The past six weeks have been very kind to the stock market, enough to rekindle the old Wall Street maxim to “sell in May and go away.” Of course, late April/early May coincides with the release of the second round of quarterly earnings reports for most companies, which tend to be construed as either confirming or reversing a trend set by the first set of quarterly reports released three months earlier.

This recent run up in stock prices coincides with a drop in implied volatility as measured the VIX, or the “fear index” as it is often referred to. A decline in the VIX is usually interpreted as being positive for the stock market, although the actual historical relationship is just the opposite. The VIX essentially interpolates implied future volatility by process of elimination; after all of the other measurable components of an index option have been subtracted out, whatever is leftover must be attributable to expected volatility.

While the logic behind the formula is unassailable, the manner in which it is interpreted is open to debate. Just because a certain amount of volatility is expected does not meant that it will, in fact, occur. To our way of thinking the VIX is more of a lagging indicator than a leading one; combined with the natural human tendency to overestimate the negative consequences of current threats the result is often a temporarily inflated VIX level that gradually subsides as the actual consequences prove to be less severe than originally feared.

In other words, much of the recent rise in the stock market and simultaneous decline in the VIX is the result of old fears not being realized more so than the absence of new fears.  

Of course, it’s often the threats that you don’t see coming which create the most damage as they leave you no time to prepare. By the time a threat can be recognized and measured it is no longer much of a threat unless it is of enormous magnitude. How big of a threat to the financial markets is Russia’s recent aggression in the Ukraine? In financial terms it represents only a moderate level of risk, perhaps more dangerous as a diversion that prevents us from noticing something else brewing in another part of the world for which we are not adequately prepared.

By historical measures the U.S. stock market is only mildly overvalued, trading at a moderate premium to its historical P/E ratio. Certainly not cheap, but certainly no bubble, either. And since we can’t predict the short term direction of the stock market, what we do instead is identify companies that are doing the right things and are undervalued relative to their peer group. We think that is the most reasonable way to approach the stock market, and one which does not allow fear to cloud our judgment.

NASDAQ Composite Index:                                                                           

Friday, May 23 = 4,185.81

Year to Date = + 1.0%

Trailing 7 Days = + 2.3%

Trailing 4 Weeks = + 1.5%

PORTFOLIO UPDATE

Even though we preach the gospel of innogration on a daily basis, it still sometimes humbles us when we witness it operating with such precision. To wit, three months ago we recommended buying Lenovo (OTC: LNVGY) with a buy limit of $22 (on that day, February 24^th, it closed at $20.28). It breached our limit price a little over a month later, and hasn’t looked back since.

Today it traded above $25 for the first time since February 3rd, largely on the strength of its latest quarterly earnings report released last week which included higher than expected operating revenue, gross margin and operating profit, coupled with an announcement that it is on the lookout for more companies to acquire (and would be able to finance another billion dollar acquisition, if necessary).

Many investors may ask themselves, why was Lenovo worth more than $27 in late January, then worth only $20 (a 25 percent decline) one month later, and now worth $25 (a 20 percent recovery) three months after that? Even more importantly, why did we wait until late February to recommend buying it at $20 when a lot of other investors were dumping it?

The answer to both of those questions requires an understanding of what innogration is, and why it is critical in correctly evaluating tech stocks.  As we have stated many times before, most stock market valuation methodologies are based on extrapolation which take current values and then assume a fairly constant rate of change going forward. That’s a huge problem when it comes to tech stocks, as by their very nature they are constantly innovating in an effort to disrupt the very environment in which they operate.

In the case of Lenovo, it identified a future opportunity in the Chinese hardware market that other companies were abandoning. No amount of extrapolating Lenovo’s current financial statements or prior stock market performance would have clued you in to what was about to happen. However, a model which is truly predictive and built around the key drivers of innogration would have picked up on the rapidly changing landscape in which the company would be operating going forward.

Similar to Lenovo, Ricoh (OTC: RICOY) is also making an aggressive play on the Asian hardware market. We first recommended buying Ricoh back in late December when it was trading near $52. Since then it has traded above $63 and dropped back down to $54 before recently climbing back up to $60. In large part that volatility is probably due to a lack of clarity as to exactly what Ricoh’s innogration strategy really is, since the idea of cornering the Asian market for printers, copiers, and fax machines is not exactly the stuff of a James Bond movie.

However, we think both companies are executing a solid growth strategy built around the notion that the PC hardware market in China and India will continue to grow for years to come, which in turn will spur sales within its hardware ecosystem. A skeptic might point out that even if both companies are correct, at some point in time those geographic markets will eventually experience a decline in PC hardware consumption similar to what is already occurring in the U.S. and other developed countries.

That is most certainly true, and at present we can only conjecture as to how each company will react at that time. What we do know is that it is virtually impossible to predict trends in tech consumption several years into the future, so attempting to do so is an exercise in futility. Instead, we attempt to identify companies that possess the necessary ingredients to successfully innograte into those product areas as they arise, and let the market sort out the winners and losers.

We reiterate our buy recommendation on Ricoh up to $60, and now rate Lenovo a hold with a target sell price of $30.