Gearing up for Q2

What’s worse than being on the sidelines during a major rally? Being short during a rally.

It’s even harder when I watched my list of stocks to buy climb to amazing heights:
ATW +20%
CF +26%
WLT +40%
ACI +40%
MVL +30%
GNK +48%
ETFC +3%

I look at the last quarter and I have the following takeaways:
1. I am a damn good stock picker
2. I am too greedy sometimes. I tried to buy these stocks on the cheap and missed out.
3. I am wrong so far on the bear. I think it will bite and I’ll continue to wait.
4. I bought puts at one of the worst times last quarter. Fortunately, they are long term puts, but relying on a major market pullback for some of them

I followed the exact wrong approach to the market last quarter. So I ask myself, what do I do now, this quarter?

I think my big mistake was expecting Q1 to be the point where GDP reports showed negative growth and corporate earnings were bad. As it turned out, the GDP stayed in positive territory and most companies continued to show growth. Nevermind how they were able to show growth (for example, relying on dollar conversion rates), the fact is that earnings growth stayed positive. Well, except for banking and housing related (construction, retail, etc).

The fundamentals continue to point downward. Everyday more bad news is released. Today it was Walmart. Walmart grew, but at the expense of other retailers as consumers migrate spending to low priced retailers. And even mighty Walmart guided down for the rest of the year.

Does the market reflect these developments? At this time, the Dow is down 8% from its high 7 months ago. At the same time, the Dow Jones P/E has shot up to 86
http://online.wsj.com/mdc/public/page/2_3021-peyield.html?mod=topnav_2_3002
To put this in perspective, a year ago it was 18.

Here are the Dow Industrials:
3M
Alcoa
American Express
American International Group
AT&T
Bank of America
Boeing
Caterpillar
Chevron Corporation
Citigroup
Coca-Cola
DuPont
ExxonMobil
General Electric
General Motors
Hewlett-Packard
Home Depot
Intel
IBM
Johnson & Johnson
JPMorgan Chase
McDonald's
Merck
Microsoft
Pfizer
Procter & Gamble
United Technologies Corporation
Verizon Communications
Wal-Mart
Walt Disney

Could that Dow PE 86 be somewhat distorted by recent earnings due to the housing and financial sectors? That is, a sudden drop in the E would make the P/E race up. Financial companies: AIG, BoA, Citi, & JP Morgan
Housing: Home Depot

Certainly there is some impact, but countering it is the record setting gains at Chevron & Exxon.

So the Dow is high not because of math but because earnings are not keeping up. But the projections are for earnings to grow and for the Dow P/E to return to normal. Based on current forward projections, we should see a P/E of 14 if the Dow stays at 12,800 and earnings come in where they should.

That is, the market expects earnings to grow 500% in 12 months. Is that likely? Almost all of these companies are actually forecasting single digit growth. Walmart just guided down. And that’s based on projections of no US recession and no global recession.

It’s quite simple: either E must grow or P must come down or both.
Or, to put it a different way, growth in P doesn’t look very likely.

Consider the S&P. The S&P P/E is 22, historically it trades at 15. If forecasted growth is achieved, then it will hit targets. Again, growth in P doesn’t look likely.

At this point, the Dow is down only 8%.

Clearly Wall Street expects only good news. Zales has a P/E of 30 and a forward P/E of 17, despite sales growth of 6% after a major margin impacting promotional clearance sale. It is down 30% from its high. Harley is also down 30% from its high despite a drop in sales, worsening cash flow and slipping margins.

For these reasons, I am confident that the markets and stocks will drop. But it won’t drop until bad news materializes. That could be in July when GDP and quarterly earnings get released. 60 days away. I will stick with my strategy of being bearish, but I will also take a few long positions.

Also, I am sitting out ETFC this week. I think that Options expiration this Friday will play havoc with this stock. Next week is the week to move. As a reminder we have 1000 shares of ETFC and 2000 additional shares that have a covered call of $4, expiring this Friday. I want to write the June $4 or $5 on whatever shares we have next week.