Investing – Time Cures All

In this month’s article:

• To the surprise of many, July caps the biggest five-month rally since 1938.
• Better-than-expected earnings, short covering and money on the sidelines chasing return drives the rally in July
• Expect profit-taking and buyers coming in on dips in the next two months
• Optimism, tempered with caution are the bywords for the next two quarters

Investing in July

At the end of June, almost everyone was bracing for a downturn in the markets. Second quarter earnings was about to be upon us. Looking back to March, the market has already come very far. Too far, too fast most said. Earnings would bring reality, and reality would bring the market down. That sentiment was supported by the head and shoulders formation that technicians saw in the charts, a classical bearish indicator. As we entered July, the shorts lined up and many decided to sit on the sidelines.

Yet July turned out to be a big surprise to the upside. On August 7th, the Dow closed at 9370, 43% above the closing low of 6,547 established on March 9th. The five months from March to August would go down in the record books as the best five-month rally since 1938. In July alone, the Dow was up 8.6%, the best monthly performance since 2002 and the best July for the Dow (in percentage terms) since 1989. the index had had its best five month rally from March through early August would go down on record as the best five month rally since 1938.

The fuel for this rally was better-than-expected earnings. Goldman Sachs led off with blowout numbers, but the market remained skeptical, saying that Goldman was unique. Then others followed, and the trend soon evolved: revenue remained weak, but companies had severely slashed costs. As a result, profits were actually much better than expected. And that became the rallying cry of this earnings season. To be sure, there were major disappointments, but the bulk of companies reported fell into in line with the season’s theme. By the end of July, more than 70% of companies had reported better-than-expected earnings, one of the highest quarterly readings in the last ten years. And the market rallied. Or more accurately, continued its rally. As of August 6th, 87% of stocks in the S&P 500 were above their 50-day moving averages.

Still, many argued that the market was ahead of itself and that it had to face reality. Mohamed El-Arian, the renowned CEO and co-CIO of PIMCO (the world’s largest bond fund) and former manager of Harvard’s endowment, is on record saying that “the market seems to be on a sugar high.” Many agreed with him. After all, companies were beating expectations by cutting costs, not by increasing revenue. And the consumer, the biggest part of US economy, remained weak and wasn’t spending. In the market itself, all indications were that the market was overbought, and many stocks were already trading at a reasonable multiple to 2010 earnings. Meaning, the market was already assuming that companies were hitting their 2010 earnings targets.

Nevertheless, the good news continued, and so did the rally. On Friday, August 8th, better-than-expected employment figures capped the rally. The Labor Department announced that nonfarm payrolls fell by 247,000 jobs in July, compared 443,000 a month earlier. The news put unemployment at 9.4% vs. 9.5% a month earlier. Many were expecting much higher employment, possibly approaching the 10% range. On Friday, the Dow reached its year high of 9,370.

What Makes A Rally

So is this rally deserved? Are we overextended? Many think so. Today, the wizened financial analyst Dick Bove of Rochdale Securities said that bank stocks were “trading on fumes” and that the recent bank rally was driven by psychology, not by a change in the near term earnings outlook. “The rational investor would step away from psychology at this point and take some profits,” he said. “I suggest this even though I am not changing the long-term buy ratings on my favorite stocks.”

I think much of what Mr. Bove says makes sense. But before we get to that, let’s look back a bit and what is driving this rally.

Like all rallies, this July boost was driven by several factors. It began with good earnings news and lots of short covering, I believe. As I mentioned, the technicians all saw a “head and shoulders” formation in the charts (see last month’s article) and so many went into July short. The “fast money” – especially the technicians, short-term traders and hedge fund money were all ready to profit from a market decline through earnings season. The good news spoiled that plan and brought in money that was on the sidelines. As the market moved up, the shorts had to cover. There were many days through the month of March where selling pressure would come in through the day, only to be pushed back by a late-day rally. On most days in July, the bulls were in control.

A second important factor was the money on the sidelines. As mentioned, the “fast money” was short coming into July. Fundamentalists were on the sidelines, already concerned that we had come “too far, too fast.” That left the fund money sitting on the sidelines. According to one estimate, more than 42% of the capitalization of the stock market has been sitting on the sidelines parked in money market funds earning 1%. The good news brought many of these savers back into the market.

And it wasn’t just a matter of chasing returns. Many fund managers are benchmarked to the S&P 500 index. So at the beginning of July, the S&P was down about 1% year-to-date. As the market rallied in through July, the S&P turned positive on the year. By the end of the month, the S&P was up 7.6% year-to-date. So if a fund manager stayed on the sidelines, he or she would show no gains while the S&P would be up 8.6% for the month. Fund managers could only do one thing: dive into the market and chase it.

In a situation like this, valuation becomes less important than momentum. Or perhaps, call it psychology if you will. And this explains why the market kept going up, even though fundamentalists like Mohamed El-Arian were saying that the market was on a sugar high. Basically the fund managers came into the market based on better-than-expected news, and the shorts (the “fast” money) were forced to throw in the towel and to join the party as well.

What’s Next?

So given all these dynamics, what’s next? After such a big run, a pullback seems to make a lot of sense. I would expect a shallow pullback, mostly because there’s not much news coming up in the next several weeks. So it’s unlikely that we’ll get significant bad news that will drive the market down. There have been lots of buyers recently, so many will take profits, but no one wants to sell at a loss, so there’s downward resistance. Also, lots of shorts have taken their position off, so there’s less selling pressure from those players.

I’m also inclined to believe that there will be buyers on dips in the market. With this quarter’s better-than-expected earnings and unemployment, many are optimistic about the next couple quarters. And with still a lot of money on the sidelines, there’s cash out there looking for returns.

As we approach late September and October, I believe that we will need to be cautious. So far, we’ve cut costs, but haven’t really increased revenue. And I think that it takes a while to get spending going. Ask yourself this: if you had been spending too much and had even lost of bit of money in the market, you would cut costs as much as possible to pay bills and to stabilize your situation. Once things are stable, it doesn’t mean that you’d start spending right away. You’d probably save up a bit of money and build up some reserves before putting a dent in those credit cards.

I think the economy works the same way. As we approach Q3 and Q4, we have reason to be optimistic, because we’ve stemmed much of the bleeding. We will probably have some revenue gains, but I would be skeptical about big jumps in revenue. So how the second half turns out will depend on where the market is as we enter Q3 and Q4. If we’re overextended, we risk disappointments in either quarter. If we’ve corrected, consolidated, moved sideways for a while, we might be better situated for moderate numbers in the second half of the year.

This last week, many were declaring, “the recession is over!” That just means that growth might be positive. It doesn’t mean that we’re spending the way we did in the boom days. I remain long-term positive, but things will take time, and as they say, time cures all.

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.