Paranormal Activity to Another Black Monday?

Simon Maierhofer of ETFguide.com writes Whats Next - Minor Correction or Major Collapse?:

Over the past few months, every attempt by the bears to depress prices has been met with renewed buying pressure, resulting in even higher prices. What goes up, however, has to come down and some subtle signs are indicating that this decline might be more than a simple correction, much more.

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) recorded a closing high on October 19th at 1,097. The Financial Select Sector SPDRs (NYSEArca: XLF) 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) 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).

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) 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), 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), industrials (NYSEArca: XLI), materials (NYSEArca: IYM) and consumer discretionaries (NYSEArca: XLY) 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), 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) 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?

Given Friday's action in the stock market, you might be worried about that another Black Monday is right around the corner. Financial journalist Jon Talton writes Echoes of another great crash -- and the lessons we refuse to learn:

This is the anniversary of Black Monday, the day in October 1929 when the stock market crashed. The Dow saw a record drop and things only got worse as the week progressed (there was a Black Tuesday, too).

It's clear now that the crash of that day was not the beginning of the Great Depression but its loudest symptom. Other areas of the economy had been faltering for years and income inequality was near record highs, but this was cloaked by the mania on Wall Street, back in the day when banks could engage in highly speculative trading.

Of course, that toxic environment was rekindled in our time by the repeal of the Depression-era Glass-Steagall Act in 1999, and we got just what the reformers of the 1930s would have feared.

Milton Friedman made his mark as a great economist (as opposed to a great polemicist) by work with Anna Schwartz showing how the Federal Reserve botched its response to the crash, turning what might have been a short-term panic into a deep depression. This was a lesson current Fed Chairman Ben Bernanke was determined to implement -- and indeed, Fed action pulled us back from the brink.

Where, exactly, "back from the brink is" nobody can say with precision. Average Americans are still hurting and the job market is a disaster, although nowhere along the lines of the Great Depression. We have yet to see the unintended consequences of Bernanke's "anything it takes" strategy, which was not followed by meaningful regulatory reform.

Time will tell. But the severity of the Depression forced major changes, such as the prohibition of commercial banks from engaging in high-risk ventures. This time, no such overhaul is happening. None of the swindlers who created the bubble have been called to account -- Bernie Madoff is penny-ante -- and the systemic risks that existed before our crash continue.

In other words, this time things didn't get bad enough. But the risk of new crashes is if anything higher than ever. And our current predicament seems to have no quick solution or the will to push one through. So we rattle along on a bottom -- better, to be sure, than in 1929, but more perilous in its own ways.

I don't get too excited when I see one day sell-offs. I was talking to a trader who told me he thinks hedge funds are unwinding risk trades going into year-end. Maybe they are or maybe this is another classic shakedown of nervous investors before they bring this market much higher.

[Note: Bears and bulls should listen to Tim Knight's Halloween video commentary. He might be right but I think he's underestimating the force of the global liquidity rally.]

Either way, enjoy your Halloween weekend and try not to think about the markets. I hear 'Paranormal Activity' is sweeping America (see trailer below). A good horror flick should help keep your mind off the nightmare on Wall Street.