Tuesday, May 25, 2010
• In September 2009 investors were elated to be at today’s stock market levels. As investors, logically or not, we care more about the path we take to get to such levels than the levels themselves. That is normal, or at least to be expected.
• The five most dangerous words on Wall Street are said to be “this time it is different.” Different this time are our reactions to current price levels. The typical metrics used to identify major market tops are still nonexistent, suggesting a continued correction within a primary uptrend.
• The average correction is twelve percent (that would bring the S&P 500 down to 1,070 points, below our April 4th estimate of a drop to 1,085 points). Given the generous nature of the rally from the March 2010 low, we need to prepare for the possibility of a much stiffer correction than anticipated.
• Due to increased saber-rattling from North Korea, we are tightening our “stops” (closing levels at which we may reduce equity and raise cash).
• The most probable scenario from these levels is a rise for the stock market. However, our discipline is to protect portfolios from the possibility of massive losses. Berkshire Money Management acknowledges that the potential error in doing so is to diminish portfolio returns on the upside, but we feel that the cause of protecting your portfolio is greater than reaching for a few more percentage points of return.
What is it that is different this time? It’s us. You and me.
Remember when the S&P 500 hit 1,050 points on September 15, 2009? Remember how good that felt? It is interesting, if nothing else, that we feel so discouraged when the economy has eight months of solid improvement and stock prices are for sale at the same levels.
If the stock market had advanced to these levels at this date in a linear fashion from the March 2009 lows we would probably all be doing cartwheels in celebration. But humans don’t care about levels – we care about the path we took to get to those levels. So while even lower levels would still be an improvement from March 17, 2009 (the date in which Berkshire Money Management started to get back into the market), we care a lot about the path we may have to take to potentially lower levels.
My point is that while it is most probable that while this decline is a buying opportunity, we need to prepare for the possibility that this is something that could become more discouraging.
In our May 16, 2010 paper “Disruption of the Primary Trend” we noted that “an oxymoron as it may be, the conservative risk-taker can make any trade (investment) they wish to so long as they have an exit plan.” We went on to write:
“Berkshire Money Management’s exit plan typically is to identify stock market tops and then to work down equity positions (just as we did in 2001-2002 and 2007-2009). But if we build up equity positions in the expectation of a rebound that never comes, our exit plan is to reduce equity/raise cash if we continue to cross and hold below certain technical levels (such as a declining 200-day moving average.)”
The five most dangerous words on Wall Street are said to be “this time it is different.” Yet, given the speed, extent, and volatility of the pullback in stock prices over the past month, the temptation may be strong to conclude that perhaps, just this once, things are, in fact, different. And by different the concern would be that the stock market has fallen into a new bear trend without the historical forewarnings of a major top.
What history tells us is that we, the people, change; the market does not. We become different. We are risk takers when stock prices go up and we are risk averse when stock prices decline. That is normal, or at least to be expected.
In the aforementioned “Disruption of the Primary Trend” we noted some of the tools used to identify major tops – none of which have been present. For example, there were no indications of selective buying interest, as the advance-decline lines for all the major market indices were recording new rally highs (as opposed to some “fading” by certain sectors or asset classes while the major indices continued to push higher on the back of fewer and fewer names). Also, measures of expanding Demand (i.e. buying) and contracting Supply (i.e. selling) were still bullish. So, if the indicators that have provided reliable warnings of market tops for decades were giving all-clear signals (at least in terms of correction vs. bear-market), how can the market plunge over the past month be explained?
One possible explanation lies in the extent of the rally from March 2009 low to the April 2010 high. As discussed in the “Disruption of the Primary Trend” the advance from low to high, while not a record, was still described as “impressive”. And just as the rally had been impressive, the following pullback looks to be equally impressive.
How impressive? According to research done by Fidelity Investments, when you consider that a correction is a decrease in prices of greater than 10% but less than 20%, the minimum and maximum decline is defined by its parameters. That is to say there have been corrections of both the 10% and the 19% variety. The median decline of stock market corrections have been 12% and has lasted 54 days (or just shy of eight weeks).
That would put such a typical correction of the S&P 500 at 1,070 points in mid-June. (On April 4th Berkshire Money Management had suggested a pullback to 1,085 points over six-seven weeks).
The question remains – how impressive could the pullback be?
If Berkshire Money Management was asked that question on Friday morning (May 21st), we would have drawn a line in the sand and declared the bottom at (the S&P 500 closed at 1,087 points that day). The price action had been classic, and the follow through – so as to remain classic – should have been very robust buying of stocks on Monday morning. Instead, the decline continued.
While the losses in the current market decline are extensive, they are still within the limits of past corrections that have occurred within ongoing primary uptrends. The severity of the decline may be in response to what may have become a far too generous rally.
On Friday we felt strongly that the correction was over. The subsequent price action (Monday, and as we write this at 6:00 am on Tuesday, the futures market, too) makes us feel far less confident. In the “Disruption of the Primary Trend” piece we wrote that our exit plan was “to reduce equity/raise cash if we continue to cross and hold below certain technical levels (such as a declining 200-day moving average).”
Well, the 200-day moving average is still upward sloping, and not declining. However, given the added fundamental concerns of North Korea’s saber-rattling, we have internally discussed tightening those “stops” by reducing equity exposure should the S&P 500 violate and close below 1,050 points.
While we fully acknowledge that the greatest probability from these price levels is a very generous rally, such a reduction of equity would not be an emotional reaction of fear. Rather, such a reduction of equity would be part of a discipline (we encourage you to re-read the November 15, 2007 article “Cut and Run at 1,438” and the June 10, 2008 article “Cut and Run at 1,312”).
This is a discipline that may very well diminish portfolio returns on the upside. We’re o.k. with that because such a discipline is intended to protect clients from massive declines. After all, if a new multi-year bull market is about to begin, then we will have multi-years of a bull market in which to participate.
The probability is that the stock market rallies strongly from here. But because we have yet to see the type of robust buying we see at capitulation levels (and there have been many signs of capitulation), we need to start thinking about protecting your portfolio from the possibility of something more significant.
We have written in the past that there are two types of errors money managers can make. The first type of error is that we are too aggressive when the stock market crashes and you lose more money than you should have. The second type of error is that we are too conservative when the stock market rallies and you make less than you might have otherwise made. We tend to lean toward that second type of error.
(By the way – those error types are better than the error of our competition who are always in the market during crashes, bear markets, recessions, etc.).
Bottom Line: Discipline. Discipline is what allowed Berkshire Money Management to protect portfolios from the drops in 2001-2002 and the drops in 2008-2009. We were fortunate during those periods that when we followed our discipline of reducing equity that the markets actually crashed, thus leaving us armed with boatloads of cash at extremely opportune times.
The negative-side of such discipline is that the steps used to protect a portfolio could lead to reduced returns should the market go up, instead of down.
We like to think of reducing equity exposure like insurance – it’s there if you need it, but you hope that you don’t. And there is a cost to it if you don’t use it, but instead of writing a check for the insurance premium to receive the protection, for investors your portfolio’s returns are less than what it might have otherwise been.
And while we don’t like leaving money on the table, we dislike losing money even more.