What's Next - Minor Correction or Major Meltdown?

By Simon Maierhofer

On 12:33 pm EDT, Tuesday October 27, 2009

It was after midnight on April 15th, 1912 when the unsinkable did the unthinkable. Built and labeled as unsinkable, the Titanic was the most advanced and largest passenger steamship of its time.

Even though the Titanic's crew was aware of the fact that the waters were iceberg-infested, the ship was heading full-steam for a destination it would never reach.

Being aware of danger is one thing; acting prudently for protection is another.

Today, investors find themselves in an environment that is infested with symbolic icebergs. For savvy investors willing to pay attention and heed warnings, this doesn't necessarily translate into a financial shipwreck, while others might soon be reminded of the Titanic when they look at their account balance.

Iceberg cluster #1: Lack of leadership

Throughout the financial meltdown financials, real estate, and homebuilders fell harder and faster than broad market indexes a la S&P 500 (SNP: ^GSPC) and Dow Jones (DJI: ^DJI). Beginning with the miraculous March revival (more about that in a moment), the broad market rose while financials, real estate, and homebuilders soared.

Those three sectors led the decline and led the subsequent (mock) recovery. Since it is reasonable to assume that those sectors will continue to lead the market throughout this economic cycle, it behooves investors to watch such leading sectors closely.

The S&P 500 (NYSEArca: SPY - News) recorded a closing high on October 19th at 1,097. The Financial Select Sector SPDRs (NYSEArca: XLF - News) reached their closing high a few days earlier on October 15th. Since their respective closing highs, the S&P 500 has dropped 2.82%, while XLF has already shed 5.64%.

A more pronounced performance slump is visible in the home builders sector. The SPDR S&P Homebuilders ETF (NYSEArca: XHB - News) peaked on September 16th and has fallen 9.97% since. Keep in mind that XHB's lackluster performance comes on the heels of the biggest monthly increase in total home sales in ten years.

Even though the inventory of existing homes fell 7.5% month-over month in September (to 3.6 million units), the shadow inventory of 3.5 million foreclosed homes is probably weighing heavily on home builders. Shadow inventory represents foreclosed homes that are vacant, still included on bank's balance sheets, but have not hit the market yet. 3.5 million homes equal about 1 - 2 years worth of supply.

Iceberg cluster #2: Non-confirmation in the technology sector

Apple, Wall Street's new darling, reported block buster earnings and rallied over 10% to new all-time highs. Microsoft reported better than expected numbers and spiked 7.4%. Investors loved Amazon's outlook so much that they bid up the stock by over 33%. Combined, the three companies account for nearly 24% of the Nasdaq (Nasdaq: ^IXIC), yet the Nasdaq is traded lower today than before earnings season on October 14th. The same is true for the Technology Select Sector SPDRs (NYSEArca: XLK - News).

If 24% of the Nasdaq's components rallied between 7 and 33%, without lifting the index, a lot of tech companies must be hurting. In fact, the Nasdaq's (Nasdaq: QQQQ - News) performance is masking the decline IBM, Intel, and many other once high-flying tech companies have seen over the past 1-2 weeks.

Iceberg cluster #3: Earnings are a lagging - not leading - indicator

Even though expectations were low to begin with (beating earnings forecasts was likened to an A student asked to achieve only a C), there is no arguing that this quarter's reports were much better than last quarters.

Many view this as a sign that the economy had hit rock-bottom back in March. In fact, 80% of economists now believe that the recession is over (probably the same 80% that didn't see the recession coming in 2007). However, as the chart below shows, earnings per share (EPS) are directly linked to the stock market's performance at best and a lagging indicator at worst.

Alcoa, one of the biggest components of the hottest sector - materials (NYSEArca: XLB - News), surprised investors with a positive third quarter. Year-to-date, however, Alcoa lost $0.75 per share. This compares to a profit of $2.95 per share in 2007. At this point, Alcoa does not even have a P/E ratio, since Alcoa has no 'E' - earnings.

Considering the relationship between stocks and earnings, it would be interesting to know what caused the March bottom.

Throughout February and March, Wall Street was covered by a veil of uncertainty and worry that the country would slip into another depression. Ever since the Great Depression, there've never been as many articles referring to the Great Depression as in March.

It is exactly that kind of pessimism that foreshadows market bottoms of some significance. Such pessimism rids the market of weak stock holders and opens the door for buyers to bid up prices. That's exactly what the ETF Profit Strategy Newsletter predicted via the March 2nd Trend Change Alert.

Below is a brief excerpt taken from the Trend Change Alert: 'A multi-month rally, the biggest rally since the October 2007 all-time highs, should lift the indexes by some 30-40%. Tuesday's (2-23-09) 4% spike may be an indication of the initial intensity of the rally. Beaten down sectors like financials (NYSEArca: VFH - News), industrials (NYSEArca: XLI - News), materials (NYSEArca: IYM - News) and consumer discretionaries (NYSEArca: XLY - News) are likely to see the biggest percentage gains over the next few months.' Many of the recommended ETFs gained triple digits in the upcoming months.

This rise in stock prices and consumer sentiment, along with serious cost-cutting by publicly held corporations, shrank corporate losses and even created profits for some corporations. But once again, it was rising stock prices that resulted in better than expected profits, not vice verse.

Iceberg cluster #4: No demand for products

It seems like companies have boosted their production. The key question is whether this uptick is merely due to an effort to restock inventories, or actual demand by the consumer. Fortunately for investors, there's an easy way to find out.

If there is real demand by consumers, it will be reflected by shipping and transport companies. Products in demand need to be shipped from the manufacturer to the consumer or wholesaler. A look at the transportation/shipping sector providers, therefore, an easy and logical answer.

UPS shipments fell for the sevenths consecutive quarter. UPS' profits fell 43% year over year due to lower demand for packaged deliveries. Burlington Northern, the biggest component of the Dow Jones Transportation Average (NYSEArca: IYT - News), reported that its freight revenue dropped 27% year over year.

This is exactly the opposite of what you'd expect to happen in a new, sound bull market.

Iceberg cluster #5: (Over) valuation

Would you buy the Dow Jones at 10,000? It probably depends on where you see the Dow trade a week, a month, or a year from today. Many investors and Wall Street gurus are advocating to buy the Dow at current levels.

Let me ask you this: Did you buy the Dow at 7,000? If you didn't buy the Dow a few months ago at 7,000, why would you buy it today at 10,000? Today's Dow is 50% more expensive than it was seven months ago, yet more people are willing to buy now than in March. Aside from the stock market, there is no other 'salesman' able to sell a product for a 50% premium.

Bait-and switch at its finest

How can the stock market get away with this? The only difference between March 2009 and today is perception. Even though it defies logic, stocks are perceived to be a better deal today than in March.

Imagine what will happen when the perception changes. Once investors start believing that they can buy stocks later at a lower price they will wait, buyers will dry up, and stocks will plummet.
It's no stretch to expect lower prices. Even though prices have come off multi-decade lows, earnings are lower than any other time since the Great Depression. The S&P 500's P/E ratio (stock price divided by annual earnings), based on actual reported earnings have sky-rocketed to all-time highs.

Anybody buying the S&P 500 at current prices is paying 138 times as much as reported earnings. In other words, based on this year's earnings, it would take 138 years of profits to repay your investment.

Would you buy a Subway franchise at 138 times its annual profit if you knew that 15 - 20 is the historical average? 15 - 20 is the average P/E ratio over the past 100 years. Anybody buying now will have to be prepared for significantly lower prices.

Some things never change

History teaches us that overvalued markets can't last forever. History also teaches us how far the market will have to drop to reach fair values. The bear markets of the 1930s, 1940s, 1950s, 1970s and 1980s have provided us with a valuation reset template.

Every bear market bottom has seen P/E ratios drop to historically low levels. Investors, however, don't have to rely on P/E ratios alone. Dividend yields, mutual fund cash levels, and the Dow measured in the only true currency - gold (NYSEArca: GLD - News) provide another window into the future - a nearly fail-proof composite indictor.

The October issue of the ETF Profit Strategy Newsletter plots the historic performance of the stock market against P/E ratios, dividend yields, mutual fund cash reserves, and the Dow measured in gold, along with target levels for the ultimate market bottom. A picture paints a thousand words and those charts speak volumes about the market's future.

Did you know that the Titanic received an iceberg warning less than two hours before an iceberg brushed the ship's starboard side, buckling the hull in several places? An angry communications officer responded: 'Shut up, shut up, I am busy; I am working.' There are plenty of indicators warning investors today. Will you heed the warning and avoid financial shipwreck?

© 2009, ETFguide.com

Remember this is October...

Traditionally October has been a time of year that brings fear to the mind of investors. Several of our proprietary indicators are flashing warning signals of an imminent decline in the equity markets that could be rather sharp.

Dranger In The Press

Dranger has been receiving lots of press lateley

Dranger Capital Management's Trading Strategy In Full Swing

Dranger Capital Management's Trading Strategy In Full Swing
By: Angel Reyes

Investors this week used the options markets in an effort to protect against a market sell off. As our readers know, Dranger Capital Management ("DCM"), has been way out in front of this trading strategy as evidenced by its #2 ranking on Barclays.

Trading has been heavy in the S&P 500 ETF where traders bought twice as many put options than calls. Such a strategy, one that DCM employed throughout this summer, points to the possibility of the S&P falling off its recent highs.

DCM continues to follow its proprietary trading strategies to make money for itself and its clients with little more risk than general market risk.

Call today to talk to our CEO and portfolio manager Tony Rigas 866-460-3147, or send an email for more information to trigas@drangercapital.com .

Traders Position Themselves for S&P 500 Pullback
By ED WELSCH

Investors used the options market to buy protection against the possibility of a broad market pullback, a day after the four-week summer rally showed signs of sputtering.

Trading was fairly heavy in the S&P 500 ETF, where more than twice as many put options traded than calls, according to Track Data. The strong activity in puts, which give the right to sell the fund, suggested trading was focused on the possibility of a downdraft in the Standard & Poor's 500-stock index.

"This is clearly a sign of people running for cover and for some protection," said David Gompert, senior market analyst at TradeMonster. Put trading starting to pick up in September contracts also showed traders were getting cautious about the market going into the fall months, Mr. Gompert said, which have historically been "brutal" for the stock market.

One strategy traders pursued to protect against a market correction is called a "1-by-2 put ratio spread," and was seen Tuesday in third-quarter SPY put options, said Steve Claussen, chief investment strategist of OptionsHouse LLC.

Quarterly put options expire at the end of the month rather than midmonth like standard options. About 62,000 third-quarter SPY puts traded at the $90 strike and 31,000 traded at the $95 strike, which roughly correspond to 900 and 950 on the S&P 500.

In that trade, the investor sells twice as many puts at the lower strike to finance buying puts at the higher strike. In effect, the trade breaks even if the S&P 500 falls between 950 and 850, with a "sweet spot" at 900. That level corresponds with the predictions of some of the more bearish market strategists who expect a pullback to where the S&P 500 was before its earnings-season rally, as opposed to the more bullish consensus of strategists expecting the S&P 500 to end the year above 1000. The S&P 500 index closed Tuesday at 989.67.

More put trading that may be tied to macroeconomic worries also took place in shares of children's clothing maker Gymboree, with 25,000 puts trading against 5,000 calls.

The bulk of the action was in September $40 puts, which traded for $2.70 each and break even at $37.30. Gymboree shares closed down 1.4% at $39.82 on apparent anxiety before the retailer's second-quarter earnings report, which is expected after the market close Wednesday.

Sentiment around Gymboree, which sells items like backpacks and lunchboxes as well as clothes, may be suffering from weak expectations for the back-to-school shopping season.

Despite near-term worries reflected by the defensive maneuvers in the options market, the broader market action showed traders were still optimistic about the chances of economic recovery, with the S&P 500 and Dow Jones Industrials retracing some of their losses from Monday and Friday; both indexes finished the session up 1%.

One outsize, long-term options trade Tuesday also likely reflected a strong optimism over an eventual recovery: more than 30,000 $15 call options traded in Wisconsin-based manufacturer Manitowoc, which closed at $6.66 Tuesday. The success of Manitowoc's construction cranes and commercial-kitchen-equipment manufacturing is tied strongly to an increase in capital investment that would come with an economic recovery.

The catch is that the options traded in longest-dated January 2011 contracts, and only break even if Manitowoc shares more than double from their current price over the next 18 months.

"They are going out as far as they possibly can in time," Mr. Claussen said of the traders making the bet on Manitowoc, "which maybe says they think a recovery is coming -- they're just not sure when."

Write to Ed Welsch at ed.welsch@dowjones.com

Printed in The Wall Street Journal, page C5

Futures trading involves significant risk and is not suitable for everyone.

DCM Correlation

I recently came across an article that bears directly on our trading strategy here at Dranger Capital Management (DCM). As many readers know, our strategy remains bearish on S&P 500 with both short and medium term holding periods. The strategy follows some basic market principals and incorporates the VIX and overbought/oversold indicators to accomplish above-market returns with little more risk than market risk. See our current rankings in Barclays.

As the author below notes, two factors have made important contributions to stock market returns following recessions. The first is valuation. Depressed valuations typically produce above-average returns going forward for 7-10 years. The second factor that drives market returns “following U.S. recessions is: prospective GDP growth. Each quarter, the U.S. Department of Commerce releases an estimate of what is known as "potential GDP," as well as estimates of future potential GDP for the decade ahead. These estimates are based on the U.S. capital stock, projected labor force growth, population trends, productivity, and other variables. As the Commerce Department notes, potential GDP isn't a ceiling on output, but is instead a measure of maximum sustainable output.

The comparison between actual and potential GDP is frequently referred to as the “output gap.” Generally, U.S. recessions have created a significant output gap, as the recent one has done. Combined with demographic factors like strong expected labor force growth, this output gap has resulted in above-average real GDP growth in the years following the recession.” Unfortunately, we’re not seeing an output gap. Indeed, we’re not sure this recession is over.

Bottom line: “Aside from a gradual recovery of the "output gap" created by the current downturn, there is no structural reason to expect economic growth to be a major driver of investment returns in the years ahead. With valuations now elevated above historical norms, there is no reason to expect strong total returns on an investment basis either.”

As we’ve noted several times in the past few months, the single market driver is speculative and program buying. Everyone is hoping the recession is over and failing to look at the fundamentals that underlie this current recession. Overpriced stock and an output gap would be a natural place to look if one we’re of the opinion that the recession is over and U.S. stocks will again begin a sustainable ascent. DCM isn’t seeing those fundamentals, so we’re positioning ourselves to take advantage of our insight. At DCM , our trading
record speaks for itself, see our latest rankings in Barclays.

See the full article below:

Growth in "Potential GDP" Shows Limited Potential

By John P. Hussman, Ph.D.

Historically, two factors have made important contributions to stock market returns in the years following U.S. recessions. One of these that we review frequently is valuation. Very simply, depressed valuations have historically been predictably followed by above-average total returns over the following 7-10 year period (though not necessarily over very short periods of time), while elevated valuations have been predictably followed by below-average total returns.

Thus, when we look at the dividend yield of the S&P 500 at the end of U.S. recessions since 1940, we find that the average yield has been about 4.25% (the yield at the market's low was invariably even higher). Presently, the dividend yield on the S&P 500 is about half that, at 2.14%, placing the S&P 500 price/dividend ratio at about double the level that is normally seen at the end of U.S. recessions (even presuming the recession is in fact ending, of which I remain doubtful). At the March low, the yield on the S&P 500 didn't even crack 3.65%. Similarly, the price-to-revenue ratio on the S&P 500 at the end of recessions has been about 40% lower than it is today, and has been lower still at the actual bear market trough. The same is true of valuations in relation to normalized earnings, even though the market looked reasonably cheap in March based on the ratio of the S&P 500 to 2007 peak earnings (which were driven by profit margins about 50% above the historical norm).

Stocks are currently overvalued, which – if the recession is indeed over – makes the present situation an outlier. Unfortunately, since valuations and subsequent returns go hand in hand, the likelihood is that the probable returns over the coming years will also be a disappointingly low outlier. In short, we should not assume, even if the recession is ending, that above average multi-year returns will follow.

That conclusion is also supported by another driver of market returns in the years following U.S. recessions: prospective GDP growth. Every quarter, the U.S. Department of Commerce releases an estimate of what is known as "potential GDP," as well as estimates of future potential GDP for the decade ahead. These estimates are based on the U.S. capital stock, projected labor force growth, population trends, productivity, and other variables. As the Commerce Department notes, potential GDP isn't a ceiling on output, but is instead a measure of maximum sustainable output.

The comparison between actual and potential GDP is frequently referred to as the "output gap." Generally, U.S. recessions have created a significant output gap, as the recent one has done. Combined with demographic factors like strong expected labor force growth, this output gap has resulted in above-average real GDP growth in the years following the recession.

The chart below shows the 10-year growth rates in actual and potential GDP since 1949 (the first year that data are available).

The blue line presents actual growth in real U.S. GDP in the decade following each point in time. This line ends a decade ago for obvious reasons. The red line presents the 10-year projected growth of "potential" real GDP. This line is much smoother, because the measure of potential GDP is not concerned with fluctuations in economic growth, only the amount of output that the economy is capable of producing at relatively full utilization of resources.

One of the things to notice immediately is that because of demographics and other factors, projected 10-year growth in potential GDP has never been lower. This is not based on credit conditions or other prevailing concerns related to the recent economic downturn. Rather, it is a structural feature of the U.S. economy here, and has important implications for the sort of economic growth we should expect in the decade ahead.

The green line is something of a hybrid of the two data series. Here, I've calculated the 10-year GDP growth that would result if the current level of GDP at any given time was to grow to the level of potential GDP projected for the following decade. This line takes the "output gap" into effect, since a depressed current level of GDP requires greater subsequent growth to achieve future potential GDP. Notice here that even given the decline we saw in GDP last year, the likely growth in GDP over the coming decade is well under 3% annually - a level that we have typically seen in periods of tight capacity (that were predictably followed by sub-par subsequent economic growth), not at the beginning stages of a recovery.

The situation is clearly better than it was at the 2007 economic peak, where probable 10-year economic growth dropped to the lowest level in the recorded data, but again, the likely growth rate is still below 3% annually over the next decade even given the economic slack we observe.

Aside from a gradual recovery of the "output gap" created by the current downturn, there is no structural reason to expect economic growth to be a major driver of investment returns in the years ahead. With valuations now elevated above historical norms, there is no reason to expect strong total returns on an investment basis either.

The primary element that is favorable at present is speculation – excitement over the prospect that the recession is over. Investors are presently anticipating the good things that have historically accompanied the end of recessions (strong investment returns and sustained economic growth), without having in hand the factors that have made those things possible (excellent valuations and a large output gap coupled with strong structural growth in potential GDP).

Persistant Market Manipulation

The persistant computer program buying continues to push prices upward and create an extremely overbought environment. The market internals are painting a different picture about the continued sustainablitity about this move. Four times in the last 14 trading days, the S&P's have gone up 1% or more, with the volume being lower or only marginally better on the NYSE versus the previous day.

Looking at the volume totals on Tuesday 8/12 shows an even uglier picture. The market breadth was extremely weak with decliners surpassing advancers by more than 2.5 to 1. Meanwhile, the market finished up close to 1%.

As we move into the fall, we think the volatility will increase further, and we continue to believe that the probabilities of further price appreciation from here are extremely limited, and favor remaining short.

Extremely Overbought

The market continues its aggressive move upward without taking a moment to catch its breath. We have had postive months posted since March, which is not normal. The DJIA has rallied as of this a.m. 43% since March '09, while the Nasdaq has gone up over 57% in the same time frame, a pretty impressive move indeed.

We view this situation of 5 positive months in a row as a once in a 75 year occurance and see the market as very overbought. This overbought environment can continue longer (as it did with the Nasdaq in 1999-2000), nothing is impossible. However the higher it goes in this manner, the more painful the return to normalicy will be. In other words, the higher it goes without a correction, the harder the fall will be. That's historically the pattern, not to mention using some common sense.

Additionally, the economic reports coming out and the corporate earnings being reported, have been better than the previous reports on the whole. Things have gotten less bad. But look at what the comparisons numbers were - they were weak to begin with.

Once last thing to consider. There has been an overwhelming Bid to the market, particularly in the last two weeks. All buy programs present. The selling programs, for whatever reason, have not been present. We see them as taking a rest, not extinct.

Redline - Too Much, Too Fast

The market has moved so fast and blown through all resistance levels in a few days. We are extremely over bought in the short term and looking for the market to pull back. The S&P has moved up over 13% in last 12 trading days without even giving back 2%. Very unusual and not normal market action.

Whether it is computer related buy programs and/or high frequency trading driving this up, we are seeing a fear of missing out in the market.

So, we are positioned for at least a small correction, if not something bigger.

Remember the Nasdaq in 1999 to 2000. The further the market goes without a setback, the harder the fall when it develops.

Market in hyperdrive

Will the bulls get tired? Option Expiration week can have a buy bias & it certaily has this week. The computer buy programs have been at a zenith level. However, there has been so much power put into this move up over the last three days, that it may not have much energy left. This resembles an exhaustion gap up move. When the "buy at any price" crew leaves, the correction is usually sharp and very unpleasant. Thus, we are closely monitoring the situation for a short entry that will most likely present itself over the next few days.

Lack of Buyers in the market

Low interest in the market by institutions has created an environment where there were no sustainable rallies today. The market is in a tug of war between the bulls and bears, where the short term looks oversold, but the mid term still shows the market having some excess to work off. It should have been easy for the bulls or bears to score some points and give the market some direction.

So, we are left to see if the bulls will take it back above 905 or if the bears will make their move and push prices lower. Then the market will need to do some consolidation at a lower level before the next move up takes place.

Market Outlook

DCM believes that the equity markets will continue to be volatile and the indices may ultimately be very close to where they are today over time.