July, 2010
Half of the people can be part right all of the time,
Some of the people can be all right part of the time,
But all of the people can’t be all right all of the time.
I think Abraham Lincoln said that.
-Bob Dylan
We have spent a fair amount of time in these pages discussing the merits of investment fundamentals and valuations and also looked at a good number of charts. Clearly we see the value in both methodologies and strongly believe that success in the markets depends upon one’s ability to implement both.
There are times, however, when both fundamentals and technicals agree and yet an investment based on these findings is unsuccessful. The company may be doing very well financially and be trading at a reasonable valuation. The chart suggests that the stock price is making a bottom. Still there is something unaccounted for and the stock price continues to decline.
Conversely economic fundamentals may be very poor jobs hard to come by and debt and deficits out of control. The stock market displays a very clear topping pattern. Stocks defy these indicators and trade higher.
Obviously there is something unaccounted for in these types of situations and that is sentiment. Just as Bob Dylan said 40 years ago quoting Abraham Lincoln over 140 years ago, “all the people can’t be all right all of the time.” And when the fundamentals and technicals are so obvious as to lead the crowd in a certain direction investors should be very skeptical.
This is exactly the case with the stock market over the past couple of months. The major stock market indexes, most notably the S&P 500 index, have formed clear head and shoulders patterns, one of the most popular technical patterns in the business.

Recently it looked as if these patterns predicted imminent doom for stocks. In addition, economic indicators have been weakening suggesting an increasing possibility of a double dip recession. The only reason that stocks could not break down decisively, we believe, is that too many traders were counting on just that possibility.
A recent article in the Wall Street Journal provides evidence to validate this theory:
“In decades of market analysis, I can’t remember a time that I’ve heard [so] many analysts quoting some support or resistance level as being critical for the market,” John Hussman, president of Hussman Investment Trust, wrote in his weekly commentary. “The object of discussion has increasingly turned to the implications of this particular chart formation or that, as if some magic number or another absolves investors from having to think about the big picture.”
The recent focus on technical analysis has “really hammered home how the volatility is getting so extreme,” said Ryan Detrick, senior technical strategist at Schaeffer’s Investment Research.
The Standard & Poor’s 500 index narrowly fell on Wednesday, snapping a six-day winning streak in which it had gained more than 7%. But those gains came on the heels of a bigger losing streak in which the index fell in nine of the previous 10 sessions and dropped 8.5%.
“When the market goes down, people turn to the charts because it gives them peace of mind,” said Katie Stockton, chief market technician at MKM Partners. “They want answers, and if they can’t find the answers in the fundamentals, they turn to technicals.”
The S&P 500 dipped below 1040 during the losing streak, level considered the “neckline” for what chart watchers call the index’s “head-and-shoulders” formation. The head-and-shoulders pattern consists of two smaller rallies, considered shoulders, that sit on each side of a larger rally, the head. It is typically viewed as evidence of the market topping out and a precursor to a larger reversal.
But the index has bounced back in the past few days…
…to the tune of 6% in less than two weeks. Technicians trading the head and shoulders breakdown have had little opportunity to cover their shorts as stocks have marched steadily higher over that time. For now, the head and shoulders pattern has failed to work.

Technology Stocks Battle the "Death Cross"
The predictability of these types of patterns may just be compromised by the fact that so many traders have become technicians but that is a question to explore in another issue. For now, we can simply recognize that the potential breakdown for stocks was broadly anticipated and failed for this very reason.
Last issue we discussed removing our market hedges. In the meantime we actually used the negative sentiment created by the popularity of his head and shoulders pattern as a buying opportunity (see Jesse’s My Back Pages for the play-by-play) and it has paid off.

But Financials Hold the Key
Things aren’t so clear though today. Economic fundamentals are indeed very poor; leading economic indicators are rolling over; job growth is nonexistent and the economy is displaying none of the signs of the typical recovery. In addition, the head and shoulders pattern is popular because it usually works. These signs can’t be ignored.
Still we believe there is too much talk of deflation today. Early this year you’ll remember us discussing at length the prospect of Japanese-style deflation here in the United States. At the time very few were discussing this possibility. Today it is on the minds of nearly every economist and financial commentator and it has clearly seeped into public consciousness. Over just the past month Google searches for deflation have surged 300% and Treasury yields have plummeted to record lows in some maturities.
It is much easier for us to take a position in the debate such as the current one regarding deflation when it is less popular as it was earlier in the year. Now that traders have put on the deflation trade (long treasuries and short stocks) we find ourselves much less comfortable with the position.
We are admittedly poor trend followers, a flaw we readily recognize (see our TLT trade in recent issues for an example of selling too early). We simply believe it is better to position oneself closer to the beginning of a trade and get out near the middle than to get in closer to the end of a trend and suffer consequences similar to what new short-sellers experienced trading the potential breakdown of the recent head and shoulders pattern.
We still believe in the deleveraging thesis over the long-term, however, we now have little conviction in regards to the near-term direction of the stock market. The head and shoulders pattern may eventually work for traders, especially if most soon abandon the idea. The fundamentals still line up with the technicals and if this current rally flips traders to the bull camp you can be sure we will, in the very least, be putting our hedges back in place.
Certainly, we have not given up hope that an end to this epic bear market of the past decade may soon be at hand. There are signs that investors, disillusioned by increasing volatility and persistent poor performance, continue to abandon the equity market.
The Wall Street Journal recently ran an enlightening piece:
Small investors’ faith in stocks, which surged in the 1990s, has collapsed since the technology-stock debacle and the Enron and WorldCom scandals of 2000-2002. The 2007-2009 financial crisis only made things worse. Now, the pullback among ordinary investors means they are a declining force in a market that is increasingly dominated by professionals.
Some were tantalized by equities during the 70% rally that began in March 2009 and ran through April. But mutual-fund data and other clues suggest that that brief infatuation has ended.
In 2002, investors withdrew more money from mutual funds that invest in U.S. stocks than they put in. Then from 2007 through 2009 they withdrew money for three consecutive years. That marked the first three-year period of withdrawals since 1979-1981, according to the Investment Company Institute, a mutual-fund trade group.
Ironically, early 1982 marked the end of a long period of stock market malaise and the beginning of the biggest bull market in stocks on record. Sadly most investors had just thrown in the towel and missed out.
The article profiles the Potyks, “a comfortably retired couple in San Antonio,” who have a soured on the financial industry in general. “In the military, you learn that you want people you can respect, trust—who have integrity,” Mr. Potyk says. “Over the last five years or so, I find that our financial institutions have no shred of the character I describe.” Those who have read our recent issues will know that we vehemently agree with Mr. Potyk.
We can’t, however, endorse his reaction: the Potyks have sold all of their stocks and are now 100% invested in fixed income. The problem with this relates back to the sentiment issue we discussed earlier. Getting out of stocks today is very likely to mean selling nearer to the bottom rather than the top (give or take a few years). Likewise, buying bonds today, after a thirty-year bull market is very likely to mean buying nearer the top than the bottom (give or take a few years).
Turning to the bond market, its recent performance suggests the Potyks are not alone in their sentiments as investors have increasingly come to favor the long bond over more volatile investments like stocks. The yield on the 10-year Treasury is now below 3%. In stark contrast, fully half of the stocks that make up the blue-chip Dow Jones Industrial Average pay a dividend yield that is higher than the 10-year Treasury note.

Over the Next Decade Would You Rather Earn This...
This means that investors would rather be locked into a guaranteed 2.95% return (the current yield on the long bond) over the next ten years than own a portfolio consisting of Verizon, AT&T, Pfizer, Dupont, Kraft, Merck, Chevron, Johnson & Johnson, Coca-Cola, Home Depot, McDonald’s, Proctor & Gamble, Intel, General Electric and ExxonMobil that yields over 4%, or about 40% more in income!

...Or This?
Only during a devastating deflationary collapse would this bond investment outperform this hypothetical portfolio of equities (more evidence that the deflation trade is
getting crowded). Should inflation come into play over the next decade long bond investors could very easily see a 50% drop in the value of their investment. Strong, multi-national companies with pricing power such as those mentioned above would most likely be able to adapt to the changed environment and their investors would probably avoid the same wicked fate as those bond holders.
There are other signs that stocks are cheap relative to bonds. Wayne Waley of Witter & Lester recently wrote an interesting analysis of stock market values during low interest rate environments:
Since 1970, the average P/E, where E is calculated on trailing 4 quarter earnings, has been 19.55, slightly higher than the 15 most of us were trained to expect as the norm a couple of decades ago. The trend higher in trailing P/E’s is due largely to the collapse of earnings in 2008, that shot P/E’s temporarily into the triple digits, thus distorting averages, and secondly due to the fact that, as you can see in the table, stocks ‘tend to’ trade in a higher P/E plane when interest rates are extremely low, as they have been over the last decade. Anomalies, such as the 08 fourth quarter earnings collapse are the reason a lot of statisticians prefer to reference medians instead of averages. The median P/E since 1970 is 17.24.
The S&P 500 closed at 1078 on Friday (July 9, 2010). Trailing one year earnings, through the first quarter of 2010, were 60.83. We will have a better handle on second quarter earnings in a couple of weeks, but if we conservatively estimate that 2nd quarter earnings are simply equal to first quarter earnings, the trailing 12 month earnings go to at least 65.0, which would put today’s P/E at 1078/65 = 16.58, which is below the 90% confidence range (17.55-46.47) for low AIR periods.
The 90% confidence bands are very wide at all levels of interest rates and leave a lot of room for both Bulls & Bears to reside. I don’t know anyone that is anxious to pay 46.47 times earnings to own the S&P 500, regardless of the level of interest rates, so I added a table column, I called “Wayne’s (P/E) Band”, that seemed to simply make common sense given all considerations I have studied. So my take is that with interest rates extremely low, I’m inclined to view the market as cheap at 15 times earnings and expensive at 22.5 times earnings. Using trailing earnings of 65, that would put us in a S&P 500 range of 975 to 1462.5.
Last issue we wrote, “Based on the data provided by Yale’s Robert Shiller we believe that fair value for the S&P 500 is somewhere in the range of 900 to 1000,” thus our fair value estimate corresponds with Waley’s “cheap” range. However, we are intrigued by the idea that “cheap” is relative. Relative to their own past performance we believe stocks are merely fairly valued currently but compared to bonds, however, stocks are indeed cheap. To wit Waley continues, “Not only are rates in our low interest rate level where high historic P/E’s are justified, rates are way below 5% and the current earnings yield on equities (6.0%) is nearly 3 times the yield of typical mid curve interest rates (2.08), a relationship spread we have not seen in over 30 years.” Hence the glaring disparity between the long bond and the hypothetical dividend portfolio described above.
All that being said, it gives us increasing confidence to know that investors are currently abandoning the stock market just as it is becoming more attractive as an investment class. And it is interesting to note that people remember the last major bear market ending in 1982 when, in fact, the selloff that year did not even begin to approach the lows set in 1978 or 1974, for that matter. Stocks bottomed higher that year than in those prior years so the ‘bull market that began in 1982’ actually had its beginnings years before that date.
If history is to rhyme, then stocks this time may not ever approach the low set last year but investor sentiment should decline to lows not seen since 1982. And that will be the buying opportunity we have been waiting for.
“The Felder Report” – July 2010
The Felder Report (TFR) is published monthly by Felder & Company, LLC. There is no cost to subscribe. Felder & Company also syndicates Jesse Felder’s free weblog available at http://felderandcompany.com For more information contact us by mail at P.O. Box 790, Bend, OR 97709, by email at admin@felderandcompany.com or by telephone at (541) 389-3345. Felder & Company (F&C) is an Investment Adviser registered with the state of Oregon and various other states. Information in TFR comes from independent sources believed reliable but accuracy is not guaranteed and has not been independently verified. All material published in TFR is subject to change without notice from F&C. F&C’s security recommendations disclosed in TFR are the opinions of Jesse Felder and the performance results of such recommendations are subject to risks and uncertainties beyond the control of F&C. F&C is the manager of individual client investment accounts and as adviser F&C, or its associated persons, may purchase and sell securities identified, recommended and analyzed in TFR. In consideration of performance objectives of its individual client accounts, F&C may purchase and sell securities identified in TFR without notice to newsletter subscribers and may take a position in such securities that is inconsistent with the recommendations disclosed in TFR. Previous, successful recommendations may not be indicative of the results for all recommendations, and in fact certain recommendations have resulted in losses. Subscriber information is never sold, shared or otherwise distributed to third parties.














Certainly, professional money managers are feeling very good about the stock market right now. Mark Hulbert, who makes a living tracking investor sentiment, recently wrote that “[among professionals] bullish sentiment is approaching dangerously high levels.”
Though some may ignore them, we continue to see signs that this is, indeed, a deleveraging cycle. Core CPI (Consumer Price Index) saw a rare decline in January. This should not be surprising to those listening to corporate America. Companies have been bemoaning deflationary forces for months.
While the Federal Reserve reported that total consumer credit actually increased in January this was led by auto loans. Revolving credit, mainly credit cards, declined yet again and the trend certainly remains lower. As the Wall Street Journal reported last month, “U.S. banks posted last year their sharpest decline in lending since 1942.” Clearly, this is not your average economic cycle.
The supply and demand picture, however, clearly supports this bullish minority’s view. Dave Rosenberg, Chief Economist and Strategist at Gluskin, Sheff & Assoc., recently drew our attention to the fact that the supply of long-term treasury bonds is currently at a thirty year low. Long bonds now make up less than ten-percent of all Treasury debt outstanding.
Stocks have rallied right back up to their mid-January highs over the past couple of weeks; the volatility index is back to its lows; and the dollar has finally pulled back some after a very strong thrust higher.
In addition, stocks are running into resistance just as the economy may show signs of slowing. The government stimulus has run out and the current gridlock in congress is not a promising sign for those looking for additional measures to be put in place.
We have also started to look at the Swiss Franc as a possible beneficiary of improving sentiment in Euroland though we have not pulled the trigger and bought it yet. The CurrencyShares Swiss Franc Trust (NYSE symbol: FXF) is an ETF that tracks the currency well. We still have, “no interest in playing the whose-shit-smells-least game of foreign currency trading over the long term.” Over the short-term, however, we think the Swissie may see some interest among traders looking for an alternative to the Euro/Dollar duo that has dominated the financial news media lately. Sentiment has clearly shifted in favor of the dollar lately and this makes the trade less attractive to us.

















