“Undercut Low?”
October 10, 2011
“What do you mean by an undercut low?” was a question I received in numerous emails after last Tuesday’s verbal strategy comments. Well, for the past few months I have been talking about the similarities to the declines, and subsequent bottoming sequences, of October 1978 and October 1979. Yes, I know that back then the economy was better, the interest rate environment was different, politics were more settled, Europe was stable, etc., but I am referencing just the pricing action of the D-J Industrials (INDU/11103.12). As often stated, those aforementioned declines were just as severe, and just as quick, as what we experienced from the 7/27/11 intraday high of 12751.43 into the selling climax lows of August 8th and 9th. Following those extreme oversold lows the major indices have pretty much mirrored the 1978/1979 patterns by trading in a fairly tight range, rallying a few sessions and then declining for a few to the point where participants needed Dramamine! In those late 1970s sequences the INDU violated the selling panic lows twice with an undercut low so often referenced in these letters.
An “undercut low” is when a much watched level, like the panic low of early August (1101.54 basis the S&P 500), is violated on the downside just enough to get everyone really bearish and cause them to sell out their portfolios. Subsequently, the indices turn up and rally, “locking in” a low. And, that was our bet last Tuesday when in that morning’s verbal strategy comments we recommended buying the index of your choice on the belief we were going to experience an “undercut low.” To be specific, I said to buy the trading vehicle of your choice and if we rallied into the afternoon hold on to that position for a trade. The quid pro quo was that if we were not rallying late in the day to sell said position and live to “play” another day. In retrospect, at least so far, the 1970s pattern continues to track. Now one particularly observant financial advisor (FA) asked last Friday if I thought last Tuesday’s low (1074.77) could be retested over the coming weeks. My response was, “Yes it could and that would still be in keeping with the October ‘78/’79 experiences.” A number of other FAs asked if last week’s collapse below 1101.54 meant we are going into another whole new “leg” to the downside toward minor support at 1050, or major support at 1020 – 1030.
Speaking to that question, we have always said a “decisive” break below 1101.54 was needed on a closing basis to constitute the raising of even more cash than we already have. By decisive we have repeatedly stated 5-10 points on the S&P 500 (SPX/1155.46) was what was meant by “decisive.” Moreover, it has to be on a closing basis to be valid. Therefore, last Monday’s close of 1099.23 wasn’t enough; and, Tuesday’s intraday low of 1074.77 didn’t count because that day’s closing level was 1123.95. Yet another FA wanted to know if last week represented another Dow Theory “sell signal.” Asked and answered I replied, “By my pencil a Dow Theory ‘sell signal’ was recorded on 8/4/11 when the INDU broke below its March 16, 2011 reaction low, thus confirming a similar break by the D-J Transportation Average below its March reaction low.” At the time we wrote about the signal and have spoken of it numerous times since then. To get another Dow Theory “sell signal” would require a close below the July 2010 reaction lows of 9686.48 for the Industrials and 3906.23 for the Transports, at least by our method of interpreting Dow Theory. Regrettably, to get a Dow Theory “buy signal” under my methodology would require a close above the May 6, 2011 high of 12807.36 by the Industrials with a similar close from the Trannies above their July 7, 2011 high of 5618.25. Of course, some Dow Theorists would suggest a close above the August 2011 closing highs of 11613.53 and 4683.96 would do the trick, and I certainly hope they are right.
Whoever is correct, we have been pretty cautious over the past two months, except for last Tuesday’s bullish trading “call,” believing that if we are going to err it is going to be by being too cautious. That’s why we have made very few trading recommendations and why we have concentrated on dividend-paying stocks with strong fundamentals that have favorable ratings from our analysts. All but two of those stocks hopefully made their respective “panic lows” back in early August. The two exceptions are LINN Energy (LINE/$35.21/Strong Buy) and The Williams Companies (WMB/$24.97/Outperform), both of which made new reaction lows early last week before recovering late in the week. Again this week we offer these names for your consideration. One of the reasons for the “painful ups and downs,” and new reaction lows referenced in last week’s letter, is that analysts are whacking forward earnings estimates. For example, according to our friends at Bespoke Investment Group:
“Over the last four weeks, analysts have raised forecasts for 276 companies in the S&P 1500 and lowered forecasts for 780. This works out to a net of -504, or -33.6% of the index, and represents the lowest level since April 2009.”
We have watched such shenanigans for nearly 50 years. When stock prices are rising analysts tend to raise their earnings estimates. When prices are falling they lower estimates. Maybe a good current prism for investors would be to look at the 276 companies where analysts are raising estimates.
As for the economy, in last Monday’s missive we noted that 14 of the 18 economic reports issued in the previous week came in better than expected. That trend continued last week with 11 of the 16 releases showing better than estimated results. Of particular interest were better than anticipated numbers on employment, vehicle sales, vehicle production, construction spending, and manufacturing/non-manufacturing PMIs. In fact, the composite Purchasing Managers Index is consistent with +1.8% GDP growth for 3Q11. Additionally, U.S. Machine Tool Orders have soared, same-store sales for the average casual dining chain were up 2% in September (an acceleration from August) and railcar traffic trends for the past two weeks have been quite strong (particularly intermodal). All of this is inconsistent with an economy entering a recession. As stated, we guess people could actually talk themselves into a recession, but at the current time the metrics actually suggest the economy is marginally strengthening. To be sure, cyclical sensitive sectors, namely housing, has been so weak it is difficult to envision how much more it can contract. Household balance sheets have improved since the 2008/2009 “Financial Fiasco.” The trade deficit is likely to improve due to slower import growth and a decline in energy and commodity prices. Said price declines should also check headline inflation and lift households’ purchasing power. As for ECRI’s (Economic Cycle Research Institute) statement that a recession is “imminent,” while the folks at ECRI are very smart, they did call for a recession last year that never arrived.
The call for this week: Amazingly, on October 3, 2008 the SPX closed at 1099.23, the exact same level as on October 3, 2011 right before “Turning Tuesday’s” triumph. In observing the data, one can make the case that the U.S. stock market is cheaper today than three years ago. Thanks to my friend Doug Kass for that insight. Also from Dougie, “The U.S. stock market, on a P/E multiple basis, appears to be discounting 2011 S&P 500 earnings of about $78 a share, which I believe will turn out too low. (The current rate of earnings is annualizing at $100 a share in third quarter 2011). But, given risk premiums (earnings yield less corporate bond yields), the market is discounting 2012 S&P 500 profits of slightly under $60 a share, which to me, seems ridiculous.” Something else to contemplate is that while the SPX briefly violated its intraday low of August 9, 2011, the Volatility Index (VIX/36.20) did not breach its August 8, 2011 intraday high of 48.00, nor did the number of stocks making new annual lows exceed that of 8/8/11. Then too, according to Ned Davis Research, since WWII quarterly losses exceeding 14% (3Q11 loss was 14.33%) have been followed by rebounds the next quarter 89% of the time. The average gain during the next quarter has been +5.3%. More importantly, since the 1920s there have been 24 quarters when the SPX declined by 14% or more. The average rebound over the next 12 months was ~12%, while the average 12-month gain since WWII has been ~23%. The real question for this week is following last week’s oversized near-term rally, “Can the SPX surmount its 50-day moving average at 1177.87 that has contained every rally attempt since September 16, 2011?”
P.S. – A good example of a Brain Study: If you can read this you have a very strong mind – 7H15 M3554G3 53RV35 7O PR0V3 H0W 0UR M1ND5 C4N D0 4M4Z1NG 7H1NG5! 1MPR3551V3 7H1NG5! 1N 7H3 B3G1NN1NG 17 WA5 H4RD BU7 N0W, 0N 7H15 LIN3 Y0UR M1ND 1S R34D1NG 17 4U70M471C4LLY W17H 0U7 3V3N 7H1NK1NG 4B0U7 17, B3 PROUD! 0NLY C3R741N P30PL3 C4N R3AD 7H15. WE CONTINUE TO INVEST, AND TRADE, ACCORDINGLY, CONSISTENT WITH OUR RIGHT BRAIN, WHOLE BRAIN, INVESTMENT STYLE.
