Ten Checkpoints Before Market Liftoff

Market bottom or bear trap? Should investors start moving cash back into the market or wait till lower lows later this year?

At my firm, we've been accumulating cash since March. I'm itching to buy the stocks on our preferred list, many of which are trading at multiyear lows, but I'm looking to see confirmation that the three monster rallies of the past two weeks are more than short-covering. Here are 10 parameters I'm tracking before I jump back in:

Economic Environment

1. First Call's analysis of forward earnings remains bullish. First Call is a market data service that aggregates analysts' reports on individual companies, industry sectors and the overall S&P 500. First Call provides a weekly summary of this information, which I check every Monday morning. In aggregate, the S&P 500 is expected to grow 4.3% in 2002 and 19% in 2003 after falling 17.3% in 2001. On the basis of forward price-to-earnings ratios, First Call estimates that the S&P 500 is 29% undervalued. In particular, I track how quickly analysts' generally optimistic forecasts are being revised downward. The recovery in corporate profits was originally projected for the first half of 2002, then the second half, now the first half of 2003.

Related Stories

Document Your Investment Strategy

Chart the Future of Your Retirement

Reverse Engineer Your Mutual Fund

2. The Fed sits tight. In recent days some market watchers have called for the Federal Reserve to cut rates before year-end to give the stock market a boost. The problem with a Fed move is that it would signal that the economy is sliding back toward recession without doing much to stimulate spending. Corporate borrowing and mortgage lending rates are tied to the yield on the 10-year Treasury, and that rate is at a 40-year low. The Fed can also boost the economy by expanding the money supply. If the money supply grows too slowly, borrowers won't be able to find credit. If the money supply grows too rapidly, inflation can result. Check the Federal Reserve's Web site for information on money supply growth, particularly M2 and M3. The Fed sharply boosted money supply growth last year to offset the recession, and it remains in an accommodative mood.

3. Ten-year Treasury yields move higher. Although low Treasury yields are generally good for the economy, a gradual increase in the 10-year Treasury yield to about 5% would indicate that investors were reallocating some funds from fixed income back to equities. Pension funds, for example, generally maintain fixed percentages of stocks and bonds in their portfolios. Following this spring's falloff in stocks and rally in bonds, these ratios are now out of synch.

Another factor to track, if you can get access, is the "credit spread" -- the difference between yields on the 10-year Treasury and yields on lower-graded corporates. The spread right now is fairly wide at 4.6% and was as narrow as 3.3% in May (it peaked at 5.0% after last year's 9/11 attacks). If the spread starts to narrow again, it indicates that bond investors are more willing to accept the higher risks of corporates, which means they're more bullish on the outlook for corporate cash flow.

4. LBO, M&A and IPO activity picks up. In the early 1980s, when the stock market was deeply undervalued, management at many companies decided that the private market value of their firms was greater than the market capitalization awarded by their publicly traded stock, and they tried to capture the discrepancy by borrowing money to buy out the public shareholders in a leveraged buyout or LBO transaction. I haven't seen resurgence in LBO activity, and that indicates that while companies are no longer overvalued, they aren't dramatically undervalued. Also, corporate borrowings remain high, and that limits the potential of this type of transaction.

If companies were truly undervalued, it would be cheaper for them to buy up existing companies rather than build businesses from scratch. There is a limited amount of M&A activity these days (for example, the acquisition of PayPal by eBay (EBAY - commentary - Cramer's Take)), but not at the level that would indicate screaming bargains.

Too much IPO activity is not good for the stock market (new issues increase the supply of stocks vying for investor's funds), but no IPO activity (as we see now) indicates that investment bankers can't entice fund managers to take risks.

Technical Environment

5. The VIX goes lower. The VIX, or Volatility Index, peaked recently over 55, levels last seen right after the 9/11 attacks, and previously during the emerging-market crisis in October 1998. The VIX is a measure of the "insurance premium" demanded by options market makers, in this case primarily on sales of S&P 100 put options; so, high VIX levels imply high fear of further market declines. Ironically, high sales of index put options tend to drive the stock market lower, because the option market makers hedge sales by shorting index futures. If the VIX falls below 30, it would indicate that stock owners are no longer panicking about lower stock prices, and it also would remove some selling pressure from the options market makers.

6. Indexes open lower/close higher. For months, stocks have opened higher and closed lower, as investors used any rally to lighten positions and hedge funds batted the averages around. In the last week or two, averages have opened lower but closed higher. This indicates that long sellers are done and that short-sellers are getting nervous.

7. We see higher lows and higher highs, especially week over week. The S&P 500 declined about 12% in the first six months of 2002 and another 12% in the first three weeks of July. During the decline, down weeks exceeded up weeks about 5 to 1, and up weeks rarely gained ground relative to the previous week's decline.

The last two weeks reversed this trend with higher highs and higher lows. It would be really constructive if the market closed higher this week, because it would give investors confidence that the July 24 low was a true bottom.

8. The advance/decline line turns higher; new highs expand relative to new lows. A rising advance/decline line confirms a rise in stock market averages, because it means that the average stock is rising, not just the mega-cap growth stocks (e.g., General Electric (GE - commentary - Cramer's Take), Wal-Mart (WMT - commentary - Cramer's Take), Microsoft (MSFT - commentary - Cramer's Take) and Pfizer (PFE - commentary - Cramer's Take)) that dominate the index averages. New lows outnumber new highs 3 to 1 on the NYSE, 9 to 1 on the Nasdaq. Each stock on the new low list means that every investor who bought that stock in the last year is under water. As new highs gain relative to new lows, it eases the psychological pressure on stock investors. You can check these numbers weekly in the Market Laboratory section of Barron's or daily at StockCharts.com.

9. The trading indices (TRIN and TRINQ) show volume backing up price action. Volume confirms price action. You can check the TRIN (NYSE) and TRINQ (Nasdaq) indicators, which combine advance/decline and up-volume/down-volume indicators into a single, short-term money flow indicator. The formula is:

In general, a TRIN of less than 1 implies that money is moving into stocks, and greater than 1, out of stocks. At end of day Wednesday, the TRINQ was 0.32, with 2,247stocks up and 1118 stocks down. Up volume (1.38 billion) swamped down volume (223 million), so overall a very bullish indication of money flowing into stocks. Investor's Business Daily's "The Big Picture" charts and commentary (page B2) explain additional short-term technical indicators.

10. Equity fund money flows turn positive. The final piece of information I'm looking for is to see equity fund money flows turn positive and stay positive. The three big rallies of the last two weeks were primarily driven by short-covering. The rally cannot be sustained without new money coming into stocks, whether from individuals buying stock mutual funds or from institutions raising their equity allocations.

AMG Data calculates cash flows weekly, monthly and quarterly. In July, $40.9 billion (or about 1% of equity mutual funds) was withdrawn, with half the money distributed to bond funds, the rest to money market funds. A modest $1.9 billion was withdrawn the first week of August. The information is also summarized in Barron's, in the Mutual Fund section.

Overall, I'm still sitting on my hands, not yet investing my cash. On the basis of these 10 indicators, however, the environment for stocks is substantially friendlier than it was a month ago.

---

As originally published, this story contained an error. Please see Corrections and Clarifications.

David Edwards is a portfolio manager and president of Heron Capital Management, a New York management firm. At the time of publication, his firm was long eBay, General Electric, Wal-Mart, Microsoft and Pfizer, though positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Edwards appreciates your feedback and invites you to send it to David Edwards.