New Reality Check: It’s A Bear Market Rally Unless Proven Otherwise

I’ve often noted that markets don’t move in a straight line. Even during one of the worst bear markets in history, when the Dow lost around 90 percent of its value from 1929 through 1932, there were numerous double-digit percentage rallies along the way (see “Bear Market Rallies”).

So, just in case you feel a sudden urge to join the permabulls, panicky short-sellers, serial bottom-callers, and greater fool investors who’ve helped drive the market up 25 percent since it hit oversold extremes in early March (aided, of course, by relentless Washington cheerleading and smoke-and-mirrors earnings announcements), below are (just) three reports that put a slightly different spin on this allegedly bullish new reality.

“Equities Still a Bubble and Equity Guys Out of This World, BNP Paribas Says” (FT Alphaville):

Yes, really. In a note issued late on Thursday, the credit analysts at BNP Paribas argued that “despite a close to 5o per cent drop in equity valuations, equities look not only rich but are significantly mispriced and are a bubble waiting to be pricked.”

Moreover, they contend that equity analysts are “ignoring the tremendous value embedded in investment grade credit.”

Here are some highlights, which include quite a lot of snickering at the “unfathomable” bullishness of equity types (emphasis ours):
Over the past equity bubble decade, it has become fashionable for equity analysts to concentrate on Operating earnings as opposed to As Reported earnings, which factor in write-offs and restructuring charges (Charts 1 and 2). While the difference between the two measures was insignificant until the internet bubble, that difference has grown significantly to the extent that operating earnings look like numbers plucked out of thin air with little resemblance to economic reality. As credit analysts, we are taught that, for a given revenue base, rising costs lower profits, raise leverage and lower creditworthiness. How equity analysts can ignore this fundamental credit analysis is unfathomable to us.

Using current valuations, if one were to calculate the P/E multiple on 2009 earnings, one lands up with 14x using operating earnings and 30x using as reported earnings. We will leave investors to make their own judgement but P/E multiples of 30x certainly scream bubble to us.

As for the use of earnings yield, which they deplore as “another false measure”,

Equity analysts, using the operating earnings measure have also made the argument that earnings yield are significantly higher than 10-year US Treasury yields and hence equities offer value. This relative value comparison is fundamentally flawed on two counts. Firstly, as we have pointed out, operating earnings are not true earnings and secondly the relative value comparison, should be made to corporate bond yields not treasuries, which would be an appropriate apples to apples comparison. Using this measure, clearly it again illustrates the tremendous value in investment grade credit as opposed to equities.

And then there is the Goldman Sachs (GS) top:
Every bull and bear cycle is usually characterised by a significant event that anecdotally indicates over or under valuation in equities. The 2007 top was characterized by the generosity of Blackstone, which thought it fit to share its profits via an IPO, the equity piece of a highly leveraged entity and a known liquidity extractor.

The recent secondary offering by Goldman Sachs, could well mark the top of this bear market rally because GS, we believe would only issue equity at these valuations for two reasons, namely because it needed to as losses on its highly illiquid Level 3 assets continue to mount, or   because it saw its equity valuation as being grossly overpriced.

The lack of institutional participation and endorsement of this deal, radio silence from Mr. Buffett, who, as a consequence of this deal got diluted and with both Moody’s and S&P maintaining their Negative Outlook despite the equity injection, it points to GS being very opportunistic in exploiting its equity overvaluation and having the need to build a buffer for future losses.

Time will tell, how significant this GS top will be but for now it makes us very wary of equities, especially US financials, as they have become the playground of day-traders.

They also the purported green shoots in mortgage applications - “not a sign of new home purchases but simply refinancings”.

As for commodities and trade,

We will simply let the hard data and the charts do the talking here as commodities and the Baltic Dry index continue to show a “U” or “L” shaped recovery with no sign of “V”.

For the record, they’re expecting a “U” shaped recovery.

“Insider Selling Jumps to Highest Level Since 2007″ (Bloomberg):

Executives and insiders at U.S. companies are taking advantage of the steepest stock market gains since 1938 to unload shares at the fastest pace since the start of the bear market.

Gap Inc.’s founding family sold $45 million of shares in the largest U.S. clothing retailer this month, according to Securities and Exchange Commission filings compiled by Bloomberg. Daniel Warmenhoven, the chief executive officer at NetApp Inc., liquidated the most stock of the storage-computer maker in more than six years. Sales by the co-founders of Bed Bath & Beyond Inc. were the highest since at least 2001.

While the Standard & Poor’s 500 Index climbed 26 percent from a 12-year low on March 9, CEOs, directors and senior officers at U.S. companies sold $353 million of equities this month, or 8.3 times more than they bought, data compiled by Washington Service, a Bethesda, Maryland-based research firm, show. That’s a warning sign because insiders usually have more information about their companies’ prospects than anyone else, according to William Stone at PNC Financial Services Group Inc.

“They should know more than outsiders would, so you could take it as a signal that there is something wrong if they’re selling,” said Stone, chief investment strategist at PNC’s wealth management unit, which oversees $110 billion in Philadelphia. “Whether it’s a sustainable rebound is still in question. I’d prefer they were buying.”

Insiders Sell

Insiders from New York Stock Exchange-listed companies sold $8.32 worth of stock for every dollar bought in the first three weeks of April, according to Washington Service, which analyzes stock transactions of corporate insiders for more than 500 institutional clients.

That’s the fastest rate of selling since October 2007, when U.S. stocks peaked and the 17-month bear market that wiped out more than half the market value of U.S. companies began. The $42.5 million in insider purchases through April 20 would represent the smallest amount for a full month since July 1992, data going back more than 20 years show. That drop preceded a 2.4 percent slide in the S&P 500 in August 1992.

The index rose 1 percent to 851.92 yesterday after better- than-estimated earnings at companies from Marriott International Inc. to ConocoPhillips and EBay Inc. overshadowed falling home sales and higher jobless claims.

Looking Forward

The S&P 500 has jumped 26 percent in 32 trading days through yesterday, the sharpest rally since 1938, on speculation the longest recession since World War II will soon end.

Stocks rebounded as President Barack Obama outlined a $787 billion package of spending and tax cuts to stimulate growth, the Treasury unveiled plans to finance as much as $1 trillion in purchases of banks’ distressed assets and the Federal Reserve pledged to buy more than $1 trillion of Treasuries and bonds backed by mortgages to drive down interest rates.

With corporate America stuck in its seventh straight quarter of earnings decreases, the longest in seven decades, executives may have become too cautious, said Penn Capital Management’s Eric Green.

Investors are looking to the final quarter of the year, when S&P 500 companies will increase operating income by 74 percent, according to analyst estimates compiled by Bloomberg. They forecast profits will fall 32 percent in the second quarter and 19 percent in the third.

“Things are a lot better than they were,” said Green, director of research at Penn Capital, which oversees $3 billion in Cherry Hill, New Jersey. Recent history also shows that “insiders have been wrong,” he said.

Confidence Game

Jeffrey Immelt, CEO of General Electric Co., purchased 50,000 shares at prices from $16.41 to $16.45 on Nov. 13, when the stock closed at $16.86. The shares have since fallen 30 percent after the Fairfield, Connecticut-based company reduced its dividend for the first time since 1938 and lost the AAA credit rating from S&P that it held for more than 50 years.

Insiders of consumer and technology companies have been selling the most stock relative to the amount they purchased this month, data compiled by Washington Service show.

John Fisher, Robert Fisher and William Fisher, whose parents Donald and Doris Fisher founded San Francisco-based Gap in 1969, sold a combined 2.99 million shares at between $15.11 and $15.36 a share on April 3 and April 17, SEC filings show. Gap rebounded 54 percent from its low on March 6. The stock gained 0.5 percent since the Fishers’ last sale.

Reasons to Sell

Gap spokesman Bill Chandler said that “from time to time, based upon the advice of financial advisers, the members of the Fisher family will decide to sell stock.”

Warren Eisenberg and Leonard Feinstein, who founded Union, New Jersey-based Bed Bath & Beyond in 1971, sold 1.05 million and 1.1 million shares at $30.90 apiece on April 9, the most since at least December 2001, the filings show.

The offerings came one day after Bed Bath & Beyond surged 24 percent, the biggest advance in nine years, on a smaller than estimated decline in fourth-quarter profit. Spokesman Ken Frankel said Eisenberg and Feinstein, who currently serve as co- chairmen of the largest U.S. home-furnishings retailer, sold for “estate-planning purposes and diversification.”

At NetApp, Warmenhoven sold 1.25 million shares, the most since at least 2002, for about $21.3 million between April 3 and April 21 at prices from $16.10 to $18.10 a share, the SEC filings show. Shares of the Sunnyvale, California-based company, up 47 percent from the March 9 stock market low of $12.52, gained 1.8 percent since then.

Moving On

Warmenhoven sold shares he received from exercising stock options that were due to expire next month, according to an e- mailed response by Lindsey Smith, a spokeswoman for NetApp. He reaped a profit of about $7.3 million selling the shares at an average price of $17.08 apiece, based on the conversion price of $11.25 for options he held, the data show.

“They’re going to say, ‘Thank you very much,’ and move on to cash or something else,” said David W. James, who helps manage about $2 billion at James Investment Research Inc. in Xenia, Ohio. “This is not a situation that suggests to us we’re seeing an economic recovery.”

“Bear Market Rally? Look at Gains & Volume” (The Big Picture):

In the light of today’s rally, perhaps it would be instructive to look at the volume on some past rallies. Fortunately, William Hester at Hussman Funds has done the heavy lifting for us, as these two charts show:

Changes in S&P 500 Leading to, and Coming Off of, Major Troughs

(Note: Data set = bear-market bottoms since 1940 )

Volume Changes From Major Bottoms

(Note: Data set = bear-market bottoms since 1940 )

Charts courtesy of Hussman Funds

Eventually, one of the Bear market rallies will be the one that is the turnaround. But until then, its guilty until proven innocent.

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