The Big One

It has been, for some 26 years now, a yearly ritual on Wall Street and in various financial media to mark the anniversary of the stock market crash of October 19th, 1987, otherwise known as "Black Monday." While the anniversary last month was displaced form the scripts of the talking heads by the political shenanigans in Washington over the government shutdown, the occasion was still noted, at least as a bit of stock market history. Typically, such historical analysis is tinged with the question, Could it happen again? To consider that question, we need to be explicit about what "It" was. Many people will remember that the Dow Jones dropped by 508 points that day. More important, perhaps, is that this point drop constituted a fall of some 22.61%, which, if applied to the market today, would be a decline of some 3,500 points on the Dow. And that would be enough to send traders and investors clutching their chests and proclaiming, like Fred Sanford (Redd Foxx, pictured above, on Sanford and Son), that this time it is "The Big One."

Could it happen again? I am always of the opinion that just about anything can happen, and history has already given us, by way of the 2008 financial crisis, a repeat performance--it just didn't happen all in one day. (For the record, between October 2007 and March 2009, the market dropped more than 50%.) The choice here, as if we had one, is between a slow-acting poison like Walter White's infamous Ricin in Breaking Bad or the more common method of execution on that show, a bullet to the head. Either way, it's pretty ugly. I still have vivid memories of the ugliness of 26 years ago. I was working for an investment management firm at the time, and I remember that several of us were just gathered around the old Quotron monitor, watching with stark disbelief as the points ticked away on the averages. The "shock and awe" continued over into the next morning, when everyone in the office was summoned to be in the conference room just after dawn for what felt more like a group therapy session than a strategy meeting. What impressed me most at that time was how the reaction of the investment professionals was so different from the investors who actually had lost money, at least on paper. During the ensuing days after the crash, I spoke with a number of seasoned investors, all of whom had suffered losses. Every one of them voiced the sentiment that they wished they had more cash to put into the market. What the professionals saw as an Armageddon, they saw as opportunity. So, just what sort of temperament allows an investor to take such market drubbings in stride?

While temperament no doubt plays a role, the more helpful answer here involves positioning. We can't inoculate ourselves against market declines (at least we can't without significant opportunity costs), but we can inoculate against the damage that can be done to our standard of living by such declines. To put it another way, the steps that we can take to ensure that we will never lose money are the very same steps that will ensure that we never make money. No risk, now reward; no guts, no glory. As we have pointed out in this space before, you shouldn't buy a single share of stock until you have determined what percentage of your assets you should have, or are comfortable having, in equities. In Wall Street terminology, this is known as the "asset allocation" decision. By way of example, imagine a forty-year-old investor who earns, at his job, some $300,000 per year. This fellow lives below his means and has managed to accumulate, say, $500,000 in savings. How should he invest that money? While there is never a "one size fits all" answer with regard to financial planning, this person is a good candidate for significant equity exposure. Assuming he has at least 20 years until retirement, he doesn't need his investments to supplement his income to support his standard of living. That means that he can invest for the long term and ride out the major swings in the market. The investors who weren't rattled by the 1987 crash had other assets, probably some money in bonds or a business that was their main source of their income.

Now, as another example, consider a sixty-year-old with just a few years until retirement. The income she makes from her job will soon be gone, so riding out major market declines is not really an option. The standard move here is to shift money from stocks into bonds, or at least to invest in more conservative, dividend-paying stocks. She should probably take her gains in Netflix (NFLX, $333) and buy Johnson and Johnson (JNJ, $93), or maybe some municipal bonds. The general rule here is that you're going to sleep better at night if you aren't relying on your stock gains to pay the rent or to make an upcoming college tuition payment. If your stocks continue to go up, you've grown your nest egg for the future; if they go down, you can weather the storm without suffering much detriment to your immediate financial health.

I have found that individual investors can be very good at picking stocks but notoriously bad at market timing. During a bout of significant market volatility a couple of years ago, a friend of mine said that he had had enough and was thinking about selling all of his stocks and going to cash. I advised him not to take such a drastic step, and I pointed out that he was falling victim to a binary, "all-or-none" way of thinking. Maybe, I suggested, he could scale back enough so that the market volatility wouldn't cause him such heartburn. I believe he took my advice, because selling out would have caused him to miss the market's major move up over the past year. The problem is that investors are tempted to sell when things look really bad, and if they do, then they get frustrated watching a major move to the upside and, you guessed it, they buy back in at the top. At times it is, indeed, the "darkest before the dawn."

Of course, we have to acknowledge that right now it's not very dark out there. Quite the opposite, in fact, as the sun seems to be shining on the market with the clouds off in the distance. And while we may not be experiencing the "irrational exuberance" that Alan Greenspan warned about years ago, we would be wise to remember that the market has come a long way lately. My wife and I have some cocktail napkins that feature a photograph of three women behind bars in jail and the caption, "The trouble with trouble is that it starts out as fun." Well, it has been--and may continue to be--fun of the barrel of monkeys variety, but how will we know when that fun is morphing into trouble? (In real life, that would be when the little voice in my head tells me that it's 2:00 in the morning and time to call a cab and go home.) No one is going to ring a bell to tell us that the market rally has ended (and if someone did, everyone else would hear it and stampede for the exits all at the same time). The best course of action might be incremental, as opposed to radical, steps. If you have a stock that has doubled, you can sell half the position and then "play with the House's money." It is a good idea to review your portfolio regularly and scale back any outsized positions, always staying diversified. Dividend-paying stocks are often less volatile than aggressive growth stocks that don't pay dividends, so you should keep that aspect of diversification in mind.You can set mental stops and raise them as a stock moves higher as a way to protect your gains or limit losses. Most of all, though, if you have arrived at your asset allocation based on a serious consideration of your other resources and your future financial needs, you are less likely to be seized by panic when the market swoons.

All of the above suggestions are for steps that we should be taking as part of our regular investment discipline, whatever the market is doing. So, is there anything with predictive power as to an impending market sell-off? The technicians, who study charts and volume, purport to tell us where the market is heading. Of course, since the quantitative definition of a bear market is a market that is down 20% from its highs, that's not very helpful except for confirming a changed trend. Although I do pay attention to the technicians, the cynical side of me thinks that what the chart-followers are really saying is that the market will continue to move up until it doesn't. Not very helpful. If I were forced to make one prediction, it might be the cause of a downturn, rather than the timing of one. In order for the rally to continue, the market will need to navigate successfully the transition from being driven by Federal Reserve stimulus to being driven by earnings. The good news is that the economic strength that would cause the Fed to take its foot off the gas is the same strength that would lead to better earnings growth. But, if the Fed is no longer able to control interest rates, if the bond market is going to demand higher rates because we can't get our fiscal house in order, it is conceivable that we might see higher rates without economic strength. That would mean a lower present value of future earnings AND the prospect of higher rates choking off the recovery. That is the kind of scenario that could trigger a swift and brutal sell-off.

Investors would be wise to look for signs of such trouble in the bond market. At least we should remember the words of Walter White, as they might be applied to that market: "How are you feeling? Kind of under the weather? Like you've got the flu?"

Life is short. Get busy.

Jim

Disclosure/Disclaimer: My family members and/or I own shares of NFLX and JNJ. 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.

Target Practice

Of all the questions asked of me about investing, one of the more common ones these days concerns target prices for stocks, specifically whether I use target prices in my investment work. Whenever stocks have moved up significantly, as they have in 2013, investors start thinking about whether they should cash in their gains, and so they go looking for some sort of signal or talisman to tell them that a particular stock or the market as a whole has reached a level from which no further advance is probable. It would be nice, of course, if such a foolproof indicator existed, but there really is no such thing. The short answer to the question is, yes, I use target prices, but the question reminds me of the one about the dog that habitually chases cars: What would the dog do with a car if he caught one? So, today we'll consider how investment analysts arrive at target prices and whether hitting that target should cause us to take any action. The question, then, is okay, So Now What?

What a target price implies, assuming that it is higher than where the stock is trading, is that some sort of fundamental analysis indicates that the stock is actually worth more than its current market price. You certainly wouldn't want to buy a stock at $50 per share if the analysis suggests it is only worth $40. So, where does someone come up with the $40 value? There are at least a couple of different approaches. Investors who follow a strict value discipline typically arrive at a stock's intrinsic value by analyzing the company's sales, profit margins, earnings, cash flows, assets and liabilities. This is the approach you would take if you were buying a business outright--value investors approach it in precisely this way, valuing the entire enterprise as if they were going to buy it lock, stock, and barrel. If the stock is trading at a big enough discount to this intrinsic value, it becomes a buy candidate.

Two years ago shares of Disney (DIS, $65) were trading around $30 per share, and it appeared to be a situation where the "sum of the parts" was greater than the whole. That is, if you examined and valued each of Disney's assets--the theme parks, movie studios, the ABC television network, Marvel, Pixar, and ESPN--and then added it all up, you would arrive at a figure substantially higher then $30 per share. One analyst noted at the time that ESPN alone was probably worth more than $20 a share. In this case, the company's intrinsic value is not exactly or necessarily the same as a target price, but it functions in the same way because once a stock reaches its intrinsic value, it no longer holds the appeal it once had for true value investors. The target prices I've seen published for Disney today are in the $75 range, which implies a potential upside of about 15% from the current stock price. Another example is Scripps Interactive Networks (SNI, $77), which is the company behind the Food Network, Travel Channel, and HGTV, collectively  known as "lifestyle-oriented content." In a recent Barron's article, one money manager contends that the company should be worth about $90 per share based on EBITDA valuation, while another analyst suggests it could be worth worth around $98 to $100 per share if another media company were to buy it (known as "private-market value"). I would never recommend buying a stock on takeover speculation alone, but here you have a company that offers value even without a takeout.

Arriving at target prices for growth stocks typically involves a more explicit focus on future earnings. Celgene (CELG, $147), the biotechnology company, said back in January that the company should earn around $5.50 per share in Fiscal Year (FY) 2013 and expects to earn $13.00 to $14.00 per share in 2017. Now, that is some serious growth, if they can achieve it. The highest price target I can find for CELG now is $172 per share. If we do a little "back of the envelope" math, we might apply a multiple of 20 to those future earnings for a potential price of around $280. So, why is the current price target not higher? Well, for two reasons. If you read the fine print, you'll see that those published price targets are typically based on a 12-month time frame. The other reason, though, is like the family going on vacation where the kid in the back seat keeps asking, "Are we there yet?" Well, no, we are not there yet, and that is the point. The year 2017 is more than three years out, and a lot can happen--both good and bad--between now and then. The longer the time frame, the greater the uncertainty. It is this uncertainty, though, coupled with the company's potential, that gives investors the opportunity. Would I sell Celgene if it reached $172 before the end of this year? No, because my time frame is much longer than that. That doesn't mean the target price is worthless, because it is good to know that the analysts who follow the stock closely don't see it as currently overvalued. What if Celgene reached $280 per share within the next few months? Depending on the circumstances, we might conclude that the stock had "gotten ahead of itself," which would suggest that the market has taken all of that future potential--and all of those potential future earnings--and factored them into the stock price today. That would still not be, in my view, a reason to automatically sell the stock. I will sell a stock if the reasons for owning it in the first place no longer hold true. Accordingly, I will be following the news on Celgene very closely to see whether they can stay on track, how their clinical trials are going, and information about any new drugs in their pipeline. If there are any material changes or disappointments, I'll have to reevaluate. For now, I'll just say that I hope I still own this stock in 10 years.

We'll also note here that target prices are not static, or at least that we don't want them to be. I love it when investment firms raise their price targets on my stocks. If an analyst has the strongest available buy rating on a given stock, then about the only way that he or she can "pound the table" any more forcefully is to raise the target price. Such increases are often accompanied by a ratcheting up of earnings estimates, and that tends to occur after a company has reported much stronger than expected quarterly earnings. We saw this in the latest earnings season with Starbucks (SBUX, $75), Michael Kors (KORS, $75), and Facebook (FB, $47), to name just a few. The point here is that we want to use target prices to our greatest advantage, but we don't necessarily want our decision to sell a stock to be governed by a view of the company that is much more short-sighted than our own.

Life is short. Get busy.

Jim

Disclosure/ Disclaimer: My family members and/or I own shares of DIS, SNI, CELG, SBUX, KORS, and FB. 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.

Where Have All The Stock-Pickers Gone?

Earlier this month, WalMart (WMT, $73) and Macy's (M, $44) both reported quarterly financial results that disappointed Wall Street and set off a commotion among analysts and commentators, all of whom are thinking aloud about what this says about the health of the consumer and the economy. Reading the tea leaves for signs of economic strength or weakness has become the obsessive sport du jour because, of course, we might find some clues there as to when the Fed would start to taper its massive bond purchases. Given the amount of ink (liquid and digital) and airtime devoted to such divination, you would think that Ben Bernanke had left his job at the Fed to coach the Alabama football team. Perish the thought, though, because at least Alabama is probably going to win.

Meanwhile, Urban Outfitters (URBN, $42) and TJX Companies (TJX, $54) both posted impressive results. Granted, this is not a true apples-to-apples comparison, since WalMart and Macy's are general merchandisers while the latter companies are specialty retailers, but the distinction actually makes the divergence more compelling. As investors, we know how important it is to understand the big picture, otherwise known as the macroeconomic environment--we don't want to fall victim to failing to see the forest for the trees. However, the concern here may be the opposite, namely that we might fail to see the trees for the forest. The big picture matters, but stock-picking is also all about the little picture, the microeconomic situation unique to each individual company. To stretch the analogy a bit, some of those little trees will grow up to be big and strong, while others will be smothered by the shade canopy, also known, for our purposes, as the competition.

The stock market has been driven higher by lower interest rates, courtesy of the Fed, even as earnings growth overall has been nothing to write home about. Investors have been willing to pay more for each dollar of future earnings, because lower interest rates make each dollar of those earnings more valuable in terms of present value. If the market is going to continue its advance, better earnings will have to carry the ball from here on as interest rates inevitably edge higher. If that pass is successful, the market just might make it through the transition. The good news, as I see it, is that the same factors that would lead the Fed to taper decisively would be the same ones that pave the way for better earnings growth--namely, a more robust economy.

For some time now I have been hearing individual investors say that their investment money is in index funds or Exchange Traded Funds (ETFs). Now, when you put money in those funds the manager is going to buy the stocks in that sector or the stocks in a particular index. That approach has worked out well for some investors, at least to the extent that the rising tide of falling interest rates has lifted all boats. But that's not really stock picking, because you're getting just average companies along with some good ones. So what happens when the tide isn't rising anymore, when interest rates are not pumping up the market? My guess is that individual stock picking will be even more critical to investment success. We're actually seeing that now, as the better growth stocks have performed relatively well during this most recent bout of market volatility. As an example, we've seen weakness in housing-related stocks, the actual home builders in particular, as investors worry that higher interest rates could dampen the housing recovery. However, Ceasarstone (CSTE, $43), the Israeli maker of engineered quartz for kitchen counter tops and other surfaces, has seen its stock advance steadily, up some 170% since the beginning of the year. The reason? Great earnings that seem to indicate that their business is taking market share from more traditional sources of counter tops such as granite.

We could make a similar observation about Michael Kors (KORS, $73) and Starbucks (SBUX, $72), both of which seem to be grabbing a bigger piece of a pie that's not growing robustly. TJX, the operator of discount stores, is taking market share from the likes of Macy's and J.C. Penney, while Costco (COST, $113) seems to be eating into WalMart's business. And just this morning (Monday), Stratsys (SSYS, $112) and 3D Systems (DDD, $52), the makers of three-dimensional printers, are moving higher after both being initiated with Buy ratings at Citigroup. It's all part of the disruption that investors might miss if all they can see is the forest. As famed investor Peter Lynch (pictured above) once said, "The person who turns over the most rocks wins the game."

Judgment Day is coming, as the street preachers like to warn, but it's going to be a separation of the winners from the losers, the companies with stellar earnings growth being the winners. Aren't those the businesses you really want to own? I welcome the return of a more serious focus on stock picking, because that is how individual investors can really gain an edge, if they do their homework and have good sources of information and research. Maybe if General Douglas MacArthur had been a stock picker instead of a military hero, his quote might have been, "Old stock pickers never die; they just fade away." Let's hope they really are coming back.

Life is short. Get busy.

Jim

Disclosure/Disclaimer: My family members and/or I own shares of URBN, TJX, CSTE, KORS, SBUX, COST, DDD, SSYS. 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.

Zombie Investors

The Walking Dead

I have always found that cocktail parties provide a nice laboratory for studying some investor psychology, particularly when the gears of conversation are greased with a few rounds of Bombay Gin, and if you're willing to stir the Petri dish a bit. It sometimes doesn't even take the alcohol to relax the inhibitions enough to bring out the bragging rights. Finding a winning stock apparently triggers the same part of the brain as hooking a 40 pound striped bass or bagging a ten-point buck--something to do with evolutionary psychology, perhaps, and that "hunter-gatherer" genetic wiring. I have witnessed various forms of a conversation that goes like this. Some guy is talking to a group of his fellow guests (typically men, as these parties seem to self-segregate by gender), and he is regaling them with a tale of a certain stock. He first discovered the stock when it was trading at $10, and within a few months it was at $15, then within another few months it had jumped to $20. He seems to know just about everything about it. Since this subject engages my attention, I ask him, as my role in this experiment, whether he still holds his entire position, or if he has taken any profits. His reply, like air whooshing out of a deflating balloon, is that he never bought any of the stock in question--but he sure has been watching it.

Here we have exposed the hallmark trait of the Zombie Investor: inaction. Investing is not a spectator sport, and you can't make any money in stocks without actually buying some. Our zombie in this case has likely acquired his inaction tendency from experience. He doesn't have a true portfolio, but has instead been a serial speculator, fixating on one particular stock at a time, buying at the wrong time, and selling in an emotional frenzy of fear. The hunter has become the deer in the headlights. The more literal, albeit fictional, zombies that grunt and growl their way through AMC's Sunday night gore-fest The Walking Dead (my wife's favorite television show at the moment) are anything but paralyzed, however. Their problem--and the central problem for all of the non-zombie characters in the story--is that something has disabled a large part of their formerly human brains, leaving them governed by their primordial, reptilian brain stems. Today's Zombie Investor suffers not just from inaction, but also from making decisions based on emotions, as if something blew the circuit breakers in their brain compartments for logic and reason.

A familiar case is the investor who will not take a loss in a stock because he is determined to wait for the stock to go up enough to get out at breakeven or better. Now, I want to emphasize that inaction can indeed be the best course of action in some cases--Don't do something, just sit there! as the reversed saying goes--but we need some guidelines for when, and when not, to take action. The first step is to determine whether a stock's decline is due to something company-specific or merely part of an overall market sell-off. I don't like to sell stocks in broad market declines, and that is why I don't like stop-loss orders. As a primer here, a stop-loss works as follows. Let's say you buy a stock at $20 and want to limit your losses to 20%, so you place a stop-loss order to sell the stock if it drops to $16. The thinking goes that small losses can turn into bigger losses, so this is a way of enforcing the discipline to go ahead and take those (hopefully smaller) losses. If the outcome is positive, though, and your stock goes up, then you can raise the stop-loss in tandem with the stock's advance--it goes to $30 and you raise the stop to $24; it goes to $40 and you bump up the stop to $32. The problem with this strategy is that your stop-loss order doesn't know the difference between a change in your company's prospects and a broad-based swoon in the market. We can consider the so-called "Flash Crash" of May 6, 2010, as a cautionary tale. For some reason, the Dow Jones average dropped suddenly by about 1,000 points before quickly erasing most of that decline. Proctor and Gamble (PG, $80), which opened the trading day at $61.91, traded as low as $39.37 before closing at $60.75. So, a stop-loss order here likely would have resulted in your selling the stock at a very unfavorable price. Rather than turn your investment decisions over to "automatic pilot," an alternative would be to use "mental" stops, where you don't place an official order. Instead, you have a price in mind of when you must consider selling the stock. At least this practice gives you time to evaluate the reasons for the decline and whether you should continue holding the position.

Some times, of course, a stock just doesn't work out as we expected, and there are indeed fundamental reasons why it may no longer be a good fit for our portfolios. Let's look at the case of Cree (CREE, $56), the maker of those LED light bulbs, which last week committed the unpardonable sin of failing to hit the "trifecta" with its latest quarterly earnings report. Earnings per share came in right at the consensus estimate, but revenues fell short, and the company's forward guidance for earnings was below the prevailing consensus. That might not be the kiss of death for all stocks, but CREE is (was) a high-flying momentum stock with a P/E (price-to-earnings) ratio that priced in a near-perfect future of growth. The stock took a drubbing, falling now some $20, or about 25%, in the four trading days since the report. Bank of America/ Merrill Lynch chimed in with its assessment that the stock is still over-priced and reiterated a $26 price target, citing the inevitable competition that CREE will face in the retail market for those new bulbs. Predictably, some analysts said the growth thesis was still intact, but the prevailing response was lowered ratings and price targets. Is this a buying opportunity? I don't think so. The stock is in that no-man's-land now, technically broken from a momentum perspective but still too expensive to be a value stock.

I sold my CREE shares at just about breakeven, as my experience has taught me that such high-flyers don't rebound quickly or easily. More important, though, is that one chief reason to sell any stock is when the reasons you bought the stock in the first place no longer hold true. That's a company-specific assessment, of course. I bought CREE as a growth and momentum stock, fully aware that even the slightest stumble would negate the case for owning it. As part of my diversification discipline in the accounts I manage, I am a firm believer in diversifying across investment styles--some value, some traditional growth, some momentum. And in the momentum category, LinkedIn (LNKD, $230) saw its analyst ratings and price targets move up following its earnings report. Despite all indications that CREE would perform in similar fashion, it did not. I "hired" the stock to do a job for me, and when it failed to deliver I let it go.

Maybe an investor has invested, say, $12,000 in a particular stock, and maybe there has been some development that has called into question the case for owning that stock. So now the position is worth $10,000. The investor can talk herself into waiting for the stock to get back to her cost basis, or she can view that $10,000 position as a source of funds. Is the current holding really the best place for that $10,000? Maybe she focuses on what is still there and available instead of the loss. A rose by any other name, to be sure--no amount of wishful thinking or redefinition is going to change the bottom line. Investing, though, is all about what's going to happen in the future, and sometimes our reality checks that come in the form of financial reports tell us that the future may not be as bright and smooth as we had initially thought. There will always be another opportunity knocking.

So that we can end on a more positive note, we'll revisit the television zombies. The AMC Network (AMCX, $65) has managed to pull off at least three shows that are both highly popular and critically acclaimed: Breaking Bad, Mad Men, and The Walking Dead. That would have been unthinkable for a cable network not so long ago. I think the investment case here is all about content, because something has to fill all of those channels that come through our cable boxes and our computers. In a future post we'll look again at some content companies such as Disney ($62), Lionsgate (LGF, $34), and CBS (CBS, $51). The way we receive media content may change over time, but someone is always going to be creating new programs and movies; that's the American Way. In the meantime, watch out for zombies--and don't turn into one. You want your bragging rights to be about something other than the one that got away.

Life is short. Get busy.

Jim

Disclosure/Disclaimer: My family members and/or I own shares of AMCX, LNKD, CBS, DIS, LGF, and PG. 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.

Endless Summer

Part of summer's allure for me as a kid was the season's fleeting nature, the realization that it was here and quickly gone, as evanescent as the last Eskimo Pie on the Merry Mobile ice cream truck. Whenever my mother would hear me say that I wished it could always be summertime, she would say something like, Well, if every day were a vacation, that wouldn't be much of a vacation, now, would it? Of course she was right. The idea of a childhood summer was all about a break from the normal routine, and my summer days were decidedly lacking in structure, the hours always lending themselves to some spontaneous laziness. Doing nothing usually would lead to something, though, if you had a little imagination. Today's kids, in contrast, seem much more scheduled, with summer camps, swim team practices, tennis lessons, and math tutors, with barely time in between to catch a breath--or a firefly. Either way, summer offers something that isn't usually available the other nine months of the year, something for our mental scrapbooks.

Like the lingering memories of a summer romance, some experiences of summer stay with us for a long time, beyond Labor Day and even past Christmas. Several months from now we may look back on the past July and realize that, amid the barrage of market news that fills our inboxes and CNBC each day, there were a few gems of information worthy of our attention. There is, of course, an earnings reporting season for each season of the calendar year, but a couple of the results from the second quarter may be pointing the way toward what we might expect going into the new year. First,  the results from Ford (F, $17), an "old economy" stock if there ever was one, soundly beat expectations for both earnings and revenue. Notable here is that Ford was able to post good results despite Europe still acting as a drag on its operating performance. Many investment strategists have been telling investors to focus on those companies that do the majority of their business here in the United States, which is understandable given the global economic weakness. Sooner or later, though, there's likely to be some recovery in Europe, and by the time it occurs to everyone that such a recovery is definitively underway, it will be a bit late to invest in the companies that will benefit. In a recent article, Barron's named Ford as one way to play a European recovery. I can't get too excited about a company that is projected to grow at only 5%--and note that the P/E ratio of 11 may look cheap, but it is twice the growth rate--but the value here is what Ford's results might presage for other economically-sensitive companies. In other words, it could be less a bellwether and more of a harbinger.

Another eye-catching earnings report came from a "new economy" stock, our old friend Facebook (FB, $38.50). Earnings and revenues that came in well above the consensus forecasts sent shares soaring, up about 50% over the past few weeks (Ford, by the way, is up about 30% year-to-date). Investment analysts who wouldn't touch the stock at $25 are now falling all over themselves to tell you to buy it at $38 and change (FB is now trading slightly above its offering price). Price targets have been ratcheted up to the $45 range. This catch-up behavior may just seem to add to our cynicism about Wall Street, but there is actually some method in this seeming madness. Market prices reflect, among other things, a company's prospects and perceived risk. The risk with Facebook has been all about the concern over how the company can monetize its business model, particularly in the growing mobile area--how it can turn our eyeballs and our clicks into profits. A stock's price has to account for such risk, and in this case we can reasonably conclude that FB trading at $25 was pricing in that risk. Along with great earnings and revenue numbers, the company also reported that the monthly active user count was up 21% in June, while the mobile active user count jumped 51%--and the company now has more than one million advertisers. Facebook has answered the market's call to "show us the money"--or at least some money. Those results, then, alleviate some of the perceived risk, as there is now evidence that the company can actually make money. And that is hard evidence, backed up by the numbers. So, it does make some sense that the stock is more attractive at $38 than it was at $25, since part of the discount for risk doesn't need to be there anymore. Investors who bought the stock at $25 (or as low as $18) were willing to shoulder that risk, and they have been rewarded for doing so--that's how risk works in the market. Investors who want in today have to pay more--they don't get to enjoy the ride from $25 to $38 because they weren't willing to take that risk.

As with Ford, Facebook may be more harbinger than bellwether. The results, thus far, serve to validate the social/mobile/cloud business model, where a good many companies are seeking their fortunes. My brother-in-law and I recently were discussing Yelp (YELP, 51), and he asked, somewhat rhetorically, how I'd like to be in the business of publishing the old printed yellow pages. Had that conversation occurred a few weeks later, I could have said that I would love it, because maybe I could sell the business to Jeff Bezos. Seriously, though, people are still "letting their fingers do the walking" (the old ad slogan for the yellow pages), but those fingers are on the smartphone keypads. On our recent drive to the beach, our daughter introduced us to an app called "Waze," something of a modern-day version of the old Citizens' Band (CB) radio, where users post the latest information about road conditions, traffic, and speed traps (Smokey!). I'm hoping that all those users have a passenger to use the device, lest they end up posting about the road hazard they have just created. The list of what's at your fingertips is growing beyond the more familiar names like TripAdvisor (TRIP, $80) and Open Table (OPEN, $68). This is the convergence of social, mobile, and cloud. These applications rely on input from users--that's the social aspect. As I've noted here before, the mobile revolution is all about being connected without being tethered. Waze is not going to do you any good if you have to be at your desktop computer to use it. And, of course, the cloud is what makes it all work, because all of that computing power is not in some software installed on your device, but rather in a massive network of servers that you tap into. As more companies pile into this space, it's ever more important to beware of the hype and to recognize that there will be winners and losers. As with Facebook, it's all about the eyeballs, the number of users paying attention--and the advertisers who are willing to pay to reach those users. Pay attention!

As for other takeaways from this summer, we have more economic reports and more from the Federal Reserve. Second quarter economic growth was better than expected, but first quarter growth was revised downward. Two steps forward, one step back for the economy. Mr. Bernanke apparently has learned that too much talk about tapering is tantamount to yelling "Fire!" in a packed theater, where it's the traders, not the cinephiles, who stampede for the exits. I think what Mr. Bernanke is really saying might be closer to "Last Call!". Amid all of this struggle between interest rates and economic growth, we have seen some stellar financial results. Middleby (MIDD, $202), discussed in our last post, clocked in with second quarter earnings at $2.00 versus an estimate of $1.78, and revenues that were ahead of forecasts. The stock jumped $23, or 13%, following the news. Lions Gate Entertainment (LGF, $34) reported earnings of $.18, well ahead of the $$.08 estimate, with revenues topping forecasts, as well. Michael Kors (KORS, $72) also beat on the top and bottom line, and comparable store sales were up 27%. Goldman Sachs reiterated its Conviction Buy rating on the shares and raised its price target to $100; KORS is up 41% year-to-date. Goldman reiterated its Sell rating on Coach (COH, $53) and lowered its price target to $47. COH is down more than 3% year-to-date, and some analysts think it's a great value here. I'll go with Goldman on this one--my money is on KORS. It's all about stock-picking here, which is always the case, but even more so when there's no tailwind of robust economic growth.

What the summer gives, the winter can quickly take away--but stocks are not Caladium leaves, which predictably die off with autumn's first chill. I suspect that there are a number of companies with true staying power, and they may really show us something when growth actually picks up. As for summer itself, I guess that one sign of adulthood is the realization that a summer day is really just like any other day, only hotter. But don't tell that to your children--like beer and romance, they'll encounter that on their own soon enough. And several months from now, when you find yourself still at the office for the earlier twilight, you might start humming the last line of that old Nat King Cole song: You'll wish that summer could always be here.

Life is short. Get busy catching fireflies.

Jim

Disclosure/Disclaimer: My family members and/or I own shares of FB, MIDD, LGF, and KORS. 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.

Home Improvements

Sometimes I think that the best strategy for improving one's home is just to get away from the place for a while. The more time you spend at home, the more you are going to notice that bathroom that needs remodeling or those kitchen cabinets that need to be upgraded. And maybe this just isn't a good time to have your kitchen or your bathroom--or your wallet--torn up, so you live with it, even as those flaws hold your attention like a piece of old spinach stuck in the teeth of your dinner companion. If you plan your escape, you might realize the benefits of an "out of sight, out of mind" experience, and, upon your return, you might gain a new appreciation for your familiar environs, imperfections and all.

Getting away is exactly what my wife and I did back in January, when we spent an extended weekend at the Alluvian Hotel and Spa in Greenwood, Mississippi. If you're not familiar with the place and think a small town in the Mississippi Delta seems an odd location for a destination vacation, I'll point out that the Alluvian is owned by the Viking Corporation, the maker of high-end kitchen equipment, which has its headquarters right there in Greenwood. When I was conducting a little research for our trip, I learned that Viking was being bought by Middleby Corporation (MIDD, $181). Mibbleby is not a household name, because the stuff they make is not likely to turn up in your household. The company is a leading manufacturer of commercial kitchen equipment, and the Viking purchase gives the company a new presence in the residential market. Owing, at least in part, to the company's visionary CEO, Selim Bassoul, Middleby's stock is up some 280% over the past five years (gaining 80% over the last year alone). With a market capitalization of $3.4 billion, MIDD is a "mid-cap" stock that has probably escaped the attention of many investors. I have only rarely heard it mentioned by the talking heads on CNBC, a lack of attention that I take as a big plus.

My fanciful concept of home improvement aside, what literal home remodeling and vacations have in common is that they are both forms of what economists call consumer discretionary spending, aptly named because such expenditures can typically be postponed. This part of the economy stands in contrast to the consumer staples sector, which is characterized by continued buying of consumables such as food and household products. Pampers diapers and Tide laundry detergent from Proctor and Gamble (PG, $80) will probably still find their way into consumers' shopping carts regardless of the state of the economy, as will Raisin Bran and Corn Flakes from Kellogg (K, $67). It is worth noting, though, that some of these staples stocks have done quite well of late, with PG up 23% and K up 41% over the past year. Some market observers think such strength in a recovering economy is unusual (investors tend to favor such stocks in a faltering economy), but one explanation may be that it is this sector that has historically offered good dividend yields, with dividends that are both reliable and growing. Faced with the meager yields in the bond market, investors have bid up the prices of these stocks as an alternative source of income. With the higher stock prices, the dividend yields are lower now than they were a year ago, with PG now yielding 2.99% and K 2.75%; that's still better than the 2.57% yield on 10-year Treasuries.

Mr. Bernanke and the Fed have pushed interest rates to historic lows to encourage all sorts of spending, but there's no guarantee that this will work. John Maynard Keynes once noted that stimulative monetary policy could be like "pushing on a string," but I prefer to think of it as a classic example of the "leading a horse to water" problem. No matter how low interest rates may be, you're not likely to borrow money to start adding on to your home if you think you may be out of a job in six months. The cavalry riding to the economy's rescue here may be the wealth effect, the tendency of people to spend more if their investment portfolios are rising in value. This doesn't mean that people are cashing in their stock gains to fund increased expenditures directly--it just means that people are more willing to rev up the Visa card for that trip to Disney World if they've got a higher net worth to back them up. An increase in portfolio value from $500,000 to $600,000 (+20%) is a pretty powerful enticement to spend, even if you're not tapping a single penny of that money. This cavalry, though, is quite a few horses short of a full battalion because not everyone is fortunate enough to own stocks. The stagnant wage growth that has characterized the economy for some years now might lead some to think that the approaching cavalry is actually the Horsemen of the Apocalypse, delivering yet another reminder of what we have considered here many times as our "Tale of Two Cities" economy. That's one reason why a middle-market retailer like J.C. Penney (JCP, $16.50) has seen its customers move to the lower-end discounters. If you pay a visit to discount retailer T.J. Maxx (TJX, $52), you might just encounter part of the J.C. Penney diaspora browsing the clothing racks. Accordingly, we would expect any boost in consumer discretionary spending to be skewed to the higher end. As Willie Sutton supposedly said when asked why he robbed banks: "That's where the money is."

A measure of cynicism about the economy's lethargic pace is certainly understandable, but the fact is that things are at least moving in the right direction. The Federal Reserve would not be signaling a potential tapering of its bond-buying stimulus if its radar array of economic models and statistics weren't picking up a glimmer of something on the horizon--maybe those AWOL cavalry members. And we can say right now that the consumer sentiment and confidence numbers have been encouraging. Another plus is the housing sector, which now seems firmly on the mend after the bruising it took in the recession. What's important to remember is that investing is all about the future, and the market anticipates and discounts what conditions are likely to be some time hence. It may seem like a gloomy disconnect that stocks rally amid the sluggishness in the economy, but that's actually good news--or at least the market strength presages better news. The arrows, for the most part, are pointing in the right direction.


The consumer discretionary part of the economy includes a number of sub-sectors--apparel, restaurants, hotels, and automobiles, to name a few. Probably no company covers as much of the waterfront here as Visa (V, $192), because they collect a toll every time someone swipes of one their credit or debit cards. Last week Visa reported earnings and sales numbers that beat expectations, and the company offered upbeat guidance for the rest of the year. The stock, which traded at a new 52-week high of $196 after the report, is up about 48% over the past year. If we are looking to this sector for stock ideas, we have to find companies that have something going for them other than just being positioned to benefit from the trend of increased spending. If the overall pie is growing slowly, then our companies need to be able to take a bigger slice of that pie. The other part of the Visa story, what we see as the secular or longer-term trend, derives from the fact that a majority of the world's transactions are still paid for with cash. That may seem surprising when the person in front of you at the convenience store pulls out his Visa debit card to pay for a $6.00 pack of Marlboro, but we're really looking at the global situation here. That gives Visa a pretty long growth runway, over and above how it will benefit from a cyclical recovery in spending.

In the retail apparel sector, we might take a look at Urban Outfitters (URBN, $42), the trendy clothing store aimed at the younger demographic. Personally, I'll have to say that whenever I see a group of women dressed in these clothes, I am tempted to ask them if they are auditioning for roles as extras in the next production of Les Miserables. However, I learned a long time ago not to let my fashion taste influence my investment decisions (and Brooks Brothers isn't a publicly-traded company). The company also owns Anthropologie and Free People, both with plenty of room for more locations both domestically and internationally. It's not just about locations here, though, because, unlike some other bricks-and-mortar retailers that have suffered from the juggernaut of online shopping, URBN seems to have leveraged its online presence to its advantage. You might want to get in touch with your inner hipster and conduct more research--nose piercing not required. Also hitting a new 52-week high after a stellar earnings report last week was Starbucks (SBUX, $72). The company is not content to rest on its laurels and merely welcome back the customers who once again are ready to pay $5.00 for a latte. They have plans for a greater variety of food and drink items, designed to get people in their locations beyond the peak latte-sipping hours. CarMax (KMX, $48) is a specialty retailer I find interesting, with its hassle-free and haggle-free approach to buying and selling cars. If you were in the market for a "previously-owned" vehicle, you'd probably find yourself spending a great deal of time perusing the locally-owned used car lots, each of which may not offer much of a selection. There you might encounter a salesman who wants to "friend" your daughter on Facebook with the idea of taking her out for a gourmet dinner at Applebee's and a test drive in his 1975 Eldorado with a cooler full of Pabst Blue Ribbon tall boys. KMX just might spare you that nightmare.

As we wrap this up we'll take another look at Middleby, and note that the calculus for buying a piece of commercial kitchen equipment is different from the considerations involved in selecting a residential stove or oven. While MIDD is not in the consumer discretionary sector, the connection is that the demand for its products is a derived demand--derived, that is, from the consumer demand for eating out. Restaurants don't buy new ovens to impress the neighbors, but to better and more efficiently serve their clientele. That means cooking food faster and keeping it at the right temperature until it is served, and this is where Middleby's investments and innovations have paid off for both its customers and its shareholders. Maybe its purchase of Viking is not a game-changer, but it keeps MIDD on the growth path with a new market.

In the lobby of the spa building at the Alluvian sits a gleaming, stainless steel Viking cooking machine the size of a Chevy Suburban. This beauty was tempting, but about six months before our trip to the Alluvian, my wife and I did replace our 25-year old stove top, and in the interest of full disclosure I'll tell you that we bought the Wolf brand. They had just come out with a modular stove top that better suited our needs and our counter space. We selected four gas burners, a grill, and a steamer. I wanted the deep fryer instead of the steamer, but my wife said no way was I going to turn our kitchen into a grease-soaked chamber of horrors. So, we're currently in the market for a Fry Daddy. As the wife says, "Take it outside!"

Life is short. Get busy.

Jim

Disclosure/Disclaimer: My family members and/or I own shares of MIDD, PG, K, TJX, V, URBN, SBUX, and KMX. 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.

Only The Strong Survive

When it comes to the litany of life's frustrations, or at least the frustrations of investing, few experiences rank higher than losing money. Seeing one's treasure evaporate, as almost all investors witnessed during the market and financial meltdown of 2007-2009, makes for an ulcer-inducing angst all its own, where the only palliative is a bottle of scotch emptied in the company of misery. But what about the frustration of failing to make money in a market that is soaring? The most intense frustration, after all, is the one you're dealing with today, even if past frustrations were of greater consequence. So, if the market is jumping like Richard Simmons (pictured above) at a caffeine-fueled aerobics class but your stocks can't seem to get out of bed, that's going to be a problem--and you're probably not going to feel comforted by the reminder that it's not 2008 all over again.

Very often the conventional investment wisdom tells us that the antidote for such under-performance is patience, and this is valid to an extent.  We can't expect our stocks to go up immediately after we buy them. In fact, our case for owning any particular stock likely is based on our assessment of the company's future potential--a potential that is not currently reflected in the stock price. We may have to wait some time before the market recognizes such potential. That is all well and good, but we also need to remember that where patience is supposedly a virtue, the conditions that try our patience are assumed to be temporary. If your spouse comes home from work every night to knock back a fifth of Jack Daniels and kick the dog, then the dog, at least, is not going to appreciate your patience. Or, as Albert Einstein once observed, one definition of insanity is doing the same thing over and over again and expecting different results. So, in the interests of preserving our sanity, let's take a look at some situations where patience might not be a virtue.

First on the list of usual suspects is the possibility that we have been lured into a value trap with some of our stocks. As we've reviewed here previously, it's called a trap because the stock looks cheap on some traditional measures of valuation, but is actually cheap for good reasons. My "poster child" value trap stock has been Radio Shack (RSH, $3.00), which a number of research sources were calling a "buy" at $15, then at $12, $8, and all the way down to its current price. One didn't need to be a Chartered Financial Analyst (CFA) to know that selling consumer electronics in a bricks-and-mortar retail store was not exactly a growth business with strong competitive advantages. Furthermore, a stock trading at a price-to-earnings (P/E ratio) multiple of 10x may look cheap, but it's not so cheap if earnings are growing at only 5%. Likewise, a stock with a P/E ratio of 30x is not necessarily expensive if earnings are growing at 25%. A commentator on CNBC recently remarked that "Valuation in itself is not a catalyst." That quote should be taped to every investor's computer screen as a reminder that without some positive catalyst down the road, a stock can languish--and appear cheap--for a very long time. These stocks are likely to be a drag on your overall performance, because even a consistently rising market is not likely to bring them out of the dumps. Investors may be more tempted by such stocks in a soaring market, because the natural tendency is to eschew the strongest stocks and seek out something that hasn't participated in the rally. This is sometimes a mistake. The idea of finding a discarded diamond while rummaging through trash bins sounds intriguing, but the reality is that the vast majority of what you'll find is indeed there for a reason.

Patience is appropriate in more legitimate value cases, where a company with a solid business and strong competitive position has hit a rough spot, or has at least been out of favor. As an example, shares of Coca Cola (KO, $41) are up only about 5% over the past year. The company has a nice dividend yield of 2.75%--if you have to wait for performance, it's good to be paid for your patience. Ebay (EBAY, $53 ) took a hit this week after reporting earnings that slightly missed expectations. A big part of the investment case here is PayPal, which is making inroads with its payment processing services. I also find Scripps Networks Interactive (SNI, $72) interesting. The company owns HGTV, Food Network, Travel Channel, and has the Internet presence to go with them. The stock is up 33% over the past year, but still, in my opinion, offers value.

Another possible culprit in under-performance is really not so much a culprit as a circumstance of timing.  Different  sectors in the market are strong at different times, and being in the wrong place at the wrong time can be a drag on shorter term returns. Consider, as an example, the oil refiners, which are not really growth stocks in the traditional sense. Marathon Petroleum (MPC, $68) rose from about $43 last summer to a high of $93 early this past spring, and if you owned the right companies in this sector during that time frame, they would have contributed significantly to your outperformance. The market's love for these stocks has largely been due to what is known as the "crack spread"--the difference between what refiners pay for crude oil and the price they can get for the refined product (gasoline, for instance). New supplies of oil here in the United States have kept the price of what is known as West Texas Intermediate Crude relatively low compared with the price of Brent North Sea Crude. The refiners have been in the sweet spot of paying the former price while the price at the pump is supported by the latter, higher price. Lately this crack spread has been narrowing, and with it the benefit to the refiners. So, what helped your performance for a time is now detracting from it. The home builders have followed a similar track. They are not typical growth stocks, either, but they have seen tremendous increases in earnings coming out of the housing bust. Ryland Group (RYL, $41) rose from $23 last summer to a high of $50 this spring, but then Mr. Bernanke started talking about tapering the Fed's bond buying. Higher interest rates may not kill the housing recovery, but they won't help it, either.

Now, let's step back for a minute and recognize one important thing. We need to evaluate our investment performance over longer periods of time, and no one is likely to beat the market averages every single quarter. The shorter term numbers are a regular test, not the final exam. But, if we don't have infinite patience to own Coca Cola and aren't nimble enough to catch Marathon Petroleum at just the right time, then what is the answer? Most investors understand the importance of diversification, but many of them may miss diversifying across varying investment styles. Certainly it is important to own good value stocks and to have the patience to stick with them, but it also helps to devote a portion of one's portfolio to true growth stocks--and the best of the best growth stocks are going to exhibit strong relative strength. This means that they are not going to look cheap, and, in a perverse bit of reasoning, they are probably not worth owning if they do look cheap. Intuitive Surgical (ISRG, $373), the maker of robotic surgical systems, was a darling of growth stock investors for a time, but has more recently been plagued by slowing growth and some supposed safety concerns. You would have done quite well owning the stock from 2010 until the first quarter of 2012, when the shares went from around $300 to almost $600, but the relative strength has been suffering since then. Now this week the stock is down again on the heels of more disappointing results, even setting a new 52-week low at levels not seen since 2011. If you want to take a round trip, take it to Tahiti and not in your stocks. The point, though, is that the declining relative strength gave you some time to abandon ship--you are more likely to sell these types of stocks on the way down, not on the way up. Does this make ISRG a value stock now? Nobody knows, because the market has always valued the company as an aggressive growth stock. Investors who buy it here may well be adding more risk to the burden of patience.

Experience shows that such growth stocks can be very powerful and profitable, but only the rarest ones will continue their outperformance over more than a few years (think Microsoft in the 1990s). Experience also shows that such strength is important to own, in measured doses, in a strong bull market. If we're hunting for strength today, here are some stocks that may fit the bill: Cree (CREE, $68), a maker of those new LED light bulbs; Celgene (CELG, $135), the biotechnology company that is on a roll with new treatments and plans for earnings to reach the $13-$14 range by 2017; Netflix (NFLX, $265), which has transformed itself from a mail-order dvd rental company to a video streaming service and now to a content provider with a boatload of recent Emmy nominations; Lions Gate Entertainment (LGF, $32), with the Hunger Games and Twilight franchises; and LinkedIn (LNKD, $201), the Facebook for grownups. What all of these stocks have in common is that they have had tremendous runs already and thus will likely fall the hardest in a general market decline or with any disappointing company-specific news. No risk, no reward--no guts, no glory.

The final point I'll make today is to emphasize that the companies mentioned above are not for all investors, and no investor should buy only the strongest stocks in terms of relative strength. So, consider how much risk you need to be taking. Someone with 20 years until retirement might want to own some Celgene shares, for example. But if your daughter is a high school senior and you're thinking about putting her college fund in LinkedIn or Netflix to gain some quick extra bucks, then while you're at it you'd better pick up a job application for her at Hooters. Because that's how she might end up paying her college tuition. The market may occasionally do what we expect it to do, but you can bet that it will never do what we need it to do. So tread carefully and be careful out there. And be strong--but don't dress like Richard Simmons.

Life is short. Get busy.

Jim

Disclosure/Disclaimer: My family members and/or I own shares of KO, EBAY, SNI, CELG, NFLX, LGF, MPC, RYL, SNI, and LNKD. 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. Stock prices are as of noon, Central Daylight Time, July 19th, 2013.

Gunfight At The Wall Street Corral

Major market declines, such as the drop we experienced in June, can cause investors to lose their appetite for risk just as watching the movie Django Unchained (starring Jamie Foxx, pictured above) during dinner might ruin your appetite for that plate of spaghetti and meat sauce that someone just served you. Those market swoons serve as a reminder that, yes, stocks can go down, something that investors might not be too concerned about since the averages have essentially gone straight up since the end of 2012. Whether the carnage is brought on by jittery investors all headed for the exits at the same time, or delivered by Quentin Tarantino in a burst of blood and guts, the results can be pretty messy--and cause us to check our risk exposure and the safety on that gun. So, just what caused the market to reverse its advance, even if that just turns out to be a pause?

There is a showdown on Wall Street now, and to understand it we need to go back to some basics. In very simple terms, a stock's price is a function of two factors: the company's profits, or earnings per share, and the price that investors are willing to pay for those earnings (expressed as the price-to-earnings ratio). As for earnings, a major worry in the market is that the lackluster economic growth we've had since coming out of the Great Recession will hamper corporate profits--and, ultimately, take a toll on stock prices. In the latest round of quarterly earnings reports (commencing again in July), we saw evidence of the economy's sluggish but positive growth in the sales (revenue) numbers, which often came in below expectations even as the profit numbers were beating expectations. Corporations have become quite adept at cutting costs, and the weak labor market has taken wage pressures out of the equation as a problem. Even modest economic growth (that is, we are not in a recession) can pave the way for stocks to do well if companies can take more of each revenue dollar to the bottom line.

On the other side of the gunfight is the value that investors will place on those earnings, a value that is strongly influenced by interest rates. A dollar a year from now is worth more when interest rates are at 2% than when rates are at 4%, for example. The Federal reserve, chaired by Ben Bernanke, has been pumping liquidity into the economy to keep interest rates at rock-bottom levels. One way to look at it is to say that the Fed doesn't want you keeping too much money in the bank, so it's going to create conditions where you are not rewarded for doing so. The Fed wants you to buy a house or start a business, or otherwise go out on the risk curve to put that money to work so that the economy will kick into a higher gear. A stronger economy means more jobs, and the Fed has stated explicitly that it wants to see the unemployment rate lower by about 100 basis points (a full percentage point). Mr. Bernanke and his crew exert this power over interest rates by buying up a slew of bonds--and paying for those purchases with money that they create out of thin air. So the Fed ends up with a bunch of bonds on its balance sheet and the economic system ends up with the cash--cash that didn't really exist before. This has been a big positive for stock prices, as investors seek out the higher returns that can come from taking on more risk (this is known in current jargon as the "risk-on trade."). The June market decline was ushered in by Mr. Bernanke's comments suggesting that the Fed might slow down its bond buying. The prospect of rising interest rates is a headwind for the stock market, often referred to as the Fed "taking the punch bowl away from the party."

Wouldn't it be nice--Nirvana, actually--if we had a strengthening economy to propel earnings and falling interest rates to place a higher value on those profits? Sure it would, but that's not the way the economy works. The Fed is not going to keep pushing down interest rates once the economy really gets going, so if the Fed continues its aggressive monetary accommodation, that is a sure sign that the economy is not getting any better. So, there's the set-up for the showdown that will influence the direction of stock prices. A strengthening economy would be good news, of course, and more robust growth likely would mean better earnings all around. The trade-off, though, is that higher interest rates usually come with the package.

There are a couple of points worth making here amid all of the media chatter about the consequences for the stock market. First, all that talk is about the stock market overall, what we might expect from the average stock. As investors, we are not seeking out the average stock--if that were our goal, we could buy index funds instead of engaging in the meticulous research of true stock-picking. It is true that a bad environment for the stock market is likely to hurt all stocks, but we can at least put the odds in our favor by careful stock selection. As an example, let's take a look at Tile Shop Holdings (TTS, $30), a specialty retailer of manufactured and natural stone tiles that is up 200% over the past year. If you want tiles for your home, you can either go to Home Depot for their selection and probably save some money, or you can go to a professional designer and likely pay a lot more. TTS has created a niche in the middle as a specialty retailer that carries a wide variety of such products, priced above what the big box home improvement stores offer but below the high end. Part of the reason for the strength in the shares is no doubt the improving housing sector, which has made for a nice tailwind. The other reason, though, is that the company has a long growth runway with only 72 stores in 23 states--and plans for a total of at least 100 locations. An intriguing growth story, but rising interest rates could put the housing recovery at risk. So there's the showdown in microcosm--will the growth of TTS be able to overcome the waning of investor enthusiasm for everything tied to housing?

Another point to consider is that the Fed is talking about "easing up on the gas" of monetary stimulus, not "slamming on the brakes" (more jargon!). You might think that this is a critical, finer point that investors have missed--but not so fast. Interest rates may not rise dramatically anytime soon, but it is hard to envision a scenario where they will fall from here, absent another full-blown recession. The issue is not that rates are going sky-high, but rather that we have probably seen the lows in rates for this cycle--and maybe for a very long time. That is not good news for holders of long-term bonds, because the only way to see bond prices appreciate is with falling interest rates. Bond investors who think rates are headed higher should keep their maturities short, so that they can invest maturing proceeds at higher rates.

We'll take our stock gains however we can get them, but I would rather see my stocks propelled by their own earnings prospects rather than by the opiate of falling interest rates. People always ask me if I think the market will go up from here, but they soon catch on to the fact that I am incapable of giving a "yes" or "no" answer. The better question is whether we will continue to see an environment that is favorable for owning equities. Perfection doesn't happen often for the stock market, but a combination of interest rates that don't rise dramatically and an economy that shows better growth would likely keep the rally going. That's a lot to hope for, and unexpected outcomes in either direction could give us Wall Street Unchained, with either blood in the streets or champagne in our glasses.

On another note, I'll acknowledge that it has been some months since I last posted to this blog. I express my sincere thanks to my readers who have told me how much they miss reading these installments. The good news here is that I have been extremely busy engaged in the activities that generate the thoughts and ideas for this space, so expect more regular posts going forward. Thank you.

Life is short. Get busy.

Jim


Disclosure/Disclaimer: My family members and/or I own shares of TTS. Individual stoks are mentioned here for the sole purpose of illustrating investment concepts, and nothing stated here should be construed as advice to buy or sell any security.