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.