Shanghai stock index: How far to go?

It’s been a while since I posted anything using technical analysis. Back in early April, I had written about the 50 day 200 day Moving Average crossover in the Shanghai Stock market. I think we should look at the Shanghai index as a ‘leading indicator’ to gauge US markets. This crossover happened a good 2 months before the US markets did. We also got an early non-confirmation of the March lows when the Shanghai index failed to make a new low at that point of time. (Though of course volume and breadth were other valid non-confirmation signals as well).

Since I believe this is a cyclical rally in a secular bear, I wanted to use Fibonacci analysis to gauge the retracement levels in the Chinese markets. This basically gets you an idea of how far this bear market rally retracement should go. While you might not believe in Fibonacci or technical analysis, it's still useful to keep these levels in mind as selling and buying pressure would appear around these levels from people following these trends. As can be seen from the chart below, we’ve already crossed the 38% retracement level, which means the 50% retracement at 3800 on the Shanghai Index is in play. This suggests further upside ahead.




Since we’ve crossed the 38% retracement on the Shanghai index, I expect a similar move on the S&P 500 as well. A similar 50% retracement on the S&P 500 gets us to 1100, which suggests the stock rally should go through the 1000 level. (Note: I wrote this up on Sunday)



Babak points out the over-extended nature of the current rally, and the similarity to the speculative blow-off of October-November 2007. The RSI indicator in the chart is also similarly showing an overbought reading in excess of 70. This marked the top during the previous bull run. However, the overbought conditions became even more overbought, and stayed that way before the markets corrected. In fact, the Shanghai market went up more than 100% after registering RSI readings in excess of 70!!

Note also the similarity of the 1 day 7% decline last week to the February 26th, 2007 one day decline of 8.8%. (John Authers talks about this in FT.) The Shanghai markets continued rallying for the next few months after the decline in February 2007.

Add in the recent Dow Theory buy signal, and investor bullishness should persist. Ebulient animal spirits are back in vogue.

All this suggests that it’s not yet time to play the markets on the short side (except maybe for a multi-week short-term pull back).

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Should you be bullish now?

Technical Take nicely sums up why being bullish now may not be a smart move:

To embrace higher prices with sentiment so extremely bullish, you must embrace the notion that we are in a new bull market. You must embrace the notion that higher oil and higher interest rates don't matter. You must embrace the notion that second derivative growth will lead to real, sustainable growth. You must embrace the notion that our housing and commercial real estate troubles are all behind us. You must embrace the notion that a PE of 150 on the S&P500 doesn't matter. You must embrace the notion that we can have an economic recovery without any meaningful change in unemployment. And we can go on and on and on...

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Goldman Sachs predicts a lost decade.

Wow, I somehow completely missed this one.

Goldman Sachs (GS) is essentially predicting a lost decade for most of the developed world.

The graphs below are from the Goldman Sachs Global Economics team:

• Output gap will not be filled till almost 2016-2018 for most of the developed economies.
• Unemployment must remain high till this time. Chimes in nicely with PIMCO's Billl Gross who feels that unemployment will remain high on a structural basis (in what El-Erian calls a deleveraged, deglobalized and reregulated world).
• I have a hard time believing the inflation theme given such data points. At the very least, inflation is 3-4 years away.
• Mexico looks like it will suffer because of it’s proximity to the US and the swine-flu.
• Indonesia and Australia are interesting non-mainstream ideas.
• It clearly helps to be a commodity exporter. The commodity super cycle is alive and well.
• Clearly, China and India look like the places to be. Sidenote: The domestic demand growth story of India is possibly the best secular growth story I can think of over the next decade, as opposed to depending on the “change” from an export dependent economy to a domestic demand driven economy in the case of China. Domestic consumption is already 60%+ of the economy in the case of India. Probably great news for the Indian Rupee as well.
• I’m not convinced as to why UK should recover before US. The UK real estate market has been described by Jeremy Grantham as the only remaining asset class bubble, and I would generally expect Europe to lag US in recovery. The chart below illustrates that the real estate markets in Europe have been lagging those in the US.

Here’s what the team says:

• Emerging markets are likely to see a return to trend growth about six months, on average, before advanced economies. Similarly, emerging markets on average will close their output gaps – the difference between actual growth and trend growth – about two years before advanced economies.
• Equities should grind higher in the months ahead and long-dated equity vol is expensive relative to the improving macro backdrop.
• Countries that get back to trend growth sooner should see their currencies strengthen.
• Emerging markets, particularly Asia, should offer more opportunities for outperformance for equities and forex, and could support commodity prices, especially industrial metals.
• Suggests going long GBP and short EUR/GBP
• Carry trades should prove popular because of smaller current account imbalances.
• Recommends Hong Kong (EWH), Taiwan (EWT) and Chinese (FXI) equity markets.

2009 so far looks like a repeat of the old weak-dollar, strong-commodities, strong-emerging markets story. Not sure how sustainable that’s going to be. The decoupling story is back in vogue.

Source:
Goldman: Past the worst
http://www.investmentpostcards.com/2009/05/27/goldman-past-the-worst/

Fuller money
http://www.fullermoney.com/content/2009-05-26/document.pdf

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A bullish setup.

So I twittered this message yesterday end of the day:

Watch out! Looks like next week will decide how the month shapes up. Looks bullish. #MKT http://bit.ly/gnuC0

I was basically looking at this chart courtesy Bespoke :



Well, we finished up yesterday. I thought it would be interesting to see what the average performance would look like over the next week, and next month, if over the next day the markets were up. I took the subset and here’s what I got:



4 out of 5 times, the markets ended up higher over the next week and next month . Even if you exclude the extreme outliers, or take the median, the conclusion is still bullish. (Small data sample setups like these are always suspect. But this does tend to agree nicely with a "rally till July" which I suspect is how events might be unfolding. )

PS: I had actually written this up last night but somehow missed posting it.

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Google in Dow: are you kidding me? A look at possible replacements.

It’s almost a foregone conclusion that General Motors (GM) is going to be replaced from the Dow. People have started speculating on possible replacements:

From Yahoo Finance:

In a research note last month, Nicholas Colas, chief market strategist for BNY ConvergEx Group, laid out seven possible replacements for GM: bankers Goldman Sachs Group Inc.(GS) and Wells Fargo & Co.(WFC); high-tech firms Cisco Systems Inc.(CSCO), Apple Inc.(AAPL), Google Inc.(GOOG) and Oracle Corp.(ORCL); and agricultural products maker Monsanto Co.(MON).

Based on the market moving impact of high price stocks on the Dow index, I would safely rule out Google, and even Goldman Sachs and Apple would be pushing the envelope. Why? If Google were to be added at the current price, it would comprise 28% of the Dow index! Thus Google CANNOT possibly be a serious candidate for the price weighted Dow. With close to 10%, the biggest weight in the Dow currently is IBM. Even Apple or Goldman Sachs would contribute close to 11% and 12% respectively to the index, which is why I think their addition to the index is unlikely.

If that’s not reason enough, here’s another fact: What's the number of current Dow components not paying a dividend? Answer: ZERO. If this were to hold true going forward, that would rule out Google, Apple and even Cisco from the list of contenders. (Now, I know Cisco CEO John Chambers has promised a dividend before he quits, but that’s not happened yet.)

So assuming the analyst got the initial list of candidates right, there are only three possibilities in my opinion: Oracle, Monsanto and Wells Fargo.

I did some further reading and pulled together a list of additional replacement candidates from various commentators:

• WSJ’s Marketbeat suggests Deere (DE), Toyota Motor(TM), and British Petroleum (BP).
• Felix Salmon adds Amgen(AMGN) and Nike (NKE) to the list.
• CNN Money suggests Pepsi(PEP), Conoco Philips(COP) and Schlumberger(SLB) as additional names.


• Fox Business quoting Wall Street analyst Matthew Hougan adds Philip Morris (PM).
• This Reuters article further suggests Aetna(AET), FORD (F), Nucor(NUE) and Travelers(TRV).
• This CNBC article suggests, in addition to the names listed above, Amazon (AMZN) and Abbott Labs(ABT)

After the removal of Honeywell(HON) and Altria(MO) from the Dow, here’s what the committee had said:

On CVX addition: "As usual when we make any change we review all the stocks. In doing so, we saw that the financials industry was under-represented -- notwithstanding the current turbulence -- and that the oil and gas industry's growing importance to the world economy called for another representative to join ExxonMobil Corp.

On Honeywell removal: “Honeywell is being removed because it's the smallest of the industrials in terms of revenue and earnings. Additionally, the role of industrial companies relative to the overall stock market has been shrinking in recent years.”

At that time, Honeywell had net income of approx. $2.5 Billion, and revenues of ~ $35 Billion.

With Oil down to less than half from the peak, it seems unlikely that the committee would add another oil major, which makes me want to rule out COP, SLB and BP. Further, because of their emphasis on revenues and earnings, I would rule out Amgen, Abbott Labs, Nike, Nucor, Amazon and Aetna.

After adding AIG and BAC in the last 10 years and watching them lose most of their stock value, I’m not too sure how enthusiastic the board will be about adding another financial to the list, except perhaps to replace an outgoing financial.

This would leave: Oracle, Pepsi, Deere, Monsanto, Wells Fargo and Philip Morris as the serious candidates. PM and PEP sound like safe bets in this uncertain environment. Monsanto would be an interesting name given that agriculture could be a big growth industry going forward. One interesting pair which hasn’t been discussed are the drugstore chains, CVS and Walgreens. The Dow is underweight financials and health care compared to the S&P 500, so we could always see a name from those sectors.

If I were to make a guess, CVS/Walgreens, Oracle, Pepsi, Monsanto, Wells Fargo and Philip Morris would be my replacement picks. While I might be wrong on some of my conjectures, what seems certain is that the new Dow entrant is definitely not going to be Google.

Time will tell. Stay tuned!

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Quotable quotes: the Market direction edition

Which way do you feel like lurching, Mr. Market?

I guess this week can be wrapped up as the 200 day MA week! Everyone was talking about the significance of a breakout above that level on the S&P500 and the Dow.

-We are at a point where the YTD losses are being erased. That could feed in some “extra cash” and keep us going sideways/up for the next few weeks.
-All that emerging markets money which went into commodities could very well rotate into stocks.
-We've had some solid action, with the S&P closing at or near it's intra-day high.
-Can we have a rally if the energy prices go down, dragging the energy and materials sector with them? Can we sustain this rally if the commodity prices/sector continue going up?
-I’m looking out for a Yen breakout and a ten year yield breakout. I think we could be seeing 4% yields on the ten year and a 107 on the Yen before we are through with this rally. (I’ve talked about a reversion to the 200 day MA in my posts earlier). (You can also check out an earlier market direction post)
-I feel the risk-reward situation is for a 5% upside, and a 15% downside.

Well, why listen to me? Let’s catch up on what the strategists are saying on the market direction in this marathon edition:

• Teun Draaisma : We think the bear market rally is at or near its end. We do not recommend investors to be short yet, and our index target implies 0% downside on a 12-month view. If we were to go 5% higher from here, the risk-reward to short equities would be good.



• Rick Santelli: It’s a question of realistic expectations. Realistic is that the darkest impact of the credit crisis and the industries in the construction and the housing sector may be behind us. But it's the rate of change.. it’s kind of how much of the path we have going forward. The truth is somewhere in between. Having a bottom is one thing. Having a parade that we are going to the moon is the other end. :)



• Michael Kahn: The good news is that last week's stock market slide was halted right at the rising March trend line. The better news is that the Russell 2000 has finally broken free from its 2008 trading range. The rally is still on the ugly side with market breadth lagging behind price action and volume still fading.
  
  Another bit of ugly comes from the NYSE advance-decline line, which has not yet moved above its 2008 range. Market breadth has not confirmed the rally, at least not with any degree of confidence.
  
  Based on the evidence, we do have a rising trend but one that does not have solid technical underpinnings to sustain it. That means short-term investors can follow along as long as they never take an eye off the long-term chart. It is still a bear market rally.
  
  
• Mark Hulbert : The average equity exposure of the market-beating newsletters over the past 20 years is only seven percentage points greater than for the market-lagging newsletters. In March, the comparable difference was 21 percentage points. This lessening of the bullish plurality is not an outright bearish omen, in my opinion. But it does point to the bullish case not being as strong as it was two months ago.
  
  To be bearish right now, you have to bet that the market timers who have lagged the market over many years are now, uncharacteristically, going to be more on target with their forecasts than the timers whose market timing calls over the years have added value.


• Jim Rogers :US stock market is still too high as far as I'm concerned! Some stocks went down a lot, but the overall average is down, what, 6%? I'm surprised the market is not down more! The recession is going to be a lot worse than what we've had in a long time. I may be wrong, won't be the first time I am wrong. But it won't be the first time the stock market is wrong either! Zinc and nickel are down 50%. I've started looking at metals again. India and China are still there! Dollar might rally for the rest of the year!


• Jeffrey Saut: Isn’t it amazing how fear has morphed into greed in a mere seven weeks, for now the cry on the “Street of Dreams” is about the new bull market that has emerged! We, on the other hand, have turned cautious. Our caution centers on the belief that our economic problems are NOT all behind us, the Dow Theory “sell signal” of November 21, 2007, the double-top chart configuration of the SPX at 1560-1570, and the 20-month moving average (MMA) (aka “The Snake”) that has often represented the demarcation line of bull and bear markets.



• Bill King: For obvious reasons, permabulls, street paper pimps and their stooges in the financial media mitigate the fact that financial firms are raising and must continue to raise enormous amounts of capital and overemphasize purported good news.
  The big sucker rally that we warned almost always follows March (1907, 1929, 1980), and sometimes April (1987) crises as well as soft Q1s in recession years (1990, 1991, 2000, 2001, 2002) is now occurring. And after such sucker rallies, an autumn debacle is a very high probability.



• David Kotak, Cumberland: We are fully invested worldwide in equities using exchange-traded funds. We will hold these strategies as long as we see the expansion of the Fed’s tools applied for the purpose of restoring the financial system to more normal functionality. When and if we see the Fed reaching a level of cessation of expansion of the tools, we will be proactive in reallocating assets.
  
  For now this activity is very bullish for equities, and it supports our notion that the US slowdown will be shallower and shorter than it would otherwise have been, had the Fed not become aggressively proactive last December and continued that pro-activity to present.
  
  

• Wilbur Ross : At best we are in a period of stagflation. In the worst case a combination of inflation and a poor economy, largely due to the consumer. Consumer is tapped out and sort of fatigued. I don’t see multiples expanding.



• George Soros : I think this is a fairly difficult bear market really. I could be wrong, but this is it. I think this is a bear market.


• Lawrence McMillan: This has been a very strong week, and -- for now -- the danger to the bullish case has passed. $SPX twice tested the trend line, bottoming at 1384 and 1386 last Friday and Monday, respectively. That held, tentatively at first, and more strongly now that $SPX has risen above the 1420 level -- an area that had inhibited advances five separate times this month. Clearly, our observation last week that the trend line was the most important thing about the $SPX charge, was true. In summary, all systems are bullish, and that is evident by the trends in these indicators: the rising bullish trend on the $SPX chart, and the (declining) bullish trends on $VIX and the equity-only put-call ratios.
  
  Moreover, breadth is overbought, and thus conducive to the bullish case as well. We see no danger to the uptrend until at least two of these reverse direction -- something that doesn't seem too likely at the moment. Equity-only put-call ratios have remained on buy signals since shortly after the March bottom.



• Anthony Bolton (Fidelity Special Situations) : The recent snap-back in share prices could be short-lived as stock markets face renewed weakness. Equity markets might not hit lows until early next year. The equity market’s slide that began last August might mark the beginning of a prolonged bear market and that the recent rise in equity prices is a “bear market rally”.
  



• John Catsimatdis: The dollar is being devalued 30-40% The Dow is still at 12000 something. Yes, it has a lot to rise.


• Ron Baron: Dow Jones was 11700 on 2000. It’s now 12500. So market has gone up about 1-2% for the past 8-9 years, so yes there is a lot of opportunity in our opinion.


• John Hussman : With the U.S. stock market still relatively overbought in an unfavorable Market Climate, there is continued risk of substantial and possibly abrupt stock price weakness. As I've noted frequently, I rarely have much of an opinion on near-term direction except when conditions are either overbought in an unfavorable Climate or oversold in a favorable one. We observed some initial weakness late last week, but we remain braced for more significant trouble.
  At the same time, we have to recognize that the rebound through early last week brought market internals not far from the point that would begin to feed purely speculative “trend chasing.”


• Clark Yingst, chief market strategist at Joseph Gunnar & Co: A lot of the lack of volume is accounted for by the deleveraging of the hedge funds. Requirement of more collateral is a reason for this. Near term Dow resistance level is at 13200. The market is anticipating a better US economy 6-9 months further out. We don’t necessarily agree with that. But we are taking the market action at face value, trying to capitalize on that. We are more inclined to view individual stocks as short term trading vehicles rather than investment vehicles, thinking that if that scenario does not unfold later this year, the market could have a serious retracement.



• Jeremy Grantham : Sit on the sidelines, unless you're one of those nimble, quick-on-the-button traders who can move money around really fast and leap in and out at the right times. That's a good way to make money if it's your skill set. But for ordinary dudes with a seven-year [time] horizon like us, you've got to pick the long-term fundamental events and stick to them. The toughest thing to do is to stay out of the market, load up on cash and fret about all the money you're not making. But that's probably the best advice. Let the other suckers take all the risk.




• Alec Young(Standard & Poor's): We are bullish but a little more cautious. We think the market continues to move up through the year. We priced in a weak economy and high oil. We still have enough macroeconomic headwinds eg. analyst revising earnings estimates downwards, that we believe the direction is going to be more two steps up, one step back.



• Robert Pavlik, of Oaktree Asset Mgmt: I’m very positive on the stock market. I think the market has all the ingredients right now for it to move higher as the year goes on. We are faced right now with a lack of confidence. As we approach the 200 day MA we have an interesting chart pattern developing. It’s an ascending triangle, which is a very positive pattern for going forward. We just need one catalyst to get us over the flat line going up and the market goes up from there.




• Barton Biggs: Sophisticates are bearish and pessimistic. I am bullish and I believe we have seen the worst. Tech is a major place to be. A great trade would be long financials and IBanks, and short Materials and energy sector.




• Bill Strazzullo, Bell Curve Trading: The response to the sell-off has been extraordinary. Traders are buying because they have a backstop in the Fed. & Govt. The price for this liquidity is a weak dollar. Does the risk-reward make sense, with all the major issues and challenges? We had looked towards the move towards 1450 on April 10th, and this is where we get off the train.



• Jordan Kotick (Barclays Capital): Markets around the world are breaking to new all-time highs, led by Brazil. Brazil still has a lot of upside.


• Stephen Pope(Cantor Fitzgerald Europe): I don't think people can actually afford to sell in May and disappear because there's too much money sitting in the wings that needs to find a home


• (From Quantifiableedge): Dr. Brett Steenbarger tracks the 10-day moving average over the 200-day moving average of the CBOE total put/call ratio. That reading dropped below 0.85 for the first time since October – also not a good time to be long.


• Liz Ann Sonders: The current bear market for the dollar is the longest since at least 1967.The current period ranks second in terms of declines, down 41% (July 2001 peak to April 2008 trough), behind the 48% decline seen from February 1985 to December 1987. Entering a new bull market for the dollar would bode well for equities, as the average performance of the S&P 500 during dollar bull markets (averaging 1,708 calendar days) is 86% versus only 16% for dollar bear markets.
  
  I've often noted the perfect inverse correlation historically between core inflation (excluding food and energy) and market valuation. However, historically, sustainably high food and energy prices have eventually filtered into core inflation. If we get a commodity price reprieve, it should lower core inflation expectations—which could lead to equity valuation expansion.


• VixandMore: Strong bear signal from VIX:VXV ratio lowest level to date on Thursday, previous low was 12/21/07. At the very least, the bulls should consider some downside protection in the current market environment. I suspect the bears are preparing to pounce very soon…


• Check out that short interest!


• Michael McCarty(Meridian Equity Partners) (on the low VIX): This measure broke through a trend established in early 2007 and now appears to be headed lower. The move down is real, and that for investors represents a sea shift, much like in sailing from a headwind to a tailwind. The movement in pricing of risk is now beneficial to stock prices.

Drop me a line if you liked this.

Full Disclosure : No positions

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Market insights from the top minds.

I was watching a CNBC interview with the top market minds and I thought they raised some valid points. (Catch the video interviews here and here)

Paul Mc Culley talked about how the Fed had severely reduced the fat tail by the Bear Stearns bailout. In the latest Bill Gross PIMCO missive though, he talks of PIMCO considering a possibility, not the probability, of a fat-tail. Clearly something these guys are watching closely.

Bob Doll talked about uncertainty being good, because maximum uncertainty usually coincides with a low.

I enjoyed listening to John Bogle. When a fundamental long term index investor like John Bogle talks of headwinds to the economy and a tough slog ahead, it pays to take note. With the S&P 500 yielding around 2.2% as opposed to the historical norm of 4%, and a price multiple of 16 to 19 times earnings, he’s clearly not optimistic about intermediate term returns. (He said that he’s been through 9 bear markets and never seen one like this before.) He’s worried about a weak financial system, and the slippage of financial concerns into the real economy.


On turnover in the stock markets:
Bogle talked of a huge speculative environment, with turnover in the stock market reaching 275% last year, as opposed to the 1929 peak of 140%. I’m not sure if a high turnover is a sign of excessive speculation. A lot of things have changed over the decades. We’ve had new financial instruments which are based on the underlying stock (ETFs, options, futures and other derivatives). Trades which are a combination of these tend to drive up the market turnover. Products which package and sell different types of risks and volatility are not necessarily a bad thing. 40% or more of the transactions are through program trading. A lot these are seeking out arbitrage plays amongst the different financial products, exploiting short term pricing inefficiencies. Turnover has enhanced market liquidity and made the markets more efficient. Hence I disagree with the fundamental assertion that turnover points to speculation. Also keep in mind that the cost of a transaction has come down to almost zero in today's world.


On commodities: Bogle: “What bothers me about commodities is that they have no internal rate of return. It is rank speculation. All that's behind is someone's willingness to pay more or less. In a booming world, people will pay more for everything, and I don't like the idea of speculating on price.”

Abby Joseph Cohen: “All commodities combined are about 10% of the business costs in the US industries. The impact here is not as high as compared to other countries “
Remained a long term bull on commodities, but with oil trading at $100 based on fundamentals.

On Inflation: Bogle complained about the understatement of inflation numbers, with inflation being a lot higher than the recorded numbers shown, and a lot higher than the expected numbers seen. For instance, he considered the inflation protected 10 year treasury yielding 2.3% “mind boggling conservative”.

An interesting exchange took place between Kennneth Heebner and Bogle, where Heebner remarked about the current situation reminding him of August 1982, and Bogle retorting back about the current valuations. Heebner’s response: Global opportunities are a lot greater today than they were 30 years ago. I think this is an important consideration in any historical study of valuations. Even Jeremy Grantham concedes that given the global linkages and the increased market liquidity, a higher long term price earnings multiple is warranted.


I certainly hope we don’t see 12 times earnings on the S&P 500. Could this be the fat-tail PIMCO is considering?

Full Disclosure: No position in any securities mentioned.

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The bullish thesis for a rally: a technical indicator review.

While we could be in for a rough period for the remainder of the year, there is a growing conviction that at least an intermediate term bottom has been set, and we could be due for a rally. A few indicators point towards increasing risk appetites amongst investors. Here's a review of some of them:

• The yen carry trade(JPYUSD) trade is extremely oversold right now, and below 200 day MA. There's always a reversion to the mean with respect to the 200 day MA. Resumption of the carry trade has been bullish for equities in the past.
  

• Tips look like they've entered a period of downtrend, indicating growing risk appetites.

• Bond yields rallied and broke their downtrend, at least for now. (Hat tip: Bespoke group) Previous bear rallies failed at this level. That's a positive.

• S&P broke through the 50 day MA decisively and has been making a series of higher highs and higher lows since the March lows.
  
  



• VIX in some sense anticipates future stock market volatility. The 200 day MA has acted as support ever since the credit turmoil began. VIX dropped below the 200 day MA. This should imply lower volatility for the next few weeks, which in turn is bullish, assuming of course that it stays below the 200 day MA. It looks like a correction in the long term upward trend in volatility (that's not a clever way to look at this though) .
  
  


• Credit default risk on the investment banks has declined dramatically. (Hat tip to the excellent folks at Bespoke again) Is it time for a rally in the financial sector?
  
• Traderfeed has some more thoughts on why we could have hit a market bottom.

If Dow Industrials can close above 12,750, it will trigger a Dow Theory buy signal. (Refer to this post on the strength of the transports). Alongwith a break of the S&P 500 above it's overhead resistance at 1390, that should pull in new money, and help the averages up another 5-10%, if we can close above these numbers.

Disclosure: None

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Market commentary by Citigroup’s chief strategist.

I saw this interesting interview of Tobias Levkovich on CNBC last week. He shared some good points:

• Market Valuations: His price target is 1550(S&P 500), based on valuations, sentiment, and implied earnings growth. Predicts flattish earnings(~$86) in 2008 and 2009 for S&P500. Energy and materials will underperform in 2009 (because of declines in the commodities sector). This would be offset by outperformance in the financials and the consumer discretionary. Refused to discuss specific valuations. Valuations need to be discussed based on risk premiums, historical context, and bond yields; and not in a vacuum. Pointed out that homebuilders looked deceptively cheap in 2005.
  
  
• Commodities: Cyclical conditions will effect the commodity trade severely. To put it simply, commodity prices do go down in a recession. (Note: I discuss this in my post here). A similar thing happened during the inflationary 1970s recession. Agriculture, fertilizers and the chemicals look like the dot-coms.
  
  
• Savings rate: This is going to get worse in the next 5-10 years because of demographics. Retiring baby boomers would be using their savings. (This would be worldwide.) Not really a problem because wealth is growing enormously. Implication: Savings rate isn't a useful metric anymore. This could potentially have negative implications for the markets?
  


• Elections: Current year would be the first time since 1928 that sitting President or VP isn't up for reelection. So the administration doesn't have the motivation for election year stimulus that normally happens. Conclusion: Historically, election years have been good for the stock markets. May not be true this year.



• Asia: Asian companies have really low return on equities (ROEs), even though asset turnover is at a 16 year high. Whenever this turnover goes low, the ROEs will collapse. Don't want to be there when that happens. Not sure where this data point came from, but this is interesting if true. (Note: To understand the DuPont ROE breakdown, refer to this entry)
  


• Real estate: Real Estate bubble and appreciation are far worse outside the US. So you cannot point to the US selectively. I agree. Except the problems in the US are not just about house price appreciation, but caused primarily due to negligent and fraudulent lending practices.



• Post-elections: Critical issue for the post election year is this: are we moving towards more protectionism? Will we abrogate on tax treaties? What about tariffs/ protection quotas? Could be very devastating for markets. Asserts that taxes will go up across the board regardless of who gets elected. This is because they will look to fix AMT before they extend the Bush tax cuts.



• Markets: He talked of a W shaped pattern in the markets. Things will get worse before they get better. The worsening credit conditions effect the economy with a 9 month lag. Hence mid-year to year end, we'll still have problems and will see a slowdown in the industrial side of the economy. Earning estimates for the year end are still too high. Note that there has been some chatter about a double-dip recession. See this and this. Double dip is essentially a W pattern.



• Industrial sector: Talked about an industrial sector slowdown. Even though people talk of resilience in the US exports and the BRICs, two thirds of the “international” for US companies is in Europe. This could hence slow down.

Disclosure: None.

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Quotable quotes on market direction...

• Steve Shobin, chief market strategist, AmeriCap Advisers: “We’ve had a lot of characteristics of a bottom: A watershed event in Bear Stearns, a crescendo of bad news, aggressive action on the part of the Fed, excesses in bearish sentiment and today a strengthening of the weakest link (financials). I think the window of opportunity is open for a couple of months.”

• Kenneth Tower, chief market strategist, Covered Bridge Tactical: “I am optimistic that we’re near an important low and it may have been yesterday.”

• Peter Boockvar, equity strategist, Miller Tabak: "The deleveraging process is nowhere near complete, and the housing industry continues to struggle. Stocks may be putting it all together for a strong rally today, but it should not be considered the beginning of a new bull market. This rally is more the lack of further bad rather than anything good. The bulls are way too premature if they think four-and-a-half months of a bear market are enough to correct the messes we were in.”

• Tobias Levkovich, head of investment strategy, Citigroup: “One could argue that the credit bubble’s bursting and de-leveraging process could mean a bottoming out in the 1,165 area for the S&P 500 or 8.3% lower than the troughs seen thus far”

• Random Roger: "Whatever comes of all of this I think it will take a while before it is all sorted out. The media will continue to ask if now is the time to buy but keep in mind that this bear market could last until April, 2009 and still be considered normal."

• Mark Hulbert's "Double Nine-To-One" signal. "The next the 60-trading-day period produced a 22% return annualized."

• Barry Ritholtz arguing for a 20%+ rally over the next 2 months

EDIT : As Barry rightly points out in the comments section below, this was referenced in February and is probably no longer valid.

• Quantifiable edge on Tuesday: "Looking out 2 weeks there appears to be a huge bullish edge. Thirteen of fifteen winners and an expected value of 3.6% over the period. Going out 90 days the average trade would have returned over 9%."

• Traderfeed indicator review foresees bullish divergences: "All in all, we can see from the indicators that we're in a bear market mode; that we're testing the January lows; that weakness among financial stocks has been leading recent market weakness; but that there are early signs of waning new lows and waning downside momentum across the broad market."

• Art Huprich's Technical Analysis : "The ongoing dialog is along the lines of “Is the stock market still confined to an overall down trend or has signs of a potential bottoming pattern developed?” While the bottoming pattern hasn’t been completed, I believe that “characteristics of a bottoming pattern have developed.”"

• Richard Russell: "Since the stock market typically hits bottom around the middle of a recession, then working backwards Steve thinks that the stock market could hit bottom around April or May. But if this is fated to be BIG recession, say a sixteen month recession, then the stock market should hit bottom about nine months into the recession, which means a market bottom in the July to August 2008 period.”

• Yutaka Yoshino (Nikko Citigroup): “In the five times the DJIA has undergone substantial corrections during economic slowdowns, real interest rates declined so far they became negative four times. In each of these cases, interest rates turned negative and stocks bottomed at roughly the same timebecause share prices have corrected substantially in advance of the next FOMC meeting, if another cut brings real interest rates to around zero, we believe this could be a powerful trigger for a rally.”

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Reasons to be bullish or bearish:

Bullish:

1. 2008 election period timeframe. The administration and the PPT will do what it takes so that George W Bush junior doesn't suffer the fate GB senior did. A slowdown coupled with a lousy market would basically wipe out any chance Republicans might otherwise have had.

2. China Olympics. China induced liquidity in terms of interest rates and an undervalued currency. They'll do their best to ensure an orderly world economy before their big moment in the sun next year. I'm not too sure if the Chinese markets can double from where they are right now. A PE of 110?

3. Fed rate cuts. Historically, stocks have outperformed by a big margin over a 6-12 month period after the fed starts cutting rates.

4. Massive 9:1+ up day the day Fed cut rates.

5. Over the short term, analysts have cut estimates sharply, which should be bullish when companies start reporting next month.

Bearish:

1. Rising 10 year yields. Rising yields often presage declining markets.

2. Margin pressure on companies because of commodity inflation. This might manifest itself towards the latter part of 2008.

3. Short term overbought. The markets should experience some profit taking the next week or two.

4. Pre-earnings funk before we hit October. Seasonally a weak time to be invested.

5. Long-term. Wouldn't surprise me if the earnings estimates of the Financials are revised downwards. With the financials contributing 31% of the S&P, how is that bullish for the market?

6. Real-estate induced consumer weakness.

IMHO, Any weakness over the next 2 months would be a great buying opportunity for the next 6-12 months.

Check out the massive 1000 point breakout in the BSE index in India. Indian sensex had been under performing most of 2007. As it breaks out, prepare for BSE 20,000. That's a good indicator of the return of risk appetites. Is this the final hurrah for the Indian markets? Stay tuned for my analysis on market returns in India given current interest rates, rupee valuations, and BPO forecasts.

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