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Earnings Season - Trigger for the Correction?

(January 11, 2004)

Dear Readers:

I hope every one of my readers have had a great Christmas and a happy New Year's.  May all of you enjoy great stock market gains in 2004.  It is back to work for all of us and I am looking forward to the stock market action this year.  It will be interesting, indeed.

As some of you may know, my grandfather passed away on November 1st of last year.  His birthday is actually today, and if was alive today, he would be 84.  My grandfather invested and speculated (on his business, not stocks) in another era, when things were generally more conservative.  The world was still suffering the effects of the Great Depression and World War II, and leverage and speculation was generally frowned upon.  Things did not get crazy again until the 1960s - with the S&P P/E ratio topping at about 20 and the dividend yield just slightly below 3%.  That fateful year was 1966 - it marked the end of the great bull market that began all the way back in 1949, when the Dow Jones Industrials was only at 160.

The late 1990s marked the end of another great era.  Speculation was rampant, and yet while the underlying principles are the same, if you had transported the speculator from the 1920s and the 1960s to the 1990s, he or she may not feel at ease at first glance.  The tools are different.  Speculation has gotten more scientific.  The number of stocks on the New York Stock Exchange has multiplied, and there was this new "exchange" called the NASDAQ, with the volume dealt there eventually surpassing the volume being dealt on the NYSE sometime in the late 1990s.  The industries were different.  Auto and radio companies dominated the speculative trading in the 1920s, while the color TVs and the airlines made people fabulously rich in the 1960s.  The 1990s was first the age of the personal computer and then the internet.  Things got so crazy in the end that even biotechnology, fuel cell, and superconductor stocks were traded to astronomical heights towards the end.

Today, things are even more speculative, as exemplified by the latest refinancing boom and the astronomical rise in housing prices in certain parts of the country.  With ever-lower interest rates, people are now offered 0% deals on anything from a plasma TV to an automobile.  Home equity loans and home equity line of credits were created just a few years ago, and today they are universally widespread.  It is now not uncommon to see a 3.5% to 5% interest rate on a home equity line of credit.  Who can resist?  And where will they "invest" that money since returns on everything is so dismal?

And yet, one thing has been sure in the stock market (besides the fact that over 80% of all investors ultimately turn out to be suckers): that of the cycle from undervaluation to overvaluation and then back to undervaluation.  Let's turn to the following chart (courtesy of for more clarification:

SP500 P/E Ratio 1943-2002

Here we see a historical chart (updated as of October 31, 2002) of the P/E ratio on the S&P 500.  The last major low of the S&P 500 P/E ratio was May 1980, a little bit over 23 years ago.  From time to time, the market has threatened to revisit that area of undervaluation, but years of manipulation by both our government and Federal Reserve have not allowed that to happen.  It is to be said here that under Dow Theory (and the personal beliefs of this author) no amount of manipulation by our government can derail the primary trend in the long run (just witness the latest Japanese intervention in the currency markets). Following is a more updated and condensed version (courtesy of

S&P 500 Index Relative to Normal P/E Range

Stocks are still overvalued on any historical basis.  I believe we are currently in a primary bear market, and before this is over, we will see some major undervaluation in the stock market.  Note that the government and the Federal Reserve also tried to hold back the primary trend in the late 1960s and early 1970s.  President Johnson's Great Society and tax cuts were just two of many things that were used to manage the "New Economy."  It ultimately failed - as anyone who was alive and kicking during the 1970s can tell you.

In my last commentary before Christmas, I asked the rhetorical question: "How hot is hot?"  Well, things have certainly gotten "hotter" and crazier since then.  The S&P 500 has been up seven weeks in a row, something that has not happened since 1996.  The VIX has also been on a tear, making new lows all week (despite the spike on Friday - which is still too early to be labeled a reversal yet).  It remains to be seen whether the low VIX can indeed be categorized as an extraordinary period or whether volatility levels are moving back to volatility levels not seen since the 1992 to 1997 period, when a VIX of between 10 and 20 was considered normal.  If the latter is the case, I would have to guess that there will be more stock market gains ahead. This is evident in the following chart:

CBOE SPX Market Volatility Index

Then there is sentiment.  Lawrence McMillian, author of "Options as a Strategic Investment" and the Option Strategist website (, stated that the dollar weighted value of the put/call ratio has not been this low since the late 1990s and on his Friday commentary that: "Depending on how you look at it, this is either the strongest rally in a long, long time, or buyers are extremely uncautious and have created a house of cards that is about to topple. Virtually all of the technical indicators that we follow are overbought, but very few are actually on sell signals. Since an overbought market can continue to get more overbought -- and this one has already been getting more overbought nearly every day -- it's impossible to pick a top.  Unfortunately, if a correction develops, it is likely to be sharp -- perhaps short-lived, but sharp. And when markets are this overbought there often isn't any way to accurately anticipate the onset of such a correction, for it normally arises before actual sell signals arise."

We have also discussed the percentage of bullish vs. bearish advisors (source: Investors Intelligence and in the past and there has been no change in terms of sentiment measured using this method:

Market Sentiment vs. S&P 500 (Bullish Advisors Minus Bearish Advisors: 36.9%)

Over the last few years, once the spread of bullish vs. bearish advisors rise above 29%, we have always had a relatively big correction.  The market action over the last few months has totally destroyed this precedent.  I would tend to agree with McMillan here.  This is unlike anything we have seen in the last few years and while the market is overbought, I believe we will see higher highs ahead, as this move will probably only die in exhaustion.

A significant development this week was the crossing of the Lowry's Buying Power Index over the Selling Pressure Index - something that has not happened in the last four years.  Such a crossing has virtually always guaranteed a rally in the next three to six months.

My current view is that while the market is overbought and is subject to a correction anytime soon, the longer term trend remains bullish.  A correction here will be normal and healthy, since the market is so overbought.  What could cause the correction?  Well, the official earnings reporting season was kicked off last week, with the first Dow Industrial Component, ALCOA, reporting.  More reports will be flowing in this week - and the author will be keeping an eye on the following earnings reports this week.

Earnings Reports Dates

Again, what would cause the long-awaited correction?  Perhaps it is earnings, or it may be the declining US$.  Or it may be higher energy prices and/or higher interest rates.  Breadth is still good, but the mid caps and the small caps have been losing relative strength (against the S&P 500 and the Wilshire 5000) for the last seven weeks (even though there was a slight bounce last week) - something that usually precedes a correction or a longer-term decline.  One thing is for sure.  The market is now very overbought, and holding stocks into earnings season could be a very risky proposition, indeed.  At this point, it is easier to watch from the sidelines.

More to come next week, dear readers.  There is a lot of things I want to write, but nothing I cannot save for next week.  Until then, happy investing.

Henry To, CFA

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