Your Own Worst Enemy

April 7, 2009

By Author_Ego

No doubt about it, this market’s price/volume action continues to impress. When we rally, we do so on heavy volume; when we pullback, volume contracts and, more than that, we have gotten into the habit of closing in the upper part of the day’s range. Just what you want to see. Yet don’t be lulled into thinking that all is now hunky-dory (the Put/Call falling to .60 tells me many have). This rally, while impressive given the gains of the past month, still leaves much to be desired.

As it stands now, only the Nasdaq trades above its downtrend line:

Both the S&P 500 and Dow seem to have stalled at their respective trend lines, if only for the moment (more on this to come).

Yet even more importantly, the IBD 100 (Investor’s Business Daily’s index of stocks with superior earnings and price performance) is trading not only below its trend line but its 50 day moving average as well. That’s less than ideal, of course, and rather disconcerting. But, to be honest, what’s even more disconcerting is the fact that this index has rallied far less than the others and on such weak volume to boot.

Which brings me to my point: For all these gains, this remains a rally in want of leadership. That chart of the IBD 100 should not surprise anybody who scans for and follows stocks of fundamentally superior companies on a nightly basis. It’s truly been a “dash for trash,” as I read recently in The Economist. After all, it’s not like it’s a secret that the stocks which have performed the best over the last month are the ones that were mauled the worst the year before:

BZH: 228%
AIG: 214%
SRZ: 177%
CETV: 172%
C: 164%

And, naturally, the thin, cheap and speculative stocks of the world have been far from ignored. This phenomenon is nothing new, of course. It’s happened many times in market history where you get a rally lead by beat-up, former leaders and speculative-type stocks. Check out what was doing back in the early 1960’s. Back then we had a new, young President that was inspiring millions around the world with his soaring rhetoric and a market that was starting to ramp up on the backs of former leaders and low-priced, speculative stocks with no real earnings. Sound familiar? In fact, it was a fascinating time for many reasons, not the least of which was that the likes of Nicholas Darvas, Gerald Loeb, William O’Neil and Bernard Baruch were all operating at the same time. And, lo and behold, they were all coming to the same conclusions about the health of the rally. By late 1961, in fact, Darvas had become so disillusioned by the lack of quality that he stop trading altogether, deciding that the market was trying to tell him something. And so it was. 1962 turned out to be a rough year. It wasn’t until October that some true leadership finally emerged which ended up fueling a multi-year bull market. William O’Neil’s personal account grew from $5,000 to over $200,000 in 18 months, proving yet again that patience and perseverance always pay off.

And, no, I’m afraid to say that this is not 1962. Another glaring difference is this: back then earnings and dividends were actually growing, even as the market sold off. The exact opposite is true today. According to Morgan Stanley, the consensus forecast for 2009 is 21% lower than it was in January. Think about that. Folks, January wasn’t all that long ago. The scary part is Morgan Stanley contends earnings will have to be revised down yet another 30% from here. So, if the market could talk, it might say something like this: “2009, I knew 1962; 1962 was a friend of mine. 2009, you’re no 1962.”

Finally, I’ve taken interest in certain analysts’ comments regarding the banks recently. The reason for my interest has to do with the fact that so many believe that the banks have put the worst behind them.

One of these analysts is a gentleman by the name of Richard Bernstein, the former Chief Investment Strategist at Bank of America/Merrill Lynch. I say “former” because after writing a note on 3/30 advising investors to take advantage of the rally in banks to sell their shares, it was announced the very next day that he would be leaving the firm. His chief complaint, it seems, was that simply removing the toxic assets from the balance sheets of banks will do nothing but prolong the financial crisis, as what is needed, he argued, is sector consolidation. He compared the actions taken by the U.S. government to those of Japan in the 90’s.

Another analyst who has caught my attention is Calyon Securities’ Mike Mayo, who was until recently employed with Deustche Bank. He put out a report entitled “Seven Deadly Sins of Banking,” in which he says the banks’ loan losses could possibly hit 5.5% by 2010, a truly horrifying prospect. The 11 banks he mentions in his report read almost like a short-sale watch-list. It should come as no surprise that his earnings forecasts are much lower than Wall Street’s. He calls the government’s fixes to the banking crises “window dressing,” citing the change in mark-to-market as merely a change in “optics” that hardly alters the underlying fundamentals.

These reports lead me to my final thought:

After all the anger and frustration over the bailouts, the housing debacle and the losses in the stock market, I truly believe many around the world are pining for some good news. This is what makes it so easy to be lulled into believing the worst is over. You gloss over the facts and ignore the truth because you are simply worn out. And adding to this sense of exasperation is some of the talk emanating from the seats of our governments. “Legacy Assets,” “Global Governance,” “Quantitative Easing.” Such is the language being bandied about by our leaders around the world. Yet what exactly do these phrases mean and, more importantly, what exactly do our leaders mean when they say them? Your Average Joe would no doubt be hard pressed to give you a satisfactory definition, which is exactly the point.

“The great enemy of clear language is insincerity. When there is a gap between one’s real and one’s declared aims, one turns as it were instinctively to long words and exhausted idioms, like a cuttlefish spurting out ink. In our age there is no such thing as ‘keeping out of politics.’ All issues are political issues, and politics itself is a mass of lies, evasions, folly, hatred, and schizophrenia. When the general atmosphere is bad, language must suffer.” (George Orwell, “Politics and the English Language”)

Earnings season officially starts tomorrow. Don’t ignore the facts or get caught up in the exhilaration of the rally, should it continue. Earnings could turn out better than we think, who knows? Though I doubt it. I see a lot of stocks right now getting weaker, not stronger. Like Darvas, I try to take my cues from the market. While we could certainly rally higher, I would be careful with any buys here. I’d keep it small and on a very short leash. Keep pruning those watch lists, too, both long and short, and be prepared for anything. Cash is still very much king. Stay on top of the market and your patience and perseverance will be rewarded! It’s at these precise moments where one can be his own worst enemy. “It sounds very easy to say that all you have to do is to watch the tape, establish your resistance points and be ready to trade along the line of least resistance as soon as you have determined it. But in actual practice a man has to guard against many things, and most of all against himself – that is, against human nature.”
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