Rate Cuts, Earnings and Patience (Oh My...)
By Kit Cohan, Optionetics.com
01/16/2001 12:00:00 PM
Now that the Federal Reserve has decided that money needs to be easier to borrow rather than harder, where should we look for quickest impact? Certainly there are no end of candidates since an easier monetary policy makes financial life easier for just about everyone; however, let's think through the impact of a cycle of rate cuts. But first, let's look at what is different in this cycle of rate cuts compared to the last one.
The last rate cut cycle was triggered by the failure of Long Term Capital Management, an extremely leveraged and extremely large hedge fund whose failure had the potential to damage the global markets. The Fed cut rates aggressively to deal with the liquidity crunch associated with this fund failure, and the markets rallied strongly from the lows put in when this institution imploded. At that time, the economy was still growing strongly, so those earnings expectations had plenty of reason to keep climbing. What is different about the economic landscape now as compared to then? Well, a lot actually. The economy has slowed to the point that the Fed felt compelled to implement a sudden rate cut. In addition to increased energy costs for consumers and corporations (taken a good look at your monthly heating bill lately?), increased health care benefits costs for corporations, and dropping consumer sentiment, there is still that nasty bear market we have been battling for what seems like forever. Is it over yet? Well, that depends on where you look to answer that question. Does all the damage done by the bear suddenly disappear? That would be nice, but it isn't likely. Layers of resistance in charts needs to be worked through, and most importantly solid bases need to be built. The good news is that some are already in place, they just may not be in stocks you are used to playing.
Earnings expectations drive stock prices, and the bear we've been fighting was a classic case of multiple contraction. When the economy was strongly powering ahead as it was at the end of 1999 and into 2000, investors were willing to pay a lot more for those potential earnings, to the point where the markets in general and tech stocks in particular were at extreme valuations. In a strong growth environment, such expansion in stock price multiples can be supported, but in a slowing economy those prices started to look a little too high. When the first earnings warnings arrived last spring, those multiples contracted severely and the contraction phase has ground on like that pink Energizer bunny it seems.
So, who benefits first from a rate cut? The standard answer for the markets in the past has been financials and retailers. For financials, such as banks and brokers, a rate cut is an immediate increase to their bottom line since their cost of doing business is directly tied to the cost of borrowing. Retailers are traditionally an excellent place to look for the first signs of a resumption of growth in the economy, because a rate cut should stimulate the consumer, and consumers account for 2/3 of our country's economy activity. A look at the chart of WMT strongly suggests that the "smart money" has been moving into this area for some time. The banks and brokers were showing a lot of choppy but potentially consolidating action until the surprise rate cut, when many of the charts in this sector that I follow suddenly broke upwards through the resistance levels I had identified as breakout points. Upon announcement of the rate cut, the market became extremely volatile and option prices were fluctuating wildly, and getting a fill on a spread order became quite difficult. Did I miss my only chance to get in? Not at all, prices will settle down a bit from this market-moving event, and using technical analysis I will note where these retail and financial stocks get back to the trend line I am following before I place a trade. Patience is often rewarded.
Remember this statement that you have seen in the fine print for every mutual fund ad: Past performance is no guarantee of future results. Let's think this one through. Not only does this apply to mutual funds, it also applies to individual stocks as well. How many of us kept buying dips all last year because the object of our attention was worth so much more just a few short weeks ago? Unfortunately, that string of dips in tech stocks kept dipping lower. As traders we need to wake up and smell the coffee when we have a series of failed directional trades, because perhaps the market is sending us a message that the trend is not being matched by our expectations. Such results should send you back to the charts to see if there is something you are not seeing in terms of market trends.
Even with the recent great bullish performance of the market in response to the sudden rate cut by the Fed, the Nasdaq is still struggling. If you are a student of technical analysis you have likely noted that until the downward trending channels of the NDX or the COMPQ are breached to the upside, then risk still remains in being too bullish here. We are still working our way through an earnings season that has seen a huge increase in the number of companies missing their earnings expectations. Perhaps the wisest course of action is to wait for a bullish confirmation in these indices and for the earnings misses to cease knocking individual stocks for a loop.
One of the frustrating things about being a trader is having the patience to wait for the perfect opportunity, when all things align in your favor. Patience is just as important to being a trader as is the ability to identify a good trade. While you are exercising that patience is when you can do the real work: looking for opportunity.
Looking for opportunity can seem like such a broad topic that it is hard to decide where to begin. Rather than sorting through a randomly selected list of stocks, try starting first with the major indices. Put on your best set of technical analysis glasses and dispassionately look at the daily and weekly trends. Draw some levels you see as support and resistance, potential breakout or breakdown levels. If you see a channel, draw that as well. This gives you a general tone for the overall market. The next step is to look at sector indices that interest you based on what you have noted for the overall market. There are dozens of sector indices and of course some are more relevant than others to your style and trading interests (see Frederic Ruffy's excellent daily analysis in "Sector Watch" and "Index Intelligence"). Pick a set of sector indices that represent the types of stocks you like to trade, and make it a habit to note their behavior on a daily basis. Look for levels of support and resistance in the sector indices, and if an index catches your eye then it is time to look deeper into the stocks that are in that index. If the index suggests the sector is in a downtrend, then it doesn't make any sense to be looking for bullish trades on stocks within that index. This sounds elementary, but have any of us placed trades without first looking at the sector index that includes that stock?
Your next step should be taking a look at when earnings will be announced. This is always important and lately even more so due to the earnings misses we have already seen and also due to implementation of Regulation FD. There have been some recent high profile failures in meeting earnings targets. Many earnings expectations have been lowered by analysts and stocks have responded with a sickening thud before the companies are forced to confess. Regulation FD is now in full force, so companies can no longer leak positive information to counter a rumor or stock price drop due to "guilt by association" with a similar company that has announced earnings issues. Expectations and earnings were so high last year at this time and by and large they were being met, so beating last year's earnings growth rate is a tough act to follow. This is made even tougher by the fact that the economy has slowed sharply, since growing earnings in the face of a declining economy is quite difficult. Getting a quarter or two past these tough comparisons will make a lot of corporate accountants and tech stock traders rest much easier.
With the Fed now cutting interest rates it may be too late to be short anymore; hopefully the old saw about not fighting the Fed still holds true. But it is also probably too early to run back into the tech darlings that burned so many over the last 9 months. There is still plenty of risk out there in the form of tech companies that have yet to announce their earnings for this quarter. Rather than run immediately into what performed well in the past, consider looking for bullish sectors first before running full speed into the arms of a stock that loved and then left you last year. Those old flames could still be in a bad mood. |
