DON'T BELIEVE A WORD OF IT!

I have always enjoyed reading the popular business magazines. These magazines reflect what is interesting to the public right now. The public is usually interested in knowing what investments have been working well or they like to read about how terrible a situation has become. This is good information that usually needs to be used as a contrary indicator.

A couple of weeks back, I wrote that the bottom has been called in Coke (KO) because the company was featured on the front cover of Business Week. In preparing to write about this phenomena, I came across THE BIG PICTURE. A blog written by Barry L. Ritholz. Ritholz does an excellent job of explaining the concept. The following several paragraphs are excerpts from his blog.

"What exactly are Contrary Indicators?

Contrary Indicators are the data points, signs, and events whose actual significance to the market is the exact opposite of what their initial impression suggests. These counterintuitive signals can reveal when great masses of investors are collectively reacting emotionally to a given event or stimulus. When the herd becomes violently emotional, they typically shoot first, and ask questions later. This invariably results in poor investment decisions.

Contrary Indicators are rather simple in operation; They reveal when a significant number of investors (often a majority) have become too enthusiastic or too pessimistic reflecting moments of excessive fear or greed. This excess gusto occurs prior to, or coincident with, major inflection points.

Investors (individuals, mutual fund managers, pension fund directors) with a longer time horizon should be aware of external indicators before deploying fresh capital.

4) The Magazine Cover Indicator

The covers of national news magazines and business publications show what's making news today. The markets, on the other hand, are a future discounting mechanism, anticipating future events, and reflecting them in price and trend.

Magazine covers sell magazines; Covers stories are featured because they are resonating with the public at that moment. When an editorial committee decides something is worthy of their publication's highest profile, it usually means that trend has already reached its climax.

Why does this work as a contrary indicator? When a magazine covers focus on the Bear Market for example, it's already been priced into the market. Whatever response the magazine engenders is typically the last spasm of its cover subject.

The July 2002, Time Magazine's cover had this title: "Will You Ever Be Able to Retire?" The cover graphic was an elderly person serving burgers to teens at a drive-thru window, while another graphic showed a senior working as a lifeguard. The implication was that people's retirement accounts were so irredeemably damaged that Senior Citizens should plan to work at McDonalds through their golden years.

It's not just the popular press that works this way: Even business publications can mark the top or bottom for both companies and sectors. "The Great Telecom Crash" was the cover story for July 18th 2002 Economist. That cover story nailed the July lows in the sector by a matter of days."

Barry L. Ritholtz, Market Strategist

Ritholtz writes about the magazine covers and other contrarian indicators but the magazine portion of the story is bigger than just the cover. David Dreman has written at least a couple of books some years ago that detailed several aspects of the phenomena. A couple of the titles I recall are The Contrarian Investment Strategy and The New Contrarian Investment Strategy. Dreman puts his money where his mouth is. For the past fifteen years, he has beaten the S&P 500 by better than 3% per year compounded! Had one invested $10,000 in the S&P one would now have $41,000 but $10,000 in Dreman's fund would now be $61,700!

The above explanation by Barry is largely correct but there may even be devious purposes involved in the published stories. Consider the following comment of author Michael Crichton, "There are many groups in contemporary society who find in their interest to promote fears. A free society, a free press, has a lot of good features, but giving you an accurate view at the world is not one".

I read somewhere that Business Week has, since 1994, published nine stories from one author about potential take-overs. The record is 0 for 9. If this is actually true, there are several possible reasons. It could really be part of the phenomena of the magazine finding stories that it knows its readers will enjoy. However, 0 for 9 sounds so weak to suggest that someone is feeding bad information on purpose.

I don't suggest that you draw conclusions from heresy. However, my study of the markets for 40 plus years has brought me to the belief that much of what is published in national business magazines should be used as contrary indicators.

The Business Week year-end double issues is currently for sale. In it I find article after article that I will use as contrary indicators. Some of these are simply too easy. Others may not give a clear answer as to how an investor should respond but only the direction to avoid. Leave a comment if you have experience with contrary indicators.

1. Sellers should sell options to increase income. Nope! The majority of all investors should avoid options all together. At best, they will increase their transaction costs. One likely result is that their best stocks will get called away right when they break out on a long positive move. The old saw says it best; "Option traders never die, they just expire worthless".

2. Investors should seek higher yielding bonds and trust accounts. Nope! The current spreads between high risk corporate bonds and muni-bonds gives little boost in yields in exchange for the added risk. International bonds were mentioned as another source of high income but currency risk should be avoided. Another mention was high yielding energy trust. Avoid! Energy trust can decline in value if oil declines in value. Only pros should play high risk games.

It is true that potential rewards go up as risks go up. Perhaps a good analogy is of a game of 7 card stud. If you play well in a game of penny ante, you may win often and you will never win or lose a lot. However, should you step-up to a $100-$200 game, your potential to make a lot of money will increase from zero to some positive number but if you have joined a professional game, chances are you will lose a lot. If you must buy bonds in the current market, stick with bonds that do not require sophisticated credit or other analysis.

3. Buy international companies. Specifically mentioned were Brazil, Russia, India and China. Not Me! I am buying big American companies. Now that the US Dollar has declined dramatically, I believe it will be American companies that will do well. Russian and Indian stocks are hard to buy except in mutual funds that have high operating expenses. Russia is in the middle of nationalizing its largest oil company; more could follow. Brazil stocks are up about 400% in 3 years. There are low fee ETFs (Exchange Traded Funds) for Brazil and China but the China fund is only a few months old. In the same way that making the front cover is a contrary indicator, starting a new fund is also. The two most ballyhooed new funds were the gold funds and the China fund, I would avoid buying either.

4. Renewable energy stocks! HA! HA! HA! How many times have you heard this one. Although there is no doubt that Iowa Bob will work at getting corn or soybean oil into the next energy bill, the fact remains that the current price of oil does not support the use of renewable energy sources. The laws of economics are simple and do not waiver. If energy of one type cost too much, an alternative will be substituted. Will the natural gas pipeline to Alaska be built? Absolutely yes! The state of Alaska and the US Government will each reap tremendous benefits as will the American and Canadian consumer. Will it take ten years? Yes! Will car companies increase production of hybrids? Yes! But remember, hybrid cars use gas as their fuel. That's right, oil provides the fuel for hybrid cars. Will they one day be fueled by hydrogen? Probably? Will that be anytime soon? NO! Since Libya capitulated, the rush is on to develop 30 Billion proven reserves in Libya. Iraq, Russia and China will each develop fields with proven reserves of 20 Billion or more. The US has enough coal to last 250 years and clean technology is available and at current prices making sense. In the state of Indiana there are currently 13 coal fired utility plants approved for construction. It is likely that clean burning coal utilities will use electricity at night to produce hydrogen. Do not chase windmills or solar panels. Even after significant tax incentives, these technologies are marginally cost effective in just a few situations.
5. Buy companies with big operating margins. It may sound silly to go contrary to this one but I think my Food Lion example of past generations is the best example. Grocery stores have very small margins but they sell a lot of suff. Some of the most successful investments over the next 5 years or more will be investments in low margin businesses that have pricing power. Plenty of high margin businesses will find that they have no pricing power. When their costs go up, their margins will be squeezed and their stock price will come down. Wal-Mart operates with a small operating margin. Don't you only wish you had mortgaged your house to buy Wal-Mart 25 years ago!

6. "Under-neath the twin peaks of Yahoo and Google--both pricy after sharp run-ups--a prosperous industry is taking shape." Bah Hum-Bug! The article goes on to tell about companies such as Double Click and i-Village. The fact is that Double Click has offered itself for sale and can't find a buyer and i-Village is having trouble competing in a tough market. In the mean-time, Yahoo and Google (and EBAY for that matter) continue to buy sizeable businesses cheaply and they continue to add services. For example, Yahoo recently added MusicMatch to its stable of media broadcasting companies and it has contracts with virtually all cell phone companies to offer internet services of one type or another. It recently added traffic reports to its map's of communities. Google and Yahoo are serving up about 40% and 29% of all ads in the internet world. Double Click may find a buyer someday but Google and Yahoo are two of my largest holdings and I sold my Double Click months ago.

7. Big banks are take-over targets. This implies that one should buy big banks. This one is really interesting. Merger and acquisition activity is on fire. Consolidation is occurring in most industries. In recent weeks we have seen mergers in software, healthcare, electric utilities, wireless phone service and internet services. My family has been lucky to participate in several of these. I have suggested that the public needs to buy stocks while they are cheap relative to bonds. Otherwise the company will buy its stock back or another company will swallow it up. Big banks have been consolidating for years and I would not be surprised if another deal is announced soon. However, the take-overs where I have made the most have been when I bought stocks that were fundamentally cheap.

Banks tend to struggle when the yield curve flattens and when interest rates go up. The fed has raised the cost of funds to the banks 5 times in the past 5 months. The spread between funds borrowed at short rates and funds lent at long rates has fallen. Also, refinancing fees have recently dropped like a rock. When interest rates were on the way down, some folks refinanced several times. The bank made fees each time but are now stuck with a low rate loan on the books. I plan to avoid bank stocks, mortgage companies, REITs and utilities because I see their costs rising. I will continue to hold shares in BB&T which is a very well run regional bank but I do not expect to add to the shares for the next several years.

8. Magazine cries wolf in regard to housing again! I wish I had a nickel for every article that has been written about the housing problem in the past 5 years. Ironically, we are finally getting close to an inflection point but the prescribed solutions are ridiculous. If it is really such a crisis that one needs to protect against, then one should sell his house. The reality is that housing values continue to increase as a result of supply and demand. It is true that the interest rate is a part of the total cost and therefore the total increase in value has helped by low interest rates. It is also true that house prices would have been going up even if rates had been higher. Again, it may be that supply is about to finally catch up to demand.

Housing starts declined last month. The magazine suggest that one should protect ones self by signing up for as large a credit line as possible but then not borrow the money. This is financial folly. Why pay fees to set up a line of credit based on a variable rate when rates are on the way up? If rates are indeed about to rise, one should lock into a fixed 30 year loan and pay the least amount per month as possible. One should use the resulting improvement in cash flow to make sure all variable rate debts are paid off. In today's tax environment, one should avoid car loans and credit card loans. The debt against your home is probably at a lower rate than car loan rates and the house loan is tax deductible.

9. Value stocks pricy, buy growth stocks. Wow! This one is almost wrong by definition. I own growth stocks such as EBAY, GOOG and YAHO so I know a pricy stock when I see one. The magazine article goes on to recommend international, energy, real estate and global resources. Again, I say, buy big American consumer staples and health care stocks. Remember, I put some more money where my mouth is on Friday. I bought several hundred shares of PFE on the opening at $23.52. Drug stocks have been hammered with bad news for at least a couple of years. One should buy stocks based on what is expected for the future not on what happened in the past. America is aging quickly. The baby boomers of my generation will spend billions on drugs in the next 10 years.

10. Without going back to find the actual market predictions, let me encourage you to read the previous report about Ken Fisher's forecast. The summary is that the results in the first year of the presidential cycle tend to be a single digit average but almost never a single digit result. In other words, it tends to be a really good or really bad year. The Business Week consensus was for a single digit year. My guess is for a 15% or better total return for the S&P.