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Portfolio strategy update Editor’s Note: The following portfolio update is from David Gottstein’s monthly Dynamic Research Group’s newsletter. It was compiled in early May.
CURRENT MARKET NEWS
A schizophrenic market
It is always challenging to figure out where money wants to go. We are usually confronted with such choices as bonds, equities, real estate and foreign currencies.
This market doesn’t seem to know where or with whom it wants to go. A new level of market sophistication has sliced risk/reward classification into narrowing layers, particularly in the equity segment. High-tech, New Economy, Blue Chip, and Growth and Non-growth Old Economy labels attract vastly different valuation levels.
The most speculative, hyped and highest growth segment of the market pays the highest PE’s as its price of admission to the party of high returns. Perhaps it does so to keep pace with the robust broad market returns of the past.
This part of the market, which represents the highest of expectations, is unmercifully reprimanded with frequent and great disappointments, explaining its risk-induced wide volatility. Here we find the truly speculative side of the market, matched with the highest returns. As with High-tech, these hot growth and hype areas attract the hottest and most fickle of money. Buyer beware: it is a market of stocks. There will always be good technology stocks to own, even in a bear market.
It is painful when people lose large amounts of money. The volatility of the market creates winners and losers. Those who are hurting usually take some time before they re-enter the markets. People have not lost money in the Blue Chip sector like they have in the NASDAQ recently, and the old guard is looking better and better. The earnings and growth prospects for most of these companies are real, growing and actually up very handsomely: over 20 percent again against the first quarter of last year. We think there is an ongoing rotation out of excess valuations into more fundamental valuations that will continue for the near future.
This flow is focused on the solid, growth-oriented Old Economy stocks. These companies can still grow their earnings 10-15 percent for a relatively indefinite time period. There are many of these kinds of companies, and as prices rise, valuation selectivity becomes more and more important.
The companies that will receive little respect are the older technology companies that have trouble sustaining even a 10 percent growth rate. This will be the case particularly if they do not have a healthy dividend payout ratio policy. Buying these types of stocks may get you above average returns because of depressed prices, but don’t expect a rush of new money into this sector. One sector may seem cheap when its PE’s near single digits, while other sectors could be cheap at a 50 PE. There appears to be no rationale to it all.
Don’t fight the Fed The economy is still growing too fast, and the whites of labor inflation eyes have been spotted. There is no reason to believe that the Fed won’t use higher short-term interest rates (its main weapon against inflation) until inflation flags recede.
As we previously mentioned, earnings are again roaring in above 20 percent, with no end in sight. This means that even though earnings are rising, market PE’s will probably not be sustained. With the S&P at roughly a 26 PE, they may be a few points higher than where they must settle when the Fed is through, offsetting the valuation gains that earnings growth produces. Selectivity becomes even more critical here, in an effort to balance opportunity and preservation of capital. We are maintaining a 7.5 percent cash position to allow for purchases at somewhat lower prices.
Good luck this month.
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