Tuesday, May 26, 2009

Have Consumers Misplaced Their Confidence?

The headlines were full of bad news today, yet stocks rallied strongly anyway. North Korea tested a nuclear bomb, GM moved a little closer to bankruptcy, and housing prices continued to plummet. However, investors decided to pay more attention to the consumer confidence number.

According to the Conference Board, the Consumer Confidence Index jumped from 40.8 in April to 54.9 in May. This index, which is based on a survey of 5,000 households, had a cutoff date of May 19.

Given the recent and very strong rally in stocks, it is no surprise that confidence climbed. After all, the S&P 500 was 34% higher on May 19 than it was at its March 9 low. A rally of this magnitude would make even the most pessimistic consumer a little more confident.

One notable change was the big increase in the percentage of respondents who are expecting an improvement in the labor market in the near future. This is somewhat surprising since unemployment commonly continues to rise for several months after recessions end. Furthermore, most economists are forecasting very anemic growth in the U.S. for several years to come. Demand for goods and services could remain weak for a long time as consumers and businesses focus on shoring up their balance sheets.

GDP growth of just 1-2% will not do much to help the labor market. As a result, the unemployment rate could remain above 8% for quite some time. That's not the kind of outcome that will help boost consumer confidence.

Wednesday, May 20, 2009

VIX Falls as Stocks Rally

There has been a lot of talk lately about the Volatility Index commonly called the VIX. Investors often look at the VIX to determine how much fear there is in the markets. For a prolonged period, 2004-2006, the VIX traded at very low levels. For most of those years, it traded well below 20, suggesting not only that investors had little fear of risk, but also that they were complacent. However, the VIX started rising in 2007. It peaked in late 2008 above 80 as the financial crisis made front-page news.

Recent talk of the VIX has focused on its rapid decline. It is now below 30, yet still well above the 2004-2006 levels. This suggests investors have become less fearful of putting money at risk, but they are still far from being complacent.

The VIX is actually the instantaneous standard deviation from the Black-Scholes Option Pricing Model. Traders sometimes use this model to identify overvalued or undervalued options. The model relies on several variables, one of which is the underlying stock's instantaneous standard deviation. This variable is almost impossible to measure. However, if all the other variables are known, the standard deviation can be backed out of the Black-Scholes equation. In the case of the VIX, the underlying stock is actually the S&P 500 Index.

The VIX tends to rise when the market sells off, but it falls when the market rallies. In other words, it is a better measure of downside volatility than overall volatility. Furthermore, the VIX is not a reliable forecaster. The market does not rally simply because the VIX falls. In fact, it is more accurate to say that the VIX falls as the market rallies.

Monday, May 18, 2009

Finding Religion in Your Jeans

On March 25, I recommended buying True Religion Apparel (TRLG) in the Forbes Growth Investor investment newsletter. The stock was selling for $11.60 at the time. On May 8, a few days after the company released first quarter results, I told subscribers to sell. The stock closed that day at $21.97.

While the stock is not obviously overvalued, it's no longer a screaming buy. The company reported a 19% year-over-year increase in sales. That's impressive in a recession, but it's also a considerably lower growth rate than TRLG posted in recent periods. Furthermore, the company's largest segment, U.S. Wholesale, saw an 11% decline. In addition, the operating profit margin fell 70 basis points and net income climbed by only 9.8%, well below the increase in revenues.

Yet with $76.5 million in cash and no debt, TRLG is a very healthy company. Even in this severe recession, the company has had no problem convincing fanatically devoted customers to purchase its overpriced jeans. During the first quarter, TRLG commanded an average price of $262 for a pair of ladies' jeans in its full-priced stores. Perhaps more amazingly, it got $287 for each pair of men's jeans. More than 40% of its sales now come from the men's category.

TRLG is trying to increase the number of branded stores and is pushing for growth in the more profitable Consumer Direct and International segments. However, if it hits the high end of management's guidance, full-year revenues will be up only a modest 10%. EPS will be down slightly. I believe management is being deliberately conservative with its projections. Nonetheless, unless the recession ends quickly and more consumers develop an urge for high-priced jeans, growth at this company will likely continue moderating.

Tuesday, May 12, 2009

First Quarter GDP Likely Fell by More Than 6.1%

In the May issue of the Forbes Growth Investor, I wrote about the dramatic decline in international trade. Today, we were given more evidence of this. The "U.S. International Trade in Goods and Services" report for March was released this morning. Not surprisingly, due to the recession, we saw fewer imports and exports. However, imports fell by less than exports. Imports were down $1.6 billion to $151.2 billion in March from $152.8 billion in February. Exports dropped $3 billion to $123.6 billion in March from $126.6 billion in February.

The Advance estimate for first quarter GDP was -6.1%, but that report showed a bigger decline in imports than exports. As a result, net exports added 1.99 percentage points to the first quarter GDP report. The Preliminary estimate for first quarter GDP comes out on May 29. This is a more accurate estimate because it is based on more complete data. Unfortunately, today's trade data indicates that the contribution from net exports was less than shown in the Advance estimate. As a result, GDP in the first quarter likely fell by more than 6.1%.

Thursday, May 07, 2009

We Remain Skeptical Despite Strong Results

The recent market rally prompted us to close out some positions in the Forbes Special Situation Survey. In the last few days, we pocketed gains of 38% in 2.5 months on Chicago Bridge & Iron (CBI) and 35% in 6 months on Goodrich Corp. (GR). In March, we closed out EnerSys (ENS) for a 123% gain in 4 months and Western Digital Corp. (WDC) for a 46% gain in 3 months. However, today, we took a 64% loss on Coventry Health Care (CVH) in 28 months. These sells have reduced the number of open positions in our recommended portfolio to 13.

According to the Hulbert Financial Digest, our recommended portfolio has gained 7.2% on an annualized basis (excluding dividends) over the past 3 years. That ranks us #4 overall out of 183 investment newsletters. Our 5-year record comes out to 10.1% on an annualized basis, good enough for #5 overall. Year-to-date, Hulbert has us showing a 16.1% gain.

One reason we have pared back our holdings is because we are somewhat skeptical of the recent rally. While things are getting worse at a slower rate, they are still getting worse. We believe there is more bad news to come. Investors may react by selling aggressively when that happens.

Wednesday, May 06, 2009

Unions Destroy Shareholder Wealth

Just as Ben Bernanke gives us some hope that the economic recession may be coming to an end, here's something new to worry about.

A working paper published by the National Bureau of Economic Research (the same organization charged with declaring the start and end of U.S. recessions) and summarized by Linda Gorman concludes that unions destroy shareholder wealth. In "Long-Run Impacts of Unions on Firms: New Evidence From Financial Markets, 1961-1999," authors David Lee and Alexandre Mas find that a union victory costs the owners of the company an average of $40,500 per worker.

Union advocates often argue that unionization does not result in a loss of profits. Indeed, the authors of this paper provide evidence that unionization has little impact on profits and return on assets. Unfortunately, they also find that growth at companies where unions win organization elections falls short of growth at companies where unions lose. In other words, unionization may not decrease profits, but it does put an end to the growth of profits.

Because the stock market is a discounting mechanism, investors anticipate this end to growth and sell the shares. The loss in equity value begins when the union wins an election to organize and continues for 15 months. The net result is large negative returns of 10-14%. It also turns out that the greater the margin of the union's victory, the greater the loss in shareholder wealth. This could also explain why unions are sometimes reluctant to take ownership stakes in organized companies.

With a new administration in Washington strongly backed by the unions, it's a good bet that organized labor will expand its reach in coming years. The authors of this paper estimate that a doubling of unionization will cause equity values to fall about 4.3%. This should give the administration something to ponder as it tries to save General Motors and Chrysler.

Monday, May 04, 2009

Short Term Bearish; Long Term Bullish

The following commentary is from the May issue of the Forbes Growth Investor.

The S&P 500 is up almost 30% from its March 9 low. This has some investors wondering if we are now in a new bull market. Whatever you choose to call it, we remain skeptical and warn you not to become complacent. After all, it is not as if all the problems in the economy have suddenly gone away. On the contrary, they are growing worse. The only difference is they are now getting worse at a slower rate.

Take the latest S&P/Case-Shiller report on housing prices. The 20-city index documented an 18.63% decline in housing prices from February 2008 to February 2009. However, that was a little better than the 19.03% decline from January to January. In other words, things are getting worse, but at a slower rate.

The GDP report for the first quarter of 2009 also was interesting. The 2.2% rise in personal consumption expenditures was certainly welcome news, but it was not enough to offset big declines in inventories and fixed investment. Furthermore, international trade is falling off a cliff. Exports fell 30%, which came on top of a 24% decline in the fourth quarter of 2008. Imports plunged 34%. They were down 17.5% in the fourth quarter. Overall, the economy contracted 6.1%, but that was somewhat better than the 6.3% contraction in the fourth quarter of 2008. In other words, things are getting worse, but at a slower rate.

The Federal Reserve added fuel to the stock market’s rally when its Open Market Committee released a statement saying,“… the economy has continued to contract, though the pace of contraction appears to be somewhat slower.” You guessed right:Things are getting worse, but at a slower rate.

Of course, things cannot get better until they first start getting worse at a slower rate. Therefore, investors are not wrong to cheer. A bit of a rally in stocks is fully justified. However, a 30% rally in just a month-and-a-half seems extreme. We continue to believe long-term investors should think more about buying than selling. Anyone with an investment horizon of five years or longer is not likely to regret buying stocks today. Nonetheless, we also expect a meaningful sell-off in stocks in the short term. Earnings season will soon come to an end. Given the strength of the recent rally, profit takers will be tempted to take some money off the table. This kind of activity could easily drive the Dow lower by about 500 points or so. Be prepared to buy more of your favorite stocks when that happens.