Trader’s Narrative

Today the venerable Dow Jones Industrial index is undergoing changes to its component stocks: Altria Group, formerly Philip Morris (MO) and Honeywell (HON) are being replaced with Chevron (CVX) and Bank of America (BAC).

Actively Passive
Which explains why I always chuckle when people get into debates about “passive” (aka index) funds vs. “active” funds. As today’s change should evidence, all funds, including indexes are active.

Somebody has to decide: a] what to put into an index b] rebalance it using some formula and c] make changes to the components, from time to time.

In an active fund, those calls are made by the manager who charges a hefty fee and in the case of an index fund like the Dow Jones the decision is made by the editors of The Wall Street Journal. Same difference.

The only real distinction is the portfolio turnover and the MER. While changes to the Dow happen every few years, an actively managed portfolio can have positions traded into and out up to several times a day.

Better Out Than In
Another interesting twist to this debate is that historically, stocks deleted from the Dow Jones end up outperforming the ones that replace them. That goes for not just the Dow but all major indices.

For example, Chevron was in the Dow before until it was deleted on November 1st, 1999 in a swap that involved 3 other boring stocks getting dumped for sexier stocks: Home Depot (HD), Intel (INTC), Microsoft (MSFT) and SBC Communications - now AT&T (T). The editors of the WSJ weren’t immune to the lure of the internet bubble.

The four new stocks went on to produce an average loss of 40% while the deleted and unloved stodgy ones produced an average gain of 27%. So the Dow would have been much better off had there been no changes at all!

The most (in)famous change to the Dow is the elimination of IBM from the index in 1939. While it was eventually added again, according to Norman Fosback, the Dow would now be twice what it is today had there been no change.

Still like indexing? still think it is passive?

Technical Analysis
Rather than a typical technical analysis of the Dow using its own chart, I thought I’d share something a bit more advanced and perhaps more insightful.

The chart below is a ratio of two breadth indicators: the percentage of Dow components above their 50 day moving average, divided by the percentage of Dow components above their 200 day moving average. If it sounds familiar, you’ve probably read this: “Timing the Market with % Above MA Ratios”

Whenever the ratio spikes, the Dow is extremely oversold. The current ratio has spiked because the denominator is 13.33% - the lowest it has been in five years.

Anything in the 2.0+ range is beyond extreme. We’ve only exceeded this level in recent times when the market was making the 2002-2003 bear market bottom.

Fundamental Analysis
According to Morningstar’s fundamental analysis, the Dow is undervalued by 17%. They arrived at this valuation by doing an analysis of each component. They also expect the index to rise 50% in the next 3 years.

According to Jeffrey Ptak, “The Dow hasn’t looked this cheap to us since September 2002 when the index stood at 7,592″. Sound familiar?

The research note was released before today’s changes to the Dow but Morningstar added a note saying that Chevron and Bank of America will actually make the Dow even more undervalued, reducing both trailing and projected price earnings ratio and increasing the dividend yield.

I’m not big on fundamental analysis but when it dovetails so neatly with technical analysis, I can’t help but take notice. Oh and for another take on the general market fundamentals, take a look at the IBES model.

Remember to add your own thinking and due diligence.

This is just a quick follow up. For further details see my first message from last summer on the I/B/E/S Valuation Model for the stock exchange.

What’s amazing is that according to this model, we are even more undervalued now. Pretty much as “cheap” as the bear market bottom in 2002. So, when a fairly good historical indicator goes totally berserk like this, it can be two things:

1. circumstances have changed (GIGO principle)
2. something real is going on

If you like the first option, you can trot out the 10 Year Note’s crazy low yield and blame it for the outlier result.

If you like the second, you can retort with, “Pshaw! We had the same rates in 2002 and look how far equities ran.”

In either case, it’s your call.

(FYI:I’m leaning towards #2)

Hoo-Kay… let’s see. Why is this a buying opportunity for someone with a medium to long term time horizon?

Glad you asked.

Fund Flows
We already know that the vast majority of investor’s money is flowing oversears, eschewing the US equity market. But with the recent market decline, investors are now pulling money out in a panic. According to TrimTabs, they withdrew $7.6 Billion last week. That sort of panic is similar to what we saw in late February 2007 when investors pulled $6.5 Billion.

Insiders Are Buying
Meanwhile, insiders have been scooping up unloved shares at a pace not seen in 3 years. That was in August 2004 as stocks hit an intermediate bottom. Ask yourself, is there anything insiders know that we don’t? Who would I rather side with? insiders or Mom’n'Pop investors who are ruled by emotion?

Sentiment
Speaking of emotion, while sentiment surveys are not yet in, I suspect that we’ll see a marked decline in bullishness and a rise in bearishness. Only one is in so far and it shows a tilt towards bearishness as fear grips investors. But looking at unorthodox places like newspaper headlines and media stories we can find a lot of negative chatter.

“Usual Suspects” Show Fear
The usual indicators that most people turn to are showing fear: volatility indices and the put/call ratios. And the increasingly popular % of stocks above a moving average.

Scapegoat: Sub-Prime Mortgates
Everytime the market falls, a convenient reason is trotted out to explain it in a sound bite. Today’s is the subprime mortgage market. In the spring it was China’s fault. They sneezed. We caught a cold. While it is ugly out there in the subprime market, risk profiles are returning to more normal levels.

It is not the end of the world as we know it. According to the credit default swap market, we are in full blown panic right now. As a result the financial sector has gotten crushed to absurd valuation levels. Over the long term, this is one heck of a great buying opportunity as people panic and throw out the baby with the bathwater.

Market Internals
Popping the hood on the market and taking a peek inside we see that the internals are also showing panic and fear. At levels which historically have installed important market bottoms. Take a look at the new highs, versus new lows. The advance decline line, likewise has found a high probability buy zone here.

The Commercials
Like the insiders, they know something. They aren’t telling exactly what, but who cares? All we need to do is follow what they do. That’s the most convincing argument they can put forth: money where their mouth is. The commercials have steadfastly and consistently increased a ginormous net long position. Who do you want to side with? them or the little guy who was buying calls like crazy just before the market dove off?

Fundymentals
Let’s not give the technical tools all the fun. How abou the IBES model? It is showing that equity markets are very cheap here. Yes, very. And cheap. Don’t like the IBES? Fine. How about that the market’s forward multiple is 14.7, which is a little below its 20 year average? Still think the market is inordinantly expensive and in need of a fall?

Bond Market
A lot was made of the bond market’s fall in June 2007. But guess what, the yields spiked on the 10 year and 30 year Notes have fallen dramatically. Don’t believe me? Pull up a quote. If you’re a chart and system junkie, take a look at the 30 day rate of change for the bond market.

Traditional Technical Analyisis
Price, moving averages, trendlines and good ol’ support and resistance. The market has fallen to its 200 day moving average, where it has found footing before several times. The uptrend is still intact. And the S&P 500 is right at the support (previous resistance) line at 1460(ish) - check out the graph.

Bad News Trio
Bad news is everywhere: American Home Mortgage is in bankruptcy, Sowood Capital, imploded taking with it hundreds of millions of investor’s money. And just today rumours were swirling of Beazer Homes’ (BZH) bankruptcy. As far as I know they were unsubstantiated. But the important thing is that the negative headlines and fear is palpable. Just this week there was an article on the Wall Street Journal asking if the bull market was over? This cluster of negative articles and media attention accompanies market bottoms, not tops.

The IPO Market Speaks
When things get frothy, the IPO market goes insane. Crazy ideas are funded and taken public. Remember the turds from the bubble years? e-Stamps anyone? Right now though we have a healthy IPO market. One that is open and functioning without being irrationally exuberant. That bodes well for the market in general as this study from Thomson Financial shows.

Earlier this month I mentioned the IBES valuation model and how it was telling us that US equities are extremely undervalued. The Barnes Index is another valuation model which is similar to the IBES.

Keep in mind that these valuation models are really broad strokes. They are not meant for nimble, short term traders. They attempt to outline the general tone of the market and perhaps its long term trajectory.

So what is the Barnes Index? Like the IBES model it compares the stock market to the bond market. But unlike the IBES it considers both the short term yield and the long term yield (the yield curve in other words):

Barnes Index = (Treasury Bond Yield X Treasury Bill Yield) divided by (S&P 500 Dividend Yield X S&P 500 Earnings Yield)

So in essence it pits the “returns” from stocks, in the form of dividends and earnings versus the “return” (yield) from bonds. Market risk is highest when you can make more by investing in risk-free assets. The normalized chart below comes from Decision Point (the excellent technical analysis service run by Carl Swenlin).

Click to Enlarge Graph

Since it began in 1970, the Barnes Index gives us a few more years than the IBES model. The last buy signal was given in early 2003, at the bottom of the bear market. At its current level, it is neutral.

In 1973, when the Barnes Index was also at similar levels, the market topped. Also in 1981. But then again, in 1990-1 although it stood where it does now, the market went much higher.

Notice that similar to the IBES the model imploded into irrelevance due to the “bubble years”. In 1997 it crept into the redline and stayed there almost constantly until late 2001. Which proves that no model or forumla can ever predict or explain the market. All we can ever hope for is a crude approximation.

No that isn’t a typo, I really do mean undervalued. And extremely is the correct adjective also.

Sometimes a graph just speaks for itself:

So what is this graph ?

It comes from the Institutional Brokers’ Estimate System (sometimes written as I/B/E/S) which started in 1976 for US equities and 1987 for international equities. IBES is a huge database that gathers the different estimates of earnings by stock analysts for the majority of U.S. publicly traded companies.

The IBES valuation model compares the 12-month forward estimate earnings yield (earnings/price x 100) of the S&P 500 to the current yield of the 10-year Treasury note.

Lets see how one would have done following its guidance:

• it got you in at the start of the bull market in the 1980’s
• it cautioned you just before the crash of 1987
• it flashed a warning again in late 1991
• but it was premature as the market dipped only a little bit and went much higher
• it got you back in in late 1993 which was during the plateau - just before another dramatic liftoff
• it told you to buy again when the market dipped in late 1995 (fantastic!)
• it signalled caution in 1997 which resulted in a sideways trading range 2-3 years
• it repeatedly signalled caution during the bubble years
• it told you to buy again in mid 2002 - almost the exact bottom of the bear market!
• it has remained stubbornly flashing a buy signal ever since