The Perils of Investor Optimism

Chris Johnson of Schaffer's Investment Research says love is blind, even in the market. So he looks for solid stocks that are scorned

"Expectational analysis" is how Chris Johnson, director of quantitative research for Schaeffer's Investment Research, describes his approach to spotting promising investments. Essentially, he looks for stocks that investors and analysts seem to be down on -- but are technically and fundamentally sound.

Johnson studies such factors as put/call ratios and the number of analysts optimistic about a stock. Too much optimism drives him away. In the current market, his approach leads him to the consumer and oil and oil services sectors, and specifically to Procter & Gamble (PG ) and Marathon Oil (MRO ), among others.

Looking at the broad market, "it's a good time for investors to wait on the sidelines," says Johnson, given the overhead resistance he sees from a technical viewpoint. The best opportunities, he notes, are for "those willing to trade short-term both long and short positions."

These were some of the points Johnson made in an investing chat presented June 24 by BusinessWeek Online on America Online, in response to questions from the audience and from BW Online's Jack Dierdorff and Karyn McCormack. Edited excerpts follow. A full transcript is available from BW Online on AOL, at keyword: BW Talk.

Q: Chris, the market is still having its ups and downs. Is it waiting for the Fed, the election, stability in Iraq, or what?

A:

All of the above, really. A little of each. Right now the market is reacting in some ways to a lack of news, when there seems to be a large amount of potential occurrences...uncertainty around a number of items seems to be increasing. We'll certainly get some clarity on the Fed in the next week [when the Fed is set to make it next rate-setting announcement].

But on top of all that, and continuing, is the threat of terrorist activity, and the election in November. Right now I'm looking at the market as one that has the potential to continue its sideways progression, offering the best opportunities to those willing to trade short-term both long and short positions.

Q: Where do the major indexes stand from a technical perspective? Volume has been rather low lately.

A:

I think the lack of volume over the last few weeks is an indication of both investors and traders wanting to keep their powder dry ahead of a few events, namely the handover in Iraq and the first potential rate hike that we've seen in more than a few years.

As I look at my charts as of the close this afternoon [June 24], we continue to see the Nasdaq struggle with the 2000 level, which is both a psychologically significant level and, to some degree, technical, which adds some concern for the short-term outlook. The S&P 500 is also teetering right at the 1150 level, which has historically been significant resistance.... Given that the market has some significant overhead resistance, I think it's a good time for investors to wait on the sidelines.

Q: Any ideas on a good low-priced stock?

A:

Looking at a few screens that I use for stocks that are potentially technically oversold, and have good signs of an upcoming surge, Activision (ATVI ) is one stock below $20 that I find somewhat attractive right now. The stock is currently trading in the $15 range, has been as high as the $16.50 to $17 range in the last few months, and is right now showing some potential to make a move at the top of that range and actually potentially break out of the top end, taking the price higher. Though I think $20 would likely be the short-term top of the next range.

Q: What are your thoughts on Panera Bread (PNRA )?

A:

First of all, in the name of due diligence, I have to point out that I love their sandwiches and eat there often.... On a more serious note, Panera is one of the companies in the restaurant industry that seemingly surged from nowhere and has certainly left its mark on the Street.

When I look at the technicals of this stock, I see one that's in the process of rolling over a long-term upward trend. In other words, the stock has broken below some key trend lines that have, in the past, provided support for the company.

In addition to the technical worries for Panera right now, when I look at the sentiment for this company, based on both the options activity and the analysts' rankings on the company, I see some signs of worry as well. Currently, Panera's put/call ratio stands at 0.45, meaning that there are more than two times the number of calls as there are puts on the company. This is in the lowest 10% of readings over the last year.

What this tells me is that option traders' outlook for the company, or perhaps better, expectations for the company, are very optimistic. Switching over to the analyst rankings, Panera currently has 12 out of 17 of the analysts ranking the stock at a buy or higher, with a lot of those 12 ranking it a strong buy.

That tells me that a lot of the capital that follows analyst rankings and recommendations has already been priced into the stock. Given this optimism and this sentiment, I believe there are better opportunities in the market than Panera will offer.

Q: What will an interest rate rise do to the market next week, and is there a certain stock to play long?

A:

Let's first address the interest rate issue. It's widely known that most analysts expect a 25-basis-point increase next week. Some argue this increase is already factored into the market, and to some degree I believe it has been. I do have some concerns, though. The first would be with the wording that goes along with whatever action the FOMC [the Fed Open Market Committee, the central bank's rate-setting arm] takes. As we know, reading between the lines of the statement...[has] become almost more important than the action during the meeting.

Another concern is that there may be a bit of optimism toward the effect of the Fed raising rates.... So what we're basically seeing is investors and analysts telling us that an interest rate increase isn't bad for the market and will likely only result in positive market activity. This makes me a bit uneasy.

Now on to the next question -- what stock would I consider strong in a rising interestrate market. One of the stocks that continues to pop up on my radar screen is Procter & Gamble (PG ). A recent 2:1 split has taken the stock to $55 per share, matching its December, 1999, high. The company has been in a strong technical uptrend.

Despite this uptrend, though, sentiment remains somewhat pessimistic. The same put/call ratio that I mentioned for Panera for P&G lies at 1.18. This indicates that there are currently more puts open on P&G than there are calls. The reading is in the top 2% over the last year. In other words, option investors have been very active on the put side of the market, indicating pessimism toward the company.

Looking at the analysts' ratings on P&G, 50% of the analysts covering the stock right now have it as a hold, despite the fact that this has been one of the stronger performers on the Street. At some point, these analysts will capitulate and switch their recommendations to the buy arena, supplying the power to push P&G higher. Overall, I see this as one of the stronger performers over the next year.

Q: What's the best sector and industry to be in?

A:

Let me twist the question a bit to identify a few things -- first of all, the sectors I'm most wary of. I continue to look at the semiconductor, software, and network sectors as those that are likely to offer the least opportunities for investors. This is based on the fact that not only are they technical laggards in this market but they also continue to display signs that investors have not sold their positions after a strong year of performance in 2003. They continue to look at the next 6 to 12 months as recovery months for these stocks, which can be dangerous.

Looking at some of the sectors that have caught my attention, one of them happens to be the consumer sector. More than a few of the companies in that sector continue to display signs of pessimistic sentiment, while at the same time displaying technical and fundamental strength. According to our expectational analysis approach, these are signs of stocks that will continue to outperform the market.

Another sector that not surprisingly has my attention is the oil and/or the oil-services sector. Obviously, fundamentals of these sectors continue to drive prices of these stocks higher, while at the same time investors have not fully embraced this strong performance, indicating that the stocks should not yet be considered overbought.

Q: You said the best sectors included consumer and oil and oil-service companies -- any stock names for us there? You mentioned P&G.

A:

To reiterate, P&G, also Colgate-Palmolive (CL ). And looking at the oil sector, Marathon Oil (MRO ) is one of the companies in this sector that is currently showing a pessimistic outlook from investors, with a relatively high put/call ratio and low analyst recommendations, despite the fact that the stock is nearing its 1998 highs in the $38 range. Marathon has recently trended along its 10-month moving average and has found staunch support at this trend line. Given the technical strength and negative sentiment, all indications are that this run will continue.

Q: What drug stocks do you favor? Merck (MRK ), Pfizer (PFE ), Wyeth (WYE ), Novartis (NVS )?

A:

Looking at the drug sector as a whole, it's very hard for me to find a stock I like here. On a sector basis, sentiment has been very optimistic. Investors have been moving cash and long positions to the drug sector for some time. This is evident by a put/call ratio that's now reaching some of its lowest levels over the last year.

Looking at the four stocks that you've mentioned...I have recently recommended a short position in Pfizer to our subscribers. The only company mentioned that I would consider with some potential would be Novartis. It has more or less treaded water, with a slight upward bias, since hitting an intermediate bottom in March. Some technical strength can be seen here, as the stock has now broken above its intermediate-term moving averages. In addition, the company remains above its 10- and 20-month moving averages.

Q: Can you sum up for the average investor how to apply your contrarian approach?

A:

Certainly. The word contrarian is normally easily confused with just doing the opposite of what everyone else is doing. Obviously, it's not that easy, and using that simplistic approach will result in negative returns. Our approach is to apply what we call expectational analysis. This includes using information in a contrarian manner only when it makes sense.

What I mean by that is, this evening you've heard me talk about technically strong companies with negative sentiment outlooks. This is a situation that we find attractive, because the sentiment is counterintuitive, because a stock that is technically strong should be displaying optimistic sentiment.

In many cases, when we find a stock that is fundamentally strong with a pessimistic outlook, it's indicative of a large amount of sideline cash that will capitulate at some point, flow into that stock, and drive the price higher. The reverse is true as well. When we find stocks that are fundamentally struggling, technically struggling, yet still loved as indicated by low put/call ratios and high analyst rankings, we want to avoid it, because those individuals who are in love with the stock will decide to cut bait. And when they sell, it will drive the price lower.

This is an extremely simplistic explanation of our approach -- it's normally good to see real-life examples. One that I always point my finger at is Lucent (LU ) through the tech correction. Lucent was a high-flier that over a few years turned into a single-digit midget. The stock didn't bottom out until investors finally fell out of their love affair and dropped their optimistic outlook for the stock.

This is one example of how an optimistic sentiment can damage a stock severely. When investors are disgusted with a stock, it's an indication that the selling pressure has been purged, and stocks can be driven higher. That does sum up our expectational-analysis approach. You can visit our Web site (www.schaeffersresearch.com) for more information on how to apply this to your trading.

Edited by Jack Dierdorff

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