Keep These Quality Stocks and Lay Low

06/14/2012 8:15 am EST

Focus: STOCKS

Jack Adamo

Editor, Jack Adamo's Insiders Plus

As the second quarter comes to an end, more and more signs are pointing toward continued floundering...and that means you need to hang on to your rock-solid stocks, and take some profits on stocks that have run, advises Jack Adamo of Insiders Plus.

Barron’s published its Mid-Year Roundtable this past weekend. Opinions on where we’re headed were varied, but Scott Black, one of the normally bullish contingent, turned bearish.

The ever-optimistic Abby Cohen of Goldman Sachs said, “Long-term investors are starting to take advantage of the drop in stock prices because they see good value. Many companies in the Standard & Poor's 500 with strong balance sheets and lots of cash generation are buying back their shares...Also, merger and acquisition talk is building.”

I’ve always held (as does Warren Buffett) that most buybacks waste shareholder money. And contrary to the conventional wisdom that mergers and acquisitions are bullish, my observation has been that they occur near market tops when organic growth fails and mergers are the last resort to keep the party going.

Mergers are only good for the acquired company, assuming its stock was bought at a premium. If you can predict what companies will be acquired, my compliments. Otherwise, let the buyer beware.

On the other side of the opinion balance sheet, the more sober Felix Zulauf made observations like: “Weaker consumer demand in the West weakens manufacturing in places like Asia, which weakens natural-resource producers such as Australia or Brazil.

“My two major themes into 2013 are euro disintegration and China weakness...China won't be able to save us, as it did in 2009.”

And last but not least: "The tower of debt is compounded by the gigantic over-the-counter derivatives market. In the past ten years the notional value of derivatives worldwide has grown from $100 trillion to almost $800 trillion.”

Remember derivatives? They were the biggest cause of the 2008 crash. Until the recent announcement by JP Morgan (the best-run bank according to Wall Street’s wisdom) that they had lost at least $2 billion this quarter on trades gone sour, most people had forgotten about derivatives.

They were supposedly being reined in by the Commodity Futures Trading Commission and the Dodd-Frank Bill. However, the Wall Street-Washington connection being what it is, the CFTC is still discussing measures. And Dodd-Frank, which has yet to take effect, has been so watered down by now it will be like having a pre-school crossing guard in charge of policing the Mafia.

My own view is that, yes, there are some decent (not great) stock values out there, based on historical metrics. Some P/Es of good companies are below median. However, earnings are no longer measured by historical values—they are all “adjusted” earnings now, and these P/Es are only good assuming earnings expectations are correct. There’s virtually no chance they are.

When I look past all the economic theory and rhetoric, the work that impresses me most is Fred Hickey’s company-by-company analysis of the tech sector, the primary engine of recent US economic growth, thanks mostly to Apple (AAPL).

Hickey is not just the best in his field, he’s the most thorough analyst of any industry I’ve ever seen. To put Hickey’s recent comments in a nutshell (some from his Barron’s interview and some from his current newsletter), Europe in aggregate is the world’s biggest market. It is suffering badly. Spending of any kind is being deferred. In addition, the US dollar has strengthened considerably against the euro, making US products more expensive there.

American tech firms are going to report noticeably lower earnings in the second quarter than are expected. This is not just theory. Hickey analyzes every major company in the tech sector and listens to all of their conference calls. He quotes CEO after CEO telling how the business climate is downshifting.

Most of the companies who met Q1 earnings expectations missed on revenues—a sure sign that reserves and other estimated accounts were fudged to meet their earnings guidance. That means more trouble ahead. You can only do so much fudging before you cross the line into outright accounting fraud, which most companies won’t do.

Those who think that “What happens in Europe stays in Europe” are in for a rude awakening when second-quarter earnings hit the street. The effect will be somewhat lessened by companies lowering earnings guidance a few weeks before they report, then miraculously beating them.

But as gullible as people are, such tricks can still only hold up the market for so long. After the big money gets out, the news will take on a more pessimistic air as the major investment banks and hedge funds short stocks. Retail investors will sell, the market will plummet, and the whole cycle will start again.

I hate to sound so cynical, but that’s been the pattern, and there’s no sign it is about to change. The world has a tough row to hoe.

Demographics in the developed world are very negative, with an aging population that will spend less and save more. Earnings growth will be slower, and with slower growth comes lower P/Es and lower stock prices. Defense will be the rule, and offense will have to be very selective.

From our point of view, I’m comfortable enough with the stocks we own. Long-term, they should all do well. I recommend reinvesting dividends if you don’t need the income, so that when the drops come, you’ll be buying more stock at lower prices.

I’m happy keeping a lot of cash on the side at the moment, as well as keeping our hedges. We’re likely to make money on our put options, because second-quarter earnings are going to be bad enough that even the Fed’s QE 3.0 and all of Wall Street’s cheerleaders won’t be able to hold the market up. But if I’m wrong, the stocks we own should make up some of the difference.

For now, I want to, basically, stand pat. If you want to take a little money off the table in stocks that have had big run-ups, do so, but don’t go dumping stocks wholesale.

Domestic utility companies like Southern Company (SO) and Dominion Resources (D) are still very strong, so I’d hold them, but pocketing a little of our big profit in Lorillard (LO) or trimming a little off British American Tobacco (BTI) or Vector Group (VGR) to raise some cash is OK.

I may make some specific recommendations in this regard sometime in the next few weeks, depending on how the market goes. But if so, it will be minimal.

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