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Erlanger Squeeze Play
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20 stocks for the beginning of the end
See why market experts I trust say the worst still lies ahead -- but so does a reversal. And why, as we worry about a financial meltdown here, another is already occurring in Europe.
By Jon D. Markman
While you might think that bearishness has recently sped toward a climax with markets at six-year lows, two analysts who have called the decline for this column with deadly accuracy over the past two years say that investor anxiety is still only inching toward an apex, compared to similar periods in the past -- and that a tradable bottom may yet be weeks away.
Paul Desmond, editor of the institutional newsletter Lowrys Reports, says that so far the broad market has experienced just a single day in the past three years in which 90% of the volume and prices on the New York Stock Exchange were to the downside. That was last month, on Sept. 3. He believes the record of the past 100 years shows that should be as many as five such days of wholesale selling before the bear is satisfied. (See here and here for details.) On Tuesday, he told readers, many of whom are major fund managers chomping at the bit to begin buying again: Many clients have asked if some structural change in the stock market -- decimalization, options, program trading, etc. -- might be responsible for the sparseness of 90% Downside Days during the current decline. While we have looked at those issues, the real problem seems to be that investors still see themselves as in for the long term. Until investor psychology becomes negative enough to inspire panic selling (90% Down Days), the overhead supply of stocks will stifle any rallies.
This makes sense, in a cruel way. Only when most of the markets inventory is obtained at extreme wholesale prices (lets say, 50% off) by a new class of purchasers will stocks seem cheap enough to own with any conviction. Its like a nice jacket purchased at 90% off at a major department store sale: It might not even fit, but at prices like these its not even worth the effort to try to return it.
Still short on short-sellers
Phil Erlanger is another sentiment guy who understands the healing power of pain -- and is not yet convinced there has been enough of it.
The Massachusetts-based technical analyst spent years at Fidelity Investments giving the likes of portfolio managers Peter Lynch and Jeff Vinik advice on timing the purchases and disposals of billion-dollar stock positions. Now independent, he still plies his trade mostly on behalf of institutional managers, but he also publishes a $250 per year newsletter called Erlanger Squeeze Play (see link at left) for everyone else. It focuses on the ebbs and flows of fear and greed in financial markets. His special expertise is determining whether bulls or bears have made the biggest bet for or against any individual stock or market, and who would feel the most distress if the trend were to go in the opposite direction. Every important rise and decline in stock, he thinks, is a reaction against the false beliefs of the biggest players in the previous move: The larger the mistake of those players, the larger and longer the following move.
Its pretty simple, if you think about it. When a stock goes up sharply after a fall, it is taking money away from bears who stay short too long. When a stock goes down sharply after a rise, it is taking money away from bulls who stay too long. The more bears needing to cover as the move goes against them, the more fuel for a surge. The more bulls needing to sell as the move goes against them, the more fuel for a decline.
To gauge sentiment, Erlanger focuses on the level of short-selling primarily because his research shows that the greatest number of short sales are historically made at exactly the wrong time, when a stock or market is the most likely to reverse and explosively move up. Short-sellers not only represent opinion, they also represent potential demand for a stock as they cover.
The trouble with the current market, Erlanger says, is that short-selling is near multi-decade lows despite the two-year decline. In other words, market players from Munich to Minneapolis continue to be complacent, expecting that every rally represents the start of a new bull market. Without enough short-sellers to convert into buyers, he believes, the market cannot advance with any sort of explosiveness.
The beginning of the end
Erlanger was bullish throughout most of the 1980s and 1990s as a result of his studies, only turning mostly bearish in 2000 and extremely bearish this summer, so he is no perma-bear with a fixed point of view. He currently believes that a single extremely sharp decline is still in the cards in the next month, which could be followed by an equally sharp rally that might return the market to the levels of early summer.
In Mondays letter to clients, he was sounding positively chipper. The beginning of the end is at hand. As panic sets in, and capitulation ensues, we will look to exit our short positions, he said. Remember, we took most of our short positions when most felt lovingly about the market's prospects. We want to start taking long positions when most have finished puking. We are not there yet, but we are close. Stay tuned.
On Tuesday, he exited two major profitable short positions that bet against the broad averages and told readers: The big question is whether or not we get a clear sign of capitulation. By clear we mean something other than the meandering, drunken crow style of decline. Many, ourselves included, have been looking for a dramatic surge in downside velocity. If (market volatility measures) become more extreme, we may start to contemplate a tradable low without the drama. It would be just like the market to fail to give traders what they are looking for.
The best way to play a potential plunge and recovery, Erlanger-style, would be to short stocks with the worst performance relative to the market yet sporting the lowest short-interest ratios relative to their own five-year histories, and to go long stocks with the best performance relative to the market yet featuring the highest amount of short-selling. See the two tables below for his top 10 long and short candidates.
I will follow these over the next couple of months and report back. For the moment, there seems little doubt that underdogs are fun in sports, not in your retirement portfolio.
| Erlanger shorts: Oct. 7, 2002 | | Symbol | Company | 10/7 close | Power Rank * | | VRTS | Veritas Software | 12.28 | 7% | | CEFT | Concord EFS | 13.14 | 8% | | MXIM | Maxim Integrated Products | 21.98 | 8% | | MCD | McDonald's | 17.45 | 9% | | NSM | National Semiconductor | 10.60 | 9% | | PSFT | PeopleSoft | 12.07 | 9% | | INTC | Intel | 13.82 | 13% | | VLO | Valero Energy | 23.95 | 14% | | CSC | Computer Sciences | 24.85 | 15% | | HD | Home Depot | 24.21 | 15% |
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* Power Rank is Erlanger's proprietary system that rates stocks from 1-100, with 100 being best. The highest-ranked stocks have the best relative price strength and are the most shorted.
| Erlanger longs: Oct. 7, 2002 | | Symbol | Company | 10/7 close | Power Rank | | CHD | Church & Dwight | 33.06 | 100% | | UL | Unilever | 37.23 | 100% | | YELL | Yellow | 27.01 | 100% | | HRS | Harris | 33.61 | 96% | | NXTL | Nextel Communications | 7.74 | 93% | | AFL | Aflac | 29.66 | 92% | | QCOM | Qualcomm | 29.49 | 92% | | INTU | Intuit | 43.82 | 90% | | HET | Harrah`s Entertainment | 47.49 | 88% | | OXY | Occidental Petroleum | 28.72 | 88% |
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On Tuesday, my colleague Jim Jubak explained the nightmare scenario that could result from a derivatives-induced failure at J.P. Morgan Chase (JPM, news, msgs). But no one in the United States seems to be focusing on the slow-motion banking-system implosion that is already occurring in Europe. Two German financial services giants -- Commerzbank (CRZBY, news, msgs) and Allianz (AZ, news, msgs) -- have each lost nearly 70% of their value in 2002, following a series of wrong-way bets on interest rates, stocks, derivatives and loans, as well as bad luck with insurance liabilities from terrible summer floods.
Bad loans, dwindling revenue
In a report published Monday, Goldman Sachs reported that corporate indebtedness in Europe has doubled while interest coverage ratios -- which measure the ability to pay for debt -- have been cut in half. Goldman said ratings downgrades by Moodys Investor Services for its universe of 154 leading corporate issuers have exceeded upgrades by 20:1 this year. Last week, Commerzbanks chief executive told investors that he was sharply raising the companys estimate for bad debts, an admission that knocked another 15% off his stock price.
When kicked in the wrong direction, credit and equity values push off each other in a death spiral. As a banks stock price falls, so do its bonds. As the bonds value falls, ratings agencies downgrade them. The debt downgrade makes it more expensive for the company to borrow, so stock investors react to the downgrade by selling shares. Rinse and repeat.
The problem has worsened for Commerzbank because, from a strategic point of view, it wagered its future on success in the capital markets rather than simply on making loans. That was a good idea back in the 1990s, but in a bear market amid a faltering economy it has proved a disaster. As its stock speeds toward zero, Europeans fret that Commerzbank will disappear in a fireball of insolvency and take the rest of their banking system with it. That is unlikely to happen, as illiquidity is the only thing that can kill a bank, and German regulators are unlikely to allow it. But markets move in the short term on fears, not facts, and for the moment the fears feel as real as rocks on the Rhine.
Meanwhile, at Allianz, owner of the PIMCO family of mutual funds in the United States and the Dresdner Bank in Germany, as well as part-owner of other German banks, an aggressive round of cost-cutting, including elimination of more than 11,000 jobs, has failed to keep pace with a cascading loss of revenue. In a report issued last week, a skeptical Merrill Lynch analyst said the companys provisions for loan losses were overly optimistic -- and further loan write-offs, should they be necessary, would lead to a worsening of the companys financial position. Merrill sees earnings and revenues at Allianz in either case coming in below expectations for the coming fiscal year, and finalizes its assessment with the declaration that even at todays all-time low price, shares lack valuation support -- a fancy way to say theyre still not cheap.
The debt hangover
Of course, the problem with loan losses and declining revenue at financial services firms is not limited to Germany. The international consulting firm Oliver, Wyman & Co. estimated in a report published this week U.S. and European investment banks together are poised to write off a record $130 billion in loan losses this year. These banks all took advantage of high spirits in the 1990s to lend to companies they wished to seduce as new equity- and debt-issuance clients. But now, the strategy is ending in tears in every major financial capital. Not only have the likes of Enron (ENRNQ, news, msgs) and WorldCom (WCOEQ, news, msgs) folded under the weight of crushing debt, now the banks themselves are buckling as their investors see increasingly little likelihood the loans will be repaid.
J.P. Morgan said last week it would fire about a fifth of its investment banking employees to cut costs as its income evaporates, while it, Citigroup (C, news, msgs), Merrill Lynch (MER, news, msgs) and peers also face lawsuits and government probes that will distract their executives for years. A single successful federal or class-action lawsuit brought against any of them could result in an award large enough to force insolvency. Theirs are the deep pockets that hordes of brutalized telecom investors will pick clean.
In this way, debt issued and taken on during the 1990s has become the asbestos of the financial services industry -- a lead weight that will weigh these companies down for years to come, a weight that will not go away even if the U.S. and global economies recover, a weight that will keep lawyers employed for generations. Successful asbestos lawsuits, once considered outrageous and unwinnable, caused the bankruptcy of one-time basic industry leaders like Armstrong Holdings and W.R. Grace in 2000 and 2001. Dont think it cant happen to the banks.
Fine Print
Two recent columns on long/short hedged portfolios -- Play both sides of this market to win, 10/2/2002 and StockScouter's hedge-your-bets portfolio up 30% -- have generated a lot of reader interest, so heres an update on performance. The 20-stock Oct. 2 long/shorts hedge portfolio published on Oct. 2 is already up 6.19% so far, according to my calculations: +12.9% for the shorts and -0.57% for the longs. If you were to take just the top five longs and five shorts for a 10-stock portfolio, the results are a little better: 8.2% overall, with shorts +17% and longs -0.57%. The most successful short has been Brocade Communications (BRCD, news, msgs), which has plunged 39% since the start of the month; and Tyco International (TYC, news, msgs), which has fallen 24%. Just when you think these stocks cant fall any further, they do. The day people completely give up on these, it seems, will result in the 90% Downside results expected by Desmond. On July 17 I explained why Emulex (ELX, news, msgs) was due for a fall due to the deteriorating quality of its earnings. At the time, the stock was at $26.25, and I suggested a decline to $6 to $8 was in store. This week, it got to $8.25 amid the general decline in storage-technology stocks. Since its price/sales multiple is still double its pre-bubble average, it wouldnt be a surprise to see shares slip further. Another earnings-quality problem that I highlighted earlier this year also reached my bearish target over the past week: Toys R Us (TOY, news, msgs) (click here for the column) was around $17 then in early June, and has fallen off the shelf to rest at $8.25, a two-decade low. I was surprised to see its big institutional owners, Brandes and Harris Associates, not back into the stock at its three-year low around $10. The stock is now really, really cheap on multiples to earnings, sales and book value, but technically there is no support till around $6.50, its January 1984 price. If the value tribe isnt stepping in here, there must be something seriously wrong.
While Jon 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, Jon Markman owned no stocks mentioned in this column.
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