RealMoney Silver - Even a Value Investor Has to See the Forest

Even a Value Investor Has to See the Forest
By Tim Melvin
RealMoney.com Contributor
5/14/2008 12:29 PM EDT

It is no secret that I spend most of my time searching for stocks that are too cheap not to own or that offer a trading opportunity. I also review options trades on stocks that I believe are underpriced, and I can sell puts to create a better entry or just collect the premium. I review special situations to find combination trades and to set up a specific set of trades over the next year or so.

Most of the investors I admire, such as Walter Schloss, Chris Browne and John Templeton, have always said that they ignored the market and economic outlook and concentrated on individual securities and opportunities. Most of the time I do exactly that and focus on finding stocks and trades that fit my selection criteria.

However, information moves faster today, and the leverage of derivatives and other instruments can change market direction in ways that did not exist in years past. An awareness of general economic conditions and trends can help me avoid value traps, such as financials, some of the retailers and real-estate-oriented stocks.

Once in a while I need to come up for air and take a look at what is going on in the market and economy to give me a backdrop for my trading and investing activities.

It's Cold Outside

I have made no secret that I am generally bearish on the stock market. So far it has been the right thing to do. Looking at a chart of monthly prices (yes, I know, value guys are not allowed to use charts -- we are not supposed to use options either -- and I wonder if I will get kicked out of the club), prices have pretty much fallen in a straight line since the 1576 high in October.

After that high, we had five straight months when prices closed lower. In April, we finally reversed that trend and had an up month. So far, the trend is continuing, as we are up slightly so far in May. April saw another key trend reverse for the first time this year. On a weekly basis, the number of new highs exceed the number of new lows as investors piled into the markets in hopes that continued Federal Reserve moves would halt the oversold condition of the stock market. We have now retraced about 50% of the October-to-April selloff, and I won't be shocked if stocks move up throughout May and possibly even challenge the October highs.

So, we should buy right? Well, no, not really. I will not be surprised to see prices collapse either. This market is not cheap. On a reported basis, the S&P 500 trades at 20 times earnings, hardly a level I would call cheap. Earnings so far are down 20% year over year, and I do not really have a reason to believe they will improve in the second quarter. In fact, as retail sales and margins continue to fall, I believe they will get worse.

Equally troubling is that earnings and market leadership is coming from energy, food and raw-materials producers. Energy and food stocks we have talked about before. The prices in these segments are booming as global demand continues to push them higher. Specialty chemical stocks, as well as steel and coal stocks, are also soaring as higher raw-material costs push their earnings and stocks higher. This is wonderful news indeed if you are long those sectors. It is not so wonderful if you make, sell or consume just about anything else.

Higher energy and raw-material costs are going to continue to squeeze overall profit margins. These rising costs will also reduce revenue if the trend continues, as both corporate and individual consumers will have to cut back discretionary spending to meet basic costs. I believe the stock market may well be priced to perfection in an imperfect world.

Macro Misery

The economy? Let's be honest here for a minute. While Wall Street attempts to kick off a rally and bring back the boom times, those of us on Main Street know the truth. The economy stinks. Consumer confidence and sentiment numbers have both dropped off a cliff, falling almost 50% so far this year.

Real estate prices continue to fall, and more homeowners are struggling just to meet their mortgage payments. Retail sales are horrible. The slight increases in some areas have been far lower then the increase of the cost of goods required to manufacture products, and the gains for the most part have been at warehouse and discount stores as consumers try to save money.

Unemployment has risen so far in the past six months and may well climb higher over the summer months as fuel prices continue to squeeze the economy. To make things a little worse, bond prices are starting to fall as inflation concerns begin to be realized, causing interest rates to rise.

The big picture as I see it right now is that the stock market, while it may rally a bit in the short term, should be a lot lower, given the earnings and economic environment. The market is a popularity contest in the short run, but in the intermediate to long term it usually reflects reality at some point. That will be the time to get excited, when everyone else is scared of stocks and selling indiscriminately. We have not reached that point at all so far in 2008, but my view of the big picture tells me we probably will.

Until then, I will own the too-cheap-not-to-owns, build my list of small bank stocks and exercise the patience my mom swore I never had.