Are Cover Stories Effective Contrarian Indicators?
(April 8, 2007)
Dear Subscribers and Readers,
I hope everyone is having a great Easter. For folks who don't celebrate Easter, it is also a good opportunity to take some time out and “smell the roses,” so to speak. While the pace of life has been ever-increasing, especially with the dawn of the internet and subsequently, the Crackberry, much of the evidence today points out that workers who generally work shorter hours (and I am not talking about the French 35-hour week model) will not only lead fuller, healthier lives, but are usually much more productive while they are working as well. February 19th was “International Slow Day,” but that doesn't mean you can't celebrate this day on brief occasions all year round. Take your wife out to a movie, read to your kids, and take the dog out for a walk. Life is too short (even if we all make it to over 100) to spend most of your time working (although I have definitely been guilty of this in the past!).
Before we begin our commentary, let us do an update on the two most recent signals in our DJIA Timing System:
1st signal entered: 50% long position on September 7th at 11,385, giving us a gain of 1,175.20 points
2nd signal entered: Additional 50% long position on September 25th at 11,505 giving us a gain of 1.055.20 points
In last weekend's commentary, I discussed my current scenario for the housing market, and that the “next shoe to drop” will be the Alt-A sector and many loans that have negative amortization features and/or other loans that also have second loans ("piggyback loans") attached with them. I also stated that this, in itself, similar to the latest subprime troubles - will not have much effect on the economy, but whatever regulatory pressures that emerge from this (much tighter lending standards) will have the effect of constraining liquidity going forward. Note that after I wrote about this, Bill Gross from PIMCO also published views that were similar to mine as well. Quoting Bill Gross' April commentary:
It will not be loan losses that threaten future economic growth, however, but the tightening of credit conditions that are in part a result of those losses. To a certain extent this reluctance to extend credit is a typical response to end-of-cycle exuberance run amok. And if one had to measure this cycle's exuberance on a scale of 1-10, double-digits would be the overwhelming vote. Anyone could get a loan because shabby credits were ultimately being camouflaged within CDOs that in turn were being sold to unsophisticated foreign lenders in need of yield as opposed to ¼% bank deposits (read Japan/Yen carry trade). But there is something else in play now that resembles in part the Carter Administration's Depository Institutions and Monetary Control Act of 1980. Lender fears of potential new regulations can do nothing but begin to restrict additional lending at the margin, as will headlines heralding alleged predatory lending practices in recent years.
Coupled with the aftereffects of being in a housing and subprime bubble (i.e. not many potential homeowners will take out a subprime mortgage anymore, just like those who swore off from buying technology stocks for the rest of their lives since the 2000 to 2002 technology bust), liquidity may be constrained for years to come. In the meantime, however, the stock market is still doing nicely and my guess is that “the next shoe” won't drop until at least a couple of months from now.
Speaking of liquidity, however, on a more immediate basis, I want to update our readers of a chart we initially posted in our January 14, 2007 commentary (“The Permanent Income Hypothesis”). In that commentary, I stated that I first got the idea of constructing this chart from Ned Davis Research – who had constructed a similar chart for a Barron's article in late 2006. At the time, his assertion was that based on this chart, he does not believe the rally in the U.S. stock market is close to “exhaustion” just yet, or in other words, a significant top. Following is an update of that chart showing the ratio between U.S. money market assets (both retail and institutional) and the market capitalization of the S&P 500 from January 1981 to March 2007:
While the ratio between money market fund assets and the market cap of the S&P 500 is not a great timing indicator – what it does show is the amount of “cushion” that we have in order to insure against a significant market decline. Also, while this indicator is telling us that we are closer to the end of the bull market than the beginning of one, it is also telling us that we are not close to exhaustion just yet. Based on historical experience, this author will not be too concerned about the end of the current bull market until this ratio hits a reading of 15% or below. Finally, given that this ratio has just risen from 17.29% as of February 28, 2007 to 17.44% as of March 31, 2007 (the highest reading since August 2004), chances are that the equity markets will be higher in the weeks and months ahead. For the individual investor who is not leveraged and who is already long, a buy-and-hold strategy (instead of trading around the volatility) still makes the most sense. For now, we will remain 100% long in our DJIA Timing System – although we reserve the right to trim our position should the technicals of the market deteriorate in the days ahead.
Let us now discuss the title of our commentary: Are Cover Stories Effective Contrarian Indicators? In the latest edition of the Financial Analysts Journal (Volume 63, Number 2), authors Tom Arnold, John Earl, and David North (Arnold, Earl and North are all associate professors of finance at the University of Richmond, Virginia) examined the after-effects of featured stories in Business Week, Fortune, and Forbes. The study was done with data over a 20-year period from 1983 to 2002. One unique feature of this article is that aside from anecdotal evidence (such as the infamous “Death of Equities” article on Business Week in 1978, the October 1997 Business Week cover story on Netscape and “how it plans to outrun Microsoft, and finally, a February 2000 Business Week cover story on “The Boom”), there has not been a formal statistical study done on the powerful contrarian signals of a cover story on the major and mainstream publications.
Well, look no further, as authors Arnold, Earl, and North have finally take a good stab at it. Quoting from the abstract of the article:
Headlines from featured stories in Business Week, Fortune, and Forbes were collected for a 20-year period to determine whether positive stories are associated with superior future performance and negative stories are associated with inferior future performance for the featured company. “Superior” and “inferior” were determined in comparison with an index or another company in the same industry and of the same size. Statistical testing implied that positive stories generally indicate the end of superior performance and negative news generally indicates the end of poor performance.
There were other restraints and assumptions that went into the study, of course, but in essence, the authors concluded that the appearance of a cover story on Business Week, Fortune, or Forbes has tended to be a signal for the end of the extreme performance that has gone on prior to its publication (whether it was positive or negative). Despite this conclusion, the author asserts that (and this is backed up by the data) negative cover headlines “apparently do not provide a good signal for … contrarian strategies when performance is measured against an index or measured on a size / industry-adjusted basis – despite a popular belief that such stories are a contrarian signal.” In other words, while negative (and positive) stories usually signal the end of the trend that preceded the cover story, the only useful purpose of using the “cover story indicator” is as a judge of mainstream sentiment – not necessarily as a buy signal unless you believe the Business Week article has gotten the story wrong. However, if one believes in the fundamentals of a certain company which Business Week has recently highlighted in a negative light (such as the January 15, 2007 Business Week cover story on Home Depot), then the cover story is most probably a good signal for aggressively buying the company.
Let us now discuss the most recent action in the U.S. stock market via the Dow Theory. Following is the most recent action of the Dow Industrials vs. the Dow Transports, as shown by the following chart from October 1, 2003 to the present:
For the week ending April 5, 2007, the Dow Industrials rose 205.85 points while the Dow Transports rose 106.36 points, as the two popular Dow indices are still mired in a consolidation phase. This may change in the upcoming week, especially given the rumors flying around of an LBO of Dow Chemical and as U.S. pension funds' required quarterly contributions are due on April 16th (for those defined benefits pension plans which have adopted the calendar year as their plan year). More importantly, however, the internals of the stock market remained strong as the A/D lines of the NYSE Common Stocks only Index and the S&P 400 made all-time highs last week, while the A/D lines for the S&P 500 and the S&P 600 are only slightly below their March highs. In addition, the Dow Jones Utility Average made a new all-time high last Thursday at the close. Given that the stock market does not typically top out until four to six months after a peak in the NYSE A/D line (although there are exceptions, such as during June 1946 when the NYSE A/D line and the Dow Industrials topped out at the same time), and the Dow Utilities, we are definitely still not close to the end of this cyclical bull market, just yet. For now, we remain 100% long in our DJIA Timing System – and will continue to do so unless evidence suggests that we should trim down our position.
I will now continue our commentary with a quick discussion of our popular sentiment indicators – those being the bulls-bears percentages of the American Association of Individual Investors (AAII), the Investors Intelligence, and the Market Vane's Bullish Consensus Surveys. The latest four-week moving average of these sentiment indicators increased from last week's 18.3% to 19.9% for the week ending April 6, 2007. Following is a weekly chart showing the four-week moving average of the Market Vane, AAII, and the Investors Intelligence Survey Bulls-Bears% Differentials from January 1997 to the present week:
While the four-week MA of this indicator hit its most pessimistic reading since September 8th of last year on March 23rd, (and is now rebounding) the fact that it isn't bouncing from a more oversold level suggests that any upcoming rally will probably not be too spectacular, although the chances of a new rally high in both the Dow Industrials and the S&P 500 are definitely real. Given that April tends to be a strong month for the stock market (especially since required quarterly contributions for calendar year-based DB pension plans are due April 16th), my guess is that the stock market should have an upward bias over the next couple of weeks. Should this rally be accompanied by a spike in readings in the Market Vane, the AAII, and the Investors Intelligence Surveys., however, this author will probably become more cautious and trim down our 100% long position in our DJIA Timing System.
I will now close out our commentary by discussing the latest readings of the ISE Sentiment Index. For newer subscribers, I want to again provide an explanation of ISE Sentiment Index and why it has turned out to be (and should continue to be) a useful sentiment indicator going forward. Quoting the International Securities Exchange website: The ISE Sentiment Index (ISEE) is designed to show how investors view stock prices. The ISEE only measures opening long customer transactions on ISE. Transactions made by market makers and firms are not included in ISEE because they are not considered representative of market sentiment due to the often specialized nature of those transactions. Customer transactions, meanwhile, are often thought to best represent market sentiment because customers, which include individual investors, often buy call and put options to express their sentiment toward a particular stock.
When the daily reading is above 100, it means that more customers have been buying call options than put options, while a reading below 100 means more customers have been buying puts than calls. As noted in the above paragraph, the ISEE only measures transactions initiated by retail investors – and not transactions initiated by market makers or firms. This makes the indicator a perfect contrarian indicator for the stock market, and it has had a great track record so far according to the following Wall Street Journal article. Following is the 20-day and 50-day moving average of the ISE Sentiment Index vs. the daily S&P 500 from October 28, 2002 to the present:
As one can see from the above chart, the 20-day moving average of the ISE Sentiment dropped to a reading of 98.5 on March 21st (representing the most oversold reading since a reading of 97.6 at the close on October 30, 2002) and has since bounced back to a reading of 110.2 last Friday. In the meantime, the 50 DMA is playing “catch up”, declining from 115.7 to 114.1 – a low not seen since October 23, 2006. The pessimistic readings coming out of the ISE Sentiment Index suggests pervasive pessimistic sentiment – signaling that the market is definitely a “buy” basis the Dow Industrials or the S&P 500.
Conclusion: While the continuing deterioration in the mortgage market, the homebuilding market, and housing prices is a red flag for both the stock market and the world's financial markets, this author does not believe the “next shoe” will drop until at least a couple of months from now. Moreover, current liquidity levels suggest that the cyclical bull market still has further to run. Furthermore, valuations, technicals, and breadth also suggest that the intermediate term trend remains up, for now. Should market internals or valuations deteriorate substantially over the next couple of weeks, we will definitely trim down on our 100% long position in our DJIA Timing System – but as of Sunday evening, we will remain 100% long. We will continue to reevaluate our position in our DJIA Timing System, and will send out a real-time email alert to our subscribers should we decide to trim our long position in our DJIA Timing System in the upcoming days or weeks.
As for whether cover stories on the most popular business magazines are contrarian by nature, the current evidence – while suggesting that they may not be – also suggests that the appearance of a cover story (whether it is positive or negative in nature) is generally a signal that the prevailing trend is about to end. From a contrarian standpoint, this is usually a good time to go the other way – although such signals are only good if fundamentals confirm as well. For subscribers who are interested in speaking further about this phenomenon, please email me and we will discuss.
Henry To, CFA