Respite or Resurrection?

By KOPIN TAN | MORE ARTICLES BY AUTHOR

Determining whether last week's gain was a rebound from oversold depths, or if the worst is over.

 

 

A stock market that has fallen for five straight months and absorbed its worst quarterly drubbing since late 2008 is already bracing for the worst. That complicates the task of determining if last week's 2.1% gain was a momentary reflexive rebound from deeply oversold depths, or if we've reached that point where the market has already priced in most of the potential bad news.

One can make a strong case for both. Since World War II, quarterly losses exceeding 14%―the third quarter's slide was 14.3%―have been followed by rebounds 89% of the time the following quarter, and these have averaged gains of 5.3%, says Ned Davis Research. Economically sensitive stocks have already been pummeled, Treasuries snagged their biggest quarterly gain on record, and panicked investors yanked more than $87 billion from U.S. stock mutual funds over the past four months, which marked the worst flight from stocks since 2008.

It doesn't take a lot to surprise a stricken market, and the addition of 103,000 new jobs in September and a slight manufacturing uptick did the trick for now. But it's hard to believe a sustained bull market has begun, says Jason Trennert of Strategas Research Partners, "until policy makers address in a serious manner the great sources of the world's current misallocations of capital," including America's enormous budget and trade deficits and Europe's faltering experiment with a single currency.

Until then, the market's violent swings will continue, with investors torn between reasonably valued stocks on one hand, and the uncertainty caused by Europe's debt contagion and the uncomfortably wide range of possible policy actions on the other.

Any further signs that the U.S. might manage to avoid a recession certainly will limit the downside of a market that has already pulled back 20% or so. It helps that the inverted yield curve that has preceded other recessions is absent this time, and the U.S. isn't exactly burdened with restrictive liquidity demands or tight fiscal policies. Fresh from the worst recession in generations, the U.S. also has fewer excesses and less glut that cry out for serious correcting. After a recent slump, real personal consumption is expected to have risen 1.5% in the third quarter. Weekly unemployment claims are near to or below 400,000, U.S. auto sales have bounced back more than 14% since June, and the 23 retailers tracked by Thomson Reuters saw same-store sales increase 5.1% in September.

Some good signs: The Standard & Poor's 500 index on Tuesday dipped to 1075, an intraday low for the year. But the number of stocks making new lows at the New York Stock Exchange didn't swell above levels seen earlier this year, which technical analysts call "a positive divergence." European stock-market indexes that have been forcing the action stateside also did not plumb fresh hell.

With Washington afflicted with policy paralysis, much will depend on how Europe's unknowable debt drama unfolds. The European Central Bank last week moved again to buttress the Continent's flailing financial institutions, and the Bank of England announced plans to buy £75 billion's worth of assets. But Fitch Ratings downgraded Spain and Italy, after Moody's slashed Italy's government bond ratings.

James Paulsen, Wells Capital Management's chief investment strategist, argues that "the most serious threat for the U.S. economy is not a period of sluggish or nonexistent euro-region growth, but rather a full-blown global financial contagion." But he deems that unlikely, because "the problems are well known and have been for some time." Most U.S. financial institutions also don't hold vast amounts of troubled sovereign securities. Even if contagion were to infect the U.S. financial system, our banks have emerged from the lessons of 2008 to become more liquid and better-capitalized. One hopeful sign Paulsen cites: European and U.S. 10-year government swap spreads have started to part ways, with Euro swap spreads widening to 2008 levels, while U.S spreads remain near their tightest in the past decade.

HAS OBITUARY WRITING EVER BEEN such a competitive sport as when Steve Jobs passed away? Judging by the global group hug―witness the tributes and outpouring of "iMourns" and "iSads" the world over―the planet feels a deep and abiding love for a man who has transformed how we communicate and entertain ourselves in this digital age.

Alas, calls for his company to ascend to the Dow Jones Industrial Average are premature. Apple (ticker: AAPL) is too big for the blue-chip benchmark.

For a start, the Dow is a price-weighted index, which means components with the highest share prices hold the most sway. International Business Machines (IBM), whose shares trade near 182, carries 10 times the weight of General Electric (GE), whose shares trade below 16. With each Apple share pushing 370―twice the starting price of its new iPhone 4S―Apple will affect the benchmark twice as much as IBM, by far the Dow's most influential stock currently. In fact, the Dow's 30 components sport an average price per share of just 48, so Apple's addition could dominate the staid benchmark.

Should the Dow tweak its weighting, so that it might include the true-blue chips of this era, like Apple and Google (GOOG)? Or is it time for Apple to split its stock? Amy Lubas, Ned Davis Research's technology and industrials strategist, counted three prior two-for-one stock splits in Apple's history (in June 1987, June 2000 and February 2005). Shares underperformed the S&P 500 by 1.1% on average roughly a month after these splits, but outgunned the market by 4.3% a year later.

Possible inclusion in the Dow isn't by itself an incentive to split shares. Apple's stock fetches just 12 times projected profits, well below the median 30 times over the past decade. But a rather high 70% of shares are held by institutional investors, and individuals and casual fans alike may be daunted by the high dollar value of each share. Apple reduces the price tags of its toys to make them more widely accessible, so why not its shares? "With a stock split, the stock could open up to a large new set of retail buyers," Lubas notes. And we've all seen how much the world loves Apple.

ON MONDAY, OCT. 3, 2011, the Standard & Poor's 500 index ended the trading day at 1099.23―the same exact level where it closed on this same exact day in 2008.

Comparison junkies can't help but notice a few things: Economic readings generally look less dire today than three years ago (see table). Even the few exceptions were encouraging: The country's unemployment rate stood at just 6.1% on Oct. 3, 2008, but that's because stricken employers had just started laying off workers in those early days after Lehman Brothers collapsed. The unemployment rate today may be uglier at 9.1%, but at least the situation isn't rapidly deteriorating.

While economic data look less menacing today, sentiment has grown far bleaker. Consumers are testy and investors tetchy. Is it market fatigue, or a dawning awareness and grudging acceptance of the stiff price we paid to avert disaster three years ago?

By almost any measure, the U.S. stock market is cheaper today than it was three years ago, says Douglas Kass, president of Seabreeze Partners. The S&P 500 trades at 12 times what companies earned over the past 12 months, compared with 15 times when the index landed at this same level in 2008. A cheaper price tag, quite rightly, isn't reason enough to buy, and fed-up investors want some assurance that the market's recently violent vacillations are behind. Does that make us older and wiser, or just older and crankier? 

Then and Now

The S&P 500 closed at 1099 last Monday, exactly where it landed on that date three years ago. While the economy today looks less dire, investors seem far more fearful―and stocks look cheaper.

Indicator	Oct. 3, 2008	Oct. 3, 2011
S&P 500 Index	1099.23	1099.23
Monthly nonfarm payrolls	-159,000	0
Unemployment Rate	6.1%	9.1%
Weekly Jobless Claims	481,000	395,000
U of Michigan Cons Confidence	70.3	59.4
Personal Income	0.5%	-0.1%
ISM Manufacturing Index	43.8	51.6
ISM Nonmanufacturing Index	50.2	53.3
US Auto Sales (mil)	9.6	10.17
Deficit as % of GDP	-3.1	-8.4
US 10-Year Treasury Yield	3.60%	1.76%
Gold	$835.50	$1,658.32
Crude Oil	$97.65	$77.61
S&P 500 Price-to-Earnings*	15	12
S&P 500 Price-to-Sales*	1.96	1.65
S&P 500 EV/EBITDA *	9.97	8.7
* Trailing 12 months Most recently available data on each date.
Source: Seabreeze Partners, Bloomberg