Market Outlook | May 2, 2011

“The two most powerful warriors are patience and time.” - Leo Nikolaevich Tolstoy

Playing Field

Some point out the disconnect between economic health and stock behavior. This discrepancy is not easily visible as perception presents a positive story. A similar disconnect might exist between recent earnings optimism and current market pricing. Interestingly, a short-term oriented mindset is known to favor “momentum” and, in turn, reflect a lower volatility. Meanwhile, investors waiting for a better buy point will be required to exhibit patience and inquire on the influential themes. Similarly, those seeking to take profits from recent gains will have to show grit and fight greedy urges. At this junction, speculating on either side of the direction is not comforting for decision makers. Instead, most money managers are inclined to accept the trend while getting more clues from earnings chatter and monthly economic data.

Too Familiar Pattern

The acceleration of stock indexes mirrors commodity prices, which questions if risk aversion truly exists in this cycle. Instead, ‘fear’ has slowly subsided with each upside movement since March 2009. The skeptics fear that either a distorted message is transmitted or we’re entering a fragile state in this cycle. Yet, the S&P 500 Index is setting up to revisit the 1400 range as the next target. Perhaps, then can we measure the conviction of new buyers as it may serve as a vote of confidence.

The glaring aspect of this run is not the actual upside move but the continuation of an established and synchronized trend. Interestingly, the themes from most of the 2000’s remain dominant these days. The energy related run is reflected in Crude prices as well as the Oil Service index. On the same note, Gold is making new all-time highs in a well-documented explosive move. Finally, the US Dollar weakness is decelerating, and US interest rates are not moving significantly—a macro combination that is too familiar for experts as well as casual observers.

The Challenge

Finding distinct ideas in liquid markets is not easy, especially for bargain hunters. There is a risk of overpaying in a market (S&P 500 Index) that has risen by nearly 35% since July 1, 2010. Being a contrarian alone does not provide a full answer, especially for those seeking growth-like returns. Being selective in specific ideas is an approach worth considering, especially from a longer-term view. Importantly, traditional indicators may suggest overbought/overvalued conditions, while irrational behavior can persist longer than imagined. Thus, balancing the logical reality from the perceived reality is the challenge in weeks ahead.

Specific Ideas:

PSEC (Prospect Capital): A private equity firm that offers a small cap exposure in financial services. In this business cycle, the company is geared to capture opportunities related to venture capital, lending, and capital raising. The stock price is not stretched and removed from all-time highs of $18.97 in 2006.

VIVO (Meridian Bioscience): A profitable company in the diagnostic test kits for respiratory and gastrointestinal diseases. This is a small cap healthcare firm that pays out dividends and is run by highly rated management. A projected 16% growth rate appeals to long-term investors as any weakness closer to $22 offers an attractive entry point.

HWAY (Healthways, Inc.): After a sluggish 2 + years, early signs of a recovery were stirred in recent earnings announcement by increasing contracts from traditional health plans and employer markets. The short-term optimism is a sign of confidence in healthcare reform. In addition, pure fundamentals, such as the price/cash flow, are below industry average.

Article Quotes:

“Given the extraordinary fiscal and monetary indulgence that has been heaped upon the economy in recent years, it is tempting to believe that the world has changed in ways that make structured, historical, value-based analysis inappropriate. But in my view, this gives far too much long-term credit to short-term phenomena. It's certainly true that we ought to adapt to the possibility that valuation "norms" will be higher (and long-term return expectations will be lower) in the face of persistent policy efforts to elevate asset prices and foment bubbles. Still, our estimates of expected market returns have remained very accurate even in the most recent decade, so the lesson is not that valuations don't matter, or that 2+2 no longer equals 4 (our long-term return estimates are essentially basic algebra), but rather that policy makers may engender higher valuations and lower long-term return prospects more frequently in the years ahead than they have in the past.” (John P. Hussman, Ph.D, May 2, 2011)


“Meanwhile, the biggest dangers lie in an area that politicians barely mention: the labour market. The recent decline in the jobless rate has been misleading, the result of a surprisingly small growth in the workforce (as discouraged workers drop out) as much as fast job creation. A stubborn 46% of America’s jobless, some 6m people, have been out of work for more than six months. The weakness of the recovery is mostly to blame, but there are signs that America may be developing a distinctly European disease: structural unemployment. Youth unemployment is especially high, and joblessness among the young leaves lasting scars. Strong productivity growth has been achieved partly through the elimination of many mid-skilled jobs. And what makes this all the more worrying is that, below the radar screen, America had employment problems long before the recession, particularly for lesser-skilled men.” (The Economist, April 28, 2011)

Levels:

S&P 500 Index [1363.61] – Ongoing multi-year recovery by making new highs. Breaking above 1350 to reaffirm further strength.

Crude [$113.93] – A surging run as the commodity is up 35% since late February 2011. Charts suggest that prices are stretched in the near-term.

Gold [$1535.50] – New all-time highs, yet again, for another week. Currently, the index is 14% removed from its 200-day moving average.

DXY – US Dollar Index [72.93] – Making new lows for the year as weakness persists at a faster pace than multi-year downtrend.

US 10 Year Treasury Yields [3.28%] – In 2011, yields have stayed within a range of 3.20-3.40%a sideways pattern that keeps fixed income investors in suspense.


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