A Dash of Insight

Fighting the "Fundamentals"

How should one interpret the market rally?

One widely-held viewpoint is that the rally has occurred despite weak fundamentals.  This means the market is over-extended and due for a correction or even a crash.  Those taking this position cite continuing high unemployment, a continuing high rate of foreclosures, threats to commercial real estate, the "spent-up" consumer, high debt levels, and a generalized concern about government policy.

These have all been the factual backdrop for many months.  These factors have not changed.

Another Approach

An alternative viewpoint is that the US equities in March reflected a worst-case scenario, revisiting depression conditions.  If conditions -- still bad -- improved from those levels, then many individual stocks deserved higher valuations.

What has changed since March?  Two things - -both important.

Forward Earnings.  Ed Yardeni follows the forward earnings estimates quite closely (subscription required).  He writes as follows:

Earnings are turning. S&P 500 forward earnings is turning up rather nicely and consistently since it bottomed at $62.92 per share during the week of May 8. Last week, it was up 12% from the bottom to $70.49. It’s up for 17 weeks in a row to the highest level since January 23. As 2009 ends, forward earnings will converge to analysts’ consensus expected earnings for 2010. This estimate has also been moving higher from a low of $73.37 during the week of May 8 to $75.29 last week

Interest Rates.  Investors have a choice in asset allocation.  When there are extremely high corporate bond rates, this is an attractive alternative to stocks.  If one is taking a risk in buying corporate paper instead of Treasuries, the return should be compared to expected stock gains.

The Atlanta Fed does a nice job of summarizing many economic indicators.  Here is a recent look at corporate credit.

 

There is an obvious improvement in corporate yield spreads.  Lower yields make corporate paper less attractive in comparison to stocks.

 

Credit default swaps show the same picture.

Conclusion

However one defines the "fundamentals" it should not be a static concept.  The data show that stocks have less risk and more potential reward than was the case a few months ago.

Those choosing a static definition of the fundamentals -- looking at backward earnings, for example -- miss out on the changes in risk and reward.

Considering these data, one could easily make the case that stocks are just as attractive now as they were last Spring.  Prices are higher, but risk/reward is also better.

Sell in September? Time for Reality!

Anyone paying attention to market news must know that September is the weakest month for stocks.  Mark Hulbert, one of our favorite writers, calls it The Cruelest Month.  He provides a table of returns, summarized as follows:

Notice from the table that in all but one of the last 11 decades, September was a below-average performer. In more than half the decades, in fact, the month's rank was dead last.

Why, given such an overwhelming record, would anyone question September's bad record? Because there is no good theory for why the month should be such an awful month for the stock market. And, without such an explanation, there's the distinct possibility that the statistical pattern is just a fluke.

As one can see, Hulbert is well aware of data mining.  He mentions the popular "butter production in Bangladesh" example.

Hulbert next considers a number of hypotheses and invites readers to share their own ideas.  His thought is that a good explanation would make the September story more convincing, although he shares the information that day traders do not wait for any hypothesis testing!  The sophisticated audience of "A Dash" may not find that very convincing.

Hulbert's Market Watch colleague, Irwin Kellner, has a number of reasons for September weakness, including the possibility of a self-fulfilling prophecy.

Why Both Articles are Wrong

Here at "A Dash" we are veteran debunkers of mythical market lore.  Most people (including our employers when we started in the business) just want to see the data --- all of it!  Traders all believe in patterns.  The more data the better.

The idea of random results is lost on most, like the "day traders" Hulbert mentions.  There are twelve months.  There will be a distribution.  Some will be good and others will be bad.  Always.

What if there is a reason?  A hypothesis does not really help.  When you already know the outcome, any smart person can invent a compelling reason.  New readers can revisit our discussion of this topic, where a group of very smart grad students were given a list of findings and asked to provide reasons.  They did very well.  Only after the class were they told that all of the relationships were reversed!

The scientific method works only when one begins with the hypothesis.

Let us try an experiment.  Instead of taking the currently constituted months of September, instead put all of the individual trading days in a basket.  (We know that this basket has a negative bias, but bear with us).  From this basket we create trading months.  From the days in the other months, we create comparison months.

This is an interesting approach to getting beyond the data mining issue.  It is (unfortunately) not our idea but that of Andrew Moe.  He writes as follows:

When comparing the months composing September to a random basket of days the results are random. Attempts to find seasons of non-randomness are frequently subject to data mining bias, as the same permutation test debunking the September drift is easily used to identify (falsely) statistically significant periods.

The study. Running a bootstrap permutation study on Dow data from 1960 to 2008 we estimate the empirical distribution of differences in monthly return between September and other months. We test the hypothesis that a random September is no more bearish than a composition of random days sampled with replacement. We find that the mean difference between populations is 0.0695%, yielding a p-value of 0.3612 – random.

Our Take

Here are four good reasons to ignore the September weakness articles.

1. This is a widely advertised theory.  Even if you do not believe in completely efficient markets, one would expect some anticipation.
2. We have already had a decline of nearly 2%, exceeding the expected monthly decline on the first day.  Should we now expect normal trading for the rest of the month?
3. The evidence shows that the September pattern is not a statistically significant deviation.
4. Other seasonal methods (Sell in May, Presidential Cycle) have not worked well in this time of turmoil

Quite obviously we do not know whether stock prices will mover higher or lower during the rest of September.  We do expect trading to reflect fundamental information about economic changes, as well as perceptions and trader lore.

Picking the Right Pundit

High on the list of investor mistakes is chasing performance.  Even though the top market pundits are aware of this fact, they make the same mistake -- time after time.

Buying what worked last year is the easiest way to pick stocks, sectors, or managers.  It is also the worst.  Despite this, it is the key question that every new investor asks.  It is natural.  It seems relevant.  For most investors it is the most obvious part of "due diligence."

When we are having a good year in stock picking, as we are now, it is easy to go with the flow.  But it is not really what we recommend.  Our long-term record -- and that of others -- should be the real question.

The False Litmus Test

We are in an era where CNBC introduces every bearish pundit with "He was one of the first to see the problems in the [housing, credit, CDS, derivative] market.  There are no track records on those who missed some big gains by making very bearish predictions many years before the collapse.  Taking the other side, people like Warren Buffett were well aware of the risks, maintained cash, but bought back into the market "too early."

We now have a bunch of rookies who think that Warren Buffett has "lost it."  They also think that some perma-bear is a genius.

One of the big news stories of the day was the SEC filing from hedge fund manager John Paulson, noted for making big money by shorting financial stocks last year.  When a major bear on a sector switches positions, that is news.

Today on RealMoney Jim Cramer observed "Buffett got this period wrong and we bid up anything he buys. Paulson got it right and we are supposed to ignore him." 

Cramer repeatedly highlighted Regions Financial (RF) and also mentioned it in his regular "Stop Trading" spot on CNBC.  The stock rallied after his early comments and popped eight cents again on high volume during the CNBC appearance.

Everyone noted that Paulson had a large position in Bank of America (BAC).  Cramer felt that RF was the stronger play.

Our feeling is that both Paulson and Buffett deserve respect.  There are many different methods that generate above market returns in different time frames.  The facile emphasis on last year's pundits has already been a losing move for many investors.  And please note that Cramer was not disparaging Buffett, but emphasizing Paulson.

Meanwhile, Felix Salmon (one of our featured sources) was highlighting a bearish Bloomberg article by Jonathan Weil, suggesting that the footnotes showed that Regions Financial was insolvent!

We can imagine investors selling the stock based upon Weil or Salmon, buying it based on Cramer, or being very confused after reading both.

Another Example

Tonight's Kudlow program had a segment with Elaine Garzarelli.  The assembled punditry scoffs whenever she appears.  Her great call on the '87 crash is an ancient memory, and most now dismiss her bottoms up method of evaluating stocks and sectors.  We disagree.

Most pundits do not really consider her methods, which are actually quite good.  She has a viewpoint that may well prove to be correct, flying in the face of the conventional wisdom of traders.  Here were a few key points:

• Her 2010 S&P earnings estimates are $73 and she is looking for a multiple of 17.5.  That corresponds to the pre-Lehman market of 1250 in the S&P 500.
• She sees the biggest threat to this valuation as an increase in risk spreads.  Corporate bonds are an alternative to stocks.
• She also replied to Kudlow that more FASB efforts to impose unrealistic marks on existing holdings would be a big negative.
• She sees the downside for stocks as 4 to 7 percent, mostly based on normal fluctuations.

Our Take

The Garzarelli earnings estimates and multiple are actually quite reasonable given current interest rates and growth projections.  The S&P at 1250 gets back to pre-Lehman levels.  It is not "bubble land."  That was at a time when the market expected a recession, but not a depression.  It represents a good initial target for stocks.  It is not an extreme target.

The declining risk spreads have increased the valuation for stocks.  She is correct in noting that any increase in bond yields is the biggest risk for stock valuation.

Making a major investment in equities implies a significant reward/risk picture.  This ratio of 5 or 6 to 1 is pretty attractive.  The exact timing (September selling?) is a bit of a guess.

Full disclosure -- We have a small position in BAC, a larger position in regional banks, and we are taking a serious look at RF.

Looking Back, Looking Ahead

Today marks some important changes both in market fundamentals and in psychology.  On such occasions we interrupt our regular writing agenda for more specific market commentary.  This is an occasion where readers unfamiliar with our recent work should take some time to follow the links.

In recent days we have tried to provide some perspective on the market turmoil and what to watch for.  Some of these ideas are starting to play out, but there is more to come.

A Review

Here is a brief review of the last few days.

We reviewed a number of popular myths and provided a brief assessment.  We then showed how some shallow thinking was leading many to be excessively negative.

We made timely shifts from bearish to neutral to bullish via our TCA-ETF system.  Investors in the program had a gain of 9.7% today.  Being in the right sectors means a lot.  Our current holdings seem to capture the rapidly revised thinking of market strategists.

We wrote about possible catalysts, including this suggestion:

Housing initiatives.  The Treasury is hinting at a new plan to reduce mortgage rates.  The Fed has already acted.  We expect the market to be skeptical of both, so it may take some real evidence to change opinions.

In addition to the Fed statement today, there was other important news, setting up the rally.  The Obama Administration seems to be embracing a major plan to cut mortgage interest rates to 4.5% for everyone.  We have the full story on our sister site, ElectionStocks.com.  This story is very big in many ways and for many sectors.

Being Modest

We are very cautious with a period of success.  There are so many who think they know so much.  In fact, investors should look not to a single market call, but to long-term history.  We tried to illustrate this with our football analogy.  In our own methods, we try to emphasize the long run.

Looking Ahead

Today's trading could represent a change in market psychology. There are plenty of fund managers who are either caught short or under-invested.  The negative sentiment has been palpable.  The news of scandals and the market declines have tested the resolve of many long-term investors.  We expect some managers and investors alike to shift gears.

There are more catalysts to come.  We continue to collect ideas on this front.  More to come, with several interesting ideas.  Briefly put, those making negative forecasts on the economy, on corporate earnings, and on stocks have a doubtful platform.  They are not just fighting the Fed.  They are also fighting the Treasury and the incoming Obama Administration.

Investors do not understand government policy, and have expected immediate reaction from the many programs.  They have been dazed by acronyms and have lost focus as a result.

There is a firm determination to avoid a major recession.  The market will look ahead, beyond the recession that is now a year old.  This may already be starting.

Conclusion

We have ridiculed strategists calling for a five-percent gain in the next year.  This is silly, when intra-day moves are frequently greater.  The only reason to invest in stocks is an expectation for a major rebound.  Few are willing to talk about valuation, when the consensus mentality disparages earnings prospects.  We note some courage on this front from Morningstar, where they see the Dow as 30% undervalued. (Hat tip to Abnormal Returns, helping everyone see what otherwise might be missed.  None of us can check everything!)

We shall comment further on valuation issues, with a focus on expected and trailing earnings.

Starting with the Result: The Blowout of the Week

Stock market methods have different time frames.  If a method trades on an intra-day basis, the trader can get into the "long run" very quickly.  If the trades are weekly, it takes longer.

The long run is elusive.  Since prices are more psychology than value, the definition of the long run depends upon changes in cycles of psychology.

This concept is very difficult to grasp.  We all want to render a verdict.  When is the right time?

Looking Outside the Box

One of our regular themes at "A Dash" is educating investors by getting them to think about something different.  Only then do we bring the point back to investing.

This is most easily done with examples where there are frequent predictions and results.  The world of sports provides such an arena for testing.

Readers should note our earlier article, Investing is not Gambling.  Having said this, the predictive problems share many elements.  There is a wide array of methods, both fundamental and technical.  There are many pundits using methods of all types.  The nature of the forecasts involves probabilistic distributions, even though the consumers of forecasts do not realize this.

When the results are in, it all seems to have been certain, almost pre-ordained.  The various factors that cause swings get lost in the outcome.

The Blowout of the Week

Since we do not condone any illegal wagering, let us suppose that the reader resides in Nevada and can make a legal bet on an NFL football game.  Each week there are many choices.  Let us consider this week's big winner.

The Minnesota Vikings were a three-point underdog at Arizona.  The Vikes, trying to nail down the NFC North championship ran up a 28-0 lead and coasted to victory.  Those who bet on them never had to breathe hard.

Their great running back, Adrian Peterson, rushed for 165 yards on 28 carries.  Getting another chance to start in place of the injured Gus Frerotte, Tavaris Jackson threw for four TD's.  The Viking defense had continual pressure on Cardinal QB Kurt Warner.  The Arizona coach felt that his team "did not come to play."

This was an obvious wire-to-wire victory for those who saw the correct elements.  Right?

Getting it Right

We have identified a handicapper who predicted this victory on his "premium service."  Should we sign up for his package next weekend?  Does he have special insight into football?  Into the Vikings or the Cardinals?  He absolutely nailed this blowout pick......

There were some free services where the prognosticators picked the Vikes to win.  Should we look to them?

It is something to think about......

Another Round of Panic

Trading and investing are quite different things, a matter of time frames.

Today's trading was sparked by the ISM services report, something that has not attracted much attention in recent years.  The Market has focused more on the traditional ISM manufacturing survey, partly because it has a longer history, and a clear link to GDP.  For those who have forgotten that report, released two trading days ago, it suggested GDP growth of 3% as of mid-January, the time of the survey.

The ISM service release was surrounded by some controversy because of a change in the method of calculation and the early release of the data.  The ISM, in circumstances nicely reported by Kelly Evans of the WSJ,  admitted in a conference call that information might have leaked, so they announced the result before the opening.  We are always amazed to see that people do not realize that big traders can always find a way to play information when regular stock markets are closed.  Globex futures trading, anyone?

Significance of the Report

Most market participants realize that the service economy has assumed greater importance in recent years.  The large move in the index played into the recession fears of many.  As the market declined, this seemed to be confirmation of increasing recession odds.

The market and media reaction was that if many react to a piece of data, it must be right.   Let us look a bit deeper into this information.  When so many stampede, there may be a contrarian opportunity.

We have tested the ISM service series against employment changes and other economic data, and we find it to be pretty good.  When comparing it to the ISM manufacturing index we discovered that it did not add much information.  We now have a single data point where there is a significant divergence.  This would be nice to test, but there are not many other divergences to use.

Our review of today's news did not find anyone else who highlighted this statistical fact, or wondered about the meaning.  This provides an edge for our readers.

Other Interpretations and Advice

We realize that those with a predisposition to seize upon any evidence of incipient recession are touting today's number, even if they never mentioned it before.  Readers might want to compare the current interpretations from these sources with those from past months when the services figure was stronger than manufacturing.  There is a lot of selective perception at work.  Pick your favorite source and do a search to find out whether this number was ever highlighted when it was strong.

Briefing.com, an unbiased interpreter of information, reports as follows:

The data seem inconsistent with the harder figures on spending and investment and world trade which really provide the trends for domestic growth.  We also believe that the intent of this ISM index -- to reflect on growth for the entire economy outside of manufacturing -- is a mighty grand objective given the simplicity of the survey questions. 

For each component (e.g.  activity, employment, orders), the question to the survey respondents is simply, "Are conditions stronger, unchanged or weaker than the prior month?"

Gary D. Smith, who has a strong multi-year record of market forecasting, provides excellent daily commentary on his blog.  Unlike some other providers of links,  Gary cites information from every possible source.  He tells the "whole truth" without any cherry-picking of information.  Here is his take:

I continue to see the US Fed as now “ahead of the curve” and the odds of an intermeeting rate cut are rising meaningfully. The VIX is rising 8.0% today to a high 28.0. The ISE Sentiment Index hit a below average 102.0 and the total put/call is hitting an above average 1.12. Finally, the NYSE Arms has been running very high again all day at 2.47, which is also a positive. I still view the odds of a full retest or new lows in the market as unlikely and further weakness providing good entry points in favorite longs for investors.

Read the entire article to get the full context.

The Earnings Mythology

The recession hypothesis is getting an additional boost from commentators who claim that forward earnings are in decline.  Briefing.com has some great information on this:

According to Thomson Financial, fourth quarter 2007 earnings are expected to decline by 20.7%.  The main reason for the decline is the financial sector's whopping 105% decrease in earnings.  If the sector was removed, earnings would grow by 11.0%.  Homebuilders are also a drag.  For example, the consumer discretionary sector's earnings would grow by 7%, instead of declining by 15%, if homebuilders were removed from the calculation.

In general, we do not like throwing out the worst or best sectors from the overall S&P 500 earnings.  This might be an exception.  The last quarter is a bit unusual because of the forced write downs of mortgage securities.  Some believe that there are many more write downs to come.  We think that the FAS 157 losses might actually overstate the impact on these firms.  They voluntarily chose to keep securities on the balance sheet, probably because the expected performance to exceed current value in an illiquid market.  The jury is out on that question.

Meanwhile, the rest of the market sectors are not showing mean reversion, recession, or any other sort of earnings decline.  For example, Colin Barr's nice review of the Disney report highlights a good past quarter, and good future prospects.  This is a company that one would expect to be hit by consumer distress, if it were already an important factor.

Forward earnings will depend greatly upon how financial stocks rebound from current conditions.

Conclusion

Markets look forward.  Even in recessionary times, a fact not yet in evidence, forward earnings look through the recession, setting the stage for rebounds in stocks prices.

The Stress Test

As we write this, foreign markets have plunged over the weekend.  Stocks will open lower -- much lower -- at a frightening level.  Individual investors may well panic.  Some traders will see this as the indicator they have been seeking - a dramatically lower opening that provides a buying signal.

We reported our own short-term indicators (negative) and our intermediate-term indicators (waiting for the washout).  We will be buyers on the opening.

The Problem:  A Crisis of Confidence

There has quite obviously been a leadership crisis.  Any appearance by a government official -- Bernanke, Paulson, Bush -- seems to lead to another decline of 200 or so in the Dow.

What should we make of this?

During the weekend we have not only read the typical Internet sources, but talked with various fund managers and astute observers.  There are two common themes:

1. No one has any confidence in the various fiscal stimulus plans or in Fed Chair Bernanke.  No one.
2. The conclusions seem to be based upon market reaction, not actual economic data.

When there is such a unanimous viewpoint, it suggests opportunity.

Staying Calm

The best opportunities for trading and investing come when others react on emotion rather than facts.  Let us take a look.

Market commentary has dismissed anything positive, and has done so for at least a month.  Economic data suggesting economic growth of about 1.5% -- jobless claims, ISM report, Michigan consumer confidence -- is ignored.  None of these readings is close to normal recession levels, but the market sees a recession as a fait accompli.

Fiscal stimulus has been dismissed, largely because the President's package lacked specifics.  This commentary comes from those who have no particular expertise in public policy development.

Almost no one in the blogosphere provides public policy insight, especially when combined with a knowledge of economics, politics, and hands-on investment experience.  Our individual accounts under management have beaten the S&P 500 by about 6 points per year for ten years.  How?  The biggest gains come when we find a solid contrarian theme.

The Plan for Fiscal Stimulus

The Bush plan has been criticized for a lack of specificity.  We are amazed at this reaction!

Anyone who understands politics knows that the key to policymaking is compromise.  Markets should give more credit to the President's advisors, who urged him to take a moderate course.  Anyone really interested in understanding this should read the Pulitzer Prize winning work of Robert Caro, Master of the Senate:  The Years of Lyndon Johnson.

Politics is the art of compromise.  Republicans and Democrats alike have a motive to stimulate the economy during this election year.  They will probably get it done, with a combination of individual and business incentives.

They will be joined by additional Fed rate cuts.  Monetary and Fiscal policy will both be in force.  If a recession is imminent (something that has yet to be determined, despite the widespread commentary) these actions will mitigate the effects.  Meanwhile, stocks are already reflecting a severe reaction.

Bond Insurers

We are aware of the continuing speculation about bond insurers.  The worst-case speculation is a series of falling dominoes as credit market counter-parties cannot pay up.

This is exactly the sort of case where government acts swiftly and decisively.  The historical precedents include, among others,  Long Term Capital Management, Mexican Debt, Brady Bonds, and the Resolution Trust action after the Savings and Loan issues.

The key point to understand is that when private errors start to have major impacts on the general public, government gets in gear.  This will not be immediately apparent to the talking heads on CNBC or the Internet punditry, since they are not public policy experts.

When reading these discussions, one should compare the projected losses to the overall stock market losses -- those hitting average investors and pension funds.  That is the comparison that government officials will make.  Our own estimate is that tomorrow's opening losses alone -- one day -- will dwarf the entire cost of backing up the bond insurers.

Government officials look at cost/benefit analyses.

Our Conclusion

A crisis in confidence always provides a stress test.  Government may seem very slow to react.  A few weeks is really fast!  In "trader time" the reactions take an eternity.  In terms of actual economic impact, the delays are modest.

Despite the widespread speculation, no one really knows the extent of the slowing in economic growth.  Policy actions will have an effect, either to prevent or to mitigate a recession.

Meanwhile, equity investors seem to be selling without reason.  Short-term traders may look for indicators like our Gong Model.  Average investors should take a longer view.

Market Response to Recessions

Each day the market gets "new information" about a slowing rate of economic growth.  If the rate of economic growth slows enough, it can and will be interpreted as a recession, when the NBER does a retrospective analysis of the data.  What does this mean for investors?

An Interesting Table

Let us take a good look at some data from the Wall Street Journal, and highlighted by The Big Picture.

An objective look at this table suggests a major disparity between events of the 70's -- Watergate, Arab Oil Boycott, double-digit inflation and unemployment, double-digit interest rates -- and the more recent history of the last forty years.  The only significant decline associated with a recession happened from the over-valued market of the Internet bubble.  Current market PE ratios are vividly different from that era.

A second question relates to recession dating.  For almost a year, starting with the low GDP reports in Q1 '07 and especially now, many pundits have suggested that we are already in a recession.

The "official" recession dating takes place after a major decline has been observed.  At that point, the NBER dates the recession, the points used in these charts, as the prior peak in output.

Our Take

The most important question for investors and traders is how much of the slowing economy is already reflected in forecasts, earnings projections, and stock prices.  Careful readers of bearish pundits should be asking the question raised by the table:

If the recession really is underway, hasn't the market already reflected reduced earning potential?

Regular readers of "A Dash" know that we believe that forward earnings have reflected recession expectations for many months, driving forward earnings yields to low levels when compared to other asset classes.

Each day brings new and redundant information, completely consistent with slowing  GDP growth.  The market responds, each time, as if this is fresh information.  Slowing growth implies a mixed picture from companies.  We cannot expect them to make wildly bullish comments on prospects.

Those who wait for this optimistic look from companies will have waited too long.

When to Pull the Trigger

There is a special psychological barrier for those contemplating the purchase of U.S. equities -- long-term investors and traders alike.  The memories of losses in the 2000 era are still fresh.  Those who do not study the fundamentals of market valuation -- forward earnings and interest rates -- see a market reaching the old highs as a sign of danger.

Background

Consider the following key facts:

• In the long run, stocks outperform bonds;
• The current expected yield from stocks is significantly higher than the risk-free bond yield; and
• The overall market, and many of the most attractive growth stocks, have now pulled back significantly from recent highs.  (We see many attractive stocks.)

Paralysis

We talk with many individual investors, nearly all of whom have lagged market averages in their own accounts.  The biggest single mistake is that they can always find reasons not to invest.   One very intelligent person was referred to us in 2004.  He was worried about the outcome of the Presidential election.  That was about 30% ago in the S&P 500, but he was buying condos instead.  He still does not own any stocks.

There are always many things to worry about.  The leading Internet financial sites emphasize the "wall of worry."  Unfortunately, they do not explain it.  A market plagued with many concerns, like this one, is actually the best opportunity.  When the issues are known, market prices reflect the worries.

How NOT to Act

Here is what we often see.

The market makes new highs.  The investor says, "It is is too late.  I missed the best time to get in.  I can't chase this.  I made a mistake earlier, but I cannot buy now."

The market pulls back.  The investor says, " Wow!  I'm glad I did not invest a month ago.  There are plenty of problems.  Look at the selling.  The market is going lower."

Notice that the investor cites the direction of the market when it is moving lower, and the level of prices when it has moved higher..

Using this approach there will NEVER be a correct time to invest.

A Solution

The best approach for investors is to have a disciplined method.  This can be based upon fundamentals or system.

But this is easy to say.  We know that the real problem is getting started.  So here is our best investment advice as 2007 comes to an end:

Do something!  Buy a partial position.

This is what the pros do when in doubt about timing.  Establish a position.  If prices go lower, you can buy more.  If prices go higher, at least you are participating in the gains.  This is much better than following a method that leaves you permanently on the sidelines.

New Market Highs: What's the Downside?

As the market reaches new highs, investor fear increases.  Much of this relates to a focus on price without regard to what has happened to earnings and the economy since the 2000 era.  How should the investor consider this?  Is the story different for traders?

One approach is to consider the downside risk.  This means more than just speculation about recession odds and the other elements of the Bear Playbook.  While no one can say with certainty what will happen with equity markets, there are ways to get a handle on the probabilities.

The Intermediate Time Horizon

Many investors and their managers operate on a time horizon measured in months, not days. There is a lot of discussion about short-term market moves and sentiment indicators. We are interested in a longer term sentiment measure. The forward market P/E is good for that purpose.

We use the cap weighted S&P 500 for this purpose because that is the vehicle for the millions of investors who buy index funds or closet index funds. We use forward earnings because we are trying to predict.

When the forward earnings yield on the S&P 500 is 6.7% and the ten-year note is about 4.5%, that shows a high level of skepticism about earnings. You can call it a risk premium, but if so, it is a big one. It shows that the powerful voices of market bears have been heard. Over half of the country thinks we are in a recession or about to be. A recent online poll of investment advisors (!) showed over 25% expecting a 1987 style market crash. Wow!

Gary D. Smith calls this a negativity bubble and we agree. The fact that an index is at a new high does not necessarily imply euphoria using this approach. The risk premium is an objective measure which also worked well in 2000.

Using Data on Forward Earnings

Here is a good question.  What would happen to the market if forward earnings declined by as much as they did in any year-over-year period since 1979 and the market got a small P/E bump to 15.5. (That's when the First Call series starts).

The answer: A decline of 14.4%. The biggest forward earnings decline (almost 18%) came in the year ending with November of 2001. If forward earnings now fell by that amount and the P/E moved to 16 (still a very high risk premium), the S&P would be down less than 12%. It is difficult for market to crash when so much risk is built in.

The time period includes both the 1987 crash and the 2000 bubble, so it is quite relevant.

Conclusion

The market, despite new highs, reflects a lot of skepticism.  It is ironic that the many pundits predicting recession and a market decline believe that they have had no impact.  In any market there is a chance of decline.  Meanwhile, any reduction in worries could lead to a much higher P/E multiple.

It is all about risk versus reward.  To analyze this, the investor must know what is already built into the market, not just a black-and-white doomsday scenario.

For traders, this analysis shows why there is a continuing bid under the market, even in  corrections.  Active traders who have recognized this have profited in the last month.