In my previous posting, I discussed buying into a bear market. In it I stated that in order to buy into a bear market, defined as a decline in the S&P 500 Index (the "Index") of at least 20%, I would need the fulfillment of two necessary conditions: 1) a sentiment indicator, Investors Intelligence Survey of Investment Advisors, must show at least 60% bulls and 20% bears; and 2) the Index must have retraced a Fibonacci number. I must admit a mea culpa. I meant to say "60% bears" and "20%" bulls. Some writers intentionally place an error like that in their texts in order to test the reader's attention span. I assure you that this was not the case.
Furthermore, I checked the percentage bears at the major market bottoms in 1974, 1982, 1987, 1990, and 2002. They were 67%, 61%, 46%, 56%, and 43% respectively. So if one were to wait for 60% bears before acting, one would have missed three of the five last major bottoms. Apparently, the "60% bears" rule isn't a good one. However, the above figures can serve as some input as to how high these figures are at major bottoms.
At this point in time, the percentage bears is 33%, well below levels of previous bear market bottoms. Furthermore, with a decline of roughly 10%, the current market action only qualifies as a "correction".
Let us assume that the high in the Index this year, 1553, is a bull market high. The bull market began in 1002 at a level of 775, and the Index has roughly doubled since then. The Index is up a total of 778 points. Reverting to Fibonacci numbers, 3/8, 1/2, and 5/8 retracements would result in levels of the Index at 1262, 1164, and 1067 respectively. I would probably begin buying at around 1200 in the Index if and only if the percentage bears was in the low to mid forties range.
Most Wall Streeters are hoping that this recent ten percent correction is all the downside we will have, and the current bull market will continue without an intervening bear. We must realize that Wall Street benefits far more in a bull market than a bear.
As bridge players say, "Let's review the bidding" with respect to where we are in the economic cycle. During the beginning of the new millenium, Alan Greenspan was worried that the U.S. economy, as a result of the internet stock market bubble, would go the way of Japan, which suffered a severe recession and a stock market that is still down more than 57% from its high EIGHTEEN YEARS ago! He wanted to let the air out of the stock market bubble slowly and cushioned the shock by lowering the federal funds rate to 1%, the lowest since the end of World War II. That policy was partially successful since the ensuing recession was mild. Unfortunately, with this low interest rate policy, he transferred the asset bubble from the stock market to the housing market. Home valuations are now about 40% higher relative to GDP than the norm.That is lower than the S&P 500 Index at its high in 2000, when it was selling at a P/E 100% higher than the norm. During the last several years, Bernanke has tried to let the air out of the housing bubble slowly by slowing raising the federal funds rate to 5.25 %.
The key question as to whether we have entered a bear market is whether the housing problem results in a recession in the U.S. If so, I am afraid that we have begun a bear.
It is possible that even without a recession, we can experience a bear if the current debt crisis results in the potential downfall of a major money center bank, investment bank, or hedge fund. The news of that problem might, in itself, create the buying opportunity that we have discussed above. Tune in!
Friday, August 17, 2007
Wednesday, April 11, 2007
Buying into a bear market
I want to discuss what to many is very scary: buying into a bear market. First, a disclaimer. There is a word to describe those who always discern the exact bottoms of bear markets, and that word is "liar." Over my money management career, which spanned twenty-seven years, I experienced the stress of at least four bear markets. (I retired at the end of 1995 and, thus, did not have to cope with the bear that started in March, 2000.) You probably have heard the expression that trying to find a bear market bottom is like "trying to catch a falling knife." What I would like to accomplish in this post is to have you look upon a bear market as an opportunity rather than a terrifying event that paralyzes you from taking action.
As an aside, the worst bear market I ever experienced was that of 1973-74, which resulted from a perfect storm of an overvalued market, recession, and high interest rates. I know one small cap growth mutual fund manager who had two consecutive down 40% years. Another person, who ran one of the few hedge funds at the time, had a terrible two years and would wake up in the middle of the night sweating and wondering whether he would soon be driving a cab. The first guy rebounded and eventually retired a couple of decades later a with a huge net worth! The hedge fund manager became a leading Wall Street pundit! The moral of these stories is "Don't despair!"
There are two necessary conditions that must occur before I would buy into a bear market: 1) a "contrary" sentiment indicator, Investors Intelligence's survey of advisory sentiment, must indicate at least 60% bears and no more than 20% bulls; and 2) the bear market must have retraced the previous bull run by a Fibonacci number.
Sentiment indicators are contrarian indicators. Those that measure investor bullishness and bearishness are valuable when there is an abnormal amount of either. For example, when there is an extreme of bullishness, the assumption is that most who want to buy are already in, and the market will soon start down. The opposite is true in the case of a very high level of bearishness. I must warn you that these sentiment indicators are only predictive at extremes. They are threshold indicators, not linear ones. In other words, a move in bullishness from, say, 48% to 50% is just noise, with no predictive value. I have been keeping the advisory sentiment figures for forty years, and have only acted on them fewer than a dozen times. This approach obviously takes discipline and patience. The publishers of these indicators sometimes recommend to readers that they taken action when the indicators haven't reached extreme levels. In my opinion, that is dangerous.
Investors Intelligence has been publishing their survey of advisory sentiment every week for decades. I find them the most reliable sentiment indicator. They used to publish their weekly findings in Barrons, but that was ended a few years ago. Their survey is, however, available to subscribers for an annual fee of several hundred dollars, a very wise investment.
The concept of Fibonacci numbers has a mystical quality to it. However, many money managers use them. For a lengthy explanation of them you might want to Google "Fibonacci numbers."
The important Fibonacci numbers for money managers are .382, .500, and .618. I look at these as percentage retracements of the previous bull market move that occurs during a down market. Thus, possible buy points might occur after 3/8, one half, and 5/8 retracements of a previous bull market move. For purposes of example, let's take the current bull market, which started at a Standard and Poors 500 Index level of roughly 775. Let's assume that the 2007 high thus far of 1460 is a bull market high. Retracements of 3/8, 1/2, and 5/8 of the 685 point bull market move would be levels of 1203, 1118, and 1032 in the Standard and Poors 500 Index. How would you determine which of these levels would be buy points? There is usually symmetry in market cycles. That is, if the amplitude and duration of the previous bull market were long, then the ensuing bear market would likely be the same, so that, under those circumstances, I would wait for the 1/2 retracement to begin buying rather than the 3/8 one. (As I have written above, this buying would only occur if the sentiment indicator had also kicked in.)
Most bear markets end in what is known as a capitulation phase, selling climax, or puking phase. They all describe a scenario where the selling accelerates on very high volume. At this juncture, there is irrational selling. Many sellers have had enough of the pain and just want out!--which provides a
great buying opportunity for those with patience and discipline. A contemporary way to time a selling climax is when the VIX indicator of option implied volatility reaches levels in the 40-50% range.
After a bear market low, usually there is a successful test of that low. The Standard and Poors 500 Index might even penetrate the former low, but there are fewer stocks within the index making new lows at that time. So even if you miss the low, there is an opportunity to get in soon thereafter.
One might ask, "Aren't you ignoring fundamental analysis"? Despite being primarily a fundamentalist, I have found that fundamentals are of no value in recognizing bear market bottoms. I have often said that if I could make only one phone call during a bear market to help me find a buy point, it would be to Investors Intelligence.
As an aside, the worst bear market I ever experienced was that of 1973-74, which resulted from a perfect storm of an overvalued market, recession, and high interest rates. I know one small cap growth mutual fund manager who had two consecutive down 40% years. Another person, who ran one of the few hedge funds at the time, had a terrible two years and would wake up in the middle of the night sweating and wondering whether he would soon be driving a cab. The first guy rebounded and eventually retired a couple of decades later a with a huge net worth! The hedge fund manager became a leading Wall Street pundit! The moral of these stories is "Don't despair!"
There are two necessary conditions that must occur before I would buy into a bear market: 1) a "contrary" sentiment indicator, Investors Intelligence's survey of advisory sentiment, must indicate at least 60% bears and no more than 20% bulls; and 2) the bear market must have retraced the previous bull run by a Fibonacci number.
Sentiment indicators are contrarian indicators. Those that measure investor bullishness and bearishness are valuable when there is an abnormal amount of either. For example, when there is an extreme of bullishness, the assumption is that most who want to buy are already in, and the market will soon start down. The opposite is true in the case of a very high level of bearishness. I must warn you that these sentiment indicators are only predictive at extremes. They are threshold indicators, not linear ones. In other words, a move in bullishness from, say, 48% to 50% is just noise, with no predictive value. I have been keeping the advisory sentiment figures for forty years, and have only acted on them fewer than a dozen times. This approach obviously takes discipline and patience. The publishers of these indicators sometimes recommend to readers that they taken action when the indicators haven't reached extreme levels. In my opinion, that is dangerous.
Investors Intelligence has been publishing their survey of advisory sentiment every week for decades. I find them the most reliable sentiment indicator. They used to publish their weekly findings in Barrons, but that was ended a few years ago. Their survey is, however, available to subscribers for an annual fee of several hundred dollars, a very wise investment.
The concept of Fibonacci numbers has a mystical quality to it. However, many money managers use them. For a lengthy explanation of them you might want to Google "Fibonacci numbers."
The important Fibonacci numbers for money managers are .382, .500, and .618. I look at these as percentage retracements of the previous bull market move that occurs during a down market. Thus, possible buy points might occur after 3/8, one half, and 5/8 retracements of a previous bull market move. For purposes of example, let's take the current bull market, which started at a Standard and Poors 500 Index level of roughly 775. Let's assume that the 2007 high thus far of 1460 is a bull market high. Retracements of 3/8, 1/2, and 5/8 of the 685 point bull market move would be levels of 1203, 1118, and 1032 in the Standard and Poors 500 Index. How would you determine which of these levels would be buy points? There is usually symmetry in market cycles. That is, if the amplitude and duration of the previous bull market were long, then the ensuing bear market would likely be the same, so that, under those circumstances, I would wait for the 1/2 retracement to begin buying rather than the 3/8 one. (As I have written above, this buying would only occur if the sentiment indicator had also kicked in.)
Most bear markets end in what is known as a capitulation phase, selling climax, or puking phase. They all describe a scenario where the selling accelerates on very high volume. At this juncture, there is irrational selling. Many sellers have had enough of the pain and just want out!--which provides a
great buying opportunity for those with patience and discipline. A contemporary way to time a selling climax is when the VIX indicator of option implied volatility reaches levels in the 40-50% range.
After a bear market low, usually there is a successful test of that low. The Standard and Poors 500 Index might even penetrate the former low, but there are fewer stocks within the index making new lows at that time. So even if you miss the low, there is an opportunity to get in soon thereafter.
One might ask, "Aren't you ignoring fundamental analysis"? Despite being primarily a fundamentalist, I have found that fundamentals are of no value in recognizing bear market bottoms. I have often said that if I could make only one phone call during a bear market to help me find a buy point, it would be to Investors Intelligence.
Thursday, March 15, 2007
The Seven Percent Solution
Before anyone reads this blog, I should warn them that I am literally a greybeard. You can assume that these are the meanderings of an addlepated geezer or reflections of someone who had spent several decades as a hedge fund manager, still retains most of his brain cells, and wishes to share his experiences and observations about the current state of financial assets. If you accept the latter, read on.
The long term growth trend of the S&P 500 Index's price is around seven percent annually. It is no coincidence that the long term growth of the Index's earnings is roughly seven percent as well. That growth rate results from the aggregate effects of labor force growth, productivity gains, and price increases.
Stocks and indices trade in channels, with an upper trend line and a lower one. I am especially interested in the lower one because it can give one a rough idea of very long term downside risk. There are seveal ways to compute where the S&P 500 would be on the lower line of the channel:
(1)Take the bear market bottoms of 1974, 1982, 1987, 1990, and 2003 and form a trendline; or take each of those lows and compound at seven percent. Seven percent doubles roughly every ten years, so this makes the computation quite easy. For example, in 1987, the Index bottomed around 205. Twenty years later, compounding at 7% a year, the Index would have quadrupled to 820. Or take the 1990 low of around 290. Compounded at 7% a year, the lower trendline would be around 914. Or the low of 775 in 2003 at becomes 1015 today. Apparently, the lower trendline is at least more than 25% below the Index's price today of around 1400.
Why doesn't Wall Street ever talk about this? The market rarely touches this downtrend line. After all, since 1974 there have been only five times the Index came close to the lower trendline. That's once every six years! Not a parameter useful in an industry that thrives on day to day activity preferably in an up market.
Implicit in this exercise is a strong belief in the concept of "reversion to the norm or mean".
For example, in aggregate, the profit margin of the Index is currently around 13%, much higher than the average 8%. The average yield to maturity of the ten year U.S. Treasury note is roughly 300 basis points above inflation. Now it is 210. If you took the $92 earnings estimate of the Index for 2007 and reduced it to reflect an 8% margin, the estimate would be $57. If you upped the inflation premium to 300 basis points, the ten year would be around a 5.4% yield to maturity. If you then took $57 of earnings and 5.4% yield and inserted them into a dividend discount model, you would probably come out with a number far below 1400 in the Index, perhaps close to the figures we arrived at using our "seven percent solution".
My conclusion is that in order to have a belief that the Index is cheap currently, you must not be a believer in the notion of reversion to the mean.
On my next blog, I shall try to explain how I used to find entry points to go long in a bear market .
The long term growth trend of the S&P 500 Index's price is around seven percent annually. It is no coincidence that the long term growth of the Index's earnings is roughly seven percent as well. That growth rate results from the aggregate effects of labor force growth, productivity gains, and price increases.
Stocks and indices trade in channels, with an upper trend line and a lower one. I am especially interested in the lower one because it can give one a rough idea of very long term downside risk. There are seveal ways to compute where the S&P 500 would be on the lower line of the channel:
(1)Take the bear market bottoms of 1974, 1982, 1987, 1990, and 2003 and form a trendline; or take each of those lows and compound at seven percent. Seven percent doubles roughly every ten years, so this makes the computation quite easy. For example, in 1987, the Index bottomed around 205. Twenty years later, compounding at 7% a year, the Index would have quadrupled to 820. Or take the 1990 low of around 290. Compounded at 7% a year, the lower trendline would be around 914. Or the low of 775 in 2003 at becomes 1015 today. Apparently, the lower trendline is at least more than 25% below the Index's price today of around 1400.
Why doesn't Wall Street ever talk about this? The market rarely touches this downtrend line. After all, since 1974 there have been only five times the Index came close to the lower trendline. That's once every six years! Not a parameter useful in an industry that thrives on day to day activity preferably in an up market.
Implicit in this exercise is a strong belief in the concept of "reversion to the norm or mean".
For example, in aggregate, the profit margin of the Index is currently around 13%, much higher than the average 8%. The average yield to maturity of the ten year U.S. Treasury note is roughly 300 basis points above inflation. Now it is 210. If you took the $92 earnings estimate of the Index for 2007 and reduced it to reflect an 8% margin, the estimate would be $57. If you upped the inflation premium to 300 basis points, the ten year would be around a 5.4% yield to maturity. If you then took $57 of earnings and 5.4% yield and inserted them into a dividend discount model, you would probably come out with a number far below 1400 in the Index, perhaps close to the figures we arrived at using our "seven percent solution".
My conclusion is that in order to have a belief that the Index is cheap currently, you must not be a believer in the notion of reversion to the mean.
On my next blog, I shall try to explain how I used to find entry points to go long in a bear market .
Sunday, March 4, 2007
Are hedge funds partially responsible for last week's decline?
The hedge fund industry, now numbering several thousands funds with
$1.25 to 1.50 trillion (unleveraged) under management has become a very powerful market force. However, the hedge funds utilize a myriad of strategies, so that the total leveraged positions are not all in the same asset classes. For example, there may be a convertible hedge fund, a short only one, a distressed securities one, etc. The only similiarity among them is that most have the same legal structure, a partnership that can go short as well as long and most have incentive compensation agreements, and most can borrow against the assets. There is one theory that hedge funds reduce volatility in the market because they sell short as well as buy long.
My opinion is that they can be destabilizing at this point in time. The amount of money now in them makes the strategies very crowded. That coupled with the need for performance to justify the enormous fees in my judgment creates pressure to go out further on the risk spectrum, which could ultimately lead to a purging of hedge funds. That happened in the 1973-1974 bear market.
A specific example is the so-called unwinding of the "yen carry" trade. Basically, the Bank of Japan has set a very low short-term interest rate, now .5%, recently raised from .25%. According to my friend, Bob Aliber, who taught currencies at the University of Chicago Business School, a hedge fund now has to pay 1.5 to 2.0% to borrow yen, which is still much lower than borrowing in the U.S. The problem is that the yen may appreciate against the U.S. dollar. One could hedge the currency by buying yen futures, but the cost of doing so would eat up the interest rate advantage. So the hedge funds have been borrowing cheap yen and buying assets in other countries. Last week, the yen APPRECIATED against the dollar by about three percent. That is one year's carry advantage gone. The quick reacting hedge funds probably sold the assets the yen purchased to pay back the yen borrowings. This put downward pressure on the prices of those assets and upward pressure on the yen since they had to buy yen to pay back the loan.
This is becoming wordy. Tune in for more ramblings.
$1.25 to 1.50 trillion (unleveraged) under management has become a very powerful market force. However, the hedge funds utilize a myriad of strategies, so that the total leveraged positions are not all in the same asset classes. For example, there may be a convertible hedge fund, a short only one, a distressed securities one, etc. The only similiarity among them is that most have the same legal structure, a partnership that can go short as well as long and most have incentive compensation agreements, and most can borrow against the assets. There is one theory that hedge funds reduce volatility in the market because they sell short as well as buy long.
My opinion is that they can be destabilizing at this point in time. The amount of money now in them makes the strategies very crowded. That coupled with the need for performance to justify the enormous fees in my judgment creates pressure to go out further on the risk spectrum, which could ultimately lead to a purging of hedge funds. That happened in the 1973-1974 bear market.
A specific example is the so-called unwinding of the "yen carry" trade. Basically, the Bank of Japan has set a very low short-term interest rate, now .5%, recently raised from .25%. According to my friend, Bob Aliber, who taught currencies at the University of Chicago Business School, a hedge fund now has to pay 1.5 to 2.0% to borrow yen, which is still much lower than borrowing in the U.S. The problem is that the yen may appreciate against the U.S. dollar. One could hedge the currency by buying yen futures, but the cost of doing so would eat up the interest rate advantage. So the hedge funds have been borrowing cheap yen and buying assets in other countries. Last week, the yen APPRECIATED against the dollar by about three percent. That is one year's carry advantage gone. The quick reacting hedge funds probably sold the assets the yen purchased to pay back the yen borrowings. This put downward pressure on the prices of those assets and upward pressure on the yen since they had to buy yen to pay back the loan.
This is becoming wordy. Tune in for more ramblings.
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