Tuesday, January 11, 2011


Inflate or Not?

This question gets to the heart of monetary policies being pursued to restore economic growth. A recent study presented at the American Economic Association's (AEA) annual meeting asserts that the Fed should push inflation to 2.5% or so while holding rates at zero, creating a negative real interest rate. While not contemplating who actually pays in a negative real rate environment, the AEA believes that negative rates will spur growth and employment.

In contrast, the brilliant John Hussman points out this week that economic growth typically follows periods of high real interest rates, because this incentive to save creates the capital investment that generates growth. Hussman offers some real-world data, not theory, to bolster his point. His chart shows that economic growth or contraction correlates positively with real interest rates.

Bernanke is pursuing option A at the moment, trying to create inflation while keeping rates low. This could create a spurt of growth, but is likely to incent the sort of mal-investment that caused the housing bubble of the last decade. I put more faith in the reasoning of a real-world practitioner like Hussman, who has data to support his thesis.

Will the Sun Shine on Solar in 2011?

My nomination for the most unjustly unloved group right now is the solar stocks. The group performed terribly last year despite great sales and earnings growth, as investors refused to believe that various government subsidies would continue to drive business. Every year, German feed in tariffs are about to get cut, U.S. tax credits are about to expire, Italian subsidies are about to go away -- and on it goes. Yet, every year the price per kilowatt continues to decline, making projects more economical, and low interest rates create low hurdle rates to get projects funded.

Because of these fears, the group is beaten down to absurd valuations, especially given the prospects for growth in 2011. There are no signs of demand receding, and in fact, the news from LDK yesterday indicates that market conditions are still very strong. Tell me in what other group can you buy spectacular growth at single-digit P/Es?

Solar Stocks

I will grant that many of these names are Chinese, and no one trusts the Chinese bookkeeping. I argue, however, that these global players are in a different league than the reverse-merger microcaps that dot the fraudulent landscape. The solar names are large and globally prominent companies, and must keep the accounting squeaky clean in order to win business around the world. I don't think the low single-digit P/Es are sustainable, and these stocks are likely to get the "double dip" of rapid EPS growth and multiple expansion this year.

Revisionist History

Changes in expectations matter greatly in finding the best stocks.

After not working from mid-2008 through mid-2009, earnings estimate revisions made a comeback as a powerful indicator of stock price performance in 2010. Generally speaking (since there are always exceptions), the greater the change in the EPS estimate over the course of 2010, the better the stock price performance.

High returns were associated with larger positive revisions, while poor returns were associated with negative revisions.

Of course, there is one important detail to mention: You don't know in advance which stocks will have the largest upward revisions!

In 2009, the market precisely tracked the last post-bubble bursting in 2003, with a bottom in the spring followed by a robust rally in which many felt the market got ahead of the fundamentals. And 2004 was sideways to down until the fourth quarter, when a rip-roaring rally appeared as the economic recovery took hold. Not surprisingly, 2010 followed the same pattern.

Naturally, the question now is whether 2011 will follow the 2005 pattern, when the S&P 500 gained only 4% after a painful year of trading up and down. Doug "Orson Welles" Kass did make this call recently in his outlook for 2011. The 2005-2007 market was driven by a lot of unnatural acts occurring in the fixed-income and housing markets, which are unlikely to be repeated, however. If similar bubbles form in some other asset class, which is possible given the easy conditions at the moment, the markets could follow this pattern.

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