by Hal Eddins, Managing Director, Capital Investment Council
And the results are now in….the market’s focus over the next 8 weeks should be the midterm congressional elections. Midterm elections occur in the even numbered years without a Presidential election; they come 2 years into a presidential term…hence the name.
We researched the last 11 midterm elections back to 1962. We then used a date range of October 1 through November 19. That way we could capture the entire election time frame without getting into Thanksgiving Day data. In the 11 mid term election periods since 1962, there were 9 positive periods and only 2 negative ones. The average change for the period was a positive 4.80%. That’s worth getting out of bed for. The average change from the low price of the election period to the high was 11.06% so expect volatility. As to the Election Day itself, there were 8 positive days versus only 3 negative. The average date for the low of the period is Oct 8 and the date for the high is Nov 11. While the market is fairly indifferent as to the victors of the election, it’s important to bear in mind that some sectors benefit more than others depending on who wins. In the wake of the Republic victory in November of 2002, tobacco, pharmaceuticals, and defense contractors did particularly well. Keep those dates in mind, and we’ll see how it plays out.
As a follow up from our Da Vinci code trivia in June, we offer the following thoughts. We recently came across this in Ty Boyd’s excellent newsletter. It will not make you a dime but it is entertaining. The so-called rule of three - the mathematical law of proportion - has been important in human interaction since the dawn of time. Shakespeare wrote "Friends, Romans, countrymen." Aristotle gave us the "beginning, middle and end." Three little pigs, three blind mice and the three bears populate nursery rhymes. In jokes, three ministers or three people from different countries draw a laugh. Winston Churchill promised four things during World War II: blood, sweat, toil and tears. That most people remember only "blood, sweat and tears" illustrates the power of the rule of three. Pay attention to this in your next several conversations and you’ll see how often it crops up.
If you think housing does not matter to the economy then you might want to think again. Recent economic reports indicated that the U.S. gross domestic product grew at 3.5%. Housing accounted for 2 whole percentage points of that growth. Housing continues to slide and foreclosures are up dramatically. August foreclosures in such “can’t miss markets like Florida and Nevada were up 62% and 255% respectively. Remember, a housing slowdown impacts not only the builders, but also the realtors, the home improvement stores, the lawyers conducting the closings, and so on. It is also alarming to learn that 10% of all outstanding mortgages have no equity at all. That shows quite a few “Johnny come lately” types buying into the housing bubble. One final albeit scary thought on the direction of housing: American Express announced last week a new feature that will allow customers to use their AMEX card for a down payment on a condo!
In the investing game it’s all about risk and reward. It’s interesting to finally see the risk side of the commodity trade come to the fore after so many years of seeing only the reward. I’m speaking of course of Amaranth, the hedge fund giant who lost $7 billion in a week on a natural gas bet. It’s not that oil, natural gas or any of the other commodities are “bad”. The problem is that the reward side has become much less lucrative as the commodities related stocks have rallied almost without pause over the last three years. For example, Schlumberger (SLB) is not a “bad” company, in fact, it’s an excellent one. However, Schlumberger is involved in oil services, and this tends to be a highly volatile industry. Taking the volatility into account, it’s hard to justify owning Schlumberger at 24 times trailing earnings. Schlumberger has experienced 5 runs of over 50% both up and down since 1997. It is the ultimate in “buy low and sell high”. We are not picking on SLB; you could choose any one of their competitors such as Baker Hughes or Halliburton. We will be first in line to buy these stocks once the price comes in a bit more in line with reality.
We have felt for some time that large caps are undervalued, and the data finally bears this out. On a cash flow basis, large cap growth stocks are selling at an average of 12.8 times. By comparison, value stocks are trading at an even higher multiple of 13.6 times cash flow. This is the only time in the last 30 years this has occurred and is further evidence to how cheap the likes of Wal Mart, Home Depot and Eli Lilly are.
Retailers have enjoyed a robust September. Let’s raise the hood and see what is really going on. At Capital Investment Counsel, our focus has been on the retailers catering to basic or nondiscretionary purchases. These stores include Wal Mart, Family Dollar, and Dollar General. All three companies (that rule of 3 again) have enjoyed 10% plus rallies in the last three weeks. We feel this may continue over time. The dramatic drop in oil prices during September has been the catalyst for much of this rally. A continued drop in oil prices back to the longer term median price will continue to assist the American consumer. The government recently released August’s retail sales. John Succo of Vicis Capital noticed that the non auto sector showed a $560 million increase. Of this increase, $296 million came from food sales. Food is a predominately nondiscretionary purchase. As the economy slows, Americans will continue to migrate to this type of spending. We will continue to spend, but what we spend it on will change. The Macy’s customer will likely migrate down to Target. Target shoppers will head over to Wal Mart, and the Wal Mart faithful will move to Dollar General and Family Dollar. These companies are still very cheap and it will not take much incremental change to add significantly to their bottom line. In fact, Dollar General just installed a state of the art Manhattan Associates inventory system just like the one used by Wal Mart. This improvement should help Dollar General continue to compete against the “Beast from Bentonville.”
