Stock Gurus: Bill Miller

Legendary stock guru Bill Miller appeared on CNBC today. He manages a Legg Mason fund, and holds the record for beating the S&P (15 years), until the crash of 2008, that is. His portfolio has since rebounded as much as 40-80% (depending on what you’re looking at).

Mr. Miller is just behind Warren Buffet in the world of value investing. I respect his opinion, but like everything else, I think you have to keep things in perspective. For example, if you’re down 70% one year, and then up 100% the next year, you’re still down 35%. So don’t let these percentages fool you.

Also, you have to keep in mind that value players favor looking at valuation, which creates a bias. In Mr. Miller’s case, he may tend to underestimate the macro picture. I’ll give two examples. The first is real estate. Mr. Miller is long real estate and argued for a recovery. He’s down on that investment – he joked about being “early”. But oddly, no one on the desk of reporters (which is why I think it’s such a shame that reporters are asking questions) asked what happens when interest rates go up. Real estate will go down again, I believe, and how much depends on how much inflation there is. If that’s true, it means that he’s very early on real estate, the cycle isn’t over. On the same day, Professor Shiller of the well-known Case-Shiller Index admitted that there’s better than a 50% chance that real estate prices will go down again.

The other example lies in the 2008 crash. Mr. Miller didn’t see it coming, and that’s because he was looking more at valuation (price-to-book, PE, etc.) than at macro trends (in my opinion, he didn’t say that). In this interview, admitted that they’ve learned a lot. Before, he would have said that the depression scenario was off the table. Now, he has a different view: there are two different kinds of downturns – liquidity , as in 1987, when the Fed pumping money into the system was enough; and asset or balance-sheet downturns, where the value of assets decline and this is what the Great Depression was. This actually makes lots of sense. Consider the post dot.com period, when savings went down, but employment held up relative to 2008; and individual’s assets – such as real estate actually gained. In 2008, both savings and assets took a hit. So that’s a good way to look at it, I think.

Mr. Miller does think that there are still great values in the market, and of course, that’s the interesting part. He believes that the worst is over, but the recovery is far from complete. And the risk after a major event such as the 2008 crash is relatively low.

Mr. Miller’s example was IBM, which trades at 12x this year’s (2010) earnings. The company has top line growth of close to GDP levels, so not much exciting there. It’s the bottom line that’s interesting – it produces cash, so IBM buys back stock and earnings go up. It has performed consistently, even in this down market. I agree, lots to like there, especially for retirement portfolios.

Other picks include regional banks, that are trading at discounts to book value with good capital ratios; GE, Walmart, JP Morgan (with earning’s power of $6 or so, implying a $60 stock at 10x PE); Bank of America (with earning’s power of $3.50, implying $35 stock at 10x PE); JNJ, Pfizer; Merck and MGIC (which provides mortgage insurance, trades at about half of what it’s worth, and will someday make money in mortgages again).

I am long General Electric, JP Morgan and Bank of America.

The Week Ahead: Monday, April 25, 2009

After a three-day weekend, the market faces a week highlighted by economic news, a possible GM bankruptcy and a huge volume - $101 billion – of Treasury notes coming to auction. In terms of GM, no one expects the bondholders to walk quietly into the night, making bankruptcy highly likely, regardless of what happens on the union side. Also, the economic indicators are expected to be weak.

So unless there is surprise in the economic indicators, the Treasury auction and the dollar the centerpiece of the week. The last Treasury auction was just a bit weak, and given concerns about the amount of debt that the US has, this week’s auction could be even weaker. That could set off a series of consequences – the dollar could continue to weaken; interest rates, especially in the longer dated maturities, could inch up; commodities would rise; gold would gain; and weak dollar plays such as Proctor & Gamble, Coke and McDonald’s could rise. Some say that all this might trigger a general sell off in the market, but that remains to be seen.

Should interest rates rise, that could also spark a reaction by the Fed , which would start buying securities to keep interest rates low. That’s because the Fed’s priority has to be to keep the credit market working, and that only happens if interest rates stay low.

What does all this mean for an investor? Basically, it’s a trader’s week, because things could move very quickly. We could head one direction and then reverse, depending on how things play out. If you’re placing bets, a quick trigger finger may be necessary.

Longer term, I’m still watching certain stocks as a long-term investment. For the financials, which have been under pressure lately, I’m looking to see how much further they may retreat, and whether they will fall below their recent secondary offering levels. Again, I’m looking to build a position in the financials over time (meaning, no need to commit everything now), the favorites being Goldman Sachs, Morgan Stanley, JP Morgan and Wells Fargo. Bank of America is interesting, but requires caution. All of these banks face the possibility of increased losses over the next couple quarters. While I think the disaster scenario is unlikely, pullbacks actually remain very likely.

Market Update

So it was fairly obvious that the market has been turning. We got a bit of a head fake Monday, but weak volume and selling into the close on Tuesday and Wednesday should make today's retreat no surprise.

I'm looking at the charts this morning, and it looks to me as if we have resistance around 8,000 on the Dow, 850 or so on the S&P.

For the financials, we have to start looking at individual charts to determine entry points. Generally, though, I think that we should look for opportunities in the diversified, big banks and trading houses - GS, MS, JPM, WFC, BAC. The investment banks, GS and MS, will do fine and will benefit from being the only two true investment banks standing. JPM, WFC and BAC are diversified, so while they will be hit by credit cards, loans and commercial loans, they will make money from other business lines, including refinancings and the investment banking side of their houses.

I continue to like BAC and think there is a decent chance that they will make it through without substantial government conversion of preferred shares. Still, BAC does have some risk - potential losses from Countrywide, credit cards, loans and commercial loans remain significant and could outpace earnings. So this is one that has to be watched very carefully, particularly at earnings.

Here's a couple levels I'm watching. Keep in mind that resistance is never a guaranteed floor, only a probably floor.

- GS: some resistance around $127-130; more around $120; it's capital raise was at $120

- MS: resistance looks to be around $26, it's latest capital raise was at $24

- WFC: resistance is around $24, the offering was at $22

- JPM: short term resistance of $34, next level is $32.00-$32.50. JPM is also approaching it's 200-day and 50-day moving averages.

- BAC: no clear resistance level, although $11 looks like a possibility. It's capital raise was at $10.

As for Citi, the government preferred conversion continues to hang over the stock, so don't expect much change until that transaction is executed. I've spoken about USB before, and I continue to like it, but it is a more traditional bank and exposure to credit cards, loans and commercial loans without investment banking revenue to offset pending losses. The same remains true for regional and smaller loan driven banks.

On the commodities side, caution is recommended. Let's start with copper. For a while Freeport McMoran (FCX) was driven by the belief that China might drive growth. Now that consensus opinion sees China's buying as nothing more than stockpiling, copper needs a reason to go higher, and I don't think there's a substantial demand reason to be buying copper.

With natural gas, in the long term it's a buy, but in the short term, huge supply remains, and natural gas prices took a major hit today. I would expect natural gas to correlate with the market in general and the economy; when stocks rise, the market believes the economy has better prospects, and natural gas usage will go up as it's used in homes and in manufacturing. When the market goes down, we obviously have the reverse.

Oil here is tricky. Technically, the chart isn't broken, so it may have more to go. Very possibly this is driven by expectations that demand will increase for the summer driving season. Also, the dollar is sinking. Both of these could continue to drive oil, but expect decent volatility here.

Finally, Treasuries are falling as supply continues to be high, and the Fed today bought less than expected. I missed a buying opportunity Tuesday and Wednesday in the TBT (short Treasuries), which was about $49-50 over the last two days. As we approach the close, the TBT is a little over $52. Longer term I continue to see the TBT as a buy.

I'm long GS, MS, JPM, BAC and natural gas stocks CHK and XTO. I do not hold shares of WFC, FCX and TBT.

Stress Tests Cause Stress

So now we know the answer to the question, "Where's the pullback?"

It now looks likely that the stress tests could cause some stress, weak pun

intended.  Needless to say, Geithner has handled this badly, but it is what

it is.  We now have a situation where stress test results will be released

over the two weeks.  Apparently, the government will give the banks some

time, probably six months, to raise money.  To improve capital ratios, the

government may convert preferred shares to common, as in the case of Citi.

This could be a major problem for the weaker banks.  As long as there is a

threat of conversion, the weaker banks won't be able to raise capital - who

wants to buy with dilution hanging over their heads?  If the government

converts first, then that will dilute the common and drive down the share

price.  There is a possibility that the weaker banks could raise capital

after conversion of preferred shares, but the stocks of the weaker banks

won't be happy in the meantime.

So I am still researching the following possible trades:

1) buy AAPL on a pullback after earnings.  If more bad news is in the making

I will wait until the bad news clears.  The market is jittery, and any

significant bad news can take the entire market down.

2) GS and/or JPM, probably after release of stress tests.  Difficult to call

timing on this, but the basic idea is that the stress tests could catalyze a

pullback, then it would be time to buy GS or JPM, especially if they could

pay back the TARP.  I will wait on MS and WFC earnings to see where they

stand.  Bank of America has the cloud of conversion over it.

3) If conversion of preferred is likely with BAC, then there could be a play

in the preferred stock, just as there was with Citi.

The Week Ahead: Where's the Pullback?

Many are waiting for a pullback.  Many think it should have happened already.  And the case for a pullback is pretty strong. The fundamentals point to increasing loan, commercial loan and credit card losses in the banks.  The technicals say that the market is overbought and that we're very close to upward resistance.  And common sense should say that after more than 24% to the upside, the probability of down is higher than the probability of up.  

That pullback may very well come this week, as the busiest week of earnings, with more than 140 companies reporting, comes upon us.  There's not much possibility of surprises left in banking; Intel has indicated that tech is unlikely to lead to any market-moving surprises; and with the fundamental economy weak, it's doubtful that the industrials can lead the market higher.  

Still, the market has defied the naysayers for the last two weeks.  That includes me by the way - I positioned myself for a pullback two weeks ago and missed some really good upside.  And I'm not a alone of course.  Many have been waiting for the market to correct.  

I still believe that it's extremely difficult to call the exact top or the bottom, so getting close is good enough.  And the last two weeks are a reminder that the market often ignores our proclamations and confounds our expectations.  So it's worth asking - is there a scenario where the market keeps rising?  

In order for that to happen, I think we would need more good news over the next two weeks.  Earnings would have to be better than expected, and outlooks would have to be non-negative.  The stress tests would have to be non-events.  That is, the government identifies the weaker banks, we figure out how much capital has to be raised, and we DO NOT go into a panic thinking that major banks will collapse.   

Over the next couple weeks, just stabilization, the sense that things aren't collapsing, the sigh of relief that says the worst is over and we can move on - this is enough, I think, to move the markets up, or in the worst case, lead to a shallow pullback.  If we can get that sense of safety, then the money on the sidelines would come in and help move the markets upward.  

How likely is this scenario?  Very hard to say.  For me, the stress tests are a bit of a conundrum.  If there are major banks that need lots and lots of capital, then wouldn't the bear attacks just start all over again?  The truth is, we have to face the possibility that the stress tests might lead to the exact result that they were intended to prevent - an attack on the weakest banks. At the least, the market likes to worry.  Give the market a reason to worry, and it will.  

What does that mean for the investor?  I think you have to position yourself for the downside, but be prepared to move if we see possible upside.  This market wants to move up, and at the very least wants stay up.  The coming catalysts could move things either way.  I've been positioned for the downside by being on the sidelines for the last two weeks.  

Two other things to keep in mind over the next couple weeks.  First, we have begun to differentiate between the stronger stocks and the weaker stocks, especially among the banks.  So far, Goldman Sachs and JP Morgan are among the strongest, and any pullback should be considered a buying opportunity. 

Second, we may still have to face serious problems in Q2, and potentially in Q3.  Those losses in loans, commercial real estate and credit cards aren't going away; all the banks have said they expect these losses to increase.    The consumer remains weak and will be so for some time.  There's a real possibility that the gains of this first quarter will wane, and that losses will increase.  That's a very bad formula for Q2.  

By the way, there's also some specific trades on the horizon.  Apple reports this week.  Apple typically sells off after earnings, because the company blows always the earnings and then gives really conservative guidance.  I would look at any pullback as a buying opportunity because Apple is expected to have new iPhone models in the summer.  

FYI, I am long AAPL, GS and JPM.  

The Shape of Things

Well, we now have a decent sense of earnings season. Banks did better than expected. Where to from here?

There's not much left in terms of potential surprises. We have Citi reporting tomorrow, and if the last few weeks are an indicator, Citi should do well in its lending and should surprise there. Writedowns remain a question. Also, tomorrow is options expiration, and given the heavy shorting in Citi, there's going to be a lot of short covering pressure. That says Citi should pop tomorrow, but the traders know this, and are getting ready to sell into any pop. For me, not much of a trade, because I can't sell faster than the guys on wall street. The traders will sell seconds into the open after earnings. I think I'll pass.

That leaves Bank of America. Again, they could do well because they have capital markets and lending exposure. Writedowns remain an issue, but if they used purchase accounting with Merrill the way Wells Fargo did, the worst of the Merrill writedowns might be past. That leaves loans, commercial real estate, and credits cards, where losses should be up. JP Morgan confirmed as much today. Still, they may make up for those losses by making money lending and in investment banking, like Wells, JP Morgan and Goldman.

So the question is whether Bank of America's run up to the $10 range is as far as it will go. It could be like JP Morgan today, where today's positive earnings led to negligible movement in the stock; it may have run as far as it can go for now. If you want to be really aggressive, there could be a small play in buying Bank of America ahead of earnings, and selling at the close before earnings. If Citi does well tomorrow, Bank of America could have a small pop, and at $10, small pops could be a decent percentage. Not worth a huge bet, but a possibility if your gambling bones are itching.

And finally, we may have a bit more information when Wells Fargo reports. We'll know about Wells' write offs. But there shouldn't be much new news there, and if anything, downside risk is higher because the quality of earnings could be weaker than expected.

Morgan Stanley also reports next week, but no one expects Morgan to do anything market moving. The best results are out, and Morgan, as mentioned, has commercial real estate exposure that will ding earnings. But that's about it; not as strong as others, but not bad is the expectation. In other words, not much of an event for the market.

After this week, there's not much in terms of upside surprises that are possible. Plus with options expiration, everyone will reposition next week. Right now, I think resistance is around 8,000 on the Dow, 850 or so on the S&P. I've heard people say 900 on the S&P, but every time I look at the charts, 850 seems to be the battleground to me.

The remaining known event that could move the market either way is the stress tests. Given what we know now, which is that the stress tests will tell us which banks are weaker and will give us a capital plan for helping those weaker banks, the release of the stress test results could actually be a positive. That's because we'll have clarity. It's now unlikely that many banks will go to zero, or that the government will let them do so. And a situation like Citi where the government converts its preferred shares to common and massively dilutes the common seems unlikely. The banks that have reported are in decent shape, Morgan Stanley should do fine, Citi's future has already been decided, leaving Bank of America as the last big bank that could face such a fate. There could be pluses in Bank of America's earnings, and there's no indication that it could be a disaster that warrants the government converting its shares from preferred to common.

So consider this additional possibility: the government recently flip-flopped, deciding to release results of the stress tests, where they had previously decided they would be mum about the results. One reason to release the results is that it sets the stage for banks to repay the TARP. As we know, certain banks have been clamoring to do so. If the government gives them the green light post stress test, Goldman and JP Morgan will pop, they're just itching to execute the wire transfer. Wells and Bank of America have had similar rumblings, while Morgan Stanley has said it might be several months. Regardless, if banks start repaying the TARP, the market should pop.

The other possibility is that we could get a sell-off and correction. For the most part, the banks, to date, have held their gains. So that argues for a shallow correction.

Is there a scenario with significant downside? We would need major bad news, which at this point seems unlikely. There is a possibility of a down leg in coming quarters if bank revenues aren't as high but losses continue. At this point, it's a possibility to keep in mind but not necessarily something to bet on.

One other theme. It's time to come back to stock-picking and medium or long-term investing. We are stabilizing, barring any major down legs in the market. The more we settle, the more the trader's market will recede, and the more the longer term investor returns. And yes, it's a great time to buy for the long term.

That's if for today,

Ming