I recently started interviewing for summer internships, and this is titled after the first question posed to me. Going back to the fall, I was worried about the global economy – late in the game compared to some, perhaps, but not before a brutal two months from late September to late November. The short version of the outlook is that we’re already a month into 2009, and the same two concepts from the fall (scarce and expensive credit, and the global downturn) continue to dominate headlines, and there is no reason that should soon change. The slides linked to at the end are from the presentation I gave on this topic about a week ago.
(A sidenote: if you are located near Boston or Philadelphia, and would like a motivated intern this summer, please review my resume and contact me.)

Everything in the markets might be a function of price, but just because many stocks are down substantially does not necessarily translate into an automatic bargain. One quantitative method I use as a simply proxy for estimating forward returns helps crystallize the risk aversion of this market: for the Dow Jones Industrial components (excluding financials), Kraft (KFT), McDonald’s (MCD), and Coca-Cola (KO) were valued at the richest multiples – calling into question their future returns. Commodities and cyclicals were the most heavily discounted, with Chevron (CVX), Caterpillar (CAT), and Boeing (BA) topping the list with potential high future returns. Be it stocks or Treasuries, this is a bull market in less-risky assets. If there is unpredictability regarding your financing or cash flows, your stock has been hurt.

The question with the cyclicals and commodities that currently look “cheap” is whether or not they have earnings power down the road, and if they have the financial strength to be around for those better times. If not, better to accept lower but positive returns from some of the leading names in the consumer staples space, for example.

In the case of financials, there’s no sign that the negative momentum has stopped. A similar theme can be seen with housing.

Foreclosures are a burden on both sectors, and are a function of negative equity coupled with a negative life event – i.e. a death, divorce, or unemployment. Unemployment is screaming higher; has this been accounted for in terms of future losses for banks on their mortgage assets?

Alright, so the market typically turns higher before macro indicators say the bottom is in. The real figures I’m watching involve borrowing – debt to GDP, for instance. Although household borrowing was negative for the first time in over 30 years at the last release of the Fed’s Z.1, a decline of less than 1% for one quarter does not mark a true reversal in deleveraging the system. Right now, the focus is on transferring or backstopping private debt, using the public (government) balance sheet. This might lessen the acute pain, but drag out a grisly recovery period involving little-to-no growth amid deleveraging… unless monetizing the deficit becomes an acceptable solution.

via Urban Digs

Could emerging markets be a different story? The EEM ETF lost 50% in two months, and East Asia has seen export figures fall between 20% and 45% year-over-year. Also, commodity prices have barely inched up off the lows, which suggests no new marginal demand – not a good sign for the resource-driven emerging market economies

I have looked at a handful of foreign stocks, primarily in Brazil and Mexico, but so far have not been sufficiently impressed to make a purchase. Having sat on my hands for the last six months, I’ll admit to being ready to make another buy – if and when the right opportunity comes along.

So, what to do? Nobody is expecting to make easy money in the markets, but going back to the original Dow Jones Industrials model, there are a few stocks that look to have sustainable, differentiated (non-financial) business models valued cheaply enough to deliver 8% to 12% annual returns in the future. Although this is by no means a finalized list, I plan on looking at Disney (DIS), 3M (MMM), Home Depot (HD), and Pfizer (PFE).

See the slides from the presentation.

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