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