Friday, July 18, 2008

Was that THE BOTTOM?

The market action this week showed the classic signs of investor capitulation. The most important sign was the enormous volume seen in XLF. My trading desk sources reported huge buying interest in XLF on Wednesday and Thursday, indicating that there was real institutional money buying the Financials – a sign that these stocks may have seen an intermediate bottom.

Phoenix not rising yet
Despite these bullish indications, I don’t think that this marked THE BOTTOM for the S&P 500 this cycle. I may live to regret this but I am not buying the low-priced, near bankrupt Phoenix stock basket that I described here and here.

Sentiment indicators are bullish
Sentiment certainly got very bearish. Short term sentiment indicators such as AAII got to bearish extremes, which is contrarian bullish. As mentioned previously, high volume market action in the Financials, the most troubled sector of the market, was consistent with capitulation. We also have the news that superbear David Tice is selling his firm, another contrarian bullish indicator.

Low expectations going into Earnings Season
We are also going into Earnings Season with low expectations. Bespoke Investment Group reported on Thursday morning that with 11% of the S&P 500 reporting, the beat rate is 72%. What is most surprising is 34% of the reporting companies have been in the Financials sector, which has been the most challenged of companies in the market. (These statistics are pre-MSFT, MER, GOOG reports after the close Thursday).

Valuations are constructive
As I mentioned before, one of my personal rules of thumb is to look for the investment banks to trade at 1x book value. The stock prices of Merrill Lynch (MER) and Morgan Stanley (MS) did touch their stated book value this week. However, there are well documented problems as to what book really is for a bank and MER reported a $4.6b loss after the close Thursday, which took book value down further.

But long-term sentiment isn't bearish enough
In many ways this has been a classic cycle like the ones we saw in the 1960s, 1970s and 1980s. For the market to bottom, we need some recognition that we are in a recession. This poll is showing that sentiment is getting to near that point but it isn’t quite there yet. Even Europe is weakening and soon there may be nowhere to hide.

Wait for late cycle stocks to weaken
In a classic cycle, the late cycle resource stocks collapse as economic growth slows and inflationary expectations fall. While the near term corrective action in oil prices represent a start, resource stock investors need to feel more pain before this cycle is over. These charts from Bespoke Investment Group show the relative strengths of the different sectors within the S&P 500. While Energy and Materials have weakened, the action in the last two days is barely a blip in the overall trend and that trend needs to be in serious reversal before we can see an overall bottom in the market.

Wrong leadership in the rally
Another important indicator that this is not THE BOTTOM: in past bottoms, we saw large caps lead the way (see chart here). In the last two days of the rally, the small cap Russell 2000 has been the leadership. I would theorize that with an important market bottom institutions jump in with both feet and buy the most liquid part of the market. To put the relative liquidity of the stock market in context, the top 20% of the S&P 500 by market cap represents roughly two-thirds of the weight of the index. If you had a large amount, say $10-20 billion, to put into the market while everyone else is buying, what would you buy?

A bear market rally
After considering all of the evidence, what are we left with?

This has the feel of a bear market rally, which can see the S&P 500 move up 10-20% before the bear market resumes. No doubt there will be volatility as we go through Earning Season but the path of least resistance is up. Enjoy the ride and see this as an opportunity to lighten up your long positions.

No comments: