Top Gun FP Client Note: Dow 10,000

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NOTE: Every week I write a Client Note for my clients.  For a limited time, I am allowing non-clients to sign up and receive the Client Note.  You can sign up at the top right hand corner of the website.  Here is this week’s.
We’ve been more and more amazed at the strength of the rally.
You have to listen to and respect the market.  Sometimes the market just wants to go up.
– David Pedowitz, Portfolio Manager, Neuberger Berman
It took off so quickly.
At this point we’re just riding the bull.
– Manu Daftary, Portfolio Manager, Quaker Strategic Growth Fund
We’re not buying it.
– Neil Hokanson, a Solana, CA-based investment advisor in mid-April who was won over when companies reported better than expected 2nd quarter earnings
Quotes from “Stocks’ Rebound Won Over Investors”,  The Wall Street Journal, October 15, C1
There was an interesting article in last Thursday’s WSJ, after the Dow closed above 10,000 for the first time in about a year.  It profiled three professional money managers and how they grew to embrace the rally.
Neuberger Berman portfolio manager David Pedowitz had 18% in cash before the rally began.  By the end of June, he had reduced cash levels down to 7.5%.  Over the summer, he put aside his reservations about the rally drawing down cash levels to 2.5% by the end of the third quarter.  Lately, he has been taking some profits. 
Solana Beach, CA-based investment advisor Neil Hokanson, with $300 million under management, had no interest in stocks in mid-April.  He saw junk like Citigroup and AIG rallying and said “we’re not buying it” at the time. 
2nd quarter earnings, however, convinced Mr. Hokanson.  Even though the better than expected reports were mostly due to cost cutting, he thought it would put a floor under the market.  While he didn’t increase his exposure to stocks, he shifted away of defensive names like Procter & Gamble into more cyclical stocks like Best Buy and Toyota.
Portfolio manager Manu Daftary had pared cash in his Quaker Strategic Growth Fund to 15% from 20% at the end of June, but he was still holding more cash than usual.  Up until that point, he’d focused on defensive names like health care whose businesses hold up well in recessions. 
In July, however, Mr. Daftary was changing his mind.  He was impressed by the ability of companies to tap the debt markets, which would tide them over through the hard times, and by the strength of the market action.  He began adding higher risk, cyclical stocks like materials companies and casino operator Las Vegas Sands.
Last Wednesday, Bank of America-Merrill Lynch released their October Survey of money managers.  The survey covered 229 money managers with $616 billion under management from October 2 to October 8.
The survey shows that professional money managers have fully embraced the rally at this point.  Cash positions are at their lowest levels since January 2004 with a net 7% underweight cash in October compared to a net 10% overweight in September.  A net 38% are overweight equities. 
I found the anecdotal WSJ piece and the more comprehensive survey fascinating for two reasons.  One, they show that professional money managers are All-In at this point.  Two, I get the sense that the market action was the fundamental factor causing many pros to embrace stocks. 
Even though the anecdotes suggest a lot of doubt about the underlying rationale of the move, it is very hard to stay out of the market when it is roaring higher.  Money managers are judged against the indexes and so being out when the indexes are surging is a professional hazard.  It becomes a game of musical chairs as investors chase the market higher in order to keep up and everyone is hoping to grab a chair and get out when the music stops.  The stock market becomes its own, self contained world.
Third quarter earnings are well underway and the story seems to be the same as the second quarter: Revenues remain under massive pressure but companies are beating low estimates through cost cutting.
Yesterday morning, Eaton Corp (ETN), an $11 billion S&P 500 manufacturer, reported 3rd quarter earnings that beat estimates.  Adjusted EPS were $1.21 beating street estimates of $1.00.  They forecasted 4th quarter adjusted EPS between $1.15 and $1.25, above analyst estimates of $1.03.
Still, sales of $3.0 billion were down 26% from the year ago period and adjusted EPS was off 38% from last year’s $1.95.
At its current $64 a share price, Eaton is trading at 26 times its forecast of $2.40-$2.50 in adjusted EPS delivered on Monday morning.  The shares appear to be pricing in an economic recovery that is still very much missing from its actual results.
Further, the quarter was helped by a 16% year over year reduction in Selling & Administrative expenses to $553 million from $659 million.  That kind of cost cutting has reverberations throughout the rest of the economy.  For example, check out “Cost Cuts Lift Profits But Hinder Economy”, The Wall Street Journal, October 14, A1.
The same kind of thing was in evidence this morning when $60 billion manufacturing titan, and S&P 500 and Dow component, United Technologies (UTX) reported 3rd quarter earnings.  EPS of $1.27 net of restructuring charges and one time gains beat analyst estimates for $1.12.
Still, revenues were off $1.7 billion or 11.6% from the year ago period and adjusted EPS was down 6.7%.  Part of the story was a $241 million (14.5%) cut in Selling, General & Administrative expenses.  CEO Louis Chenevert said: “Order rates for most of our businesses have largely stabilized, although the shape of recovery is still uncertain.  What is certain is the cost traction across UTC.
At $65, UTX is trading at 13.6 times forecasted 2009 earnings of $4.77 net of restructuring charges and one time gains.
Let me quickly mention three other reports with the same theme:
Giant construction equipment maker Caterpillar (CAT) reported 64 cents EPS this morning compared to estimates for 6 cents.  Still that was down 54% from a year ago on a jaw dropping 44% drop in revenues.  The quarter was aided by a $154 million decrease (14.5%) in SG&A expenses which added 24 cents a share to earnings compared to last years quarter.
At its current price around $60, CAT is trading for more than 30 times the mid-point of this morning’s 2009 EPS forecast of $1.95 excluding redundancy costs.
Dupont’s (DD) earnings of 45 cents beat analyst estimates for 33 cents.  But that is still down 20% from last year’s 56 cents on a 18% drop in revenues.  Dupont cut SG&A expenses by $103 million (12%) adding 11 cents a share compared to last year’s quarter.
Railroad operator CSX Corp (CSX) last Thursday reported EPS of 74 cents, beating analysts who were looking for 71 cents.  Still, that’s down 20% from last years 93 cents on a 23% drop in revenue.  The revenue decline was the result of an 18% decrease in rail units shipped and a 5.5% decline in rail price per unit.  The quarter was aided by a $537 million (24%) decrease in operating expenses which added $1.35 a share compared to the year ago quarter. 
What it all adds up to is a contracting economy as large, public corporations improve profitability by cutting costs and scaling back operations in the face of declining demand.  The better than expected EPS numbers combined with massive government liquidity are fueling an asset market boom while the real economy of jobs, work and production languishes.  The fat cats on Wall Street, Washington D.C and the executive suites of large, public corporations are thriving.  But the average middle class American faces job insecurity and declining wages as the real economy sputters.
* I was planning on reporting 3Q performance today but Scottrade Advisor is having some sort of problem with the statements so I will do it next week.
Greg Feirman
Founder & CEO
Top Gun Financial (
A Registered Investment Advisor
9700 Village Center Dr. #50H
Granite Bay CA 95746
(916) 224-0113

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