Is It Safe?

In this feature, we take a look at companies including Wal-Mart (WMT - Snapshot Report), Costco (COST - Snapshot Report), Gap (GPS - Analyst Report), Diamond Offshore (DO - Analyst Report) and Merck (MRK - Analyst Report).

That question is a vital one right now, even though every time it is asked, I think of Laurence Olivier asking it to Dustin Hoffman in "Marathon Man."  Clearly there has been some very important progress on the policy front.  After weeks of delay -- as we started with an awful plan and struggled to make it mediocre -- we finally decided to do the right thing.  

Fortunately, "the right thing" was included as an option in the struggle to make it mediocre.  Injecting cash directly into the balance sheets of the big systemically important banks and taking ownership stakes in return is exactly the right medicine to stabilize the financial system.  The second major initiative is to guarantee interbank lending.  Think of it this way: the buying of big chunks of preferred stock is aimed at fixing the engine, the guarantee of new interbank loans is designed to fix the transmission.  

Is it enough?  Will it work?  Does the car also have three flat tires and is out of gas?  It's hard to say right now.  The stock market was certainly encouraged.  What it means is that we are now, in all probability, looking at tough times reminiscent of the early 1980's, not at tough times reminiscent of the early 1930's.  Did the early 1980's suck?  Oh yeah.  Were they far better than the early 1930?  Big time.  We have a nasty worldwide recession already baked into the cake.  Finally, however, we have decided to turn the oven off.

To shift metaphors here, the stock market is the barometer, it is not the storm.  Has the storm subsided?  It was impossible to tell yesterday since the true storm is in the credit markets and the bond market was closed yesterday.  The early indications today are that it has helped, but only a little bit.  The storm is still blowing, but its intensity has diminished a bit.  It is down from a Category-5 to a Category-3 storm.  

For example, the TED spread (the difference between the yield on interbank lending and T-bills) has declined from 4.57% on Friday/yesterday to 4.28%.  Is that good news?  Yes, but it is still an awful reading.  To have any confidence that the storm has abated, we really need that spread to decline to under 1.0%.  Under completely normal circumstances it is less than 0.50%, especially given the low overall interest rates (a 4.28% spread is much more significant when it is 4.50% vs. 0.22% than when it is 14.50% vs. 10.22%).  However, even after the storm stops blowing we will have to go out and survey the damage, and the damage to the real economy is already extensive and severe.

The market was clearly very oversold on a technical basis, and the selling had be indiscriminate.  Good firms -- with solid balance sheets, with no need to access the credit market and products that people will continue to buy in hard times, and fat, well-covered dividends -- were getting trashed right along with companies that are knock, knock, knocking on heaven's door.  

While we may have seen the bottom on Friday, I strongly suspect that we will go back down and retest those levels.  The next decline is likely to be more slow and grinding, and will separate out the weak companies from the strong.  I have no doubt in my mind that earnings estimates for the fourth quarter and 2009 are far too optimistic, and will be cut dramatically over the coming months.  We are already seeing the cuts take place, virtually across the board.  Over the last four weeks, almost four estimates for 2009 earnings have been cut for every one increased for S&P 500 companies, and in no sector has the ratio been less than 2:1.  Most of the increases were leftovers from three or four weeks ago.  

The story is substantially the same for 2008 earnings.  Yes, P/Es based on current expectations are low, but they will rise as the expected "E" declines.  There will be many more dividend cuts than increases over the next year, so the fact that it is easy to find stocks with dividend yields far in excess of what government bonds are yielding is cold comfort.  However, the decline in earnings estimates will not be uniform across the board.  Not all companies will cut their dividends, and some may increase them.

For a value investor, the sell-off over the last month should leave you feeling like a kid in the candy shop (albeit one who's allowance has recently been cut).  Look for the right sort of companies that have been beaten down.  Strong balance sheets first and foremost.  Products that are needed (not just wanted) second.  High, well-covered dividend yields third.  

I would continue to avoid the Financial sector.  Quite frankly, with the mark-to-market rules eased, it is impossible to know if their books belong on the fiction or the non-fiction shelf.  They will be diluted, and frankly should not have the right to pay anything in the way of dividends.  The term "fraudulent convenience" comes to mind when thinking about a bank paying a dividend.

I would avoid the retailers, with the possible exception of those that fit the "inferior goods" theme.  Examples of this would be Wal-Mart (WMT - Snapshot Report) and Costco (COST - Snapshot Report).  This is going to be a Christmas controlled by the Grinch, not Santa.  With the housing ATM gone for the foreseeable future, and virtually nothing in the way of savings, consumers will have to cut back.  The mid-priced retailers will be hurt most of all.  Firms like J.C. Penney (JCP - Analyst Report), Kohl's (KSS - Snapshot Report), Gap (GPS - Analyst Report) and Macy's (M - Snapshot Report) come to mind.   Drug stores like Walgreen's (WAG - Analyst Report) and grocery stores like Kroger's (KR - Analyst Report) would be places to hide out if you simply must have a retailer in your portfolio.

Despite the decline in oil prices due to falling demand, I still like the Energy sector.  Think about the consequences if demand for the major oil services firms or the offshore drillers were to decline.  It would mean an acceleration in the decline of world oil production, and would permanently cripple any hope for an economic recovery down the road.  This is a fantastic opportunity to invest in names like Halliburton (HAL - Analyst Report), Baker Hughes (BHI - Analyst Report) and National Oilwell Varco (NOV - Analyst Report).  The deepwater drillers have their earnings virtually locked in for the next three years, and yet are trading at P/E's that suggest that their earnings are about to go over a cliff.  This is the time to be buying names like Transocean (RIG - Snapshot Report), Diamond Offshore (DO - Analyst Report) and Pride (PDE - Analyst Report) with both hands.  

The major drug companies are also a great place to look for bargains.  Pfizer (PFE - Analyst Report), Merck (MRK - Analyst Report) and Bristol Myers (BMY - Analyst Report) are good examples of the bargains that can be found in this area.   

Read the full analyst report on JCP

Read the full analyst report on KR

Read the full analyst report on WAG

Read the full analyst report on HAL

Read the full analyst report on BHI

Read the full analyst report on NOV

Read the full analyst report on RIG

Read the full analyst report on DO

Read the full analyst report on PDE

Read the full analyst report on PFE

Read the full analyst report on MRK

Read the full analyst report on BMY