Wednesday, October 8, 2008

Q&A: What To Buy?

Jerry e-mailed to ask: "What stocks would you recommend buying during this downturn? XOM, COP, GE?"

This gives me a good opportunity to write a little about what I've been up to lately and what I'm thinking today. Of course, what I'm thinking today could differ significantly from what I'll be thinking tomorrow in this market.

As a quick reminder, I am not a day trader. Most of the positions I take are for the long-term though some are shorter-term opportunistic trades. In addition, I pursue a long/short strategy with most client portfolios. Part of the portfolio is long, and part is short. Where that split falls depends on the number of compelling short ideas I find as well as market and sector valuation (and the degree to which the government prevents me from shorting).

Obviously, the short portion of the portfolio has done well. I'd love to attribute that to my genius, but there isn't much you could have shorted recently and not's because of my genius. Of course, a true genius would have held an even larger short position.

The long portfolio has been a mixed bag. It was designed to be defensive, and it had been up until this latest "baby and bath water" stage in which any semi-liquid security has been tossed overboard. The only things rising these days seem to be Treasury securities, gold, pessimism, some currencies, and the number of political ads on TV. The portion of our long portfolio that has done well is the exposure to cash, gold, the Japanese yen, and the Chinese yuan (renminbi). These positions have fortunately been the largest holdings in most portfolios. I wish they'd been larger still for they haven't offset the losses from the other long holdings.

With the decline in the market of the past 2 weeks, I've been gradually covering my short positions (SRS, QID, TWM). I have a few remaining (MS, BWLD, COF, AMZN, and HOG). I also still have some put options in some accounts on the QQQs. I anticipate closing most of these positions out in the near-term if the market doesn't spike higher (which would not be surprising). I'll probably keep the BWLD short a little longer as it hasn't come off its high too much, the valuation is still rich, cost (margin) pressures are building, and restaurant spending is a discretionary expenditure that is easy to rein in when times are tough. Buffalo wings are tasty, but I can put tabasco sauce on my tofu dogs and watch the game at home.

On the long side, I think the best long-term buys today are in some of the emerging markets and in the commodity space. Again, these should not be bought if you're looking to make a quick buck or if you're the obsessive type who monitors his investments every few minutes. They could easily fall significantly from here before finding a bottom, but if you are a true long-term investor, these are the areas I would focus on. Many of my long positions are in these two areas, and as I've indicated, I've been very gradually adding to them as they've come in, and I plan to roll the gains from the short positions into these areas.

As for emerging markets, I like China and Russia right now. You want exposure to China over the next couple of decades (probably longer) given their growth prospects and rising incomes, and you can get it today at a very reasonable price given the tremendous decline in their stock markets. There are some good, non-speculative, individual Chinese stocks to own, but most people would be better off with an ETF/fund (FXI, PGJ, GCH, CAF).

I also think Russia is looking interesting. That market has been blown apart from the "war" with Georgia and the decline of commodity prices on which Russia is highly dependent. Some degree of continuing conflict with its neighbors has already been discounted, and I believe the long-term outlook for many commodities is quite bullish. Russia is in a much better position than it was during its 1998 financial crisis. The Russians should have enough reserves to make it through the downturn as they are far less dependent on external financing than they were in 1998. Russian stocks are currently trading at some of the lowest multiples in the world right now - typically a good time to buy. One of the easiest ways to gain exposure to Russia is with RSX.

On the commodity front, I like many commodities long-term, but the supply-demand balance and time frame differs for each. In general, commodities are being knocked down of late due to declining demand from a contracting global economy as well as the general de-leveraging underway that is hitting all risky assets. These factors are currently overpowering the supply side of the equation. Longer-term, however, we need to watch what's going on with supply as well. Heading into this downturn, supply of many commodities was struggling to keep up with demand.

Currently, due to lower commodity prices, inability to access funding, declining demand, and higher costs, there is a steady flow of news detailing mine/project closures and postponements. In many cases, it's too expensive to start a new project even if you're able to scrape together the funding to do so. This will eventually lead to even lower supply. Once the global economy settles out and starts to grow again (and it will some day), I suspect it won't take long for investors to realize how serious the under-supply situation is. Some of the commodity names I'd recommend taking a look at include POT, MOS, DBA, DBB, SLV, GLD, NEM, GDX, TCK, RIO, BHP, AEM, PAAS, SSRI, NGD, and COW, but there are plenty of others interesting names as well these days.

The market cycles between financial assets and hard assets, although neither have been working over the past few months. I believe that commodities are still in a long-term bull trend and that the bull market will reassert itself at some point and run quite a bit further. My preference is to have "direct" exposure through ETFs as well as owning stocks that operate in the commodity space. I had hoped that the commodity-related stocks would have held up better, but in the current environment, everything liquid is being sold regardless of long-term prospects. The good news is that these stocks are offering amazing entry levels for the long-term investor, assuming we're not going back to living in caves and chasing our meals with clubs.

Let me turn to gold. I've been a big fan of gold for about 5 years now, and I think it makes sense for just about everyone to have some exposure here. Gold has performed well of late, and it's our largest single holding in most portfolios. I'm actually a little surprised that it hasn't done even better given the global financial stresses. The recent relative strength of the dollar is likely the key factor keeping gold from exploding, but the explosion in the money supply that's underway, the declining level of (already low) interest rates, the terrible shape of the U.S. government balance sheet, and the implosion of the financial system should be supportive, to put it mildly. At some point, I think there's a good chance of a gold mania.

As for gold vs. gold stocks, I own both. Currently, despite the price of gold hanging in there, gold stocks have been beaten up, and many are trading near their 52-week lows. If you have a longer-term horizon, you have a wonderful opportunity to put a basket of these stocks together and tuck it away. You could also buy GDX which would give you exposure to a basket of mining companies. In addition, owning actual gold coins somewhere offshore wouldn't be a terrible idea either.

As for XOM, COP, and GE specifically, my feeling is that there are better opportunities available. These names aren't likely to outperform the market when things eventually turn, and they haven't really provided much of a hiding place thus far. If you have a longer term time horizon I would focus more on companies that will be more leveraged to the upturn. If you like energy (I do long-term), take a look at PBR, CHK, APC, and XTO. Also take a look at the drillers, especially the offshore deepwater plays. It's probably a little early here still, but these will be strong winners again.

As for GE, anything with significant financial exposure is still off limits for the time being. I've had a net short position in financials (wish it had been bigger) during the decline. The problem has been that no one really knows what any financial company's balance sheet really looks like. If you don't know the quality of the balance sheet and you buy still buy the stock, you're simply gambling. I save my gambling for the poker table. And buying the larger banks because you think the government won't let them fail is a flawed strategy. True, Wells Fargo and Bank of America won't be allowed to fail, but as we've seen, you shouldn't expect the common shareholders to be bailed out.

One final note if you're picking individual stocks. Equity investors never worry much about the balance sheet or cash flow statement when times are good. Now that times are not so good, the balance sheet and cash flow statement are critical. If you're not going to look at 10-Qs and 10-Ks then you shouldn't be buying individual stocks. Companies with too much debt and/or too high a reliance on external financing are off limits. These are potential company killers. High debt with strong cash flow may be fine if the cash flow remains sufficient during the downturn.

UPDATE: I was a bit sidetracked from this post today due to the market. The market has now closed -- down another 675 points. Today's action isn't shocking given sentiment and the lifting of the short ban.

At this point, I have turned from bearish to neutral on the market overall. There is certainly more room for downside, but after a 40% decline in the market, normalized P/E is looking more reasonable, and I'm having a much easier time finding attractive long ideas. This market is either ready to implode or we're due for an explosive bear market rally.

At the end of the day, I closed out my short positions in MS, COF, HOG, and AMZN. Currently, the only short I have is BWLD. At these levels, I'll be putting some cash to work on the long side in some of the names mentioned earlier. Never a dull moment.

Disclosure: The Rubbernecker is long on long-term buying opportunities and short of shorts.

The Market Rubbernecker is affiliated with Aspera Financial, LLC, a registered investment advisor. Please read the disclaimer on the home page of the Market Rubbernecker site.