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This bear still has some bite
Those of you tiptoeing over to the bull camp may lose your step in mid-September. Here's why two top technical traders say there's more downside ahead.
By Jon D. Markman
Its psych-out time in the nation's stockyards. Bulls contend the market will continue to advance because there are plenty of doubters to convert to buyers. Meanwhile, bears contend the market will soon reverse and fall because there are plenty of skeptics to convert to sellers.
The market is always a mind game, to be sure, but at certain inflection points, the misgivings, regrets, hopes and dreams of all big players pile onto a giant, dangerous bonfire that attracts public attention. The object of the private investor is to avoid being burned while figuring out which side is feeding the flames with false beliefs about the future that will cause them to lose money, and which has an accurate perception of the future that will help them make money.
Bulls and bears cant both be right. One side will win. This is not a high-school debate where you get points for a well-argued wrong answer.
Im lining up in the bear camp as the bulls have the most to prove.
Mid-September stall?
What, after all, has changed since the July 24 lows except that prices have risen and big-company chief executives have signed a piece of paper asserting that, to the best of their knowledge, for the moment, theyre not liars or cheaters? A change in the news cycle is all. A modest decline in bad vibes from regulators and companies and world politics, coinciding with the typical lull between earnings-reporting seasons.
Havent we seen this before?
Many observers have scurried back to the history books in recent days to attempt to prove that the summer reversal was similar to ones in June 1932, June 1953, July 1962, September 1974 and July 1982. Each of those, the historians say, came out of the blue just as the reversal last month did. Stocks had been going down, down, down for weeks on end, and then one afternoon, prices inexplicably lifted and kept on going.
Perhaps that will happen again, but my own multi-decade time machine is broken. I can only look over my shoulder a couple of years, and from that perspective, the recent reversal looks a lot more like the fake-out rally of May 2000, which lasted two months; the fake-out rally of April 2001, which lasted two months; and the fake-out rally of October 2001, which lasted two months. In each case, sellers stood aside for a short time to allow bulls to reset the pins, before striding back into the lane and bowling them over again.
If this line-'em-up-then-knock-'em-down scenario plays out once more, it will begin to look in the next week or two like the bulls gave their best effort in the first month of the rally -- that is, through the end of last week. The next few weeks would be flat with a mildly upward bias. And the next leg of decline would commence in mid- to late September.
Tony Kolton, head honcho at Logical Information Machines in Chicago and one of the more capable market historians around, tells me that even bulls should beware the mid-September time period. He notes that rally off the bottom in 1982, also a midterm election year, lasted until Sept. 22 but was followed by a swift and scary correction. Likewise in 1932, says the former Chicago options pit trader, the summer rally lasted until Sept. 9 and corrected a fast 15% and nearly, but not quite, revisited the old lows.
He pointed out, as I have reported here before, that over the past 100 years the best day on average to invest new money in the stock market has been Oct. 10 -- though in the past 25 years that distinction has shifted later into the last week of October.
Checking the fudge factor
One of the dangers in projecting the future out of our memories of the past is that we tend to fudge a lot to make our point. Its valuable therefore to check in with researchers who have created measures of market emotion and fundamentals that help compare historical periods objectively. Many institutional investors that I speak with believe that Paul Desmond, president of Lowrys Reports in Florida, has a set of market-washout heuristics that work pretty well.
I last spoke with Desmond in late July for an article called Psychology suggests we havent hit bottom yet. He instructed us then that absolutely every major bear-market bottom in the past 85 years has been characterized by a series of days, approximately a month apart, in which 90% of the volume of the New York Stock Exchange is in declining stocks and 90% of the price changes in the exchange is in declining stocks. The bottoming process ends, he says, only when those hellacious days are followed by at least one day of the opposite effect -- that is, when 90% of the volume and price change is to the upside. The formula for the volume change is Downside Volume / (Advancing + Declining Volume). You can get the volume figures on this page on our site; the price change cant be easily calculated.
Desmond asserts that there were no 90% downside days amid the panic selling following Sept. 11, nor amid the panic selling in late July. There were two 90% upside days last month, July 5 and July 29, but they are meaningless, historically, unless they follow the big downside days. (In Barron's magazine two weeks ago, Ned Davis of Ned Davis Research in Florida said that his measure of 1,500 stocks did record a 90% downside volume day in July. But Desmond scoffs that the only valid event occurs when volume and price both immolate in tandem. Other methods of imitating his work, he says, produce too many whipsaws.)
Desmond, whose experience stretches back to the 1962 bear market, said that he believes there is still a tremendous amount of stock overhanging the market held by individuals who regret that they didnt sell the last time they had the chance, in the spring this year. They are anxious to get out if they can break even. And they will provide the supply, he believes, if the market continues to rebound into September. He has advised his institutional clients to start selling into rallies this week and next.
If Desmonds scenario plays out, its easy to imagine a scenario where the market goes down harder and faster in October than it did in July, as investors who were disappointed by their failure to get out in late August throw everything overboard in a mad, irrational rush to the exits. Of course, fears and flinching over the Sept. 11 anniversary wont help. In Desmonds view, investors will come to feel so whipsawed, distracted, disgusted, cheated and angry that falling prices will feel like a crushing weight. And that would potentially lead to the 90% downside volume and price days that could bring the final and lasting wipe-out, a real bottom that leaves investors facing truly cheap prices -- not forward price-to-earnings multiples for slow-growth companies like Coca-Cola (KO, news, msgs) of 29, or drug-store chain Walgreen (WAG, news, msgs) at 37. (See more stocks for which expectations appear too high in Table 1.)
| Expectations too high? | | Company Name | Symbol | PEG ratio | % EPS growth next year | Forward P/E | Aug. 26 close | | AT&T | T | 3.5 | 19.9 | 69.5 | $12.59 | | Coca-Cola | KO | 2.8 | 10.6 | 29.5 | $53.01 | | Microsoft | MSFT | 2.6 | 10.9 | 28.7 | $52.10 | | Procter & Gamble | PG | 2.5 | 10.1 | 25.4 | $90.40 | | Cisco Systems | CSCO | 2.5 | 16.7 | 42.0 | $14.49 | | Eli Lilly | LLY | 2.5 | 9.1 | 22.3 | $59.65 | | Gillette | G | 2.2 | 12.2 | 27.3 | $31.37 | | 3M | MMM | 2.1 | 11.8 | 24.9 | $127.25 | | Oracle | ORCL | 2.1 | 13.1 | 27.5 | $10.57 | | Walgreen | WAG | 2.1 | 17.8 | 36.9 | $35.70 |
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2 for the bulls
My boss implored me this week to be more like James Stewart, the SmartMoney magazine columnist we publish who has been steadfastly bullish during the summer decline on names like AOL Time Warner (AOL, news, msgs), Tyco International (TYC, news, msgs) and Aquila (ILA, news, msgs). In contrast, he complains that Ive been steadfastly negative since throwing in with the bears in late spring -- arguing for short sales of Toys R Us (TOY, news, msgs), Electronic Data Systems (EDS, news, msgs) and Emulex (ELX, news, msgs) and urging skepticism over General Mills (GIS, news, msgs).
I hate to disappoint my boss, so heres at least one idea on the long side: Since the Bush administration seems to be ready to launch a move to cut the tax on dividends, consider companies with strong StockScouter scores and big dividends. A couple are Annaly Mortgage Management (NLY, news, msgs) and Anworth Mortgage Asset (ANH, news, msgs), yielding 16% and 13%, respectively.
Fine Print
Desmonds weekly institutional research report is mostly read by professionals who pay up to $12,000 per year, but you can get a weekly version for about $300 per year. Visit Lowrys Reports. To generate the table above, I used this screen, Stakes High 2. Its a modification of a screen I used in this column, 11 stocks where the stakes are too high. Short sales of those 11 stocks would have generated a gain of 16% through Aug. 21, versus the market decline of 11% in the period. On the long side of my ledger, the eight stocks I recommended as potential candidates for buyout by vulture capitalists have rebounded smartly in the past few weeks, up an average of 12%. Feast along with the buyout vultures. They are led by Quanta Services (PWR, news, msgs), up 49% and Nabi Pharmaceuticals (NABI, news, msgs), up 40%.
While Jon Markman cannot provide personalized investment advice or recommendations, he invites you to send comments on his column to jmarkman@microsoft.com. At the time of publication, he owned the following stocks mentioned in this column: Microsoft.
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