9 Reasons Why We Are Close to, If Not Past, the Bottom 26 comments
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As many readers recall, I was INCREDIBLY bearish beginning in the summer of 2007 after nervously watching what was being seemingly ignored but was increasingly playing out to be the disaster scenario we hear about ad nauseum now. I continually reiterated my concerns for the next several months despite the uptick in the market.
One of my favorites, that I originally titled "Time to Build an Ark", was changed by the editorial staff of Seeking Alpha to "It's October - Should We be Buying?, in which I projected an 1150 S&P 500 right about now. I typically tend to be early (yes, I lost money shorting internet stocks in late 1999), and I walked away in May from my earlier predictions that the Bear Market would end in the Fall.
I have contended (and still do) that money can be made on the long side, but it has been tough. I believe though that it will soon be a lot easier. I am no Pollyanna - we are indeed facing economic challenges of epic proportions - and not just our country. I want to share some observations and data that I believe support that there is enough blood in the streets and a high enough awareness of the problems (and a pathway to their solutions, which will still take considerable time).
Love him or despise him (I actually do both, but that's a different story), Jim Cramer, the pundit for the masses (and the pros, who would never admit it!), is one to watch. Just like his berserk Bernanke beseechment a year ago (he was right to worry, but he didn't have the right solution), Mr. Cramer is a bit EMOTIONAL right now. He continues to advise everyone to sell, sell, sell. "It's time to be defensive." It's not just him - it's everyone!
My clients, my friends and family, the media - almost everyone that I encounter is petrified. Where were all these folks a year ago? It seems to me that when almost everyone is negative, it's probably not a great time to "sell, sell, sell".
So, what am I seeing that gives me some confidence that we are close to if not just past a bottom? Here is my list, in no special order (except the best for last):
- It's that time of the year
- We got the spike in VIX
- Credit Spreads reflect dire pessimism
- Put/Call and sentiment ratios reflect dire pessimism
- We have a "confirmed rally" according to IBD
- Market strength in early recovery sectors
- Valuations are extremely low
- Rates are likely to stay low
- ***The right solutions are in the public domain now
Hitting the points in order, it is worth noting that every bear market in my 43 years, has ended between August and October (1973-74, 1982, 1990, 2001-2002) and the sharp declines of 1987 and 1998 as well. I don't believe this to be coincidental, as the end of the summer vacations, the focus on the balance of the year with respect to earnings, and perhaps the quarterly tax date of 09/15 all contribute. In any event, one can't assume that just because we are in the right time of the year means that it is automatically a good time to buy (1973 and 2001 certainly weren't!), but it is one supporting element.
The next three points all relate to measures of confidence. Implied volatility in options spiked to extremely high levels; sentiment, measured by either survey or put-buying relative to call-buying, moved to rather extreme levels and the TED spread (or swap spreads) moved to all-time highs, reflecting a preference for cash/Treasuries. In other words, while stocks are acting poorly, it isn't in a vacuum. Clearly, there is extreme pessimism. One doesn't have to do much more than open one's eyes and ears, though, to make that observation.
Investors Business Daily [IBD], a paper long published by the brilliant William O'Neil (I subscribed to his weekly charting product as a teen in the early 80s), daily issues its characterization of the market. Based upon a set of rules developed over many years of observations, the paper declared on Thursday night that we are in a "confirmed rally".
For those not familiar with this work, you should visit www.investors.com to learn more - it is worth one's time. In any event, to be in a confirmed rally, the market has to first stop going down, which is measured by a large increase in a major index after marking a new low (i.e. Thursday a week ago). To earn confirmation, the market must maintain those lows and at some point on the fourth day or later (though much later is usually indicative of a weak rally ahead) increase in price in excess of 1.7% on an increase in volume.
So, before you go load up, do realize that though no rally takes place without these conditions, the existence of these conditions doesn't necessarily promise a rally. All it says is wake up and look at leading growth stocks, according to Mr. O'Neil.
The "confirmed rally" ends when the prior low is taken out or perhaps later when "distribution" (heavy selling) hits the market. I urge you to give this objective analytical framework some attention despite your being perhaps unfamiliar with it. I believe that if you were to sell the market now, it would be analogous to taking a hit in blackjack on 16. Good luck with that!
Stocks have been bashed, no doubt, and it seems to be getting worse. In fact, we made new lows this month in the S&P 500, the Dow Jones Industrial and the NASDAQ. I found it curious that the Russell 2000 and the S&P 600, which consist of smaller companies, preserved the double-bottoms from earlier this year (January and March).
This is an interesting divergence. One explanation is that smaller stocks tend to be viewed as riskier and fell further and faster as liquidity dried up. Perhaps they got "too low" earlier this year relative to their fundamentals. Also, the larger companies tend to be more multinational, and the moves in the dollar (weakening and then strengthening but relatively unchanged now in 2008) could explain the relative performance as well.
In any event, I am encouraged by the strength. I do acknowledge that part of it may be due to the hedge-fund community getting a bit too aggressive in its shorting and throwing in the towel. This was clearly evident a week ago Friday (9/19). In any event, take a look at the chart below (click to enlarge) and you can see the clear better performance of smaller stocks this year and this quarter.
What strikes me as an even greater divergence is that Financials are ZOOMING, especially smaller companies. I have written on several occasions that the smaller companies could benefit from the demise of overleveraged large competitors. I own Cullen Frost (CFR), for instance (you can see all of my holdings for other Financials), which I wrote about in February (as well as subsequently when I put it in my Conservative Growth/Balanced model portfolio).
Despite the massive wealth destruction of certain large Financials this quarter, the overall value of large-cap Financials has increased 5% QTD compared to the S&P 500 falling 5%. Surely, some of this is just a correction of perhaps overly pessimistic pricing after the July lows, but it sure looks like THE LOW is in for the sector.
So, the headlines are as ugly, even uglier than one could ever imagine, but the stocks are UP this quarter. Maybe some of it has to do with the new shorting rules, but I would note that the stocks have actually declined since they were implemented.
While Healthcare and Staples aren't too surprising as relatively strong performers in a weak market pricing in recession, what's up with Consumer Discretionary? Across market capitalizations, it is up this quarter, no doubt a function of the collapse in energy prices. I guess that I conclude my review of returns by saying that if the world were really coming to an end, I don't think that small stocks would be up on the quarter as well as Financials and Consumer Discretionary. These areas are what one would expect to be leaders in the early part of a recovery.
Stocks are in many ways quite inexpensive. Whether one looks at the broad market or individual stocks, PEs are relatively low. If interest rates rise dramatically or the estimates prove to be way too high (and they are too high - see my recent article), then the low valuations won't be as low as they appear. Given the severe economic headwinds for the consumer, I would expect rates to be low for some time.
The inflation threat has passed - we are back on disinflation (if not deflation) watch. The earnings estimates will come down soon, but the low valuations seem to more than compensate. As I look out, I expect PEs to improve, perhaps significantly, as the credit crunch passes (let's say in 2010). A year from now, the market will be priced based upon the expectations for 2010. Even if the market earns then only what it earned last year, there is room for the market to advance as the PEs rise (assumes low rates and contracting risk premium). I know that at the bottom of a market, when earnings are depressed, PE ratios should actually rise. That gives me a little confidence that despite my concerns about earnings estimates, the market appears to be able to absorb the cuts. Witness the reaction to the General Electric (GE) warning this week.
One can talk about technicals, fundamentals, valuations and even politics, but it's all for naught if the overall economic environment is so overwhelmingly negative as can be the case when credit is contracting. I was worried a year ago that the only policy response deemed appropriate for consideration was to "cut rates". As many pointed out, this response, while directionally correct, wasn't likely to do anything in and of itself except exacerbate inflationary concerns and destroy the value of the dollar.
Why it has taken so long to see possible solutions has a lot to do with why the problems got to be as big as they were. Nobody cares when everything is OK, especially politicians. For instance, they wait until AFTER the hurricane to address a systemic problem with New Orleans. Well, I digress.
The fact is that we now have the business community, the people and the politicians all aware of the problems and, in fact, working towards solutions that can truly change the outcome by addressing the fundamental problems. I stated a year ago that there is "no rate at which a lender will lend to an insolvent borrower" - just lowering rates doesn't help.
From the Bear Stearns and Countrywide (CFC) mergers to the more recent dealings with the GSEs (FNM),(FRE), AIG (AIG) and now WaMu (WM), it is clear that the officials are working to restore liquidity to the market and to eliminate immediate risks. More importantly, the suggested plans to stop fire sales have the potential to halt the downward spiral. Who wants to buy equity or assets of distressed institutions when there isn't a floor?
The RTC plan, despite many flaws, worked, and it is likely that the measures being discussed too will allow for a more orderly liquidation of distressed assets. There is plenty of "good" capital out there on the sidelines - Mr. Buffett showed that this week with the Bank of Goldman Sachs (GS). It is the progress we are making in dealing with the fundamental problems rather than Band-Aid solutions like rate-cutting (which feels good to all debtors until they realize their rates aren't the ones getting cut) that encourages me the most.
The market has rallied hard in the past when the end was in sight. Hopefully, that will be the case now. I am not that optimistic at all that we are in for a long period of double-digit returns for stocks in general, but I do believe that we are in a position where investing in stocks (and probably corporate and mortgage-backed bonds) will be rewarded compared to investing in "risk-free" assets.
Personally, I favor companies that tend to be smaller but facing large market opportunities with strong balance sheets, but I also recognize that companies that are larger and/or of worse financial position may also offer opportunity here.
Disclosure: Long CFR
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This article has 26 comments:
For people like me, just talking about him voids me out to the rest of your article. Although I did still read it and the thing that still worries me going forward is a possible consumer crash in the coming years along with forced inflation.
But back to Cramer since he ironically is the object of my vent, and to borrow a quote from Buffett, since the tide is gone, Cramer is buck naked to the world now. And that is not a pretty sight!
Deflation?No hyperinflation coming soon in theatres nearby...
with the massive external influences effecting the economy and the market this past week, how was it possible to exclude these factors when reviewing the data to determine the end of a bear market?
is this a continuation of the IBD rallies confirmed on 02/13/08 and 08/15/08?
What about the VIX spikes of 01/24/08 and 03/14/08?
How did you factor in comments like "we are currently facing the worst economic crisis in 100 years"?
Hopefully, the article engages you to ask yourself what is the right price given the facts. What will earnings be? How much should investors pay for them? When I do that exercise, I come up with a pretty attractive pricing in the market, but I know that there is still downside.
1. Technical analysts, and in particular the bottom-callers amongst them, evidently rely on history as a guide to the future. As they look back in their charts in search of comparability, where is it that they find the confluence of a financial system implosion, an apparently deepening economic slowdown, the end of an epic credit bubble, massivley overleveraged consumers, a government risibly in hoc - worse than that, in hoc to foreigners - and a deeply manipulated system of capital allocation which has not been allowed to properly adjust?
2. Why should stock market participants care more about the name of the month than the fact there is a black hole where the financial system used to be?
Believe me, while this may be the worst challenge since the 30s, there have been plenty of challenges since then of significance. To say "don't use technical analysis because this time is different" would be a mistake in my opinion.
By the way, I am not telling everyone to go out and buy stocks - happy days are here again. I thought we had a good bottom in 10/02, but it took 5 months for me to make the bull call back then. I remember it well, as I was on vacation in Panama when it became clear to me. I can't tell you how long it took most of the pros to figure out that the markets had flashed a green signal. I just hope that my institutional clients and subscribers to my model portfolios don't miss out on opportunities to the upside when they do occur. If one is bearish now, one is clearly investing with the consensus in my opinion. That works, until it doesn't work. A sure path to poor performance is to always be on the consensus or always against it. Good performance comes from being in front of changes in the consensus. To do that, one has to understand technicals, fundamentals, valuation and have some good luck too.
Assuming that credit starts flowing again, interest rates will have to go up or we will have serious inflation.
Ask yourself. If interest rates were at 8%, where would the market be?
LordDarley
My second panel is trailing PE - it goes back only to 1989. Currently at 17.5, it is below the median but not an extreme. The times when it was lower, interest rates were considerably higher. You mention that rates must rise, and I don't believe that to be the case necessarily. A sluggish economy typically sees less demand for borrowing. Rising unemployment curtails wage pressures. The slowing of the rest of the world has changed the inflationary thesis. If rates rose to 8%, then stocks would certainly be worth less (absent the reason being extremely high growth in earnings, which is not very likely).
My bottom panel is perhaps the most interesting - the long-term GDP level. While Stocks have grown in the past 30 years before dividends by 8.6%, the GDP has grown by 6.3%. I believe that the decline in interest rates justifies some of the difference, but I also believe that over time equities should grow slightly in excess of GDP growth. If one were to go back 10 years, those two measures were very out of line. In the past decade, stocks have grown 1.5% before dividends, while the GDP has grown by over 5%. Since late 2000, stocks have declined 2.2% while the GDP has increased 4.9%. So, we have seen the stock market come back in line with the general "value" of our economy. It's not an extreme, but we certainly aren't in a situation similar to late 2000 where the stock market is wildly overvalued. If one goes back to the bottom in 2002, stocks have increased just 6.2% annually now, while GDP has grown 5.5% annually. In other words, the ratio of the value of the stock market to the annual GDP is very similar to what it was after one of the worst bear markets ever.
one bitterly cold winter, some horses began running with an improved single shaft sulky, which cut seconds off their times. the crowd did not consider this to be a significant factor in a race, but i did. horses dropping down from canada had been accustomed to facing the cold northern wind. when they joined horses from florida, i gave them the edge. however, when a horse coming from canada wore the single shaft sulky for the first time, i loaded up! (later, when the crowd finally took note of these factors, these changes were factored in and everyone began betting on these game changers.)
in the stock market, a few significant new factors will complement each other to make some stocks overwhelming favorites, in the face of long odds against. when the wind begins to blow cold and the mudders, whose mothers were mudders, are assigned a new post position or the fed changes just a few rules to accomodate them, place your bets and pay your bills.
i still remember being outside on a bitterly cold day, when the number eight horse, romped home ahead of the field, at eight to one, with my hundred on his back and the announcer screaming in disbelief, "here comes... ben loooogan!"
the cash lines are always shorter than the bet lines. so, remember these rules:
1. never bet the milk money.
2. never bet the chalk. if the odds are too short, stay out of the race.
3. "pattern recognition is the hallmark of intelligence."
I have been involved for 30 years in the capital markets and have learned a lot and learned that a lot of "theory" proves only to be that. In the end, the only thing that ultimately works is buy low and sell high (or its variations of buy high and sell higher, etc.!). In any event, I acknowledge with humility that THEORETICALLY PE ratios reflect three variables: Future earnings, the risk-free rate and the risk premium. THEORETICALLY, when the past earnings are "depressed" by slowing growth, skimpier margins, etc. (as is the case now), the PE ratio should be HIGHER than average, all things equal.
Ah, but all things are never equal. Interest rates are low in terms of the risk-free rate (Treasuries) and high in terms of the risk premium (credit spreads). I would make the case that the likely scenario several years out is that there could be some slight upward pressure on Treasury rates, but credit spreads are likely to contract. Ultimately, stock prices should be a function of earnings growth over the next several years.
You make the statement (to which I agree and have put so in writing) that the earnings estimates for 2009 are too high. I believe that rather than the massive rebound that analysts cumulatively imply, we are most likely to see flat to modest growth in the first year of recovery, though 2010 should be more robust. Energy earnings, which have been a huge driver for the S&P are too high. We should get growth from Consumer and Financials, but probably a lot less than expected. Still, keep in mind that these sectors are EXTREMELY depressed. The headwinds for the consumer have been blowing for several years now in fact. This year the S&P 500 earnings are likely to come in at about $75. If the market is in recovery a year from now, a multiple of 20X on a trailing basis isn't extreme at all. That is the low-end of where the multiple was from May of 2003 to March of 2004 (rising from a low of 18. Treasury rates were slightly higher then - 4-5% on the 10yr. That gets us at a potential 1500 on a "trailing 20X" a year from now. Maybe too aggressive. Haircut it to 16X, and you are still talking about a decline of about 10% - not the end of the world. If my expectations for say 82 or so in 2009 are right, and the year-end trailing multiple falls to 16 two years from now, the market will still be higher in two years (not much, at 1300).
Please don't mistake my position for being a superbull - I can't get there. Rates are low, the future economic growth will be somewhat muted most likely. My point is that it is highly likely stocks reflect this scenario. There is probably a nice tradeable bounce here, but the more important point is that people shouldn't abandon their long-term investment strategies today. It requires two good decisions - getting out at the right time (which was blown already, quite frankly, but could still prove to be "not too late"), but, perhaps more challenging, especially if the first decision proves wrong (but even if not), getting back in.
Personally, I got out a bit too early (last summer rather than in the fall), and I got back in a bit too early in many regards (the March lows). My focus, for the most part (with a few glaring exceptions), has been smaller companies that in fact have done well since then. For me, it is harder to buy in after stocks "feel good" than to take a bit of pain by anticipating a bottom.
I also think that it's entirely possible for the S & P to rally as much as 25-30% in the next 6 to 12 months. This would not be as bullish as it appears on the surface. A 25% rally from here would only take the index to 1500, at which point it could peter out without making a new high. If this were to happen, it would fit with my view of the economy being mired in low growth/mild recession for longer than most expect.
The key, of course, is how to play such a robust rally in a very weak economy. And the question that is on almost every investors mind right now is- which investments should I avoid today? The fear of meltdown and a return to the great depression is palpable. It's primarily because of the pervasiveness of this fear that I end up agreeing with you- we must be near the bottom.
The growth engine of the USA has been exported to keep costs low for companies selling in the USA. As the developing countries raise their standard of living, each one fades as the preferred supplier. Japan yielded to Singapore which yielded to Hong Kong which yielded to Korea yielded to Taiwan yielded to Malaysia yielded to China and India which will eventually yield to someone else.
We are actively exporting our computer knowhow so other people will benefit from the manufacturing operations.
If we came up with an economical way to generate energy from the sun, etc. the salesmen would make money but the manufacturing would be subcontracted to the world. Thus the wages are exported and the profits go to the company owners who invest it overseas.
It is hard to see a return to the "glory days".
valuestockinvestors.bl...
Yes, the doom and gloom is palpable right now, but I do agree with one thing the rate of fall of the market has slowed despite the volatility. There definitely is resistance, but ask yourself why is it there, and what news could come out to significantly make it more negative? I guess if the US went insolvent, but who is left to fail that is bigger than already too big to fail companies? JPM, BAC, GS? Not much left.
Globalization has been a HUGE fiasco. A few crooks at the top make the lion's share of the profits, and consumers face job pressure and wage stagnation, leading to less CONSUMPTION. Excessive greed always bites you in the a**. I'd like to see all the trade deals, starting with NAFTA renegotiated so Americans actual get a fair shake.
As for bottom-fishing: I think if the spring home buying season upticks, maybe it'll mean an uptick in the economy. As we stand, I'm predicting a pretty weak "Black Friday".