Saturday, October 18, 2008

Market Update



Another wild day on Wall Street yesterday, although this time the swing was only 500 Dow points (the lowest of the week). It seemed like the market was going to take off in the mid-afternoon, only to get stopped cold and abruptly lose 4%.

Why did this happen? A look at the 60 minute chart shows that the downtrend line from the previous highs served as major resistance. The indices are forming huge symmetrical triangles. We should expect the S&P to fall to around 880 to test the lower part of that triangle. Then, the market will either: A) bounce up from there and try to break through the top part of the triangle again, B) bounce up and come back down again, or C) just fall straight through that downtrend line on this new wave down. The break of the triangle to the downside will trigger more massive selling. For conservative investors looking out more than 1-2 days, no major moves should be made until the triangle resolves to the upside or the downside. I can't tell you which way it will break, I can only tell you that when it does, it will cause major movement in the direction of the break. One pessimistic thing from a technical standpoint is that despite the very oversold conditions via a whole host of indicators, we cannot sustain a major rally. In the past 100 years, very oversold condidtions have always led to major snapback rallies. The 14% rally we had this past Monday may have been all the bulls can truly muster up. The other bearish problem is that these types of triangle resolve to one direction or the other about 2/3rds through the triangle, so according to my drawing on the chart above, we may have 2 chances at breaking to the downside but only 1 more chance (if we bounce up again) to break through the topside. These patterns do not keep going until the points of the triangle meet.

I mentioned that I had gone "long" the S&P and NASDAQ via the SSO and QLD. As I indicated in the comments section of "Double Bottom" yesterday, I got out of these positions late in the afternoon, as a failed rally on a Friday afternoon (and the downtrend line serving as fierce resistance), did not make me keen on holding long positions going into Monday morning. I'm sure that type of mentality among traders contributed to the decline in the last 90 min yesterday...who trusts this market? Bad news of failing banks, etc. tends to come out over the weekend and Monday's market could be ugly (again).

For all of you think that this technical analysis is baloney, let me point you to an interesting article today that utilizes fundamental analysis. In short, based on valuation, stocks are still not "undervalued". Based on data from previous recessions and stock market lows, valuations might need to drop even further, and estimates by these experts put the S&P in a range of 400-600 to get into the appropriate range (yikes). These facts are confirmed by the wise folks at Comstock Partners who also suggest stocks are far too overvalued (see text posted in the comments section for this entry...it's a bit long and didn't want to clutter the board).

8 comments:

Cocameister said...

Comstock Partners, Inc.
Market Now Fairly Valued--But Not Cheap


October 16, 2008



For the first time since we started writing these comments in early 2000 the market has declined to levels where it is reasonably valued on all five of our major parameters-not cheap, mind you, but reasonable. This does not mean that the market can't decline significantly to bargain levels as it has done at a number of past bear market bottoms. In fact there's a good chance that it does exactly that. But it does mean that forecasting a much lower market is no longer the layup it was at far higher levels. Based on data provided by Ned Davis Research, we note the following.

As we stated in last week's comment, we advised you to view the article on the right side of our home page, "Limbo, Limbo, How Low Can it Go?" in order to see the overvaluation of the stock market. Well, since the market dropped so much since early Thursday when we wrote the comment, things have changed. If you now view the charts, we would advise you to plug in the latest values of the various indicies that are displayed by NDR research. The charts on "Limbo, Limbo" show the market at still extreme valuations in every metric except price to book value. However, if you plug in the latest values of each of the indicies displayed (S&P 500, DJIA, and S&P Industrials) you will see that all the metrics have fallen to normal or close to normal valuations. The NDR charts that we use cannot be updated to show the latest valuations so you have to use the latest market indices' prices to adjust the valuations. The S&P 500 and the Dow are easy to find the latest prices for, and the S&P Industrials are displayed in Barron's each week (last weekend it ended at 1118).

On reported (GAAP) earnings, the metric we prefer, the S&P 500 is now selling at 15.9 times trailing 12-month earnings compared to a an 82-year average of 16. At a number of past bottoms the index has troughed at P/E multiples between six and ten.

The Dow Jones price-to-dividend ratio has dropped to 26 (yielding 3.85%) compared to a 93-year average of 27.2. Note, however, that on numerous occasions the ratio has bottomed at less than 17.

The S&P Industrials price-to-cash flow ratio has declined to 8, compared to a 50-year average of 9.6. It's significant ,though, that the ratio lingered between 4 and 7.5 for the 7 years between 1947 and 1954, and for 12 years between 1974 and 1986..

The S&P price-to-sales ratio recently dropped to 0.8, compared to a 54-year median of 0.92. The ratio bottomed at 0.38 in 1974 and 0.35 in 1982.

Finally, the S&P 500 price-to-book ratio recently fell to 1.5, well below the 30-year norm of 2.4. However, the ratio troughed at slightly below 1.0 in 1982.

It is evident from the above-mentioned metrics that the market, for the first time in a long while, is now in a zone of fair valuation, although it is far from cheap. If history is any guide the market can still go a lot lower, and probably will. The credit crisis is the greatest since the depression, while the recession looks as if it will be lengthy and possibly deep. The global authorities have gone to great lengths to avert a financial meltdown through nationalization, massive lending, asset purchases and buying equity. Their actions and statements indicate that they will do anything necessary to avert a systemic breakdown of the financial system, and they will probably succeed, although not without some serious bumps along the way.

A serious recession, however, can't be avoided. The economy was slowing perceptibly before the credit crisis, and has now fallen off a cliff into the unknown. We are seeing significant slowdowns or outright declines in consumer spending, employment and production, and this will get worse as the effects of the credit freeze show up in the current quarter and beyond. The market has been so busy reacting to events on the credit front that it has not, until the last few days, paid much attention to the declining economy we see ahead. The fact that the market is now in a fair valuation range means that bear market rallies are more likely and that we will have to be more alert in looking for a cylical bottom. However, we do not sense that the market has yet discounted the potential length and depth of the recession, and history tells us that stocks can still decline significantly from current levels.

elsquid said...

wow. some seriously sobering stuff. i actually think this is pretty good for those our age with steady incomes (over the long term, a great buying opportunity for these next couple years or however long this lasts). i really feel for those who are nearing retirement though, i think this is just devastating for them.

as you recommend, i will be waiting for the market to define itself before taking any further action.

one question for you: why doesn't the pattern keep going until the triangle closes? or at least more than the one upside chance and the two downside chances?

elsquid said...

one more question (just went back and read your comments from friday afternoon - didn't see them before):

if we are in the range of support at 880-900 and resistance at 984, what keeps you from putting in a buy order at 900 (or so), a sell stop at 875, and a limit sell at 980? what is the risk to riding this margin within the "converging triangle"?

Cocameister said...

Hi Elsquid,

Great questions.

First, regarding the triangle and how it plays out...that is simply what I have learned from following the folks on the websites I mentioned. I don't have the actual data in front of me, but I've heard more than one technical analysis expert say that the triangles usually resolve about 2/3rds of the way in. If it keeps going to the end (rare), then something strange was happening. If you start regularly following the websites, you will learn about a whole host of patterns, including bull and bear flags, ascending triangles, descending triangles, bullish wedges, bearish wedges, etc. Also, one of the most important (and profitable) patterns to learn is the volatility "squeeze" leading to a breakout. It really is fascinating stuff.

Regarding your second comment, I completely agree with you. In fact, I may just do what you suggested, but with a slight modification. I will place a multicontingent order that goes like this: If SPX last < 885 and then if SPX last > 895 then buy SSO. Now, for some reason Fidelity doesn't let this trade go through, even though the order screen lets me enter exactly what I said. So, what I would have to do is find the equivalent levels on SSO and say "if SSO last < 28 then trigger a limit buy order if SSO >= 28.5. Why do this instead? Well, this way you only buy the SSO (or S&P) after it hits support and starts coming back up. If you place the order your way, it probably will work, but if scenario C plays out, you will have a wasted trade, as your trade will trigger and then your stop will trigger, and all you have done is locked in a loss. By doing it my way, you only buy once the market shows that scenario A or B are playing out and thus the risk of making a losing trade is less.

Regarding the limit sell once the trade is placed, again it is a very viable strategy, but if the market decides it wants to bust through the resistance this time you will lose the upside gains. Instead, I prefer placing a trailing stop order so that I lock in profits but continue to reap from the upside momentum if that's what the market Gods have in store.

I hope this helps.

Cocameister said...

Elsquid,

FWIW, Tim Knight, master technician made a post this morning that agrees with my take. Check it out:

http://slopeofhope.com/2008/10/symmetrical_triangle.htm

Anonymous said...

i hope you fools give the same amount of attention to your jobs that you give to this boring blog. elsquid, COCOA does NOT = GOD. i mean, really :(

Cocameister said...

Anonymous,

If this blog is so boring and annoying and liberal, then stop reading it!!

Don't you have anything better to do?

Cocameister said...

Elquid,

Check out Stocktiger.com as well for free technical analysis videos every night.

He's got some good market recap tonight and also gives breakout candidates for the next day.