Articles from Oct 2006

Market is a forward looking mechanism

When you see a GDP growth below one percent and at the same time market rallying to new high, probably the market has already discounted the poor GDP and is anticipating GDP growth rate recovery.

PONDER this apparent mystery. In the three months to the end of September, the American economy grows at its slowest rate in almost four years as the long-feared housing market slump shows up for the first time in blunt statistical reality.

But in precisely the same three-month period, the stock market bulls ahead. The Dow Jones industrial average breaks through its record level (set back in early 2000, when the economy was coming off its fastest rate of growth in almost 20 years) and then ploughs on through the 12,000 barrier with apparently no sign of slowing.

Is the market behaving irrationally? Are investors failing to properly discount the real risk of an outright US recession? Or is the market acting as it is supposed to, as a forward-looking, rather than coincident, indicator? Will the third quarter of this year turn out to be the nadir of the slowdown, with corporate profits in the coming six months fully validating investors’ optimism in the durability of the US expansion?

Analyst rush to revise earnings estimates

Like a broken record I keep repeating look at the earnings to understand markets. Here is the latest update on earnings from Zacks.

The most important point in this analysis is :

Looking ahead to next year, the revisions ratio has finally pushed above 1.0, to 1.07. This ratio has been trending upward over the last few weeks and sits slightly above our last reported number, 0.96.

I consider this ratio to be extraordinarily important. With the economy slowing, housing in a free fall and the yield curve inverted, one can easily make an intellectually coherent case for a recession next year. However, there has never been a recession where earnings grow at anything close to a double-digit rate. This is the elephant in the room that must be explained by any recession predictor. There is no way that the expected growth rate will come down unless estimate cuts exceed estimate increases.

Expect the bears to spin this. The fact is the earnings are much stronger than the macro analyst and bearish TV pundits make it out to be. Some of them have no idea about how to interpret earnings trend and those following them blindly will be in for rude shock.

With over 59% of the S&P 500 reported, third-quarter earnings results thus far have been a positive surprise and show a clear win for the bulls. Median reported EPS growth sits is 12.3% and positive analyst surprises outnumber negatives by over 4:1. It seems that investor�s low expectations for third-quarter earnings reports have proven unfounded. Though there are still over 200 companies in the index left to report, it�s clear that the market�s recent run-up now has a leg to stand on.

So far, the growth leaders have been the Telecom and Industrial sectors. Telecom has only seen four of its 10 companies report, however, so the numbers are not very telling. On the other hand, over 70% of Industrials have reported, and the numbers have clearly boosted the sectors outlook. Positive surprises outnumber negatives in the sector by over 7:1 and the median surprise sits at an impressive 3.1%. Median reported third-quarter growth for both sectors has been 26.1% for Telecom and 21.7% for the Industrials.

The growth laggard at this point in the reporting season is Consumer Staples, with a median growth of 7.4%. This is more favorable than expected however, as the sector�s surprise ratio is over 5:1, with a median surprise of 2.5%. The two earnings surprise leaders for the sector were Estee Lauder (EL) and Supervalu (SVU). Food firms Conagra (CAG) and McCormick (MKC) also posted double-digit surprises.

Cautious but not negative

The market acted the way it should on Friday, trapping the late bulls. Even though I am cautious I am not negative in the long run on the markets. The market is in correction mode. Where it goes from there , I will play week by week. Corrections in bull markets are sharp and vicious shaking out most late bulls and offering a mirage to short sellers and bears. It is too early to say the rally is over.

As a practical matter, it makes greater sense to respond to known market conditions,like breakouts, relative strength, earnings, momentum etc. In that thinking mode it allows allow you to adjust our stance as conditions change. Conversely, if you position yourselves based upon a macro prediction about the future, you are stuck with defending that prediction until it comes true or sticking with it until you lose enough that you are forced to capitulate.

Market action during the period from May 2006 to the present serves as a prime example of how the hypothesis based investor miss good profit opportunities. During the decline from the May top it was broadly accepted that the bull market top was finally in place and that a major decline was beginning. The rally out of the summer lows was dismissed initially as a short-term technical bounce in the context of a longer-term decline. The bears held fast. They became vociferous. As prices approached the level of the May top, they hoped that a bearish double top was forming. The bears stuck to their hypothesis.

Now the last couple of weeks of rally left the bears with little on which to hang their hats. It is easy to tell apprenticed investor to trade what you see and not what you think, but hard to practice for the gurus themselves.

There are number of negative things in the news cycle for the market to keep climbing wall of worry. The negative or just barely positive GDP number is what is making bears excited. But the market is forward looking mechanism, so it might have discounted that and may be looking many quarters ahead.

GDP, housing, wage growth, etc. might get macro analyst all excited but as a trader you can not trade based on it. As a trader when you look at a piece of data your first question should be what is the trade in this. Does it indicate long or short or neutral trade. Next set of questions should be has the market discounted this news or is surprised by it.

The earnings continue to show a good picture and many of the stocks which had earning acceleration and earning surprise have a long way to go. Overall market action may dampen their rallies for sometime but with a good catalyst, they will resume their upward climb.

50 stocks with bearish momentum

Markets have probably entered correction zone, so good time for short sellers.. Here is a list of stocks with recent bearish momentum characteristics. If the market corrects at these level, some of these stocks will have accelerated downside momentum. If you are bearish guru followers or if you are enamored by bearish arguments and outraged by the bull move so far, this list might help you find some profitable trades.

If you go through them microscopically, you will probably notice bearish sector trends. Watching momentum can help you both on bullish and bearish side.

To understand more about this list read my old post.

AF,Astoria Financial Corp
AKAM,Akamai Technologies Inc
ALO,Alpharma Inc
AN,Autonation Inc
AT,Alltel Corp
BGG,Briggs & Stratton Corp
BXS,Bancorpsouth Inc
BYD,Boyd Gaming Corp
CECO,Career Education Corp
CFR,Cullen Frost Bankers
CINF,Cincinnati Financial Cp
CKFR,Checkfree Corporation
CMX,Caremark Rx Inc
CTV,Commscope Inc
DADE,Dade Behring Holdings Inc
DRI,Darden Restaurants
EW,Edwards Life Sciences
EWBC,East West Bancorp Inc
FRX,Forest Laboratories Inc
GD,General Dynamics Corp
GNW,Genworth Financial
HNT,Healthnet Inc
IFIN,Investors Fin Svcs Cp
IR,Ingersoll-rand Ltd Cl A
JBL,Jabil Circuit Inc
JEF,Jefferies Group Inc
LEG,Leggett & Platt Inc
MHK,Mohawk Industries Inc
MHS,Medco Health Solutions
MOT,Motorola Inc
MUR,Murphy Oil Corp
NOC,Northrop Grumman Corp
NTAP,Network Appliance Inc
ORLY,O'reilly Automotive Inc
OSK,Oshkosh Truck Corp
PHLY,Philadelphia Consolidated Holding Corp
PL,Protective Life Corp
PPC,Pilgrim's Pride Corp
SGMS,Scientific Games Corp
SIE,Sierra Health Services
STJ,Saint Jude Medical Inc
THG,The Hanover Insurance Group Inc
TXN,Texas Instruments Inc
UB,Unionbancal Corporation
UHS,Universal Health Svcs B
VSEA,Varian Semiconductor Equipment Associates Inc
WL,Wilmington Trust Corp
WLK,Westlake Chemical Corp
WTNY,Whitney Holding Corp

When to be bullish and when to be cautious

A prince being thus obliged to know well how to act as a beast must imitate the fox and the lion, for the lion cannot protect himself from traps, and the fox cannot defend himself from wolves. One must therefore be a fox to recognize traps, and a lion to frighten wolves.-Niccolò Machiavelli

Earlier in my trading career I used to be caught completely by surprise by days like today, but now the most important skills I have developed is anticipating zones of likely corrections and market turns. It helps a lot in avoiding market traps.

I use a simple indicator to anticipate market turns which I talked about earlier when I became bullish in August. It is based on a ratio of up and down stocks price in last 65 days. It gives you an objective consistently tradable signal. The same indicator was flashing danger signals since last few days. Yesterday when I ran my end of day scans it was clearly flashing trouble, so most of the morning, I spent reducing positions to bare minimum and now watching the action from sideline.

Tuesday, August 01, 2006
Some stocks set for rallies

The overall market action may look dreary but below the surface there is a strong rallies developing in some sectors and it looks like these rallies have legs.
How does a market turn and how can you anticipate market turns. Everyone has different ways to do it and it is a function of your understanding of overall market mechanics. It is also a function of your trading philosophy. Those who go by fundamentals look at stocks trading below a certain valuation levels. The macro players look at interest rates, liquidity, consumer spending, jobs etc. The cycle followers and Elliot wave followers look at cycles and their length. Technical traders look at support, resistance, chart patterns etc. No matter what trading style you follow you should have a way to determine overall market direction.
I follow a very simple objective method to determine market direction. It is based on a ratio of up and down stocks price in last 65 days. It gives you an objective consistently tradable signal. Going by that indicator we have a high probability of a rally developing in next couple of weeks.
When a rally starts developing you will see first set of stocks starts to rally, they have follow through , then more join in. In last couple of days certain set of stocks have started moving and are also witnessing follow through. So the early birds are off and that also gives clear indicator of what sectors are likely to rally.

Interesting trading blogs/sites

There are few trading blogs I track regularly. Many of the most popular are known to people, and some of them offer general commentary on market. Many blogs are just marketing tools for newsletters or other advisory services. There are number of blogs catering to day traders but few blogs by traders have long term approach.

The Instantbull ranking of Best of Breed is dubious. Many of the sites on it are just snakeoil salesmen using their blogs to sell newsletters, some of the newsletters have atrocious returns, hey but they are popular.

Here are two blogs/sites with interesting approach to market. If you go through them, both have very profitable replicable strategy for swing or long term trading.

Wishing Wealth : This one has a interesting twist on CANSLIM strategy.

DJ Interactive Markets :
This one is focused on trading small caps using earning and momentum.

Market correction

Markets have not corrected so far and sector rotation continues. But I am now extremely cautious on market direction. Sometimes moves like yesterdays are misleading. So I am expecting a correction at this stage and protecting profits is first priority.

The earning based trades is what I am willing to continue to invest in because, they work very differently.

The big picture on housing

Marc Gerstein, Director of investment research, is one analyst I track regularly. His posts are very insightful and often ahead of the curve. Here is his insightful take on the housing market.

Homebuilder stocks seem to be following the classic Wall Street scrip: buy before bad news turns into good news.

Wall Street lore says bulls can take comfort in the failure of beaten-down stocks to drop further when more bad news comes out. The idea is that this is a sign that bears who correctly anticipated the slump are finished with their selling and that the next major market event will be further buying by those who anticipate the next upcycle. The housing sector may be playing to this script. Yesterday, the National Association of Realtors (NAR) reported that U.S. existing home sales slowed from an annual rate of 6.3 million in August to 6.18 million in September, a bit worse than the 6.2 million forecasted by economists. Nevertheless major homebuilder stocks like Centex Corp. CTX, DR Horton Inc.DHI, KB Home KBH, Lennar Corp. LEN.N, Pulte Homes Inc. PHM.N, and Toll Brothers Inc. TOL rallied.

Business cycles don't turn on a dime, so it's likely we'll see plenty more bad news on the housing front, in terms of industrywide statistics and homebuilder earnings. But it looks like Wall Street is already looking beyond this.

US housing slump likely to avoid recession

A British think tank argues that the housing slump is unlikely to lead to a recession.Most newspapers lead with the story of decline in housing prices. Now is that a surprise, it was expected for long time that at some stage the housing prices will stop going up and decline.

The easy trade on this was over long ago. The home builders will change strategy and tactics to counter this. During the boom the mantra was large houses. Now to improve affordability they will shift to smaller houses. There is lot of talk about discounting by home builders, isn't that a logical response to market conditions. The car makers resorted to 0% financing to simulate demand. Price promotion is a legitimate marketing tool used by millions of businesses worldwide everyday, but the bears make it sound like a scandal or criminal behaviour.

The other point constantly being harped about is options arm. Options arms is the new Y2K equivalent problem. It is so well publicised that most with option arms are already seeking solution to their problem unless they are living in a cave. Mail boxes are flooded with various solutions to option arms, if you read newspapers, or listen to radio the solutions to option arm is the most heavily advertised thing currently. That is the case at least in part where I live, things might be different in the analysts caves.

The worst people to get your information on macro trend is from salesmen. Lot of commentators are quoting the real estate agents as source of their bearish hypothesis. Anyone who has worked long enough with sales people in any industry knows that the worst analysers of trends in industry are sales people. Their view is completely driven by their incentives and commission. Most of them lack long term perspective like the so called macro and big picture analyst who rely on them to form their opinion.

One of the things about housing is that people are willing to live with bad decision for long time. So unless faced with dire emergency no one is going to go and sell house because prices are dropping. Sellers who do not find buyers at the price they want will pull out of market. The worst sufferers are speculators and flippers. Consumer behaviour in high ticket, high involvement, and high conspicuous value products like housing is not as simple as some of the analyst are basing their hypothesis on.

THE slump in the US housing market will see the American economy slow sharply next year, but it is likely to escape a plunge into recession, one of Britain’s leading economics think-tanks said yesterday.

Fears of the scale and impact of the housing downturn were fuelled yesterday after bleak figures showed that the average price of new homes in the US tumbled by 9.7 per cent last month from a year earlier.

The steepest annual fall in new home prices in more than 35 years followed figures on Wednesday that showed prices for existing homes suffered a record year-on-year drop of 2.5 per cent in September, the worst fall in four decades.

But despite the price falls, Britain’s National Institute of Economic and Social Research said yesterday that it was very unlikely that the US would be pitched into recession.

Small cap earnings will be in focus next

Next week onwards the earnings focus will slowly shift to small caps. This is where you will find lot of opportunities. The small caps are poorly covered by analyst, many of them have no analyst earning estimate, many do not offer guidance or pre announcement. Many of them are novice in the great Wall Street earnings game, so they are yet to learn earning manipulation. This creates for an interesting trading situation.

Over reactions to earnings are very common in the small cap world. Every earning season a handful of companies from this group will have blowout earnings and then they are discovered by the market. If they have low float then the mixture of blowout earning and low float acts to propel them several percent higher in few months. Many of today's well known stocks like NTRI, HANS, GROW, IAAC, etc were in similar situation few years back.

Some of these are just one earning season wonders, some have the staying power like HANS, NTRI, GROW etc as they continue to show good earnings for next 6-8 quarters and end up making several hundred percent moves. Season of opportunity for earning traders starts next week.