Contributing editor Tom Slee is with us this week with some thoughts on what we're likely to see in the stock markets in the coming months and what we should do about it. Tom managed millions of dollars of pension money in the insurance industry during his career. Over to him.
Tom Slee writes:
It's hard to believe but at one time stock brokers played golf in the summer. They slipped away and relaxed, knowing that the market was safely on hold. Volumes were low and orderly. It was an entirely different world, a far cry from the present uproar.
Nowadays traders are too scared to go out for a coffee. There is almost constant turmoil. As you know, we even had a period of outright bedlam during the second week of August. On Monday, the Dow plunged 634 points, its sixth-largest loss ever, and then averaged 450 point swings for the next three days. It was the wildest ride the Dow ever recorded; a roller coaster par excellence. Investors were shell-shocked. Coming on top of continuing bad news it seemed as though we were reliving the 2008 disaster.
Since then things have stabilized a little and it's apparent that those wild market swings were exacerbated by computer-driven trading programs. But the damage has been done. Every piece of bad news triggers another sharp sell-off. Rallies are lacklustre. A lot of the oxygen has been sucked out of the markets. People have lost heart. In fact, many bailed out all together.
London's Financial Times estimates that $50 billion worth of stocks were sold globally during that wild week and the proceeds shifted to money market funds. That is more than flowed from stocks to bonds in the wake of the Lehman Brothers collapse. An astounding $1.6 billion in U.S. 401(K) retirement plans was switched from stock to bond funds one day after the initial plunge, the fifth largest 401(k) transfer ever recorded. Adam Bold, founder of money manager Mutual Fund Store, reacted by pointing out that workers have seen their pensions devastated twice in three years. "A lot of people are saying: 'I can't handle that again'."
I am not suggesting that we are already in an epic bear market or that the business recovery has stalled completely. As a matter of fact, corporate earnings suggest otherwise. My feeling, rather, is that this latest rout has taken a lot of starch out of investors. They are going to be reluctant to drive prices in the near future regardless of what happens and we have to factor that into our investment strategy. The present political economic problems are serious but not insurmountable. We knew that the recovery was going to be long and difficult. Well it is. Now we have to add investor confidence to our concerns. That may be hard to quantify but it's important.
Here, as I see it, is the situation. U.S. economic growth is slowing and likely to come in at around 1.5% next year, a miserable performance at this stage in the recovery. Canada should post about 2.4%, far less than we were hoping for. At the same time, it's obvious that the European sovereign debt crisis is far worse than anticipated. Government as well as corporate bonds are being tainted. Analysts are concerned that commercial banks will retrench, stop lending to each other, and that credit will dry up. That would send us into the sort of tailspin we saw in 2008.
It's not a pretty picture. However, there is nothing new there. We have known about the slow recovery and the European problems for some time. So why the sudden market panic in August? Nothing had changed.
Commentators point to Standard & Poor's infamous downgrade of U.S. debt but that was expected, even discounted. More important, the downgrade had no fundamental significance. It triggered an avalanche of money into, not out of, American Treasury bonds. Keep in mind that none of the other 71 credit rating agencies, with access to the same information, adjusted their U.S. debt rating. Are they all wrong?
The answer, I think, is that investors finally caved in under the unrelenting doom and gloom. The Volatility Index (VIX), the infamous "Fear Index," had climbed to an alarming 48, well above the 30 reading that shows investors are nervous. We were primed for a correction anyway but because investment risk tolerance was extremely low the selling quickly turned into widespread panic.
Investment risk tolerance is a vastly underestimated component of the market. Focused on results and forecasts, we tend to forget that a great deal of market movement hinges on investor sentiment, in other words people's optimism. It's so important that the Institute of Chartered Financial Analysts has researched the issue and divided investors into four categories -Spontaneous, Methodical, Individualist, and Cautious - primarily to determine appropriate portfolio mixes.
In my own experience, though, it's much more complex than that. Risk tolerance is a personal characteristic and it's constantly changing. For instance, surveys show that when things are going well a lot of people confidently claim that they never worry about the markets. Yet these very same investors become extremely worried after a sobering correction and start watching the Dow every hour or so. It's an understandable reaction. So we can safely assume that there is a lot of worry out there right now, perhaps fear.
I think that we have two things to consider. First, now that we have all been very badly battered for the second time in three years, this is a good time to reassess your own investment tolerance level. Has the recent market route made you nervous even though your own holdings weathered the storm reasonably well? If so, give some thought to rebalancing your portfolio. Increase your cash and fixed-income components. As Gordon has pointed out, everything now points to a period of volatile and very difficult markets. There is no sense in remaining apprehensive, even miserable, while we ride out the storm.
Second, we now have to factor widespread anxiety into our stock price targets. As a rule, our targets are established by projecting a company's future earnings and then estimating how much people are going to pay for these. To give you an example, Royal Bank is expected to earn about $4.50 a share this year and in June, before the downturn, the shares were priced at $54. Investors were willing to pay 12 times the estimated profit. As Royal should make approximately $5 a share in 2012 it was reasonable, using the same multiple, to assume that the stock would trade at around $60 next year. Now, however, the mood has changed. Going forward, Royal is more likely to command an 11 or even 10 multiple, which would suggest little growth in the stock. With a reduced risk tolerance, people are going to be defensive, reluctant to bid up good earnings and quick to punish disappointing results. I think that we have to lower our market price projections, regardless of how companies perform.
It's sad because despite all the doom and gloom, corporate America is churning out record profits. As I write, 40% of the S&P 500 companies have reported and 70% beat profit expectations while an astonishing 83% exceeded their revenue forecasts. However, as with the first-quarter results, these numbers are not being reflected in the market. People are unimpressed, inclined to regard the glass as half empty rather than half full.
My feeling, therefore, is that we should realign our portfolios and shift the emphasis to defensive, dividend-paying stocks. Or to put it another way, focus on companies that are not dependant on expansion or affluent times. Utilities and pipelines fit this bill. At the same time, we should reassess our holdings of second tier or more speculative securities, in particular any junior commodity plays. Some managers, such as J.P. Morgan Chase, feel strongly that global demand will support further price gains, especially in copper. They may be right but junior copper stocks are largely powered by optimistic short-term investors concerned with exploration plays. These optimists are going to be in short supply. So I think that we should restrict our commodities exposure to well-established producers.
The portfolio review is going to take several months but there is no immediate urgency. All of our holdings are solid, well-managed companies. This is more of a stock review. The idea is to try and identify investments that are likely to perform relatively well in nervous, volatile markets. The commodity stocks are a good place to start because that is where the traders are. You'll find my thoughts on some of my specific recommendations in the updates that follow.
New pick: Kinder Morgan
Before we get to those, however, I have a new pick for your consideration. Just so there is no misunderstanding, we remain extremely cautious here at IWB. However, there are always investing opportunities even in turbulent times and we are constantly on the lookout for them.
One stock that looks particularly attractive right now is Kinder Morgan Inc. (KMI). This company is the general partner and substantial owner of Kinder Morgan Energy Partners, one of the largest pipeline master limited partnerships (MLPs) in the United States. We do not recommend the partnership itself, despite the higher yield, because of the onerous tax burden on Canadian shareholders, including a 35% withholding tax. However, the corporation is taxed as any other American corporate entity so that issue is not a concern.
The stock closed on Friday at $25.19 and pays a $1.20 dividend (figures in U.S. currency). This means the shares yield 4.76% and management has indicated that we can expect a 10% increase in the dividend in 2012. As a major pipeline operator, Kinder is relatively defensive and should earn about $1.20 a share in 2011 and at least $1.25 next year. I will provide a full report next time but KMI now becomes a Buy at $25.19 with an initial target of $33.
About the author:
Gordon PapeGuruFocus - Stock Picks and Market Insight of Gurus