Dark Horse Hedge

Wall of Worries Wednesday – But Climbable!

Wall of Worries Wednesday – But Climbable!

By Phil of Phil’s Stock World

Duncan Frearson of Smith Street Capital puts it well:

Anyone who has kids knows when the lights go out, the boogey man appears. We are in the unfortunate position where problems in Europe, the end of some government stimulus programs, some large budget gaps and a growing oil leak have turned off the market’s lights. The boogey man has entered the mind of the market causing some fearful behavior.

Investors and fund managers are clearly in panic mode.  We are not in a double dip, and there are no real indications we are going into one but the fear of renewed recession has sent investors stampeding into oil, out of oil, into copper, out of copper into gold, out of gold ($1,186 today), in and out of the Nasdaq, AAPL, Small Caps, Financials… on and on and on with virtually no actual changes in earnings or outlook from any sector other than the general trend of SLOWLY improving conditions.

Panic is easy to provoke.  Get 5 people to act crazy outside a store and tell them the whole town has gone nuts and they need to shut the windows and turn out the lights.  Once they listen to you, take your show to the next store but now you can point to the first store as an example of the panic that is on the streets.  By the time you get half a dozen stores (think funds) to panic, you don’t even have to do your little show anymore, people just see store shutting down and they ask them what’s up and rumors take on a life of their own and, before you know it, the whole town is in a panic over nothing real at all.

“At the end of the day”, Frearson continues, “the earnings power of a company is all that matters and thus understanding customer behavior is paramount. For the economy as a whole we should ask ourselves: are we currently spending beyond our means? Individuals are earning at record levels – around $10,103 billion for real disposable personal income in Q2 and we are only just beginning to push real spending beyond Q4 2007 levels leading to a savings rate in the 3.5% range, according to government data. The debt service coverage ratio and the financial obligations ratio both indicate the consumer is de-leveraging into a more stable financial foundation.”

Last month, the ECRI’s Short-Term Index turned down and pushed the fear levels to new highs.  Zero Hedge’s title was “ECRI Leading Economic Index Drops To 44 Week Low, Predicts Massive Economic Contraction” and the WSJ said it was ”Confirming A Sense Of Gloom” but the Managing Director of the ECRI said (in the comments of the WSJ article, that nobody reads):

The purported false alarms from “the ECRI” mentioned in this article [WSJ article] come from a mistaken and simplistic view that negative growth in ECRI’s Weekly Leading Index (WLI) is tantamount to a recession forecast. In fact, since 1983, cyclical downturns have taken WLI growth under the zero line a dozen times, but recessions have followed on only three of those occasions – times when ECRI actually made a recession forecast.

Since ECRI itself has never used WLI growth going negative as a recession signal, it is important that such “false alarms” are attributed not to ECRI or even to the WLI, but to what is a mistaken interpretation of the WLI.

In fact, at the very least, ECRI itself would need to see a “pronounced, pervasive and persistent” decline in the level of the WLI (not merely negative readings in its growth rate) following a “pronounced, pervasive and persistent” decline in ECRI’s U.S. Long Leading Index (not discussed in the article), before it makes a recession call.

What the LONG-TERM ECRI Indicators are showing is this:

Meanwhile, it’s 8:30 and, once again Mohammed El-Erain has the floor on CNBC for an extended period and he says “the new normal” is a World of dismal failure and contraction as nation after nation tightens their belt to make sure they have enough money to pay back the $1Tn he lent them.  That’s the sunshine report for our pre-market.  At 5am, for Europe’s open, CNBC has a special guest too, who got out of bed early and spent the whole hour with them.  He was kind of gloomy too but that’s not surprising as he was Arnab Das, the managing director of Global Economics.  Who is Global Economics?  Why that’s Roubini’s firm!

See, Phil – they don’t have Roubini and El-Erian on CNBC EVERY time they are trying to panic the market, sometimes they have El-Erian and Roubini’s Managing Director or sometimes it’s Gross and Roubini and sometimes it’s Greenspan (now on Pimpco’s payroll) and one of the above so please, PLEASE don’t say they always have Roubini and El-Erian trying to frighten the markets – that’s just not true…

How long can the Gloom and Doom squad keep the market back on it’s heels?  Frearson postulates that the longer stability is maintained, the more consumers will feel comfortable about increasing their spending. Ironically, U.S. states are increasing general fund expenditures in their FY 2011 budgets to $635.3 billion from $612.9 billion in FY 2010, according to the National Governors Association. Increased tax revenue from improving economic activity, the usage of remaining American Recovery Act Funds and “rainy day” funds will help stabilize a recovery. Confidence is slowly returning as employment stabilizes. Gallup polls suggest higher income consumers are beginning to spend more and this will filter down to middle income and eventually to lower income consumers even in light of the declining equity markets due to restructured personal balance sheets. Companies, in turn, will respond with increased production, inventory rebuilding and increased hiring.

Let’s keep in mind that our beloved Fed Chairman, Ben Bernanke, has already printed more money in the past for years than this country created in the first 230 years.  That money is sitting in bank vaults and on corporate balance sheets and tied up in shiny bits of metal and speculative gold futures and zero-interest TBills and it is ANXIOUS to seek a better rate of return once the fear and panic subside but, that would be catastrophic for Pimco, who loaned out $1Tn at fairly low interest and that would be bad for GE, who borrowed $500Bn at very low interest rates so they will use ALL of their influence to keep those rates as low as possible for as long as possible.

The Fed is bailing out banks and bailing out companies like GE by either buying up their assets WITH YOUR MONEY at face value (40% over market) and they are lending companies like GE YOUR MONEY at 0.25% interest while you continue to pay 5% interest on your home loan.  Isn’t that ridiculous?  Of course it is.  But you put up with it because you are scared!  You are scared because GE tells you to be scared through their TV network – you will do anything to avoid things getting worse, even when anything includes submitting to repeated corporate gang rapes that affect you now, in your future and in the future of your children and their children.

Wake up America – this is pathetic!

Asia and Europe turned down a bit but not too much.  What does it matter, though?  Fundamentals are not relevant at the moment.  Nothing matters until investors grow a spine and I’m not counting on that!  We have our disaster hedges and we had a lot of fun riding that pullback yesterday with DIA puts and this morning we have 10 new well-hedged entries on some of the beaten-down Dow components we looked at in yesterday’s post so bring it on markets – you keep panicking and we’ll keep buying!

Be careful out there…

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Sector Detector: Fundamentals-based Rankings Unbowed by Market Turmoil

Last week, the S&P 500 came perilously close to the dreaded 50-day moving average cross down through the 200-day moving average. This is usually considered by technicians to be an extremely bearish development. The S&P 500 came closer last week than the other major indexes, and actually set new lows for the year. Today, the “death cross” happened for the S&P 500, but not for the other major averages.

Moreover, all major market indexes have fallen beneath or are challenging their 2010 lows from February, May, and June. If the market is going to gather support and mount some sort of effort to climb out of this situation, it’s going to have to get started soon or risk a much larger decline that could carry the S&P 500 down to 950.

Nevertheless, Sabrient’s SectorCast-ETF rankings are showing remarkable stability. Back in January, after the market had become a bit frothy with optimistic speculation after the bull run off the March 2009 V-bottom, the SectorCast-ETF model took a decidedly conservative turn, with defensive sectors Healthcare, Consumer Staples, and Utilities at the top and Financials, Industrials, and Materials at the bottom.

But this time, despite the immense doom & gloom we hear in the news, the model is indicating that Wall Street analysts are still showing optimism about earnings improvements in some of the more economically sensitive sectors, and it is telling us that forward valuations are still quite reasonable – especially in the wake of this sharp recent correction.

Latest rankings: Information Technology (IYW) maintains its stranglehold on the top ranking with a score of 73. IYW fares the best (on a composite basis across its constituent stocks) in the percentage of analysts increasing earnings estimates, and it ranks high in return on equity, return on sales, and projected year-over-year change in earnings.

The second place spot has been moving around among XLE, XLF, and XLV, and in fact this week, Healthcare (XLV) has yielded to Energy (XLE). Despite having the worst score (along with XLB) in the percentage of analysts increasing earnings estimates, XLE has by far the best score in projected price/earnings ratio (PPE). Its aggregate PPE is a low 8.7, which easily outdistances the 9.5 of second-place Financials (XLF). XLE also scores quite well in projected year-over-year change in earnings.

Top-ranked stocks within IYW and XLE include Micron Technology (MU), Seagate Technology (STX), Valero Energy (VLO), and Hess Corp (HES).

Telecommunications (IYZ) remains at the bottom by a wide margin with a score of 37. It scores poorly on a composite basis (across the U.S. telecom stocks that make up the ETF) in almost all metrics, particularly projected year-over-year change in earnings across the stocks in the sector, projected P/E, return on equity, and the percentage of analysts increasing earnings estimates.

Consumer Staples (XLP), Materials (XLB), and Consumer Discretionary (XLY) continue to fight it out to stay out of the bottom two. Consumer Discretionary (XLY) got that indignity last week, but this week it happily gives it back to Consumer Staples (XLP), which scores a 48, joining IYZ in the short portfolio.

The spread between the top and bottom sector scores remains at 36, which is still tighter than the mid-60’s we were seeing earlier in the year. I prefer to see wider top-bottom spreads to provide added confidence in the relative rankings, but this range seems to be the new reality for now – at least until a firmer market trend develops.

Low-ranked stocks within IYZ and XLY include Verizon (VZ), Global Crossing Ltd (GLBC), Proctor & Gamble (PG), and Colgate-Palmolive (CL).

These scores represent the view that InfoTech and Energy stocks may be relatively undervalued overall, while Telecom and Consumer Staples stocks may be overvalued.

Performance: I have tracked the performance of each of the prior four weekly portfolios as of the market close on Tuesday, 7/6/2010. Each portfolio assumes that the top two ETFs are entered long and the bottom two are entered short, all at the opening prices on Wednesday. Of course, for those who prefer not to sell short, this could be run as a sector rotation strategy – with perhaps the top 3 or 4 sector ETFs long.

As the market remains quite weak, our top-ranked sector ETF (IYW) has been hit pretty hard. However, the more defensive XLV has held up better than the market. Only the 6/16 portfolio, which had XLF as a long position, is negative. The other long/short portfolios are all positive, and all four are well ahead of a straight long position in the SPY. The more recent addition of economically-sensitive XLB and XLY as short positions has been helpful to short performance, since IYZ and XLP are more defensive in nature and tend to hold up better in a weak market.

This fundamentals-based quantitative model portfolio is positioned to thrive in a bull market that favors high-quality stocks, while also being prepared to protect the investor if the market continues to weaken.

Disclosure: Author has no positions in stocks or ETFs mentioned.

About SectorCast: The rankings are based on Sabrient’s SectorCast model, which builds a composite profile of each of the ten ETFs in the table below based on bottom-up scoring of their constituent stocks. The model employs a fundamentals-based multi-factor approach including forward valuation, earnings growth prospects, analyst revisions, and various return ratios.

SectorCast has tested to be highly predictive for identifying the best (most undervalued) and worst (most overvalued) sectors, with a one-month forward look. Of course, each ETF has a unique set of constituent stocks, so the sectors represented will score differently depending upon which set of ETFs is used. For Sector Detector, I use eight Select Sector SPDRs, but because the SPDRs combine InfoTech and Telecom into one ETF, I use the two iShares for those sectors rather than the SPDR Select Technology ETF.

About Trading Strategies: There are various ways to trade these rankings. First, you might run a sector rotation strategy in which you buy long the top 2-4 ETFs from SectorCast-ETF, rebalancing either on a fixed schedule (e.g., monthly or quarterly) or when the rankings change significantly. Another alternative is to enhance a position in the SPDR Trust exchange-traded fund (SPY) depending upon your market bias. If you are bullish on the broad market, you can go long the SPY and enhance it with additional long positions in the top-ranked sector ETFs. Conversely, if you are bearish and short (or buy puts on) the SPY, you could also consider shorting the two lowest-ranked sector ETFs to enhance your short bias.

However, if you really don’t want to bet on which way the market is going, you could try a market-neutral, long/short trade—that is, go long the top-ranked ETFs and short the lowest-ranked ETFs. And here’s a more aggressive strategy to consider: You might trade some of the highest and lowest ranked stocks from within those top and bottom-ranked ETFs, such as the ones I identify above.

About Performance Tracking: I track each week’s set of ETFs (2 longs and 2 shorts) as a mini-portfolio over the course of four weeks. Because SectorCast does not include any technical triggers, this will give the fundamentals-based model a chance to achieve its predicted move. You might also watch just the two long positions as a separate long-only sector rotation strategy.