I’ve said it here multiple times that when markets move in one direction too long, they often have a countertrend move that is half of the previous move.  The Dow Jones was at 9653 on election day (November 4th) and fell to an intraday low of 7449 over the next several trading days.  That was a 23% drop pretty much straight down.  In two days, it bounced half way back up.  In other words, we dropped 2204 Dow points from November 4th until November 21st (intraday).  Now, we have jumped half of that drop, or 1158 points to the intraday high yesterday.  That’s perfectly normal.  Picture dropping a ball off of a building.  It wouldn’t bounce back to the roof where you dropped it from.  It would bounce back maybe 1/3 or 1/2 way back up.  That’s exactly what the market has done in the last few days.  What’s interesting is that when it’s hit that level of around 8600 on the Dow, it has failed 2 days in a row.  In addition, we’re also right below the 21-day moving average, a place rallies have failed in the past.  So, one test to see the longevity of this rally will be if we can move up from here and break through some of these technical levels.

Multiple Expansion? 

In good markets, we always hear about multiple expansion.  The means P/E ratios getting larger.  In other words, if a stock earns $1 per share and the stock is at $10 per share, then it’s P/E ratio is 10.  So people are willing to pay for 10 years worth of earnings today.  When investors are really happy and bullish, they may pay for 20 years worth of earnings, or a P/E of 20.  That would mean the company is still earning $1 per share, but the stock is now $20 per share. 

There’s one other way we can get multiple expansion.  We can have the “E” in the P/E fall.  So, what if the stock is $10 per share but the company now earns $.50 per share?  That’s a P/E of 20.  So, be careful.  I hear everyone on television saying stocks are cheap.  Some are and some aren’t.  But, if you’re not confident in the “E” part of the equation, then you can’t trust the “P” part either.  I think overall, earnings for a lot of companies are still too high based on the estimates by analysts. 

Therefore, we may get multiple expansion, but it’s not the kind you or I want.  We want it because people are more excited about buying stocks and are more willing to pay even more for a years worth of earnings.  I think the multiple expansion (if it comes) will come from the earnings going down faster than the stock prices.  A more realistic scenario is that stock prices will come down just as fast as the earnings.  So, if earnings fall 20%, then prices will have to fall 20% to have the same P/E as we do now. 

The P/E may be fine at 10, but that doesn’t mean the stock can’t go down much further and still have a P/E of 10.  As always, make sure you’re doing your homework not just on past information but current information and (realistic) projections.

There is a big misconception that the stock market is cheap.  Sure, it’s cheaper than it was on a valuation basis now compared to a few months ago and certainly compared to 1999.  But, if we don’t know where earnings are going to bottom, how can we value stocks accordingly.  In addition, valuations haven’t mattered when there is this much fear.  As long as there is no demand for stocks and a ton of fear, valuations won’t matter.

But, we all know that over the long-run, it’s all about profits (earnings).  And, right now, there are definitely cheap stocks out there & sectors.  This is the time to build that shopping list of “dream team stocks”.  This is your chance over the next few months to buy some of the best companies in the world at very very cheap prices.  Just don’t make the mistake of assuming that’s the entire market.  They’re not all cheap.  But, there are businesses where demand is growing, debt is manageable, and the stock is too cheap because of fear.

We know there is and will continue to be demand for medical products & services regardless of what kind of economy we’re in.  That means selective healthcare companies that are on the cheap can slowly be bought.  How about global infrastructure?  Is that going to stop?  No.  It’s slowing down, but global growth will resume and the companies that do most of their business abroad will benefit from that.  Demand for their services and products.  That’s what we’re looking for.  How about companies in the fertilizer and agribusiness space.  Extremely cheap right now.  These are just a few areas I’m watching carefully.

Over the next few weeks, I’ll be examining some of those “dream team stocks” that we’ve always wanted but are just now getting the opportunity to buy at reasonable prices.  Call in to my radio show from 7-8 a.m. CST weekdays at 1-877-777-7713 toll free to let me know what stocks are on your list.

Remember, this will be a gradual process of accumulation.  This is not something to do overnight.  This will be a multi-month process.  Also, if conditions remain the same and you do accumulate a stock or two, keep your hedge on by shorting the overall market with an exchange traded fund until the demand for the overall stock market picks up and the desire to sell exhausts.

The market’s up about 500 points today.  This is after a 500 point up day on Friday.  So, from the bottom Friday, we’ve already rallied about 16%.  Why?  Because Obama is naming Geithner Treasury Secretary and because Citigroup got bailed out.  So, let me get this straight.  We’re happy that one of the largest financial institutions in the world had to be bailed out after saying everything was fine as late as Friday?  Haven’t we seen this before?  They must get a deal done by Sunday night before the Asian markets open….or else?  Well, they’ve gotten “deals” done before and the market reacted similarly.  Those rallies all were reasons to sell, not buy more.  It’s amazing that investors aren’t learning from the past.  The economy continues to slow and we’re having to bail out a huge institution like Citigroup.  And, that’s a reason to celebrate?  I don’t think so.

That’s like me as a Spurs fan celebrating because Tim Duncan only broke his leg.  He didn’t have to get it amputated.  Is that really reason to celebrate?  He’s still going to be out the entire season (in my fictitious scenario).  That’s what today feels like to me.  It’s an oversold rally that should be sold.  I shorted some on Friday and have shorted more today at the end of the day.  Don’t get me wrong, the euphoria can last a little longer.  But, I don’t see evidence that this is the beginning of a new bull market.  Given that, there are only trading rallies in a bear market.  What more do you want than 1000 points in 2 days?

As the world deleverages or reduces its balance sheet, I’m doing the same.  Selling more positions and reducing my allocation to stocks.  As I’ve been very light in the stock area for some time, there’s no time like  the present to reduce those holdings even more.

In markets like these, we always learn alot.  There are always new variables and events that have never happened before.  So, what we have to do is continue to learn and get better at investing and trading.  One thing (among others) I’ve learned in this market is to sell news related rallies.  We’re oversold and should get a rally at some point, but looking back every rally we’ve had because of some news event was a good selling opportunity.

I’m using the news of Tim Geithner becoming the next Treasury Secretary as a selling opportunity.  I’m not going to over do it but I will continue to sell into rallies as the internals continue to deteriorate.  Don’t get me wrong, I think it’s huge who Obama is naming in his cabinet.  Remember that a bigger driver of equity prices in the short run is emotion.  When investors are fearful, they sell.  When they aren’t confident, they sell.  Investors haven’t been very confident lately partially because it looks like nobody is driving the bus.  The parents aren’t home.  So, for investors to embrace the pick of Geithner is a positive.  No doubt about it.  But, I know that what matters is demand for stocks and fundamentals.  And neither one is very good right now. 

So, enjoy the rallies as they are normal and part of every bear market.  But, don’t get used to them and don’t take anything for granted.

I had a caller this morning say he’s 2/3 invested in his 401-K with 1/3 still in the money market.  He said he was dollar cost averaging in the rest and was wondering from a technical analysis standpoint, should he keep doing this.  I told him he should be dollar cost averaging, but not in the market.  He should be dollar cost averaging out of the market.  He said “really”?  That’s when it dawned on me that there are still people that are trying to buy the dips instead of sell the rallies.  There are still too many that are used to bull markets and too passive.  We have massive liquidation going on right now.  The selling pressure has not stopped.  The sideways pattern that was developing the past few weeks has broken and a new round of sellers are entering the game.  In other words, there is still plenty of ammunition for lower prices.  It looked like it was exhausting, but the selling is re-accelerating.

If you still own too many stocks which basically means 1 or more, then you don’t want to panic and sell at potential lows.  On the other hand, you can’t afford to keep losing money.  I would be averaging OUT of the market.  As much as I didn’t want to, I sold some today.  Now, keep in mind, I don’t have a lot in equities right now but any is too much in this environment.  We have the Treasury once again changing the rules on us and changing the game.  We had Paulson on television giving a speech and not saying anything but more of the same.  The creativity we saw a few weeks ago has disappeared and it looks like everyone is on cruise control in Washington just waiting until the next administration takes over.  Markets hate uncertainty and that’s what we have right now.

So, the only choice we have is to dollar cost average.   OUT though, not in.  Why not sell everything today?  Because volatility is still high and we will stll get huge rallies.  No question about it.  And that may be around the corner.  But, for now, you can average out of positions or add shorts.  Or both.  But, just keep in mind, that we will rally and hard.  Don’t get whipsawed. 

Also, don’t forget about bonds.  There are still plenty of good deals out there.  Just be careful and do your homework.

With the market moving sideways (volatile, but sideways), I’m starting to see some stocks and sectors holding up on a relative basis.  There’s a couple of ways to play this.  First, you could simply avoid the weak areas and go into the strong areas.  Or, you could do a pairs trade.  For example, this month XLP (the consumer staples ETF) is down about 3%.  But, during this month, consumer discretionary through the XLY ETF is down about 20%.  So, shorting the weak and going long the strong could have netted about 17%.  Now, I’d rather do this trade on the other side meaning when everyone is a little more confident and we’ve had a rally.  The reason why is because the weakest areas can rally the hardest sometimes so we could see financials, materials, & consumer discretionary rally hard when we get the next rally.  Also, there is some relative strength with energy vs. financials. 

I think we are setting up for a rally and after it’s run its course, look out for these types of trades to work.

Hank Paulson & Ben Bernanke are on television testifying and at this very moment the Dow Jones is up about 120 points.  Amazing!  A rally even while they speak.  They haven’t exuded confidence over the past few months and everytime they talk, down we go.  Could be a buy sign?#$?@  Stay tuned.

Over the past several years, I’ve used plenty of structured notes to accomplish various investment strategies. A structured note is simply a bond made by a company to accomplish a certain investment goal of yours.   For example, a few years ago I was bearish on the dollar vs. the BRIC (Brazil, Russia, India, & China) currencies.  I didn’t really feel like going and investing in these various currencies by investing in each one through the traditional methods.  So, investment banks such as Lehman Brothers, Barclays, JP Morgan, BNP Paribas, etc. would build these into a bond and make a spread.  I got a bond with principal protection and a whole bunch of upside and the issuing company got a fee to build the bond.  The currencies went up against the dollar, I sold my position, and everyone was happy.  They can be created to be very exotic.  For example, the one I owned gave me 650% of the return of the basket of BRIC currencies against the U.S. dollar.  That’s a lot of leverage.  Now, keep in mind that I wasn’t using leverage.  The reason I got that kind of leverage was because the options prices they used to create these were cheap at the time.  They use options and treasuries to build them.

Over the years, I’ve had these on currencies, foreign equity markets, just about everything you can think of. They are great because they allow you to do very sophisticated strategies and wrap them up in a bond where you principal is protected but you have a tremendous amount of upside.  But, one thing many investors didn’t think about when buying these was the paper they were written on.  That’s who is backing these bonds.  So, you might get the investment theme right, but the issuer incorrect.  I’ve made lots of money on these over the years.  The one case I didn’t get my money back was with Lehman Brothers.  I never dreamed (nor did anyone else) they would file for bankruptcy.  But, they did.  I did my homework by buying structured notes from a company with a very very long track record and a company that was very well respected.  But, at the end of the day, there were things the company owned I never dreamed of.  Their massive leverage caused them to fail.  

Just a few weeks before they went bankrupt, they were touting that their structured notes were 100% principal protected.  Now, us bondholders are waiting to see what we’ll get during the bankruptcy proceedings.  So, it’s very important to not only do your homework on your investment theme, but who’s making the bond for you.  Fortunately, I diversified and bought small pieces of the Lehman Brothers bond.  But, still, not a fun experience.  Every investment has risk.  Money market investors saw this a couple of months ago when a very old “conservative” money market fund went below the traditional $1 per share.  It went to $.97 per share and for the first time in a long while, money market investors didn’t get their principal back.  Risk comes in all forms and fashions.  You can have principal risk, reinvestment risk, interest rate risk, etc.  

A common company many of these notes are written on is Toyota.  Seems like a safe enough company.  It’s struggling like everyone else but it should be safe, right?  Well, they are now in jeopardy of losing their AAA/aaa status.  If that happens, the people that own bonds not only in the company Toyota but structured notes with Toyota’s backing could see their bond values fall.  I’m not saying they will lose their principal, but it’s something to watch.  If they get the downgrade and the bond values fall, it forces the bondholders to potentially have to hold their bonds longer to get their principal back.

As always, the moral of the story is to do your homework.  Everything has some kind of risk.

I’m always looking for companies where the fundamentals and charts don’t match the market.  The market’s fundamentals are getting worse, not better.  And the charts?  Well, you could argue positively and negatively.

One company I own and continue to believe in is Gilead Sciences, Inc. (GILD).  The stock is up over $1 today while the market is down about 100 points on the Dow.  It’s been up all day and I think it can re-test its highs from the summer of $57.63.  This biotech company discovers, develops, and commercializes therapeutics to advance the care of patients suffering from life-threatening diseases.  Some of their products include antivirals, antifungals, & antibacterials.  These aren’t discretionary items last time I checked.  This company has 40% sales growth, over 60% return on equity and alot of cash. 

Its 21-day moving average just crossed its 50-day moving average and the 200-day moving average is around $50 per share.  If blows through that, you could see that old high re-tested.  The more this market stabilizes and moves sideways, it gives Gilead a chance to do great things.

This isn’t a recommendation to buy this stock.  It’s just a place to start your research.

You could almost sense it.  If we went through the old lows, then down we would go.  Well, we did go through those old lows.  And, the selling picked up because amateur technicians around the world all had their stop losses get triggered at those old lows.  I had people tell me they were going to do that.  I told those people and on the radio, we’re in a range.  It’s not perfect.  That means we may break through the lows and shake out the weak hands and then start rallying.  I didn’t expect a 900 point intraday move on the Dow though. But, we had more bad economic data, weak earnings from Intel, more discussion about an automaker bailout and we actually started up, then we fell and fell and fell.  The selling accelerated into the afternoon.  The volume picked up, the stop losses triggered, the capitulation was in place, and up we went. A huge move.  

What’s next?  That’s your real question you want answered.  Well, we need to see what tomorrow brings.  What makes the market difficult is the moves are so big.  You can go from oversold to overbought in just a few hours.  Is it too late? Was that the rally?  Perhaps.  It’s just too early to tell.  The encouraging part was the volume was much heavier during the rally.  In fact, the total volume was the highest since October 10th on the S&P SPDRs.  October 10th was a reversal day and then we went up 900 points the next day.  Today was impressive because it was almost a 90% upside volume day and all of this was just in the 2nd half of the day. From 12:00 p.m. (almost to the second), it was a different market.  Tomorrow has a lot to live up to.  If we see volume anywhere close to today and we have another 90% up day, then we may have something.  Otherwise, this will just be another rally we’ll have to sell into.

For tonight, we need look over the entire portfolio and make a decision on every position.  Are these positions long-term holds or short-term trades (rentals).  Everything should have a strategy attached to it. Especially after a 600 point rally.  

I still believe we’re in a range.  It’s a big range but a range nevertheless.  This means when confidence comes back, we sell to those confident people.  When the are too scared as they were this morning, you buy from those scared people.  

Keep this in mind though.  Don’t assume anything.  Just when you think you have the formula which has been sell all big rallies, that may (may) be the time you should be buying rallies.  It’s too early to tell but let’s keep monitoring it.  Great day though.

Have a good evening.