October 23, 2007
With the latest Quarterly Report I sent out a letter. In that letter I wrote:
“Well, the correction that ended in August is behind us – or is it? For those that follow my website articles you know that I like to give both the good and the bad news. And doing that sort of thing often times gives me (and my colleagues) a bad rap. We economists are fond of saying, “on the one-hand this could happen; on the other hand that could happen.” In response to that it was President Harry Truman who exclaimed in frustration ‘give me a one-handed economist!’
Really what economists do is assign probabilities (there is an X% chance this will happen; there is a Y% chance that will happen). Admittedly, I can understand why many folks see this sort of advice as meaningless. Take, for example, Dr. Alan Greenspan’s recent prognostication that there is a 33% chance of a recession. Who cares about the odds (so asks non-economists)? Is there going to be a recession or not?
With that spirit in mind I am going to tie one of my hands behind my back (figuratively speaking) and spare you – this one time, and just because I want this letter to fit on one page – the painful assignment of statistical probabilities and just tell you what is going to happen in the US economy and the US stock market for the next six months: There will be no recession, but within the next six weeks the S&P 500 will dip to its August lows (about 1,400 points) and then embark on a sustained rally that will lead us into the second quarter of 2008.
While the recent rally has improved its breadth (advancers versus decliners) recently, it has still been pretty unhealthy compared to past post-correction rallies. Most of the index appreciation has been due to reduced supply (not as much selling) as opposed to improving demand (more buying). Rallies that sustain themselves are built upon growing demand; rallies that fail (even temporarily) are built upon shrinking supply.
My one-handed economist view is that there will be some emotional turmoil that will soon be forgotten (sort of like the last few months)…”
I wanted to add to those comments. I did conclude the letter by saying that “my two-handed economist view is that there is about a one-in-three chance (give or take) that the S&P will fall 5-10% from current levels before a sustained rally is restored; there is a one-in-three chance (give or take) that the S&P will dip just 3-5% in the next few weeks and then renew price growth commensurate with earnings growth. The result is that it makes sense to be invested right now and just accept that the market has embraced normalcy, that the market has again become volatile.”
There are two things to take from the closing comments. The first thing is that nothing in the market is certain (which is why I like to err on the side of conservatism – because most of us are more overwhelmed of the pain of losing that we are overjoyed by the pleasure of gaining). And that is why a good economist/adviser always weighs the probabilities (as opposed to betting the farm on any one outcome).
For example, although the letter really warned of a 10% drop, we believed that there was still a good chance that any downturn would be limited to about 5%. However, the S&P 500 dropped about 4% from its high close on October 9th to its low close on October 19th and I believe that the same concerns for a correction remain (more on that in a moment). That is not to say that the market will go straight down from here – we might even see another closing high before the market turns down again (more on that later).
The second thing to take from the closing comments is that any correction would likely be similar to the one in August (or most other corrections for that matter) where it felt as if the world was falling apart and that the pain was unbearable, but just weeks later the market’s movements were pretty much forgotten. As such, I mentioned that being invested through it wouldn’t be a bad thing (well, at least weeks after the bottom it would no longer feel like a bad thing).
However, I want to add to the idea of staying invested through this particular possible correction. Going back to June 24, 2007 I wrote an article entitled “Return Compression is the Enemy” (if you haven’t yet read this article, you should now because it will help in understanding the rest of this article).
The summary of that article is that pretty much all asset classes and all sectors were performing so similarly over the previous year that it was all but impossible to outpace the broad markets (you can’t beat the market if everything is performing the same as the market). But more recently return compression has shifted, albeit slightly, to return dispersion. As such, this could likely be a good time lighten up on some laggards, hold cash for a short period as the market adjusts (i.e. cross our fingers and hope for more than a 4% correction), and then reallocate the assets towards sectors/asset classes that have better relative strength.
Here is why I like this strategy. If things go well and the markets go down, then the benefits are obvious (cash can be put to work in stocks at a lower price). But if the markets actually do well, then you still end up with a better allocated portfolio (you give up some short-term gains but put yourself in a better position to maximize intermediate-term gains). There’s not a big risk associated with the strategy. Although this is probably a strategy that you only want to use for wider-dispersion sectors/asset classes (ex. from heavy financials to heavy tech; from heavy domestic value to heavy foreign growth); for sectors/asset classes with narrower dispersion you may want to either just switch now without holding cash for any time or you may not want to switch at all.
So why the expectation of a market fall? Simply stated, stocks are a crowded trade. What I mean is that in the near term everyone who has wanted to buy stocks has bought stocks (somewhat related, in the longer term, as explained in my recent “Where’s the Little Guy” article, the individual investor has yet to come into the market en masse and that bodes well the longer term market prospects). Another way to put it is that investors are very optimistic, and this shrinks demand (just like the widgets we learned about in Economics 101, prices of stocks fall when demand falls).
Some popular metrics of optimism are pretty bearish right now (at extremes, the more bullish people feel, the more bearish it is for the market because investors are historically wrong at turning points). For example, the latest Investors Intelligence survey registered 62% bulls and 19.3% bears – historically that’s a level that should, at the very least, cause an eyebrow to rise. Similarly, the NDR Crowd Sentiment Poll and the survey of American Association of Individual Investors are confirming that stocks are a crowded trade.
But I hate to be a one-indicator-investor, even when there is a lot of confirmation on that one indicator. Unfortunately earnings expectations for this quarter have been pretty bad. Right now they are expected to be stellar for Q4 2007 and Q1 2008 – and for technology and heath care companies they probably will be. However, I am concerned that financials will drag down the aggregate earnings numbers as well as suppress overall market returns. And while the bad news is that this will likely be one of the reasons for a correction in the coming weeks, the good new is that it provides an opportunity to take advantage of the aforementioned return dispersion.
Now when might the market turn down? We need to give it a little time. Last Friday (October 19th) was a big down day with, 90% of the volume coming from declining stock prices (what, in the past, we have called 90%-down-days). Typically after such a day the market rallies anywhere from 2-7 days. With good earnings news coming out yesterday and today (Monday and Tuesday) we could very well see a firming of prices this week and into next week before the market again turns down.
The rebound on Monday was typical of past knee-jerk rallies after big down days in so much that the biggest upside action in terms of both volume and gains appeared to be, as on research team put it, “another episode in the triumph of hope over reality”. The finance sector, consumer discretionary stocks, and even homebuilders – possibly the three biggest losers out there – did very well. The Monday follow up of Friday’s fall off was indicative of hopeful bottom fishing. The very near term (again, the next 2-7 days) should be alright for the stock market, but any rally should be viewed very skeptically.