IS THIS A “MAJOR MARKET TOP”?
A reader recently responded with several excellent reasons why this could be the formation of a major market top and what Robert Prechter referred to as the next leg down in the bear market. Although I turned near-term bearish recently, I am not convinced that this is a major turning point. In this piece I respond to “Our Man In NYC” and the reasons why I believe this is not a major market top, but more likely a correction within the uptrend:
Our Man In NYC:
Thanks for the great response. I’ll give you my brief thoughts on each topic you touched on.
- CRE: Still a huge problem, but it’s a slow motion train wreck. The majority of the troubles in CRE are spread out over the next 3 years and will hinder bank balance sheets, but won’t serve as the “all at once” wallop RRE was in 2008.
- RRE: I said that last years stability in housing was a head fake and I still think we’re heading lower, but the stimulus will continue to bolster prices in the near-term. There will be one last surge in activity as the tax credit ends this year. Late 2010 and 2011 has potential for substantial declines in residential as resets surge, foreclosures remain high, inventory remains high, stimulus ends and the laws of supply and demand reassert themselves after the government’s temporary price fixing. The next leg down isn’t quite here yet.
- Sovereign Risk: Greece is getting bailed out in all likelihood, but all in all, another slow moving iceberg. The S&P story on the UK is alarming. As readers know, I think debt is why we’re ultimately still in a bear market, but it’s not a NEAR-TERM concern.
- Liquidity: The Fed remains accommodative. China appears to be on the verge of a wind-down. Alarming, but at 10.7% GDP I think investors will ultimately view the near-term downturn as a buying opportunity in emerging markets. Stimulus and accommodative policies are nearing an end, but the process will remain lumpy as the U.S. keeps rates near zero for all or most of 2010.
- Terrorism: Agreed. Always a risk. Not an investable/foreseeable event, of course.
- China: Still showing strong growth. Not quite a bubble yet in my opinion and substantial downside should be viewed as a buying opportunity.
- Trade/Protectionism: Not the negative many would like to make it out to be. This global economy is too intertwined for 1930′s style protectionism to develop.
- Valuation: Primarily a rear view mirror indicator. So long as earnings continue to outperform the market will look cheaper than investors currently assume. Not a reliable indicator of future price action in my opinion. The PE is one of the most misunderstood and unreliable indicators investors have ever used.
- Deleveraging: A slow motion train wreck. As regular readers know, this is one of the primary reasons why the bear market is still with us. However, as we saw in Japan, stimulus and government spending thwarted major downturns for prolonged periods of time. The stimulus in the U.S. isn’t over yet.
Comments and coherent responses are welcome/encouraged.
Well thought out and rational, but I fear you are wrong. As a technician I see the ominous signs mounting.
Technicals are a piece of the puzzle, but don’t trump fundamentals.
Your looking at fundamentals based on unsustainable govt policies.
True, but does that mean they will stop having a positive impact at this moment? The data says no in my opinion. Later in 2010 and 2011 are the more likely times to get very bearish.
Didn’t Technicals trump fundamentals for all of 2009?
Also if many in the investment world foresee weakness in late 2010, why wouldn’t they begin selling now? That’s why markets are suppose to be a leading indicator, cause they know if something is sustainable or not.
great posts by our man in nyc and tpc.
i have been thinking recently about some of the insights provided by behavioral economics, which among other things speak to our mental over-reliance in expecting history (recently quite negative) to repeat itself and the painfulness of losses when compared to the pleasure of gains.
many people are reporting the sighting of bubbles, focusing on the negative, which is of course important in order to protect the downside, but this sensitivity to the black swans can obscure the ability to see the good news, the white swans.
if 4Q GDP growth is a large number, maybe the market will tell us that we were focusing too much on the bad news.
Well, I think the other side of the same argument is all the people expecting return back to “normal” any time now after a couple of years of suffering. However, that “normal” was always illusory .
You said you’re all ears for the bearish case. Here is one grizzly bear’s case:
- The Truth About Earnings: Multiples still matter. They have for the last one hundred years and I don’t understand why they wouldn’t be valid today. On an AS REPORTED basis, this may be the most expensive market in history. You’re absolutely right about PE ratios being confusing and invalid. But on an AS REPORTED basis, I don’t know how this chart doesn’t scare the hell out of you:
http://www.decisionpoint.com/TAC/SWENLIN.html
Now I understand your counterargument here. “It’s backwards looking and I care more about what future earnings look like.” My response to that is simple: I will take the reported number over the projected number every single day of the week. One is based on something resembling rock hard fact, the other is purely conjecture.
If I may be so bold as to offer an explanation for what I believe is your over-emphasis on the analyst game: You come from Merrill Lynch, perhaps there is a subconscious bias towards analyst projections that I, as someone who’s never worked in the financial sector or on Wall Street, don’t have. And I know that you get that analysts are clowns. But your interpretation of the ER is still based on this circus.
- The Dollar
Anybody with a basic understanding of technical analysis can see that the trend has changed. Given the uncanny correlation between the USD and SPX, these are significant headwinds for the bullish case. If you want a fundamental case, there’s a reflexive relationship to explain the correlation. Lower USD means greater profits for any US export companies. Higher USD means lower profits. If the dollar really has turned (and the fact that $1.4000 didn’t hold is a huge tell), stocks are overvalued. How overvalued? I think the my points above say something about that.
- We are Japanese
I’ve discussed this ad nauseum. I would agree with your bullish bias if this was a run-of-the-mill cyclical recession. It isn’t. Balance sheet recessions are very, very ugly by nature. We have a massive amount of debt to clear before we reach some form of ‘normal’. We’re nowhere near that yet. Further, QE doesn’t really do anything to help us deleverage. I think you’d agree with me that QE is a big part of the bullish thesis. If I’m correct that QE is irrelevant, that’s another huge headwind. All the other major balance sheet recessions saw massive 80%+ drops. Why can’t it happen here too? That’s why I believe 666 is a joke that will be broken.
Of course there’s more (massive downside volume on the down days, the top was formed on waning volume which is what nearly always happens at tops, leaders have become laggards, financials have broken down, etc etc etc etc). Feel free to poke holes, you’re only doing me a favor by testing this bearish thesis.
The circus is the show though. That is the game on Wall Street. Coming from “the inside” as you view it gave me the knowledge to learn how the game works and see these “clowns” in action. Comps to expectations – that’s how the game has always worked and always will. If you’re waiting for a market that is based in reality and not on expectations then you’ll be waiting for quite a long time.
I get the argument about using trailing earnings, but no one cares what Microsoft reported LAST quarter. The money will move based on what MSFT says about NEXT quarter. It’s a fact. Trailing earnings don’t impact TODAY’S price movements. Just watch what happens in a few hours when they report.
Stocks aren’t permanently damaged by a weak dollar. The dollar is more a reflection of the low interest rate policy and deficits. Both of which are reasons why I agree with your final point. I have written several pieces on why we are Japanese, but understanding Japan is paramount as well. Japan remained strong as long as the government continued to pour money into the economy. With our stimulus far from over I am skeptical of this being a major top.
This is a short-term call. Who knows? I have been wrong plenty of times before.
This is where I have to respecfully disagree with you. “Comps to expectations” specifically around earnings is, IMHO, a small part of the game, especially near turns b/c the clowns are always the last to see the turn. What do I think plays an infinitely greater role than the circus? The fact that the markets move in waves of optimism and pessimism, and Elliott Waves only partially explain this phenomena. Right now we’re excessively optimistic. Waiting for optimism to reach Oct 2007 levels isn’t going to happen, the participants aren’t quite that dumb given what’s happened over the last two years. We won’t reach reality on the downside, we’re going to swing way past it, just like we did in March.
Your comments about MSFT’s P/E are valid. The catch is that I’m not talking about MSFT or any other individual security. William O’Neil extensively tested P/E ratios across individual stocks and found little to no correlation. I argue there’s a strong but lagging relationship between as reported P/E and the market taken as a whole. Like Rosenberg’s analysis, can you trade off it? Of course not, but we do have to revert to the mean and I don’t see how it won’t be ugly.
With Japan, this is a huge misconception about their predicament. The Japanese held GDP at bubble levels BECAUSE OF massive amounts of stimulus. You cannot look at it and say “They wasted their money or didn’t do enough b/c they didn’t grow.” That line of thinking doesn’t make sense…GDP wouldn’t have held at bubble levels w/o the stimulus. It would have tumbled over 25% as it did in the Great Depression. I don’t believe we have the stomach to continue our stimulus efforts b/c we need stimulus for at least 15 years, just like the Japanese. Something like 43% of Americans want to end stimulus. And I as a short seller will be blamed when markets tank as a result.
Lastly, I don’t mean to be disrespectful by citing your Wall St background (Wall St sounds like a swear word these days). Your experience with ML gives you a tremendous edge over me in areas like risk management. However, it handicaps you in a way it doesn’t handicap me. Wall St is notoriously bad at calling bubbles. Given the case I laid out, I’m calling a bubble of epic proportions and hence a major market top. We’ll see what happens. What I love about trading is that we cannot both be right about big top or no big top..the market every single minute differentiates winners from losers. Good luck!
Thanks VCC. I love the debate. Definitely my favorite thing about the site. Tons of smart people making valid and intelligent points.
I hope things work out for you. And I hope I don’t buy back into this market before the wheels really start to come off
Likewise, and I appreciate your responsiveness to us little guys! Nothing falls in a straight line, there will certainly be plenty of trade-able countertrend rallies as the wheels come off, the first one being, in my opinion, in the 1035 ballpark. But the multi-year outlook is simple: Cash is King!
Great debate guys, and thanks for the name check/response TPC!
TPC — I don’t think we’re in too much disagreement on the underlying (excluding forward looking expectations, where I’m clearly far more skeptical thinking too many cos have baked in recovery to their nos) but differ on the timing.
Oh, and I’m with VCC on multiples beyond the PE-10 expensiveness. The problem is that Earnings for ’10 are so heavily back-end loaded that a V’s built-in. Yes, analysts will lower them as we get closer (allowing companies to “beat” the lowered nos) but that just takes a reasonable number to a bleah number — not something I’m willing to pay (a serious premium) for.
Without revenue growth (and we’ve seen precious little, ex-financials, vs. what is supposed to have been “end of the world last year”) there’s only so much more impact cost-cutting can have.
Separately, but relatedly, one (semi-random) thing I think/worry about is…what if companies are cutting off their nose to spite their face.
That is, clearly it’s in every company’s best interest to cut costs (and the best/easiest way is to lay people off) but in an over-leveraged (and aging!) economy driven by consumers…does it just compound the problems & create a negative spiral (which stimulus can only hold up for so long).
The most important thing to note is timeframe. I still think the market could remain bolstered by stimulus and earnings into H2. Then comps get really difficult and the stimulus ends. That’s when this market could get really dicey.
We’re all on the same page in the near-term, but I just don’t see this downturn turning into a 20%+ downturn. I think there will be a buying opportunity in here.
Many people have pointed to the similarities between the 2003 and 2009 stock rallies. 2004 and 2010 are also starting out similar:
2004 – top 10754 mid-Feb, Q1 decline to 10007 with stairstep to 9708 in Oct
2010 – top 10765 mid-Jan, Q1 decline 10 10055 so far.
Personally, I think a 20% decline 1st half and retrace, but with 2011 and 2012 opposites of 2005-2007 bull market.
As far as how good is 5% 2009-Q4 GDP growth, for $14 trillion economy, this is only a $140 billion increase per quarter. At a cost of $700 billion to $2 trillion, does not seem like a very good return.
James,
The comparison isn’t valid for one main reason: What’s the most interest-rate sensitive industry out there? Housing! There was no major housing bubble yet in 2003 and Greenspan could use housing as an economic tailwind. Unfortunately the Man of the Year doesn’t have the same luxury given the pathetic state of the housing market, even after all the stimulus. History doesn’t repeat but boy does it rhyme. USA 1929-1931 is one valid comparison as is Japan 1989-1991.
TPC,
Please explain your statement that PE10 is an unreliable indicator. Looking at the Schiller S&P data since 1871, I show greater than 50% R^2 in a regression between PE10 and future real returns over the next 20 years. Thus, it has been, by definition, the most reliable predictor over that time period for 20 yr returns.
Thanks for your insights.
Timing is paramount when using such an indicator. There is no real reliable way to use this indicator in a strategy. Ie, it is not applicable. When do you go short, when do you go long? Did you short in 1995 when the market looks expensive and get crushed for 5 years? Would you have bought near the the March bottom? Not. Do you sit out from 1995 on waiting for a market that still doesn’t look cheap and you’re effectively out of the market for the last 15 years? PE10 has shown an expensive market for almost 20 years. How does that help us invest? Using trailing PE or forward PE’s is even worse….
TPC,
an excellent article on the same subject…
http://www.tradersnarrative.com/interview-with-matthew-claassen-cmt-3489.html
Interesting. He seems to be on the same page as I am. Nice thoughts. Thanks.
That’s one of the better informed and most civil bull / bear top debates I’ve ever came across, thanks C’s (TPC, NYC & VCC)!
My 2 cents is that we’ll see a good correction, maybe 20% but then rally for a double top before re-testing 666. Whether we break it all depends on the Fed and future stimulus.
And I agree with Faber, “We’re doomed!”
Also a definite derisk in the air .. HK, oil, SOVX, HYG …
…the major market top was in March of last year. Bear markets feed on market timers.