A Dash of Insight

How to Profit from the Obama Stocks

Understanding public policy decisions is crucial to investment success.

This has never been more true.  Government intervention is changing the nature of every business.  As an investor, you need to figure out what is going to happen, and whether it affects the companies in which you own stock.

Over the last several days we have emphasized how easy it is to make mistakes in the minefield of politics.

• You can misunderstand the difference between politically controlled agencies and the civil service.  We will explain how to tell the difference.
• You can confuse your role as citizen with your desire to make money as an investor.
• You can ignore good sources of information, just because you disagree with their politics.

We have some more mistakes to highlight in this series, but there is a positive side.  We strongly encourage readers wanting to follow this approach to review the links above.

We are going to show how to figure out where to get information, and how to use it.  Part of our success in client portfolios relates to a disciplined approach to public policy analysis:

We want to succeed no matter who is in power.  We put personal opinions aside.  We analyze the likely results, and figure out which stocks will gain.

It sounds simple, but hardly anyone can resist the temptation to confuse opinion with analysis.  Most of the current pundits are offering opinions about politics at the very time that stimulus dollars are starting to hit.  This is good for their ratings, but bad for your portfolio.

They jumped the gun months ago picking "Obama stocks" on his inauguration.  The earnings effects have yet to show.  Meanwhile, companies have gotten lean and mean.  Many are showing reasonable earnings even in a time of economic distress.  Let us find these winning stocks.

As background, here is a recent article we wrote for TheStreet.com's RealMoney site.  It is a bit  introspective, but regular readers of "A Dash" may find it useful.

From RealMoney.com, 4/30/2009

When I started writing for RealMoney, I had an idea: I wanted to study how the nexus of politics, public policy and specific stocks could provide a big edge to readers. Almost two years ago, I launched a Web site, ElectionStocks.com, and hired some staff support. Since I watch political news and the markets for most of the day, I feed ideas to the team; I also write some pieces and review the work.  We started by covering about 20 candidates from both parties. We identified issues and stocks for each of them. As the field narrowed, we focused on stocks that could work regardless of who was elected. I was looking for names I could suggest as good stocks with great potential political drivers.

The Best Advice?

Sometimes the best advice is a warning against any particular action. We had no precedent for an election and transition in the middle of an economic crisis. Many analysts and researchers were going on TV with their "Obama stocks" at the time of the election, at the start of the year and on the day of the Inauguration -- the election cycle offered three chances for publicity.

The cold reality? This time was really different. Even when the election results were certain, no one could know which of the Obama proposals would survive in the Senate, nor how quickly they would be passed. More important, a single issue dominated all others: dealing with the "toxic" assets. The new administration did not seem to understand that this was the keystone for all problems. The first approach to the problem of price discovery was Treasury Secretary Tim Geithner's maiden voyage ... and a stock market disaster.

The biggest Obama mistake has been the failure to deal with this problem; no one on the team appreciated the significance. The result? We are getting the announcement about the particulars of the Public-Private Investment Program on May 15, more than six months after the election; Hank Paulson went to Congress in September. This will go down in history as one of the worst responses to a financial crisis, partly caused by the transition in administrations.

Simply put, this was not a time to buy stocks because of the winning candidate's positions. Those who did so had big losses, because the general economic questions overwhelmed any specific stock ideas.

I've been watching elections for 40 years and studying how the election cycle affects stocks for more than 20 years -- I taught political science and public policy for 13 years before entering the investment business in 1987. I also devoted particular focus to this cycle -- I'm confident that I'm among the most qualified analysts on the subject -- and still I refrained from pushing the investment ideas our team developed.

It was not right, and I knew it.

How to Make Money

Part of investment success is avoiding losses. I hope that readers of my commentary on Obama policies have shared my caution. When the stimulus package was passed, we identified some stocks that would benefit. As is often the case, the problem was the time lag. While the market attempts to look ahead, there are very few experts on government spending. It is very complicated. I follow everything said about Obama and stocks and filter the prospects through almost 40 years of training and experience. Here is my general conclusion:

• Initiating new policies is more difficult than you think -- much more difficult. Be skeptical.
• I always look for the "default policy" -- what will happen if nothing changes in the law.

Now Is the Time

It may seem silly to some, but now -- 100 days into the administration -- is the correct time to start thinking about Obama stocks. Here's my reasoning:

• The stimulus package was widely dismissed by market pundit, mostly because it did not do what they preferred. The actual spending is starting to hit, and will show up in corporate earnings.
• The budget process is prolonged. The Street hated the proposals as "too liberal." We are now about to learn -- for the first time -- what will really get passed. It is time to pay attention.
• We are getting policy details. People do not realize how long it takes to make a transition. The new secretary of Health and Human Services was approved just yesterday; how could we project health policy before this? The Specter party switch also affects prospects, especially for every health stock.

Unless you are monitoring factors like these, you are out of step with reality.

What to Buy

Over the next few weeks I plan to highlight several different groups of stocks, each of which may benefit from Obama policies. I will downplay those where I think congressional prospects are poor and emphasize those where prospects are good.

Meanwhile, my team has constructed a stimulus package portfolio. We have carefully monitored opinions from a wide range of experts featured on financial media. (RealMoney's own James Altucher's ideas are prominent in the portfolio.) The portfolio has had a positive result, but the results are nothing special so far. That's good -- most people bought the Obama stocks too early, got discouraged, and bailed out. This relative loneliness in the space provides a good opportunity.

Here is a preview of our coming articles:

• Health care: Information technology stocks will definitely do well. Other health stocks depend upon the yet-unknown details of the plans. Look at Athenahealth (ATHN) 
• Alternative energy: We like First Solar (FSLR) , and it is part of the portfolio. A number of other good choices (courtesy of James A.) are also included. 
• Infrastructure: There are several choices in this space -- check out KBR (KBR) . 
• Defense stocks: This is a surprise to many who see Obama as cutting defense, but cutting the costs for Iraq may not translate into lower returns for specific contractors. We see good prospects for many defense holdings. Jim Cramer also is noting this strength on earnings calls.

It is hard to believe. I would not have predicted it in advance. The best time to buy the Obama stocks is after the first 100 days. Stay tuned for more specific picks and how you can use Obama's policies as you craft your portfolio.

A Costly Error in Analysis

There is a serious analytical mistake gaining increasing popularity.  Once you are aware of it, you will see it several times every week.

An Easy Example

As we often do at "A Dash," let us step away from the world of investing.  Many important ideas can be more easily understood from a completely different perspective.  Here is the situation.

In our Illinois District for State Representative, there was an open seat.  It was a hotly contested race.  The GOP candidate had a record of service on the School Board and the City Council, but this was her first effort at a bigger office.  Her Democratic opponent was a long-time teacher, and a member of homeowner groups.  This was a hot contest in our community, which is traditionally Republican, but has growing support for Democrats.  The Democratic candidate had plenty of financial help and the Obama coattails.

A key issue in the campaign was negative advertising.  The Dem candidate attacked her opponent on abortion rights.  The expensive campaign material, delivered to our house several times, featured a coat-hanger on the front.  There were other negative ads, but you get the idea.

When the election results were in, the GOP candidate won by fewer than 700 votes out of 50,000 cast -- a real squeaker.

Her media reaction was as follows:  "This shows that negative campaigning does not work in our district."

Indeed!  Our own assessment was that the intense, heavily-financed negative campaign is what made it close.  Without the attacks, the GOP candidate, who had better visibility, better credentials, and a better base, would have won in a walk.

What Comparison is Right?

The problem is the difficulty in determining what analysts call "the counterfactual" situation.  Here is how we described it in a past article, analyzing the Greenspan Legacy:

In reviewing public policy decisions historians or analysts often use a concept called the counterfactual.  This approach is designed to thwart the kind of thinking that many know more commonly as "Monday morning quarterbacking."  What would have happened if Truman had not approved dropping the atomic bomb?  What if Bush had not invaded Iraq?  We know what did happen, but not what would have happened.

Current Applications

Here are two very prominent current examples of this error:

• The stimulus package did not do any good.  The economy still declined.
• The TARP program has not helped.  AIG and other companies still need more help.  Nothing is having any effect.

There are many other examples, and we invite contributions to the list.

A Message for the New President

President-Elect Obama:

The country has voted for new leadership.  The perceived economic crisis is at the front of concerns.  You won a great victory with support from people of all ages, and varying political persuasions.

The stock market is not providing you with much of a honeymoon.  Rightly or wrongly, many investors choose fixation with some of your ideas, while ignoring your main theme of strength and unification.

Today's stock market decline will be perceived by some as skepticism about your leadership.  It is no more relevant than yesterday's stock market increase.  Many other factors are at work.

The Most Important Action

To figure out what you should do,  look at the biggest threat.  Let me state it quite simply:

The Threat.  The financial assets held by major financial institutions are viewed with extreme skepticism.  Investors, pundits, and many accountants do not understand the rules for evaluating current holdings.  In the post-Enron world, everyone assumes the worst.

People assume that any mortgage holdings are worthless.  This started with sub-prime holdings and concern over adjustable-rate mortgage resets.  Even though we have moved through the reset period, the concern persists.  Now the concern has turned to other credit holdings -- Alt-A, auto loans, student loans -- whatever.

A leading market analyst opined today that all of the financial institutions will need much greater capital infusions to keep up with the decline in their asset values.  This was the proximate cause of the late-day selling in the market.

The Solution.  We know that you have many astute advisers.  Some of these people are focused on specific constituencies, and it may be appropriate to help them.  Others have a strong theoretical background, perhaps not focused on markets.

With this in mind, here is the most important solution:

Stabilize trading in the various debt securities.

The original "Paulson Plan" sought to establish a market for the various securitized debt instruments, popularly described as "toxic waste."  Sadly, this is the general level of market understanding.

Instead, why not engage in financial jujitsu?

Since market participants cannot determine the value of these holdings, everyone assumes the worst.  Even the most astute market pundits now believe that the government will merely invest in companies--an ever-expanding list.  They see increasing demands for more capital.  Since the Bush Administration has not yet acted to buy distressed securities (mostly because it takes time to implement), they believe it will not happen.

The only way to stop this death spiral is a method of actual price discovery for securitized debt.  As you assemble a transition team for Treasury and TARP, we hope that the people you choose understand this problem -- fully and completely.

Simply investing more in various financial, insurance, and auto companies is not a solution.

There are some excellent ideas for price discovery in credit markets.  Leading experts like Bill Gross have suggested that current prices for these securities are far too low.  Top economists have contributed suggestions.  Meanwhile, it is difficult for anyone to trade in these debt obligations without a liquid market.

For Final Emphasis

Let us be clear that we do not recommend that the government buy distressed securities at poor prices.  We hope that you will use your power to create a price discovery mechanism where we can find stability in financial assets.

This is a win-win-win solution.

1. It is good for the current holders of these securities, since they get a fair market.
2. It is good for the buyers, since the yield-to-maturity on the performing segments of the assets outweighs the risk.
3. It is good for the economy, since it ends the death spiral.

There is no single action that you can take before Inauguration Day that will have more impact.

Election Day Rally

When two events happen at the same time, there is a strong psychological basis for connecting them.

Today is such a day.  The widely-expected end of the election and Obama victory is somehow getting linked to the stock market.  We discuss this, and future investment opportunities, at our sister site, ElectionStocks.com.  Please check it out for a more detailed analysis.  This will be the source for future stock-specific recommendations as we analylze the emerging Obama plan.

The key issues are still ahead of us.  Our read is that Obama is constrained by the economic environment.  We are very interested in his first decisions.  These will include the following:

• How to handle the funds approved for the "rescue plan."  Our hope is that there will be continuing attention to establishing accurate pricing for distressed assets, not just investments in private companies.
• The approach to fiscal stimulus.  There is widespread agreement on the need.  The implementation is open to debate.  Will something emerge from a lame-duck Congress, or will Democrats wait for the new term to get a package they like.  The trade off is delay versus a plan they really want.
• The attitude toward taxation.  An Obama administration is expected to increase taxes in a way that will affect capital gains and, perhaps, dividends.  We will be watching closely to see how Obama, as a President-Elect, views these issues.  Our forecast (based on better insight than most) is that many proposed tax increases will be deferred, perhaps for two years until the expiration of the Bush tax cuts.

Investment Notes

Somewhat to our suprise, the TCA-ETF model has already indicated some sector buy signals and more are imminent.  The climate is more positive, perhaps validating the signal from our Gong model.

While the Democrats sing Happy Days are Here Again, we have no such illusions.  There are continuing issues.  We will closely monitor the plans for dealing with the acknowledged housing and credit problems.

Candidates and Fuel Prices

Sophisticated market observers and economists joined today in objecting to Presidential candidate positions on energy issues.

The Statements

Sen. McCain was first with a proposal for a "gas tax holiday" this summer.  Sen. Clinton joined in, leaving Sen. Obama as the only holdout for maintaining federal gasoline taxes.

Sen. Clinton has been even more aggressive about high profits for oil companies.  This afternoon, as spotted by Colin Barr, her campaign complained about the decline in ExxonMobil stock, in spite of excellent earnings. 

There is something seriously wrong with our economy when Exxon’s record $11 billion in quarterly profits are seen as a disappointment by Wall Street,” Clinton said. She went on to use the company’s latest gains to reiterate her call for a gas tax holiday — a proposal has been criticized by economists who say it won’t result in lower prices for consumers. “I believe we should impose a windfall profits tax on big oil companies and use that money to suspend the gas tax and give families relief at the pump.

The Reaction

Not surprisingly, these proposals generated near-universal dissent from the economic community.  The complaints about profits and the ExxonMobil stock decline of 3.6% created similar objections among sophisticated market observers, like the panel on Kudlow and Company.

Barry Ritholtz is ready to give a good lesson to the candidates.  Check out his article about how the candidates fail Econ 101 (a course frequently cited at The Big Picture!).

We are delighted to find ourselves in agreement with Barry, the economists, and the savvy market observers on Kudlow's excellent program.

But here is the question:  Do the candidates really not understand how economics and markets work, even at the level of Econ 101?  Or is their motive a different one?

Is This Credible?

Well -- McCain admitted that he was soft on economics and was reading Greenspan's book to bone up!!  In spite of this, we think his team has enough economic horsepower to "speak truth to power" as we say in the public policy business.

Senator Clinton's case is even more clearcut.  She turned $1000 into $100,000 in only ten months of cattle futures trading, a record that none of us can claim.  She did it by "following the market closely" and "making her own decisions".

So she understands markets.  Her campaign also knows the proper role of experts, according to the Wall Street Journal.

Clinton’s position on the gas tax runs counter to that of economists across the political spectrum who argue that a temporary tax reprieve would do little to lower gas prices this summer.

“There are times a president will take a position that a group of quote-unquote experts will agree with and there are times when a president will take a position that a group of quote-unquote experts won’t agree with it,” campaign spokesman Howard Wolfson told reporters today, “Sen. Clinton believes this is the right policy.”

An Alternative Explanation

Instead of assuming that people intelligent and successful enough to be Presidential candidates are stupid, let us instead assume that they are smart.  As time winds down in a life-or-death struggle, the candidate looks for anything that might work.

It is natural to look at the issues of the day and gauge the public reaction.  Everyone is worried about high fuel prices.  Whom do they blame?

Here are data from a 2007 poll.  We follow such polling questions constantly and the numbers do not change that much.  The data show that the average person blames big oil or government for high fuel prices.  They do not understand much about market forces.  They go for conspiracies and simple-minded answers.  It is a winning tactic, at least in the short run.

If you were a candidate, would you try to educate the 2/3 of the people who are wrong-headed, or would you "go with the flow?"

Here is the poll question:

Who do you blame the most for the recent increase in gasoline prices - oil producing countries, oil companies, President Bush, Americans who drive vehicles that use a lot of gasoline or normal supply and demand pressures.

Oil companies	43%
President Bush	20%
Supply and demand	13%
Oil countries	11%
American drivers	4%
Not sure	9%

Pandering?

Barry calls the candidate efforts "pandering" and the term seems to fit.  Let us take careful note of the circumstances:

• An issue where nearly all of the top experts -- people who have relevant credentials and have reflected carefully -- draw a conclusion different from many average  people.
• Many consumers of the information believe in conspiracies and simple, common-man explanations.
• The candidate, someone in a position of leadership, chooses to exploit the public mis-perception rather than to educate and to lead.
• The resulting pandering helps the candidate, but might well hurt the average voter -- the person consuming the candidate's message.

This all has an eerily familiar pattern.  It is something to think about.

And by the way, we do not think any of the energy proposals have a ghost of a chance of passage.

Weekly Sector Update

The apparent shift in Fed policy was partly anticipated by the markets.  As a result, the expectations concerning the dollar changed.  The TCA-ETF portfolio from last week had a number of "weak dollar" plays, foreign markets, energy, and basic materials.  The data for this week (as of Wednesday's close) show a shift in the rankings, with more emphasis on technology.  (This is evolving rapidly).

The table below shows this week's rankings.  Vince has adjusted the strength scale to aid in the interpretation.  The underlying method has not changed.  A reading of zero indicates the average expected performance of a sector over a one-month time frame, the general time horizon for the model.  A reading of 50 indicates an expected return that is one standard deviation above the average, roughly the top third of returns.  A reading of 100 indicates an expected return of two standard deviations above the average.

While we update the model daily, we have introduced a program for average investors that does weekly trades unless emergency adjustments are required.  A report on this program is available upon request.

(Click to see the chart)

Bailing Out Bond Insurers: It's Big, Really Big

Today's dramatic market turnaround was due largely to the leaks, rumors, and eventual news stories about a meeting convened by New York Insurance Department Superintendent Eric Dinallo.  Wisconsin, which has a very active insurance industry, was also represented by Commissioner Sean Dilweg.

Some vague early stories dribbled out from hard news agencies with a stronger Bloomberg story a bit later.  Subscribers to RealMoney Silver could have paid for their subscription by following the Doug Kass commentary, which came out in time to catch about 40 points in the S&P.

Why So Important?

To appreciate the news, one has to realize that many of the media explanations for early selling were wrong.  The talking heads were speculating about the Fed and the meaning of the inter-meeting rate cut.  The real problem was an expanding concern about the companies insuring bonds.  If these companies fail, the credit ratings of many bonds are imperiled, and we get another round of write-downs from financial institutions.

Because this news hit the bulls-eye for market worries, it had an immediate impact.

How to Judge a Bailout

The beauty of the news today is that it requires no government action, and no taxpayer money.  It is reminiscent of the Long Term Capital Management rescue, where the New York Fed provided a meeting room for the financial firms most affected.  After discussion, they went around the table and all of the firms (except Bear Stearns) contributed to the rescue.  The process, described well by Roger Lowenstein in his book, When Genius Failed:  The Rise and Fall of Long-Term Capital Management, did not really save the original investors in the hedge fund, but it rescued the financial system from the falling dominoes that come with counter-party risk in the derivatives market.

Please note the key distinction.  Measures that require legislation take time.  Those that help financial institutions cooperate work much more quickly.

We expected some kind of action to shore up these insurers, because the stakes are so high.  It is a "too big to fail problem."  We are surprised (and delighted) by the speed of insurance regulators in taking action.  It is part of our viewpoint that a solution to current problems is going to take more than just fiscal stimulus or interest rate cuts.  There are several different aspects to the problem, and each requires a solution.  This means that many different agencies of government must act.

It is relatively easy for government to take popular steps like tax cuts to many individuals and businesses.  We expect such a program, and we think it will help.  So will the Fed's interest cutting moves.

But these are not targeted solutions.  The Fed's TAF approach was targeted, and it has worked well.

What is Still Needed

There are two steps remaining that will be more difficult.

First, we need attention to the jumbo loan market.  In many parts of the country housing prices are high enough that average mortgages exceed the $417,000 limit on Fannie and Freddie.  The Administration is holding out for a comprehensive reform of the GSE's before supporting an increase in the limit, something that requires legislation.  The House has passed a bill, but the Senate has been very slow.  The Washington Post editorial on this subject hits the mark:

Last May, the House of Representatives passed a bill that would remedy this situation. The legislation would replace OFHEO with a new, independent Federal Housing Finance Agency, which would regulate not only Fannie and Freddie but also the 12 regional Federal Home Loan Banks. The Senate, however, has done exactly nothing since then. Its inaction has been due in part to differences on other points of the bill between Republicans and Democrats -- and in part to the fact that the Senate Banking Committee chairman, Christopher J. Dodd (D-Conn.), was pursuing his long-shot presidential campaign. In recent weeks, both President Bush and Rep. Barney Frank (D-Mass.), who shepherded the House bill, have called on the Senate to get busy. It's not often that George W. Bush and Barney Frank agree on anything. In this case, they are both right.

Second, we need to get some valid pricing and trading in existing debt obligations (CDO's) which have been marked to market at distressed prices.  This may require some buyer of last resort, either governmentally or privately.  There is a continuing demand for extra yield, but it needs to be correctly priced and rated accurately by agencies.  This was a good idea that was poorly implemented, and it will return.  How long will it take?

These two steps are needed for qualified buyers to have access to mortgages, firming up demand for housing, and helping existing borrowers to work out their loans.  Some think this  process will take several years.  We disagree.  It will happen more quickly, but it will require more innovative actions of the sort we saw today in the bond insurance market.

Implications for Investors and Traders

The news today coincided with various technical interpretations of testing support and a double bottom.  Our own Gong Model finished the day with the hammer cocked -- finally!  This means that the Gong will ring as stocks recover.  The ringing of the Gong is a very unusual and meaningful indicator.  It provides an intermediate-term buy signal, suggesting significantly higher prices within a few months. 

Today's news is good enough that potential buyers may see a combination of technical and fundamental factors supporting action.  Obviously, many did today.  Our view is that this is more than just a "bear market rally" or trading bounce.

Problems remain, but several of the key steps to maintain economic growth have already been taken.

 

Election 2008

Investors and traders alike are becoming interested in next year's elections.  While some are jumping to conclusions about the outcome, we think the story is just beginning to play out.

Things are beginning to heat up, with regular coverage on the networks and the chance that the New Hampshire primary will be moved to December.  This could alter the campaign dynamics dramatically.

Our Election Project monitors the daily news on the campaign front with the investor in mind.  We do not advocate any party or candidate.  Our objective is to examine each candidate's issue positions and prospects.  We then try to identify specific stocks that may gain or lose with that candidate's changing fortunes.  We actively solicit input on candidates, issues, and stocks.  Readers can best do this via comments at the forum.  We will use these to develop specific candidate stock portfolios to be tracked at Stockpickr.com.

Investors following the election should also monitor the insightful commentary of my colleague at TheStreet.com, John Fout.  John not only writes regular articles on the campaign, but he now has a daily feature tracking political blogs.  This search link locates the most recent columns.  This is a great addition to what we do in tracking the regular news sources on a daily basis at Election Stocks.