Was There a Selling Climax?

Was There a Selling Climax?
August 13, 2011
David R. Kotok


“The carnage was stunning. The breadth was negative by about 69 to 1. In the Crash of ’87, the ratio was a less bearish 57 to 1. On the NYSE, there were 3129 stocks down and only 42 up. That’s the worst daily performance found in records going back to 1984 (hat tip Keene Little). Down volume overwhelmed the meager up volume so stunningly, it may have set a record. Also a bit different was the composition of the selling. The public seemed to remain on the sidelines in the selloff up until Friday. For the last two trading sessions, there are signs that the public had begun to panic and dump shares (hat tip Rafael Diamond). The lop-sided internals and public selling are often seen in interim selling climaxes. One example that jumps to memory was October 10, 2008, in the midst of the frenzy that followed the fall of Lehman. On that day, 90% of the shares traded made new 52-week lows. That short-term selling climax was followed by a very sharp rally that lasted a couple of weeks. Let’s see if Monday’s washout produces something similar. Despite its 634 point drop, the Dow was not the worst performer. The S&P fell the equivalent of 766 points, the NASDAQ the equivalent of 785 and the Transport equivalent was a loss of over 800 points. That’s some carnage, leaving the averages down nearly 18% in just eleven sessions. Wow!”

Source: Art Cashin’s Comments, morning notes, Tuesday, August 9, 2011.


Art Cashin is the dean of the college of financial professionals on the floor of the New York Stock Exchange. You see him on TV and you can find him at UBS floor operations at the NYSE. For those who have not met him, let me attest to his character as a perfect gentleman – reserved, polite, and extremely knowledgeable, with exceptional sharpness in his guidance. I consider it one of the great privileges of my life to have been able to break bread with him and to be in his “chat group” of emailers, where we often share observations.

Art’s letter on Tuesday, August 9th, summed up the present issue. It evoked memories of the climactic selling in 1987. It also triggered the most fundamental question one must now ask: was this a full, classic selling climax or an interim selling climax with another waterfall ahead?

In 1987, a new Fed Chairman by the name of Alan Greenspan was troubled by the action in the foreign currency markets, and decided to raise interest rates and defend the US dollar. In raising interest rates, Greenspan triggered enormous gyrations in the US stock market, as well as an economic slowdown. The market went up rather robustly in the first half of 1987, in a manner very similar to the first four months of 2011. In August of 1987, the stock market peaked at questionable valuation levels. A selloff commenced and became vicious. By October, 1987, the stock market had lost approximately a third of its value and registered one of the bleakest Monday selloffs in history. That day was nicknamed “Black Monday” and rivaled the October, 1929 Monday crash as an historical metaphor. The following day, Tuesday, witnessed an interim, one-day, intraday reversal. Stocks sold off during the day, rallied, and then closed higher on very high volume. In 1987, that notorious Monday marked the low. In 1929, the interim climax was followed by an extended bear market. So, which of these metaphors applies in 2011?

Let’s return our gaze to the present day. Was the low achieved on August 9th at exactly 2:44 pm, when the S&P 500 Index traded within pennies of 1,100? So far, that intraday low is the bottom. As we know, the subsequent rally has carried the market higher, notwithstanding very high volatility.

If we look at the entire period of the selloff from the peak on April 29th to the intraday trough on August 9th, we find the high for the S&P 500 Index is 1,360 and the intraday low is 1,100. Does this mark the completion of a fast, 20%, bear-market correction? Did the climax on Tuesday mark the final bottom of this drastically unsettling period?

The answers to these questions will not be known for months. There is a very good chance that we have seen the bottom of the selling climax. Alternatively, we may retest it. There is a chance that another substantial down leg lies ahead. The debate among investors is fierce.

At Cumberland, we were defensive during the May selloff. That was a good call. We reentered the stock market too soon. That was a bad call. We bought positions that subsequently were washed down along with many others during the past two weeks. Remember, on Black Monday, 2011, 3129 of the NYSE-listed stocks went down, while only 42 went up. Stocks have been recovering since the bottom on Tuesday. We continue to hold them. We did not sell in panic. Our experience is that panic selling is usually a mistake.

Let us get to the valuation of the market. One of the longer-term best measures is something called the “equity risk premium.” In order to determine the equity risk premium, one compares the earnings yield of stocks with the riskless alternative. Today, one can estimate that the earnings in 2011 for the S&P 500 Index for the entire year will be approximately $95. If you take the S&P 500 at 1,150 and divide by the $95 dollars, you get an earnings yield of approximately 8.3%. Subtract from that earnings yield the interest rate on the 10-year Treasury note, which, for the purpose of this discussion, is 2.3%. You are now left with 6% as the equity risk premium, if you do this calculation using the long-term riskless benchmark as the reference. If you use the short-term riskless benchmark, the interest rate on Treasury bills, you would subtract 0% from the 8.3%, and you would get an equity risk premium that reflected the entire earnings yield attributable to the S&P 500 Index.

Equity risk premium is a strategic guide on the valuation of stocks. It does not help you trade on a day-to-day basis. It simply says: I can have my cash earn 0% without risk, or I can invest in a basket of stocks, called the Standard & Poor’s 500 Index, and I can earn a return through the companies’ business activities of 8.3%.

Alternatively phrased, I can invest in a 10-year Treasury note and earn 2.3% without risk, or I can participate in the earnings of the stocks. Whichever reference you use for the riskless side, the resulting valuation of the stocks is the same. In the course of history, they are remarkably inexpensive now.

What an investor now confronts is this: do I want to own a basket of IBM, Johnson & Johnson, Exxon, Proctor & Gamble, and others, where the collective return on the investment at today’s market price is approximately 8.3% and is likely to grow over the next number of years? Or, do I instead want to own a riskless investment and earn 2.3% or 0%, if I view it as a cash alternative? That is the strategic valuation argument.

Whether we have a final selling climax or an interim selling climax with another deteriorating selloff before this turmoil is over is a question for a trader. For an investor, the relevant question is: what is the likelihood of a positive outcome if I position a basket of stocks today? This basket can be accomplished with exchange-traded fund (ETF) strategies, so one does not have to determine which individual stocks to purchase.

Let us dissect the latter question. Most of the time, most of the stocks will rise in price because of the nominal growth of the GDP of the United States. The same is true when it comes to the rest of the world. Remember, stocks are priced in nominal terms. They earn income in nominal terms. They report earnings in nominal terms.

What do we know about the growth of nominal GDP in the US? We know that the size of the US economy is approximately $15 trillion dollars and that it is growing slowly in nominal terms. We can make some very conservative assumptions about growth and inflation rates. Combine them, and we project a growth rate of the nominal GDP of the United States at approximately 3%, which we will use for the purpose of this commentary. It could easily be 4% or 5%, so our 3% is very conservative in our view. That means approximately $500 billion a year will be added to the GDP of the United States, on average, and in each year over the next foreseeable period of time. Call it five to ten years. The GDP of the United States at the end of this decade is likely to be around $20 trillion.

We also know that there is a profit share that comes out of the GDP that flows to the corporations that we just mentioned. Moreover, we know that those companies are going to be around, because we expect the S&P 500 companies to survive any short-term turmoil. What does that say for the profit share? It says that the profit share is somewhere between 6% to 10% of the GDP. The business structure of America will add somewhere between 6% to 10% of the incremental growth of GDP to its profits, on an annual basis. We can therefore project what the earnings will be and what the earnings yield will be five and ten years from now.

Our conclusion, “simply put,” is that stocks are now very inexpensive. When an equity risk premium is estimated at 6% to 7%, it is in the very remote outlier section of history. It says that you are being paid handsomely and in an extraordinary amount to own shares of fine American companies.

History would suggest that every time you had the opportunity to enter the stock market with an equity risk premium this high, you succeeded. There is no evidence in history that a strategic, serious investor was able to obtain an equity risk premium of this amount on a continual basis. Why? Because stock prices rise when the equity risk premium is this high, which is how the equity risk premium gets back to a more normal range, like 2% or 3%.

We believe the stage is set now for the US stock market to double by the end of the decade. The equity risk premium is giving us the guidance to make that statement about the valuation. It is quite possible that the Standard & Poor’s 500 Index could see 2,000 before the end of this decade arrives. The implied level for the Dow is 20,000.

At Cumberland, we are moving accounts, new funding, and existing cash, into fully invested, strategically diversified positions in our US exchange-traded fund accounts. Those accounts will have representative positions amounting to exposure to nearly 1,000 stocks in the United States. We do not advocate putting all the eggs into any one basket. We believe that the current high equity risk premium will reward investors whose horizons are in strategic periods of time.

What you do if you are a trader is a separate matter. We do not know how to day trade; we never did, and we expect that we never will.

From a strategic investment point of view, we think one of the great opportunities to position in the stock markets is now being presented to investors. For our clients, we intend to take advantage of this opportunity.

The history of selling climaxes gives us comfort. The policy response or outcome often determines if they are interim climaxes or final climaxes. In 1929, the federal government tightened credit after the 1929 crash. It passed protectionist legislation (Smoot-Hawley). It turned the 1929-30 recession into the Great Depression. The final low for Stocks was in 1933.

In 1987, Greenspan reversed himself after Black Monday. The October climax was a final one and marked the low.

In 2008, the first selling climax was an interim event. It took the Fed three more months to get the global TAF working. The final bottom was March, 2009 and coincident with the restoration of worldwide liquidity provisions by our central bank and the other major central banks.

In 2003, there was a stealth climax. At the onset of the Iraq war, the futures market had the Dow down 600 points. As soon as it became apparent that the US air force controlled the skies over Iraq, the market reversed itself and closed the gap. In NY, the market rose. The climax does not appear in the NY trading statistics. You can find it in the London statistics on futures trading.

In 2011, the Fed moved quickly. The expectation today is that cash will earn zero for the next two years. Bernanke knows that the negative wealth effect from a stock market sell off can take a half a point out of GDP. He acted decisively in order to avoid that loss of output.

We remain bullish. We are targeting an S&P 500 index level above 2000 by the end of the decade.

David R. Kotok, Chairman and Chief Investment Officer

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