Friday, June 13, 2008

Timing the rise of the Phoenix (and market)

Despite my recent bearish tone on I am no permabear. In fact, I am waiting for signs of a market bottom in order to buy Phoenix stocks, a strategy that has yielded some eye-popping returns in the past. Here are some of the different indicators of market direction I am looking at in watching for signs of a market bottom and their current readings:
  • Valuation - neutral/slightly bullish
  • Investor psychology - bearish
  • Economic - bullish
  • Technical - waiting for a capitulation bottom

Valuation: Neutral to mildly bullish
As I write this, the 10 year yield is about 4.2% and the S&P 500 is trading at 21.8 times reported earnings and 14.6 times forward earnings. In recessions, analysts cannot forecast forward earnings well so we’ll throw out the forward P/E. Using reported earnings and plugging the results into the Fed model, which has well documented problems, the market is slightly undervalued.

One of my other favorite rules of thumb in looking for a bottom is the valuation of the investment banks. The investment banks tend to bottom out at a price to book ratio of 1 during periods of economic stress. The major investment banks such as Morgan Stanley (MS) and Merrill Lynch (MER) are now trading at 1.3-1.4 times book, down from about 1.5-1.8 in late April. Lehman Brothers (LEH), which has had well publicized troubles, now trades at a discount to book value, as are some other brokers such as E-Trade (ETFC). The trouble is, of course, we don’t quite know how good the book value figure really is as there may be further write-offs coming down the road.

Despite these mixed signals, the market may not get screamingly cheap as we are likely in a period where the market moves sideways (see previous comment). Based on these considerations, I would rate the valuation metric as being neutral to mildly bullish.

Investor Psychology: Problem sectors not stabilizing yet
I like to keep an eye on the problem areas of the economy in order to time the turn in the market. The troubled industries in this recession are financials and real estate. Employment is another area that inevitably falls off in economic slowdowns. The financials and investment banks may be near levels where they stabilize but these stocks and the other problem groups are still underperforming with no end in sight.

The chart below shows the relative returns of the S&P 500 Capital Markets Index, which is comprised mainly of investment banks, against the S&P 500. The group has been in free fall against the S&P 500 but it is approaching a region that technical support has shown up in the past.

Similarly, the S&P 500 Financials has also been in a relative free fall against the S&P 500 but is nearing a relative support zone.
Other problem areas of the market aren’t so lucky. The chart below shows the S&P 500 Homebuilders relative to the S&P 500. The group is still falling and is has not yet declined to a relative technical support zone.

A similar picture holds for the relative chart of the S&P Supercomposite Human Resources and Employment Index (temp and employment agencies). Any improvement in employment should show up quickly in these stocks.
Economics: Conditions for market rebound present
The first step to recovery is recognition that there is a problem. This June 16, 2008 headline from Newsweek and front page story is an indication that the recession story is now in the public consciousness. There was a similar “Waking up to the Recession” cover in BusinessWeek on March 24, 2008. In the past, an excellent time to buy equities has been when the public recognizes that the economy is in a recession as most of the gloom and doom is already embedded in investor psychology.

Another economic signal I look for is an upward sloping yield curve. The current yield curve is indeed upward sloping, indicating that the central bank is in easing mode – a bullish sign for equities.

Technical: Timing the bottom
Given the current market backdrop, the S&P 500 is likely to decline and test the March low in the next few weeks. Would such a re-test be successful? For that I turn to the technicians. Most technical analysts identify intermediate term bottoms with two components: an emotional panic capitulation sell-off followed by confirmation that the bottom is in place in the ensuing rally.

A classic panic capitulation bottom would be a high volume day with the market trading down for most of the day and then closing near the highs of the day. The flamboyant technician Joe Granville, who correctly issued an all-out buy on the market in February 2003, has been quoted as focusing on parabolics to gauge these extreme moves.

After a capitulation bottom, technicians typically want to see some form of strength on the follow through. This Investors Business Daily article, written about two weeks after 9/11, is a good sample of what to look for at market bottoms.

When I see the panic bottom, the rally follow-through and the a majority of the other valuation, economic and psychology indicators flashing bullish, I plan to plunge ahead and buy the low-priced Phoenix stocks (with the appropriate stops of course) and hang on for the ride.

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