Fagan Associates Archive for June, 2010

The oil spill in the Gulf of Mexico is tragic on a number of levels, most important being the loss of eleven lives, workers on the BP oil rig.  We can add to that the potential life changing disruption for the people living along the Gulf Coast, the environment, the economy and the loss of animal life.  Furthermore, the potential for the spilt oil to eventually travel around Florida and up the Atlantic Coast is nearly unimaginable.  That said, investors can also glean several valuable lessons from this event.

Probably the most important lesson that investors can learn from this tragedy is that diversification is of utmost importance when it comes to investing in individual securities.  Let’s assume that your portfolio totaled approximately $100,000 and that at the time of the spill you owned 100 shares of BP which was then trading at around $59.50 per share for a value of $5,950.  BP therefore represented 5.95% of your portfolio.  Today, BP trades at or around $34.50 per share and has acted as a 2.50% drag on your portfolio relative to the stock market.  That’s not great, but it will not destroy your portfolio.  You will live to fight another day.

Investors should also diversify across sectors of the economy.  Since the oil spill, not only has the stock price of BP been pummeled, but so has those of deep-water drillers as well as oil service companies.  It is appropriate to slightly overweight an industry.  However, to grossly overweight an industry is like playing with fire.  You can get burnt.  Lesson number one.  Diversify among companies (at least twelve to fifteen) and across industries.

Don’t chase companies solely for the dividend.  The landscape is strewn with companies that used to pay high dividends only to then have to cut that dividend as a result of poor market conditions, changes in government legislation or poor company performance.  Some of the “widow and orphan” stocks that investors relied on for income have severely cut their dividend over the past couple of years.  Consider General Electric, Bank of America, KeyCorp and JP Morgan Chase, just to name a few.  BP pays out $3.36 per year in the form of a dividend.  At the time of the disaster that would have resulted in a dividend yield of 5.65%, attractive to many investors.  Today, due to the decline in the share price that yield approaches 9.00%.  However, don’t be surprised if BP either cuts, suspends or eliminates their dividend to conserve cash during this period of uncertainty for the company.

Finally, remember that nothing is for certain and to think you “know” what is going to transpire or you “know” that BP is a good buy at these levels is arrogant.  Investing is like eating ice cream, everything in moderation.

THE BOTTOM LINE – Investors would be wise to diversify across companies, across industries not invest solely for dividend income.  This should help preserve sudden portfolio drops due to changes in the outlook of a company or an industry.

If there is one thing that stock investors dislike more than anything else, it is uncertainty.  Unfortunately, today there exists a great degree of uncertainty which is reopening the deep wound that investors still feel from the bear market that ended in early March 2009, the second one in less than ten years and one that took the major indices down by more than fifty percent.  Although many of the uncertainties noted below are real, we believe that within seven or eight percent the stock market has taken them into consideration.

Contrary to what many thought just a few months ago, one of the bright spots in the global economy is the United States.  The balance sheets of many of our major corporations have never been stronger and corporate profits have surged off the bottom.  Despite the fact that this has not yet been felt on Main Street, it is nonetheless a necessary precursor to a rebound in the labor market.  Understandably, many are skeptical that this will transpire.  However, looking back at in what order economies recover, one can see that the labor market is a lagging indicator as employers are reluctant to hire back too early in the economic cycle in fear that they will just have to lay people off again.  Nonetheless, we will watch the labor market closely as the United States cannot have a sustainable economic recovery without a recovery in the labor market.  Keep a close eye on Initial Claims for Unemployment Benefits as well as Continuing Claims for Unemployment Benefits which are released every Thursday and despite some improvement, remain stubbornly high.

Another concern affecting the ability of the stock market to further their fifty-plus percent gains off the March 2009 lows is continued weakness in the housing market.  Home prices in major markets such as Tampa, Phoenix, as well as in many cities in California and the Midwest remain thirty to fifty percent off their peaks set during 2007.  Furthermore, demand remains relatively tepid, slowing down the depletion of current inventory as well as the construction of new homes.  On the bright side, ironically the sovereign debt troubles in Greece and its drag on the Euro has resulted in a stronger dollar which should help keep interest rates and therefore mortgage rates low, supporting the demand for housing which is more affordable than it has been in forty years.

A third concern negatively impacting the willingness of investors to commit capital to the stock market is the belief that the rapidly growing Chinese economy, one that helped lift the global economy out of the severe recession, is slowing thereby reducing the demand for raw materials as well as consumer goods.  We agree with this assumption, although disagree to what extent it is slowing.  China posted annualized gains in its Gross Domestic Product (GDP) over the past three quarter of more than ten percent.  Although we are no experts regarding China, the reports we read from those who are predict that mid- to upper single-digit gains in Chinese GDP represents the “slowdown.”

There are many other concerns that are providing a headwind to our stock market, not the least of which include the negative sentiment of our voting population toward politicians, the distrust of Wall Street exacerbated by the “Flash Crash” we experienced a few weeks ago when the Dow Jones Industrial Average plummeted more than 700 points in seven minutes and our ballooning deficits, both public and private.

THE BOTTOM LINE – This period of malaise in the stock market is not without precedence and is in fact, quite normal by historical standards.  Yes, it can go on for quite awhile longer.  However, the longer stock investors go with little or no monetary reward, the greater that reward will be when the time comes.  We are not saying that time is now.  However, we are saying that at or around current levels, stocks seem relatively fairly valued, especially with Certificate of Deposit rates closer to zero than two percent and the ten year U.S. Treasury Note closer to three than four percent.  Make a shopping list.  Be patient and extend your intended holding period awhile.