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11 stocks for a lurking bear market
Mr. P, an East Coast hedge fund insider, has been uncannily right about the economy and markets in recent years. His outlook for 2005: Watch out. These names should do well in a downturn.
By Jon D. Markman
Buckle your seatbelts, says Mr. P. Its going to be a bumpy flight.
Its been a long time since I checked in with Mr. P, research director of a major East Coast hedge fund who has supplied SuperModels readers with uncanny market-timing advice over the past four years. And, in a moment, you may wish that I hadnt.
Back in our first encounter in January 2001, he climbed out on a limb to forecast a 3-percentage-point decline in the fed funds rate that year and equity distress. He went on to forecast an end to the bear market in October 2002, a huge war rally in March 2003 and a dull, trading-range market for 2004.
Now Mr. Ps way-out-of-consensus belief is that the U.S. and global economies will slide into a pronounced recession in 2005 -- an event that will take stocks down 20% or more, boost bonds, spike the dollar and juice commodity prices. The plunge in stocks will end by the third quarter, he forecasts, followed by a rally that leaves prices modestly higher.
The 5 big worries
Several theories underpin his forecast.
Operating leverage for companies is too high. The operating leverage of major U.S. companies is two standard deviations higher than normal, a condition that, in the past, has augured recession. The simple definition of operating leverage is fixed costs divided by total (fixed plus variable) costs. When companies have high operating leverage, they rely heavily on fixed rather than variable costs. The greater the degree of operating leverage, the more earnings are at risk of small errors in forecasting sales -- as costs will stay high while revenues fall.
Companies have achieved this state essentially by curtailing spending on variable costs as much as possible and stacking up cash. On one hand, theyve got low interest rates, low inflation, low offshore wages, low taxes and deferred taxes. Theyre paying down debt and arent hiring. On the other hand, they arent buying a lot of new equipment, nor are they expanding domestic factories. Bulls suggest that companies rising stockpiles of cash are evidence that capital spending is a tinderbox waiting to be lit, but Mr. P believes it indicates that companies fear the future. They are like squirrels, he says, hoarding acorns for a long winter. Last year was the first in a long time in which more corporate debt was retired than issued.
Why would there be a decline in sales, when so many pundits are forecasting a rosy future? Mr. P says its simple: Higher short-term interest rates + higher oil + reduced fiscal spending + higher taxes + a big increase in dangerous, sub-prime real-estate lending = a splat for consumer spending.
Nobodys talking about recession. Mr. P is intrigued by how far off the radar screen the concept of a recession is at this time. Of all the questions posed to the presidential candidates at their first two debates, he noted, no one has asked what either would do in the event of a recession. All answers on both taxes and spending, indeed, were predicated on the consensus belief that the economy is, and would continue to, roar. The fact that no one is even considering that this can happen will give us an order-of-magnitude change like you have never seen, he said.
Rising rates will draw cash from stocks. If the U.S. Federal Reserve continues on its path to raising short-term interest rates to the level that it considers equilibrium, or 3.5% to 4%, bank certificates of deposits -- which are largely invested by financial institutions in short-term debt -- will draw a lot of money away from stocks. A guaranteed 4%, Mr. P says, would look pretty great next to the lousy fixed-income returns of the past few years, not to mention next to stocks that have gone nowhere this year and might be declining next year.
Why would the Fed raise rates if the economy is stalling and stocks are declining? It may have to in order to encourage foreigners -- particularly China, Japan and the oil-producing states -- to continue to finance the U.S. deficit and maintain price stability. If China follows through with its plan to switch its currency peg from the U.S. dollar to a basket of world currencies, then it will have much less incentive to repatriate all the money it receives from its U.S. exports back to the United States in the form of bond purchases.
Mr. P believes the Treasury will have to pay higher rates to attract investment. Indeed, he thinks that oil-producing and Asian countries have been major buyers of U.S. dollars in recent months in an attempt to prop up President Bushs election chances. And they might shift their currency purchases to euros after November.
Crude oil supplies really are tight. In the same vein, Mr. P foresees oil peaking at around $60 in December and then tailing off for awhile, back to as low as $45. He observes that oil is going through the process of price discovery. Since there is no transparency in oil reserves, especially in Saudi Arabia, speculators are jamming prices up to see the point at which more supply can come on the market. If no additional supply comes on, they will attempt to prove through price that the Saudis have not been honest about their ability to provide the world with spare capacity (as noted in this column, Is Saudi Arabia running out of oil?). The market is saying, We dont believe you -- prove it, said Mr. P, noting that he does not himself think that either Saudi Arabia or Russia have the reserves they have claimed.
High-priced homes with big, high-rate mortgages are vulnerable. Very importantly, he fears that the rise in sub-prime real estate lending on high-priced homes in states like California will end very badly -- potentially with tens of thousands of defaults from people who obtained zero-down or interest-only mortgages. The potential for a crash in the housing market is not anticipated, he said. Thousands of people who are not creditworthy have been allowed to buy homes for almost nothing, and, if they are pressured by job losses or other effects of a recession, they will just walk away -- putting even more pressure on the banking system and homebuilding sector, not to mention the government, which could be called upon for a bail-out.
The bleak bottom line
The bottom line: Mr. P believes that a confluence of higher interest rates and higher energy prices will depress consumer spending and corporate earnings. The financial markets will begin to sniff it out soon after the election, if not before. He sees the broad indexes trading down for the first seven months of 2005 as a compression in price/earnings ratios exacerbates a decline in profits. Bonds will be seen as a safe-haven trade, as well as the more defensive stocks such as the consumer staples companies, such as Colgate-Palmolive (CL, news, msgs), which have already been hammered in recent weeks.
Because some investors will wish to bet on something during the decline, Mr. P thinks commodity prices -- particularly industrial metals -- will continue to move up on a combination of expanding demand from China and raw speculation.
"We're bearish because we see a global slowdown and because we can see that both candidates are taking the economy for granted," he said. "If I'm right, you will soon have the most confused electorate in the world, as they come to realize that despite all of the words published during the race, none prepared them for the biggest challenge of the first year of the new presidency."
If you find yourself in Mr. Ps camp, here is a list of stocks that should outperform the market should his prediction turn out to be prescient.
| Stocks that may thrive in a bearish environment | | Company | StockScouter Rating | Oct. 11 closing price | | Valhi (VHI, news, msgs) | 10 | $15.05 | | Texas Industries (TXI, news, msgs) | 10 | $51.20 | | Novamerican Steel (TONS, news, msgs) | 10 | $27.36 | | Steel Dynamics (STLD, news, msgs) | 10 | $38.35 | | Phelps Dodge (PD, news, msgs) | 10 | $93.25 | | Potlatch (PCH, news, msgs) | 10 | $46.18 | | Olin (OLN, news, msgs) | 10 | $19.43 | | NL Industries (NL, news, msgs) | 10 | $19.36 | | Norsk Hydro (NHY, news, msgs) | 10 | $76.10 | | Mueller Industries (MLI, news, msgs) | 10 | $43.75 | | Commercial Metals (CMC, news, msgs) | 10 | $39.35 |
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Fine Print
Economist Ed Hyman of the ISI Group said in his report to institutional customers on Monday morning that if oil stays above $50 through the election, he will cut his expectation for annualized GDP growth to 2.5% from 3%. Additionally, he noted that a survey by The Business Council, which is made up of honchos of S&P 100 companies, found that nearly three-quarters of CEOs see GDP growth in the range of 0% to 2% in 2005. . . . The Weekly Leading Index of the Economic Cycle Research Institute has also begun to slip again after stabilizing amid a steep six-month decline. You can check it out here.
Jon D. Markman is publisher of StockTactics Advisor, an independent weekly investment newsletter, as well as senior strategist and portfolio manager at Pinnacle Investment Advisors. While he cannot provide personalized investment advice or recommendations, he welcomes column critiques and comments at jon.markman@gmail.com; put COMMENT in the subject line. At the time of publication, he held no positions in the companies mentioned.
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