Big Stocks Still Surprise

By on August 4, 2006

Originally published in August 1997:

Bill Clinton, as well as Alan Greenspan, are going to come out of this renaissance period looking like a couple of the most brilliant leaders of this century. Actually, both of them have had very little to do with what is occurring. Mr. Greenspan seems to have just caught on to the fact that this economy can grow healthily without igniting a nasty bout of inflation.

The continued maturation of the U.S. workforce will continue to have a profound effect on productivity, inflation, the budget deficit and stock prices. Inflation is already low and going lower; productivity growth is accelerating and the budget deficit should disappear next year and will likely remain in surplus until late in the next decade. This will cause interest rates to plunge. Long term rates will likely spend more time below six percent than above over the next 10 years.

Big Stocks Still Surprise

The big stocks continue to show incredible strength. Over the past year to date a little less than five percent of the stocks in the S&P 500 have provided about 50 percent of the return in the that index. Very few money managers have been able to top the return of the big blue chip indexes due to the concentration of returns in so few names. I certainly don’t expect to beat the Dow or the S&P 500 in this kind of environment, but the two portfolios are performing surprisingly well given their relatively high cash positions. The model will perform well given any normal correction, and I have a list of great stocks to buy if it gives me the appropriate signal. I’m concentrating my focus on companies that can provide growing earnings and growing PE ratios, which is the double whammy that produces returns above the norms. The large cap stocks overperformance could end at any time which would create a lot more opportunity in the small to mid-size stock arena. However, these things run in cycles and it is impossible to predict how long they’ll continue, but one thing is certain….this era will come to an end, but probably not anytime soon.

A Fictional Account Beginning in the Year 2006:

Joe Schwab was extremely pleased with his situation. He was retiring next year and had been funding his company provided 401(k) plan to the maximum extent possible over his last eight years of employment. Not only that…he had inched his participation in the stock market up to 80 percent of his total retirement funds. He felt like a genius. A stock market genius. Back in 1997 with the Dow around 8,000, he was too timid to place a big bet on the market. It seemed too much like gambling. In the old days he only had about 30 percent in stock funds. But the market kept going up with only some minor 10 percent drops along the way up. Oh, there was that abrupt 30 percent drop in 2003, but the market quickly recovered, like it always did. In fact, the Dow moved back up to the 13,000 level in 10 short months after it bottomed out at 9,056. Unfortunately, Joe dropped his stock allocation from 60 percent to 30 percent when the Dow dropped below 10,000 and didn’t bring it back to the original 60 percent until the market topped 13,000 again in 2004. Nobody’s perfect.

The market had gone up 40 percent in the last two years and people were saying it was 1995 to 1997 all over again. At 18,200 the Dow was ahead of just about everybody’s wildest dreams. A massive net $90 billion was being added to mutual funds every month. Joe’s own retirement kitty was a cool $1.2 million. With the market going up a minimum of 15% a year, he was looking at an income of at least $150,000 a year. It was more money than he ever thought he’d retire on. In fact, it was more income per year than he made while he was working. With all of this income coming in he would be able to buy his dream vacation home in the mountains, a modest motor home, take a cruise once a year and visit Vegas whenever he felt like it. Life was definitely going to be good.

But something happened toward the end of the year 2006….and it was not good. The $90 billion being added to mutual funds peaked in the summer of 2006. Then the upward trend started reversing. First, it started sliding slowly to $85 billion in September…$83 billion in October…$82 billion in November. The market was holding above 18,000 and the number of shares traded on the NYSE was fairly steady at around 1.5 billion a day. In November Coca Cola, Merck and their ilk were still holding up and trading at over 60 times earnings, however, small stocks were becoming weak. The IPO market was still going strong with new electronic gadgets being invented and hyped to investors like the thing they implant in your skin so you don’t have to carry a wallet or even cash. However, something just didn’t seem right.

On December 8, 2006 the market dropped a fairly stunning 1,000 points to 17,098 and attempted a feeble comeback to 18,000 toward the end of December, but it couldn’t break the 17,600 mark. It looked like another “baby” correction and the market would be in a trading range of 17,000 to 17,600 for the time being. On January 7, 2007 statistics came out regarding mutual fund inflows which showed net withdrawals of $10 billion for December! There hadn’t been a net withdrawal month since the bottom was reached in June 2003. The market only dropped about six percent and already people were withdrawing more money from mutual funds than they were putting in….something was very different this time. After this news was released, the Dow dropped 1,500 points to 16,048, eclipsing the point record for a single day drop, but not coming close to the October 1987 drop in percentage terms. Joe was getting a little concerned since the market was down about 12 percent from its high. He even considered cutting back on his allocation to stocks but remembered how badly it worked out the last time he tried that. Besides, he still had nearly $1.1 million which was a lot more than he ever expected. He was willing to scale back his retirement income from $150,000 to $140,000, or so. He knew the market was near a bottom…it just had to be. Plenty of experts were saying a Dow of 20,000 was just a matter of time, but if it wasn’t maybe he wouldn’t visit Vegas as often as he wanted to.

Find out how Joe fares the rest of the year 2007 in the next issue.

Portfolio Updates

Keane Inc. (AMEX: KEA; 61 1/8) declared a two for one split to be effective around August 29th. KEA also reported very strong revenue (+34%) and earnings (+73%) growth compared to the second quarter last year. KEA just signed a deal with Toyota of America to assist them in their transition to the year 2000. This company is poised to capitalize mightily on the year 2000 dilemma, otherwise known as the Y2K problem. Their only problem will be finding enough qualified people to work on all of the contracts they’re signing.

NVR L.P. (AMEX: NVR; 17 5/16) reported impressive earnings…$0.71 vs. $0.54 for the second quarter last year. This stock continues to perform well (recently anyway). The strong relative strength ensures that it will remain in the conservative portfolio, but it also means I’ll continue to show off one of my more embarrassing mistakes made this decade.

Carnival Corp. (NYSE: CCL; 42 1/8) decided not to fight Royal Caribbean (NYSE: RCL; 39 11/16) any longer over their plans to purchase Celebrity Cruise Lines. Carnival, by offering a competing bid, caused RCL to pay about three percent more for Celebrity than they otherwise would have. A crippling bidding war did not occur, which I’m very thankful for. Both of these stocks have firmed up in recent weeks.

LSI Logic Corp. (NYSE: LSI; 31 1/2) recently announced that the company will purchase up to 5 million shares on the open market from time to time. This represents about five percent of LSI’s outstanding shares. This is welcome news as LSI’s stock price has been struggling lately, despite the strong prospects I see for the Company. There was a rumor circulating that LSI would lose the contract with Sony to outfit the new Playstation game console with a custom logic chip. This dropped LSI below 30 briefly. However, the rumor was unfounded and LSI moved back up, but it is still languishing in the low 30’s.

Recommended Allocations

Aggressive portfolios: 75% equities, 25% cash.

Conservative portfolios: 55% equities, 45% cash.

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