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