Earnings Risk

*****That was a huge rally for stocks yesterday. The major indices all jumped around 10%. Volume was pretty strong.
I said in yesterday’s Daily Profit that we were long overdue for a “…little oversold, liquidity driven rally.” And honestly, I wish yesterday’s rally had been a little more, well, little.
How high do we think the Dow can run? I’m sure we’d all like to see recent losses reversed. But that fact is, our banking system has changed in ways we don’t yet understand, we’re in the early stages of a global recession that could send American unemployment through the roof, and given recent earnings estimate adjustments, the S&P 500 trades at a not-so-cheap-anymore 17X earnings.
Yesterday, the Dow Industrials took back a full 25% of its losses for October. Three more days like that and it’s like the banking crisis never happened. Only it did. And I have to say – it’s not a good sign that investors are getting so happy so soon after such a massive calamity.
Stocks need to be grinding out small gains right now. Five straight days of 30-point gains on the Dow will do a lot more for investor confidence than these one-day moonshot rallies.
Let me put it this way: Does a 900-point rally make you want to buy stocks? Or does it make you think now might be a good time to take some money off the table?
*****The financial media says yesterday’s rally was about bargain shopping for stocks and today’s expected interest rate cut. There haven’t been many more anticipated rate cuts. And when everybody’s on one side of a trade, getting through the exit can be difficult.
It’s like what happened with Volkswagen stock on Monday. Porsche came out and said it had bought more VW stock and currently owned 75% of the company.
Well that news sent short-sellers into a panic.
Apparently, VW had been a very popular short candidate. Something about a big slowdown in car sales. Anyway, all the shorts suddenly had to buy VW stock to cover their position at the same time. Their relentless buying pressure drove the stock up 190%. At one point, VW was worth $370 billion, more than Exxon-Mobil (NYSE:XOM) or Microsoft (Nasdaq:MSFT). By the end of the day, VW was stock was up just 25%.
I don’t know how much short-covering had to do with yesterday’s rally, but it was certainly a factor.
*****Bloomberg is reporting that analyst estimates for the S&P 500 has that index trading for 10X forward earnings. That’s the lowest forward P/E for the S&P 500 since 1985.
That’s cheap, no doubt. But I can’t help but think there’s downside to those analyst earnings estimates. Because the trailing P/E for the S&P 500 is around 17, which suggests that analysts expect earnings to grow at a fairly good clip.
But don’t forget – as a result of the credit squeeze, economic activity has slowed significantly in the last month. And the damage will show up in 4th quarter earnings.
While it’s possible that a lot of sales and deals are just shelved at the moment and could be back in play in the weeks to come, there’s no guarantee of that. It’s reasonable to expect earnings estimates – and valuations – to come down.
*****The FOMC meets today. A 50 basis point cut is widely expected. These days, it seems smart to give the market what it wants. And what’s the risk? Banks aren’t lending anyway, might as well cut rates.
*****I have to say, I’m really impressed with all the feedback I’ve been getting. Daily Profit readers are definitely an engaged bunch. You’ve sent some great comments and informed questions. And I’m truly flattered that you enjoy the Daily Profit.
Of course, I have a couple more questions to answer…
*****Herb writes “I have been doing the opposite of selling stocks. Instead, I have been buying utility stocks which are paying nice dividends in the 7 to 10 percent range. Is this a good move on my part?”
Absolutely. Cash is king these days, and solid income generating stocks are a great way to go. That’s the rationale behind my recommendation of MLPs. Utilities depend on financing, and when interest rates are low, utilities tend to do well.
*****Drew asks “Is now the time to buy Las Vegas Sands and MGM/Mirage for the long term?
Given the potential for unemployment to rise significantly in the months ahead, I’m not wild about gaming stocks right now. During the recession of 2002, MGM Mirage (NYSE:MGM) fell from $20 to $10. And it didn’t get back over $20 until 2004.
The stock has fallen from $94 to under $10 in the last year. That’s a steep drop for sure. But it will get worse if the recession gets worse. MGM won’t move significantly higher until the economy and unemployment recovers. That means you can wait to buy it until there are signs of recovery.
*****Steve wrote “I wrote about a week ago concerning your take on emerging market etf’s.  Some have said to hold onto them, especially since they are down over 50%, because the earliest places we will see recovery will be in the emerging markets (China’s GDP will still be around 8%). These indexes can go down fast, but can bounce back fast too.  At least that’s what I have heard others remark.  What’s your take?”
I also can’t say I’m wild about emerging markets right now. There’s just too much risk out there. We really don’t know how deep the global recession will go. And no emerging markets will recover until the US economy does.
Much like the casino stocks, I think you can wait until there are signs of a recovery before jumping into emerging markets.
*****Here’s a trading question from an anonymous e-mailer ”I am new to trading stocks and I am confused about selling stocks.  There is a BID PRICE and there is a market price and asking price. For example; if I buy a stock at 0.30 and it goes up to 0.60 but the BID price is 0.28, will I be getting the BID price if I sell the stock or the current market price.”
The ask is the price at which you can sell a stock. The bid is the price at which you can buy a stock. A market order simply means you’re willing to sell at whatever price you can get.
Market orders should only be used if you absolutely have to make a transaction and price is a secondary concern. In other words, you won’t always get the best price. I prefer to use a limit buy or limit sell order when making a transaction.
*****And finally, Don B. has this to say “The national debt will have to be repaid.  That means increased taxes of one kind or another. That is inflationary. Also it is my guess that inflation will be rampant and debts will be repaid with funny money.  I think the only investment is in companies making money in an essential service.  Food, fuel and pharmaceuticals come to mind.  Any comment? Bonds appear to me a loser in value.  Convertible bonds may be the way to go.  Any suggestions?
My first comment is: why would anyone want to be president right now? Because you are right, the US government needs to raise cash in the worst way. The Treasury is expected to issue debt (bonds) in record amounts to fund the bailout plan.
Not only that, but with unemployment expected to hit the highest levels in decades, the government is widely expected to turn to deficit spending on infrastructure (roads and bridges) to get people working.
Inflation shouldn’t be a big problem until the economy turns around. Then it could be a big problem. In the meantime, bonds are safe. But they are barely keeping track with inflation. If/when inflation returns, bonds will get killed.
I’m not a fan of convertible bonds (these are corporate bonds that can be converted to stock under certain conditions). Convertible bonds carry much of the same risk as stock, but don’t give you the upside that stocks do. If you want to invest for inflation, think commodities. As you know, I like the MLPs and natural gas stocks like Chesapeake Energy (NYSE:CHK).

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