Barclays Strategist: Recovery Will Be Strong

While there is still quite of bit of pessimism and talk of gloom and doom swirling around the market and the economy, Barclays head of asset allocation Tim Bond is sounding positively sunny.

“History provides abundant evidence that the deeper the recession, the stronger the bounce. Even the recovery from the Great Depression conformed to this rule; real US GDP grew 10.8 per cent in 1934 and 8.9 per cent in 1935,” Bond writes in the Financial Times, citing several signs that we’re experiencing a “V” type recovery. “Over the rest of this year, the standard cyclical timing of a US economic turning point tells us pessimistic expectations are likely to collide with the economic reality of a strong recovery. The net result is almost inevitable, in the shape of an inexorable continuation of the equity rally.”

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Swensen on Why Individual Investors Will Always Be at a Disadvantage

WealthTrack has released some previously unaired parts of Consuelo Mack’s May interview with Yale Chief Investment Officer David Swensen. In the clip below, Swensen discusses a variety of topics, including why he thinks some corporate bonds are a good bet for professional investors but not a good bet for individuals; why individuals will always have trouble beating the market; and why his strategy in picking managers to invest Yale’s funds with is “all about the people”.

Where Do We Go from Here? Sonders, Yardeni & Others Weigh In

With the market continuing to surge, recently surveyed a number of top strategists to see just how much room they think stocks have to run, and found a good deal of optimism that was tempered by caution.

Among the strategists: Charles Schwab Chief Investment Strategist Liz Ann Sonders; Yardeni Research President Ed Yardeni; and Bespoke Investment Group Founder Paul Hickey. Here’s a sampling of what they had to say:

Sonders: “The train has been leaving the station for many indexes, and investors don’t want to be left on the cash platform,” Sonders said. She says investors are putting cash into just about anything, including higher-risk bond sectors, emerging markets, U.S. stocks, and commodities. “It’s been my strong view that a lot of what we’re seeing is ‘capitulation in’ vs. the ‘capitulation out’ that tends to occur as bear markets are ending,” she said. “I don’t think we’re finished with that process, but it won’t last forever.”

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Gross on GDP, the “New Normal”, and Why Watching Fees Is More Important than Ever

In his August Investment Outlook on PIMCO’s web site, bond guru Bill Gross talks about two key — and interrelated — issues: whether the government will be able to “reflate” the economy to match past longer-term GDP growth figures, and why avoiding the big fees most investment advisors and funds charge is so crucial today

Gross says nominal GDP growth has to grow close to 5% — its long-term average — for the economy’s long-term balance to remain intact. “Now, however, things have changed,” he says, “and it is apparent that there is massive overcapacity in the U.S. and indeed the global economy,” which has driven GDP down. “If allowed to continue -– and this is my critical point –- a portion of the U.S. production capacity and labor market will have to be permanently laid off. … Employment levels become unsustainable, retail shopping centers unserviceable, automobile production facilities unprofitable, and the economy itself heads towards a new normal where unemployment averages 8 instead of 5%, housing starts total 1.5 instead of 2 million, and domestic auto sales 12, instead of 16 million annual units.”

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Guru Rating Changes: Coach on the Rise, Intel Takes a Hit

Each week, I take a look at which stocks my Guru Strategy computer models have newfound interest in, and which they have soured on. Here’s a look at some of the stocks that my strategies have upgraded or downgraded today. Among the gainers is upscale retailer Coach, Inc., while the downgrades include chip-making giant Intel Corporation.

Validea Guru Strategy Upgrades/Downgrades -- July 29, 2009

Validea Guru Strategy Upgrades/Downgrades -- July 29, 2009

Top Strategists Talk “Buy-and-Hold”

The Financial Times recently interviewed several top strategists about the viability of “buy-and-hold” investing, and found that some are espousing more of a “buy-cheap-and-hold” approach.

“In a challenge to the received wisdom of holding stock market investments for 20 years or more, to smooth out short-term volatility, some suggest that measures of cheapness can be used to make buying decisions and enhance performance,” writes the Times‘ David Stevenson. Here’s a sampling of what some of these strategists had to say:

Robert Arnott, founder of Research Affiliates: “Basically, we have an industry which has developed a cult of equities — a notion that if you buy stocks you will win, if you’re patient,” he says. “The reality is something very different, and that is that stocks do win over the very long run… but they win over spans measured in generations, not measured in years. And they win in fits and starts.”

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Why Jeremy Grantham Is Bored with this Market

Just a few months after he said that equities were undervalued for the first time in two decades, Jeremy Grantham now says the broader market is again overvalued — though he sees substantial opportunities in certain areas of the market.

In the GMO chief’s second-quarter letter, Grantham says that a year ago, stocks were overpriced, and a quarter ago, they were underpriced. “Now they have all — or almost all — converged for a few unusual moments at fair value,” he says. “A year ago, it was very easy to know what to be: a risk avoider. It was not so easy reinvesting when terrified, but most of us knew that we should have been doing more. But today? It’s difficult to be inspired at fair value.”

Grantham says there is still “presumably at least a decent shot (say, 50/50) at [the S&P 500] rising over 1000 in the next two to three quarters.” But, he adds, the recent rally has been driven by stimulus and speculation, with low-priced, volatile stocks leading the way, and GMO’s estimate of S&P fair value is now below 900. “Given our view that we are in for seven lean years in which the market will be looking for an excuse to be cheap, we recommend taking some risk units off the table, including becoming underweight in equities — between 1000 and 1100 on the S&P, if it gets there this year. Around 880 you should continue to move slowly to fair value, twiddle your thumbs, and wait to see what happens. Boring! Otherwise, it is time to focus on the lesser issues: which types of equities are cheaper or more expensive than the market.”

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Pabrai on Buffett, and the Current Market

Fund manager and author Mohnish Pabrai — a Warren Buffett disciple who a couple years ago paid $650,000 in a charity auction for the right to have lunch with “The Oracle of Omaha” — tells Fox Business News about what he’s learned from Buffett, and how he’s profiting from the rebound.

The segment also includes some recent comments Buffett made on his own approach, and his thoughts on market timing.

Dreman Strategy Making Big Comeback

Every other issue of The Validea Hot List newsletter examines in detail one of John Reese’s computerized Guru Strategies. This week’s issue looks at the David Dreman-inspired Contrarian Investor strategy, which is up more than 25% this year and more than 40% in the past three months. Below is an excerpt from the newsletter along with several top-scoring stock ideas based on the Dreman investment strategy.

Taken from the July 24, 2009 issue of The Validea Hot List

Guru Spotlight: David Dreman

While all the gurus I follow have built their fame and fortunes using different investment approaches, there is at least one striking similarity that most — if not all — of them share: They are contrarians. When the rest of Wall Street is zigging, they are zagging; when Wall Street zags, they zig. By having the strength of conviction to march to their own drummers and not follow the crowd, they have been able to key in on the types of strong, undervalued stocks that have made them — and their clients or shareholders — very happy.

But while most of the gurus upon which my strategies are based are contrarians, one stands out among all the others: David Dreman. Throughout his long career, Dreman has sifted through the market’s dregs in order to find hidden gems, and he has been very, very good at it. His Kemper-Dreman High Return Fund was one of the best-performing mutual funds ever, ranking number one out of 255 funds in its peer groups from 1988 to 1998, according to Lipper Analytical Services. And when Dreman published Contrarian Investment Strategies: The Next Generation (the book on which I base my Dreman strategy) in 1998, the fund had been ranked number one in more time periods than any of the 3,175 funds in Lipper’s database.

Born in 1936, Dreman became interested in the stock market at quite an early age. His father was the chief trader at a large commodity firm in Winnipeg, Canada, and young David would often accompany his father to floor of the exchange as a youngster. According to Dreman Value Management’s website, while at the exchange he was able to observe first hand the dynamics of a very active market and the reaction of the traders and the markets in general.

After graduating from the University of Manitoba, Dreman first worked as a security analyst at his father”s trading firm in Winnipeg. By 1977, he had opened his own firm, and soon he was posting impressive results by focusing on stocks that were overlooked, “beaten up,” or sometimes in the midst of an outright crisis. Throughout his career, he did the same thing, finding winners in such beaten-up stocks as Altria (after the tobacco stock plummeted amid lawsuit concerns) and Tyco (which had been hit hard by an embarrassing CEO fiasco).

Psychology Matters

How — and why — did Dreman manage to pick winners from groups of stocks that few other investors would touch? The answer may at least in part go back to young Dreman’s days on his father’s trading floor, when he got to see how the market moved, and, more importantly, how the traders responded to it.

Dreman, perhaps more than any other guru I follow, is a student of investor psychology. And at the core of his research is the belief that investors tend to overvalue the “best” stocks — those “hot” stocks everyone seems to be buying — and undervalue the “worst” stocks — those that people are avoiding like the plague, like Altria and Tyco. In addition, he also believed that the market was driven largely by how investors reacted to “surprises”, frequent events that include earnings reports that exceed or fall short of expectations, government actions, or news about new products. And, he believed that analysts were more often than not wrong about their earnings forecasts, which leads to a lot of these surprises.

When you put those factors together, you get the crux of Dreman’s contrarian philosophy. Because the “best” stocks are often overvalued, good surprises can’t increase their values that much more. Bad surprises, however, can have a very negative impact on them. The “worst” stocks, meanwhile, are so undervalued that they don’t have much further down to go when bad surprises occur. But when good surprises occur, they have a lot of room to grow. By taking a “contrarian” approach — i.e. targeting out-of-favor stocks and avoiding in-favor stocks — Dreman found you could make a killing.

Focus on Fundamentals

Specifically, Dreman compared a stock’s price to four fundamentals: earnings, cash flow, book value, and dividend yield. If a stock’s price/earnings, price/cash flow, price/book value, or price/dividend ratio was in the bottom 20 percent of the market, it was a sign that investors weren’t paying it much attention. And to Dreman, that was a sign that these stocks could end up becoming winners. (In my Dreman-based model, a firm is required to be in the bottom 20 percent of the market in at least two of those four categories to earn “contrarian” status.)

But Dreman also realized that just because a stock was overlooked, it wasn’t necessarily a good buy. After all, investors sometimes are right to avoid certain poorly performing companies. What Dreman wanted to find were good companies that were being ignored, often because of apathy or overblown fears about the stock or its industry. To find those good firms, he used a variety of fundamental tests. Among them were return on equity (he wanted a stock’s ROE to be in the top third of the 1,500 largest stocks in the market); the current ratio (which he wanted to be greater than the stock’s industry average, or greater than 2); pre-tax profit margins (which should be at least 8 percent), and the debt/equity ratio (which should be below the industry average, or below 20 percent). By using those and other fundamental tests in conjunction with his contrarian indicator tests (the low P/E, P/CF, P/B, and P/D criteria we reviewed before), he was able to have great success finding strong but unloved firms that had the potential to take off once investors caught on to their true strength.

Because Dreman took advantage of the overreactions of others, he found that one of the best times to invest was during a crisis. “A market crisis presents an outstanding opportunity to profit, because it lets loose overreaction at its wildest,” he wrote in Contrarian Investment Strategies. “People no longer examine what a stock is worth; instead, they are fixated by prices cascading ever lower. Further, the event triggering the crisis is always considered to be something entirely new.” Dreman’s advice: “Buy during a panic, don’t sell.”

The Picks

As you might imagine, my Dreman-based 10-stock portfolio — which includes the top stocks picked by my Dreman strategy — will tread into areas of the market others ignore because of its contrarian bent. Its current holdings, for example, include two financials, some telecoms, a utility, and a healthcare company, all of which involve areas that have been lagging in recent months (except for financials, which still have a significant cloud of fear hanging over them). Here’s the full list of the portfolio’s holdings:

Validea Dreman-Based 10-Stock Portfolio

Validea Dreman-Based 10-Stock Portfolio

Since its inception, the Dreman-based model has been a strong performer, but it’s been a rocky road at times. The portfolio was one of my best from 2003 through 2006, at least doubling the S&P 500′s gains in each of those years. But when value stocks went out of favor in 2007, so did the Dreman model. It lost 12% that year and was hit quite hard in last year’s crisis, losing another 54.8%.

But then, just as Dreman has done in his career, the portfolio took advantage of others’ fears. It snatched up a lot of bargains that others had discarded, and is up 25.4% this year (including 41.7% in the past three months), putting it up 40.3% since its inception more than six years ago. That’s an annualized gain of 5.8%, in a period in which the S&P 500 has fallen 0.4% per year. The Dreman model has also been my most accurate approach, making gains on more than 60% of its picks over the long haul.

Bouncing Back Strong, Miller Now High on Tech, Financials

Bill Miller — who beat the market for a remarkable 15 straight years before struggling the last three — is bouncing back strong this year, with his Legg Mason Value Trust fund up almost 20% in 2009. Now, he says that bargains “abound” in the U.S. market, and that technology and financial stocks will lead the market upward.

“Bull markets typically begin when the following four conditions are present: the economy is bottoming, profits are bottoming, the Fed is stimulating, and valuations are low,” Miller writes in his second-quarter letter to investors. “That’s where we are now. The path of least resistance, as Jesse Livermore used to call it, is higher.”

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