|
11
Oct
|
I wanted to summarize this past historic week with some real metrics, and a discussion on value stocks. Hopefully there is something for everyone.
- The VIX is over 50 for the 5th consecutive day. We broke 75 for the first time on Friday. It is increasing on the daily chart. As a point of reference, in 1987 the VXO was over 75 for 9 straight days, followed by 8 days at over 50. As a relative point of interest, the Oct 1987 crash was 172 on the VXO.
- The TED spread rose steadily all week, and closed at an all time high of ~4.60 .
- We had historical volume yesterday 10/10. The week of 9/15-9/19 also had historical volume for the week, that was an options expiration week. We had the first intraday 1000 point DOW swing in history. 1000 points means we are now in range of a circuit breaker in this low confidence environment. Many of these large scale metrics are continuing to move in the wrong direction and are even accelerating. There is a growing possibility with options expiration being next week, that the worst hasn’t happened yet.
A quick comparative of 2000-2002 to 2007 – present . SP500 Year 2000-2002 . Top to bottom – 25 months
- High 9/1/2000 . 1530
- Downwave Wave 1 – 12/21/2000 . 1254
- Rebound 1 – 1/31/2001 . 1383 +129 . +10.3% . 49% retracement
- Downwave Wave 2 – 3/22/2001 . 1081
- Rebound 2 – 4/19/2001 . 1253 + 172 . + 15.9% 100% retracement
- Downwave Wave 3 – 9/21/2001 . 944 (A year + 20 days = 38.3% retracement from the high. Can’t make this up!)
- Rebound 3 – 1/9/2002 . 1174 + 230 . + 24.3% 74% retracement
- Downwave 4 – 7/24/2008 . 775
- Rebound 4 – 8/22/2002 . 965 +190 . + 24.5 % . 48 % retracement
- Downwave 5 – 10/22/2002 . 768 (which looks to be a retest of the July 24/2002 previous low.)
SP500 Year 2007-Present . Top to bottom currently 12 months. (less than halfway through the time period of the previous decline)
- 2007 High 10/11/2007 . 1576
- Downwave Wave 1 – 3/17/2008 . 1256
- Rebound 1 – 5/19/2008 . 1440 +184 . +14.6% . 58% retracement
- Downwave Wave 2 – 7/15/2008 . 1200
- Rebound 2 – 8/11/2008 . 1314 +114 . +9.5% . 47.5% retracement
- Downwave 3 – In progress… Note the markets high was a year ago. In 2000 down wave 3 ended a little over a year later with a 38.2% retracement.
…
Yesterday – 10/10/2008 – SP500 – Low of 839.80 . +97 point upswing in 45 minutes… 11.6% gain… keep that in perspeective as to where the top of this next current leg may be in the weeks ahead if this turns out to be a short term bottom. The last major high was August 11 and we were at 1313. A 50% retracement puts us at 1076. +236 off the 839.8 low. or a gain of 28.1% that falls in line with some of the major moves of the 2000-2002 SP500 decline which was 230 points in wave 3. The parallels are potentially very similar. As clearly seen yesterday on 10/10/2008, most investors are not going to catch the full measure of any major upswing, especially if they are part of intraday moves, both to the up and down side. The short term bounces above look enticing, but bear market counter trend rallies are especially difficult to play. Most investors will not catch ‘the meat’ of the move, but only a fraction, and that is if they are light on their feet.
*** IN A BEAR MARKET, TECHNICALS TRUMP FUNDAMENTALS. *** THIS IS RULE 1.
Value Stocks- This is the world’s biggest value trap. Most companies have fallen through 5/10 year support levels with increasing volume. Their charts are broken. Any rally or pop is met by investors simply trying to sell into strength in hopes of breaking even, and the old floor which stood for 5 or 10 years will become a difficult ceiling to overcome in this still deleveraging environment which will take months to play out in full. The decline in 2000-2002 took 25 months. It eventually leveled off, but anyone who bought at this stage of the correction, was far too early and took years to make their money back. A 6% dividend yield at a five year high, doesn’t help the owner of a stock that continues to fall another 33-50% over the next year. Investors who are seeking healthy yields will turn to fixed instruments, which do not risk depreciation of their principal. As for the eventual recovery? Take a look at historical examples of how moderate or slow that process can be. Many companies ‘at the bottom’ will sell for current price/book, even price/sales ratios of less than 1. I can pull dozens of examples from 2002 across various sectors, companies who were still great, but no longer making record profits, and had no intermediate term growth prospects. We are not there yet… For value investors- this is not the bottom. It will be months down the road as this forced deleveraging continues it’s course, the economy searches for a foreseeable bottom of the now global wide recession, and this news driven market will create plenty of traps for early longs who think the bottom is in based on any valuation metric. In a recessionary environment with no firm end in sight, investors flee to quality, horde cash, and pay down debts. There are relatively fewer people behind you to prop up the stock price, and even less waiting to bid up that price, no matter what its fundamentals.
The earnings trough- Most companies on a trailing P/E or PEG ratio look cheap right now. It is because it is still early, these earnings numbers may well decline. They have not hit their earnings trough yet. When the companies are in their trough, the E in the equation drops, sometimes dramatically leading to exponential PE ratios (which makes a stock ‘look’ expensive by these metrics.) If trailing earnings are negative, the PE will be negative. Most cyclical and high dividend companies will fall into this pattern. Future P/E for many companies, is still to be determined. Many have to mark down estimates in the months ahead if this credit freeze even indirectly impacts their business. For dividend payers- monitor the company’s cash flow which is where dividends are paid from. As long as cash flows remain adequate and the pay out ratio can be maintained, the dividend should remain safe. GE having to merely maintain its dividend, make a $10B secondary offering, plus an infusion from Buffett, was a giant red flag to future near term expected cash flow.
Cyclical stocks – Long term Investors – Some examples of cyclical value traps (metals/others). AA, PCU, X , POT. These are best viewed through long term linear charts. At the bottom, these companies will not be making any foreseeable profits. Allow the moves the time to finish in the months ahead…
*** What we are watching is the end of the game plan of – borrow short, buy long. This is why a lot of these high dividend stocks are being dumped. Normally, they provide a great (and relatively safe) ‘spread’. This is an easy game when times are good, but when there is a major flight to quality, and people have to de-lever they have to dump the investment, even though it pains them and it’s attractive on a fundamental basis. The US dollar in this time of crisis for the foreseeable future should continue to strengthen, increasing its relative purchasing power. This will devalue assets denominated in dollars, including all the hard assets, commodities, as well as stocks… Until there is a light at the end of the tunnel for a firm economic rebound, in which the US with its firming dollar must lead the world out of, the game plan should remain – cash is king.
Great post. I also don’t think we there yet.
http://social.stocktock.com/profiles/blog/show?id=2348194%3ABlogPost%3A1153
Michael,
Excellent, Excellent post. Thanks.
I take one exception to your argument. This market, at this time, is trading on a derivatives melt down. NEITHER FUNDAMENTAL NOR CHARTS MATTER until the effect of derivatives is faded.
One of the most important tests market will face this week is option related selling. GS and other investment houses ried their margin requirements and sent letters to large funds on Oct 1 and Oct. That and some delta hedging bought us this severe selling this past week. If they are able to stabilize the market this week, we can expect a 1-2 month rebound.
In July expiration, they were able to pull the market up by banning naked shorting and in Sept they pulled it up by banning all shorts. This derivatives monster is too big even for the Federal Govt. handle. One should hope some short-covering this week and some other new trick will save the market.
Many put options sellers are deep under water. If the markets do not rebound significantly next week, we are looking at an abyss on Friday the 17th or Monday the 20th. One positive note is that option put-call ratios improved during the day on Friday. Delta hedging on the upside actually helps markets stage a rally.
October 11th, 2008 at 4:14 pm
Mohan, can you explain that last part?
“Many put options sellers are deep under water. If the markets do not rebound significantly next week, we are looking at an abyss on Friday the 17th or Monday the 20th. One positive note is that option put-call ratios improved during the day on Friday. Delta hedging on the upside actually helps markets stage a rally.”
A put option gives the holder the right to sell an underlying security to the writer of the option, at a specified price, up to a specified date. As I understand it, if the price of the underlying security goes down, the put will rise in value.
So why would the puts be underwater now? And the rest of your train of thought I just don’t get…Please explain!
October 11th, 2008 at 5:51 pm
The puts are underwater from the perspective of the seller or writer of the put. The buyer of the put is doing well, it is the entity that wrote the put that is deep underwater. Usually these are financial institutions, the ones that can least afford to have further stresses.
October 11th, 2008 at 9:36 pm
There are two sides to each trade. Covered calls and puts are never a problem. The guy who sold the puts naked might have done so thinking that it is easy money. His original strategy might have been to short the market if and when market goes down to certain level. This is called dynamic hedging or delta hedging. Under normal corrections, the houses and big hedge funds will have enough liquidity to turn things in their favor and make the options they sold worthless.
What we are witnessing is no ordinary correction. Even big houses are broke. Heck, even the government is broke. Unless this market quickly turns around, those sellers of naked puts on indexes will be broke.
Here is the biggest shocker to me… None other than Warren Buffet (through his Berkshire Hathaway) is stuck in this derivatives mess. This explains why he is so heavily pushing for the bailout. He called this sell off an “Economic Pearl Harbor.” Now I know why.
Buffett’s Berkshire, meantime, fell sharply last week, as its class A shares dropped over $25,000, or 18%, to $113,100. Berkshire’s equity portfolio, which stood at $69 billion on June 30, is falling in value, although it’s ahead of the major averages this year. Berkshire has written, or sold, long-dated put options on some $40 billion of equity indexes, including the S&P 500. Those put sales, which amount to a bullish market bet, are deep in the red, although Berkshire doesn’t have to post collateral against any paper losses. We estimate those puts could have cost Berkshire as much as $2 billion in the third quarter and several billion more dollars this quarter, with the S&P down over 20%. Berkshire ultimately may score with these puts if they expire worthless at maturity between 2019 and 2027. But the normally savvy Buffett made a mistake investing in financial derivatives, about which he has long warned. Berkshire had no comment.
He did this after giving several lectures on ill effects of the monster called derivatives. There goes my respect for the man whom I thought is the most honest man in America.
I heard rumors about Buffet getting stuck in derivatives trade. But I dismissed the rumors. After reading Barron’s article on this, for the first time, I am really scared on how this will end.
Here is the link to Barron’s article.
http://online.barrons.com/article/SB122369310004425503.html?mod=b_hps_9_0001_b_this_weeks_magazine_home_left&page=2
October 12th, 2008 at 3:13 am
Thank you for your comprehensive explanation. I see things much clearly now. I greatly appreciate the time and effort you put in your comments. Learning a great deal from you.
Lets not forget that for the most part we are trying to find a near term bottom that we can trade off. Is the final bottom in? Perhaps, perhaps not, I would tend to think at this point a test of the dot com lows is probably in order as there isn’t really any significant support level where we are sitting now. What I would like to see is a large scale bounce as what is perceived as value is bought. We don’t need to figure out where the true values lie just where they are perceived as being of value as that will (as stated) attract the early /eager value seekers.
If you are a long term investor you can gamble with a small position here because NO ONE really knows where the bottom is until months/years after it has happened. This is still a high risk environment and if you are a long term holder I would actually want to pick up a small position of a few choice stocks here. If this is the bottom, great you’ve picked the bottom, if it isn’t then when we get to what looks like a bottom again I would suggest pushing in another small position into those stocks and lowering you’re average cost. I like to do this using dollar value rather than share size as for the same dollar value you’ll get more shares and end up at a lower price entry. The key point here is SMALL POSITIONS, you never ever ever ever ever ever ever ever ever want to take large risk at dangerous points in the market. This is good risk management and regardless of being an investor or a trader or a swing trader if you don’t manage risk properly you are just gambling.
As Michael points out there is lots to support futher downside after this but what we want to find is a tradeable bounce as the early investors get back into the market on perceived value.
Cheers
Very good analysis.