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Jubak's Journal
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My formula for buying stocks in a rocky market
Yes, there will be a buying opportunity from this crummy market. But its not here yet and may not be for a while. Heres why, and what you can do to get ready to buy or sell.
By Jim Jubak
Its not especially hard to figure out why the stock market is teetering.
The Federal Reserve has signaled it will raise interest rates in 2004, oil prices have hit $40 a barrel, terrorist activity seems to be heating up, and no one can see a quick way out of Iraq. This is just the kind of environment that drives investors to the sidelines.
In short, there are a lot of reasons to sell right now and nary a reason to buy. So its no wonder that the Dow Jones Industrial Average ($INDU) busted below the March 24 low of 10,048 in recent sessions and fell below the indexs 200-day moving average at least for a short time on Wednesday. And its no wonder that the Nasdaq Composite Index ($COMPX) has done the same, falling below its March 23 low of 1,902 and its own 200-day moving average.
Its devilishly difficult, however, to know where the market is headed or what to do about it.
My advice is hold onto your cash, if you have any. Wait for a signal that the market is about to turn in the short term.
From a long-term perspective, if you havent sold already, the pain may not be over, but were getting very close to the point where selling no longer makes any sense unless you are an agile and experienced trader.
To project the future of this market for stocks, I think you have to separate the short-term and the long-term pictures.
Jubaks view of the short term
This market, in the short term, is well-defined by financial history and established patterns of technical analysis by a method called distribution. Thats a fancy name for investors doing more selling than buying. Distribution down days are marked by heavy volume. However, distribution up days dont produce equally heavy volumes. The market indexes may climb on those days, but they climb on relatively light volume. The conviction in a distribution clearly rests with sellers.
Distributions can end in one of two ways:The speed of the decline can accelerate. And an orderly decline can turn into a rout. So far weve had a relatively orderly distribution: A test of the March lows is an expected, rather than an unusual, event. Contrast the drops in the Dow Jones Industrial Average and the Nasdaq Composite with the volatility in Japans Nikkei 225 Index ($JP:NI225), which dropped 4.8%, or 554 points, on May 10. If the size of the drops on the down days for the Dow and the Nasdaq start to move higher from the 1% and 2% losses weve seen in the last week or so, then the market could be setting up a big decline, something much greater than the 6.5% correction from the February high that weve seen to date on the Dow and the 11% correction that weve seen from the Nasdaqs January high.
A distribution can end with a rotation in market leadership. In this case, the most beaten-up sectors get cheap enough to attract buyers and lead the market out of woes. The clearest sign that this would be just such a distribution and no more would be for beaten-down technology stocks to strengthen against the rest of the market. So far, technology hasnt shown that kind of move into a leadership role. Until you see a clearer short-term signal, the smart thing to do is to stay on the sidelines rather than attempt to guess a market bottom on insufficient evidence.
But what if you arent sitting on cash trying to figure out when to buy? What if, instead, youre invested in stocks that are dropping and trying to figure out whether to sell?
Jubaks view of the long-term picture
Heres where the long-term picture can help:
Whats called the Fed model of valuation (since its widely believed that the Federal Reserve uses this method in deciding if stocks are over- or under-valued) gives investors a good picture of the relationship between stock valuations and interest rates. (Its less useful as a way to calculate the correct market valuation in my opinion.)
Basically, the method involves comparing the projected future price-to-earnings ratio of the Standard & Poors 500 stock index ($INX) to the inverse of the current yield on the 10-year Treasury note.
Right now, First Call projects that earnings per share for the S&P 500 for four quarters from now (thats through the first quarter of 2005) will be $65.60. That works out to a forward price-to-earnings ratio of 16.7 at the close on May 12.
Compare that to the inverse of the yield on the 10-year Treasury. The yield was 4.8% on May 12. Divide 100 by 4.8 to get the inverse. That works out to 20.8.
So according to the Fed model, the stock market is now undervalued. It has a projected P/E of 16.7 when it should have a P/E of 20.8.
If thats the case, why is the stock market selling off?
Because no one believes that the yield on the 10-year Treasury will be just 4.8% in early 2005. If the yield on the 10-year note climbs to 6%, then stocks are fully valued on these projected earnings. And who wants to take on all the risk of potentially higher oil prices, more terrorism, slower economic growth, higher inflation and more rapid rate hikes for no gain and simply a return of invested capital.
Use the Fed model to get a fix on the market
If you play with these assumptions, you can calculate a long-term trading range for stocks. When investors get deeply pessimistic and fear that interest rates might climb more quickly than expected, to, say, 6% by the first quarter of 2005, then fair value for the S&P 500 is 1,096. If youd need a potential 10% gain to invest in stocks with Treasury yields at 6% and all the risks that Ive mentioned, then the S&P 500 would be an attractive buy at 996.
So think of the bottom of the long-term range of this market as 996. Thats 100 points or 10% down from here. Since the S&P 500 is already down 5.22% from its March 4 high of 1157.76, the total drop would be about 14%. Thats a very solid correction but certainly not a crash.
Now, lets say investors feel more hopeful and believe that the yield on the 10-year note will climb to just 5.5% by early 2005. And they believe an 8% return is juicy enough relative to future risks. In that case, the S&P 500 looks like an attractive buy at 1,104 or just about 7 points above the close on May 12.
Think of that as the new rough trading range -- between a low of 996 and a high of 1,104 -- that this index is moving toward in the new age of projected interest rate increases.
Where the market stands in this range at any particular moment depends on three variables:Projections for interest rates a year from now. The lower they are, the higher stocks should be valued.
Projections for future earnings. Any earnings growth above projections, as we had this quarter, drives up stock valuations.
Investors judgment of risk. This is the most important variable, and the better the news makes us feel, the higher stocks will be valued.
How bad will the news get?
Focus on the last of those three variables for a moment and ask, Where are we in the news flow? Is the news about to get much, much worse from here? Short of predicting the unpredictable act of terrorism, its hard to imagine the news flow getting much more negative. Is the news flow about to get better? Not immediately, certainly -- but not so far away, either. Crude oil is likely to pull back from $40 a barrel, if only temporarily. Some kind of political handover will be engineered in Iraq. The Fed will raise rates a reassuringly small amount in June or maybe even surprise the market by not raising rates at all. All of that will make investors more willing to buy stocks at a level above the bottom of the potential range Ive sketched in at 996.
Modify any and all of my assumptions to fit your own view of the world, and calculate your own trading range for stocks.
Using my assumptions, selling makes very little sense, given that were below the top of the trading range at 1,104 that I calculate for the new higher interest rate world. Selling at todays price is a three-way bet:- That the news will get worse from here.
- That investors will decide that their worst current fears about the speed with which the Fed will raise rates are still not pessimistic enough.
- That oil prices will spike upward, and stay there, from the current $40.
Its not time yet to buy
Put the short- and long-term perspectives together, and I think they define a market that over the long term is moving toward a new and lower trading range. It takes into account the expectations for higher interest rates in the future, and, in the short term, it is being pushed toward the lower end of the range by an over-supply of bad news.
My conclusions:- Dont buy yet. Wait for a signal that the short-term distribution is over.
- Remember that the rest of May and at least part of June could bring more pain.
- Expect that over the course of the rest of 2004, the market will gradually move into something like the trading range Ive sketched. The reset of stock valuations wont happen all in one move.
- Dont sell now unless you think you can re-buy at the bottom of the range or unless you think the news will turn even darker in the near term.
- For the rest of 2004, get used to this kind of volatility. This is the result of the real uncertainty that investors face on interest rates, energy prices and terrorist acts.
In my next column, Ill take a look at another sign that this is a bad news market: The growing fear on Wall Street that the Federal Reserve might not raise rates in June.
New developments on past columns
5 big-picture reasons to snap up energy stocks
The supply squeeze in oil just got a little tighter. According to the International Energy Agencys report for April, global demand for oil is now running at 80.6 million barrels a day, up 330,000 barrels from the agencys last monthly forecast and 2 million barrels a day higher than in 2003. Driving the growth in demand: the transportation sector in developed countries and an increase of almost 1 million barrels a day in demand in China. At the same time, according to the agency, world oil production fell by 440,000 barrels a day in April to 81.5 million barrels a day.
Editor's Note: A new Jubaks Journal is posted every Tuesday and Friday.
E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak did not own or control shares in any of the equities mentioned in this column. He does not own short positions in any stock mentioned in this column.
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