9 Reasons Why We Are Close to, If Not Past, the Bottom

Well, there's another reason: Markets do not go up or down in a straight line. Look at an LT or IT chart of any major index. 9 Reasons Why We Are Close to, If Not Past, the Bottom by: Alan Brochstein posted on: September 28, 2008 | about stocks: CFR / GS Font Size: PrintEmail As many readers recall, I was INCREDIBLY bearish beginning in the summer of 2007 after nervously watching what was being seemingly ignored but was increasingly playing out to be the disaster scenario we hear about ad nauseum now. I continually reiterated my concerns for the next several months despite the uptick in the market. One of my favorites, that I originally titled "Time to Build an Ark", was changed by the editorial staff of Seeking Alpha to "It's October - Should We be Buying?, in which I projected an 1150 S&P 500 right about now. I typically tend to be early (yes, I lost money shorting internet stocks in late 1999), and I walked away in May from my earlier predictions that the Bear Market would end in the Fall. I have contended (and still do) that money can be made on the long side, but it has been tough. I believe though that it will soon be a lot easier. I am no Pollyanna - we are indeed facing economic challenges of epic proportions - and not just our country. I want to share some observations and data that I believe support that there is enough blood in the streets and a high enough awareness of the problems (and a pathway to their solutions, which will still take considerable time). Love him or despise him (I actually do both, but that's a different story), Jim Cramer, the pundit for the masses (and the pros, who would never admit it!), is one to watch. Just like his berserk Bernanke beseechment a year ago (he was right to worry, but he didn't have the right solution), Mr. Cramer is a bit EMOTIONAL right now. He continues to advise everyone to sell, sell, sell. "It's time to be defensive." It's not just him - it's everyone! My clients, my friends and family, the media - almost everyone that I encounter is petrified. Where were all these folks a year ago? It seems to me that when almost everyone is negative, it's probably not a great time to "sell, sell, sell". So, what am I seeing that gives me some confidence that we are close to if not just past a bottom? Here is my list, in no special order (except the best for last): It's that time of the year We got the spike in VIX Credit Spreads reflect dire pessimism Put/Call and sentiment ratios reflect dire pessimism We have a "confirmed rally" according to IBD Market strength in early recovery sectors Valuations are extremely low Rates are likely to stay low ***The right solutions are in the public domain now Hitting the points in order, it is worth noting that every bear market in my 43 years, has ended between August and October (1973-74, 1982, 1990, 2001-2002) and the sharp declines of 1987 and 1998 as well. I don't believe this to be coincidental, as the end of the summer vacations, the focus on the balance of the year with respect to earnings, and perhaps the quarterly tax date of 09/15 all contribute. In any event, one can't assume that just because we are in the right time of the year means that it is automatically a good time to buy (1973 and 2001 certainly weren't!), but it is one supporting element. The next three points all relate to measures of confidence. Implied volatility in options spiked to extremely high levels, sentiment, measured by either survey or put-buying relative to call-buying, moved to rather extreme levels and the TED spread (or swap spreads) moved to all-time highs, reflecting a preference for cash/Treasuries. In other words, while stocks are acting poorly, it isn't in a vacuum. Clearly, there is extreme pessimism. One doesn't have to do much more than open ones eyes and ears, though, to make that observation. Investors Business Daily [IBD], a paper long published by the brilliant William O'Neil (I subscribed to his weekly charting product as a teen in the early 80s), daily issues its characterization of the market. Based upon a set of rules developed over many years of observations, the paper declared on Thursday night that we are in a "confirmed rally". For those not familiar with this work, you should visit www.investors.com to learn more - it is worth one's time. In any event, to be in a confirmed rally, the market has to first stop going down, which is measured by a large increase in a major index after marking a new low (i.e. Thursday a week ago). To earn confirmation, the market must maintain those lows and at some point on the fourth day or later (though much later is usually indicative of a weak rally ahead) increase in price in excess of 1.7% on an increase in volume. So, before you go load up, do realize that though no rally takes place without these conditions, the existence of these conditions doesn't necessarily promise a rally. All it says is wake up and look at leading growth stocks, according to Mr. O'Neil. The "confirmed rally" ends when the prior low is taken out or perhaps later when "distribution" (heavy selling) hits the market. I urge you to give this objective analytical framework some attention despite your being perhaps unfamiliar with it. I believe that if you were to sell the market now, it would be analogous to taking a hit in blackjack on 16. Good luck with that! Stocks have been bashed, no doubt, and it seems to be getting worse. In fact, we made new lows this month in the S&P 500, the Dow Jones Industrial and the NASDAQ. I found it curious that the Russell 2000 and the S&P 600, which consist of smaller companies, preserved the double-bottoms from earlier this year (January and March). This is an interesting divergence. One explanation is that smaller stocks tend to be viewed as riskier and fell further and faster as liquidity dried up. Perhaps they got "too low" earlier this year relative to their fundamentals. Also, the larger companies tend to be more multinational, and the moves in the dollar (weakening and then strengthening but relatively unchanged now in 2008) could explain the relative performance as well. In any event, I am encouraged by the strength. I do acknowledge that part of it may be due to the hedge-fund community getting a bit too aggressive in its shorting and throwing in the towel. This was clearly evident a week ago Friday (9/19). In any event, take a look at the chart below (click to enlarge) and you can see the clear better performance of smaller stocks this year and this quarter. What strikes me as an even greater divergence is that Financials are ZOOMING, especially smaller companies. I have written on several occasions that the smaller companies could benefit from the demise of overleveraged large competitors. I own Cullen Frost (CFR), for instance (you can see all of my holdings for other Financials), which I wrote about in February (as well as subsequently when I put it in my Conservative Growth/Balanced model portfolio). Despite the massive wealth destruction of certain large Financials this quarter, the overall value of large-cap Financials has increased 5% QTD compared to the S&P 500 falling 5%. Surely, some of this is just a correction of perhaps overly pessimistic pricing after the July lows, but it sure looks like THE LOW is in for the sector. So, the headlines are as ugly, even uglier than one could ever imagine, but the stocks are UP this quarter. Maybe some of it has to do with the new shorting rules, but I would note that the stocks have actually declined since they were implemented. While Healthcare and Staples aren't too surprising as relatively strong performers in a weak market pricing in recession, what's up with Consumer Discretionary? Across market capitalizations, it is up this quarter, no doubt a function of the collapse in energy prices. I guess that I conclude my review of returns by saying that if the world were really coming to an end, I don't think that small stocks would be up on the quarter as well as Financials and Consumer Discretionary. These areas are what one would expect to be leaders in the early part of a recovery. Stocks are in many ways quite inexpensive. Whether one looks at the broad market or individual stocks, PEs are relatively low. If interest rates rise dramatically or the estimates prove to be way too high (and they are too high - see my recent article), then the low valuations won't be as low as they appear. Given the severe economic headwinds for the consumer, I would expect rates to be low for some time. The inflation threat has passed - we are back on disinflation (if not deflation) watch. The earnings estimates will come down soon, but the low valuations seem to more than compensate. As I look out, I expect PEs to improve, perhaps significantly, as the credit crunch passes (let's say in 2010). A year from now, the market will be priced based upon the expectations for 2010. Even if the market earns then only what it earned last year, there is room for the market to advance as the PE's rise (assumes low rates and contracting risk premium). I know that at the bottom of a market, when earnings are depressed, PE ratios should actually rise. That gives me a little confidence that despite my concerns about earnings estimates, the market appears to be able to absorb the cuts. Witness the reaction to the General Electric (GE) warning this week. One can talk about technicals, fundamentals, valuations and even politics, but it's all for naught if the overall economic environment is so overwhelmingly negative as can be the case when credit is contracting. I was worried a year ago that the only policy response deemed appropriate for consideration was to "cut rates". As many pointed out, this response, while directionally correct, wasn't likely to do anything in and of itself except exacerbate inflationary concerns and destroy the value of the dollar. Why it has taken so long to see possible solutions has a lot to do with why the problems got to be as big as they were. Nobody cares when everything is o.k., especially politicians. For instance, they wait until AFTER the hurricane to address a systemic problem with New Orleans. Well, I digress. The fact is that we now have the business community, the people and the politicians all aware of the problems and, in fact, working towards solutions that can truly change the outcome by addressing the fundamental problems. I stated a year ago that there is "no rate at which a lender will lend to an insolvent borrower" - just lowering rates doesn't help. From the Bear,Stearns (BSC) and Countrywide (CFC) mergers to the more recent dealings with the GSEs (FNM),(FRE), AIG (AIG) and now WaMu (WM), it is clear that the officials are working to restore liquidity to the market and to eliminate immediate risks. More importantly, the suggested plans to stop fire sales have the potential to halt the downward spiral. Who wants to buy equity or assets of distressed institutions when there isn't a floor? The RTC plan, despite many flaws, worked, and it is likely that the measures being discussed too will allow for a more orderly liquidation of distressed assets. There is plenty of "good" capital out there on the sidelines - Mr. Buffet showed that this week with the Bank of Goldman Sachs (GS). It is the progress we are making in dealing with the fundamental problems rather than band-aid solutions like rate-cutting (which feels good to all debtors until they realize their rates aren't the ones getting cut) that encourages me the most. The market has rallied hard in the past when the end was in sight. Hopefully, that will be the case now. I am not that optimistic at all that we are in for a long period of double-digit returns for stocks in general, but I do believe that we are in a position where investing in stocks (and probably corporate and mortgage-backed bonds) will be rewarded compared to investing in "risk-free" assets. Personally, I favor companies that tend to be smaller but facing large market opportunities with strong balance sheets, but I also recognize that companies that are larger and/or of worse financial position may also offer opportunity here. Disclosure: Long CFR