Sunday, September 21, 2008

• The details of the government’s recent bailout plans are still too unknown and too fluid (and too expansive) to list here.  However, it will have significant short-term bullish ramifications for the stock market. 
• Although a stock market rally is likely to occur in Q4 2008 and into Q1 2009, it is just as likely that this will be yet another “Sucker’s Rally” that will play on investor’s optimism and greed to try and suck them back into equities before the rally ultimately fails and drops to new lows.
• Participating in such a rally is more akin to speculation than it is to investing.
• Despite massive amounts of government spending and intervention, we maintain that a US recession by 2010 remains a high probability.

Last week was historic.  We are not going to get into the opinions of the government’s actions (of which we have many), we are only going to deal with the hand that we have been dealt.  And we will also spare you the details as 1) not all of the details have been ironed out, 2) the information is so fluid that it changes not day-by-day, but rather hour-by-hour, and 3) every local and national paper will continue pushing out details as they become known.  But I’ll touch on the highlights and how they may affect the management of your portfolio.

A 10-Day Pause

The Securities and Exchange Commission (SEC) has instituted a 10-day ban on short-selling of 799 financial stocks, just one day after the UK Financial Services Authority took a similar step.  This pause runs through October 2, 2008, but can be extended another 10-days at expiration (through October 12) and up to another 30-days in total (coincidentally, right up to the November election).

I may be extremely cynical when it comes to politics, but I find it difficult to believe that this pause will not be extended through the month of October.

Bottom Line to the 10-Day Pause:  Hold-to-Buy the market for 1-month

A 4-Month Rally

This past week was one of the most, if not the most, volatile weeks in stock market history.  Its significance as to the bigger picture of bear and bull markets remains to be seen.  But the immediate implications suggest a tradable rally that will last into 2009 and bring the S&P 500 up to 1,400 points.

We have written about the significance of 90% DownSide Days (where 90% of the Down Volume equals or is greater than 90% of the sum of Down plus Up Volume, and where Points Lost equals or is greater than 90% of the sum of Points Gained plus Points Lost) followed by a 90% UpSide day.  A series of 90% DownSide days is important in putting in a stock market bottom because the panic selling eventually exhausts the desire to sell and drives prices down to levels low enough to attract renewed buying enthusiasm.  These declines usually end when demand (i.e. buying) is strong enough to register a 90% UpSide day. 

This pattern of 90% DownSide Days followed by a 90% UpSide Day has been present at every major stock market bottom in the last 75-years.  In the month of September we have had four DownSide Days (on the 4th, the 9th, the 15th, and the 17th), as well as (so far) one Upside Day (the 19th).  There have been only 17 recorded cases in which there were four 90% DownSide Days on the New York Stock Exchange within a twenty day period.  In 14 of those 17 cases, the fourth 90% DownSide Day was followed quickly by a 90% UpSide Day, each marking that start of at least a tradable rally.  Thus, we can be reasonably well assured that the stock market will drift higher over the weeks, or even months, to come.

But the bigger question is whether or not this expected rally will be the advent of a new, multi-year bull market.  Considering stock market valuations as well as that this bear market having been only about half as intense as other lengthy bear markets, the probabilities do not support the start of a new bull market from this week’s low. 

On the subject of valuations, the stock market is, admittedly, fairly valued.  However, during bear markets stock prices overshoot to the downside and bring valuations to discounted levels.  On the subject of bear markets severity, bear markets lasting less than 12-months average 31% declines (down to 1,087 S&P points); bear markets lasting more than 12-months average 42% declines (down to 914 S&P points).

From a historical context, we are right on the edge of which way the market will go in the long-term.  A prudent strategy in a very uncertain environment would be to closely monitor the quality of the rally after the current short-squeeze subsides, watching for broad, vigorous demand.  However, if the quality of the rally begins to fade significantly at any point then we will know to maintain our defensive positions.

This may seem like a wimpy stance, but consider how we have applied this practice in the past:

• In my old newsletter, The Navigator, on September 28, 2001 we urged action and claimed that “equity valuations are better than they have been in years.”  The S&P 500 rose 10.4% from that day until January 1, 2002 when I then warned that “the earnings yield (of the S&P 500 has dropped to about 4.3%, and the yield of the 10-year Treasury note has shot up to 5.1%  What does this mean?  It means that I’ve had my three months of bullishness, but now I must adhere, once again, to a more bearish sentiment.”  The S&P 500 then fell 27.6% until October 11, 2002.

• In the www.BerkshireMM.com archives, I wrote the January 23, 2008 article “When Everyone is Looking One Way…” in which we predicted a rally.  The rally came but then we posted the February 11, 2008 article “Revisiting The Risk Level” where we suggested that the rally had ran its course; it had.

• In the July 17, 2008 article “1969 Revisited” we called for yet another rally, but warned that it could very well be a “Sucker’s Rally.”  Once again, the rally came and then the rally failed.

As impressive as this-year end rally may be, there is yet compelling evidence that we have made “the” bottom, as opposed to simply “a” bottom.

Bottom Line to the 4-Month Rally:  Hold-to-Buy the market through 2008.

 A Lifetime of Higher Taxes

We mentioned above that we would not get into the details (even those that are known) of the recent bailout plan.  But suffice it to say, the bailout is being paid by you and us – the taxpayers.  What does that mean?  It means that no matter which party takes the White House, taxes on both capital gains and dividends are going higher.  And that is bad news for stock prices.

Again, we can be considered cynical, but any time that the government can raise taxes by doing nothing (in this case, by letting the Growth & Reconciliation Acts expire at the end of 2010), they will tend to do so.  Given the cost of this bailout, they likely will not have the choice anyhow. 

Bottom Line on Higher Taxes: Even if we are embarking on a new long-term bull market, equity returns (and thus equity allocations) should be held at lower than normal levels.

Difficulty for the Economy in 2009

In past www.BerkshireMM.com articles we have written about a US recession possibly coming in 2010.  In the last couple months there are signs that we can move that date up to 2009.  To be clear, we are talking about two subsequent quarters of negative GDP growth, as opposed to the “Common Sense” recession of last year.

The Conference Board publishes monthly its index of Leading Economic Indicators (LEI).  The LEI index has its flaws at picking upcoming recessions, but it is quite good at predicting economic recoveries.  It’s most recent release on September 18 saw the LEI index fall in August, its third decline in four months. 

From its January 2006 high, the index is down 3.7%, surpassing the 3.6% peak-to-trough decline recorded for the 2001 recession.  A faster 4.2% annual rate of decline in the index over the past three months indicates that the economy is slowing as quickly as it was when GDP contracted late last year and late in 2000 just prior to the last recession.  As suggested above, the LEI index is not great at predicting recessions, but it is good at predicting recoveries.  And while the massive bailout may be a game-changer, currently the index’s weakening path points to no signs of recovery.

(For the sake of comparison, a peak-to-trough decline of 5-10% in the LEI index would put the current slowdown in the same category as the 1981-1982 and 1990-1991 recessions.  Such an outcome is increasingly likely.)

Bottom Line on Difficulty for the Economy in 2009:  While a recession in 2009 is far from inevitable, the chances are currently great enough that it is far too risky except for the most aggressive of investors to chase any potential 4-month rally. (To be sure, Berkshire Money Management has consistently beaten the market by investing and not by chasing returns).

The Bottom Line:  From these levels, there is a high probability of a rally for the stock market lasting into 2009.  However, without more compelling evidence that the rally will sustain itself and mark the beginning of a new, long-term bull market, we cannot consider it adequate long-term risk-management to chase short-term returns.  (If you consider yourself a more aggressive investor, we encourage you to call and talk to us).