Friday, August 10, 2007

IS THIS A BEAR MARKET?


Trouble in paradise.

With recent turmoil in the market, headline news about sub-prime meltdown, several hedge funds collapsing, talks about "liquidity" crisis, and the Dow dropping hundreds of points on a daily basis, panicked investors are asking themselves if they should sell everything.

The answer is no. Yes the real estate industry is suffering, and yes hedge funds with sub-prime exposure are getting hit. While those events make excellent headlines which frighten investors and increase viewer readership, I view the current market downturn as a normal correction. We are in the fifth year of a long bull market which has gone virtually uninterrupted. The last correction was over a year ago during late Spring 2006, so it was simply overdue. 8% to 10% declines are common and a normal part of the health restoring process during bull markets, and you are witnessing one now.

Investors with a long term horizon of at least a few months will be nicely rewarded and should not get distracted by the headlines.

What are the key major factors that contribute to bear markets, and are they present today?

1. Excessive valuations. There was reason to be concerned about "irrational exhuberance" in the late 90's and early 2000's, when P/E ratios were in excess of 30. The high valuations in U.S. markets at that time contributed to a major downturn in the 2001-2002 period. The same thing happened a decade earlier to Japanese equities whose valuations had mushroomed to P/E ratios in the 50 range, eventually collapsing and causing a 12 year bear market for Japan.

None of those conditions are present today. The P/E ratio on the S&P 500 is in the high 15's range based upon 2007 earnings, and 14 based upon 2008 projected earnings. This is well below the acceptable range of 17 to 18, typical in environments such as the one we have today, with the economy growing moderately, contained inflation and relatively low interest rates.

The current downturn is paving the way for the S&P 500 index to grow into the 1700 area.

2. Recession. Bear markets tend to precede recessions, as stocks are purchased based upon growth expectations. So if you think company revenues will be lower next year you will naturally bid less for the shares.

The economy continues to chug along at a 2% to 3% rate. While it's nothing to get excited about, it is still very respectable, especially in the context of low unemployment rates in the 4.8% range and the fed's last two years of tightening rates.

3. High inflation. Investors flee equities during periods of high inflation, in favor of hard assets such as real estate. Inflation is bad for the stock market and equities in general.

With the current inflation in the 2% range, improvements in productivity, an abundant flow of cheap goods from China and India continuing to provide the american public the ability to maintain its pursuit of bargains, it would be hard to make a case for an inflationary environment. In addition the high price of oil also acts as a counter-inflation measure by taking a greater percentage of the consumers' wallets and curtailing their spending in other areas.

4. High interest rates. Rates and equities perform in opposite direction. During times of high interest rates, bonds attract risk free returns at the expense of equities, and valuation ratios drops. High interest rates are another market enemy.

While rates have gone up in the last 2 years, they are low by historical standards. Fed rates at 5.25%, the prime at 8.25%, mortgage rates in the mid 6's, may all be higher than a couple of years ago but way lower than 10 years ago. The current interest rate and money supply environment is favorable to equities and consistent with P/E ratios in the 17 range.

So, what do we do now and what should be expected?

Volatility will continue because investors are nervous and the headlines ugly. Investors should use this to their advantage by purchasing equities on down days. At this stage Gevity Ventures is investing in companies that meet the following characteristics:

1. Large capitalization with solid balance sheets. This is not a good environment for small caps, investors are looking for safety and established companies that can weather the storm.

2. Growth oriented. We are finding excellent value in the large high tech names, companies like Cisco, Microsoft, Symantec, Yahoo, Qualcomm, Dell and Intel. They have low valuations because to a great extent they failed to participate in the rally of the last 4 years and are now trading at attractive prices. Their balance sheets are solid with billions in cash and little or no debt.

3. Companies that pay dividends. We like some of the large banks that are trading at great discounts and reward investors with solid dividends like Bank of America and Citigroup. The brokerage industry also offers good valuations. I doubt Merrill Lynch, the Nasdaq, The New York Stock Exchange, Nomura Securities, all publicly traded organizations, are going out of business any time soon, and they are cheap. There is also excellent value in defensive stocks such as the food industry with Kraft (one of Warren Buffett's holdings), pharmaceuticals like Pfizer and Amgen, and great dividends with Canadian oil and gas trusts such as Pengrowth and Harvest Energy that yield in excess of 15%.

The stock market is in the middle of a storm and will get through it as it always eventually does. Patient and calm investors will be rewarded.