More Wine With That Turkey?

This post was originally published Nov 28, 2007 on Stockhouse.com http://www.stockhouse.com/Community-News/2007/November/28/More-wine-with-that-turkey-

A year ago, America’s investment community sat down for their annual turkey gorging with smiles on their faces. The S&P 500 had risen 150 points since August without even an inkling of a correction, and economic problems were distant concerns, or only for those in far away lands.

A year later, those same folks might be asking for a little extra wine with their turkey. The S&P 500 is down over 150 points in just over a month and closed last Wednesday just below its open for the year. Most are afraid to go into the office in the morning as bad news is a daily occurrence for the same credit markets that the last five-year expansion was based on.

But still, a debate rages among analysts: Is it a buying opportunity or the beginnings of a bear market? Indicators that most use to try to forecast the outcome are currently coming up extremely mixed, and the result seems to be mass confusion, rather than any semblance of consensus.

Some point to the extremely prevalent Presidential cycle that will keep stocks buoyant until at least elections take place at the end of ‘08. Even more difficult for bears to swallow is the cycle of seasonality, whereby most positive stock market returns occur in the winter months. Some point to the P/E ratio and declare stocks to be cheap. But arguments can be made to the contrary.

Could it be that the seasonal cycle occurred early this year, with investors scooping up stocks in August and bidding them up 15% in just two months? Similar to the Presidential cycle many believe in the four year cycle. But most thought that it made its bottom in the summer of 2006, three years and eight months after the Oct 2002 lows. Now, of course cycles are not perfect or to-the-day type things. If it could happen four months early, could it not happen 12 months late? Cycles are an average result of past events. If they were 100% they wouldn’t exist.

Valuation methods like P/E became popular after the 2000 bubble when stocks went past all historical norms in the “new tech economy.” So now with stocks priced at an entirely reasonable average P/E of 15.5 for the S&P, analysts scream BUY! But could they be forgetting the other half of the ratio? If earnings fall, can that bring the price down without affecting the ratio? Yes, of course.

There are a number of other indicators available as well. Some of them, like the Dow Theory, are over 100 years old. On Wednesday, the DJIA closed below what would be considered its sell signal (Industrials and Transports both closing below a previous low - August). This should be a signal for a bear market. But again, no signal is perfect.

Hope still remains that the credit crunch was just an overblown bad dream, that everything will ”normalize” and we’ll all have a thrifty Christmas. For a while investors thought that a few rate cuts by the Fed would do the trick, but since then the credit markets have worsened and stocks are now below the level they were before they got those cuts. Psychologically, this is very bad for the stock market which assumed that lower rates meant higher stock prices. For the first time in five years investors are being punished for ”buying on the dips.” The fact that this is happening in November could in fact turn out to make matters much worse for a number of reasons. Among them, investors trying to preserve their capital and withdrawing it from the market for holiday expenditures. Additionally, institutional managers trying to salvage their yearly gains and year-end bonuses move money to cash.

It appears that the market is in bear mode and doesn’t want to leave any time soon. With the constant stream of bad news and stocks making new lows day after day it is hard to imagine otherwise. Typical bear market activity is marked by constant declining stock prices followed by enormous rallies that aren’t sustainable for more than a day or two. Bull markets are the opposite. Consistent and measured increases, met with sharp declines. Action over the last month is of the former.

To me, the downside possibilities far outweigh the possibility for a major year-end rally. But there is always the chance of retailers reporting good traffic and sales for the Christmas season. This would probably send the market back into orbit. But given current consumer confidence levels and the limited ability for consumers to take on more credit, how likely is that? Another rate cut by the Fed is expected, but how much that will help matters is unclear. It has already been revealed that the emperor has no clothes.

To conclude, the U.S. markets are long overdue for a prolonged bear market that would wash out some of the excessive speculation and return stocks to more reasonable levels in relation to realistic economic expectations. The market is at a psychological crossroads, where more selling could beget more selling. At these times, it is often better to wait until the dust settles than to attempt catching the proverbial falling knife. Markets generally move far further in both directions than most believe before they change direction.