"Perhaps the twin stock market crashes – 50% between 2000 and 2002 and 55% between 2008 and 2009 – left most of us in the investment business with a sort of financial 'PostTraumatic Stress Disorder.' Before these back-to-back meltdowns were seared into our minds, a 4-5% market setback was just a 4-5% market setback. But with two historic bear markets now fresh in our experience, every minor correction revivifies those recent traumas and sends us back into our emotional foxholes. Such a dynamic may partially explain the fact that the Yale 'Crash Confidence Index' is currently showing 'excessive pessimism' in the face of a 25% advance in stock prices over the last half-year. Stocks are, in fact, up a full 100% from the 2009 lows, but current confidence that there will not be another crash within the next 6 months is very low. In fact, confidence is currently at levels that have in the past been associated with beaten up equity markets and buying opportunities – not robust markets and selling opportunities."
- Paul Macrae Montgomery, Universal Economics, May 21, 2012
I will devote most of the remainder of this commentary to the technical position of the market, as my esteemed colleague, Paul Montgomery, provides such clarity in his assessment above of the sentiment backdrop in his most recent weekly report to his institutional subscribers. Suffice it to say, this was also a week that included a Reuters piece entitled "Investors lose faith in stock valuation compass," with analysts quoted as expressing concern that "traditional valuation measures," while indicating a relatively cheap market, don't do the job in today's turbulent times. As Paul might also note, during the initial pullbacks from real market tops, analysts can't reiterate fast enough the buying opportunity afforded by these pullbacks due to more attractive valuation. In addition, a national business weekly published a study this week concluding the recent market pullback "confirms the bear's return."
The 131-point correction in the S&P 500 Index (SPX) from its intraday peak of 1,421 on April 2 to its intraday low of 1,291 on Monday checked in at 9.2%, which is certainly within the bounds of a "healthy correction" (as bulls tend to define them – at least during periods in which bulls are commenting on such matters). In addition, there is a confluence of support at the 1,287 level consisting of the 40- and 80-week moving averages, which have worked quite well (though not perfectly) over the past 15 years (see accompanying chart). A level of significance that has been broken on this market correction is 1,333 on the S&P, which marks the doubling point from the intraday bottom at 666 in March 2009. I have commented a number of times in this space about the importance of these "doubling points" from lows, and in fact the market stumbled on numerous occasions in the 1,333 area in 2011 before the sharp pullback that began in August. But note that as of today's close, we are just a 1% rally away from re-taking 1,333.
Another price of great interest is the $60 level on the Power Shares QQQ Trust ETF (QQQ), which represents about half the QQQ peak of $120.50 achieved on March 24, 2000. All QQQ rallies in 2011 were capped just below $60, which was not penetrated until January 2012. Friday's QQQ pullback low of $60.76 could mark a tradable bottom as the "half-high" begins to act as a support level.
My general conclusion remains that the ongoing combination of a relatively strong stock market overlaid with a backdrop of investor sentiment that can be argued to be bearish in the extreme bodes well for stock prices. But within the context of an over valuation of market risk, I believe there is under valuation of some stock-specific risk – namely, that reflected in the pricing of the options on JPMorgan Chase (JPM). Implied volatility for JPM options, while certainly not cheap historically, has come in by more than 5 points from Monday's peak levels. While there has been a modest rally in the shares off the lows, neither the share price nor subsequent developments regarding the company and its trading activities are signaling the worst is over. So we view the opportunity to protect against further shocks to the company through reasonably priced put options as worthy of your consideration.
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