The 10-Day View
Posted by Eddy Elfenbein on August 8th, 2011 at 1:57 pm

The market sinks even lower. The S&P 500 just broke below 1,150. The market is lower than where it was in July 1998. To put that in context, that was a few weeks before Google ($GOOG) was founded.

The Morgan Stanley Cyclical index (^CYC) is now down to 838. That’s an amazing loss. The $VIX has been as high as 41 today. That’s more than double where it was two weeks ago.

S&P downgraded both Fannie Mae and Freddie Mac. Also, Bank of America ($BAC) is getting hammered after news broke that AIG ($AIG) is going to sue them over the mortgage debacle.

The Summer of Discontent
Posted by Eddy Elfenbein on August 8th, 2011 at 10:59 am

The stock market continues to plunge. The S&P 500 has been as low as 1,154.10 this morning. That’s another 100 points below the close from last Tuesday’s awful market. That S&P 500 is currently down 3.65%.

Once again, it’s the cyclicals that are getting pounded the most. The Morgan Stanley Cyclical Index (^CYC) is currently at 852.97. That’s a stunning drop of close to 21% since July 21st. The CYC is trailing the market for the 17th time in the last 18 sessions.

The fact that this sell-off is being led by cyclicals tells me that it’s more due to economic concerns rather than concerns of the debt-ceiling debate. Although financials aren’t doing well, Treasuries continue to soar. That’s an odd thing to see after a downgrade. The Long-Term Bond ETF ($TLT) is up more than 9% since July 14 when S&P warned that it might down U.S. debt.

Gold just broke $1,700 and the $VIX is now over 40.

Here’s a look at the cyclical index divided by the S&P 500.

Morning News: August 8, 2011
Posted by Eddy Elfenbein on August 8th, 2011 at 6:37 am

ECB Buys Italian, Spanish Bonds in Strategy to Defuse Crisis

Global Finance Leaders Pledge Bold Action to Calm Markets

Japan in Ratings Cross-hairs as Debt in Focus

Britain, Other Eurozone Countries Face Ratings Cut: Jim Rogers

Nigeria to Inject $4.5B Into Nationalized Banks

Crude Oil Drops On US Downgrade; Nymex May Test $80/Barrel

Gross Praises S&P’s ‘Spine’ as Buffett, Miller Say Rating Company Erred

Moody’s Says U.S. Needs to Find More Deficit Cuts

Stock Index Futures Tumble on S&P Downgrade

VIX Term Structure Evolution Over Last Ten Days

Reinsurerer Hannover Re On Track For Full Year After Net Profit Rise

Foreclosure Woes Fuel Wider Loss at Fannie

Berkshire Makes $3.25B Bid for Transatlantic

A.I.G. to Sue Bank of America Over Mortgage Bonds

Epicurean Dealmaker: School for Scandal

Joshua Brown: Shots Fired: Peter Brandt Says Welcome to the Global Bear

Brokers With Hands on Their Faces

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RIP: AAA
Posted by Eddy Elfenbein on August 5th, 2011 at 9:28 pm

For the first time in history, the creditworthiness of the United States of America has been downgraded:

A cornerstone of the global financial system was shaken Friday when officials at ratings firm Standard & Poor’s said U.S. Treasury debt no longer deserved to be considered among the safest investments in the world.

S&P removed for the first time the triple-A rating the U.S. has held for 70 years, saying the budget deal recently brokered in Washington didn’t do enough to address the gloomy long-term picture for America’s finances. It downgraded U.S. debt to AA+, a score that ranks below Liechtenstein and on par with Belgium and New Zealand.

The unprecedented move came after several hours of high-stakes drama. It began in the morning, when word leaked that a downgrade was imminent and stocks tumbled sharply. Around 1:30 p.m., S&P officials notified the Treasury Department they planned to downgrade U.S. debt, and presented the government with their findings. But Treasury officials noticed a $2 trillion error in S&P’s math that delayed an announcement for several hours. S&P officials decided to move ahead anyway, and after 8 p.m. they made their downgrade official.

S&P said “the downgrade reflects our opinion that the fiscal consolidation plan that Congress and the Administration recently agreed to falls short of what, in our view, would be necessary to stabilize the government’s medium-term debt dynamics.” It also blamed the weakened “effectiveness, stability, and predictability” of U.S. policy making and political institutions at a time when challenges are mounting.

So we’re a bigger credit risk than Liechtenstein. Who knew? (Well, S&P I suppose…but still!)

This is mostly theatrics. Everyone knows the numbers of America’s finances; they’re no secret. The idea of downgrading the debt of a superpower is frankly, a bit silly.

Think of it this way: America’s creditworthiness is rated every minute of every day. That’s what the bond market is. Any ratings agency can issue a report and say what they want about our debt — that’s no big deal. What is a big deal is that investors around the world are willing to pay absurd amounts to lend to us.

Ultimately, that’s what a credit rating is all about. If creditors trust us, our credit standing is high. Look at interest rates, not at what a bunch of analysts say in New York.

Working Dollars (1956 Cartoon)
Posted by Eddy Elfenbein on August 5th, 2011 at 5:00 pm

Mines in Brooklyn!

More Issues With the CAPE
Posted by Eddy Elfenbein on August 5th, 2011 at 3:24 pm

In yesterday’s New York Times, David Leonhardt wrote that stocks are still too expensive. He based this on the cyclically-adjusted P/E Ratio (CAPE) which is similar to the normal P/E Ratio except that it uses the average earnings for the past ten years.

I’m not a big fan of this metric for a few reasons. For one, it has a poor track record. The biggest reason is that earnings are cyclical and therefore, so is the market. As a result, I don’t see why the cycle needs to be adjusted. Not only that, the cycle is the most important part.

Also, Robert Shiller (the major proponent of CAPE) uses reported earnings which I don’t think is the best measure. In my opinion, operating earnings give you a better picture of what’s really happening. There were barely any reported earnings in 2009 which artificially inflated P/E Ratios. That glitch will be embedded in the CAPE for several more years.

Leonhardt notes that the CAPE is currently at 20.7 which is 6% above its 50-year average of 19.5. First, 6% above average is hardly “expensive.” Second, if you followed that metric, you would have been out of stocks for almost the entire past 20 years.

Leonhardt wrote:

But the 10-year ratio does have a pretty good track record. In 2007, when many Wall Street traders and economists were claiming that stocks were still a great buy, the 10-year ratio knew better. Likewise, it helped predict the market’s rebound in early 2009, when optimists were not easy to find.

That’s not correct. By following the 19.5 CAPE rule, you would have missed almost the entire 1990s bull market and would have gotten into stocks only between October 2008 and November 2009. Shiller himself said that the market was fairly valued in July 2009 when the S&P 500 was at 900.

So How’s Your Day Going?
Posted by Eddy Elfenbein on August 5th, 2011 at 2:25 pm

Mine…kinda hectic.

The Dow gapped up 170 points at the open, plunged 416 points by noon, and now we’ve regained almost all that back (the chart below is of the S&P 500). The $VIX came close to 40 at noon.

“Double Dip” on Google Trends
Posted by Eddy Elfenbein on August 5th, 2011 at 11:38 am

The “Double Dip” meme itself has already experienced more than one dip.

July Jobs Report
Posted by Eddy Elfenbein on August 5th, 2011 at 8:31 am

NFP: +117,000

Private Sector: +154,000

Healthcare +31,000

Retail +26,000

Manufacturing +24,000

May Revision: From +18,000 to +46,000

June Revision: From +25,000 to +53,000

Unemployment Rate: 9.1% down from 9.2% last month

CWS Market Review – August 5, 2011
Posted by Eddy Elfenbein on August 5th, 2011 at 7:09 am

Ugh! There’s not much else to say about Thursday’s stock market except that it was a total disaster. It was the Rocky V of trading days. But unlike Rocky V, we can’t pretend that Thursday never happened. In this issue of CWS Market Review, I’ll review the damage. More importantly, I’ll tell you what’s really going on and what you need to do to protect yourself during a frenetic market like this.

As we all know, Wall Street can be a serious drama queen. When the bears go on a rampage, well…they’re pretty hard to stop. There’s an old saying on Wall Street: “If you can’t sell what you want, sell what you can.” That’s exactly what happened. I mean, AFLAC ($AFL) at $42?? Dear Lord! And Reynolds American ($RAI) yielding 6.3%?? Heavens to Murgatroyd; that’s the equivalent of 718 Dow points!

I can’t predict when all this madness will end but I can say that we’re already well-protected. On Thursday, our Buy List out-performed the S&P 500 by 27 basis points. Of course, that simply means we got shellacked somewhat less than the other guy, but the important point is that investors didn’t massively abandon the high-quality stocks I favor like they did everything else. This is key and I’ll dissect it more in a bit.

Now let’s look at some of the numbers. I’ll warn you: If you have a weak stomach, feel free to skip this section. On Thursday, the S&P 500 plunged 60.27 effing points for a drop of 4.76%. Yuck! That’s the index’s worst loss in 18 months. Plus, this sell-off comes on the heels of an eight-day losing streak which culminated in Tuesday’s 2.56% wipeout. All told, we’ve lost 10.78% in the last nine trading sessions.

Want to see how much the sellers are in control? On Thursday, the Nasdaq’s up volume swamped its down volume by a ratio of 85-to-1. Think about that. Even the Smurfs were no help. Since they rang the opening bell last week, the Dow has dropped 760 points. Short blue bastards.

What’s especially frustrating is that I saw a lot of the larger trends coming but I was wrong in anticipating just how hard they would hit. For example, I’ve repeatedly warned investors to stay away from cyclical stocks, but I didn’t think the Morgan Stanley Cyclical Index (^CYC) would perform quite so poorly. Consider this: The cyclicals have trailed the overall market for 17 of the last 20 trading sessions. That comes to a loss of 18.32% which includes a staggering 6.68% drop on Thursday.

Similarly, I told investors to keep an eye on the S&P’s 200-day moving average. I even cautioned folks that there are often three tests of this key support level. That’s exactly what happened. The S&P 500 bounced off the 200-DMA twice in June but never closed below it. Then on Tuesday of this week, the S&P 500 finally breached the 200-DMA. That gave the bears a huge confidence lift because by the closing bell on Thursday, the S&P 500 stood nearly 7% below its 200-DMA. Once again, I wasn’t surprised by the retest but I didn’t anticipate that rout that followed.

For some background, the 200-day moving average is one of these silly rules that has a surprisingly good track record. The evidence is clear: The S&P 500 has performed much better when it’s above its 200-DMA than when it’s below it. In the short-term, momentum is a key driver of the market and for some reason the 200-day moving average captures this well. If history is our guide, the stock market will likely spin its wheels until we surge above the 200-day moving average.

So is it time to sell? Absolutely not. In fact, this would be a terrible time to sell. The stock market may indeed head lower in the short term, but the best opportunities are in stocks. As I’ve said many times, the earnings outlook for our Buy List stocks continues to be bright. Just this week, both Becton Dickinson ($BDX) and Wright Express ($WXS) not only beat Wall Street’s earnings estimates but also raised guidance. For Wright, it was the second guidance increase this year. If some hedgie needs to raise cash by dumping WXS, that’s his problem, not ours.

I urge investors to be patient. Wall Street likes to shoot first and ask questions later. Remember, we had a 16% sell-off last year due to another “Double Dip” that failed to come. Do not give into the market’s panic.

Here’s what’s happening: Investors are quickly moving out of areas that are seen as risky and into areas that are seen as safe. What we’re witnessing is the unwinding of the QE2 trade. Last November there was an especially brilliant and prescient article at TheStreet.com which explained how the Fed’s QE2 policy would cause a shift in favor of riskier instruments. Now that trade is falling apart in a major way. All across the board, investors are dumping risk and hoarding security. Fear is giving greed a major beat-down.

Just look at the two-year Treasury yield which dropped to an all-time low of 0.26%. That means that an investment of $1 million yields you a whopping profit of $7 per day. I honestly think you could find more loose change on a DC metro car. The yield on the one-month Treasury actually become negative for a brief period which means you had to pay the government to borrow your money. The long-end of the curve has been even more popular. The price for the 10-year T-bond jumped by more than 2% on Thursday and the price of the 30-year rallied by 4.66%. Gold just hit a new all-time high this week of $1,681.72 per ounce. Safety is trumping everything. Everything.

In last week’s issue, I discussed the alarming rise of the Volatility Index ($VIX). I noted that the VIX had spiked up from less than 16 to 23.74 in just three weeks. Please; that was nothing. On Thursday, the VIX jumped more than 35% to reach 31.66. That was the biggest jump in more than four years. To give you an idea of what the VIX means, a reading of 30 means the market expects the S&P 500 to swing by an average of 8.66% over the next month. Note that it doesn’t indicate which direction it will move, just that it will move a lot.

The Federal Reserve meets again next week and there’s growing speculation that the Fed will launch another round of quantitative easing, QE3. For now, call me a doubter. So far, the Fed hasn’t given us any indication that it’s looking to buy more bonds. The last time around, the Fed made its intentions very clear to Wall Street. Part of the reason I missed the strength of this sell-off is that earnings for the overall market have been quite good. Of course, earnings results are backwards-looking. What’s troubled the market so much recently has been growing evidence that the economy will soon take a turn for the worse.

Every day we’ve gotten bad news on the economy. Starting last Friday, the second-quarter GDP report came in very soft and the first-quarter report was revised downward. The government revised the GDP numbers for several quarters and it showed that the recession was worse than we original thought and that the recovery was weaker than we thought. In real terms, the economy grew by less than 1% for the first half of this year.

Then on Monday, the ISM Manufacturing Index dropped to 50.9 for July which is the lowest level in two years. Any number above 50 means the economy is expanding, while any number below 50 means the economy is receding. Also, the Commerce Department said that factory orders dropped by 0.9% in June. That’s the first drop for that metric since the recession ended.

On Tuesday, the Commerce Department reported that consumer spending dropped by 0.2% in June. That’s the biggest fall-off since September 2009. This is very important because consumer spending represents 70% of the U.S. economy.

On Wednesday, the ISM Service Index came in at 52.7, its weakest level in 17 months. Since February, the index has dropped by seven points. Also, ADP ($ADP) released its jobs report which showed that the economy created 114,000 jobs last month which is far from a strong number. The government will release its report on Friday morning. (I’m writing this in the wee hours of Friday morning.) Wall Street expects a meager gain of 85,000 jobs.

These negative reports are causing analysts to pare back their growth forecasts. JPMorgan Chase ($JPM) cut its estimate for third-quarter growth (which we’re nearly halfway through) to just 1.5%. As bad as this is, there’s still no hard evidence that we’re in a recession. That may come, and the odds are higher than they were one month ago, but it’s still not here yet. For now, I suspect that the economy is due for a period of slow and disappointing growth but not a full-blown recession. I’m not writing off the possibility of a recession, but I don’t think it’s probable.

The best part of a fearful and panicked market is that you can find good values and that’s what prudent investing is all about. I want to highlight some Buy List stocks that look especially attractive right now. If you can get shares of Nicholas Financial ($NICK) for less than $11.50, you’re getting an amazing deal. As I mentioned before, AFLAC ($AFL) and Reynolds American ($RAI) are both very cheap. How about Oracle ($ORCL) at $28? I strongly doubt that will last. Abbott Labs ($ABT) is a solid buy that now yields 3.9%. I also think JPMorgan Chase ($JPM) is worth a look now that it’s below $38 per share. The yield alone will get you 2.6%.

That’s all for now. The Fed’s meeting and QE3 speculation will dominate headlines next week. Be sure to keep visiting the blog for daily updates. I’ll have more market analysis for you in the next issue of CWS Market Review!

Eddy

P.S. This Sunday, I’ll be on Kevin Whalen’s radio show on WRKO at 7:30 p.m. to discuss (what’s left of) the market and the economy. I also want to thank everyone who submitted a question for my Q&A. I hope to have that up soon.