Archive for May, 2013

Market Falls 2.32%

Wednesday, May 22nd, 2013


It was an ugly day in the market in spite of the fact that it looks like a less than 1% down day.

How can that be? The market started out its normal ramp higher on no fundamentals (but on plenty of Fed stimulus and talking heads on television telling us why the market can’t go down), peaking at 10:30 EST. Then, its being reported by Doug Kass on his blog, the machines took over when a sell program clicked in when the yield on the S&P 500 and the 10-year Treasury Note hit the exact same level:


I am looking at this as a 2.32% drop because from the top today (1,687.18 on the index) to the bottom (1,648.86 on the index) the market fell 2.32% – and subsequently recovered 0.35% into the close.

The above graph, courtesy of the Zero Hedge blog, shows how the two yields have been trending in recent weeks – as the stock market has moved higher, the yield on the S&P 500 Index has moved lower.

At the same time, the upward trend in yield since last Summer (as we’ve noted here on this blog a few times) – and in particular the big run up in the past couple of weeks since Japan started its own high octane money printing – has taken one of the support legs out from under the stock market.

If you are one of the people that has started to buy stocks for the yield this year because your CD’s and government bonds just weren’t paying anything – you now have a dilemma: do you continue to accept the added risk of investing in the stock market in order to get a 2.03% average yield on the market or do you invest in a 10-year treasury note with no credit risk (and no risk to your principal if you intend to hold the note until maturity)?

What you might see here is that if you bought into the stock market this morning at a 2.03% yield and the market dropped 2.32% from its high to low today, you are actually in the red, losing more on the principal of your investment than you will earn in dividends over the course of the entire year.

Now, the stock market does not exist in a vaccuum and people who are buying stocks for dividends aren’t buying the S&P 500 index in most cases. They are buying something like the Dow Jones Select Dividend Index that yields 3.33%, or one of many individual stocks that is yielding over 4%, to get some sort of realistic cash flow to live on. But how many of them will get scared by this sort of drop in the market and begin to sell their stocks because they cannot stomach to see their investment fluctuate in value (particularly downward)?

It is hard to say exactly, but based upon the 30+ years I’ve been in this business, a significant number of them will be sellers if this sort of thing continues. It happens every time we see the market go up for an extended period of time – people who are not stock market investors, who have lost significant amounts of their wealth in past corrections/bear markets/crashes and vow “never again” get convinced that markets can only go up and they are missing an opportunity. When they get in, it is time for us to be sellers and raise cash.

This past experience is widely known and understood by professional investors, and it is why the computerized traders set the parameters in their automated sale programs to automatically liquidate stocks when the yield on the stock market fell to match the yield on the bond market.

The question is, will this be a one day event (if the past six months is any indication, it very well could be an isolated instance – and after hours, the market has recovered 0.18% which might give credence to that one day assessment) – or will this be a multiple day event that will allow us to move back toward the 200-day moving average, a healthy situation that could provide the basis for a move to even higher highs by year-end.

Earlier this year, I posted a graph I really like that is correlated such that it is a leading indicator of the S&P 500 Index: the Mortgage Finance Index.


You can see how it (the red/black line) turns up before market rallies and down before market pullbacks – and it is still pointing down which could very well mean that the one-day theory won’t play out.

Another indicator that has a good track record is the CNN Greed and Fear Indicator:


This comes from the Market Authority newsletter, but the way it works is that anytime the indicator reads > 90, you have extreme Greed in markets and within a week the market pulls back. You can see that we are at 91 on the index as of earlier today. This is another indicator that would likely point to the one-day theory being wrong, particularly if those new to the stock market decide to minimize or cut their losses and not experience a large pull back similar to some experience in the past – which ultimately leads to a self-fulfilling prophecy.

The final thing that has me thinking that we can see more than one-day down this time is that the hedge fund momentum driven stocks that have been a big part of driving the stock market higher were crushed today (as reported by Doug Kass):

OpenTable (OPEN) -6.2%
Zillow (Z) -6.2%
Herbalife (HLF) -5.8%
Green Mountain Coffee Roasters (GMCR) -5.8%
LinkedIn (LNKD) -4.5%
SodaStream (SODA) -4.2%
Netflix (NFLX) -3.8%
lululemon athletica (LULU) -3.1%

Momentum investing is a strategy that aims to capitalize on the continuance of existing trends in the market. The momentum investor believes that large increases in the price of a security will be followed by additional gains. The strategy looks to capture gains by riding “hot” stocks and selling “cold” ones. To participate in momentum investing, a trader will buy an asset, which has shown an upward trending price, not based upon any fundamental aspect of the company other than its price is moving higher. The basic idea is that once a trend is established, it is more likely to continue in that direction than to move against the trend.

Unfortunately, when a momentum trend breaks, it breaks in a significant way. A good recent example of this is Apple losing 40% since September. And, many of us know someone that quit their job in the late 90’s to become a day trader and their boasts of how easy it was to make money in the market – where are they now? Likely not day trading as a career.

I’ve written here that the fundamentals of the economy, corporate earnings, and valuation would eventually matter to equity investors. There is no way of knowing if we are at that point or if today’s pullback will be shrugged off and the liquidity driven market moves higher on the backs of these hedge fund darlings.

My view is that the risk continues to be to the downside for the market and having cash on hand is a smart move long-term, no matter how dumb you look for not gambling alongside everyone else (and absent fundamentals, this year’s liquidity driven P/E expansion is really just a bet that the market will continue to move higher – much like the momentum driven day traders bet their family savings, kids college funds, etc., in the 90’s).

I will happily invest the cash we have been accumulating into some very good companies 5%, 10% or 15% below current prices. Investors need to look at the market with a 20-year time horizon and not a 20-day or 20-week horizon. If you are a winner over 20 years because you focus on fundamentals like earnings, valuation, and risk management – even if you underperform for periodic 20-day or 20-week time frames – you make a lot more money by focusing on the long-term.

We began to buy some very good companies as they pulled back 10% to 15% over the past few weeks – if we can get a broad sell-off that takes the rest of the market down to reasonable valuation levels, we will put the rest of the cash to work we have on-hand. Otherwise, we will continue to be selective and focus on the fundamentals and so we can continue being long-term winners.

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Make your bets in Las Vegas, not the stock market.


A Good Thing?

Wednesday, May 1st, 2013


The graph above comes courtesy of the Zero Hedge blog, and shows the Chicago Purchasing Manufacturers Index dropping into recessionary territory. This is an economic indicator that I follow fairly closely when it is released each month because it is a fairly accurate representation of US economic activity.

Readings on this index above 50 tell us that the US economy is expanding. Readings below 50 tell us that we are contracting. This week’s release of the April numbers showed a drop to 49, a 3 1/2 year low and the first reading in recessionary territory since the recovery began in 2009.

If that isn’t enough, take a look at this one:


This graph, also from the Zero Hedge blog, overlays the US Macro Economic Index over the S&P 500. Its pretty easy to see that this indicator of economic activity is confirming the Chicago PMI reading of economic doldrums in our country.

However, the perplexing thing is that the stock market has continued to move higher in spite of the economic signs that the country is in trouble.

Over the past couple of weeks, we’ve seen the following announcements:

>First quarter GDP came in at 2.5% instead of > 3% forecast

>Durable Goods Orders were down -5.7% compared to the -3% estimate

>The Dallas, Philadelphia and Empire State PMI’s all came in below expectations

>March Existing Home Sales report showed significant weakness

>Corporate Earnings Reports have been ugly, with such big names as Apple, Exxon, IBM, Amazon, MMM, AT&T, Procter & Gamble. Intel, Qualcomm, General Electric, United Technologies, United Health, JPMorgan, Wells Fargo, Bank of America, Morgan Stanley, Goldman Sachs, Caterpillar, McDonald’s and Starbucks all missing their earnings estimates.

But what has the stock market done? As you can see, its gone up.

Everyone knows that I have said (for a few months now) that the market has gone up unsupported by the fundamentals. It has gone up based upon the fact that investors are buying overvalued stocks because they believe the Fed liquidity will keep pushing the market higher. So far, they’ve been proven right and I have looked wrong.

However, at some point, earnings and economic fundamentals will matter and all of this move – or at least most of it – will be wiped out in a correction that will take 100 or 200 points off the S&P 500 Index.

Looking at a fair value for the S&P 500, if you take trailing 12-month operating earnings per share of $97.53 and multiply that times an average P/E ratio of 15, you come up with a value of 1,462.95 for the index compared to 1,582.70 where it stands now.

If we were looking at a period of time where corporate earnings were going to explode higher (8% higher earnings growth would give a fair value of 1,579, or roughly where we closed today), then you can justify today’s prices. But, as you can see from the list of companies that missed earnings and lowered their forward earnings estimates, that its likely not reasonable to expect earnings to explode higher.

What we are seeing is called a P/E multiple expansion. Investors are pushing the price of the index higher, increasing the P part of the equation, while earnings are flat to contracting, lowering the E part of the equation. This is really not a sustainable situation, but it is one that can continue on for some time.

What we could very well see is a rolling correction instead of full market correction. A rolling correction is one where various economic sectors of the market fall in price while others continue to move higher.

If you check out the year-to-date performance of the various economic sectors of the market, you will see that we have in fact been experiencing a rolling correction:


You can see that the defensive areas of the market (Utilities, Staples, and Health Care) are all performing quite well, but that the other economically sensitive areas of the market are in trouble.

But, with the report from Procter and Gamble this week, and many of the other S&P 500 leaders listed above, check out what has happened to the sector performance over the past week:


Technology has made a big push higher from its YTD depths as investors have begun to shift money out of overvalued defensive areas into the undervalued areas.

One week doesn’t make a trend, but if this investor action continues, we will likely see the losing sectors YTD begin to be winners and the winners YTD fall – all with not a lot of impact on the overall index.

In anticipation of this happening, we have begun to add to the YTD losing sectors, putting some cash to work – not a huge amount, but selectively buying when the market gives us an opportunity. For example, we picked up some IBM at $192 and its now trading just below $200; some Caterpillar at $80.53 which is now trading for $83; some GE at $21.72 which is now trading at $22.15; some Intuitive Surgical at $471 which is now trading at $490; some Gold Miners Index find at $28.36 now trading at $29.65; and some others.

We are entering the critical “sell in May and go away” time of year, so we do not want to be overly aggressive.

On a final note, I wanted to show you the year-to-date performance of various sectors of a balanced portfolio:


An interesting thing I want to point out is that if you look at the performance of the index itself, you see that YTD the S&P 500 is up 10.97%. However, if you look at the individual sectors, Utilities are up the most on the year at 7.5%.

What we have is a situation where investors are dropping a lot of cash on mutual funds who are buying S&P 500 futures that are driving up the performance of the index itself but the actual companies in the index are not performing. This happens from time to time and it is just not sustainable.

If you were in a typical balance portfolio that is 65% equities and 35% fixed income, your YTD performance would be roughly 4% based solely on the index numbers above.

If you were in an all equity portfolio diversified across all sectors, included both large and small cap stocks, and included both domestic and foreign stocks, your YTD performance would be roughly 4.9% based upon the index numbers above.

The impact of the Federal Reserve’s money printing is finding its way primarily into large cap S&P 500 type stocks through the futures market. Actual company stock prices are less impacted and as you see in the sector detail above, the index is overstating the real returns of the market.

Is the money printing a good thing? Temporarily for S&P 500 index investors the answer is yes, but if history is a guide, at some point both earnings and economic fundamentals will matter again. And when that happens, investors will want to have cash on hand so they can be buyers based upon valuation.

That is still our primary strategy until either we get a correction or earnings and economic fundamentals return to an economic expansion reading. Until then, risk management dictates that we be conservative.

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