Many money managers feel that, at this juncture, there is an anomaly-- "investment grade" corporate bonds are more attractive than stocks. At the long end of the maturity spectrum, these bonds may have 8% yields to maturity. While I prefer my strategy of 40% in stocks and 60% in treasury securities (at this time, 90-day treasury bills), I can understand the attraction of corporate bonds SO LONG AS THEY ARE COUNTED AS PART OF THE EQUITY EXPOSURE AND NOT PART OF THE FIXED INCOME EXPOSURE!
The U.S. economy is currently in what will turn out to be the worst recession since the depression of the Thirties. While I believe that efforts to stimulate the economy will gain traction in late 2009, there is more than a de minimus probablity that monetary and fiscal policy will prove ineffective in offsetting the secular deleveraging effects, with a deflationary spiral ensuing. Under this most dire circumstance, many corporate bonds, currently "investment grade", could fall into default, and, even worse, eventually be worthless. An investor with a portfolio of 40% stocks and 60% corporate bonds could be wiped out!
Tuesday, December 30, 2008
Sunday, December 21, 2008
There Is No Such Thing As A Free Option!--At Least For Any Length Of Time!
In this week's Barron's, there is reproduced almost in entirety an article written in 2001 raising questions about Bernie Madoff. (By the way, what a great name for a swindler who "made off" with other people's money!) In it, there is a description of Madoff's strategy as a "split-strike conversion". This involves the purchase of an underlying stock, the purchase of an out-of-the-money put option, and the sale of an out-of-the-money call option. Upon reading this, I started to reminisce....
More than a quarter of a century ago, I was drawn to an arcane form of hedging using listed options. As I have mentioned in a previous posting, I am risk averse, and was attracted to the original concept of a hedge fund, which attempted to beat the market with less than a market risk. The Chicago Board Options Exchange ("CBOE") began trading in the early 1970's, and The American Stock Exchange ("AMEX") started to trade options a few years later. Many of the options traders on the CBOE were used to hedging due to their having traded on the Chicago Mercantile Exchange. Due in part to this "hedging mentality" the options traded on the CBOE became efficiently priced very quickly--that is, they traded at or close to their theoretical value as determined by complex formulae using integral calculus, such as the Black-Scholes model. The traders on the Amex, however, were by and large speculators who "didn't know from theoretical values". This allowed disciplined hedgers to take advantage of option price inefficiencies. One could go long an underpriced option and short a less underpriced option in a ratio of options sold to options bought that was "market neutral", wait until the two prices became closer to theoretical values, then close out the position for a profit. This activity is known as option spreading.
I rented an AMEX options seat and started trading in these spreads. As a market maker on the floor, I could trade with very little margin and almost no transaction costs. A retail client of an options trader could not compete with a market maker of equal skill due to the above advantages. The commissions alone would eat up the profit potential.
I started making some money, and raised capital from several people who knew me from the past. During this period, I could put the spreads on without any time elapsing between transacting the long and short positions. This was a form of arbitrage--which is the simultaneous or nearly simultaneous purchase and sale of equivalent securities for profit.
The window of opportunity for making money in this comparatively riskless way was quite brief. After all, money is fungible. If a casino allowed a bet whose payoff exceeded the odds of winning, so much money would flow into that bet that the casino would be bankrupt very quickly. In the case of AMEX option trading, the best bridge, chess, and backgammon players in the country descended on the AMEX floor to become market makers. After all, many of these people were "bridge bums" who made a paltry living playing their game for money or were hired by lesser players to win tournaments for them. My first hedge fund experience was as a junior general partner in a fund managed by a very famous bridge player, who was then in his sixties. He hired as a "gofer" one of the best young bridge players in the country. A few years later, that gofer started trading options on the AMEX, made a small fortune, and then staked some of his bridge buddies, and made a large fortune.
With the onslaught of these games players, the AMEX option market became efficient. One could establish juicy spread positions only by "lifting a leg", which required estimating which way the underlying stock was going, taking half the spread immediately,, and the other half after time elapsed. This increased the risk of options hedging and required short-term trading skills that I did not possess. I shut down my options firm and returned the capital to my investors.
Now let's discuss the "split-strike conversion" strategy purported to be Madoff's way of generating those consistent, high returns for his accounts. A "conversion" refers to transforming a put into a call. Long stock and long put is mathematically
equivalent to long call. So Madoff allegedly created a call with a lower strike price than the call he sold. Sound familiar? That is simply a call option spread.
Given that those spreads became pretty efficient, either Madoff was prescient in "lifting a leg" or he was very good at trading around his position once it was established, or both. While it is mathematically possible to achieve those impressive returns, the probability of doing so is de minimus given the fact that Madoff charged his clients commissions. Even if Madoff were the world's best trader and the fiftieth best trader were a market maker with far less friction costs, that market maker would have had Madoff for lunch. And this doesn't take into account the amount of money that can be profitably managed this way. Certainly, $17 billion leveraged would be a stretch!
My take on Madoff is that he started out generating excellent returns, but found that increasingly difficult to achieve legitimately. He then turned to more nefarious strategies.
More than a quarter of a century ago, I was drawn to an arcane form of hedging using listed options. As I have mentioned in a previous posting, I am risk averse, and was attracted to the original concept of a hedge fund, which attempted to beat the market with less than a market risk. The Chicago Board Options Exchange ("CBOE") began trading in the early 1970's, and The American Stock Exchange ("AMEX") started to trade options a few years later. Many of the options traders on the CBOE were used to hedging due to their having traded on the Chicago Mercantile Exchange. Due in part to this "hedging mentality" the options traded on the CBOE became efficiently priced very quickly--that is, they traded at or close to their theoretical value as determined by complex formulae using integral calculus, such as the Black-Scholes model. The traders on the Amex, however, were by and large speculators who "didn't know from theoretical values". This allowed disciplined hedgers to take advantage of option price inefficiencies. One could go long an underpriced option and short a less underpriced option in a ratio of options sold to options bought that was "market neutral", wait until the two prices became closer to theoretical values, then close out the position for a profit. This activity is known as option spreading.
I rented an AMEX options seat and started trading in these spreads. As a market maker on the floor, I could trade with very little margin and almost no transaction costs. A retail client of an options trader could not compete with a market maker of equal skill due to the above advantages. The commissions alone would eat up the profit potential.
I started making some money, and raised capital from several people who knew me from the past. During this period, I could put the spreads on without any time elapsing between transacting the long and short positions. This was a form of arbitrage--which is the simultaneous or nearly simultaneous purchase and sale of equivalent securities for profit.
The window of opportunity for making money in this comparatively riskless way was quite brief. After all, money is fungible. If a casino allowed a bet whose payoff exceeded the odds of winning, so much money would flow into that bet that the casino would be bankrupt very quickly. In the case of AMEX option trading, the best bridge, chess, and backgammon players in the country descended on the AMEX floor to become market makers. After all, many of these people were "bridge bums" who made a paltry living playing their game for money or were hired by lesser players to win tournaments for them. My first hedge fund experience was as a junior general partner in a fund managed by a very famous bridge player, who was then in his sixties. He hired as a "gofer" one of the best young bridge players in the country. A few years later, that gofer started trading options on the AMEX, made a small fortune, and then staked some of his bridge buddies, and made a large fortune.
With the onslaught of these games players, the AMEX option market became efficient. One could establish juicy spread positions only by "lifting a leg", which required estimating which way the underlying stock was going, taking half the spread immediately,, and the other half after time elapsed. This increased the risk of options hedging and required short-term trading skills that I did not possess. I shut down my options firm and returned the capital to my investors.
Now let's discuss the "split-strike conversion" strategy purported to be Madoff's way of generating those consistent, high returns for his accounts. A "conversion" refers to transforming a put into a call. Long stock and long put is mathematically
equivalent to long call. So Madoff allegedly created a call with a lower strike price than the call he sold. Sound familiar? That is simply a call option spread.
Given that those spreads became pretty efficient, either Madoff was prescient in "lifting a leg" or he was very good at trading around his position once it was established, or both. While it is mathematically possible to achieve those impressive returns, the probability of doing so is de minimus given the fact that Madoff charged his clients commissions. Even if Madoff were the world's best trader and the fiftieth best trader were a market maker with far less friction costs, that market maker would have had Madoff for lunch. And this doesn't take into account the amount of money that can be profitably managed this way. Certainly, $17 billion leveraged would be a stretch!
My take on Madoff is that he started out generating excellent returns, but found that increasingly difficult to achieve legitimately. He then turned to more nefarious strategies.
Saturday, December 6, 2008
Counterintuitive Behavior--A "Tell"
In each of the movies "House of Games" and "Casino Royale", there is reference to a "tell", a familiar term to poker players. A "tell" is a poker player's behavior, perhaps a tic, that reveals to his opponent what he holds. The opponent can "tell" whether or not the player is bluffing.
Money managers are looking for "tells" that reveal what the stock market will do in the future. Counterintuitive stock market behavior is such a "tell". We encountered such behavior yesterday when the market rose in the face of a much worse-than-expected employment report. While this report is subject to many revisions, it is still very important to investors. Yesterday's market action signals that, at least during the short term, the market is very oversold and has an upward bias.
We have been in a recession for a year already. At this point, the recession is deepening and we will suffer through many more worse-than-expected news items. Bear markets, however, end before the news gets better. As mentioned in previous postings, I believe the bear market for most stocks ended on October 10.
Bull markets tend to ignore bad news. Yesterday's counterintuitive behavior is a welcome sign.
Money managers are looking for "tells" that reveal what the stock market will do in the future. Counterintuitive stock market behavior is such a "tell". We encountered such behavior yesterday when the market rose in the face of a much worse-than-expected employment report. While this report is subject to many revisions, it is still very important to investors. Yesterday's market action signals that, at least during the short term, the market is very oversold and has an upward bias.
We have been in a recession for a year already. At this point, the recession is deepening and we will suffer through many more worse-than-expected news items. Bear markets, however, end before the news gets better. As mentioned in previous postings, I believe the bear market for most stocks ended on October 10.
Bull markets tend to ignore bad news. Yesterday's counterintuitive behavior is a welcome sign.
Monday, November 24, 2008
The Good News and The Possible Bad News
The Good News
The Obama economic team is excellent--a good blend of high intellect, experience and fresh faces. Prior to Friday's announcement of Geithner as Treasury Secretary, there appeared to be a leadership vacuum in Washington. Paulsen had folded up TARP. Bush was acting like a lame duck. Obama had been silent about his economic team.
Not only has Obama fleshed out and announced his team, he also has shown over the weekend that he understands the gravity of this country's economic situation and the necessity for injecting a huge dose of Keynesian fiscal stimulus ASAP to restore confidence in both the public and private sectors. He is showing a pragmatic side that is essential if our economy is going to emerge from this mess. This is not the time for ideology.
Our economy is experiencing a "liquidity trap", the severity of which has not been seen since the Thirties. Lenders are reluctant to lend and borrowers to borrow -- primarily due to lack of trust in our financial institutions and confidence in our economy's future. Monetary policy is ineffective in jump starting the economy --a phenomenon known as "pushing on a string" -- hence the need for massive fiscal stimulus.
Hopefully, the stimulus plan will address the decline in home prices, which got us into this mess in the first place. Mounting foreclosures are poison to the housing market. Furthermore, there should be no hint of protectionism. Such a path in the Thirties aggravated the downturn.
The Citicorp "rescue" plan is a de facto step toward nationalization under the guise of a "passive" investment. From my point of view, the action is constructive, but doesn't go far enough. What is needed to restore trust in banks is a secondary market for their toxic securities. Such a market would establish the clearing prices for them. At that point, the banks would know how much additional capital is needed to begin lending again; and that capital would either be raised privately or, if necessary, by the U.S. Treasury.
We have all heard the adage that "those who do not study history are doomed to repeat it". We have a Federal Reserve Chairman who is an expert on what happened in the Thirties. Let's hope that his and our study of that horrific time will prove sufficient to avoid the doom of repeating it.
The Possible Bad News
Last week the breaching of two interrelated, important trends occurred --the long-term upward price trend of the S&P 500 Index (the "Index") and the long-term rise in the consumer price index ex food and fuel. These breaches may be aberrations, but if not, are very significant because they would signal, respectively, a secular downtrend in the Index and deflation.
As you know, I have been closely watching the market's testing of the October 10 lows in order to discern whether that date constituted a major market bottom. Until last week, all tests were successful. Even now, the number of new 52 week lows and the consolidated daily volume haven't yet reached the October 10 levels. However, the Index last Thursday closed at 752. In past postings, I have said that the Index's price is the least important of the three criteria I had been observing. However, the Index at 752 is a special case because it is BELOW THE 2002 BEAR MARKET LOW OF 776. Since this secular bull market began in 1974, never has a succeeding bear market low been lower than a preceding one. This raises the specter of a secular downtrend in the Index.
The consumer price index ex food and fuel declined a tenth of one percent last month--a rare decline. Only during a few years since the Depression has modest deflation occurred, but that was nothing compared to the 5-10% annual deflation during the Thirties. If this decline persists, it may become embedded in the collective pysche of consumers--a truly dangerous development. Consumers would then expect prices to continue falling, so why buy now? The effects of lower prices and lower consumption on corporate earnings would be devastating. The Index earnings would enter into a secular downtrend, mirroring the possible secular downtrend in the Index's price alluded to above.
While this potential risk should be kept in mind, I believe "net-net" that the recent developments regarding Obama's economic team and stimulus program will trigger a very significant rally, perhaps to a level of 1100 to 1200 in the Index. At that point, I for one must decide whether or not the Index remains in a secular uptrend.
The Obama economic team is excellent--a good blend of high intellect, experience and fresh faces. Prior to Friday's announcement of Geithner as Treasury Secretary, there appeared to be a leadership vacuum in Washington. Paulsen had folded up TARP. Bush was acting like a lame duck. Obama had been silent about his economic team.
Not only has Obama fleshed out and announced his team, he also has shown over the weekend that he understands the gravity of this country's economic situation and the necessity for injecting a huge dose of Keynesian fiscal stimulus ASAP to restore confidence in both the public and private sectors. He is showing a pragmatic side that is essential if our economy is going to emerge from this mess. This is not the time for ideology.
Our economy is experiencing a "liquidity trap", the severity of which has not been seen since the Thirties. Lenders are reluctant to lend and borrowers to borrow -- primarily due to lack of trust in our financial institutions and confidence in our economy's future. Monetary policy is ineffective in jump starting the economy --a phenomenon known as "pushing on a string" -- hence the need for massive fiscal stimulus.
Hopefully, the stimulus plan will address the decline in home prices, which got us into this mess in the first place. Mounting foreclosures are poison to the housing market. Furthermore, there should be no hint of protectionism. Such a path in the Thirties aggravated the downturn.
The Citicorp "rescue" plan is a de facto step toward nationalization under the guise of a "passive" investment. From my point of view, the action is constructive, but doesn't go far enough. What is needed to restore trust in banks is a secondary market for their toxic securities. Such a market would establish the clearing prices for them. At that point, the banks would know how much additional capital is needed to begin lending again; and that capital would either be raised privately or, if necessary, by the U.S. Treasury.
We have all heard the adage that "those who do not study history are doomed to repeat it". We have a Federal Reserve Chairman who is an expert on what happened in the Thirties. Let's hope that his and our study of that horrific time will prove sufficient to avoid the doom of repeating it.
The Possible Bad News
Last week the breaching of two interrelated, important trends occurred --the long-term upward price trend of the S&P 500 Index (the "Index") and the long-term rise in the consumer price index ex food and fuel. These breaches may be aberrations, but if not, are very significant because they would signal, respectively, a secular downtrend in the Index and deflation.
As you know, I have been closely watching the market's testing of the October 10 lows in order to discern whether that date constituted a major market bottom. Until last week, all tests were successful. Even now, the number of new 52 week lows and the consolidated daily volume haven't yet reached the October 10 levels. However, the Index last Thursday closed at 752. In past postings, I have said that the Index's price is the least important of the three criteria I had been observing. However, the Index at 752 is a special case because it is BELOW THE 2002 BEAR MARKET LOW OF 776. Since this secular bull market began in 1974, never has a succeeding bear market low been lower than a preceding one. This raises the specter of a secular downtrend in the Index.
The consumer price index ex food and fuel declined a tenth of one percent last month--a rare decline. Only during a few years since the Depression has modest deflation occurred, but that was nothing compared to the 5-10% annual deflation during the Thirties. If this decline persists, it may become embedded in the collective pysche of consumers--a truly dangerous development. Consumers would then expect prices to continue falling, so why buy now? The effects of lower prices and lower consumption on corporate earnings would be devastating. The Index earnings would enter into a secular downtrend, mirroring the possible secular downtrend in the Index's price alluded to above.
While this potential risk should be kept in mind, I believe "net-net" that the recent developments regarding Obama's economic team and stimulus program will trigger a very significant rally, perhaps to a level of 1100 to 1200 in the Index. At that point, I for one must decide whether or not the Index remains in a secular uptrend.
Friday, November 14, 2008
"All In!"--A Double Entendre
Yesterday, the October 10 lows survived the greatest test yet. The number of NYSE new lows Thursday was 776 versus 2901 on October 10; the consolidated volume yesterday was 7.6 billion shares compared with 11.2 billion on October 10. However, the S&P 500 Index did drop to a new intraday low of 819 versus 839 on October 10. As I have discussed in a previous posting, a slightly lower price (this was less than 3%lower) does not detract from my contention that October 10 marked the low for most NYSE stocks during this bear market. There has been at least one major bear market that ended in a similar way, with a breadth climax followed in a few months by a lower Index low but with far fewer new 52 week lows.
In a phrase well known to poker players, I am now "all in". I have completed my equity position started last March. I am also "all in" in terms of fatigue--hence the double entendre.
I want to make clear that an "all in" equity position for me, aged 69, is 40% of my total financial assets. The remaining 60% is in U.S. Treasury bills. Hopefully, I can sell those bills and purchase the 10 year Treasury Note sometime in the future when note yields exceed 5%, compared with 3.7% currently.
I was entirely in Treasury bills at the beginning of 2008, purchased half of the equity position in March and filled the other half during October and November. Basically, I have dollar-cost-averaged, but with only two tranches determined by my market timing approach laid out in my previous postings. The average cost of my position is roughly 1080 in the Index--not bad but should have been better.
Those of you who have read my previous meanderings have been saturated with my
claim that a measure of fear and greed rather than an earnings estimate is the better timing indicator of major market turns. The principal reason for that is that the stock market tends to bottom well before earnings bottom.
However, I have often touched on the "fundamentals". My last posting was a discussion of earnings estimates. In it I estimated that earnings for the next four quarters could drop from the high of $91.45 in mid-2007 to as low as $48 in mid-2009. "Normalized", or trendline, earnings at that time would be $64. Applying the 15 average historical price to earnings ratio to trendline earnings would result in a trendline S&P 500 Index price of 960.
The bears find that calculation ridiculous! They point out that the bear markets in 1974 and 1982 bottomed at ten times depressed earnings! (That would imply an Index level below 500!) My response is that you must take into account the level of interest rates during those lows. In 1974 and 1982, interest rates were much higher than now. The five-year treasury note was yielding 7.8% at the 1974 stock market bottom, 10.2% in 1982, and 2,3% today! Interest rates determine the rate at which future earnings and dividends are discounted to the present. A much lower interest rate results in a much higher present value.
For perspective, Goldman Sachs used to publish a table showing their "Justifiable Share Price for the S&P 500". I have one from 1994. The five-year note interest rate assumptions ranged in 50 basis point increments from 8.0% to 6%. At 8%, the justifiable value for the Index was 339; for 6%, it was 491, a 45% increase in value
solely due to a 200 basis point, or 25%, reduction in the interest rate assumption.
Perhaps a more relevant comparison would be with the 2001-2003 bear market when interest rates were more comparable. Earnings bottomed at $38.85 in 2001 and the Index eventually at 770, for a price to earnings ratio of just under twenty. At the recent intraday low of 819, the Index was selling for seventeen times my recession low earnings of $48. (And by the way, few, if any, have that low an estimate.)
In a former posting I suggested that the upside target would be the Index highs of 2000 and 2007. That double top is at 1565. The key question is not whether the Index will reach that price, but when? Here is a simplistic way of estimating. We can back into it. The historical average p/e is fifteen. At 1565 and a p/e of 15, earnings should be 1565 divided by 15, or roughly $104. Normalized earnings at mid-2009 are $64. Compounded at 7% annually, $64 becomes $104 in seven to eight years. So sometime in 2016 at the latest, the Index should reach the old highs. From the October 10 low of 840 to 1565 in 2016, the Index would have generated an 8% compound annual appreciation plus a 2%-3% dividend yield--a handsome total return indeed!
What the bears have to keep in mind is that, at some point, the market will begin acting well in the face of dreadful news. That may already have begun. Furthermore, the current dividend yield on the Index is around 3%, and treasury bills are yielding a mere 0.3%. Moreover,the five-year government note is yielding only 2.34%. The combination of these factors will ultimately lead to an episode of spontaneous combustion when the investment goal changes from "return OF capital" to "return ON capital". I wouldn't want to hold excess cash at that time.
201
In a phrase well known to poker players, I am now "all in". I have completed my equity position started last March. I am also "all in" in terms of fatigue--hence the double entendre.
I want to make clear that an "all in" equity position for me, aged 69, is 40% of my total financial assets. The remaining 60% is in U.S. Treasury bills. Hopefully, I can sell those bills and purchase the 10 year Treasury Note sometime in the future when note yields exceed 5%, compared with 3.7% currently.
I was entirely in Treasury bills at the beginning of 2008, purchased half of the equity position in March and filled the other half during October and November. Basically, I have dollar-cost-averaged, but with only two tranches determined by my market timing approach laid out in my previous postings. The average cost of my position is roughly 1080 in the Index--not bad but should have been better.
Those of you who have read my previous meanderings have been saturated with my
claim that a measure of fear and greed rather than an earnings estimate is the better timing indicator of major market turns. The principal reason for that is that the stock market tends to bottom well before earnings bottom.
However, I have often touched on the "fundamentals". My last posting was a discussion of earnings estimates. In it I estimated that earnings for the next four quarters could drop from the high of $91.45 in mid-2007 to as low as $48 in mid-2009. "Normalized", or trendline, earnings at that time would be $64. Applying the 15 average historical price to earnings ratio to trendline earnings would result in a trendline S&P 500 Index price of 960.
The bears find that calculation ridiculous! They point out that the bear markets in 1974 and 1982 bottomed at ten times depressed earnings! (That would imply an Index level below 500!) My response is that you must take into account the level of interest rates during those lows. In 1974 and 1982, interest rates were much higher than now. The five-year treasury note was yielding 7.8% at the 1974 stock market bottom, 10.2% in 1982, and 2,3% today! Interest rates determine the rate at which future earnings and dividends are discounted to the present. A much lower interest rate results in a much higher present value.
For perspective, Goldman Sachs used to publish a table showing their "Justifiable Share Price for the S&P 500". I have one from 1994. The five-year note interest rate assumptions ranged in 50 basis point increments from 8.0% to 6%. At 8%, the justifiable value for the Index was 339; for 6%, it was 491, a 45% increase in value
solely due to a 200 basis point, or 25%, reduction in the interest rate assumption.
Perhaps a more relevant comparison would be with the 2001-2003 bear market when interest rates were more comparable. Earnings bottomed at $38.85 in 2001 and the Index eventually at 770, for a price to earnings ratio of just under twenty. At the recent intraday low of 819, the Index was selling for seventeen times my recession low earnings of $48. (And by the way, few, if any, have that low an estimate.)
In a former posting I suggested that the upside target would be the Index highs of 2000 and 2007. That double top is at 1565. The key question is not whether the Index will reach that price, but when? Here is a simplistic way of estimating. We can back into it. The historical average p/e is fifteen. At 1565 and a p/e of 15, earnings should be 1565 divided by 15, or roughly $104. Normalized earnings at mid-2009 are $64. Compounded at 7% annually, $64 becomes $104 in seven to eight years. So sometime in 2016 at the latest, the Index should reach the old highs. From the October 10 low of 840 to 1565 in 2016, the Index would have generated an 8% compound annual appreciation plus a 2%-3% dividend yield--a handsome total return indeed!
What the bears have to keep in mind is that, at some point, the market will begin acting well in the face of dreadful news. That may already have begun. Furthermore, the current dividend yield on the Index is around 3%, and treasury bills are yielding a mere 0.3%. Moreover,the five-year government note is yielding only 2.34%. The combination of these factors will ultimately lead to an episode of spontaneous combustion when the investment goal changes from "return OF capital" to "return ON capital". I wouldn't want to hold excess cash at that time.
201
Thursday, November 6, 2008
Earnings Estimates or "Look, father, the security analysts wear no clothes!"
Prior to entering the hedge fund business in 1968, I spent my first four years on Wall Street as a security analyst. I felt that I added value to the equity portfolios of my firm's clients. However, I realized early on that most analysts parroted back what management told them. There was very little analysis. Most analysts were mere journeymen. Since then, whenever I hear what analysts in aggregate are estimating for the S&P 500 Index's earnings, the so-called "bottom up" approach, I ignore the findings. The better approach is the "top down" one, which scrutinizes macroeconomic variables.
In previous postings, I have mentioned that the aggregate profit margin of the companies in the 500 Index had reached 13% versus the normal 8%. This occurred in the year ending mid-2007, when earnings were $91.47. At that time, normalized earnings would then have amounted to 8/13 of those lofty earnings, or roughly $56.
Historically, normalized earnings have grown at a 7% compounded annual rate. (See my early posting entitled "The Seven Percent Solution".) So normalized earnings for mid-2009 would be $56 compounded for two years at 7%, or roughly $64.
I have long held the position that deleveraging the economy would cause a very serious recession. It wouldn't surprise me if earnings declined 25% from the normalized level. Reducing normalized earnings of $64 by 25% would bring earnings down to $48. The "bottom up" estimate for the four quarters ending mid-2009 is $86.95! Guess in which estimate I place more faith!
In previous postings, I have mentioned that the aggregate profit margin of the companies in the 500 Index had reached 13% versus the normal 8%. This occurred in the year ending mid-2007, when earnings were $91.47. At that time, normalized earnings would then have amounted to 8/13 of those lofty earnings, or roughly $56.
Historically, normalized earnings have grown at a 7% compounded annual rate. (See my early posting entitled "The Seven Percent Solution".) So normalized earnings for mid-2009 would be $56 compounded for two years at 7%, or roughly $64.
I have long held the position that deleveraging the economy would cause a very serious recession. It wouldn't surprise me if earnings declined 25% from the normalized level. Reducing normalized earnings of $64 by 25% would bring earnings down to $48. The "bottom up" estimate for the four quarters ending mid-2009 is $86.95! Guess in which estimate I place more faith!
Saturday, October 25, 2008
A Successful Test Of The October 10 Lows or "Everything Is All Right So Far!"
Yesterday, Friday morning, October 24, I awoke with the news that the S&P 500 Index Future had traded at a 5% preopening limit down, with the Asian markets having closed down 8-10% for their trading day. My immediate thought was "Fasten your seatbelts! We are going to test the October l0 lows!"
In my October 16 posting entitled "Puking Redux", I discussed the criteria I analyze to determine if a retest of a major low is successful. In order of importance -- breadth (number of new 52 week lows), volume, and price. At the end of trading yesterday, here are the comparisons with October 10, the recent "capitulation" day:
October 10 October 24
Number of 52 week new lows: 2901 1125
Composite volume: 11.2 billion 6.5 billion
Intra-day low price 840 853
Closing price 900 877
While yesterday's intra-day low was within 2% of the low on October 10, the number of new lows was less than 40% of the new lows on October 10. This reinforces the notion that a breadth climax occurred on October 10. Furthermore, the volume yesterday was less than 60% of the volume on October 10--evidence of a volume climax as well on that date. The pricing was mixed, with a lower closing price yesterday but a lower intra-day price on October 10. However, pricing is the least important criteria of gauging a successful test. My conclusion is that yesterday's test was, indeed, successful.
To be sure, none of this rules out further tests in the future. After all, the percentage bears, at 54.4% last Wednesday, hasn't yet reached the threshold 60% level I consider very important. Also, disconcerting are the rumors that some very large hedge funds are in trouble.
With respect to the monies I have earmarked for equities, I am now five-sixths invested. Unless Monday's action indicates another test, I shall complete my buying program then.
I am reminded of the story about the man who jumps from a skyscraper and at each floor is heard yelling "Everything is all right so far!" At the end of each trading day, I feel like that guy!
In my October 16 posting entitled "Puking Redux", I discussed the criteria I analyze to determine if a retest of a major low is successful. In order of importance -- breadth (number of new 52 week lows), volume, and price. At the end of trading yesterday, here are the comparisons with October 10, the recent "capitulation" day:
October 10 October 24
Number of 52 week new lows: 2901 1125
Composite volume: 11.2 billion 6.5 billion
Intra-day low price 840 853
Closing price 900 877
While yesterday's intra-day low was within 2% of the low on October 10, the number of new lows was less than 40% of the new lows on October 10. This reinforces the notion that a breadth climax occurred on October 10. Furthermore, the volume yesterday was less than 60% of the volume on October 10--evidence of a volume climax as well on that date. The pricing was mixed, with a lower closing price yesterday but a lower intra-day price on October 10. However, pricing is the least important criteria of gauging a successful test. My conclusion is that yesterday's test was, indeed, successful.
To be sure, none of this rules out further tests in the future. After all, the percentage bears, at 54.4% last Wednesday, hasn't yet reached the threshold 60% level I consider very important. Also, disconcerting are the rumors that some very large hedge funds are in trouble.
With respect to the monies I have earmarked for equities, I am now five-sixths invested. Unless Monday's action indicates another test, I shall complete my buying program then.
I am reminded of the story about the man who jumps from a skyscraper and at each floor is heard yelling "Everything is all right so far!" At the end of each trading day, I feel like that guy!
Tuesday, October 21, 2008
An Epiphany--Maybe
On last Saturday, October 18, Joe Nocera's article called "Shouldn't We Rescue Housing?" appeared in The New York Times. After reading it, I had what may have been an epiphany--which Webster's Dictionary defines as "an intuitive grasp of reality through something usually simple and striking." I say "may have been" because, in order to have been an epiphany, the future reality has to be confirming.
As the title indicates, Nocera argues that the next rescue effort should be concentrated on stabilizing home prices. I strongly agree. After all, the bursting of the home price bubble is the central cause of the credit crisis and recession. And if the slide in home prices and the buildup of unsold home inventories continue unchecked, the result will be a further vicious cycle of lower home prices, more delinquent mortgages, and more foreclosures leading to lower home prices.... This would prolong and deepen the recession.
It doesn't take a "phi beta kappa" to figure this out. So why hasn't this already been done? First of all, the more immediate problem facing our economy as recently as October 10 (it seems like ages ago) was a freezing up of the credit flows necessary for commerce to flourish in this country. Unless action were taken quickly, our economy and the remainder of the world to boot would probably have lapsed into a depression. I wrote about this in my October 12 posting "Scared Straight." Now, after the rescue efforts by Treasury, the Federal Reserve and Congress, the flow of credit seems to be at least partially restored as evidenced by the decline in the three month Libor rate.
The second reason why we haven't heard a lot about rescuing housing is the upcoming election. In dealings with my local government, I learned long ago that there can be a vast difference between "reality" and "political reality." "Reality" is something should be done to rescue housing. "Political reality," all about votes, is how will any housing rescue plan affect the imminent election?
Nocera writes "there are lots of Americans who were not greedy or foolish during the housing bubble, and many resent the idea that their neighbors might get a bailout they don't deserve." From a political point of view, that potential for resentment weighs heavily in the decision whether to act now or after the election. After all, the number of homeowners without mortgages and the 96% of mortgagees who are current on their payments dwarf the number of people delinquent on their mortgages. The ratio is more than 24 to one. So why risk the wrath and votes of at least 24 homeowners to win the vote of one?
I believe that, immediately after the election, the president-elect will propose a major, effective housing rescue plan. By the end of the year, that plan should become law.
How does this affect my view of the equities market? It increases the probability that the S&P 500 Index's intra-day low of 840 on October 10 will mark the low of this bear market. At the very least, any serious test of that low should be later rather than sooner. With this in mind, yesterday I added more to my equity position by purchasing shares in the T. Rowe Price New Asia Fund. This fund has roughly 40% of its capital in China, 30% in India and the remainder in other Asian emerging economies. Its price range has been a low of $3.92 in 1998 and a high of $22.06 in
2007. From the 1998 low to yesterday's closing price of $8.70, the fund has appreciated at a compound 8.3% annual rate, less than the weighted-average real growth of the portfolio's underlying economies. Last year, there was a huge influx of foreign money into this fund due to the much higher real growth rate in Asia and the theory that there is a decoupling between the U.S. economy and the Asian economies. The decoupling theory has been discredited, and U.S. investors, due to the greater decline in the Asian markets than here, have been redeeming shares. It seems like a good entry point. There is the risk that China's booming economy is overseen by a Communist government. I regard this fund as a high growth, high risk investment. When I am fully invested in equities, 75% will be in an S&P 500 Index fund and 25% in this Asian fund.
As the title indicates, Nocera argues that the next rescue effort should be concentrated on stabilizing home prices. I strongly agree. After all, the bursting of the home price bubble is the central cause of the credit crisis and recession. And if the slide in home prices and the buildup of unsold home inventories continue unchecked, the result will be a further vicious cycle of lower home prices, more delinquent mortgages, and more foreclosures leading to lower home prices.... This would prolong and deepen the recession.
It doesn't take a "phi beta kappa" to figure this out. So why hasn't this already been done? First of all, the more immediate problem facing our economy as recently as October 10 (it seems like ages ago) was a freezing up of the credit flows necessary for commerce to flourish in this country. Unless action were taken quickly, our economy and the remainder of the world to boot would probably have lapsed into a depression. I wrote about this in my October 12 posting "Scared Straight." Now, after the rescue efforts by Treasury, the Federal Reserve and Congress, the flow of credit seems to be at least partially restored as evidenced by the decline in the three month Libor rate.
The second reason why we haven't heard a lot about rescuing housing is the upcoming election. In dealings with my local government, I learned long ago that there can be a vast difference between "reality" and "political reality." "Reality" is something should be done to rescue housing. "Political reality," all about votes, is how will any housing rescue plan affect the imminent election?
Nocera writes "there are lots of Americans who were not greedy or foolish during the housing bubble, and many resent the idea that their neighbors might get a bailout they don't deserve." From a political point of view, that potential for resentment weighs heavily in the decision whether to act now or after the election. After all, the number of homeowners without mortgages and the 96% of mortgagees who are current on their payments dwarf the number of people delinquent on their mortgages. The ratio is more than 24 to one. So why risk the wrath and votes of at least 24 homeowners to win the vote of one?
I believe that, immediately after the election, the president-elect will propose a major, effective housing rescue plan. By the end of the year, that plan should become law.
How does this affect my view of the equities market? It increases the probability that the S&P 500 Index's intra-day low of 840 on October 10 will mark the low of this bear market. At the very least, any serious test of that low should be later rather than sooner. With this in mind, yesterday I added more to my equity position by purchasing shares in the T. Rowe Price New Asia Fund. This fund has roughly 40% of its capital in China, 30% in India and the remainder in other Asian emerging economies. Its price range has been a low of $3.92 in 1998 and a high of $22.06 in
2007. From the 1998 low to yesterday's closing price of $8.70, the fund has appreciated at a compound 8.3% annual rate, less than the weighted-average real growth of the portfolio's underlying economies. Last year, there was a huge influx of foreign money into this fund due to the much higher real growth rate in Asia and the theory that there is a decoupling between the U.S. economy and the Asian economies. The decoupling theory has been discredited, and U.S. investors, due to the greater decline in the Asian markets than here, have been redeeming shares. It seems like a good entry point. There is the risk that China's booming economy is overseen by a Communist government. I regard this fund as a high growth, high risk investment. When I am fully invested in equities, 75% will be in an S&P 500 Index fund and 25% in this Asian fund.
Thursday, October 16, 2008
Puking Redux
In my last posting entitled "Entering the Puking Phase", I indicated that the market's behavior on Friday, October 10, may have been a capitulation -- signaling the end of this vicious bear market. However, I only put to work one third of the remaining funds allocated to equities, at a price of 900 in the S&P 500 Index(the Index). That is because I wanted to wait until the following Monday or Tuesday before committing the rest. Only major news out of last weekend's world leader meetings could disturb this climatic process. Major headway toward restabilizing the flow of monies throughout the financial system was announced, and the equity markets around the world erupted to the upside.
I applaud the moves last weekend. They are necessary to restore the flow of credit throughout the global financial system. The three month Libor rate, a barometer of fear in the credit markets, has started to come down to more normal levels--a good thing. The restabilizing of the credit markets will allow the U.S. economy to avoid a depression, but we are still faced with a prolonged recession, which I contend started in December, 2007, and will continue through mid to late 2009. Afterall last year's vast erosion of financial assets was caused by the decline in home prices. So far, there has been little governmental intervention to hasten the normalizing of the homes-for-sale inventory, which would alleviate the downward trend in home prices. The government may take action to accelerate this normalizing process, which would spark a significant equities rally.
The low in the S&P 500 Index on October 10 was 840 intraday and 900 at the close. During most bottom processes, there is a test of these levels. A successful test would allow me to invest the remainder of monies allocated to equities.
What constitutes a successful test? In order of importance: (1) breadth of the market (number of new lows for the year),(2) volume, and (3) price. Price is the least important because we have experienced major bottoms wherein slightly lower prices for the Index were reached during the test, yet the breadth and volume were more favorable, which signaled that the original bottom was really THE BOTTOM for most equities. On October 10, the number of new NYSE lows for the year was 2901 out of a total 3335 issues, a rare event indeed. NYSE composite volume was 11.2 billion shares, almost twice the average for the last several months. We should compare these levels with those occurring when and if the Index revisits 840.
Now for a mea culpa. The percentage bears from Investors Intelligence yesterday showed no movement upward from the previous Wednesday. (Actually at 52.9%, it was a smidgen below the previous 53%.) To put it mildly, I view that as counterintuitive. Afterall, the Index had one of its worst ever downdrafts during the previous week. It was my understanding that I.I. called the more than 100 investment advisors each Friday for their market opinions, tabulated the results during the next two business days, and published the results on Wednesday. I called the service and discovered that the procedure was different. I.I. subscribes to the advisory letters or emails and compiles the numbers on Tuesday night for publication on Wednesday. So some advisors who were turning bearish might have changed their minds after Monday's rally. If so, and if the Index is in the process of testing last Friday's low, the percentage bears should increase when the number is published next Wednesday.
A good money management approach is to analyze each investment according to an expected return-to-risk ratio. During my money management career, I found a ratio of three-to-one to be about as attractive as I could find. What was that ratio when the Index hit its low of 840 last Friday? The upside potential is roughly 1565, which may take five or six years to reach. That would be at roughly the two highs of the bull markets that ended in 2000 and 2007, which constitutes a massive double top.
The low is difficult to ascertain. From a technical point of view, perhaps we should look at the trendline for the Index from the two most important bottoms during my adult lifetime, 1974 and 1982. After all, if we are witnessing a deleveraging of the economy back to the days of more normal leverage, perhaps the preleveraging trendline is appropriate. That trendline is now at roughly 600.
What could take us down to that level? If the supply of money is plentiful BUT the demand for it isn't there, the resulting recession would be horrendous. This is what is known as the dreaded "liquidity trap" or "pushing on a string".
The earnings of the Index under those circumstances would possibly be in the 45 area, down from the high 80s at the top. That would take into consideration (1) a reversion to the normal profit margin of 8% from the inflated 13% at the high and 2) an adjustment from that level to account for the recession. The indicated dividend for the Index, which topped at over 29, would probably decline to the mid-twenties. At 600, the Index would be selling for around 13 times earnings and yielding 4%, a very attractive level historically, especially given the 2-2.5% core inflation rate.
If this estimate of reward at 1565 and risk down to 600 is assumed, then the upside at 840 is 725 points and the downside 240, for roughly a three-to-one ratio. You might ask if 1565 is more probable than 600 during the next six years? This may sound strange, but I think so.
I applaud the moves last weekend. They are necessary to restore the flow of credit throughout the global financial system. The three month Libor rate, a barometer of fear in the credit markets, has started to come down to more normal levels--a good thing. The restabilizing of the credit markets will allow the U.S. economy to avoid a depression, but we are still faced with a prolonged recession, which I contend started in December, 2007, and will continue through mid to late 2009. Afterall last year's vast erosion of financial assets was caused by the decline in home prices. So far, there has been little governmental intervention to hasten the normalizing of the homes-for-sale inventory, which would alleviate the downward trend in home prices. The government may take action to accelerate this normalizing process, which would spark a significant equities rally.
The low in the S&P 500 Index on October 10 was 840 intraday and 900 at the close. During most bottom processes, there is a test of these levels. A successful test would allow me to invest the remainder of monies allocated to equities.
What constitutes a successful test? In order of importance: (1) breadth of the market (number of new lows for the year),(2) volume, and (3) price. Price is the least important because we have experienced major bottoms wherein slightly lower prices for the Index were reached during the test, yet the breadth and volume were more favorable, which signaled that the original bottom was really THE BOTTOM for most equities. On October 10, the number of new NYSE lows for the year was 2901 out of a total 3335 issues, a rare event indeed. NYSE composite volume was 11.2 billion shares, almost twice the average for the last several months. We should compare these levels with those occurring when and if the Index revisits 840.
Now for a mea culpa. The percentage bears from Investors Intelligence yesterday showed no movement upward from the previous Wednesday. (Actually at 52.9%, it was a smidgen below the previous 53%.) To put it mildly, I view that as counterintuitive. Afterall, the Index had one of its worst ever downdrafts during the previous week. It was my understanding that I.I. called the more than 100 investment advisors each Friday for their market opinions, tabulated the results during the next two business days, and published the results on Wednesday. I called the service and discovered that the procedure was different. I.I. subscribes to the advisory letters or emails and compiles the numbers on Tuesday night for publication on Wednesday. So some advisors who were turning bearish might have changed their minds after Monday's rally. If so, and if the Index is in the process of testing last Friday's low, the percentage bears should increase when the number is published next Wednesday.
A good money management approach is to analyze each investment according to an expected return-to-risk ratio. During my money management career, I found a ratio of three-to-one to be about as attractive as I could find. What was that ratio when the Index hit its low of 840 last Friday? The upside potential is roughly 1565, which may take five or six years to reach. That would be at roughly the two highs of the bull markets that ended in 2000 and 2007, which constitutes a massive double top.
The low is difficult to ascertain. From a technical point of view, perhaps we should look at the trendline for the Index from the two most important bottoms during my adult lifetime, 1974 and 1982. After all, if we are witnessing a deleveraging of the economy back to the days of more normal leverage, perhaps the preleveraging trendline is appropriate. That trendline is now at roughly 600.
What could take us down to that level? If the supply of money is plentiful BUT the demand for it isn't there, the resulting recession would be horrendous. This is what is known as the dreaded "liquidity trap" or "pushing on a string".
The earnings of the Index under those circumstances would possibly be in the 45 area, down from the high 80s at the top. That would take into consideration (1) a reversion to the normal profit margin of 8% from the inflated 13% at the high and 2) an adjustment from that level to account for the recession. The indicated dividend for the Index, which topped at over 29, would probably decline to the mid-twenties. At 600, the Index would be selling for around 13 times earnings and yielding 4%, a very attractive level historically, especially given the 2-2.5% core inflation rate.
If this estimate of reward at 1565 and risk down to 600 is assumed, then the upside at 840 is 725 points and the downside 240, for roughly a three-to-one ratio. You might ask if 1565 is more probable than 600 during the next six years? This may sound strange, but I think so.
Sunday, October 12, 2008
Entering the Puking Phase
Those of you who have been reading my previous postings since I began Pywrite in March, 2007 have been bombarded by my notion that psychology, not logic, is the better way to discern bear market bottoms. In other words, at bear market lows, a sentiment indicator of fear tends to be a coincident indicator while the economic fundamentals tend to lag.
Sentiment indicators are contrary indicators in the sense that a very high level of bearishness is a positive sign. Once the percentage bearish exceeds a threshold level last seen at previous bear market lows, the market tends to be at an attractive buying level. Investors Intelligence weekly questions investment advisors as to their feelings about the market and categorizes them as bearish, bullish, or bullish but awaiting a correction. In the past, when the level of outright bears reached 60% of advisors, that, in hindsight, proved to be a buy point. The percentage bears reached 53% in the latest published reading, but that sentiment didn't include last week's horrific decline. Unfortunately,the next reading will be published Wednesday and will represent the sentiment as of last Friday. While a rise from 53 to 60 would be a rare event in one week, last week's market action was the rarest of events. So there is the possibility that the 60 level was reached, but we won't know about that until midweek.
Another indicator of extreme fear is what is known variously as a "capitulation phase", a "selling climax", or a "puking phase". That occurs at the end of an exhausting bear market, when customers call their brokers and say, "I WANT OUT! I DON'T CARE AT WHAT PRICE!" Those occur very infrequently. They are characterized by 1) a violent downdraft in the morning, followed by a rally that takes the market at or near its previous day's close; and 2) very heavy volume. Friday's action resembled such an event. However, the volume, while very heavy, probably should have been higher, and this happened on a Friday. Rarely does a bear market end on a Friday because investors have the weekend to absorb the terrible news from the previous week and tend to panic on a Monday or Tuesday. A mitigating circumstance would be some very positive news emerging from the meetings among world leaders this weekend. Absent that, there could be climatic action on Monday or Tuesday.
As indicated in previous postings, I have been waiting until either a "puking phase" or a sentiment indicator of 60% bears before committing more money to equities. Friday's action sufficiently resembled climatic action to warrant putting to work some, but not all, of the remaining money held in reserve for equity investment. Accordingly, I invested one-third of that money in a Standard and Poor's 500 Index Fund at Friday's closing price of 900 in the Index. The remainder may be invested as early as next Monday or Tuesday.
Sometime in the near future, I will discuss what the market is discounting at a level of 900 in the Index, and what the upside potential and downside risk are at that level.
Sentiment indicators are contrary indicators in the sense that a very high level of bearishness is a positive sign. Once the percentage bearish exceeds a threshold level last seen at previous bear market lows, the market tends to be at an attractive buying level. Investors Intelligence weekly questions investment advisors as to their feelings about the market and categorizes them as bearish, bullish, or bullish but awaiting a correction. In the past, when the level of outright bears reached 60% of advisors, that, in hindsight, proved to be a buy point. The percentage bears reached 53% in the latest published reading, but that sentiment didn't include last week's horrific decline. Unfortunately,the next reading will be published Wednesday and will represent the sentiment as of last Friday. While a rise from 53 to 60 would be a rare event in one week, last week's market action was the rarest of events. So there is the possibility that the 60 level was reached, but we won't know about that until midweek.
Another indicator of extreme fear is what is known variously as a "capitulation phase", a "selling climax", or a "puking phase". That occurs at the end of an exhausting bear market, when customers call their brokers and say, "I WANT OUT! I DON'T CARE AT WHAT PRICE!" Those occur very infrequently. They are characterized by 1) a violent downdraft in the morning, followed by a rally that takes the market at or near its previous day's close; and 2) very heavy volume. Friday's action resembled such an event. However, the volume, while very heavy, probably should have been higher, and this happened on a Friday. Rarely does a bear market end on a Friday because investors have the weekend to absorb the terrible news from the previous week and tend to panic on a Monday or Tuesday. A mitigating circumstance would be some very positive news emerging from the meetings among world leaders this weekend. Absent that, there could be climatic action on Monday or Tuesday.
As indicated in previous postings, I have been waiting until either a "puking phase" or a sentiment indicator of 60% bears before committing more money to equities. Friday's action sufficiently resembled climatic action to warrant putting to work some, but not all, of the remaining money held in reserve for equity investment. Accordingly, I invested one-third of that money in a Standard and Poor's 500 Index Fund at Friday's closing price of 900 in the Index. The remainder may be invested as early as next Monday or Tuesday.
Sometime in the near future, I will discuss what the market is discounting at a level of 900 in the Index, and what the upside potential and downside risk are at that level.
Sunday, September 21, 2008
Scared Straight
The events of last week were astonishing! Two men, both pro free markets and anti moral hazard, travel to Capitol Hill to meet with Republican and Democratic leaders, who are normally divisive, especially six weeks prior to a presidential election. What they said essentially was that, if a major plan to restore confidence in our financial markets wasn't approved immediately, commerce in this country would grind to a halt. The looks on the faces of the participants coming out of that meeting were as if the Congresspersons had just seen "Jaws" and were told they had to go scuba diving the next day. Talk about fear! And apparently, the plan, which involves purchasing the toxic debt instruments from financial institutions, insuring most money market investors from loss, and restricting short selling in the financial services industry, has a very good chance of being approved quickly, of course with some modifications and add-ons.
What led to this? One event was an unintended consequence of the Lehman bankruptcy. A highly regarded money market fund held some Lehman paper, which was worthless, and as a result the fund's price fell to "under a buck". This led to a fleeing from this particular fund and money market funds in general, with the money pouring into Treasury bills. In fact, I understand at one point the Treasury bill yield was below 0 percent! A buyer was paying the U.S. government to hold his money! Since commercial paper financing is essential to the liquidity of major companies in the U.S., a freezing up of this market would have dire consequences unless something were done quickly.
Another event which occurred Thursday was the unraveling of the common stocks of Morgan Stanley and Goldman Sachs, the two large investment banking houses left standing after the collapses of Bear Stearns and Lehman, and the announced merger of Merrill Lynch with Bank of America. This happened after both banks reported better than expected earnings. If allowed to continue, Morgan Stanley, in particular, would have had to link up with another entity, and still may have to do so. The waterfall decline of these stocks, if writ large to encompass the entire market, would have produced the long awaited capitulation phase. More about that later.
And finally, Paulson and Bernanke had been fighting this financial contraction on a case by case basis and probably realized that some major policy change had to be in place to stem the downward spiral.
Will this plan work? If by "work" one means averting a depression by restoring confidence in our financial system, I believe the answer is yes. I applaud what Paulson and Bernanke did. And the cost to taxpayers may not be as much as the pessimists expect. It depends on the prices at which the Treasury purchases the toxic debt. However, the deleveraging of this country's balance sheet will continue, although this plan will help move this process along. And home prices haven't yet started to climb again. The financial companies still must raise equty capital to replenish their balance sheets. In short, the plan avoids a disaster but doesn't avoid a continued recession.
Was last week's low of 1156 for the S&P 500 Index the low of this bear market? It is my sense that, had the meeting among Paulson, Bernanke, and Congress not occurred, the stock market was heading toward a classic selling climax, which I have discussed ad nauseum in previous postings. We will never know. However, while last week's action didn't fit the precise characteristics of one, particularly because the decline and rally didn't occur all in one day, from peak to trough, the S&P 500 Index declined roughly 9%, then ralled back to almost even. And the volume of trading was at record levels. The CBOE volatility index, called the VIX, reached 42, an unusually high level that only occurs near major turns. While this index has been reliable, it has not existed for very long. The I.I. percentage bears indicator has been around for more than forty years. The lastest week's figure will be out Wednesday. However, the survey is taken on Fridays, so the sentiment of advisors would have been measured after the rally on Thursday afternoon and won't be representative of the fear levels immediately prior to that.
The good news is that even if last week's bottom were THE BOTTOM, there is almost always a test of it in future months. If that test is successful, that would be an opportunity to put more money to work.
What led to this? One event was an unintended consequence of the Lehman bankruptcy. A highly regarded money market fund held some Lehman paper, which was worthless, and as a result the fund's price fell to "under a buck". This led to a fleeing from this particular fund and money market funds in general, with the money pouring into Treasury bills. In fact, I understand at one point the Treasury bill yield was below 0 percent! A buyer was paying the U.S. government to hold his money! Since commercial paper financing is essential to the liquidity of major companies in the U.S., a freezing up of this market would have dire consequences unless something were done quickly.
Another event which occurred Thursday was the unraveling of the common stocks of Morgan Stanley and Goldman Sachs, the two large investment banking houses left standing after the collapses of Bear Stearns and Lehman, and the announced merger of Merrill Lynch with Bank of America. This happened after both banks reported better than expected earnings. If allowed to continue, Morgan Stanley, in particular, would have had to link up with another entity, and still may have to do so. The waterfall decline of these stocks, if writ large to encompass the entire market, would have produced the long awaited capitulation phase. More about that later.
And finally, Paulson and Bernanke had been fighting this financial contraction on a case by case basis and probably realized that some major policy change had to be in place to stem the downward spiral.
Will this plan work? If by "work" one means averting a depression by restoring confidence in our financial system, I believe the answer is yes. I applaud what Paulson and Bernanke did. And the cost to taxpayers may not be as much as the pessimists expect. It depends on the prices at which the Treasury purchases the toxic debt. However, the deleveraging of this country's balance sheet will continue, although this plan will help move this process along. And home prices haven't yet started to climb again. The financial companies still must raise equty capital to replenish their balance sheets. In short, the plan avoids a disaster but doesn't avoid a continued recession.
Was last week's low of 1156 for the S&P 500 Index the low of this bear market? It is my sense that, had the meeting among Paulson, Bernanke, and Congress not occurred, the stock market was heading toward a classic selling climax, which I have discussed ad nauseum in previous postings. We will never know. However, while last week's action didn't fit the precise characteristics of one, particularly because the decline and rally didn't occur all in one day, from peak to trough, the S&P 500 Index declined roughly 9%, then ralled back to almost even. And the volume of trading was at record levels. The CBOE volatility index, called the VIX, reached 42, an unusually high level that only occurs near major turns. While this index has been reliable, it has not existed for very long. The I.I. percentage bears indicator has been around for more than forty years. The lastest week's figure will be out Wednesday. However, the survey is taken on Fridays, so the sentiment of advisors would have been measured after the rally on Thursday afternoon and won't be representative of the fear levels immediately prior to that.
The good news is that even if last week's bottom were THE BOTTOM, there is almost always a test of it in future months. If that test is successful, that would be an opportunity to put more money to work.
Tuesday, September 16, 2008
One/half Retracement of 2002-2007 Bull Market
In my last posting entitled "A Topsy-Turvy Economy", I indicated that I was awaiting the following conditions before I put more money to work: 1) a one/half retracement of the entire Bull Market that began in 2002 and ended in 2007, which would be roughly 1170 in the S&P 500 Index; and 2) a level of 60% or more bears in an Investors Intelligence weekly sentiment reading. One of these conditions occurred this morning when the S&P 500 Index broke through the July 15 low of around 1200 and penetrated 1170 on the downside.
Unfortunately, the latest I.I. percentage bears is under 42 and the highest level thus far in this bear market is 50. A weekly reading is forthcoming tomorrow, but I doubt it will be 60 or higher.
Like the proverbial single phone call allowed one under arrest, if I had only one call to make regarding market timing at major turns, it would be to I.I. Why? The reason is that bear market bottoms occur when there is a maximum of fear. Fundamentals don't really matter because stock markets are a discounting mechanism and bottom well before the fundamentals improve. In fact, usually at bottoms, the fundamentals look dire.
In an early posting in 2007 I discussed that the long term trend line of the S&P 500 Index should be kept in mind because it represents the worst case downside scenario for the market if one assumes that the world isn't coming to an end. That trendline was almost met at the bottom of the last bear market. I refer to it as "Wall Street's Dirty Little Secret" because The Street thrives during bull markets not bear markets, so that trendline is rarely mentioned.
The trend line at this juncture is slighly below 1000, and the Index just broke through 1200. Let's assume that I had been stranded on a deserted island without any news input for the last year. I was then told that home prices had declined 15 to 20%nationwide, Bear Stearns and Lehman were no more, Merrill Lynch was no longer independent. Freddie and Fannie debt had to be bailed out, and AIG was teetering on the edge of bankruptcy. Then I was asked, "Where do you think the S&P 500 Index is trading?" I would answer "Near the trendline!" I would be flabbergasted that the Index was 20% higher than that.
In short, the market has held up extremely well. Unfortunately, the two primary sources of the unusually high profit margins last year, namely the financial and oil industries, do not have bright profit outlooks near term. The earnings of the Index, which peaked in the high 80's, could drop to the 60's at the trough. That would justify an S&P level closer to the trendline.
While the rate of decline in home prices is dropping, absolute prices are still in decline. The deleveraging of our nation's private balance sheet continues. Alan Greenspan recently mentioned that this was "a once in a century situation". In my opinion, this warrants a fear rating that accompanied the major bottoms of 1974 and 1982, when the percentage bears were 67 and 61 respectively.
One event that would warrant putting more money to work would be an old fashioned selling climax, with a sharp drop (perhaps 10% or more) on extremely heavy volume and a rally that brings the market back to unchanged or higher, all during the same trading day. That would present a buying opportunity perhaps before the fear indicator had reached extreme levels.
Unfortunately, the latest I.I. percentage bears is under 42 and the highest level thus far in this bear market is 50. A weekly reading is forthcoming tomorrow, but I doubt it will be 60 or higher.
Like the proverbial single phone call allowed one under arrest, if I had only one call to make regarding market timing at major turns, it would be to I.I. Why? The reason is that bear market bottoms occur when there is a maximum of fear. Fundamentals don't really matter because stock markets are a discounting mechanism and bottom well before the fundamentals improve. In fact, usually at bottoms, the fundamentals look dire.
In an early posting in 2007 I discussed that the long term trend line of the S&P 500 Index should be kept in mind because it represents the worst case downside scenario for the market if one assumes that the world isn't coming to an end. That trendline was almost met at the bottom of the last bear market. I refer to it as "Wall Street's Dirty Little Secret" because The Street thrives during bull markets not bear markets, so that trendline is rarely mentioned.
The trend line at this juncture is slighly below 1000, and the Index just broke through 1200. Let's assume that I had been stranded on a deserted island without any news input for the last year. I was then told that home prices had declined 15 to 20%nationwide, Bear Stearns and Lehman were no more, Merrill Lynch was no longer independent. Freddie and Fannie debt had to be bailed out, and AIG was teetering on the edge of bankruptcy. Then I was asked, "Where do you think the S&P 500 Index is trading?" I would answer "Near the trendline!" I would be flabbergasted that the Index was 20% higher than that.
In short, the market has held up extremely well. Unfortunately, the two primary sources of the unusually high profit margins last year, namely the financial and oil industries, do not have bright profit outlooks near term. The earnings of the Index, which peaked in the high 80's, could drop to the 60's at the trough. That would justify an S&P level closer to the trendline.
While the rate of decline in home prices is dropping, absolute prices are still in decline. The deleveraging of our nation's private balance sheet continues. Alan Greenspan recently mentioned that this was "a once in a century situation". In my opinion, this warrants a fear rating that accompanied the major bottoms of 1974 and 1982, when the percentage bears were 67 and 61 respectively.
One event that would warrant putting more money to work would be an old fashioned selling climax, with a sharp drop (perhaps 10% or more) on extremely heavy volume and a rally that brings the market back to unchanged or higher, all during the same trading day. That would present a buying opportunity perhaps before the fear indicator had reached extreme levels.
Thursday, July 24, 2008
A Topsy-Turvy Economy
Let me get this straight! I am sixty nine years old. I was brought up: 1) to save money; 2)to purchase a home only when I could afford one because home ownership is a privilege not an entitlement; and 3)if a person overextends by taking on excessive debt, that person should suffer the consequence of bankruptcy or foreclosure on his home. Now I find that my savings, largely in Treasury bills, are yielding 2%, far below the prevailing inflation rate; and, as a result of the government's intervention to save Fanny and Freddie, I am going to be taxed in order to bail out the profligates! What is wrong with this picture?
The stock market may have experienced some sort of distorted selling climax last week, with a washout of the financial stocks under very heavy volume on Tuesday and a sharp rally on Wednesday. In the distant past, a selling climax involved the ENTIRE MARKET'S cratering on very heavy volume in early trading and recovering to break even or better, all WITHIN THE SAME DAY. Tuesday probably marked the low in the financials for this cycle. The question is whether Tuesday's low was an interim bottom or THE BEAR MARKET BOTTOM for the S&P 500 Index?
At the low on Tuesday, the S&P 500 Index flirted with 1200. Often the market bounces off such round numbers. Moreover, bear market rallies can be seductive.
To review, I purchased a half position when: 1) the percentage bears reached the previous bear market high; and 2)the S&P 500 reached 1270, a 3/8 retracement of the previous bull market. I have been awaiting the next Fibonacci 1/2 retracement at 1170 and a level of 60% bears. The percentage bears is now at roughly 50.
So far, I have not acted. Even if 1200 marks the low, there is usually a successful test of that low within a few months. My style of investing requires patience and discipline, but, on the other hand, also the flexibility to change my mind if the market tells me to. Tune in!
The stock market may have experienced some sort of distorted selling climax last week, with a washout of the financial stocks under very heavy volume on Tuesday and a sharp rally on Wednesday. In the distant past, a selling climax involved the ENTIRE MARKET'S cratering on very heavy volume in early trading and recovering to break even or better, all WITHIN THE SAME DAY. Tuesday probably marked the low in the financials for this cycle. The question is whether Tuesday's low was an interim bottom or THE BEAR MARKET BOTTOM for the S&P 500 Index?
At the low on Tuesday, the S&P 500 Index flirted with 1200. Often the market bounces off such round numbers. Moreover, bear market rallies can be seductive.
To review, I purchased a half position when: 1) the percentage bears reached the previous bear market high; and 2)the S&P 500 reached 1270, a 3/8 retracement of the previous bull market. I have been awaiting the next Fibonacci 1/2 retracement at 1170 and a level of 60% bears. The percentage bears is now at roughly 50.
So far, I have not acted. Even if 1200 marks the low, there is usually a successful test of that low within a few months. My style of investing requires patience and discipline, but, on the other hand, also the flexibility to change my mind if the market tells me to. Tune in!
Sunday, April 6, 2008
High End Manhattan Coops Always Appreciate--NOT
In my last posting, I discussed the tragedy of Bear Stearns and concluded that even the high end of Manhattan property will probably fall 20-25% in price after years of a "seller's market". (This conclusion also pertains to the high end of related locations such as the Hamptons.)
The transition from a "seller's market" to a "buyer's market" usually involves an intermediate phase, when sellers price at the recent peak; but buyers, sensing the prospect of lower prices, hang tough with their bids. The result is a stalemate, characterized by a reduced number of transactions and a buildup in inventory for sale. The Manhattan market entered this phase during the first quarter of 2008. The number of transactions declined by 34% and inventories rose 20%, much higher than the normal 8%.
The next phase is the beginning of a buyer's market. Those sellers who must sell start to close the gap between bid and asked by reducing their asked price. This starts a downward trend. Given the extent of the property appreciation during the last ten to twenty years, which I would characterize as reaching "bubble" levels, a 20-25% decline seems modest. Afterall, an asset that has sextupled in price could easily correct a Fibonacci 3/8 of the appreciation, which would be a decline of 31%.
Manhattan high end property values are primarily a function of Wall Street's net hirings or firings and the level of bonuses paid out at the end of the year. Most of the prestigious and largest firms pay modest salaries with bonuses accounting for a huge percentage of total income during good years. It has already been announced that employment at Bear Stearns will perhaps be cut in half. The other major investment banks will probably reduce their staffs to some extent. Even if they don't, 2008 earnings for these firms will probably decline significantly. (The first quarter earnings were down sharply.) Yearend bonuses will follow suit.
Most real estate agents tend to appear optimistic most of the time. Afterall, their compensation is a function of activity. They point out that the weak dollar is propping up property values at the high end as foreign buyers with stronger currencies swoop in. That has had some positive impact; but in my opinion, that will eventually be overwhelmed by the developing negative Wall Street situation.
If I am right about this, at some point a great buying opportunity will occur. But when? Historically, it takes roughly a year after a bear stock market ends to clear out all of the excess real estate inventory. Even if the stock market bottomed in the first quarter of 2008, one would have until the first quarter of 2009 to buy.
I would strongly urge any buyer to be a tough negotiator. That involves an initial bid much lower than the offering price. I would also suggest that you, as a buyer, not show that you are enamored with the property.
While the secular trend in the prices of Manhattan high end coops is definitely up, there have been periods of sharp decline. An example is the 1973-74 period. Then a virulent bear stock market, high interest rates, and some risk that New York City was in deep financial trouble created a perfect storm to drive down coop prices. What a great opportunity to buy a coop in one of the premier buildings in New York City! I have a friend who did purchase a seven room tower apartment in one of the great coops in Manhattan during this time. The by-laws of this building allowed the tenant shareholder to sell his shares back to the corporation for nothing in order to relieve the shareholder from having to pay maintenance. (Technically, if other shareholders were bankrupt, the remaining solvent shareholders would have to foot the total maintenance bill. That is why the "put" option was written in.) My friend thought about offering to buy the shares from the seller for nothing, but took a good look at him and realized the seller was much bigger and could probably outrun my friend. He then bought the shares for $125,000. They were, at the recent peak, worth roughly $13,000,000, an unleveraged compound annual 15% return over 33 years. (The National Association of Realtors says that home prices have appreciated at the rate of inflation plus 1.7 percentage points, which amounts to roughly 5% annual appreciation since 1926.) My friend's $125,000 investment would be worth only $625,000 today if it only compounded at 5% a year. What a fabulous investment he made! Not that I expect THAT bad a real estate market this time around. However, this story does demonstrate how important an entry point can be in any asset purchased for investment.
The transition from a "seller's market" to a "buyer's market" usually involves an intermediate phase, when sellers price at the recent peak; but buyers, sensing the prospect of lower prices, hang tough with their bids. The result is a stalemate, characterized by a reduced number of transactions and a buildup in inventory for sale. The Manhattan market entered this phase during the first quarter of 2008. The number of transactions declined by 34% and inventories rose 20%, much higher than the normal 8%.
The next phase is the beginning of a buyer's market. Those sellers who must sell start to close the gap between bid and asked by reducing their asked price. This starts a downward trend. Given the extent of the property appreciation during the last ten to twenty years, which I would characterize as reaching "bubble" levels, a 20-25% decline seems modest. Afterall, an asset that has sextupled in price could easily correct a Fibonacci 3/8 of the appreciation, which would be a decline of 31%.
Manhattan high end property values are primarily a function of Wall Street's net hirings or firings and the level of bonuses paid out at the end of the year. Most of the prestigious and largest firms pay modest salaries with bonuses accounting for a huge percentage of total income during good years. It has already been announced that employment at Bear Stearns will perhaps be cut in half. The other major investment banks will probably reduce their staffs to some extent. Even if they don't, 2008 earnings for these firms will probably decline significantly. (The first quarter earnings were down sharply.) Yearend bonuses will follow suit.
Most real estate agents tend to appear optimistic most of the time. Afterall, their compensation is a function of activity. They point out that the weak dollar is propping up property values at the high end as foreign buyers with stronger currencies swoop in. That has had some positive impact; but in my opinion, that will eventually be overwhelmed by the developing negative Wall Street situation.
If I am right about this, at some point a great buying opportunity will occur. But when? Historically, it takes roughly a year after a bear stock market ends to clear out all of the excess real estate inventory. Even if the stock market bottomed in the first quarter of 2008, one would have until the first quarter of 2009 to buy.
I would strongly urge any buyer to be a tough negotiator. That involves an initial bid much lower than the offering price. I would also suggest that you, as a buyer, not show that you are enamored with the property.
While the secular trend in the prices of Manhattan high end coops is definitely up, there have been periods of sharp decline. An example is the 1973-74 period. Then a virulent bear stock market, high interest rates, and some risk that New York City was in deep financial trouble created a perfect storm to drive down coop prices. What a great opportunity to buy a coop in one of the premier buildings in New York City! I have a friend who did purchase a seven room tower apartment in one of the great coops in Manhattan during this time. The by-laws of this building allowed the tenant shareholder to sell his shares back to the corporation for nothing in order to relieve the shareholder from having to pay maintenance. (Technically, if other shareholders were bankrupt, the remaining solvent shareholders would have to foot the total maintenance bill. That is why the "put" option was written in.) My friend thought about offering to buy the shares from the seller for nothing, but took a good look at him and realized the seller was much bigger and could probably outrun my friend. He then bought the shares for $125,000. They were, at the recent peak, worth roughly $13,000,000, an unleveraged compound annual 15% return over 33 years. (The National Association of Realtors says that home prices have appreciated at the rate of inflation plus 1.7 percentage points, which amounts to roughly 5% annual appreciation since 1926.) My friend's $125,000 investment would be worth only $625,000 today if it only compounded at 5% a year. What a fabulous investment he made! Not that I expect THAT bad a real estate market this time around. However, this story does demonstrate how important an entry point can be in any asset purchased for investment.
Monday, March 17, 2008
We all own Bear Stearns stock
Over this weekend, J.P.Morgan acquired Bear Stearns for $2 a share. Those of us who didn't DIRECTLY own Bear Stearns equity should not breathe a sigh of relief. INDIRECTLY, we who live in or near Manhattan own Bear stearns stock. Forget the impact in the near term on our common stock portfolios or the long term impact of the Fed's recent intervention on the nation's budget deficit. For those of us who own coop apartments, condos, and homes in the New York area, the major impact will be the substantial decrease, perhaps on the order of 20 to 25%, in property values, even at the "high end" of the spectrum. The deleveraging of our nation's economy will cause employment on Wall Street to shrink; and when that happens, property values will shrink as well.
As far as the stock market is concerned, we are entering the "puking" stage, or, for those more refined, the "throw in the towel" stage. This may be necessary to reach a durable bear market bottom. The final so-called selling climax is accompanied by a very rapid descent in stock prices on very heavy volume. Here is where Fibonacci numbers are helpful. The next such number, a 1/2 retracement of the bull market over the last five years, is 1170 in the Standard & Poors 500 Index. The last Fibonacci number, a 5/8 retracement, is 1070.
As far as the stock market is concerned, we are entering the "puking" stage, or, for those more refined, the "throw in the towel" stage. This may be necessary to reach a durable bear market bottom. The final so-called selling climax is accompanied by a very rapid descent in stock prices on very heavy volume. Here is where Fibonacci numbers are helpful. The next such number, a 1/2 retracement of the bull market over the last five years, is 1170 in the Standard & Poors 500 Index. The last Fibonacci number, a 5/8 retracement, is 1070.
Wednesday, March 12, 2008
Bottom Fishing
The sentiment reading from Investors Intelligence, which is published weekly on Wednesdays, indicates today that 43.3% of investment advisors are now bearish, a very significant figure because that was the level at the last bear market bottom. That, coupled with the 3/8 retracement of the last bull market, a Fibonacci number, fulfills the two necessary conditions for a bottom mentioned in previous blogs. Accordingly, I am now investing one half of my financial assets allocated to equities. That money will go into the T. Rowe Price Standard and Poors Index Fund.
I am only investing half because past bear markets have ended with the percentage of bears rising to well over 60%. Furthermore, the deleveraging of the macroeconomic balance sheet is just beginning and may last for many more months. The period of economic malaise may prove to be longer than average.
I am only investing half because past bear markets have ended with the percentage of bears rising to well over 60%. Furthermore, the deleveraging of the macroeconomic balance sheet is just beginning and may last for many more months. The period of economic malaise may prove to be longer than average.
Wednesday, January 23, 2008
Close, But No Cigar
Most U.S. families have most of their net worth in two asset classes, their homes and their common stocks. At this point, the prices of homes have declined 6-7% from their peaks on a nationwide basis, an event unprecedented since the Depression of the 1930s. As I explained in a recent posting, there is probably more decline to come. The impact of this has already hurt consumer spending, as evidenced by the poor retail sales during the Christmas season. The stock market, reflecting the probable onset of a recession, has entered a bear market. I am 68 years old. During my adult life, I have never experienced a time when both asset classes were in decline nationwide. (We did have that circumstance in New York City during the 1973-74 period, which is the subject of a future posting.)
While the outlook is bleak, the stock market is a discounting mechanism and will bottom long before the clouds lift. Right now, as one wag quipped, "My 401K is rapidly becoming my 301K!"
In earlier postings, I said that the two necessary conditions for buying in a bear
market are 1)a level of at least 43 to 60 percent bears in Investor Intelligence's weekly survey of investment advisors, and 2) A 3/8 minimum retracement of the previous bull market, which is a Fibonacci number. Yesterday and today, the down market has retraced 3/8 of the bull move from 2002 to 2007. However, unfortunately, this week's percentage bears rose to only 31.5%, well below the threshold buy level of a minimum 43%. While it is safe to say that the percentage bears will rise next week, it probably won't yet reach 43%. So, at this juncture, I have not yet entered the equity market. Close, but no cigar!
While the outlook is bleak, the stock market is a discounting mechanism and will bottom long before the clouds lift. Right now, as one wag quipped, "My 401K is rapidly becoming my 301K!"
In earlier postings, I said that the two necessary conditions for buying in a bear
market are 1)a level of at least 43 to 60 percent bears in Investor Intelligence's weekly survey of investment advisors, and 2) A 3/8 minimum retracement of the previous bull market, which is a Fibonacci number. Yesterday and today, the down market has retraced 3/8 of the bull move from 2002 to 2007. However, unfortunately, this week's percentage bears rose to only 31.5%, well below the threshold buy level of a minimum 43%. While it is safe to say that the percentage bears will rise next week, it probably won't yet reach 43%. So, at this juncture, I have not yet entered the equity market. Close, but no cigar!
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