Case, Shiller and Michael Lewis

| About: ProShares Short (SH)

Has anyone yet drawn the parallel between "Liar's Poker" and what's going on in the market right now? A friend of mine who has no particular vested interest in the stock market used to say "I don't keep up with the stock market, it's just a big Ponzi scheme." An interesting viewpoint, though I don't necessarily agree with it.

It has occurred to me recently, though, that what's been unfolding with most of our nation's largest financial institutions is a bit of "we've all been playing Liar's Poker for an awful long time now, bidding the stakes up higher and higher, and as is the nature of the game, only one player (JPM, at least for the sake of this metaphor) can win and everyone else (including the taxpayer) loses." The unregulated CDS market (along with irresponsible business practices and outright negligent management) turned our financial markets into a gambling system, and effective regulation of the CDS market must be a cornerstone of rebuilding our financial system.

I'll now point to a previous post and say that, if you're just looking for a trade, read the first and last paragraph of that post and my thoughts below. If you're interested in AIG, CDS (the contracts), and what all is going on with the break in our market right now, read the whole (previous) post. The gist from a trading standpoint is, when AIG reported on 3/2, I decided that the S&P index was a good sell from 700 to 600. The Henry Blodget SAI post I discuss in the last paragraph of that post suggests a 5-8x P/E multiple on the S&P is a more likely nadir based on the current market/economic environment. So, just to establish a low watermark, if we go 8x $55 in 2009 S&P earnings, we get to 440.

*Technical note: you can read the Blodget post (please spare me the embarrassment of your thoughts on anyone who listens to Blodget for trading advice), but he uses a Shiller P/E method that normalizes for cyclical earnings fluctuations by looking at a 10-yr avg/normalized earnings number. There is no perfect earnings measure in this kind of economy, but Shiller's approach is as good as anything I've come across. Please share your suggestions in the comments.

I don't go calculate current consensus on 2009 S&P EPS myself, partly because it would be a waste of time, but my understanding is that we've already gone from $65 to $55 in the past few months, so $55 is probably a better-than-base case estimate, as that number may still be on the way down. So I'm taking the high end of Blodget's suggested range (being optimistic, within that framework) and applying that to the $55 EPS number. Looking at the same items another way, we could be more sanguine on the "bottom" multiple and assume that 2009 S&P EPS continues its downward revision trend and gets to $50, which gets us to 10x = $500, a calculation I've heard mentioned in the financial press, which implies a bottom of 500 for the S&P.

What I'm getting at is, I decided I could trade the S&P from 700 to 600, and it probably wouldn't be a bad trade to initiate it now and take it from the 680 range down to 550 over the next couple of months. If I had more "sack," or more risk capital, I'd probably add to the trade and look at 550 as a reasonable point to close out.

As I've discussed in the past, I also believe that a meaningful deceleration in the big negative YoY numbers we've been seeing in the monthly Case-Shiller releases will touch off a pretty healthy rally in stocks. I could discuss which stocks I'd jump into at that point, but that's another post. From a trading standpoint, I just wanted to make the point that I think you can probably trade the S&P down to 550 or below, but as I'm not as risk-loving as I used to be, I'm not going to try and call the exact bottom. Again, I recommend watching the Case-Shiller numbers, and I believe that's a good way to participate in the next meaningful rally, when it comes. I've traded the Proshares SH Short S&P ETF. Honestly, I don't know the best long (not "ultra," though of course that's another option) S&P 500 ETF. Hopefully readers/commenters will share long S&P ETF suggestions though, honestly, I haven't gotten near to that point yet; I'll probably take a look before the next CS report.

Beyond that, I'll also opine that the next big rally won't necessarily signal the end of the bear market, or rather, that I'd expect to see the market move sideways for a period after that rally, and I think that will just be a stock picker's market.

Disclosure: Author holds a position in SH

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