Will the Winning Streak End?
by Paul J Nolte CFA, Dearborn Partners. May 23, 2007
Joltin' Joe, one of the greatest streaks in baseball of all-time was to hit safely in 56 consecutive games. A record that has been approached over the past 10 years, but many have fallen well short. The stock market celebrates 56 days from the market bottom with yesterday's close with a rise of over 10% for the Dow and an S&P 500 that closed within a hair of a new record high. It seems that every time the opening bell is rung, the market advances, much as every game DiMaggio played – he would get a hit. So is this record "untouchable" – as is the Yankee Clipper's? Obviously time will tell, however we may be in the middle portion of a run in stocks that mirrors that of the late 1990's, when the OTC market was on a tear. There are some glaring differences and some similarities that we will review over the next few paragraphs that may point to further gains in the markets in the weeks ahead, but that it will – at some point (like any hitting streak) come to an end. Unlike Joe, the markets may not go on another hitting streak once this one is done!
Valuation levels are at their lowest levels in 10 years, according to the Wall Street Journal and any investment broadcast. And it is true; however, the valuation levels beyond the 10 year horizon put today's valuation levels at the top end of historical ranges. Essentially we went from an expensive market in 1997 to a crazy expensive market, and today we have made it back to just plain expensive. There has been much written about valuations, using operating earnings, trailing or expected and which way is best. We use a trailing 12 month "all in" earnings, which point to a market with a P/E ratio over 18x AND margins on those earnings are at or near record highs. IF the market multiple were to get to a more "normal" or even the median ratio of the past 100 years, the markets would be selling for 30% less than they are today. If we anticipate returns of 10-15% over the next year, we are looking at a 2 to 1 loss potential for each percent return we might get – better offerings are in the mundane bond market.
But investors are already anticipating a market decline – just look at the amount of short-selling that has been reported and the amount of money used to buy put options (that appreciate as the market declines). The report on NYSE short-interest released after the close yesterday showed the third consecutive month of very high shorting activity – all in the face of a relentlessly rising market. The shorts are now getting it in the shorts – and are or will be forced to cover, creating additional buying power to push the markets ever higher. Importantly, the rise in short interest is coming as volume has actually been declining, so the "days to cover" for many stocks and the market as a whole is actually rising – again putting upward pressure on stocks. One other indicator that we have used in the past and has been in the press in the past year is the ISEE index of option activity. This measures the buying activity in the options markets – both calls and puts, not existing positions, but "new" purchase and sales. Below is a summary of the index since the end of 2002. Each time the call option buying activity gets heated (with readings over 200), the markets will generally struggle and begin a corrective phase. When put buying is very high (and the readings below 145), the markets begin a bottoming phase and generally rise. Since June of '06, the readings have consistently been below 145, indicating a market primed for a rise.
In fact, some of the lowest one day readings in this series occurred early in March, just as the market was melting down from the increase in rates in China. Investor's clearly are already on the defensive and have more buying power than selling power (meaning, I bought, next decision is to sell, and vice versa) at their disposal. To top off the sentiment readings are the monetary aggregates that have been rising at much higher than 6% annual rates, flooding the markets with liquidity – never mind what the Fed is saying about the economy, interest rates or whether they will cut anytime soon.
But the economy is doing poorly – why hasn't the market reflected the higher energy prices and slowing economic growth? There has been a large disconnect between the financial markets – buoyed by the money flows and merger activity and the "real" economy, hurt by slowing real estate and higher energy/food prices. The common belief is that the markets will eventually reflect the poor economy and begin going down. However, we believe that the markets will actually continue their rise until "something financial" disturbs the markets enough to react. A whiff of "something financial" was seen late in February as China began to try to slow their economic growth by raising rates – putting into jeopardy the merry-go-round of money flowing from our shores to China to Japan and back here. What made the decline deadly was not the fact that it happened, but how the various asset classes reacted. Over the past couple of years, we have noted the correlation between assets classes no longer follows their historical relationships. Look at nearly any asset class you care to name and how has it performed over the past 3-5 years. Since May of 2004, the CRB index is up over 10%, Gold is up over 50% and REITs have compounded at better than 10%. This relationship is at odds with historical norms. So when the markets unraveled, all these asset classes (bond yields actually rose from the end of February to end of March) took it on the chin. The danger in the markets are not that the economy slows – it already is (and many argue already in recession), but the risks are that the hiding place will be short-term money – so the great sucking sound investors are likely to hear will be the liquidation of investments ACROSS asset classes.
So party like it is 1999, but like the great DiMaggio (and even Cal Ripken Jr) streaks are meant to come to an end. However, the impact of their streaks ending was upon a small group of people. The market streak ending will be felt around the world and will impact investors for months/years to come. The lasting question is when will that occur? Unfortunately I cannot answer it, but I do know that it is looming somewhere in our future and beginning preparation today (by reducing exposures to the various markets and building a cash reserve) will put you in better shape to take advantage of the eventual bargains that will come out of the cathartic correction that is a part of the markets as is breathing for you and me.
Since the markets are open again today, they are trading higher and above their record highs. However, as with the past couple of days, those levels have proven to be a high hurdle to clear. Of note, volume levels continue to decline as the markets march higher – a trend worth keeping an eye upon. The Dow ended the day lower by 14.30 points to close at 13525.65, and the S&P 500 was also down, losing 1.84 points to close at 1522.28. Crude was up .09, closing at 65.06, and gold gained 2.30 for a close of 661.55.
© 2006 Paul Nolte