Bermuda: Wall Street is More Upbeat
LOM Weekly Perspectives

A whole group of bigwigs have been urging folks vociferously to buy stocks. Let’s see - - it includes New York mayor Michael Bloomberg, Treasury Secretary O’Neill and the President himself. And, with the first signs that corporate governance issues are being addressed by legislation, it looks like some investors have heeded the calls, thinking that they are now assured of bagging exceptional value in the market. But if you think the trio is offering sound investment advice, ask yourself if you ever heard them exhorting investors to sell, back in the spring of 2000.

Looks like some investors have donned their optimistic glasses again and are ready to count the chickens before they are hatched - - many times over. Meanwhile, a host of Wall Street gurus, distressed at the scale of value destruction, are convinced the bottom has been reached and are chirping more volubly than ever. Others, more impressed by how much air was pumped into the balloon during the nineties are not so sure that we have seen the last of the deflation. Then again, where is the reference point? If you fit a trend line to the Dow pre-1995, by eyeballing it (you can use a regression method, if you like), you get fair value at around 6,000 today. Doing the same to the S&P 500 gives you a level of about 600 now. Alternatively, if you think that performance over the 1995 to 2000 period is the norm, then you will obviously get higher levels for the indices, making equities undervalued and consequently a good buy.

As for the price to earnings ratio (P/E), the problem, as usual, is with the E. First of all, as we all know, the numbers are distorted by crooked accounting and management practices. But even if we overlook these issues there remain some big items to consider, such as the under-funding of pension and health plan, and the treatment of employee stock options. If properly accounted for, they will knock the wind out of the E. The P/E ratios that are normally bandied about are unadjusted and, as such, are biased downward making the market look cheaper than it is. But then, hope fear and greed have never been strongly influenced by realities, at the best of times. In current conditions, without a good fix on fundamentals, sentiment is going to play a big role in the market. Investors will find it tough to separate valuable information from the noise.

Are we going to sink to the lower depths? Not necessarily, if positive sentiment can be fired up. And the degree of fear among the authorities is high enough that they would not be averse to some form of market manipulation to push stocks higher. However, there is no evidence that there has been talk between Wall Street kingpins and Washington to boost the stock market by means other than verbal exhortation. Instead, we hear a torrent of upbeat talk, which must have some short-term effect on those investors who retain lingering hope of a return to the good days of the late nineties. So greed temporarily replaces fear, leading to an upswing in the market. Given the magnitude of the recent advance, we may have underestimated the degree of residual hope still left in the system.

Many in the household sector haven’t felt the pinch that badly, yet - - except the sub-prime sector. House prices are still holding up and loans are cheap and fairly easy to get, judging by the evidence. Consumer borrowing outside real estate has recently been growing at a pretty hefty pace, which means that households may be ready for one last fling at spending before the saving rate is finally forced higher. All of which has been good for the banks, whose earnings have been underpinned by lending to households. The authorities, of course, are very keen to keep house prices and stock values puffed up for as long as possible to avoid inevitable adjustments in the household sector.

As we have mentioned before, this is a trader’s market, requiring calculated entry and exit. Smart portfolio managers buy and sell the same stock repeatedly, rather than just buying and holding it. And it makes no difference whether or not it is a blue-chip, because most of them have revolving roles as stars or dogs over quite short time periods. By and large, the same thing holds for sectors too. A quantitatively based method of frequent sector switching works better than sector selection determined by fundamental considerations. The downside of the above strategies is higher trading cost and, for taxable investors, possibly higher capital gains taxes. However, they may still be more profitable net of the above costs.

Investors would be wise to think of this market more in terms of little bulls and bears, rather than big bulls and bears. We should learn to take advantage of the swings, until we can discern that a long-term, trending, bull market is shaping up - - and that won't be anytime soon. Now, an oscillating, largely sideways, market requires a different skill-set to trade profitably, compared with trading a trending one. It necessitates the judicious assessment of entry and exit points as well as careful risk management strategies. In a moody market with a lot of sentiment-driven swings it is also a good idea is to keep a close eye on sentiment indicators such as put/call ratios, the advance/decline ratio, mutual fund flows, short interest ratio and the VIX.

This is the last time that the Weekly will be written in the present format. In the future, it will provide succinct summaries of economic and financial market developments. The author would like to thank all readers who have found it interesting to read.