Nearing Bottom

It was another rocky week. The market continued its recent downtrend despite solid earnings reports and encouraging economic data. This bodes well for a healthy turnaround over the winter, something I’ve been calling for over the past seven weeks as we’ve built our portfolio. I’m still calling for it.

We’re in the thick of earnings season and about two-thirds of companies have beat estimates so far. That’s typical. Let’s review this week’s highlights.

On Tuesday, IBM beat by 13 cents and management was very upbeat in the conference call about the fourth quarter outlook. Johnson & Johnson beat by a penny. United Technologies beat by 2 cents and was cheerful about fourth quarter prospects. Pharmaceutical company Novartis beat by a penny. 3M beat by 4 cents but warned that the fourth quarter might fall slightly short of current estimates. Merrill Lynch beat by 21 cents.

On Wednesday, Dow companies Altria and Honeywell beat by 5 cents and 2 cents respectively. Banks J.P. Morgan Chase and Bank of America beat by 3 cents and 2 cents respectively. Office Depot beat by a penny, General Dynamics by 6 cents, and EMC by a penny. Yahoo! and Motorola both beat by 2 cents.

Technology was a mixed bag.

Shares of computer disk drive makers fell Wednesday after Bear Stearns downgraded three companies in the sector, citing future industry weakness evident in Seagate’s dour 2006 outlook. “After the first indication of weakening in July, with Seagate’s fourth-quarter results last night, we are seeing additional signs of softness, which raises concern of potential for further weakness,” Bear Stearns analyst Andrew Neff wrote in a report to clients. He said concern is not about the demand for disk drives, but more about supply issues among customers. That means that some of the strength in the market might really be an inventory buildup. Now that stores have plenty of stock, they’ll stop buying for a while. Bear Stearns cut Seagate, Western Digital, and Maxtor to “Underperform” from “Peer Perform.”

Then things brightened up when Intel reported operating earnings a penny ahead of expectations for the third quarter. Revenue was also ahead of expectations but revenue guidance for the current quarter was $10.2 billion to $10.8 billion, putting the mid-point at $10.5 billion. That’s less than the current market consensus of $10.65 billion, so people were disappointed. This is par for Intel’s course, though. They’re usually cautious at the start of the quarter and then sharpen guidance towards the upper range later. I’m pretty sure Intel will meet the $10.65 billion expected.

Standard & Poor’s concurs with me and raised its 12-month target price by $1 to $30 based on applying a price/sales below Intel’s historical average to their forward sales estimate. They see Intel nearing the bottom of its price channel on p/s and upgraded the stock to buy on that improving valuation picture. Intel moved to 4 STARS (buy) from 3 STARS (hold).

On Thursday, earnings kept rolling in. Beaters were Coca-Cola by 4 cents, SBC by 6 cents, Pfizer by 3 cents (but warned of lower than expected profits for the fourth quarter), Eli Lilly by 2 cents, Ingersoll-Rand by 3 cents, McGraw-Hill by 3 cents, and Baxter by a penny. Nokia just barely beat estimates but said average selling prices were under pressure. UPS met expectations as did eBay, but then the online auction giant warned of a slowing performance this quarter. Ford missed by a penny.

Pfizer killed Thursday’s tone on among big caps and eBay killed it among tech and smaller issues. The NYSE had just one up stock for every three down and only one 52-week high for every four 52-week lows. The selling became so intense in the final hour that the exchange implemented trading curbs.

On Friday, Investments are shown only to KELLY LETTER subscribers. Click to try the letter for free. missed earnings by a penny, but reported third quarter profits 56% higher than second. That disappointment sent shares down 2.9% today and puts us down 8.2% since investing last month. However, the company adjusted its full-year earnings forecast to a range of $2.14 to $2.24 per share, up substantially from its earlier guidance of a $1.80 to $1.90 per share. Analysts estimate full-year earnings of $1.85 per share. The company is preparing for a strong Christmas season, in part by selling Apple’s popular iPod. Standard & Poor’s upgraded the stock to 3 STARS (hold) from 2 STARS (sell).

Google blew everybody away by reporting net earnings that grew over sevenfold and beating revenue estimates by $117 million. That sent the stock up 12% Friday to an all-time high of $339.90. First Albany and Lehman Brothers raised their price targets to $450 a share. Google is now up nearly 340% from its initial public offering just 14 months ago.

Caterpillar, meanwhile, missed expectations by 12 cents and fell 10%. The Dow’s having a rough October. Both Caterpillar and Pfizer are Dow components.

Still, earnings overall are looking fine. Most companies are ahead of estimates. Few have warned.

Economic reports have been healthy. Inflation remains a potential problem because the data are not consistent.

One good sign is that oil prices are down around $60. Gas prices have also come down and look set to continue that way. The high cost of heating oil was expected to become a problem over the cold winter months, but some good news has arrived from the weatherman. Forecasters at NOAA’s Climate Prediction Center predict this winter to be 0.7% warmer than the 30-year norm measured by nationwide heating degree days for December, January and February. If we can get cheaper gas and a lower demand for heating oil, things may not be as bad as previously thought. Keep your fingers crossed, and wear warm clothes instead of turning up the thermostat.

September housing starts rose 2.4%, a very good number. Analysts had expected a decline. Hurricane Katrina is already a waning factor, and this latest bit of good news shows that her impact on the national economy was far less than feared.

Also, unemployment claims dropped to 355,000 from 390,000 the week before. The impact from the hurricanes was 40,000, so the underlying trend is still just above 300,000. This reflects a strong job market.

Looking over the above, you could be forgiven for wondering why stock prices are dropping. If you’ve been reading my scribblings for any length of time, though, you’re not surprised by it. I’ve been targeting November for the start of a good winter rally. We look to be on track for that to play out.

Consider readings of the Hulbert Stock Newsletter Sentiment Index, which reflects the average stock market exposure among a subset of short-term market timing newsletters tracked by the Hulbert Financial Digest. Last Friday, the index dropped to -30.1%, very close to its lowest level in over six years. (The negative reading means that the average short-term market timing newsletter tracked by Hulbert is recommending that its subscribers be short the stock market.) Besides Friday, the only other time over the last six years when the index got any lower was at the market’s mid-April low, and even then it was just barely lower. The index then dropped to -30.6%, and a nearly 600-point rally in the Dow ensued.

Add to that evidence the volatility we saw this week. Stocks were way up on Wednesday and then way down on Thursday. That’s a well-understood pattern when bottoming out. The dropping on positive earnings and confusion over economic data are normal, too.

There are brighter days ahead and now is a time that screams for new investment money. All of our portfolio positions are good candidates for initial or additional investment.

That includes our latest purchase, Investments are shown only to KELLY LETTER subscribers. Click to try the letter for free.. The stock ended the week at $112, up 23.2 percent today and more than double its Wednesday IPO offer price of $54. I sent a note to subscribers advising them to buy under $110. The Kelly Letter buy price was $107.60. The stock closed Friday at $112, putting us up 4.1% already.

What better way to profit from the market than to buy the exchanges on which everybody trades? They’re all either public or going public. You can buy the Nasdaq (NDAQ), the Chicago Mercantile Exchange (CME), and even Archipelago Holdings (AX), the electronic trading platform. The New York Stock Exchange is trying to acquire Archipelago and then go public itself.

The New York Mercantile Exchange is planning to go public. So is the Chicago Board Options Exchange. The Philadelphia Stock Exchange sold 25% stakes to four banks and that might put it on the road to becoming public.

This approach to investing is like buying the casino instead of playing the slots. Every transaction that goes through these places leaves a tiny profit in their coffers. Whether the investor makes money or not, the exchange always profits.

Now, admittedly, this week’s pace in our recent buy cannot continue. It’ll have to slow down and might even retrace. But if it takes after its larger cousin, the Chicago Mercantile Exchange, it’ll be a good investment. CME had its IPO in Dec. 2002 at $43. It closed today at $348. That’s a 709% gain in under three years. It basically never looked back from its quick start. Here’s the chart.

It’s not alone. Nasdaq started the year at $10. It closed Friday at $29. Archipelago started the year at $20 and closed Friday at $40.75. Clearly, this is an industry with wind in its sails.

For our portfolio, this is a welcome diversifier from our value plays. Most of our portfolio was built by purchasing shares on the cheap and waiting for a recovery. This one is not cheap, but is rising quickly and should provide us with a little boost while we wait for our primary holdings to recover.

In addition, there are several names I’m watching for a chance to get good prices toward the end of this down leg. It won’t be too long before we see a rising market and the bargains will be gone. I know it’s hard to believe amid dark headlines and falling prices. That’s why you should believe it.

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