What to Ask Mr. Market

What to Ask Mr. Market

By Michael Santoli, Barron's | 25 November 2007

Thanksgiving is not the sacred holiday at which four essential questions are asked across the celebratory table. Yet given the recent market environment, suggestive of high emotion and low margin for error, questions seem more appropriate than mock-confident assertions.

In fact, this market— having dropped 10% for the second time in four months toward its August lows, before Friday's who-didn't-see-that-coming holiday bounce— has shown enough probable cause to warrant a firm yet open-minded interrogation.

The most pressing question is whether we've entered a bear market, whether this commotion we're hearing is a bear pounding on the door or merely the same old bull falling down the stairs again. Thing is, markets don't respond to such blunt interrogations. The answers to subtler, more oblique questions nudge us toward the truth.

• First, how much damage has been done? Plenty— maybe almost enough to reflect the economic pessimist's favored scenario. The average price of the stocks in the broad S&P 1500 index was off nearly 14% at Wednesday's close from its June 4 high, notes Wayne Kaufman, technical analyst at Friedman Schnaier & Associates.

Nearly a third of the stocks were down at least 20% from their high. Fewer than 30% were above their 200-day moving average. Yet Kaufman notes that certain barometers of investor distress are still short of the levels seen in mid-August. It's enough, at least, to expect a bounce.

Put it this way: If this is still a bull market, it soon should rise significantly. Kaufman, whose trading approach features that admirable blend of discipline and flexibility, is poised for such a bounce, but is keeping the market on a short leash.

• Second, what about all the Dow Theory chatter? Several scriveners have dipped pens into inkwells and written that the Dow industrials' breakdown has triggered a formal Dow Theory sell signal, confirming the washout in the Dow transportation average. This sounds scary, but mostly amounts to another way of saying "lots of stocks are weak, especially economically sensitive ones." As a shrewd trader friend observes, "The market trades on technicals when no one knows what the hell's going on." Note that the late 1990s Dow Theory sell signal came several months and many percentage points ahead of the ultimate top.

Dissent has arisen from several quarters. UBS strategists put forward the Baltic Dry index (a measure of spot cargo demand) as the 21st century transport average. It remains strong. Jason Trennert of Strategas Research points to his firm's index of the S&P 500 stocks with the tightest historical links to GDP trends. It's flashing slowdown messages, but is well above 2001 recession levels.

• Third, are investors depressed enough to elicit a bottom? By bull-market standards, yes, or just about. Ned Davis Research— as good a beacon of sanity as can be found in tough markets— was cited here near the August lows calling for a bounce but saying no "fat pitch" on sentiment was implying an important bottom. Good call.

The firm last week was about at the same place, saying that individual-investor and newsletter-writer sentiment is negative enough to invite a year-end rally. But, adds NDR, maybe nothing more powerful than that, given the lousy tape action that hints at "bear-market conditions."

One side note: Last week, the ratio of corporate insider selling to buying was down to four, deep in buy signal territory and at a level last seen the week of Aug. 23.

• Fourth, and what about that supposedly strong fourth-quarter seasonal effect, anyway? Seasonality is climate, not weather. It offers general tendencies, not daily or weekly advice on what to wear or how to trade. This suggests that the swift 10% drop during a supposedly strong seasonal period has bruised traders' confidence enough to allow calm and perhaps higher prices to mark December. Let's just say the grand jury has yet to hand up an indictment on this market. But it's deliberating strenuously.

You know the story will be written sometime in the next year, the one about the deep-pocketed, steel-gutted opportunists who surveyed the carnage in the housing and mortgage markets and made a killing buying dollars for pennies.

For the small-time speculator, here's a way to bet on panic ebbing in this sector. Home builder Pulte Homes (ticker: PHM) has an exchange-listed senior note (ticker: PHA) that yields almost 11% and is near the top of the company's capital structure. It trades at 16.81, or 67% of its $25 face value. Pulte is among the more financially stable builders and has an unchallenging debt-payback schedule for the next few years. One caveat: The securities are thinly traded, allowing in small-timers only.

Normxxx    
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