Comments on Tuesday’s 416 Point Drop

I know, I know… I write a stock market blog and have gone more than 24 hours without mentioning the fact that we got a 400 point drop in the Dow in a single day. Since I’m a long term investor and not a trader, the events of this week really aren’t all that important to me. I really didn’t do much of anything on Tuesday other than just sit back and watch the television screen after it became apparent that something was happening that we don’t see every day.

So, why haven’t I been very active in the market this week, and what do I think about the whole thing? First, while four hundred points sounds like a lot, in the whole grand scheme of things, it isn’t. From peak to trough, intraday, we saw a 5% drop in the S&P 500 over three trading days, which is pretty substantial, I admit. However, if you use closing prices it was less than that, and if you include Wednesday’s snap back rally, it was even less than that. Currently, the S&P 500 sits 3.7% below the highs it made in February. To me, this is much to do about nothing. If we had gotten a 3.7& drop over the course of a month or two, few people would think anything of it.

Let’s take a step back and put the drop in perspective. I began to get a little cautious when the S&P 500 crossed 1,400 because I thought the market was overbought. However, it kept going up, rising another 4% within weeks. Even with this 3.7% “correction” (I’m hesitant to say that it is over) the S&P 500 is still above 1,400. So, I don’t really think this pullback has been big enough to warrant putting every cent of cash to work. We just haven’t retraced enough of the gains for me to be optimistic that the smoke has cleared, hence I am not all too enthused about the market’s short to intermediate term prospects.

If the sell-off continues, which I suspect it might, then I will likely do some buying. I’d say we would need another 3% to 5% downside from here for me to get to that point. If we instead rally right back up to the highs, then my same overbought worries will persist and I will likely take some money off of the table to save up for a rainy day, or the next 400 point fiasco.

To sum up, I really don’t think too much has changed despite this week’s events. The market is still up a lot and even with the pullback, I still don’t think we are going to see double digit returns this year. It would still take a more typical market correction for me to get aggressive on the long side, so right now I’m really just focusing on individual companies in this environment.

Market Winning Streak Reaches 8 Months

Readers of this blog know I have cautious on the market since the S&P 500 broke through the 1,400 level, but stock prices have continued to rise (about 3 percent more, in fact). January marked the eighth straight month of gains, the longest monthly winning streak in a decade.

Traders will likely try and play the momentum until it fades, but keep in mind that rallies like this are rare, and will end. The first quarter is typically a seasonally strong one, leading up to tax day in April when 2006 IRA contributions are due. The old saying “sell in May and go away” usually spells trouble for the market in the summer, before the historically strong fourth quarter begins.

I can’t tell you how many more months we will see gains for the U.S. market, but the streak will end, so just make sure you are not blind-sided when it does. It is very easy to get lulled into a false sense of security when things are going well, but they often will turn on a dime. We will see a pullback this year, and it will feel painful. Just be prepared for it, so you make rational decisions when the time for action is upon us.

CNBC: Stop Hyping Your New Web Site!

A few years back CNBC, in partnership with MSN and some investment companies, began promoting the “StockScouter” ranking system. The quantitative formula ranked stocks using a 1-10 scale on numerous criteria and investors could sort companies by their StockScouter ranking on the CNBC/MSN web site.

This was fine, except they took it a bit too far by mentioning the StockScouter ratings constantly on the air during CNBC broadcasts. After each executive interview they would tell you what StockScouter said about the company being profiled. Not only that, but when portfolio managers came on air recommending stocks, their opinions were followed by a comparison to StockScouter’s opinion, which often led to the awkward on-air moment when a top-rated fund manager was told by Sue Herrera that StockScouter rated their top holdings “a 2 out of 10.”

Fortunately the StockScouter was removed from CNBC airwaves eventually, probably due, in part, to the fact that it would give very high “safety” ratings to stocks like eBay (EBAY) and Yahoo! (YHOO) on a consistent basis, shares that clearly were not “safe” investments.

Well, it looks like CNBC is wasting viewers’ time again with the relaunch of “the new CNBC.com” web site. The site went live in recent weeks and at every moment they get, CNBC anchors try and convince viewers that the information on the site is somehow new and better than any other site out there. Among the earth-shattering innovations on the new CNBC.com; advanced charting, up-to-the-minute news items, and even… hold your breathe… a portfolio tracker!

They even have a special desk where anchors sit and guide viewers step by the step through the process of charting a stock, etc. I know CNBC has plenty of time to fill during the day, and obviously they want people to go to their web site. However, hyping their product offerings so much during the actual broadcasts, especially when it has little to do with the rest of their content, is extremely annoying. They really should just run a few commercial spots every hour to advertise the web site so people like me aren’t tempted to change channels when they do a segment of CNBC.com 101.

Does a Roller Shoe IPO Signal that this Market is Too Hot?

As you may have noticed, 2006 has been the year of the consumer IPO. Familiar and popular consumer brands have debuted on the public market to much fanfare. Names like Chipotle Mexican Grill (CMG), Crocs (CROX), Mastercard (MA), and UnderArmour (UARM) have all made investors a lot of money. Of that group, Crocs is really the only one that I looked at and said to myself, “Boy, that will be a great short when the fad dies and the stock’s momentum dies down.”

Well, that is until we learned that a roller shoe company called Heely’s (HLYS) was going public at $21 per share on Friday, putting the firm’s value at more than half a billion dollars. Shoes with wheels on them? Wall Street can’t be serious.

I am not saying the company isn’t selling a lot of shoes right now, and retail investors are going to bid the stock up a lot just like they did with Crocs as soon as it starts trading. That said, I can’t believe this company is going public. It must say something about the overly bullish stock market environment we find ourselves in right now.

While I won’t be buying any Heely’s shares, I hope they go through the roof. Maybe the company’s market value even hits a billion dollars or two when it’s all said and done. What an excellent short candidate that would make it.

Is Annual Guidance a Reasonable Expectation for Investors?

Regular readers of this blog are aware that I think public companies giving out quarterly earnings guidance is something that should be eliminated in order to ensure that management teams run their businesses for the long term, not with a goal of “hitting the quarter” any way possible.

It is also fairly unreasonable to expect a CFO to be able to predict whether certain expected revenue will be booked in June or July several months in advance. It can make all the difference in the world in trying to meet or exceed previously issued guidance on a three-month basis, but should investors really care if a big order is shipped on June 25th or July 5th? I tend to think not.

Fortunately, many companies have ceased issuing quarterly guidance. Some, however, are taking this practice a step further by halting annual guidance as well. I was listening in on the Affiliated Computer Services (ACS) quarterly conference call yesterday afternoon, and they announced that they will no longer provide revenue or earnings guidance on an annual basis. ACS’s 2007 fiscal year began in July, so investors looking to get some sort of idea of how the next year will shape up are at a loss.

So, this brings us to an important point. Should investors be upset if they aren’t provided annual guidance? I tend to say “yes.” Forecasting an entire year (without breaking it down by month, quarter, or even half) shouldn’t be as difficult and unproductive as issuing quarterly guidance. I don’t care if some business gets pushed into Q2 from Q1 at the last second, but I still want to have some idea of how 2007 is going to look compared with 2006.

If I don’t have any idea how fast a company will grow its earnings, how can I assign the stock a multiple that I think represents fair value? It makes life awfully difficult. Just give us a range of, say 5%, for forward annual growth. If ACS says 2007 growth in earnings will be 5%-10%, I have an idea of how much to pay for the stock. If I don’t know if growth is expected to be 0% or 15%, the fair value ranges I could come up with become so wide they are fairly useless.

 

So Far, So Good on the Earnings Front

We still have a lot of reports to come, but so far second quarter profit reports have once again come in very strong. Aside from the obvious, a fairly strong economy, I think there are two key reasons why we are seeing strong corporate results.

The first is clean corporate balance sheets. Public companies are flush with cash which gives them a lot of flexibility in managing their business. Excess cash has been used for acquisitions as well as share repurchases quite heavily in recent quarters. M&A can be very accretive if done right, and buyback programs can add a penny or two to the bottom line in any given quarter.

The second reason earnings have been so strong, in my opinion, is because managements have finally figured out that the key is to under-promise and over-deliver. This is true in any business, public or private. However, in the go-go days of the late 1990’s, stocks would only rise if the firms beat numbers and raised guidance every three months. CEOs had to be overly optimistic in everything they said in order to prop up their already richly valued stocks. As a result, expectations got way out of line and eventually the bar had to be ratcheted downward.

I think today is different. The trend has been to beat numbers and issue cautious guidance. This serves to hurt share prices right after results are released, but it brings expectations down for future quarters. Then, the company beats the reduced expectations the next quarter and again issues cautious guidance. The cycle simply repeats itself over and over again. Executives have finally figured out that hyping their company’s future prospects can end badly if they fail to deliver on the lofty promises.

Readers of this blog know that I’d prefer companies shun quarterly guidance completely. However, if they insist on giving out financial projections every three months, at least most are setting the bar low enough that they can at least hit, and often even surpass, their projections.

 

Will Earnings Help Alleviate the Geopolitical Selling?

Geopolitical concerns always spook the markets short term, but longer term investors most likely shouldn’t panic by making bold changes to their overall investment strategy. The situation overseas can change nearly overnight in some cases, and history shows that lost ground due to panic selling is often made up within several weeks or months.

After a nice rally off the June lows (around 1,225 on the S&P 500) it appears we will retest those lows, which would not be a bad thing. Rather than try and predict what will happen in the Middle East, I will instead be focusing on Q2 earnings reports. The three or four dozen companies I follow begin reporting on Monday. Recent stock price action suggests the numbers will be weak, but I am not convinced quite yet that will be the case, despite the negative reports thus far from the likes of Advanced Micro Devices, 3M, EMC, and Alcoa.

If we look back three months ago, I was pleasantly surprised by how well the companies I owned did. Stocks were mostly flat to slightly down after reporting profits in-line or above expectations. Several blowout quarters were rewarded nicely by the Street, and most importantly, there were only a handful of poor reports.

I don’t see a lot that has changed over the last few months, so my gut says that the reports won’t be as bad as stock prices are currently indicating. Of course, that doesn’t mean they will all pop to the upside if numbers are solid, but it would give me comfort in an otherwise tough market environment. In addition, there have to be at least some cases where stocks will react very well to decent reports, just because the shares were pricing in bad results.

If I am right and this earnings season turns in a fairly decent performance, hopefully the market will stabilize. Right now I have no reason to believe we are heading below the 1,200-1,225 range on the S&P 500, which is 1%-3% lower than current levels. The low end of that range represents an official 10% correction from the highs, and the high end signifies a successful retest and holding of the aforementioned June lows.

Heading into Earnings Season

This week marks the start to earnings season. Much will be made of the possibility for yet another quarter of double digit gains in profits for the second quarter. Still, I would not expect a meaningful market rally as these reports come in, even if we do end the quarter with 11 or 12 percent growth, which I think is likely. The bulls screaming that the market is cheap at 14 times forward earnings are overly optimistic, in my view.

First of all, you can only get a P/E of 13 or 14 if you use operating earnings, which is basically the number companies report after stripping out many various items that negatively impact earnings. If you use GAAP numbers, the S&P 500 is trading at 16 times this year’s estimates, and 15 times 2007 projections. That makes the market fairly valued, based on historical context, not cheap. With double digit profit growth in 2007 unlikely, you can see why I don’t think this market will soar to new highs anytime soon.

Okay, so how do investors play this market? I would focus on stocks that have below-average valuations and with whom you have a high level of confidence that they will at least hit, if not beat, their numbers. Such a strategy gives you the potential for either multiple expansion (which the S&P 500 will not provide) or earnings per share revisions to the upside (which can lead to share price gains even if multiples stay where they are). Obviously, the double play would be to get both.

Finding names that fit this description is not an easy task, but it’s really the only way to make good money in this range-bound market environment.

As Second Quarter Ends, IPO Market Heats Up

Investors had a tough second quarter as the S&P 500 closed June up a mere 1.8% for the year. Unlike prior periods, where the IPO calendar slows dramatically in dicey markets, we have actually seen a pickup in IPO activity in recent weeks. Why the sudden interest?

With the average stock not doing much of anything, investors seem to be looking anywhere for places to make money. New offerings, whether well-known consumer brands like J Crew or Mastercard, or much hyped ethanol plays like VeraSun and Aventine, offer the potential for a quick payoff, something that has been lacking for several months in the market.

The retail investor seems to be jumping in with both feet to the IPO market, which I would use as an indication that it’s time to tread carefully. Despite lackluster financials, small investors jumped all over the J Crew deal, causing a huge spike. On a valuation basis though, the stock does not appear cheap. The ethanol plays are also expensive, with the Aventine deal actually dropping more than 10% on its first day of trading last week.

History has shown that IPOs are some of the worst investments around. Just think about why this is likely the case. Companies don’t sell shares to the public unless they think they can get a great price. Why are ethanol companies going public now, even though oil prices have been high for a fairly long time? Perhaps they are sensing that speculative interest in the industry is at elevated levels and they want to take advantage of that.

The fact that many deals, including J Crew, are being brought to market by private equity firms is another red flag. These buyout firms bought companies years ago when prices were depressed. Now the so-called “smart money” is selling their stakes to the retail investor via IPOs. Which side of that trade do you think is going to come out on top?

Of course there will be exceptions, but I would caution investors to be careful when venturing into the IPO market. There is a reason why someone has decided this is the right time to sell. With initial public offerings having been relatively poor investments over time, make sure you pay attention to the stock’s valuation, not just what company you are dealing with.

M&A Not Slowing Down

Another “Merger Monday” is shaping up nicely today, as deals continue to pour in at record levels. Wachovia (WB) buying Golden West (GDW) for $25 billion is by far the biggest deal of the day, but perhaps the most interesting is the bidding war for Aztar (AZR), casino operator and owner of the Tropicana Casino in Las Vegas.

In March, Pinnacle Entertainment (PNK) agreed to acquire Aztar for $38 per share, more than 20% above where AZR stock was trading at the time. Late Friday, the two parties agreed to a revised price of $51 per share. It’s not often that a company has to increase the price of a friendly takeover bid by 34%, but in this case, three other suitors emerged and a bidding war began.


Although Pinnacle has a signed merger agreement with Aztar at $51, it might not be done yet. Two of the bidders appear to be out of the mix, as Ameristar Casinos (ASCA) officially dropped out, and Colony Capital hasn’t been heard from since their $41 bid was trumped. Columbia Entertainment, however, saw their $50 cash bid expire Friday afternoon, and could very well come over the top sometime this week.

What is all the fuss over Aztar about? The Tropicana, although fairly old in Vegas terms, sits on prime real estate on the Vegas Strip. The buyer would like to knock it down and build another brand new casino, much like the newest hot spot, Wynn Las Vegas. Vegas is hot, and as a result, Aztar’s real estate appears to be worth far more than shareholders thought a couple of months ago when the stock was trading at $30 before the initial bid from Pinnacle.

Not only will it be interesting to see how the Aztar situation is resolved, but the overall theme of an immensely robust M&A market should be a focus for investors. The best way to play this, aside from speculating on which firms get bids next, is to go with the investment banks whose advisory fees are sky-high with the current deal flow.