Are Cover Stories Effective Contrarian Indicators?

By: Henry To | Thu, Apr 12, 2007
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Dear Subscribers,

I hope everyone is having a great Easter. For folks who don't celebrate Easter, it is also a good opportunity to take some time out and "smell the roses," so to speak. While the pace of life has been ever-increasing, especially with the dawn of the internet and subsequently, the Crackberry, much of the evidence today points out that workers who generally work shorter hours (and I am not talking about the French 35-hour week model) will not only lead fuller, healthier lives, but are usually much more productive while they are working as well. February 19th was "International Slow Day," but that doesn't mean you can't celebrate this day on brief occasions all year round. Take your wife out to a movie, read to your kids, and take the dog out for a walk. Life is too short (even if we all make it to over 100) to spend most of your time working (although I have definitely been guilty of this in the past!).

Before we begin our commentary, let us do an update on the two most recent signals in our DJIA Timing System:

1st signal entered: 50% long position on September 7th at 11,385, giving us a gain of 1,175.20 points

2nd signal entered: Additional 50% long position on September 25th at 11,505 giving us a gain of 1.055.20 points

In last weekend's commentary, I discussed my current scenario for the housing market, and that the "next shoe to drop" will be the Alt-A sector and many loans that have negative amortization features and/or other loans that also have second loans ("piggyback loans") attached with them. I also stated that this, in itself, similar to the latest subprime troubles - will not have much effect on the economy, but whatever regulatory pressures that emerge from this (much tighter lending standards) will have the effect of constraining liquidity going forward. Note that after I wrote about this, Bill Gross from PIMCO also published views that were similar to mine as well. Quoting Bill Gross' April commentary:

It will not be loan losses that threaten future economic growth, however, but the tightening of credit conditions that are in part a result of those losses. To a certain extent this reluctance to extend credit is a typical response to end-of-cycle exuberance run amok. And if one had to measure this cycle's exuberance on a scale of 1-10, double-digits would be the overwhelming vote. Anyone could get a loan because shabby credits were ultimately being camouflaged within CDOs that in turn were being sold to unsophisticated foreign lenders in need of yield as opposed to ¼% bank deposits (read Japan/Yen carry trade). But there is something else in play now that resembles in part the Carter Administration's Depository Institutions and Monetary Control Act of 1980. Lender fears of potential new regulations can do nothing but begin to restrict additional lending at the margin, as will headlines heralding alleged predatory lending practices in recent years.

Coupled with the aftereffects of being in a housing and subprime bubble (i.e. not many potential homeowners will take out a subprime mortgage anymore, just like those who swore off from buying technology stocks for the rest of their lives since the 2000 to 2002 technology bust), liquidity may be constrained for years to come. In the meantime, however, the stock market is still doing nicely and my guess is that "the next shoe" won't drop until at least a couple of months from now.

Speaking of liquidity, however, on a more immediate basis, I want to update our readers of a chart we initially posted in our January 14, 2007 commentary ("The Permanent Income Hypothesis"). In that commentary, I stated that I first got the idea of constructing this chart from Ned Davis Research - who had constructed a similar chart for a Barron's article in late 2006. At the time, his assertion was that based on this chart, he does not believe the rally in the U.S. stock market is close to "exhaustion" just yet, or in other words, a significant top. Following is an update of that chart showing the ratio between U.S. money market assets (both retail and institutional) and the market capitalization of the S&P 500 from January 1981 to March 2007:

Total U.S. Money Market Fund Assets / S&P 500 Market Cap (January 1981 to March 2007) - 1) Ratio at a major low at the end of August 1987 - signaling a major top and preceding the October 1987 crash. 2) Ratio touched an eight-year high in October 1990 - preceding a great rally in the stock market whcih would not end until Summer 1998. 3) Ratio vacillated near all-time lows from early 1999 to early 2000 - suggesting the market was hugely vulnerable to a significant decline and a subsequent bear market. 4) Ratio touched 20-year highs! 5) Ratio increased from 17.29% to 17.44% during March - the highest reading since August 2004. Given such high readings, the likelihood of a bear market from current levels is not overly high.

While the ratio between money market fund assets and the market cap of the S&P 500 is not a great timing indicator - what it does show is the amount of "cushion" that we have in order to insure against a significant market decline. Also, while this indicator is telling us that we are closer to the end of the bull market than the beginning of one, it is also telling us that we are not close to exhaustion just yet. Based on historical experience, this author will not be too concerned about the end of the current bull market until this ratio hits a reading of 15% or below. Finally, given that this ratio has just risen from 17.29% as of February 28, 2007 to 17.44% as of March 31, 2007 (the highest reading since August 2004), chances are that the equity markets will be higher in the weeks and months ahead. For the individual investor who is not leveraged and who is already long, a buy-and-hold strategy (instead of trading around the volatility) still makes the most sense. For now, we will remain 100% long in our DJIA Timing System - although we reserve the right to trim our position should the technicals of the market deteriorate in the days ahead.

Let us now discuss the title of our commentary: Are Cover Stories Effective Contrarian Indicators? In the latest edition of the Financial Analysts Journal (Volume 63, Number 2), authors Tom Arnold, John Earl, and David North (Arnold, Earl and North are all associate professors of finance at the University of Richmond, Virginia) examined the after-effects of featured stories in Business Week, Fortune, and Forbes. The study was done with data over a 20-year period from 1983 to 2002. One unique feature of this article is that aside from anecdotal evidence (such as the infamous "Death of Equities" article on Business Week in 1978, the October 1997 Business Week cover story on Netscape and "how it plans to outrun Microsoft, and finally, a February 2000 Business Week cover story on "The Boom"), there has not been a formal statistical study done on the powerful contrarian signals of a cover story on the major and mainstream publications.

Well, look no further, as authors Arnold, Earl, and North have finally take a good stab at it. Quoting from the abstract of the article:

Headlines from featured stories in Business Week, Fortune, and Forbes were collected for a 20-year period to determine whether positive stories are associated with superior future performance and negative stories are associated with inferior future performance for the featured company. "Superior" and "inferior" were determined in comparison with an index or another company in the same industry and of the same size. Statistical testing implied that positive stories generally indicate the end of superior performance and negative news generally indicates the end of poor performance.

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Henry To

Author: Henry To

Henry K. To, CFA

Henry To, CFA, is co-founder and partner of the economic advisory firm, MarketThoughts LLC, an advisor to the hedge fund Independence Partners, LP. is a service provided by MarkertThoughts LLC, and provides a twice-a-week commentary designed to educate subscribers about the stock market and the economy beyond the headlines. This commentary usually involves focusing on the fundamentals and technicals of the current stock market, but may also include individual sector and stock analyses - as well as more general investing topics such as the Dow Theory, investing psychology, and financial history.

In January 2000, Henry To, CFA of MarketThoughts LLC alerted his friends and associates about the huge risks created by the historic speculative environment in both the domestic and the international stock markets. Through a series of correspondence and e-mails during January to early April 2000, he discussed his reasons and the implications of this historic mania, and suggested that the best solution was to sell all the technology stocks in ones portfolio. He also alerted his friends and associates about the possible ending of the bear market in gold later in 2000, and suggested that it was the best time to accumulate gold mining stocks with both the Philadelphia Gold and Silver Mining Index and the American Exchange Gold Bugs Index at a value of 40 (today, the value of those indices are at approximately 110 and 240, respectively).Readers who are interested in a 30-day trial of our commentaries can find out more information from our MarketThoughts subscription page.

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