Streetwise
SATURDAY, SEPTEMBER 24, 2011
A Market in the Twilight Zone
By MICHAEL SANTOLI
For the short term, the standard ways of navigating the equity markets may not offer much help. The main question: Is this a retest or a relapse?
There is a meteorological moment, reached twice every day, in every location on Earth, known as "nautical twilight." This is the time when the center of the sun is six to 12 degrees below the horizon, meaning that navigation at sea using the visible horizon is no longer possible.
Is this one of those periods when the financial markets are experiencing nautical twilight, when the standard means of finding our way—corporate fundamentals, valuation, interest rates and inflation—are rendered unhelpful?
Perhaps so, in the very short term. When risk-asset markets show signs of credit stress and forced liquidation, it is a foolish investor who stands in front of the selling stampede and chants, "But stocks are cheap, stocks are cheap."
The important thing about nautical twilight is that it occurs before dawn as well as after sunset, and knowing that offers reassurance that when darkness falls, it doesn't mean the sun has been extinguished.
As world stock markets buckled last week, at the exact rate that investors' faith in any rescue from a desperate European sovereign-debt crisis fizzled, the main question is whether this is a retest or a relapse.
A retest of the August stock-market lows just above 1100 on the Standard & Poor's 500 Index is the bullish call; Friday's close was 1136.43. When stocks drop nearly 20% in a matter of weeks, they rarely stand up, dust themselves off and resume their cheery climb. They often need to see whether they can find more sellers at those lower levels before the danger passes.
A relapse would involve a replay of the 2008 experience, with long-simmering excess leverage spilling into a mad rush for safety as distressed banks are subjected to the harshest discipline that markets can conjure.
CLEARLY, THE MARKET WOULDN'T be fibrillating the way it is if most investors were confident that this were a mere retest, a prelude to a textbook September bottom giving way to a fourth-quarter rally. The chance of relapse, hinted at by ripples of significant stress in the bank-funding arena (mostly in Europe) is being taken rather seriously by fearful investors at this stage.
This is understandable—in fact, it would be odd if the market weren't reflecting this possibility. But there are important distinctions between today and three years ago. The 2008 crash was a bank-solvency crisis compounded by a liquidity crunch. The liquidity piece today is less of a concern, because central banks are ready to provide emergency funding in a way they were not back in '08. The solvency factor is quite important, however, and the need for more capital and/or more transparent loss recognition among European banks will remain an overhang on risk appetites.
Maybe it will take a truly radical financial-market tantrum to focus political and central-banker attention on the prospect of overwhelming money printing to buffer this crisis. Or maybe no such measure is in the offing.
The fact that professional investors—trained in the spreadsheet arts of weighted average cost of capital and discounted long-term cash flows—have been compelled to make asset-allocation decisions based on political calculations has heightened the angst quotient for sure.
JASON TRENNERT OF STRATEGAS Research Partners has for a couple of years been espousing an investment posture distilled as "bullish until the bill comes due." This summer, he told clients that the check had landed on the table, and he accordingly became more defensive.
As Trennert pointed out Friday: "Frankly, we can't remember a period in which an effective market forecast was ultimately so dependent upon effective political forecasts on both sides of the Atlantic. Until greater clarity is achieved regarding almost existential questions about the global-financial system, it appears that retail and institutional investors alike will be content to suffer the potential of negative real returns from bonds rather than the potential of large absolute losses in stocks."
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Close. Another factor confounding Wall Street players is the fact that the current generation of investors and observers (present company included) have scant experience with what has, over the course of market history, been a standard feature: The cyclical bear market.
With the exception of the cute little downturn in the very early '90s, as real estate struggled and the Gulf War was brewing, for the last 30 or so years market drops have either been crashes, 50% meltdowns or mild corrections. Could this retreat simply be one of those cyclical bear markets of the 1966-82 variety, in which the index shrinks back from the upper end of its long-term range in order to reset economic expectations and stock valuations?
There are instances of cyclical bear markets of at least 20%, in which a recession was priced in but never arose, including in 1962. If the U.S. market were to drop enough to match, say, what Germany's market has lost, then we have another 10% or 15% of remaining downside. But does the U.S. truly need to suffer as much as Germany, given the European realities? You can find as many traders willing to credit the American markets for their resilience as those betting that we need to feel just as much pain as the "core" of Europe.
If this is one of those long-forgotten cyclical bears, then we enjoy the added advantage that the decline began with the market still a good deal below its all-time high. And the S&P 500, on an absolute basis, remains below where it sat before Lehman fell three years ago, despite much higher corporate profits and a greater recognition of the macro risks built into market expectations.
The man who's known here as the "mystery broker" had, at last report, been anticipating a retest of the August lows followed by a late-September/early October bottom and a pretty good year-end rally. He lately has noted that the bounce from the August lows had all the hallmarks of a bear-market rally, with "all of the defensive groups and some 'cult' growth stocks" remaining strong.
He's especially tuned to the financial sector, which he says must outperform for any rally to be sustained, and interprets the technical damage as saying that the Aug. 8 market lows are unlikely to hold. But he figures a crowd-confounding rally will ensue to take the S&P back above 1300 by year's end.
IN EUROPE, STOCKS SEEM even cheaper than in the U.S. The European Shiller 10-year price/earnings multiple, for example, is down to 11.9 times, as noted in UBS European equity strategy research—close to the 10.3 of February 2009, near the market low.
The Shiller P/E, which is cyclically adjusted, uses 10-year average earnings, and is inflation-adjusted.
"The market is getting closer to pricing in a recession akin to 2009," says Karen Olney, the UBS head of thematic strategy. "The market won't fire up," she adds, "until you get a tangible sustainable solution that goes beyond what the European Central Bank is doing right now."
AS NOTED ABOVE, VALUATION is a slippery tool in playing the market for short-term tactical advantage. But it is invaluable, so to speak, in highlighting good or bad entry points for long-term investors.
JPMorgan equity strategist Thomas Lee calculates that 53% of the stocks in the S&P 500 are trading at less than 12 times forecast earnings for the next 12 months. In March 2009, when the market reached a 13-year low and proceeded to almost double over the subsequent two years, 67% of large stocks traded below a 12 forward multiple. This is no time to bet on wholesale increases in stock multiples, but this metric certainly highlights the amount of risk that has been drained from equities on a fundamental basis.
Lee concedes that the key question is whether this is a 1998-type gut check or a post-Lehman kind of collapse. The 1998 event was "a test of the financial system," while Lehman was a system failure. Yet, in the six months following each episode the same sectors were standout performers: consumer services, semiconductors, software, retail and technology hardware.
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