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May 31, 2006
No Relief For Bargain Hunters Yet
By Brady Willett

A sharp sell off in oil, a massive bond market rally, a Fed pause, or a plunge in the US dollar that, somehow-someway, neatly unifies global central bank interests. Yes, there are many events that could spark a massive relief rally in the stock markets. Yet for all of the potential rallying points, one point can not be easily dismissed: stocks are not cheap. To be sure, on a GAAP basis the Dow is trading at 20-times earnings, the average dividend yield on the S&P 500 is only 1.76%, and the average REIT is yielding less than the 10-year Treasury bond.  As for the forward looking earnings estimates, they remain simply that: If you know what the GAAP earnings on the S&P 500 are going to be in the coming 12-months - or if you know what will constitute GAAP earnings 12-months from now for that matter - you know a great deal more than most. 

What is known is that following one of the longest streaks of double digit profit increases in US history, and even after the most recent correction, the price to earnings multiple on the S&P 500 is 17.41 GAAP (or more than 18.5 at the core, est.).  The long-term average since 1935 is 15.68.

Bargain: Something offered or acquired at a price advantageous to the buyer.

Unless you conclude the earnings party is set to continue or you are willing to gamble on expanding market multiples because you feel good, US stock prices are hardly a bargain at current levels.
How Overvaluation Spread It’s Wings

If you threw a dart at any quality REIT in 2000 and held it you made big money.  If you selected any small cap stock trading near book value in 2001 and held it you made even bigger money.  If you picked up anything that offered a reliable dividend/distribution in 2002/03 you made big (and safe) money. But as the easy money days faded away – yes, making money buying what was unpopular was easy during the 2000-2003 bear – value investors went into hibernation. 

Although recent market turbulence has awakened many value investors, it has done little to promote widespread undervaluation. Rather, since March 2003 stocks have seen very few corrections as a steady influx of money has been dispersed into every possible crevice of the markets.  This fanning of capital has tapped any hint of undervaluation, and convinced nearly everyone that a new bull market has been born (incidentally, it is difficult to agree that a sustainable bull is in the works with energy and precious metals two of the industries recently leading the charge).

Needless to say, for market bears and value investors the last three years have been exceptionally brutal on the mind, although not necessarily on returns. The lesson since 2003 has been that even during secular bear markets stock prices can rally strongly.

Plots Thicken

Lichtenstein has been joined by Pirate Capital and together they are pushing for change at Angelica. Although a little sloppy on the balance sheet side of things, if natural gas prices behave Angelica is worth monitoring on weakness leading into October. A weaker greenback helps make Hawaiian Macadamia nuts more competitive and Mauna Loa is making distribution advances. This could bode well for ML Macadamia Orchards LP in the long-term.  Sturm, Ruger & Co., a potential turnaround candidate, may not necessarily be negatively impacted by slumping US economy.  Rather, take away a few of the company’s smaller private competitors and rid the company of its casting business segment and RGR could perform well.  Lack of growth doesn’t take away from the fact that TC Pipelines remains a yield target on weakness (be aware of the unconsolidated balance sheet).

Suffice to say, thanks to recent market weakness these and other potential undervaluation stories (from the
Watch List) are cropping up on a daily basis.  Similar hopes for falling stock prices have been dashed before, but, to borrow a Wall Street axiom, this time things really could be different.  The US housing ATM machine is closing down, the threats of peak oil and peak earnings (especially in tech) are casting an ominous shadow, the US dollar is threatening to decline in a disorderly manner, and liquidity is getting tighter.  If this coalescence of negative forces were not enough, the bond market is no longer paying attention to stock market weakness, precious metals are not convinced that inflation and/or a financial crisis can be avoided, and the biggest carry trade of all-time (Yen) is threatening to shut.

Decline Already!

Volatility in the global financial markets can oftentimes presage a financial crisis.  And while another LTCM or Asian-style crisis would not be welcomed news to the majority of investors, it would serve to speed up the purging process in the markets and stimulate bargain hunters. It is always a good idea for the bargain hunter to be prepared for the possibility of a sharp decline.

Failing an unexpected financial crisis, it may be prudent to stay cash heavy until fund redemptions, economic recession, and/or more attractive valuations arrive.  While you wait research and be ready to invest in companies you understand and believe will be successful in the long-term.  Two big caps with a global reach worth consideration are Microsoft and Coca-Cola.  Although not screaming undervaluation on any level, a lot of shareholders have watched MSFT and KO shares do absolutely nothing for six and nine years respectively. Prices could become attractive if these investors start throwing in the towel.

In short, another month like May and the stock stories and large cap losers could be worth pecking at. Then again, another month or two like May and some real bargains may finally arrive. Given that the US consumer has not had to tighten their pursestrings for 15-years, no one can be certain how ugly things will get for the US economy and financial markets.  What can be said is that with no longer-term market worries as yet resolved, May 2006 is unlikely to mark any type of bottom for the markets.

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