‘Buy’ Signals Flashing With Plunge in Confidence: John Dorfman

Consumer confidence last week hit its lowest level in five months, the Conference Board reported in its monthly sentiment survey. The confidence index fell to about 50, far below its 20-year average of about 94.

Many observers are taking the news hard. “Faith in the economic recovery is failing,” said Guy LeBas, chief fixed-income strategist at Janney Montgomery Scott LLC in Philadelphia.

For investors in the stock market, though, the bad consumer-confidence number could actually turn out to be good news.

Ned Davis Research Inc. in Venice, Florida, studied returns for the Dow Jones Industrial Average when confidence as measured by the Conference Board survey is high, medium and low.

When it is high (above 113) the Dow gained an average of only 0.2 percent over the next 12 months. When confidence is moderate (between 66 and 113) the index gained 5.9 percent.

The biggest gains came when confidence was low (66 or less). Then the Dow plowed ahead by an average of 13.1 percent.

Why is consumer confidence a contrary indicator for stocks? When confidence is low, many people have withdrawn from the stock market, whether because of fright, disgust or simple lack of funds to invest. Lots of cash is on the sidelines, and that cash is potential fuel for a rally.

When confidence is high, many investors have already committed much of their capital to stocks, and there is little left to fuel the fire.

Sudden Drops

Historically, stocks have also performed quite well following sudden drops in confidence. Joseph F. Kalish and Veneta Dimitrova, analysts at Ned Davis, studied 14 cases in the past 31 years in which the Conference Board number dropped at least 9.8 points in a month, a trigger that was reached with February’s 10.1-point decline.

Twelve months after such an event, they found, the Standard & Poor’s 500 Index had gained an average of 8.7 percent, excluding dividends. There were gains in 11 of the 14 cases.

A look at the historic extremes of the Conference Board’s measure may also be instructive. The highest reading in the past 20 years was in May 2000, about two months after the Internet- stock bubble started to deflate. Since then, the S&P 500 has yielded a return of negative 12 percent, including dividends.

Confidence Reading

The lowest confidence reading in the past two decades was about 25, in February 2009. That was just a few days before U.S. stocks began a major rally of about 50 percent in the subsequent six months.

If the next 12 months bring decent gains to investors, lots of folks will be surprised -- but that’s normal. If consumers see unemployment coming down and wages rising, greed will gradually replace fear.

For the moment, consumers are timid and tapped-out. One industry that has suffered greatly as a result is homebuilding, with many stocks down as much as 80 percent from their peaks of 2005.

I started turning somewhat bullish on homebuilders in August 2009, but urged investors to go in slowly. Today, I think we have a reasonable purchase point.

New home sales reached an all-time low in May, when the seasonally adjusted annual rate was 267,000 homes. That was down from a record high pace of almost 1.4 million homes a year in July 2005.

Shredded Balance Sheets

Sales in June increased to a still-very-weak rate of 330,000 houses a year. I think that from here it will be a long, slow climb, though I believe an improvement is more likely than a further deterioration.

All of the homebuilding stocks today are cheap. However, many of them had their balance sheets shredded in the past five years. I would buy those that still have debt less than stockholders’ equity.

One that qualifies is Toll Brothers Inc., based in Horsham, Pennsylvania, which builds upper-end homes. After a nine-year run of making money, Toll Brothers had losses in 2008 and 2009 and is forecast to post a third straight loss in 2010, albeit not as bad as last year (73 cents a share compared with $4.68 in 2009).

Analysts expect Toll Brothers to return to profitability in 2011, to the tune of about a dime a share. The stock sells for 1.2 times book value.

Jones New York

Consumers may have pent-up demand to buy clothing as the recession recedes. One beneficiary could be Jones Apparel Group Inc., a New York-based company that sells mid-priced clothing both wholesale and through its own network of more than 900 stores.

The company’s brands include Anne Klein, Jones New York, Evan-Picone and Gloria Vanderbilt. I think the price point for its clothing puts it in a good position in a recovering economy. The stock sells for 11 times earnings.

As they get less gloomy, consumers might also spend a bit more on their gardens and pets. That is the turf of Central Garden & Pet Co., which has its headquarters in Walnut Creek, California.

Central Garden gets little respect from analysts. It is covered by seven, five of whom rate it a “hold” and two of whom call it a “buy.” Yet the company reported record earnings last year of 94 cents a share and is expected to tack on a few cents more this year.

Disclosure note: I have no long or short positions in the stocks discussed in this week’s column, personally or for clients.

(John Dorfman, chairman of Thunderstorm Capital in Boston, is a columnist for Bloomberg News. The opinions expressed are his own. His firm or clients may own or trade securities discussed in this column.)

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