It is tempting to repeat what I said last month in this section....in fact it is too tempting for me to pass and so I will say simply that the markets are still being held hostage to the Eurozone fiscal crisis, a somewhat softening US economy, the upcoming "fiscal cliff" at the end of 2012 if Congress doesn't act on the Bush tax cuts, and the election.At the risk of oversimplifying, none of these events is "new news" and I believe the markets have already discounted much, if not all the bad news that any of these events may bring.

More importantly, earnings season is about to begin, and companies who miss estimates or take down guidance will be punished severely. Nike, for example, disappointed investors last week and the shares dropped 14%. Weak earnings could trigger a market correction.

However, I am comfortable owning carefully selected stocks as I believe that fundamentals and execution will drive earnings and stock price performance. An environment where valuations and expectations are low, returns have been weak, liquidity is plentiful, fear is rampant, and the investment choices offer little (or no) real return strikes me as a good environment to be looking for the right stocks, particularly for investors (as opposed to traders). Here is the my most recent featured stocks table:

Featured Stocks — Closing Price: July 3, 2012

This chart shows all PCM's recommendations for the past twelve months.
Previous recommendations are available on request.

Should I be in the stock market?

I've had this conversation with about a dozen people over the past month or so, and my answer is: that depends on your risk tolerance, time horizon, liquidity needs, and other unique circumstances. John Authers, one of my favorite financial journalists who works at the Financial Times put it this way in a May article:

Economic realities will always trump human hope in the end, so long-term investors should position themselves to take advantage of this. For now, that means protecting against further trouble in the eurozone. And when it comes to buying opportunities, they require you to buy when you are scared witless. The eurozone will probably form just such a moment some time soon. But rather than obsess about timing, most people would be best advised to keep dribbling money into stock markets, and otherwise to stay diversified. To do anything else would be the triumph of hope over experience.

I couldn't agree more. On an anecdotal basis, I can say that in these conversations, the overwhelming majority has shied away from putting ANY money into equities, and those who are professional investors are either sitting on large portions of cash (50-60% of their assets) or are looking to short. In my opinion, and with respect to the headlines and macro environment, it won't take much to keep this market heading up. As I said, I think the biggest issue right now is earnings.

Featured Stocks:

I reiterate holding GUKYF shares as a speculative play at todays' price of $3.35

I am also recommending SeaDrill ("SDRL"), a deep-water driller which has recently corrected from ~$42 to ~$32. I like the long-term growth opportunity in the deep-water drilling market, and SDRL has signed some impressive contracts, including one with Tullow Oil (London "TLW") for up to $650,000 per day. Management has indicated that they expect near-term supply/demand imbalances to persist, which will keep day rates elevated. They have also stated that customers have already begun approaching them about extending contracts that expire in the next year or two. SDRL's 8.6% yield is an added bonus, and I recommend buying SDRL up to $37.50.

Please feel free to contact me with any questions and please let me know if you'd like to be removed from distribution.

• Telular ("WRLS") reported in-line earnings and re-iterated full-year guidance (to double EBITDA) and subsequently shares were down 18%.  At the current $7.50, they yield 5.9%, and trade at 6.8x the midpoint of that guidance. WRLS generates 99% of its revenues from the US, raised the dividend 10% last November, and is expected to raise it again later this year. 
• Seagate ("STX") beat estimates by 25% when it reported in April, and the shares reached $32.  In May the shares fell 28%, to $23.   Currently they trade at barely two times 2012 estimates of ~$10 per share and the company is buying back 25% of outstanding shares. The yield is 4.5%. 

The market is being driven again by a combination of European headlines, softening US economic data, the uncertainty of the Presidential election, and the pending "fiscal cliff" if tax laws aren't extended.  I've said many times that the market dislikes uncertainty more than anything else, and there is an abundance of it right now.  The next earnings season won't begin for another month or so, and the election is still five months away, so I expect more choppy, headline driven action.

For the third consecutive year, markets have started well, and then sold off entering summer.  Friday's exceptionally weak employment report and the attendant downwards revisions means that employment growth has averaged below 100,000 the past three months, and non-farm employment in the US is still 3.5% below where it peaked in January, 2008, a drop of 5 million jobs.  The unemployment rate has held above 8% for 40 consecutive months.   Most recent data have been mildly disappointing, such as the gain of only 1.9% in Q1 GDP, and the ISM report, which dropped to 53.5% in May, from 54.8% in April, for example.  Globally,  the story is no better as Europe, China, India and Brazil are each slowing measurably.  

Trading patterns are also flashing bearish signals, as six of the past seven trading sessions (prior to June 5) have seen S&P futures peak before 10:45 A.M.  Persistent early intraday highs are a characteristic of most bear markets.  In addition, the number of deep-in-the-money June puts outweigh calls by a 5:1 ratio, which suggests the possibility of a decline before the June 15 options expiration date is higher than normal.  (Source: Jerry Hegarty "Hegarty's Newsletter" June 5, 2012)

My conclusion is that, while I think the likelihood of a recession is very low, I remain more or less defensive and am increasing positions and adding names judiciously.          

Are there ANY reasons for optimism?

Glad you asked and yes, there are.  For starters, yields in Treasuries are now at historic lows (yes, they can go lower, but no, I don't think the risk/reward is in the owner's favor at these prices and yields, especially for anyone with a time horizon more than say, two years), and the yield on the S&P 500 is 2.2%, well above the 10-year note's 1.5% yield. There's an old saying that you can have cheap equity prices or good news, but you can't have both at the same time.  In addition, corporate balance sheets are in great shape, broadly speaking, and, according to Barron's (June 4, 2012), the ratio of insider sells to buys is about 5:1, well below the 12:1 which denotes bullish tendencies.  

Valuations broadly speaking, are good, with the S&P trading at 12x forward estimates, and roughly 13x trailing twelve months earnings.  In Europe, valuations are even better, with a high single digit P/E ratio and 4.1% dividend yield (Source: David Rosenberg "Breakfast with Dave" June 4, 2012).   None of which is to say that things can't weaken from here, but I think the chances of the markets rolling off a cliff a la 2008 are virtually zero, as today's events have been discussed for months, even years.  Earnings and overall employment are higher than they were last year, and the drop in oil prices is starting to show up in lower gasoline prices.

The recent FT headline "Is this the Death of Equities?" (May 26-27) and Wall St. Journal's' "Investors Brace for Slowdown" (June 4 on the front page and above the fold in block letters) are signs of some degree of capitulation, which is a good thing, as far as I'm concerned.  Another tidbit I heard in May was from a friend at one of the major investment banks who is in charge of recruiting both undergraduates and graduate level students from an Ivy League school in New Haven, who told me that he was greeted by protesters when he arrived on campus this spring.  Taken individually, none of these is enough to make any strategic decisions, but combined with the dash for safety reflected in Treasury prices, and the ongoing withdrawal of funds from equity mutual funds, I am beginning to feel that there might be a light at the end of the tunnel after these past 13 years of no return in the major US indices.   

Owning the Right Stocks  

I've said many times that while I'm aware of the macro environment, what I'm really interested in is finding good businesses and owning them at the right prices, the "Land of Tall Trees". Finding these situations and growing with them over the long term is still a good way to generate wealth in the equity markets, and I am very excited about the names in Peattie Capital portfolios. Here is the latest summary of Peattie Capital's Featured Stocks:

Featured Stocks — Closing Price: May 31, 2012

This chart shows all PCM's recommendations for the past eleven months.
A list of all recommendations for the past 12 months is always available on request.

Featured Stock: Mako Surgical ("MAKO")

I think the market has overreacted to Mako Surgical's ("MAKO") first quarter earnings miss, as the share price has dropped from $45 to a recent $22.  That strikes me as a severe haircut for taking down estimates for unit sales of the company's "RIO" surgical systems from a range of 56-62 to a range of 52-58, and a slight sequential drop in procedures from a fourth quarter 2011 beat. Shortly after the report, one of the company's early venture capital backers sold the last of their shares at approximately $25, fueling another 10% drop.  

In a presentation a few days later, management re-iterated the new guidance, explaining that two-thirds of the company's revenues are generated in the second half of the year historically.  Management was confident that the Q1 miss was a "one-time" event, and that they had good visibility into bookings and were therefore confident in their forecasts.  As for the VC sale, it had been planned beforehand, as the VC wanted to take profits and move on.    

MAKO's long-term opportunity is very attractive, based on the aging population and the very low penetration (10%) of what they consider their market opportunity.  In a presentation at a conference yesterday, Maurice Ferre, CEO, emphasized that MAKO's focus was on partial knee replacement, which costs less, and has shorter recovery times than traditional full knee replacement.      

I would prefer that MAKO be profitable before I own it, which will probably happen in 2013.  However, by then I think the shares will be significantly higher.  Given the sharp selloff on what I think is "transient" news, I am recommending buying MAKO up to $23.25.    

Market Commentary

I have read many articles citing the similarities between 2011's market performance and 2012's thus far, and the "sell in May and go away" adage has been appearing too.  (To be sure, there is evidence that the six month period from May through October is weaker than that of November through April).  From a macro perspective, Europe is clearly weakening and Spain in particular is taking its turn in the headlines. 

In the US the economic data are mixed, but still show a slow recovery.  China's data have been mildly better than expected, and so the probability of a global synchronous recession is low.  In addition, I maintain that Bernanke will be true to his word, and will keep the targeted Fed Funds rate at current levels at least through 2014 as he has stated.  There are other reasons to be constructive about the markets as well: valuations, broadly speaking are reasonable; interest rates remain extraordinarily low and don't offer competitive returns or growth opportunities, corporate balance sheets are healthy, and investors withdrew $8.6bn from equity mutual funds in the first quarter (Source: Michael Santoli "Q&A With Mr. Market" Barron's April 30), which is a positive as far as I'm concerned.   

On a more micro level, the most noteworthy single data point I've seen is the most recent Investors Intelligence Survey in which the bulls jumped to 43.0% of investors from 41.9% in the prior week, and the bears dropped from 23.7% to 20.4%.  So now the bull/bear spread is 22.6, up from 18.2, and the bull camp is more than twice the size of the bear camp, which will be a headwind, at least for the time being.   The first three trading days of May are collectively down as well, which is a subtle win for the bears, I think.  Looking further out in 2012, we are approaching an election, which could be divisive and create uncertainty, and absent an extension of the Bush era tax cuts, estimates are that US GDP is facing a 3.5% hit starting in 2013, according to Alan Binder (Grant's Interest Rate Observer March 23, 2012).

My overall conclusion is that we may see some near-term choppiness, and I am a bit more defensively positioned in most portfolios.    

One difference between 2012 and 2011 is that shares are trading on their own fundamentals and earnings power rather than being being driven by headline risk and swept up (or down) in a highly correlated mass.  Whether that continues in a correcting market, when correlations move towards one, remains to be seen. In the meantime, stockpickers have a chance to demonstrate their skills.   

Owning the Right Stocks  

I've said many times that while I'm aware of the macro environment, what I'm really interested in is finding good businesses and owning them at the right prices, and I am very excited about the names in Peattie Capital portfolios.  So far, companies in PCM portfolios are reporting strong results, and share prices have been responding favorably.  For example, three core PCM holdings reported earnings yesterday, and two are trading at their  all-time high: American Tower Corp. ("AMT"), and Macquarie Infrastructure ("MIC"). The other, Telular, ("WRLS") reported solid earnings after the close last night and reiterated guidance of $16-$17mm EBITDA for 2012, or more than $1 per share. Several more names report earnings in the next couple weeks, and I am optimistic about their prospects as well.        

PCM's "Featured Stocks" have performed particularly well.  Here is the latest summary: