FYI | Jun 09 2010
By Mike O’Rourke, Chief Market Strategist BTIG
Ever since May 3rd when we switched from Bullish to Neutral, clients have been asking what will make us bullish again. For those who remember the call, after 18 months of being bullish, we switched to neutral because of the April ISM Manufacturing.
We explained, “All of that being said, we believe today’s ISM Report provides the signal that the recovery rally from the March 2009 low is essentially over. Although there might be additional single digit gains left over the intermediate term, it is unlikely they will be compelling enough for opportunity to outweigh the risk.“
Our decision had nothing to do with Europe’s sovereign debt crisis even though it is a risk. As a matter of fact, we believe the U.S. is a likely beneficiary of this crisis. The nearly 3% yield on the 10 year and nearly 4% yield on the 30 year are gift enough, but attractive valuations are now an added bonus.
Just like most others on Wall Street, we would rather be lucky than good. In that same note we stated, “As we noted last night, we do not foresee a major down leg, but we do envision a market that marks the time where rallies should be sold and dips could be bought.”
Instead of dips, it was a round of precipitous drops starting immediately, then three days later there was the flash crash that briefly took the S&P 500 to a few handles above where it settled. The simple fact is that we have never believed the bear thesis behind this move, and following a month of selling and many new headlines, we still don’t believe it. We have characterized it as, and still believe it is, an “Echo Panic.” Nonetheless, we are well aware that the market does not care what we think.
The final line of the May 3rd note was “We need better valuations (lower prices or higher earnings) to compel us back into the bull camp.” Without a doubt, a short 20 trading days later, the market has undoubtedly provided better valuations.
When you believe in the fundamental bull case and the bear case offers you a sharp correction, you know you are on opportunity’s doorstep.
There have been a couple of twists in that short time frame.
First, we believed that if the S&P 500 broke the 1090 level the market was entering a behavioral mode, and important long term drivers like valuations and earnings will become secondary to short term drivers like daily volatility, hence the moniker “Echo Panic.”
Second, there was last week’s release of the May jobs report. The report was disappointing, but one number subject to large revisions is not enough to shift one’s view. The good thing is a month into this panic, we have been able to narrow this market down to three factors that would move us back into the bullish camp.
The three factors break down into the following categories: Valuation, Behavioral/Volatility and Economic. (To be fair and clear, we could be swayed into the bearish camp, but the potential catalysts for such a move appear remote at this juncture.)
Valuation. Simply put, valuations are very attractive. The S&P 500 is trading 13x this year’s earnings. If you are conservative and knock off US$10 from next year’s US$95 estimate to take it to US$85, the S&P 500 is less that 12x that conservative estimate. For those who choose to hide in Treasuries yielding 3.18%, good luck. Those who have staying power and risk management are already exploiting the valuation opportunity.
Behavioral/Volatility. Again investors are witnessing many events similar to those that occurred from late 2007-2009. Swap Spreads expanded (although from very tight levels), Libor has been rising. Rumors are rampant about problems at this institution or that government (although this time it is in Europe).
Over the short term, fear will certainly overpower fundamentals and it is a matter of staying alive in the short time in order to reap one’s profits in the long term. Today, the Vix potentially failed its next upward move. If it can finally break and stay below 30 for approximately a week, it will be as close as you can get to a “coast is clear” signal. It is likely the market will be 3%-5% off its lows when that occurs, but the level of risk will likely be lower by a multiple of that.
Economic. The setback of the May jobs report needs to be reversed. The weekly Initial Jobless Claims have been a tremendous indicator throughout this recovery. They need to resume their downward trajectory. Last week’s reading was 453,000 claims. The cycle low was set in February at 439,000. Being 14,000 claims away from that level makes one realize how achievable new cycle lows are. That being said, the number has been stubborn in moving lower and ignoring it has proven perilous.
There are no hard and fast rules here. We could look for a combination of these factors or maybe substitute other factors in, such as AAII sentiment or other economic data points.If the facts change (as with the jobs report), so may our view. For the time being, this is what we are watching. Valuation is in place, Behavioral/Volatility is likely to fall into place in coming weeks. Initial Jobless Claims remain stubborn but it is a question of when, not if.
The views expressed are O'Rourke's, not FNArena's (see our disclaimer).
Disclaimer: https://btig.com/disclaimer.php
