This has been one of the more interesting weeks I can remember in watching the markets. Why? Because I have a host of indicators telling me completely opposite things.
On the one hand, sentiment is skewed negative and the press is bombarding us with bad news on a daily basis. On the other, stocks look extremely expensive, and complacency is everywhere. I'll present both sides as best I can today.
For the record and to share my process, I'm getting out of the way. I had a host of puts spread out across the board in Canadian Financials, Consumer Discretionary and Staples, and index puts in general. The value of those puts more than doubled over the last two weeks and I reduced my exposure by more than that, leaving me with some limited short side exposure. They have summer expiries. Other than that, I took a position in the double short silver ETF (ZSL) on Tuesday morning.
The Bull Case
Many sentiment indicators are at negative extremes. For example, the Daily Sentiment Index from trade-futures.com reads 3% stock bulls as of last Friday. This is commensurate with both October and November lows. Compiled in a completely different manner are the Investors Intelligence (oxymoron, I know) data. The percentage of bulls suffered a huge weekly decline this week. Again, usually a signal of an imminent low.
The mysteriously accurate Tom Demark Sequential buy/sell indicator (which, I admittedly don't understand very well) is suggesting a monthly and weekly buy setup is at hand.
Even the "perma bear" Bob Prechter was suggesting that now is a good time to cover shorts in preparation for what he calls a "wave 2 rally." Prechter, the undisputed authority on the Elliot Wave Theory believes that the end of Wave 1 is nearing. Ultimately, he believes we are in a "Grand Supercycle" correction greater than the Great Depression and by the time all 5 waves down are complete, the Dow will be well below 1000.
Some of my other indicators have taken a turn for the worse as well. For example, the daily breadth indicator that I cite often:
Additionally, the argument can be made on a number of fronts that relative strength in various markets and sectors is suggestive of a rally. The October decline saw all markets and all sectors making new 52-week lows with almost zero exceptions. So if this was a true "break of the lows" we should see everything participating anew. Here is a partial list of those that have broken their October lows, and those that have held them:
Holding: S&P 500, Russell 2000, Nasdaq Composite and 100, Discretionary Sector, Healthcare Sector, Materials Sector, Emerging Markets, Nikkei (Japan), FTSE (UK), ASX (Holland)
Broken: Dow Industrials, Dow Transports, Financials Sector, Staples Sector, DAX (Germany), CAC (France), MBI (Italy), SMI (Swiss), IBEX (Spain), Eastern Europe and Russian markets
AORD (Australia) and TSX (Canada) are both debatable.
The Bear Case
While sentiment as measured by a number of services indicates excessive pessimism, I really wonder how accurate those measures are. And here's why: Every once in a while I punish myself and listen to the financial news-media for days at a time. I do it in order to get a feel for the overall tone of the market. Normally, I just have it on to listen to something specific, but occasionally I immerse myself in it. My vehicle of choice is Canada's BNN. It is bad, but not nearly as bad as CNBC or Bloomberg. That is, they at least make an attempt at balanced reporting.
Listening to BNN this week and last, I get the opposite feel as from the published numbers; the majority of analysts, pundits, traders, fund managers and anchors are bullish. How can this be? How can analysts be bearish and bullish at the same time? I've come up with a theory to explain this. Quite simply, these folks are saying one thing and doing another.
I see it day after day, and now it all makes sense. Nearly every one of these people are "advising caution" and believe lower prices are "very possible" because the credit market issues have "not yet been resolved." But as the interviews go on, it becomes apparent that these people are not simply sitting on the sidelines and waiting. They're fully invested or nearly so and tout their cash positions of 20%. They all seem to believe that "their" stocks won't be the ones making new lows.
Because BNN is based in Canada, and because Canadian stocks are heavily weighted to the Materials sector, there is a lot of coverage of the major stocks in that sector. During the lunchtime trading hours, BNN has a show called "Market Call" where an analyst or manager comes in to tout his favourite picks, and take calls on listeners questions. Without fail, throughout the course of this program, distressed Canadian investors call in about companies like Suncor, Encana, Enbridge, or many of the energy trusts, all of which have been decimated, and ask "what should I do?"
Over the course of the last two weeks, I've yet to come across one of these guys who advises nearly everyone to sell what they have and wait to buy anything else. They all suggest that everyone should have "a little of this" and "a little of that" in their portfolios.
So if these guys (and some gals) consider themselves bearish, why do they insist on hawking the same stocks that people have been getting destroyed on? Why not tell them to take the losses and wait a few years? The answer to that is simple. It's not their job. They are paid to sell stocks. And the news station has them there to do so. Neither gain any short-term benefit by telling people to go away and come back later. Additionally, they don't know how to do anything other than pick a portfolio of stocks. That's all they've done for their entire careers. Sitting in cash is not something they're comfortable with.
How prevalent is this? How many investors are bearish, yet find themselves fully invested in their "favourites?"
An indication of this potential complacency can be found in the Volatility Index. It has not broken out of its recent consolidation despite the overall markets making new lows or at least re-visiting their autumn lows. In fact, the index (sometimes referred to as the "fear index") is about half the level it was back in October when stocks were at the same price. This suggests that either the fears back in October were way overblown, or we are way too complacent now. See it below:
Another very disturbing piece of evidence I have come across the last few days has been the plummeting corporate earnings (now referred to as "corporate losses"). 93% of companies in the S&P 500 have now reported their 4th Quarter numbers. And they have been an absolute disaster. The total losses amount to nearly $12 per share for the quarter, bringing the full year 2008 reported earnings for the index to $26.16. (Q1 - +15.54, Q2 +12.86, Q3 +9.73, Q4 -11.97). Divided by the price on my screen right now (775), we get a 1 year trailing earnings multiple of P/E 29.62. We are now approaching the absurd multiples reached during the dot.com bubble.
To be fair, these are only 1 year multiples. If this were the only way to determine value, we would have to conclude that after 4 quarters of negative earnings, the S&P should be priced at 0. That is obviously not true. However, the value of a basket of money losing enterprises would not be very much.
Others will argue that these are only "reported" earnings, and if one were to use "operating" earnings we would have a P/E multiple of 14.19. My response to that is: "if if's and but's were candy and nuts..." Operating earnings don't include things like goodwill reductions, plant and property writedowns, and any other losses from businesses that are "non-core". For example, General Electric would only report their performance in selling dishwashers and airplane engines, but leave out losses they've incurred by lending money to people so they can buy those goods. In other words, operating earnings are in la-la land, and reported earnings reflect reality.
To be sure, losses of $12 per share will not occur indefinitely. And companies will at some point write down the value of their assets so far that they have to mark them up again. But that is a long time away.
Indeed, a lot of technical indicators are reading oversold. The danger, of course, in reading into oversold indicators, is that "oversold" can turn into "more oversold." Those that were buying in early October after the indicators were reflecting extremes like those in March or January ('08) got absolutely punished.
Other indicators, like the put/call ratio, are telling us that we have lots of room left to the downside.
All in all, a convincing argument can be made either way. Therefore, I elect to stay out of the way. At least for now.
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