Current Market Risk Analysis

Who are the real contrarians?  Bearish market analysts point to indicators related to those who are actually trading right now — AAII surveys, the option volatility (VIX), put-call ratios, and the like.

Doug Kass looks at the short ratio of hedge funds, an interesting approach.  The problem with all of these measures is twofold:

  • They ignore those who have left the market — individual investors who have plunged into real estate and mutual fund managers who have significant foreign market exposure–chasing recent performance.  The market veterans who look at fundamentals have been "all-in" for some time, and they are not getting fresh money.  This is a manifestation of the backward thinking of individual investors.
  • The hedge fund measure does not reflect the vast increase in money managed by hedge funds.  There is much more money in the hands of managers who short aggressively, looking for the next market tick.

The hedge fund money will shift rapidly with the market.  The individuals, sadly, will come late to the  party.

Here is an idea about how to see the overall risk.  Let’s look at the growth in S&P earnings since 1960.  Even in the very worst recessions, the earnings decline was about 15%.  Take a look at the data, showing a decline of about 15% in 2000-2001, a similar amount in 1981-83, and a bit more in 1974-75.

Here is the lesson.  First, there were very few declines in a 45-year history.  Second they were all brief, with a brisk rebound.  If you want to play for this, you had better be agile, or else think this is the worst market in fifty years.

Remember that bearish analysts are predicting a slowing in the rate of earnings growth, not an absolute decline.  Remember also that they are ignoring that the analysts themselves are already projecting a weakening economy.  Nevertheless, let’s assume the worst case in the 45-year market history.

Let’s assume a 15% decline in earnings from the current forward projection (Thomson First Call) of aobut 88.40.  Even with that decline the forward PE of the S&P is about 16.5.  This is over 6% earnings yield.

The market can ignore earnings, as it has for the last two years.  It is already a very unusual phenomenon — a reverse bubble.  What happens when companies get great earnings and improve their balance sheets?  Let me quote from the excellent commentary by James Altucher, once again from a paid service on  (If you are trading yourself, you should subcribe, or check out the views of those who do).  This is a great explanation.

"S&P 500 companies are sitting with a ratio of cash over market
cap that is higher than it’s ever been before. They aren’t going to
just put that cash in a checking account while their stocks go down.
Here is what they will do:

  • Buy other companies;
  • Buy back stock;
  • Pay a dividend;
  • Make investments in R&D and infrastructure.
  • All of
    those items boost stock prices and boost the economy. We haven’t even
    really seen the effects yet of the massive cash that’s sitting on the
    sidelines right now in corporate America."

    Introducing the Concept of Local Market Efficiency

    Anyone who has experience in the market learns respect.  Your account tells you daily the verdict of the market.  The Efficient Market Hypothesis, which is a central theme at "A Dash," holds that each piece of news gets accurately priced into every stock in a forward-looking fashion.

    I have maintained that markets can get very far from an accurate valuation.  One need look no farther than the recent "bubble era" where stocks reached incredible multiples of sales with miniscule earnings.  Despite this macro failure, the market operated "efficiently" on a day-to-day basis.

    The concept that I am introducing here — Local Efficiency — is an accurate description of how most market participants behave.  They accept yesterday’s values as valid and ask what the directional impact is of any piece of fresh news.

    Taking today as an example, there was news about increased MIddle East tension.  This was obviously a fresh negative for the market to the extent that this geopolitical risk was not already discounted in stock prices.  How did it play out?

    Let’s look to the comments of Doug Kass in his excellent commentary on StreetInsight, a paid service of  Kass is generally bearish, calling himself the anti-Cramer, but he makes frequent long-side trading calls and he had one going today when the news hit.  He quickly posted two things:

    1. Cancel all longs.
    2. The market was not adequately discounting geopolitical risk.

    The first of these statements identifies pretty typical market behavior — bids get pulled.  Everyone knows this is negative, but perhaps does not know the magnitude.  Step back and check it out.  The market declined by less than one percent from this point, with extra selling in anything related to a strong economy.

    Given that people were pulling bids, what does the selling tell us about the risk factor?  From the reaction, not much.  The Kass approach is typical of what many (most?) of the fast money traders follow and it has enormous influence.  My problem with this approach is that there is no fundamental anchor for where individual stocks or the market as a whole is valued.

    Local efficiency assumes that yesterday’s prices were right.  Those who are bearish (or reversing the analysis in 1999 were bullish) see each piece of negative (or positive in 1999) news as vindication of their thinking.  The same facts are repeatedly discounted without regard to underlying value.

    There is no way of knowing exactly how long this will persist.  Some of the smartest minds in the business got buried in 1999-2000 by shorting the market at ridiculous valuations.

    What is needed is some concept of the overall market risk, my next topic.

    Earnings Season

    There has been an interesting trend over the last two years.  The naysayers about the US and global economies, including many who must be viewed as "perma-bears" have predicted that earnings will move lower.

    Each quarter the earnings growth begins with a very high forecast by historic standards.  The actual earnings exceed that forecast.  The market response is much lower.  The PE multiple for the overall market is reduced and justified by the argument that this "is the peak of the cycle."

    Let’s take a look at the data from Thomson’s excellent reports.

    Click to enlarge.
    You can see the pattern quite clearly.  After years of double-digit earnings increases, the story just keeps getting better.

    What will be the cataylst?  Perhaps something will happen to force the "hot money" players to decide that the worse has already been priced in.  Since this process has been going on for years, that day may come soon.