Where the Market is Now
And What can be Learned from Last Year
In Case You Missed It
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This month brings the two-year anniversary of Cabot Small-Cap Confidential and in honor of that, I’m bringing you a multi-part series with Editor Thomas Garrity. Today Tom will explain where he thinks the market is going, his favorite investing book and what he learned from last year’s bear market. I hope you enjoy it!
(You can read last week’s issue here: http://www.cabot.net/Issues/CWA/Archives/2009/09/Small-Cap-Anniversary.aspx)
Question: What is your current outlook on the stock market?
Answer: My stock market outlook for the near term is tempered, turning more optimistic beyond the next 18 months. There are many indicators we can employ to determine the future movements of the stock market. One of the best insights we can gain is to look at the economy and the lending markets, given that they both interlink with the financial markets. Over the last several months, we’ve witnessed unprecedented levels of high unemployment, falling home values and bank liquidity constraints. All of these variables have influenced consumer and business spending, the output of the economy, and have been ultimately interpreted and reflected by the major indexes.
Judging by some of the individual returns racked up recently, you’d think that the past investor losses have been forgotten and that the economy is expanding. It’s possible to extrapolate above-average economic growth judging by the gains in the stocks of big name companies like Alcoa, Bank of America and American Express, among others. But I think the big moves in these large-cap companies can be attributed more to U.S. government intervention than to an economic recovery.
I do think that the United States is on the road to prosperity again, jump-started by the federal government’s economic stimulus package. But I believe the U.S. economy needs to show proof of its recovery if stocks are to continue such rapid gains. Stock markets tend to move in extremes. We’ve already seen one side of the pendulum swing from distress to content, and any further market appreciation will have to come from GDP growth. Therefore, while I foresee additional returns for the stock market, they will be kept in check until the economy improves.
Question: What is your current outlook on small-cap stocks?
Answer: My answer to the previous question was a great build up to this one. In faltering markets, small-cap stocks characteristically fall much farther in price than stocks of other asset classes. Investors can take this well-known small-cap phenomenon with despair or take it in stride. I choose the latter because market returns have a habit of smoothing out over time. The dips that are so characteristic of small-caps tend to produce more than just average returns. History demonstrates that small-caps produce higher returns over time than any other asset class. In the past 50 years, small-caps have lead the pack out of recessions, leaving most, if not all, larger capitalization stocks to lag behind in performance. Small-cap stocks inherently grow faster than the stock market, and while they can’t avoid being harmed by stock market woes or economic gyrations, over the longer term, they are quite possibly the most reliable asset class.
Question: What is your favorite investment book?
Answer: How I Made $2,000,000 in the Stock Market by Nicolas Darvas
In his book, Nicholas Darvas relates how he combined both fundamental and technical analysis to select the best stocks. Darvas realized early on the power of investment themes and knew the importance of finding the next big thing. Darvas knew that having the right idea would attract the most investors to a stock and subsequently boost share price, but he also knew that it was important to leave emotions at the door. Darvas knew the importance of this investing maxim: Don’t fall in love with your stocks!
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Question: What would you say to an investor who has been scared off by last year’s bear market?
Answer: It’s OK for investors to be scared off by a bear market as long as they are using their time on the sidelines to look for bargain stocks that have been sold off undeservedly. Always have a Watch List, in both good times and bad, so that when your favorite stock goes on sale, you can make a purchase. If you don’t have an immediate need for your funds for retirement or another near-term obligation, you should put that sideline capital to work for you. Investing should closely approximate your risk and comfort level. If the stock market makes you feel uneasy, then putting your money in cash is a good choice. When you do decide to re-enter the market, stock selection will be even more critical than your timing was to get out of the market.
Question: How does the economic climate factor into your stock picks and outlook on the market?
Answer: As always, I’ll be sticking to finding companies that are leaders in their businesses. The only difference given the current market is that I may alter the selection criteria a little. The market has always operated with a here and now mentality when it comes to forecasting earnings. Analysts typically look out three to six months or 12 months and longer to determine a stock’s valuation. In the coming year, I’ll still base my target prices on earnings power, but my range of expectations for the future value of those potential earnings will be shorter. I’ll also be screening investment candidates for any debt, and favor those that have cash and liquid assets. I’ll continue to focus research efforts on industries that are less constrained by discretionary spending.
Investors’ patience has been tested this year and confidence in the stock market is limited. Therefore, there’s no reason for institutions to take on higher risks than are warranted. In light of this new paradigm, investors should revisit the old investment principles, when balance sheet risk and near-term profitability were in focus.
Question: What did you learn from last year’s bear market?
Answer: In the recent bear market, I learned what I failed to in the previous bear market: While it’s true that small-cap stocks generally trade outside the daily moves of the market, in market downturns, every investment can get punished. It doesn’t matter how well a company is operating, if the economy gets sick, the market makes it difficult to hold almost any security. All boats float and sink by the same tide. In the future, I’ll cut my holdings when the market takes a hit like it did last fall to help mitigate my losses.
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In case you didn’t get a chance to read all the issues of Cabot Wealth Advisory this week and want to catch up on any investing and stock tips you might have missed, I have links below to each issue.
Cabot Wealth Advisory 9/14/09 – The Rise and Fall of EMC Corporation
On Monday, Timothy Lutts wrote about the lessons that can be learned from the rise and fall of EMC Corporation and one of its founders, Richard Egan. Tim reminded us that data storage stocks can give but they can also take away. Tim finished by writing about another data storage stock that experienced this very fate. Featured stock: STEC, Inc.
Cabot Wealth Advisory 9/17/09 – All That Glitters …
On Thursday, Michael Cintolo revisited the ECRI Weekly Leading Index, which just experienced its highest growth rate ever, indicating that the economy is on the path to recovery. Mike also wrote about some technical chart patterns that can be helpful and why others aren’t that important. Mike finished by discussing several ways to play the gold rally. Featured stock: SPDR Gold Trust Fund (GLD), PowerShares Double Gold Fund (DGP), Market Vectors Gold Miners Fund (GDX), Agnico-Eagle Mines (AEM), Goldcorp (GG), Iamgold (IAG) and Gold Fields (GFI).
Until next time,
Editor of Cabot Wealth Advisory
Editor’s Note: Don’t forget about our Limited Time Anniversary Price Rollback for Cabot Small-Cap Confidential. Subscribe by September 30 and save 30%! Click now to get started.