Paul Rabbitt Rabbitt Analytics .com
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Post-Trauma Rebuilding Begins

It's time to start rebuilding stock portfolios, but investors are cautioned to "husband" their capital. The recession-hurricane has passed. While a few lingering showers may move through, investors are emerging from their shelters, and looking about for rebuilding opportunities.

There have been many casualties: whole corporations have disappeared, retirement plans have been decimated, and the trauma has everyone on a raw edge. Many investors just want to get back even and are prone to make desperate and rash decisions. Additionally, many investors just want to be able to sleep at night and have lost their appetite for stocks regardless of their merits.

But the American spirit is resilient and determined and resourceful. And the American economy is diverse, driven by entrepreneurs, and remains a desirable destination for global capital.

"Normal" Is Coming

The new normal will include companies with successful business and financial strategies. Investors can be profitable in this environment by maintaining a steady course and a strong risk-discipline while increasing holdings in a diverse portfolio of equities. There will be plenty of opportunities over the next one to three years to make money. Bear-market losses do not have to be urgently recovered overnight.

Some Mistakes Not to Make

Don't "bet the farm" on junk companies, and don't "fly to safety" by buying bonds.

Interest rates have likely achieved their lows and will probably creep higher gradually, beginning in mid-2010. Over the past decade, the usual premium returns paid to investors in equities as they take the risk to build American corporations has evaporated. Meanwhile, returns to bond investors, who do not take this risk, have flipped their relationship to equities, delivering significantly higher returns to equities. The bull market in bonds is likely over, and the resulting out-performance of bonds is unlikely. We would not be a buyer of intermediate or long-term bonds at this time.

The markets will sort themselves out, and volatility will gradually be reduced as a new "normal" is established. Some issues have doubled and tripled since the market bottomed in March, and some portfolio managers have delivered eye-popping performance. Many of the stocks that are rocketing ahead carry with them inherent risks including complete dependence on the economy, limited liquidity, and high volatility.

Stocks of the largest gains recently have included companies that were hurt the most by the economy over the past year and a half. One can extract that investors are seeking to leverage up on the economic recovery. They are identifying recovery candidate-stocks by flowing capital into stocks of companies that were hurt the most during the recession. While this strategy worked in the early stages of the bull market that began in 2002, it will not have the same kick this year and has inherent risks. This economic recovery will be much more laborious.

Switch Away from Bear Strategy

Stocks have risen lately on bad news including the bankruptcies of General Motors and Chrysler. In bear markets, stocks go down on both good and bad news. Investors are looking beyond negative headlines towards an improved future. Liquidity is near an all-time record high. When cash is abundant, stocks rise. Furthermore, there has been little, if any, investment-banking over the past two years, resulting in minimal supply of new stocks. The resulting demand/supply ratio for stocks is attractive. This is not the time to be shorting stocks, other than for quick trades.

After shunning risk for the past year, it is now time to take on the risk of the equity markets. A beta of 1.0 (average market risk) and 15% cash is recommended for "business-risk" type investors. A minimum 25% should be deployed into global stocks with emphasis on emerging markets. Top countries include: China, Malaysia, Brazil, India, and Russia. China's economy is expected to recover first, thereby leading the world's economic recovery as other emerging economies follow. The developed countries’ economies will lag, hampered by high levels of unemployment and rising tax trends. Here in the US, investors should emphasize the energy and finance sectors with good-sized positions in non-durables and services.

Classic fundamental stock-market research techniques have begun yielding above-market performance for the first time in over a year. As a result, investors should convert long ETFs into diversified stock portfolios.

In our writings at the beginning of the year, we posited that stocks would probably hit bottom somewhere at the end of the first quarter or middle of the second quarter. Stocks made a bottom in early March. This coincides with improvements in manufacturing and consumer sentiment resulting from the administration's stimulus package.

A Note for Chartists

Due to the bear market, there are few stocks with attractive long-term charts. With stocks rising slightly since the first of the year, it is suggested that chartists shorten their chart time-horizons to six months in order to identify securities that are participating in this current constructive phase.

Inflation Should Remain Near 1%

Core inflation is actually expected to be lower this year than it was last year, coming in somewhere near 1.5%. The FOMC recently stated, "Massive global excess supply of labor and productive capacity will contribute downward pressure on wage inflation and price inflation".

Consumers have encountered spot cost-increases in energy, medical services, and education. The summer driving season has arrived, but consumers are expected to balk at $3/ gallon gasoline, thereby reducing driving. Energy prices may climb through mid-July, but then should peak and fall back to average $65 a barrel in 2009. Manufacturers are left with very little pricing power due to weak consumer demand. Historically, stocks rise as long as inflation remains below 7%.

Economy on Target to Emerge in Q3

Second-quarter GDP is expected to decline by 2.7%. Third quarter GDP is expected to rise by .3%; in the fourth quarter it is expected to rise by 1.7%.

The economic crisis of the past 18 months has begun to dissipate. The economy is expected to return to growth status during the third quarter. The potential for a robust economic recovery is diminished. Government borrowings to provide economic stimulus need to be repaid. Still, a double-dip recession is not expected. The most recent FOMC statement said that, central bankers are much more concerned with a fallback into recession than with the economy over-heating anytime soon. Upward pressure on tax rates is a certainty. While the bottom in interest rates has been achieved, they will probably remain low for the next 12 months before beginning to creep higher.

The US government acted properly in providing stimulus to avert a potential depression. Political pundits may argue the approach used by the current administration. We believe that whether stimulus is added in the form of corporate tax breaks and benefits to private enterprise versus extension of unemployment benefits and provision for basic employment opportunities is a moot point. Ultimately, stimulation has to reach the consumer, put money in their pockets, increase consumer confidence, and restart consumption. Our economy remains two-thirds consumer-driven. The consumer can't be left out of the recovery equation. For now, consumer activity is expected to be flat due to the housing price decline and stubbornly high unemployment rates.

Jobs are a lagging indicator of the economy's health. Job losses in May came in below expectations. The 345,000 losses are nearly half the average monthly drop experienced during the first quarter. Auto industry shutdowns will hamper employment gains for the remainder of this year.

The 5.7% decline in first-quarter GDP had a silver lining. US corporations managed to reduce inventories by $91.4 billion, adding to the already $60 billion in reductions in the previous two quarters. The US economy will begin to grow when inventories have been reduced, thus forcing manufacturers to begin producing products and to reduce layoffs, finally leading to new hiring.

Paul Rabbitt is an independent research analyst and portfolio manager. He is CEO of Rabbitt Capital, and chief portfolio manager of hedged and private capital. He is President RabbittAnalytics.com, delivering independent stock research to private and institutional clients since 1998 featuring the "Q" Stock Ranking system, a twelve-factor stock risk/return model ranking 2500 stocks daily, since 1989, with one of Wall Street’s best published track records.

Paul previously held dual roles as both Senior Portfolio Strategist and Chief Quantitative Analyst at CIBC Oppenheimer where he was an employee and partner for twenty years.

Institutional Investor Magazine has ranked Paul among the top eight quantitative strategists. He is a frequent commentator in the national and international media.