CWS Market Review – September 30, 2011

I’m happy to see this ugly third quarter end. This will be the market’s worst quarter for stocks since 2008. For the last several weeks, the stock market has been stuck in a tight trading range. The S&P 500 has now closed inside a 100-point gap—between 1,119 and 1,219—for 40-straight trading sessions.

Frankly, being caught in a trading range is frustrating. Every rally is quickly met with a sell-off, and every sell-off is quickly turned around. Thursday, in fact, was a microcosm of the last two months. The S&P 500 soared as high as the level of a 2.16% gain early in the session. Then stocks delivered a collapse worthy of the Red Sox. By 3 p.m., the market was down nearly 1%. That’s a peak-to-trough drop of more than 3%. Yet in the last hour, we rallied to close higher for the day by 0.81%.

In this issue, I’ll explain the dynamic driving this back-and-forth market. Fortunately, this may soon come to an end. By mid-October, the third quarter earnings season will be ramping up and we’ll get a chance to see how well corporate America did during the third three months of the year. This could be what the market needs to finally break out of its trading range. One historical note is that since 1945, whenever the market has tanked by 10% or more in the third quarter, the fourth quarter has gained an average of 7.2%.

I should warn you that since early June, Wall Street analysts have been paring back their earnings estimates for the third quarter. At one point, the consensus estimate was as high as $25.03 but it’s now down to $24.64 which is still a pretty good number. That’s not a huge downgrade, but analysts are clearly becoming more cautious and they’re lowering their forecast for Q4 and for 2012 as well. Analysts have a tendency to trim their numbers right before earnings season starts. The good news is that earnings have topped expectations for the last 10 quarters in a row. I’m not certain that this will be the 11th, but it may be close.

As an aside, I should say that I don’t place a great deal of faith in Wall Street’s forecasts. Some people like to dismiss these forecasts out of hand which I think is a mistake. Here’s the key: In the short-term, analysts’ forecasts really aren’t so bad.

As a general rule, analysts move in two modes. They either slightly underestimate earnings or they vastly overestimate earnings. The former is the rule of thumb during an expansion and the latter happens when the economy falls apart. Where analysts are horrible is in seeing the turning points. As such, I don’t rely on them for that. The analysts are very good at predicting that the trend will continue, which sounds harsher than I mean it to sound.

For last year’s third quarter, the S&P 500 earned $21.56 so the current estimate translates to having a growth rate of 14.3%. For the fourth quarter, Wall Street sees earnings of $25.98 which would be earnings growth of 18.5% over last year. That strikes me as being too high, so I’ll expect earnings to be cut back over the next several weeks. Either way, the Q3 results will be the determining factor in setting expectations for Q4. I’ll feel a lot better when the S&P 500 breaks above its 50-day moving average which is currently at 1,200.

Unfortunately, the stock market has been held captive lately by events in Europe—more specifically, the prospects for the Greek economy. The good news is that the German parliament just approved an expanded bailout fund. The bad news is that the fund has to be approved by all 17 countries that use the euro and that’s not going to be easy. Markets around the world have been severely rattled recently. Worldwide, initial public offerings are being shelved at a record pace.

We’re currently in an “all or nothing market.” Each day, the market tends to shoot up a lot or get hammered hard. Whenever there’s good news out of Europe or from the U.S. Fed, we see all the sectors of the market rally strongly. Usually, financials do the best while gold and bonds do poorly and volatility rises. When the news is bad, the exact opposite happens. It’s as if all the passengers on a boat rush frantically from one side to the next. There’s little in between.

Look at some of these numbers: In August and September, the S&P 500 closed up or down by more than 2% 17 times. In the 12 months before that, it happened just nine times. In the last two months, stocks and bonds have moved in opposite directions nearly 75% of the time. Only recently has gold broken from bonds and moved downward in a serious way.

I’ll give you a good example of the irrationality of the “all or nothing market”: Shares of AFLAC, ($AFL) soared 6% on Thursday. I love AFLAC, but I’m sorry: their business is just too boring to move around that much in one day. The problem isn’t the business. The problem is the mindless traders trying to use AFL as a proxy bet on Europe. (AFLAC’s finances are fine as we’ll see when they report next month.)

Volatility is a topic that causes confusion among many investors and it’s misunderstood by many professionals as well. Increased volatility isn’t necessarily bad for stocks. In this case, the increase in volatility is a reflection of two warring theses for the economy’s future. The market is trying to decide whether investors will rotate out of Treasuries and take on greater risk in stocks or whether stocks will continue to languish as investors seek protection in bonds. It’s this tug-of-war that has kept the S&P 500 locked in its trading range. Given the absurd prices for bonds and depressed earnings multiples for stocks, the smart money is on higher stocks, lower bonds and decreased volatility. Consider that right now, there’s currently over $2.6 trillion sitting in money market funds earning an average of 0.02% per year.

We’re already seeing signs that one side is starting give way. Gold, for example, has been crushed over the past three weeks. Also, previous “can’t-lose” stocks like Netflix ($NFLX) are feeling the pain. They key is that the trends that were consistently winning no longer are. As a result, investors will start to key in on overlooked trades. I can’t say when this will happen, but earnings season seems like a prime catalyst.

The Volatility Index ($VIX) closed Thursday at 38.84. That means that the market believes the S&P 500 will swing by an average of plus or minus 11.23% over the next month. Let’s compare that with the recent auction for seven-year Treasuries which went for a record-low yield of 1.496%. That means that the zero-risk return for the next seven years in Treasury debt is roughly equal to the one-month volatility—not return, just average expected swing—of stocks.

It’s like the old saying that “a bird in the hand is worth two in the bush.” If that saying were revised for today’s market it would be “a bird in the hand is worth 30,000 in the bush!”

In last week’s CWS Market Review, I highlighted some high-yielding stocks on our Buy List like Abbott Labs ($ABT), Johnson & Johnson ($JNJ) and Reynolds American ($RAI). I still like those stocks a lot. Interestingly, shares of Nicholas Financial ($NICK) have been weak lately. The stock is normally a very strong buy, but it’s exceptionally good if you can get it below $10 per share.

One of the few cyclical stocks on the Buy List is Moog ($MOG-A). The stock has been trashed along with most other cyclicals, but don’t make the mistake of lumping Moog in with everybody else. This is a very good company. Last quarter, Moog beat earnings and raised guidance. The stock is now going for about 10 times’ guidance. Moog is a very good buy up to $36 per share.

That’s all for now. Be sure to keep checking the blog for daily updates. Next week, Wall Street will be focused on Friday’s jobs report. Expect more bad news, I’m afraid. I’ll have more market analysis for you in the next issue of CWS Market Review!

– Eddy

Posted by on September 30th, 2011 at 7:35 am

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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