Ramping Against the Bears

By Duru

July 23, 2005

Five or six years ago, a stock like Google's could be offered up as yet another sign of a stock market bubble out of control. On Thursday evening, the stock gyrated like mad in after-hours trading as traders tried to understand the implications of Google's "warning" of a coming seasonal slowdown in Internet use. Given how fast Google continues to grow both revenues and earnings, I would argue two things: 1) this ain't no bubble my friends, 2) seasonality, shmeasonality - keep buying the dips - a slow season precedes a strong season. There are two big differences that distinguish the Google action from the outlandish euphoria we have grown to rightfully fear: 1) Google is making real money and has real customers paying with real cash, 2) the analysts and pundits are still not completely on board…while we saw Prudential proclaim Google is going to $400, we have Guzman scoffing at the madness with a $200 target. In fact, at the time of writing, we have 25 of 34 analysts pounding the table with a buy and 9 hold-outs. So, people are generally positive, but we are not at euphoric levels just yet. My prediction is that GOOG will continue to ramp against the bears for now.

(Trading note on GOOG options - see my standard disclaimer on stock talk. Folks who tried to bet on GOOG earnings through front-month options, those expiring in August, likely lost a lot of money. Options sellers were the big winners this time. The following table shows that both calls and puts near current stock prices lost money across the board. No doubt the puts suffered because GOOG did not drop enough given the implied volatility preceding earnings. The only buyers who gained anything were those crazy enough to spend several thousand dollars a pop on each put. The main implication here is that only strategies that included the selling of some volatility in combination with buying had any chance of working…or at least keeping you in the game. Once folks dust themselves off from this mini-disaster, the fun should begin anew!):

GOOG @ 302.40
Aug 05 Calls
Symbol	Last	Chg	Bid	Ask	Volume	Open Int	Strike
GOUHN	33.9	-11.6	33.6	34.4	991	3,580	270
GGDHP	25.5	-11.7	25	25.6	1,269	3,789	280
GGDHR	17.5	-9.4	17.5	18	3,250	5,356	290
GGDHT	12	-8.3	11.7	11.9	11,936	12,961	300
GGDHB	7.3	-8.1	7.2	7.4	17,648	29,594	310
GGDHD	4.5	-8.5	4.4	4.6	16,180	18,920	320
GGDHF	2.7	-7.4	2.65	2.7	12,256	14,208	330
GGDHH	1.6	-5.2	1.5	1.6	9,605	16,925	340
Aug 05 Puts
Symbol	Last	Chg	Bid	Ask	Volume	Open Int	Strike
GOUTN	1.05	-1.95	0.95	1.05	7213	14,759	270
GGDTP	2.25	-2.75	2.2	2.25	14,515	22,295	280
GGDTR	4.7	-3	4.6	4.9	14,621	14,674	290
GGDTT	8.8	-2.7	8.7	8.7	14,700	12,880	300
GGDTB	14.2	-4.2	14.2	14.5	7,531	7,004	310
GGDTD	21.2	0.5	21.2	21.8	1,630	2,393	320
GGDTF	31.5	2.9	29.4	30	459	854	330
GGDTH	38.8	4.5	38.4	39	212	396	340

Back on November 9, 2004, I issued a challenge to the bears. I have heard so many dire scenarios for the past 3 years or so, of which, almost none have come true as yet. A few days later, I got wary again and wondered whether the dollar would finally crumble and issue forth a new bear cycle. Today, we find a resurgent dollar and a stock market that is back in rally mode with the major indices once again at four-year highs and numerous smaller indices at all-time highs. Now, you know me, I would have to be dragged kicking and screaming before I would ever admit to be a raging bull, but those of us interested in the here and now of the markets have to learn how to work with the market and not against it. In that sense, I would have to admit to being bullish. This bullishness grates directly against my guess that the pattern of program trading on the NYSE suggested that we could at best expect a trading range from the S&P 500 in the short-term and most likely would usher in some kind of sustained decline. Nevertheless, I do see enough individual stories that look bad and keep getting worse to prevent me from getting to raging bullish levels. For now, I am willing to play along with the growing cheers for a rally to November, and I will do my best to keep my bears' manual free of dust until then.

And why should we dare to believe that bears will continue to be frustrated? For one, earnings from corporate America continue to look OK. The soft patch of 2005 came and went with the blink of an eye. Now, we find the following stats (as reported by my "buddy" Michael Martinez, an AP business writer, in an article called "Majority of Earnings Top Estimates So Far", July 22, 2005):

"As of Friday morning, 202 of the Standard & Poor's 500 index components had reported earnings. Of those, 145 companies, or 72 percent, reported earnings above Wall Street analysts' expectations, according to Thomson Financial. Another 31 companies, or 15 percent, had earnings right in line with estimates. And only 26 companies, or 13 percent, failed to meet forecasts….According to Thomson, there have been 2.8 negative earnings outlooks for every one positive outlook issued among the companies in the S&P 500. On average, that's higher than the 2-to-1 negative-positive ratio index companies traditionally have seen. It's also much higher than the 1.7-to-1 ratio in the previous quarter and the 1.2-to-1 ratio at this time last year."

Obviously, the story continues to be mixed. While earnings are generally coming in just fine thank you very much, companies are discouraging us from extrapolating too much of these good times into the future. This is another bullish sign. While the economy maintains a healthy attitude (for example, see the latest minutes of the Federal Reserve's meeting), caution reins supreme and companies are actively managing analysts' expectations to the low-end of things rather than the stratospheric (again, refer to Google's handling of the analyst masses). You could argue that perhaps companies have pulled in some demand from the current quarter to the last, but I would say that they are just continuing to play the expectations game. Ever since the bubble popped, CEOs and CFOs have been generally more guarded and cautious with their forecasts. The monstrous amounts of cash that companies are sitting on demonstrates this conservative stewardship. (For example, Greenspan noted in recent testimony that "capital expenditures were below the very substantial level of corporate cash flow in 2003, the first shortfall since the severe recession of 1975…Capital investment in the United States has only recently shown signs of shedding at least some of that caution.") On top of this, Greenie's continued campaign to boost interest rates will only make cash conservatism look all the more attractive.

Speaking of Greenie, his latest testimony confirmed my claim that the Fed will continue to raise rates longer than some more optimistic pundits currently expect: "…our baseline outlook for the U.S. economy is one of sustained economic growth and contained inflation pressures. In our view, realizing this outcome will require the Federal Reserve to continue to remove monetary accommodation." One thing I forgot to note in the midst of this conundrum of higher short-term interest rates, lower long-term rates, and a higher stock market is that the Fed continues to claim that they are merely being less accommodative. They have not yet said that rates are specifically being set to cool off the economy. This means, for now, that current interest rate levels continue to support economic growth. In fact, Greenie has now come to accept lower long-term rates as a structural reality I the global economy that he is almost powerless to bend:

"The drop in long-term rates is especially surprising given the increase in the federal funds rate over the same period. Such a pattern is clearly without precedent in our recent experience…. Considerable debate remains among analysts as to the nature of those market forces. Whatever those forces are, they are surely global, because the decline in long-term interest rates in the past year is even more pronounced in major foreign financial markets than in the United States…

This decline in inflation expectations and risk premiums is a signal development. As I noted in my testimony before this Committee in February, the effective productive capacity of the global economy has substantially increased, in part because of the breakup of the Soviet Union and the integration of China and India into the global marketplace. And this increase in capacity, in turn, has doubtless contributed to expectations of lower inflation and lower inflation-risk premiums…

…As best we can judge, both high levels of intended saving and low levels of intended investment have combined to lower real long-term interest rates over the past decade."

So, you can fear future inflation and/or slowdowns all you want, but you are probably better off believing the economic and corporate reports that are in front of your face right now. Yet again, we witness the bias for ramping against the bears.

Wherever the market goes from here, just be careful out there!

© DrDuru, 2005