Beginning-of-the-Week Thoughts

I usually go through this exercise–mentally only or on paper–of cataloging my current fears and concerns and why they might be wrong.  This time, I thought I’d do it electronically.

Volatility seems troublingly low

Implied volatility is at levels that, in the past, have suggested trouble for markets, and there seems plenty to worry about.  What’s more, stock markets have moved strongly higher, including something like 30+ days without a correction in the S & P 500.  Volatility is now investable with the advent of iPath S & P 500 VIX Short- (VXX) and Medium-term (VXZ) Futures Exchange Traded Notes (ETN).  Basically, they’re like ETFs in a different guise.  When volatility rises, their prices go up, and vice versa.

Here’s the chart.

A slam-dunk sell, right?

Not so fast, Tiger.  While dips below 20 have also been decent long-term indications of trouble ahead, it was painfully wrong, for a long time, as shown below, and a return to those levels would produce a very painful loss in either of the volatility ETNs.  And, as difficult as it has been to spot mini-tops since the bear market bottom a year ago, one has to be especially careful of using single indicators to suggest bailing.

The weekend “rescue” of Greece by the other European Union nations is only a short-term fix.  The rest of the PIGS–including Greece–are not done squealing.

I haven’t come across much to counter this line of thinking.  Seems to me these are big risks that have been papered over.  Here’s an excerpt from an update from David Kotok of Cumberland Advisors.  He’s a sharp knife, and he thinks the situation in Europe will be resolved okay.

We believe there will be a Greek version of the “hunkering down” outcome. We saw the Baltic version of this process recently in Latvia, where an austerity program cut the deficit in half last year and markets immediately resumed functionality.

Furthermore, we believe the euro will not only survive this test but emerge stronger and more reliable after it. The other EU countries are already moving to improve their fiscal process.

For the present we are underweight Europe in our global portfolios and we are watching carefully before taking a bullish position on the euro. Notwithstanding the recent news, it is still too soon to buy. But when the buying opportunity comes it will come fast, and the nimble will benefit. Surviving this crisis and successfully improving the internal European banking system are the key to the euro emerging as a battle-tested reserve currency.

What we see happening in Greece and in the euro zone is monumental in monetary history.

Maybe one of our bullish datapoints is becoming less bullish.

We’ve had this idea of a bubble in bonds as front and center amongst our bullish data points.  The idea is that, with a record amount of flows into bonds and bond funds by investors fleeing–following a shellacking in stocks in 2008–to safety–the first minus sign in a bond fund investor’s account statement, along with a continued rise in stock prices, and those flows will reverse back to stocks.

Today’s Barron’s had an article titled, “Accentuating the Positive, at Last,” with a sub-title that read,

“Retail investors are finally warming to U.S. stocks, as worries about a double-dip recession subside.  Good news:  one analyst sees the S & P 500 rising another 10% to 15% over the next six months. ”

That article also pointed out that retail (i.e. non-institutional) flows into equity funds were positive for four weeks straight.  And mutual fund managers aren’t letting that cash sit around, which would be a source of buying power.  Recently, Ned Davis mentioned that equity fund mutual funds have their lowest levels of cash–even adjusting for the ultra-low cash yields (which raises the opportunity cost of holding cash)–ever.

What’s more, in at least the 10-year Treasury futures pits, the speculators–this is the group traditionally left holding the bag when markets turn–have their largest ever short position.  They’re very bearish toward the 10-year, and that’s a pretty good proxy for bonds, in general.  I think it’s hard to find a bond bull.

Earnings expectations are high.  Stocks are set to disappoint.

That’s my worry; it’s not the company line. 

Analysts really have high expectations for companies.  According to the consensus of analysts surveyed by Bloomberg, earnings for fiscal 2010 are expected to be 19.9% for the S & P 500 excluding financials; 15.8% for 2011.  In 2010, Financials are expected to show growth of 99.1%; Energy 44.0%; Technology 34.2%.

According to Ned Davis Research, those estimates are in a zone that has, historically, produced per annum returns of minus (-) 3.4%.  Contrarians won’t be surprised to learn that stocks perform best when estimates are the worst.


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