1. Historically, from now to year’s end has been a good time for stocks

2. There’s too much pessimism, and that means investors have fled stocks for the safety of cash . . . earning 0%*

3. Valuations are relative low, and dividends are relatively high (see * above)

Read on for all the details.

Market Update

With the situation in Europe still up in the air, it’s too soon to say the worst is over for stocks. The Europeans have one summit, follow it up with another, and then declare that a final answer will be provided at a third date. At each occasion, market participants hope that a solution will be forthcoming. Domestically, there are still concerns that low growth might turn into no growth, or negative growth; i.e. recession. Still, with October more than half over, the calendar becomes very friendly toward stocks. September has historically been the worst month, but October has had more memory-searing drops, like Black Monday in 1987.

The market’s action of the past few months did much to shake investor confidence. I’ve included below just two indicators that suggest the selling of August 9 was climactic, shaking out the weakest hands.

1. Selling climaxes – these occur when a stock reaches a 52-week low but finishes the week with a gain. Recently, those skyrocketed, indicating that a lot of folks could take it no longer and sold at the bottom.
2. Investor sentiment surveys – surveys of both professionals and individual investors show record high pessimism. Historically, these have marked market bottoms of various degrees.

•In addition, stock valuations are supportive. While stocks aren’t dirt cheap as a group, there certainly are groups of stocks where this is the case. As a group, valuations are reasonable. Dividends have been higher, but relative to interest rates, dividend yields are very high.

The pessimism is high from other angles, too. First, Citigroup maintains several Economic Surprise indexes. Those indexes track economists’ forecasts for economic indicators to what those indicators actually turn out to be. So, for example, each week economists publish their estimates for weekly claims for unemployment insurance. This week, for example, they’re forecasting 401,000 new claims will have been filed. If 395,000 claims are filed, the economists will have been too pessimistic; if 415,000 claims, then too optimistic. Citigroup charts that ongoing relationship, and for the U.S., since June 2, economists have been consistently too pessimistic. Here’s what that chart looks like.

In many ways, until just a couple of weeks ago, the market’s action felt worse than in early 2009, when everyone was nearly certain the world was about to end. Clients and others certainly radiated this feeling, with some saying the equivalent of—as one client did, “I think I’m going to take my toys and go home.” Do you count yourself among those? Don’t feel bad. The National Association of Active Investment Managers is an association of,

“registered investment advisors who provide active money management services to their clients, in order to produce favorable risk-adjusted returns.”

One thing NAAIM does is survey its members to, essentially, gauge their sentiment toward stocks. One thing its members do is FREAK OUT!  As you can see below, they recently registered their worst sentiment reading since late 2008.

With selling climaxes, sentiment surveys of individual investors, and anecdotal observations, one can make a strong case for a retail investor class that has fled from stocks in the short term. (On a longer-term basis, one could say that small investors have never returned to stocks, in that they report lower allocations to stock now than in 1999.) Throw in economists’ forecasts and the NAAIM survey and one can add in professional pessimism. Finally, the press continues to pipe a funeral dirge, as evidenced by another dandy cover story from The Economist, which is shown below—oh, my; this one’s a beauty!

Combine the calendar and pessimism toward stocks with progress in Europe—they’re saying the right things—and a better than expected corporate earnings season, and the fourth quarter could turn out to be a pretty good one. That leaves us feeling pretty good about stocks. Our key strategy services have yet to confirm this view with official shifts, but they seem to be leaning that way. If they do, we are likely to allocate more to stocks, less to bonds and cash, and to become more aggressive within equity portfolios.

Graig P. Stettner, CFA, CMT

Chief Investment Officer

Tower Private Advisors

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Below

• Rally caps on
• Europe gets closer to a solution
• Consumers, scared to death about the economy, assuage their fears by spending money

Capital Markets Recap

 This week’s market action saw an embracing of risk assets and a flight from safety. At least three factors, mentioned here in some form over the last few weeks, had primed the pump–compressed the spring–choose your metaphor–for the rally.

• Excessive pessimism sent investors from the risk of stocks to the safety of cash.
• October 12 marked the date that, historically, has marked the beginning of the fourth quarter rally for stocks
• Last week saw capitulation by investors as marked by Selling Climaxes. A selling climax occurs when a stock makes a new 52-week low and goes on to finish the week with a gain. As Investors Intelligence puts it, “they are a sign of accumulation and indicate that stocks are passing from weak hands to strong ones.”

Top Stories

 Like an aircraft carrier turning in a sea, Europe continues to inch closer to a final solution. Stories on the European financial crisis were in Bloomberg’s top stories every day this week. Included in those were one saying that German banks were bracing for a 60% haircut on Greek debt they hold. As recently as July, the European banks had agreed to a 21% reduction in the value of their Greek debt holdings in the event of a default. Today’s top top story said that the European Union was looking at a “one-time 50% Greek debt writedown, bank backstop.”

Here’s an excerpt from the story.

Oct. 14 (Bloomberg) — European officials are considering writedowns of as much as 50 percent on Greek bonds, a backstop for banks and continued central bank bond purchases as key planks in a revamped strategy to combat the debt crisis, people familiar with the discussions said.

The Greek bond losses may be accompanied by a pledge to rule out debt restructurings in other countries that received bailouts, such as Portugal, to persuade investors that Europe has mastered the crisis, said the people, who declined to be identified because the negotiations will run for another week.

In the works is a five-point plan foreseeing a solution for Greece, bolstering of the European Financial Stability Facility rescue fund, fresh capital for banks, a new push to boost competitiveness and consideration of European treaty amendments to tighten economic management.

This approximates the solution that one of our key research partners, BCA Research, has prescribed for Europe, although they say that an open-ended pledge by the European Central Bank to purchase debt of the troubled PIIGS would pretty much end the crisis. That’s what the Federal Reserve engaged in here. They called it “quantitative easing;” others called it “monetizing the debt;” you called it “printing money,” and it’s as objectionable to the Europeans as it is to you. They hint at that with the phrase, “continued central bank bond purchases.”

Now, here’s the deal with the so-called haircut.

European banks hold Greek sovereign debt; it’s the latter that is affected by the so-called haircut. However, even though the market is pricing the bonds at a small fraction of their face value (the Greek one-year note below is selling at 45% of par), the banks are pretending they’re worth somethink like the par value they paid for them. In fact, they’re only pretending to pretend; some sick version of accounting only requires them to carry the bonds at their cost. When Greece defaults on its sovereign debt it’s not like they won’t pay anything. Instead, it’ll be determined–agreed to, rather–that, say, just 50% of the debt won’t be paid back, and the banks will have to write down the value of their Greek debt by 50%. That hit comes goes right to the equity section of the bank’s financial statements–that’s capital to you and me, and it’ll leave those banks undercapitalized, at best; bankrupt at worst.

In the midst of a gradually recovering stock market, the third quarter earnings season started this week, with Alcoa kicking off–and, as usual, missing the ball–the big cap company earnings parade. Alcoa missed its earnings estimates, while Google exceeded its estimates. Analysts have been grudgingly reducing earnings on the companies they cover, so it could make for a rough earnings reporting season.

The other big story didn’t make the list of top stories, per se, but the release of the September 21 Federal Open Markets Committee meeting minutes were highly anticipated. As usual, instead of wading through them for you to find some gem the Wall Street Journal found on Wednesday, I give you a word cloud of the release. The larger the word the more frequently it appeared in the minutes.

This Week

There were four important economic releases in the U.S. this week. Two were as expected; two, not. The National Federation for Independent Business’s Small Business Optimism index came out on Tuesday, almost just as expected. The actual figure was 88.9 versus expectations of 88.8 and a previous release of 88.1 Also about as expected was the weekly Initial Jobless Claims figure. Economists were looking for 405,000, and the actual figure was 404,000. The previous week’s 401,000 was revised up to 405,000. Historically, 400,000 was the demarcation line between an improving (less than 400,000) and a deteriorating (more than 400,000) jobs picture, and that level is proving difficult to penetrate, suggesting that the pace of layoffs is staying constant.

You and I would not be surprised to know that consumer confidence slipped recently, but apparently the economists eyeballing the University of Michigan Consumer Sentiment release were oblivious to the hit suffered in 401(k) plans and other investment accounts. Instead of the modest improvement (what?!) they expected (from 59.4 to 60.2) the index fell to 57.5, which is essentially the lowest level since 1980, as shown below. As consumers, however, we are notorious for saying one thing and doing another. For example, if consumers’ expectations for the future had darkened, one would have expected them to cut back on spending as they retrenched. Instead, Retail Sales grew sharply in September. Excluding Auto Sales they jumped by 0.6% (versus expectations of 0.3% and a previous figure of 0.1%); Excluding Autos and Gas, they jumped by 0.5% (versus expectations of 0.4% and a previous increase of 0.1%).

 Next Week

Key indicators to watch

• Empire State Manufacturing Index (Monday) – October
• Industrial Production (Monday) – September
• Capacity Utilization (Monday) – September
• Producer Price Index (Tuesday) – September
• Consumer Price Index (Wednesday) – September
• Federal Reserve Beige Book (Wednesday)
• Initial Jobless Claims (Thursday) – weekly
• Leading Economic Indicators (Thursday) – September
• Philadelphia Federal Reserve index (Thursday) – October

Housing indicators

• NAHB Housing Market Index (Monday) – October
• Housing Starts (Wednesday) – September
• Building Permits (Wednesday) – September
• Existing Home Sales (Thursday) – September

Graig Stettner, CFA, CMT

Chief Investment Officer

Tower Private Advisors

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In a note I was preparing to send out yesterday morning, I had said the Monday’s action was akin to a quarterback being sacked for a loss. But there was at least one missing element in Monday’s action. Namely, it lacked confirmation. Confirmation is the word used to describe what happens when different markets and indicators act in a similar fashion to confirm the action of another market or indicator. For example, Dow Theory says that if the Dow Industrials make a new low/high and the Dow Transports don’t do the same thing, then the move is not confirmed, and should be considered suspect. So, on Monday, the S & P 500 made a new closing low for the year but the Fear Index did not. Translated–and based on just that one measure–market participants were less fearful on Monday than they were back on August 9.

Speaking of fear, it’s almost becoming palpable. Featured below is the cover of the latest issue of The Economist. The caption is, “until politicians actually do something about the world economy…BE AFRAID.” Now, while the caption is entirely true, what it suggests is that once it reaches top-of-mind at The Economist, investors have already factored much of the fear into asset prices. Indeed, if we head down the black hole, it will be ugly on portfolios. But one way to factor that fear into asset prices is to sell them and sit on the cash. What happens if there’s a lurch in the direction of doing something for the economy? Those same investors are going to wish they had that cash back in those assets they were in such a hurry to unload.

We hosted the Chief Economist from Strategas Research Partners for breakfast and lunch meetings today. He says we’re in the second half of a four-year business cycle, and he estimates that we have nine quarters left to go. That’s two and a quarter years before the economy begins to decline. If you think that’s optimistic, there wasn’t a person in the room who didn’t leave characterizing the outlook as gloomy. In last Friday’s blog I posted a survey about the likelihood of recession in the next 12 months. 66% of the responses placed the likelihood at 50% or higher. The economists, themselves, are no better, as this dead horse carcass illustrates. In the green box–for that time period–the economic releases have been better than what economists had forecast. Stocks should strat to reflect that, especially if anything goes right in Europe.

Here’s another. Rydex is a fund family that caters to traders. They’ve got leveraged funds that are directional and inverse, so you can express almost any view toward many asset classes, and they don’t care how often you’re in or out of their funds. As a consequence, the allocations to the Rydex funds are great laboratories for contrary sentiment indicators, and the best sentiment scientist is Jason Goepfert of sentimenTrader. He’s gone back and looked at all the times when assets in Rydex’s cash money markets have been 150% or more of their stock funds, and the returns following such times. The results are overwhelmingly positive. After 3, 6, and 12 months, there has never been a losing period for stocks, and the median returns are big, like 18.8% after three months, 26.3% after six, and 39.2% after 12–median returns, not averages skewed by outliers. For shorter periods, the returns were positive almost 90% of the time.

Finally, keep this in mind:

There’s someone buying all those stocks that are being sold.

While companies are buying back some shares, they can’t buy them all back. The brokers and investment banks don’t buy the shares. Almost by definition, they’re being bought by investors with longer time frames than the sellers. The sellers are worried about next week, the buyers are discounting future cash flows and are thinking about what the shares will be worth next year. 

Graig Stettner, CFA, CMT

Chief Investment Officer

Tower Private Advisors

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• Optimism is like a tinder  drenched with water. It won’t start with any source weaker than a blow torch.
• In contrast, Pessimism is like very dry tinder; it only takes a spark.

There are a variety of sentiment measures. In last Friday’s I covered the sentiment expressed in the weekly survey of the American Association of Individual Investors. This post will look at put and call options. Here’s a bare-bones primer on options.

• Put options (puts) rise in value as a security price declines. Generally, puts are purchased either to hedge (protect against a decline in) a current position or to speculate on an asset declining.
• Call options rise in value as a security price rises. Calls might be purchased instead of buying the underlying security. For example, one might buy call options on Cisco Systems instead of Cisco shares. Less money is put up.
• Put and call options may be bought and sold in combination. For just one example, one might sell a call option on one security and buy a put option on the same security with the proceeds.
• Options are like milk; they have expiration dates.
• Option prices are, generally, more volatile than the underlying securities

As a group, investors tend to be an optimistic lot, so the normal pattern is for more call options to be bought than for put options to be bought.  Over the last few years, about 65 puts have been bought for every 100 calls bought, for a ratio of 0.65. While our tendency is to be optimistic, occasionally we go the other way. We do it when it seems like the world might end–or at least Europe–and certainly Greece. That is, we’re doing it now.

So, here’s a look at a pile of dry tinder. The ratio of puts:calls is now back to levels last seen in November 2008. What is shown below is for options on equities and ETFs; there is also a put:call ratio the includes options on indexes, but those often involve hedging activities that may be unrelated to sentiment.

Please notice the powerful rally that ensued just from the ratio moving back to normal. Notice, too, that the put:call ratio didn’t mark the ultimate bottom, only a time when investors had gotten way to pessimistic. In short, the time to be nervous is not now. For now, at least, stay the course.

The biggest source of push-back we get from clients and others regarding almost anything having to do with history–this being one example–is that this time it’s different–it’s never been like this before. How true, how true; it’s never the same. But what is always the same is people and their emotions. They’re what led Charles Mackay, author of Extraordinary Popular Delusions and the Madness of Crowds, to say,

“Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, one by one.”

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Below

•  Risk on, again?
• Ugly economics, bouyed consumer, go figure

Today’s theme song comes from the Steve Miller Band…

Time keeps on slippin’, slippin’, slippin’

Into the future

Time keeps on slippin’, slippin’, slippin’

Into the future

Time keeps on slippin’, slippin’, slippin’

Into the future

Time keeps on slippin’, slippin’, slippin’

Into the future 

Capital Markets Recap

Of late, the stock market has been described as risk on/risk off–sort of a Karate Kid market. Lately, it’s been in the latter mode, with rallies being sold, and pessimism increasing. If the two highlighted items, below, are any indication, we’re likely to be going back to the risk-on setting. Optimism has been coming down a lot. Small-cap stocks (first green highlight) are the high-beta area of the U.S. market; they rallied this week; the CBOE Volatility Index pulled back, suggesting that investors became a bit more sanquine this week.

Top Stories

Endgame is the title of a new book by John Mauldin. The title refers to that time when governments can no longer roll over their debts. Greece continues to inch closer and closer to that point, as evidenced by its 5-year Credit Default Swaps. In plain english, the price of ensuring against a default by Greece has increased by 42% since the beginning of the year. And so, naturally, the Greek Prime Minister vowed to, “press ahead with new austerity measures,” according to a Bloomberg story. Oh, and, Sir, the IMF says it, “may not release [the] next tranche of Greek aid.”

What’s more, the ECB has called the Greece problem “contained.” You might recall that word was used by Ben Bernanke to describe the housing crisis in the U.S. early on in its so-called containment, which containment nearly brought the world’s economy to its metaphorical knees.

• Hewlett Packard floated its biggest debt issue yet, with $5 billion worth of two and three-year floating rate paper. Here’s my take on that. HP is not, to my knowledge, stupid. Long-term corporate bond deals have been coming with ridiculously low yields, so there’s no shortage of appetite for such things. And everyone knows that interest rates are going up–that’s the only direction they can go, right? My guess is that it’s a combination of two things. Corporate bond spreads (the incremental yield offered over Treasuries) are very low, and there probably is a general fear or rising rates, making these bonds even more saleable; meanwhile, HP is not worried about rates rising. That’s a $5 billion bet against rising rates.
• The U.S. issued its shares of American International Group saw this week and raised $8.7 billion for itself–the U.S., that is; not AIG. That’s sorta like an IPO…
• …but unlike this one…as you might know, LinkedIn, the professional’s version of Facebook had a–how do you say?–successful IPO last week. The shares were sold at $45, and, just like in the Tech Bubble heyday, they rocketed to $122.70. ‘Trouble is, the newly minted millionaire insiders can’t cash in on their success for half a year. An analysis by Gamco says that the shares could fall to $30 once insiders and investment bankers are free to sell. I sort of feel cheated–’seems like I ought to get some of that dough. Here’s a company–just like Facebook–that wouldn’t be worth a dime without user-created content. Not worth a dime . . . hmm; betcha it heads that way.
• A story on the Bloomberg terminal this week said that U.S. farm exports were expected to jump to a record that is 26% higher than last year’s tally. But with much of the nation well behind historic marks that has to become increasingly questionable.

This Week

I’ve expressed the concern, for a number of weeks now, that the economists have been overestimating the strength of the economy . . . badly. Here is an updated chart that shows the economic surprises. When the economic releases are coming out better than what economists have been expecting the index goes up; when they overestimate, it heads down. My concern has been that the stock market (the S & P 500) in orange has sort of decoupled from economic reality. I realize that a good portion of S & P 500 earnings come from non-U.S. sources.

Fleetwood Mac said it this way:

You can go your own way

Go your own way

You can call it

Another lonely day

You can go your own way

go your own way

Indeed, the economic statistics have been souring. Here is just a handful of them that I have cherry-picked to support my contention.

1. The Chicago Federal Reserve National Activity Index turned down this week
2. Core Capital Goods Orders fell this week; biggest decline in six months
3. The broadest measure of U.S. home prices, the House Price Index, fell by 2.5% in the first quarter, the biggest decline since the end of ’08
4. Second coming of Q2 GDP remains unchanged at 1.8%, in contrast to economists’ expectations for an increase to 2.2%
5. Initial Jobless Claims have stubbornly remained above 400,000, with nasty implications (chart below)
6. Personal Income and Spending have stalled out, stymied by gas prices
7. Pending Home Sales fell by 26.8% on a year-over-year basis

And, yet, University of Michigan Consumer Confidence continues to rebound in the face of factors like those  above and high gas prices and a lackluster employment picture.

Last Week

Next week is likely to produce some economic fireworks

Key indicators to watch

• ADP Employment Change report (Wednesday) – May
• ISM Manufacturing (Wednesday) – May
• Initial Jobless Claims (Thursday) – weekly
• Non-farm Payrolls (Friday) – May
• Unemployment Rate (Friday) – May
• ISM Service Sector (Friday) – May

Regional indicators

• Chicago Purchasing Managers index (Tuesday) – May
• NAPM Milwaukee (Tuesday) – May
• Dallas Fed Manufacturing Survey (Tuesday) – May

Housing-related indicators

• Case-Shiller Home Price Index (Tuesday) – March (!)

Have yourself a dandy Memorial Day Weekend.

Graig Stettner, CFA, CMT

Vice President & Portfolio Manager

Tower Private Advisors

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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

• Sentiment getting overstretched:  short-term pullback ahead
• GMO quarterly letter and its takeaways are well worth your time
• States’ fiscal conditions may not impact state municipal bonds as badly as some expect
• Good economics this week; big week, next

This one’s a bit long.  Read the underlined parts and you’ll get the gist.

Capital Markets Recap

It may be that investors had gotten too complacent and decided to price back in some fear or it may be something more insidious, but the S & P 500 was down by just 0.56% this week, but implied volatility (aka the Fear Index) jumped by 18.29%.  What it implies remains to be seen.  You can infer what I think it means by reading further.

Top Stories

Earnings continued this week with 156 companies having reported earnings between Monday and Friday morning.  Unlike last week’s results, there was a slightly positive correlation between stocks reporting earnings surprises (i.e. earnings beat estimates) and stocks with positive 5-day rates of change, as the chart below shows.  Still, the R-squared of 0.027 tells us that just 2.7% of the stock-price movement is a result of earnings, alone.

From here, things start to taper off, with just 102 companies reporting next week.  We’ll have to start looking for the next bogeyman behind stock price movement, even though the chart above suggests that earnings results have next to nothing to do with stock price movements in aggregate.

So far, we seem to be doing a bit better than average.  81.9% of companies have beaten estimates, as compared to the more typical 70s level.  The best results have come from the finance sector, where the average result has been 18.4% better than the consensus EPS estimate and 108.63% year-over-year improvement, followed by consumer discretionary, where the respective figures are 11.24% and 31.70%  Information technology and industrials were the almost-tied second best for year-over-year growth, at 56.61% and 55.43%, respectively.  The telecommunication sector (only nine companies in toto) is the only sector showing negative year-over-year growth at -9.20%.

Sentiment toward stocks is again becoming a bit frothy.  The oldest sentiment survey is the Investors Intelligence survey of investment newsletter writers.  It showed a troubling 45.6% of newsletter writers were bullish.  That’s not a freak-out, head-for-the-hills level, but it’s enough to be worrisome.  Freak-out level is about 55%, which was seen in early May. 

The cute little creature below right is a lemming.  He/she has the nasty distinction of having a habit of running off cliffs en masse.  It turns out that a 1958 Disney documentary on the subject was highly doctored to show the critters leaping headlong into the sea. Nevertheless, the image stuck.  In investments, the lemmings’ thinking is captured in the weekly American Association of Individual Investors (AAII) survey. Unlike the II survey, which shows a ways to go before sentiment gets frothy, this group of folks has more bulls (%) than at any time this year (chart below.)

Investors Intelligence also tracks what it calls Buying and Selling Climaxes.  A buying climax occurs when a stock–in a week–reports a 52-week high (low for a Selling Climax) but closes the week (Friday to Friday) down by 10% (up for a Selling Climax).  It essentially captures the weak hands buying from the strong (buying climax) and vice versa .Buying climaxes reported on October 25 came with this one-liner:  Buying climaxes jump – now approaching dangerous levels.  They reached their highest levels since late July, which is right about when stocks took their nasty September–yes, that’s right, September moved forward to August–drop on the heels of investment expert Glenn Beck’s featured Hindenburg Omen.

There have been ample reasons for stocks to rally, namely Quantitative Easing, next week’s elections, earnings.  QE, again, is when the Federal Reserve tells the Treasury to crank up the printing presses so it can buy securities.  Elections are when the electorate gets to choose between the lesser of two evils.  Earnings occur when companies manipulate their income statements to produce positive bottom lines.  QE, extrapolated ad infinitum, means that risk assets (i.e. stocks) will go up.  The election means that we’ll have Congressional gridlock–as opposed to the fluid superhighway we’ve had for the last two years, when stocks have done better.  We’re also entering the–stop me if you’ve heard this–best year of a President’s first term AND the fourth quarter of year two . . . uh . . . now, Gordo, for stocks.  Finally, as noted above, earnings have been better than expected–as usual–and better than as usual. 

Here’s the punchline (man, I hate that one):  stocks have had plenty of reasons to rally, so they did.  We think it’s time to sell ahead of the news, reducing or hedging stock exposure in individual-security portfolios.  A well-worn investment saying is buy the rumor; sell the news.  So do it.

Now don’t get me wrong, the table is being set for positive results in a medium-term time frame (think 1-12 months out); it’s the short term that is troubling, as is the long term.  As to why the medium term looks good . . .  

• While there’s ample reason to call the current environment different (they all are), the Presidential cycle has not been repealed. 
• QE will produce excess money, which will flow into risky assets (my guess for the next bubble is emerging markets). 
• The only factor above which shouldn’t be cited as a force for the next year is earnings.  That bar is being set higher, and stocks do better when it’s lower.

Still, we think the market has fully absorbed those positives; thus, the short-term direction is lower.

Jeremy Grantham, of GMO, might be one of the sharpest minds around when it comes to top-level discussion of asset classes, economics, and prevailing winds.  His most recent Quarterly Letter was titled Night of the Living Fed, and featured the following cover image.

In it he castigates the Federal Reserve for recklessly fostering asset bubbles, acting before and during as if it can manipulate markets, and then claiming afterwards it was helpless in seeing–much less addressing–asset bubbles.  In one breath, the markets are inefficient and we can affect them; in the next, markets are efficient, and who are we to interfere?  The Fed is presently attempting to prop up/goose the stock market by printing money (politely, Quantitative Easing), because, “the market is far more sensitive to monetary factors than is the real economy.”  A rising stock market will produce a wealth effect, making consumers feel like spending more.  Last time they did that, they produced the housing bubble, a far more serious affair, in which, Jeremy claims the housing-related employment likely masked a structural decline in employment.

Here are his asset class implications, all direct quotes except where noted.

• Emphasize U.S. quality companies, which are still cheap in an overpriced world
• Moderately overweight emerging market equities
• Moderately underweight the balance of global equities
• Heavily underweight lower quality U.S. companies
• Carry extra cash reserves for a volatile market with insecure fundamentals
• For the very long term (20 years) overweight resources [his view, not GMO's]
• Also, that in spite of “if ever there were an argument for “this time is different,” this is it, year three of the Presidential cycle (2011) should be a good one
• [Paraphrased] If the value of paper currencies are based on faith, how much more is gold, which “pays no dividend, cannot be eaten, and is mostly used for nothing more useful than jewelry. . . I believe that resources in the ground . . . are more certain to resist any inflation or paper currency crisis than is gold.”

I read a copy of Moody’s Special Comment, Why US States are Better Credit Risks Than Almost All US Corporates.”  It focused special attention on the plight of Illinois, as it takes the honors of state-in-deepest-doo-doo, and used the strengths of that state to bolster the case for all states, and in turn, general obligation municipal bonds of all states.  As an aside, Illinois could eliminate its annual budget deficit with a 2% high in its income tax rate; not pleasant, but not a killer.  Here are the strengths of state G.O. debt versus corporate debt:

1. Unlike a corporation, states can increase revenues without mitigating capital spending
2. Expenses can be reduced without hurting revenues, unlike with a corporation
3. There are strong legal protections for debt service payments–in many states, those payments rank above those to vendors
4. Limited ways to avoid debt obligations, unlike the bankruptcy protection for corporations
5. Recovery in the event of default is expected to be considerably higher
6. Reduced confidence in state “management” less important than with a corporation
7. Little competitive pressure amongst states vis-a-vis corporations
8. Less event risk and the possibility of federal government support

This Week

As of this Friday morning the economic news has been, almost across the board, good.  Existing Home Sales were better than expected: 4.53 million (annualized rate) versus 4.30 million (expected) and August’s 4.13 million.  The Case-Shiller Home Price Index grew at 1.70% in August, albeit at a slower pace than in July, but notice that the data is a month behind the existing home sales and . . . New Home Sales grew by 307,000, versus August’s 288,000 annual run rate and the expectation for a 300,000 rate.  Initial Jobless Claims fell by an unexpected 21,000 from last week’s upwardly-revised 455,000.  The resulting 434,000 were 16,000 better than the 450,000 the dismal scientists expected.  Today gave us the first look at Q3 GDP.  It grew by 2.0%, just as the economists foresaw.  (We’ll get two more, refined releases of the same data at the end of November and December.) At 70% of GDP, it goes without saying that consumer spending is a huge part of each quarter.  Q3 saw the best level of consumer spending (aka Personal Consumption Expendituress) since Q4 2006.  It was largely expected, however; economists expected 2.5%; the actual figure was 2.6%. Also helping GDP was a partial reversal of Q2′s huge bounce in imports (33.5% annual growth rate) to an annual pace of 17.4%, and that helps the final factor in the equation below. 

Output = Consumption + Government + Investment + Net Exports

All was not well, however, as the Chicago Fed’s National Activity Index, which has a very high correlation to future economic activity, weakened from August.  Also, while the headline Durable Goods Orders grew far better than expected (3.3% v. 2.0% ) and better than August (-1.3%), the non-transports, non-defense–i.e. core orders–were disappointing, falling by (-)0.6% versus August’s 4.1%.  Core orders is the best measure we have of capital spending, so those figures were not encouraging.  The Chicago Purchasing Managers Index came out better than expected (60.6 v. 58.0), and some key components of the survey went in the right direction. 

• New Orders jumped from 61.4 to 65.0 (read that as 65% of respondents said new orders had increased.)
• Employment moved up from 53.4 to 54.6. 
• Production increased from 64.3 to 69.8
• Prices Paid rocketed from 55.0 to 68.9, welcome news for the deflation-focused Fed

Next Week

Big week ahead with Nonfarm Payrolls report on tap

Key indicators to watch (in order of importance)

• Nonfarm Payrolls (October) – Friday - always the month’s most important
• Unemployment Rate – (October) – Friday – none other figure more important than J0e 70%
• ADP Employment Change (October) – Wednesday – as an augury of the biggie
• FOMC Rate Decision – Wednesday
• Initial Jobless Claims (weekly) – Thursday
• ISM Manufacturing (October) – Monday
• ISM Service Sector (October) – Wednesday
• Personal Income, Spending, and Savings

Peace

Uncle Graig

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Prior Posts

• Sentiment and [YIKES] politics
• Sentiment update

Below

• Rally continues + more sentiment
• Nonfarm Payrolls relief
• No WR&O next week

Capital Markets Recap

If you check out the prior posts and read below, you’ll get the impression of a dead horse being beaten, but the subject of sentiment is a powerful and important one, in my opinion.  There has been excessive bearishness, and here’s another version of it.

We know that individuals–based on their preference for bonds over stocks–aren’t enamored with the outlook for stocks.  That’s evident everywhere from what they search for on Google to how they respond to surveys.  But they’re not the only group.  Speculators in futures, those who aren’t commercials (the commercials are investment banks, in this case) are even more bearish, and they’ve expressed that view with real money.  Their net-long position (long futures minus short futures) is negative; that is, they have more shorts than longs; that is, they’re betting on stocks falling (middle panel, below.)  Whereas individuals might stop searching for “Hindenburg Omen” on Google and respond to surveys different–that’ll reduce their bearishness–the only way for the speculators to be less bullish is to close their short futures contracts, and that will push stocks higher.  In other words, if stocks continue to rally it’ll produce a vicious cycle–if you’re short and have to cover.

Top Stories

• Somebody once said that it’s impossible to take any three letters in the English language, put them together in any order and not come up with a government agency we couldn’t do without.  This week a newish one was brought to the fore.  Not to be confused with the body that insures the safety of your deposits, the FCIC–the Financial Crisis Inquiry Commission–grilled a number of folks who were on the scene when the financial world collapsed, almost bringing down Main Street.  Dick Fuld of Lehman Brothers insisted it wasn’t an issue of capital that brought the firm down, it was an issue of liquidity.  Chairman Bernanke, however, said the Fed didn’t think it was possible to save the company.  The discount window had been opened for other firms because they had collateral the government felt confident in, as AIG did.
• Burger King (BKC) was bought out by a Brazilian private equity firm, and as often happens, it was discovered that option trading in the stock ballooned just before the bid.  The same thing happened this morning, with the S & P futures rising a minute before the [positive] Nonfarm Payrolls Report was released.  Some guys have all the luck.
• Last week’s recap featured a chart showing that searches for “double dip”–as in another recession–hit a high for the year.  That’s another source of fear for the bears who are sitting on cash or in bonds, yet another high was reached that contradicts that fear.  Copper is often referred to as the metal with a PhD because of its leading tendency with respect to the global economy.  It, too, made a high this week.  It was just a 90-day high, but were it not for April, it would have been a high for the year.  It’s fair to ponder removing April, too, as that was a time of high enthusiasm about stocks.  That enthusiasm translated to a bullish copper position.  Now, though, it’s copper showing strength, and it’s not supported by bullish sentiment on stocks.  I conclude, therefore, that the strength in copper is signaling something else is afoot . . . like a global economy that is not flirting with the dreaded double dip.

• We like emerging markets as an investment favorite, if for no other reason than that emerging market economies look stronger than developed markets in terms of their economic fundamentals.  For example, virtually all measures of debt relative to their economy look supremely better than that of the developed nations.  That’s widely known, however, making the emerging markets area–as they say–a crowded trade.  In terms of rowboats, it’s like everyone looking over the same side of the boat.  The Bloomberg terminal featured a four-word phrase that should send shivers through anyone who was older than 30 when the internet bubble burst:  this time it’s different.  And the circumstances of this version are a lot like then, when we were presented with the new economy.  According to this week’s Bloomberg story, the MSCI Emerging Markets index is trading at levels that, in 2008, marked  the peak in that market.  HSBC, Deutsche Bank, and Morgan Stanley say it’s different this time because, “developing nations have less debt, more profitable companies and are growingg twice as fast as advanced economies.”  Write this down:  all asset bubbles have their beginnings in trust, and they’re inflated by a so-called paradigm shift–the this time it’s different.
• Copper is used around the world, and, withouth looking, China is probably the minor buyer.  The U.S. surely uses more, but China is likely behind the growth in copper demand.  So you might assume that means the global double-dip risk is low, but the Cass index of Freight Shipments says the risk is low in the U.S., too.  That index reached its second-highest level in two year, as shown below.

This Week

As I pointed out in two prior posts, this market has been primed to rally.  There has been too much pessimism.  In addition to the sentiment surveys cited and the political winds blowing, there was also a 2010 record of selling climaxes last week.  That occurs when a stock hits a 52-week low but finishes the week up more than 10%.  It’s a measure of the weak hands (i.e. dumb money) selling their shares to the strong hands (i.e. smart money.)

While there were some positive-surprise reports this week–e.g. Pending Home Sales up by 5.2%; prior -2.6%; expected -1.0%–they were just excuses for stocks to rally.  Given that today’s Nonfarm Payrolls Report measures the one-month change in payrolls–very imprecisely, to boot–it, too, is just an excuse. 

Still, at the margin of the margin it was positive.  Instead of the loss of (-)105,000 jobs that was expected, the headline loss was just (-)54,000.  That was lower than last month’s headline figure (-131,000), but the same as the revised figure.  Private Payrolls rose by 67,000; more than the 40,000 anticipated.  July’s change was revised up from 71,000 to 107,000, making the two-month average 87,000.

Manufacturing Payrolls, however, were disappointing, as they fell by (-)27,000 instead of the 10,000 increase economists expected.  The Unemployment Rate ticked up to 9.6% from 9.5%, but was the result of more folks entering the labor force, looking for jobs.  The Participation Rate–the percentage of the population in the work force, either working or looking for work–rose from 64.6% to 64.7%. That translates to an additional 685,000 looking for work.  This is a to-be-expected phenomenon as the economy improves–grudgingly or not.

Another minor positive was the increase in Average Hourly Earnings.  They rose by 0.3%, versus expectations of +0.1% and July’s +0.2%.  That pace is well above 2010′s average and is better than the average of 2007, 2009, and just shy of 2008′s mark.

Next Week

There are less than a handful of indicators in all of next-week’s holiday shortened work week.

Key indicators to watch

• Initial Jobless Claims (weekly) – Thursday

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As far as stocks are concerned, the only thing better than a Democrat White House is a Democrat White House with a Republican Senate.

Since 1901, the Dow Jones Industrial Average has returned 7.46% per year when the President was a Democrat (2.95% when a Republican).  However, with a Democrat President, when Congress is controlled by the Democrats the return per year is less, at 6.90%.  When the Republicans control Congress and the White House is occupied by a Democrat, the return jumps to 9.63% per year.  Thus, the saw, “the market loves gridlock.”

intrade, is a prediction market website, pictured below.  There, one can speculate on everything from will Brett Favre play a down in 2010 NFL season? (yes, 97.4%) to will the Dow Jones Industrial Average close above 10,000? (See further below).  If you’re intrigued by the idea of prediction markets, you can find a lot more on them by clicking here.

Here are three intrade contracts regarding the mid-term elections.

1. Will the House be under Republican control after the mid-term elections?  The contract is pricing in a 77.9% likelihood, which largely reflects published polls–again, with the difference that intrade contracts require real money.
2. Will the Senate be under Democrat control after the mid-term elections?  The contract is pricing in just a 25% chance of that.
3. Will the Democrats keep their 60+ vote lead in the Senate?  Just a 3% chance of that.

So, by most measures, the Democratic party will likely lose one body of Congress, and with just a slim chance, both, but the odds are high that the Democrats lose their filibuster-proof majority in the Senate.  Either way, that’s approaching gridlock, when markets perform at their best.  Furthermore, the third year of a Presidential administration–donkey or elephant–is the best year for stocks.  And yet sentiment is lousy. The intrade contract for the DJIA closing above 10,000 is just at 50.9%, meaning the odds are pretty good that we end up just about where we are now.  Here’s the chart of that contract.  Either the market is ignoring the likely mid-term election results or sentiment would even be worse without them.

Parenthetically, notice the similarity to the American Association of Individuals Investors – % Bullish respondents, below.

Just so you don’t get your political dander up and decide to let loose with some fiery comment, I’ve disabled comments for the first time with this posting.

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The guiding idea behind looking at sentiment is that the mass of investors is wrong.  In other words, it’s a contrary approach.  As an investment strategy, however, it can be costly to go against the majority of investors as a practice.  Instead, Ned Davis points out that the it’s at the turning points in markets, when sentiment is at an extreme, that it pays to go against the crowd.  In his book, The Triumph of Contrarian Investing, Ned says that,

A top in the market is the point of maximum optimism, and a bottom in the market is the point of maximum pessimism.

When sentiment is changing at those extremes and reverses, however, that sentiment is usually right until the next extreme.  In other words, the crowd is usually right, except at extremes.  Charles Mackay, in the 1800s, was one of the first to print an authoritative work on sentiment, The Madness of Crowds, and a quote that sticks in my memory from it is this one:

Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one.

 There are many gauges of investor sentiment available.  One of the most common is from the American Association of Individual Investors (AAII).  Each week it polls its members, asking whether they’re bullish, bearish, or neutral.  Also, on a monthly basis members are asked what their asset allocation amongst cash, stocks, and bonds.  Investors Intelligence has the longest running sentiment survey, but its survey covers just investment advisors.  It, too, asks whether the respondent is bullish, bearish, or neutral.

 With the data in hand, there are a number of ways to look at it.  The simplest is to just look at the percentage in each camp.  A record number of bullish respondents tends to be bearish for the markets, while a record number of bearish respondents tends to be bullish.  The neutral category can be problematic, however, and needs to be considered in the mix.  For example, a paucity of bulls should be considered in light of the neutral camp, as this latter group tends to largely be bulls waiting for a pullback in the markets.  So, additional mathematics can be performed to allow for this, such as considering only the ratio of bulls to the total of bulls and bears.  That, in itself, won’t be helpful unless compared against that ratio over time and at turning points in markets.

Most of these surveys–and other variants–are arcane and only known and used by a few.  There are, however, a number of sentiment sources that are not often considered as such, and one was remarked on this week by the ultimate slicer and dicer of sentiment, the excellen sentimenTrader service.  He took a look at the monthly Conference Board Consumer Confidence index, which, last week, took an unexpected nose dive.

From last week’s Weekly Recap & Outlook, I had this to say about the release.

The Conference Board’s Consumer Confidence measure fell from 55.9 to 46.0, well below the expected 55.0. Like many sentiment surveys, the Conference Board’s inquires about current and future conditions. According to the group’s press release,

“Concerns about current business conditions and the job market pushed the Present Situation Index down to its lowest level in 27 years (Feb. 1983, 17.5). Consumers’ short-term outlook also took a turn for the worse, with fewer consumers anticipating an improvement in business conditions and the job market over the next six months. Consumers also remain extremely pessimistic about their income prospects.”

It turns out that big drops in Consumer Confidence from already low levels can be very good contrary buy signals.  You can see that in the chart below.  Jason considered big drops in confidence when confidence was already depressed; i.e. below 100, the dotted line below.  I’ve draw in circles on the confidence indicator (lower panel) and the corresponding levels in the S & P 500 (top panel) to help you in seeing the connection.

Finally, we believe that markets are going to be range-bound for a number of years, until about 2016, as we deal with a number of issues.  I’ve added some dashed horizontal lines to indicate what might be the trading range, and it looks like extreme lows in consumer confidence might be a good way to determine extremely atractive buying opportunities, while tidbits like this observation should give indications of when to add to positions.

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