“If you don’t change your indicators for the changing causal relationships you are doomed!”
In past missives I have discussed why I do not believe the Cyclical Adjusted Price Earnings Ratio (CAPE) is a good measure of valuations. The problem is that the CAPE uses a 10-year backward looking average of earnings. In the current case that means it incorporates the 2008 earnings disaster, which in my opinion was a six standard deviation event that is not supposed to happen in our lifetimes. Therefore if you want to use the CAPE as a valuation tool it probably makes sense to wait until 2019 when the 10-year trailing average of earnings normalizes. Similarly, Warren Buffett’s Market Capitalization to GDP analysis also does not make sense to me as a valuation tool. As previously stated, the problem here is the U.S. government adjusts the GDP numbers for five years. I used to use the attendant slide in presentations. It lists all the changes made to GDP for five years after the initial report (see chart 1 on page 3). By the way, I include 1985 as it is my all-time favorite on how wildly the numbers swing. In 1985 the GDP number was revised from +0.3% to +4.9% five years later. Therefore, anyone who sells or buys on what the U.S. government tells you happened in the first or second quarter of this year is putting way too much emphasis on near-term noise. If you want to know what GDP was for 2014, ask me in 2019.
Last week I received a number of calls from the media about the much heralded Hindenburg Omen. Those calls resulted from the triggering of the Hindenburg signal that occurred on September 18th and 19th. Given its ominous name, the media loves to trumpet such a signal. For the signal to be valid four properties need to happen. First, the D-J Industrial’s (INDU/17113.15) 50-day moving average (DMA) needs to be rising. Second, the number of new 52-week lows has to be at least 2.2% of all issues traded and changed in value. Third, the number of new 52-week highs must also be at least 2.2% of issues traded and changed in value. And fourth, the NYSE McClellan Oscillator must be negative. All of those metrics were met six sessions ago. Over the last three decades the odds of a major stock market crash following such a signal stand at around 30%, while the odds of a sharp decline of 10% are pegged at roughly 50%. However, while in the past the Hindenburg Omen has a decent track record, in more recent history it does not. For example, in August 2010 a Hindenburg signal was registered, yet the S&P 500 (SPX/1982.85) tripled following said signal. The problem with this indicator is that the number of closed-end funds, exchange-traded funds, preferred shares, and other fixed income centric securities masquerading as equities skews the new high/new low statistics. Nevertheless, the Omen brought on numerous questions not only from the media, but from many of our financial advisors and their clients about, “Is this the beginning of a bear market?” So rather than continue to respond to each question, I decided to write about it in this report. I like this story.
The year was 1971 and I had just been hired into this business on Whitehall Street in New York City. It was Camelot when we used to walk down the stairs from the American Stock Exchange floor into Harry’s at the Amex Bar & Grill. The exchanges used to begin trading at 10:00 a.m. and stopped trading at 3:30 p.m. I was dutifully sent out every morning at 9:30 a.m. to fetch coffee and danish for the traders on the desk. As I walked out of the trading room I would pass by my CEO’s office. It didn’t take too many passes for me to notice there was a big red number 4 artfully painted behind his desk roughly half way up the wall. After six months I finally summoned the courage to ask him what the “red 4” meant. As he tilted back in his chair, and with a fatherly smile, he said, “Kid, that’s the number of bear markets you will experience in your career. Don’t ever forget it!” And, I have never forgotten those sage words. So let’s count. I have lived through the 1973-1974 bear market, the 1981-1982 affair, the 2000-2002 debacle, and the 2007-2009 crashett. That makes four bear markets. Therefore, if my first boss was anywhere right there will not be another bear market until I retire, which should be no time soon.
Still, last week the “bears” came out of their caves emboldened by the back-to-back Monday/Tuesday two-step of -107 and -117 point sessions. Wednesday saw a 154-point gain for the INDU, but I told trading types to ignore the dead-cat bounce rally. Comes Thursday and the Bear Boos reached a crescendo with a Dow Dive of some 264 points, which brought the senior index down to its 50-DMA (16939.19), but it did not break that moving average. However, the SPX did break below, and closed below, its respective 50-DMA (1976.76), setting up a downside non-confirmation. Thursday’s Thumping also registered an extreme oversold reading from the NYSE McClellan Oscillator and qualified as a 90% Downside Day. Recall a 90% Downside Day is when 90% of all points traded, and all volume traded, comes in on the downside and is indicative of panic selling. This was the first 90% Downside Day since this year’s January/February 6% decline that occurred during its bottoming process. Often such 90% readings are associated with a short-term trading bottom and that’s what happened on Friday as the SPX gained 16.86 points, and in the process the SPX recaptured its 50-DMA. Typically, 90% Downside Days are followed by a recoil rally lasting two to seven sessions. Also of interest is that the Short Term Trading Indicator registered a signal of extreme oversold conditions of 50. Then too, the Volatility Index (VIX/14.85) spiked higher last week, suggesting the potential for a change of trend.
To me, the equity markets have not felt right since July despite the Dow Theory “buy signal” of a few weeks ago. In past missives I have written about the negative divergences and particularly about the junk bond market crash. As can be seen in the nearby charts, the correlation between the two has been remarkably high until recently. The junk bond complex began declining in July, and while the Russell 2000 (RUT/1119.33) has fallen pretty much in lock-step with junk bonds, the SPX has not until last week. Also of note has been the U.S. dollar strength. Since 46% of the SPX’s revenues are international, the greenback’s strength has caused forward earnings estimates to be reduced (see chart 4). Hereto it is worth mentioning that a stronger dollar is an effective tightening of monetary policy. Speaking to the sectors, the only macro sector that is short-term oversold, at least by my work, is the Energy complex. The energy space has been bludgeoned since July with a number of stocks off more than 30%. One stock from Raymond James’ research universe that has been particularly punished has been Goodrich Petroleum (GDP/$15.33/Strong Buy), which has declined significantly from its recent high, prompting our fundamental analyst John Freeman to write the following in his company comment of September 2, 2014:
We reiterate our Strong Buy on Goodrich as the Tuscaloosa Marine Shale (TMS) picture becomes clearer with each subsequent well result. Our rating upgrade last month was predicated on our belief that the core of the play had been defined following a series of step-out wells. ... The upcoming Bates 25-24H-1 well can potentially expand the acreage credit we are giving Goodrich as that well is being drilled right at the 11,000’ depth horizon (natural fracturing will be better, but the shale will be thinner than what is present in the core). The other three upcoming well results are all being drilled right in the fairway of the play. These wells should provide further support for the core of the play (and where all of our current NAV value lies).
The call for this week: I will be in NYC, Montreal, and Toronto seeing accounts and speaking at various events this week. If past is prelude something big will happen when I am out of the country. My guess is that it will be the U.S dollar. Ever since the dollar got strong commodities and precious metals have been socked, and the SPX has basically been stuck around 2000 for three months. The dollar is currently the most overbought it has been in decades. Watch the Dollar Index, if it makes a trading top and begins a pullback look for a rally in stocks, as well as commodities. This morning the SPX futures are down again (-9.00) as U.S. air raids in Syria kill civilians, seven Ukraine soldiers are killed despite the alleged ceasefire, and the Swiss show the good sense to vote down the equivalent of Obamacare (http://news.yahoo.com/public-versus-private-swiss-mull-health-system-shift-073917245.html;_ylt=AwrBJSAxZihUJXUA8YHQtDMD). I continue to think 1965 to 1970 is the key level for the SPX.