Tuesday, September 23, 2008

Looking for the Bottom

Arguably current equity market conditions in the U.S. are the bleakest in decades. We have observed considerable wealth destruction in the past few months that have left most investors on the sidelines in cash holdings. At some point the inadequacies short-term interest rates and inflation risk become as concerning risks on equities. While we remain bullish on most stocks in The Crystal Equity Research coverage universe, particularly after assessing the capacity of each operation to withstand a period of weak demand and inflation, we are approaching stocks with depressed prices with caution. In our view, it is preferable to incur inflation risk and low interest rates than to observe stagnant equity investments in “dead money” stocks.

We argue the decision to return to aggressive buying should be made following two separate steps. First, the price-to-book value can be a good gauge of whether a quality company with strong operations is nearing a “bargain” valuation. The P/BkVal ratio can be compared to a peer group or compared to the company’s particular historic high, low and average P/BkVal ratio. Of course, the ratio should not be used in a vacuum and consideration should be given to the overall health of the balances and cash flows (cash balances and cash flow, working capital adequacy, and future cash payment requirements) as well as the strength of the operation (sales growth, profitability). In other words, if the operation is considered sound then the P/BkVal ratio can be used under current market conditions to determine when to assume a long position. Investors should not overlook the use of options as a means to configure a long position, lower total capital outlay and hedging the risk of bad timing.

Second, there are several market indicators that could be useful to monitor the equity markets settlement to a “bottom.” In previous comments we have discussed the CBOE Volatility Index (VIX) which was 34.98 at the close of trading on Friday, September 26th. This signals an extremely volatile and undecided market, most likely reflecting the fear and uncertainty that has gripped both equity and credit markets in the last few months. We do not believe valuations for individual stocks are likely to be held back even in the wake of positive fundamental developments under such volatile equity market conditions. Our view is that the VIX must return to the low 20s before bull case scenarios will have broad support.

The Put/Call Ratio has been a popular indicator for some investors to signal a market bottom or top. However, the rising popularity of Exchange Trades Funds, which can be used as an alternative hedge position to options, and the recent disruption in short selling strategies that rely on options, may have altered the validity of the Put/Call Ratio. The most recent Put/Call Ratio in the U.S. was 1.01, a level which provides a very weak signal for a market bottom and therefore provides little encouragement for even the most stubborn contrarian investor.

A third indicator, the TRIN or ARMS Index, has gained some attention in recent years. This Index is based on the ratio of stocks advancing against stock declining divided by the ratio of the trading volumes for the same. An increasing TRIN indicates a bearish market and a falling indicates a bullish market. Its intended use is for short-term trading decisions as an indicator of overbought or oversold conditions. As such could be a valuable mechanism for pinpointing the market bottom with greater precision. The TRIN is currently at 0.83, indicating the market is overbought.

Altogether, with individual weakness considered, the three indicators are in harmony that the U.S. equity market has not reached a bottom. This condition does not bode well for an expansion in valuation metrics.

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