It is common sense that 30% a year returns cannot be achieved without taking risk. Obviously those risks need to be intelligent and David Tepper believes his upside is much greater than his downside. But he realizes there will be times when hes wrong and will lose money. Many hedge funds are so focused on avoiding losses that they do not allow themselves to make any money. Hedge funds worry that if they suffer a draw down investors will redeem. So they play not to lose and end up suffering losses by a thousand paper cuts. I believe that this behavior has played a large role in the underperformance of the hedge fund industry in recent years. Many hedge funds would be wise to take something from the David Tepper interview other than the fact that they can now buy with reckless abandon.
We saw the highest reading in years on the NAAIM survey last week. Yesterday we saw the most call buying in over a year on the ISE. We also saw extreme call activity at the CBOE. During any other time of year these kind of extreme readings would almost guarantee poor performance going forward. But I have seen numerous occasions where these extremes don't effect the market at year end.
I have mentioned numerous times in recent months that I like to give the market the benefit of the doubt during these seasonally strong periods. Despite this I found myself a little more hedged than I wanted to be for yesterday's strong rally but still moderately net long. I do not plan to add to my hedges despite the negative signals my sentiment indicators are giving off.
I was hoping for a decline this week that would dampen sentiment. Instead the modest advance has sent sentiment towards excess bullishness. The AAII bears, Investors Intelligence bears, Hulbert newsletter writers & the NAAIM are all approaching levels of excess optimism.
I believe that the risk in the near term is to the downside and have added to hedges as the market has climbed. The market has laughed at my plans for a decline and then a rally into year end. I still believe this can occur but the timetable has been pushed out a bit.
InsiderScore.com is reporting extreme amounts of insider selling, especially among founders who own large stakes in companies. This is likely due to capital gains tax rising next year. While this selling is likely not related to fundamentals the additional supply of stock does not help. Towards the end of the month many company insiders will be in a blackout period as we approach quarter end so the selling from insiders should lessen.
The special dividend announcements have been coming in fast and furious. Most of these special dividends are scheduled to be paid in the latter part of the month. If a portion of these dividends is reinvested it should be an incremental positive for the market.
A move lower into the middle of the month would make the market oversold, with seasonality turning positive in the latter part of the month and a slew of special dividends scheduled to arrive. The short term outlook remains iffy but it should get better once we get past mid month.
While I am cautious about the very short term, the intermediate term picture is not as clear. Sentiment indicators show that investors remain on the bearish side despite the recent rally and intermediate term seasonality favors the bulls. Normally I would say that this combination is enough to make me very bullish in the intermediate term. But it is difficult to know what effect a change in capital gains rates will have in the last few weeks of the year. There is also the possibility that all the special dividends have a positive effect on the market.
My plan is to use strength early this week to put on some hedges but to remain net long. It takes extreme optimism for me to get neutral or bearish at this time of year and we certainly are not seeing that.
A few companies have announced special dividends for the latter part of December. If this trend picks up and an abnormally large amount of dividends are paid out in late December it could give the market a lift as some investors reinvest these dividends. The ideal setup would be for us to see a correction into mid December, all the while many more special dividends are announced. That would make for an excellent risk/reward long setup.
Normally, I would expect to see a retest of the recent lows at some point but in recent years we have seen numerous instances where the market moves in a single direction with nary a correction. In the past week I have sold my trading longs and written covered calls against some of my core positions. I would now describe my posture as a medium sized net long position. Have great weekend and a belated Happy Thanksgiving.
- Rydex traders are positioned nearly as bearishly as they have been all year.
- Hulbert newsletter writers are recommending an outright short in the S&P 500, which is not seen very often.
- Both Investors Intelligence and AAII bears are at the highest levels in a year.
- The market is deeply oversold
The oversold reading, the excessive pessimism and the very strong seasonality help make a very strong case for the long side. I am positioned aggressively long.
Annaly invests in agency securities. It subsidiary Crexus invests in CMBS. Chimera, Annaly's other subsidiary invests in non-agency RMBS. Annaly said on its latest conference call that the opportunities in agency securities are not attractive because the Fed has distorted the market. Now that Obama has been re-elected for a second term it makes it likely that these distortions will not end any time soon. It makes sense for Annaly to diversify into other markets.
The reason I believe that Annaly has offered to buy Crexus but not Chimera is because Chimera is not current on its financials. It is a matter of time before Chimera becomes current and when they are I believe they will be bought by Annaly. The type of assets that Chimera holds had a tremendous rally in the third quarter. Chimera last reported economic book value of $2.87 as of the end of June. I estimate that current economic book value is over $3.20. If Annaly pays the same premium that it paid for Crexus that would equal roughly $3.35
- The assets in Rydex bear funds as compared to Rydex bull funds reached their highest level since June. This applies to the leveraged funds as well.
- The CBOE put/call ratio has been above 1.10 for three days in a row. That is extreme put activity.
- The volume in SDS, the Ultra short S&P 500, was the highest in over a year on Friday, per sentimenTrader.com.
We have often seen follow through selling on Monday's after a nasty week followed by a Turnaround Tuesday. I am already positioned long but if we do see a decline on Monday I plan to expand my long position. I believe a rally is in the cards.
- We saw panic in the most important stock in the market, Apple. It seems to me that we finally saw panic in Apple today after weeks of people trying to call a bottom. Volume is tracking higher than anytime in over six months. This more of one of those "you know it when you see it" type of calls as its difficult to measure panic in an individual stock.
- Put buying is high for a second day in a row.
- New 52 week lows have contracted from yesterday even though the market has made a lower low. this is a positive divergence.
- We saw several extreme readings yesterday that typically lead to a rally within a few days. Today's carnage only adds to those odds.
I have taken some trading longs in anticipation of some sort of a bounce.
Two sentiment indicators I look at typify current investor psychology. The leveraged bull funds at Rydex have close to the lowest amount of assets seen all year. This is a big drop from a few weeks ago and shows that many of the bulls have given up. At the same time the bear funds also have close to the lowest asset levels seen all year. While investors have backed off their bullishness they refuse to get bearish. The same can be seen with the Investors Intelligence bears, which refuse to climb as well, while the bulls have backed off.
I am continuing to give the market the benefit of the doubt in this typically strong seasonal period. I added to my net long positioning yesterday but not by as much as I planned to because the sentiment indicators have yet to line up.
|Dow’s “summer” gain — over the six months beginning on 5/1||Dow’s “winter” gain — over the six months beginning on 11/1|
|Average since 1896||1.7%||5.1%|
I learned the hard way that seasonality works by fighting the market at the strongest parts of the year earlier in my investment career. Seasonality is not a be all and end all. It is one of many indicators I use to form a market opinion.
The highs in the market came a little over six weeks ago making us oversold in the intermediate term. Its not a great oversold reading because we chopped around for a while after the market made a high. If we get some turmoil into the election we will likely get a better oversold reading and sentiment is likely to be excessively bearish. That would likely prove to be a good buying opportunity.
At this time of year I make an effort to have a positive bias. I have used the recent weakness to build a medium sized net long position. If we do get a further decline into the election I will likely take a more aggressive stance on the long side.
- The ISE equity showed the most put buying since early June.
- The VIX popped
- The TRIN reading was extreme
- We broke below widely watched support levels that likely cleared out some weak hands.
All this should lead to some sort of a bounce, which we are seeing this morning. Its possible that this bounce will be the beginning of a bottom but the intermediate term sentiment and oversold indicators are not extreme enough to have a strong conviction that this was a bottom.
We are seeing a break this morning below widely watched technical levels. This could lead to a decent washout and accelerate the move towards extreme pessimism. I continue to believe that the best course of action is to buy extreme pessimism and sell optimism. It looks like we are on our way to an oversold reading combined with excess pessimism.
Companies and private equity firms are borrowing at the lowest levels in history in order to repurchase shares and take over other companies. With yield scarce everywhere the only place left to get yield has become the stock market. In addition, we are heading into a typically strong part of the year. This makes it difficult to be overly bearish as well.
Given this backdrop it is difficult for me to have a strong view on intermediate term market direction. My best guess is that we are in some sort of range where it will pay to buy oversold and sell overbought.
The Nasdaq was down something like six days in a row before Monday so an oversold bounce was not unexpected. However, now that we have bounced and investors have once again turned optimistic the risk/reward is more muddled. The market has only rallied for two days so its too soon to turn bearish with any conviction.
I believe the most likely outcome for the next few weeks will be some sort of a trading range. I would not chase the market either lower or higher.
How can I trust the book value of a company that is not up to date on their financials? Before I tackle this I want to point out again that the book value is not at issue in the restatement. I view Chimeras portfolio as two separate portfolios: a levered agency portfolio and an unlevered non agency portfolio. On the agency side its difficult to see how the book value can be wrong as the securities are relatively simple to value. It is far more likely that any mispricings are on the non-agency side. Chimera has roughly $3.1 billion in equity. They hold roughly $2.6 billion in RMBS, mostly junior securities. The dealer marks on Chimera's portfolio are 67 bps lower than Chimera's marks. From speaking to people in the industry dealer marks on junior RMBS are very tough and conservative. In the current regulatory environment its difficult to see how the numbers could be that far off. Chimera also holds a roughly $285 million portfolio of securitized loans. These loans are prime, jumbo, first lien residential mortgages. This is a seasoned portfolio with average FICO scores of over 750 and 75% LTVs. They are priced slightly below the remaining loan balances. Its difficult to see how these loans are so mismarked as to drastically change the valuation of the company. If there is a drastic mispricing of Chimera's assets I cannot figure out where it could be.
I believe that pure play agency mortgage REITs such as Annaly Capital Management and America Capital Agency Corp. are at risk. Agency mortgage REITs make money two ways. The spread between agency securities and treasuries plus off of the yield curve. As a result of the Fed buying agency securities there is no more spread between agency and treasuries once one accounts for prepayment risks. There could even be losses if prepayments come in high. This leaves the agency mortgage REITs as a levered play on the yield curve. Agency mortgage REITs have already started to sell off and its possible that Chimera gets lopped in with them. Chimeras agency exposure is relatively small and any decline in sympathy with the agency mortgage REITs would be an opportunity. If one is worried about the agency mortgage exposure I would recommend shorting a pure play agency mortgage REIT against 15%-20% of the dollar value of this position.
Chimera pays a 13.4% dividend and I estimate that its economic book value is greater than $3.00 (GAAP book value is even greater but does not reflect reality). Chimera currently trades at $2.62 and would need to appreciate by 14.5% in order to reach my estimate of economic book value. Chimera last reported economic book value of $2.87 as of June 30. The type of junior mortgage backed securities that Chimera holds have risen strongly since then and I estimate that the economic book value is now above $3.
What is the catch and why does such a discount exist ? Chimera has dropped precipitously in recent years as some of their securities had not performed as expected and they are delinquent in their SEC filings.
GAAP accounting treats investment grade securities and non investment grade securities differently. Chimera used the investment grade accounting treatment on non investment grade securities. The difference amounts to which line item the income flows through, interest income or other. The end result is the same. The book value and the cash flow are unaffected by this. Chimera is delinquent in their filings as they correct these errors going back a few years.
The securities that Chimera holds have underperformed other private label RMBS in recent years. This is reflected in the market value of those securities and in turn Chimera's economic book value. I don't believe an additional discount needs to be applied to Chimera.
Chimera trades with a large margin of safety due to its significant discount to economic book value. I believe that over time that it will trade back to economic book value. Investors are being paid 13.4% while they wait. This is an attractive risk/reward in a market with few bargains.
In the very short term we could see a bounce after a nasty day like yesterday but this is likely not the bottom. The decline is only three days old and a nasty day like yesterday that comes early in a decline usually sees some follow through. The intermediate term sentiment indicators are still showing excess optimism although they are no longer extreme. Ideally, I would like to see the market become more oversold and intermediate term sentiment turn more neutral or even negative.
My initial reaction is to do some buying on weakness but to leave plenty of room as a better opportunity is likely in the coming weeks.
There is a bear case to be made as well. Despite the short term negativity, the intermediate term sentiment indicators are still close to excess optimism. The oversold reading is not great as many of the down days were only slightly down. In recent years we have seen numerous instances where the market picks a direction and goes there in a straight line despite oversold or overbought readings.
I would much prefer it if the intermediate term sentiment indicators were showing excess negativity instead of excess optimism. I would also prefer a better oversold reading. Still, I believe the odds favor a bounce in the coming week. As a result I am moderately long.
The reason I don't believe this is a great buying opportunity is because sentiment is still too bullish on an intermediate term basis. With that said its likely any further dips in the next couple of days could be bought for a bounce. Once we get a bounce the market outlook becomes a lot murkier. We have seen in recent years sentiment stay extreme heading into year end numerous times. At the same time staying long when there is excess optimism is a dicey proposition. A further decline in October that sours sentiment would create a better opportunity into year end.
For my part I am moderately long. I was out of the office yesterday but stuck in a buy order on Tuesday to remove some hedges if we dipped further. That order was filled yesterday morning. I will look to use a bounce in the coming days to reinstate those hedges.
Last week I pointed to some signs that the crowd may have turned excessively bullish and since then some more signs have piled up.
- Market Vane bulls are the highest since June 2007.
- The NAAIM survey of manager sentiment is above 80, which has been about as high as it gets.
- The 10 day moving average of the CBOE put/call ratio is the lowest its been in one and a half years.
- I spent quite a bit of time this past week listening to Bloomberg radio and there was not a single bear.
The vast majority of sentiment indicators are now pointing to excessive optimism. The anecdotal evidence I am seeing is pointing to excessive optimism. While these periods of excessive bullishness tend to last longer than they used to, they still do not tend to end well.
Now that Yahoo is well on its way to monetizing its Asian assets I am willing to give them credit for these assets. Excluding cash and Asian assets Yahoo sells for 0.6 times estimated 2013 EBITDA. As a comparison AOL sells for over 4 times EBITDA. Regardless of what one thinks of the business the price is extremely low.
There is a catalyst in place for higher prices. Yahoo! will return $3 billion to shareholders in the near future. There should be an announcement shortly as to how they will do this. I suspect at the current price they will opt for a share repurchase or a tender offer although a dividend could be involved as well. I am long shares of Yahoo!
- The amount of money in bullish Rydex funds versus bearish is within spitting distance of an all time record.
- Hulbert Nasdaq market timers are recommending a 64.7% net long. They have gotten as high as the mid to high 70's but is clearly in the high end of bullishness
- Last week we had a 52 week high in call buying at both the ISE and CBOE
- The Investors Intelligence bulls are above 54%, which is approaching the danger zone. Unfortunately the bears are still above 24%. The best signal is when the bears are below 20%.
We have seen numerous rallies in recent years where the extreme bullishness did not matter for a long time. However, eventually the extreme bullishness did matter and all the gains were subsequently taken away. If we are not in extreme bullish territory than we are on the precipice.
In the short run the market is getting quite frothy and I am expecting a pullback to start in the next few days. I expect that this pullback will likely be bought and that the market will climb from there. I will likely buy into that pullback and allow myself to be about 50% net long with very conservative, cheap, low beta names.
I have not yet decided if I will attempt to play the coming pullback I envision. I am leaning towards not because I will be out Monday and Tuesday of next week. Once we get a pullback I will likely hold my nose and buy.
Mutual funds and ETFs basically stay invested at all times but hedge funds have huge swings in exposure. These huge swings in hedge fund exposures tend to exacerbate a trend. While few hedge funds would admit to being momentum vehicles, as a group they act much like one would expect a momentum vehicle to act. This leads to seemingly endless rallies and endless declines.
One must respect the possibility of further upside as we have certainly seen examples of such situations in recent years where a market refuses to rest. With that said, I believe we are at a high risk point for some sort of a pullback/correction. It seems to me the bears have given up and everybody is certain QE will take us up forever. Im not so sure but not brave enough to do much about it except stay defensive.
The large AIG offering was a good opportunity to take a stab at the short side. I will be relying on my sentiment indicators to guide me as to when there is excess bullishness. This may lead me to take more stabs at the short side in the next couple of weeks. There was a good amount of call buying yesterday despite the down day. I suspect we are in the excess optimism stage of the rally and are topping out but will wait until I see the white if the bull's eyes before making more short side attempts.
As a result of the heavy secondary issuance calendar I decided to short SPY in the pre-market and move to a roughly market neutral stance from an already defensive stance. I was originally planning on waiting for the sentiment indicators to confirm my suspicion that market participants are excessively bullish. However, with this much supply the short term upside should be limited regardless.
At Rydex there is more than 5 times as much money in bullish funds as in bearish funds. That is close to an all time high. We are also seeing some extreme readings in option indicators, with the ISE equity closing yesterday at 215. I will be looking for confirmation from the sentiment surveys in the coming week.
I am not interested in catching the last few percent of a rally. That is where I believe we are. There should be better chances to buy stocks even if we go a little higher first. Have a great weekend.
The sentiment indicators I follow are just shy of extreme bullishness. One last rally that sucks in the hedge funds and pushes the sentiment indicators into extreme territory would likely lead to a meaty correction. However, if the market declines now hedge funds would likely use the weakness to increase their exposure and I don't believe it would go very far.
There is an undeniable profit slowdown occurring as we are seeing profit warnings on a daily basis, with Fedex being the latest. With valuations being in the realm of normal and the possibility a profit slowdown the risk/reward in the market does not seem great. I continue to wait for market participants to push this market to one extreme or another before I take a strong stance.
The Investors Intelligence survey is showing 49% bulls and 24% bears. It has generally taken a reading closer to 20% bears or below before we have seen lasting tops. We are getting closer but are not there yet. Consensus, Hulbert and Market Vane are also very close to showing extreme bullishness.
Most sentiment indicators I look at are very close to showing extreme bullishness but are not there yet. I suspect one more push higher where we make marginal new highs would do the trick. This rally is clearly not in the early innings. It is too late for me to want to get long but I want to see the sentiment indicators reach an extreme before going short.
When I began investing one of the biggest mistakes I would make was to always want to be involved. A well thought out investment would work out for me. At that point I would be itching to find another investment and often gave back my gains. It was not until I broke that pattern that I was able to make money more consistently. This is one of those times where I don't want to force anything and would rather wait for better opportunities.
Market Vane, Hulbert and Consensus are now within spitting distance of showing extreme bullishness but are not there yet. I suspect that if we get another rally in early September the sentiment indicators will reach an extreme. That would set us up for a bigger correction in the September/October time frame.
I am not a fan of the market at these levels. The valuations are so-so and the macro-economic risks remain. Everybody seems to be in agreement that China is facing a large slowdown. Most believe that we will be able to decouple from China and it will effect us minimally. In my experience it rarely works that way, especially in a connected world.
The bull case is that credit spreads are low, allowing for cash M&A and share repurchases. The US economy seems to be moving along, albeit slowly, and profits are largely holding up. Most market participants are not positioned aggressively and many are badly trailing the market. If the economy holds up its possible that many of these managers will be forced to chase the market.
For the vast majority of my investing career the market has been overvalued. There is no reason we can't go there again. But this is not a thesis I like to invest based upon. I am long a few value names but have some market hedges in place. I am also engaged in some relative value trades. This is not a time where I am being aggressive.
The Investors intelligence survey is my favorite of the surveys. It doesn't tend to jump around. I can't remember many good tops in bull markets where the number of bears weren't very close to or below 20%. According to the most recent survey the bulls are at 47.3%, and the bears are at 24.7%. Investors are now bullish but its still not at an extreme.
- The NAAIM indicator is one of the two indicators I follow showing extreme optimism. It is sitting at a multi-year high and measures the sentiment of active investment managers.
- The 10 day moving average of the CBOE put/call ratio is the other sentiment indicator I follow at an extreme. It scored a new one year low last week. This measures call activity versus put activity at the CBOE. A low reading shows a lot of call activity.
- The 10 day moving average of the ISE equity only ratio is another put/call measure. This put/call measure is not at an extreme and is not confirming the CBOE measure. It is currently at 159 where as tops tend to occur when this is over 200.
- The Investors Intelligence survey of newsletter writers has 26.6% bears. Tops tend to occur with this reading below 20%.
- The AAII individual investor survey has bulls at 37%. We typically see a reading over 50% before a top. This survey is very jumpy and is my least favorite.
- Hulbert Nasdaq market timers are recommending a 60% long position. This is high but tops typically see a 70% reading.
- The Consensus bulls are at 63%. They were above 75% in the spring
- The Market Vane bulls are at 64%. Typical highs are above 65%. This is very close to an extreme.
I force myself to look at a wide array of sentiment indicators. The reason I do this is because it stops me from picking and choosing the ones I like in order to affirm my bias. There are few perfect tops where every indicator is in line. But at most good tops the majority are at extremes. We are getting there but are not there yet.
When ARCT opened for trading it traded much cheaper than other comparable triple net lease REITs. It still trades at a big discount to its peers today. The most expensive stock in the triple net lease sector is Realty Income Corp (O). Below are some comps:
ARCT trades roughly 30% cheaper than O, has better tenants and longer lease terms. It is not even a contest deciding which is the better investment. I believe the reason for the discount is that ARCT is below the radar because of the manner in which it came public. I believe there are a number of catalysts on the horizon that will close the valuation gap between these two REITs:
- ARCT will likely be added to the MSCI US REIT Index(RMZ) in November. This is the main US REIT index and is considered to be the benchmark.
- Jana Partners recently filed a 6.2 million share position and is now the largest shareholder. This may bring attention to the stock as well.
- ARCT should receive more sell side coverage in the next few months.
- As ARCT reports more quarters and gains analyst coverage it should start to screen very well. Many dividend investors use stock screens.
The 30% valuation gap between ARCT and O is unwarranted. There are numerous catalysts on the horizon that may serve to close this gap. Hence, I am long ARCT and short O.
In the past year and a half defensive stocks have outperformed and are no longer cheap. The market is fairly priced and I am finding much fewer pockets of value. I have recently established some pair trades as a result. These are similar companies that trade at drastically different valuations. Over the next few days I plan to post my explanation for some of these trades.
I thought this lockup expiration would play out differently for a number of reasons:
- The entities that were eligible to sell are the same that sold shares in the IPO so there was less urgency to take something off the table
- Microsoft was one of the companies eligible to sell and I do not believe they are in a rush to sell their remaining shares
- The short sellers were already heavily anticipating this lockup expiration.
- From a game theory perspective it made sense for these firms to allow a short squeeze to occur and then start dribbling out shares or do a secondary. The roster of holders were mainly large venture capital firms such as Elevation Partners. I was not expecting a race for the exits.
I went long Facebook yesterday on the theory that the lockup expiration was being over anticipated. I did not believe these large firms would start a rush for the exits, but would be more methodical in their selling.
I took a 5% loss in my Facebook trade this morning. I was clearly wrong in my assumptions. But that was not the reason I believe I made a bad trade. The reason I made a bad trade is that I did not believe in Facebook from a fundamental perspective. In other words I veered from the type of trades I typically do. I have done many trades where I take crowd psychology into consideration but I generally believe in the companies fundamentally. I will chalk this up as another expensive lesson courtesy of Mr. Market. Stick to my knitting.
Unfortunately, the reality is that the market is muddling along and it does not look like we will get a good overbought reading or extreme optimism this week. This makes choosing a market direction much tougher. The market is in an uptrend so betting on a reversal without extreme optimism is a tough bet. At the same time I cannot bring myself to get on board with deteriorating fundamentals and so-so valuations. I am waiting for the bulls or bears to push this market too far in either direction.
There has always been performance chasing for as long as there have been markets. But it is even more extreme in today's markets. The market does not stop going up until it sucks everybody back in. We are currently in that process which is why I am monitoring the sentiment indicators. The sentiment indicators are likely to turn extreme before we see a lasting top.
Last week the bears wasted an overbought reading but it was a mild reading. If the bulls manage a rally this week the bears will get a better overbought reading towards the end of this week. Additionally, sentiment seems primed to tip into excess optimism. I don't believe the market has much upside and expect that we will see a turn lower later this week. If we rally in the early part of the week I will consider selling short later this week.
Most of the sentiment indicators I follow are not showing the type of enthusiasm that the CBOE put/call ratio is but they are moving in the bullish direction. Anecdotally, I am seeing a lot more bullishness. I was listening to an interview on Bloomberg radio where two guests were asked for a theme song for the market. One suggested "Here comes the sun" while the other suggested "Dont worry about a thing". The second guest was introduced as being normally very bearish.
After two months of rallying market participants have finally turned bullish. Unfortunately, this likely means we are in the latter part of this rally. There is still room for sentiment to get more bullish before I would categorize the bullishness as extreme but I believe we are in the danger zone.
Companies like Mcdonald's and Priceline continue to lower estimates. The momentum of the world economy and earnings are lower and the economy will not turn on a dime. When the economy is at stall speed there is a high risk of a negative shock. Fundamentally and from a valuation standpoint I do not like the risk/reward in the market.
The stock market is not the economy and the two can diverge for long periods of time. There are some positives from a market perspective. Market participants are not positioned aggressively and a rising market increases the pressure for those underinvested to get back in. Additionally, ultra low rates allow companies to lever up, repurchase shares or do cash takeovers. Many yield hungry investors are looking to dividend stocks rather than bonds.
While I do not like the risk/reward I respect the bull case. The stock market has spent the better part of the last twenty years being overvalued so there is no reason it cannot go there again.
The missing ingredient for the bears is sentiment as the sentiment indicators remain muddled. This is somewhat surprising for a rally of this magnitude and duration. One sentiment indicator that is showing excess optimism is the 10 day moving average of the CBOE put/call ratio as seen below. It is now approaching the highest call activity of the year. Unfortunately for the bears other sentiment indicators including the ISE put/call ratio are not confirming this optimism.
I remain cautious on the market and believe that the bears now have the wind at their back in the very short term. Sentiment still has room to get more bullish before we see an intermediate term top, which is why I am cautious but not bearish.
The market is now overbought so I believe that the odds favor the bears for the balance of the week, although tomorrow is more of a coin toss. Have a good night.
Many safe stocks such as consumer staples and utilities trade richly. Stocks such as Coca Cola and Colgate trade at twenty times forward estimates. This is the norm for these "safe" dividend paying stocks. The valuations are even more egregious in the REITs and MLPs.
Despite the rich valuation in many stocks the overall S&P 500 is trading at 14 times forward earnings. That is because if a stock does not fall into this safe or high dividend category no price seems to be too low. I understand the benefit of managements that return cash to shareholders. It makes it a lot less likely that they will do a stupid acquisition or destroy shareholder value in other ways.
I am doing my hunting in the cheaper area of the market. In many cases these managements are returning cash to shareholders, just in the form of a share repurchase rather than a dividend. I see limited upside in purchasing mature companies at twenty times earning. If any of these "safe", mature companies stumble the downside could be large.
An attractive valuation:
Amdocs trades at 8 times 2013 expected free cash flow to enterprise value, which equates to a 12.5% after tax yield.
Low economic and financial leverage:
Amdocs has $900 million in cash and no debt. Roughly 80% of Amdocs business is recurring. Amdocs creates billing software for telecom and cable companies. In many cases it completely manages this IT function for them. These contracts are typically 5 to 8 years long and the switching costs to a new billing system are very high. It happens very irregularly that customers switch away.
Management that is a good steward of capital:
Amdocs has repurchased 20% of the shares outstanding in recent years and has promised to return at least 50% of future free cash flow to shareholders.
There are risks to Amdocs in that a small amount of customers make up a large portion of their revenue. However, the earliest of those larger contracts are up for renewal in 2014 and I believe it is very unlikely that a customer will switch away. Additionally, Amdocs is dependent on the telecom industry where there are not many new carriers so it will be difficult to grow much. I believe that the low valuation and the high visibility are a good trade off for the modest growth.
One of the biggest positives supporting the market in the past year has been share repurchases. Last summer when everybody was preparing for another 2008 companies were repurchasing shares at a record pace. This has now changed as TrimTabs reports that announced share repurchases are at very low levels. Furthermore, insider selling has picked up in the past week. These are big headwinds if they continue.
The S&P 500 is nearing 14 times forward earnings with a deteriorating economic and earnings outlook. It is difficult for me to be bullish under these conditions. Unfortunately, valuation is a bad short term timing tool and performance anxiety may continue to dictate direction.
The market is now oversold and will remain so for the next three trading days. The bulls will have the wind at their back for that period. The chart below is the 10 day moving average of the NYSE Advance-Decline line. The line should move higher over the course of the next three days.
The sentiment picture remains muddled. There is no clear bullish or bearish consensus. The largest camp is the confused camp, which I count myself as part of. The seasonality picture is negative as August has been a down month since 1990 on average. Seasonality is weak for the next 8 trading days. The chart below is August seasonality by trading day from CXO Advisory:
The stock market is not the economy so it does not necessarily mean the stock market has to follow the economy. However, I believe that with a negative fundamental backdrop, fair valuations and muddled sentiment the upside is limited and not worth the risk.
Market sentiment is muddled. Newsletter writers measured by Investors Intelligence actually turned slightly less bullish this week. I was expecting to see a big uptick in bulls after this weeks rise. Rydex traders turned even more bullish yesterday. There is no clear signal from the sentiment indicators.
I have had very mixed views on the market for a few weeks now. The only thing I feel strongly about is that if the ECB does not act forcefully tomorrow the economy will continue to deteriorate.
Wellpoint was trading at less than 8 times 2013 earnings when I bought the stock plus they were planning to buy back over 10% of their shares outstanding this year. I believed the reason for the discount was Obamacare. Only 25% of their profits, small group and individual, is likely to be effected by Obamacare. I figured that even if 25% of the profits went away the stock price was still too low, which I did not believe would occur. Obamacare will bring more customers and likely more profits over time.
Early in the past decade, when the HMO industry was still young, profits for the HMOs declined as they tried to expand too aggressively. Since then there has been consolidation and a lot of the profits have gone to shareholders rather than into expansion. It has been a decade long profitable run for the HMOs. But at the end of the day it is an insurance business and there is an underwriting cycle. It now seems that we have hit the top of that cycle as profits are declining.
I was caught long at the top of the cycle. This is precisely the reason I avoid cyclical companies. While I recognize my mistake I do not want to compound it by selling out at any price. If the market gives me an out I will take it but current prices are already pricing in a dire outcome so I am holding tight.
In the intermediate term the market is now overbought. In the short term we could see a pullback in the next few days but a better overbought reading would occur if we rallied one more time after that. Most sentiment indicators are mixed but some are showing too much optimism. Rydex traders are positioned very bullishly and the investment advisors polled by the NAAIM are about as bullish as they have been all year. From the NAAIM:
Looking solely at statistics I am more partial to the bearish camp. However, if the ECB acts forcefully none of this will likely matter and we will likely go higher until we are at a bullish extreme. As I have little insight to what the ECB will do I am neutral.
The news out of Europe last week was an incremental positive. The ECB finally admitted that the high rates of peripheral countries were a problem. They will now attempt to address these issues instead of ignoring it.
In summary, we had positive news out of Europe last week but a 60 point move in the S&P 500 incorporates that good news. If the ECB fails to act strongly or if the economy continues to deteriorate despite ECB action there is now room for downside in the market whereas valuations were previously pricing in deterioration.
The ultimate bull case is that if peripheral rates can be brought down far enough this plan could have the effect on the European economy that TARP and QE had on the US economy in 2009. A virtuous cycle of more liquidity and greater optimism would lead to a cyclical recovery from very cyclically depressed levels.
The bear case is that we have seen similar rumors before and that ultimately the ECB has stopped short of using the force that is necessary. Bringing peripheral rates down by 1%-2% might remove the risk of a short term meltdown but will not help the European economies recover. Even worse it allows the frog to slowly boil as the urgency for a permanent solution is delayed.
Without knowing what is rumor and what is fact it is difficult to make a judgement on the market. The 60 point rise in the S&P 500 has significantly raised expectations for ECB action. If the ECB fails to act as strongly as the rumors suggest or if the actions will be taken further out in time the market would likely not take it kindly. If the ECB does act this will put a lot of pressure on the conservatively positioned investment community to buy, even if in the long run the action turns out to be too little.
This makes the stock market outlook even tougher. Market participants are not positioned aggressively so if they perceive this as a green light from the ECB than we could see higher prices. At the same time the economy and the earnings outlook are deteriorating. I remain uncertain of market direction.
We have been seeing a high stakes game of chicken where the stronger countries refuse to help, while the weaker countries refuse to ask for assistance. In the meantime the Eurozone is falling into a deep recession. In the past week Spanish 10 year yields soared above 7% while Italy's neared 7%. The game of chicken was coming to a head and this may have forced a solution.
This morning Mario Draghi said he would do anything to keep the Eurozone together including intervening to close sovereign spreads. This has taken the near term tail risk out of the market and is the reason we are higher today. But this also allows the game of chicken to continue and the economy to continue to deteriorate in the interim.
In recent days I have gone over numerous reasons why the market is strong despite terrible news. To summarize:
- Market participants with modest levels of equity exposure
- Market participants who have been punished for panicking the past two summers
- Reasonable valuations
- Lean corporations
- Strong corporate bond markets
While I respect these positives and would not be shocked if the market managed to climb higher I do not like the risk/reward. With earnings estimates coming down the upside seems limited. The economic slowdown will not turn on a dime and can potentially gather momentum. If the slowdown worsens the downside could be significant. I see the market not responding to bad news and I respect it but I don't want to join the party.
There are some early signs that the credit cycle might be turning. Three municipalities in California declared bankruptcy in a single week. We are seeing rapid earnings decline in the more cyclical sectors and its a matter of time before we see some bankruptcies. But the fact is that junk markets are at record low yields and there is little stress seen in yields.
As readers can see I have been torn lately between the bull and the bear case. The more I analyze the situation the less clear it becomes to me. It seems that I am not the only one that is confused as we have been seeing wild swings in both directions recently.
There are a number of reasons that the market is not responding violently to the recent very bad news:
- While corporate profits have been weakening, valuations are still reasonable. It will take a large drop in profits before valuations become a headwind.
- After a 12 year old secular bear market, market participants are not positioned aggressively. There are simply fewer people to scare out.
- Panicking has cost market participants a lot of money in recent years and like Pavlov's dogs they may simply be responding to their recent experiences. This is the most troubling reason the market may be holding up.
Long time readers know that I usually give precedence to market related factors rather than macroeconomic related factors. I believe that macroeconomic factors are now very negative and they deserve increasing precedence. The economy is weakening, as are profits. There are numerous imbalances and the potential for a hard landing in China and a depression in Europe. This is simply too much for me to ignore now that it has begun to effect the economy and profits.
I believe the risk/reward from current levels are poor. It is pretty clear that there is downward pressure on earnings. Valuations are reasonable so we could see some P/E expansion as long as profits don't fall out of bed, but given the deteriorating profits outlook upside is likely to be limited. However, there is also the risk that the deterioration in profits accelerates and the downturn in the economy worsens. I believe the upside is limited to a few percent while the downside potential is quite large.
I am reluctant to turn bearish before the market is overbought, which is still about a week away . Today is only the fifth day of the rally and it typically takes ten trading days for a rally to exhaust itself. Typically we see a rally, a pullback and another rally so its possible that we are setting up for a short term pullback.
From a fundamental standpoint earnings are coming in weak but they are not falling off of a cliff. At the current modest valuations the market can absorb slight reductions to estimates. The bears will argue that earnings are a lagging indicator and are set to go lower. The bulls will argue that there are few excesses in the economy and corporations are lean which should lead to more of the muddle through we have been seeing for years.
I see the merit in both the bull and bear argument and am indecisive. I see opportunity in specific stocks and sectors. For instance the HMOs are a defensive sector that are not economically sensitive. Most defensive stocks have gone up a lot but the HMOS have done the opposite. Aetna and Wellpoint, which I own, trade at 7 times next years expected earnings.
UnitedHealth reported this morning showing that health care utilization rates remain low, which is good for the bottom lines of the HMOs. Mitt Romney is now leading in some polls. I believe there is a free embeded call option in these stocks if Romney wins. Even if Romney does not repeal Obamacare he is likely to make it less onerous on the HMOs. If Obamacare moves forward i believe a worst case scenario is already priced into these stocks.
Many of the issues plaguing technology companies remain. But there is some evidence this morning that the woes may have been priced in to the more beaten down stocks. EMC missed on EPS but is trading 6.5% higher this morning. Intel had a big miss and lowered its outlook yet the shares are looking flat. Checkpoint missed and lowered their outlook and are trading higher. Normally big misses by three tech companies would mean much lower prices.
I still believe that tech is over owned but not nearly to the extent it was a few months ago. The issue of overseas earning seems priced in as shown by this mornings reactions to poor numbers. Unfortunately, the issue of capital allocation remains. These giant cash hordes are coming into focus as a result of investors preference for dividends. In mid-April I wrote that technology was over owned and set to under perform. I now think that technology will perform more inline with the market.
Google is growing at 20% a year and trades at less than 11 times next years FCF to EV, while many stodgy stocks that pay high dividends trade at nearly twice the valuation. There is an advantage to companies that pay dividends in that the risk that management blows the money is greatly reduced. But at some point it makes sense to buy their non dividend paying counterparts.
I believe that high dividend paying stocks are trading too rich but this is a trend that could continue. Over time this valuation gap is likely to close but predicting when this will occur is difficult. Large repurchases, initiations of dividends and takeovers of non dividend paying companies could potentially close this gap. In the meantime it makes sense to be cognizant of this trend. Buying companies that initiate sizable dividends and trade at low valuations may be a way to arbitrage this trend.
It seems that dividend paying stocks are the new bonds. Many income investors are being forced into dividend paying stocks unable to find yield anywhere else. This adds a dynamic to the market that is difficult to quantify. Yield chasing does not typically end well but its possible that we are still in the early innings.
Large market participants are positioned conservatively and they have a lot of room to add if they were to turn bullish. Low rates have income starved investors and retirees venturing into dividend paying stocks, a trend that can continue and even accelerate.
It is very important to remember that the economy is not the stock market. Even assuming that the slowing economy will eventually hit earnings hard, that does not mean the market cannot go higher first. In October of 2007 we were nearly 10 months into the subprime crash, yet the S&P 500 was making an all time high. The very bullish case is that we are currently seeing the same muddle through growth we have been seeing for years. If this turns out to be the case the market has the potential to go significantly higher.
With the S&P 500 trading at 13 times expected earnings I see little reason to be bearish. But with the economy slowing and numerous imbalances there is a higher than normal chance of an economic accident. As long time readers know I am not scared to put myself out there when I have high conviction. But given all these cross currents I do not have a strong opinion on the market at this juncture.
Growth is slowing, earnings estimates are declining and we are in the summer months, which have historically been a weak period for the stock market. Given this backdrop I only want to trade from the long side when sentiment is at a pessimistic extreme. That is currently not the case as many sentiment indicators I follow are pointing to slight optimism.
I do not like the current risk/reward on the long side of the market but I also do not like the bear side. Current valuations leave room for an earnings slowdown. A large earnings slowdown will be difficult as there are few excesses in the economy and at corporations. I believe the best course of action is to wait until the bulls or bears push this market too far in either direction. We are down six days in a row so a bounce is certainly possible, if not probable, but I don't believe it will be great because of the lack of negativity.
Short term newsletter writers that Hulbert tracks are recommending a net long exposure of 52.5%. They have actually increased their recommended exposure into the teeth of this decline, which is a negative from a contrary standpoint. Rydex traders are also positioned optimistically.
The bad news on the earnings front and from the EU continues to roll in. With all this bad news I am not willing to step in and buy until I see excess pessimism. While we could bounce on the sixth day this is not a fat enough pitch for me.
Expectations have been for roughly $105 in S&P 500 earnings for 2012. At a modest 14 times earnings that would equate to the S&P 500 at 1470. Even at at $95 a 14 multiple would put the S&P 500 at 1330, not far from where we are currently trading. The point being that earnings estimates have some room on the downside before the markets valuation would become a negative.
I do not expect to see the type of earnings decline we saw in 2008-2009. The housing bubble resulted in excesses in the economy and at corporations that are not present currently. That said, given the size of recent earnings warnings and slowing economies around the world a sizable decline in earnings is still possible.
The bottom line is that the valuation argument for the S&P 500 is getting weaker. Earnings estimates are almost certain to decline but the magnitude of the decline is the key. The bulls still have some cushion in regards to valuation but its getting thinner.
Obamacare seems to be a foregone conclusion for market participants even though Mitt Romney has vowed to get rid of Obamacare if he wins. While Wall Street has written off Mitt Romney he is actually leading in some polls and is raising more campaign money than Barrack Obama. If Mitt Romney wins these stocks will likely soar towards historical multiples, well over 50% higher. I am not predicting he will win but I believe he has a much better chance than the market is giving him.
Even if Obamacare comes to fruition it does not necessarily need to be a disaster. Wellpoint has been labeled as the most susceptible to the new laws, although that may have changed as a result of their takeover of Amerigroup. Only 25% of Wellpoint's profits come from individuals and small groups, the business lines with high risk from Obamacare. 75% of Wellpoint's earnings streams are likely to see little effect from Obamacare.
Obamacare uses the HMOs in order to administer health care. This will mean tens of millions of new customers. There will be little reason to compete on price as there will be plenty of new customers to go around. It is baffling that everybody assumes this will destroy the HMOs. Its entirely plausible that the HMOs will find a way to make money off of these new customers. Its also entirely possible that the Obamacare rules are tweaked if they are too onerous to the HMOs.
I am not arguing that there isn't uncertainty surrounding the HMOs. My argument is that prices are extremely attractive with tremendous upside if the disaster scenario being priced in does not materialize.
We have had three straight down days and European stock and bond markets are rebounding this morning. An up day today would not be very surprising but there is little reason to think that this would lead to a strong rally with the indicators mixed and all the uncertainties.
The catalyst for my purchase was an aggressive 4 billion British pound share repurchase program. That share repurchase program is about to be completed and its uncertain if a new one will replace it. Additionally, I own software companies with heavy European exposure and don't want to be too heavily weighted towards Europe.
It was a difficult decision to sell Vodafone. If my portfolio were doing better I would probably allow this position to stay. I will continue to follow the company and suspect that I may own it again at some point.
In the very short term the market has run very far and we received bad news out of Europe. That leads me to believe that the upside will be difficult in the short term. But a few days of the market going sideways or down would change that.
The US economy seems to be muddling along and not buckling under the weakness is Europe thus far. Selling because of European fears has been costly in recent years so its possible that we ignore Europe until the effects are seen here. The big run up and the news out of Europe makes me cautious. The reason I am not bearish is that valuations are reasonable and I believe market participants are still positioned somewhat cautiously. In recent years we have seen the market go straight up until it sucks everybody in. If the ECB had done more today I would have thought we see that once again. With Europe a drag I believe it is less likely but bears must leave room open for that possibility.
I do not see an easy trade at the current juncture as we are extended in the short term but there is still room on the upside in the intermediate term. I am market agnostic after the recent move.
The market has been absolutely brutal to any stocks with "issues". No price seems to be too low for a stock with uncertainty. I wrote a post a few weeks back about how recently valuations did not offer much support to stocks. I pointed to the sheer number of value traps in recent years. In addition many market participants operate with "risk management" which equates to a stop loss, so losses beget losses.
Even though I am a value investor I have managed to avoid the value traps in recent years, other than a short foray into Hewlett Packard last year. In the past few months I have not been able to escape the side effects of the brutal bear market for value stocks. It has been a grueling experience and one I will not soon forget. It has reinforced the idea that one must account for all possibilities and make sure the portfolio can withstand it.
The key to the market will be the extent of the earnings slowdown. The bursting of the tech bubble and the real estate bubble led to massive declines in earnings and large market declines. The current situation is different in that valuations are starting out at a much lower level and there are much fewer excesses in the economy and on the corporate level. I believe the market will remain in a trading range until the extent of the earnings slowdown becomes clearer.
I have been talking about a trading range recently due to Europe. Friday's news of an EU agreement got us to the very top of that range. If the ECB follows through on Thursday with more help for Spain and Italy its likely that the trading range will move higher with the yearly highs marking the high end of the range.
In the shorter term I believe the market is getting extended. The market has generally been going up for four weeks now but it seems like Friday the crowd finally started to embrace it. We are not at a bullish extreme but gains should be harder to come by.