We Have Nothing To Fear But Uncle Sam Himself

No, this won’t be a Limbaugh/Beck/Cato Institute inspired rant against the evils of big government. Rather, today’s commentary focuses on the FUD factor - fear, uncertainty, and doubt – that many small businesses harbor toward where the US economy (and the regulatory side of our government) is headed.

Investors know the adage that the markets abhor uncertainty. In the current economic climate, what should be appreciated equally as much is how uncertainty is playing into a diminished US economic recovery: global multinational big earnings notwithstanding.

When I started focusing on the potential of a bifurcated earnings season several months ago, I noted the risks to the US economy and the need for a sustainable, organic economic recovery. As the primary engine of jobs growth, small businesses are key to a sustainable economic recovery – a point highlighted in my September 22nd David Malpass podcast interview and recently emphasized again in a Bloomberg Surveillance radio interview with the National Federation of Independent Businesses (NFIB) chairman, Bill Dunkelberg.

As Mr. Dunkelberg noted in the November 20th Bloomberg radio interview, normally in an economic recovery one of the first groups out of the box to embrace the prospective better times ahead are small, independent businesses. Optimistic by nature, this group wants to find ways to make payroll and grow their businesses. However, as Mr. Dunkelberg also noted, such is not the case in the current recovery as the normal optimism is absent. In its place is a still very high degree of FUD - much of it anchored in concerns over regulatory and legislative change.

There are two implications to this small business tale of woe – one economic, the other market.

As the recent 3Q09 earnings results demonstrate, the global growth story along with the weak US dollar is benefiting the large, multinational while masking what could be the start of a hollowing out of the US economy. The longer term economic implications are obvious – weakened domestic growth impacting the key jobs engine of the economy, small businesses, limits hiring and wage increases, which further inhibits the US consumer’s spending habits and feeds into the new frugality, which then diminishes the US economy’s economic vigor. When you add to this mix the angst over change noted above, the cocktail you end up with is not a very pleasant tasting concoction.

As for the market dynamic to all this, it is a fruitful exercise to compare the price action of the large and mega cap sector of the market to the mid, small, and micro groups for signs of price performance divergences. If a divergence begins to develop (a point I first noted on September 29th), then a market recognition of the real economy risks noted above will very likely set the stage for a more meaningful market pullback, most likely in the first quarter of next year.

As the above chart* shows, such divergences have begun to occur - the recent highs by the large and mega cap sectors (SPX and OEF) are thus far not being confirmed by the Smids and micro cap groups (MDY, IJR, and IWC). Moreover, the late October/early November pullback made lower lows in the Smids and micro caps but not in the large and mega cap areas. Both market developments are facts that have not occurred since the bull rally got started in early March.

Crying Uncle

Maybe all will be well as the rising tide of big business eventually lifts the smaller boats. Then again, a scenario similar to Japan in the 1990s make occur in which big business exploits their competitive advantage at the expense of their smaller, more domestic brethren via pricing pressures to gain market share. And we all know how that story turned out.

*click image to enlarge

Vinny on foxbusiness.com

Note: If the video isn't immediately available, try reloading the page. It may several tries before the player properly loads.

We (Still) Don't Know What We Don't Know

So, here we are. More than two years into what started out as a credit crisis, one plus year after the Lehman collapse and a question that pertains to the one of the central workings of the equities market cannot be answered.

At last evening's Market Technicians Association Educational Foundation seminar, the question your trusty moderator (that's me) posed to the esteemed panel with its decades of experience was in regards to volume. Specifically, the equity markets' volume as recorded each day for every stock traded. That is, the volume that accompanies the price action that results in the market capitalization of the stock market that results in the market value of every investor's portfolio.

Many market analysts have noted the low volume that has accompanied this bull rally. Some have used this fact as a reason to be more cautious, even bearish. Others have cited that low volume bull rallies have occurred in the past and this one is no different. However, in the past, the volume recorded for equity trades completed were quite accurate and reliable, being recorded on exchanges and reported accordingly. Today, the picture is not quite so clear.

With so much trading occurring in the off the exchanges hidden recesses of dark pools and structured products, I asked my very knowledgeable panel, can any investor rely on the volume figures being generated in this current market to measure the strength of the price action of a stock? The answer received was, "We don't know". Well, if this well connected, highly informed group of individuals doesn't know, you can easily assume that just about no one knows. Do you?

The importance of understanding this issue goes beyond its impact on basic market analysis tools (such as technical analysis) and cuts to the heart of a financial system that is still shrouded in opaqueness.

Transparency remains elusive. Yet, transparency (knowing what investors need to know) is vital to the restoration of a sustained confidence in a system that can be measured. When trades occur in the dark corners of dark pools and other off-exchange structured products, clarity as to what exactly is transpiring becomes the victim and investors seeking to measure the market become the equivalent of a bystander to a drive-by financial shooting.

Investment Strategy Implications

Nothing increases the risk factor of any investment more than the dangers posed by ignorance. Yet, here we are. More than two years into what started out as a credit crisis, one plus year after the Lehman collapse and we still don't have a clear idea of what exactly is transpiring in a central part of the capital markets - equities.

For those who might be tempted to dismiss such concerns I simply point to the two key impacts of changing equity prices: the wealth effect and the cost of capital. Both directly impact the real economy, in the current case in a positive way. Were it not for rising market values, the current government policies designed to rescue the US (and global) economy would be brought into doubt. And doubt, a close cousin of uncertainty, is a bad thing for a fragile economic environment.

Price without volume is an incomplete measure of the strength (or weakness) of a market move. Yet, in the current environment, price is the only metric that can be tracked with clarity. Volume, its indicator of power, cannot.

Two years and running and we still don't know what we don't know.

To further the exploration of what we don't know tomorrow I will describe how hedge fund replication products pose a potential threat to the equity markets.

At the Intersection of Fundamental and Technical Analysis

This evening I have the privilege of moderating a panel discussion for the Market Technicians Association Educational Foundation. My goal is to gain insight into the economy and markets at the intersection of fundamental and technical analysis with my esteemed panel: Robert Barbera, John Mendelson, Jason DeSena Trennert, Louise Yamada, CMT, and Edward Yardeni. Some of the likely questions that I will pose in the Q&A portion of the program that I control as moderator are:

• Will the US economy evolve into a growth period with less reliance on government stimulus programs and more of a self-sustaining, organic nature?

• How will the US jobless rate decline in an environment where the job creation machine of the US economy – small and mid sized businesses – are credit constrained and have limited access to the benefits of a weak US dollar and the global growth story?

• Will the globally oriented companies in the US follow the example of their Japanese counterparts of the lost decade of the 1990s and take advantage of their stronger economic position vis-à-vis the more domestically oriented companies and engage in pricing pressures to gain market share thereby further depressing the economic recovery ability of the smaller, more US centric companies (which thereby further inhibits their ability and willingness to hire)?

• Is the third question noted above the reason why small and micro cap sector have been lagging the market rally of late (thereby producing a price divergence and the prospects of a market correction)?

Tomorrow, I will share with you the answers I receive to these and other questions along with several thoughts and observations.

Until then, if you have any questions you think I should pose to the panel, feel free to send them to me at vinny@bluemarbleresearch.com.

Beyond the Sound Bite: An Interview with Michael J. Mauboussin

"In my latest interview with the Chief Investment Strategist for Legg Mason Capital Management, we discussed a bottom-up view of the markets, the sustainability of the US economic recovery, and key segments of his new book: "Think Twice: Harnessing the Power of Counterintuition", including concepts such as decision making danger zones.

All Beyond the Sound Bite podcast interviews can be found at beyondthesoundbite.blogspot.com
To listen to this week's interview, click here

A Market Derived Valuation Model

When it comes to valuing the market should an investor start with his/her conclusions and then see if the market is in agreement (intrinsic value to market value stuff)? Or should an investor start with the market’s conclusion (in the form of its current price) and then attempt to identify what would have to be produced (in the form of projected future earnings) to justify the current price?

To accomplish the former, all one has to do is turn to the media and give a listen to the myriad of talking heads pontificating on what should be by starting with what they perceive is the message of the economy (or industry or company) and then debating their conclusions with that reached by the market.

To accomplish the latter, an investor would start with the message of the market and then seek to match it with an appropriate set of inputs (such as earnings, growth rates, and a discount factor) to determine what inputs would be necessary to match the current price. To do this, an investor would need a process by which the message of the market (in the form of its current price) is the start point from which the justification for that message must be acquired. Allow to illustrate how this could work.

The accompanying table* starts with the message of the market in the form of its current price. In this case, we use the S&P 500. That price level is then inserted into a simple, yet elegant valuation model that lists what earnings would be needed to justify current price levels. Next, an important part of the equation is the discount rate is used to bring the future cash flows (operating earnings) back to their present value**. Then, the current price is projected 12 months ahead. The final step is to divide an assumed P/E ratio into the forward market price to produce a calculated earnings level to justify that future price. What you have is what subscribers to my newsletter see every week – a market derived valuation model that seeks to identify what earnings and P/E might “match” the message of the market.

Each week I plug in the current price and then move the earnings numbers up or down to produce the market derived fair value that comes close to matching the current price. What this does is help me understand the expectations of the market that are built into its current price and the appropriate earnings necessary to justify that price. From this point, I can then decide if I am in agreement with the conclusions reached or beg to differ.

Investment Strategy Implications

One can obviously argue with several elements of the valuation model. For example, one might disagree with the time period used. Another might conclude that some of the assumed inputs, such as the discount rate (which is also the assumed required return for large cap stocks), are inappropriate. Then there is the use of a terminal value, the time period involved (just over 3 years hence), and its inputs (4% growth rate).

While valid, this is beside the point in the sense that by placing the market’s implied valuation via its current price into a valuation model that attempts to match the market’s implied value with the appropriate earnings necessary to justify the current market price enables an investor to challenge or accept the market’s conclusion (via its current price).

You can choose your metaphor - chicken or the egg, cart before the horse. Sometimes, focusing on the message of the market first enables one to hear more clearly.

*click image to enlarge
**Note: The growth rate is calculated as a result of the earnings inputs and the discount factor. This is important as we want to keep the focus away from our opinion about what should occur and on what the market says will occur.