A (bear's) VIEW FROM THE STREET

ByStander

Abby Normal
Gene Wilder once stared in a movie called “Young Frankenstein” which was a spoof on Mary Shelly’s novel “Frankenstein”. In the movie Igor is sent by Dr. Frankenstein to retrieve H. Delbruck’s brain from the hospital so that Frankenstein will be intelligent. Of course, if things worked out as planned it wouldn’t be a funny movie so, Igor, being just slightly off, locates the requisite brain and just as he picks up the glass jar lightning cracks outside, scares him, and he drops the brain on the floor. Panicking he searches and locates a second brain, A B Normal’s and returns to the castle. Of course, when Frankenstein awakes there is something not quite right. Dr. Frankenstein queries Igor about what happened and discovers the truth when Igor explains that he dropped the first brain and took “Abby Normal’s” brain instead. Click here to watch.
That is where we are today…the brain of investors has been swapped with Abby Normal’s…or so it seems. We reported back in 2007 that Chinese investors were lining up around the block to open trading accounts which noted that the markets were approaching speculative excess. Well, after those investors were pretty much completely wiped out during the crash…they are back.
There is no doubt that China’s fiscal stimulus is percolating and that the economy has turned higher, but the equity market there has surged 85% so far this year, so how much is priced in at this point is a concern. It looks like speculative fervor is back — the volume of credit that has flowed into the economy this year has amounted to one-third of GDP. Not only that, individual investors opened 484,799 accounts in China last week — the most since January 2008 and five times as many that were opened last January. This may be one sign of … irrational exuberance.
This exuberance is not only seen in China but also in the U.S. as well as investors seem to have completely forgotten about the butt whipping they had over the last year and are looking for any reason to take risk with their hard earned capital.

Another sign that investors have lost their normal minds can be seen by simply looking the volatility index. At the peak of the market in 2007 as we discussed the slowing economy the media was spouting the virtues of a “Goldilocks Economy” and a soft landing scenario. Investors were complacent and showed no signs of fear of loss. As the market collapsed in 2008 investors panicked and sold everything they could at any price. Now, after two 50% declines in the market over the last 8 years investors are BACK! They have no worries about loss, expectations of a globally growing economy and everything is back to Abby Normal.

And, if you need signs of delusion, just look at the fact that even in the face of a 49% plunge in earnings, UPS still managed to rally 2.3% yesterday.
David Rosenberg stated: “We would have to say that we look at UPS, the world’s largest package delivery company, as a major artery in the global economy. It ships products that span all aspects of manufacturing and financial services, so it is extremely broadly based in terms of its representation in world GDP. As a result, it is very difficult to reconcile what the company did and what it had to say with the widespread view that a major inventory cycle is somehow kicking in; unless all the shipping action is taking place at FedEx (which we know from last month’s statement is hardly the case — sales down 20%). UPS guidance was downbeat, with the company saying that shipments will remain ‘significantly below’ last year’s levels and sharply cutting its EPS forecasts for 3Q (to 45 - 55 cents from 60 cents), and as is the case with so many other companies, revenues sagged 17%. There is still no top-line growth.
Look at Microsoft — the largest software company in the world — it posted a 29% drop in profit and sales (this isn’t enough to offset the earlier Intel news?). Amazon.com, the world’s largest internet retailer, posted a decline in profits and below-target sales despite its aggressive price discounting strategy (the stock still rallied nearly 6.0%!). Bonds sell off (Treasury announced $115 billion of new supply for next week, above the expected $112-113 billion) but as they do, the real yield rises because deflation pressures are still intensifying in the real world — look at McDonald’s, which posted a 7.0% YoY revenue falloff.

And what’s this? American Express, the hottest stock in the Dow this year, posting a 48% plunge in net income. How does one square the pervasive belief that the credit crunch is over with that statistic?”
Take a look at the charts to the right from the most recent Railway Association report (June 09). While there is a small uptick in rail traffic over the last month it doesn’t even get close to the already horribly suppressed levels from January of this year.
Much is being made of the looming inventory cycle and how far production has fallen below demand. We also heard this in late 2001 and early 2002 and in fact, there was a spurt in real GDP growth in the first half of ’02 when inventories added an average of two-percentage points to headline growth, accounting for 80% of the total pickup in the economy.
IF…and I do mean IF…we are about to enter a major growth spurt in the economy the FIRST place we should see it is in transportation of goods from suppliers to producers and producers to consumers.
Small upticks off of massive declines are simply statistical noise and do not lend themselves to accurate forecasting models.
David Rosenberg picked up: “But there has never — ever — been an inventory cycle that was sustained without the front-end support of final sales growth. And the aborted inventory story of 2002 was exactly that as sales and GDP growth both converged at zero by year-end —- new lows in the equity market were not far behind. Admittedly, this last leg of the bear market rally has been huge, taking the S&P up an impressive 8.0% over the past month, even in the face of mixed economic and earnings news. And as Mr. Market, that malevolent beast, tests our resole, we remind ourselves that in the month leading up to the all-time high of 1,565 on October 9th, 2007, the S&P 500 was also up 8.0%, also in the face of a mixed data landscape. The lesson here is that it could be dangerous to extrapolate the short squeeze of the high-beta stocks into future price performance.”
Moreover, it is extremely difficult to get overly excited about a sustained inventory bounce versus a temporary restocking when you look at the depth of the actual collapse which is further evidence of Abby Normal when you look at the run up in rail stocks along with the rest of the market. Furthermore, containerboard and paper box prices are deflating; UPS package volumes in June were down 4.7% YoY, compared with -3.9% in March and -2.1% in December; and total railway carloadings, as of July 18th, were 18.8% below last year’s levels and those levels represented an economy that was already eight months in recession.


We are not sure what the appropriate label is for a market that has managed to shrug off four consecutive months of negative core retail sales in the face of what was the most pronounced fiscal stimulus in modern history.
Rosenberg pointed out that; “Over that period, core retail sales fell at a 4.2% annual rate, and going into the second half of the year, there is no more cash-flow support from Uncle Sam at a time when a rising unemployment rate has already taken organic personal income down by a record 1.9% year-over-year (in nominal, not real terms). The odds of a consumer-led fourth quarter relapse are very high, in our opinion. And, as for all this talk about inventory rebuilding, all we an say is that outside of the auto sector, I/S ratios have barely budged from their cycle highs so we just don’t see that the restocking story is broadly based enough to have enough legs to make a difference beyond the current quarter’s motor vehicle production rebound. It’s going to known as pop, snap, and crackle.”
Remember what Ben Bernanke had to say at this week’s congressional testimony: “Despite these positive signs, the rate of job loss remains high and the unemployment rate has continued its steep rise. Job insecurity, together with declines in home values and tight credit, is likely to limit gains in consumer spending.” And without the consumer, there can be no sustained inventory cycle.
Positive GDP Tick Coming
However, like we said in last weeks article on the “W” shaped recession. We will most likely see in the coming months a positive tick in GDP due to inventory restocking. It will be artificial and short lived but a positive GDP number nonetheless which will give the bulls plenty to crow about.

Alan Blinder of the WSJ said in an op-ed titled The Economy Has Hit Bottom that we could be in for a few quarters of 3–4% growth, which is largely statistical in nature as housing stops subtracting from headline GDP and inventory liquidation subsides. In the final analysis, there is no sustained recovery in the absence of a revival in consumer spending and that is the wild card in the outlook.

However, without consumer spending increasing without government assistance and with employment remaining extremely weak the more optimistic projections and sustainability of such recovery remain very questionable.
But, then again, welcome to Abby Normal.

Quality Of Abby Normal Earnings
Finally, the market has been rallying over the last week, according to the media, due to “better than expected earnings”. Really, let’s take a look at a few:
Over the past couple of weeks the expected year over year trend in S&P 500 corporate earnings has gone from -35.7% to -35.2%. Only 62% of the 100 S&P companies that have reported managed to beat their low-balled earnings estimates, which is hardly a stellar result. This is deserving of a 5% rally in just one week? To date, despite the hoopla over Goldman, Apple and Intel, this has been a highly uneven earnings reporting quarter. However, the sharp comeback staged by Mr. Market just goes to show how desperate investors are for any good news they can get their hands on (we can’t say we blame them — it’s a critical part of the human condition to be optimistic).
Meanwhile, the earnings reports thus far, while once again impressive at the headline level, become less impressive the more you dig and the story of reaching or beating estimates due to cost-cutting remains intact — and revenues are still deflating:
􀂾 Yahoo posted a 13% YoY drop in revenues even as EPS beat estimates by two cents
􀂾 Apple was viewed as a big positive, but mostly due to a 303% surge in iPhone revenues; iPod revenues fell 11%! And Mac revenues dropped 18% as the company cut prices to move volumes
􀂾 Caterpillar was another bellwether that was treated with euphoria – yet even as it marked up its full-year EPS range from $1.25 to $2.25 a share, it trimmed its revenue guidance to a $32-36 billion band (from $31.5-38.5bln)
􀂾 Intel’s story seems to be one more of market share than economic revival seeing as rival AMD posted a 13% revenue slide AND there was NO sign of enterprise spending. Very suspicious.
􀂾 Lexmark (printer maker) posted a 20% reduction in its revenue base last quarter
􀂾 Seagate’s revenues were down 19%
􀂾 Western Union saw a 6.9% revenue decline
􀂾 Starbucks revenue dropped 5.0%
􀂾 Southwest was the only airline to make money, but even here its revenues fell 8.8% (it laid off workers — 4.0% or 1,400 — for the first time ever)
􀂾 Coke did very well in China and India but its sales in the United States were down 4.0%
􀂾 EBay’s revenues slipped 5.0% YoY (even as it raised 3Q guidance).
􀂾 Qualcomm (#1 maker of chips for cell phones) saw its revenues dip to $2.75bln from $2.76bln
􀂾 GM sales were down 15% from already-depressed levels of a year ago
􀂾 Whirlpool’s revenues came in below expectations and plunged 18% YoY
􀂾 IBM revenue dropped 13% below expectations but beat on the top line.
􀂾 Sun Micro revenue was well short of expectations.
􀂾 GE, the best proxy for the U.S. economy had a profit decline of a WHOPPING 49% with revenue down 17%.
At the same time, the poor results from Morgan Stanley and Wells Fargo, not to mention the slate of disappointments from many of the regional banks, highlight the risks that are coming to the fore from the sharp deterioration in credit tied to the commercial real estate sector. Wells Fargo, in particular, saw its non-performing loans in commercial real estate skyrocket by 69% last quarter to $7.6 billion (average commercial real estate values have already dropped 35% from the peak, surpassing the deflation rate recorded in the housing industry).
So, in reality companies have been beating their low ball expectations though layoffs, terminations, cost reductions, lower work weeks and lower wages. That isn’t a good mix for a strong economic recovery but then again maybe this is the first step towards a new normal and the final shift from what we have all become accustomed to which has been nothing short of Abby Normal…now, if Obama can just find his brain.

Faith Based Rally – Or More Abby Normal
Friends, this is a faith-based rally, pure and simple. As powerful as it is, this rally to new post-Lehman highs is being driven primarily by the technicals and short covering.
As you can see in the table below all 10 sectors have had a massive run in short covering over the last couple of weeks amidst a mysterious number of stocks being called in on short books – all of sudden you can’t borrow stocks to short. Something strange is going on here.
There has been a 72.19% drop in short interest across securities most likely due to the infusion of TARP money into the markets to capture the spread. Shorts had been increasing up until the end of June. What caused the massive unwinding of short positions all the while fundamentals being thrown out of the window to be replaced by the most orchestrated short-squeeze in history? Very Abby Normal.

There is no doubt, however, that momentum is extremely strong at this time, and this often exerts a self-perpetuating move in the market, and in both directions. As we saw in March, the negative momentum ends once the selling pressure is exhausted. At that time, signs that Armageddon was not in fact setting in, helped to underpin the move off the lows. In the
current trading environment, this rally ends with the reverse — buying power subsides and evidence mounts that either the recession does not end this quarter or that any recovery is aborted (as we saw unfold in 2002 under very similar market circumstances).
One of the big boons to the market since March has been the expansion of market liquidity – however, the Fed is now allowing its balance sheet to shrink and the once red-hot growth in the monetary base has now completely stagnated. Our concern is with valuation to some extent, as the market (and the consensus) is discounting an earnings stream ($75 on S&P 500 operating EPS) for 2010 which we do not believe will occur much before 2012 at the earliest. Furthermore, history shows that post-bubble credit collapses are followed by years of economic fragility, recurring deflation pressure and lingering double-dip recession risks.
More Signs Of Excessiveness
The 10-day advance/decline line is a widely followed breadth indicator that is used to measure both the health of a move as well as inflection points. It is calculated by finding the average daily number of advancers minus decliners over the last ten trading days. Bespoke Investments posted a chart of the 10-day advance/decline line for the S&P 500. As shown, the recent rally has put the 10-day A/D line well into overbought territory and at a level that has indeed marked a peak during prior rallies in the past year. During the rally in early December and the initial rally off the March lows, the 10-day topped out right where it is now. After 12 up days for the Nasdaq and an average gain of 13% for S&P 500 stocks since July 10th, it's time for a breather.

As of the close yesterday, 85% of stocks in the S&P 500 were trading above their 50-day moving averages. As shown in the chart below, 85% is high but it's not quite as high as the levels we saw in April and May but if the market corrects from here the chart could be pointing out a downward trend developing. It is too soon to tell but it is also important to note that while the number is not as high as in April and May it is considerably higher than where the market has peaked in the past.

Abby Normal Conclusion
Be that as it may, the equity markets have clearly broken out in terms of price. The question is: Is it real or not. Or is it just the C-wave (final leg) of a bear market rally. Volume would indicate that it remains a bear market rally as would the fundamentals as we witness stocks rallying even in the face of what has been a mixed earnings season at best (despite the CNBC hype) and continuing deflationary signs of negative revenue growth across a wide swath of industries.
Earnings may be beating low-balled estimates for the majority of S&P 500 companies, but there is no questioning the fact that we are also seeing a sustained decline in revenues. Weak top-line growth is being driven by weak employment trends and by persistent social trend towards frugality, which is still in its early stages. Social changes by their very nature do not occur over months or quarters but over years. The strategy of long-term investors even in the face of this elongated bear market rally and volatility has been to focus on income orientation and capital preservation. We feel that it is extremely important to understand the degree of the volatility and to consider the extent of the switch in market sentiment that has taken hold now in just the last two weeks.
To reiterate — what we are still witnessing is a trading opportunity rather than a fundamental shift in the outlook. We must take into account what the risks are going to be once the buying momentum is lost. Over the near-term, it is obviously prudent to tighten stops and at the same time have a very careful eye on entry levels, but the medium-term and longer-term trends still suggest that we are in cyclical spurt in what remains a secular bear market.

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水中花

Insightful!

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I need to be rational but the market will not.

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