The Bear Turns Mildly Bullish

For the past 7 months, I have been negative on the market. While it took a bit longer than I expected for my thesis to play out, I believe that the consensus is beginning to reflect what I believe wasn’t properly incorporated previously. Over the past week or so, I have covered all of my shorts and have actually gone long in the context of playing a bear market rally. I could be dead wrong – I know that it is dangerous to bet against the primary trend, which is now clearly a bear. Further, we are in the middle of a crisis and haven’t yet seen the worst of it. Finally, it seems like just a little bit more of a decline could spark a panic. A prudent person would probably just sit it out if possible, as there should be plenty of chances to buy in coming months. The only person that should buy is the speculator/nimble trader or the person who might get suckered in at the top of a rally.

So, why has this confirmed bear (8/6, 8/22, 8/31, 10/22, and 12/16 are some of the many articles I shared on Seeking Alpha) who expects that we are only about half-way done in terms of price declines and quarters away from a bottom going on the record with his own investments, his advice to clients and his published articles expressing optimism? In a nutshell, it is WAY overdone. The seasonal patterns were inverted in late 2007 – the typically weak September/October period surprised to the upside and then the typically strong close to the year was disastrous. As I wrote recently, this behavior flagged a bear market. Well, in January, we have had capitulation in what is typically a decent month as inflows are invested and risk tolerance increases. With options expiration passing and so much bad news already out, I believe that we are done (for now).

It sure feels bad. The markets haven’t been like this since 2002. The results of my two favorite screens that I run on StockVal every day aren’t helping me at all. One screen, designed to identify shorts (or sale candidates) and that I shared in September, has been slim recently. For the first time, it gave me an error message today: “There are no stocks passing this screen.” This is a bummer, because I have found some great ideas off of this screen. What it tells me is that the cat is way out of the bag. On the other hand, the other screen, developed to identify smaller, undiscovered companies with high growth and reasonable valuation, is kicking out only two names. At year-end, there were only six. In a typical month, there have been 10-15 names meeting the stringent criteria. This tells me that people are selling the momentum stocks too (relative to the market). While the lack of output from my screens speaks loudly to me, I doubt that it is enough to convince the reader. So, here are some other observations:

• The market is oversold (see chart)
• Sentiment (measured in many ways, but P/C ratio for one) is extreme
• Treasury yields are the greatest contrarian indicator – way too low
• Dollar decline may be over as solutions beyond rate-cuts are explored
• Financial stocks have retraced 70% of their rise from 2002-2007
• Consumer Discretionary stocks have retraced 56% of their move
• The largest banks will all have reported after BAC on Tuesday – the news is out
• ABK and MBI are already assumed bankrupt for the most part
• Financials are having little trouble raising capital (don’t get excited!)
• The newspaper headlines reflect recession expectations
• We are near long-term support levels for the oversold R2000 (see chart)
• Investors rotated last week into Consumer and Small-Cap and out of Energy
• Friday’s action had the “safe” Health, Utility and Consumer Staples leading down
• The rolling over of the leaders is a sign of capitulation (as expected)
• Cash must be burning a hole in the pockets of institutions!

When I take all of this into account, I conclude that playing from the long-side is safer than the short-side. I have written about many of my shorts, most of which have fallen so much I couldn’t maintain the positions even if I felt that the market were going to keep dropping. The dogs have been run over, and the kings have been kicked off of their thrones. So, how can one best go long in this environment? For long-term investors, I continue to believe that this year will treat Healthcare the best. I wrote about 7 stocks to own two weeks ago, the last two of which I purchased this week. I would suggest that biotech should work – I described my favorite ETF for the sector in December, SPDR S&P Biotech (XBI). It will be interesting to see how well the sector does if we do rally. The rally’s potential will be suspect if they lead the way short-term. I think that Consumer stocks could lead the way in this rally, as they are extremely cheap.

I also believe that Financials are due for a rally and have purchased the ETF Financial Sector SPDR (XLF). Do be careful there, as the reward could be great, but the risk is still very high. It is quite possible that THE lows are in on that sector, though I expect a long base rather than a v-shaped bottom. I think that small-cap could perform best short-term. Finally, many of the leaders that have been whacked hard are likely to draw buyers. Don’t get carried away – it’s just a rally! Hopefully, a rally!

Disclosure: Long XLF with a very short leash

Comments

[User 132822]

The news from Europe and Asia indicates that your going long is a bit early. On the other hand, time will reward the buyers even if you could buy a lot lower in a couple of months.

[robster]

go long mid 2008.

[AlanBrochstein]

Yes, I feel a bit premature! It looks god-awful frightening.

[Peter Davis]

Well, that's about the dumbest thing I've read in a while. Basically, you're saying that the market must be capitulating because things are so bad. Good thing you wrote it before today's selloff.

Why is everyone trying to call a bottom? This market shows no signs of capitulation, just more and more selling.

[mmmparsley]

Some Russell 2000 stocks can't go much lower. Many are trading well below book value as if these mid-tier companies are bankruptcy candidates - and they most assuredly are not.

The market is way oversold, and we're seeing traders heavily margined forced to capitulate to savvy trader who are scooping up shares at a bargain.

There is no reason for Asia to go down. Many countries are still trading at 10-15 PE's and have very significant positive balance of payments. Asian consumers have only begun their spending spree. Many of these companies are trading at VERY low PEG ratios so there is plenty of room for slowed growth already priced into these foreign equities.

The only market that is still arguably overbought is in Shanghai. US traded Chinese ADR's are valued rather nicely right now, with a few expections such as BIDU, CTRP etc.

Fundamentals are all that matters in the long run - and stocks are fundamentally undervalued even when adjusting for slowed global growth.

[A.S.D.]

Alan, do you still think so, after today? A serious question.

[mmmparsley]

Wake up. We aren't lemmings, we are investors.

Volume is not higher than in mid-August. What you are seeing is a bubble bursing stemming from heavily margined accounts. Corporate earnings are slowing, but global growth remains strong. Even if it didn't, the cash printing press is flooding the market with new cash, so unless you think none of that cash is going to find it's way into the equity market you should be holding tight through the drop.

International growth is still very strong and most country's PE's are still rather low - especially considering the torrid growth rates. Slowed growth is more than priced into foreign equities right now, so put 2 and 2 together and realize that the heavily margined are paying a severe price for their greed right now. We're putting the flailing out of their misery while rewarding those who put capital aside with very cheap prices on equities.

[AlanBrochstein]

At this moment, I certainly regret my own position as well as sharing with the world that I have relaxed my bearishness near-term when I do maintain grave concerns about the balance of the year and the recognition that I am underestimating the near-term risks of a major crash. Predicting an exact level or an exact time-frame is obviously challenging. I became very bearish in July, yet it took quite some time to play out. In both 2001 and 2002, the path towards signficantly lower prices was paved with brief but powerful trading opportunities. I do sense that we are near one, but my confidence level is certainly not that great. So, in response to the question from "foreigner", I say yes, I still think so, with the continuing caveat that this is a high-risk call only for speculators/aggressive investors as I mentioned in the article.

[CasinoTony]

"Hold on tight to your dreams." It's a Honda Accord commercial but holds true for the common investor. DO NOT PANIC, DO NOT SELL YOUR HARD FOUGHT SECURITIES. When you purchased your securities was it a value tested buy -or- a speculation? If a spec, sell it when you can, if a good company, hold for the long term. GOOD LUCK.

[hammerhead]

Crashes do not come from overbought markets. They come from oversold markets. By your own admission, this is an oversold market. 25% of the US is in serious recession, 5 out of 7 monolines are toast, cash strapped states will have to raise muni bond yields in order to borrow in this uninsurable market, the weak GSEs are the only entities holding up what is a modicum of a housing market, we are the greatest debtor nation in the world, our citizens can't pay their credit card debts, our banks need infusions of foreign capital to stay afloat, our troops and resources are bleeding in Iraq, and we have a financial genius for a President. Yep, no reason for this market to continue its decline.

[mmmparsley]

Hammerhead,

I totally agree with you that the US markets that operate and sell their products within this country are going to struggle. However, with inflation running rampant, do you really think the DOW is going to go down when it's pegged to the dollar? I'd rather have my money in producers than in cash.

That being said, I wouldn't put my money in one of those companies. However, as paper money loses its value, what do you think is going to pick up the slack? International stocks are trading at very attractive PE's after today. Those economies are still going to grow despite trouble in the US. In fact, they developing countries may stabilize their economies more than ever in the past as they stop subsidizing our debt and begin consuming their own resources.

Do you really think that with all the American companies which are world-class innovators with current of potential global products are going to go down in dollar value? The way I see, as new money hits the market, all speculative innovations go up in dollar terms.

The one thing I wouldn't want to be in is bonds. 2008 is going to be the year of inflation.

[NoFate]

Here are some facts:

1) The trend is your friend. The trend is down.

2) DEFLATION is coming. Bank margins are toast and credit is drying up quickly.

3) Loans are future earnings. MEW got spent allready and foreclosures destroy wealth ($2-3 trillion problem).

4) It doesn't matter how F-ing great America is ...recessions happen. Always have and always will.

5) Cash is KING! BUY LOW ...wait for a true bottom, don't catch a falling knife.

6) Equities can ALWAYS go lower. NASDAQ went from >5000 to 1200 in 3 years. Anyone want to argue this point.

7) The Decoupling theory is BS. Emerging Markets are going down also. They may go from 12% growth to 4 or 6% ...but you think this is not going to affect their stock price??

8) Stock valuations are based on FORWARD looking PEs. Wall Street still thinks US earnings are going to increase 14% in 2008 and this is what the E in the PE is based on. Goldman finally came out with -6% recently. How do you think this is going to affect things?

Any more questions?

[NoFate]

7 con't) US consumes 40% of World GDP. Our economy is $13 trillion ...India and China combined is around $2 trillion. They are sceeee-rewed without the US consumer.

[TexasRadio]

"Behind the financial storm tearing at the world economy is one of the biggest asset bubbles in history"

"The main risk to the world economy is a deflationary spiral in asset
prices"

Those headline quotes are from The Ecomomist's special report of August 2007. Unlike so many contemporary pundits, they do not view the period 1929-1945 as an anomaly. For good reason.

[Ezzyme]

Alan,

Many thanks for your short term analysis. I bought QQQ calls on Friday (along with a couple out of the money puts). The oversold conditions and technical chart patterns have me still believing, but this is a short term trade. I have little doubt that we are heading for a major low in the next couple of months. As I see it, when the Fed chairman goes to congress and asks them to help while keeping the FF rate 1.4% above two year notes and above thirty years, we are screwed. With the Feds latest cash injection auction, the bids were 60 billion for a 30 billion offering at an average of just .05% under the FFR. Think of what the demand would be at 2.5? That's how much the credit markets are being starved. $100 billion fiscal stimulus? US equity markets alone have lost around $3 trillion dollars already! People have been predicting that the consumer is overburdened with debt and will cut back spending, and it hasn't happened - yet. But if jobs start shrinking the third shoe will have dropped. 0% interest rates won't help us then. Funny, having a student of the great depression presiding over what could turn into the next one.

Lastly, corporate margins shrink much faster than revenues, as most have grown, and profits shrink exponentially faster.

[rvantass]

Alan, it is way too soon to call a bottom. With the Democratic candidates all talking about how they are going to save us, and with the negative expectations created by the sag in world markets, my prediction is that the market will open "gap down" this morning, and continue down from there. The rally you expect may or may not develop during the day; my personal belief is that it will not. Today will be a pivotal day in any event, with the volatility providing great opportunities to lose or make lots of money.

[A.S.D.]

Good call so far, if you didn't panic and dump early this morning. Thanks for the article. By the way I'm hoping something positive comes out of this mess such as a ban or restrictions on professional shorting.

[AlanBrochstein]

Shorting isn't the problem. Poor regulation and greed are the issues. No, I didn't panic - bought hand over fist pre-market and then later as well. The rate-cut game is dangerous and argues for more of a short-term rally rather than the end of this downturn. I submitted an article last night highlighting a solution that I think would serve as the basis for a more permanent bottom. I don't expect that a plan such as mine will be implemented until this summer or early fall, but maybe they will pleasantly surprise me.

[A.S.D.]

Alan, what I really hope for is the creation of a new watchdog agency comprised of ex insiders turned whistle-blowers to prvide visibility and to monitor Wall Street/Main Street players. Without those con men's "extracurricular activities" subprime lending and other related issues could not have caused problems of this magnitude. My issue with professional shorts is that they artificially push down the markets below reasonable levels- let's not forget that not all market participants are traders and do you really want to see grandma's retirement account take a big hit? Aside from that my big problem with professional shorts right now is that many of them are the same people who caused this mess on the other side. In US criminals are not allowed to profit from their crime. The same should apply to Wall Street.