Market Pullback Ahead?

Sam Stovall, the well respected chief strategist at S&P Capital IQ, was on Yahoo Finance's Breakout segment and pronounced that stock market will likely have a 5-10% modest pullback.

"You're better off watching for a tsunami than you are an earthquake because the lack of volatility usually indicates that it's a matter of when, not if, we're going to have a market decline of 5% or more," says Sam Stovall, the chief equity strategist at S&P Capital IQ, in the attached video. The good news, however, is that although we're overdue for a shakeup, he says "I don't think it's going to turn into a bear market."

He says, a check of economic, monetary, sentiment, earnings and more all suggest a shallower, more subtle pullback is in store, rather than something more sinister.

Thus, Mr. Stoval joins a chorus of pundits calling for a modest decline including Liz Ann Sonders of Charles Schwab, who stands out for her modesty and composure among the pantheon of market prognosticators who clamor for your attention. Here is what she wrote:

Headwinds have reemerged and investor concern is heightened yet again. We still believe stocks can run further, but a pullback is more likely in the near-term. 

My investment experience is perhaps modest compared to some of the strategists out there. It did however encompass 20 years, including both bull and bear markets. I have come to believe that a pullback of 5-10% can happen anytime in the stock market. Those of us in the market long enough knows how difficult it is to predict future movements. However clairvoyant we may be, we have all been wrong so often that we start to speak of Mr. Market in personified and reverential terms as if it is the embodiment of wisdom. However, even those who profess such respects for the market can not constrain their desires to know her evanescent whimsy. If the market is to have a pullback and only to reverse course in short order, who are then the suckers selling into such ephemeral doldrums? It is difficult enough to predict a downturn, but to predict a downturn and a reversal seem to me have crossed some kind of boundary of modesty.

  

Risky Business

Joel, you wanna know something? Every now and then say, "What the heck." "What the heck" gives you freedom. Freedom brings opportunity. Opportunity makes your future.

That is a dialog between Miles played by Curtis Armstrong and Joel Goodsen played by Tom Cruise in the 1983 movie "Risky Business." The original quote of course used certain other four letter word which has been changed for the purpose of good taste. This might as well be the utterance of Ben Bernanke to Mr. Market.

Today, Mr. Market pretty much said "what the heck" to the so called sequester. The dysfunction of our national government in its failure to reach a sensible solution to our mounting debt problem did not seem to perturb the market much. Stocks was down perhaps for two hours in the early trading hours and by a little more than a half a percent. Then it merrily went its upward ways. Investors now seem to heavily vested in the idea of a Bernanke put. Whatever happens, the Fed will be there to rescue the market. For Joel Goodsen in "Risky Business," he was able to regain control of a chaotic situation and obtain admission to the college of his choice, not to mention the girl of his desire.

Will the easy money policy of the Federal Reserve spin out of control and lead to unforeseen consequences? Will investors be agile enough to exit the party when the Fed eventually takes the punch bowl away? The plot thickens.

Penney for My Thought

What percentage of success is attributable to luck and what percentage by design?

Ron Johnson, the new CEO of J. C. Penney and the man credited with the success of Apple Stores, so far seems to have met neither on his new job. The latest earnings report from Penney was a disaster, at least in the eyes of Wall Street. Here is how Reuter reports it.

(Reuters) - Shares of J.C. Penney Co Inc (JCP.N) opened 19 percent lower on Thursday after the department store operator reported its sharpest drop in sales since announcing a transformation plan 13 months ago.
  The results prompted at least three brokerages to cut their price targets on the stock, which has lost 48 percent of its value in the past year.

"We were most surprised by the more than 1,000 basis points decline in gross margins in the quarter," Deborah Weinswig of Citigroup wrote in a note, cutting her price target on the stock to $22 from $25.

Mr. Ron Johnson of course insists that turning around a long time failure like Penney is a multi-year project and he needs more time to execute on his new strategy. I have no basis of doubting Mr. Johnson's sincerity. However, it has been my general observation that in the world of business, predictions are never wrong; they are merely premature. Strategies are never erroneous; they always need more time. Here is a thought. Perhaps the success of Apple Stores have something to do with those iphones and ipads and less to do with selling said items on tables instead of counters. 

Bernanke to the Rescue

After a modest sell off, albeit one accompanied by a sharp rise in volatility, Mr. Bernanke once again rode to the rescue. Appearing in his semi-annual Humphrey Hawkins testimony to Congress, the Fed chairman re-assured the market.

 In the current economic environment, the benefits of asset purchases, and of policy accommodation more generally, are clear: Monetary policy is providing important support to the recovery while keeping inflation close to the FOMC's 2 percent objective. Notably, keeping longer-term interest rates low has helped spark recovery in the housing market and led to increased sales and production of automobiles and other durable goods. By raising employment and household wealth--for example, through higher home prices--these developments have in turn supported consumer sentiment and spending.

There in fact has been talks among the jittery wall street types that the Fed chairman may address the possibility of ending asset purchase sooner.  However, the effectiveness of monetary policy depend just as much on credibility as it is on setting interest rates. Whatever private concerns Mr. Bernanke may have, he has to maintain his unwavering public stance. It is clear that the Fed is trying to raise asset price to foster stronger economic activities. It will continue to do so until the stipulated bonds of inflation and unemployment rate have been breached.

Advice for investors: don't fight the Fed.

The Italian Job

Even since the release of Federal Reserve's January meeting minutes showing a few members' concerns of the long term consequences of QE, the stock market had acquired a downward bias. However, none of the subsequent trading days have showed such panic as today's closing hour. For the day, S&P 500 was down 1.8% and the volatility index rose 34%. The reason for such panic was attributed to election results in Italy. Here is a Reuters report explaining it.

The center-left coalition led by Pier Luigi Bersani won the lower house by around 125,000 votes and claimed the most seats in the Senate but was short of the majority in the upper house that it would need to govern.

Neither Grillo, a comedian-turned-politician who previously ruled out any alliance with another party, nor Silvio Berlusconi's center-right bloc, which threatened to challenge the close tally, showed any immediate willingness to negotiate.

World financial markets reacted nervously to the prospect of a government stalemate in the euro zone's third-largest economy with memories still fresh of the financial crisis that took the 17-member currency bloc to the brink of collapse in 2011.

Grillo's surge in the final weeks of the campaign threw the race open, with hundreds of thousands turning up at his rallies to hear him lay into targets ranging from corrupt politicians and bankers to German Chancellor Angela Merkel.

In just three years, his 5-Star Movement, heavily backed by a frustrated generation of young Italians increasingly shut out from permanent full-time jobs, has grown from a marginal group to one of the most talked about political forces in Europe.

Berlusconi's campaign, mixing sweeping tax cut pledges with relentless attacks on Monti and Merkel, echoed many of the themes pushed by Grillo and underlined the increasingly angry mood of the Italian electorate.

It has always been a worry for the market that how long the citizens of Europe's peripheral nations will accept the yoke of austerity. Regardless of how Italian election finally shapes up, the expanding influence of this anti-austerity block can not be denied. Mr. Grillo, who is the leader of the anti-austerity movement, wants Italy to hold a referendum to decide whether it should stay in the Euro zone. Of course, we are a long way from Italy leaving the Euro zone. But the existence of such a possibility has given the market a strong reason for pause.  

Is TI the New Model for Mature Tech Companies?

Amid the hoopla of the Dell buyout and the ensuing shareholder push back, the stock price of another Texas tech giant reached a 52 week high. In a press release last Thursday and a subsequent conference call on Friday, Texas Instrument outlined its new capital allocation strategy.

DALLAS, Feb. 21, 2013 /PRNewswire/ -- Texas Instruments Incorporated (TI) (NASDAQ: TXN) today said it will increase its quarterly dividend by 33 percent, from $0.21 per share to $0.28, payable May 20, 2013, to shareholders of record on April 30, 2013. Annualized, the new dividend will be $1.12. Additionally, TI authorized the repurchase of an additional $5 billion of its common stock bringing the total outstanding authorization to $8.4 billion.

These increases reflect the company's ability to generate cash and management's commitment to return it to shareholders. Over the past few years, TI has built a business model for growth and high margins with its focus on Analog and Embedded Processing semiconductors. As a result, TI believes it can consistently convert 20-25 percent of its revenue into free cash flow* and return 100 percent of that free cash flow (less debt repayment) to shareholders.

Much of mature tech giants today including Microsoft, Intel and Cisco are generating copious amount of free cash flow and seeing their cash holdings increase each quarter. Should these companies choose the lead of Texas instrument and pay out substantially all free cash flow, none will ever complain about an under-valued stock. Investors can only hope that TI is the new model.

Cisco and Heinz

Cisco reported earnings last night. Once upon a time, the market would move according to what Cisco reported or had to say on their earnings conference call. Today, it barely noticed. Instead, a much stodgier company grabbed the stage. Heinz was being acquired by Warren Buffett and Brazilian private equity firm 3G Capital for $72.50, about a 20% premium to previous day's close.

In late 2000, when I was a mutual fund manager canvassing around the country and ballyhooing the worthiness of my own special blend of stocks and bonds, I surveyed a roomful of financial advisers. If they could hold one stock, what would that company be? For their one and only Valentine, most advisers chose Cisco. Of course at the time, Cisco was trading in the high 60's and carried a PE multiple in the triple digits. Heinz, being a food company, of course was never showered with such affection during the growth crazed years of 1999 and 2000. In late 2000, it carried a price around $40 per share and a PE multiple of  16.

Fast forward 13 years ahead, Cisco had grown revenue from $18.93 billion in fiscal 2000 to $46.06 billion in fiscal 2012 for a compound annual growth rate of 7.1%. Earnings per share had grown from $0.39 to $1.50 during the same period for an annual growth rate of 10.9%. Heinz, on the other hand, had grown, revenue, also on a fiscal year basis, from $8.94 billion to $11.65 billion equating to 2.1% annual growth. EPS had grown from $2.51 to $2.87, a minuscule growth rate of 1% annually. Now for the number that  really matters to investors, at today's stock price of around $21, Cisco had lost more than 70% of its value and Heinz had gained more than 80% at the buyout price.

So for lesson #1, the stock market has a propensity to overvalue growth. Overpaying even a great company can have acutely negative consequences for your portfolio.

Even before today's $12 climb, Heinz at $60 was trading at 21 times it latest fiscal year end earnings while Cisco only sports a multiple of 14. Cisco is by no means an inferior business compared to the ketchup king. During the latest fiscal year, Cisco had a gross margin of 61% and return on asset of 8.8% while Heinz had a gross margin of 34.3% and return on asset of 7.7%. The natural questions is of course, why does Cisco which grows faster and has superior return characteristics, trade at a much lower multiple than Heinz. The answer is  Heinz will still be selling Ketchup 10 years from now while Cisco may very well be supplanted by an emerging technology or may have to re-invent an entirely new product line.

So here is lesson #2, the stock market has a propensity to overvalue innovation. In fact, companies with long and stable product lines always have the superior business models over companies that had to re-invent themselves.

At $72.50, Mr. Buffett is paying 19 times Heinz fiscal 2014 earnings estimate, which I believe is overly optimistic. I think given his extremely low cost of capital, Mr. Buffett is paying a fair price for an extremely slow growth company. I also tend to think that the market is also over-estimating the business risk of Cisco who occupies a dominant position in networking and is well entrenched in enterprises and governments alike.

For my money, I will bet on Cisco at $21 over Heinz at $72 for the next 10 years.