Sunday, May 22,, 2011

• Chatter regarding the start of a new long-term bear market has increased. Berkshire Money Management expects the primary trend of the cyclical bull market to continue with expected corrections and a brief (think months, not years) cyclical bear market.
• The next correction will only be an opportunity to make portfolio adjustments, as opposed to jumping into cash and then back into the market. Those opportunities are saved for the big moves, not the little gyrations.We are not expecting a big move (ex. the start of a new bear market) because the stock market’s failure to rise above it’s mid-February high has been primarily due to a lack of Demand (i.e. Buying), as opposed to an increase of Supply (i.e. Selling).
• There appears to be little question that the current bull market is aging. And in an aging bull market, strength becomes much more selective among stock sectors and asset classes. Given this evidence of increasingly selective strength, it becomes especially important to focus portfolios on the strongest sectors and asset classes.

Given that the stock market has traded essentially flat since it’s mid-February high, even though it is trading near a three-year high, there has been much recent chatter by the punditry calling for the potential for a major market top arriving in June, coinciding with the end of some of the Federal Reserve’s QE2 program (See April 28th’s “The Fed’s Blueprint”). As we wrote about in April 20th’s “What’s Next?” report these types of trendless stalemates in the stock market have no correlation to the beginning of a new bear market.

But we at Berkshire Money Management are no Pollyanna’s. In our Economic Outlook for 2011, we wrote that

• “It’s quite likely that a mid-year (August?) high would mark the end of the cyclical bull market that started in March 2009 and the start of a new cyclical bear market.”

And in the aforementioned “What’s Next?” article we wrote

• “Most stalemates have been resolved to the downside as nervous investors begin selling to reduce risk, obviously creating the downward Selling pressure on prices needed to complete a short-term correction and thus attract renewed buying enthusiasm at the lower stock prices. “

A “new cyclical bear market” (i.e. a stiff correction that spans months) is part of the cost of doing business in the stock market. For example, in our January 17th report “Sharp, but Ordinary Correction” we wrote:

• “At this point the worst-case scenario decline looks to be more consistent with an ordinary and regular and (ultimately) uneventful 7% drop in the stock market.  There is no need for an actionable response to get very conservative.”

The stock market later experienced a 6.5% correction (pretty close to our guess of 7%) by March 16th, before rebounding back to, and treading near, its recent highs. It was quick, it was fast, and it was painful if you paid too much attention to it. But now those folks that had paid too much attention to it mostly have forgotten about it. The next correction may not be as quick (months, not weeks), and it may push the 7% envelope (threatening our Economic Outlook for 2011 S&P 500 Risk Level of 1,215-points, about a ten percent drop). But ultimately the next correction will only be an opportunity to make portfolio adjustments, as opposed to jumping into cash and then back into the market. Those opportunities are saved for the big moves, not the little gyrations.

For better or worse, we expect a little gyration, not a big move (all things relative). We are not expecting a big move (ex. the start of a new bear market) because the stock market’s failure to rise above its mid-February high has been primarily due to a lack of Demand (i.e. Buying), as opposed to an increase of Supply (i.e. Selling). Every major market top over the last three-quarters of a century has been preceded by at least a multi-month (and frequently longer) pattern of rising Selling – and that is just not currently occurring. Pundit comments of impending doom are many, but at present few of the indicators that have, historically, warned of major market tops are in evidence.

At the same time though, there appears to be little question that the current bull market is aging. And in an aging bull market, strength becomes much more selective among stock sectors and asset classes. This evidence is nowhere more evident than in the number of issues trading above their 10- and 30-week moving averages (WMAs). Currently, both the 10- and 30-week moving averages are in downtrends dating from late 2010 (10-WMA) to early 2011 (30-WMA). These downtrends suggest fewer and fewer stocks, sectors, and asset classes are showing strong uptrends. Given this evidence of increasingly selective strength, it becomes especially important to focus portfolios on the strongest sectors and asset classes.

The Fundamentals Support the Technicals

Berkshire Money Management is meaningfully more optimistic about the economic outlook than is the consensus of economists (and we have been so since we called the end of the recession on June 30, 2009). U.S. businesses are doing very well; firms are profitable, their cash positions are ample, and their debt loads are low.

Driving these improvements are exceptional profit margin and solid sales growth. Operating margins are about as wide as they have ever been, and more than double what they were in the early 1990s. Labor costs fell sharply during the recent recession, as businesses generated enormous productivity gains. While seven million fewer people are working since the start of the recession, real GDP is currently well above its pre-recession peak.

Businesses are awash in cash. The quick ratio of liquid assets (mostly cash) to liabilities that come due within one year has surged to a record high. The ratio of interest payments to cash flow is low by historical standards, as nonfinancial businesses have de-levered and refinanced at lower interest rates.

The issue is no longer whether businesses can expand more aggressively, but whether they will – and firms appear to be regaining a bit of their swagger in that regard. The nightmare of the Great Recession seems to be fading, along with the uncertainty created by policy debates.

Business investment spending and payrolls are expanding more strongly. Investment in equipment and software grew over fifteen percent last year in real terms, and is on track to post another double-digit gain this year, helped by tax breaks passed late last year. Private sector payrolls are up by over two million since job growth resumed a little over a year ago, and in recent months, monthly job gains have accelerated to more than 200,000. This pace may be disappointing in the context of the deep hole created during the recession, but it is clear the economy is now climbing out of that hole.

Households, however, still have much to do to get their balance sheets in order, but they are on their way. According to the credit bureau Equifax, total household debt outstanding has decreased by more than $1.1 trillion since peaking almost three years ago. The decline has been seen in all kinds of debt except for student loans, and has been particularly notable in high-cost credit cards. The downside to the good household news is that only about one-fourth of the decline in household debt has been voluntary; an estimated three-fourths of the decline has occurred because of defaults and charge-offs. The macro-economic consequences of so many defaults and charge-offs could have further damaged the financial system, but CEOs of major banking institutions now appear to see the write-downs as a path toward stronger capital positions and profitability. Banks have turned profitable again, seeing a one percent return on assets after two years of substantial losses.

The Bottom Line: While talk seems to be escalating about an imminent end to the bull market, time-tested measures of Supply and Demand suggest the market’s primary uptrend remains alive and well.  Given the age of the bull market, however, investors should restrict new buying to the strongest issues and avoid bargain hunting in laggard and trodden-down stocks. The next correction will only be an opportunity to make portfolio adjustments, as opposed to jumping into cash and then back into the market. Those opportunities are saved for the big moves, not the little gyrations.