Investing in 2010: The Opportunity Continues

Let me begin with my best prediction for 2010: I will not match last year’s picks!

In my preview last year I suggested that the market had a gift for investors. There was too much negative sentiment about bailouts and the economy. It took some time to prove out, but it was basically accurate, and for the right reasons.

I named four stocks. The worst of these was up 40% (from the date I wrote the article through the date I am writing this). The average return, without dividends, was up over 85%.

When everyone was worrying about having missed the rally, and many were calling a market top at the end of August, I did a review of these picks indicating more room to run.

The four stocks gained an average of 18.7% after this article, in the last four months of the year.

I emphasized this with a debunking of the “Sell in September” calendar theory.

Obviously, my clients were not exclusively in these four stocks, but we had a great year and have had a nice run for the eleven-year history of our investment program.

The Opportunity Continues

This year’s story is more complex. While the opportunity is no longer “a gift”, it is still very strong. In this article I will discuss the right attitude to take, some mistakes to avoid, and some winning traits that are especially important right now.

Next, I will consider some key themes for the year and the opportunities I see as a result. Finally, I will show what this means for the individual investor.

The investment landscape is as challenging as ever. A survey article like this cannot anticipate everything that will happen during the year. It can provide a starting point, and emphasize what to watch. It will pay to monitor data and developments, remaining objective at all times.

The Winning Perspective

The objective for 2010 is to find successful investments. This requires three things:

1. Identifying companies where business prospects are better than most expect.

2. Finding an attractive stock price to establish a position.

3. Waiting for the market to recognize what you have already seen.

You are not rewarded for being accurate in economic forecasting, since stocks are not GDP futures. In particular, you are not rewarded for confusing your political opinions with investing.

Three Mistakes to Avoid

False Comparisons

Where You Finish Depends on Where You Started

There is a popular methodology that is very expensive. The analyst finds some time in the past that he thinks is comparable. So this recession is like the 70’s. Or the yield curve is like Japan. Or here is the path of job recovery in the last several recessions.

This is all completely bogus, and you should ignore it. There are not enough cases and there are too many dissimilarities. Any disciplined researcher would reject this approach. So why is it so popular? Most writers are not experts in research methods, but they are wordsmiths. And by the way – adding a chart or two to the article does not make the analysis a solid quantitative piece. It usually invites the reader to become an “instant expert” by looking at a misleading chart.

Most people these days are aware of the dangers of computer models that “post-dict” by looking at all of the old data. The human mind is the most powerful computer, with plenty of imagination.

Why are these comparisons so bad?

I’m going to state this in very simple terms. Most recessions were mild, this one was deep. Trying to compare the other paths to this one is sloppy work. There is a chorus of pundits and fund managers stating that the 2009 market rally from the bottom was not justified by the fundamentals. They see plenty of problems. The rally is greater than that from other recessions. Ergo, the rally has moved too far. The problem is the failure to recognize the starting point. The March bottom was not the low from a normal recession, but a “death warmed over” bottom. It was 25-30% lower than expected by most bottom-calling methods (including ours).

Ignoring Data

There is a powerful movement encouraging people to ignore data. Many pundits find something wrong with every report. At the extreme, the government reports are characterized as political and manipulated. The private reports are often viewed as biased as well. This is a powerful leveling force for those who have limited methodological skill.

In a world where anecdotes rule, everyone can tell a story.

Getting Political

The investment discussion became highly partisan early in 2009. We can expect another year of the same. It is a serious investor error to confuse political opinions with forecasts about the economy or the market. Even a program that we do not like – a wretched compromise – will have some impact. It is better to identify the winners and losers.

I call it political agnosticism – a willingness to make money no matter what party is in power.

Winning Ways

Find Solid Forecasting

Predicting the economy is not easy. It is easy to criticize economists, saying that they are all foolish. Successful investing does not require perfect economic forecasting, it only requires an edge. In 2008 those making the most extreme calls got a lot of notoriety. I recommend taking a longer viewpoint. The consensus of economists is an interesting piece of information. Some of the respondents in these polls have their own macro-economic models. Most are interpreting the work of others.

I emphasize that we are all consumers of data and forecasts. I find the forecasts from the Economic Cycle Research Institute to be very valuable. The ECRI makes public some general information, including this article written for an audience of investment advisors.

Conclusion: The ECRI is bullish on the economy

Mid-Course Adjustments

No matter how well a forecast is prepared, things change. When the circumstances change, you must be willing to adjust. In 2008, the fall of Lehman was a game-changer for the economy and all related forecasts. No one knew for sure what would happen. We now know what occurs when there is a complete cessation of normal lending.

In 2009, many pundits expected a complete economic collapse. They underestimated the combined force of massive government interventions. This was also a game-changer, and it called for a revised forecast.

Ignoring the Political Debate

The GOP is headed for major gains in the mid-term elections and will make things seem as bad as possible. This is good strategy. The Democrats will try to show economic progress. Many of the arguments – measuring the number of jobs created or saved is a good example – depend upon sophisticated methods, assumptions, and conclusions where there will never be agreement.

Investors should focus on data, not the political spin. In 2009 the political argument became an economic one, just as it did in 2004 and again in 2008. We can expect much more of the same in 2010.

Focus on real measures of progress, or the lack thereof.

My Major Themes

Pulling this together, I see several key themes. These observations are the background for winning investments:

• Market valuation is quite attractive. We have not yet hit the initial target of pre-Lehman market prices, even though the depression-like scenarios are off the table. The market has traded in line with corporate bond rates (based upon forward earnings). The rates still reflect elevated risk, and bonds also carry the risk of increasing rates. The market is attractive by comparison. This is a stronger approach than the backward-looking methods that give excessive weight to the post-Lehman earnings.
• Economic growth is looking brisk. There is plenty of additional running room. The mere removal of negative factors, like the decline in housing, adds to economic prospects. Many critics ignore the natural economic tendencies – using slack resources and adding productivity.
• Corporations are starting to invest. Recent earnings reports from Research in Motion (RIMM), Micron Technology (MU), and Oracle (ORCL) show that business investment is beginning a rebound. This is only a start, with room to run. The Windows 7 launch creates a business upgrade need. Delaying investment was an easy choice during the recession. It can be a driver as it is reversed.
• Government stimulus continues. Many do not realize that the stimulus package is spread over three years, with most of it still to come. The Fed remains accommodative.

What to Watch

There are several data themes to observe closely.

• Housing sales and prices seem to have stabilized with the help of various programs. With continuing mortgage resets and high foreclosure rates, this bears watching.
• Credit growth. Everyone understands the problem of excessive lending. The economy depends upon what I call normal and sensible lending. So far, credit is still tight, especially for many emerging businesses.
• Employment must start to come around. Job growth lags the economy and the market, but we need to see improvement.

My Themes

I see several strong investment themes. My standard is the expectation of 25% appreciation, a double in three years. It does not pay to be greedy and swing for the fences. Obviously, I do not hit the target with every pick, but using this guideline helps to find a balance of winners.

Technology: This will be an early move for businesses and it should have legs. Investors can look to the big names in the group to get appropriate exposure. I like and own Microsoft (MSFT) and Intel (INTC).

Growth: Every portfolio needs some growth stocks. There are several choices, but I continue to like Apple (AAPL). If you back out cash holdings and look at forward earnings, you see an attractive price-to-earnings growth (PEG) ratio. You can play technology and growth more conservatively via XLK.

Health: The year-long cloud over health stocks has lifted. Investors can look to the sector for choices in managed care, big pharma, hospitals, and information technology. I am looking for a basket of these stocks for client accounts, but you can play the sector effectively with an ETF - XLV.

Cyclical Stocks: As the economy improves, some companies are poised for exceptional profit growth. I look for stocks with exceptional leverage on operating earnings. This is a work in progress, but my current favorite is Allegheny Technologies (ATI). I bought this in the mid-30s for clients, but there is still plenty of potential.

Energy: This is a special case. There is slack in energy markets, but it could be taken up quickly. I am less enthusiastic about energy as an immediate play, but we could find ourselves back to the tipping point as the year progresses. I have de-emphasized energy at this point, but I could revise my opinion rapidly if the global economy comes around.

Emerging Markets: I expect more stability in the dollar, but a continuing secular growth story in emerging markets. There is plenty of news in individual countries so investors can play this via ETFs including EEB or EEM.

Summary

There is a widespread feeling that the “easy money” was made last year. In fact, we actually just got back to square one. The many skeptics set up a traditional environment for a rally. As corporate profits and revenue growth prove out, the relevant stocks will react.

Investors have trouble buying stocks that are well off of the lows. This is a mistake. Few people call an exact bottom in any stock. At some point, the fundamental story becomes attractive. Some of my biggest successes came after I waited for real evidence – not buying the bottom, but picking a time of lower risk. Many stocks are now in that range.

Individual Investor Implications

For the investor who has “missed the rally”, there is still time. I do not see the market rally as in the “late innings". Well-chosen specific stocks can do very well—gains of 20%+.

For those with a negative world view - suppose you think that the Fed, the President, and the Congress are all blundering. You do not need to be “all in” on this viewpoint. Consider allocating some investments to stocks with great potential. A few big winners can help you if your overall political viewpoint is incorrect.

For those who are worried about risk - consider a program with a built-in asset allocation method. There is a demand for this. We have developed such a product, and so have others. It allows you to dip in, with a limit on possible losses and attention to increased risk. Our approach shifts to other assets based upon quantitative methods.

Each investor is different. You need to consider your investment goals, your full range of assets, your risk tolerance, and other factors. If you do not know how to do this, you might consider getting some professional advice.

Most new investors I talk to are under-invested in stocks, ill-prepared for retirement, and have nothing to combat inflation. A general rule is to determine your “normal” stock allocation and increase it by about 10% to reflect the current opportunity.

[We own most of the stocks mentioned in both personal and client accounts, and we are shopping for positions in the others.   The article originally appeared a week ago as part of Seeking Alpha's series where ten managers were invited to provide their thoughts about 2010. 

I really appreciate Seeking Alpha's kind invitation to participate in this series.  Seeking Alpha has become much more dynamic and important in the last year, drawing contributions from many strong sources.  Readers of "A Dash" will find many good ideas in the series, which is refreshingly different from the MSM approaches.]

Comments

[Mark]

many observers may not be anticipating the impact on the business cycle that that may have over and above the natural demand factors for technology

Mark

[oldprof]

Thanks, KT!

You have a good point about how to look at different perspectives.

Jeff

[oldprof]

Venn -- I'm sure you are correct. I have to keep reminding myself to focus on my actual audience.

My instinct is to try to offer something that will help all comers. The idea of doing a little of something to hedge your position is sound, but so is your advice.

Thanks,

Jeff

[KT]

I thoroughly agree with your insights. Many short term players may not agree with this idea - thinking that the market has gone too high too fast and waiting for major pullback. Most are influenced by comparison with pasts - which never experienced the unimaginable starring at the brink of the abyss in 2009. Sure there will be consolidation along the way, but I think the general trend is up.

I believe most retail players are still underinvested.

The bests comment of yours:

"Investors have trouble buying stocks that are well off of the lows. This is a mistake. Few people call an exact bottom in any stock. At some point, the fundamental story becomes attractive. Some of my biggest successes came after I waited for real evidence – not buying the bottom, but picking a time of lower risk. "

Have a good year in 2010.

[VennData]

"...A few big winners can help you if your overall political viewpoint is incorrect..."

Speaking to these people is hopeless. They act as if they cannot believe for a moment that their "political viewpoint" is anything but 100% right, fed by the sophistry of the politicotainment industry.

Though you haven't heard "Socialism" for a couple of weeks, or complaints about "the end of the dollar" the meme now is "The End of America."

[Randy]

"stocks are not GDP futures" AMEN

[Chris Tinker]

Hi Jeff - Happy New Year. Unfortunately I agree with all of the above - which is clearly going to worry a contrarian such as yourself! One theme that I would add to the above is the impact on credit creation that the normalisation of asset markets is set to cause. With billions being raised in IPOs in emerging markets and credit markets very clearly back open for business in terms of capital raising by corporates, many observers may not be anticipating the impact on the business cycle that that may have over and above the natural demand factors for technology etc. that you have already identifed.

best of luck in 2010

Chris