Getting To The Late Innings

I view sentiment indicators as being similar to a compass. They do not tell you exactly where you are in a rally or a decline but help you get your bearings in knowing if you are in the early, middle or late innings. Investment advisers are as bullish as they have been in nearly a year and  a half according to the NAAIM survey as seen below. This is not something seen in the early innings of  a rally. From the NAAIM:



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.

 

 

Sitting On My Hands

I am currently at my lowest level of stock market exposure since 2006. On a big day I would not expect my portfolio to move much more than 0.30%. Valuations seem in the realm of fair in regards to the vast majority of individual stocks that I look at. Market participants are too bullish for me to want to trade the market from the long side  but not excessively bullish enough for me to want to go short. I am seeing fewer opportunities and as a result am doing less.

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 Update

Stock market volume has been at multi-year lows while the market has been trading sideways for three weeks. In this type of environment it is difficult to come up with something insightful to say on a daily basis, which has been the reason for the dearth of posts recently. In this post I will give an update on some sentiment indicators and take a step back and give some of my bigger picture views.

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.

Some Sentimental Updates

When I went over my sentiment indicators in yesterday's post I did not mention Rydex. The Rydex indicator has been like  a broken clock recently. For the past 8 months Rydex has been showing high levels of optimism. To be fair the levels of optimism were more extreme until May. Last night the number of bulls to bears shot up 4.91 times, a level not seen since May. The leveraged bulls to bears ratio shot up to 4.3 times, also a level not seen in many months. Rydex is now in extreme optimism territory.

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.

A Rundown Of The Sentiment Indicators

The market has gone straight up and we could see a short term whack at any point. However, in order to get a lasting top we will likely need to see sentiment at an extreme or very negative news. While there are a couple of sentiment indicators at extremes the vast majority are not. Below is  a rundown of various sentiment  indicators I follow:

  • 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.

A REIT Pair Trade that Could Yield 30%

American Realty Capital Trust (ARCT) is a REIT that owns commercial properties with triple net leases. ARCT was a private REIT that went public in March although there was no IPO. On March 1 the shares started trading and private holders were able to sell their shares on the public market.

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.

Fewer Opportunities

In the past year I believe that many of the mispricings in the market have disappeared. For years the market was putting a big discount on defensive stocks. That was where I was doing most of my hunting in the past few years. Healthcare, biotechnology, select telecom and staples were trading very cheap even during times when the market had gotten overheated. For the past couple of years I had been long stocks in these sectors, while at times hedging my market exposure.

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.

 

Anatomy Of A Bad Trade

There has been endless talk about the Facebook lockup expiration. 271 million shares were eligible for trading today on top of the 421 million already trading. Markit reported that roughly 100 million shares of Facebook were sold short up from 30 million a few weeks ago.Recent lockup expirations in social media stocks have led to large declines so short sellers were lined up to take advantage of this one.

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.

Watching The Paint Dry

I prefer when market sentiment is at an extreme, either the crowd is very bullish or very bearish. The risk/reward for a contrary trade becomes very high at that point. That is the reason I was hoping for a move higher this week. I thought a move higher would push us to extreme optimism with a good overbought reading.

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.

Bulls On Offense

It appears that the bulls are not going to waste their opportunity to take the market higher. The overbought/oversold indicator I use will be dropping negative numbers for the next three days which gives the bulls an advantage. If the bulls manage a rally we will have a better overbought reading on Friday. I will monitor the sentiment indicators over that period. If we see extreme optimism combined with the overbought reading we will be primed for some sort of a pullback or correction.

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.

The Last Part Of The Rally

One of the measures for the overall market that I like to look at is corporate liquidity. Are corporations buying shares (share repurchases, cash takeovers) or selling shares (secondaries, IPOs, insider selling)? Last week saw over $7 billion in secondary offerings and continued insider selling. This Thursday the lockup is expiring on a few billion dollars worth of Facebook stock. At the same time share repurchase announcements and cash takeovers  have been slow in recent months. Corporate liquidity is favoring the bears.

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.

The Bears Blew It

The market has been overbought for the past three days and all the bears managed was a sideways market. The bears were on offense and failed to put any points on the board. On Monday we will no longer be overbought. If the bulls manage a rally next week we will get a better overbought reading at the end of the week. We also might see more sentiment indicators get to extremes. Have a great weekend.

 

Don't Worry About A Thing

There is slowly increasing evidence that market participants may be getting a bit too excited. The call activity at the CBOE is approaching the highest level all year. The updated chart is shown below.


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.

No Great Shakes

Estimates for S&P 500 earnings have been coming down and now stand at $102. With the S&P 500 at around 1400 we are at roughly 14 times forward earnings. This seems fair but on the generous side given the uncertainties and negative economic momentum.

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.

Advantage Bears

The market is now short term overbought as seen below. It is not a great overbought reading but it is enough to put the odds back in the bears favor. The market is also overbought on an intermediate term basis.


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.

Lucky Shot

It looks like I got lucky with the timing of my post this morning about how ridiculous the valuations of defensive stocks are. The utilities, consumer staples, healthcare and REITs all closed lower on the day even though the market was solidly higher. The hiding spots were blasted while the laggards led the way. I think this might be the beginning of a rotation out of safety.

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.

 

 

A Tale Of Two Types Of Stocks

In the short run the market will not be overbought until the end of the day today or tomorrow. The reason it is unclear is because starting tomorrow the 10 day moving average of the NYSE Advance-Decline line will be dropping positive numbers for 3 days. But tomorrow's number is only slightly positive while Thursday and Friday we will be dropping large positive numbers. The oversold reading that has been supporting the bulls ends today and this indicator will soon be aiding the bears for a few days.

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.

Why Amdocs Is My Kind Of Stock

There are three main attributes that I look for in a stock and Amdocs is a perfect example of that type of stock

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.

 

I Don't Like It But I Respect it

The best thing the market has going for it is that the S&P 500 is up about 10% for the year and hedge fund managers are drastically underperforming. The cost of further underperformance is high and is causing severe performance anxiety. Most surveys  and anecdotal evidence points to market participants positioned somewhat conservatively, with room to add market exposure. While I do not like the fundamental case for the market I would not bet against the market until sentiment turns more bullish.

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.

Just The Stats

From a fundamental standpoint this market has me mystified. The situation In Europe is finally beginning to effect profits and the economy but the stock market does not care. This morning's post will strictly look at the stats.

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 Nail In The Coffin

By taking no action Mario Draghi guaranteed that for the rest of the summer the economy will continue to deteriorate. There is unlikely to be any material action from the ECB before September unless things get ugly first. The momentum of the global economy is negative and I see nothing to break that momentum.

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.

Waiting On The Central Banks

The market is in wait and see mode as we hear from the Fed today and the ECB tomorrow morning. Clearly the more important decision will be coming from the ECB. If the ECB does not do something drastic than the trajectory of European and global growth is likely going lower. If the ECB does something drastic the hope is that we would end the vicious cycle and enter a virtuous cycle of higher prices, confidence and growth.

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.