Is this rally real, and can you time the market?
The Amateur / Vad Yazvinsky 4/21/2008 3:33 PM ET
Don't make too much of last month's rally. Market fundamentals tell me the big picture is still far from clear
Buy to cover all shares sold short on Pier 1 Imports (PIR, news, msgs), Cyberonics (CYBX, news, msgs) and Levitt (LEV, news, msgs) at the open.
Buy to cover $1,500 worth of shares sold short on BlueLinx Holdings (BXC, news, msgs) and NextWAVE Wireless (WAVE, news, msgs) at the open.
Sell short $2,000 of Corus Bankshares (CORS, news, msgs) at the open.
Sell all shares of Global Sources (GSOL, news, msgs) at the open.
Buy $2,500 of Celgene (CELG, news, msgs), Nvidia (NVDA, news, msgs), Brush Engineered Materials (BW, news, msgs) and National Instruments (NATI, news, msgs) at the open.
Buy shares of Vanguard Mid-Cap (VO, news, msgs) with remaining cash at the open.
"How many legs does a dog have if you call the tail a leg? Four! Calling a tail a leg doesn't make it a leg."
-- Abraham Lincoln
Last month's rally probably made the big picture quite a bit murkier in the minds of most investors. Despite (or because of?) widespread predictions of impending "doom and gloom," markets shined, with many beaten-up "value plays" casually rebounding in high double digits and the Dow Jones Industrial Average ($INDU) up almost 10% from its March lows. But is this rally a true sign of things to come? Has anything changed fundamentally since the early March lows? Is it now safe to assume the U.S. economy is out of the woods?
I don't think the answers are very clear at the moment, and thus anyone who answers these questions with great confidence is likely to be simply wrong.
On the surface, last month's comeback couldn't have been any more convincing. But it was not triggered, in my opinion, by solid and consistent economic data. Rather, it was a chain reaction in response to the Fed's bailout of Bear Stearns (BSC, news, msgs). The implicit government guarantee on counterparty risk has, in effect, eliminated the bankruptcy threat for any medium or large financial institution in the United States. This led to drastically improved liquidity and lower spreads in the commercial mortgage-backed securities market.
With fear dominating the headlines for the majority of the first quarter, volatility inflicted severe pain on hundreds of large hedge funds. This, in combination with a Fed-induced leverage crackdown on major investment banks, led to another simultaneous unwinding of leveraged short bets and triggered a massive short-covering rally. Combine that with seemingly never-ending gains in most commodities-related stocks and add all the technically driven "signs" -- higher lows, higher highs, triple bottoms -- and you've got yourself a recipe for a "healthy" rally.
But let's be realistic. According to data from The Wall Street Journal, earnings of 678 companies that have reported so far (through Friday, April 18) are down an astounding 22% year over year. Wall Street predicts a familiar "hockey stick" jump in earnings in the last two quarters of the year, leading, according to the Journal, to a 15% full-year gain in earnings for the Standard & Poor's 500 ($INX). But I simply don't buy the notion that, with the economy at a virtual standstill or even in recession, total earnings could possibly grow in healthy double digits for the year. I think that earnings expectations for the second part of the year are still far too high, and thus markets likely will be disappointed come the third quarter of the year.
But does it really mean you should sell your stocks today and run away? I don't think so.
With so much cash still on the sidelines, and with momentum and technical investors finally jumping on the rally bandwagon, the Dow could easily go up another 500 points. But, in my opinion, the total potential upside for the remainder of the year is limited to no more than 5% to 7% from today -- roughly break-even for most market indices. And if the recession is more severe than expected (six to seven months of flat or negative growth), the downside target would probably mean retesting January lows, or roughly 7% to 8% down from here.
True, given significant improvements in the values of commercial mortgage-backed securities, we might have already seen the ultimate lows in the financial sector. The tech sector is still growing in healthy double digits, and industrials are benefiting from growing exports. But with the commodity bubble looking increasingly unstable and the Fed's rate-cutting cycle coming to an end, the current risk/reward tradeoff (over three to six months) is overall quite balanced. So most of the potential upside from here likely will come from picking better stocks and sectors, rather than from a simple buy-SPDR S&P 500 (SPY, news, msgs)-and-hold strategy.
A quick note: I have received several e-mails from readers asking me why I insist on being 100% invested at all times. Doesn't the safety of cash offer a valuable protection against the declines in a bear market? The answer is, quite frankly, "no" in my skeptical mind. Moving a large portion of your portfolio into cash is nothing more than a timing bet.
I have found that attempts to time the market tend to be useful only if you are trying to underperform the market over the long haul. Even if you think your ability to predict the market's next move is higher than 50-50, the odds are still not in your favor. You have to time not only when to sell but also when to jump back in, which means you need to make two concurrent predictions of where the prices are heading, with each prediction likely being around 50%. You don't need an MBA to realize the odds are against you.
I don't want to bore you with exact calculations, but depending on several assumptions, you need to have an average predictive ability of 70% to 85% to beat the fully invested average market portfolio. How does that sound? You can find a quick quantitative primer with exact calculations and formulas here.
My recipe for dealing with market timing is very simple: Good investors should keep their portfolios fully invested at all times. When at a crossroads, it's OK to protect the downside with short positions or invest in low-cost exchange-traded funds if you are not certain which stocks to buy. Don't waste money on commissions; those brokers make too much money from me as it is.
Anyway, feel free to visit my blog or e-mail me your questions. For anyone interested, you will be able to ask me questions in person during the MSN Strategy Lab Panel and at MSN's booth at The World Money Show in Las Vegas, held May 12-15.
AI
