Friday, June 10, 2011

Week in Review 6.10.11

For as bad as today was, I don’t think that it was quite as bad as Google finance seems to think it was.  Currently the website is showing that the Dow was down 12,124 points (or 100%) for the day.

Computer glitches aside, it certainly was a bad day for the equity markets as the Dow did fall 172 points, or 1.42%. As I’m sure most are aware, this marks the 6th straight week of decline for the averages, which I’m told hasn’t happened in some X number of years, a fact which is surprising only because we didn’t have a similar streak during the carnage of 2008.

This 6 week decline takes the S&P back to almost flat for the year; the broad index is up only 1.04% year to date.  We haven’t gone much of anywhere, but it’s definitely been an exciting trip so far considering that we were at 1370 at the beginning of May when we started our free fall.  We now sit 6.8% lower from that point.

In the throws of this correction it’s sometimes hard to remember what the prevailing wisdom was on April 30, but certainly it was much less gloomy than the rhetoric is today.  Market moves always seem to start out benign and end with a bang.  The lead headline on May 2nd was not a bearish one, but in fact a bullish one: Osama bin Laden had been killed.  Likewise, this move will almost certainly end on a bearish note rather than a bullish one.  Whether or not this was the capitulation day, the climax of the move, remains to be seen, but my intuition tells me it was not.

Still, I continue to believe that we are closer to the end of this selloff than the beginning for several reasons. 

1) The bears are getting their story line straight: this is about the end of QE2.  At the beginning of a move justifications are often numerous and unclear, at the end the reasons are crystallized.  At different times, this selloff has been about a lot of different things: dollar strengthening, Eurozone falling apart, commodities correcting, tsunami supply chain issues, debt ceiling issues, soft patches.  But now, the justification for the move seems to be crystallizing over the issue of the end of QE2.  The idea that there may not be a QE3 has caused markets to anticipate a coming slowdown and price in uncertainty.  To be clear, there will very likely not be a QE3.  There will however be a moment in which the market gets clear confirmation of this fact, and most likely confirmation will send us much higher rather than lower, against the conventional wisdom.  This is a classic sell the rumor buy the news.

2) We’re approaching oversold levels: The RSI(14) for the S&P 500 is at 32, which is below where it was when the March selloff reversed.  We probably need to duck further into oversold territory for a selloff of this magnitude, which means that 1250 is definitely in play and maybe even lower, but anything below 1250 is much more likely to end in intraday snap back than accelerated decline.

3) Stocks are cheap and only getting cheaper (particularly the financials):  I realize that financials have been left for dead, but at some point the market is going to have to realize, as Bruce Berkowitz said this week, that these companies are basically priced for failure.  JP Morgan, which is generally considered to be the highest quality money center bank in the country, is trading for 8x earnings.  Bank of America is selling at a 20% discount to tangible book and has reserves that are in excess of 4% of its total loan portfolio.  There are very few scenarios in which it seems plausible that Bank of America is worth less than $13 per share and it’s likely worth a lot more.  The true earnings power of BAC (based on 70 years worth of historical returns on equity for the banking system) is probably somewhere around $2.  Is the largest deposit franchise in the US really only worth 5x normalized earnings?  Even outside of financials, there’s a lot of good merchandise out there at reasonable prices.  Energy and Industrials for example are both sectors, which have really nice opportunities to capitalize on.

Markets have a way of moving farther and for longer than anyone expects, but there’s a strong case to be made that this move is almost over.  From these levels risk reward seems to suggest that being a buyer rather than a seller is most prudent.

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