Monday, July 28, 2008

Mixed signals

The S&P 500 closed at 1234 today, only 20 points above its bear market low of 1214. The recent bounce peaked at 1282 last week, and the market has fallen 3.7% since then. (I hope that the readers who were considering SSO haven't bought any yet!)

Market indicators are giving mixed signals right now. In the bullish column are a recent trend line break, money flow and the McClellan Oscillator. On the bearish side, sentiment is moderately optimistic. In addition, sector breadth, despite the McClellan Oscillator, is less than ideal due mainly to the opposite motions of the energy and finance sectors.

The market may be setting up for a double bottom, which would require a bounce near S&P 1214 followed by a rally above 1282. If that happens, then a medium-term rally will likely follow. However, until those two criteria are met, we should not assume, hope, or otherwise count on the double bottom occurring; it's also possible that the S&P will plow right through 1214 this week on its way to new lows.

So I'm staying in cash for now, waiting for either a reversal pattern (like a double-bottom) or for more agreement among the various indicators.

Wednesday, July 23, 2008

How to use Market Forecasts: Do the Opposite

The following example is almost too good to believe.

On July 16, 2008, Jimmy Lathrop published an article on Seeking Alpha entitled: "Why I'm Committed to the UltraShort Financials ETF." I remember seeing the title of this article on the day it came out, and I thought to myself that I'd never seen the word "committed" used about any investment like that before. It struck me as a contrarian indicator. The charts within the article used the closing prices of July 15th, meaning it was probably written on the morning of the 16th at the latest.

I wish I'd had the conviction to follow through on my philosophy. On the day Lathrop's article appeared, the ETF in question (ticker symbol SKF) fell 20%. It has since fallen a total of 42%, taking SKF from it's all-time high of $203 on July 15th down to $117 today.

Market sentiment, such as one finds in the timing of articles like this, is primarily a short-term indicator, and not necessarily a forecast of long-term bear-to-bull market reversals, so this is not a critique of Mr. Lathrop. Financials may indeed start sliding again and reach new lows, meaning Mr. Lathrop's SKF call would end up with a net gain after all. However, I suspect that his article was inspired by some very strong feelings on his part (and everybody else's) after the huge financial sector losses (SKF gains) on July 14th and 15th - and this extreme sentiment is precisely why SKF "chose" that day to reverse course, if only temporarily. Every potential seller of financials was completely cashed out by that point, so there were no more sellers left.

Of course, it would have been more prescient if someone had written a similar article back on May 2nd, when SKF was trading for only $92, but that's just not how the market works. SKF was cheap then (financials were expensive) precisely because too few people were convinced that it should be otherwise. So the daily tsunami of financial commentary out there is very useful if you can surmise the consensus forecast and then do the opposite.

Tuesday, July 22, 2008

Dow breaks upper trend line

The Dow Jones Industrial Average has now joined the S&P 500 in breaking its upper trend line, so it looks like the bear market rally is official.
I've sold the remainder of my SDS holdings, which puts me 100% in cash.

Sunday, July 20, 2008

Dividends going bye-bye

I've already discussed here how corporate dividends have been giving way to stock buybacks, and how this has reduced the yields and true worth of U.S. stocks. Now, to make matters worse, many companies are actually reducing their already inadequate dividends.

Heather Bell at Index Universe reports that 97 U.S. companies reduced their quarterly dividend payments in the second quarter of 2008, which is the largest number of dividend reductions since 1990. Let's think about what this really means: American companies collectively found enough cash to buy back $171 billion worth of shares in the 3rd quarter of 2007, and more than $1 TRILLION worth in the last 2 1/2 years, but are now unsure of their ability to pay only $70 billion in quarterly dividends. If these companies had saved that trillion dollars instead of buying back shares with it, then they would have plenty of cash reserves now for maintaining their dividend payments during these lean times, and those constant dividends would actually make it worthwhile to buy and hold U.S. stocks. (*gasp!*)

But stocks aren't really investments right now. As far as the average U.S. investor is concerned, stocks are simply pieces of paper that corporations are trying to buy back as fast as they can. Prices are falling this year partly because companies don't have as much buyback cash as they used to. If and when corporations restore their cash flows to 2007 levels, they can resume their buybacks, and prices will rise again. The only trick for you and me then is to predict when this turnaround happens, and to stay out of the market until then. The dividend payments we get for buying and holding simply aren't worth the price.

Thursday, July 17, 2008

S&P 500 breaking trend lines

In the last 3 days the S&P 500 has broken both the upper and lower trend lines of the declining channel pattern.The lower breakout on Tuesday didn't last, with the S&P closing at the end of the day back inside the channel. Today the S&P broke the upper trend line and actually ended the day outside of the channel.

Despite this seemingly inconsistent behavior, it's clear that the market is working on a trend change. Given the mildly bearish sentiment and money flow numbers, a bear market rally is probably in the cards. However, since the Dow and Nasdaq still have significant trend lines to cross, and since sentiment isn't at the bearish extremes of March '08 or August '07, I'm not completely committed to a rally just yet. One of the most troubling signs is that many people have been expecting either a bear market rally or an end to the bear market altogether - and you know what I think of the majority's expectations.

Tomorrow I will sell 50% of my SDS position and keep the proceeds in cash. I'll sell the remaining half if and when I see more indicators of a breakout bear market rally.

Tuesday, July 15, 2008

The crowd is wrong again: Dow closes below 11,000

One of the cornerstones of my investing philosophy is that the majority usually gets it wrong. For example, if most investors think that the market is going to stop falling and start rallying, then the market will probably continue to fall.

My online polls (on the sidebar to the right) are there to see what the majority thinks of the future, and the idea is that the majority will be wrong in these surveys as well. So far the strategy is working pretty well. One poll which closed earlier this year asked readers what they were invested in, and the majority (68%) answered "stocks/mutual funds," which so far have been the worst investments now that the market is at a 2-year-plus low.

Now a plurality has made an incorrect forecast. Another poll of mine which closed earlier this year asked readers where they thought the Dow would bottom-out in the current bear market. I gave four choices in 2000-point increments, and the largest number of respondents (36%) answered "above 11,000." The Dow just closed at 10,962 today, so the method has come though again.

So far in the current poll on gasoline prices, a large majority (62%) thinks that prices will "linger between $3 and $6." This is either good news or bad news, depending on whether the majority are too high or too low!

Don't fight the trend

Iran launches dozens of new missiles!
Iranian missiles are fake!
Oil Rises!
Oil Falls!
Second largest bank failure in history!
Fed rescues Fannie Mae and Freddie Mac!

What do all of these news stories have in common? Answer: None of them caused the S&P 500 to break out of its declining channel pattern.The irony is that the S&P will probably break out during a slow news day.

Not only does technical analysis tend to work, but it's much easier than trying to stay on top of the tsunami of financial and geopolitical news. Over the past couple of weeks I've heard from many people who are jumping back into stocks, citing one reason or another why the bear market is finally over. I've also seen people predicting "bloodbath" crashes following bad news. Neither extreme has panned out. The Market just continues on its merry way.

Don't fight the Fed trend!

Thursday, July 10, 2008

Textbook declining channel

The S&P 500 chart has formed a perfect declining channel pattern.

Every market trend like this has the same fate: it eventually breaks out. In the case of a declining channel, the direction of the breakout usually predicts what comes next. If the S&P breaks through the upper trend line, then there will probably be a limited rally like the one which occurred between March and May. On the other hand, if the S&P passes below the lower trend line, it would probably signal the start of a steep plunge.

Most of the indicators that I watch are still neutral, which implies that a short-term bottom isn't here yet. So I'm sticking with SDS, the ultra-short ETF.

Wednesday, July 09, 2008

A Trillion Dollars Down the Crapper

Today the S&P 500 index closed at 1244, which is lower than the closing price on November 18, 2005.

Stock prices are ephemeral, so nobody can honestly claim to have "money" in an investment account unless he actually sells his stocks and collects the cash. That's why it's incorrect to claim that investors have lost such-and-such amount of money during this bear market. The truth is that not a single dime has been lost due to price changes. Every time there is a stock transaction, a buyer gives money to a seller. The only difference between today and October of last year is that less money is changing hands during the exchanges. The only real loss in the whole process is the brokerage fee.

Dividends, however, are not ephemeral. Dividends are payments of cold, hard cash to stockholders of profitable corporations. As I've discussed in more than one previous post, the last several years have seen corporations replacing dividend payments with stock buybacks - to the point where nearly all of the S&P 500's total earnings have been used up in stock repurchases. The masses of irresponsible talking heads on Wall Street have assured us that buybacks are good for investors, because they reduce the number of shares on the market and push prices higher. I've already pointed out the fallacy of the former point: corporations that buy back shares with one hand are usually giving new shares to executives with the other, so the share count isn't improving as much as advertised.

Now we can safely put to rest the second buyback lie: that investors benefit from them because they make stock prices go up. Remember, the market is lower today than it was in November 2005. In 2006 and 2007, the S&P 500 companies spent over $1 TRILLION on stock repurchases, and that number doesn't include the as-yet untabulated buybacks in the first half of 2008. Since the average price of an S&P 500 stock today is the same as it was before that $1 trillion-plus was spent, we now have a super-sized example of buyback money that had absolutely no permanent effect on stock prices.


So where did that money go? The truth is that you could have collected some of that money if you sold your stocks in 2006 or 2007, because many of the buyers were in fact the corporations themselves. But that's part of the problem. Buybacks actually encourage the savviest investors to sell their stocks! So much for long-term investing.

Loyal stockholders who chose to hold their shares for the long haul collected not one penny of that buyback money. To add insult to injury, they also collected relatively little in the way of dividends. Even worse were those poor souls who actually bought stocks in that time frame, because they were competing with the companies themselves to buy shares, and therefore had to pay the temporarily inflated prices.

Consider what would have happened if corporations had instead given that $1 trillion to buy-and-hold investors in dividend payments like they used to do. One trillion dollars works out to about $3,300 for every man, woman, and child in the United States, or perhaps $10,000 for every household. I'll wager there's not an investor out there who wouldn't mind another $10,000 cash in his retirement account right now. To top it off, there wouldn't have been as much share price inflation in 2006 and 2007, meaning the current bear market probably would have been more mild.

One trillion dollars down the drain.

Right now stocks look more like weekly lottery tickets than long-term investments.

Tuesday, July 08, 2008

Graduation Day

With the S&P 500's drop into bear market territory yesterday, all of the market newsletters that have remained bullish since October 2007 have now officially blown their forecasts. I've been a subscriber of Bob Brinker's Marketimer newsletter for a couple of years now, and it is one of those newsletters that advised their subscribers to remain fully invested in stocks throughout the entire decline. I was already straying from Brinker's advice in June 2007, and I stopped following Brinker altogether in January 2008, so I'm not bitter about the poor forecasting. In fact, rather than rip on him for getting it wrong (like many subscribers are doing now), I'd like to express my appreciation for the things I learned from Marketimer.

The most important message that I got from Brinker's monthly newsletter is that the behavior of the overall stock market is not random, and can actually be predicted on long-term time frames. Most of the readers of this blog have probably accepted this fact by now, but I'll wager that most investors are completely unaware of this. From the moment I realized this truism, I made it my goal to figure out what Brinker was doing behind the scenes, and then to improve upon it.

Marketimer's goal is a simple one: to preserve capital by being out of stocks and stock funds during bear markets (20% decline or more). Brinker doesn't worry about smaller corrections of 5% or 10%, although he has taken advantage of them by signaling favorable times for adding any lump sum of new money to stocks. To predict the future value of the S&P 500, he uses a proprietary algorithm that combines factors like inflation, interest rates, and the average P/E ratio of the market. Some of the factors that Brinker takes into account seem like overkill; for instance, he actually keeps tabs on the esoteric money supply numbers. More to the point, now that he's missed a bear market forecast, his model obviously has shortcomings.

My first foray away from Brinker's method was in the summer of last year. Brinker was bullish as usual at that time, but my budding timing skills told me that a correction was imminent, and I cashed out of the stock market in mid July. A correction indeed followed, and I went back in 100% in late July, a bit earlier than the correction bottom in August. By October I had learned a great deal more, and when Brinker predicted that the S&P would rise to the mid-1600's in his October newsletter, I was again anticipating a correction, and I emailed a sell signal to friends and family on October 5th. The market top was 4 days later on the 9th.

Despite my success at out-timing Bob Brinker up to that point, I still used his newsletter as a safety net, figuring he must still be better than me in the long run. After all, he's Bob Brinker. Who the heck am I??

During that same period in the latter half of 2007, I was noticing very negative macro issues in the market that nobody else seemed to be talking about - including Bob Brinker. The dividend yield of the S&P 500 had been historically low for several years, and I was wondering: "shouldn't the market eventually drop back down to restore normal yields?" I also realized that certain market sectors were starting to fall while the rest of the S&P 500 was still rising. First it was REITs that turned south, then dividend-paying stocks followed, and finally the value half of the market started to dive. Brinker never mentioned any of it.

I also knew that corporate stock buybacks had been increasing astronomically for several years, to the point where companies were using almost all of their earnings to re-purchase stocks. It walked, talked, and smelled like a buyback bubble to me, and that would mean (1) that stocks are overvalued now thanks to the extra buying pressure, and (2) that when the buybacks eventually ebb, it would pull the floor out from under prices and the market would collapse. But nobody was talking about it.

So when the November 2007 market swoon came around, there were conflicting ideas in my head. My own understanding of market signals, technical indicators and fundamentals told me to fear for the future and stay out of the market, but Brinker's November newsletter was as rosy as ever, still sticking to the 1600's forecast. By the time the S&P dropped below 1400 in January, I realized it was time to take off the training wheels. That was the moment I graduated and stopped following Marketimer.

I now realize that market gurus like Bob Brinker rely too much on economic forecasts and market fundamentals - neither of which are very reliable predictors of future market performance. There are far more prescient indicators of the market's direction, and they have little to do with earnings per share or GDP growth rates. However, even though Bob Brinker doesn't use them, and even though he has now been completely surprised by a bear market, I still owe him a debt of gratitude. I wouldn't be the market timer that I am today without getting the idea from him in the first place.

Monday, July 07, 2008

Congratulations - It's a Bear!

By an amazing coincidence, the S&P 500 index closed today at 1252, the precise threshold of a bear market. This is exactly 20% lower and 9 months after the October 9 high of 1565. With the Dow already in bear territory, there's no denying it any longer: we are in the second bear market of the decade.

It's not unheard of to have two or three bear markets occur within 10 years of each other. Notable bear market groups now include:

1961-70 (three bears)
1966-74 (three bears)

In fact, looking at that list, I'm inclined to think most bear markets occur in groups.

By the way, most of the indicators I look at are saying that there's still room to fall from here before the next short-term/sucker rally. My long-term forecast made in January still calls for the S&P to eventually fall to 940.

Thursday, July 03, 2008

Buy and hold and lose.

The S&P 500's close of 1261 on Wednesday was lower than the closing price of 1272 on January 6, 1999.

With an average dividend yield hovering around 2% for more than a decade, the U.S. stock market has been a poor investment since the mid-1990's. The rallies of the late 90's and mid-2000's were really just speculative stampedes that had more in common with pyramid schemes than any fundamentally driven price appreciation. Many people thought buying stocks in October 2007 was a good idea - not for the dividends, but because they thought prices would just keep going up.

I'm not really complaining for myself. Sure, I would rather have access to a universe of stocks with yields of 4% or 5%, but in lieu of that I'm happy to surf both sides of the speculative waves now that I can anticipate them. I only wish that the average ma and pa investor could do the same. Instead, armies of financial planners have been telling those 401(k) investors to buy and hold their overvalued stock funds throughout this entire period. Shame on these "professional advisers." They're supposed to know what makes a stock worth holding, and they should have known better.

Wednesday, July 02, 2008

On the precipice

The stock market crossed a few important barriers today, but I think the most critical goalposts still lie ahead. The Dow 30 index has finally closed in bear market territory, (down more than 20% from October 9) but the S&P 500 is still 9 points away from an official bear. For its part, the S&P 500 ended today with the lowest closing price since July 2006, but it hasn't yet passed below the intra-day low of 1256 reached on March 17 of this year.

I'm convinced that the S&P 500 index level of 1252 remains key to the resolution of the current market downturn. A close below that level would mark a new multi-year low for the S&P, and would place both major indexes in an official bear market. Then we might see some real panic.

Stay tuned!