After a huge run, the market takes a breather and awaits earnings before deciding what to do next. In this month’s article:
- Waiting for Earnings – faced with the reality of earnings, the market has pulled back. Still, volume is light, and investors are looking to earnings for more direction.
- Investing in June – the market went sideways and money rotated through sectors, a sign that the market was near a top. Meanwhile, it was a month where it was important not to rely on superficial explanations of what was happening in the market.
- Investing Strategy – As I said last month, it’s a great time to be making a stock shopping list. Picking an entry point remains the challenging part. Updates on some stocks mentioned previously, including Apple, Goldman Sachs, Morgan Stanley, Boeing and the TBT.
Waiting for Earnings
So we all know that the market had a big run from March through May. Except for a bump in early June, we’ve pretty much been going sideways since May. And for the most part, the market knew that we had gone very far, very fast. Most (including myself) were looking for a correction around the corner. And the market defied that expectation, heading sideways, until now.
The market is pulling back, correcting, and the only question now is how much. A quick look at the chart for the S&P gives us some parameters. In early June, we hit recent upward resistance of 950.
Much has been said in the last month about the “head and shoulders” pattern that formed in May and June (see chart). It’s call “head and shoulders” because that’s exactly what it looks like – the head, formed by the high at 950, and the two shoulders to either side, formed around the 930 range. If you draw a line under the lowest points in the head and shoulders formation, you’ll get the lower resistance level, called the “neckline”. In this case the neckline is slightly upward sloping, making resistance about 895. The chartists say that the head and shoulders formation is a sign of a “top”, and if you break below the neckline, you’re headed lower. That happened last week, and today we stand at 883.
If we look a little more, we’ll find that the chart has some more interesting information. First, you’ll find that the 200-day moving average (the yellow line) is 883. As mentioned, we’re at 883. If we draw another line through the highs of April, we’ll find that line is at about 874 (which we touched on Wednesday, July 8, 2009). So we have another resistance level in this range. If we fall below 874, our next level is 822-830.
What does all that mean? The bears have taken us down to 874, and at the moment, we’re waiting to see if that level will hold. If it doesn’t, we’re likely to head to the 822-830 level. And whether we hold or fall below this level will depend on earnings, which started this week, but really get interesting when several big hitters – JP Morgan Chase, Intel, Bank of America, Citigroup, Nokia and Goldman Sachs report next week.
And what’s the outlook for earnings season? It’s difficult to say, really. We’ve been very optimistic, based on share prices, over the last few months. So it’s likely that some forecasts will be too high. By the same token, we remain in a weak economy, and that would pull down expectations. There’s no clear case for saying expectations are too high or too low. Personally, I expect the season to be very mixed. And unlike the last year or so, where entire sectors moved together – regardless of the quality of individual stocks – I think that this quarter, we’ll be separating the weak from the strong in each sector. As mentioned in past articles, individual stock-picking is back.
Investing in June
If you’re a regular reader of this column, you will have noticed that I like to look at patterns. In fact, that’s the whole premise of these articles – that by observing the market, and seeing patterns, you can get a better handle on where the market is heading. This month, there were two lessons that stood out in my mind.
First, there’s a lot to learn from watching a market move sideways.
Financials led the rally, and by May and June, the financials were trading at a fair market multiple to next year’s earnings. That meant the financials were fully priced. Basically, they were at the upper range of their trading ranges.
As a result, financials started to top out and money flowed into other sectors of the market. One of these was commodities. They too helped carry the market forward. But these commodities started to exceed fundamental values. By all accounts, there was a solid supply of oil, and fundamentals would have put the price of oil in the high $50s. Nevertheless, oil marched as high as $73 last week, before dropping and touching $59 today. Likewise, the supply of natural gas was quite high, but natural gas climbed up, but began to turn in early June, several weeks before oil did.
So money flowed into financials and into commodities. And when these started to look toppy, they flowed into other sectors. During the sideways move of May through June, one sector would get a bump one day, and it would be another sector’s turn another day. Consumer staples, retail, healthcare, utilities, etc. – they all had their day, some longer, some shorter.
Keep in the mind that as the money was roaming around looking for the next place to be, the head and shoulders pattern was forming. The first shoulder, which is a “local” high, followed by the head, representing an attempt by the bulls to keep moving. Then the second shouder – another attempt to push the market up, but not as successful as the “head”.
Eventually, money ran out of places to go. Investors were unwilling to go further into sectors that had already moved 30-40%. So we started to see a pullback in the financials, and last week, we finally lost the commodities trade as oil and metals all pulled back.
So my takeaway for the future is that when you see this pattern of sideways movement, combined with rotation through sectors, it's a signal that the market doesn’t know where to go. It doesn’t believe that it should put more money in the sectors that have done well, and if the market isn’t moving up as this rotation occurs, that means the market doesn’t have a lot of conviction in these other sectors as well. That says that a down leg is becoming more and more likely – a trend confirmed by the “head and shoulders” in this case.
Second, the headlines like to talk about fundamentals, but sometimes, market moves are more about money flow and trading opportunities.
If you were just to look at the headlines, I think you would end up with a superficial understanding of events, and that wouldn’t prepare you for the turns that the market takes.
For example, take the commodities trade. When the rally started in March, people were looking at demand from China, saying that it was driven by a recovery; much was said about how China would “lead us out of the recession”. Now the accepted consensus is that China’s stimulus package was working, but that China will not be the engine of growth. And in fact, China was buying a lot of oil and copper and other commodities, but it turns out that China was stockpiling. In fact, China was the ultimate speculator – it was buying when commodities were cheap and storing them for future use. On the oil side, China admitted as much, saying that it had been buying oil to fill up its own strategic reserve. China even stated that the continued rise in oil was unsustainable, and that further demand from China was unlikely because it had nearly completed purchases for its strategic oil reserve. If you think about it, there’s only one reason China would say this: so that prices would go down, and it could eventually buy more.
Even as the market retreated in the last couple weeks, the headlines were saying things like, “Market retreats on worries about the recovery.” These statements imply that the market was overly optimistic about the recovery, and that the market was now changing its mind. In other words, headlines often imply that the market is thinking about fundamentals.
I think a better explanation is that the market acknowledges fundamentals, but sometimes, its more about money flow and trading – both of which are not about fundamentals. Even as oil traded toward the recent $73 high, analysts were saying that there was ample supply and that the fundamentals pointed to oil in the high $50 range. So the market knew this, I think, and it didn’t care. The market was more concerned about riding the wave of the oil trade, and the market was going to ride this wave as long as it could. When it was over, everyone got out – and this explains why oil fell from $73 to $59 or so within a week. It wasn’t about fundamentals, it was about trading. If you understand this, then it tells you to be careful as oil hits a high like $73, and to get out as fast as possible when it turns. If you think it’s about fundamentals, you’re likely to be holding on as the market turns.
In recent years, the volatility caused by trading – and some would say “speculators” – has increased. Years ago, only a few could trade futures. Nowadays, there are ETFs and all sorts of vehicles for trading futures. The result is that volatility in commodities has increased. Ironically, this is exactly what happened with real estate in the last decade. Wall Street created all these vehicles for securitizing real estate debt, making it possible for tremendous amounts of money to flow in and out of real estate. This made is what made the real estate bubble possible. I think that we just had a “mini” commodities bubble when oil hit $73 – meaning that the move to $73 was driven by “speculative” trading rather than by “fundamental” investment. And it’s not just a matter of terminology – if you know you’re in a speculative environment, you have to be ready to move much faster.
Investing Strategy
For the next six months to a year, it will be a great time to buy stocks. Finding a good entry point is always a challenge, but as I’ve said before, sometimes it’s easier – and saner, not to find the perfect entry point but to just average your purchases instead. Here’s some updates on some recently mentioned stocks. I am long all of the stocks mentioned below – Apple, Goldman Sachs, Morgan Stanley, the TBT and Boeing.
Apple
I continue to be a fan of Apple. I think the iPhone will be a huge product, much like the iPod was before it. People with regular phones are converting to smartphones, and the iPhone is the smartphone of choice for many. It’s a great union of performance and function, and the applications available will give the product an edge. Meanwhile, Mac computers are selling well and increasing their market share. And in fact, the iPod and the iPhone have helped convert many PC users. Looking ahead, we have the back-to-school and Christmas seasons, and I believe people will still buy smartphones and computers (especially for education) in a recession.
The challenging part is when to buy, because pullbacks in Apple stock don’t always last very long. I’ve been looking toward the $133 level, and for a brief moment yesterday Apple fell to the $135 range. If the market breaks below 874 on the S&P, it’s likely that Apple will drop as well.
Keep in mind that Apple is a momentum stock – meaning that it has some important characteristics to keep in mind. Being a momentum stock, if it ever disappoints, it can fall quickly, that’s the nature of the beast, if you will. Valuations are also tricky, because these stocks always look expensive. It’s much more a matter of riding the train when there’s momentum. If Apple does well from here through 3Christmas (which I think it will), the stock may fall in January if there’s not some new news at the Apple conference in January.
Goldman Sachs
I continue to be a fan of Goldman as well. The firm will benefit from consolidation in the investment banking business – there just aren’t as many banks left. Also, many see possible record profits on the trading side. On the negative side, share issues this quarter will cause dilution, and interest on TARP money will take some money out of earnings. Still, these are one-time effects.
Like Apple, pullbacks in Goldman are few and quick. Last month I said I’d buy some at $135, and lots in the $120 range. Those targets remain valid. Yesterday the stock pulled back to the $135 range – very briefly. Today, it was upgraded and went back up to the $143 range.
Morgan Stanley
I also like Morgan Stanley long-term. Last month, I said that this one to dollar cost average. I nibbled at $28.95, knowing that it could very well go down because the stock, like Goldman, was trading in the high end of fair value for 2010. I put a stop on the trade. About a week after I nibbled, the stock fell below my stop and the shares bought at $28.95 were automatically sold. Today, it’s at $25.88, and I will likely take another nibble. Truth be told, it’s hard to say what will happen at earnings. It should do respectably well, but it hasn’t wanted to take the risk that Goldman has, so it may not make as much on the trading side of the house. TARP payments and accounting issues could very well dent earnings. So it’s a toss up, really. So if I take a nibble at the stock, I do it knowing it could very well go down again. Which is why I would only nibble. If you like the stock, I would only recommend buying a bit, or waiting if you want more certainty.
The TBT
One trade I’ve recommended is to be short Treasuries over the long-term. The thesis is simple – people have bought a lot of Treasuries because they wanted something safe. At some point, money will come out of Treasuries and back into the market and into other riskier instruments. So longer-term, I have high confidence in this trade.
Still, in the short-term, there will be variability. For example, if the market breaks below 874, then investors will go back into Treasuries, and the TBT will fall. It is best to own the TBT when the market is doing well; that means people will take more risk and will be less interested in Treasuries. So you could very well wait to make sure that the market doesn’t go down further before buying into the TBT.
Boeing
Talk about a stock being hated. A few weeks ago, Boeing was saying that it’s landmark plane, the Dreamliner, would fly by June 30th. In mid-June they found that there were stress issues in the wings, and so had to delay – yet again – the plane’s maiden voyage. The stock has since dropped about $11 and stands at
$39 today. Management declined to set a date for the plane’s maiden voyage.
I still think that someday, the Dreamliner will fly, the economy will come back, and air traffic will climb. Of course, this is longer-term. Investing wise, this is not a stock you have to buy today by any means, and there are very clear risks. In fact, the stock is more likely to go down again before it goes up. With no immediate target date for a flight, I think it’s very likely the stock will decline as impatient investors decide to put their money elsewhere.
So you have a few choices if you want to invest. You can buy within the next few months, before the plane flies. You’ll get the lowest price, but there’s always the risk of another delay, which could really hurt the stock. Or you can wait until the Dreamliner flies, in which case you would have more certainty. Of course, there will still be production risk (they don’t produce planes fast enough, or there are problems with the supply chain) and the economy will remain a risk (people may wait to order planes or might try to delay delivery until the economy is better). If you like the thesis, which investing approach you take depends on your risk profile and of course, your patience.
As always, I encourage you to consult your own investment advisors before making any investments. I don’t claim to always be right; I can only present you my logic, and I hope you will take the time to do your own homework and decide if you agree or disagree with the arguments presented here. Also, if you really feel like spending some more time on stocks, there’s more on my blog at
mingloinvesting.blogspot.com .
Until the next time, sleep well.
Ming Lo is an actor, director and investor. He has an A.B. from Harvard College, Cum Laude, and an MBA and an MA Political Science from Stanford University. Prior to going into entertainment, Ming worked at Goldman, Sachs & Co. in New York and at McKinsey & Co. in Los Angeles.
All material presented herein is believed to be accurate but we cannot attest to its accuracy. The writings above represent the opinions of the author, and all readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed may change without prior notice. The author may or may not have investments in the stocks or sectors mentioned.
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