Is the Sucker's Rally Over?

I am calling it: the Dow will fall below 8,000 shortly and below 7,000 in the near future. I think that this whole 40% gain was a sucker's rally and that it will get brutal again in the not too distant future.

What are your thoughts on the market?

 

I think that the fundamentals don't support current prices in either equities or commodities (especially crude oil) but there is so much liquidity being dropped into the market from the central banks that its pretty hard to make a call. Would love to get some perspective from the traders/HF guys.

 

First, let's start with P/E. S&P at 950 seems a fair price and we have a seemingly normal P/E - around 16, depending on how you normalize earnings. However, remember we used to have P/E around 7 in the recessions of 1974 and 1982. The later recessions (1990 and 2001) aren't as serious as the one we're now having, so still there is chance for P/E to drop back to single-digit range. This could happen if the market is driven by fear, i.e, another round of bad news.

Second, the financial institutions are still deleveraging, so banks can't lend that much to fuel further economic growth. Some still have toxic assets on their balance sheets. And there are credit card loans which may or may not go bad.

Third, people have been talking about consumer spending. Historically, consumers won't start spending unless they have permanent jobs. So where do you think the jobs come from? How about some government spending on building new houses, as we did in previous recessions? I really don't see we need extra supply in an already depressed housing market. Alternative energy sounds like a plan, but don't know how Obama's gonna roll it out yet. My point is, consumer confidence doesn't come out of nowhere, but I can't think of a turning point.

That said, I won't bet on it because shorting S&P simply involves too much risk. Just my 2 cents.

 
Best Response

POINT 1 regarding commercial real estate:

Well, I see the point in worrying about the high default rates - things such as commercial real estate defaults are yet to come in full force obviously.

Commercial loans are different though than personal credit card debt - in the case of real estate, a bank immediately assumes control of the property, adds this to their book of assets, and thus the write down associated with it is significantly lower since they get hard assets in return. In contrast, when someone defaults on their personal debt there is no thing such as peonage anymore where a bank can have an asset.

Peonage rules though, and if it was reenacted I bet those crazy borrowing days would end faster (you listening Obama?).

But yeah, I think volatility runs rampant and the fact that BOA/Wells has been trading at like a 7x Beta for the past month (higher volatility than VIX?) shows that the financial aspects of the crisis are far from over.

POINT 2: Consumer spending correlating with permanent jobs

This recession has proportionately effected younger folks more than older folks as compared to previous recessions. Younger folks don't have the same family obligations that older folks do. Thus, the increase in even part-time jobs would have a stronger positive effect on consumer spending then it would have in previous recessions - young people don't need to save at the same high rate as older adults do.

So, these two points slightly temper the 7000 Dow Call, but yeah its gonna be a while before we hit 9000 and maintain a level in that area.

Interested to see what people think about what I just said - I'm totally unqualified to talk macro.

 

"First, let's start with P/E. S&P at 950 seems a fair price and we have a seemingly normal P/E - around 16, depending on how you normalize earnings. However, remember we used to have P/E around 7 in the recessions of 1974 and 1982. "

ST Interest rates were about 15% in 1982. Can't compare PEs without adjusting for rates.

 
spinner:
Buyside <span class=keyword_link><a href=https://www.e-junkie.com/ecom/gb.php?ii=1145861&amp;c=cart&amp;aff=44880&amp;ejc=2&amp;cl=175031 rel=nofollow>CFA</a></span>:

ST Interest rates were about 15% in 1982. Can't compare PEs without adjusting for rates.

could you elaborate on this?

I think what he meant was that high rates = less investment capital due to high borrowing costs = lower average PE

 

The reason for the 40% rally or whatever you mentioned is because everything was so drastically oversold from a tech analysis perspective that a sharp bounce up occurred. We are now nearing the proper valuation for what our current economic situation is. From a fundamental standpoint I believe that the bottom (when I say bottom I mean where the market consistently bounces/hovers) is 8200. 7800 is the support after that.

If the market dips to 8200, which it may although I do not expect it, I would be a big buyer.
http://stockcharts.com/h-sc/ui

Go to that link. Scroll Down. Where it says overlays add Parabolic SAR and Bollinger Bands. Remove the 200 Day SMA

Scroll Down a tad more and where it says Underlays add Wilders DMI(ADX).

As you can see, MACD just turned bearish and tomorrow Parabolic SAR will officially turn bearish. I agree that there will be a another few days sideways or down but seeing how Wilders DMI (ADX) is decreasing (which means that the last few days has no real trend forming) I would have to say that we will not be seeing under 8000. Also, you can draw an upward trend line on that graph from March 20th to today. Support for this 2 month trend is approximately 8500

I also don't think, from a pure speculative rationale, that the Dow will go below 7500 ever again, in the history of the stock market. With that being said, that is pure speculation.

 

“Buyside CFA wrote: ST Interest rates were about 15% in 1982. Can't compare PEs without adjusting for rates. could you elaborate on this?”

I’m using the idea of a justified P/E. The concept is generally applied to individual securities, but (as a very loose approximator) it could be applied to the aggregate market:

If P = D1 / (R – G) Then P/E = D1/E / (R – G)

Hence, interest rates and P/E ratios are inversely related.

 

MM won the Nobel mainly for the Capital Structure Irrelevance theory.

1) – What I’m talking about is not related to that theory - I’m not talking about firm financing – I’m talking about the rates investors use to discount the firms’ expected cash flows. 2) The idea that capital structure is irrelevant rests on the ridiculous assumptions of no taxes and no expected costs of bankruptcy.

 

The whole historical P/E comparison is bullshit - you can get 10 strategists in a room and they will come up with 10 ways to compare historical P/E ratios across rates, inflation, time period, etc. etc.

The macro factors are a giant cock in the ass if you really think this isn't a sucker's rally. People are still losing their jobs, consumer debt is piling up, companies are getting buttfucked up and down their inventory cycles, the employment report is a fucking joke, real estate is STILL nowhere near true value (if you have your house on the market for 500k but no one buys it, is it really worth 500k?). The only real question is when are we going to see the massive inflation bounce.

Remember, second derivatives are a completely bullshit argument - shit never moves in a straight line.

ideating:
The whole historical P/E comparison is bullshit - you can get 10 strategists in a room and they will come up with 10 ways to compare historical P/E ratios across rates, inflation, time period, etc. etc.

The macro factors are a giant cock in the ass if you really think this isn't a sucker's rally. People are still losing their jobs, consumer debt is piling up, companies are getting buttfucked up and down their inventory cycles, the employment report is a fucking joke, real estate is STILL nowhere near true value (if you have your house on the market for 500k but no one buys it, is it really worth 500k?). The only real question is when are we going to see the massive inflation bounce.

Remember, second derivatives are a completely bullshit argument - shit never moves in a straight line.

I agree with you regarding historic PE. This isnt a suckers rally...it is just the market returning to a technical equilibrium after being egregiously oversold. Do i think we are gonna see 11000 by Jan 2010-of course not. But the economy lags the market by 6 months. Job loss is slowing...we are still losing jobs but at a much slower rate than in January.

If you think the eocnomy will straighten out (job loss will be minimal, etc...) by Q1 2010, than guess what...we are damn near close to the bottom is we haven't hit it already.

If you had to look at a chart starting October 2007 and going to October 2011 I believe it would look like a V shape down and a U shape on the way up. We are no longer gonna shoot up, but the amrket will crawl back

 

Def pointless (who pays dividends anyway?). My point is that you will pay less (and thus have a lower P/E) for a given dollar of earnings/cash flows if you have higher interest rates. That’s why you can’t compare the current P/E with that of 1982. The S&P P/E of 7-8 in 1982 wasn’t just due to a recesision – it was partly a function of interest rates.

At first glance, current P/E’s look very high compared to some other recessionary periods. But if you look at the moderate P/E and current interest rates, things look more like a bottom. 10 year treasuries are yielding less than 4%, and investors are stilly shying away from equities.

Please don’t think I’m bullish here. I’m talking about 2 numbers. And there are a million other bad ones.

 
Buyside <span class=keyword_link><a href=https://www.e-junkie.com/ecom/gb.php?ii=1145861&amp;c=cart&amp;aff=44880&amp;ejc=2&amp;cl=175031 rel=nofollow>CFA</a></span>:
Def pointless (who pays dividends anyway?). My point is that you will pay less (and thus have a lower P/E) for a given dollar of earnings/cash flows if you have higher interest rates. That’s why you can’t compare the current P/E with that of 1982. The S&P P/E of 7-8 in 1982 wasn’t just due to a recesision – it was partly a function of interest rates.

At first glance, current P/E’s look very high compared to some other recessionary periods. But if you look at the moderate P/E and current interest rates, things look more like a bottom. 10 year treasuries are yielding less than 4%, and investors are stilly shying away from equities.

Please don’t think I’m bullish here. I’m talking about 2 numbers. And there are a million other bad ones.

I agree that ST rates may have some impact on the discount rate in the first couple years. But from a valuation perspective, we can't take ST rates (i.e, 14% in 1982) for LT required rate of return, which is normally 7-8%.

We now have a P/E of 16 and a 4% interest rate. For a moment let's assume ST rate would go back to 1982 level, so we will have 14% ST rate for the first five years. In fact, the adjustment (to 1982 level) can only wipe out less than 10% of the present value. So, the adjusted P/E will be around 15, still quite above the 7-8 P/E in 1982.

 

You guys traders or economists? Who cares where we are heading. Play the charts, make money either way as long as we see some volatility. The same people "predicting" are usually the ones who are reluctant to swallow their pride and change their views on the market if it turns against them. Forget playing P/E's, Macro indicators, etc. We all know there are flaws and we should fall, none of these will help you with timing. The same people who are calling for the Commercial Real Estate sector to be the "second shoe" to drop, have been getting kicked in the face the past months by that same shoe. Only Price Pays!

 

I really can't comment too much on what an appropriate number for the S&P/Dow (and my knowledge of equity valuations using P/E's is nothing more than basic), but I can touch on the two important developments that have been propping up the economy in the past 6 months: (1) economic stimulus by the government, (2) quantitative easing by the Fed.

The impact of the government's stimulus package is peaking at the moment with the rest of the stimulus hitting in a drawn out manner through 2011 - a process too drawn out and small to have too much of a meaningful impact. To the credit of the government, the stimulus package has done a good job filling in the consumer spending gap created by higher saving rates, high levels of unemployment, fall in household assets, etc...

The QE conducted by the Fed was extremely successful in lowering interest rates (everything from Treasuries to the mortgage market). This kind of aggressive monetary policy is absolutely necessary given the lack of the ability for the Fed to stimulate interest-sensitive consumption (houses, autos, durables, etc...) by cutting interest rates as is done in a normal business cycle due to the fact that the FF rate has been at 0-.25% for months. By artificially repressing rates through market purchases of Treasuries and MBS, the Fed had been successful in lowering borrowing rates for many different types of borrowers and stimulating interest-sensitive consumption. However, yields on Treasuries and 30 year-mortgages have skyrocketed in the past couple of weeks and the Fed has stated multiple times that they have no plans to intervene in markets and conduct QE (Sidenote: I personally find this highly unlikely given the exorbitant borrowing needs of the government to fund all of the economic stimulus and the upward pressure caused by massive government debt issuance on interest rates across the spectrum. Another discussion entirely...). Increases in borrowing rates stand as a serious impediment to economic recovery as they obstruct interest-sensitive consumption which acts as a means of recovery in a standard business cycle.

IMO, this current mess will not be solved via interest-sensitive consumption as normally occurs - instead it will be a long, painful drawn-out deleveraging process. The positive feedback loop between unemployment and consumer spending will continue to drive the economy into the ground. Households, which face a significant loss in asset value, reductions in income, and high borrowing costs unless the Fed ramps up its policies of QE, remain under significant pressure to cutback spending and reduce debt levels.

The real question becomes one of how households will reduce levels of debt and in my mind, there are 3 possibilities: (1) debt restructuring, (2) default, and (3) inflation. The government has restructured some debt via subprime borrower payment plans, GM-Chrysler debt, et al., but for the most part it is a very messy a process and they seem eager to avoid it. They have made it very clear that they want to avoid a deflationary-depression situation (Great Depression-esque) with high default rates. And that leaves a situation of debt reduction with a moderate to high level of inflation - essentially equivalent to the Fed running the printing presses.

All three of these situations have radically different and difficult to estimate effects on performance of equities as an asset class. In general, debt restructuring and default would tend to put downward pressure on equities. Whereas, equities would tend to perform well in a moderate inflationary environment (as would commodities) - relative to bonds and other asset classes.

I know - long diatribe with no clear anwers, but just my 2 cents on what is going on from a very big picture perspective

 

Good point. I've had this argument with finance professors before (using current vs. historic rates in the discount rate).

Here's the other side of the equation: Don't you think the 1982 equity market would have been much better if treasuries were at the current level? If the 10 yr treas in 82 was 15%, wouldn't the P/E have been much higher? If the rates had quickly decreased from rom 15 to 4, there would have been a huge shift into equities.

I keep talking about 82. I feel like Uncle Rico.

 

Decent post unfortunately buyside cfa is trying to bore us with his finance 101 math equations. Im a seller that hes someone thats actually taking risk by his posts.... just too theoretical.

A large part of me wants to believe that we continue this trend as till the end of the quarter so money managers can say they have certain positions on the books to attract new money flows.

Technically speaking (and its great to see im not the only chart junkie on wso anymore) things are looking mixed.

Bullish General uptrend S&P above critical 200, 150 day moving averages

Bearish S&P broke through 925 which was acting as short term support. S&P unable to break through 2009 highs decisively.

The next key support area on the way down is 875 which was the prior resistance. If we break 875 the next area is 850 which is where the 150 day moving average is currently. If we break that level i expect a lot of momentum selling and stops being hit. Whether you want to accept it or not the market has been trading off technicals a lot the past several months.

Personally I havent been fighting the tape and have been trading to the long side. Shorts have been giving me problems because of late day rallies. As a trader I will trade cautiously and look to get more aggressive at the 875 level where we should see some more clarity.

"Oh the ladies ever tell you that you look like a fucking optical illusion" - Frank Slaughtery 25th Hour.

"Oh the ladies ever tell you that you look like a fucking optical illusion" - Frank Slaughtery 25th Hour.
 
trade4size:
Technically speaking (and its great to see im not the only chart junkie on wso anymore) things are looking mixed.

Bullish General uptrend S&P above critical 200, 150 day moving averages

But both DMA's are still pointing downwards. Anyway, anyone else getting sick of hearing DMA over and over again in the news lately?
 

Hey guys, I was just trying to be sarcastic with the M&M propositions, I hated my advanced corp. fin class because of M&M. I even got 5 points deducted from my exam because I wrote that a benefit to issuing senior debt is getting a lower interest rate (I know, how dumb was I?). I wish we had some special font we can use when posting sarcasm, because it is hard to convey the tone on a message board.

Anyway, if I remember correctly from class there was a Fed Model to estimating future P/E:

Future P/E = 1/Rf (10 year treasury) in which case P/E = 1/0.037 = 27

The Fed Model indicates that the fair value of the S&P 500 is equivalent to a P/E = 27. I guess we can throw that formula out the window.

 

the 150 actually is sideways right now after months of being downsloping thats a bullish sign. Will take a while for the 200 day to change its direction.

"Oh the ladies ever tell you that you look like a fucking optical illusion" - Frank Slaughtery 25th Hour.

"Oh the ladies ever tell you that you look like a fucking optical illusion" - Frank Slaughtery 25th Hour.
 

Guys, guys, you are all missing something with MM. We're not talking about the total enterprise value of a company (or bundle of companies). We're talking about the value of EQUITY. Borrowing costs absolutely matter, both in practice and in theory, when you're talking about an equity investment and price multiples relative to earnings available to shareholders.

That is all.

 

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