Talking Head Alert: foxbusiness.com Today

Okay, so I look prescient (at least for 3 days) after last Thursday's appearance on Bloomberg radio's "Talking Stock with Pimm Fox and Courtney Donohoe" some 60 S&P 500 points ago. Now what?

Today's talking head appearance affords me another opportunity to describe my emerging bear call and can be viewed at foxbusiness.com (not on cable) at 1 PM (eastern) today.

In addition to my submitted suggested talking points (below, sent yesterday), I hope to explain why
1 - Big market moves within defined trading ranges mean nothing.
2 - On its own, moves above and below the 200 day average also mean nothing.

Plus the emerging bull market in Komboloi (see accompanying image).

Suggested talking points:

Commentary: Blind Faith

* Bottom up type of investors - those that make investment decisions based primarily (many exclusively) on earnings - have helped drive stocks to current levels.
* Following their lead is a very dangerous practice for investors, as bottom up investors have an investment method that is fraught with danger.
* Last Thursday's stock market rally illustrated just how dangerous their approach to investing is: driving stocks higher on the news of the Eurozone deal without full knowledge of the deal's consequences.
* Their method - earnings matter above all else - is anchored in the belief that what's good for business is good for the economy. To believe this is to believe in laissez-faire economics, that unfettered markets work best, that government that governs least governs best.
* One would think that the recent experience (2007 - 2009) would have put this thinking to bed. But old ideas based on an ideology (dogma) die hard.

Market Assessment

* There is neither a fundamental nor a technical analysis reason to change my early bear call.
* My proprietary Mega Trend is still strongly in the bear category.
* Earnings are on the verge of a serious decline into 2012 (and beyond) as the Eurozone slips into recession.
* At best, stocks should sell at a low double digit P/E, not the current average (15 times) P/E.

Actionable Items

* Resist the siren call of the bottom up bulls. Keep a low equity exposure (50 to 60%).
* Put on mega cap, small cap hedges (long mega cap OEF, long the inverse small cap RWM).
* Be prepared to drop the equity exposure below 50% when the second wave of the bear emerges.

To view the segment live, click here.

Bottoms Up!

Giving the devil his due, the bottom-up crowd has won this round, as earnings results are not disappointing as economists did for the third quarter. Therefore, in light of the recent market action, it seems more than productive to understand the nature of this important (but not dominant) segment of the market.

Most investors are bottom-up oriented. They buy and sell stocks with a passing reference to the sector and style tilt their portfolios produce. Like many sports teams, portfolios are populated with the best ideas. Sectors and styles are a by-product. Individual company earnings results, performance metrics (such as profit margins, growth rates, etc.), and valuation levels determine the buy/sell/hold decisions made. From that comes the action taken.

This situation is largely due to tradition and training: traditional among individual investors, training among the professional crowd (the CFA program, for example). It is what the financial media obsesses on while providing limited, yet sorely needed, education on what constitutes good portfolio management.

As one of the two essential elements that drive stock prices up or down (the other being financial market liquidity), earnings results can dominate the moment, as they appear to have done thus far this month. When good earnings results motivate investors to act positively, the momos (the real power in today’s market) join the party, as they are indifferent to the reasons that drive investors and are far more interested in an excuse to act. As long as money is abundant (financial market liquidity), the upside bias exists. Which brings us back to earnings results.

As long as companies deliver positive earnings results and financial market liquidity remains ample, the bottom-up crew can move markets (aided and abetted by the momos, of course) to a significant degree. Should earnings falter, however, then the dual impact of declining results and diminution of financial market liquidity (in the form of redemptions and withdrawals) can produce a negative feedback loop to the real economy (Soros’ “reflexivity”). Yet, more importantly, within this investing approach lie the seeds of its own destruction.

Bottom-up investing is aided and abetted by ivy tower fantasies about efficient markets, assisted with high-sounding phrases like “price discovery” and “capital asset pricing models”, and supported by economic methodologies that are anchored in traditional metric analyses. Such traditional economic methodologies do, however, come with two significant blind spots: the inability to forecast with any degree of accuracy and consistency (certainly commensurate with a practice that fancies itself as a “science”) and an inability to do global macro analysis particularly well.

The first point is self evident and saturated with historical fact. For example, one need only look at today’s consumer confidence miss to see just how off the mark these “social scientists” can be. The second point was made most evident in the debacle known as the Great Recession. Moreover, the inability to do global macro well also comes with an inability to incorporate contagion’s speed and source (real and/or financial economy).

This is a big part of how the world works in Wall Street. It is the dynamic reality that exists in the surreal world of finance. It is the state of denial that many who play the investing game occupy. And it is why it is so essential to step back and smell the global macro rose, which right now has a decidedly foul odor to it.

But, hey! “Who cares?”, say the bottom-up boys and girls. "Earnings are good and that’s all that matters to me."

At Least The View Is Lovely

Stocks on the move today. Here's a picture that captures the moment.

The Global Stock Market Panic of 2011

Here are two data points* that suggest that the drop in stocks is the 2011 version of an old fashioned stock market panic.

The valuation table lets the market tell you what P/E and S&P 500 operating earnings fit the current level. From this one can decide which combination makes the most sense. Unless earnings are about to fall off the cliff and/or their risk factors have risen dramatically, the P/E combination of a below average P/E of 14 times $95 is the most central point. Other combinations imply plunging earnings with rising P/Es (not logical) or plunging P/Es and rising earnings (also, not logical).

The chart shows the one month performance of selected global markets as of 12 noon (eastern) today. The point here is simple: unless one believes that a global recession is just around the corner and that emerging markets and high quality European companies are going to impacted in such a way that global growth and corporate profits are about to fall off the cliff, then the synchronized plunge makes no sense. Yes, one could argue that developed economies and the higher risk components within are at risk. But does that mean everything at every level is about to come to screeching halt, including those areas where growth is good and profits are both of a high quality and strong?

Investment Strategy Implications

The most logical culprit for this global stock market panic is a momentum-driven-hedge-fund-induced-high-frequency-trading-exacerbated panic than a justification for a global economic catastrophe lurking just around the bend. If true, this is a powerful indictment against the failure to appreciate the changing structure of the market. Also, if true, then investors should recognize this for what it is: a panic within a bull market correction.

*click images to enlarge

Bernanke to Wall Street: More Cowbell

“I got a FEVER! And the only prescription...is MORE COWBELL!”
-Bruce Dickinson (Christopher Walken)

There are two reasons why the stock market is trading where it is. One deals with valuation levels. The other is liquidity. These factors are the most direct to stock market levels. From a stock market point of view, the larger macro economic, political, and societal (including cultural and demographic) issues matter only to the extent that they ultimately impact the inputs to the valuation levels – cash flows, growth of the cash flows, and the uncertainty (the risk) of receiving those cash flows – and liquidity, specifically liquidity to the financial system.

It is on this second factor, financial system liquidity, that many fast money professional investors (hedge funds, high frequency traders, prop desk traders) are paying the most attention to in today’s testimony by Fed Chairman Ben Bernanke. As the primary market forces that move markets at the margin, fast money types want to know that the Bernanke Put (rising prices of risky assets help produce the wealth effect, which helps the broad economic environment) is still operative.

Based on what they heard thus far, all is good. Or as the Saturday Night Live quote above suggests, the fast money crowd has a fever (they always have a fever) and generous Ben assures them that there will be more cowbell.

Investment Strategy Implications

Hang in there. A resolution to the sideways market is not far off. As noted on several recent blog postings, the clock is ticking and appears to be set to strike midnight very soon.

Will it ring a new day for the bulls or will investing Cinderellas themselves with pumpkins and not stagecoaches for transportation? Right now, it's anybody's guess.

The Fine Art of Valuing the Stock Market

When I appear on foxbusiness.com* today with Tracy Byrnes, one of the items I hope we discuss is the accompanying valuation table (click image to enlarge).

Then are several ways to employ this table but perhaps the most useful way is to:

1 - Start with today's price level for the S&P 500.
2 - Then find those P/E and projected operating earnings in present value section (right side) of the table that roughly match today's price.
3 - Now look at the future value (left side) of the table. That is where the market projects it will be 12 months hence.
4 - Decide if you agree or disagree with the market's conclusion.
5 - Let the debating begin.

Valuation is a subjective process that attempts to bring into the equation what investors forecast earnings will be AND what they (and this is key) believe the appropriate P/E that should be applied to the forecasted earnings. There are many factors to be taken into consideration. For example, an above average P/E (say 17) can mean:

1 - It is appropriate in terms interest rates, growth rate of earnings beyond the next 12 months, quality of earnings, and degree of risk (global macro), Therefore, the current level of the market is far too pessimistic at 17 times $85.
2 - It is appropriate as earnings will tumble but, for a variety of additional reasons, the P/E will anticipate that the earnings decline will be short lived.
3 - It is inappropriate as rates will rise, risk is and will be far greater in the not too distant future, and the growth rate in earnings will disappoint. Therefore, a lower P/E is more appropriate.

And that's only a start. Other P/E and earnings mixes lead to other combination of factors.

What the accompanying table provides is a way to reverse engineer that process by starting with the current level of the market and then identifying what the current level suggests.

Therefore, taking yesterday's close, the following P/E and operating earnings closest are:

14 x $102 (average of $100 and $105)
15 x $95
16 x $90
17 x $85

As step #5 says, "let the debating begin".

*To view the 12 noon eastern time appearance, click here.

Super Bulls - Welcome Back to Earth!

Lately, life has not been kind to the super bulls who, just a few months ago, were all aglow with expectations of record busting highs for stocks. Triple digit S&P 500 operating earnings times above average (>15) P/E ratios = Big bucks!! Who said, “Greed, for lack of a better word, is good”, was dead?

Never mind the fact that the root causes of the damage wrought by the Great Recession were never fully and properly addressed. Who cares if, metaphorically speaking, treating the cancer in the global economic patient with antibiotics and morphine will most likely not work? Corporate profits, courtesy the global technological and labor arbitrage plus robust, if somewhat suspect, emerging economies growth, are off to the races. And, when combined with the Bernanke put, lofty P/Es (>15) times robust earnings = great returns.

So, what has really happened these past several months?

The valuation levels you see in Table 1 provide the parameters for fair value for the S&P 500. At yesterday’s closing price, Earth at its historical P/E (15 times) rate times a more realistic (yet, still record busting) operating earnings (for the next 12 months) = fair value.

It may not be Heaven, and it hopefully won't devolve into Hell, but Earth is where the markets have settled in - for now.

A Head and Shoulders Bottom?

If you have read any of my technical analysis work over the past years, you know that I am not a pattern recognition guy. However, there are times when one can't help but notice the emerging pattern involving long term interest rates. Specifically, the head and shoulders bottom that appears to be forming in the 10 year US Treasury (see accompanying charts).

When you add into the equation the following recent comment in an Economist article - "Since mid-November America’s Treasury has issued some $589 billion in extra long-term debt, of which the Fed has bought $514 billion." - it is hard not to conclude that once QE2 ends and the Fed stops buying long term Treasuries that a major demand factor will be removed from the mix.

The obvious equity market impact of rising rates is in valuation models, which will note that the cost of capital has just gone up thereby making equities less attractive. Could this explain why stocks have recently traded sideways?

Is Technical Analysis Dead?

Something very peculiar is happening with equities.

For more than a year, stocks have not performed according to technical analysis Hoyle. Stock markets have risen on far below average volume. Correlations for virtually all economic sectors and many asset classes hover just below 1.00. And many technical analysis tools have been rendered impotent. Why is this so? Perhaps the answer lies in the nature of the beast: the structure of the market.

Over the past several decades, the structure of the market has changed. In the 1960s and 70s, traditional institutional investors (mutual funds, pensions, insurance companies, and large asset managers) replaced individual investors as the dominant traders of the day. Recently, hedge funds and now high frequency traders (with algorithmic traders in tow) have supplanted traditional institutional investors as the dominant volume drivers in equities. At the same time, products and services such as dark pools, derivatives, and structured products operate outside the traditional norms of equity investing.

Yet, most investors and many in the financial media operate as though there are virtually no effects, no consequences – intended and otherwise – that have occurred in this new environment. All is as it was. Or is it?

As for technical analysis, of all the tools that have worked with a reasonable degree of accuracy, perhaps none have been impacted more by the brave new financial innovation world than sentiment indicators.

Once the bastion of sound investment strategy, the human emotions of greed and fear afforded astute investors and traders with the opportunity to exploit the polar ends of investment human behavior. Ride the greed and fear train for as long as possible then, when things go too far, shift to other side (the contrarian side) of the equation. Not easy to do but highly rewarding if done correctly. However, given the changed world equities operate in today, the question has to be asked, Do such tools work in a world dominated by black box methodologies? A financial world without humans?

When it comes human emotions such as greed and fear, does a hedge fund manager, an algorithmic trader, or a high frequency trader base their decisions on judgment? Do they feel anything? Do they get swept up in the emotional tide of the times? Or is virtually every action taken done based on a set of rules and parameters that do not rely on such human qualities?

And that brings us back to the issue of technical analysis and, specifically, sentiment indicators. Do they still work? Has technical analysis lost a key tool in its toolbox?

Based on the evidence at hand, in the case of sentiment indicators, the answer has to be yes. In the case of volume indicators, the answer is also yes. In the case of momentum indicators, the answer is no.

The one market variable that is least impacted by our financial innovation brave new world is price. And price changes over time, which is what momentum indicators are all about, are tied to the real world of valuation, which is, in turn, tied to the real economy.

Is technical analysis dead? No. But I find it hard to argue for the status quo when so much has changed. Or Keynes once said, “When the facts change, I change my mind. What do you do, sir?”

The Gambler

Who knew Ben Bernanke was actually Bret Maverick?

Using its dual mandate – price stability and full employment – as a rationale (excuse!?) for unilateral action, the Bernanke Fed has embarked on a grand experiment hoping that the wealth effect on financial assets will somehow stimulate the deleveraging US consumer to suddenly reverse course, revert to form, and shop ‘til he/she drops. The Bernanke Fed also hopes that the US consumers’ primary asset –his/her home – will somehow overcome the foreclosure fiasco and miraculously increase in value thereby adding spending fuel to the wealth effect fire.

Finally, the Fed is hoping that its actions will encourage the banks and corporations to disgorge themselves from the mountain of cash they have been hording and start lending and hiring again.

The cumulative effect of this grand adventure is to hopefully enable the US economy to reach an economic escape velocity and enter into the self-reinforcing, sustainable virtuous circle thereby enabling the Fed to enter into its exit strategy.

In today’s Washington Post, Mr. Bernanke provided his audacity of hope with arguments that had so many holes in them as to resemble Swiss cheese. Here’s a few morsels with his comments in italics and mine beneath:

Easier financial conditions will promote economic growth.
By how much? And when?

For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance.
What about the large supply of unsold homes? What about the impact of the foreclosure fiasco?

Lower corporate bond rates will encourage investment.
Possibly, but where will that investment occur – in high cost/low growth markets like the US or in low cost/high growth markets like emerging markets?

And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending.
Unlikely without the support of the US consumers’ most important asset – the home. (see above noted point) Moreover, deleveraging to save for an uncertain future is a strong force for soon-to-retire baby boomers, who know that entitlement reform is in the offing.

Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.
Not if companies decide to invest elsewhere, as noted above. Also, small businesses, the driver of jobs growth, will wait to see demand before committing to new hires and higher wages.

The Federal Reserve cannot solve all the economy's problems on its own. That will take time and the combined efforts of many parties, including the central bank, Congress, the administration, regulators and the private sector.
Correct, but unlikely given the looming political gridlock environment ahead.

But the Federal Reserve has a particular obligation to help promote increased employment and sustain price stability.
And this provides the justification to act unilaterally – without the aforementioned other parties involved as well as the cooperation and coordination of other central banks and countries around the world?

Steps taken this week should help us fulfill that obligation.
How's that hopey, changey stuff goin' for ya?

Investment Strategy Implications

The music is playing and the actors are dancing, driven in large part by the underperforming and desperate momentum lemmings from hedge fund land. Valuation levels are now moving well above average (>15 times) anchored in solid corporate profits, low interest rates, very ample liquidity, and belief that the cyclical forces at work will overwhelm the unresolved secular structural issues.

It is imperative that investors remember this one point – just because a company was founded in the US, is domiciled in the US, and derives some of its profits and growth from the US doesn’t mean it has to rely on the US for its future growth and profitability. And therein lies the rub with Bernanke’s argument: will QE2 (then QE3, then QE4) provide strong economic growth and prosperity for the US? Or will it produce yet another bubble in assets and other markets (notably emerging economies) leaving the US economy in worse shape than when it started?

Ultimately, the all important asset allocation question is: To what extent should an investor participate in this monetary Mephisto Waltz? The answer I've come to is listed to your left.

Doing The Valuation Math

As the thank-goodness-we-aren't-headed-into-a-double-dip-recession-or-deflation relief rally continues, perhaps a quick look at the valuation math for the US equity markets might be helpful.

As the accompanying table illustrates, the three likely near term scenarios with expected earnings and prospective P/E ratios provide a useful valuation guide. I have bracketed the most likely P/E ratio for each prospective forward 12 month earnings scenario (mid 2011). (Obviously, an above average P/E for the doomsville scenario makes little sense.)

As I describe in the equity analysis classes that I teach every fall, the math is fairly easy. Getting the inputs correct is the hard part.

Note: even more difficult is getting the inputs correct for the right reasons!

The Misdirection Market

Magicians do it. So do con artists.

In the coming weeks, the focus for most bottom-up oriented investors will be the earnings results. The trend chasing hedge funds will play that momentum game, too.

As I have articulated repeatedly, 2Q10 earnings results are set to come in at to slightly above consensus expectations. Few surprises should emerge. For bottom-up oriented investors and the hedgies, this is where the attention and action will be focused. Stocks will respond accordingly as results and guidance are dissected.

While this quarterly process is underway, another very important process will occur – macro economic data for the third quarter. It is this data that will provide the early indications as to whether the US economy will sustain its recovery or begin the long (and very dangerous deflationary) slide to double dip land.

Sometimes it is lost on the bottom-up oriented crowd that earnings are the END POINT of the economic chain. To be sure, the feedback loop from the micro (corporate earnings) to the broader macro economic environment is an essential part of the economic chain (capex spending, wage increases, new hires). However, most indicators suggest that a positive feedback loop is muted due to concerns about the sustainability of the economic recovery – Alan Greenspan (misguided) speeches notwithstanding*.

Should 3Q10 macro economic data points come in below consensus expectations, the risks of something more than an economic slowdown (which is occurring right now) could develop producing a nightmare scenario that would produce a global economic recession and all its consequences.

What makes all this extra worrisome are the technical signals emanating from the markets.

Synchronicity

Markets, countries, regions, sectors, and most industries have gone sideways - in some cases since the fall of last year. Such sideways action can only mean one of two things – consolidation or distribution.

Consolidation is the pause that refreshes the bull market. Distribution is the topping action that precedes a bear market. The resolution will signal the next phase of the market. Frankly, my money is on the new bear primarily for a whole host of fundamental reasons, some of which are noted above and throughout this blog.

Moreover, nearly all of Europe has flipped into bearish territory (Mega Trend reversals) while key emerging markets border on the edge of joining the bear club. Only the US stands in modestly good shape, but it, too, appears to be following in the footsteps of other global markets.

Investment Strategy Implications

Chill until, is the operative strategy. Let the earnings season and the new quarter evolve. It is still a bull market until it isn’t. Warnings signs may abound but until the yellow light turns red, it appears advisable not to jump the gun too soon. Yellow lights can stay yellow for quite awhile. Moreover, while it is rare, strength can evolve from those markets that have not turned bearish (US, for example) thereby helping to reversing those that have (e.g. Europe).

Also, it is advisable not to be too preoccupied with second quarter earnings results. And most definitely do not be lulled into a false sense of security by traditionally trained economists with their trend extrapolating methodologies and notoriously bad track record spotting economic turns. The misdirection of the recent earnings results and poor forecasting tools are substantial risks investors would be wise to avoid.

Finally, as noted last week , determine if you want to take the bold approach (100% invested in equities) or the more cautious (60 to 80% invested). For what it’s worth, Blue Marble managed accounts are in the latter category.

*subscription required

We Are BP

“We are about to embark on a momentous experiment to discover which of the two stories about the economy is true. If, in fact, fiscal consolidation proves to be the royal road to recovery and fast growth then we might as well bury Keynes once and for all. If however, the financial markets and their political fuglemen turn out to be as “super-asinine” as Keynes thought they were, then the challenge that financial power poses to good government has to be squarely faced.”
Lord Robert Skidelsky, FT, “Once again we must ask: ‘Who governs?’”, June 15, 2010

The transitional nature of this stock market fits perfectly with the transitional nature of the global economy – are we headed for the virtuous circle of sustained economic growth or will the decision to withdraw fiscal stimulus advocated by the G20 members result in a double dip (or worse)? The early answers to this question will not be found in the present but in the near future – specifically the third quarter of this year.

Once we get the at-to-slightly-above-consensus 2Q10 earnings results out of the way, most of the focus will shift to the third quarter. Early into the third quarter, macro economic reports will provide an advance notice of what lies ahead for 3Q10 earnings. If the traditionally trained economists are correct, 3Q10 economic results should present no problem and come in at or above consensus expectations thereby ensuring that 3Q10 earnings results will meet the current optimistic projections.

If, however, third quarter macro economic data issued week after week produce below consensus results, then 3Q10 earnings results are nearly certain to come under expectations. Then the fun begins.

Stock Market Signals

All this would coincide with stock market action that will reflect a resolution of the sideways performance exhibited by virtually all indices since the fall of last year. This resolution will present itself in the all-important Mega Trend. If the Mega Trend* reasserts itself with price moving back above both key moving averages AND in the process reverses the recent bearish Mega Trend signals from Europe, then the trading range of the past 8 months has been a consolidation range, the bull market is back in gear, and the real economy will likely not suffer a double dip (or worse).

If, however, the Mega Trend in the US and Asia follows the lead of Europe and produces a bearish reversal signal, then it’s game over – the real economy outcome will likely be something far worse than a double dip.

Investment Strategy Implications

Going into the third quarter, investors who subscribe to the above have two choices: Bold or Cautious.

Bold would recommend a 100% exposure to equities. Cautious would suggest a 60 to 80% equity exposure. While both approaches stand at the ready to shift gears should a bearish outcome become evident, I believe there are two advantages to choosing the cautious stance.

First, any near term decline (i.e., a move to the lower end of the trading range, which is 1000 to 1050 in the S&P 500) would generate a negative return but positive alpha, while any near term advance (i.e., a move to the top end of the trading range, which is 1150 to 1220 in the S&P 500) would produce a positive return but negative alpha. A form of portfolio insurance, if you will. Secondly, and perhaps most importantly, a cautious approach keeps the mind focused on the worse case scenario and will help facilitate rapid action once the below consensus economic readings start filtering in and the bearish Mega Trend signals are generated.

Chill Until

Stocks do not trade in a range indefinitely. A resolution to the upside would say that the trading range was a consolidation, that the bull market will resume, that global markets that had been weak were temporary, that the economic handoff of government spending to private sector sustainable growth has been successful, that the virtuous circle has taken hold, and that earnings and other key inputs into the valuation process will be better tomorrow than they are today.

Alternatively, a resolution to the downside would declare that the trading range was a distributional top, that global markets that had been weak were a warning sign, that the economic handoff of government spending to private sector sustainable growth has not fully occurred, that the virtuous circle has not fully taken hold, and that earnings and other key inputs into the valuation process point toward a tomorrow that will be worse (I would argue far worse) than they are today.

Alfred E. Neuman Would Be Proud

If there is anything to be learned from the recent crises it is that incremental thinking to rapidly deteriorating situations produce catastrophic results. Here’s a partial list:

• It’s only a subprime mortgage problem
• The banking crisis is contained to the financial sector
• Greece is a very small part of the European economy
• It’s just an oil spill, a leak

With virtually no margin for error this time around (as in extremely limited government flexibility), any economic deceleration or decline could snowball rather quickly. The wrong thing at precisely the wrong time. Partying like it's 1937.

All That Jazz

The quote from Lord Skidelsky above says it well - we are about to embark on a grand experiment, we will improvise as we go along, we are confident in our experts, we have faith in our meritocracy, we are BP.

Will this work? We will find out soon enough.

*Use the search function at the top left of this page for prior blog postings on the Mega Trend.

Technical Analysis Rule of Thumb re Selling Climaxes

In order to qualify as a selling climax, stocks must NOT close below yesterday's closing price over the next 3 trading days. As the first chart shows, given the deterioration in the near term indicators tracked (momentum and MACD) and the fact that the short term indicator tracked (slow stochastics) is not in deep oversold territory (below 20), the odds are high that stocks WILL close below yesterday's close and the air pocket corrective phase we just lurched into will likely continue. The most pressing question is: does that mean something more than the long overdue healthy correction? No, for the following reasons.

The fact that we entered the correction with some degree of technical analysis weakness but not an overwhelming amount of it suggests the decline will be contained and not usher in a bear market. As the second chart shows, divergences between the S&P 500 and other key global indices (e.g. EAFE (EFA), Asia Pacific ex Japan (EPP), and Latin America 40 (ILF)) were evident (my "Sell in May and Pray" mantra) but not so pronounced to warrant ringing the bearish bell. Moreover, as the third chart makes abundantly clear, the Mega Trend HAS NOT reversed itself. Until price crosses both moving averages AND the 50 day crosses the 200 day AND both averages point southward, the bull market is intact. However, all this could change in the coming months as the following paragraph illustrates.

The next most pressing question then becomes: how low will this correction go? The market intelligence/technical analysis tools I use only provide direction not amplitude. That said, given all of the above plus history plus valuation considerations, the odds are that the decline will likely turn out to be a garden variety correction of 10 to 15% - this despite the dramatics exhibited yesterday and the unquestionably horrendous advance/decline data (> 10 to 1). What follows will likely be an attempt to reestablish the bull and it is in that rally that key signs of broad market strength must emerge - most notably global indices must improve their relative performance. If in the subsequent rally phase broad market participation does not emerge and further technical analysis damage does, then the odds for an end to the bull market will increase significantly.

Bottom Line: Correction not apocalypse now.

We’ve Seen This Movie Before

The dramatic news on Friday (re Goldman Sachs) has a more narrow impact (directly on Financials) and a far more limited impact on the broad market as the economic recovery and its sustainability are significantly more important to equity prices overall.

The limited broad market impact would be for Financials to begin to struggle and potentially produce a negative contribution to higher prices. However, the likely offset is a rotation away from Financials and into other sectors where less governmental activism exists. This is similar to what occurred with the Healthcare sector, as the debate became law. Healthcare stocks may have underperformed but the overall bull market remained intact. The same is very likely to occur going forward re Financials and the broad market.

Concerns re an activist government (greater regulation, lower profit margins) appear to be somewhat overblown. The Obama administration's axiom – “Don’t let the perfect be the enemy of the good” – demonstrates both a pragmatic approach to issues and no intention of destroying whole industries and the companies within, the histrionics of the right wing opposition notwithstanding. The price that is being asked to be paid (in the form of greater/tighter/smarter regulation) appears to be a very reasonable one given the economic debacle that succeeded the more laissez-faire approach to regulation.

What may be some concern to investors is the masterful manner in which the Obama administration has finessed their opposition. In a series of events that can only be viewed a classic Clintonian, consider what occurred the past week:

• On Wednesday (April 15, 2010), President Obama meets with congressional leaders at the White House to discuss financial regulatory reform.
• Senate Republican minority leader Mitch McConnell (providing an outstanding example of Pavlovian behavior) steps out of the meeting (fresh from his recent sojourn to the titans of Wall Street) to declare that President Obama is on the wrong side of this issue.
• On Friday, the Securities and Exchange Commission charges Goldman Sachs with investor fraud.

At this point, someone needs to hand Senator McConnell a towel to wipe the egg off his face.

This week, more bank earnings results will be reported, including those from none other than Goldman Sachs (Tuesday, April 20th). The results are sure to further inflame the public outcry re bank bailouts and buttress the efforts of the Obama administration and the Democrats to push through financial regulatory reform.

The consequences of a victory in financial regulatory reform will have repercussions in this fall’s midterm elections. Moreover, it is the manner in which Obama handled the Republicans this time around that is yet to be fully digested by most investors (think Bill Clinton and his famous triangulation strategy). It does appear that the Obama administration (and President Obama, in particular) have relocated their political voice and have combined that with a governing style that needs to better appreciated by investors.

Investment Strategy Implications

Right now, what matters more to equities is the global cyclical recovery. The challenge will be whether the economic handoff (from government spending to sustainable private sector growth) can truly occur. That is a question that still remains to be answered. Despite the solid earnings results of 4Q09 and thus far from 1Q10, it is hard to determine whether growth can be sustained without the life support mechanisms put in place by governments around the world. And the growth in debt, the extraordinary and inventive governmental actions (quantitative easing, for example) and the generous amounts of liquidity cannot go on indefinitely.

The longer-term structural problems (e.g. debt levels, consumer demand in emerging economies, imbalanced domestic growth policies in key emerging economies (notably China), the currency straightjacket on weak economies within the Eurozone, among others) along with the aforementioned Obama’s emergent political skill wait in the wings and may become the rationale for the long overdue market correction. These fault lines are to be monitored closely for signs that they will become the focal point for investors. This is where market intelligence earns it pay*.

In the meantime, the excess liquidity and encouraging cyclical growth remain center stage for most investors. A clear case of the cyclical over the secular. Accordingly, there is little reason for investors to move to the sidelines and adopt anything more than a cautiously bullish position. There will come a time for a more aggressively conservative view. That time does not appear to be now.

*The absence of traditional investors is also a worrisome sign as trading continues to be dominated by the fast money crowd. More on this in a future posting.

Earnings Season Is The Reason…

…not to sell your equity positions. At least not yet.

Based on the fact that a sufficient number of macro economic reports came in above consensus expectations during the first quarter, there is a high probability that 1Q10 earnings results will exceed earnings expectations in the coming weeks. And that appears to be more than enough of a reason for investors to sit tight with their equity holdings for just a touch longer.

Producing its second highest reading since being created one year ago, the Blue Marble Research proprietary Macro Economic Reports Indicator (MERI) registered a +8 for the first quarter of this year. The +8 number is second to the +12 reading for 2Q09, a quarter that resulted in well above consensus earnings reports for that quarter. Since most investors are of the bottom up stripe, waiting for the good earnings news should help restrain same investors from heading for the exits BEFORE the positive data is shared. The most immediate stock market relevance to the earnings reports is what happens to stock prices as the results are published. For those more bearishly inclined, the soon to be reported good news earnings season sets up a potential “buy on the rumor, sell on the news” scenario for stocks. However, on its own, such an occurrence is likely to NOT result in the long anticipated big correction (>10% in the US, >20% in higher beta markets).

Not Enough For The Big Enchilada

For something more substantial to occur to the downside in stocks, something more substantial needs to arrive on the scene to serve as the catalyst that brings into doubt both the sustainability of the bull market AND the economic handoff (from government spending to private sector growth) necessary for a sustainable economic recovery. There are many candidates capable of serving the role of stock market correction catalyst, with the leading prospect being rising long-term US interest rates. In this regard, the 10 year US Treasury rate is the prime suspect for the role.

As I noted in last week’s commentary, a rise in longer-term interest rates would produce a hit to valuation models that would be both direct and immediate. In its most simplistic form: rates up, P/E ratios down. Given the fact that so much of this bull market is anchored in the above average P/E ratio thesis (>15 times earnings, so justified due to low interest rates and low inflation), rising rates hold the potential of blowing a meaningful hole in that view – enough to take stocks prices down for the prescribed market correction amount (>10% in the US, >20% in higher beta markets).

What About Higher Growth Rates?

All fundamental valuation models identify two factors has having the largest impact on the present value of an asset – the discount rate (which includes interest rates) and the growth rate (of future cash flows/earnings). Accordingly, the offset to rising interest rates – rising growth rates – would most likely not occur as immediately as the bulls would argue due to concerns regarding the viability of sustained economic growth, as the aforementioned economic handoff will be brought into question courtesy the implications embedded in higher long-term interest rates. Regardless of what might be speculated re rising long-term rates, the very fact that rates are now on a upward glide path should be more than sufficient to raise the appropriate cautionary views toward equities.

Then there is the technical analysis hit to the market, as the upside move in rates would trigger a plethora of market technicians’ forecast of a major, multi-year head and shoulders bottom – with its measured upside move to 6%. As investors seek to make sense of the rising rate environment, market technicians will do their part in duly noting the message of the market – whatever it may be saying.

Our Old Friend The Shadow Banking System

Another equally important candidate for the catalyst role would be a global version of the Greek fiscal drama currently underway. As the lack of transparency in the sovereign and other debt markets (which I would include US states and other governmental municipalities throughout the world in that mix), just who is on the hook for what remains shrouded in the shadows (as in the shadow banking system). Such as point was noted quite articulately in yesterday’s FT commentary by Ken Rogoff.*

Investment Strategy Implications

To some investors, what I described above could easily be perceived as an attempt to squeeze out a few more basis points from the overvalued, long-in-the-tooth stock market stone. Such thinking may actually turn out to be correct. However, absent a catalyst it is hard to envision what could derail the bulls momentum.

Given the massive amounts of cash still sloshing around the world economy and financial markets, the strong economic health of most businesses, globalization damaged but not broken, and the global growth story still fairly intact, it appears logical that something more substantial will be needed to bring into doubt the bullish case. And that is what market corrections are all about – doubt that what was will resume.

For such doubt to arise, a catalyst is most likely needed to trigger the requisite angst that is the hallmark of a stock market correction. In this commentary, you have the two leading candidates for that role. There are others.

This is not a matter of if but when (and who).

*”Bubbles Lurk in Government Debt”, Financial Times, April 7, 2010.

Happy Anniversary. Now What?

Yesterday marked the one-year anniversary of the bear market low in stocks and the subsequent bull rally. Therefore, a review of where we were, where we are now, and, importantly, where we are likely to be headed, seems to be in order.

To refresh your memory, let’s go back to March of last year and note the following excerpts from commentaries made by yours truly regarding the end of the world as we knew it:

March 5 – “Bears Out of Momentum”
“…are we headed non stop to 600? Before I get to why the 600 call is unlikely right now, let me address 2 factors - one fundamental, the other, a market dynamic.”
To read the complete commentary, click here

March 12: “Why Divergences Work”
“Tuesday’s big up-market demonstrated a tried-and-true investment axiom: When market conditions are ready, a catalyst is all that's needed to get the show on the road. The show, in this case, is a cyclical bull rally. And the catalyst was the Citigroup's earnings statement. Here are some of the particulars….”
To read the complete commentary, click here

March 26: The Cyclical Bull Within the Secular Bear
“In stocks, we seem to have a cyclical bull within the secular bear. Investors (and the world economy) have been given a reprieve - that is, until next year, when all the money and all the regulatory changes thrown at the economy and the financial system must evolve into greater private market participation.

In the case of the US economy, capex must take the economic handoff from government and become the principal driver of economic growth, as US consumer spending continues at a more muted pace. For the consumer, balance-sheet repair will almost certainly continue as its largest component -- the aging baby boomers -- set aside real savings out of income to provide for themselves in the rapidly approaching retirement years.

Therefore, as the US economy goes through its transition from its overly leveraged consumer bias to a greater level of corporate activity -- driven largely by exports to the real growth engine of the next decade and longer, emerging economies -- investors should consider repositioning their portfolios to include more emerging-markets investments.”
To read the complete commentary, click here

The rest is history. Stocks rallied, emerging markets did best, and investors were rewarded for their courage and wisdom in relying on time tested market tools, such as the valuation parameters and the divergences principle described above.

Okay, now what?

Investing is a game of “What have you done for me lately?”. In accordance with that game, investors cannot sit on their laurels and revel in the joy of their courage and wisdom. When it comes to investing, the past is always prologue. And it functions as a guide to what is likely to be.

In attempting to predict where markets are headed, it is just not enough to use the past as a valuable guide to what will be. It is also necessary to remember that markets are driven by investors, and investors are people whose tendencies have a certain predictive dynamic due to the simple fact that they are human. This is just another way of saying that human nature doesn’t change; we, as investors, just emphasize different things at different times. Moreover, the principles of asset values are also a reliably consistent tool, one that enables an investor to estimate what the fair value for any given asset might be.

Taken together, the three principles to follow – history as a guide, the constancy of human nature, and estimates of fair value – enable an investor to apply the same tools and principles that got the above noted rally forecast correctly and apply them to today’s market environment. With that said, let’s first briefly consider where we came from and what it means for the equities markets going forward.*

Back From the Brink

The massive capital infusion governments around the world threw at the financial then economic crisis enabled the world economy and markets to step back from the abyss of global collapse and regain some sense of stability. However, government stimuli are good for only so long. Eventually, end user demand must take over and drive the world economy, which will drive the world’s equity markets higher. In this regard, the jury is still out as to whether such an economic handoff will actually occur.

The US consumer, engine of end user demand for most of the past several decades, remains in the throes of balance sheet repair. Paying down debt and building sufficient cash reserves for that rainy day is still priority number 1. Occasional episodes of spending beyond their means will occur from time to time (as it may have last month based on the surprising increase in consumer borrowing). But with the bulk of baby boomers bordering on retirement, balance sheet repair will remain the secular trend for the foreseeable future.

Therefore, the hope that an emerging middle class in developing economies can pick up much of the global growth slack left by the reduction in US consumer demand. This, along with a sustained level of infrastructure and corporate capital spending (capex) rebuilding vital to both developing and developed economies, are central to a sustainable growth phase for the world economy. However, a hope is not a certainty, and whether the handoff will occur and just how robust will it be is one of the key areas to focus on going forward.

At present, the odds do favor such an occurrence, but many obstacles remain in place not the least of which is confidence. For example, in order for infrastructure and corporate capex spending to occur in earnest, policy makers must muster the political will and organize their priorities and corporate senior management must believe that current long range spending plans will result in future growth rates and profitability in excess of their cost of capital. This is one of the key areas where the analytical focus must be centered.

*In my next commentary, I will address the second and third areas – fundamental valuation models and market intelligence readings. Until then, enjoy the ride.

Correction Now? Not Likely Without the Set Up.

There are certainly many justifiable fundamental reasons for stocks to take their long overdue (and healthy) corrective tumble right now but in one important aspect such a decline is not likely to occur just yet – the set up is absent.

It is an extremely rare occurrence when a meaningful correction (10%+) occurs without certain market preconditions in place prior to the decline. Absent these preconditions, market declines have an “out of the blue” quality to them and tend to be limited to the 3 to 5% range. The rationale for the preconditions (the set up) is rather straight forward – before a trend reversal can take place, weakness must begin to emerge so that the apparent forces that drove prices higher were actually exhibiting signs of exhaustion when one looks beyond the headline major indices. Typically the signs of weakness are most apparent in the form of divergences – price action divergences between the major, headline indices and other important sectors of the market.

The first chart above (click image to enlarge) shows that such a divergence had potential in November into December last year but was clearly resolved to the bull case before the year was out with higher highs being made with all size indices confirming. As the chart clearly shows, however, no such divergences preceded the current drop*.

Another aspect of the set up is the price point at which the decline takes place. For example, when a decline begins at a price point of no consequence (e.g. NOT at a moving average) the decline again has the features of an “out of the blue” style drop. Moreover, it always adds power to the decline argument when price crosses a key moving average, such as the 50 day moving average, at the same time the 50 day crosses the longer term 200 day moving average. (This is what some call the “golden cross”, which I have labeled a mega trend reversal.)

The second chart above makes this quite clear as the US market is a long way away from producing such a reversal signal. Price has broken its 50 day moving average, but it has done that several times before**. Moreover, price is well above its 200 day moving average and the 50 day is a long way from crossing the 200 day***.

Investment Strategy Implications

While there are many fundamental reasons for equities to decline (over valuation being one of them), the technicals of this market do not argue for a sustainable decline at this time.

*The same conditions are found when comparing US to various global indices.
**The above chart is only the last 6 months. Since the bull rally began in early March 2009, price has crossed the 50 day 3 times.
***The correction case would morph to the bear case should price remain below both moving averages and both moving averages point downward. Hence, the mega trend reversal.

Doing the Valuation Math

Now that my market forecast events have begun (with NYSSA's event last Thursday), it's time to do a little valuation math for the year ahead. So, based on the initial comments heard at last week's event and elsewhere, here you go:

18 times $80 (S&P 500 operating earnings for 2010) = 1440.
1440 minus a present value discount (12%) = 1267

This is the bulls’ case for why stocks should go higher this year – an above historical average P/E times a robust earnings growth for 2010 minus an historical average discount rate (bringing the future value back to the present*) equals a most profitable year.

The valuation debate is a paradox – simple yet complicated. Simple in that the formula is rather easy to compute. Complicated in that the social science known as investing involves numerous variables, many of which are highly subjective. For example, the P/E used in a valuation model is based on the views of the investor for the economic and market times of the moment and the near future. In the current case, the bulls would argue that an above average P/E is appropriate for the current and near future because history says so – low inflation + robust economic growth + strong corporate balance sheets = above average P/Es. Exactly what level above the historical average P/E (which happens to be 15) is the subjective wiggle room and a key area of the valuation debate. Then there is the earnings number.

$80 operating earnings for the S&P 500 for 2010 is the best case number I am hearing of late. Of course, this number is open for debate. The final two components that investors might want to ponder doing the valuation math involve the discount rate and the time period.

In the above illustration, I used the historical average return for large cap stocks, which has often (but not always) been 12%. Some would argue that 10% (or lower) is a more appropriate going forward expected return for stocks given the slow growth environment envisioned for the next several years for advanced developed economies. Then there is the time period one discounts the future value. In the above case, I use 12 months. Some might argue things are far to dynamic and a 6 month discounting time period is more appropriate.

Investment Strategy Implications

Wherever you fix the fair value of today’s market, the valuation math always needs to be done as it provides the return context for an asset. For what it’s worth, I think these times are extraordinary and do not warrant an above average P/E (which signifies a below average risk climate). Rather, I would argue the uncertainty factor for 2010 is considerably higher than the bulls believe, despite the prospects of a robust earnings period for the large cap, multinational companies that populate the S&P 500. Risks in areas broad (e.g. geo political, US domestic political, developed economies’ internally generated growth) and specific (e.g. sector specific issues such as those facing the financial services and healthcare industries, sustainability of Chinese growth, regulatory change) are abundant and should be ignored at one's financial peril.

All of this leads to the more prudent conclusion that an average P/E times a moderately higher earnings growth rate is appropriate. In other words,

15 times $74 = 1110
1080 minus 12% = 977

Therefore, at today’s price of 1140 the market is currently 14% overvalued.

Liquidity driven markets have a funny way of producing overvalued markets. And an even funnier way of producing justifications for just about any fantasy valuation levels one wants to concoct. At least for a while.

*Note: It is important to remember that on any given day stocks sell at a discount to their expected future value. Therefore, today’s price is always a discount to where stocks should be in the near future.

Appearances Can Be Deceiving

If there is one thing that the New England Patriots have in common with the stock market it’s that neither is quite all that they are cracked up to be.

Like the Patriots, the stock market has a certain amount of star talent supporting its run for success. The Pats have the skills and talent of Belichick and Brady that enable an otherwise mediocre team from drifting into the domain of the pigskin wannabees. In the case of the stock market, it is largely the skills and talent of the stimulus machine (monetary and fiscal) that enabled (emboldened might be a better word) investors to lift prices to above historical average P/E land.

Investment Strategy Implications

Quarterbacks know that handing off the ball to a solid running back makes their life that much easier. The stock market equivalent rests in the economic handoff from stimulus to sustainability. Thus far, that has not quite occurred. Yet, valuation levels strongly suggest that such an occurrence is not only inevitable but will be highly successful (as in earnings growth rates that a V shaped economic recovery makes possible).

Sorry Bill and Tom, this will likely not be your year of glory. Your skills and talent will likely not be enough to mask the weaknesses that underlie your team. As for equity investors, they are accordingly well advised to be sensitive to the economic weaknesses that are masked by huge sums of liquidity. In sport as in the markets and the economy, appearances can be deceiving.