Earnings season is now in full force. For the most part earnings are okay - not stellar - but not horrible. Interestingly, forward guidance seems improved over last quarter's also. Previous cost cutting has allowed margins to increase. In fact, there are a few very encouraging trends emerging. More and more companies are announcing that they will expense employee stock options and more are including additional disclosure in their earnings releases. A lot of companies are now including a full balance sheet and a statement of cash flows. This was rare just a year ago. However, the biggest problem we see is that everyone is too optimistic about the rest of the year. Conventional wisdom is convinced that the economy is recovering with companies enjoying very easy year-over-year comparisons for the remainder of the year. With the credit markets now in turmoil, we continue to believe that the ever-expanding pool of credit available to consumers and businesses will dry up. Consumer spending will not be slowed by the consumer deciding to spend less, but by lenders reducing credit availability.
While I was intending to discuss company earnings, the current volatility in the markets is the real story. This is truly an historic phase in the financial markets. The market is more focused on the unfolding stress in the credit markets and investor sentiment than anything associated with company fundamentals. Actually, short-term traders and those hedging other positions are setting prices right now. Recently, Art Cashin stated on CNBC: "Traders would rather put a gun in their mouth and pull the trigger than miss the bottom." This mindset combined with a lack of conviction in specific stocks leads to this hyper-volatility of late.
If the few couple weeks of market volatility has not been enough for investors, today's action should convince anyone that the current market environment is anything but stable and healthy. After selling off hard in the first hour, the market reversed course and rallied without ever looking back. By the end of the day, almost every index closed at its session high. Additionally, the highs of the day were about 8% to 9% above the morning lows across the board. In short, it was a classic bear market buyer's panic.
|Index||Today's % change||% high from low||YTD Return|
|AMEXBroker / Dealer||5.3%||10.6%||-29.2%|
|Dow Jones Ind.||6.3%||8.9%||-18.3%|
|M.S. High Tech||5.2%||8.6%||-46.0%|
Today's reversal capped off two days of huge selling. After falling 11% Monday and Tuesday, the Philly Bank index fell another 5% Wednesday morning before launching into a 12.4% rally. After today's gains the S&P Bank Index remains 18% lower for the month. Widow and orphans have been on a wild ride. The Dow Jones Utility Index fell 7% the first two days this week, extending the month decline to 30%. Wednesday, it fell another 3%, before closing 12% higher. The Philly Gold Index fell faster than a Double Eagle off a building. The XAU dropped 17% in the first two days of the week, then an additional 5% Wednesday morning before rallying 12.3% off the lows of the day.
We are living through a truly historic period. Today was the highest volume day ever on the New York Stock Exchange. It was also the largest point gain in the Dow Jones Industrials since 1987, and keep in mind it started the first ten minutes over 160 points in the hole.
The market has been acting sick, and today's action is not any indication of a miraculous return to good health. The spin will likely be that the bottom is now in place and that everything has to be looking better. We are suspicious Healthy markets do not have 9% intra-day swings.
This week, the New York Stock Exchange announced that short interest rose to a new record in July. Shares sold short increased 4.8% in the last month, which was the previous record. Yet, traditional short selling fund managers have not been aggressively shorting this year. Measured by the CSFB/Tremont Hedge Fund Index, dedicated short biased managers were up 9.3% for the first six months of the year. June accounted for the overwhelming majority of the gain, up 7.6%. We believe a substantial amount of the current short selling activity has been by aggressive trading-oriented hedge funds that are trading which ever way the tape reads. Instead of the traditional short selling manager that conducts extensive fundamental and "grass-roots" research. This is just the latest manifestation of a capital market system that focuses on short-term results and rewards speculation. Trading dynamics seem to dominate fundamental analysis for both good and bad companies.
Since most of the trading is based on momentum of the market, the managers that do the research are scared away from the market. They do not understand how stocks are being priced and are deciding to try and wait out the storm. This type of order flow results in few managers having conviction in their own trading. When stocks are declining, bids are canceled. Likewise when stocks are rising sellers cancel their offers. This exacerbates the volatility. From talking to other managers and traders, everyone is exhausted and hoping for a little market stability, including myself. Unfortunately, chances are high that these market conditions will remain for quite awhile.