What To Do In This Volatile Market
Stockscores.com Perspectives for the week ending October 25, 2008
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In this week's issue:
Normally, I try to write newsletters that are general in nature, looking at trading techniques or strategies, perhaps a consideration of the psychological side of trading. In consideration of the very abnormal market conditions, and the questions that I am sure many of you have about your stock positions, I thought I would discuss my perception of this market and where I see opportunities.
Never before have we witnessed this sort of selling pressure and so it creates unparalleled pain for some and we may see that it creates unbelievable opportunity for others. To understand what is happening requires that we first understand what stock prices represent.
When you buy a stock, you are buying the company's ability to make money in the future. The stock market is a forum for buyers and sellers to debate what those future earnings' expectations are. Stock prices do not move on what has happened, they move on what will happen, so when prices go down, it is because investor expectations for future earnings have gone down. Prices go up because market participants believe the company will make more money in the future than they had expected in the past.
This conflicts with how commodities, or just about anything else, is priced. Commodity prices are based on supply and demand. If the world has a hunger for oil and oil is scarce, prices will go up. If there is a glut of oil and people stop driving their cars, oil prices should go down.
The reality of the stock market, at least in the shorter term, is that stock prices are affected by supply and demand. But it is not the supply and demand for stocks, it is the supply and demand for capital. There is a severe shortage of investment capital in the world right now and that has meant that investors are clamoring to sell stocks so that they can raise cash.
The reasons are probably well known to you all by now. The world was heavily leveraged and disillusioned about the protection that derivates provided against loss from this leverage. Over valued real estate was financed by banks because they believed that insurance in the form of default credit swaps would protect them against those who could not afford to service their debt.
A simple explanation goes as follows. A bank lends money to a homeowner in the form of a mortgage secured by the property. The mortgages are bundled and sold as a bond. The bond salesman, interested in extracting as much value from the bundle of mortgages that make up the bond, wants to have as high a rating on the debt as possible. If the people that borrow the money to buy the home are of a high credit risk, then the bond will sell for less because the buyer of the bond expects that some people won't pay their mortgage. But, there are companies that will insure against those losses, allowing the bond salesman to put a higher credit rating on the basket of mortgages because the default risk is protected by the insurer.
This system works ok if the number of people that default is within historical limits, but what happens when an abnormally high number of people all default on their mortgages at the same time?
Well, as we have seen, first the bond insurance companies and those that underwrite them fail to pay out the insurance that the bond salesman bought. The lenders try to sell the houses but with so many houses on the market at once, prices fall and now the amount owing on the property is far more than what the property is worth.
The bondholders find that the "A" grade bonds that they bought are really very high risk because the insurance company can't pay for the defaults. Some of these bonds are worth maybe 10 cents on the dollar.
Many of the bonds are bought by banks, who suddenly find that these low risk investments that they bought are close to worthless. They no longer have a lot of capital, and if they don't have capital then they can't lend money to their customers who want to buy houses, cars and grow their businesses with credit. This compounds the problem of lowering home prices because now there are far fewer buyers. The economy slows down because people and businesses are not able to buy stuff unless they pay cash.
So, what does all this have to do with the stock market? The crash in the housing market has severely contracted the amount of capital available to invest in the stock market. The supply of money is low which means the demand for stocks is low. People are selling, not because they believe that the ability for companies to make money is so much less, but because they have to sell to raise capital.
So, we have an important breakdown in market efficiency. Stock prices do not reflect the present value of future earnings expectation as they should, they instead reflect the supply and demand for cash.
This should create an amazing opportunity if the supply of capital improves because, when it does, people will buy undervalued stocks and send prices up to where they should be in terms of fundamental value. A stock that today is trading at $40 may really be worth $80 but the supply of capital has made prices artificially low. So long as the supply of capital can normalize, stocks prices should also normalize.
But here is the caveat that should not be forgotten. The lack of capital in the global economy will hurt companies' ability to make money in the future. You could argue that the company trading at $40 is worth $80 because it is only trading at 5 times earnings when normally it trades at 10 times earnings. But what will earnings be if there is a major global recession? Perhaps $40 is fair value when you consider what the company will make rather than what it has been making.
Here is my best guess on how to answer that question. Economies tend to grow and contract in linear fashion rather than exponentially. This means that a chart tracking long term growth or contraction can be typified with a straight line and not a curve.
If you look at stock prices, you will see some stocks that have suffered a price decline that follows a straight, downward sloping line. These, it can be argued, have been reasonable price falls determined by a true loss in value of the underlying company. Other stocks have fallen so steeply that their price drop fits a curve with an increasing slope. These stocks appear to have lost value because of market inefficiencies, particularly the lack of capital supply. It is in these stocks that I think the best opportunities reside.
When the capital comes back, these parabolic downward trends should come back up to meet their long term, linear downward trend line. In some cases, this represents the potential for 50% - 100% gains.
So, we should be looking to buy stocks that are far below their long term, linear downward trend lines. When the government's injection of capital in to the financial system takes hold and allows for an increased supply of capital, these stocks should come back up.
Here is the problem. There is no limit to how far below the linear trend line a stock price can go (actually, there is a limit, price can only go down to zero). So, trying to call the bottom is like trying to catch a falling knife.
But what we can do is manage the risk inherent in trying to pick the bottom and, metaphorically speaking, protect ourselves from being cut too deeply if our initial attempts fail. Here is how I am doing that.
I look for stocks that are far below their downward trend lines and buy them on days when they close above their open after hitting new lows early in the day. This is a sign that the buyers took back control intraday on a stock that the sellers held firmly in their grasp at the start of the session. It is a good, short term measure of momentum shift.
I buy them near the close with a plan to sell if the stock falls back to make a new low. This way, I know my risk in the trade; it is the difference between what I pay and where I plan to take my loss. What is important in determining what stocks I buy is the upside potential relative to this downside risk.
The upside potential is the distance back up to the downward trend line which probably reflects the true fundamental value of the company. If my downside is $1 and my upside is $10, then I can be wrong on trying to call the bottom 9 times in a row and still make money if I get it right on the 10th time. Thus, I want to take trades where the reward potential of the trade is significantly higher than the risk.
And now, some examples to hopefully make more sense of this approach …
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I used the Stockscores Market Scan and the Dead Cat Bounce strategy to identify stocks that are in downward trends and are far below their long term downward trend line. I focus on those that were hitting new lows on Friday morning but came back up to close above their open. I like to see strong volume on Friday and I want the upside potential to the downward trend line to be much greater than the downside risk to the low of the downward trend.
Friday's trading brought a lot of examples with a high proportion of Gold and Mining stocks, making me think that the market believes this group will turn around first. Here are a few stocks and Exchange Traded Funds that I think are worth considering with the understanding that trying to catch the bottom is a difficult thing to do and it may take a few tries.
It is a good idea to consider the intraday, 15 minute chart on Monday to make sure that we get a confirming entry signal for these stocks if you wish to consider them. I like to see a break of the intraday downward trend or a break from a rising bottom.
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1. GDX
GDX is a Gold ETF which has fallen sharply over the past three months. I estimate the downward trend line is at about $30 and the stock closed on Friday at $17.80 with a low of $15.83. That means it has about $2 of downside and $12 of upside. I think the odds of it bouncing are better than 1 in 6 so I consider this a trade that is worth considering.
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2. T.LLL
Investors have not been too flexible in their selling of T.LLL (LULU on the Nasdaq) and have sent it below the downward trend line which is at about $22. Closing price in Friday was $14.14 and support at the low is at $12.50. This gives it close to a 4 to 1 risk reward potential on a swing trade for the bounce.
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3. URE
Capital makes the real estate world go around, and in its absence this sector has been pummeled. The downward trend line is at about $25, the stock closed Friday at $8.25 and support is at $7.23. That is nearly a 17 to 1 risk reward potential, giving this trade a buffer for errors if the first few attempts to call the bottom do not work.
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References
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Disclaimer
This is not an investment advisory, and should not be used to make
investment decisions. Information in Stockscores Perspectives is often
opinionated and should be considered for information purposes only. No
stock exchange anywhere has approved or disapproved of the information
contained herein. There is no express or implied solicitation to buy or
sell securities. The writers and editors of Perspectives may have positions
in the stocks discussed above and may trade in the stocks mentioned. Don't
consider buying or selling any stock without conducting your own due diligence.
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