I’ve posted my second update to Current Market Tactics

I’ve written the second part of my update to Current Market Tactics.   If you’re on the blog, you can also reach the post by clicking the tab at the top of the page.

Shaping a Portfolio for 2011 (V–and last): sectors

There are only two sectors I want to comment about–utilities and technology.


Utilities in emerging markets can be attractive growth companies.  Demand for their output typically rises quickly as a country industrializes and as a nascent consumer sector becomes more affluent and wants/is able to pay for more services.  All this growth requires near-constant expansion of plant and equipment, which the utility can, most times, only pay for by issuing new capital.  This implies rate-setters must establish a rate structure that’s profitable enough for the utility that investors are willing to keep on buying the company’s stock and bonds.

In a mature environment, the story changes radically.  Demand growth becomes a function of changes, up or down, in the population.  No new plant is required, so the main source of pressure on the regulators is from the votors, who want their utility bills to be as small as possible.    So rate increases are harder to come by.

Since the utilities can’t pick up and move, they effectively become price takers, growing at the rate of inflation–if that.  So they begin, more or less well, to diversify into non-regulated businesses.

My point?  …utilities in developed economies don’t do well when interest rates are rising or when investors are woried about inflation.  For the reasons I’ve described above, their cash flows–and as a result their dividend payouts–from the regulated businesses can’t rise much.  And regulators will drag their feet in allowing recovery of higher costs, as well.  So they can’t keep pace with competing fixed income investments.

I don’t buy the inflation fear story that has been circulating on Wall Street recently.  But worries about deflation–which would arguably be good for utilities–seem to be a thing of the past for this cycle.  That alone is probably enough to ensure utilities in the US will continue to underperform.


We’re in the midst of a technology revolution, which is seeing an explosion in demand for wireless, social networking and cloud computing.  Yet IT was an underperforming sector in 2010.  Yes, there was a large selloff in January as investors who had nursed their 2009 winners into the next tax year took profits.  But still…

The easiest way to see what’s going on is to look at the largest tech stocks by market capitalization–the ones with the greatest contribution to the sector’s performance.  They are, in order:

Apple     $300 billion+

Microsoft     $250 billion-

Google     $200 billion-

IBM     $185 billion+

Oracle     $150 billion+

Cisco     $115 billion+

Intel     $115 billion+

Hewlett Packard     $100 billion+

Amazon     $80 billion+

Qualcomm     $80 billion+.

The ten make up about $1,575 billion in market cap.

Okay, AAPL, GOOG, AMZN and QCOM are relevant to the current technology revolution.  But they make up only $610 billion of the total, or about 40%.  The rest are pretty much companies of the past, and as such, dead weight.

This implies to me that you can’t get effective stock market exposure to the current tech revolution through a technology index.  It seems to me that you either have to pick individual stocks or look for an actively managed fund.  Personally, I’d take my chances with one or two individual stocks.

Shaping a Portfolio for 2011 (lV): what I think equity exposure should look like

US stocks

Based on the idea that we have at least one year (and maybe several) of expanding US and overseas economies ahead of us, I think a US portfolio has to continue to be tilted toward economically sensitive sectors and away from defensive or stable growth ones.

True, today’s stock market circumstances are different in some respects from those that prevailed during the second half of 209 and much of 2010.  But the differences are mainly ones of emphasis rather than general direction.

small instead of large

Eighteen months ago, stocks were significantly cheaper.  Skepticism about the potential strength of economic recovery was high. Because of this, there was no percentage for most investors in taking the risk of owning second-or third-tier stocks. Yes, you might have had higher returns from taking on the extra risk…but  why?   You could still have made very good money—and significant outperformance—from buying plain vanilla large capitalization names.

I don’t think that’s true any longer. This year there’s be much more money to be made in smaller names. This isn’t a profound insight (although it will likely prove a profitable one). It’s the normal market progression during an up phase.

growth instead of value

A second element of market maturation, a shift from value stocks to growth names, appears to me to have already begun last September.   This trend will likely continue throughout 2011. Why? Value stocks are typically very sensitive to an upturn in the economic cycle and therefore move earlier.

You might explain this by saying that investors first discount the fact of economic recovery and only later get more specific by beginning to focus on the distinctive aspects of a particular upturn. Or you might say that it’s only after the initial surge of pent-up demand from recession is satisfied that the ability of a growth company to generate steady profit growth from unique or unusual products begins to catch the market’s fancy. In any event, it’s what happens.

sectoral structure

From a sectoral point of view, I think the overweight areas should be—in no particular order:



Consumer Discretionary



Underweights should be:





I personally have one neutral, Financials, because I don’t know enough to have an opinion. So I’ll be content with not gaining or losing relative performance in this sector.

geographical exposure

I’m a US-based investor and am ultimately concerned about returns in US dollars.  I still have a preference for having a considerable amount of non-US exposure, however. But my preference is milder today than it was a year ago and has a somewhat different focus.

For the past two years, both professional and individual investors have asked themselves whether there would be more economic strength inside or outside the US and decided the question was a no-brainer.  They put themselves, correctly, squarely in the “elsewhere” camp, especially in emerging markets.

Several aspects of the inside/outside situation have changed, in my opinion:

–some emerging economies have begun to fear overheating, given the relatively stimulative money policy of the US and the large flows of portfolio capital into their stock and bond markets.  So their governments are acting to slow their economies down.  This shrinks the growth differential between them and the developed world.

–the US is finally beginning to pick up economic momentum, shrinking the relative growth gap further.

–the EU has decided the best road to recovery is to repair government finances as soon as possible, sacrificing near-term economic growth in the process.  This has widened the negative growth gap between the EU and the rest of the world.

The home country/foreign exposure decision depends principally on your personal economic circumstances and risk preferences.  Having said that, I think any changes should be in the direction of:

–more exposure to the US economy, especially retail

–much less exposure to international index funds (which are mostly Europe and Japan, two ugly economic areas at present), as well as European ones

–possible shift away from emerging markets funds toward Pacific ex Japan or China funds

–orientation away from US firms with large European exposure

–considering Europe-based firms that earn most of their money elsewhere.

Shaping a Portfolio for 2011 (lll): what could go wrong/right

what could go wrong?

My base case for the S&P 500 for 2011 is that stocks will go up by 10%.  Personally, I think tb.he year could shape up to be better than that, just as 2010 was. Still, there’s no sense in going overboard by making too aggressive a goal for the year.

If I’m more or less correct, the positives will take care of themselves.  It will be (and always is) much more important to try to think out what could go wrong, how to see the bad news coming and how to defend your portfolio against it.

the obvious

The obvious thing that could go wrong is that we’re at or close to the top of the cycle and that we should be becoming defensive now instead of remaining aggressive.

the rest

Putting that aside, I see a number of main worries:

1.  EU problems with the banks in peripheral countries might spiral out of control—and have negative repercussions for the rest of the world. My guess is that Europe muddles through. But in the final analysis this is a political issue, the kind I find it extremely hard to handicap.

My stance for some time has been to avoid companies with substantial revenue exposure to Europe and to look for European companies with big foreign—US or emerging market—exposure. The revenues and profits of such companies will be relatively secure, and stock market money flow will gravitate to these “safer” names, particularly if worries are accompanied by weakness in the euro.
2.  At some point, the US will remove the emergency stimulus now being given to the economy by super-low interest rates. If there’s a surprise about this process, it may be that action will come sooner than expected (my sense is that the consensus thinks rate rises will begin next winter, at the earliest).

Typically stocks are flat to up during this process. I expect the same will happen this time. But that could be wrong. I’d be more worried if stocks were trading at 25x forward earnings instead of 12x+.

3   The US has accumulated a large amount of government debt. The country’s creditors today are not as charitably-minded as those during the decades immediately following WWII. The consensus view is that he US has considerable time to repair its finances—and even increase its borrowing– without tiiggering a debt or currency crisis. That might prove too optimistic.  Discord in Washington, or some overt sign that politicians are looking to inflation as a way of wriggling out from repaying its obligations, might spark a change of heart.

4.  money flows to emerging markets. It’s important at least at some times, and this is one of them, to distinguish between emerging markets and emerging economies. The practical difference? Citizens in emerging economies usually have very low incomes. They typically have little in the way of savings. Their companies usually don’t offer pensions. Most investors in developed economies/markets realize this much. But from a market perspective, this means there are few, if any, local institutions and virtually no individuals to act as buyers if foreign investors get scared and decide to sell.  Sharp declines in emerging markets could have ripple effects on the rest of the world’s equities.

What could go right

1.  Economic recovery in the US could be stronger than anticipated.

2.  The EU debt crisis might be closer to resolution, or more fully discounted, in today’s stock prices than I think.

3.  Individual investor flows might begin to shift away from bonds and return to stocks, both US and foreign.

Shaping a Portfolio for 2011 (ll): stock market prospects

The #1 question

The most basic question for any individual investor to answer as he constructs an equity investment strategy for the new year is whether stocks are likely to go up or down over the twelve months.

My answer for 2011 is that stocks will be up, modestly. Ask me what “modestly” means and I would reply “around 10%,” based on the idea that the earnings growth for the S&P in 2011 will be of about that magnitude.  In rough terms, a quarter each of the earnings of the S&P 500 come from emerging markets and from Europe (including the UK). If we say that emerging markets profits will be up by 20% this year, the US by 8% and Europe by 4%, we get one percentage point of aggregate profit growth from Europe, five from emerging markets and four from the US.

The reality is, I think, that no one can forecast earnings even one year forward with great accuracy.  Perhaps a more persuasive justification for thinking that 2011 will be an average year for equities would be that the US economic growth appears to have begun to accelerate last September. Industrial production is rising, consumer confidence is improving, companies seem to be rehiring at a faster rate and, in consequence, consumer spending has a firmer tone. This implies to me that 2011will be a much better year economically than 2010 was.

In addition, I don’t think this better news is fully discounted in today’s stock prices. Earnings for the S&P 500 will likely come in at about $90 for 2010. A 10% earnings gain would imply eps for the index of around $100 for 2011. If so, that would mean the index is now trading on about 12.5x forward earnings. This is a modest multiple, considering the 30-year Treasury is yielding 4.5%. Historically, a 12.5x multiple would be more in keeping with an 8% long bond yield. Relative to bonds, their closest competitor among liquid investments, and even factoring in 150 basis points in increased interest rates, stocks look cheap.

easy money and caveats

Commentators are very fond of saying that “the easy money has already been made.” In hindsight that’s often an appropriate comment. But it ignores the considerable angst that an investor always faces when trying to predict future events, rather than analyze the past.

The reason this hackneyed phrase—one I dislike intensely–nevertheless comes to mind as I’m writing this is that the markets have begun to hoist two potential red flags about the current bull market. I don’t think they’re immediate concerns, but they weren’t evident at all a year ago.  They are:

time. On March 9, about two months from now, we’ll enter year three of rising stock prices. A typical inventory-driven market cycle consists of two and a half years of up and a year and a half of down. Under normal circumstances, then, this means that at the two year waypoint one should be at least considering becoming more defensive.

I think it’s too early to do so during this cycle, because the downturn wasn’t an inventory issue.  It wasn’t a minor one engineered by the money authority to take some excess steam out of a booming economy. Instead, it was a full-blown, train-wreck, shoot-yourself-in-the-foot financial disaster. As we can see from the two oil crises (1973-74 and 1981-82) and the internet meltdown (2000-2003), severe recessions take longer to recover from.  So the post-recession bull market should last more than two and a half years.

I think we have to put the end of the bull on our checklist of stuff to watch out for, in a way we didn’t need to last year. But I don’t think it’s a burning issue today. And I think it’s way too soon to assume a defensive portfolio posture.

the consensus of Wall Street pundits is now bullish, and more so than I am. This fact is a bit more troubling because buying high is so seductive and because you typically make money be betting against the consensus. Also, I’m a growth investor, so I find it particularly difficult to be bearish. Still, my reading of the market is that investors are still overly cautious. Two factors make me think this:

a. in the first half of an up cycle, value stocks tend to outperform. During the second half, that is, for well over a year in an inventory cycle, growth stocks do better. In this cycle, growth stocks as a group have only been outperforming for about four months.

b. as a bull market matures, the discounting mechanism changes. Investors go from paying attention only to bad news to incorporating good news into prices as well. That has clearly already happened.  But as time passes without new disasters striking, investors go from discounting good news as it’s being announced to anticipating future positive developments.  At the top, market participants aretypically discounting at least a year, and often more, in advance. I don’t think we’re at all close to doing that now.

The #2 question

The second question an investor, even in the US, should ask himself is whether economic strength will be greater in the home country or abroad. To the extent that you invest in foreign stocks, you should pose this question for each country where you’re going to buy a listed stock.

This doesn’t mean you should necessarily avoid countries where there’s poor economic growth.  I think, that you should have a preference for stocks whose revenues come from fast-growing areas and be skeptical of those main businesses are situated in slumping regions.  So the answer to this question tells you whether to concentrate your efforts on studying domestic or foreign-oriented companies.

My thumbnail sketch for 2011:

US:  better growth abroad, but not by as great a margin as last year

Europe:  weakest region in the world. Much better growth abroad

Emerging markets (investable ones): better growth internally, but not by as great a margin as 2010

Japan:  hopeless. As for the past twenty years, much better growth abroad

That’s it for today.  Next post:  what can go really right/wrong.