Staying Short Despite the Rally

Right now in the real world, conditions are terrible. Earnings for the third quarter look to be down for 22% of the S&P 500, while 30% of the 500 fell short of analysts' estimates, a number 50% greater than average according to a report from Thomson Reuters this week. I warned earlier this year that third- and fourth-quarter estimates were far too high, and I was not pessimistic enough: As Doug Kass reported Monday, Goldman Sachs (GS - commentary - Cramer's Take) has now lowered its EPS estimates from $500 to just $53 next year.

Also keep in mind that the strongest sector in the third quarter was energy companies, and those earnings will evaporate with the current price of oil. Retail earnings will not improve with rising unemployment and falling home prices for some time to come. Anything related to the auto industry is unlikely to have good earnings next year. I do not see any sector strong enough to buck the trend.

The current market multiple is nearly at 16 -- far too high for a negative-growth environment. That number implies a lot more downside for stock prices. Using the old Ben Graham formula for P/E ratios (8.6 * (4.4/AAA 10-year bond rate)), I get a number less than 10. That leaves room for enormous additional downside pressure on stock prices.

My only saving grace this year was realizing I was not smart enough to figure out where the economy was going to go and hedging my stock purchases -- I am continuing that policy for now. Every day I run stock screens that show me ever-longer lists of very cheap stocks. Forest Labs (FRX - commentary - Cramer's Take), which trades at less than 7 times earnings and has very little debt, hit my radar screen recently. The stock has caught the attention of some successful investors, including Fairholm Capital, LSV Management and Renaissance. However, I am having a hard time pulling the trigger after a two-day rally.

---

At the time of publication, Melvin was long DOG, SH and FSTR and short TLT, although positions may change at any time.

Tim Melvin is a writer from Stevensville, Maryland, who spent 20 years a stockbroker, the last 15 as a Vice President of Investments with a regional firm in the Mid Atlantic area. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Melvin appreciates your feedback; click here to send him an email.