November 15, 2007

I’ve got some good news regarding the stock market, but it is important to read this article because I go beyond the good news and get into some detail regarding what might make me more negative and thus likely react by taking action in your portfolio.

(If you do not want to delve into the lengthy rationale I put behind managing your portfolio, I completely understand.  After all, probably one of the reasons you hired a financial adviser is because you no longer want to nor have the time to read five pages of research.  Knowing that, you can skip down to “The Bottom Line” at the end of the last page.  Still, if you are going to read one package of research this year then I encourage you to make this article those four pages).

I have positioned the managed portfolios of Berkshire Money Management to take advantage of a bull run that I have been clear to forecast.  However, at the same time, I have been very vocal (at least through the written word) that before we get a bull run that the stock market will most probably re-test the August lows of 1404 points on the S&P 500. 

I announced this for two reasons.  First, I wanted to explain why I was holding stocks while the market went down.  The super-brief and super-cynical answer might be “because that’s what the stock market does.”

I do have a slightly better answer.  Stock market corrections, while emotionally painful, are very hard to forecast with precision.  I must emphasize the “with precision” part of that sentence – and that refers to precisely pinpointing the top as well as the bottom.  In my personal defense, it is not that I am not smart enough to figure that out (well, that’s part of it), but it is that the tools used to identify such moves are very blunt. 

So if we get out of the market a month or two ahead of time (or even a week or two), because we cannot precisely identify the top of the market, if we are lucky then we will only miss out on 2-6% of the return as the market gets to the top. 

Then if we get back into the market a month or two after the fact (or even a week or two), because we cannot precisely identify the bottom of the market, if we are lucky then we will only miss out on 2-6% as the market bottoms

So if a correction is of the 5% variety, then if we are lucky we can either pick up an additional percentage point, or maybe lose seven (trust me on the math).  If we are lucky.

If the correction is of the 10% variety, then if we are lucky we can either pickup six additional percentage points, or maybe lose two.  Again, if we are lucky.

If we are unlucky, then the result may be bigger losses. And even if selling out results in less anxiety while the market is going down, that does not relieve the anxiety of missing out when the market goes up.  Nor does selling out assure any type of improved stock market returns (because you miss some returns on the way up as well as on the way down).

To be clear, it is not as if I did not see this current correction coming – I just do not see the economy slipping into recession and I do not see problems with valuations (in other words, I am expecting a correction and not a crash). 

Again, to be clear, it is not as if I did not see this correction coming.  I actually announced it (among other places) in the October letter I mailed to you with the Quarterly Report.  Also, in the May 3, 2007 article “Correction Coming” I predicted a correction for the summer (which started in July and ended in August).  Part of the article read as follows:

“I don’t like being the bearer of bad news, but there it is – sometime in the next twelve months the market should go down 10%.  And the next 5% correction  should start soon – maybe within the next few months (summer doldrums?).  I certainly do not want to come across as cavalier or uncaring about your portfolio, but these “smaller” corrections I largely just shake off.

Yes, I cringe when they happen.  No, I don’t like admitting that we’re going through a tough time in the market when a client is invested in said market.  But that emotional pain is a just a function of what, almost by definition, the market does; and while I’ll probably never get used to it I have (somewhat) learned to accept it.  So please don’t think I’m lecturing (I don’t mean to be), it is just that when the next correction comes I don’t want you to think I’m ignoring the risks (or your portfolio) by not going to 100% cash.

And if a correction is coming, why wouldn’t I go to 100% cash?  Well, the quick, easy answer is that the tools do not exist to accurately predict these little 5-10% bumps.  Cyclical calls are easier to forecast because indicators are less mixed at those junctures.  These smaller price swings in the market typically are a factor of short-term swings in demand.  For example, if “sentiment” is optimistic then everybody who wants to buy stocks (at that time) has already purchased stocks (i.e. there is no more short-term demand) and stocks will likely dip lower.   (Then the question becomes how big of a dip and when does it reverse – more confusing questions).”

I said above that there were two reasons why I announced the coming corrections.  The first was to explain why I was holding stocks while they went down (only poor timing tools available; expecting a correction and not a crash). 

The second reason, quite honestly, was to get on the record of letting you know that I knew it was coming so that you understood the market pullback was not taking me off guard and that I was planning my investment strategy for your portfolio around a market drop.  Believe me – while I have had some good success over the last fifteen years picking corrections it is entirely frustrating and humbling that over that time as well as for the hundred years prior there has been no great advancement in financial technology allowing for better timing of short-term market fluctuations.

In the beginning of this article I promised some good news.  I’ll give you the summary and then get into the details.  The big jump in stock prices on Tuesday (November 13th) qualified as a 90% upside day for the NYSE and just short of one for the NASDAQ (90% on volume, 88% on points gained).   That followed the 90% downside day on November 7th, which was the third such day in the last 30-days.

I have written a lot about the value of using 90% upside days (90% of all volume up and 90% of all points gained up) and 90% downside days as a forecasting tool.  I won’t go too much into that again today, but suffice it to say, a 90% upside day is a very bullish indicator because it shows broad demand for stocks.  And, ultimately, the value of anything (stocks, apples, widgets) is solely dictated by supply (selling) and demand (purchasing).

Lowry’s Research has done a lot of work in this field and on a recent conference call they dissected the historical occurrences of these days and how, if at all, they coincided with stock market rallies.  I’ll get into some interpretations of those findings, but first some recent history.

November 7th qualified as the third 90% downside day within the last 30-days.  That might have, by itself, been enough to exhaust supply (i.e. selling) to the point where we could expect a brief rally.  However, that short-term exhaustion should be put into perspective.  The 1973-1974 decline saw fourteen 90% downside days and lasted 21 months.  In other words, heavy selling by itself does not lay the foundation for a sustained  reversal.  A sustained rally, especially one that suddenly shifts from heavy selling, typically must be occur with renewed and broad demand (i.e. a 90% upside day).  (A quick bad news comment, important market bottoms following steep declines are usually formed with a re-test of the recent low.  So it would not be unexpected to see the S&P 500 go back to test 1438 points before it bounced back up in a meaningful way).

Again, with a grateful nod to Lowry’s, they did the dirty work and came up with some historical data that I think will clearly and plainly identify why this recent 90% upside day is good news, but also it will help me clearly and plainly share with you why I do not yet feel as if we are out of the proverbial investment woods just yet (but the odds are certainly favoring the bulls).

Going back to 1955 we took a look at instances where there were two or more 90% downside days within a 30-day period.  We then tracked how many of those were in fact followed by 90% upside days in the next 30 days, and if there were or if there were not, what happened.

Overall there were 37 instances of two or more 90% downside days that occurred within a month’s time.  Here is how the numbers played out:

28 of the 37 instances were followed by 90% upside days. So only 9 times where there were 2 or more 90% downside days where a 90% upside day not follow within 30-days.  We will first discuss those 9 instances.

No 90% Upside Day Follow Ups

Of those 9 instances that were not followed by 90% upside days, 5 of those instances were followed by bear market rallies (the stock market went up for a while, but it was not sustainable and thus fell back to new lows).

Of those 9 instances, 2 eventually saw a 90% upside day more than 30-days later.  Those two instances stand out – one was January 1990 and the other was July 1986.  In both instances the market went sideways (although in January 1987 the market did take off and ultimately led to a large collapse in asset prices).

Of those 9 instances, 1 saw no 90% upside day and was followed by a sideways market for nine months (November 1991).

Of those 9 instances, 1 saw no 90% upside day but it did eventually take off.  However, that occurrence was March 1975, three months after a very clear market bottom in December 1974.  Looking back at the 1974 crash it was very clear that was a major market bottom, as opposed to this August where there was no clear evidence that was a major market bottom.

So, there were no instances where there was a quick reversal to a major market rally after experiencing 2 or more 90% downside days where there were no 90% upside days within the next 30 days.  Where the market did go up it was months later.

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.

The Bottom Line

So what is the investment play (but please keep in mind, we do not invest according to just any one indicator)?

For now, invest according to the expectation of a market rally.  Maybe drop some defensive positions and keep the cash ready for more aggressive investments, but largely hold what you own.

If the market drops and closes below 1438, I might very well sell some US equity positions.

If the market drops and closes below 1404, I might very well sell some more US equity positions.

Where might proceeds go?  The obvious answer is a temporary position in cash.  However, I am also looking at a no-coupon absolute return Certificate of Deposit (CD) that is short the REIT market. 

Modified June 5, 2008