As we approach the end of September, the spooky month thus far has not lived up to some investors fears. Of course, we still have a week before it actually ends, and to be honest, October's reputation is not much better. Having said that, when examined closer, there is no empirical evidence that unequivocally confirms that either month significantly deviates from the normalized returns over time. But if psychology comes into play, this Halloween could be scary in more ways than one. The action yesterday and the follow through today is not surprising, given that the last few days the market has shown very little desire to push higher, especially as we approach many analysts’ target of 1100 and a psychologically tough level of 10,000 on the Dow. The leadership has changed over the last few month or two, from Financials to Energy and Commodities, which are supported mostly by the weakness in US dollar. Today, we are likely get some rebound in the US dollar as we have a typical official speak of needing a strong US currency, blah, blah, blah. Well, nothing too surprising. RIMM blew up after the close, reporting OK earnings, but clearly disappoint investors with its outlook. I have not been a fan of RIMM for some time, as it should have been obvious even to a 3-year old that a combined competition from Apple’s new iPhone and PALMs new smartphone, plus a crappy Blackberry Storm would not amount to anything heroic. Duh! For the record I was not short RIMM, as it's not really one of the stocks I’ve been following too closely lately. Well, RIMM is one of the bellwether Nasdaq stocks and QQQQ’s so I think it may spill over into other tech and consumer stocks, pressuring the markets tomorrow. But let’s put tomorrow aside for a moment.
So once again, as I do every once in a while I ask myself – where do we go from here? What are we NOT pricing in at current levels?
Looking at major indices, let's examine what the current level is pricing in. At 1050-1100, we are clearly more than adequately discounting the end of recession, a mild economic recovery, and some sequential earnings growth for the next two quarters (seasonally adjusted). To quantify, the market is priced for a 3-5% sequential earnings improvement in each of the next two quarters. For FY09, most estimates are for $50-$55 for SPX and $74-$75 for 2010. This yields 14x-15x forward PE on the index. Certainly it’s no longer cheap, but from a long term perspective, it’s not exorbitant. Investors also seem to be comfortable with $70 oil and USD scrapping the bottom of the barrel. I guess we have also come to accept a looming double digit unemployment, at some not too distant future. So this is status quo for the markets or the base case. The status quo, would like have the market stuck in a narrow trading range, with a slight upward bias. I see a 20% chance of this market just humming along between 1000 and 1100 on the SPX for the next 12 months.
What market is NOT pricing in is a double dip. But the chances of the economy falling back into recession, in my opinion, are not great. If it happens, we would likely see a pullback of roughly 150-200 points in the SPX or roughly a 20% percent correction from this level. I assume there is a 10% chance of a double dip. The government has already demonstrated that it will save the economy at ALL costs, so they will just throw more money at it, if necessary. Stimulus 1-100 will be deployed. Obama to the rescue. Print the money until we run of trees.
The market is also NOT pricing anything more than just a mild recovery. The sentiment is only looking for cost savings driven earnings recovery. A pleasant surprise may come if we actually get sales to recover, as companies with good leverage will get tremendous operating margin expansion. If you believe this may happen, than 2010 estimates of $75 might be a bit on the conservative side. I believe that global economic recovery is on its way, and with a pause here and there the engine will keep going. In my assessment, I assign this scenario a 60% chance. If I am right, I can see the market getting to 1200 over the next 12 months. My confidence also stems from the simple fact that unlike debt-ridden consumer, corporations for the most part did a god job righting their balance sheets, paying down debt, and taking advantage, especially recently to refinance high coupon debt with equity or lower coupon debt. Many have cash-rich balance sheet and guess what, you will see a lot more M&A activity over the next 12 months. This alone could give this market a 3-5% boost.
Finally, the market is NOT pricing in a V-shaped recovery. I am not a buyer of this theory and only give it a 10% probability. However, I am beginning to hear at least a small contingent of people starting to raise a possibility of a strong economic rebound. Well, if they are right, we may actually get another 30%+ from here, as the euphoria will suck even the most cautious investors back into the market. Greed will rule the world once again, ladies and gentlemen!
In my analysis I am not focusing on anything beyond 12 months. I am also operating under the assumptions that the “buy the dip” mentality dominates the investor sentiment. The last three feeble pullback attempts yielded 3.8%, 6.5% and 9.1% respectively. As I am writing this, we are down about 3% from yesterday's high. The ideal pullback would get us down to around 1010-1015, a decent 6.5% selloff. I think the bulls would be aggressively buying this level. But who knows if we even get it down that much. You may disagree with the bulls, and bring forth powerful economic arguments to support your view, but keep in mind that being intellectually right doesn’t amount to being rich. Most sane economic views do reflect a rather difficult economic, fiscal, and political future for US. But to traders, this is purely academic, as one just can’t ignore the real power that moves the market - fear and greed. Well, the fear is all but a distant memory now. The caution is still there, but definitely not fear. The only fear that is still here, is the fear of underperformance. No other major (investible) asset class can even remotely compete with equities. The cash is trash. The move in bonds, for the most part appears to be over, gold seems to be going up on pure speculation (as inflation appears to be less imminent) and real estate..well, you know. With liquidity abound (Thank You Uncle Sam!), it seems to be finding its way into the capital markets, and not to where it should really flow – the real economy. But, I am not an economist, and there are plenty of other posts that address this issue in a lot more detail.
One should understand that there will certainly be bumps along the road. The volatility will most certainly pick up, as the economic and earnings data will be mixed. It’s almost an unwritten law of the markets – the periods of low volatility are followed by the periods of explosive volatility. Use Bollinger bands to help you gauge volatility over time. VIX is another decent proxy that I use. The volatility can kill your portfolio, even though the end target is 15% higher. The sooner you really understand this, the less inclined you will be to only follow gurus with the highest returns. You need to pay attention to how much risk they take to produce these outsized returns. One needs to be especially vigilant during pullbacks. Focus on your portfolios, as concentration in the wrong sector or being caught with too many high beta stocks could bring losses much more severe than the overall market.
Based on the very rudimentary assumptions laid out above, I use a blended probability approach to arrive at the expected outcome of about 14%-14.5% gain, or roughly 1,200 level on SPX by the end of next year. That is my macro anchor and the rest of my work focuses more on fundamentals, technicals, and portfolio management. It is becoming more clear to me every day, that the day of ‘easy’ macro trading are over for now. What I mean is that the individual sector and stock selection will be a lot more important now than during the last 12-15 months, when one could short anything or go long anything and it was only important to get the market direction right. I don’t see these ‘market’ gurus being very successful over the next 12 months.
To that extent, I believe I will be focusing more of my time on what I do best - picking investible themes, and individual winners and losers.
I remain an opportunistic buyer of certain materials, energy, healthcare and emerging markets (mostly Chinese, Brazilian and other Asian equities/ETFs). I try to stay true to my risk management discipline and blow my losses out when they exceed 7%, adjust beta up or down, and double and triple my bets when the risk/reward becomes highly attractive. This happens when several of the Major Market Moving Factors I monitor are lining up in the same direction.
I wanted to share my favorite dozen names, that I would love to buy/add on a pullback. Here is the Maven’s Dozen (not in any order): ANR – best coal play, highly leveraged to metallurgical coal, cheaper than comps; BHI – driller/oil services company, recently acquired BJ Services, making it one of the best offshore, deepwater drillers with international order book. DNDN- the only prostate cancer vaccine that’s hit the phase 3 trial endpoints out of the park, likely to be approved in mid 2010, RINO – a Chinese company focused on pollution removal and wastewater treatment and cheap multiple, REXX – very cheap way to play Marcellus Shale with $6 in proven reserves, all hedged for the next three years. SLB – best way to play oilfield services and rebound in Russian investment in oil exploration. FWLT – infrastructure play, great mgmt and reputation, solid backlog and balance sheet, play on recovery in oil and gas investments. CYNO – bellwether in aesthetics lasers, with $7 in net cash, just waiting for some sort of recovery in vanity spending and easier credit; XTO – my favorite E&P company, 79% of its gas production hedged for 2009 and 29% hedged in 2010, locking in more than $2 billion in free cash flow this year to reduce net debt. STEC - has tremendous market opportunity in enterprise SSDs, strong backlog and visibility, although competitive concerns are a real risk. PWRD – one of the strongest games pipelines, generates tons of CF, cheaper than other major Chinese online game companies, a way to play the growth in broadband penetration and consumer spending in China. APC – another excellent way to play a recovery in nat gas prices. MOS – a potash and fertilizer play, while this year is a throw away, the inflection point is in sight, and 2010 should be significantly better.
As always, do your own due diligence and research. Use technicals to help you determine attractive entry points, have and exit strategy WRITTEN down with both gain and loss in mind.
Apologies for a very long post (I really didn’t post in a few weeks, so have a lot to say). Your comments, as always, would be much appreciated.
Good Luck!
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