Thursday, January 31, 2008

February Forecast: Flat or Fool's Trap

Given the S&P's 6.1% drop in January, the forecast for February doesn't look good. Since 1950, every January drop of 5% or more - except one - was followed by an unremarkable February performance of between -2.5% and +0.9%.

The only exception to this January-February trend was in 1970, when a 7.7% drop in January was followed by a 5.3% rally in February. However, this rally was a sucker trap, as the market proceeded to fall 22% through March and April of that year, completing a -35% bear market.

Party like it's 1946.

The current market decline is looking more and more like the prelude to the 1946 market crash, the only difference being the magnitude and speed of the decline.


The pattern this time is progressing more slowly by about 2-to-1, but the dips and bumps are larger on a percentage basis. By this point in 1946 the market had fallen 8%, while today the market is about 15% off of its October '07 high.

What followed after July 1946 made the prelude look like a walk in the park, as the market fell a total of 22% from its preceding high:


This time I expect the crash conclusion to be proportionally larger, with the bottom around 40% below the high mark.

If the market continues to follow the 1946 pattern (and that's a big "if"), then the current rally will continue until the end of February, reaching about 1450 on the S&P. After that we would expect a free-fall through March and April to the target price of Dow 8500/ S&P 940.

(One of ) the worst Januarys in History

Ariel Nelson reports on CNBC that the S&P 500 is headed for its worst January in history. January has historically been one of the best months in the stock market, so just having a down month at all is newsworthy, and it doesn't bode well for the remaining eleven months of 2008. According to Nelson, the Dow has fallen 5% or more in only 11 previous January stretches, and the average stock market performance for the remainder of those years was -.05%.

Here's my own look at every sub-5% January since the birth of the S&P 500 index in 1950:
  • January 1960 (-7.2%) was part of a -12% correction that spanned Aug. '59 to March '60.
  • January 1970 (-7.7%) was part of a -35% bear market lasting from Nov. '68 to May '70.
  • January 1977 (-5.1%) and 1978 (-6.2%) nearly marked the beginning and end points of the same -19% correction.
  • January 1990 (-6.9%) initiated a -18% correction which ended in October of that year.
  • January 2000 (-5.1%) was followed by an 8% climb to an all-time high on March 24, after which the S&P 500 suffered a -48% bear market.
Using the Dow 30 to look further back in time, there are two more January declines of note since 1929:
  • January 1939 (-7%) was part of a -23% crash from Nov. '38 to April '39.
  • January 1941 (-5.5%) occurred near the beginning of a -32% bear market which ended in April '42.
The grand average of the crashes and bear markets listed above is a 27% drop from top to bottom. As of today the S&P 500 is 13% off its October high, so history tells us that we probably have further to go.

Saturday, January 26, 2008

The Buyback Bubble Motherload

Excessive share buybacks have reduced dividends and caused U.S. stocks to become over-priced relative to their payoffs, and I'm convinced that the current crash represents the recognition of this problem by investors. A good medium-term play would be to sell short the companies with the largest buybacks in order to get the maximum payoff from this decline.

The Power Shares Buyback Achievers fund (ticker PKW) is an ETF which has collected all of the worst buyback offenders into one basket, allowing investors to buy them (or short them) as a group with one click. Companies have to buy back at least 5% of their shares per year in order to be included in the fund's lineup. Not surprisingly, the dividend yield of the group is anemic - less than 0.5% - and that makes it particularly attractive for selling short.

This ETF includes some well- known powerhouses. Microsoft, Exxon, Time Warner, Goldman Sachs and Prudential together comprise nearly one-quarter of the holdings. At first glance it might seem crazy to bet against this group of titans, but it makes sense when you consider what's been happening over the past few years. These companies have been generating enough cash to buy back 5% of their own market capitalization every year. In the best case scenario, without any options dilution, these buybacks have been increasing shareholder stakes in the companies by 5% per year. Thus, after 4 years of buyback activity, long-term investors now own 22% more of these companies, and have been collecting (best case) a 0.5% dividend yield in the meantime.

Had these corporations paid dividends with that money instead, investors would have been pocketing at least 5% per year in cold, hard cash. The question is: would investors rather own $1000 of a company that pays a 5.0% yield ($50 per year), or $1,220 of the exact same company paying a 0.5% yield ($6 per year)? That 8-to-1 difference exemplifies the dividend bubble, and I think it is the reason why investors are finally heading for the exits. If I'm right, then PKW should be hit harder than most in the coming months.

Currency Harvest finally paying off?

I pointed out in a previous post that the Currency Harvest Index (which uses the "carry trade" strategy) performs very well during bear markets, but that otherwise its results are unimpressive. The Currency Harvest Fund (DBV) tracks this index, and it's been following the S&P 500 pretty closely for the past year:

However, just recently the fund has veered off significantly from the stock market's trajectory. In the past month, DBV is down only 3% compared to the S&P's 11% loss.

If you already believe that we are in a bear market, then this recent behavior supports the notion that DBV may be a stellar investment for the next several months. On the other hand, if you're not yet convinced that we are in a bear market, then this brand new disconnect between DBV and stocks may be one more piece of evidence that the bear has arrived.

Friday, January 25, 2008

The World Crashing in Harmony

Here's more evidence that the market's current decline is not like all of the other corrections that we've had over the past few years:

The S&P 500, Europe and Japan, (EFA) and Emerging Markets (EEM) have all been falling in virtual lock-step since the S&P's October 9 high. The same is true if you break the market down by large/mid/small cap or value/growth.

If you look back at previous corrections, you won't see this cozy herd behavior in the indexes. Emerging Markets had been leading the charge in previous dips - diving more steeply in the beginning and remaining well below the S&P and EFA until the correction had ended. This time around, Emerging Markets actually continued to climb gradually for several days after the S&P had already begun its descent. And now, incredibly, all indexes are still within 2% of one-another.

This can only mean one thing: for the first time in a long while, investors around the globe are buying and selling all stocks as a block without differentiating between them. Call me crazy if wish, but that sounds a lot like long-term investors pulling their money out of global index funds.

Thursday, January 24, 2008

Throwing money around

Congress and the President have just agreed to pay taxpayers $150 billion increase the national debt by $150 billion to help stimulate the economy. And they're doing this in an election year ... what a shocker!

If you've ever wondered what qualifications are required to be a politician, now you know that basic math skills aren't among them. If the much-feared recession actually materializes, then you can be sure that Congress will be spending even more on various social programs to "help those who have fallen on hard times."

Here's the best part: this gigantic federal budget of Medicare, Medicaid, Social Security, "Income Security" and other entitlements is increasingly being funded by foreigners who buy U.S. treasuries to collect the interest. But the Federal Reserve Bank has been slashing interest rates lately, meaning they are effectively reducing the interest paid to new treasury buyers. It's hard to imagine why any European or Asian investors would want to invest in either U.S. stocks or U.S. bonds right now, especially if inflation starts to rise.

Wednesday, January 23, 2008

What stock buybacks actually accomplish

In a nutshell, stock repurchases or "buybacks" are just a way for corporations to pay executives and other employees at the stockholder's expense.

At first glance it looks like companies are paying money to loyal shareholders when they buy back shares of stock. However, don't forget that companies also give stock options to executives and other employees, and these options end up putting new shares of stock back in to the market. When an executive exercises his stock options, he is essentially getting brand new shares of stock for an older, lower price, and then immediately selling them to the market at the higher current market price.

When you follow the shares and the money, it becomes obvious that there are two oppositely-directed cycles at work. In the first cycle, shares of stock go (1) from the market to the corporation in buy-backs, (2) from the corporation to the employee when options are exercised, and then (3) right back to the market when the employee sells for a profit.

In the other cycle, money goes from corporations to the market in buybacks, and then on to the employees who are selling their brand new shares. Since the employees in effect bought these shares from the corporation at bargain prices, there is a net flow of money from the corporation to the employee by way of the stock market. Outside shareholders may hear lots of news about all of the money being spent on share repurchases, but in the net they get Bubpkis.

Many well-respected market gurus have touted the benefits of buy-backs, including their tendency to raise share prices, but higher prices don't help new investors who are just starting to buy stocks. Besides, we are being reminded now of just how ephemeral prices can be. When the market returns to 2004 prices in a few more weeks, buy-and-hold investors will be pondering just where all of that magnificent buy-back money went.

If corporations simply gave half of their dividend profits to executives in the form of bonuses, without the pretense of "buying back shares," then at least the market would have been able to correctly price stocks without having to suffer the current crash.

Tuesday, January 22, 2008

Prediction: Dow 8500, S&P 940

If the current market crash behaves like the crashes of 1929, 1946, 1961-2, and 1987, then it will bottom-out around Dow 8500 and S&P 940. Not all of the market bottoms in that list were final; in some cases the market paused for several months before falling even further. The low reached in 1929 was only temporary. Several months later the market continued to fall even further but at a slower pace. In 1987 on the other hand, the market nadir was a real one, and it was a golden opportunity to buy back in to stocks.

In terms of economic causes for the current crash, I think there are characteristics which are a mix-and-match of some of those in 1929, 1987, and the 2000 bear market onset.

In 1929 the stock market was overvalued by investors who were allowed to buy $9,000 worth of stock with only $1,000. The economy had been growing quickly in the 1920's, and it was the stock market crash and the resulting loan defaults and bank failures which actually triggered the great depression. Today the stock market is overvalued because corporate stock buybacks have resulted in reduced dividends, (the true worth of a stock) and have artificially inflated prices with additional buying pressure. News of an economic slowdown was already in the air in the fall of 2007, and the slow unwinding was probably the spark which finally triggered the crash that was waiting to happen.

The year 1987 was not particularly bad for corporate profits. Earnings had pulled back a bit in 1985 and were flat in 1986, but they were on the verge of a late-1980's surge. The only problem in 1987 was an over-valued stock market which had nearly doubled in value in just 2 years. After the crash in October of that year, the stock market and the economy both continued on their merry way upwards. If corporations start paying their dividends again, and if the economy doesn't shrink too much, then today's crash could ultimately resolve in the same way.

The year 2000 featured an historically over-valued stock market and a booming economy on the verge of a recession. The over-valuation was due in part to a breakdown in the system of earnings reports and forecasts, which left many investors to believe that profits were larger in both size and rate-of-growth than they actually were. By 1999, "experts" were even trying to convince people that P/E valuation no longer mattered, and that the sky was the limit for stock prices. When the first rumblings of recession began to reveal the lies, investors grudgingly pulled out over the next couple of years. Today the obfuscation is not in the earnings reports or forecasts, but in the idea that buy-and-hold investors still get their fair share of the earnings. They don't, because companies have stopped paying dividends to buy-and-holders in favor of paying day traders to sell their shares.

Coincidentally, a return to Dow 8500/ S&P 940 levels would raise the dividend yield to the 3.0% - 3.5% range, which is finally back in the historically reasonable range of 3% to 6%. The market must at some point return to the even higher 6% yield level, and that would require a drop to Dow 5000/ S&P 460 today. On the other hand, corporations could stop their idiotic buyback frenzy and go back to paying dividends, and that would double the market's dividend yield overnight even if prices didn't change. But I don't think that will happen until Congress or the SEC act to limit corporate buybacks.