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Jubak's Journal
Recent articles:
• 10 big, fat cash cows, 10/21/2003
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Why 'bad' news may help stocks
Worries are just what the market needs because they push down expectations, which then can be exceeded. The result: stocks climb higher.
By Jim Jubak
Want to predict the course of the stock market in the short-run, say over the next two months? Look at the balance between expectations for good and bad news.
When everyone is expecting nothing but the best of weather, look out for disappointments and a falling market.
Its when investors are worried and their worries turn out to be overblown that stocks move up, climbing that famous Wall Street wall of worry. That pessimism, in fact, provides the fuel for stocks to move upward as worriers on the sidelines are converted to active buyers
So where are we now? Expectations for bad news have increased in the last two weeks, though not enough yet to fuel another leg up in the market for the rest of the year. For that we need more worry -- exactly the kind that you get as a result of a 149-point drop in the Dow Jones Industrial Average ($INDU) or a 2% drop in the Nasdaq ($COMPX) like those the market delivered Wednesday.
To see where we are, let's look at 4 areas where bad news is actually good news.
Meanwhile, in the bizzaro world
The economy. On Monday, the Conference Board said its index thats designed to predict economic trends, the Index of Leading Economic Indicators, fell 0.2% in September -- the first drop in four months.
Looks like the economy, which economist estimate grew at a feverish 6.1% rate in the third quarter, is about to cool down. Fourth-quarter growth may come in at just 3.8%.
But this bad news is good news for investors because it gives them something to worry about, which in turn gives the economy and stock market room to deliver better-than-expected news in the fourth quarter.
Before this news, investors had started to speculate about fourth-quarter growth of 6%, or 6.5% or 7% and maybe even better. If you remember that the 6.1% projected for the third quarter would be the fastest growth rate in about four years, youll understand that expectations for 7% growth are right at the top of the scale.
Thats a problem because when expectations climb that high, the chance of an upside price diminishes. And projected growth has a way of getting factored into stock prices, so investors looking to buy in recent weeks have been hunting for news to convince them that fourth-quarter growth would be better than expected. With expectations at the top of the scale, the likelihood was that the news, rather than being surprisingly positive, would be at least mildly disappointing.
Now that this bad news is out there, the economy has a chance to pleasantly surprise investors if growth picks up again to the torrid pace of July and August and the slowdown in September turns out to be merely temporary.
Another bubble?
Stock valuations. The worry is that at current levels stocks are wildly overvalued. That certainly looks to be the case even for the S&P 500 Index ($INX) if you look at reported earnings. The indexs price-to-earnings ratio for the trailing 12-month period stood at 30, just about twice the average of 15.5 since 1935.
The picture is even worse for Nasdaq stocks. Investors are worried about getting caught in another market bubble.
But the numbers are pretty much where they should be after you adjust for our current position in the economic cycle. As the economy recovers and companies stop taking big write-offs to cover the costs of closing plants and cutting workers, earnings stage a quick and huge recovery. Projected earnings per share for the next 12 months for the S&P 500 Index is projected to jump to $48.95 from todays $34.55, which will push down the P/E ratio to 21. It's still not cheap, but it's not as scary as 30.
The turnaround in the Nasdaq composite will be even more pronounced. But 1,500 of the 3,400 Nasdaq stocks tracked by our Stock Screener show losses for the trailing 12-month period. Wall Street analysts project that about 700 of those money-losing companies will swing to the positive side of the ledger next year. The shift will move the price-to-earnings ratio for the entire index into more comfortable territory.
Is liquidity a problem?
The money supply. The latest (seasonally-adjusted) numbers from the Federal Reserve show a slowing in money-supply growth, or an actual contraction. M1, a relatively narrow measure of the money supply that includes currency in circulation and demand deposits at commercial banks, barely grew in September from August. More inclusive measures such as M2 and M3 contracted in the month. These numbers have led some Wall Street professionals to worry that a liquidity shortage could hold down the market.
But this liquidity change, if it holds up as something other than a one-month glitch, may be important to the long-term economic growth rate. (And remember that next year is an election year. I doubt that the Federal Reserve will tighten the money supply significantly going into a presidential election.)
In any case, a dip like this in the short-run in the money supply is insignificant to a stock market wondering how much of the money parked in money market and bond funds will come back to stocks soon. Individual investors have just started to tiptoe back into stocks and their behavior, rather than Federal Reserve liquidity, is whats critical for the market in the short run.
Does the bull need a cane?
The bull is old. The S&P 500 is up about 33% from its low on Oct. 9, 2002, and the Nasdaq is up 72%. Worried investors ask how much higher can stocks go and how much longer can the bull run?
Well, a ways yet. According to research from Jim Stack, editor of InvesTech Research, the median bull market lasts for 2.6 years, so this one-year-old is still far below the historical median. (The historical median, Stack points out, would put the peak of this bull market about six months after next years presidential election.) This bulls gains, impressive as they are, are also well below the historical median of a 77% gain on the S&P 500.
The run-up in stock prices, in other words, represents a classic wall of worry that wont keep money out of equities for long if stocks start to look strong again.
But thats just one side of the ledger. Theres also good news that is indeed worth worrying about.
Now to the 'bad' good news
Lack of fear. About 57% of investment advisors are bullish, which isnt good news because readings over 55% are often signs of an overbought market. Short-interest on the New York Stock Exchange ticked upward a bit recently, but its still near recent lows. The Chicago Board Options Exchange volatility index, the VIX, has moved back to near the September lows, signaling that few investors are worried enough to pay much for options to protect them from stock market volatility.
Investors who've watched the VIX fall consistently during the rally from the March lows know that stocks can climb for quite a while even as this index shows low levels of fear. But a lack of fear does remove one important type of fuel for any near-term rally.
The rating game
Analysts going to "buy" from "hold." Its the shift in opinion to a "buy" from a "sell" or a "buy" to a "hold" that gives a stock a boost. When analysts are uniformly in the "buy" camp, that fuel is gone and the next likely move is a downgrade. One of the reasons that Microsoft (MSFT, news, msgs), for example, has gone up so sluggishly during this rally is the very "strong buy" that Wall Street has had on the stock for months. Three months ago, 16 analysts rated it a "strong buy." Two months ago, still the same 16 "strong buys" were there. Last month, there were 17 "strong buys." Currently, there are 15. No analyst has had a "sell" on the stock during that three month period and only two have rated it "hold." (Microsoft publishes MSN Money.)
You can see other stocks consuming their fuel. Intel (INTC, news, msgs), for example, has moved from 10 "holds" and two "sells" three months ago to five "holds" and one "sell" now.
To the degree that this good news from analysts is in current stock prices, thats bad for future stock prices.
As you can see from my list, I think the bad news is lining up in favor of a move up in stocks through the end of the year. Id feel more certain of that if a few more bad days in the market raised the fear level in the VIX and made advisors a little less bullish. That kind of bad news would be good for stocks.
As we stand, the odds favor a rising market through the end of the year. But the bias isnt so strong that Id throw caution to the winds. This is time to be cautiously optimistic and to let your portfolio climb your own wall of worry.
Editor's Note: A new Jubaks Journal is posted every Tuesday, Wednesday and Friday. The Wednesday edition stems from Jim's appearance on CNBCs Business Center most Wednesday nights at approximately 5:45 p.m. ET.
At the time of publication, Jim Jubak owned or controlled positions in the following equities mentioned in this column: Microsoft. He does not own short positions in any stock mentioned in this column.
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