Stocks… Oversold and Ready to Rally?

Richard Croft
October 18, 2011
4 minutes read

How quickly sentiment can change. Global markets have rallied despite little concrete evidence of a solution to macro uncertainties facing the global economy. Which is to say; Europe?

The optimism reflects a view that a broad solution will soon be implemented. And to that end, we have European leaders and large European banks sitting at the same table talking from the same page.

It took some arm twisting to get both sides to this point. Much of which came from rating agencies that either downgraded or warned of downgrades to Spain, Italy and Belguim, as well as to a number of Italian, British and Portuguese banks.

With both sides talking traders are hopeful that we get clarity as to the size of the problem. Ideally, traders want the biggest European banks to come clean and mark to the market the value of the debt on their balance sheet. And they want the European leaders to put in place a large enough bailout fund to handle a worst case scenario.

Initial estimates price the problem somewhere around €100 billion (US $141 billion). Although in September the International Monetary Fund estimated the loss on bad state loans at twice that amount. US Secretary Treasury Timothy Geithner has also weighed in but more as an advocate for ensuring that any bailout package is large enough to deal with a worst case scenario.

As for the right solution, there are two points of view. The EU solution is to have banks raise capital. But that’s expensive and harms shareholders. Moreover simply adding to a bank’s reserves does not guarantee that the banks will actually lend. In fact they could cut back on lending which would plunge Europe and the rest of the world back into a recession.

As for the banks, they would rather have the EU backstop the bad debt allowing it to be priced at full value effectively eliminating the need for capital. The banks argue that state loans to countries like Greece were at one time considered risk free investments, and that private institutions have no recourse if governments cannot or will not get their fiscal house in order.

The point is the EU has moved away from a position that its debt problems were not a serious problem. And by doing so, effectively removed Europe from the front page and allowed traders to focus on third quarter earnings, which if Google is any indication, may entice more traders off the sidelines.

From a technical perspective, a recent report from National Bank suggested that Canadian stocks are deeply oversold and poised for a breakout rally in the next three to six months. With the earnings yield for the S&P/TSX more than three percentage point higher than the yield on long term corporate bonds, equities have become commensurately more attractive, setting the stage for a significant rally in coming months.

Of course, all bets are off if the US sinks into recession in there is a significant financial shock from the eurozone. Although as pointed out, the probability of that has receded in recent days.
Aggressive option traders willing to bet on a year-end stock rally might consider rolling over existing bullish positions (if established back in August) or establishing new ones in the big stock index ETFs, specifically, the iShares S&P/TSX 60 ETF (TSX: XIU, Recent price $17.15).

The strategy of choice would be to buy January calls. Specifically, you could look at the XIU December 17.50 calls at 55 cents or better.

Richard Croft
Richard Croft http://www.croftgroup.com/

President, CIO & Portfolio Manager

Croft Financial Group

Richard Croft has been in the securities business since 1975. Since February 1993, Mr. Croft has been licensed as an investment counselor/portfolio manager, operating under the corporate name R. N. Croft Financial Group Inc. Richard has written extensively on utilizing individual stocks, mutual funds and exchangetraded funds within a portfolio model. His work includes nine books and thousands of articles and commentaries for Canada’s largest media channels. In 1998, Richard co‐developed three FPX Indexes geared to average Canadian investors for the National Post. In 2004, he extended that concept to include three RealWorld portfolio indexes, which demonstrate the performance of the FPX portfolio indexes adjusted for real-world costs. He also developed two option writing indexes for the Montreal Exchange, and developed the FundLine methodology, which is a graphic interpretation of portfolio diversification. Richard has also developed a Manager Value Added Index for rating the performance of fund managers on a risk adjusted basis relative to a benchmark. And In 1999, he co-developed a portfolio management system for Charles Schwab Canada. As global portfolio manager who focuses on risk-adjusted performance. Richard believes that performance is not just about return, it is about how that return was achieved.

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