Musing on the Markets : Valuation

V Shaped Rally ≠ V Shaped Recovery

Vinny Catalano, CFA — Wed, 23 Sep 2009 16:56:00 GMT

Yesterday’s posted interview with David Malpass brings into sharp focus a key aspect of the US economic recovery that far too few investors are tuned into. Specifically, the underappreciated dynamic that second, third, and lower tier companies (the backbone of employment growth in the US) may not deliver the much anticipated above consensus earnings results this and future quarters ahead. Moreover, as the backbone of employment growth, weakness in second, third, and lower tier companies act as a depressant on wages, hours worked, and consumer sentiment. Therefore, how the US (and global economy) will reach a sustainable recovery without the US consumer is a riddle wrapped in an enigma.

Lacking a large exposure to global markets (where the growth is and where the weak US dollar helps deliver strong short term results), the SMIDS (small and mid cap companies) on down are vulnerable to disappointing investors with at or below consensus earnings results next month. In this regard, David points out in the interview that above consensus earnings results this coming 3Q09 for large and mega cap multi nationals may come to pass via pricing power pressures on all companies offset by volume growth courtesy a cannibalization of the units growth to lower tier companies.

(As a reminder, 2Q09 bottom line results surprised to the upside thanks to cost cutting, as top line growth was largely in line with expectations. In the current quarter ending next week, expectations are for above consensus earnings results produced by top line growth that surprises to the upside (with cost cutting is largely done). With the US economy still on its knees, it is hard to see how US domestic top line growth (revenues = price x units sold) can surprise to the upside. How this happens for companies that will not benefit from global markets (and a weak dollar) is a mystery soon to be revealed.)

Investment Strategy Implications

In a liquidity driven stock market, all logic goes out the window – for a while. Justifications for over valued markets abound. And buy high to sell higher becomes the music that all performance based investors must dance to. Phrases like “melt up”, thanks to expectations that the $3.5 trillion sitting in near zero percent money market funds will be forced into equities, is the support rendered for P/E ratios that warrant above average (i.e. 15 times) levels. Sound familiar?

In such times, a prudent investor is a contrarian investor. Momentum driven/fast money “investors” awaiting sideline money to sell to on the basis of melt ups and a sustainable global economic recovery rooted in a deleveraging US consumer may turn out to be a fantasy bubble about to burst.

Vinny Catalano, CFA, is President and Global Investment Strategist with Blue Marble Research (BMR). BMR publishes the "Sectors and Styles Strategy Report" newsletter, which contains the market beating Model Growth Portfolio. To learn about subscribing as well as other benefits, click here.

When, Not If

Vinny Catalano, CFA — Tue, 15 Sep 2009 15:24:00 GMT

Now that the S&P 500 has hit my full year target of 1050 (made last December 30 as published in the Wall Street Journal’s “MarketBeat” blog) - with 3 months still left to go, I might note, cyclical bulls (like me) who have turned increasingly more cautious over the past two months (as stocks moved well passed their fair value targets) continue to sell into the rally. The portfolio consequences of this sell-into-strength decision are two fold – reduced profits and reduced exposure to a pullback.

As stocks moved higher into overvalued territory, the first course of action was to maintain a portfolio’s equity exposure (assuming it was less than 100%) to the total assets managed, which for accounts managed by my company was in the low 90% range. When stocks continued to march ahead these past few weeks, the course of action shifted to reducing the equity exposure, which now stands in the mid to upper 80% range. This modified market timing (a/k/a sector and style tilting) works best in portfolios geared for the long term and subscribe to the diversification with a tilt approach to managing money*. Eventually, stocks that have taken a shine to the stratosphere will feel the gravitational pull of profit taking, common sense, and a cooling down of the animal spirits momentum “investing”. A correction then ensues.

On the assumption that a correction will eventually occur (and it will), the timing of the correction may be domain of the foolish and the insightful but the process is not. From experience investors should assume that one of the following will likely occur:

Air pocket – investors rise one morning to find stocks gap open to the downside in a big way. Volatility rises as price action becomes more erratic with many whipsaw movements. Bye bye steady up, hello wild and wooly.

Sudden but moderate – a decline starts and continues as market pundits proclaim the healthy qualities such a Goldilocks version of corrections exhibits.

Erosion – the decline sneaks up on you. Slow, steady, and highly corrosive. The flip side of the past several months. Of the three possibilities listed above, I would opt for #1, the air pocket. However, whatever correction does emerge, investors are best served by being clear about their portfolio strategy action steps before, during, and into a correction. I have articulated the general outlines of my approach. What’s yours?

Investment Strategy Implications

Eventually, stocks will experience a pullback. The gravitational forces of profit taking, common sense, and a cooling down of the animal spirits momentum “investing” will help markets absorb and reflect on where the fair value for an asset class belongs. At 1050, expectations now put stocks at 1170 (10% discount factor) 12 months hence, which means that operating earnings need to reach $78 by 3Q10 – a number that only the most optimistic of forecasters has recorded. Alternatively, there are those who argue that a higher than normal times P/E (15 times) is appropriate (e.g. due to low inflation, good rates of return on equity, large amounts of liquidity still sitting on the sidelines), despite the fact that so much remains highly uncertain. All things considered,

When, Not If appears to be a good investment conclusion to reach at this time. And being a contrarian investor (as opposed to a follow the crowd momentum “investor”) means taking money off the table is a prudent course of action at this time.

*see my August 27 Minyanville article

Vinny Catalano, CFA, Global Investment Strategist with Blue Marble Research publishes the "Sectors and Styles Strategy Report" newsletter, which contains the market beating Model Growth Portfolio. To learn about subscribing as well as other benefits, click here.

The 3 Phases of this Bull Market

Vinny Catalano, CFA — Tue, 25 Aug 2009 13:41:00 GMT

The stock market rally since early March appears to have three distinct phases to it.

The first phase was the backing off from the economic abyss. The second phase was a bounce to fair value normalcy. The third phase (the one we are in now) is what I would call the return to business as usual phase (or “Recession. What recession?).

From where I sit, the first two phases were justified on many levels. Both phases featured massive amounts of government intervention combined with strong technicals to produce a rally to fair value. The elimination of the tail risk of the Great Depression II was followed by the above consensus macro economic readings (my MERI indicator), which was reinforced by the above consensus earnings results of 2Q09. Stocks rose to a reasonable fair value. So far, so good.

Unfortunately, at this point the seeds of questionable earlier decisions began to bear fruit. (Now, this going to sound very libertarian, so here goes.) Instead of pursuing the necessary cleansing process that all excesses produce, the Obama administration (which includes the US Treasury and the “independent” Federal Reserve) opted for a massive debt transference from the private to the public sector with the hope that time will heal all wounds. Along with this decision to socialize the bad behavior of the private sector most responsible for the crisis, the financial services industry, the Obama administration supported its core structure built on the laissez-faire era of the past two decades, accepting the largely unsubstantiated argument that financial innovation is a vital and necessary good for the economy.

With the government’s tacit support of the status quo, the investment mood shifted from fear and concern to hope and then enthusiasm.

The evidence of this mood shift back to the animal spirits days of yore came from a logical source – the financial services industry, the very sector of the global economy that provided the financial innovation grease to the out of control freight train of credit. And what better symbolic locomotive than Goldman Sachs, whose earnings report of July 14th whistled the bad old days were back in action. At this point, the Obama administration swung into action – with silence.

With its absence of outrage, the increasingly politically tone deaf Obama administration sent the public policy signal that its okay to bring the world economy to its knees, its okay to get bailed out with taxpayer money, its okay to shrink the competitive landscape (via Bear and Lehman’s demise), and its okay to return to the way things were – big profits and in your face fat bonuses.

The product of this wink and nod to Wall Street was the backlash at town hall meetings, which were as much about fairness as they were about healthcare reform concerns, a paranoid view of government, and a reactionary view of what constitutes being an American. It also produced an enthusiasm for stocks and an implied return to the bad old days.

Investment Strategy Implications

When you combine all these factors with the massive amount of investment capital ($3.5 trillion) still sitting in the near zero interest rate money market sidelines, the rising belief among many institutional investors that P/Es above their historical average are justified in the current low inflation environment, and the fledgling confidence that the global economy is on the mend* (along with the blind faith that the economic data from China is real), it is understandable how valuation levels could get to where they are today – stretched.

The investment question then becomes, “Is this a solid enough foundation upon which sustainable bull markets are built?” I have my doubts.

*I suggest reading Nouriel Roubini's comments in yesterday's FT.

The Macro Economic Reports Indicator: Not A Good Omen

Vinny Catalano, CFA — Wed, 29 Jul 2009 14:35:00 GMT

Since peaking on July 10, the Macro Economic Reports Indicator (first introduced on this blog on June 17) has stagnated. Including the two major macro economic reports issued this week (consumer confidence and durable goods orders), the indicator now sits a full 3 points below its July 10 peak (see table*). This is not a good omen for future earnings expectations.

Investment Strategy Implications

With so much stock market value built into future earnings reports, below consensus readings in the macro economic sphere suggest a heightened risk factor to future earnings reports coming in above expectations – a necessary ingredient for higher equity prices.

As noted in yesterday’s blog posting, earnings need to be rather robust over the next six to twelve months to justify current equity valuation levels. When macro economic reports, especially the kind that were issued thus far this week, come in well below consensus expectations (not to mention the sizable downward revision in today’s durable goods orders), investors are advised to proceed cautiously.

*click image to enlarge

It Ain't That Simple

Vinny Catalano, CFA — Tue, 28 Jul 2009 14:19:00 GMT

15 times $70 = 1050
1050 minus 10% = 945

This is the fair value math for the S&P 500. An appropriate P/E times a believable operating earnings number (12 months forward – mid 2010) minus an appropriate discount rate (stocks are, after all, a discounting mechanism). Of course, one can debate the inputs and the appropriate discounting time period, but the methodology is flawless.

Embedded in the methodology are elements that should (but often don't) go beyond simple business cycle, industry, and company analysis. Factors such as:

• A new world economic order
• A new financial services business model
• The appropriate amount of government intervention

Factors that I will discuss at next Tuesday’s New York Society of Security Analysts “Market Forecast” luncheon.

Unfortunately, these macro factors are not part of most investors’ toolkits. Beyond how such macro factors will impact the shape of the business cycle, big think subjects (such as, What economic philosophy will be the guiding force now that laissez-faire/cowboy capitalism is no longer the dominant principle?) have no way of being incorporated in your standard research methodology. Beyond the subjective aspects of such information, it is difficult to impossible for many investors to fit a new world economic order, for example, into your standard discounted cash flow model. Put differently, there’s no CAPM for the obvious yet out of the box factors that move economies and markets. Yet, they do matter.

Investment Strategy Implications

By all accounts, stocks are more than fully valued. Only those with the rosiest of glasses can envision earnings and P/Es greater than those listed above. Then again, a return of animal spirits overriding the highly uncertain transitional macro elements noted above is not out of the question – especially with $3.5 trillion* still sitting in near zero percent money market funds.

*A hefty 41% of the market value of the S&P 500

Four Steps to 1050

Vinny Catalano, CFA — Wed, 01 Jul 2009 13:01:00 GMT

The Fourth of July is just a few days away. So, how about a four step process to investment fireworks for this summer?

The media is attributing yesterday’s stock market swoon as being driven by the disappointing report on US consumer sentiment. No doubt it is a contributing factor, however, a single data point does make a trend, for when one expands their time horizon beyond the day a decidedly bullish trend has emerged over the past 8 weeks as the above table clearly shows.

Investment Strategy Implications

The investment implications for the above consensus results rests in the likely upward adjustments economists will make to their forecasts, which will in turn produce increased earnings expectations from bottom up analysts. As noted previously, this would occur for the following reason:

Earnings (cash flows) are one of the key fundamental-analysis inputs upon which valuation (and therefore investment) decisions are made. The fundamental premise is that, in the aggregate, current earnings expectations incorporate the consensus view. Therefore, whenever macro economic reports come in above or below consensus expectations, economists change their outlook, which in turn cause individual company analysts to adjust that macro economic component of their industry and company forecasts. However, since this process occurs with a meaningful lag, investors can gain a competitive advantage by anticipating changes to earnings forecasts as the above or below consensus reports are filtered into the forecasts.

In regards to current earnings expectations, consider the following statistic from contrarian value investor and behavioral finance expert, David Dreman (from last week’s NYSSA conference): from 1973 through 2008, the average analyst forecast error is 39%. That means that 2Q09 operating earnings for the S&P 500, currently estimated by bottom up analysts at approximately $14, may actually come in as high as $19.50 or as low as $8.50.

In light of the above consensus data noted above, the lag component of the forecasting process, along with an increasing number of economists estimating that the trough of the recession was reached this quarter, it would not surprise me if the 2Q09 earnings reports tilt more toward the higher number. Should that occur, then all the angst heard over the past few weeks re low volume would dissipate rather quickly as some of the $3.5 trillion still sitting in money market funds moves off the near zero percent interest rate sidelines.

And if that were to occur and stocks made a strong move to the upside, then old school market technicians will ring the bullish bell as completed bottoms and moving average signals will abound.

So, here is how a major bull market begins in earnest:

1 - Above consensus macro economic readings produce
2 - Above consensus earnings reports which
3 - Moves funds moving out of money market funds which produce
4 - Bullish readings by old school market technicians which results in

1050 or higher in the S&P 500.

Let the fireworks begin!

Marking Time

Vinny Catalano, CFA — Wed, 17 Jun 2009 17:57:00 GMT

As dramatic as yesterday’s market decline was, there are several reasons to conclude that a market that was clearly fully valued (see last week’s June 9 postings) was one that was susceptible to any signs of economic and/or political areas of concern.

On the economic side of the equation was last week’s negative reading in my Macro Economic Consensus Trend indicator (see accompanying table and description below). After many weeks of net positive readings, last week’s negative -3 net contributed to taking some of the positive froth out of the fully valued market.

As for the political dynamic, more than a few areas of concern – Iranian election results, the loose screw in North Korea, and the US President and media Star in Chief with his major government initiative du jour – was more than the market could bear.

However, as important as all these factors are, it does appear that the more significant event that will determine sustainability of the cyclical bull market will be the earnings reports, which begin next month. For 2Q09 earnings will provide the most direct sign that the above consensus economic data generated over these past months (noted above) has interpreted into higher corporate profitability. And it is higher profits that will be needed to justify the expected 1050 for the S&P 500 that current market levels imply.

Investment Strategy Implications

Investors can hoop and holler, wish and hope, and stocks can surge and plunge, but the proof will be in the 2Q09 pudding as to whether the anticipation of economic stabilization and higher corporate profits imbedded in a fully valued market come to pass in the form of higher stock prices. Until then, marking time is the more likely outcome.

*Earnings (cash flows) are one of the key fundamental-analysis inputs upon which valuation (and therefore investment) decisions are made. The fundamental premise for the above analysis is that current earnings expectations incorporate the consensus view. Therefore, whenever macro economic reports come in above or below consensus expectations, earnings forecasts will adjust accordingly – with a lag. As economists change their outlook, the individual company analysts, taking their economists’ changed outlook, will follow suit and change their forecasts accordingly. By monitoring the data in real time, an investor can gain a competitive advantage by anticipating changes to earnings forecasts as the above or below consensus reports are filtered into the forecasts.

Note: To learn more about the "Sectors and Styles Strategy Report" newsletter, which contains the market beating Model Growth Portfolio as well as other subscriber benefits, click here.

A Fully Valued Market

Vinny Catalano, CFA — Tue, 09 Jun 2009 13:27:00 GMT

excerpt from this week's "Sectors and Styles Strategy Report":
The huge disconnect continues. As noted in last week’s report and in several blog postings, the financial markets are signaling not just economic stabilization but a robust (V shaped) recovery. Whether this comes to pass remains to be seen. However, very supportive at and above consensus macro economic reports strongly suggest that earnings expectations will do more than stabilize – they should rise in the coming weeks and months. While such action will provide the real economy results to the markets’ expectations, much of the value has been realized as noted in the three valuation models used (page 2).

The plus side of the equation is the anticipation of more Mega Trend bullish signals (pages 4 and 5). However, unless one believes that a P/E greater than 15 is appropriate, then stocks are likely to enter more of a trading range with rotation and sector selection being key.

Here’s how the full value argument plays out:

15 times $70 = 1050
1050 minus 940 (current S&P level) = 110
110 divided by 940 = 11.7%, which is right around the historical return for large cap stocks of 12%.

Hence, fair value has arrived. Unless, of course, higher earnings and/or higher P/Es are expected. Such a view is not held here.

Note: To learn more about the "Sectors and Styles Strategy Report" newsletter, which contains the market beating Model Growth Portfolio as well as other subscriber benefits, click here.

9 ½ Weeks

Vinny Catalano, CFA — Tue, 12 May 2009 18:31:00 GMT

Time flies when you’re having fun. For it was a mere 9 ½ weeks ago stocks were as desirable as a hug and a kiss from a Mexican lover, a point President Obama made note of just a few days ago re he and Hillary. For the bulls, these 9 ½ weeks were like the movie of same name – hot. However, the bulls (including many new converts, especially from the land of momentum lemmings – the hedge fund world) should not forget that in the movie the lovers (Basinger and Rourke), drawn by the heat of the moment, have something as substantive and sustainable as a chimera.

At the historical average P/E of 15 times an optimistic $60 operating earnings number for the S&P 500 for 2009, stocks are projecting a robust earnings rebound into 2010, a point made by my “Beyond the Sound Bite” guest from last week, Subodh Kumar, with a $75 call for next year. Only if that occurs AND/OR only if one accepts the talk I hear from some institutional investor circles that a P/E above its historical average is fitting for the times courtesy a low inflation rate (18 times is the number I hear), can an investor find fundamental support for the fragile technical analysis base stocks have built. However, it does give one pause when the leadership for this market is the same leadership that existed before the great tumble. Generally that is not how new bull markets get started and sustained, as the more common occurrence is for new leadership to take the helm. Rather, bear market parades are led by those who led before.

Investment Strategy Implications

9 ½ weeks ago I argued that stocks were grossly undervalued. Now, 9 ½ weeks later, stocks, while not grossly overvalued, are more than fully valued. Built on the sand of a fragile technical analysis bottom led by those who led before make it more than justifiable to take some money off the table – most conservatively done by maintaining whatever the current equity percent of one's total investible assets at the current level, which in accounts that I manage is in the low 90% range.

In many respects the movie 9 ½ weeks was a study in extreme behavior devoid of real meaning and lasting substance. So, it is interesting to note that the stock market movie of these past 9 ½ weeks has brought out these qualities of extremes, including the expectations of more than a few investors with calls for more upside surges or great plunges. Therefore, allow me to offer an alternative view to this edgy thinking with a reference to another character from Tinseltown – George Costanza. Perhaps what investors will get in the coming months is a stock market movie not about heat but about nothing. A drifting, sideways, mini range-bound market where selectivity matters more than trend following, lemming-like momentum investing as investors digest what has occurred and guesstimate what 2010 has to offer and the appropriate P/E.

In such an environment, you can keep your (slightly bearish) hat on.

Note: Vinny Catalano, CFA is the publisher of "Sectors and Styles Strategy Report" is a weekly investment newsletter for the independent investor. To learn about the newsletter and other subscriber benefits, click here.

Sinko de Mayo

Vinny Catalano, CFA — Tue, 05 May 2009 16:14:00 GMT

For many, today’s date has a special social significance. For prudent investors, however, today is a day that this year marks a point of caution – unless you buy into one of two arguments being passed about: stocks warrant a higher than average P/E or stocks have made their lows as certain trading patterns say the bottom has been formed.

Fundamentals First

For those who favor the first point, the arguments I hear reference inflation and the appropriate P/E for stocks. Historically, when inflation runs in the low single digits P/Es have tended to be in the higher teens – above the long-term average of 15 times. All well and good provided other conditions in the economic and financial arena are balanced - which they are not. What makes the low inflation=higher P/E argument more than a touch suspect is, frankly, a blind faith in the ability of the Fed (and other central banks) to time the withdrawal of monetary stimuli BEFORE inflationary pressures begin to build – which, if unsuccessful, would thereby blow up the low inflation leg of this fundamental stool. More importantly, given the highly fluid nature of the global economic and political environment (can you say "nukes and Pakistan"?), ascribing an above average P/E during above average times of risk(despite whatever may be possible - not probable - in the inflation end of the equation) seems to require an above average degree of faith and a below average degree dispassionate logic.

Now The Technicals

As for the technicals of the market, certain technicians of the chart pattern stripe note the various breakouts as reasons supporting the “bottom has been formed” argument. There are others, however, who are purists in this chart pattern field who would counter argue that only when a completed bottom has been made in the major indices can a bottom-has-been-formed view be agreed to. Since I am not a chart pattern guy, I will leave this debate to those in the two camps. What I will put forth is something readers of this blog are very well aware of – the Mega Trend.

The Mega Trend is the Investor's Friend

Only when price is above both moving averages AND the 50 day has crossed the 200 day AND both the 50 day and 200 day have turned up can an investor confidently declare a Mega Trend change has occurred and a new market cycle is underway. Let’s look at the performance record in this regard using two indices as evidence – SPX (S&P 500) and EFA (Europe and Asia).

As both above charts* show, when a Mega Trend occurs that trend tends to stay in place for years. In this longer-term context, you can see that considerable improvement has occurred recently, HOWEVER, neither index is fulfilled the requisite conditions to warrant a Mega Trend signal change. Price is not above its 200 day moving average and the 50 day has not crossed the 200 day. Therefore, while the 50 day has turned up and the 200 day has begun to flatten all conditions have not been met and should not be anticipated to do so until they do so. (Or as Yogi Berra would say, "It ain't over 'til it's over".)

At present, to achieve all facets of a bullish Mega Trend stocks must build on their 30% plus rally thus far and rise significantly further from here, which, unfortunately, will produce a set of overbought conditions that are unlikely to be sustained. Moreover, any further near term rally would put both indices in a sharp near term uptrend, which is not indicative of the bottoming process that precedes a Mega Trend reversal. In this regard, there are several near and short term technical analysis reasons (momentum and MACD, Slow Stochastics, respectively) that argue against stocks making such a move anytime soon.**

Investment Strategy Implications

To be clear, Sinko de Mayo does not mean Plungo de Mayo. It simply means equities have gotten more than a touch ahead of themselves and some contraction, a healthy contraction, would be best. Since articulating cyclical bullish sentiments in early March, readers of this blog acting on the views expressed have enjoyed a very healthy boost to their portfolios. Now, however, we seem to be at the opposite end of that spectrum for exactly the same reasons - only in reverse. Therefore, when both fundamental and technical analysis flash the yellow caution signal, it is advisable to, at a minimum, maintain the equity percentage of a portfolio through selective selling.

Going forward: Sinko de Mayo will likely be followed by Drifto the Summero leading to Uh Oh the Fallo. Enough with the bad rhymes. Let’s go make some money.

*click images to enlarge
**for more information on this, see yesterday’s complementary report offer. If you have not received such an offer, simply send me an email at vinny@bluemarbleresearch.com.

In a Pig's Eye

Vinny Catalano, CFA — Tue, 28 Apr 2009 14:48:00 GMT

Money has no soul.

There are times when investing is a very callous business. Such times are now when investors must dispassionately assess the investment consequences of the swine flu disease. In this regard, it is advisable to recognize that the economic (and thus investment) impact of the virus as being more systemic than specific*. While selected areas of the global economy will likely be impacted more than others – such as travel, the more significant impact to the markets rests in a rising risk factor via the uncertainty element. Therefore, whenever risk goes up, certain valuation model inputs also rise thereby pushing valuation levels lower. Hence, price declines.

Investment Strategy Implications

Right now, fears of the economic impact from a pandemic are more systemic than specific. In a fragile economic climate with most valuation readings at fair value and technical analysis readings neutral at best, it didn’t take much to tip the stock market balance to the downside. The equation is rather simple – risk (in the form of uncertainty) went up, prices go down.

In a larger context and on the assumption that a pandemic does not emerge, there is every reason to conclude that stocks are close to the end of their short-term run anyway. The tired, old adage “sell in May and go away” will likely be the case this year leaving only the boldly bullish to find the fundamental valuation and technical analysis justification for what has all the hallmarks of a bear market rally and proclaim the return of the bull. Therefore, the coldhearted investment effects of the pandemic fears are more one of timing the ensuing market pause (dip now, rally a bit, make a non confirmation high, then generally flatish for the summer) rather than precipitating a new down wave in stocks.

Now, For Another Soapbox Moment

Once again, like clockwork, the media seems to have concluded that the recent stock market decline is attributable almost exclusively to fears of a pandemic. For those less informed investors, this is what I call the “media mantra” – new news always explains why stocks go up or down on any given day. The accepted media logic to this is thus – professional investors (who dominate the trading activity) with their large research budgets and extensive experience are so naïve that they twist and turn with the news cycle. It’s as though a portfolio manager wakes up each morning prepared to make important investment decisions on the assets he/she manages based on the surprise (news) factor of the day. In my three decades on Wall Street, I know of no asset manager who acts in this manner, yet the media mantra beholden to the news cycle (and, more importantly, advertising revenues) sells this bizarro logic to the general public.

Obviously, there are times when news does move markets – but not without the fundamental and technical analysis underpinnings in place. Therefore, thenews becomes the catalyst for the investment circumstances already in place. Otherwise, how does one explain that the media regularly reports that stocks rise and fall for the same reason? (ex. “Stocks rose today because of good news.” “Stocks declined today because investors ignored the (same) good news.”)

*This point is also made by tomorrow's Beyond the Sound Bite guest, David Kotok.

Equity Market Headwinds: No Margin for Error

Vinny Catalano, CFA — Fri, 17 Apr 2009 14:28:00 GMT

While it is encouraging that equities have rallied to the point where many 200 day moving averages are either flat or nearly so and nearly all sectors, styles, regions, and countries are above their 50 day moving average, not to mention the fact that many 50 day MAs have an upward slope, there are reasons, both fundamental and technical, to be more cautious about stocks over the near term.

The concern on the fundamental side is centered on valuation. For investors may have looked into the Great Depression II abyss and concluded that the worse case scenario (under $50 operating earnings for the S&P 500 for 2009) is less likely than it was 30 days ago. However, the current level of 850 for the S&P 500 implies either an above historically good time average P/E of 15 and/or earnings above $60. Look at it this way, if stocks are a forward looking discounting mechanism and if its projected return is its historical average of 12%, then 850 today implies a 12 month price level of 952. That then supposes that 12 months forward to the end of 2010 would put the S&P 500 at 1066 (952 plus 12%). To justify 1066 and assuming the market’s historical good times P/E of 15 assumes $71 in operating earnings for 2010. That may come to pass but the great economic unknown is not 2009 but 2010, for it relies on the economic handoff from government to private enterprise and the consumer. The fundamental valuation conclusion then becomes a future time period that does not warrant an above average margin of error. Frankly, at 852 that’s a conclusion I am less than fully invested comfortable living with, more so when considering the following technical analysis points.

From a technical analysis perspective, many market technicians point to the favorable chart patterns, with bottom formations and upside breakouts. They may be right but it has been my experience that chart patterns have a far reduced predictive value than momentum and divergence indicators, and those indicators are not so sanguine right now. As the above chart* illustrates, for example, Momentum is clearly in deceleration mode and not confirming MACD’s sustained and confirming strength. Experience shows that only when both are in unison (confirming higher highs in price, for example) can an investor feel more confident of the sustainability of the move. Added to this concern is the high overbought readings in the short term indicator, Slow Stochastics. Readings above 80 typically cause markets to pause.

Investment Strategy Implications

For the above stated reasons, taking some money off the table is advisable. Granted seasonal factors, such as April being the second best performing month of the year (historically), are supportive of higher stock prices. Moreover, there is every reason to feel more confident that, for the very short term, the worst of the economic and credit crisis has passed. However, concerns both fundamental and technical seem to warrant a less than fully invested posture at this time.

*Note how the Momentum reading is nearly flat while MACD is steady up.

Less Bad = Some Good

Vinny Catalano, CFA — Wed, 01 Apr 2009 12:16:00 GMT

Equities ended the first quarter on a more optimistic note. This pertains not just because stocks are rallied yesterday but to the fact that many investors stared into the abyss of the Great Depression II and came to the conclusion that a couple trillion dollars thrown at the world economy along with an era of better regulatory management and a most appropriate change/modification to mark to market will generate 2008 operating earnings for the S&P 500 at something north of $50.

Moreover, recent economic data suggest that the debt constrained US consumer will find ways to maintain some level of spending while apportioning a larger but not overwhelming portion of earnings to savings. Lastly, emerging economies are well positioned to assist in the global economy averting a worldwide recession, despite the pain emanating out of developed economies.

Perhaps this is the economic justification for the improving technical analysis readings of late.

Investment Strategy Implications

Perception is reality. And the perception that the end of world may not occur this year has led many investors to conclude that an appropriate P/E between 12.5 (bad times) and 15 (average times) applied to a $60 operating earnings number is where equities belong. And that gets to almost exactly where the market is today: P/E of 13.75 (average of 12.5 and 15) times $60 = 825.

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Why Paul Krugman is Wrong

Vinny Catalano, CFA — Tue, 24 Mar 2009 16:01:00 GMT

Let me start by saying that on many levels, I agree with Paul Krugman. I read his blog regularly and find his work to be of significant value. I also share many of his political views and leanings. But when he makes the market efficiency argument, he has entered a space where he is wholly unqualified to roam. For in several of his recent postings that is, in effect, what he has done. Like other economists that I know, he is attempting to apply his social science skills in economics to the social science skills in investing. In this regard, Krugman is wrong on three levels.

First, to argue against the Geithner plan (accurately portrayed as seeing the problem as one of liquidity and not solvency) is argue that the markets AT ALL TIMES, IN ALL CONDITIONS know what the fair value of any asset is at any and all times. Yet, everyone acknowledges that the market for the so-called “toxic assets” is dysfunctional. And central to its dysfunctionality is their illiquidity. So, if certain markets for certain instruments are dysfunctional (which includes valuation) due in large part to illiquidity then why isn’t the conclusion that liquidity and not solvency the core of the problem?*

Second, if making the dogmatic argument for market efficiency weren’t enough, Krugman then moves into the math space and applies bizarro logic to the actions professional investors will likely take as they participate in the Geithner PPIP plan: “Let me offer a numerical example. Suppose that there’s an asset with an uncertain value: there’s an equal chance that it will be worth either 150 or 50. So the expected value is 100. But suppose that I can buy this asset with a nonrecourse loan equal to 85 percent of the purchase price. How much would I be willing to pay for the asset? The answer is, slightly over 130. Why? All I have to put up is 15 percent of the price — 19.5, if the asset costs 130. That’s the most I can lose. On the other hand, if the asset turns out to be worth 150, I gain 20. So it’s a good deal for me.”

The logic of this example falls on its face on three levels. First, no professional investor is going to invest in a 50/50 bet (20 points I win, 19.5 points I lose). That ½ point return advantage is all of 38 basis points of upside potential! Does anyone reading this believe that PIMCO, for example, will make such a bet? I don’t. Moreover, since the US government is involved in the process, it is equally hard to imagine that Geithner and Bernanke would allow the US equity stake to engage in boneheaded bid up purchases. Lastly, and most importantly, just what valuation methodology will the PPIP parties engage in? How about one that is rooted in sound economic principles, say, the discounted cash flow method. In the Krugman math example, no such sane and prudent approach will occur.

The third part of Krugman’s argument that is problematic goes right to the heart of his economic skills and the illogic of his thinking when it comes to asset values. Specifically, how will the economic stimuli (monetary and fiscal) that he so strongly advocates in favor of have a positive effect on the economy yet somehow have little to no effect on asset values? Specifically, how do trillions of dollars move the US economy yet asset values for the length of the “toxic assets” remain depressed, if not plunge further? Why wouldn't such assets at least maintain their discounted cash flow values?

You Know You’re In Trouble When Gingrich Agrees With You

Advocate views like Krugman’s make strange bedfellows. So, it is no surprise to see none other than Newt Gingrich sing the praises of Paul’s folly. At least, however, Gingrich’s argument is rooted in the political sphere as he tries to attribute motive to the Obama administration with statements such as “We are currently being run by a left wing machine that want the United States as we have known it to cease to exist”.** Whereas Krugman’s argument is rooted in the dogma of market efficiency.

Liquidity Not Solvency

The central part of the so-called “toxic assets” argument has been liquidity versus solvency. Those with an understanding of how markets work (like Geithner and his predecessor, Hank Paulson) see it principally as a liquidity problem. Those with Nobel prizes living in ivory towers see it otherwise.

I love you, Paul. But on this one, you win the booby prize.

*Of course, other factors such as the economic outlook play a key role in the depressed pricing. However, just as the case with the price of oil last summer, non economic factors play an exacerbating role.

**Setting the standard Republican fear mongering playbook aside, Gingrich’s arguments do offer an alternative methodology, which interestingly contain several very workable elements such as creating an online auction, let the participants decide the value, and cover the losses.

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Street Scan

Vinny Catalano, CFA — Tue, 10 Mar 2009 16:17:00 GMT

Billionaires are now Slumdog Millionaires because:

A. The credit markets remain frozen
B. The US economy is falling off the cliff
C. Corporate earnings are headed substantially lower (<$50 S&P 500 operating earnings)
D. The socialist programs of the Obama administration threaten capitalism as we know it
E. All of the above, and then some
***
from International Monetary Fund “Global Financial Stability Report (GFSR) Market Update”
January 28, 2009

“Until now banks have managed to obtain sufficient capital to offset existing writedowns, but that is mainly due to the massive public sector injections of capital in the fourth quarter. The worsening credit conditions affecting a broader range of markets have raised our estimate of the potential deterioration in U.S.-originated credit assets held by banks and others from $1.4 trillion in the October 2008 GFSR to $2.2 trillion. Much of this deterioration has occurred in the mark-to-market portion of our estimates (mostly securities)*, especially in corporate and commercial real estate securities, but degradation is also occurring in the loan books of banks, reflecting the weakening outlook for the economy.”
***
Aggregate assets in money market funds (institutional and retail): $4 trillion (approx.)
Total market capitalization of the S&P 500 as of March 9, 2009: $5.9 trillion
***
from Dave Rosenberg, North American Economist, Merrill Lynch
March 9, 2009

"Beige Book mentions nine positive areas
Even if we still do not see a bottom in sight just yet for the economy or the equity market, there are sectors that at least from a macro standpoint have a relatively firm underpinning even in the midst of this unbelievably severe recession and bear market phase. We have said it once and we will say it again, the Fed's Beige Book offers up the most timely and detailed information on sectors. The most recent report that was issued last week contained positive mentions on these nine areas of the economy:
􀂄 Food production
􀂄 Pharmaceuticals
􀂄 Apparel retailing
􀂄 IT services
􀂄 Biotech
􀂄 Aircraft manufacturing
􀂄 Fast food restaurants
􀂄 Discount stores
􀂄 Environmental services

Positives outperformed the market by 800 basis points
While these sectors, on average, were down 8% between the most recent Beige Book and the one that preceded it in early January, they collectively outperformed the market by 800 basis points.

21 negative sectors mentioned
At the same time, there were 21 sectors that received negative mentions in last week's Beige Book. They are listed below:
􀂄 Travel/tourism
􀂄 Education services
􀂄 Luxury goods (jewelry)
􀂄 Agri-business
􀂄 Banks
􀂄 Homebuilding
􀂄 Electronic equipment
􀂄 Computers
􀂄 Motor vehicles
􀂄 Staffing services
􀂄 Commercial real estate
􀂄 Rails/Trucking
􀂄 Furniture/Appliances
􀂄 Health care services (elective)
􀂄 Oil drilling
􀂄 Metals and mining
􀂄 Wood products
􀂄 Media services
􀂄 Petrochemicals
􀂄 Construction equipment
􀂄 Semiconductors

So, for every positive mention, there were more than two negatives. The S&P 500 sector equivalents, on average, declined 26% between the last two Beige Books, and underperformed as a group by 1,000 basis points."
***
email sent last night to "Kudlow Report" producer Donna Vislocky in response to Larry’s plea for bullish commentators:

“On tonight's program, Larry said his producers were having a hard time booking those who were bullish. Well, here I am.

As someone who is now 100% invested, I am at the opposite end of when I last appeared on your program in early 2007 when I was highly cautious. Today, however, the picture is swung completely to the other side of the pendulum.

Here are a few bullish reasons that I am more than willing to debate a bear:

1 - Investor psychology is so thick you could cut it with a knife. Too bearish now, just like they were too bullish two years ago.
2 - A mountain of cash sits in money market funds - nearly $4 trillion. The stock market value for the S&P 500 stands today at $5.9 trillion.
3 - Valuation levels in many areas are very attractive and any upside earnings surprise would drive stocks higher.
4 - Technical analysis has recently begun to generate some positive divergences - downward momentum pressures have diminished, divergences (emerging markets, for example) have, uh, emerged.

Moreover, as someone who has criticized mark-to-market since March of last year, I am in complete alignment with one of tonight's guests, Steve Forbes.”

*emphasis added