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Is The Bear
Back? - Both Sides of the Argument |
|
Lately, I have spent a lot of time
trying to assess whether we are entering the next leg down in a long term
bear market, or just suffering through a nasty correction in an ongoing
bull market.
Most of the time, the stock market
trades at a growth premium with corporate performance as
it is. Clearly, the market is trading with a risk discount
built in.
I have stubbornly and perhaps mistakenly
held on to a number of positions through this summer's decline. I could
have sold everything a month ago, and bought them all back at lower prices
today. 20/20 hindsight is always perfect vision. My worst position (6K
shares) is owned at $4.50- currently trading at $1.10. Another holding
at $18 (looking for $30) is now trading at $11.75 after reporting a blockbuster
earnings surprise to the upside for the June quarter.
After grinding sideways on low volume
from Mid April to Mid June, the market finally capitulated over the last
month. The extended sideways low volume grind was inevitably going to a
break one way or the other, and the market broke to the downside hard.
It would appear that the Bear has
wrestled the Bull from its hike up the charts for the time being.
Fears of higher oil prices and rising
interest rates have trumped earnings growth, strong balance sheets, and
historically low PE's.
The chart you are looking at (compliments
of the Agile Trader)
represents a very strange and rare anomaly. You won't see it very often,
and it won't stay this way for very long. Something will break hard, either
one way or another.
The black line represents
the level of the S&P 500 since December of 1998. The blue
line is the operating earnings of the S&P 500 over the same
time frame.
Note that up until about March of
this year, the lines have roughly followed each other. Prices generally
lead earnings by a few months as the market adjusts for perceived growth
or deterioration.
Point A on the chart represents
the beginning of '00 decline. Point B represents the subsequent
beginning of the earnings decline. Note the two events are about six months
apart.
Point C represents an unusual
anomaly. The price of the S&P has radically and visibly diverged from
the earnings line. Prices have fallen sharply while earnings have continued
to accelerate at the most rapid pace in six years. This divergence cannot
last. The lines have to begin to move in the same direction in the near
future.
Here's the Big Question- Which line
will move towards the other? Is the market accurately forecasting an earnings
collapse, wherein the blue line will turn down and follow the black line,
or will the market shake off the current IOU (interest rates, oil,
uncertainty) fears, and turn back up in concert with earnings? That is
the $64,000 question, and the one we will explore today.
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The
Bullish Argument |
 |
The bullish argument is simple; In
a word: EARNINGS. Earnings estimates for the S&P 500 stand
at $66.77 for '04, and $73.20 for CY '05 (9.3% growth). This
is exactly the kind of earnings growth the market loves. Not too radical
to the upside. Steady and sustainable.
The PE ratio for the trailing 52
weeks stands at 16.9. For the next 52 wks, the PE ratio stands at 15.3.
These are historically low levels in a low interest rate environment. Even
with the FED raising interest rates, their policy is still highly accommodative
to growth.
From Thomson Financial on
August 9th:
| This quarter will represent the
4th consecutive quarter of 20% growth or better for the S&P 500 index,
which has only occurred twice in the past 25 years. More companies are
beating estimates and fewer companies are missing estimates than during
an average quarter. With 450 companies reporting earnings, 69% have come
in above analyst estimates, 16% have matched estimates, and 15% have come
in below estimates. In a typical quarter, 58% of companies beat the estimates,
22% match estimates, and 20% miss the estimates. In the aggregate, companies
are beating the estimates by 4.3%, which is below the record high 7.9%
recorded in the Q104, but above the historical average of 3%. |
In short, earnings are strong and
rising. Earnings growth rates are subsiding, but still remain healthy.
A number of the smaller issues I cover in the OTC Journal have reported
growth, growth, growth, and the stocks keep going down, down, down.
Based on fundamentals stocks should
be going up. They are headed south. Here's the Bearish argument:
|
The
Bearish Argument |
|
The Bearish Argument is simple. In
a word; OIL. Skyrocketing oil prices have the market convinced high
prices at the pump will eventually lead to recession.
I recently read a forecast from a
semi believable source predicting oil would rise to $100 per barrel and
gold to $1,000 per ounce this decade. I can almost painfully swallow the
oil scenario, but not the gold. Gold is not a consumed resource. Therefore,
its value is mostly perceived. The supply which is already above ground
still exists.
Analysts estimate for every $10 increase
in the price of a barrel of oil, we lose 1/2 point in GDP. It's all
about the consumer being 70% of GDP. At $3.50 per gallon, the fill up at
the gas pump is going to cost $50. If we're paying $50 for a tank of gas,
we aren't driving the car to Wal-Mart as often as with the $30 fill
up. And, when we do go, we are spending less money.
Therefore, Wal-Mart's sales
go down. Wal-Mart buys less goods and hires less people. Those potential
suppliers and employees have less money, so they don't buy new houses and
new cars. The real estate agent or car salesman who would have made a commission
doesn't go to Wal-Mart as often. Earnings drop in conjunction with
the slow down. We spiral into recession- a contracting economy with negative
GDP growth and horrid corporate performance.
The following comes from Stephen
Roach, Morgan Stanley's main economic guru. He addresses the issue of whether
oil prices matter:
| I have never bought this one
either. The record is pretty clear on this risk factor: Each of the five
recessions since the early 1970s has been preceded by an oil shock in one
form or another. The key question, in this instance, is whether the US
has experienced a true oil shock. I have previously argued that while $40
oil hurts, it does not qualify as a full-blown shock; however, relative
to the post-2000 average of $29 per barrel, a $50 price tag would have
to be considered a shock (see my May 10 dispatch, "Global Wildcards").
Right now oil is hovering near the midpoint of those two possibilities
-- hardly a comforting development. For an unbalanced US economy that lacks
much of a cushion, the pain of $44 oil can hardly be minimized." |
Stephen Roach brings up a great point:
Every recession in the modern era has been instigated or pushed along by
some kind of energy shock. In short, $50 a barrel for an extended period
of time would be a major drag on the economy and probably lead to a recession.
Furthering exacerbating the problem
is the employment picture. Tax cuts were supposed to enhance balance sheets
and provide companies the capital they needed to expand. Cash is growing
on balance sheets, but companies are not using it to hire.
155,000 new jobs need to be created
each month in order to keep place with work force population growth. Wages
need to grow. Wages are currently growing at 1/5th the pace corporate profits
are growing. The "Trickle Down" hose seems to be choked for the time being
as companies appear to be reluctant to use their profits to finance growth.
It worked great for Reagan, but so far has fallen short of expectations
for Bush.
|
What
The Media Isn't Talking About |
|
War with Iraq, terrorism, and oil
production dominates the headlines every day. They are the reasons the
market is currently trading at a substantial risk discount.
The risk discount is enhanced by
fears of terrorism associated with pending two high profile events: The
Olympics, and The Republican National Convention.
I don't believe there will be any
terrorist incidents at either of these high profile events because I believe
Al Qaeda will turn its attention elsewhere.
The radical Muslim community along
with other Middle Eastern factions hate President George Bush, and will
do everything in their power to thwart his reelection bid.
The terrorist have seen the US stock
market melting down, driven by fears of higher oil prices. The recent disruption
from Russian company Yukos sent short term oil futures charging up the
charts, and stocks down.
Terrorist activities for the next
several months will be directed at the disruption of oil supplies, not
the two aforementioned high profile events. After all, oil supplies are
much easier targets and right in their back yard. Furthermore, higher oil
prices put more money in the pockets of some who finance terrorism.
$50 per barrel oil would have even
the most stalwart bulls talking recession, which would lead further declines
in stock prices.
I also believe people vote their
pocketbooks first. If the bank account and job security are good, voters
will reelect an incumbent. Therefore, rather than make some grand high
risk terrorist effort at the Olympics or the Republican National Convention,
I believe the terrorists will stay home and try to disrupt oil supplies
through to the Presidential election. It's lower risk, easier to achieve,
and economically damaging. Higher oil prices enhance Kerry's chances of
winning the election, or more importantly to them, defeating President
Bush.
Oil flow disruption as a core terrorist
strategy is not being talked about by the media.
This is not intended to be a political
opinion. This newsletter is not about politics. It is about the stock market
with a focus on microcap stocks. We had great bull markets under Reagan
and Clinton, and bear markets under Carter and Bush senior. I don't believe
the party in power does much more than affect certain sectors.
|
Where
To From Here? |
|
I am perennial bull, and this is
a bullish newsletter. We make money when stocks go up. I prefer the long
side, simply because stocks go up a lot more of the time than they go down.
Since the first publicly traded shares changed hands on the London Stock
Exchange in the early 1800's, stocks have been going up 70% to 80% of the
time.
There is also a lot more profit potential
on the long side. After all, stocks can only go down to zero. They can
go up to infinity. Ask Warren Buffet or Peter Lynch, the poster boys of
long term investing.
However, when stocks go down, they
tend to go down a lot faster than they go up. Declining markets cause emotional
turmoil, stress, and self doubt. They are painful, and we are all feeling
the pain right now.
I believe the market is getting ready
to begin a rebound phase. The sell-off is not over quite yet, but many
of the smaller, high beta issues that led the market down may have already
hit bottom, especially in the semi conductor sector.
I also believe higher oil prices
are here to stay. I don't believe we have to face long term oil prices
at $50 per barrel, but certainly when fears subside we are looking at oil
stable in the $35 to $40 range. According to Morgan Stanley's Steven Roach
and Alan Greenspan, the economy can handle those levels.
All extremes tend to mitigate and
end up somewhere in the middle. Right now, the big money "trade" is long
oil and short the S&P 500. When the big money starts unwinding that
trade, we will be moving back in a favorable direction for stocks.
Over the short term, I believe the
market wants to complete a 50% retracement of the March 2003 to March 2004
gains. Therefore, 1710 (the middle red line) is in the cards for the NASDAQ
COMP before values become compelling enough to bring fund managers back
from the Hamptons and money back into stocks.
I also believe the market needs to
go through one good high volume capitulation phase that blows everyone
out. A major flush out is coming before any kind of sustained rebound.
The next flush will test your conviction. If you can't handle it, sell
everything now.
Over the years I made the most money
by accumulating during negative environments. Favorable positioning is
accompanied by nagging doubt and pervasive fear. If it was easy, everyone
would do it.
Highly regarded technical analyst
Tom
McClellan is calling for the end of a nine month decline phase and
the beginning of a rebound on August 25th and 26th. I don't think anyone
can call it that closely, but this guy has a good track record. Other technicians
are looking for 1020 as a low risk entry point for the S&P 500.
A good, high volume sell off would
set up the big money to start covering its short position in the S&P
500, and unwinding its long position in oil futures, which would signal
trend reversals.
Another clue bolstering the case
for a rebounding market can be found in a NY Times published August 8th
entitled Seeing Signs of a Stock Recovery in Some Obscure Tea
Leaves.
Here's an excerpt from that article:
| STOCKS are likely
to rebound, at least for a while, if one obscure indicator, reflecting
the investment patterns of an important Wall Street constituency, proves
as accurate a forecasting tool as it has for the last 60 years.
The buy signal
comes from the eight-week moving average of the weekly New York Stock Exchange
specialist short-sale ratio. The ratio fell on July 23 to its lowest level,
22 percent, since at least 1943, when reliable records of the indicator
were first compiled. That means specialist firms - brokers appointed by
the exchange to maintain orderly markets in individual stocks, often by
buying and selling shares themselves - accounted for about 22 percent of
all N.Y.S.E shares sold short in the eight weeks through July 23. Selling
short is a way to bet on declining prices, and the lower the ratio, the
less short-selling the specialists are doing compared with other investors....
When the ratio
has fallen below 35 percent in the years since 1943, stocks have often
rallied.
CONRAD DE AENLLE
NY Times, August
8, 2004 |
As I have written in the past, the
market can over react emotionally in the short term, but always gets it
right in the long term. I believe the oil market has over reacted emotionally
in the short term, causing the stock market to follow suit.
Once a little time goes by without
the world coming to an end, the extremes will come back to the middle.
I have already decided to hang in
there are start scooping up some bargain basement values once we get past
this dreadful August. Of course, that's just my opinion for my own capital,
and I'm biased to the long side. You might want to go the other way with
your money.
I also believe the next leg up in
the NASDAQ will be led by microcap stocks and take us to around 2300 on
the comp (a measured move). Microcaps will lead the way because they have
sold off the most. What happens from there will be far more interesting.
Keep on eye on the market for one
more big flush. When there's blood in the streets and fear is rampant,
it will be time to back up the proverbial truck and get ready to ride the
Fall rebound.
Send your Bull or Bear thoughts to
editor@otcjournal.com.
Keep them succinct down to a couple of paragraphs. I will publish any views,
positive or negative, that make sense and could have value for the members.
If you are looking for a soap box to promote absurd extremes, don't waste
your time.
Charts Provided Courtesy
Of TradePortal.com |
