Market Action Feels Like 2001

Midway through the 8th day trading day of October, we have our 7th down day of the quarter. This market feels a lot like the painful one we experienced in late 2001. The culmination of the Nasdaq bubble bursting, the outbreak of SARS, and the 9/11 terrorist attacks led to an environment that felt as though it would go down every day and never end.

Today we have a similar scenario. Stock prices are indicating that 1) gasoline prices will remain at $3 per gallon even as refineries come back online in the coming weeks and months, 2) natural gas prices will remain high even after the winter season passes, 3) consumer spending will be poor during the holiday season and every season thereafter, and 4) the Fed will continue to raise interest rates forever. Add to it that we are in the historically poor performing month of October, and it feels like no end is in sight.

Like in 2001, today I wish I was a trader in these environments, not a long-term investor. As a trader you can just go with the trend and short this market. As a long-term value investor you need to buy stocks as they fall, knowing full well they will most likely fall further before they rebound.

However, I know that as a short-term trader I would not have been able to profit handsomely from some very contrarian bets. Shares of Royal Caribbean (RCL) fell from $30 to $8 in 2001 after leisure travel was halted in the United States. Four years later the stock closed 2004 at $54 per share, for a gain of 575 percent.

In the end, sacrificing the short-term for the good of the long-term can yield outstanding rewards. The key is stick to your convictions when it hurts the most. “No pain, no gain” rings true in the stock market as well.

Ugly Market Could Soon Be An Opportunity

Market psychology in October is never very good, based on what have been some pretty lousy performances in 1987 and much earlier during the Great Depression. Combine that history with the fact that markets rarely do well in the middle of earnings season, and a continuation to the downside short-term could present an excellent opportunity for investors.

The markets are jittery right now due to inflationary fears, which I think are very warranted. There is little doubt in my mind that Fed Funds rates will be at 4.25% by year-end. As far as 2006 goes, it all depends who succeeds Alan Greenspan. If an inflation hawk steps in, rates could very well go even higher if commodity prices keep rising and the government continues its insane spending.

Despite that somewhat gloomy backdrop, corporate earnings have held up okay, and estimates right now are for the S&P 500 companies to earn $85 in 2006. While that number is by no means assured given the current economic environment, the P/E on such estimates right now is only 14x.

If the recent slide continues, and we get the S&P 500 back down to its support level in the 1135-1150 area, all of the sudden the forward multiple is 13.5 times earnings. A lot of good things could happen if we see that kind of valuation (not seen in years) combined with a technical support level holding and a seasonally strong period (November through April) set to begin after we get through third quarter earnings reports. Continued weakness in crude oil prices would only help that scenario.

Two-Year Run Looks Impressive

It probably hasn’t felt like it to the average stock market investor, but the last 2 years have been pretty darn good. From the chart above we see that the S&P 500 has rallied 25% in the last 24 months, above the historical average for the equity market.

After such a run, it feels right to take some profits off the table. However, when you look at the current forward P/E on the S&P, it’s easy to wonder if we have more to run. Right now earnings estimates for the index are north of $80 on an operating basis for 2006, giving the market a P/E of around 15. That hardly screams “sell” even if energy and housing stocks have contributed a large amount of those earnings gains.

So, what do we do from here? Well, the S&P is retracing the recent move up and will soon test the breakout of 1,220 it made last month. If that level holds, the market might be okay despite a very impressive move in the last 24 months.

How high can we go? Well, I wouldn’t be overly bullish. I doubt we would see a P/E of more than 16 in this market environment, which indicates upside to 1,300-1325 area on the S&P, if all goes well. Hardly huge returns from here. All in all, it’s likely prudent to be fairly defensive here, given upside potential is likely only in the single digits on the major market indices.

Fortunately, Sentiment Indicators Remain Low

The UBS Investor Optimism Survey was released today and continues to point to extremely bearish investor sentiment. This contrarian indicator, coupled with record high short interest on the New York Stock Exchange, show the upward potential this market continues to have. According to the UBS Survey, investor optimism hit its lowest level since May 2003. The above chart shows how the S&P 500 has performed since then. The index has risen nearly 33% in just two years.

Despite Headwinds, Record Short Interest Suggests Future Strength

Short interest on the New York Stock Exchange rose to record in the month through April 15, according to figures released in late April. The NYSE said short interest rose to 8.44 billion shares, up from the previous record of 8.42 billion shares on March 15, and was equal to 2.3 percent of total shares outstanding.

Despite $50 per barrel oil, higher inflation, and a Fed that many believe will continue to raise the Fed Funds rate to 3.5% or 4.0%, these numbers from the NYSE are too glaring to ignore. Bearish sentiment is one of the most reliable historical indicators of future price appreciation in the stock market. In fact, the 2005 short interest record shattered the mark set in late 2002. A quick look at what the market did after that makes the case even more compelling.

A Double Top on the S&P 500?

I rarely put much emphasis on technical analysis of individual stocks. Reading charts can work, but only in the absence of material new information. Without meaningful newsflow, technical indicators will often hold up because everybody is looking at the same thing and traders will act similarly, thereby allowing the technical analysis to become a self-fulfilling prophecy.

However, as soon as the company reports earnings, receives an analyst upgrade, or announces a merger (among dozens of other possible catalysts), chart reading goes out the window in favor of a necessary revaluation of the company’s shares based on new revelations.

With indexes, however, technical analysis has a bit more merit. Many hedge funds trade the indexes as a whole, as well as individual stocks. Newsflow for an entire index, the S&P 500 for example, doesn’t occur. The S&P doesn’t report earnings. Wall Street research departments don’t have analysts covering indexes. As a result, the double top that formed recently on the S&P 500 could be concerning.

Traders focused on indexes could very well use that formation as a reason to sell, and not only their index ETF’s and futures, but their stock holdings as well (based not on company fundamentals but rather index technicals). Despite a nice move higher in February, the market is still down for the year, as January’s drop has yet to be fully recouped.

If we can’t break the overhead resistance in the 1,212-1,213 area on the S&P, the recent rally might not continue very much longer. Interestingly, the market opened the year at 1,212, which turned out to be the high for this week before we headed south once again.

Market Struggles Out Of The Gate In ’05

It looks like the stock market may fall in each of the first four weeks of the new year, a feat not accomplished in many years. January is supposed to be a seasonally strong time for stock prices, as pension fund and retirement account contributions flood the trading floors. Not so this year. It looks like the huge rally we saw in November and December has run out of steam. Take this morning for example. Blowout earnings from Microsoft (MSFT) and the announcement of yet another promising merger; Gillette (G) to be bought by Proctor and Gamble (PG), and yet the market can’t trade up.

Perhaps it’s the Iraqi election that is holding us back. If Sunday goes well, maybe the market will rally strong next week. If not, the many optimists who predicted a 10 percent market gain in 2005 may very well be disappointed. We definitely need some kind of catalyst soon, as the short term action looks bleak.

Despite a poor outlook for the broad indexes, don’t think you can’t make money if you know where to look. This truly is, to use a terrible cliche, a “stock picker’s market.” Oil prices are near $50 a barrel. Energy stocks like Suncor (SU) are still cheap. There are many financial stocks that carry p/e’s under 15 and pay nice dividends. Small caps still fly under the radar most of the time, providing below-market valuations but above-average growth prospects.

And always use overreactions after an earnings report to your advantage. Verisign (VRSN) fell 15% after hitting its Q4 targets and slightly raising its guidance. Wall Street wanted more upside to the numbers and slammed the shares, but that was wrong. Now you can pick up the stock for $25 a share, giving it a p/e of 25 with a 30 percent projected growth rate for 2005.

With the S&P Crossing 1200, Gains in ’05 Could Be Limited

The S&P 500 closed today at 1203, its highest level since the third quarter of 2001. The market’s strong rally in the last five weeks clearly has boosted morale on Wall Street, but can we expect this upward move to continue?

Unfortunately, it doesn’t look like the market has a lot more room to run. Earnings are expected to rise about 8 percent in 2005, and the S&P 500 trades at 17.2 times the current $70 earnings estimate for that index, hardly cheap.

If we take an aggressive profit growth forecast of +10 percent for next year, and put a fairly rich 18x multiple on that, we get a 1300 target on the S&P, about 8 percent higher than where the market stands today. Much like 2004, next year should prove to be another solid year for stock-pickers, but an uneventful year for index fund owners.

There are still several issues that could derail continued economic growth in the coming months; sustained $40 per barrel oil, Middle East trouble during the January elections in Iraq, as well as the fear of rising inflation and/or interest rates. All in all, it makes sense to be cautiously optimistic as investors structure their portfolios for the coming year.

History Suggests Strong Market in 2005

If you’re a numbers person, a history buff, and an investor, you will most likely find the following numbers very bullish for the coming year on Wall Street. Now, I’ll be the first to point out that I really don’t think the numbers below will really have an effect on the stock market’s direction next year. But, they are interesting and should, at the very least, peak one’s curiosity as to whether or not it is simply a coincidence that years ending in a “5” have traditionally been great for investors.

Most of us know that the historical average for stock market returns has been about 10 percent per year. Interestingly, since the Dow Jones Industrial Average was created (1897 by Charles Dow), there has never been a year ending in the number “5” in which the Dow lost value. In fact, no such year has ever failed to beat the historical average of a 10 percent gain. In fact, these years have come and gone 10 times and the Dow has averaged a gain of 34.6 percent. I have not taken the time to investigate why this may be the case, but let’s hope the trend continues. Here are the numbers for the Dow:

1905: 38.2%

1915: 81.7%

1925: 30.0%

1935: 38.5%

1945: 26.7%

1955: 20.8%

1965: 10.9%

1975: 38.3%

1985: 27.7%

1995: 33.5%

2005: ???

10-Year Average: 34.6%