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The Paper Panic
Paper stocks are one of my favorite leading economic indicators. They lead broad market price indices by a few weeks to a few months. The Dow Jones U.S. Paper Index ($DJUSPP) did not plunge as much as the S&P 500 ($SPX) during the 2000-2002 bear market. Paper stocks did not fear a severe recession during the last bear. The S&P plunged 47% then because the largest 100 Technology-Telecom stocks represented 38% of $SPX, which raised the index's P/E greater than 40 when the market was near its peak in earnings.
A paper panic began in May 2007, five months before $SPX's price peak in October 2007. $DJUSPP knew that $SPX was a paper tiger as it rallied in spite of widening credit spreads and a collapse in commercial paper prices during the summer-fall of 2007. Study Figure 3 for insights gleaned from its price trend overlaid with $SPX. Paper and credit spreads (not shown) knew that we were headed for the worst economy since the 1930s.
Paper stocks are low-quality assets (LQ) that lack consistent earnings growth. Notice that the trend lines for DJUSPP and S&P TMT earnings have both plunged since 2007 Q2. In the future, they will trough together with $DJUSPP basing as earnings begin to rise.
Notice too in Figure 1 that near peak earnings, it is wise for investors to overweight their stock holdings in high-quality (HQ) firms. HQ firms have strong balance sheets, ample free cash flow and consistent dividend growth. In 2006, our views on credit helped us to determine that a sampling of HQ stocks would exclude the Financial sector. Fundamental analysis determines what stocks are in your HQ basket.
Savvy investors ride on the backs of LQ stocks as TMT rises above the red trend line, and then jump off to ride HQ as TMT drops below Hussman's sustainable earnings line. Today we are near a trough in TMT earnings and low-quality stock prices. Consider that it is time to buy LQ stocks and to nimbly hedge your holdings with short positions (inverse equity ETFs) and corporate bonds (equity substitutes with equitylike returns). Given that there is a high likelihood that we are 10% to 20% from a capitulation low, the AI 75-50 portfolio is reducing short and gross portfolio weights.
The Best News Yet - This Week's $NDX: $SPX: & $NDX: IYK Ratios
Issue 2 of our February 2009 InFocus looked at the NASDAQ 100 as buying offense. I prefer to track the NASDAQ 100 ($NDX) as the numerator in ratios to broad market and sector indices. $NDX represents growth with large growth companies absent the Financials found in most broad indices (like $SPX). No one wants signals contaminated by Financials.
An indicator of an appetite for future growth, like the $NDX: $SPX ratio, is a measure of sentiment. It measures the relative strength of large company growth stocks to the S&P 500. $NDX: IYK tracks the relative strength of growth stocks to consumer noncyclicals. Over the past few months investors, have been willing to purchase cyclical growth ($NDX) over more stable earnings growth (IYK). This a good sign, in that they are looking past the current economic contraction.
Figures 4 & 5 display both of these $NDX ratios rising since the market's November 2008 low and its new March 2009 lows. This pattern is constructive for building a firm base off the market's ultimate low. If this ratio remains above 1.44 over the next 3-6 months, it enhances the odds of at least an intermediate term bottom for the S&P 500 near 600-650. Someday, with hindsight, the bottom might lie in this price range.
Although $NDX: IYK (Figure 5) has failed to record a new high like $NDX: $SPX, it has made a series of higher highs and lows since November 2008. This chart tells us that investors are not liquidating assets in fear, and are discriminating between firms with weak and strong future earnings.
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