Anxiety Hits the Market: What Now?

Chris Johnson of Schaeffer's Investment Research thinks investors should look at defensive plays such as telecoms and utilitiesand cash

The guessing game of when the Federal Reserve will stop raising interest rates, along with geopolitical events, and oil prices hovering around $75, is keeping pessimism alive on Wall Street. "It's a very tenuous market right now," says Chris Johnson, director of quantitative research at Schaeffer's Investment Research.

Johnson, who tracks a number of technical and sentiment indicators, recommends that investors stay defensive in these worrisome times. "We're still very much in a market landscape that's dotted with risks vs. one that's dotted with opportunities," he says. His picks: telecom stocks such as AT&T and BellSouth and utilities such as American Electric Power. Cash investments, especially money markets and CDs with rates approaching 5%, also look appealing.

Karyn McCormack of met with Johnson this week in New York City. Edited excerpts of their conversation follow.

The market is having trouble digesting the latest economic data, and there are worries about higher interest rates next week from the Fed. What's your take?

Actually, I have the same concerns. The market rallied considerably after Bernanke's comments [in late July on inflation risks], and the [second-quarter] GDP numbers came in, and more or less tipped the hands of investors, or those that wanted to speculate that perhaps we wouldn't see a hike in August.

Now that more data is coming down the pike, those worries are starting, that indeed, it's not going to be done. The "one-and-done" crowd has been around, really, since the beginning of 2006. And right now, more than ever, I think that anxiety is hitting the market. They're really trying to guess on this one thing.

As a result, the risk-reward ratio around [the Aug. 8 FOMC] meeting has kind of gone up. When we had that 200- to 300-point rally last week, it put the market in a situation where if we didn't see the Fed stop hiking rates, there was considerable risk to the downside. And with some of the longer-term technicals right now that have been supporting the market—by longer-term I mean the 20-month moving averages—that's a very dangerous situation to be in where we have that downside potential. So really, it's a very tenuous market right now.

Some people are calling for a fourth-quarter rally once we get over the anxiety this summer about the Fed and economic growth. Do you expect a rally once we get through these concerns?

As you know, we specialize in sentiment at Schaeffer's. Look at the sentiment right now, and there's a lot of pessimism in this market that has built up. Look at fund flows in the Rydex family of funds, or the equity put-call ratios, the volatility indices, all of these are showing signs that investors have been somewhat fearful. We've just not had that fundamental catalyst that has allowed the sideline money to start flowing into the market. Once the Fed gets out of the way, I believe that you're going to have that catalyst.

We've seen earnings through this quarter that have been fairly good, 65% to 70% or so of companies have come in above expectations. Outlooks have been not quite weak, but not as hot as everyone would have liked. I think that's going to be the next bump in the road. But once we get over the FOMC and interest rate question, I think you're going to find investors that are going to sidle up to the market a little bit and put money to work.

I think that overall, though, we're probably put in one of these positions where after that, there's a lack of a fundamental catalyst and you still have a market that's being technically driven. There are a lot of resistance and support trendlines that are congesting the market's day-to-day activity.

Where are you placing some money at this point?

There are a few sectors that have what we're looking for, that magic, from Schaeffer's perspective. That is, sentiment that's somewhat pessimistic—let's call it not overloved, along with strong technicals and fundamentals. Right now, utilities have some good fundamentals because of the demand there. You'd think that because of all the media attention, a lot of analysts would put their buy stamp on these companies, and that has not been the case.

This is one of the areas where less than 50%, on average, of the analysts have buy recommendations on these stocks. One reason is it's just not a sexy sector. It's one of those areas that's slower moving, but the sector is beating the S&P 500 and has good fundamentals and not overloved sentiment. So we expect the trend to continue there.

Another area is, if you have to be looking at tech right now, the telecoms. That's one of the areas where there has been some pessimism. They've been showing some stronger fundamentals, as well as some technical strength. It has been outperforming the S&P 500 considerably. So this is another technically strong, relative strength leading sector, with some fundamentals that are in line and some negative sentiment. Those are two sectors that I'd look at if I were looking for long opportunities.

Within those two sectors, can you name some stocks that you like?

In the telecom sector, AT&T (T) and BellSouth (BLS) are two companies that are, from our perspective, very attractive. In the utilities area, American Electric Power (AEP) would be a potential long position.

What about tech? The Nasdaq index has been ugly.

We've been on this theme for a year-and-a-half or two years: Large-cap tech is still that area of the market that needs to be avoided. It's still, despite the fact that it has been fairly downtrodden, among those overloved companies when you look at the analyst rankings, the options activity, and short interest. If you take Microsoft (MSFT), it has come off the ledge over the last six months. Microsoft had 95% of analysts with a buy or strong buy on it. Now it's down in the 70s. So it's getting away from that overloved status, but it's not done. And that's the problem.

If you look at all these companies: Microsoft, Cisco (CSCO), Intel (INTC), Dell (DELL), Amazon (AMZN), Yahoo! (YHOO), and Google (GOOG) to some degree, all of those have some sign of a lot of optimism still in the stock. It could be a low short interest ratio.

The majority of those that I mentioned have short interest ratios (the number of days to cover short positions based on the average daily volume) below two, and when you compare that to other companies that's very low. We look for short interest ratios of six or seven.

Also, the analyst recommendations, the average for that group I mentioned is around 70% to 75% of analysts have buys or strong buys on them. Normally we're looking for a crowd that's more the 50%, 60%, 70% as holds or lower, for a company with buying potential for the stock vs. selling pressure priced into the stock. So large-cap tech, and thus the Nasdaq, has really been one of the areas to avoid.

And what do the technical readings show?

I mentioned the 20-month moving average on the S&P 500 gave the market support in July and June. It's right around 1,234 right now. The Nasdaq closed July below its 20-month moving average for the first time since April, 2005. So the fear now, from my perspective, is that if the Nasdaq is as much a leading index as it used to be (in the late 1990s it was definitely the leading index), it has broken into what we consider technically a bear market by closing below its 20-month moving average.

In 2000 when we hit the top, there was only one month between when the Nasdaq broke below its 20-month and when the S&P 500 broke below its 20-month, and we started to fall apart technically. S&P 500 is dangerously close, and that's why my fear about the Fed is if we have an interest rate hike, and the worse case scenario is we do have an interest rate hike and the language still leaves it open for another one, so the one-and-done crowd is again completely wrong, I think we break through that 20-month in the S&P 500 and bring a lot more selling.

We're stuck at what I'd call a crossroads for the market right now. We could start to deteriorate more. And if you add the concerns such as earnings growth slowdown, geopolitical concerns, the price of oil going up to $100 instead of stopping at $75, there are more risks. We're still very much in a market landscape that's dotted with risks, vs. one that's dotted with opportunities.

So you're very cautious, and steering toward utilities and telecoms, areas with yield.

Yes, they're paying dividends, which is important right now as a defensive idea. With interest rates rising, there's a fight for what's the right thing to do. Do I put money into cash and CDs?

We're recommending up to 50%, and in some cases more, of a portfolio allocation into cash. Cash is your friend in these types of markets. If you can get 4.5% to 5% in a money market, when the market over a year is down, why not? That, at some point, becomes a drag on the market as well. You have an alternative outside of investing in the market in the form of cash, and also utilities bring yield. That's what people are looking for right now. They're looking for something they can count on.

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