Trader’s Narrative

This is a guest post by EWI.

As the major stock markets turned down in late 2007 and then started to rally in March 2009, many people who believed in fundamental analysis have begun to question its validity.

Famed technical analyst and Elliott wave expert Robert Prechter has long called for the bear market we are now in the midst of. (He views the rally of 2009 to be a bear-market rally not the beginning of a new bull market.) But over the years, his methods of technical analysis have been criticized. Here are his most succinct arguments as to why wave analysis outdoes competing forms of analysis.

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Excerpted from Prechter’s Perspective, re-issued 2004

Question: Suppose everyone agreed, “The Wave Principle is not always right, but it really is the answer”?
Robert Prechter: Well, let me begin my answer with a quote from a national financial magazine dated October 1977. “Over the last few years, the Wave Principle has gathered too much of a following and, therefore, it has less value today. Almost invariably, you can write off a technique when it gets too much of a following.” How does this statement look in light of the decade that followed it? “Elliott” had one of its greatest successes. Like the Energizer Bunny, it keeps going and going. And I believe its next success will be its biggest ever. The Principle itself is undoubtedly on an upward spiral of acceptance: three steps forward and two steps back.

Now let’s suppose that a large number of educated people accepted the Wave Principle, which is not an impossible idea for, say, a thousand years from now. There would still be room for differences of opinion on the market and the future. And there are countless other factors. Even people who practice the craft don’t necessarily take action when they get a signal. Unconscious doubt and worry often foil people’s actions. Very few traders have the emotional strength to turn even good analysis into profits.

Q: The Wave Principle is intrinsically contrarian. Does it have some built-in defense against becoming the consensus?
RP: I think so. The Wave Principle is a description of natural human behavior. This is what human beings are; this is part of their nature — how they behave. In order for markets to continue to go through these stages, a part of human nature must be to believe that such theories of mass psychology are incapable of being true — that is, something not worth examining. They must be primed to accept bullish arguments at tops and bearish arguments at bottoms. That means they have to be ever open to bogus theories of market behavior. How else will they create the patterns that fear, greed and hope produce?
Continue reading ‘Q&A With Prechter: Technical vs. Fundamental Analysis’

The PE ratio needs no introduction. For a very long term chart of the ratio, click on the image to the left. The source of the chart is the NY Times with a helping hand from the economist, Robert Shiller. I was surprised to see that we were trading at a higher PE ratio as early as last year, than the top in 1929!

The graph above is based on the average earnings for the preceding 5 years. This chart is more short term, based on the rolling 4 quarters of earnings:

Why Use the Price Dividend Ratio?
I’m not sure where I first learned about this ratio. But Stan Weinstein really made it stand out for me as a very important measure of market valuation in his book: “Secrets For Profiting in Bull and Bear Markets” The power of this ratio comes from the fact that unlike earnings, dividends can not be “massaged” by creative accounting. There are no “EBIT” dividends. They are completely immune from accounting shenanigans. They are either declared and paid in cash or they aren’t.

Also dividends are free from the year to year shocks such as “write-offs” which can affect earnings. Most companies treat their dividends with what you might say approaches reverence because dividends send such a clear and strong signal about their financial strength.

I’m loathe to dip into the fundamental analysis toolbox but from time to time, when the situation warrants, I do. But for the reasons above, I prefer to use the price dividend ratio instead of the much more popular price earnings ratio.

Basically, the ratio tells you how much you have to pay for $1 of dividends. So in a way it can be equated to the “yield” coupon of the stock market. Or the inverse dividend yield of the stock market. And because of that, it has some correlation to the interest rate. So when interest rates are high, usually the dividend yield is also high.

Here is a very long term chart of the S&P 500 Index. I’ve added two data points, one for where we were this time last year and one for now:

Source: Federal Reserve Bank of San Francisco

Dow Jones Price Dividend Ratio
A year ago, when the Dow was at ~14200, the price dividend ratio was 49. Meaning you would have had to pay almost $50 to get $1 of dividends a year. It also corresponds very closely to the S&P 500’s price dividend ratio (above).

As of now, however, the Dow’s price dividend is a more reasonable 26. This is because of two things. First, and most obviously, the Dow has come down a lot, but also importantly, dividends have increased a healthy 11.7% from a year ago.

As you can see from this long term chart of the Dow’s price dividend ratio, we are right around the long term average for this ratio:

Source: John Bogle on Mutual Funds

As we’ve all noticed in the past few days, the market has the ability to reach maximum levels and then to keep pushing into new territory (I’m looking at you VIX). So just because we are now at a much more “normal” price dividend level doesn’t mean that it can’t go lower. For example, here’s a really scary picture of what might/could happen.

Having said that, I’m glad to see this fundamental ratio not clash with other technical indicators which are pointing to a potential market bottom.

The charts above are long term but do not show the most recent years, so if you know of a more up to date price dividend ratio, I’d love to see it. Or if you have access to a platform like Bloomberg, where you can look it up, send me a screengrab. I’m sure the most recent data holds some insight.

It looks like it is the end of the line for RedEnvelope (REDE). The company is mired in losses, their credit lines have been terminated, and they have sent most of their employees packing. While their site is still up, there’s no telling what will happen.

Perhaps they will be wound down. Or maybe bought out by someone. Perhaps OverStock.com?

It is a shame since it is one of the companies that were birthed in the dot com mania of the late 1990’s and it has lasted so long. But no company can survive without profits. Since going public in 2003, their stock reached a peak of $17 and from there it has been downhill, reaching $0.28/share today. That makes their market cap just above $2.5 million.

Opportunity
The special situation here is that although the company has been bleeding red ink, they have a lot of cash on hand. As of December 31st, 2007 they had $12.3 million to be exact. And while they have no doubt dipped into that in the ensuing months, there should be more than enough there to double or triple their market cap.

At the risk of playing a fundamental analyst, here are the details from their latest quarterly results:

• total assets $33.1 million
• liquid assets (total cash + accts receivable) $15 million
• total liabilities $23.8 million
• value: $9.3 million

Now that is a very crude back of the envelope analysis and it is for the end of last year. But I really don’t think they’ve burned through it all. Which leaves a healthy margin.

Here is the graph of RedEnvelope (REDE) with their closing price and what they have on cash, if we assume the business isn’t a going concern and worth zero:

It may not show up as a significant difference on this chart because of the sheer loss of value of RedEnvelope shares, but it is more than three times the current share price.

In case REDE gets bought out, it will be for the name and the business as a going concern, which will make the offer higher than mere net cash value.

From a technical point of view, I wouldn’t touch REDE with a barge pole. It is too late to sell short and you would have to forget everything ever written about technical analysis to go long. But that isn’t how I’m approaching it.