This dip is different

Buying the dip has been a successful strategy for most currently practicing professionals, which in turn has led to a complacency about valuations and market downturns.

In a rising market, dips are a natural and expected phenomenon. You hear technical analysts talking about over-extension, support/resistance, distribution and accumulation, etc. and while I tend to believe that the money is made in the waiting, I understand the drive to increase returns through shorter term positioning. When leverage isn’t involved, dips present (often spectacular) buying opportunities, such as October 1987. Underlying all of that is the return derived from valuations. The sources of returns don’t change: multiple expansion or earnings growth. And so, when faced with those situations, buying dips becomes a valid strategy.

However, in an environment with elevated valuations, where multiple expansion (a mean-reverting series) is limited, and earnings growth limited, “buying dips” can be hazardous to your financial health. And that is where we find ourselves these days. Valuations, based on simple measures such as q-ratios or CAPE, show the market as anywhere from 30-50% overvalued. Europe is in trouble (obviously) and the eurozone will be lucky if it sees any growth at all. The obvious danger is that it pulls the rest of the world down with it – a not unlikely scenario. With roughly 30+% of earnings coming from the region, earnings growth for large multinational corporations will be limited. Additionally, a stronger dollar is deflationary (!) and makes exports less competitive – another headwind for earnings.

Can the market rally back to the recent highs? Sure, and beyond. But the fingers of instability that we have written about often are getting longer and the cracks wider, so the chances of valuations coming into line with long-term averages are higher and higher. Not a bad thing if you’re unlevered with plenty of liquidity. The key now will be to position portfolios in such a way that once the dust settles, investors will know where to find the bargains. That is where I’ll be concentrating.

Conflicting data and the hard trade

The past couple of days, we here at The Hard Trade have been trying to figure out what is actually the HARD TRADE, namely, which trade looks painful from a psychological perspective but may yet reveal itself as the most rewarding?

We’ll get to get to that in a moment, but first, here are just some of the cross currents we have read in the past 2 days (in no particular order):

• Insider’s kicked up their selling. Read the article here. You can get the details in the article, but the gist is that the ratio of sellers to buyers is relatively high. Not a great sign.
• While The World Was Focused On The Yuan, Everyone Missed The Real Tectonic Landmark. Read the full article here. Competitive devaluations? Nope. Singapore might be leading the Asian currencies up in a bid to buy up resources around the world. Should the US worry? Yup. Let’s see: higher Asian currencies means less money flowing into Treasuries as their trade surpluses drop and strategically dangerous as US loses access to raw materials globally.
• In the meantime, foreclosures jump 7% (click here for the article) but we also read that strategic defaults increase consumer spending (click here for the article). Much like the theory that broken windows and natural disasters increase GDP (Broken Window Fallacy), this doesn’t seem like a sustainable trend that can be relied on.
• In the meantime, weekly initial unemployment claims rise to 484,000. For a good summary and chart, click here.
• I follow the technicals a little less than valuation and fundamental data, but seeing the extremes on the put/call ratio certainly doesn’t add to my comfort level. Read it here. On top of that, shorts have been squeezed out already, so the support they provide is gone. Read the numbers here.
• Not that I trust these types of headlines, but heck, I was already wondering: George Soros Warns Of Biggest Market Crash To Come, As “We Are Facing A Yet Larger Bubble” Than During Credit Crisis (Click here for story.)
• Earnings wise, Bloomberg ran a story (click here) that showed how bank earnings (you’d have to be dumb to be a bank and not make money in this environment with the yield curve as it is) are driving the earnings recovery of the market. Check out this chart:

• We’ve got Albert Edwards warning of deflation (click here) and Morgan Stanley exploring the breakup of the euro (click here), while Richard Koo from Nomura compares the US real estate to Japan’s in the 1990′s and it ain’t pretty (click here).

All against a backdrop of a market that is grinding higher and grinding up shorts every day, making hedging or negative directional bets incredibly costly and painful.

The hard trade: is it harder to stay long given all the negative news out there or to go short as the market continually moves against you?

Troubled banks stand at 700+

The FDIC came out today with a report highlighting the dangers still present from commercial real estate, and in the process increased the number of distressed banks to 702. In an interview on Bloomberg, Bair tried to put it in perspective by pointing out that there are roughly 8,000 banks in the US. While true, that would mean that almost 10% of the banks are distressed. Simultaneously, the FDIC fund fell to $20.9 billion at the end of 2009 (down by $12.6 billion in the final 3 months of the year).

Read both:

• CBS Marketwatch: FDIC: Number of troubled banks rises to 702
• Zerohedge: FDIC Hits Record “Default” Level As Deposit Insurance Fund Plunges By $12.7 Billion To NEGATIVE 20.9 Billion

The implications for me are that banks are not ready to lead us much higher. Additionally, with roughly 30-40% of earnings on the S&P driven by the financial sector, which in turn is being driven by the steep yield curve, the S&P will face major resistance as margins and revenue face pressure.

This note came out July 2005! Spot on?

In July 2005, Morgan Stanley put out a note about the then-current bull market. The note reviewed previous similar bull markets and concluded that this bull market represented a scenario where earnings were pushing up stock prices, NOT multiple expansion, which is the norm. By looking at previous cycles Henry McVey posited that the then-current bull market was a temporary, unstable bull. Here are the main points:

Not Your Average Bull (from July 2005)

• Longer, but not as much fun
It might not feel this way, but we are actually in the midst of the fifth longest running
bull market ever recorded since 1928, according to our calculations. However, despite
its length, it has not been the boon to equity investors that the average bull market has
been. Equity investors have enjoyed an annualized return of just 20.0% versus the
38.2% average for the top 20 bull markets we measured.

• The current rally is atypical in that it has been driven by earnings, not P/E
The current bull run is a powerful, earnings-driven market. This distinction is
important, as we found that earnings-driven rallies typically rise and fall based on the
health of the economy, not long-term rates. If there is good news in our analysis, it is
that earnings-driven bull markets tend to last 1.5x as long as P/E-driven rallies.

• The current bull market may be unusual, but it is not without precedent
Of the 20 longest bull markets, we found seven where earnings growth explained more
than 50% of the total price appreciation. These earnings-led rallies resemble the
current environment in several important ways. Most notably, they were also
characterized by rising oil prices, Fed tightening, and stable dividend yields. On the
other hand, inflation has historically been more problematic in the aftermath of
earnings-driven up-cycles.

• Learning from the past
The aftermath of an earnings-driven bull market tends to be particularly painful. These
periods are characterized by negative earnings growth and multiple contraction.
Adding insult to injury, we also found that almost 60% of earnings-led bull markets
have ended with a recession. As such, we will continue to keep a sharp eye on the
leading indicators as they come out. (Emphasis added)

• No change to target, key themes, or Focus List
We maintain our 1,250 year-end target and $73.50 ’05 EPS estimate for the S&P 500.
From a stock perspective, our Focus List, which includes BA, BAX, CVS, GE, HSIC,
PAYX, PFE, SLB, TYC, and WMB, embodies our three-pronged attack of Rising
ROEs, Yearn for Yield, and Stable Growth.

To see the full report click here.

S&P 500 Quarterly Earnings and Prices

The numbers are in and they are certainly not the stuff of the beginnings of new bull markets. The data provided is from the S&P website. Other than formatting, no changes have been made. Some obviously interesting data points, not in order of importance:

1. S&P 500 dividend yield as of 8/12/09: 2.13% (indicated rate)
2. Based on the earnings reports as of 6/2009 (second quarter, 91% reporting as of 8/12/2009), the P/E of the S&P 500 stands at 127. Hmmmm.
3. Last quarter end, the P/E was 60.70, and the beginning of the year, the P/E stood at 25.38.
4. High P/E’s can be expected near market bottoms, as stocks don’t have much to go down and earnings continue to fall precipitously. Deflationary environments, i.e. companies lose pricing power, sales are down, and savings rates increase can mark bottoms. At some point, high P/E’s might mark the bottom. I’m not sure we’re there yet.
5. Rising about 50% off the bottom , where the P/E was in the low double digits, albeit briefly, investors must now decide whether at this point earnings will start catching up with prices.

S&P 500 Quarterly Prices, Earnings, and P/E’s

S&P 500 Quarterly Earnings and Prices

I downloaded the following data from the S&P website to figure out where we stand from a historical perspective in terms of P/E. Since the first quarter numbers haven’t been filled in yet, I did not use estimates (even though 97% of the companies have reported). The data from a valuation perspective does not look encouraging, but I’m looking for some feedback on how to interpret the data in a different light.

S&P 500 Quarterly Prices, Earnings, and P/E’s

Electronic Arts Lowers 2009 Forecast, Will Cut Jobs

Oct. 30 (Bloomberg) — Electronic Arts Inc., the world’s
second-largest video-game maker, lowered its forecast for the
fiscal year and said it would cuts jobs in response to a
deteriorating economy. The shares fell.

The company will eliminate 6 percent of its jobs to save
$50 million a year, Redwood City, California-based Electronic
Arts said today in a statement. Profit excluding some costs will
be $1 to $1.40 a share for the year ending in March, below the
$1.30 to $1.70 projected in July.

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