February 9, 2009
- A “Bottoming Process” is different than a bull market. A Bottoming Process means that, net-net, investors have stopped selling. A bull market means that investors have started to buy aggressively for long-term accumulation (as opposed to a trade).
- As discussed in our Economic Outlook for 2009, “in spite of seemingly attractive valuations, this is not the year for uninhibited pursuit of high-risk opportunities”…”Risks remain high, so [providing risk management] will result in drastically underperforming the stock market should a bull market take hold soon.”
- Also as discussed in our Economic Outlook for 2009 “instead of trying to play a market rebound, Berkshire Money Management is considering what to do if the markets and the economy remain troubled for longer than the consensus expects. Instead of looking for a market bottom (speculative investment management), we are looking at how the credit and economic crises may morph next (prudent risk management).”
- In a climate where the economy is the worst it has been since 1982, jumping back into the stock market before confirmation of a lasting bottom is sheer speculation – it may be a recipe for big gains, but it doubles as a recipe for big losses. The more prudent approach to identifying major market trends is to ignore all attempts to predict the future and to simply measure the forces of Supply (selling) and Demand (buying). Past experience shows that major trend changes in equity prices can be identified early enough to successfully capture large portions of developing trends, thus making it unnecessary to try to guess the future.
It Is A Bottoming Process
- “Professional” investors have been calling this bear-market for the past fifteen months. Given that individual investors have thrown in the towel and no longer expect to see sunny days ever again, we are now actually going through a bottoming process.
- A Bottoming Process thus is an absence of selling where it is possible, even probable, that a new bull market can start. Emphasis must be placed on the word “probable” – nothing is guaranteed. A new bull market cannot begin without buying. The continued absence of buying can possibly, but not probably, lead to another serious downleg in the stock market.
There are two things that always happen in a bear-markets. One is that institutional (aka “professional”) investors spend the entire bear market explaining how they perceive that we are going through a “bottoming process”. And the second is that the retail (aka “individual”) investor spends the last few months of the bottom of the bear market (typically through the “actual” bear market process) convinced that the market will never recover.
Interestingly, it is typically when the retail investor becomes convinced that the world is at its end that an actual bottoming process is occurring. Mathematically, that makes sense. Those institutions that are allowed by mandate to sell will do so (mind you, while continuing to argue that a new bull market is about to start at any time). And individuals are a little more honest – they’ll tell you what they really think. So when everyone starts believing that the end of the world is coming, really that typically means that the end of the bear market is coming.
We get to a point where everybody who wants to sell stocks (Supply of stocks) has sold stocks. The price of stocks is nothing if not a balance of Supply vs. Demand (buying). Selling has become exhausted since November 20, 2008. That is an important function of the Bottoming Process equation. It is not that Supply cannot again enter the market (break those lows), but you need that absence of selling, what we call Selling Pressure, to disappear.
However, the other part of the Bottoming Process equation is what we call Buying Pressure – we need an appetite for risk from stock investors. The bottom line to getting to a Bottoming Process is that we need people to stop selling and we’ve got that. Now, when does a Bottoming Process become a new bull market? It’s when Buying Pressure picks up.
So are we in a bottoming process? Yes. Just as a broken-clock is right twice a day, it was just a matter of time before they were proven right so long as they kept saying that is was a bottoming process. Is this the start of a new bull market? We can only answer that definitively in hindsight because we have to actually see Buying Pressure rise first. And we are not seeing that.
Admittedly, by “waiting to see” a lot of investment returns can be left on the table. But in this weakened economy, waiting separates speculation from investing. So why wait? If strong, broad, and persistent buying remains limited (in other words, investors do not perceive current stock prices attractive enough for long-term accumulation), then expanding Supply can re-enter the market. And expanding Supply in the face of already weak Demand means getting back to the November 20, 2008 lows (and maybe lower).
What are some of the things that we are seeing that argue this Bottoming Process will (eventually) lead to a new bull market?
- Valuation. All of the developed markets of the Morgan Stanley Capital International (MSCI) indices are substantially above their 25-year average earnings yields, dividend yields, book value yields, and cash flow yields.
- Monetary & Fiscal Stimulus. By any and all measures there is substantial rising real money supply growth in the US and most developed markets.
Thus the global scope of economic collapse has reduced the price of equities to relatively cheap levels of valuation, leaving them susceptible to a positive surprise. What might one of those surprises be? It might be the realization that the global monetary and fiscal policy response has actually started to boost lending activity.
Again, this is not to say that Selling Pressure can not or will not increase, thus pushing stock prices lower – even lower than their November 20, 2008 lows. But more likely than not, the worst is over.
Thus, until proven otherwise, the market has been and remains in a bottoming process that is now about four months old. It is a healing process in which confidence gradually returns on each retest and rally. The process is likely to culminate in an eventual upside breakout with healthy breadth and considerable Buying Pressure confirming that a sustainable uptrend has gotten underway.
In the latest global correction, the breadth has been far less severe than it was during the declines in October and November, and daily new lows are far less numerous than they were in October and November. Globally, only about 16% of foreign stock markets have dropped back below their 2008 lows, and several Emerging Markets (including Brazil and Hong Kong) are up substantially. This is consistent with our expectation of Emerging Markets being one of the leaders of the next bull market.
A global bull market, however, would require participation from the U.S. market as well as other countries that carry considerable weight in the global benchmarks. For its part, the U.S. market has tended to start rallying after Presidential inaugurations. While uncertainty weights down ahead of inaugurations, stocks have tended to start advancing within a few weeks of inaugurations. This suggests that by the time the new cabinet has been confirmed and the new policies widely recognized, the perceived negatives have been discounted. For whatever it is worth, historically, the post-inauguration rally tendency has been strongest when a Democrat has replaced a Republican in the Oval Office.
If (and we like to reiterate that word “if”) a rally in fact ensues, with improving breadth and Buying Pressure, we will likely start aggressively buying equities via ETFs and/or mutual funds. We would then be likely to emphasize not only Emerging Markets, but also Small-Caps, which would stand to benefit from their high-beta characteristics. It is important to wait for bullish signs (i.e. evidence of actually buying interest) even if that means lagging the performance of the market because we certainly cannot rule out further testing of the lows, or even breaking them.
(A Small-Cap & Emerging-Market note: The spread between Moody Baa bond yields and the 10-year Treasury note yield has already narrowed enough to have bullish implications for the relative performance of Small-Caps and Emerging Market indices. Historically, when the spread had been high and falling, as it is now, those high beta indices have tended to outperform.)
It may be worth noting the similarities between today and the Information Technology bubble-burst of 2002.
In comparing the S&P 500 Financials’ current bear market to the S&P 500 Information Technology decline:
- They are similar in percentage decline (-78.7% Financials vs. -82.5% Technology) as well as volatility – both experienced fourteen swings (up and down) of 15% or more.
- Financials are significantly more oversold than Technology was on a 44-day and a 3-year mean reversion basis.
- Technology’s weighting in the S&P 500 and market-cap loss was significantly more than Financials.
Despite our concerns about earnings impairment for Financial companies, we would still expect a significant bounce once a bear market bottom is confirmed, just as Technology outperformed at the end of its bear market (+49.5% seven weeks after the October 2002 low).
Spreads (the difference between two sets of yields) are the basic bond metric used for relative valuation. Spreads provide valuable insights no relative valuation.
- Despite the effective government takeover of Fannie and Freddie as well as the Fed being set to buy $100 billion of such securities, agency spreads are nearly three times their historical mean.
- MBS (mortgage backed securities) spreads are still 30 basis points (0.3 percentage points) above normal, even though the Fed is purchasing $500 billion (about $4 billion a day) of these securities in the first six months of the year.
- Investment grade corporates are still 400 basis points above their average, even thought they have already narrowed by 100 basis points.
- The high yield (aka “junk”) corporate spread has fallen roughly 450 basis points from its peak, but is still almost 1000 basis points above its norm.
These spreads show why we are not fans of Treasuries and are looking to upgrade our view of “spread product” (i.e. fixed income instruments without FDIC-insurance or the full faith and credit of the US government)..
We do not dislike all Treasuries, we do like TIPS (Treasury Inflation Protected Securities). If economists’ consensus view are even close to being right about inflation averaging 2.5% over the next ten years then TIPS are still a bargain, even though yields are off their peak. The spread between regular coupon Treasuries and TIPS still ranges from 0% to 1% (depending on the maturity). That makes TIPS very good investments if the CPI is either above or near that range.
On the subject of inflation, neither inflation nor deflation will be much of an issue this year. We expect the year-to-year change of the CPI (Consumer Price Index) to dip below zero in the first half, but finish the year in the positive.
Gross Domestic Product (GDP)
- GDP for the fourth quarter of 2008 was better than expected. Inventory adjustments and negative momentum will cause first quarter 2009’s GDP measure to be similarly worse.
- GDP has reached and moved past its maximum point of contraction.
Average GDP for 2008 was a positive 1.3%. That’s almost hard to believe seeing how the last four months have been so miserable. Advance GDP came out at a negative 3.8% (we expect that to become about a negative 4.5% by the time we get final numbers). The decline was broad based, but half of the decline (about two percentage points) was due to vehicles.
Yes, the numbers (as bad as they are) were better than expected. Unfortunately they were better than expected due to an increase (that’s not a typo – an increase) of inventories. Inventories added about 1.3 percentage points to GDP. But with retail sales continuing to shrink into 2009, manufacturers will have to begin cutting inventory levels. The inventory rise is a negative for future growth, since it implies that businesses will need to make a larger negative adjustment in the first half of the year. That sets the stage for a similar decline in GDP at a rate 3% to 4% this quarter as demand continues to slide and businesses work hard to lower stockpiles.
The good news is that the economy has reached and moved past its maximum point of contraction in GDP. Although still far from recovered, the U.S. is not at all likely to seize up again as it did in September and October. The descent, and the fear, has subsided because of the commitment shown by the Treasury Department, the Federal Reserve, and Congress to ensure that no financial institution will be allowed to fail with its counterparty obligations unmet. Make no mistake, the government’s commitment does not eliminate the risk of asset losses, but it does ensure that any corporate failures will not be so large and sudden as to trigger a chain of reaction of defaults.
Bottom Line: Simultaneously, investors and the economy are getting to and working through their most pessimistic levels.
For investors, the result is that investors who have wanted to sell have sold. This leaves open a greater probability of renewed stock demand (investors buying stocks for long-term accumulation) as opposed to renewed stock selling (capitulation selling occurred months ago). In other words, the next big move for the stock market (say, 20%) is much more likely to be up than down.
For the economy, the result is not necessarily a return of trend-like GDP growth. Instead, regarding the rate of decline, the worst is over.
Taken together, stock market risks have dramatically subsided. Still, risks continue to abound.
In a climate where the economy is the worst it has been since 1982, jumping back into the stock market before conformation of a lasting bottom is sheer speculation – it may be a recipe for big gains, but it doubles as a recipe for big losses. The more prudent approach to identifying major market trends is to ignore all attempts to predict the future and to simply measure the forces of Supply (selling) and Demand (buying). Past experience shows that major trend changes in equity prices can be identified early enough to successfully capture large portions of developing trends, thus making it unnecessary to guess the future.
In the meantime, spread products (MBS, TIPS, corporate bonds, agency bonds) are looking more attractive.