It's always darkest before the dawn (of earnings reports)

investment-advice-new-york

What to make of the last three months?  Stocks hit a peak for the year on April 23rd with a YTD gain of 9.8%.  Over the next 10 weeks, stocks fell 15.6%.  Over the last week, stocks gained 7.2%, leaving stocks down 0.7% on the year (all returns calculated on the S&P 500, including dividends.)  Net, our clients are nauseous!  We think stocks should reasonably grow 8%/year, but staying the course is tough when stocks rise or fall 1-3%/day.
 
Investors in recent years have been trained to react (and over-react) to every bit of daily data.  In our opinion, three months is the smallest useful unit of time for evaluating stock investments.  Why?  Corporations only report revenues and earnings once every three months.  The data that comes out along the way may be useful in tuning your analysis, but why would you buy a stock at 10AM and sell at 3PM if you truly were an investor.  (If you're a trader, short term buys and sells are the norm, but in the current environment, you'll probably be eaten alive.)
 
80% of earnings reports are delivered starting in the second weeks of January, April, July and October, which means most companies are blacked out on news in the proceeding 4 weeks.  Occasionally, you'll get pre-announcements about earnings, which are generally negative.  So we have learned to gauge the upcoming earnings reports based on the volume of negative pre-announcements.  In March 2010, pre-announcements were few, and April earnings reports generally exceeded expectations.   In June 2010, pre-announcements were mostly positive, which contrasts sharply with the bearish "macro view" espoused by most analysts.  Now we're a couple of days into earnings reports, and Intel just released the best quarter in entire 42 year history of the firm, with revenues and earnings exceeding forecasts, and with bullish guidance for the rest of the year.
 
Zacks forecasts 2nd quarter earnings to gain 21.6% compared to Q2 2009, and earnings for the year to grow 36.4% compared to 2009.  The rate of increase will slow in 2011, but will remain positive.  So now all the traders that shorted the market aggressively over the last weeks are rushing to cover, and up stock prices go!  
 
Macro analysis versus Micro analysis

We have long opined that "50% of stock returns come from being in the markets, 30% come from sector performance (e.g. technology, utilities) and only 20% comes from the individual stocks."  On that basis, many portfolio managers have abandoned researching individual companies and simply make "Macro bets" where they will buy or sell only at the sector or market level.  Thanks to ETF's, you can move your money that fast, but we're not convinced that you can generate excess returns.  Would you trade your house or your job or your spouse on a day by day basis?  No!  People would think you were crazy.  

So why all the focus on macro investing?  Since 2000, the research departments of the major sell side firms have evaporated.  We never paid much attention to buy, sell or hold ratings, but there was much useful detail in analysts' reports.  Now you have to do your own research, which is a lot harder than people think.  Nuance does not communicate well on television, which is the primary news source of most investors these days.  For example, the primary narrative on CNBC these days is "whether the risk trade is on or off."  If the risk trade is on, then investors are supposed to sell Treasury bonds, sell the dollar, sell gold, buy stocks (particularly emerging markets) and buy other commodities.  If the risk trade is off, then do the opposite.
 
You can have someone like Paul Krugman, Nouriel Roubini, Nassim Taleb or Bill Gross sketch a bearish case for world GDP in 2 minutes.  You need 30 minutes for someone to explain how Intel's investments in state of the art manufacturing facilities 5 years ago enabled the production of leading edge chips that go into laptops with built in video conferencing over Skype.  Does anyone remember that AT&T first demonstrated the "PicturePhone" at the 1964 World's Fair and that video phone technology was featured in the 1968 2001:A Space Odyssey?  The future is here!  And no one even notices.
 
Of course we pay attention to the macro picture.  But we still think there is value in micro analysis - researching individual companies at a detailed level and trying to determine which companies have a reasonable chance at growing faster than the overall market, but still have reasonable valuations.
 
Strategy

The gold market looks like yet another bubble.  Over the last three years gold gained 85% while the broader Commodities Index (CRBI) declined 19.8%.  Most commodities trade based on industrial demand (e.g. houses require copper for wiring) and even gold responds to demand for jewelry and electronics.  The current surge, however is more related to the "fear factor" trade compounded by huge hedge buying of gold futures.  Where have we seen this before?  Oil touched $145/barrel in July 2008 based on hedge fund buying.  6 months later oil traded at $31.41/barrel before settling into the current trading range of $70-$85/barrel.
 
Even after the rally of the last week, stocks still look cheap to us.  We expect the S&P 500 to close out 2010 with a gain of 8%, which is 9% higher than current levels.  The biggest psychological burden on the stock market right now is the continued poor recovery of the US jobs market.  However, corporations flush with cash and with surging revenues and earnings, are a buy.  If we waited until unemployment fell back to 4% before investing, we would most likely miss out on huge gains in stocks.