Keeping Focus When Challenged

At "A Dash" we take a broad view of major market topics.  We analyze research and highlight current issues.  Occasionally we discuss specific stocks that represent good examples of major themes.  Only rarely do we comment on short-term trading, although we have technical models for all time frames.

Today’s market action was so unusual that it deserves comment, if only because part of our mission is to help individual investors.  We did this last year at the bottom.  Those who have not traded through several of these incidents, as we have, are likely to take a superficial view of media comparisons.

Briefly put, our experience dates back through the 1987 crash, so it includes the mini-crash of 1989, the emerging market/Long Term Capital collapse in 1998, the Internet/technology bubble, and the selling after 9/11 in 2001.  The current selling is not comparable to any of these situations.

There are two principal reasons.  First, the overall market valuation is cheap when compared to interest rates and reasonable even for those who (unwisely in our view) ignore interest rates when valuing stocks.  Second, the news of today — Chinese stocks declining, retracing part of a huge increase, and a weak durable goods report — did not significantly change the fundamentals of the market.

So what happened?

  • Traders have been anticipating a 2% down day for many months.  It has been a focal point of discussion in the media, including every bearish blogger.  When the day’s decline started at 1.5%, nearly everyone was waiting to buy, expecting the inevitable 2% down day.
  • Many fund managers – -mutual funds as well as hedge funds — are overloaded with emerging market issues, including China.  Those attempting to sell did so in an indiscriminate fashion.  Individual stocks declined without regard to specific prospects.  This often happens when there is not a solid bid for the stocks that deserve to be sold.
  • The mysterious and sudden 200-point Dow decline in about five minutes in late afternoon spooked any potential buyers.  Watching the late-day commentators and media sources showed that even those bullish on overall prospects are waiting to see some leveling off.  But they are out there.  Some have been waiting since last August for a buying opportunity.

What are the important questions?

Foremost is the strength of the economy — both worldwide and in the U.S.  At "A Dash" we are expert at finding the real experts.  The best sources on recession chances have been, and continue to be, the following:

  • The ECRI, which has an excellent model using many indicators.  Their major accomplishment has been avoiding "false positive" recession predictions.  This distinguishes them from those using single indicators like the yield curve inversion (which we have discussed extensively) and speculation about housing trends or sub-prime mortgage impacts.  Lakshman Achuthan appeared on CNBC this afternoon with a very upbeat opinion on the economy.  The ECRI indicators do not show a likely recession in the next three to four quarters.  Achuthan even stated that their measures show above trend growth, better than the so-called soft landing.
  • David Malpass, Chief Global Economist for Bear Stearns, who has absolutely nailed his economic predictions over the last several years.  Malpass reported this afternoon that this was not like last year’s mid-May selling, that China was "not an inflection point", that sub-prime effects were contained, and that housing inventories were down.  Malpass also corrected the widespread media misinterpretation about Greenspan’s recession comment.  This often happens when everyone jumps at an oft-repeated headline where the "R Word" is mentioned.  Malpass highlights that Greenspan called the global economy "benign and stable."

There are so many attractive buying opportunities.  Brokerage stocks declined seven percent, even though the worst-case sub-prime effects are a small part of their businesses.  Energy stocks, especially upstream exploration and drilling names, got smacked by six percent.  Many of these companies have visible earnings for two years out, even with oil price models keyed at $35 – $40/ barrel.

Many other stocks with earnings not keyed to general economic issues were also sold hard, since buying did not emerge today.

Finally, cyclical stocks like transports and heavy equipment are suddenly out of favor.  Why?  Because both the odds of a recession and the impact of a recession have been overestimated by the market.

Tomorrow’s revised GDP report will, no doubt, show a reduction for the 4th quarter of 2006.  The ISM number may well come in below the expected reading of 50.  Weaker numbers in both reports would be consistent with the Fed plan, bottoming at a GDP growth rate that we call the Glide Path, not even weak enough to refer to as a soft landing.

Both our models and our fundamental analysis of many stocks show current undervaluation of 30% or more.  There are so many names we like.

The challenging times present the best opportunities.  Understanding valuation using forward earnings helps to identify these chances.  With many asserting that the economy is at "peak earnings" the market trades at a discount.  Most of the market is playing this as "late innings" for the economic cycle.

We believe it is the fourth inning.

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  • RB February 28, 2007  

    I agree that when ECRI says no recession, it is not wise to bet against that — despite what the bond markets seem to imply. It was interesting though that the dollar was not perceived to be a flight-to-quality bet yesterday:

  • muckdog February 28, 2007  

    Eh, we’re due for a correction. I’m happy to let this thing play out and then charge in as close to the lows as I can get. Not there yet… I don’t see a recession, either. ECRI has been pretty good with their analysis, so glad to see I’m on their page!

  • Bryan Wendon March 1, 2007  

    Jeff, I think this is an excellent post with very useful links. Keeping a sense of proportion and perspective at times like these is hard for those, like myself, who started trading during the last 4 years. It’s all too easy to be swayed by the bears chorus and to forget to look for good value buying opportunities.

  • David Merkel March 1, 2007  

    Great post. The earnings yield of the market is cheap relative to corporate interest rates, and ECRI’s long term track record is excellent. Leaving aside homebuilders and certain dodgy financials, I see good reason to be bullish here.

  • Barry Ritholtz March 7, 2007  

    ECRI’s long term track record is excellent — they are the reason why I have been saying “The odds of a recession are rising” rather than saying “We are very likely to have a recession”