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Just Another Day at the Office

On September 24th renown hedge fund manager David Tepper made headlines when he was interviewed on CNBC. In that interview he stated that the market would go up no matter what happened because either the economy was going to get better causing stock prices to rise, or the government would intervene by infusing more money into the system to prop up the indexes. Well, he was right on all counts. The economy did get slightly better; the FED also helped the overall markets by issuing QEII, and, since that day in late September, the S&P 500 has continued to percolate higher going from 1149 to 1300 last Thursday. That's a 22% gain which accounts for about all the S&P gains for the past year. It's been a 4 month ride without much of a breather.

This past week I read Vitaly Katsenelson's The Little Book of Sideways Markets, and he claims that we are in a lateral trading pattern that began in 2000 and could go on for another eight years or longer based on historical tendencies. The last decade was not an anomaly but part of a predictable pattern. Katsenelson displays statistics from the past century of boom and bust periods like the bull market we experienced from 1982-2000 and proves that after each successive out-performance of the market which includes P/E expansion, that these cycles are followed by years of P/E contraction and large swings in the indexes that stay within a range.

This is a thesis I've believed in for many years, but it's a concept that's difficult to comprehend because market P/E ratios have been inflated for 30 years so now it's hard to get your arms around the theory. I now fully embrace it. It's tough to say what the actual P/E ratio of the S&P 500 is because different analysts use different metrics to compute the number. Some use operating earnings, some use reported earnings and some follow Robert Shiller's Cyclically Adjusted Price Earnings ratio. I've looked at all three and compared to historical averages for the index, the P/E ratio looks to be overvalued in my humble opinion. Does this mean that the market is ready to crash or correct? No, not necessarily as the bulls point out. Even though the ratio is high, it can still go higher like it did from 1996 to 2000. However, I'm a believer that the P/E ratio for the S&P will trend lower, below the historical averages, so it has the potential to fall significantly.

In the Summer of 2010 I thought I caught a break in my short positions as the market corrected, but during the so called "Tepper Rally", I have been schooled in my asset allocations. Remember that not only am I short the indexes, but I'm leveraged, too. So if the market goes up significantly, I get taken out behind the woodshed to face the music. Although the rally the last four months has tried my patience, I still believe that we are in for a day of reckoning and will hold steady with my Exchange Traded Funds. It may be a foolish move, but like Vitaly Katsenelson, I am still of the school that the overall P/E ratio of the market is going to contract as the sovereign debt gets flushed out of the system somewhere down the line. When will this happen? It's anybody's guess.

I have made proclamations in previous postings that corrections are coming because of macro economic conditions like the European Debt Crisis of last Summer (and is still going on for that matter, but put on the back burner). However, I will not go out on the limb and tell you that the demonstrations and riots in Egypt are the catalyst for the next market downturn. I've been down this road before without any luck, and it only goes to prove that I don't have a crystal ball. Do I believe this is a catalyst of a market downturn? Yes I do, but only because the market has had an outstanding run and 5%-10% corrections are healthy, even in a bull market. This is a market that has legs. If the toppling of the Egyptian government isn't the tipping point of a downward spiral in the S&P 500, then I'll just have to bide my time.