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Stock Market Investors Searching for a Silver Lining

Companies / Investing 2009 Feb 17, 2009 - 06:40 PM GMT

By: Q1_Publishing


Best Financial Markets Analysis Article“When people are frightened, they cut their time horizon dramatically, ... Even advisors will say to sell because they see portfolios crumble and they fear people will have nothing left. It's really not rational, but it does happen.”

That's what David Dreman wrote in his book Contrarian Investment Strategies . Now, almost 30 years later, it's looking like it's happening all over again.

People are getting frightened they'll have nothing left.

Portfolios are crumbling.

And the market's main focus is on what the latest government plan will look like when it's revealed later this week (talk about dramatically shortened time horizons).

But hey, this was expected. We knew the stimulus plan wasn't worth much. And frankly, hopes to a government orchestrated solution having any impact in a few months time were just irrational. But this is just what we've been waiting for.

As you'll soon see, a very strong pocket of strength is forming in one sector. And it will be safe to jump in soon. It's shaping up just as we've been expecting, but first we should go over a few areas the markets will be forced to “reckon” with over the next few months.

“This is the worst”

A few months ago we questioned whether the markets really priced in 9% to 10% unemployment. It looks like the market is starting to get its first glimpse of what it will look like. And it doesn't like what it sees.

Earlier today the Dow was off more than 3% and the NASDAQ and S&P 500 were off even more. Hopes for a recovery in the second half of 2009 appear to have faded completely. Chrysler and GM (NYSE:GM) more or less failed to deliver a recovery plan today (at the time of this writing). It looks like bankruptcy or more bailout cash is only a few weeks away now.

There's practically no reason to get excited about anything over the short term. And the analyst community (which seems like it's always the last one to realize how bad things really are) is feeding a very hungry bear.

Howard Silverblatt, an analyst for Standard & Poor's, over the weekend stated, “This is the worst; after the sixth quarter of negative growth, it will be the first quarter ever of negative earnings.”

According to Sivlerblatt, the S&P is in for a horrible round of earnings this quarter. The current estimate is for a loss of $10.44. That's lower than already low expectations. John Mauldin, in 2008: Annus Horribilus, RIP (from January), noted the decline of earnings expectations for the S&P 500. Take a look at the chart below:

Earnings Estimate for S&P 500 (total $)

Date of Estimate Estimate for 2008 Estimate for 2009
December 2007 84.00 ------
February 2008 71.20 ------
June 2008 68.93 70.13
September 2008 60.00 58.87
October 2008 54.82 48.52
January 2009 48.05 42.26

It appears even those were a bit too optimistic. The worst part is the Q4 decline offsets all earnings from Q3 and puts 2008 earnings for the S&P 500 at about $28. With the S&P at 789, that puts the trailing P/E for the index at a lofty high of more than 28. And considering no signs of an economic recovery in 2009, the forward P/E could be much higher (remember, the long-run average P/E for S&P 500 is about 15).

That's just one realization the market has to go through yet. There is another problem - a potentially even bigger one.

California Leads the Way

We've talked about before how state government's are in deep trouble before. Now the whole world is quickly learning how bad it's going to get for free-spending states.

For example, excluding pension plans for former employees (which would make at least a dozen states technically insolvent), 44 states will face budget deficits this year. The average deficit across all states is 15% (that's considering fairly rosy estimates on the revenue side too). This can't go on. And to see what happens when it stops, just look at California.

The world's 8 th largest economy has the biggest budget deficit of all. It's so bad there; the government has been forced to cut back. Over the weekend California announced it will be laying off 20,000 employees. That's a little less than 10% of the state's employees.

The reason for such drastic measures? The Golden State couldn't get a budget passed. The state's Democrats wanted to raise taxes to fill the void. And the Republicans wouldn't budge. (I'm sure it's just political posturing from a party that seems to be marketing itself as the “low tax, small government” party once again – both parties have proven they can squander money as well as the other.)

Of course, California faced budget shortfalls before though. But this time around no one will lend money to California. The state is already too deeply in debt. It has the worst credit rating of any state in the U.S. And now that regulators and economic constraints are forcing banks to look at the creditworthiness of borrowers once again, California just isn't making the grade. Pension funds aren't stepping up either.

It's a stalemate and the consequences are good and bad. Over the short-term there are another 20,000 people to add to the ranks of the unemployed. Over the long term, it could mean (dare we hope!) smaller government.

But you've got to remember, we're focused on an increasingly short-sighted stock market here, so this news is bad all the way around.

An Undeniable Pocket of Strength

There's no side-skirting this one. It's ugly out there and it's getting worse. State budget deficits, a federal stimulus package doomed for failure,

The market is realizing it, slowly but surely. There is, however, a good side to it all.

Remember a few weeks ago when we talked about how Barometer Capital's little known, but highly successful David Burrows focuses on finding strength and buying it.

Well, we're seeing a pocket of strength emerge right now. In the chart below there is a clear separation between the S&P 500 (gold line) and iShares Dow Jones Medical Devices (IHI –black line) .

Both have had a rough year, but the IHI is showing some life. Meanwhile, the S&P 500 is testing its November lows. That proves there's a lot of interest in healthcare. More specifically, it shows there's a lot of interest in medical device companies.

IHI is made up of the leading medical device companies. The IHI is dotted with great companies with great products and facing many great years ahead. For instance, Intuitive Surgical (NASDAQ:ISRG) , maker of the Da Vinci robotic surgery equipment, makes up about 3.5% of IHI. And Covidian (NYSE:COV), which is a company so strongly positioned it's safe to say that every hospital in the U.S. has at least one Covidian product in it, makes up more than 7% of the IHI.

Right now there is a lot of strength in medical device stocks. And they will likely do well in the face of more market sell-offs. And they will likely do great in the event of a recovery.

That's why you stick to pockets of strength. At the Prosperity Dispatch , we believe that's the only place where you'll find safety and upside potential in a market like this.

Remember, days like today are what we've been waiting for. And they're why I'm terribly excited about the months and years ahead.

Every once in a while there you can get in on a big trend pretty early. There is absolutely nothing like it.

I bought my first oil stock in 1999. When the tech market crashed I loaded up on water utilities (sounds boring I know, but I cashed in a 3-bagger in water a few years later). And I moved into agriculture in 2006.

They don't come along often. When they do come though, they are fantastic. Healthcare is shaping up to be one of those opportunities.

Good investing,

Andrew Mickey
Chief Investment Strategist, Q1 Publishing

Q1 Publishing is committed to providing investors with well-researched, level-headed, no-nonsense, analysis and investment advice that will allow you to secure enduring wealth and independence.

© 2009 Copyright Q1 Publishing - All Rights Reserved
Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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