June 9, 2008
- Our 2008 forecast has been, is, and continues to be that following a bout of weakness in the first third of the year that the final two thirds of 2008 will be more bullish.
- Friday, June 6th was a 90% Downside Day (90% of all volume was down and 90% of all points gained was down), bringing the S&P 500 lower to 1,360 points.
- On May 20th we wrote an article that argued “on the path to a higher stock market we would consider a near-term pullback to 1,365 points to be ordinary and regular”.
- We maintain our bullish forecast for the year and into 2009. However, the 90% Downside Day on Friday combined with declining breadth and volume over the last few weeks has us concerned that our forecast may not become reality. As such, we are focusing our attention on risk management and are being proactive in beginning to frame an exit strategy that could lead to reducing equity exposure.
On June 4, 2008 we posted an article on our website titled “Contrasting Sell in May”, which had a fairly bullish tone. That tone is consistent with our commentaries regarding this current period being a bottoming process which we described as one where the S&P 500 would vacillate along a narrow channel (low/mid 1,300s to low 1,400s) for a few months before finally breaking out to the upside.
But we like to consider ourselves as risk managers as much as we like to consider ourselves return managers. Obviously that does not mean an elimination of volatility. Remember, volatility on the upside is called “return” – so we wouldn’t get rid of that even if we could. But it does mean that, from time to time, we have to take profits and/or cut losses.
On November 15, 2007 we posted an article on the website titled “Cut and Run at 1438” which suggested that, all other things equal, a drop in the S&P 500 to below 1,438 points would warrant a reduction in equity. It turned out that the S&P 500 dropped below 1,438 points in early January. And then it turned out that the S&P 500 rebounded to 1,426 points as recently as Mid-May. In between 1,438 and 1,426 the S&P dropped to 1,273 points. This strategy of reducing equity below a certain point, obviously, does not have a perfect track record.
In the long run the S&P 500 will probably be doubled what it is now. But, as John Maynard Keynes said, in the long run we’re all dead. So the strategy becomes one of “just in case” rather than one of definitive measures, or, perhaps, even high probability. Reducing equity exposure during a decline may occur just in case the market wants to mimic 1968-1970, 1972-1974, or 2000-2002.
We all remember 1972-1974, but lots of folks seem to forget that crash was set up by the prior cash and the subsequent recovery. So the pain of 2000-2002 and its subsequent recovery does not eliminate the possibility of an echo effect. Perhaps if there weren’t as many headwinds for the stock market I would not be as concerned, but just in case our bullish prediction for the rest of this year and into 2009 proves wrong, I want to have an exit strategy.
The data in “Cut and Run at 1438” mostly was supported by the notion of what we in the industry refer to as 90% Upside Days and 90% Downside Days. Friday’s headline-grabbing 400-point drop in the Dow Jones Industrial Average was a 90% Downside Day. That day’s selling brought the S&P 500 down to 1,360 points. In our May 20 article “Three-and-a-Half-Times per Year” we argued that it would be ordinary and regular to get to 1,365 points (the five point differential is not materially significant). So while it was a big day, by itself it was not, by itself, an important day in determining the direction of the stock market over the next year. Still, it brings into sharp relief other, more fundamental, factors which are important. And, fundamentally speaking, regarding the prices of stock (or anything, for that matter) not much else matters more than the Law of Supply and Demand (in the stock market, supply equals selling and public offerings – both initial and secondary; demand equals buying – both from individual as well as corporate buybacks). And 90% days tie into Supply and Demand because they attest as to the vigor of both (to put it another way, breadth matters).
During the market rally from the mid-March 2008 bottom, the buying and selling of billions of shares of stock have provided us with statistics needed to closely monitor the forces of supply and demand. As would be expected, an initial expansion of investor demand was recorded from mid-March into April. However, after that, the data has consistently shown that investors have been optimistic enough about the future so as to hold on to the stocks they already own (as opposed to selling), but investors have not yet been enthusiastic enough to renew their prior buying interest.
To be certain, at this level or slightly lower levels we could certainly witness a resurgence of demand (in other words, cheaper prices bring out buyers). To be sure, reviewing three-quarters of a century of this type of data shows that rallies which cannot attract broad, sustained demand will come to an end. So that renewed buying (or absence of any) at these or slightly lower levels will prove to be an important indicator as to what we might expect from the stock market.
The timing of our discussion regarding formulating an exist strategy so as to reduce equity exposure is of particular interest, if not importance. If in 2007 the stock market entered a secular bear market (as opposed to just experiencing the type of 20%-crash that happens every few years), then it is important to note that in past bear markets, the average of the largest bear market rallies (so not just the average rally, but the largest rallies that have occurred within the context of past bear markets) has seen the market advance 13.3% over 67 trading days. That would put the S&P 500 at 1,442 points on Tuesday, June 10.
Again, that’s the average of the largest bear-market rallies. So both the magnitude and the duration could prove to be more bullish (especially if we have not entered a secular bear-market but remain in a long-term bull-market). But if the rally begins to fail at this point, especially with the backdrop of lagging demand (buying) turning into increased supply (selling), then we might, with all other things equal, want to take that “just in case” action and reduce equity positions.
So why 1,312 points? In the “Cut and Run at 1,438” article we wrote:
90% Upside-Day Follow Up
Since we did have a 90% upside day on Tuesday, it is more relevant to currently focus on the 28 instances where two or more 90% downside days were, indeed, followed by a 90% upside day in the next 30 days.
The good news, of those 28 instances 22 marked the beginning of new and sustainable bull markets.
Of the 28 instances, 6 were just bear market rallies (rallies that ultimately fizzled out and then dropped back to new lows). So a 90% upside day is certainly no guarantee that all is clear.
Here is what is important in those 6 cases: in every one of those instances the market rallied but then dropped back to the recent low (in this case that would be 1438 points on the S&P 500). So if we drop and close below 1438 points on the S&P 500 then that would be a signal of a looming bear market, at least according to this indicator.
April 1, 2008 experienced a 90% Upside Day (the low of the prior day was 1,312 points; technically 1,273 points would be the recent low we should pay attention to, so it is really within this range where we might consider reducing equity). This was the second such 90% Upside Day (the previous one on March 18th) with no intervening 90% Downside Days.
Admittedly, the title of “Cut and Run around the range of 1,273 and 1,312” might be more accurate. The more important concept we wish to convey today is that while we have strong convictions regarding a better stock market for the next twelve months we realize that not all forecasts come true. If the market tests the 1,273-1,312 levels and fails to rally and instead attracts increased supply (selling) and reduced demand (buying), then, all other things being equal, it will make sense to reduce equity exposure – just in case.