Musings of a cynical optimist: Time to focus on the positives

PORTFOLIO POINT: A strategy to buy under-researched, under-owned and under-rated smalls caps using dollar cost averaging makes sense in the current environment.

I wrote a while back that the world is caught up in a web of negativity, click here. Since then, my email inbox has become even more depressing; words like “Armageddon”, “the End play” and similar have joined the daily headlines.

By the pundits’ reckoning we should, by now, be lining up at soup kitchens. Yet stockmarkets are telling us something quite different.

Surprised? Here are some interesting numbers. Since the start of the year, the US Dow Jones Index of 50 blue-chip stocks is up 5.5%; the broader S&P500 is up 9%, and the tech-heavy Nasdaq is up a buoyant 13%. Even in Europe, which receives the last rites daily, the two major markets boast strong recent numbers. Germany’s Dax is up 14% since January and the French CAC, despite a move to the political left, is up 4.5% in just the past month.

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Source: Google Finance. Data as at July 19, 2012

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Source Yahoo Finance. Data as at July 19, 2012

So why are major markets ignoring the doomsayers?

At the risk of being unfashionable, I keep a constant watch out for positive economic and geopolitical developments. I find quite a few each day, mostly unreported in the financial press and on-send them to my bearish friends. This annoys them considerably.

Here are a few worth considering:

Since the election of French centre-left President Francois Hollande, Germany’s hardline push for austerity (aimed at everyone else) has been effectively sidelined. This is encouraging. In order for the EU to escape its economic morass it needs to make two changes to prevent blood on the streets and a worse decline.

Firstly, it needs to initiate a degree of fiscal stimulus across the EU to create jobs, have people earn money and thereby increase tax revenue to governments.

Secondly, the timeline for reducing debt must be substantially extended. Forget about a few years. They need to consider a decade, at the very least.

Time, and lots of it, is necessary for the debt mitigation process to succeed. I am encouraged by recent events, particularly as the growing perception of this nascent change is helping improve investor confidence. Hence the better tone to leading markets.

Oh, and the solution to the Greek crisis? Use the law enforcement system to ensure that everyone pays their tax. Problem solved in two years.

Of course, I might be wrong about these changes and Europe may well get worse before it gets better.

However, Europe is not my main focus for seeking signs of economic recovery. It is the United States. Still by far the world’s largest economy, the US is, once again, reinventing itself.

US consumer spending is all-important, both to its own and to the world economy. US consumers are spending again on big ticket items: home prices, having fallen to the point that it is now cheaper to buy than to rent, are attracting buyers once again. New home sales were up 7.6% in June, a two-year high.

Motor vehicles sales are also looking good. Chrysler recently reported its best June for five years and VW America has had its best June since 1973. Although consumer numbers will fluctuate month to month, I don't think these moves are a flash in the pan. And the flow-on effect across the economy is good for mainstream America and good for stocks.

Additionally – and even more significantly – US manufacturing is becoming increasingly efficient. US corporations are now very competitive internationally and are increasing sales. Indeed, many of them are drowning in cash. As a result, I expect to see a spate of takeovers across a broad range of industries as many look to expand their businesses by cash acquisition in a cheap stockmarket environment. As this trend  develops internationally, it could bring a real spark of life into some stock sectors and get analysts to refocus on undervalued companies and industries, not only in the US, but globally. This, in turn, will bring buying back into the market.

A further bullish factor is the massive short positions taken by speculators who, if forced to cover, could turbocharge the market on the upside.

Oh, and China is restimulating. I don’t expect much downside there.

Finally, an abiding impression I took away with me from both my recent overseas travels and the two sessions of the recent Eureka Congress is that most investors have already sold what they want or need to sell, are reasonably comfortable with the stocks they currently hold, and are very cashed up.

Where is this leading?

At the Congress I discussed my analysis of market psychology. In a falling market the bears believe nothing will change and expect the downward trend to continue indefinitely. The bulls, on the other hand, anticipate that it will not. Change comes about when the brave start to accumulate bargains. This eventually results in a market bottom, as selling is exhausted and buying increases. When the two cross over, the market turns up despite often ongoing bad economic and corporate news. I think we reached this crossover point about a month ago.

That is why markets are behaving quite rationally, moving within ‘trading ranges’, but with a considerable upward bias. In fact, a major clue is that poor corporate news now often brings about a rise in the respective company’s shares. This shows that bears are exhausted and bulls are looking for the bottom.

So where are the cheap stocks?

I cannot get excited about blue-chip stocks. They are well researched and therefore usually efficiently priced, so are unlikely to outperform. This is shown by the relative underperformances of the Dow 50 blue chips compared with the less researched broader S&P500, and that index is underperforming the even less researched Nasdaq.

My own portfolio rarely holds blue chips. I concentrate on small companies with good management in environmental, in biotech and in developing gold stocks. The first two have a common thread – under-researched, under-owned and under-rated. The third, gold, is the ultimate safe haven. All three have enormous long-term share price upside potential.

I believe that it is time to begin slowly accumulating small cap stocks whose businesses have no direct connection with the global financial situation and that have something unique to offer, or are transformable. Despite the almost complete lack of interest in this ‘mini’ category, it is the companies themselves, as they go about announcing breakthroughs, new products, new contracts or new deposits, which will change investor perceptions for the better.

My buying strategy is to ‘dollar cost average’. This means, firstly decide how much you want to invest and over what period. Then spend a similar amount of money, say each week or month of your buying program. A lower share price gets you a greater number of shares and vice versa. This disciplined program results, over time, in a comfortable and comforting low-average purchase price, regardless of short-term share price direction.

I was asked by quite a few people at the Eureka Congress what stocks I own and why. I will discuss some of them in my next Musings.

Laurence Freedman has spent his entire career in investment markets. He founded EquitiLink Investment Management, which was global with over $3 billion under management when sold in 2000. He was instrumental in taking the Ten Network from receivership to the most profitable Australian media network, selling it in 2004.

He currently manages his private investment portfolio, mentors a number of resource, biotech and technology companies, and is chairman of the philanthropic Freedman Foundation, which assists young Australians and finances a broad range of medical and scientific programs and organisations. In 2001 he was awarded the Order of Australia for service to the community, to medical research, the arts, and to business and investment in Australia.

An occasional contributor to the Eureka Report when he has ‘something to say’, he’s also a regular on Twitter.