The Beginning of the End
10/15/08
My entire career I used to rely on sentiment indicators among other things to gage the mood of the market and the likelihood of rallies or declines. The Overbought/Oversold Oscillator for example below 7 was usually a good buying opportunity; anything below 10 became a screaming buy. Investors Intelligence is another indicator that may not be perfect for timing the market but is definitely good for coloring the background. 35% bulls was usually a good time to get long the market. Today, though? We have even less bulls (22%) and the Dow Jones lost 700 points yesterday. Sentiment has become meaningless. It is incredible. These are truly crazy days. What causes these wild swings and the relentless selling in the markets? It is a combination of several factors. First of all, the credit markets are still frozen. Banks do not lend to each other because they can no longer assume that their counterparty will not go out of business overnight. After all, they know how bad their own balance sheet looks, so they can only assume that the other banks balance sheet looks similar or worse. The seizing up of the LIBOR and commercial paper markets are a direct consequence. Second, the economy is in a recession which is probably getting worse before it gets better. Both of these factors by themselves can cause a severe bear market. On top of all that the third factor affecting the equity and resource markets is the construction of the hedge fund community. Hedge funds rode the wave of raw materials investing between 2004 and 2008, while attracting on the way gigantic amounts of money from all over the world. The positions in all those hedge funds were similar and leveraged. They now are all dealing with redemptions and with forced liquidations. The result are stock price collapses that have NEVER seen before. You are witnessing the mother of all bear markets. Take a look.
I wish I could go back and say "I didn't mean it". I have compared the OIL & CRB charts to the NASDAQ bubble several times this year. My wildest dreams, however, could not have prepared me for this relentless slaughtering. The charts above tell the story. The fundamentals (supply/demand) are clearly weakening and commodities are in a freefall. Any logical area of support has been broken already and every brave soul who thought that "enough is enough" and started buying in hopes of an imminent bottom, was killed and carried out "boots first". And then – when you think it is finally over - the selling becomes more vicious than ever. The insiders of all those companies, the managers and stewards of Oil & Gas producing or exploration, copper, aluminum or fertilizer companies are the last victims. Over the last week, we have seen the rug pulled out from under some executives that were forced to sell massive blocks of stock to meet margin calls. Share prices in the companies involved took it on the chin, to an even greater extent than the broader market. There are dozens of companies by now, whose insiders were margined out of their stock. Unbelievable that the entire world and all the insiders bought into the concept that natural resource stocks could only go higher and that this time it was OK to margin the heck out of the trend, because all natural resources are finite on earth (true) and therefore, this time was different (not true).
All the trend followers jumped on, put their computer algorithms to work, obtained cheap credit and bought with the extra money weapons of financial mass destruction. Richard Dooling wrote a very witty and insightful article this week in the New York Times about the dominance of mechanical trading systems, in which computers decide what company gets bought or sold. Read it. It describes our current state of affairs very well. Where are we now in the cycle of this bear market? Well, we were in a bear market until Friday around noon, when the Dow Jones briefly undercut 8,000. Then we started a bull market (a rise from the bottom of 20% or more) with a rally that brought us to 9,800 on the Dow. That bull market was over on Tuesday morning and now we are back in bear market mode. All kidding aside, let us apply some rational parameters to this madness. Barron's quoted Merrill Lynch's economist, David Rosenberg, who believes that the bear market will end when it has sufficiently discounted bruised company profits, which he reckons will slip to $63 for the S&P 500 in 2009. The low $60s seems to be the worst everybody expects for S&P 500 earnings in 2009. At an index level of 900, this amounts to a Price-Earnings ratio of 14 to 15. That seems cheap. Barron's approached the problem with the following calculation: "With stocks down 43% from their 2007 peak, how much of an earnings hit have traders discounted? Profit declines of about 27% in 1990-'91 and 40% in 2000-'01 matched the respective market pullbacks. So if profits bottom not much more than 43% or so from the 2007 peak, the market may be close to the lows. If not, then we'll have further to go, notes Michael Darda, chief economist at MKM Partners.
Above you see one example of how bottoms are formed. If stocks are truly discounting the worst right now, then the current S&P 500 level of 900 or so may constitute the bottom. That does not mean that we have entered a new bull market. Bottom formations take time. You see that the 2002 bottom began in July 2002, had a retest in October 2002, had a failed breakout attempt in January 2003, and followed by a retest of the lows in March of 2003 before finally breaking out successfully in May 2003. If this pattern holds, we have another 8 months to go, before we get through this. In this time, I believe that shares of financial companies (banks and brokers) offer great potential. But I am repeating myself!
Hermann Vohs
"Democracy is the theory that the common people know what they want and deserve to get it - good and hard. "
H.L. Mencken
Hermann Vohs is president of Cales Investments, Inc., a registered Broker-Dealer. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. Hermann Vohs and/or the staff at Cales Investments, inc. may or may not have investments in any of the markets cited above. Hermann Vohs can be reached at 303-765-5600.
This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities.
