Just imagine for a moment that the problems above were no longer with us. China and Europe are back to normal, the election here is behind us, and some NASCAR-like moves kept us from driving over that cliff. It is reasonable to assume that such a happy state of affairs would mean a higher stock market, maybe much higher. Maybe it's an new era, like the one described in the song, Age of Aquarius (Harmony and understanding/ Sympathy and trust abounding/ No more falsehoods or derisions/ Golden living dreams of visions). Time to jettison all worries and invest with abandon? Not so fast, because then, according to contrarian investment thinking, is precisely the time to worry.
Welcome to the down-the-rabbit-hole approach to investing, where good news is often bad and bad news is often good. It is, according to some, the equivalent of buying straw hats in the winter, when no one else wants them. To Warren Buffet, it means being "greedy when others are fearful, and fearful when others are greedy." It all comes down to going against the prevailing consensus, and we can take a closer look at the logic behind such thinking. We often talk about how a stock has moved higher because of outstanding revenue and profit growth, but the technical truth is that such growth causes people to buy stocks--and it is the buying pressure that actually moves stock prices. When things are going very well and stocks have staged a major advance because the environment seems just perfect for investing in equities, we have to stop and ask where the additional buying pressure is going to come from. If everyone is already invested to the hilt in stocks, who else is left to buy? We'll hear many investment commentators say that stocks really need to climb the proverbial "wall of worry"--that means, simply, that there should be enough dark clouds out there to keep some investors on the sidelines. This cash is the fuel for the next leg of the rally when those investors decide it's time to buy.
Do all of the current worries add up to a buying opportunity? The problem is that the market has not been following this script. From the June lows, the S&P 500 rose about 14% before the most recent trading sessions took it down to a still-impressive gain of about 10%. So, we have a market that has continued to advance in the face of all these problems, no doubt supported by low interest rates and easy monetary policy from the Federal Reserve. It's hard to find evidence of worry with the market as strong as it has been. Are investors just whistling past the graveyard? If they are, then the market could be set up for a really nasty decline. On the other hand, the market could be looking beyond the immediate concerns and factoring in a resolution to the fiscal cliff--almost any resolution would probably be good for stocks, just because it takes some uncertainty out of the picture. Any time there is good news (or not-as-bad-as-expected news) out of China or Europe, we've seen the market move up, so some encouraging news on the fiscal cliff would likely have the same positive effect. The investor sentiment surveys have not been showing investors to be overly bullish (remember, the more bearish they are, the more bullish it is for the market), and there is still plenty of cash on the sidelines in money market funds, earning next to nothing. Sooner or later, the quest for decent returns will entice that money out of cash and into equities. Some folks will recognize that when the crowd is trembling in their boots, it might just be an opportune time to buy.
The reality that the market may now be facing is what has been feared most about the economic slowdown: the damage done to earnings. The market can show resiliency in the face of many concerns, but once earnings start to suffer, you better watch out. It is now the middle of third quarter earnings reporting season, and that appears to be what has stopped the market's advance--or at least put it on pause. Even when companies do report good earnings and revenues, their comments about the future often cite "current macroeconomic conditions" as the reason for a tempered outlook. Not many "trifectas" today, where a company's solid earnings and revenues for the completed quarter are accompanied by expectations of smooth sailing ahead. Mellanox (MLNX, $73), a high-momentum stock, reported yet another stellar quarter of both earnings and revenues that well exceeded expectations, but then the company went on to voice concerns about the strength of its business going forward. The stock, which started the year around $30 and hit a high of $120 in early September, reacted to this guidance by falling 25%. That's a pattern we can expect to continue, where the strongest stocks are most vulnerable to major declines when there is the slightest whiff of a negative outlook. The results from DuPont (DD, $45) fell short of both earnings and revenue expectations, and the outlook was certainly not rosy. The stock sold off about 10%. Investors take note: DD has a dividend yield of about 3.8% and has never really been a momentum stock, where MLNX pays no dividend.
As the economy weakens--or as concerns about the economy weakening grow more widespread--the field of companies that can still deliver the trifecta becomes narrower. The housing sector continues, at least for now, as one of the bright spots. The home builders like Lennar (LEN, $38), D.R. Horton (DHI, $21), and Meritage Homes (MTH, $38) have been exceptional performers this year, joined by their "cousins" Sherwin Williams (SHW, $146) and Home Depot (HD, $61). Common sense--which is often not very common, and when it is common often isn't sense--would suggest that a housing recovery would lift the makers of furnishings and appliances. Whirlpool (WHR, $95), which for a long time behaved as if no one would ever buy another washing machine, has risen 100% year-to-date. Ethan Allen (ETH, $29) has recently moved up from around $25 to a 52-week high of $30. Both companies reported earnings recently ahead of expectations, but their revenues were both slightly below forecasts. Nevertheless, the market seems to be saying that all sorts of housing-related stocks will continue at the party. Who's missing from the celebration? I am always cautious about the laggards in an otherwise strong sector, but I'll mention Bed Bath and Beyond (BBBY, $58). The stock is close to its 52-week low of $56.72 and well off its high of $75.84. The latest earnings fell short of expectations but, interestingly, revenues were actually ahead of forecasts. The margin weakness may be due to the integration of the Cost Plus acquisition. My wife loves this store--she probably drops in there about once a week. If I had to pick the bricks-and-mortar survivors from online competition, I'd have BBBY on my list. We'll keep this one on our Radar Screen.
For Halloween, the market may be delivering more tricks than treats. As investors, we just have to work harder to find the house where they give out the best candy. And if the economy really does weaken substantially, stock pickins will remain slim pickins.
BOO!
Life is short. Get busy.
Jim
Disclosure/Disclaimer: My family members and/or I own shares of MLNX, LEN, DHI, MTH, SHW, HD, and BBBY. Individual stocks are mentioned here for the sole purpose of illustrating investment concepts, and nothing stated here should be construed as the advice to buy or sell any security.
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