October Auto Sales Fairly Strong

In case you missed it, October was a, by recent standards, a banner month for auto sales. We are still at levels that during normal times would indicate serious problems or would otherwise be dismissed a freakishly low, but the fact that the automakers are profitable at these sales levels speaks well to the performance of their stock prices.

Ford (F), has had quite a nice run as well all know, but it still is not that richly valued. According to Marketwatch data, it's trading at a little over 7x forward earnings estimates, which are probably too low. Even after rising so much so fast, it's still not exactly that rich. Now, will you make 10-fold on your money again? Certainly not. However, a decent 40% from here is certainly conceivable.

Looking elsewhere in the automotive sector to automotive parts suppliers, I don't see so many good buys, however. Borg Warner (BWA) is looking a little pricey, at least relative to the market. Johnson Controls (JCI), a personal favorite of mine, looks good from here, but not better than Ford. I kind of like Dana (DAN), but it still doesn't exactly scream "buy".

All of them have had impressive one year runs, however.

Notice the S&P 500 down there, having a respectable 15% gain that looks positively puny. Normally, after a sector has had such a break-out performance one would expect that it might be about to go through a phase of dramatic underperformance. However, before that happens I think there is still room to run for the sector as a whole, though Ford seems to be the best positioned. As for the looming GM IPO, I would need to take a good look at their financials. They've been somewhat opaque while in their quasi-public-private status.

Sneak Peek at July Auto Sales

This is a bit of positive news that might indicate weak May and June consumer spending may simply be chop rather than a trend. http://www.prnewswire.com/news-releases/jd-power-and-associates-reports-july-new-vehicle-retail-sales-rebound-sharply-from-weak-june-sales-driven-by-a-multitude-of-small-wins-99012694.html

That being said, virtually any of the numbers we will be reasonably talking about here would have been considered recessionary not all that long ago. The fact that Ford (F) is making as much as it is in this environment bodes well for them going forward. Trading at below 8x earnings and possibly as low as 7x next year's earnings if they keep blowing the socks off of all estimates, it's actually not terribly priced right now. I could easily see how there's another 30-40% in it from here if not more by December of 2011. Remember, just because a stock has advanced a lot does not make it overpriced. Ford by an objective measure is cheap.

Q: How do I value stocks anyway? A: Umm....

One of the basic questions that is brought up time and again is: Is the stock market overvalued or undervalued? Investors are chronically asking this question and the debate between the two factions is what creates a market. Those who think their stocks have had their run will sell and those that think that those stocks can continue to run will buy and where the two meet is the price of the stock. The question for you is which side of that trade do you come down on?

I wish there was an easy answer here, but there is no easy answer. I don't subscribe to any one view of it. Efficient market theorists insist that the price of a stock is always justified because that is what the market values it at. Well.... that's nice, but kind of useless. Then, to quote Cheech Marin's character at the end of From Dusk Till Dawn, "One place's just as good as another". Put in terms of market history, buying Microstrategy (MSTR) at $3,000 a share in March of 2000 made just as much sense as buying Ford (F) at $1 in late 2008.

Dismissing this idea for a moment, how then should stocks, or the stock market at large, be valued? One idea for the overall market is by relative valuation. This is the previously mentioned earnings yield (1/PE * 100%) and compare it to long term bonds. If the earnings yield is at 5% and the 10-year Treasury Note is at 3.5%, stocks seem cheap. If the earnings yield is at 4% and the 10-year Treasury Note is at 7%, stocks are horrifically overvalued. There are some problems with this method in that it is possible that the "E", or earnings, in the PE ratio may be temporarily distorted. Also, interest rates can change in a hurry. It is not uncommon for long term rates to move 100 basis points in a six week period.

If you have taken a microeconomics class that has discussed financial markets at all, or any finance class, you have heard of the Dividend Discount Model. There are two problems with this as well. One is that many companies do not pay dividends, or do not pay particularly large dividends as a matter of policy. As a result, these companies get the shaft in this method of valuation. Also, you have to make the leap of faith that some given level of dividend growth will be sustainable. Just because a company has grown dividends at 8% each year for the past ten years does not mean that they will continue to do so. Case in point: the financials during the 2007-2008 period. If you valued those companies with the assumption that their current dividends were a good proxy of their dividends over the next five years, you would get hosed. Purely conceptually, however, this is probably the best method. It's just that it is difficult to apply to a large number of stocks.

Strategy Sessions - Part 2: Building Your Portfolio to Protect Your Assets

As I have previously mentioned, there is somewhat of a trade off between the potential, and I will emphasize potential, for high returns and the volatility that you will incur. This relationship is not absolute as, for example, adding some stocks to an all bond portfolio actually reduces your volatility over time. However, it is a fair starting point for considering how to construct your portfolio. All of the following is based off of my own personal views and does not necessarily represent "best practices" in the industry.

Regardless of your volatility preferences, any portfolio should start with a core position or positions. Depending on how much you have to invest and whether or not you meet investment minimums, this position can either be an broad market index fund (S&P 500, Wilshire 5000, or something that tracks a global index like the FTSE All World Index) or a similar ETF. Balanced funds (a mix of stocks and bonds) are also a good choice for core portfolio holdings. If you don't meet minimum investment requirements from your desired mutual fund (ie Vanguard often has a $3,000 minimum), then I say go the ETF route. You also will have greater flexibility in changing ETFs than you will with conventional mutual funds. Just keep an eye on fees. For a small portfolio (<5,000), core positions should be the bulk of what you have. For larger portfolios, core positions can be as little as 25%, in my view.

A quick aside, on fees, you should never pay loads (up front fees) on your mutual funds and keep an eye on expense ratios. If you are paying over 0.80% in annual fees, reconsider your position. Just a .40% differential on fees can cost you 16% in long term returns. Put another way, if you would have had $100,000 in your fund at retirement, you will have $84,000. You want those extra $16,000, so keep your eye on fees.

The next layer of your portfolio can venture out a bit into more volatile, but not crazy investments. Along the fund route, these are things like sector funds that track individual market sectors you think will do well, or broad basket emerging market funds or their equivalent ETFs (EEM, for example). This can also be composed of a basket of positions in various blue-chip companies if you choose to use individual stocks. If the core portfolio is your castle, this is your outer wall. I don't know exactly what to call this, so I will go with meso-portfolio. You have your core portfolio, then your meso-portfolio. I like the scientific sound of it.

From there, you can build your exploratory positions. These can be specific country or region emerging market funds, mid and small cap stocks (provided that they have decent analyst coverage), and so on. The larger your portfolio, the larger these positions can be.