Like a couple of famous bunnies the Market just keeps on running and running - the question we've had for quite a while is why and how? The short answer, ioho anyway, is that's running on momentum. Otherwise known as sentiment or psychology, or in our coined word, euphorillusion! Strangely a recent survey of Wall St. strategies has the market ending the year at the same level they forecast at the beginning and about where it's at now. Now we've recently spent a lot of time, both in gathering, posting and leaving those posts up for you to read, on the Wall St. bonus issue. Strangely enough that's coordinated in multiple ways. What got all this going was when, after the stress test we remind you, financial earnings stopped dying. On the other hand they sure haven't been very good - the market died a small death today when Dick Bove downgraded Wells Fargo. A little while ago Whitney put GS on hold/neutral because it's more than fully valued. If you've been paying attention there's a lot of problems lurking on the banks books and the only lines of business making money have been proprietary trading. To the extent that the Financials have been driving things we think that's a foundation of quicksand. The other thing is earnings surprises, which were based on cost cuts although some companies have recently been surprising on the top line, after lowering expectations. Our bottomline is twofold - as long as its running let it run and ride along with it. But start prepping and decide what you're going to do; and we'd repeat it still might be time to take profits off the table if you're the least bit ancy.
Current Market Situation
Let's take another overly complex look at the market situation with a four-part composite chart. The reason we combine these, aside from compression, is that it forces you to consider four time frames simultaneously, which we think is revealing and important.
We'll come back 'round but let's start in the LR corner with the key point. After the 'world is ending' collapse in March and the "no it's not rally" what we see is that the market is just reaching back into the downtrend channel that's been going on since Oct07. In other words we were in a normal recession bear market that collapsed twice. Once when the sandpile of leveraged debt (remember those financials) in Sep/Oct08 and again this last Spring. Now we're still in that downtrend.
Continued ...
As you can see in the UL corner we've been running up ever since. The only other observation we'll add is that three seperate times it looked like the runup was done for (in fact Doug Kass called a top in Aug09 - and since he's the guy who called the absolute bottom to date in March, well...). The UR chart takes Fib limits from the March low to the range-bound May-early July market and moves them up and over to see what might still be going on. Again notice that the rally hit the 1030 resistance line and started to stop then broke out but looks like it's struggling to get to the 1096. If we finish the year at 1100 we'd be surprised; and not to surprised if sometime as the new realities (read employment reports) sink in if we don't see 877 again. But not just yet. Which gets us to the LL corner - the longest term sub-chart. There we've taken a straight-forward Fib chart from the '03 bottom to the '07 top and guess what - the market is struggling to reach and breach reistance at 1088. Wow, deja vu' all over again as they say.
A Foreign Perspective: Exchange-rate Market Adjustments
Via BigPicture we found the Financial Times had an interesting perspective on things by looking at the US markets from a foreign perspective, i.e. by adjusting the SPX for the drop in the Dollar. We took that idea and spun it some more by looking at the inflation-adjusted and the inflation- and exchange-rate adjusted SPX.
The inflation-adjusted (blue) SPX has yet, if you'll please note, to return to the BOTTOM of the '03 low! So much for this rally, fading or not, as we suspect. And it's not as if inflation has been all that much of a problem. The quick lesson here is that if you're in this market you're automatically TRADING, not investing. We show two exchange rate adjustments - one for the major currencies and the other for our broad trading partners but both trade-weighted. Fascinatingly the three indices roughly track each other, though the broad rate-adjusted performance shows some much wider swings. Let's try that again - for thirty years from 1973 to 2003 the major currency adjusted and the inflation-adjusted SP500 tracked each other almost identically. From 2003 forward there's been a wide swing! And, in fact, not only has performance been abysmal but the recent highs are FAR below the '03 lows!
Trading in a Range-bound Market
Or, put another way, the death of buy-n-hold! Now that's a point we've made before. But everybody's still locked into the views that got ingrained as religious icons from 1980 to 2000. Markets always go up. Lots of folks, including us, started to suspect that was no longer true and that we were in a secular, range-bound market as far back as the early noughts. Now most of the brighter and better analysts and strategiest have reached similar conclusions. In the readings below you'll find a large collection divided into three categories: current state of the market with some very interesting vidclips (we particularly recommend the BNN clip with David Rosenberg), some interesting stuff on strategies and particularly cases and concluding with a section on some of the best advice on strategic positioning and managing your investments in a range-bound market we've ever read. All of it is at least worth skimming but, if we had to pick, the single must read article is Jim Jubak's that looks at key major factors and how they're likely to play out, the title starts with "Know What to worry about..."
Barry had another great chart of his own devising which we've combined with the exchange-adjusted chart to link the points. He and his firm, FusionIQ, took a look at previous range-bound makerts and created a composite of what happens in raneg-bound, secular bear markets. BtW - where the loop closes is that if you've paid any attention whatsoever to what we've had to say about the longer-term economic outlook we're not going to see decent economic growth for years and this will be a weak and jobless recovery. Which means consumer demand aint' coming back and on and on. Again review the discussions but ultimately it indicts all of the current shibbolethic thesis that are running around, from China to commodities to gold.
So three points on the bottome-line:
1) You can't be playing buy-n-hold anymore. You need to be prepared to adjust your market position as the market fluctuates.
2) This market is running on nothing much whatsoever and the fumes are thinning out.
3) Ride it for however long your comfortable but start thinking about moving toward high-quality bonds and on the shorter end of the curve. Not just yet but start prepping.
UPDATES:
There are two keys to this energizer market (both id'd and discussed by Doug Kass among others). The first is that this is a momentum largely driven by liquidity (really wow, deja vu' all over again!). The second is that anticipation of a continuation is ostensibly based on earnings expectations beats but, underneath that, is that the folks speculating merrily away see a V-shaped recovery as likely. Despite the fact that a) all the grounded outlooks are based on a weak recovery AND b) supposedly this is widely recognized and internalized. It is, as Jim Jubak points out, NOT! To that end these are two stories you should really read:
Both are excerpted more fully at the end of the readings after the jump.
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Markets
Words from the (investment) wise for the week that was (October 12 – 18, 2009) Risky assets remained in favor during the past week, generally helped along by fairly robust economic data and better-than-expected corporate earnings reports. A number of bourses, crude oil, inflation-linked bonds and high-yielding corporate bonds and currencies recorded fresh highs for the year, whereas gold hit an all-time high of $1,070.20 per ounce. Assets such as government bonds and the US dollar saw fading demand as safe havens, now that the global economy is on the mend. Similarly, credit default spreads tightened markedly and the CBOE Volatility Index (VIX) declined to its lowest level since early September 2008.
- The Days Of 'Buy and Hold' Are Over, says John Mauldin Contrary to what "experts" have told the public for years, now is not the time for buy and hold, Mauldin says. "You can be a trader. You can ride the wave, I've got no problem with that but I don't think you want to buy something and hold it for five years."
- Current Market Boom "Can't Be Trusted," Robert Shiller Says Are we on track for a repeat of irrational exuberance?With the stock market up more than 50% since March and the Standard & Poor's Case/Shiller Index on the rise for the last three months, it's a worry, says Yale Professor Robert Shiller. "Somehow we got into this really speculative mentality and I don't think we're out of it yet." Given the current economic environment, "these booms [in the housing and stock markets] that we're seeing now can't be trusted to continue,"
The Energizer Rally: Contrarian analysis continues to reach bullish conclusions The stock market rally that began last March is, surprisingly, turning out to be like the Energizer bunny: It just keeps going and going. The Dow tacked on nearly 100 more points in Monday's trading alone. There's one group of investors who have not been particularly surprised by this turn of events, however: contrarian analysts. They've noted over the last couple of months that the rally was being met with increasing skepticism, on both Wall Street as well as Main Street. This prevailing skepticism, in turn, has formed a veritable Wall of Worry that the bull market has continued to climb. One good indication of that skepticism is the mood of investment newsletter editors. Believe it or not, they are, on average, no more bullish now than in mid April, when the Dow Jones Industrial Average was trading around the 8,000 level -- more than 20% below where it is now. This is quite significant, since the typical pattern is for the prevailing mood to become more bullish as the market rises, and less bullish as it falls. It's because of this tendency, after all, that bullishness is most extreme at market tops and bearishness is the pre-eminent mood at market bottoms. If this stock market continues to play a contrarian script, this rally will come to an end when this stubborn bearishness finally gives way to stubborn bullishness. Because contrarians don't like to predict when that sentiment transformation will occur, they usually don't hazard predictions about when the rally will finally fizzle out. But, in the meantime at least, the sentiment winds appear to be poised to continue blowing in the stock market's sails.
The Most Hated Rally in Wall Street History he key factors that have been contributing to, and may continue adding to, the ongoing rally. 1) Historical Secular Bear Markets: As discussed in August, secular bear markets tend to get massively oversold, then see a huge bounce. 2) Hated Rally: I have noted previously that this is the most hated rally in Wall Street history. Many people — both pros and individuals — all have reasons as to why it must end badly: PPT, hyper-inflation, bad economy, etc. Most bull moves do not end when they are hated, they come to a halt and reverse when they become over-owned and over-loved. We are not there yet. 3) Dollar Selloff: Yet another factor is the weak dollar, mentioned earlier in our Gold discussion. The relationship has been pretty explicit lately. See the FT’s Dollar-adjusted S&P 500. 4) Typical Recession vs Panic Selloff: From October 2007, when the Dow hit ~14,200, to about September 2008 when it slid to 11,500, we had what looked to me like a standard recession: About 8-10 months long, down about 20%. That is fairly ordinary length and depth of typical market reactions to recessions. The next 5000 points of freefall was a panic reaction to an expected end of the economic world. Recall that the widespread belief was that the system was fatally broken, and we were all going to hell. Indeed, the SPX did get down to 666 level. What we have been experiencing since that low has NOT been an anticipation of earnings improvements, or a V shaped recovery. To be blunt, it is little more than mean reversion, as the aberrational credit panic sell off gets unwound. We are now returning towards a more typical recessionary sell off. That’s when things make get alot more difficult . . .
Are Stocks Fully Valued? “David Rosenberg, of Gluskin Sheff, notes that on an operating (”scrubbed”) basis the price/earnings ratio of the Standard & Poor’s 500 has expanded a whopping 10 points since its March low, and stands at 27.6. Historically, Dave observes, when the economy is making the switch from contraction to expansion, as it did in the third quarter, the P/E is 15. Trailing earnings are untouched by clairvoyance, in contrast to forward earnings, which depend heavily on projecting the future. But such estimates have their drawbacks, particularly since Wall Street forecasters are a cheerful lot predisposed toward upbeat prognostication. A year ago, equities were trading at a modest 12 times forward estimates. In fact, as Dave puts it, with perfect hindsight, the market at the time was really trading at 30 times forward earnings. Currently, Dave reckons, the S&P 500 is priced for $83 in operating earnings, or double the most recent four-quarter trend, and normally it takes five years for profits to double from a recessionary low. Such a feat would be more than a little impressive, since revenues, for the first time ever, have registered four quarters in a row of double-digit decline. Given the going estimates for operating earnings of $48 a share this year, $53 next year, $63 in 2011 and $81 for 2012, he concludes that “the market is basically discounting an earnings stream that even the consensus does not see for another two to three years.” In Dave’s book, stocks remain more than fully priced.”
Strategy, Outlook & Cases
8 Common Mistakes Investors Make What can horse racing teach us about investing? A lot, according to Michael Mauboussin, author of More Than You Know and chief investment strategist at Legg Mason. In his latest book, Think Twice: Harnessing the Power of Counterintuition, Mauboussin cites the hype over 2008 Triple Crown contender Big Brown as evidence of some of the common mistakes investors make: Succumbing to tunnel vision. Being overly reliant on experts. Not realizing how much we're influenced by peer pressure...
Next asset bubble could come sooner than you think The next financial bubble could come sooner than you think. A year after the collapse of home values triggered the financial crisis and Great Recession, another rapid and irrational rise in the price of assets -- whether stocks, home values, oil or something else -- would seem unlikely. After all, major bubbles through history have been spaced decades, if not centuries, apart. Today, though, amid the wreckage of the last bubble, the ingredients for the next are still with us. The price of gold spiking to its highest level ever -- $1,060 an ounce on Thursday -- is one warning sign, as is the 67 percent surge since March in the Nasdaq Stock Market index. One reason is that there's a sharp rise in the amount of capital sloshing around the world in search of the best returns. Investors are still fixated on short-term gains over long-term performance. And information now travels instantly, fueling a herd mentality and feeding the optimism wired into our brains. Over the last 30 years, the value of financial assets -- such as stocks, bonds and bank deposits -- grew to be four times larger than annual global gross domestic product. Key factors: personal savings rates rose in Asian economies, companies piled up profits year after year and Middle Eastern oil-exporting countries grew wealthier. Mckinsey Global Institute estimates this measure of wealth peaked at $194 trillion in 2007. And while it fell back to $178 trillion at the end of last year, it is still dramatically larger than the $43 trillion in 1990 or the $94 trillion in 2000. Today, record-low rates for short-term loans in the U.S. -- tied to the Federal Reserve cutting its target rate for overnight bank loans close to zero -- are also now playing a role. And there's more incentive for money managers around the globe to use dollar-denominated short-term loans to buy stocks, commodities and other investments that typically deliver higher returns. That's contributing to the dollar's 6.5 percent decline in value this year against a basket of six major currencies. As the dollar has fallen, gold, copper and other commodities priced in dollars have become cheaper for overseas buyers. Gold, for example, has risen 21.7 percent in the last six months in dollar terms. But measured in terms of the euro, the currency used by Germany, France and 14 other European nations, gold is up only 7 percent over that period. While buying gold is viewed as a way for investors to protect themselves against inflation, it can be a way for money managers to profit off other investors' inflation fears. This is called momentum trading. And as money managers shift funds around the globe in search of the highest returns, they often end up piling into the same asset classes so they can show clients they're wise to the next hot investment. This is the kind of herd mentality that leads to asset prices inflating beyond their fundamental value.
Growth Stocks: Not-So-Great Expectations The U.S. economy has spent almost two years shrinking, and Standard & Poor's 500 corporate earnings have dropped more than 25% in the past year. It's not an easy environment if you're an investor looking for growth. Investors who embrace the value investing strategy have their own problems these days, especially with the stock market up 57% in the past seven months. But the challenges are no less daunting for growth investors, who favor companies that they believe have strong future growth prospects. The biggest problem for growth is the lack thereof. "It's safe to assume companies are not going to grow as fast in the next 10 years as in the last 10 years," says Bob Millen, portfolio manager of the Jensen Fund. Growth and value managers alike have been flummoxed by the stock market's wild mood swings over the past few years. An individual company's true value or its growth prospects have been almost ignored in favor of broad economic and financial forces. Many growth managers are hoping that, eventually, companies with solid, consistent growth will be rewarded. But, in these shaky times, there are no guarantees that will happen.
Manufactured surprises will keep stocks rolling, The US is entering earnings season, when companies give a quarterly update on their performances. The market will probably find some good excuses to push prices up. For the slightly longer term, it might also help to resolve some alarming contradictions when the messages from different markets are compared. It is the earnings a company generates that an investor is buying when he or she buys a stock. Earnings only partially depend on the economy, which is measured by public data. They also depend on their own specific factors. The profits cycle is not the same as the economic cycle, and earnings can do well when the economy is anaemic. But there are dangers. Earnings can, to some extent, be legally manipulated - so the season often stages big moves. This shows the extent of corporate "earnings management". Companies have been good at setting the market's expectations at a level that they can exceed. The market makes most of its progress when these manufactured "surprises" are revealed. There is every reason to believe that this trend will repeat itself over the next few weeks. The bar for this quarter is low; brokers are braced for a decline of 25 per cent in earnings compared with a year ago, according to Thomson Reuters. And companies have made fewer negative announcements than usual ahead of this reporting season, implying that fewer have bad news to reveal. So there is every chance this season will help to extend the rally in stocks. But there are some important differences from the last two earnings seasons. They showed that companies had protected profits better than many had expected, by savage cost cuts. Those cost cuts, arguably an overreaction to last year's Lehman debacle, in turn helped ensure the sudden fall in global economic activity. Bad economic times can increase companies' pricing power and their negotiating power with their employees. The tricky part will be to increase their revenues. So investors are now looking to be positively surprised by corporate revenues. After falls of 14 and 17 per cent in the past two quarters, consensus forecasts suggest that sales have fallen 15 per cent in the third quarter. And yet brokers also expect earnings to start rising at a clip of more than 30 per cent in the new year. This implies either that margins will improve or that revenues will have to boom. As the chart shows, margins are already far above historical norms, so this looks like a stretch.
Tech stocks to lead earnings season again? It’s early yet in earnings season, but I were a gambling man, I’d give the technology sector odds on leading the stock market again this quarter. Wall Street is beating the bushes for earnings growth right now. If earnings don’t go up in the next quarter or two, stocks won’t be able to continue the rally that began in March. Anbd where’s the growth going to come from? Financials are kind of iffy. Bank accounting is going to be an unprdictable mess this quarter what with write ups for rallies in toxic assets, and write downs for the rising price of banks’ own debt (yes, that counts as a loss for accounting purposes), commercial real estate loans and credit card debt. Commodities and materials stocks will do well if the dollar keeps stumbling and if China looks like its still buying, but these cyclicals are starting to seem pricy. Nope, for good ol’ fashioned earnings power right now, it’s hard to beat technology stocks. And Wall Street analysts are determined that investors won’t forget it.
Oh, Those Financials! Oh, financials, financials, financials. Here we go again. JPMorgan Chase reports quarterly profits on Wednesday; Citi announces a quarterly loss on Thursday, Bank of America delivers its results (no one knows if loss or profit) on Friday. The parade will continue right through Halloween. Cumberland does not use single stocks in its US equity account management. So while we are keenly focused on these reports, we’ll review some of the applicable ETFs instead. Since March 9 the big bank ETF that tracks the KBW Bank Index has delivered a total return of 145%. The three banks reporting this week constitute 25% of the weight of the exchange-traded fund (ETF) that mirrors that index. Its symbol is KBE. These big banks are deemed “too big to fail” and have benefitted greatly by obtaining the federal government’s direct support and guarantees. That subsidy will be revealed in their positive surprises to earnings reports Contrast KBE with KRE. It is the exchange-traded fund composed of regional banks that have not been deemed “too big to fail” by the Washington-based troika of Treasury, Fed, and White House/Congress. Many regional banks are small enough to be resolved by the FDIC, and many suffer from a greater concentration of deteriorating commercial loans than their larger brethren. Their status is reflected in the performance of their stocks. KRE has had a total return of only 49% since March 9. It has actually lagged the performance of the S&P 500 index, represented by the “Spider.” SPY has had a total return since March 9 of 59%.
Dividend stocks that beat the market Income investors today face an even tougher environment than when I began my portfolio of high-dividend stocks nearly four years ago. Interest rates, in general, are lower. The three-month Treasury bill yields just 0.09%. The yield on a two-year Treasury note is 0.87%. And if you're willing to lock up your money in a 10-year Treasury, you get paid just 3.21%. Risk is higher. Because of the big rally in junk and other distressed bonds, corporate issues are trading at higher prices, which means you get less yield and more risk. And we're a lot closer to the turn in the interest cycle. I don't expect the Federal Reserve to start raising rates in 2009, and 2010 is an outside chance. But 2011? For sure, unless the economy slips into a double-dip recession. Remember that rising interest rates drive down the prices of existing fixed-income vehicles, such as bonds
5 steps to losing your money The dollar is down about 9% against the euro since January and about 11% against a trade-weighted basket of currencies. And the damage is even worse against what I'd call the world's commodity currencies. So, for example, the dollar is down about 16% in 2009 against the Canadian dollar, 24% against the Australian dollar and 27% against the Brazilian real. There are good reasons for the decline: But it's one thing to say the U.S. dollar is likely to slide lower over the next six to nine months and quite another to say that the dollar is going to fall an additional 50% or is worthless. That sounds like Stage 5 panic to me. When I hear this kind of stuff, it makes me want to cut back on commodity-related and emerging market stocks. So what should you do? If you hold stocks or other assets that benefit from the rising belief in the falling value of the U.S. dollar, hold on. It wouldn't hurt to set actual or mental stop-loss targets 8% or so below current prices for these volatile investments. If you've missed the falling dollar rally to date, don't do anything stupid. A prediction that the dollar will tumble 50% more isn't a good enough reason to load up on anything. The dollar has months of decline ahead of it, but the decline is likely to be relatively gentle. When we're talking about the big drop in the dollar in 2009, we're talking about 11%.
China pumps up the bubble-making machinery again So much for restraint. Back in August it looked like the Chinese government, concerned about rising prices for stocks and real estate, had decided to slow down bank lending. Forget it. In September it was back to the races. New bank lending climbed to $76 billion in September from $60 billion in August. That’s a month to month increase of 26%.With all that lending China’s money supply (M2) rose at an annual rate of 29%. Economists think that any increase in the money supply much above the rate of economic growth is inflationary. Economists expect China will report 9% growth when it announced GDP figures next week. You do the math: China should be showing huge inflation. But the country is showing negligible price inflation. Why isn’t that huge increase in money supply causing run away inflation in China. Four reasons, I think. 1. Because that huge increase in money supply isn’t going into the hands of consumers who might bid up prices, but is going into loans to state-owned businesses (for the most part.) 2. Because from the state-owned businesses some of that loan money is going into new plants–which would increase demand for things like cement and machinery and would therefore be inflationary–but not a huge amount. Most of these companies are operating in industries that already have huge idle capacity so they’re not rushing to build more. 3. Because the state -owned businesses are funneling their loan money into investments in the stock market or in real estate. Prices in those two asset markets are indeed climbing. As in the United States in the run up to the tech stock bubble in 2000 and to the housing bubble, sometimes there seems to be no measurable inflation because our inflation measures don’t include asset prices. 4. Because the growth in China’s domestic money supply is turning up as inflation in international commodity prices. The money from these bank loans that is going into the domestic economy is being spent on importing iron ore, coking coal, copper, and other basic materials. That’s where the demand created by the run-away money supply is pushing up against demand constraints and sending prices higher.
Beware asset market & credit booms bubbles & busts in emerging markets Be that as it may, the world is being flooded with official liquidity by the leading central banks of the overdeveloped world. Because of the depressed state of the real economy in most advanced industrial countries (large negative output gaps whose magnitude continues to grow, high and rising unemployment rates), this official liquidity flood is unlikely to generate an overall (private plus public) liquidity flood in the overdeveloped world. Commercial banks either hoard the newly injected central bank liquidity at the central bank in the form of deposits or use it to purchase safe liquid assets, such as the sovereign debt instruments of reasonably solvent nation states. Broad monetary aggregates are growing little if at all in the overdeveloped world and credit growth to the non-financial enterprise sector and to the household sector remains minuscule. We are therefore unlikely to see a credit boom or asset market frenzy any time soon in the advanced industrial countries, let alone any pick-up in domestically generated inflation for indices like the CPI. The massive injection of official liquidity by the Fed, the ECB, the Bank of England, the Bank of Japan and other central banks in the north-Atlantic region is much more likely to show up as credit and asset market booms, bubbles and - eventually - busts in those emerging markets that are growing rapidly again, that is, most emerging markets other than those in Central and Eastern Europe. China, Brazil, India, Indonesia, Singapore, Turkey and Peru are but some of the countries at risk. The reason for this liquidity spill-over is the desire of many of the rapidly expanding emerging markets to prevent a large real appreciation of their currencies vis-à-vis those of the cyclically lagging advanced industrial countries.
Are gold and US Treasuries in conflict? My current view is that Gold and US Treasuries are both partaking of the same surge in liquidity, now washing over most asset classes. Again, had this been a standard recession, I would have been happy to be bullish on US Treasuries right from the start. But my central thesis was that US Treasuries were a dangerous asset class as rising supply met crushed trade flows. The Federal Reserve can claim, and people are free to accept, that their 1.25 trillion purchases of Agencies and 300 billion purchase of US Treasuries are simply monetary and liquidity operations. But that doesn’t make such a restrictive, narrow claim true. The FED actually had to make those purchases to avert a funding crisis. Only initially, therefore, did US Treasuries express the macroeconomic outlook for an industrial collapse, and depression. Once that panic phase reached its zenith last December, then Treasuries had to exist in the same world of shrunken trade flows and liquidity that affected other assets. But this leads us to a question: if liquidity has indeed now returned as evidenced by asset reflation, then, an opportunity should open up again for the Treasury market to express a macro view. And today, one wonders that a hint of this view may be coming to light. My friend Mike Stiller, a keen macro observer, pinged me today and alerted me to a change taking place in the above ratio of Gold to the price of the Ten Year Treasury. This chart shows that after a year of crisis, the purchasing power of Gold to the US 10 Year’s price is breaking out to a new high. This is probably going to be more exciting for the technical trader, but thematically I think the longer, macro view is also informed by such a change. After all, it has indeed been a very big week for the Dollar, Gold, and asset inflation generally. Indeed, it almost feels like a quiet crisis is unfolding as a decade of haywire(d) monetary policy looks ready to finally get some very nasty feedback from the biggest market of all: the US Treasury market. I suspect that the liquidity surge, which is now coursing dynamically through the system, is going to keep pushing assets forward with less regard to a macro view, and more with a regard to restoration from the acute phase of the crisis. And while the US Treasury bond market has too many participants to accurately characterize, it seems likely that if the kind of message expressed in the above chart persists, that a recognition phase could finally unfold about the solution we chose for our collapsed economy.
Posture and Approach
Kass: Four Stages of Market Turning Points In March, I argued that stocks were at or near a generational bottom and I recently opined that U.S. equities have topped for the year. It can be argued that there are four classical stages in a move from market bottom to market top and then back again. My position has been well-chronicled on The Edge, my exclusive trading diary on RealMoney Silver: I believe that it is different this time. From my perch, the prospects for a self-sustaining economic recovery are in doubt in the face of numerous headwinds that are not only consequential in scope but with some of those forces that didn't even existed in the last few recoveries out of recessions. Despite the celebration of the certainty in a smooth and reinforcing recovery that seems to be at the foundation of the bullish cabal, the magnitude of policy (both monetary and fiscal) decisions speak volumes of how fundamentally different conditions are in October 2009 vis-a-vis past cycles. Moreover, the due bills from those remedies and the timing and response to the withdrawal of the outsized stimulation in 2008-2009 add further to the uncertainty of the slope of future economic growth and poses risks anew. Whether the stock market is topping out and the economy's 2010 trajectory will disappoint is subject to debate (on RealMoney and elsewhere), but what probably can't be debated (and something that truly astonishes me) is the brief period of time in which we have moved from fear to greed. Finally, as an exclamation point to today's column, I again bring up portfolio manager Bill Miller. While this is not meant as an ad hominem attack on the legendary investment professional, it is almost impossible for me to fathom that despite managing a fund that was down by more than 70% in the 18-month period ending March 2009, he is once again being praised -- and has gone from goat to hero in seven months -- in this weekend's Barron's magazine cover story.
Investment Strategy by Saut: Direction Dictates
“The absolute price of a stock is unimportant. It is the direction of price movement which counts.”
“During major sustained advances in stock prices, which usually occupy from five to seven years of each decade, the investor can complacently hold a list of stocks which are currently unpredictable. He doesn’t worry about the top because he knows he is never going to sell at the top. He knows that the chances are overwhelming in favor of the assumption that he will get far better prices by waiting until after the top is passed and a probable reversal in trend can be identified than he will ever get by attempting to anticipate the top, and get out on the nose.
In my own experience the largest profits we have ever taken have come from stocks purchased while they were making a new high in a market which was also momentarily expecting the top. As I have already pointed out the absolute price of a stock is unimportant. It is the direction of the price movement that counts. It is always probable, but never certain, that the direction of the price movement will continue. Soon after it reverses is time enough to sell. You should sell when you wish you had sold sooner, never when you think the top has arrived. That way you will never get the very best price – by hindsight your individual transactions will never look daring. But some of your profits will be large; and your losses should be quite small. That is all that is necessary for a satisfactory, enriching investment performance.”
“Stock Profits Without Forecasting,” by Edgar S. Genstein
I am leaving for a speaking tour in Michigan and then will be out of the country speaking again, so I wanted to leave you with the above paragraphs to ponder. They are two of the most important paragraphs I have encountered in more than 40 years of studying markets. Do not read them just once. Go off to a quiet spot that invites contemplation and read them several times.
Cost Cuts Lift Profits But Hinder Economy U.S. stocks notched new 52-week highs again on Monday, thanks to corporate America showing better-than-expected profits. But that optimism belies deep worries among company executives about the strength of the economic recovery. In an ominous sign for the economy, much of the profit is being eked out through cost cuts. Executives say they are hesitant to reinvest such profits into their businesses. With large portions of their factories, fleets and warehouses sitting idle, some say they probably won't see reason to do so for a year or more. That means job growth and any significant rise in business spending could be a long time coming. That creates a chicken-and-egg problem at a time when the unemployment rate is already nearly 10%: Without more jobs, U.S. consumers will have a hard time increasing their spending; but without that spending, businesses might see little reason to start hiring. Already, the economy is being starved of investment it needs to nurture growth. Net private investment, which includes spending on everything from machine tools to new houses, minus depreciation, fell to 0.1% of gross domestic product in the second quarter of 2009, according to the latest government data. That's the lowest level since at least 1947. And while companies are finding the credit-market thaw is making it easier to borrow money they would need to expand, many are stashing these funds rather than spending them. Of the 100 largest bond issues globally this year, only seven listed expansion, investment, capital expenditures or research and development as the purpose of the money-raising, according to Dealogic. In industries ranging from apparel to heavy machinery, executives say they don't yet have enough faith in the recovery to take significant risks.
Zen Lessons in Market Analysis When we look at the current market environment today, it is clear that the enthusiasm about the market here is largely based on the idea that the recent recession is over, and that the economy will form a “V” shaped recovery similar, but much stronger quantitatively, to standard post-war recoveries. This is a very difficult argument to make, because the drivers of economic growth that existed in typical economic recoveries – particularly debt origination and consumption growth – are very compromised at present. Our perspective on the ongoing credit risk in the economy is much like that of economists Kenneth Rogoff and Carmen Reinhart, who foresaw the recent financial crisis, and are far less sanguine about the prospects for sustained recovery. As I've discussed in several weekly comments, this is a subject that I have struggled with in recent months. Even if we could assume that the recent crisis was a standard post-war downturn, and that we are now in a standard post-war recovery, valuations would still concern us because at these levels, stocks are not priced to deliver satisfactory long-term returns in any event. However, we would have a greater willingness to take a moderate speculative exposure based on market action and prospects for sustained economic improvement. On the other hand, when we include other post-crash periods into our data set, and allow for the possibility that those instances better describe present conditions, the case for accepting speculative exposure is much more limited. Of specific concern is the tendency in those periods for strong advances (as we've seen in recent months) to be followed by spectacular failures. Presently, my primary concern is that stocks are now overvalued, to about the same extent as they were in the late 1960's, and just prior to the 1987 crash, but certainly less overvalued than they were at the 2000 or 2007 peaks. Our 10-year total return projection for the S&P 500 is centered modestly above 6% annually, even if one assumes that the long-term path of earnings has been unchanged by the events of recent years. If we assume that the economy will require a much longer period to recover than has been typical of post-war recessions, the prospects for long-term returns are lower, but we don't need to assume this in order to be concerned about valuation here.
Know what to worry about and when if you don’t want to get spooked out of a rally–or get killed in a correction When the market is rallying and everyone is getting kind of giddy, it’s exactly when you should be worrying. You don’t want to head for the exits just because an index has crossed some arbitrary number. That’s silly. But you would like to know what the chances are that something will go wrong. How bad it might be if something did go wrong. And when. Don’t forget the “when.” Deciding to sell because you’re worried that something bad is set to happen in 12 months is a guaranteed way to leave a big chunk of change on the table. So what are my worries and what timetable are they running on? I find this list of worries and their potential schedule very useful as we climb higher and higher and get closer and closer to the end of this rally. From my list you can see there are worries, #1 and #2, that could set off relatively minor corrections as early as next week. The magnitude of these corrections (which of course are only possible and not guaranteed) isn’t enough to make me jump to the sidelines. The first moderately serious worry, #3, one big enough to make me think about wanting to miss the damage, is still only a 15% correction and doesn’t arrive until March 2010 or so. The biggies, #4 and #5, the ones I definitely want to take action to avoid, are probably not a worry until the middle of 2010. I want to keep an eye on these scenarios, since the results are serious enough to make them really, really painful to anyone trying to rebuild a portfolio. But I don’t need to move to the sidelines to avoid these possibilities just yet. You shouldn’t take any of these to mean that the market has to keep roaring ahead at its pace of the last six months. Or that you should take on stocks with high price to earnings ratios.Caution is always a good thing when a rally has taken a stock market up 60% in six months. But my list says you don’t need to go running to the sidelines right now just because we’re challenging 10,000 on the Dow and 1100 on the S&P.
‘Sell’ for Research Renegades Becomes Business Off Wall Street When Credit Suisse Group analyst Ivy Zelman refused to turn bullish on homebuilding stocks during a rally in the fourth quarter of 2006, the blowback was intense. She says investors told her that some housing industry executives were ridiculing her analysis as a “jihad,” and several of the bank’s sales representatives pressed her to upgrade “hold” ratings to “buys” on companies to appease bullish institutional-investor clients. One sales manager even sent her an e-mail warning that analysts who stayed bearish too long often lost their jobs. Zelman was furious. She’d spent 16 years dissecting the home construction business and wasn’t about to ditch her analysis and join the bulls’ party. On Dec. 7, 2006, she slapped a “sell” call on the entire group, and during the next 12 months, the Standard & Poor’s Supercomposite Homebuilding Index plunged 53 percent as the real estate market collapsed. Stefano Natella, Credit Suisse’s global head of equity research, says that while debate between the sales team and research staff over their calls is normal and healthy, the e- mail from the manager crossed the line and he was reprimanded. Even though Zelman had Natella’s support, she grew fed up with a culture that prized irrational exuberance over sober analysis. “It was no fun being the bear,” Zelman, 43, says. “I’d come home from work and just be so upset. So I started thinking, ‘If I believe in my work, why not do it on my own?’”
UPDATES:
Kass: The Earnings Season Racket Only 33% of companies beat consensus sales estimates by greater than one standard deviation vs. 40% in the last 20 quarters.The good news is that 10 out of 14 intermediary companies (distributors, etc.) beat sales by more than one standard deviation, showing inventory restocks continuing (stronger than expected), and stocks went up 5%.The bad news is that only six out of 33 end-demand companies (true picture on end demand) beat sales estimates by more than one standard deviation.Out of the seven companies that missed sales estimates by more than one standard deviation, 100% were end-demand companies.
There are several conclusions one could draw from today's column:
- The third-quarter beats were overhyped as they are the outgrowth from lowered guidance.
- If one divides the third-quarter earnings reports
by end-market categories, differentiating between the beneficiaries of restocking and those companies that are closer to the end markets and consumption, it leads to two different pictures as to the health of corporate earnings.
- If end demand doesn't pick up (and pick up quickly), the 2010 earnings outlook for many industries (such as semiconductors and other beneficiaries of restocking) will be in jeopardy, as will be the now ambitious consensus for S&P 500 earnings of over $70 a share next year.
Earnings Season Is Underway Look closely at the chart above. You will note that the last time the majority of companies failed to beat analysts’ profit expectations was the beginning of 1996. With results like this, why did the stock market ever go down in the last half-generation?The answer lies in when the estimates are taken. The study above is based on the last estimate before earnings are released. We have likened this to the point spread in a football game getting reset with 1 minute left to play.What this proves is investor relation departments have become very good at gaming the system. They do everything in their power to make sure the headlines say their company beat earnings estimates. But, beating the last estimate has no economic value. To gain any insight on the economy based on earnings estimates one must take a longer-term view. In actuality, earnings forecasts are worse now than at any time in human history. As the chart below shows, the decline in earnings in the last year was worse than any decline in the last 140 years ( no typo). The data comes from Robert Shiller who got it by way of the Cowles Commission.Do you recall anyone forecasting a biblical collapse in earnings? We do not. In fact, Dr. Jeremy Siegel set records in tortured logic to explain this was not happening last February.Rather than writing about rebounding earnings, a more interesting story might look into why consensus estimates have been so horribly wrong lately. Do the forecasters understand the degree to which they missed, and have they changed their methodology at all to avoid a similar fate should this happen again in the future? Only when these questions are answered should anyone pay attention to these highly inaccurate guesses.
