November 23, 2008

• Comparisons of this economic climate to the Great Depression are silly, if not ridiculous and irresponsible (but they do garner good headlines and post-commercial teases for the media).  The Great Depression witnessed a thirty-percent contraction of Gross Domestic Product; the two largest recessions since then (1973-1974 and 1980-1982) saw GDP contract about 3-4%. 
• Data over the past month reveal that the U.S. economy has entered a recession that will likely be more severe than either of the last two (2001, 1990-1991).  This recession, in terms of severity, will be more like the recessions in the early 1970s or the early 1980s.
• The peak-to-trough decline of the S&P 500 for this bear market has been 51.9%; the average decline of the fourteen previous bear markets has been 38%. We are getting close to the end of this decline in terms of magnitude.  Still, though, there is insufficient evidence to suggest that all of the damage has been done.  We remain in a bear-market until proven otherwise.
• Since WWII, bull markets following bear markets, on average, not only last nearly four years (46-months) but advance the Dow Jones Industrial Average by 123%, providing generous returns to equity-oriented investors.  The bottom may have come last week, or it may come in the weeks or months ahead, or it may come in late 2009 – but it is coming and Berkshire Money Management will help clients identify said bottom and then subsequently participate in those aforementioned generous returns.

The biggest and brightest financial minds, both on and off The Street, are getting obliterated this year.  Hedge funds are down 60-, 70-, 80-plus percent this year and are being forced to close up shop.  Warren Buffett’s “conservative” Berkshire Hathaway is down 39%; famed-fund manager Ken Heebner (CGM Focus Fund) is down 57%, and Harry Lange (Fidelity Magellan) fund is down 58%.  Even the living legend himself, Bill Miller (Legg Mason Value Trust) is down 64%.

Berkshire Money Management has received an influx of new assets under management from both current clients to whom we proved this year that the protection we afforded them in 2001-2002 was no fluke, as well as from client referrals of former do-it-yourself investors who, like the aforementioned investment legends, got caught up in a devastating tape.  (And by the way, thank you very much to the clients adding money and referring new clients – we are tremendously flattered and greatly appreciate it).

Many of the clients of these new accounts ask us, is it too late too sell?  Not only is it a fair question, but it is one that both individual and professional investors alike are currently struggling with.  Fortunately for clients that have been with Berkshire Money Management for a while, we are struggling with a higher-class of problem:  When do we get all that cash invested again? 

We have written a lot about just that and we are still trying to solve for that difficult equation.  But as difficult as it is, it is not nearly as complicated as the question for investors who have ridden this market down and are lost as to what to do now.  Like anyone in this business, we cannot give definite answers (investing is much more of an art than a science).  But we definitely have an educated opinion in terms of both an absolute answer (yes, it is too late to sell, or, no, it is not too late to sell) as well as investment strategy.

To be sure, we are aware that the average of the fourteen prior bear markets averaged a 38% decline, suggesting that with a current peak-to-trough decline of 51.9% we are far closer to the bottom of this market than we are from the top.  We are confident that most experienced investors realize this and that is why they ask “is it too late to sell?”

S&P 500 bear markets since 1929

We would argue, respectfully, that, no, it is not too late to sell.

To be certain, the market became oversold enough last week to experience a rally into this week’s expected light-volume Holiday trading and then into December.  It would not be unusual at all in the course of a bear-market to see a 2-month, 15% rally; they are quite common and could push the S&P 500 back up to nearly 900-points by the end of the year.

However, an oversold market can get even more oversold.  The past week’s decline produced back-to-back 90% Downside Days (90% of total volume was down) on November 19th and 20th.  This is an example of intense selling that typically leaves sellers exhausted and, for some period, leaves only buyers in the market.  The reduction of Supply (i.e. selling) combined with equal (or even greater) Demand (i.e. buying) will push up stock prices.  It is simply the law of Supply and Demand. 

Combine an oversold market, with the aforementioned expected light volume this Holiday week, plus the reduction of uncertainty by President-elect Barack Obama in announcing key members of his economic team and a $500-700 billion stimulus plan to be signed on inauguration day, that should allow for that type of 2-month, 15% rally that happens just frequently enough during bear markets to keep hope alive.

However, this has not been the only case of back-to-back 90% Downside Days during this bear market.  There were similar occurrences on October 6th and 7th, 2008, but the DJIA actually fell 13.5% over the next fourteen trading days.  And, the back-to-back 90% Downside Days on November 5th and 6th, 2008, were followed by a drop of 13.2% in the DJIA over the next ten trading days (through the close of November 20th). 

Again, to reiterate the question at hand, if you have ridden this stock market down in a fully invested position, is it too late to sell?  Our answer of “no” largely considers that the stock market over the last thirteen months has already lost approximately the same amounts as during the 1973-1974, and 2000-2003 bear markets.  But in so doing the decline has lasted only about half the time of those earlier, larger declines.  And aside from those aforementioned oversold indicators that suggest a rally could very well be at hand, there is not currently any meaningful evidence that the desire to sell has been fully exhausted or that buyers are anxious to accumulate stocks for the long-term (as opposed to a buying for a “tradable rally”). 

We here at Berkshire Money Management like to use history as a guide, or as a tool to confirm or deny any investment thesis or opinion we come up with.  Our view that it is not too late for investors who have ridden down the market from the top and still hold equities to sell is based on the shaky fundamentals that is the U.S. economy, and then confirmed by history.  To be certain, if an investor only has something like half of their assets in U.S. equities, then said investor is in pretty good shape and has enough proverbial “dry-powder” to take advantage of the inevitable (note:  when, not if) resumption of the bull market.

Those shaky fundamentals referenced above, they would not be so alarming to us if the rate of bad news was decelerating.  However, as of mid-October, the news is not just all bad, but it keeps getting worse.  If the news was all bad but actually getting less-worse then we might actually be aggressive buyers of U.S. equity (and probably other regions as well). 

One of the data metrics we like to follow, if only for its neat packaging of ten other important data points, is the Conference Board’s Leading Economic Indicators, which slid 0.8% last month.  The index is now down 4.9% from its January, 2006 high, surpassing the 3.6% peak-to-trough decline recorded for the 2001 recession.  That puts this recession, so far, at about the 1990-1991 level in terms of economic deterioration.  If the LEI should drop closer to ten-percent from its peak, then that would put this recession on par with the recessions of the early 1970s and early 1980s. 

The LEI in the last three months has accelerated in its rate of decline (the bad news keeps getting worse).  Not only does the continuing weakness suggest that we could slip from a 1991-like recession to a 1974-like or 1982-like recession, but it suggests that a turnaround is not imminent.  In recessions since 1960, the average lag between a trough in the LEI and the cyclical trough in economic activity (as determined by the NBER Business Cycle Dating Committee) has been six months.  (The interval has ranged from two months to eleven months; it was seven months in the last recession in 2001).  So, for example, if the LEI hit its trough in February 2009 then, on average, the recession could last until August 2009.

Certainly we do not want to wait until we are out of the recession to start buying equities again.  As Warren Buffet recently put it in his New York Times op-ed piece, “if you wait for the robins, spring will be over.”  But we do need to see the flow of bad news stop getting worse and worse so that we can more accurately gauge when those robins might start showing up.  To help us with that gauging, we will be watching the LEI as a group as well as its components. 

One of the components we watch very closely is weekly jobless claims.  Last week initial jobless claims jumped by 27,000 to 542,000, the most since July 1992 and well above consensus (the bad news keeps getting worse).  On a trend basis, the deterioration in labor markets is accelerating toward a 1974-like or 1982-like recession.

Given this, and to reiterate, if you know an investor who has ridden his stock portfolio down over 50%, on par with the stock market itself, you can tell that person that no, it is not too late to sell.

The Bottom Line: It is cliché that during every financial or economic hardship that we Americans argue that “it is the worst since the Great Depression” and that “it will never end.”  And we are always wrong.  We tend to somehow forget that.  We see it anecdotally and we read it in psychological studies (as an aside, many psychological studies also correctly prove that investors “remember” much better returns achieved and much better decisions made than they actually accomplished – I can’t tell you how many people I run into that actually believe that they “saw this coming” – thirteen months later!).

The stock market is closer to the bottom than to the top, and once it does hit the bottom generous investment returns await those who are ready to move back in.  Still though, the economy continues to decelerate at an accelerating pace.  Until the pace of bad news slows down, discretion remains the better part of valor.  The strategy is to remain conservative.  Reducing the risk of further investment losses is more important to us than the risk of missing the first five or six months of a new, multi-year bull market.

Specific Assets | Standard & Poor’s