Why S&P 500 Pivot Point Is 1,250

I'm not going to get into any of the reasons the stock market has been so volatile in the past few months. The talking heads on TV are doing a good enough job confusing/entertaining investors with this.

Rather, I'm going to make a case for why the S&P 500 Index has been leveling out around the 1,250 level and explain why getting in the market below that makes sense. I don't know about you but my mattress has been getting awfully lumpy lately.



When all is said and done in Europe, investors will once again return to corporate earnings as their gauge of stock market performance. What the latest earnings estimates from analysts are telling me is that most are seeing weak growth through the remainder of the year and then stronger performance next year. When analysts are uncertain about growth prospects, they simply use a simple straight line assumption which appears to be the case next year. I'm far less certain.

But for the sake of simplicity, I'm using a conservative $83 per share annual earnings estimate for consolidated S&P 500 index components. (The consensus is $91.59) My estimate assumes significant global economic deterioration in the current quarter followed by stagnancy or tepid recovery next year. I'm obviously more bearish than the consensus, but I don't see us returning to grow rates above 2-3% anytime soon.

So getting back to the 1,250 pivot point. Why is the market going to turn around this point? Based on my conservative earnings estimate, this is the level where the market's P/E ratio (price to earnings) is at its historical mean (~15). Meaning historically, the market would be cheap under 1,250 and expensive above 1,250.

I had been waiting for the market to drop below the 1000 level to put some more mattress money to work. But I'm considering the worst maybe over and that Italy will be the final shoe to drop in this European debt fiasco. I've got my eye on the 1,150 level now. What to buy then? Check back next time.

Let History Be Your Guide

There's never been so much uncertainty in the stock market about the future of the global economy. Half think we can slog along with anemic growth, while the other half think we're headed back to recession.

A chart of the S&P 500 Index is looking like an electrocardiogram since the beginning of August, when serious concerns about European debt problems as well as our country's inability (read gridlock in D.C.) to deal with joblessness and lack of capital spending by firms. Oh, and there's a supercommittee of legislators expected to deliver a plan for massive (trillions) federal spending cuts by November's end.

So, when all is in doubt what is an investor to do? For my money, I'm looking back in history to a similar time of tremendous public doubt about government and the future of the financial system. The behavior of investors then is shaping up much like as it is playing out today.

Following the crash of 1932 (2009), stock rebounded sharply over the next few years 1933-1936 (2010-2011). Then there was another pull-back, followed by a slow and steady rise back. But stocks didn't recover to their pre-crash levels for 25 YEARS! Now with new computer-driven trading technology and supposedly smarter traders, I can see that time frame today condensed by more than half. But that still means we have 5-7 years before all the bad news shakes out of the market -- the deleveraging of the global economy is done.

So . . . I'm saying we're not likely to see S&P 1500 for quite a while. It's at 1154 now.

If you look at the chart above, the best point of entry back then was in late 1941 -- after Pearl Harbor when we declared war with Japan. WWII brought on a period of tremendous economic growth and prosperity for our country and investors profited greatly. We may need a similar extreme global event to kickstart our economy again.

I can't envision one yet. I'm still 50% market 50% mattress.

U.S. downgrade deflates value of ALL investments

Waking up to headlines like this can be scary:

US debt talks teeter on edge of collapse

Experts say buy gold or keep plenty of cash. But few explain the reason why all cash-flow dependent investments will suffer when the credit of the world's largest economy is downgraded.

Here's the not-so short and sweet: When you value a company, or stock, you have to estimate its future cash flows. Obviously, the more expected cash flows, the more valuable the company. But, in order to get the value that you'd pay Today for that company, you must discount those cash flows -- meaning future cash flows are less valuable today. (The old bird in hand saying)

The discount rate almost all financial experts use to discount cash flows is the "risk-free" rate on U.S. government treasuries (U.S. debt). When the U.S. defaults, the ratings agencies (S&P) lower the country's credit rating. Investors in our debt demand to be paid a higher rate of interest in return. And the borrowing cost to the government, and this discount rate, goes up. When the discount rate rises, the value of ALL future cash flows goes down.

Now the two big questions are: Will government debt actually be downgraded, and if so how much will this discount rate rise?

My feeling is that even if the government comes to some last minute agreement to raise the debt ceiling, ratings agencies have already committed to downgrading our debt based on fundamentals. So yes, I think that barring some miracle (like Washington agreeing to the types of dramatic cuts in spending and tax increases needed, but that will cost them their jobs) the U.S. will be downgraded.

How much will investments suffer? I don't think a 5% to 10% correction is out of the question.

I've positioned our portfolio at a tactical non-commitment level of 50% market, 50% mattress. If you are on a shorter-term investment horizon (retirement looming) you should be even more conservative.

Sell all funds that hold primarily U.S. government treasuries, except inflation protected bonds. Maintain international exposure. Look to invest in Swiss-backed government debt (safest in the world). And, if you're uncertain completely, keep your money in an FDIC-backed CD.

Here's the kicker. When the government eventually raised the debt ceiling (and they will), get ready to unload some of your investments. It will be difficult. The market will jump on the news. There will be elation and hope for a resurgence in domestic growth. But nothing ever lasts.

"We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful." -- Warren Buffett

My Advice

Just watched Jim Cramer's Mad Money. You know, the guy who says "There's always a bull market somewhere." Sorry Jim, you're wrong.

Global equity markets are going down. I've expected this for some time. Just didn't realize how far up they'd rise before then on nothing more than the strength of the Federal Reserve's so called "Quantitative Easing 2" or QE2 program.

Retail investors just aren't getting back in the game. I for one have been taking money gradually out of the market since the beginning of the year. My family's sitting on a cash cushion of about 50%. Not that I'm happy about earning next to nothing in a non-FDIC insured money market fund. But the options of locking away my money at 1% a year in a CD don't offer a viable alternative.

So, I guess you could buy gold, which has started to uncorrelate with the broader stock market. For me that's just too speculative at these levels. Just look what happened to silver prices at the beginning of May.

The only real alternative is to hedge aggressively. As I said, I'm heavy into cash, but also have money in large, mid and small-cap funds as well as international exposure. I like Invesco Dividend Investor (LCEIX) for stability and dividend yield. My mid-cap money is in Scout Mid Cap (UMBMX) and small cap is in Royce Value (RYVFX) - although I'm keeping an eye on Royce since lately they've been underperforming their benchmark.

Hence readers, I'm seeing this shaping up for the future: More wrangling over the debt ceiling, a default in Greek debt, other European debt downgrades, China inflation persisting, U.S. inflation creeping up, no relief on the jobs front, oil prices coming down slightly on weakening demand, the federal reserve weighing another round of easy money and the media being consumed with political rhetoric ahead of next year's election.

Unless Uncle Ben and the Fed step in soon to offer relief or Congress raises the debt ceiling soon, the stock market is heading lower. I'm thinking this second quarter earnings season is going to be a disappointment too. So taking money out of the market now is a safe play.

For me, I'm 50-50. Jim Cramer had one thing right last night. The only way out of this mess is lower stock prices. S&P 1000-1100 is when I see the next bull market.

ETFs: The Next Meltdown

My latest rant along time back - Sept. - bashed the U.S. as I endeavored to create a globalized diversified investment strategy to play countries, rather than companies as investments. Trouble was, I focused on using the crazy-popular ETF (exchange traded fund) as my primary investment vehicle. If anyone doesn't believe that ETFs are the only game in town, read this:

US ETF Assets Hit $1 Trillion Milestone

Now, the first rule of investing - and an idol of mine Warren Buffet's favorite piece of advice - is invest in what you know. Wall Street has made that much more difficult since they decided to turn away from hiring finance majors, and instead put MIT wizzes to work as "quants" on black box investing strategies. So, being the dutiful investor, I decided to look into exactly how an ETF works. Yes, the industry has done a marvelous job marketing these products and every day there is news about another ETF opening to investors. But how exactly do they work and are ALL my family's assets safe in them?

The more and more I looked into them, the more fearful I became. Here is a product that essentially is an index fund operated by a trustee that purchases shares of equity in that index for its shareholders. Investment banks create initial share of these ETFs as creation units, which are then traded to hedge funds, other institutions and you and I - the retail crowd. What branches off from reality, however, is the fact that these banks can create an UNLIMITED number of these shares to satisfy market demand.

Now, I don't know about you, but in my opinion there can be no market when there exists an infinite amount of anything. This becomes a concern because short sellers - mostly hedge funds - can borrow ETF shares from those that own them and sell them, realizing a profit if they drop in value, but promising to pay them back to the owner if the ETF rises in value. Indeed, the amount of short interest on some of these ETFs is staggering - well in excess of the value of the underlying long holders.

Check this out

This introduces a HUGE counterparty risk to the holders of the ETF. Counterparty risk is the risk that the other player on the trade - in this case the hedge fund - will not be able to make good on their promise to give you the shares back when the ETF rises. Advocates for ETFs say these short players have to post collateral on such trades, but somehow I'm not assuaged by that argument given the recent financial subprime metldown and the fact that not even the smartest brains on Wall Street on in Washington had any idea what a CDO (collateralized mortgaged-backed security) was.

I'm not advocating that there will be a failure of an ETF. That might be the case. What I do know if the "Flash Crash" that occurred 2:45 p.m. May 10, 2010 causing the biggest one-day decline in Dow Jones Industrial Average history was linked to ETFs. By the way, regulators still don't know the exact cause.

There is a general disconnect in basic trade theory that you need a supply and demand for a properly functioning market. The demand is clearly there - $1 trillion in ETFs - the high correlation between ETFs and the overall market, etc. Investment banks and wealth managers are pushing these things are tax-advantaged investments with no more risk than the average index fund. Yet, that is not the case. These are derivative instruments - what Buffet has called "weapons of mass destruction." When you buy an ETF share, you don't own the actual shares of the companies in the index as you would in a traditional mutual fund. You own the right to a creation unit - that remember has an unlimited supply. So skyrocketing demand - unlimited supply. Do you see a problem ahead? I do.