bear market rallies

bear market rallies

Bear market rallies are counter-trend movements in downtrending markets.

In one sense, they’re analogous to corrections, only occurring in bear markets rather than in uptrending ones (which is why I’m writing about them the day after my post about corrections).

There are several big differences, though.

Corrections tend to be relatively short in their duration and in the extent of their decline.  They also tend to occur frequently and irregularly in any bull market.  Their major cause, as I see it, is overenthusiastic valuation of stocks in an environment where the underlying economic fundamentals are relatively well understood.

Bear market rallies are none of these.  Here’s how/why:

Bear markets themselves are often described as playing out in three phases, in the following order:

hope, where investors are either in denial or radically misunderstand the deteriorating economic fundamentals,

boredom, where investors understand that economies are in recession, (correctly) believe that an upturn is not likely for a considerable period of time and become reconciled to relatively poor times, and

despair, when investors, after waiting in vain for signs that economies are turning up,  give up all hope of ever seeing any improvement.  Their negative emotional state sometimes causes them to sell their stocks across the board and at foolishly low prices.  This sort of final selloff, if one happens, typically marks both the bottom of the market, the lowest point of recession and the beginning of recovery.

Significant bear market rallies typically happen only twice in a bear market.  They mark the transitions between phase one and two, as well as between phase two and three.  They can easily produce a 10% rise in the index and can last for a month or more.  Unlike bull market corrections, bear market rallies are based on a mistaken reading of the economic fundamentals.  They fail as investors work out that the view they have of the economy is too rosy.  In so doing, they usher in the next down phase.

Market tops are notoriously difficult to detect.  So many investors incorrectly regard the first leg down in a bear market as just a big correction, which they diagnose as providing a super-good buying opportunity.  That belief is what starts the first bear market rally.

As the “boredom” phase of the bear market  stretches out, investors try to anticipate the beginning of the next bull phase.  They know that bull markets typically start when sentiment is at its lowest ebb and that the first movement upward tends to be explosive.  So they begin to argue (incorrectly, for a second time) that downside is limited and upside is significant.  They also think they can see early signs of economic recovery.  These sentiments are the tinder that sparks the second bear market rally.  It, too, fails as new economic developments throw cold water on these beliefs.

What is a “correction,” exactly? Is one going on now?


A correction is the signature countertrend movement of a bull market.

It’s normally short–lasting two or three weeks.  It’s also shallow, although psychologically  it may not seem like it at the time.  Typically, the decline will be more than 3% but fall considerably short of 10%.

trigger vs. cause

I think it’s important to distinguish between the trigger for a correction and its cause.

The cause, which is always valuation, is usually easier to see.

Stock markets are ultimately driven by the economic performance of the companies whose stocks are publicly traded.  Bull markets occur during periods when corporate profits are not only expanding now but are also expected by investors to continue to do so for an extended period.  During times like this, investors can easily  become overenthusiastic and bid stock prices up to levels that are too high too soon, given consensus expectations for profit growth.  In fact, they tend to do so repeatedly.

Actual earnings expansion may eventually show–and it often does, in bull markets–that the consensus is too conservative.  But the market rarely stands still for an extended periods of time.  It either goes up, or it goes down (don’t ask me why, that’s just the way it is).  So if the justification for the price you’re paying in February for a stock will only come through an earnings report that will be made in October or in the following January, your stock probably isn’t going to sit there and wait.  If there’s no way it can go up for now, you can be very sure it’s going to start to go down.

Put a slightly different way, if the consensus thinks that S&P 500 earnings will be at best $100 for 2011 and that investors will be paying 14x for those profits, the consensus target for the S&P–until the market begins to factor in 2012 earnings–is 1400.  At 1350, this implies only about 3% upside for the market for, say, the next six months.  That isn’t enough financial incentive to choose stocks over some other, less risky investment, in my opinion.

It isn’t that the market thinks bad things will happen in the economy.  It’s a question of the odds of making a satisfactory return.  Sooner or later, this fact dawns on investors.  They slow down their buying to a trickle.

This is the position we were in a week ago.

What must–and always does–happen in this situation is that the market has to decline enough to restore favorable odds.   Last year the magic number for “favorable” seemed to me to be more than 10% but less than 15%.  My guess is that this year the number is lower,because investors are more confident, maybe 10% or so.

The trigger for a correction can be anything.  Many times it comes out of the blue. You should also note that the trigger doesn’t necessarily have to make any sense.   In 2010, for example, INTC reported the first of a series of stunningly good profit results early in the year.  The consensus concluded (incorrectly, as it turns out) that this was the high point for tech earnings in the current business cycle.  So the entire market, which had been a bit frothy, sold off.

This year the trigger is unrest in the Middle East.  My guess is that if equity markets had been 10% lower, stocks would have shrugged off events in Libya.

where are we now?

Proceeding in logical order, the first question to answer is whether we are still in a bull market or whether what we are seeing now is not a correction, but evidence of a reversal of the markets from bull to bear.

True, market tops are notoriously difficult to recognize–more so for always-bullish growth stock investors like me.  But we’ve just begun to see economic recovery take hold in developed markets.  Corporate profits seem to me to be very likely to continue to expand.  Valuations aren’t crazy high.  Interest rate hikes are a long way away.  Therefore, I interpret what we’re in now as a correction.  (Also, as it turns out, I’ve been writing that one is due for some time.)

Applying the rules of thumb I outlined above, stocks in the S&P 500 should be weak for another 5-10 trading days and bottom somewhere around 1250.

On the other hand,  there seems to have been a mini-panic in New York trading around midday last Thursday that may have taken a lot of the negative sentiment out of the market.  From intraday high the previous Friday to intraday low on Thursday, the S&P fell around 4%, which would just barely qualify for the depth of a decline.

I think trading in the next few days will be interesting to watch.  Last week’s decline really wasn’t deep enough or long enough to qualify as a correction, no matter what happened on Thursday.  So there should be more weakness to come, unless underlying sentiment is super-bullish.

what to do in a correction

As I’ve mentioned a number of times in other posts, stocks that have gone up a lot usually suffer the worst in a correction.  “Clunker” stocks (and everyone holds one or two), on the other hand, don’t decline much because they’ve never gone up.  The most useful thing to do when the market is declining is not to hide under the bed, but to upgrade your holdings.  Sell the clunkers at relatively attractive prices and buy healthier stocks at a discount.  You should make gains from doing this.  At the very least, you’ll have gotten rid of securities that would have continued to subtract from performance.

I found myself doing this on Thursday.  That’s pretty early in a correction to be acting.  I’ll be interested to see how this works out.

JP Morgan’s forex + IBM’s Watson = problems for Wal-Mart?

is the high unemployment rate cyclical or structural?

One of the more opaque, but nonetheless (I think) important, aspects of the US economy at present is the current long-term unemployment.  Is it cyclical–meaning the issue will gradually go away as the economy gains strength–or is it structural–meaning the recession prompted/accelerated a change in the way business is done, and that many of the jobs lost aren’t coming back?

For what it’s worth, I’m in the structural camp.

The Fed thinks that the unemployment is structural, too, if last year’s remarks by Minnesota Fed President Kocherlakota that monetary policy can’t change construction workers into manufacturing workers are any indication.  Despite this, the Fed continues to pump extra money into the economy through its “QE II” operations (dubbed that by some economics professor who lives near where the original Queen Elizabeth ships were built), as if the issue were mostly cyclical.

Why?  It feels an obligation to do something–on political and social grounds, I think, not economic–to help reduce unemployment, and this is the only tool it can wield.  I worry that, however well-intentioned, this will do more harm than good.  I’m by no means alone in this.

The orthodox remedy for structural unemployment is to retrain workers, something the country’s community colleges do admirably.  These institutions are particularly effective in getting women ready for better jobs.  Men, on the other hand, appear to come back to college having fewer learning skills.  They quickly fall behind in class, become embarrassed and tend to drop out.

recent evidence

(More than) enough preamble–What evidence is there for structural vs. cyclical?  Three recent items:

JP Morgan Chase

1.  At its investor day on February 15th, JP Morgan Chase talked about its $500 million plan to consolidate its global trading systems.  One result will be savings of at least $300 million a year.  Another is the elimination of the jobs of 3,000 people who manually type trade information into the firm’s computers–likely taking output from one computer and inputting it into a second because the firm’s disparate systems can’t “talk” to one another.  1,300 of the jobs are already gone.  To date, this effort has cut the cost to JP Morgan of making a foreign exchange trade from $.75 to $.10.  $.05 is the final goal.

I realize that Jamie Dimon hasn’t been at JP Morgan Chase that long and that some of the computer incompatibility has doubtless come from acquisitions made during the financial meltdown.  Still, this is a project that will yield at least a 60% annual return on investment and it’s only being done now.

It’s also 3,000 jobs as typists being eliminated.  If we figure that most of the savings are in compensation, that’s 3,000 typist jobs paying around $100,000 each!  Talk about low-hanging fruit.

Many of these jobs may be outside the US.  But not all of them.  And I think they illustrate a part of the employment situation that isn’t noticed or discussed much.  My experience is that every corporation has, say, 5%, of the workforce that adds absolutely no value, that’s “dead wood.”  Imagine the floor you work on.  There’s probably, even today, one person you’d nominate for membership in this club.  But these employees have enmeshed themselves so deeply in the company that it’s either legally too difficult or it’s just too unpleasant to eliminate the positions or to replace the employees with productive workers.

Deep recession both provided the occasion and the motivation to fix these problems.  When MSFT, which has money coming out of its ears, has layoffs, you know that’s what’s going on.  The downturn also taught managers that they could operate productively with less labor.

Having just unloaded the burden of “dead wood,” what would ever prompt you to hire it back?


2.  Watson is the IBM computer that recently soundly defeated two human champions on the game show Jeopardy. Watson can understand slang- and pun-filled speech, is chock full of mounds of trivia facts and can trigger a buzzer faster than most (at least, faster than the two human champs).  Long-term, this is not good news for librarians, tour guides or people manning information booths at the railroad station.  More generally, it suggests that having lots of local lore at your fingertips is eventually going to become little more valuable than having fingertips that can touch the correct keyboard keys.

In other words, the replacement of man by machine is nowhere close to being played out as a fact of modern life.


3.  WMT’s sales in the US continue to stagnate.  There appear to me to be two reasons for this:

–more affluent customers, who traded down to WMT during the recession, are migrating back up to the more upscale venues they frequent in better times.

–less affluent customers are trading down from WMT, to stores that are normally off Wall Street’s radar screen.  In particular, the “dollar stores,” whose target market was once single heads of household who have incomes of $20,000 or less and who typically live within walking distance of the stores, have expanded their lines of merchandise to woo WMT shoppers looking for cheaper prices.

What I find telling about the WMT example is that the retail giant’s customer base is moving in two directions, one with the economic cycle and one against it.  Private equity investors are falling all over themselves trying to participate in the dollar store phenomenon.  They might not be the brightest crayons in the financial industry box, but they see a clear opportunity.  They’re placing their bets squarely on the idea that this counter-cyclical consumer movement will be with us for a long time.

my conclusions

Nothing really concrete in what I’ve written, just a few straws in the wind.  But they’re all evidence that support the belief that the US is facing is a structural employment issue–one that can only be fixed through retraining–rather than a cyclical one that will eventually be remedied by keeping fiscal and monetary taps wide open. 

Being right or wrong on this issue won’t make much difference to stock market action this year or next.  But there are long-term consequences to what policy makers believe.  For example, if unemployment is structural, it won’t make much difference if we tighten money and fiscal policy to put our government finances on a sounder footing.  Our efforts should go into retraining, particularly for men who left high school with few learning skills.  This is the opposite of the current Washington position that we have little to lose from running super-accommodative policy.  It also puts the risk of weakness in the US$ or Treasury bond markets in a different light.

why is Las Vegas Sands eyeing Spain?

the news on Spain…

I was very surprised when I read a newspaper article last week trumpeting LVS’s negotiations with the Spanish government to open a $13 billion-$20 billion casino resort project in that country.  After all, it wasn’t so long ago (late 2008) that LVS was:

–cutting back on expansion (the steel skeleton of the aborted Palazzo expansion still graces the Las Vegas Strip),

–cautioning that the company could be in violation of its debt covenants, and

–the Adelson family was injecting $1 billion of its own money into the company to help reduce its leverage.

…comes from Singapore

The report seems to have been based on a briefing by LVS of reporters in Singapore, although the company has issued no press release I can find, nor has it filed a statement of its plans, which may include casinos in Madrid and/or Barcelona, with the SEC.  LVS is apparently far enough along with that project to be meeting with contractors in Spain in a couple of weeks.

a rosy present

Of course, the situation for LVS is a lot better today than it was back then.  Las Vegas has turned cash flow positive (although it’s still losing money).  More important,  Macau generated ebitda (earnings before interest taxes depreciation and amortization) of $341 million in the fourth quarter.  And the recently opened Marina Bay Sands in Singapore produced ebitda of $306 million during the same period, even though the resort complex isn’t quite finished.  Business in both Asian regions is growing, with LVS thinking the Marina Bay might generate ebitda of $2 billion in 2011. (I’m pencilling in $1.5 billion for Macau.)

Spain makes some sense

In addition, the Spain idea may not be as far-fetched as it sounds at first.  How so?

Making the very crude (but probably still accurate enough) assumption that depreciation and amortization (an addition to cash flow) and interest expense (an outflow of money) cancel each other out, Macau + Singapore could together generate $3.5 billion in cash, before taxes, this year.  Presumably 2012 would be stronger, at the very least because the Marina Sands will have been completed. But business there is also continuing to grow so rapidly that LVS is worried about running out of hotel rooms.

We’ll have a much better sense of LVS’s financial obligations and its debt repayment schedule when the 2010 10-K comes out, but my numbers are at least directionally correct.  They illustrate three emerging characteristics of LVS:

–the company is generating a ton of cash

–most of that is outside the US

–LVS’s mountain of debt doesn’t look so bad anymore.

What does LVS do with its cash?

Well, we know what LVS doesn’t do.  It doesn’t repatriate any more of this money to the US than it has to, since the funds sent stateside become subject to federal income tax at up to a 35% rate.  Burning the money in the street instead would at least allow you to roast hot dogs.

To my mind, it also doesn’t keep a lot of spare cash in the bank in Singapore.  Why not?  Although Singapore’s economic development model is based on Japan, its legal and political systems grew their roots during Singapore’s time as a British colony.  For the British, no monopoly–like LVS and Genting have in the casino business in Singapore–lasts forever.  And the faster a monopolist makes money, the sooner the rules that are allowing windfall profits change.  No, I’m not worried that the decade or so LVS and Genting have as exclusive casino developers will be altered.  My question is about taxes.  I think having bank balances in the billions in Singapore just invites the government to raise the gaming levy.

Interestingly, apparently in response to a question from the audience in Singapore, LVS management also said it has no intention of taking the Marina Bay Sands public, citing the illiquidity of the Singapore and Hong Kong stock markets (arguably true in Singapore’s case, but not relevant, in my opinion).  I draw three conclusions from this answer:

1) LVS doesn’t need the money,

2) LVS would like to keep 100% of the Singapore cash flow potential, which could be mind-bogglingly high, for itself,

3) Marina Sands could easily be the vehicle LVS uses to establish and fund Spanish operations, since there are no potentially pesky minority shareholders to object.  Also, Sands China will likely have its hands full with further expansion in China.

it’s how they roll

Once you get past the headline shock and realize the LVS has the looming problem of how to reinvest its Asian cash flows, Spain doesn’t look so crazy after all.  An aggressive move, yes.  But that’s just how LVS rolls.




oil refining basics: why countries like Libya are important to the world economy–plus a thought on the markets

Political upheaval in Libya is causing much more turmoil in world stock markets than the popular overthrow of the government in Egypt–even though Egypt is a much larger country with much more influence in Middle East politics.  The obvious difference between the two is that Libya is an oil producer and Egypt is not.  But when we look at the amount of oil Libya brings to the surface every day, it’s pretty small–1.6 million barrels, or less than 2% of the world’s daily usage.  How can that be so important?

The answer is that a lot depends on two factors:  the kind of oil Libya has (light, sweet crude) and the ability of the world’s processing capacity to turn different types of oil into usable products.

refinery basics

Wikipedia has a chart that diagrams the structure of a typical oil refinery.  It’s complicated.  Luckily, six years as an oil analyst taught me that you don’t need to know all the ins and outs. The Cliffnotes version:

1.  The primary refining process consists in putting the crude oil in a big metal cylinder and boiling it.  Heat causes the crude to break up into three parts:

—the lightest molecules, basically gasoline, that rise to the top of the tube

—medium-weight molecules, jet fuel, diesel fuel, home heating oil, naphtha, that settle in the middle

—the heaviest, industrial boiler fuel or “residual” oil, tar, asphalt and other junk, at the bottom.

The top two parts, or “fractions,” contain most of the value.  The third might be hard to give away.

2.   An increasing proportion of the oil available for refining is what industry jargon calls “sour” instead of “sweet. ”  That is, it contains sulfur, a corrosive element and a pollutant.  So most refineries have expensive desulfurization machinery that remove the sulfur from refined products.

3.  An increasing proportion of the available oil is also “heavy” instead of “light.” That is, it’s rich in bigger molecules and contains few small ones.  Therefore, the primary heating process yields large amounts of the junky stuff at the bottom of the column and very little of the more valuable gasoline and middle distillates.

As a result, most modern refineries also have (again, very expensive) machinery to “crack,” or break up, the large molecules at the bottom of the distilling column into smaller-molecule, more valuable output, like diesel or gasoline.

That’s all you need to know.  Light, sweet crude:  boil it and you’re done.  Heavy, sour crude:  spend billions on a “back end” to your refinery so you can make it into stuff people will buy.  Why do this?  …heavy, sour crude is a lot cheaper.

world refinery capacity:  a mixed bag

Building, or even upgrading, a refinery is a pain in the neck.  It’s a multi-billion dollar, several year project.  It requires educated guesses about what kinds of crude oil, sweet or sour, light or heavy, will be available on the market when the refinery is finished, as well as whether there will be more or less demand from competing refineries for the kinds of crude your plant is optimized for. In addition, in most developed countries, it may be next to impossible to get local government permission for any kind of building.  Do you want a refinery in your back yard?

As a result of all this, there’s still a substantial amount of refining capacity, particularly in Europe, where the owners have opted to do nothing.  So these plants can’t process anything else except the lightest, sweetest crude.

why Libya matters

That’s where Libya comes in.  Yes, Libya is only a small factor in the world oil market (the country may have huge reserves, but that’s irrelevant if they’re not being developed).  And it has a reputation as an unreliable supplier.  But the 1.6 million barrels it churns out is all easy/cheap to refine light, sweet crude that’s rich in the gasoline and diesel fuel that the US and Europe consume.

There may be lots of “extra” crude oil available on the market.  But that’s predominantly heavier and sulfur-laden.  These are only substitutes if the refineries that have contracted for Libyan crude can process these lower grade oils as well.  The frantic bidding we’re seeing in the market for similar light sweet crude argues that they can’t.

The refiners affected are in a no-win situation.  They can scramble to get the crude they need, so they can produce fuel for their retail outlets, in which case they get blamed for higher prices.  Or they can simply shut down until Libyan crude is available again, in which case they’d take the political heat for supply shortages.

In the short term, then, the mismatch between the capabilities of the world’s oil refining plants and the “slate” of crudes available to refiners will translate into higher retail prices.  Because of the unusually pure nature of Libyan crude, withdrawal of even that country’s small contribution to world crude production can cause this.

stock market effects

I don’t have any idea how the Libyan situation will play out politically.  My guess is that virtually none of the “experts” talking or writing about Libya do either.  The least favorable outcome for the world ex Libya would be a years-long cessation of that country’s oil production–sort of a mini-Iraq.  World refined products prices might be, say, 5% higher than they would otherwise be.  Consumers in the US, where taxes on gasoline are very low by world standards, would be disproportionately hurt.

Even in this case, though, I think there are much more powerful currents affecting the US economy–like the pace of recovery, mobile broadband, internet-enabled erosion of brick-and-mortar retailing.  Yes, the US would be hurt, yet again, by Washington’s failure to have a coherent energy policy.  But we deliberately haven’t had one for thirty-five years, so that’s not real news.  And somewhat higher oil prices could get lost in the welter of other, structural things going on.

To my mind, the current downdraft in world stock markets has very little to do with Libya. It has more to do with how high the markets have gone in the past six months.

The S&P 500, for example, has been steadily rising since September and is up by 28% since then.  Time for a correction?

Looking at the market from another perspective, the S&P was up more than 7% year to date as of mid-day last Friday.  Assume we could have closed out the month that way.  If 7% were an average two-month return on stocks, then the yearly return would be 42%–or 4x what history tells us is the norm for stocks.  In year one of a bull market, this might be possible.  But approaching year three?   …no way.

To my mind, Libya is more a trigger than a cause for investors to take profits after this run.  If it hadn’t been Libya, it would have been something else.

One interesting characteristic of world equities over the past few months has been–until this week–the unwillingness of stocks to go down.  I’ve been reading this as being the result of an asset allocation shift to equities and away from cash and bonds.  If so, it will be important to watch for how deep this correction is and how long it goes on. Continuation of flows into stocks would argue that the correction will be shallow and brief.  Looking at the charts, the first line of defense for the S&P is around 1300.

In short, I’m reading this downdraft as a natural part of the two-steps- forward, one-step-back character of equity markets.

Most investors simply don’t look at prices during a period like this.  That’s ok with me.  I’ve always found these times to be good for upgrading your portfolio.  Stocks that have done poorly over the past year probably won’t go down much in a correction (after all, they didn’t go up), while strong-performing stocks can be hurt badly as nervous investors “lock in” profits.  So you may be able to switch to better companies at a 10%-20% cheaper price than you would have been able to last week.  The fewer investors doing this, the better bargains for those who are.