On a daily, and perhaps weekly, basis, security prices reflect a whole host of influences, not the least of which are fear and greed. Over longer periods of time, however, security prices and trends should reflect fundamentals, and the most basic fundamentals are the economy–or economies. So, generally, stocks should rise as the economy improves and fall as it deteriorates. Non-fundamental factors can trump fundamentals for quite some time, however. One thing should be added at this point. The Surprise Index can rise while the economy is deteriorating if it’s doing better relative to economists’ forecasts.

In the chart below I’ve freshened up the chart–and complicated things by reversing the order of them. The top panel shows the Citigroup U.S. Economic Surprise index, while the bottom panel shows the S & P 500 as a proxy for stocks. I’ve divided the chart into three zones and will proceed to spill more electronic ink than necessary to explain the zones and the possible implications of where we are now, which is zone C.

• Zone A – in this zone everything is as it should be. The economy is doing better than economists expect. As that plays out economists will be forced to raise their estimates for the economy, which eventually translate into improved overall earnings for companies that comprise the economy.
• Zone B – all is not right. In this zone economists –for at least three months–overestimate the strength in the economy, yet stocks don’t reflect it, although the flattened trajectory seems to acknowledge that something isn’t right.
• Zone C – stocks play catch up, as talk of recession heats up. On August, The Economist magazine features the cover below, where recession is lurking just below the surface. Note, though, that in this zone the economic surprise index has turned up.

So, if a falling Economic Surprise Index heralded a decline in stocks, is it possible that a rising index might herald a rise in stocks? Maybe the gradual upward trajectory of the line suggests that a recovery in stocks won’t be vigorous, but if nothing else this should tell us that economic Armageddon or Financial Crisis 2.0 is not yet upon us. That’s sort of how we have portfolios structured at present. Within a modestly overweighted portfolio structure our portfolios are positioned defensively.

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With yesterday’s action, the Dow Jones Industrial Average took out its pre-Lehman Brothers-debacle price level, as can be seen in the chart below.  Not that you care, but I was home on that Monday when the market opened after the news of Lehmans’ declaration of bankruptcy, after months of Alfred-E-Newman-esque claims of adequate liquidity and other stuff.  We were making pear butter after a bountiful harvest that year, but the pit in my stomach sort of spoiled a good time with the kids.

Now that’s a real testimony to buy-and-hold investing.  If you’d only sat tight and done nothing you’d be just fine.  Hopefully, your experience didn’t include any of the casualties of the drop.  That’s one of the problems with buy-and-hold:  the dead bodies don’t talk.  Put more politely, there’s a Survivor Bias.  Only the survivors from the Titanic could tell their stories.  For example, in September 2008–yep, the same September–a couple of companies were removed from the index . . . strike up the Phantom of the Opera music . . . Citigroup and General Motors.

Phwew, glad that’s over.

Trouble is, it’s all happening amidst a huge bout of complacency.

Here are the problem items:

• Individual investors, as gauged by the American Association of Individual Investors, are as bullish as they’ve been since 2008
• Investors Intelligence maintains the oldest sentiment survey, its Advisors Sentiment survey, and that one is as bullish as it’s been since 2007′s peak
• the so-called Fear Index, the CBOE’s index of implied optimism (VIX), is at a multi-year low
• the ratio of puts:calls transacted at the CBOE is at the lowest levels of 2005
• the breadth of the advance is narrowing; that is, fewer stocks are participating in the push to new highs; that’s not healthy

Naturally, contrarians cite these as signs of the herd mentality in action, and they embody Warren Buffett’s saw, “be fearful when others are greedy.”  There’s really no problem with any of indicators so long as nothing goes wrong.  However, the market will be ripe for a correction if anything goes wrong.  On the Monty-Python-Meaning-of-Life side of things, I think most of our services view any correction as a buying opportunity for what should be a strong first half of 2010.

12/23/10 Update

I came across the following in a JPMorgan report titled  US Equity Strategy FLASH; Bullish sentiment is not contrarian in a bull market.  I generally agree with the idea.  The herd is usually right until the herd’s sentiment becomes extreme.

Key to sentiment (contrarian or not) was stage of market: Bull or Bear. One thing bothering investors in recent weeks is the seeming rise in bullishness, evidenced by positive 2011 outlooks recently (including J.P. Morgan) and positive sentiment surveys (i.e., AAII survey, or Investors Intelligence). We believe these concerns are misplaced. As shown on Figure 4, sentiment readings take a totally different context depending on the stage of the market—”bull” or “bear.” In bull markets, AAII readings (% bull less % bear) of 0 to +40 have been consistent with forward 6-month gains of 6%-7% while associated with declines of 11%-14% in “bear” markets. This makes sense to us—after all, why is it bad if we acknowledge broadening improvements?

Extreme readings remain high-quality contrarian signals. An AAII reading over 50 (% bulls less % bears) led to declines regardless of bull or bear (see Figure 4). Similarly, AAII readings of -40 or worse saw positive gains of 22% (6-mo forward) regardless of bull or bear. The current reading of 23 (% bulls less % bears) is NOT AN EXTREME READING.

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Below

• Several public surveys show bullishness at very low levels, but . . .
• Bearish is not at such extremes
• Insiders are a hopeful sign
• Much of the September nastiness may already be discounted
• Bottom line:  sentiment closer to signaling buy than sell

I’ve been thinking that sentiment toward stocks is very low, and that it discounts a lot of bad news.  I’ve had a couple of clients tell me that the traditional Fall bounce, after a bloody September, is unlikely this year because we’ve never been in the jam we’re in now.  The bogeyman (shouldn’t it be spelled boogieman? if not, it looks like some sort of golfer) is either the government printing money, the moral decay of the nation, or some other ill.  In other words, this time it’s different.  Here’s a news flash:  it’s always different; the facts are never the same.

One blog I keep an eye on, Clusterstock, had this post today:  “Face It, Nobody is Bullish Anymore.”  In it, they ran through the major investor classes  . . .

• Hedge funds – excerpt:  ” . . . these major players slashed their risk exposure to the stock market in the second quarter.”)
• Retail investors
• Equity mutual funds - looked at flows at stock vs. bond funds
• Equity analysts – very low relative levels of buy recommendations

. . . to determine that there are no more bulls.

I’m pretty sure about this next statement, but don’t hold me to it.  Each of these groups is as bearish as they’ve been since March 2009.  As they say–and I don’t know what this means–that’s neither here nor there.  What I mean is that I’m not intending to make a statement based on that, just setting up for the comparison to the one group that is approaching bullish . . . the insiders.

They’re not to the March levels–you don’t want to be around when they get there, either–but they’re approaching our InsiderScore service’s bullish zone.  One would think they’d be the best informed and best able to determine when their companies’ shares are cheap.  Trouble is, they’re usually quite early.  According to InsiderScore, they were at their most bullish level of the last several years in December 2008.  Investing with them then would have involved two+ months of pain.  And they were quite bullish at the summer 2007 dip in the market, before Lehman Bros. went down the tubes and markets turned ugly.  InsiderScore also says there isn’t much conviction behind the move, and that if financials weren’t included the results would look much worse.

Notwithstanding the insider activity, it’s difficult to find much that’s being talked about that is bullish.  That, in itself, of course, has a bullish tinge to it.  Here’s how the thinking goes:

Theoretically, when the mass of investors is bearish (bullish), they’ve already sold (bought) everything.  If not, why be bearish?  Most surveys of investors, including the American Association of Individual Investors (AAII) and the oldest sentiment survey, Investors Intelligence, have Neutral categories, allowing for those who are bearish but still exposed to the markets.

If investors have already sold, who is left to sell when the next shoe drops?  Well, in fact, the same number of shares are left to be sold, but it’s likely the savvy investors–the patient smart money–who have taken the shares from the bearish ones.

The trouble is in determining when the mass is not just bearish, but really bearish.

For example, some folks have cited the above-mentioned AAII survey, which, last week reported the fewest bullish respondents since the March 2009 low. That’s true, but the same thing could have been said in July, and while it corresponded with a brief pop in equity markets, it quickly fizzled.  You can see that chart below.

What’s missing, though, are the bears.  They’re nowhere near the levels of March 2009–there are 30% fewer bears now (49.5%) than then (70.3%), as one can see in the chart below.

That means that the bulls haven’t become bears, they’ve just gone into the neutral camp.

Yet, there is no question that sentiment is decidedly pessimistic.

In its latest Advisors Sentiment report, a survey of investment newsletter writers, Investors Intelligence also reports that the percentage of bullish respondents is the lowest since March 2009.  This survey, however, also reported the highest outright bearishness since then.

Finally, on August 23, Oppenheimer conducted an informal survey of readers of its weekly Money in Motion dispatch.  In it they proposed seven scenarios for the balance of 2010, which they converted to annual results.  So, action from here through year end would result in full-year 2010 results that ranged from -10% to +10%.  Here are scenarios proposed.

1. +7.6% full-year return
2. +10%
3. +0
4. -10%
5. -4%
6. +1%
7. 0% – a bumpier ride than in scenario 3

The responses came from “Switzerland, Germany, the UK, Canada, and Israel,” and from “Portfolio Managers (long only and hedged), Buy Side Analysts, Traders (Buy side and Sell side), Private Client Brokers, Sell Side Analysts, Commodity Traders, Currency Traders, a handful of High Net Worth Individuals and few members of the Media (print and TV).”

Here’s how the results shook out.  Just 40% of respondents thought 2010 would end up with positive returns.

We’re not at what Ned Davis would call a sentiment fat pitch, but sentiment is far closer to signalling a buy than a sell, and it likely accounts for a lot of Glenn Beck/September nervousness.

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• April 24, 2002 - the House passed Representative Oxley’s bill (H.R. 3763)
• June 18, 2002 - the Senate Banking Committee passed Senator Sarbanes’ bill
• July 15, 2002 - the entire Senate grabbed for votes and passed Senate Bill 2673
• July 24, 2002 - the committee formed to reconcile the House and Senate versions approved the final conference bill.  This marked the first of three final bottoms.

Liberally borrowed from the Wikipedia link above.

Thinking the passage of FinReg might do the same thing, I asked the fine folks at Strategas Research Partners–Dan Clifton, specifically, the firm’s Washington guy–to help us out.

In addition to his comments below on the subject, the firm also provided us with this nice overlay based on when the two bills were approved in Committee.  (The green annotations are mine).  So far, the similarity in the two lines is evident, but as Dan points out below, that was a different time, with the War in Iraq still in the future, etc.

Dan’s comments

Similarities: As you may recall the House and Senate were governed by different parties in 2002. The House, led by Oxley, has a mild plan. The Senate, led by Sarbanes, had a more aggressive plan. President Bush supported the House plan and with the 60 vote threshold required in a 51/49 Senate, investors assumed the more moderate plan would win out. The Senate passed the more aggressive version leading to a stand off between the House and Senate. Worldcom then declared bankruptcy, which occurred in the DC media market, and President Bush asked for a bill and told Oxley to allow the Senate to take the lead. This led to a more aggressive plan (one with higher costs to businesses). The S&P declined into the proceedings. It took more than 3 months later for the S&P to bottom out as investors digested the impact of the bill and investors became more bullish on the potential recovery. It is also important to note this ran into the run up of the War in Iraq which tended to overwhelm the other issues. Financial regulation occurred similar but over a longer period of time. The Worldcom event was the SEC action against Goldman Sachs, which led to more aggressive reforms. We also believe investors are at a similar point in the business cycle, looking for the upturn becoming self sustaining.

 Differences: Financial regulation is more than 2,300 pages and we are still finding provisions we did not know existed. Sarbox was 60 pages and the main provision impacting cost was a couple of sentences. The financial regulation bill also outsources the details to regulators and spreads out the timeline in some cases as long as a decade. There will be continuing uncertainty but over time the banks can adjust to the costs.

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Here’s the short-term version of lease characterization–and I’m playing loosey-goosey with this, too (if you’re an accounting type, feel free to clarify or correct by adding a comment below.) Basically, by having or not having certain characteristics–a bargain purchase option comes to mind–a lease can be characterized as operating or capitalized.  That’s a critical difference, as an operating lease doesn’t show up on the balance sheet, per se, nor does the asset that’s being leased.  A capitalized lease, in contrast, is considered long term debt, with an associated asset on the balance sheet, and that can have huge implications in corporate finance and investing.

The Economist cites a Pricewaterhouse Coopers study that, “found that it would add about 58% to the average company’s interest bearing debt.”  Rent is paid on an operating lease while principal and interest are paid on capitalized leases.  Those two items are found in different places on the financial statements:  rent is part of operating income; principal and interest payments are not.  “On the other hand, since rents will no longer be a running expense, operating earnings could see a bump upwards.”  Also, that, “since the downturn, many companies are close to their maximum debt limits, and the new rules could push them over the edge.”

Thanks to Dave Whisler, CPA, for pointing out that, “one more consideration is that in many situations companies that in the past had been in compliance with their debt covenants will now be violating them. This means that banks and their borrowers will be in a different world than they are this year. You still have the same benchmark (debt covenant) but you are calculating ratios such as debt to equity using different components than what was used when the loan was originated.”

Here’s an example of one company that would be very affected.  Walgreens (WAG), along with most other retailers, owns none (again, loosey-goosey) of its store buildings, but occupies them with operating leases; thus, there is no debt related to buildings on the company’s balance sheet.

A close look at its SEC 10-Q filing shows that its long-term debt is $2.35 billion (see below; click to enlarge).  That gives it a very modest 13.5% long-term debt to capital ratio.  Its operating leases, however, total $36.4 billion.  A portion of that ($2.2  billion) is due in the next year and is considered a current liability, so long-term debt should be $34.2 billion (36.4 – 2.2) higher.

Complete table below.

Suddenly, a company conservatively positioned–i.e. with low leverage–is outrageously leveraged at 2.08x–or on an equivalent basis, 208%!

Unfortunately, the operating lease information is buried in the notes to the financial statements, which means that one can’t screen for high or low operating leases.  It requires going through each company’s 10Q and searching for the data.

As our newest-minted earner* of the Chartered Financial Analyst† designation, Zach Higgins, pointed out, this shouldn’t be news to the analysts.  They should have looked through to the notes and seen the financial impact.  Zach’s right if the analysts do their jobs, but the same should be able to have been said about options expensing, and yet that produced plenty of softness in the big option issuers.

*  Technically, Zach needs another year of experience before he can be a holder of the coveted designation.

†  Just in case any one from the CFA Institute is trolling the internet looking for degredations of the integrity of the charter, Zach will not be a CFA.  Instead, he will be a holder of the CFA® designation.

One would think that at least the cashflow impact would be nill since the cash effect of the reclassification is zero:  the companies are still going to make the same payment.  In fact, the statement of cash flows will be different.  The statement is divided into three parts:

• Cash from operating activities
• Cash from investing activities
• Cash from financing activities

The cashflow associated with the operating lease is shown as an outflow in the operating section.  A capitalized lease’s cashflow is shown as a cash outflow in the financing section.  The operating section is considered the core of the business, since it represents what the company is set up to do (i.e. operate, sell books or machines or whatever).  The financing and investing sections represent the way the company funds its operations.

So here’s the bottom line.  Reclassifying from operating to capitalized will do the following:

1. Make operating earnings look better
2. Make operating cashflow look better; total cashflow will be unchanged
3. Make a company appear more levered

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But since late 2007, when it hit its peak of $747, it has struggled, falling as low as $247.30 in the depths of the financial crisis.  It has since recovered 50% of that loss, but its peers have far-outperformed it.

There may be a glimmer of hope for the stock in that Fortune magazine is just now recognizing the company’s situation, featuring it on the cover of its most-recent issue, shown below.

As I’ve mentioned here before, by the time a company or an issue moves from deep in a publication to the front cover or page, it’s often a sign that the worst is over. 

One piece that’s missing to complete this picture of pessimism is gloom amongst the analysts.  There are 37 who follow the stock, with 86% of them rating it a “buy,” while five say “hold” it.  That’s considerably above the average for all U.S. stocks.  The analysts’ price targets have come down, however.  At the end of 2009, the average price target was $662, while the stock was at $619.  Now, with the stock at $503, the average price target is $625.

 Technically speaking, if we look at the stock’s performance since late 2009, we can see that it bounced nicely off the July low and is now facing its first serious resistance, the 38.2% Fibonacci retracement of the move from the 2009 high to the 2010 low.  That price is $507.42.  That’s also a level that proved insurmountable twice in June and earlier this month.  After that it’s the 50% retracement at $530.54, and then the 61.8% retracement at $553.66.  After that, it’s the 2009 high.

A point and figure (P&F) chart of the stock (below) shows modest improvement (i.e. a couple of higher highs), but the stock remains in a downward trend.  The resistance is much easier to see on this type of chart.

Google bears watching.  The contrary indicator of the cover story would be validatedby a move above $508 and a reversal of the P&F trendline, which would come at about $524.

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As an aside, there were a couple of important insider buys recently.  The CFO bought $150,000 worth of the stock, while the CEO bought $144,000.  Our insider service, InsiderScore, summed those purchases up as, “top execs make first purchases in nearly a year.”

Here’s a brief description of the company.

Now, here’s the coincidental stuff, which I’ve highlighted.  Notice that the dividend yield–on an annual basis, admittedly–leaves you whole.

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David Kotok, of Cumberland Advisors, did some work on this phenomenon and discovered that the determining factor–make that A determining factor–is monetary policy, or whether the Fed is easing, tightening, or neutral on the monetary gas pedal–mostly measured by interest rate policy. 

• If it’s tightening, one should sell in May and go away
• If it’s easing, one should not sell in May, but stay invested, ceteris parabis
• If the Fed is neutral–and this seems to be a key, but unstated, conclusion from Cumberland’s work (see the original at the link below)–there are other factors that explain seasonality

Here’s Cumberland’s conclusion:

So, what do we do in 2010?

The Fed is unlikely to raise the targeted Fed Funds rate between May and October this year. They cannot lower it, since it currently is between zero and a quarter of one percent. Therefore, the application of the results of our historical study is hampered by the existence of the zero-interest-rate lower boundary. For this reason, we have to assume the Fed is either neutral or easing, and cannot be sure which applies. We have no history to guide us.

The same logic applies to other markets of the world. When we survey central banks, we find that Japan is unlikely to raise its targeted policy interest rate. It is currently near zero. The UK is also unlikely to raise its policy interest rate. In Europe, we are witnessing a massive easing of credit as the European Central Bank and the European Union create their version of a crisis response. Their policy may be likened to our American TARP and Federal Reserve activities following the failure of Lehman Brothers.

The Federal Reserve’s expansion of international swap lines appears to us to be a form of easing. Granted, it comes in response to the European crisis and the ECB initiative. However, easing is easing, no matter what form it takes.

As a result, we enter the May-October period with the working assumption that the G4 central banks are collectively easing. This should neutralize the negative seasonals in 2010. That is bullish for stock prices.

Here is the complete article.

Ned Davis Research is one of our key investment strategy providers.  (I should probably call them something like a key investment strategy partner, but who’s kidding who:  we write them a check; they send us e-mails).  Every year, NDR puts together a composite of how the year might unfold based on three historic studies:

• Four-year Presidential cycle
• 10-year (decennial) cycle
• Annual seasonality.

Here is a link to the chart.  (Just kidding, Ned & Co. if you’re out scanning the internet for copyright violations).

To avoid getting a hand-slapping from the fine folks at NDR, let me just describe the chart:  sell in May and go away.  The twist that they put on this is that they “don’t fight the tape,” which is to say that they allow their strategy to be guided by various readings and indicators.  They don’t sell just because the calendar gets flipped from April to May.

So far, however, the market seems to be holding the un-edited script that says sell in May and go away.  If we decide to go with this thinking you’ll be the first group–okay, second–to know.  First, we sell out our client accounts, then we put something on the blog.  If you want to be in the first group, you know how to find us.  Click here for starters.

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