Sunday, May 08, 2011

Commentary from

Below is a full copy of my comments posted throughout the day last week when I filled in for Doug Kass:

It's nice to be back in The Edge this morning. I'll try to follow my usual routine when sitting in for Doug, which includes:

  • giving my thoughts on how the market looks;

  • updating the four components of my "market stool" (fundamentals, technicals, sentiment, and macro outlook);

  • giving readers an update on recent stock picks;

  • and answering questions from subscribers, so please email me.
I am surprised at how many investors are ready to throw their hands up after the last few days' selloff. I think the bullish camp remains highly skittish, and that helps to keep the proverbial wall of worry high. It also helps to sustain this pattern we have seen, basically since 2009, in which the market seems to take one step back but then two steps forward. This stair-step pattern higher has kept investors on their toes and helped keep bullish sentiment from ever getting too complacent.

I'm not saying there aren't plenty of bearish arguments out there that don't have merit. There are always sound bearish arguments that sound more rigorous than the bullish case. I'm sure if everything on the horizon looked great, the market would already be much higher. So I'll try to be balanced in my analysis today, with a focus more toward how investors can make money as opposed to win the never-ending economic debate.
Looking at the first leg of our market stool, the fundamentals still look solid. Earnings growth remains robust. At the start of first-quarter earnings season, many were questioning if we would achieve double-digit growth again. Currently, with 75% of S&P 500 companies having reported, earnings growth is estimated to come in 17% higher than the year-ago period. Not bad.

Furthermore, full-year estimates for 2011 remain above $97, and soon investors will start to look toward next year's estimates when doing their valuation work. At current prices, the S&P 500 is trading below 14x this year's estimates and just over 12x next year's projections. That is quite a reasonable valuation for the market, and I think it leaves room for multiple expansion if sentiment ever improves enough.

Corporate earnings are on track to surpass their 2007 highs this year. The S&P 400 index has already surpassed its 2007 (price) high. Ditto the Russell 2000, corporate bond spreads, etc. As such, I think it is a matter of time before the S&P 500 also makes a new price high before this cycle is over.
The commodity selloff continues in earnest today. Today's action is also likely being exacerbated by a rare bounce in the dollar. Gold prices have fallen back to $1,510, oil prices are all the way back to $105, and silver is down another 5% today. The selloff in silver has been particularly severe. This shouldn't come as a big shock to chart watchers. The chart below shows the weekly ramp in the iShares Silver Trust (SLV) recently. What you can see at the end is the signs of a classic blow-off top.

At the end of the run in SLV, volume exploded just as the ETF was topping. Then it sold off with another surge in volume. That huge spike in volume right at the top is textbook blow-off action, very similar to Yahoo! (YHOO) back in 2000. I don't know if it will end the same way for SLV. The key will likely be how it acts if and when it ever rallies back to test its previous highs. If it is unsuccessful next time around and puts in a lower high, it could mark the end of a great run. But we won't know until we see it.

As for the commodity complex at large, I think that hedge funds and the like probably got a little overweight during the recent run and are rushing to take profits at the same time. So you get the effect of everyone trying to squeeze through the exit at the same time. But as long as the dollar remains in a downtrend, I expect these trades to get put back on in time. The bigger concern for me would be if the wheels start to come off in China, which I will try to touch on later.
Checking in on the second leg of our market stool, the technical picture of the market remains solid, from my perch. Starting with the big picture, the S&P 500 remains above both its 50-day and 200-day moving averages, and both of those key moving averages are upward-sloping in nature. So the long-term trend of the market remains up.

Digging a little shorter-term, the S&P 500 entered its most recent correction on Feb. 22, and it lasted about eight weeks. That is ample time during a bull market for a correction to consolidate recent market gains and build a short-term base for another upleg. The S&P broke above its February highs last week at 1343 and sprinted up to about 1370. Now the market is pulling back, and textbook technical analysis would tell us that prior resistance should become support. So, as the market tests these current levels, I would not be surprised to see it find support here.
Also, the market just completed a short-term head-and-shoulder bottoming formation. If you pull up a chart of the S&P 500, you can see the left shoulder around Feb. 24, the head near March 16, and the right shoulder around April 18. Last week, the market completed that bottoming formation by clearing the neckline. That formation projects out to a target for the S&P in the range of 1425.

As for the "sell in May" axiom, I agree that there is always some trouble for the markets in the summer months. I don't know if it will happen this month, but I do think we will chop around in the intermediate term, and that 1425 target may be a better year-end target to shoot for at this juncture. But overall, I still like the technical picture of the market.
My concerns with China are many, and I certainly can't do them all justice in this short post, but I will highlight the major issues. Also, for the record we exited all of our direct China exposure via the iShares FTSE/Xinhua China 25 Index Fund (FXI) late last year and early this year. If I had to pick my top three concerns with China right now, they would be controlling inflation, pricking the property bubble, and dealing with excess capacity.

China's central bank has said that controlling inflation is its top priority. Inflation was recently estimated at 5.4% in March, the third straight month it exceeded the government's target of 4%. And similar to many things coming out of China, I would suspect the real numbers are higher than this headline figure. China has already raised its one-year lending rate to 6.31%, and more hikes are coming -- you can be sure. So inflation is a big problem in China, and the tightening cycle is likely to reach worrisome levels in order to deal with it.

A coincident issue is the property bubble China is experiencing in real estate. The property bubble there is said to be of epic proportions, and we know how the recent real estate bubble in the U.S. ended. It wasn't pretty. China has raised reserve requirements at its biggest banks to a record 20.5%, and implemented several other measure aimed directly at speculation in real estate lending. It is extremely hard to deal with bubbles and engineer a soft landing afterward. Economists liken it to landing a plane in a parking lot. Central banks don't have a great track record in this regard, and China's central bank is experiencing this for the first time in recent history.

The third major issue I see is all of the excess capacity being built. China's controlled economy is building massive infrastructure, office buildings, housing, commercial developments, etc. as far as the eye can see. This is due to the millions of residents moving from the rural parts of the nation into the industrialized economic centers. The problem is, they are all extremely poor. Most can't afford any of the things that are being built, and so they lay idle. At some point, this, too, is likely to become a problem, and my worry is that all of the above come to a head at the same time.

If China sneezes, all of Asia and many emerging markets will catch cold. It would dampen the global economy as well. So I am certainly rooting for the nation to be successful in its efforts to cool things slowly and foster a soft landing, but investors should be aware of the size and scope of the issues with which China is dealing and the possibility for a policy mistake that disrupts the markets. Just saying.
Looking at the sentiment backdrop of the market, most of the indicators I follow are basically in neutral territory. That's about what you'd expect during a market rally that has yet to reach an extreme. By that I mean that if the market were extended and bullishness running rampant, I would expect to see highly complacent readings in the adviser surveys, put/call ratios, etc. But to date, that is not the case.

Yesterday the CBOE put/call ratio exceeded 1.0 and the ISEE was below 100. These readings support the notion that investors are certainly not complacent here. They also aren't extended enough to mark a short-term bottom (like I nailed on March 16). The AAII survey is also closer toward showing elevated levels of pessimism than it is showing elevated complacency.

A better indicator of recent sentiment might be seen in mutual fund flows. For the past two months, bond fund inflows have been exceeding stock fund flows (which have been on the decline). Last month, bond funds took in $11.5 billion while stock funds attracted only $2.07 billion. This tells me that the risk appetite among the investing public is still very cautious, and they have yet to embrace this bull market, even though it is in its third year.

I don't know what it will take to reverse all those inflows into bond funds, as well as the huge piles of cash that remain on the sidelines. Maybe it won't even happen during this up cycle. But it remains a bullish factor for the markets, and it's evidence that there is still pent-up buying power out there that could continue to propel the markets.
I think I've been fairly optimistic for the most part in my posts today. The last leg of our stool is the macro picture, and that is where the outlook is probably the most cloudy. Interest rates are low, but for how long? QE2 has caused a pickup in inflation, which needs to be monitored after the Fed's experiment is concluded. And the issues with government debt, both among states as well as the federal government, have no clear solutions in the future and are likely to foster heated debates for quite some time. I'm just glad the issues are finally being talked about in a serious manner.

Long-term bond yields have been coming down recently, hinting at an economic slowdown. But we saw the same thing happen last year as well. I think the weaker first-quarter GDP and probably weakish second-quarter GDP qualify as the slowdown, and growth should pickup in second half of 2011. My favorite economic survey, the ECRI WLI, has continued to point to modest growth and has not signaled a slowdown like some of the other indicators.

I think the uncertainty in the macro picture is what has kept a lot of folks leaning bearish. I certainly hear a lot of it from my clients, but I go back to the wall of worry theory, and remind folks that these potential negatives are the reason that valuations are still reasonable and huge cash balances remain on the sidelines.
Thanks for reading The Edge today. In my last post, I wanted to give a quick update on my stock picks for 2011. Here's an update on my top 5 picks:

  1. Priceline (PCLN), up 35%, has exceed expectations so far this year and has had a great run. The company reports earnings after the close, but I think expectations remain subdued, such that a solid report should help the stock continue its run. I think that management is executing well in a difficult environment and want to stick with this one.

  2. Mercadolibre (MELI) is up 29% -- ditto my comments above. The stock was slow out of the gate this year but recently really started to take off. Yesterday's earnings report was pretty solid, but the stock action was better. After selling off after hours, Mercadolibre bounced back today and is nicely higher. I still like the growth profile and market opportunity for this one.

  3. Intuitive Surgical (ISRG), up 34%, reported a great quarter. You can find my comments to it here. This company is expanding its addressable market, executing well, and it still has plenty of growth left in the tank. Stick with it.

  4. Mosaic (MOS), down 7%, has had a rough go so far this year, but so have all the fertilizer companies. Full disclosure, we sold all of our Mosaic when the company announced that Cargill would be distributing its stake, and we switched into Agrium (AGU). Agrium is also struggling a bit, but I want to stick with it for now, as I still subscribe to the global demand for more food and the need for farmers to maximize yields from their crops.

  5. Urban Outfitters (URBN), down 10%, was doing OK until its last earnings report, when the stock really took it on the chin. Also for full disclosure, we sold half of our positions before the last earnings call, and the remainder of the positions after the call. I still like Urban Outfitters longer term, but the company needs to deal with some merchandising issues first. Then growth should get going again. For an alternative, we have recently started to buy Fresh Market (TFM) on the whole organic and natural foods secular growth story. It's still early in the company's growth story.


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