Do Fundamentals Matter?

Jim Brown
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The equity market is imploding with the S&P-500 declining -235 points or -17% since the high on July 21st. This is the worst start for August on record and it appears the damage may not be over. There are multiple reasons for the market drop and none of them are related to fundamentals of individual stocks.

When investors see a normal market dip they take a deep breath from the loss of recent gains but then they go bargain hunting. They may repeat this process for several days in a row or 2-3 dips but eventually the losses they are taking become too painful to endure.

They start selling their least favorite positions in hopes of holding on to their core positions. As the losses continue and margin calls mount there is eventually a point where even the most hard-core investor decides to stop the bleeding and move to cash.

That is what we are seeing in the markets now. Traders and investors have seen gains turn into losses over just a three-week period and with sharper declines than anyone has seen since the market crash in 2008 when Bear Stearns and Lehman collapsed and AIG, Citigroup and others had to accept monster bailouts from the government just to stay alive.

Are conditions today as bad as 2008? They are not even close. The Q2 earnings cycle is coming to a close and 77% of the S&P beat the street in earnings per share with earnings growth of +18%. Revenue growth rose by +13%. This was a good quarter by all the normal metrics.

S&P companies now have record amounts of cash on hand and 57% more than in December 2007 just before the 2008 crisis began. More than 160 S&P companies now pay dividends greater than the 10-year note yield.

The price to earnings ratio on the S&P is now 12.5 and the lowest level since the bull market rebound began in March 2009.

Despite the positive Q2 earnings cycle there were some problems with a slightly higher than normal number of companies issuing lower guidance for Q3. This was not a flood of companies or a number of serious cuts but just a few companies worried about a decline in economic activity in July.

That decline in economic activity was due to increasing anxiety over the debt debacle in Washington and the rising concerns over the European sovereign debt crisis. In Washington some politicians used the time tested tactic of warning about Social Security checks being delayed, Medicare benefits being cut, food safety being compromised, student loans halted, etc because of the impending default of the U.S. Treasury.

The very visible partisan politics and the war of words in the press caused consumers and businesses to close their wallets and go into hibernation pending the outcome of the crisis. Consumer confidence plunged and businesses halted expansion plans and raised cash to increase liquidity.

These problems would not have been terminal except for the other problems impacting the market like the European debt crisis. With the U.S. economy slowing and the global economy still reeling from the Japanese earthquake along with forced austerity breaking out all over Europe the global economic outlook began to decline.

Each problem by itself would have been easy to overcome but the convergence of multiple high profile events all at once combined to weigh on the markets.

Normal market corrections happen all the time and all investors are aware of this and have learned to deal with it. This has developed into an abnormal correction and is bordering on a bear market.

Markets rarely decline -17% in three weeks. When a sequence of events creates a market drop of this magnitude we see different challenges come into play. A normal decline of this magnitude happens over months rather than days. That gives traders, investors, institutions and hedge funds time to adjust portfolios, buy insurance, analyze options, etc.

In a decline of this magnitude the decision process involved in those portfolio adjustments is condensed into a period of hours or in some cases minutes. Stops are getting hit across the board without regard to sectors or technical levels. Margin calls are becoming a daily occurrence. Forced margin selling takes on an entirely new ferocity.

Investors of all types are being hit with a deluge of information that requires immediate action. Individual investors are not the only ones being hit with margin calls. Hedge funds and institutions are also receiving those notices daily. This forces everyone in the market to sell whether they want to or not.

The name of the game becomes capital preservation not profit production. Individual investors have been hammered by the decline but I doubt that you or I seeing our accounts cut in half would have a tremendous impact on the market. However, hedge funds and institutions with billions on the line do have an impact on the market when they are forced to sell.

Hedge funds are down 14% to 16% year to date according to Anthony Scaramucci, managing partner at Skybridge Capital. They have $8 billion in assets under management. Scaramucci said hedge funds are now down another 12% to 14% month to date and it is only the 8th of August. These funds have been crushed and withdrawal requests were already heavy and they are accelerating. They are being forced to sell anything in sight to raise cash.

Morgan Stanley said last week normal hedge fund leverage had been cut from 1.5 to 2.0 down to as little as 0.45 meaning only 45% of their cash was invested. This is a monster hit to the markets and those slow to react and holding out for a miraculous recovery have been hit even harder. The S&P-500 declined -6.66% on Monday alone. For anyone with any leverage on the long side it was a very bad day.

The decline in equities has been so severe that investors have had to dump commodity positions to raise cash. About the only commodity posting gains is gold. Other commodities like copper, oil, grains, etc have been crushed. Fundamentals no longer matter when you are covering margin calls. It is simply a mad rush to the exits to preserve any remaining capital.

Crude oil demand is equal to existing production with very few barrels to spare. The Libyan civil war has taken 1.3 million barrels per day out of production yet China, India, Asia and Latin America are still posting strong increases in demand. There has been no change in demand or production over the last three weeks but crude prices have declined $20 (-20%) simply because investors needed to raise cash very quickly and selling crude futures were an easy way to recover capital.

U.S. crude prices are trading just over $80 on Monday night. The rationale given in the press is the risk of a global economic slowdown. This total BS with the talking heads on TV trying to find a convenient excuse for everything. Crude oil, just like the rest of commodities and equities, was dumped in the race to raise cash.

December WTI Crude Futures Chart

Does anybody really believe demand is going to decline? China is still adding about 1.2 million cars per month and the U.S. 1.0 million. China will add 19 million vehicles in 2011, up from 8.1 million in 2007. Globally J.D. Power & Associates claims we will add 76.5 million new vehicles in 2011 compared to 72.0 million in 2010. In 2012 that is expected to rise to 85.0 million and 91.0 million in 2013. By 2015 sales of new vehicles will surpass 100 million a year. Also in 2015 India will be the third largest market with Brazil in fourth position.

When the market gives us a pivotal event like a -17% decline in less than three weeks there is a very strong profit opportunity. While nobody can say without a doubt the market will be up or down on any given day or week there are certain things that give us a warning about future events. Above all nothing ever goes straight up or straight down. You can only wind that rubber band so tight before there is a massive reversal. In the next few days there will be a rebound and given the 500-600 point days on the way down we could see some serious numbers when the shorts finally get squeezed.

While I believe there is a market rebound in our future I am convinced the energy sector will be a leader in that rebound. Nothing changed in the global demand picture. Demand is still rising although it may be rising at a slightly slower rate than it was a month ago. When the U.S. economy does begin to accelerate that demand will also increase.

The drop in U.S. WTI oil prices today is a gift. An expensive gift for anyone that was long energy equities but still a gift for those willing to bet on facts and not fear. If you lost money in your energy positions over the last three weeks this is an opportunity to recover some of that money.

The US Oil Fund (USO) was trading at $39 two weeks ago before investors began the scramble to raise cash. It closed at $31.50 on Monday. I am recommending today that investors buy the January $34 call, currently $2.44 and I believe you will be well rewarded.

Buy USO Jan $34 Call, currently $2.44, Target USO at $38

USO Chart

Oil prices have been slammed to artificially low levels by the market implosion and they will not remain at this level. When the equities market does find a bottom and the panic evaporates you will see the energy sector lead the markets higher because global demand has not changed.

The market drop today was reactionary to the S&P news and the race to raise cash. Eventually fundamentals will matter again and the biggest long-term fundamental fact is rising oil demand and limited production increases.

Jim Brown

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