CVI CVR Energy Inc

Yesterday, I wrote "Just 2 Scenarios: Recession or Not" to highlight that since the market had already priced-in much slower growth, verging on a mild recession, and since we still don't know for sure if we are going to have one at all, it doesn't make sense to sell all your stocks based on any "sky is falling" scenario.

Today, I bring you that third alternative, with a twist. My title is tongue-in-cheek, a twist on the name of one very bearish economist named Andrew Smithers.

But since his research may carry some weight with other quantitative fund managers, I think it's at least worth seeing what he has to say.

Get Out While You Can

That's the gist of his message right now as he sees a "significant rally" on the horizon as companies rich in cash buy back shares. Smithers says this will be a rebound to sell as US equities are still 40% overvalued even after the current 15%+ correction.

Anna Kitanaka, in a story on Bloomberg.com Monday, writes, "Smithers said in a report dated Aug. 15 that the S&P 500 is still overvalued by about 43 percent relative to earnings for the past 10 years... Relative to the Q ratio, a comparison of market value with the replacement cost of assets, the index is about 36 percent too high."

I couldn't find that report publicly available so I will just summarize and quote from Kitananka's excellent article. For details on the valuation model, Equity Q, that Smithers uses, see his investment management website at Smithers & Co. where he has a detailed FAQ on "q" as he calls it.

Don't Be Fooled

Smithers explains that just because corporations have lots of cash doesn't equal economic expansion. Cash continues to accumulate to record levels because profit margins are so high. But as Kitananka summarizes his views, such wider profit "margins imply companies are either paying their employees too little, employing too few people or keeping their prices too high, all of which damp demand."

This is precisely the new economic landscape that become stunningly apparent after the GDP revisions of July 29. First, we finally had confirmation that stubbornly high unemployment was very precipitous of the actual growth numbers.

Second, we were forced to take a good hard look at where a big chunk of US corporate profits were coming from (abroad) since domestic demand was barely on the radar.

"How would the S&P 500 stay on pace to earn nearly $100 per share this year if China really slowed down?" was the question I started asking on August 1. Here's how Smithers saw the investor's predicament a few weeks ago...

"It is common to find that investors, often supported by ill-judged comments by investment bankers and financial journalists, try to value shares on the basis of current profits," he wrote. "This is, of course, very foolish as it means that they undervalue companies when profits are low and overvalue them when profits are high -- as they are today."

A Multi-Decade Bear Market

Smithers worked at S.G. Warburg for 27 years before starting his own investment firm and achieved some notoriety after calling stocks overvalued in his March 2000 book Valuing Wall Street.

In October 2009, as the S&P rallied to nearly touch the 1,100 level for the first time in a year, he said stocks were 40% overvalued. Listening to this bear then would have hurt.

But he has a very long term perspective in mind when he talks about the market. From Kitanaka's article, Smithers is quoted, "The U.S. market was more overvalued in 2000 than ever before. It has yet to become undervalued and will naturally do so at some stage. The bear market which started in 2000 is likely to be a long one."

Those are my italics on "has yet to become undervalued." Boy, if he didn't think stocks were cheap when the Dow was below 7,000 and the S&P below 700 in 2009, this guy is hard to please!

The reality is that he is die-hard in his economic analysis and has a really big big-picture perspective that might help some people get really rich -- eventually.

But it should be painfully obvious, to even the most die-hard Elliot Wave Super Cycle theorist that you can make a lot of money trading the gigantic swings within such decade-long sideways markets, which are always full of smaller bull and bear cycles.

It really comes down to your investing and trading time frames. Are you going to let deep and persistent "structural" problems prevent you from catching cyclical trends, swings, and counter moves? Of course you aren't.

What If the Bear is Real, and Really Nasty?

So, should we listen to Smithers now at all? I think we can still "wait and see" as I've been saying for 3 weeks now that fund managers would be doing. Take long positions on good stocks that still have earnings momentum and enjoy that 10% rally that he says is coming until we know more about a potential recession.

My line in the sand that tells me the recession is about to become real is the 1,100 level on the S&P 500. You will obviously have time to sell because we are not crashing through there yet.

My perspective, as I wrote about all through 2009 and 2010 in my column "Buy and Trade" as a market analyst for PEAK6, is that you can put the odds in your favor to trade 1-3 months swings in good stocks much better than you can time the overall market.

Not all earnings are going down the tubes and the Zacks Rank will keep you on the right side of things because as analyst estimates come down, those companies with visible and sustainable profits will stand out. And these are the stocks that will beat the market.

Here's how I summed it up last week in A Trader's Market for the Next 2 Months when I was selling puts and swing trading Cummins (CMI), National Oilwell Varco (NOV), Suncor (SU), Southern Copper (SCCO), and CVR Energy (CVI)...

You have a couple of things in your favor that create a high-probability opportunity to profit.

If there's a stock you wanted to buy last month and now it's trading 20% to 40% below that level, ask yourself "What does my risk/reward look like now?"

Ignoring for a moment the probability of recession that could take it even lower -- which is what this market sell-off is all about -- if you buy the stock "on sale" you put yourself in the investment position you wanted with a new margin of safety.

Then, if you get a 10% to 20% pop in a few days, you have the luxury of choosing that short-term trading gain or keeping the investment.

When you get these terrific volatility-driven returns in a matter of days, there is no harm in taking them. Especially since chances are we haven't seen the final bottom yet in this panic and you will get new opportunities to re-enter.

Disclosure: I am long and/or short naked puts in NOV, SU, SCCO, CVI, and CMI

Kevin Cook is a Senior Stock Strategist for Zacks.com
 
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