The Federal Reserve has become the stock market's best friend.
With policymakers stimulating the economy and driving down long-term interest rates, consumers and businesses have been induced to borrow and spend. That has helped two of the three major stock indexes hit all-time highs.
But eventually there will come a point when the easy money will tap out. And that has local investor Norm Caris hedging his bets.
"The markets are hitting new highs due to the unprecedented flood of liquidity being poured into the system by the Fed," said Caris, a Kauai resident and managing director of Los Angeles-based investment bank B. Riley & Co. "This money-printing experiment is not only driving stocks higher, but portends a brighter future for another recent investment for us: gold. We believe that the ultimate outcome of this level of federal stimulus will be inflation, and to hedge that we think investors should hold a portion of their portfolio in gold."
Caris, one of four participants in the Star-Advertiser's 12th annual investment contest, was in second place at midyear after his hypothetical $20,000 portfolio rose 24.7 percent to $24,930.96.
Dwight Melton, co-founder of the Hawaii Stocks and Options Group and a four-time contest champion, was in first with a 42.8 percent return to $28,561.14.
Barry Hyman, vice president, private client group, for the Maui branch of FIM Group Ltd., was third with a 13.6 percent increase to $22,725.71.
And Richard Dole, chief executive of Hono lulu-based investment bank Dole Capital LLC, was up 3.4 percent to $20,683.85.
For the quarter, all three major indexes eked out small gains. The Standard & Poor's 500 index had a total return of 4.5 percent while both the Dow Jones industrial average and the Nasdaq composite index were up 2.9 percent. At midyear the Dow was up 15.2 percent, the S&P was ahead 13.8 percent and the Nasdaq was up 13.4 percent.
Melton said investors are simply taking advantage of the only game in town.
"The Dow and S&P 500 are continuing to hit records because money follows returns," Melton said. "Stocks are not undervalued from most perspectives, but with low inflation, still unattractive fixed-income rates, and questions on the staying power of real estate in a period of rising mortgage rates, stocks seem to hold some selective attraction over the past six months."
Melton, who has been picking sector indexes that triple the performance of the industry or the stocks that they track, turned in the best performance in the second quarter of any of the four experts with a 7.9 percent increase in his portfolio. His best performer was Direxion Retail Bull 3X, a retail index fund, which jumped 19.6 percent during the April-June period. For the third quarter he mixed up his portfolio by purchasing indexes that track semiconductor stocks, the Russell 2000 index of small stocks and an index that tracks financial stocks. He sold indexes that follow health care, real estate and the Dow.
"The market pace should pick up over the next six months," he said. "Increasing consumer confidence, better housing data and the brighter employment outlook underscore this optimism. Also, the Fed seems unlikely to raise short-term interest rates until 2015."
Caris is not as optimistic and said caution is warranted.
"We think it is possible that we see a correction between now and the end of the year," he said.
A sudden spike of rates in June after the Fed indicated it might slow down bond purchases put Caris on notice.
"Markets got a taste of higher interest rates in June, and as we saw a month ago, we could experience a correction based on retraction of stimulus," he said.
Caris, who owns Ford and Hawaiian Airlines parent Hawaiian Holdings in his portfolio, is bullish on those two stocks. Ford rose 18.5 percent in the second quarter while Hawaiian increased 5.9 percent.
"We feel very strongly that Ford is the best-run auto company in the country and that Hawaiian Airlines is the best-run airline," Caris said. "Ford has the best lineup, best management and strongest global growth profile of anyone in the space.
"And for Hawaiians the time is right for this one. Capacity is being reduced to Hawaii, and these guys have the best service out there. Their efforts to expand in Asia will pay big dividends, and the way management is navigating a tough business environment with new initiatives is a testament to their ability."
Caris adjusted his portfolio in the third quarter by purchasing surfwear manufacturer Billabong, a debt-laden company that is in the early stages of a turnaround after being purchased by private equity firm Altamont Capital Partners. Scott Olivet, former chairman and CEO of sunglasses maker Oakley, is taking over the helm.
"Scott is one of the best in the business and we think will help return the company to profitability and growth," Caris said.
Caris is also buying semiconductor manufacturer RDA Microelectronics because of its exposure to smartphone growth in China.
He is selling Decker's Outdoor, a designer and marketer of footwear and accessories, and semiconductor manufacturer LSI Logic.
Hyman said there are three reasons the Dow and S&P 500 are continuing to hit records: the lack of investment alternatives; crowd behavior in which investors are chasing performance and selling laggards without paying much attention to value; and misunderstanding how to determine the fair value of an investment.
"Many investors felt burned by the stock market crash of 2007-2009, moved out of stocks after they fell, then were afraid to 'get back in.' So now that stocks have run up more than 170 percent from the March 2009 bottom -- in the case of the S&P 500 -- it seems many investors are feeling they missed the boat and are finally investing in stocks again. Unfortunately, many stocks that were bargain priced in 2009 are now selling at prices that are well above their intrinsic values."
Hyman said that with the Fed artificially suppressing interest rates, some investors feel they have no alternatives to keep their money working for them other than to invest in stocks, regardless of whether those stocks are priced at rational prices.
"Some investors are chasing high-priced, dividend-paying stocks (like real estate investment trusts)," he said. "Others are blindly investing in indexes via ETFs (exchange traded funds). And yet others are pouring money into mutual funds, forcing managers to get that money invested, all of which pushes indexes ever higher until the bubble ultimately pops."
Hyman made no changes in his portfolio for the third quarter after it edged up 2.2 percent during the April-June period. His best performer was Gaiam, a provider of health and fitness products, which rose 6.2 percent last quarter.
Dole's portfolio lost 6.8 percent during the quarter, but he's sticking with his picks, which include two Hawaii companies: ocean shipper Matson as well as the parent of Territorial Savings Bank. Matson rose 2.2 percent during the quarter while Territorial Bancorp slipped 4.4 percent.
"If the market continues to gain over the remainder of the year, I think that the sectors that have not participated in the rally offer the most promise," Dole said. "The recovery has to go beyond housing if it is to continue."
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