Schaeffer: A "Cover" Story
05/28/2004 12:00 am EST
"Our approach to timing is sentiment analysis with a twist," says Bernie Schaeffer, president and CEO of Schaeffer's Investment Research . "We focus on media and investor sentiment, and then add technical and fundamental analysis." Here's a fascinating look at the outlook for stocks.
"What we are trying to do is measure or identify those situations where we have extremes in investor sentiment in one direction or the other. We experience despair at market bottoms and euphoria at market tops. At a market top, buying power is exhausted. At a bottom, selling pressure is exhausted. We try to identify the situations where those emotional backdrops are in place. During an upmove, we are looking to identify a situation where a market is in the euphoria stage, where it is very vulnerable to topping. Such a euphoria stage is essentially saying that the buying power that can be committed to that market is close to being exhausted. So if you were to buy into that market at that particular point in time it is dangerous; it's a vulnerable time in the market because so much of that buying power has already been dissipated in getting the market to that particular point that it has reached.
"What we are trying to do when we are buyers, is to buy in situations where the rally is sustainable. The best way to measure whether a rally is sustainable-in addition to looking at the technical charts-is to look at that sentiment backdrop and see if there are signs that there is still sideline money out there that is able to come in and support the market. For example, big short positions that are yet to be covered could provide some buying power, and short covering pressure would help power that market higher. The same idea applies to declining markets or a declining sector. We look for the despair phase where the selling pressure has been completely or nearly completely dissipated. One of the best indication that strength is going to perpetuate itself is light coverage by Wall Street analysts or if there is heavy coverage, but a lot of holds and sells as opposed to buys. Why? Because that stock can be upgraded and that's going to fuel further gains in the stock.
"There is a mindset out there that contrarians look for the companies that are tremendously beaten down. What we're looking for is not low prices, but low expectations. We look for a combination of strong price action and low expectations. It sounds like these two factors are incompatible, but it happens all the time. The entire small-cap stock rally and tech rally of 2002 through 2003 was accompanied by low expectations. This rally was accompanied by warnings about speculative froth, with advice to stick to quality stocks and advice to stay away from risky names. That sentiment was reassuring to me, as it continued to show that everybody hadn't yet jumped aboard that train.
"What am I looking for in an ideal stock to buy? I want strong price action, and some strong fundamentals. But the strongest criteria of all from my perspective, is evidence of low expectations. Now there are a lot of ways you can slice and dice sentiment data to try to measure those expectations. You can look at put-call ratios, look at short interest, you can look at the configuration of analyst Buys, Holds, and Sells and track that over time, but there is also another very simple way of getting a handle on what those expectations are. If a stock has been weak and declining, and if you see buy recommendation in the financial media, be afraid. Don't be reassured.
"Magazine covers are an extremely powerful tool for determining situations where we have moved into a euphoria phase (a selling opportunity) or a despair phase (a buying opportunity). Magazines, which feature popular sentiment, are a great long-term indicator. For example, in November 1992, Time magazine featured a cover that read, 'Can GM Survive in this World?' This highlighted extreme despair on the auto industry and coincided with the market lows. Just 13 months later, the sentiment pendulum swung from despair to euphoria and a cover heralded the 'How Detroit is Shifting into High Gear'. But the stock market was almost completely out of phase with these perceptions. A cover on the Economist of June 2003-with the headline, 'Extinction of the Car Giants'-shows we are back to despair again in the US auto industry. Yet, since then, these companies have been showing very strong earnings. Two-thirds of Wall Street analysts rate the auto stocks as Hold or Sell, so we are in a despair-type backdrop. As such, I would expect the auto sector to be an outperformer, based upon this sentiment backdrop.
"Bulls on magazine covers are an indication of a potential euphoria environment where all the money that is going to be committed to the market has already been committed, which makes the market vulnerable. One of the most despairing series of covers that I had ever seen occurred in late 1998, when we had the decline in Russia's emerging market and the Long-Term Capital Management crises. The cover of the Economist showed a bull being steam-rollered by a bear, and Barron's bull being used as punching bag by a bear. There were some eight similar covers. Even Esquire magazine stepped into the picture. So, from our view, it wasn't too surprising that the market was close to bottoming. Of course, it is not as simple as just buying and selling based on magazine covers. And it doesn't always work, but I'm trying to highlight how these covers can be viewed in terms of assessing the sentiment backdrop during your investment analysis.
"What would I consider to be the most euphoric reaction to any event that I have ever encountered was AOL Time Warner. The people involved weren't just 'Men of the Year' but were called these 'Men of the Century' in the January 2000 BusinessWeek. In April 2001, about 15 months later we had another extremely congratulatory bullish euphoric magazine cover on AOL Time Warner called 'King of All Media'. But the record, belongs to Microsoft. There have been seven bullish magazine covers on Microsoft between mid-2000 and now. So, it is no surprise to me that Microsoft continues to be weak. On Wall Street, 28 analysts cover Microsoft, and 27 have Buy recommendations. Where is the buying power going to come from? Everybody owns it, up to their eyeballs. And the stock is going nowhere. So I expect the next major move is going to be down.
"In March 2002, GE was America's most admired company and analysts have refused to give up on the stock despite the major decline from the highs. In general, the big blue chips are in a very similar situation. The analyst community is extremely enamored of them. We see 85% of analyst recommendations as buys. Short interest is almost embarrassingly light. We think these stocks are very vulnerable. If you feel you are going to escape the ravages of a bear market through big blue chips, I'd suggest you think again. There are other big blue chips showing extreme bullish sentiment, such as Johnson & Johnson and Procter & Gamble. And after Microsoft, IBM is probably my second least-favorite tech stock. On my tech sell list, I would also throw in Hewlett-Packard, for good measure. There has also been a lot of favorable commentary on Best Buy, which is also on my sell list.
"Finally, I want to just talk for a moment about the current market environment. We know how much money has come in to equity mutual funds, and we know how bullish money managers are. The latest Barron's poll showed only 12% of money managers are bearish on the market for the next year or so, so all that money has been committed to the market. A lot of short positions have already been covered and yet the major averages are turning lower. This is of extreme concern. Earnings are good and getting better. The economy is good and getting better. Yet at the same time, the market can't seem to get out of its own way. Good news and money coming into the market, along with the market not being able to show any strength, could be called a classic distribution phase. My bet is that the smart money is distributing to the unsophisticated money. I am going to close with perhaps a relevant quote from Warren Buffet: 'If you are in a poker game and you can't figure out who the patsy is then you're the patsy'."