 12% in the last half of the 1990's which paled in comparison to the technology sector's 40% growth year-in-and-year-out at that point in time, so if I had to guess, I'd say that most of the MCD's stock price performance was attributable to its "large-cap growth" moniker of that period since operationally MCD's didn't do all that well. (We owned the stock at one point between 1997 - 1999 until we heard that MCD's had a "Bun Committee" of 12 people which was responsible for all facets of hamburger bun operations, and right away GM and IBM came to mind in terms of corporate sloth. The stock was sold the next day.)

Now the fact that we avoided the name in the 1990's and the early 2000's and then started buying MCD's right around March, April, 2003 had to be one of our better decisions as a firm to date, but what got us interested in MCD's was the fact that in early 2003, with the stock trading near $15, the stock was approaching the real estate liquidation value, and thus represented a low risk entry point.

However, the key to the MCD's story since eraly 2003 has been cash flow: pure, unadulterated, unmitigated cash and free-cash-flow generation along with improved operations.

In the last 4 years, MCD's annual dividend has increased from $0.40 to $0.55 to $0.67 to 2006's $1 per share and the 4q trailing cash flow from operations has increased from $3 to $5 bl in the last three years. The dividend yield has remained fairly constant at between 1% - 2% since 2003, as the stock price appreciation has kept pace with the dividend growth.

Free-cash-flow, or the FCF "yield" ( 4q trailing free-cash-flow as a percentage of 4q trailing revenues) has ranged from between 6% - 10% in the last 16 quarters or 4 years, much of which has been returned to shareholders in the form of stock repurchases and the aforementioned higher dividends.

ROIC or return-on-invested capital has increased from a low of 7% in mid 2003, to the current ROIC of 14%.

So what does the future hold ? With 30,000 stores currently a lot of MCD's store expansion is behind it, but this also is one of the reasons MCD's is generating so much cash flow: it is now a mature grower, and a cash cow of sorts, but through the "designated licensee" (DL) program, MCD's is trying to reconfigure ownership and the balance of franchisee's to company owned stores, and thus continues to unlock more value, and generate more excess cash.

More importantly, MCD's is improving operations: per our internal spreadsheet, the March '07 comp of 9.7% was the best systemwide sales comp for MCD's since December of 2004, and Europe's March '07 comp of 11.2% was one of the best ever for that region. (In MCD's 2006 annual report, on page 25, management states that a 1% increase in European comp's "would increase annual net income per share by about $0.02 (two cents).)

Bottom line: MCD's stock options are subsiding, thus the share repurchase program will be more accretive to shareholders, the turnaround in operations is a huge positive, and the very strong cash-flow and free-cash-flow generation will keep a floor under the stock. Since 2003, MCD's has grown earnings per share, 35%, 6%, and 20% respectively with the lumpiness due to the amount of cash being distributed and thus used for share repurchases. Current First Call eps estimates have MCD's growing earnings in the high single digits in the next three years, which, given the operational turnaround, could be conservative.

MCD's is trading at 13(x) Enterprise value to 4q trailing cash flow (hardly expensive), and is a perfect candidate for P/E expansion in a market totally vacant of such phenomena.

A move above $50 (and thus through formidable resisitance) for MCD's on good volume, and the hamburger king could run for a while.

position in MCD

GE reports Friday, 4/13/07

Friday the 13th has never been associated with good luck in any form or fashion, and yet GE is prepared to report q1 '07 earnings before the bell. Current Thomson Financial / First Call consensus is looking for $0.44 in earnings per share and $39.795 bl in revenues for year-over-year growth of 13% and 5.2% respectively.

Although typically followed byWall Street industrial analysts, a big part of GE's operating income comes from GE Capital or the financial services arm, thus you really have a two-part company: GE Capital and GE Industrial, the industrial arm which accounts for about 2/3rd's of cash flow and generates about $1 in free-cash-flow for every $2 in cash generated from operations.

With a AAA-rating (credit rating), a 3% annual dividend (and plenty of room to grow) a strong stable of global businesses spread across multi-sectors and probably the best management team in industrial and financial America, you really have to wonder why the stock has been an absolute dead-fish the last two years since it closed around $36 in December, 2004.

Here is my issue with continuing to hold the stock in client portfolios: a note out of Goldman Sachs shortly after the February 26th meltdown in Shanghai and US markets noted that GE fell 8% during the market drop lasting from late February into mid-March: if the stock goes nowhere in 2006 with the S&P 500 up 15% in that year, then goes down 8% in a market swoon, that is very poor risk-reward from a performance standpoint. (In 2006, GE returned about 6% before the dividend, versus the S&P 500's 15%. For whatever reason quality growth stocks are seeing no P/E expansion, even in good markets.)

From a valuation standpoint, there is little not to like about GE: at $36 per share, and with the current '07 estimate of $2.22 per share, GE is trading at 16(x) forward earnings, for what should be an easy 10% grower through any kind of economy. In addition, the substantial cash-flow you'd expect with a AAA-rated company, leaves GE trading at about 12(x) enterprise value to 4q trailing cash from operations, which is hardly expensive today. GE's WMC Mortgage business could be an issue this quarter since GE is liable on subprime defaults within 90 days of securitization (according to a CIBC World Markets research report) , and WMC generated almost $100 ml to GE's bottom line in '06, but again, with GE's various businesses you expect these hiccups to occur (i.e. the downside of diversification) and be offset with strength in other businesses.

Bottom line: as much as I like the company, the cash-flow and the management, the stock has been a drag on performance. I feel for Jeff Immelt: Jack Welch got the benefit of a 20 year bull market and P/E expansion, whereas Jeff Immelt has seen nothing but P/E contraction and a market very unsympathetic to large-cap growth stocks in general.

There is an old saying: "amateurs hope while professionals work" so we have to see some possible catalyst for GE in Friday's report or we have to think hard about continuing to hold a perennial underperformer.

Position in GE, GS

Washington Mutual - interesting statistic

Jim Cramer, the founder of TheStreet.com, and CNBC Mad Money guru, had an interesting piece on Washington Mutual this afternoon, with Jim in fact playing the stock the exact same we are: Jim is waiting to see what q1 '07 earnings look like.

However, CreditSights, a Wall Street fixed-income research firm which does great research (better than a lot of equity analysis in my opinion) wrote a piece on WM when the subprime issue broke in late February saiying that WM has as much as 15% risk to eps from subprime, which is less than I thought, and likely leaves the dividend intact (in my opinion).

Another interesting stat on WM: Oakmark Select, one of the family of Oakmark funds run by Harris Associates here in Chicago had a 15% position in WM stock as 2/28/07, per the recent Morningstar data sheet that Morningstar publishes monthly on many mutual funds.

Bill Nygren, a brilliant value investor, and the lead manager of Harris Associates Oakmark Fund has been bulling Washington Mutual since 1997, saying that the stock is worth between $70 - $80 on a takeout by a larger bank. (Oakmark and Harris Associates are classic value investors, along the Warren Buffett line.) Along with the Oakmark's Select's 15% position in WM, WM holds the #2 position in Nygren's fund with a 2.54% position as of 2/28/07.

At $40 per share, WM is yielding over 5% with the annual dividend better than $2 per share.

The thing is, the subprime blowback might be the catalyst to finally motivate WM to sell out, and realize some of this undervaluation. Investors have been waiting for years for the thrift to get taken out.

Technically, WM is getting oversold on the weekly chart, as it tests its 200-week moving average near $40.91.

position in WM

Micron reports Wed, 4/4/07 - one last chance

In an earlier March post to this blog, I wondered if the semiconductor stocks had become the steel stocks of the 1980's and 1990's: over-owned, overvalued, with over-capacity and the prospects of underperformance for as far as the eye can see.

With Micron Technology as the poster child for this group (I would classify MU as the most speculative play in the semi sector with very low returns on capital (if at all) and a very high degree of operating leverage with little sustainable competitive advantage) Wednesday night's report will go a long way in determining if MU is worth hanging on to in client accounts, and if there is any prospect for a DRAM ramp as a result of the Vista launch.

MU is expected to report breakeven earnings per share on Wednesday night, with $1.46 bl expected in revenues (per the First call data) versus a loss of $0.04 last year, and revenues of $1.225 bl.

Not all is lost with MU as gross margin has expanded the last three quarters and at least there is the prospect for a profit this quarter. The company diversified away from DRAM into NAND flash almost two year ago, with the last few quarter's results actually being hurt a little bit by NAND flash memory price declines, while DRAM pricing was holding in pretty well. At least in the 1990's, the key to MU was to buy the stock when the DRAM spot prices rallied and in fact when flash memory prices rose above their 200 day moving average. With the collapse of the technology market starting in 2000, MU looked for ways to diversify away from DRAM and ventured into the NAND flash market, which I think in fact will serve them well in coming years, but the company is still levered to the spot/contract pricing in both volatile markets.

Earnings estimates for fiscal '07 have come down from just over $1 per share in November '05 to the current estimate of $0.37 for the current fiscal year eps estimate. The additional memory which Vista will require was expected to have a positive impact on MU by now, although it has yet to materialize, but a couple analysts expect DRAM memory prices to bottom in the May '07 quarter.

The balance sheet for MU has actually improved since semi's collapsed earlier this decade, as the company had $3.36 per share in cash sitting on the balance sheet as of the November quarter, and had generated $2.57 in 4q trailing cash from operations, which left the stock trading at just 5(x) enterprise value to 4q trailing cash from ops.

Still, the company is burning off tax-loss carry-forwards from the massive operating losses in 2001, 2002, 2003, thus the returns on invested capital of 1% - 2% are simply a matter of there being no taxes paid. (A hedge fund manager once described MU as "an airline with a fab attached", which is investment speak for an operation that destroys capital, much like the airlines do.)

The technicals (see the monthly chart above, compliments of Telechart and www.worden.com which is our technical analysis service) have actually improved on MU of late, as the stock has attracted some interest trading near trough valuations, and just over 1(x) book value, thus at these price levels (you would think) there is very little risk to the stock. In fact, the big green volume bar indicates that the stock has seen its heaviest volume ever in 2007, which may be buying in advance of a Vista upgrade cycle.

So why own the stock with all the negatives surrounding the name ? Simply because MU is a levered play on the launch of Vista and the additional memory it would require, as well as a commodity play on the NAND flash business. Although it is unlikely that we will see a repeat of the late 1990's, there is significan leverage to MU's operations when DRAM and NAND flash prices steadily rise, as in the 1990's, eps went from a loss of $0.55 per share in fiscal 1998 to a positive $2.20 per share in 2000.

We recently added to the stock prior to the Fed meeting, and are hoping it can re-take its 200 month moving around $15 - $16 per share. If the stock can break through the $15 - $16 area on good volume, and re-take that critical support levels, MU could be a significant outperformer in 2007.

Are semi stocks the steel stocks of the 1980's and 1990's ? With the rapid speed of the tech life cycle and rapid obsolescence, winners and losers are created over much shorter time horizons than the basic industries of the previous generation. Still, we won't wait forever. MU has the possibility of a brighter future and the valuation is cheap, not without qualifiers, but we'll

give it a little more time.

position in MU, SMH

Walgreen's - good March '07 and spectacular q2 '07

Walgreen's reported March '07 comp's this morning that were in line with expectations, and told investors that due to the calendar location of the Easter weekend, April '07 comp's will be combined with March '07 comp's (as was done last year) to get a true reading of the two month activity.

In March, '07, WAG's same store comp's rose 8%, while prescription comp's rose 8.8% and front-end comp's increased 5.6%. There has been some slowing in the monthly data for Walgreen's, but not dramatically so, as the retail drug store group continues to have the best comp's in all of retail, month-in and month-out, and WAG continues to take market share from competitors.

Still, it is hard to put too positive a spin on WAG's 2q earnings reported last week: year-over-year (y/y) revenues rose 15%, eps rose 26%, and operating income rose 36% (albeit against the weakest quarter of '05) as the gross margin expanded 124 bp's to 29.68%, the operating margin expanded 129 bp's to 8.04%, and the net profit margin expanded 37 bp's to 4.68%.

WAG continues to get expense and SG&A leverage out of their formidable business model, as WAG has not had one single quarter of less than dounble-digit sales growth since 1998.

While most analysts note WAG's forward P/E of 23(x) the current '07 estimate of $2.07, WAG is cheaper on a cash-flow basis, trading at just 17(x) 4q trailing cash from operations, as the company has ended the last two quarters with free-cash-flow on a 4q trailing basis of $1 bl or more, the first time that has happened since we began tracking the company in 1995. As of the February '07 quarter, WAG was generating $2.78 in four-quarter trailing cash flow per share, about 150% higher than net income, and a good litmus test for earnings quality (i.e. cash flow as a percentage of net income).

One of the bigger internal improvments WAG has made in the past few years has been working capital, as their working capital efficiency through most of the 1990's and early 2000's was in fact pretty poor. Today however, even with continued store growth, and just 50% through their ultimate store build-out of 11,500 stores, WAG is generating free-cash-flow that is very healthy, which will hopefully continue.

Bottom line: trading at less than 1(x) 4q trailing sales, and 23(x) forward earnings for recent eps growth of 26%, and 17(x) 4q trailing cash flow (enterprise value) you would think that WAG would be a table pounding buy by most of Wall Street, but analysts look at the stock price action and the two year trading range between $40 - $50 and the horrid P/E compression, and think "I'd better stay away until the stock breaks out".

Fundamentally the stock is a great value here, and technically it looks pretty good too, as the next upward thrust should take WAG over the September '06 high of $52 per share.

Could the stock price be discounting a new business model in the form of CVS/Caremark ? Absolutely. Could the lagging stock price be forecasting as yet unseen changes down the road in insurance co-pay's (the biggest risk to WAG's business model) ? Sure, absolutely. The stock price could be discounting any number of untoward events or circumstances including the current complete disgust for large-cap growth stocks (the most likely reason), but that is the challenge in investing.

We do our homework, do the bottoms-up analysis, read what the anlaysts are saying, follow the charts and technicals and stay with the quality growth businesses, and we continue to believe that WAG is one of the best.

position in WAG

Utilities - best performing sector in q1 '07

The Dow Jones Utilities had another strong day today, recovering from the end of quarter drubbing last Friday, and finishing firmly in the green on good volume today.

The Utilities (i.e. the UTE's) were the best performing sector in a very bad q1 '07, up 8.44% according to one Reuters story published over the weekend.

There are a couple of ways using ETF's you can play the Utility sector, which is a relatively small part of the S&P 500 at 3% of the earnings weight and 3% of the S&P 500's market cap: The XLU is the Spyder ETF, of which the three largest holdings comprise 24% of the ETF, and they are Exelon at 10% of the XLU ETF, TXU at 7% and Dominion Resources at 7%.

Another way to get exposure to utilities is via the UTH, or Merrill's HOLDR's ETF: the three largest holdings comprise 35% of the UTH, and they are Exelon at 15%, TXU at 12% and Southern Company at 8%.

UTH may be a little more volatile than the XLU since TXU has a bigger weighting, particularly if there winds up to be a bidding war in TXU with the private equity buyout, similar to what happened to Equity Office Property. Both the XLU and the UTH charts look pretty good, but with TXU having a bigger weighting in the UTH, it may be a a little spicier play if there is a shooting war for TXU.

Currently, we have a position only in the XLU within client accounts. Today, the XLU closed above the $40.30 high print for the XLU on 2/26/07, and it closed above the 2/26 high on very good volume of 5.1 shares.

Once again q1 '07 has started out with Utilities and Basic Materials as the top two performing sectors year-to-date, just like last year, and yet these two sectors together comprise just 6% of the S&P 500 by market cap and earnings weight.

(Our chart is complements of Telechart i.e. Worden Technical Analaysis at www.worden.com. )

Generational bull (and bear) markets: growth has become value

A conversation I had on Monday with a hedge fund manager friend about US Steel (ticker - X) and its electrifying run off the March '03 low, also got me thinking about a conversation I had with the regional manager of the Florida office of a mutual fund firm I worked at in the early 1990's here in Chicago.

Despite the great markets of the 1980's and 1990's, the firm at which I was employed managed to have the wrong business model and ended up with a disparate mix of institutional and retail parts to the firm, some of which included regional portfolio managers for individuals, much like a brokerage firm. Management knew at some point that I wanted to move up from being a fixed-income analyst to a portfolio manager, either for individual separate account money or for a fund, and this regional manager was looking for a "portfolio management type" individual.

Our one and only phone call concluded by him saying, "Brian, I like everything about you (i.e. background, education, experience, etc.) but there is one major problem: you don't have grey hair, because you'll be calling on blue hairs." His point was that he couldn't have a portfolio manager in his early 30's talking to 60 - 70 year old clients about their money, and I couldn't disagree with him. (It wasn't an issue since I didn't want to relocate out of Chicago anyway.)

Ok, now let's return to US Steel, one of the great dog's of the 1990's: after a restructuring of X led to a re-capitalization (I am guessing) in 1991, in May of 1993, X peaked at $46 per share, and then managed to meander lower for the ensuing 10 years, bottoming at $9 per share in March, 2003, at the same time the S&P 500 rose from 445 in May of 1993, to a peak of 1,550 in March 2000 and then a low of 775 in March '03.

So what's the point to all this ? Why the belabored discussion of US Steel relative to the S&P 500, etc. etc. ? (The alternative title to this piece was going to be "Have semiconductor stocks become the auto and steel stocks of the 1980's and 1990's ?" )

The point is that the market leadership of the post 2000 bear market is now exactly what didn't do well in the 1980's and 1990's particularly energy, utilities, basic materials and other "one-off" sectors.

The top three performing sectors in 2006 were telecom, which rose 32%, energy which rose 23% and utilities and basic materials, each which rose 16% - 17%. These three sectors represent about 10% of the S&P 500 by earnings weight and market cap. Granted telecom shouldn't be a stretch for those that managed money in the 1990's, but again as of last Friday, March 16th, the best performing sectors within the S&P 500 were basic materials +7%, utilities +5%, and telecom +2%.

In 2006, the two WORST performing sectors were technology which rose only 8% in '06 and healthcare (of all things, given healthcare inflation) which rose only 6% in 2006.

Only financials had a decent year in 2006, rising 17% after the Fed stopped raising rates.

Again, my point to all this is that having graduated from college in 1982 and basically coming of age with the great stock market boom that ran from 1982 - 2000, I was always taught that financials and technology lead every bull market, and within technology, semiconductors lead tech. (Semiconductors and homebuilders were the worst performing sub-sectors of the S&P 500 in 2006: very unusual for semi's anyway when the S&P 500 was up 15% in the calendar year. )

While at the mutual fund firm referenced in the first paragraph, I was fortunate to befriend some of the old-time equity portfolio managers who were kind enough to give me the time of day and share their expertise with me. The thing was, some of these guys were so old they had managed money in the late 1960's and early 1970's and they were intimidated by technology: one grey-beard even said to me when I asked him about Intel and Microsoft, that "I don't understand the stuff, and if Buffett doesn't want any part of it neither do I."

When I heard Bill Miller the famed head of Legg Mason's flagship mutual fund, say in 2006 when talking about his underperformance that the long-run returns on invested capital for these commodity type companies are below average, (thus, like a lot of growth managers Bill was explaining his underperformance) I couldn't disagree with him, but I also thought, what if that is different now ? What if the steel and gold and copper and industrial stocks now have better returns on invested capital for extended periods of time and the Intel's and Micron's and the Microsoft's of the world are the dogs of the next ten years ?

Has the underinvestment in the 1980's and 1990's in energy, utilities, basic materials and industrials, and the explosion of technology and financials during the 1980's and 1990's now led to a prolonged period of outperformance for these sectors, and will semiconductors now suffer the same fate as steel and energy stocks in the 1990's with overcapacity, and prolonged periods of weak pricing ?

The bottom line is I just don't know, but our client's portfolios now include utility stocks, basic materials and some telecom, although I think energy has a little more downside to work off.

If I would have gone to my clients in the spring of 2000 and said let's sell all the technology, financial and all the classic growth stocks, and let's buy precious metals, basic materials (and let's put 5% of client money into US Steel which has fallen from $46 to $20), utilities, and industrials, the mob outside my office would have been reminiscent of the pitchfork and torch-bearing villagers from the movie "Frankenstein" and yet it would have been the exact right thing for me to do.

The growth stocks of the 1990's have now become the value stocks of 2006 - 2007, and a lot of young turks running hedge funds now know a market only where tech is dead, and commodities rule, and I'm still stumped by the fact that in a year when the S&P 500 returned 15%, so many quality growth companies did so poorly. Since the March 2003 low, US Steel has been a "10-bagger" rising from $9 to $90 per share, and I still can't see buying it for clients.

long most mentioned except US Steel

CME/BOT/ICE - the edge still rests with CME

CME just issued a press release saying that they will talk with CBOT management and seatholders on Thursday, March 22nd, after they update the press, CME shareholders and analysts in a series of conference calls scheduled for Thursday morning, where they will make their case for their acquisition of BOT.

My own personal opinion is that CME still retains the edge over ICE as the eventual acquirer of BOT, since in an interview with Maria Bartiromo of CNBC last week on the day that ICE announced its offer for BOT, ICE's CEO Jeff Sprecher said that the clearing operation will be split between ICE and the BOT 50% / 50%.

As I wrote in an earlier post to this blog last week, the clearing function and operation is a huge but rather silent or hidden aspect of this deal, and CME has the low-cost clearing operation, (which in fact could be a regulatory hurdle for the CME by Justice) so when Mr. Sprecher announced that the clearing would be split 50% / 50%, my first thought was "well, does BOT re-acquire the clearing function that they sold to CME in 2005, or does CME continue to clear for BOT's 50% stake ?"

Before the BOT went public in late 2005, they sold their clearing operation to CME, since CME was the low-cost clearing operation, and although this is strictly my opinion, my guess is that BOT management knew that eventually they would be acquired by the CME, since the CME tried to buy the BOT before the BOT IPO. Thus the BOT shed the clearing operation to cut overhead, and did the romantic equivalent of starting to move their furniture into their potential mate's apartment.

I can see why Justice might have an issue with the CME - BOT acquisition since the combination will control (from one graph I've seen) at least 60% - 70% of all futures volume, and in addition, with the CME's low-cost clearing operation, the combination will have Buffett would call a formidable "strategic competitive advantage" but one where - given the low-cost approach, and the depth and breadth of product offerings, the customer is certainly not disadvantaged (it would appear).

Finally, ICE is a pure-electronic exchange, and supposedly they have shut down open outcry trading at the NYBOT, which was the brick-and-mortar exchange they acquired last year. That in and of itself isn't a negative, since open outcry will and has diminished in importance since the growth in electronic trading has taken off, but open-outcry will never fully go away in my opinion, since when system interruptions occur as happened at the Chicago Board of Trade (BOT) last year, all that order flow was executed via open outcry in the pits.

The point being that open outcry traders that want a place to ply their living might be a little more inclined to prefer the CME than the ICE, given the treatment of open outcry, but this is likely the least important of all the reasons being considered.

To conclude, CME has long been a leader and innovator in the futures business, and those who have lived in Chicago and been in the financial business know the CME under Leo Melamed, took the lead from the CBOT in the 1980's and 1990's by getting into foreign currencies and euro-dollars and other innovative and risk-managing tools for the investor and trader. I don't think CME would have approached the BOT with the acquisition offer if they didn't have some reasonably good probability of clearing the regulatory hurdles.

Although the ICE offer is intriguing I still think the BOT marries CME, and perhaps gets a slightly higher offer from the CME (which the CME can afford to do, either in cash or stock) given the formidable product offerings (eurodollars, forex, S&P 500 contracts from the CME, Treasuries, grains and now metals from the BOT) and the low-cost clearing operation at the CME.

This is an educated guess, but I would still bet that CME wins BOT's hand at the end of the day.

Either way, it will be interesting.

long CME, S&P 500 index funds

Walgreens - perfect example of P/E compression

Walgreen's (WAG) is higher today on heavier volume for the 3rd day in a row, without any visible catalyst.

From the attached weekly chart (compliments of our technical charting service, the Worden Bros at www.worden.com), you can see that WAG has been stuck in a trading range for the last two years between $40 on the low end and $50 on the high end.

One of the hallmarks of the bull market since 2003 has been the leaderhip in non-traditional groups like energy, commodities and utilities, while growth stocks have seen formidable P/E compression, of which WAG is a perfect example.

In the year 2000, WAG had eps of $0.74 and peaked at $45.29 per share in March 2001, thus at that time WAG was sporting a p/e of about 60(x) earnings. Granted the stock was a tad overvalued at that point, but today WAG sports a p/e of 23(x) earnings on the $2.02 consensus eps estimate expected for '07, and what I find even more remarkable is that between 2000 and 2007, the lowest rate of earnings growth WAG saw in a year was 13%.

WAG is getting no valuation premium AT ALL for a stable, consistent, year-in-and-year-out 15% grower.

On a cash-flow basis WAG is even cheaper, trading at 17(x) 4q trailing cash from ops per share and is currently generating about $1 per share in 4q trailing free-cash-flow.

I don't have a good answer on why WAG isn't getting any upside benefit, even with the stable, consistent growth rate.

long WAG

Lehman: the issue may not be solely subprime

Technically, Lehman hit a new high last spring between $77 - $78 per share in May '06, and then, with the rest of the market, suffered through the summer months and bottomed at $58 in June, only to trade back toward its old high in the high $70's towards the end of the year.

After breaking out again in January, and trading as high as $85, the stock has since collapsed and is back in the 2006 trading range and is trading around its 200-day moving average near $73 - $74 per share, (and 200-week moving average too) supposedly on subprime mortgage worries.

I'm a big believer that technicals precede fundamentals and are the early warning system that allows a small investor to track the big dogs, and in the case of Lehman, the poor trading is indicative of something besides the subprime brush that is painting most of Wall Street red these days.

To wit, we track "forward 4q earnings estimates" for every company we follow on our proprietary spreadsheets, and for Lehman here is how the last 8 quarters have progressed:

q1 '07 - $7.41 - 20% y/y growth

q4 '06 - $7.20 - 30% y/y growth

q3 '06 - $6.85 - 35% y/y growth

q2 '06 - $6.45 - 49% y/y growth

q1 '06 - $6.16 - 45% y/y growth

q4 '05 - $5.53 - 45% y/y growth

q3 '05 - $5.09 - 41% y/y growth

q2 '05 - $4.33 - 26% y/y growth

Since the peak in late '05, early 2006, well before the subprime problems, LEH has seen analysts factor in lower forward growth estimates, and LEH has been beating earnings by less upside surprise, and the problem is in their investment banking division, particularly their profit margins within investment banking.

Since peaking in August '05 (fiscal third quarter of '05) at 24% of total pre-tax profits, LEH's investment banking pre-tax profit margin has shrunk to just 9% of total pre-tax dollars with this latest quarter ended Feb '07, even though investment banking net revenues have remained fairly constant at between 18% - 20% of total Lehman net revenues and the problem has not been fixed-income or M&A, but in equity underwriting, which has fallen to just 3% of total net revenues from its peak of 6% - 7% in August - November, 2005.

In Lehman's latest 10-K released in January, the company commented that Global Equity Finance revenues declined 1% y/y in fiscal '06 relative to '05 albeit against very tough comp's in '05, but also against a 35% increase in global equity origination market volumes.

The problem appears to be in Asia, and in particular with very tough comp's from very a few very large deals in 2005.

Is Lehman broken ? Hardly, in that with the latest quarter, equity sales and trading made up some of the equity investment banking decline, but at a lower margin. Lehman's total equity business varies from anywhere from 25% - 30% of LEH's total net revenues, so LEH whether they like to identify with it or not, is still 2/3rd's fixed-income related shop.

Actually my biggest worry about LEH looking out a few quarters is that with credit spreads at or near all-time tights, particularly within the high-grade and high-yield corporate bond sectors, their reliance on fixed-income might make the equity investment banking weakness pale in comparison.

To conclude, LEH remains a very well managed firm, with Mr. Fuld almost maniacal about controlling compensation expenses as a percentage of net revenues. For the last five quarter, "compensation / benefits as a percentage of net revenues" has been EXACTLY 49.3%, a fact I find fascinating to say the least.

Technically, LEH isn't broken but as forward eps growth gets lowered, even with a 10(x) p/e ratio, the stock may not make new all-time highs, unless and until the Fed cuts rates again. The attached weekly chart, compliments of our technical software provider, www.worden.com shows the stock testing its 200-week or roughly 4 year moving average this week, on the heaviest downside volume in many years. The 200-week moving average has provided support for the stock for some time, thus the fact that we remain above the trendline is still a positive.

To conclude, the stock is in a precarious position, but it isn't broken, and the earnings and revenue estimates are still getting revised higher, albeit at a slower growth rate. Goldman's earnings this week were a thing of beauty, thus that might be the brokerage stock of choice at this point, but we'll give LEH some time to see what transpires.

Long LEH, GS

CME: may win either way with BOT / ICE deal

It was a surprise to hear about ICE's offer for the Chicago Board of Trade this morning, but after thinking about it for a bit, I wondered if the CME wins either way, given they control the clearing for the Chicago Board of Trade.

Rick Santelli, one of the best financial reporters on television, and certainly the best at CNBC and conveniently located in the Treasury pits at the BOT, commented earlier this morning that BOT traders still think the best deal is with the CME, (which is understandable given the product breadth between the two exchanges) and the BOT traders likely know best. However the one aspect of the CME - BOT merger that hasn't been discussed publicly and may be the reason Justice asked for the 2nd review of the proposed merger, is the clearing corp. advantage that CME holds.

Long before the BOT went public, the CME took over the clearing operations for the BOT, given that the CME was the low-cost clearing operator and thus benefits from the volume at both exchanges, but the CME also got a look at BOT's operations at an intimate level.

If ICE wins in a hostile acquisition, as they have intimated they will fight if BOT turns them down, it isn't clear what will happen with the clearing, but if it stays with the CME, they still benefit (i.e. without the fees) from the volume between the merged entity in addition to what ICE might bring to the table.

It is difficult to really vet the clearing issue since the disclosure on these operations is minimal (although CME got into it a little bit in their '06 10-K) but you still have to think the advantage resides with the CME in any battle with ICE over the BOT both from the product breadth and the low-cost clearing operation standpoints.

In terms of whether CME might have to up their offer for the BOT, they certainly have the cash to do so, since for every dollar of cash generated from operations, about $0.50 falls to the free-cash-flow line for the CME. As of q4 '06, 4q trailing cash from operations for the CME was $472 ml, while free-cash-flow (after dividends) was almost $300 ml. The only other exchange we've modeled - the Nasdaq (ticker NDAQ) looks even better: $200 ml in cash from ops in '06 generated almost $180 ml in free-cash, so as you can see with the business models of these exchanges whereby higher trading volumes are being driven over a fixed-cost base, the free-cash-flow leverage is formidable.

Trading action and volume in the CME has been positive since the stock neared its 200-dma and filled the gap at $513 in February. CME's weakness here could present opportunity for the informed buyer, although headline risk and arbitrade activity may drive near-term trading action.

Long CME

Moody's (MCO) bottoming or broken ?

This morning, Goldman Sachs reported very solid results on top of very tough comp's from last year, thus I'd have to say the quarter was a winner, but we'll have more on GS's results later.

Another financial stock that has gotten pounded of late is Moody's (MCO), the credit-rating agency and a long-time holding of Warren Buffett. The above chart shows the heavy selling and the drop to the 200-day moving neighborhood for MCO, with the critical aspect of the chart being that the selling and heavy distribution looks to be ending, thus the stock should be set for a bounce.

MCO reported 4th quarter '06 earnings in early February '07 that were much stronger than expected, driven by the tailwinds of tight corporate credit spreads, heavy bond issuance as a result of low nominal interest rates, a Fed that took their foot off the brakes, and - in general - healthy corporate balance sheets. However what worries me about the above chart is the potential double-top formation in the low $70's which was the point of the May '06 and the Feb '07 high, and the heavy volume on the recent drop.

MCO is getting washed out but it bears watching. The chart is telling us that there is potential here for the stock to be broken.

Long GS, MCO

Goldman Sachs reports March13th: facing very tough comp's

Last week we said that Lehman Brothers (LEH) was going to kick off earnings season for the brokers, but in fact Goldman Sachs (GS) starts the Feb '07 quarter's reporting with the release before the bell tomorrow morning.

Wall Street analysts are looking for $4.72 per share from Goldman Sachs on Tuesday morning which amount to roughly a 1% year-over-year (y/y) decline in eps. The revenue estimate per Thomson First Call consensus is $10.692 bl or 4% y/y growth in revenues.

The real challenge to tomorrow morning's reports is that Goldman is facing whopping comparisons to last year's February quarter when the brokerage giant reported $10.34 bl in revenues versus a $7.5 bl estimate and $5.08 in eps versus a $3.29 estimate. The respective "upside surprises" for Goldman last Feb '06 was 41% and 54% for revenues and earnings respectively.

The last four year's Goldman's y/y growth in earnings per share (eps) has been 46%, 52%, 26% and 76% respectively, so with a p/e ratio of 10(x) - 12(x) earnings, an investor has (seemingly) gotten a lot more reward for the perceived risk assumed for Goldman's equity.

However, what few retail investors know or understand is the poor job most Wall Street's analysts do is forecasting their own business, and the volatility inherent in the business of Wall Street.

It is my own opinion but the majority of Wall Street analysts do a poor job forecasting results because of the opaque nature of the trading and investment banking firms. One trader or trading desk can be hugely profitable (or unprofitable) based on market conditions, and although the risk management functions have dramatically improved at Wall Street firms since the 1980's, the business still lacks transparency, which is just how Wall Street likes it.

Finally, while a lot of attention will be focused on the recent turmoil in the subprime market, I consider the real risk to the brokerage stocks to be widening credit spreads in the high grade and high yield corporate bond markets, since this will impact not only trading but fixed-income investment banking, and portends negatively for the equity market, if and when credit spreads widen. The subprime loan market is still just 5% of all outstanding bank loans, and likely a smaller percentage of the Wall Street firms available capital.

As of this posting, the high grade and high yield credit spreads indicate that there is no pressure being felt in the corporate bond markets.

Finally, by looking at a "weekly" chart of Goldman Sachs, the stock has closely tracked the 50 week moving average since the year 2000, thus there should be soild support for the stock near the $175 - $180 area, which is where the 200-day and 50-week moving averages converge.

This last equity market correction started on February 27th, or the second to last trading day of the quarter for the major brokers like Goldman and Lehman. That means they still had 89 of 90 days in the quarter with a market tailwind.

Latest correction - interesting stat from Lowry's

Lowry's on Demand is one of the oldest technical market research firms in the country, and they occasionally copy me on some of their research. Last week, Lowry's published a piece on the percentage of stocks trading above or below below their 10-day moving average, which had peaked in Feb '07 at 84.6%, and then - after the February 27th correction - fell to 3.77% on March 5th. In other words, at the peak in February, 84.6% of Lowry's stocks were trading above their 10-day moving average, but by March 5th, that percentage had fallen to 3.77%.

What was more interesting was to see the market action following such extremes when the 10-day moving average had fallen below 10% (all of this according to Lowry's research):

1.) In 78% of the cases datng back to 1990, the DJIA change two weeks later was +2.98%

2.) In 94% of the cases (18 in total) the DJIA had increased 8.9% within the following three months;

3.) In 94% of the cases the DJIA was up an average of 20.1% in the following twelve months;

Lowry's was the firm that made the call on March 12th, 2003 that we the major averages had likely put in a "significant bottom" in that month, and they made the right call. My only caveat with the above work is that the DJIA is not really "the market" although the Dow is representative of market action.

I thought it was interesting analysis therefore it is being passed on to readers and clients.

Long DIA and most major index ETF's

Brokers begin reporting week of March 12th

Lehman kicks off the brokerage reports Wednesday morning, March 14th and of the three brokerage stocks that we own for clients, Lehman looks the worst technically. If I were to rank our brokerage holdings from the best to worst in terms of how each respective stock looks from a technical analysis perspective, here is how the brokers would fall out:

1.) Goldman Sachs (GS) - in this latest drop from its high of $220 to the high $190's, Goldman never hit its 200-day exponential moving average and is still well above its 50 week moving average around $175. Volume was heavy on the way down but the stock doesn't appear to be under heavy distribution;

2.) Charles Schwab (SCHW) is our preferred discount broker and where we custody our client assets, and also happens to be a stock we like to hold in client accounts, given Schwab's asset-gathering prowess. SCHW is bouncing off its 200-day moving average although again the stock does not appear to be under heavy distribution, and given that it is a discount broker, and thus it doesn't bet its balance sheet on proprietary trading strategies as do the white-shoe firms like Goldman. Lehman, Bear, Morgan and Merrill, revenues and earnings are much less volatile than the major investment banks.

3.) Lehman Brothers - the stock fell on heavy volume beginning February 27th, and saw heavy distribution as it fell below its 200-day moving average, and this after it broke out of a one-year consolidation trading between $75 - $80 per share in January 2007. LEH is currently testing its 50 week moving average near $73 per share.

long GS, LEH, SCHW