I'm adding a growth stock to my portfolio with this column. And I expect to add as many as four more over the next four to six weeks.
Not because I'm so optimistic about the economy and the financial markets. Exactly the opposite, in fact. I'm buying growth stocks -- and adding more exposure to gold stocks -- because I'm deeply pessimistic about the economy and the financial markets over the next 12 to 18 months.
The two groups, which in normal times occupy opposite ends of the market spectrum, are to my thinking the best hedges available against the rocky times ahead over the next 12 to 18 months.
I know this is a logical stretch from conventional thinking about the asset classes you should use to build a portfolio, so let me explain how I came to this conclusion.
We're still eyebrow-deep in a financial crisis set off by truly staggering wishful thinking about risk in the markets for subprime mortgages, buyout loans and other asset-backed paper.
But unlike those in the financial press and economic-analyst communities who are now calling for a recession, I believe we're likely to get out of this mess -- in the short run, at least -- by flooding the financial markets with hundreds of billions in new money from the world's central banks. The central banks will literally paper over the long-term problems in the debt market with billions in currency.
This flood of cash will, in the next few months, restore liquidity to those parts of the debt market, such as the market for the short-term (90-day) commercial paper that companies use to fund operations, which have threatened to seize up in recent weeks. It will restore confidence among bankers, who will stop hoarding liquidity. It will produce a rally in the stock market. And it will head off any possibility of the economic slowdown in the U.S. and Europe turning into a recession.
Effects of Liquidity
But we've been here before. At best, this massive infusion of liquidity will push inflation rates higher. At worst, this bailout will create a market boom and another market panic down the road, just as the bailout of the Long Term Capital Management hedge fund and its investors, and the bailout of the East Asian economies after a currency crisis in that region, set the stage for the boom of 1999 and the crash of 2000.
I'm adding to my existing gold and other hard-asset positions to profit from the coming uptick in inflation that this latest bailout will produce. And I'm adding growth stocks to profit from the stock market boom that is likely to follow hard upon this most recent bailout.
Though I fully intend to profit on the short-term trends in stocks created by this bailout, I remain convinced that each bailout -- and the boom-and-panic cycle that it perpetuates -- will make the eventual day of reckoning in the financial markets more painful.
Each bailout reduces the chances of a soft landing for the financial markets and increases the odds we're headed to some kind of Volcker moment, like the kind of interest rate shock that then-Federal Reserve Chairman Paul Volcker engineered in the early 1980s to put a stop to the runaway-inflation expectations of the 1970s.
By relentlessly driving up interest rates, Volcker broke the back of an inflationary cycle that had sent annual inflation to 13.5% in 1981. By 1983, annual inflation was down to 3.2%. The accompanying recession saw the unemployment rate rise to 10.8%, more than twice the current 4.6% rate, at the end of 1982.
We are now in stage two in the current financial market crisis.
How the Trouble Started
I'd call stage one "The Surprise." In this stage, lenders and the investors who bought financial instruments based on questionable loans reacted with surprise to rising defaults, sinking credit ratings from the three big rating agencies and tumbling prices. "Golly, gee, whoever would have thought that when we gave mortgages to people with shaky credit histories without verifying their incomes and let them borrow even the down payments that so many borrowers would default?"
Not so long ago, lenders were pointing to still minuscule default rates on these mortgages, by historical standards, as evidence of the soundness of their lending practices. It turns out that what we were seeing was just the time lag between the day people signed a no-income-verification, zero-down, adjustable-rate mortgage and the day that payments rose enough and housing prices fell enough to make the borrowers walk away from homes in which they owed more than they borrowed.
The percentage of U.S. mortgages in default climbed to an all-time high in the first quarter of 2007 -- and it's still rising. The percentage of mortgages in foreclosure also has increased. According to the Mortgage Bankers Association, in the second quarter of 2007, 0.65% of all loans on one-to four-unit residential properties entered foreclosure. That is a record in the 55-year history of the survey, breaking the record from the quarter before. A year ago, just 0.43% of loans entered foreclosure.
In fact, the problem is not just that the market is setting a record for the percentage of foreclosures and delinquencies. Thanks to the mortgage-lending and housing-price booms, there are a lot more mortgages to borrowers with shaky credit out there than there used to be. In the second quarter of 2002, according to the Mortgage Bankers Association, there were 1.2 million subprime mortgages outstanding, while in the second quarter of 2007, subprime mortgages outstanding numbered 5.9 million.
Central Banks to the Rescue
Even as the number of mortgages and the number of portfolios holding mortgage-backed assets in trouble continues to climb, the current crisis has moved to stage two, "The Bailout."
On Aug. 9, the European Central Bank pumped $130 billion in liquidity into the European financial markets. The move followed hard on the heels of news that
had frozen the assets of three funds worth $3 billion because of the funds' exposure to assets backed by subprime mortgages. On Aug. 10, the bank added $84 billion more in liquidity to the markets.
The same day, the U.S.
added $24 billion in liquidity to the markets. The next day, it added $38 billion more.
On Sept. 6, the Fed added $31 billion, following an overnight injection of $60 billion by the European Central Bank.
In effect, the Federal Reserve, the European Central Bank and other central banks, such as the Bank of England, have become lenders of last resort -- at fire-sale prices. The European Central Bank offered its Aug. 9 loans at 4%, for example. Banks have been hoarding capital so that they can fix their own problems, and that has left borrowers seeking funds desperate for cash. The central banks have stepped into the gap by providing billions in loans to banks so that they can keep lending to battered investors in the asset-backed securities market.
This huge injection of liquidity into the financial markets puts an effective end to any real fight against inflation by the Federal Reserve and the European Central Bank, and that sets us up for stage three of the crisis, "The Shock."
Over the next few weeks, as investment companies and banks report their quarterly numbers, Wall Street will profess shock at the size of the losses and writedowns. I fully expect a "kitchen sink" quarter where the big players in these markets --
, Barclays and
, among others -- write down everything they can in an effort to put the crisis behind them.
Will they really have written off all their losses? Not a chance. Unwinding all the vehicles involved and pricing every infrequently traded asset will take quarters yet. I expect that we'll see other shoes drop at all these financial companies every quarter for some time to come.
But the size of the losses announced for the third quarter will be enough to let Wall Street feel that the worst is over. Bet your last dollar that you'll start to see talking heads argue that this is the bottom and that it's time to buy.
That argument will have just enough evidence behind it, and the financial markets will have more than enough new liquidity in them, to produce a solid fourth-quarter rally sometime after mid-October.
Refuges for Your Money
If that comes to pass, just remember that the central banks have done nothing more than paper over the current crisis. The long-term problems that have made this a period of boom-panic-boom in the financial markets will remain in place.
With this all as backdrop, I want to add more exposure to gold. That's a way to profit from the upturn in inflation that all this added liquidity will bring.
And I want to add growth stocks to take advantage of the likelihood of a post-shock rally. I've put together a list of five names -- all stocks with good growth stories in sectors that offer some protection in case of an economic slowdown.
The list consists of
Jacobs Engineering Group
. I'm adding DaVita to the portfolio with this column. I'll look to add other names from this group during what I expect to be a very volatile September and October.
A Safe Play
DaVita is my first buy from my list of five growth stocks for pessimists. I want to increase my exposure to growth stocks as we head toward the end of the year, because I believe the bailout of troubled banks by the Federal Reserve and the European central bank will kick off a liquidity rally sometime after mid-October.
But I also want to limit my downside risks -- in case I'm wrong about the rally or the economy slows more than I expect -- by buying growth stocks in parts of the economy that are relatively sheltered from any economywide storms.
Diabetes is, unfortunately, a growth industry in the U.S. The incidence of the disease is climbing by about 4% annually in our aging and overweight population. DaVita is the leading U.S. provider of dialysis and related services, serving 104,000 patients through a network of 1,300 outpatient clinics.
The stock has spent the past year building a base around $55, as worries about cuts to Medicare rates would hurt DaVita's revenue. But with increases in Medicare reimbursement rates that went into effect April 1, I believe these worries are in the past. In its Aug. 2 second quarter, the company beat the Wall Street earnings consensus by 6 cents a share, reporting 83 cents a share, as use of its anemia drug erythropoietin, or EPO, decreased less than feared after the U.S. Food and Drug Administration changed labeling. Management also raised revenue guidance for 2007 to $790 million to $820 million from $740 million to $780 million.
With operating margins expanding recently, the higher revenue guidance says to me that DaVita could surprise Wall Street again in coming quarters. I'm setting a target price of $70 a share for July 2008.
Rather than try to find another individual gold stock, I'm adding an exchange-traded fund. The
iShares Comex Gold Trust
owns gold rather than shares of gold-mining companies, so you get the appreciation of the price of the metal without the leverage of owning mining stocks (which move up more strongly than the price of gold itself in a rally) or the recent disadvantage of rising production costs that have dampened results for gold-mining companies.
With gold having moved up so strongly recently, it's hard to find a gold-mining stock that hasn't moved up like a rocket already, raising the possibility of an equally big move to the downside on profit-taking. At this moment, I believe the iShares Comex Gold Trust is the best way to increase exposure to the sector's longer-term potential while decreasing short-term risk. I'm adding these shares with a target price of $84 by July 2008.
At the time of publication, Jubak did not own positions in any stocks mentioned in this column.
Jim Jubak is senior markets editor for MSN Money. He is a former senior financial editor at Worth magazine and editor of Venture magazine. Jubak was a Bagehot Business Journalism Fellow at Columbia University and has written two books: "The Worth Guide to Electronic Investing" and "In the Image of the Brain: Breaking the Barrier Between the Human Mind and Intelligent Machines." As an investor, he says he believes the conventional wisdom is always wrong -- but that he will nonetheless go with the herd if he believes there's a profit to be made. He lives in New York. While Jubak cannot provide personalized investment advice or recommendations, he appreciates your feedback;
to send him an email.