The Scots May Understand the Current Rally

Regularly I spend both formal and informal time with portfolio managers and other types of investment professionals, as well as talented amateurs. These conversations are part of my professional work as an investment manager and are also as a part of my volunteer activities for various non profit organizations.

This June, I am hearing two very different themes. The first theme, from successful managers, is that we are experiencing a “Beta or Junk” rally. Beta is that part of a securities performance that is market dependent, as distinct from independent. Stock managers are indicating that the stocks that are going up the most are being driven by improving margins due to cost cutting, with little (if any) sales growth. Inventory is being re-ordered after being allowed to fall to the point where it was hurting customer production. Few analysts however, are predicting long-term growth in demand, and many see the current enthusiasm waning in the near-term future. What appears to be happening on the bond side is that investors see a much wider spread between the interest rates of corporate bonds of all types compared to US Treasuries. However, this spread is currently narrowing. Unfortunately the yield spread, and therefore the price spread, is narrowing because the yields on treasuries are rising. This rise has more to do with the fears on the part of some buyers that treasury yields are not compensating their owners for the prospect of inflation, combined with the need of the US government to fund the rapidly increasing deficit.

The second theme I hear, is that stocks appear to be cheap, compared to earnings; not current earnings but “normalized” earnings. The concept of normalization of earnings was found in the early editions of Security Analysis by Graham and Dodd, which comes as close to being the analysts’ Bible as anything ever written. The way Professor Dodd taught me at Columbia in the late 1950s, was not to trust any given year’s results, but to average the reported earnings and margins over at least one business cycle. Dodd would also urge us to apply the valuation metrics to the normalized results in terms of both absolute and relative price/earnings ratios and yields. There have been a number of great, value-focused managers that have applied this thinking to their portfolios. One of the greatest was John Neff who purchased Citicorp stock when it collapsed into single digits during another loan crisis. Neff had the pleasure of holding the stock for many subsequent years at multiplies of his purchase price, which aided his Windsor Fund’s performance. An interesting side note is that when John Neff retired, his small retirement dinner in New York included only two non-insiders, John Reed (then the sole CEO of Citi), and me.

This is where the Scots come in; the case for normalization is based on the concept that at some point in the future, things will be like they were in the past. According to a legend turned into the wonderful Broadway musical “Brigadoon,” there was an ancient town in Scotland that would come back to life for one day each 100 years. My concern is that in a much more dynamic market than experienced in the fifties (when I was exposed to both Professor Dodd and Brigadoon), we will pass through the normalization phase very quickly, and be on to new crises and events. One example is the expected decline in the profitability of credit cards due to current legislation in the US and UK (including Scotland). However, the smart guys at card-issuing banks may find new ways to use their credit card relationships to make money, as well as to recoup some of the loans that have been written off. Nevertheless, when it comes, this day will not be an exact revival of Brigadoon.

What do you do with all this input and folklore? My first suggestion is to avoid buying and to perhaps practice some trimming of portfolio positions that have shown unsustainable price gains since March. We could experience a major mark-up of some prices as pension and hedge funds wish to show less cash on their June 30th statements. If this mark-up is extreme, one should react. July and early August, while tricky due to less than normal volume, may well be cautiously good entry points.

While you wait and contemplate, watch out for little signs of change and keep humming.