A Trading Range Ahead

Confidence in the markets has been undermined by political uncertainties, ongoing international turmoil, and persistent concern over declining growth in corporate earnings. But most of all, the concern has been over the market itself. The strategy of buying on dips has been replaced with selling into market rallies. Attempts to buy value stocks and to average down by buying more when the price falls, so far, look like mistakes.

It’s not easy to hold the course, and harder still to step in at this point. The weak September-October season for stocks is at hand, Asia and Latin America continue to place a drag on our economy and financial markets, and the President’s problems seem to grow like a cancer. By mid-October we will be seeing the release of 3rd quarter corporate profits, and in the last three months of the year we are facing the tax selling pressure.

In recent weeks we have taken this pause in the market to strengthen our portfolios and capture tax losses to offset capital gains. Opportunities appear to be in oils, REITs and regional banks, with utilities showing considerable strength. We are focusing on strong companies with good earnings records which are selling at reasonable prices.

The bright spot on the horizon is declining interest rates. As I write this, the bell weather 30 year Treasury bond is at 5.13%; its lowest level since 1965. When rates fall, stocks become more attractive than bonds. And most market watchers feel that Mr. Greenspan will lower rates at the Fed meeting on September 29th. We do not believe that the Fed can continue to defend its position on rising inflation in view of the economic evidence. More importantly, the Fed will find its position increasingly difficult to defend politically, because high US rates are pulling money out of countries which are already suffering a severe liquidity crisis – which will eventually damage our own economy. The bad news is that this sentiment is probably already reflected in the prices of both bonds and stocks.

For now, we see the market continuing in a highly volatile trading range of 7500 to 8200 on the Dow. While this is considerably off its July 20th high of 9368, we expect the year to close in positive territory, above the 7908 level at the end of 1997.

There is other good news too. Markets are not nearly as risky as they were. The pause will allow corporate earnings to catch up to stock prices, and much of the “hot air” has been let out of some high quality, overvalued stocks. Coke, which sold at $89 and a P/E of 62, now sells at $56 (37% decline) with a P/E of 36. Gillette, which sold at $62 with a P/E of 49 now sells at $38 (21% decline) with a P/E of 30. And GE which sold at $97 with a P/E of 37, now sells at 83 (14% decline) with a P/E of 32. The average decline from the high is in the range of 40%. We still have the Berkshire Hathaways, the Compaqs, the Microsofts (selling at a P/Es of 39, 43.5, and 68, respectively), and many other high quality stocks selling at inflated prices, but that’s more the exception than the rule.

And some more good news. As some of you will recall, we follow an investor sentiment indicator called the Put/Call ratio (see previous article on our web site), which is a measurement of how investors feel about the market. When sentiment is overly negative, indicated by a ratio above .75, the market usually experiences a quick move down in the next few days, followed by an advance over the next several months. On 8/21/98 (Dow 8693) the ratio hit 1.022, its 3rd highest reading since 1985. Ten days later (8/31) the market hit its low of 7539, and has since trended upward. This pattern is consistent with the historical predictions indicated by this measurement, and tends to confirm that we are near a market bottom.